Insurance Quiz Study

CHAPTER 1 KEY TERMS 1. Attitudinal hazard (5) (Morale Hazard) - is carelessness or indifference to a loss, which increases the frequency or severity of a loss. Examples of attitudinal hazard include leaving car keys in an unlocked car, which increases the chance of theft; leaving a door unlocked, which allows a burglar to enter 2. Avoidance (13) is one technique for managing risk. For example, you can avoid the risk of being mugged in a high-crime area by staying away from high-crime rate areas; you can avoid the risk of divorce by not marrying; and business firms can avoid the risk of being sued for a defective product by not producing the product. 3. Chance of loss (4) -is defined as the probability that an event will occur. Like risk, probability has both objective and subjective aspects. Thus, buying gas for your car is an expense, while a car accident is a loss. Chance of loss is the probability that a loss will occur, which can either be an expected loss or an actual loss, divided by the number exposed to loss, or the sample population. 4. Consequential loss (11) - An indirect loss is a financial loss that results indirectly from the occurrence of a direct physical damage or theft loss. For example, as a result of the fire to your home, you may incur additional living expenses to maintain your normal standard of living. 5. Direct loss (11) - is defined as a financial loss that results from the physical damage, destruction, or theft of the property. For example, if you own a home that is damaged or destroyed by a fire, the physical damage to the home is a direct loss. 6. Diversification (14) This technique reduces the chance of loss by spreading the loss exposure across different parties. Risk is reduced if a manufacturer has a number of customers and suppliers. For example, if the entire customer base consists of only four domestic purchasers, sales will be impacted adversely by a domestic recession. 7. Duplication (14) This technique refers to having back-ups or copies of important documents or property available in case a loss occurs. For example, backup business data should be stored at a location separate from the main place of business. 8. Diversifiable risk (6) - is a risk that affects only individuals or small groups and not the entire economy. It is a risk that can be reduced or eliminated by diversification. For example, a diversified portfolio of stocks, bonds, and certificates of deposit (CDs) is less risky than a portfolio that is 100 percent invested in common stocks. 9. Enterprise risk (6) - is a term that encompasses all major risks faced by a business firm. Such risks include pure risk, speculative risk, strategic risk, operational risk, and financial risk. Hazards: e.g. natural disasters and property damage. Financial risks: e.g. asset, securities, or fiat currency risk. Strategic risks: e.g. business competition and trends. Operational risks: e.g. customer satisfaction, brand integrity, reputation, product faults and failure. 10. Enterprise risk management (7) - combines into a single unified treatment program all major risks faced by the firm. As explained earlier, these risks include pure risk, speculative risk, strategic risk, operational risk, and financial risk 11. Financial risk (6) - 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 6 months may lose money if grain prices rise. A bank with a large portfolio of Treasury bonds may incur losses if interest rates rise. 12. Hazard (5) - is a condition that creates or increases the frequency or severity of loss. There are four major types of hazards: ■ Physical hazard ■ Moral hazard ■ Attitudinal hazard ■ Legal hazard 13. Hedging (16) is a technique for transferring the risk of unfavorable price fluctuations to a speculator by purchasing and selling futures contracts on an organized exchange. A classic example of hedging involves a wheat farmer and the wheat futures market. The farmer plants his seeds in the spring and sells his harvest in the fall. In the intervening months, the farmer is subject to the price risk that wheat will be lower in the fall than it is now. 14. Hold-harmless clause (16) is a statement in a legal contract that absolves one or both parties in a contract of legal liability for any injuries or damage suffered by the party signing the contract. An apartment lease may have a hold harmless clause stating that the landlord is not responsible for any damage caused by the tenant. A homeowner hiring a roofer might request a hold harmless clause to protect against a lawsuit if the roofer falls off the roof. 15. Human life value (8)- is defined as the present value of the family’s share of the deceased breadwinner’s future earnings. This loss can be substantial; the actual or potential human life value of most college graduates can easily exceed $500,000. Second, additional expenses may be incurred because of funeral expenses, uninsured medical bills, probate and estate settlement costs, and estate and inheritance taxes for larger estates. Third, because of insufficient income, some families may have trouble making ends meet or covering expenses. Finally, certain noneconomic costs are also incurred, including emotional grief, loss of a role model, and counseling and guidance for the children. 