Study Guide for Exam 1 PDF

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The University of Iowa Tippie College of Business FIN 3400 – Principles of Risk Management and Insurance Study Guide for Midterm #1 Content of the test: -

Introduction to Risk RM Process RM Techniques Student Presentations

Total of 100 points; primarily MC questions, similar in style to quizzes (  66 points); some workout problems & some open answer questions ( 34 points)

Chapter 1: Risk: uncertainty concerning the occurrence of loss Loss Exposure：unit or object subject to a potential loss (car)造成损失的物品 Loss frequency: refers to the probable number of losses that may occur during some time period Loss severity: refers to the probable size of the losses that may occur

1. Introduction to Risk o

Explain ways to Categorize risk 1) Objective risk is defined as the relative variation of actual loss from expected loss It can be statistically calculated by some measure of dispersion, such as the standard deviation 2) Subjective (perceived) risk is defined as uncertainty based on a person’s mental condition or state of mind

Uncertainty: situations or circumstances where such probabilities cannot be estimated Measures of objective Risk: Variance, Standard Deviation, Coefficient of Variation Classification of risk: Enterprise risk 1) A diversifiable risk affects only individuals or small groups (car theft). It can be reduced or eliminated by diversification. 影响小 2) A non-diversifiable risk affects the entire economy or large numbers of persons or groups within the economy (hurricane). It is also called fundamental risk 影响大 3) Pure Risk: There are only the possibilities of loss or no loss, uncertainty to whether a loss will occur. 4) Speculative Risk: Both profit and loss are possible, uncertainty. 5) Strategic Risk: refers to uncertainty regarding the firm’s financial goals and objectives

6) Operational risk: results from the firm’s business operations. 7) Financial Risk: refers to the uncertainty of loss because of adverse changes in commodity prices, interest rates

-A peril is defined as the cause of the loss. (Examples include property damage because of fire) - A hazard is a condition that increases the chance of loss Give examples of various types of hazards 1) physical hazard 身残 2) Moral hazard 不诚实或性格缺陷增加损失，信用 3) Attitudinal Hazard (Morale Hazard) is carelessness or indifference to a loss, which increases the frequency or severity of a loss 不重视 4) Legal Hazard 法律增加损失

2. List the components of an entity’s cost of risk (see components below)

Components of a Corporation’s “Cost of Risk: i. Expenditures to reduce Risk ii. Opportunity costs of forgone operations iii. Expenses of Risk Financing (Insurance Premiums or other financing mechanisms) iv. The cost of unreimbursed losses v. Risk Management Department’s Salaries & Benefits b. Give examples of risks involving property, liability, life, health, loss of income, and financial losses （All personal Risks） 1) Property risk: Be damaged or Stolen. Destruction or theft of property 别人对你 -Direct loss: 直接由 fire or theft 造成 -Indirect loss: 由 direct loss 造成后产生的额外费用。 2) Liability risk: involve the possibility of being held legally liable for bodily injury or property damage to someone else 对他人造成损失 3) Life and health insurance: Death before the age by accident or illness. Death of young. covers medical expenses because of sickness or injury 4) loss of income: Employees who become ill or injured in accidents 不能工作的补 偿 retirement Unemployment -Disability insurance: Pay for that you can’t work, after a physical damage loss

5) Financial Risks：Include credit risk, foreign exchange risk, commodity risk, and interest rate risk 由于银行或者各种外汇造成的风险 c. Distinguish between probability of loss, severity of loss and objective risk. Chapter 3 High-Low Probability or Severity 可能性和损失程度 d. Articulate the difference between hazards and perils

