Exam 1 Review Questions PDF

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Exam 1 Review Questions

Test format: 23 multiple choice questions each worth 3.25 points and 4 short answer questions worth a total of 25.25 points. Reminder: You are allowed to bring a 3 by 5 inch notecard with handwritten (not typed) notes for use during exams. You can write on the front and back of the card. Also, please ensure that you have your calculator (cell phones not allowed). You will need a pencil to fill in a scantron sheet. Chapter 1: 

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Define “risk” and “loss exposure”. o Risk: Uncertainty concerning the occurrence of a loss o Loss exposure: Any situation or circumstance in which a loss is possible, regardless of whether a loss occurs How do objective and subjective risk differ? What happens to objective risk as the number of observations increase? o Objective risk: the relative variation of actual loss from expected loss; increase number of exposure units o Subjective risk: uncertainty based on a person’s mental condition or state of mind o Objective risk declines as the number of exposures increases Differentiate between objective and subjective probability. o Objective Probability: coin/dice o Subjective Probability: ‘My Lucky Day’ What is the difference between “chance of loss” and “objective risk”? o The chance of loss may be identical for two different groups, but objective risk may be quite different What is a peril? o Cause of the loss o Common perils that cause loss to property include fire, lightning, windstorm, hail, tornado, earthquake, flood, burglary, and theft What is a hazard? Give an example of different categories of hazards. o A condition that creates or increases the frequency or severity of loss o 4 major types of hazards:  Physical hazard – a physical condition that increases the frequency or severity of loss (ex. Icy roads, defective wiring, defective lock)  Moral hazard – dishonesty or character defects in an individual that increase the frequency or severity of loss (ex. Faking an accident to collect from an insurer, submitting a fraudulent claim, murdering the insured to collect the life insurance proceeds)

Attitudinal hazard or moral hazard – carelessness or indifference to a loss, which increases the frequency or severity of a loss (ex. Leaving car keys in an unlocked car which increases the chance of theft, leaving a door unlocked which allows a burglar to enter)  Legal hazard – refers to characteristics of the legal system or regulatory environment that increase the frequency or severity of losses (ex. Statutes that require insurers to include coverage for certain benefits in health insurance plans, adverse jury verdicts or large damage awards in liability lawsuits) Do insurers generally focus on pure or speculative risks? Why? o Pure risk: only the possibility of loss or no loss o Speculative risk: profit, loss, or no loss are all possible o Private insurers generally focus on pure risks  Law of large numbers more easily applies to pure risks (better able to predict future losses)  Society can benefit from speculative risk but is harmed by pure risk Explain the difference between diversifiable and nondiversifiable risks. o Diversifiable risk: affects only individuals or small groups and not the entire economy o Nondiversifiable risk: affects the entire economy or large number of persons or groups within the economy Briefly describe what enterprise risk management is. Explain and give an example of pure & speculative risk, strategic risk, operational risk, and financial risk. o Enterprise Risk: encompasses all major risks faced by a business firm; Such risks include pure risk, speculative risk, strategic risk, operational risk, and financial risk  Strategic risk: refers to uncertainty regarding the firm’s financial goals and objectives; for example, if a firm enters a new line of business, the line may be unprofitable  Operational risk: results from the firm’s business operations; for example, a bank that offers online banking services may incur losses if “hackers” break into the bank’s computer  Financial risk: refers to the uncertainty of loss because of adverse changes in commodity prices, interest rates, foreign exchange rates, and the value of money; for example, a food company that agrees to deliver cereal at a fixed price to a supermarket chain in six months may lose money if grain prices rise o Enterprise risk management: combines into a single unified treatment program all major risks faced by the firm Personal risks are risks that directly affect an individual or family. List the major categories of personal risks, explain the importance of each category. Explain what a direct and indirect loss is and give an example of each. 

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Premature death: the death of a family head with unfulfilled financial obligations; premature death can cause economic insecurity only if the deceased has dependents to support or dies with unsatisfied financial obligations Insufficient income during retirement: the major risk associated with retirement is insufficient income; most retired workers have not saved enough for a comfortable retirement Poor health: the risk of poor health includes both the payment of catastrophic medical bills and the los of earned income Unemployment: the risk of unemployment is another major threat to economic security; unemployment can result from business cycle downswings, technological and structural changes in the economy, seasonal factors, and imperfections in the labor market, and other causes as well

Chapter 2 

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Define insurance and explain the terms pooling, fortuitous losses, risk transfer, and indemnification. o Insurance: pooling of fortuitous losses by transfer of such risks to insurers, who agree to indemnify insured’s for such losses, to provide other pecuniary benefits on their occurrence, or to render services connected with the risk o Pooling  Pooling involves spreading losses incurred by the few over the entire group, so that in the process, average loss is substituted for actual loss o Fortuitous losses: One that is unforeseen, unexpected, and occurs as a result of chance o Risk transfer: a pure risk is transferred from the insured to the insurer, who typically is in a stronger financial position to pay the loss than the insured o Indemnification: the insured is restored to his or her approximate financial position prior to the occurrence of the loss What is the benefit of pooling losses for the purpose of insurance? According to the Law of Large Numbers, what happens as the number of exposure units increases? o The primary purpose of pooling, or the sharing of losses, is to reduce the variation in possible outcomes as measured by the standard deviation or some other measure of dispersion, which reduces risk o The law of large numbers states that the greater the number of exposures, the more closely will the actual results approach the probable results that are expected from an infinite number of exposures