16. Incorporation (16) is the legal process used to form a corporate entity or company. A corporation is the resulting legal entity that separates the firm's assets and income from its owners and investors. 17. Indirect loss (11) - is a financial loss that results indirectly from the occurrence of a direct physical damage or theft loss. For example, as a result of the fire to your home, you may incur additional living expenses to maintain your normal standard of living. 18. Law of large numbers (3) - states that as the number of exposure units increases, the more closely the actual loss experience will approach the expected loss experience. For example, as the number of homes under observation increases, the greater is the degree of accuracy in predicting the proportion of homes that will burn. 19. Legal hazard (5) - refers to characteristics of the legal system or regulatory environment that increase the frequency or severity of losses. Examples Include adverse jury verdicts or large damage awards in liability lawsuits. 20. Liability risks (11)- are another important type of pure risk that most persons face. Under the U.S. legal system, you can be held legally liable if you do something that results in bodily injury or property damage to someone else. Motorists can be held legally liable for the negligent operation of their vehicles; homeowners may be legally liable for unsafe conditions on the premises where someone is injured; dog owners can be held liable if their dog bites someone; operators of boats can be held legally liable because of bodily injury to boat occupants, swimmers, and water skiers. 21. Loss exposure (3)- is any situation or circumstance in which a loss is possible, regardless of whether a loss actually occurs. Examples of loss exposures include manufacturing plants that may be damaged by an earthquake or flood, defective products that may result in lawsuits against the manufacturer, possible theft of company property because of inadequate security, and potential injury. 22. Loss prevention (14) is a technique that reduces the probability of loss so that the frequency of losses is reduced. Example: Auto accidents can be reduced if motorists take a safe-driving course and drive defensively. The number of heart attacks can be reduced if individuals control their weight, stop smoking, and eat healthy diets. 23. Moral hazard (5)- is dishonesty or character defects in an individual that increase the frequency or severity of loss. Examples of moral hazard in insurance include faking an accident to collect benefits from an insurer, submitting a fraudulent claim, inflating the amount of a claim, and intentionally burning unsold merchandise that is insured. 24. Nondiversifiable risk (6)-is a risk that affects the entire economy or large numbers of persons or groups within the economy. It is a risk that cannot be eliminated or reduced by diversification. Examples include rapid inflation, cyclical unemployment, war, hurricanes, floods, and earthquakes because large numbers of individuals or groups are affected. 25. Noninsurance transfers (15) are another technique for managing risk. The risk is transferred to a party other than an insurance company. A risk can be transferred by several methods, including: ■ Transfer of risk by contracts ■ Hedging price risks ■ Incorporation of a business firm Examples: contracts, leases, and hold-harmless agreements. 26. Objective probability (4)- refers to the long-run relative frequency of an event based on the assumptions of an infinite number of observations and of no change in the underlying conditions. First, they can be determined by deductive reasoning. These probabilities are called a priori probabilities. For example, the probability of getting a head from the toss of a perfectly balanced coin is 1/2 because there are two sides, and only one is a head. Likewise, the probability of rolling 6 with a single die is 1/6, since there are six sides and only one side has six dots. Second, objective probabilities can be determined by inductive reasoning rather than by deduction. For Example, the probability that a person age 21 will die before age 26 cannot be logically deduced. However, by a careful analysis of past mortality experience, life insurers can estimate the probability of death and sela five-year term life insurance policy issued at age 21. 