2. RM Process a. Explain the four steps in the risk management process 1) Identify potential losses 2) Measure and analyze the loss exposures 3) Select the appropriate combination of techniques for treating the loss exposures 4) Implement and monitor the risk management program b. Explain methods of risk identification – Risk analysis questionnaires and checklists – Physical inspection – Flowcharts (see how things going on and flow rate) – Financial statements – Historical loss data c. Describe how risks are evaluated and the types of challenges that can arise in that process 1) once a risk is identified, the next step is to estimate both the frequency and severity of potential losses 2) Loss severity is more important than loss frequency d. State and explain three measures of central tendency ： Mean, Median, and Mode e. Explain the notion of a probability distribution and how it can be used by risk managers A loss distribution is a probability distribution of losses that could occur – Useful for forecasting if the history of losses tends to follow a specified distribution, and the sample size is large – The risk manager needs to know the parameters of the loss distribution, such as the mean and standard deviation – The normal distribution is widely used for loss forecasting f. Define and describe the idea of risk mapping. Chapter 4 Slides42 A risk map is a grid detailing the potential frequency and severity of risks faced by the organization – Each risk must be analyzed before placing it on the map –Involves arraying risks in a matrix g. State and explain the law of large numbers and its use in RM 1) As the number of homogeneous exposure units increases, the degree of risk decreases 2) Given a constant number of exposure units as the probability of loss increases, the degree of risk decreases Risk control: 1) Avoidance: Loss exposure never happen, chance to reduce loss to zero 2) Loss prevention: Reduce the frequency of loss (E.g.: Fall protection, Machine protection)

3) Loss reduction: reduce the severity of loss after it occurs. (Safety hats) 4) Duplication: Have back-ups or copies 5) Separation: Dividing assets to minimize the harm of single event. Separate operation or items into different location. 6) Diversification: Spread the loss exposure across different parties, securities, or transactions, to reduce the chance of loss Risk financing： ：provide payment of loss after it occurs. 1) Retention: firm retains part or all of the losses that can result from a given loss Matrix Involves the assumption of risk. If a loss occurs an individual or firm will pay for it out of whatever funds are available at the time 留存资金来 fund. --Planned retention(active): 有 assumption 时将钱放在一边 , sometimes happen, sometimes not. No choice. --Unplanned retention (Passive): no reorganization.

3. RM Techniques Avoidance: High F, High S Transfer: High S, low F Retention: Low F, Low S Retention/prevention: Low S, High F Hold-Harmless agreement: 无损协议（High-risk, hold no responsibilities to customers.） --Specify the party that will be responsible for paying for various losses

a. Define risk avoidance and provide appropriate examples; explain under which circumstances it is a suitable RM technique. When avoid risk: High risk, high frequency b. Define the notion of loss control and provide a breakdown into specific forms of loss control; give appropriate examples for each category Chapter 3 slides 14. 1) Loss control: to prevent. Risks that are not avoided. 2) conscious decisions regarding the way those activities will be conducted c. Differentiate loss control measures on the basis of timing and state appropriate examples 1) Pre-loss activities: Implemented before losses occur (Safety training) 2) Concurrent loss control: Activities that take place concurrently with losses (Fire sprinklers) 3) Post-loss activities: Always have a severity-reducing focus d. List and explain potential costs and benefits associated with loss control Potential benefits of loss control: –

Repair or replacement of damaged property

–

Income losses due to destruction of property

–

Extra costs to maintain operations following a loss

–

Adverse liability judgments

–

Medical costs to treat injuries

–

Income losses due to death or disabilities

e. List and explain forms of funded risk retention. Keep the risk self. Funder retention: Pre-loss arrangements are made to ensure that money is readily available to pay for losses that occur. 提前安排预损失 1) Credit 信贷 2) Self-insurance 3) Captive insurer Unfunded retention: Intention to pay for losses as they occur without making any funding arrangements in advance of a loss. 损失发生时支付损失 f. Explain the concept of present value and its relevance for RM decision making

$ P × ( 1+ i )N =$ Q . Or

$ P=

$Q (1+i )N

P= present value i=interest rate N=year

g. Explain the essential elements of self-insurance and describe the financial and nonfinancial factors that affect a firm’s ability to engage in funded risk retention --Self-insurance: Retention program that utilizes insurance techniques – Necessary conditions: • Group of exposure units large enough to reduce risk and make losses predictable (LLN) • Prefunding of expected losses through fund specifically designed for that purpose – Establishment of such a fund is a special form of planned, funded retention – Self-insurance does not involve a transfer of risk h. Discuss the use of statistical analysis in the selection of deductible levels --Deductible: 1) Amount you have to pay out-of-pocket for losses before insurance company will cover remaining costs 除保险外的自付额 2) one way of mixing risk retention and risk transfer 3) lower the cost of insurance and increase availability of insurance 4) Deductibles may also make management more loss conscious because losses below deductible are absorbed i. Describe risk transfer as an RM tool and list five forms of risk transfer --Typically involves payment of a premium by one party (the transferor) to another (the transferee, or risk bearer) 伤害转移 -- Diversification (Transfer of risk across business units), Hedging(Transfer to third party), Insurance(most widely used form of risk transfer) j. Explain how RM adds value to a corporation k. Explain the major considerations in implementing RM decisions