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List and explain the characteristics of an ideally insurable risk. o Large number of exposure units  To predict average loss based on the law of large numbers o Accidental and unintentional  The loss should be unforeseen and unexpected by the insured and outside of the insured’s control o Determinable and measurable loss  The loss should be definite as to cause, time, place, and amount o No catastrophic loss  A large proportion of exposure units should not incur losses at the same time o Calculable chance of loss  Insurer should be able to calculate average frequency and severity with some accuracy in order to charge a proper premium o Economically feasible premium  Something people can afford to purchase What is adverse selection, what are its implications for insurance, and how can it be controlled for? o Adverse selection: the tendency of persons with a higher than average chance of loss to seek insurance at standard rates o If not controlled by underwriting, adverse selection results in higher than expected loss levels o Adverse selection can be controlled by:  Careful underwriting (selection and classification of applicants for insurance)  Policy provisions (e.g., suicide clause in life insurance) Compare and contrast insurance with gambling as well as insurance with hedging. o Insurance vs. gambling  Gambling creates a new speculative risk, while insurance is a technique for handling an already existing pure risk  Gambling can be socially unproductive, because the winner’s gain comes at the expense of the loser o Insurance vs. hedging  Both techniques are similar in that risk is transferred by a contract and no new risk is created  An insurance transaction typically involves the transfer of pure risks because the characteristics of an insurable risk generally can be met  Hedging is a technique for handling speculative risks that may be uninsurable, such as protection against a decline in the price of agricultural products and raw materials  Insurance can reduce the objective risk of an insurer by application of the law of large numbers

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List some examples or personal lines and commercial lines of insurance. o Personal lines: refer to coverage’s that insure the real estate and personal property of individuals and families or provide them with protection against legal liability; major personal lines include the following:  Private passenger auto insurance  Homeowners insurance  Personal umbrella liability insurance  Earthquake insurance  Federal flood insurance o Commercial lines: refer to property and casualty coverage’s for business firms, nonprofit organizations, and government agencies; major commercial lines include the following:  Fire insurance  Commercial multiple-peril insurance  General liability insurance  Products liability insurance  Workers compensation insurance  Commercial auto insurance  Accident and health insurance  Inland marine insurance  Ocean marine insurance  Professional liability insurance  Directors and officers liability insurance  Boiler and machinery insurance  Fidelity bonds  Crime insurance What are some of the types of government insurance programs? o Government insurance can be divided into social insurance programs and other government insurance programs  Social insurance programs are government insurance programs with certain characteristics that distinguish them from other government insurance plans  Major social insurance programs in the US include the following:  Old age survivors, and disability insurance  Medicare  Unemployment insurance  Workers compensation  Compulsory temporary disability insurance  Railroad retirement act  Railroad unemployment insurance act  Important federal insurance programs include the following:  The federal employees retirement system (FERS)  The civil service retirement system  The federal deposit insurance corporation (FDIC)

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 The pension benefit guaranty corporation (PBGC)  The national flood insurance program (NFIP) Explain the social benefits and costs of insurance. o Social Benefits of insurance:  Indemnification for loss  Financially restored, maintain financial security and less need for government assistance; firms stay in business, avoid layoffs  Reduction of worry and fear  Source of investment funds ($5.35 trillion in 2012)  Premiums are collected in advance of the loss, and funds not needed to pay immediate losses and expenses can be loaned to business firms  Loss prevention  The loss prevention activities reduce both direct and indirect, or consequential, losses; society benefits, because both types of losses are reduced  Enhancement of credit  Insurance makes a borrower a better credit risk because it guarantees the value of the borrower’s collateral or gives greater assurance that the loan will be repaid o Social Costs of Insurance  Cost of doing business  An expense loading is the amount needed to pay all expenses, including: commissions, general administrative expenses, state premium taxes, acquisition expenses, and an allowance for contingencies and profit  Fraudulent claims  Nearly $80 billion each year  Examples of fraudulent claims include the following: o Auto accidents are faked or staged to collect benefits o Dishonest claimants fake slip and fall accidents o False health insurance claims are submitted to collect benefits  Inflated claims  Higher premiums to cover additional losses reduce disposable income and consumption of other goods and services  Examples of inflated claims include the following: o Attorneys for plaintiffs sue for high-liability judgments that exceed the true economic loss of the victim o Insured’s exaggerate the amount and value of property stolen from a home or business

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Disabled persons often malinger to collect disability income benefits for a longer duration