27. Objective risk (3)- refers to the long-run relative frequency of an event based on the assumptions of an infinite number of observations and of no change in the underlying conditions. For example, assume that a property insurer has 10,000 houses insured over a long period and, on average, 1 percent, or 100 houses, burn each year. However, it would be rare for exactly 100 houses to burn each year. In some years, as few as 90 houses may burn; in other years, as many as 110 houses may burn. Thus, there is a variation of 10 houses from the expected number of 100, or a variation of 10 percent. This relative variation of actual loss from expected loss is known as objective risk. 28. Peril (4) - is defined as the cause of loss. If your house burns because of a fire, the peril, or cause of loss, is the fire. If your car is damaged in a collision with another car, collision is the peril, or cause of loss. 29. Personal risks (7) - Personal risks are risks that directly affect an individual or family. They involve the possibility of the loss or reduction of earned income, extra expenses, and the depletion of financial assets. Major personal risks that can cause great economic insecurity include the following: ■ Premature death ■ Inadequate retirement income ■ Poor health ■ Unemployment Examples: Safety Risk. The risk of an accident or crime that impacts your health or quality of life. Health Risk. The risk of negative health outcomes such as a disease. … Property Risk. Risk to your property such as fire, flood or theft risk. 30. Physical hazard (5) - is a physical condition that increases the frequency or severity of loss. Examples of physical hazards include icy roads that increase the chance of an auto accident, defective wiring in a building that increases the chance of fire, and a defective lock on a door that increases the chance of theft. 31. Premature death (7) - is defined as the death of a family head with unfulfilled financial obligations. These obligations include dependents to support, a mortgage to be paid off, children to educate, and credit cards or installment loans to be repaid. 32. Property risks (11) the risk of having property damaged or destroyed from numerous causes. Homes and other real estate and personal property can be damaged or destroyed because of fire, lightning, tornado, windstorm, and numerous other causes. There are two major types of loss associated with the destruction or theft of property: direct loss and indirect or consequential loss. 33. Pure risk (5) -is defined as a situation in which there are only the possibilities of loss or no loss. The only possible outcomes are adverse (loss) and neutral (no loss) Examples of pure risks include premature death, job related accidents, catastrophic medical expenses, and damage to property from fire, lightning, flood, earthquake. 34. Retention (15) means that an individual or a business firm retains part of all of the losses that can result from a given risk. Risk retention can be active or passive. ■ Active risk retention means that an individual is consciously aware of the risk and deliberately plans to retain all or part of it. For example, a motorist may wish to retain the risk of a small collision loss by purchasing an auto insurance policy with a $500 or higher deductible. A homeowner may retain a small part of the risk of damage to the home by purchasing a homeowners policy with a substantial deductible. ■ Passive Retention. Certain risks may be unknowingly retained because of ignorance, indifference, laziness, or failure to identify an important risk. Passive retention is very dangerous if the risk retained has the potential for financial ruin. For example, many workers with earned incomes are not insured against the risk of total and permanent disability. However, the adverse financial consequences of total and permanent disability generally are more severe than the financial consequences of premature death. 35. Risk (2) - is defined as uncertainty concerning the occurrence of a loss. For Example, the risk of being killed in an auto accident is present because uncertainty is present. For example, the risk of being killed in an auto accident is present because uncertainty is present. The risk of lung cancer for smokers is present because uncertainty is present. The risk of flunking a required college course is present because uncertainty is present. 36. Risk control (13) is a generic term to describe techniques for reducing the frequency or severity of losses. Major risk-control techniques include the following: ■ Avoidance ■ Loss prevention ■ Loss reduction: – Duplication – Separation – Diversification 37. Risk financing (13) Risk financing is the determination of how an organization will pay for loss events in the most effective and least costly way possible. Risk financing involves the identification of risks, determining how to finance the risk, and monitoring the effectiveness of the financing technique that is chosen. 38. Self-insurance (15) is a special form of planned retention by which part or all of a given loss exposure is retained by the firm. Another name for self-insurance is self-funding, which expresses more clearly the idea that losses are funded and paid for by the firm. For example, a large corporation may self-insure or fund part or all of the group health insurance benefits paid to employees. 