--May involve considerable interaction among 1) 2) 3) 4)

Risk managers Insurance agents Brokers Insurance carriers

Explain what a Captive is: 专属保险公司 1) Insurer owned by a parent firm for the purpose of insuring the parent firm's loss exposures 2) Combines the techniques of risk retention and risk transfer 3) A captive insurer has easier access to a reinsurer 4) A captive insurer can become a source of profit 5) Costs may be lower than purchasing commercial insurance 6) Direct control of Claim Costs m. List the different types of Captives – A single-parent captive is owned by only one parent – An association or group captive is an insurer owned by several parents

l.

Consider the following case study: Andrea is a senior at The University of Iowa. She is majoring in journalism. Andrea owns a high-mileage 2008 Toyota that has a current market value of $5500. Andrea lives in an apartment in Iowa City with two roommates. In addition to her clothing and other personal items, Andrea owns a laptop computer, television set, stereo, DVD player and several hundred dollars in furniture. Andrea and her roommates have bought their own washer and dryer for the apartment (previously the apartment did not have a washer and dryer). The girls have had problems with the hot water hook-up on the washing machine leaking. Andrea runs about five miles a day in a local park which has recently had a growing crime problem. Andrea’s parents both work to pay for her tuition expenses. Andrea recently acquired a dog from the local animal shelter. Shortly after acquiring the dog, it bit her roommate. Fortunately, Andrea’s roommate did not need stitches, and since all of them like the dog, they decided to keep the animal. Identify the major risks or loss exposures that Andrea is exposed to with respect to the following categories: Personal risk, property risk, liability risk. Are any of Andrea’s risks also relevant to you? Do you engage in RM for these risks?

Sample questions: 1) A peril is a. a moral hazard. b. the cause of a loss. c. a condition which increases the chance of a loss. d. the probability that a loss will occur.

2) An earthquake is an example of a a. moral hazard. b. peril. c. physical hazard. d. objective risk. 3) The premature death of an individual is an example of a a. pure risk. b. speculative risk. c. dynamic risk. d. physical hazard. 4) All of the following statements about risk retention are true except: a. It may be used intentionally if commercial insurance is unavailable. b. It may be used passively because of ignorance. c. Its use is most appropriate for low-frequency, high-severity types of risks. d. Its use results in cost savings if losses are less than the cost of insurance. 5) All of the following are methods of noninsurance transfer except: a. entering into a hold-harmless agreement. b. hedging risk using futures contracts. c. incorporating a business. d. avoiding dangerous activities. 6) Williams Company installed smoke detectors, a sprinkler system, and fire extinguishers in its new manufacturing facility. These devices are all examples of a. loss control. b. noninsurance transfer. c. risk avoidance. d. risk retention. 7) Risk management is concerned with

a. b. c. d.

the identification and treatment of loss exposures. the management of speculative risks only. the management of pure risks that are uninsurable. the purchase of insurance only.

8) Barb, who is self-employed, is the main breadwinner for her family. Barb does not have disability income insurance because she has never stopped to consider the impact of a long-term disability upon her family. Barb’s treatment of the risk of disability is best described as a. risk transfer. b. active retention. c. risk avoidance. d. unfunded retention. 9) An insured has a fire in their plant and in addition to the damage to the building they experience an interruption in the production and loss of sales. This type od property loss is a: a. Physical Damage loss b. Direct Loss c. Indirect Loss d. No loss at all

Some more general study advice: - Revisit the quiz questions especially those you missed. - Go over the slides step by step and identify the main message. - Revisit your own notes. What is the additional information compared to what is on the slides? - Compare your notes to those of your group members. You can also get together and think of potential questions that might be on the test. - Here are some more general tips how to effectively prepare for exams: https://counseling.uiowa.edu/self-help/how-to-prepare-for-exams/...