Chapter 3 

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Describe the meaning of risk management and what a loss exposure it. o Risk management: process that identifies loss exposures faced by an organization and selects the most appropriate techniques for treating such exposures o Loss exposure: any situation or circumstance in which a loss is possible, regardless of whether a loss actually occurs What are the pre-loss and post loss objectives of risk management? Which of the post loss goals are most important? o Pre-loss objectives  The firm should prepare for potential losses in the most economical way  Reduction of anxiety  To meet any legal obligations o Post-loss objectives  MOST IMPORTANT: survival of the firm  Continue operating – for some firms, the ability to operate after a loss is extremely important  Stability of earnings  Continued growth of the firm  Social responsibility – to minimize the effects that a loss will have on other persons and on society Be able to list, describe, and apply the steps in the risk management process. o Steps in the risk management process:  Identify loss exposures  Measure and analyze the loss exposures  This step requires an estimation of the frequency and severity of loss  Select the appropriate combination of techniques for treating the loss exposures:  Risk control: avoidance, loss prevention, loss reduction  Risk financing: retention, noninsurance transfers, insurance  Implement and monitor the risk management program Identify some potential loss exposures. What are some of the ways risk managers gather information to identify loss exposures? o Property liability, business income, human resources, crime, employee benefit, foreign, and intangible property What are the two main factors managers must estimate when measuring and analyzing each loss exposure?

Loss frequency refers to the probable number of losses that may occur during some given time period o Loss severity refers to the probable size of the losses that may occur What are the major risk control and risk financing techniques? o Risk control  Avoidance: a certain loss exposure is never acquired or undertaken, or an existing loss exposure is abandoned  Loss prevention: refers to measures that reduce the frequency of a particular loss  Loss reduction: refers to measures that reduce the severity of a loss after it occurs o Risk financing  Retention: the firm retains part or all of the losses that can result from a given loss  Noninsurance transfers: methods other than insurance by which a pure risk and its potential financial consequences are transferred to another party  Commercial insurance What is the difference between active and passive retention? In what situations is retention most effectively used? o Active retention: the firm is aware of the loss exposure and consciously decides to retain part or all of it, such as collision losses to a fleet of company cars o Passive retention: the failure to identify a loss exposure, failure to act, or forgetting to act o Retention can be effectively used under the following conditions:  No other method of treatment is available  The worst possible loss is not serious  Losses are fairly predictable What is a captive insurer and some of the reasons for forming a captive? o Captive insurer: an insurer owned by a parent firm for the purpose of insuring the parent firm’s loss exposures o Captive insurers are formed for several reasons:  Difficulty obtaining insurance  Favorable regulatory environment  Lower costs  Easier access to a reinsurer  Formation of profit center If a firm uses self-insurance, how might they protect themselves from extreme losses? o Self insurance: a special form of planned retention by which part or all of a given loss exposure is retained by the firm o Self-insured plans are typically protected by some type of stop-loss limit that caps the employer’s out of pocket costs once losses exceed certain limits o

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What are some of the pros and cons of using retention as a risk management technique? o Advantages:  Save on loss costs  Save on expenses  Encourage loss prevention  Increase cash flow o Disadvantages  Possible higher losses  Possible higher expenses  Possible higher taxes What is a non-insurance transfer? What are some examples of a noninsurance transfer? What are the pros and cons to a non-insurance transfer? o Noninsurance transfer: methods other than insurance by which a pure risk and its potential financial consequences are transferred to another party o Examples  Contracts  Leases  Hold-harmless agreements o Advantages  The risk manager can transfer some potential losses that are not commercially insurable  Noninsurance transfers often cost less than insurance  The potential loss may be shifted to someone who is in a better position to exercise loss control o Disadvantages  The transfer of potential loss may fail because the contract language is ambiguous; also, there may be no court precedents for the interpretation of a contract tailor-made to fit the situation  If the party to whom the potential loss is transferred is unable to pay the loss, the firm is still responsible for the claim  An insurer may not give credit for the transfers, and insurance costs may not be reduced What is a deductible? o A provision by which a specified amount is subtracted from the loss payment otherwise payable to the insured When does an insurer pay in an excess insurance policy? o Excess insurance: a plan in which the insurer does not participate in the loss until the actual loss exceeds the amount a firm has decided to retain What are some factors to consider when choosing between insurers? o Selection of insurance coverage’s o Selection of an insurer o Negotiation of terms

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o Dissemination of information concerning insurance coverage’s o Periodic review of the insurance program What are the pros and cons to using insurance as a risk management technique? o Advantages:  The firm will be indemnified after a loss occurs; the firm can continue to operate and fluctuations in earnings are minimized  Uncertainty is reduced, which permits the firm to lengthen its planning horizon; worry and fear are reduced for managers and employees, which should improve performance and productivity  Insurers can provide valuable risk management services, such as risk-control services, loss exposure analysis, and claims adjusting  Insurance premiums are income-tax deductible as a business expense o Disadvantages:  Payment of premiums is a major cost because premium consists of a component to pay losses, and amount to cover the insurer’s expenses, and an allowance for profit and contingencies  Considerable time and effort must be spent in negotiating the insurance coverage’s  The risk manager may have less incentive to implement losscontrol measures because the insurer will pay the claim if a loss occurs Be able to provide a recommendation for the appropriate risk manageme...