39. Separation (14) The assets exposed to loss are separated or divided to minimize the financial loss from a single event. For example, a manufacturer may store finished goods in two warehouses in different cities. If one warehouse is damaged or destroyed by a fire, tornado, or other peril, the finished goods in the other warehouse are unharmed. 40. Speculative risk (5)-is defined as a situation in which either profit or loss is possible. For Example, if you purchase 100 shares of common stock, you would profit if the price of the stock increases but would lose if the price declines. 41. Subjective probability (4) - is the individual’s personal estimate of the chance of loss. Subjective probability need not coincide with objective probability. For example, people who buy a lottery ticket on their birthday may believe it is their lucky day and overestimate the small chance of winning. 42. Subjective risk (3)-is defined as uncertainty based on a person’s mental condition or state of mind. Another name for subjective risk is perceived risk; some authors use the term in their discussion of the perception of risk by individuals. For example, assume that a driver with several convictions for drunk driving is drinking heavily in a neighborhood bar and foolishly attempts to drive home. 43. Systemic risk (7) - is the risk of collapse of an entire system or entire market due to the failure of a single entity or group of entities that can result in the breakdown of the entire financial system. Examples can be Macroeconomic factors, such as inflation, interest rates, currency fluctuations. Environmental factors, such as climate change, natural disasters, resource, and biodiversity loss. Social factors, such as wars, changing consumer perspectives, population trends. QUESTIONS FOR REVIEW 1. a. Explain the historical definition of risk. 2. Historically, risk is defined as uncertainty concerning the occurrence of a loss. b. What is a loss exposure? any situation or circumstance in which a loss is possible, regardless of whether a loss occurs c. How does objective risk differ from subjective risk? --Objective risk: degree of risk: the relative variation of actual loss from expected loss --Subjective Risk: perceived risk: uncertainty based on a persons mental condition or state of mind. 3. a. Define chance of loss. the probability that a loss will occur. b. What is the difference between objective probability and subjective probability? Objective probability: long term relative frequency of an event based on the assumption of an infinite number of observations and no change in underlying conditions. Subjective probability: individuals personal estimate of the chance of loss. 4. a. What is the difference between peril and hazard? --Peril: actual cause of loss --Hazard: any condition that increases the possibility of a loss. b. Define physical hazard, moral hazard, attitudinal hazard, and legal hazard. --Physical Hazard: Physical condition that increases the chance of loss --Moral Hazard: Dishonesty or character defects in an individual that increase the frequency of severity of loss. --Attitudinal Hazard: Carelessness or indifference to a loss, which increases the frequency or severity of a loss. --Legal Hazard: Characteristics of the legal system or regulatory environment that increases the frequency or severity of losses. 5. a. Explain the difference between pure risk and speculative risk. --Pure Risk: a situation in which there are only the possibilities of loss or no loss. --Speculative risk: defined as a situation which either profit or loss is possible b. How does diversifiable risk differ from non-diversifiable risk? --Diversifiable risk: a risk that affects only individuals or small groups and not the entire community. --Non-diversifiable risk: a risk that affects the entire economy or large number of persons or groups within the economy which cannot be reduced or eliminated by diversification. 6. a. Explain the meaning of enterprise risk. a term that encompasses all major risks faced by a business, including pure risks, speculative risks, strategic risks, operational risks, and financial risks b. What is financial risk? a risk that business firms face because of adverse changes in commodity prices, interest rates, foreign exchange rates, and the value of money. c. What is systemic risk? is the risk of collapse of an entire system or entire market due to the failure of a single entity or group of entities that can result in the breakdown of the entire financial system 7. a. What is enterprise risk management? comprehensive risk management program that considers an organization pure risks, speculative risks, strategic risks, and operational risks. b. How does enterprise risk management differ from traditional risk --Traditional risk management (RM) considers only hazard and operational risk that can affect an organization; considers pure risk; seeks to prevent or reduce risks related only to losses --Enterprise: wide risk management (ERM) expands an organization's risk focus to include financial and strategic risk, allowing it to account for all eventualities that can affect its ability to achieve its goals; considers both pure and speculative risk; seeks to optimize risk taking relationship to strategic goals management? 8. List the major types of pure risk that are associated with economic insecurity. Pure risks associated with great financial and economic insecurity include the risks of premature death, insufficient income during retirement, old age, poor health, and unemployment. In addition, persons owning property are exposed to the risk of having their property damaged or lost from numerous perils. Finally, liability risks are also associated with great financial and economic insecurity. 9. Describe the major social and economic burdens of risk on society. --The size of an emergency fund must be increased.; in the absence of insurance, individuals and business firms would have to increase the size of their emergency fund to pay for unexpected losses. the higher the amount that must be saved, the more current consumption spending must be reduced, which results in a lower standard of living --Society is deprived of certain goods and services.; Because of the risk of a liability lawsuit, many corporations have discontinued manufacturing certain products. --Worry and fear are present; the mental unrest and fear caused by risk 10. Explain the difference between a direct loss and an indirect or consequential loss. --Direct Loss: defined as a financial loss that results from the physical damage, destruction, or theft of a property. --Indirect Loss: a financial loss that results indirectly from the occurrence of a direct physical damage or theft loss. 11. Identify the major risks faced by business firms. Major risks faced by business firms include property risks, liability risks, loss of business income, crime exposures, human resources exposures, foreign loss exposures, intangible property exposures, and government exposures. 12. a. Briefly explain each of the following risk-control techniques for managing risk: 1. Avoidance avoiding high risk situations 2. Loss prevention reduces the probability of loss so that the frequency of losses is reduced 3. Loss reduction reduce the frequency of losses 4. Duplication have back ups or copies of important documents or property available in a case of loss. 5. Separation assets exposed to loss are separated or divided to minimize the financial loss from a single event. 6. Diversification Spread the loss exposure across different parties. b. Briefly explain each of the following risk-financing techniques for managing risk: 1. Retention individual or a business firm retains part of all of the losses that can result from a given risk. 2. Non-insurance transfers transferred to a party other than the insurance companies 3. Insurance covers risks. CHAPTER 2 KEY TERMS 1. Adverse selection is the tendency of persons with a higher-than-average chance of loss to seek insurance at standard (average) rates, which, if not controlled by underwriting, results in higher-than-expected loss levels. For example, adverse selection can result from high-risk drivers who seek auto insurance at standard rates, from persons with serious health problems who seek life or health insurance at standard rates. 2. Casualty insurance is a broad category of insurance coverage for individuals, employers, and businesses against loss of property, damage, or other liabilities. Casualty insurance includes vehicle insurance, liability insurance, and theft insurance. Casualty insurance is a broad field of insurance that covers whatever is not covered by fire, marine, and life insurance; casualty lines include auto, liability, burglary and theft, workers compensation, and health insurance. 3. Commercial lines refer to property and casualty coverages for business firms, nonprofit organizations, and government agencies. Major commercial lines include the following: fire insurance covers losses caused by fire and lightning; commercial multiple-peril insurance is a package policy, which can be written to include property insurance, general liability insurance, business income insurance, etc. 4. Expense loading is the amount needed to pay all expenses, including underwriting and loss-adjustment expenses, commissions, general administrative expenses, state premium taxes, acquisition expenses, and an allowance for contingencies and profit. Expense loading is the amount included in the premium charged by an insurance company to cover its administrative and maintenance costs. 5. Fidelity bonds cover loss caused by the dishonest or fraudulent acts of employees, such as embezzlement and the theft of money. 6. Fortuitous loss is one that is unforeseen and unexpected by the insured and occurs as a result of chance. In other words, the loss must be accidental. The law of large numbers is based on the assumption that losses are accidental and occur randomly. For example, a person may slip on an icy sidewalk and break a leg. The loss would be fortuitous. 7. Indemnification means that the insured is restored to his or her approximate financial position prior to the occurrence of the loss. Thus, if your home burns in a fire, a homeowners policy will indemnify you or restore you to your previous position. If you are sued because of the negligent operation of an automobile, your auto liability insurance policy will pay those sums that you are legally obligated to pay. Similarly, if you become seriously disabled, a disability-income insurance policy will restore at least part of the lost wages. 8. Inland marine insurance covers goods being shipped on land, which include imports, exports, domestic shipments, and instrumentalities of transportation (for example, bridges, tunnels, and pipelines). Inland marine insurance also covers personal property such as fine art, jewelry, and furs. 9. Insurable risk: a risk that conforms to the norms and specifications of the insurance policy in such a way that the criterion for insurance is fulfilled is called insurable risk. There are ideally six characteristics of an insurable risk: There must be a large number of exposure units. The loss must be accidental and unintentional. The loss must be determinable and measurable. The loss should not be catastrophic. The chance of loss must be calculable. The premium must be economically feasible. 10. Insurance is the pooling of fortuitous losses by transfer of such risks to insurers, who agree to indemnify insureds for such losses, to provide other pecuniary benefits on their occurrence, or to render services connected with the risk. 11. 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. To see it another way, suppose that a health insurance company discovers that five out of 150 people will suffer a serious and expensive injury during a given year. If the company insures only 10 or 25 people, it faces far greater risks than if it can ensure all 150 people. The company can be more confident that 150 policyholders will collectively pay sufficient premiums to cover the claims from five customers who suffer serious injuries. 12. Liability insurance covers the insured’s legal liability arising out of property damage or bodily injury to others; legal defense costs are also paid. If you cause an accident that damages someone else's property (their car, for example), property damage liability coverage helps pay for repairs. For example, if you rear-end another car, this coverage can help prevent you from paying out of pocket to repair the other driver’s vehicle. 13. Life insurance pays death benefits to designated beneficiaries when the insured dies. The benefits pay for funeral expenses, uninsured medical bills, estate taxes, and other expenses. The death proceeds can also provide periodic income payments to the deceased’s beneficiary. 14. Ocean marine insurance covers ocean-going vessels and their cargo from loss or damage because of perils of the sea; contracts are also written to cover the legal liability of shippers and owners. 15. Personal lines refer to coverages that insure the buildings and personal property of individuals and families or provide them with protection against legal liability. Personal lines insurance refers to any kind of insurance that covers individuals against loss that results from death, injury, or loss of property. These insurance lines generally protect people and their families from losses they couldn’t afford to cover on their own. 16. Pooling is the spreading of losses incurred by the few over the entire group, so that in the process, average loss is substituted for actual loss. Pooling implies (1) the sharing of losses by the entire group and (2) the prediction of future losses with some accuracy based on the law of large numbers. Health, car, home and life insurance all practice risk pooling by insuring people who are unlikely to need insurance to cover the costs of people who are more likely to need insurance. 17. Property insurance indemnifies property owners against the loss or damage of real or personal property caused by various perils, such as fire, lightning, windstorm, or tornado. 18. Reinsurance is an arrangement by which the primary insurer that initially writes the insurance transfers to another insurer (called the reinsurer) part or all of the potential losses associated with such insurance. For example, consider a massive hurricane that makes landfall in Florida and causes billions of dollars in damage. If one company sold all the homeowners insurance, the chance of it being able to cover the losses would be unlikely. Instead, the retail insurance company spreads parts of the coverage to other insurance companies (reinsurance), thereby spreading the cost of risk among many insurance companies. 19. Risk transfer-means that 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. The most common example of risk transfer is insurance. When an individual or entity purchases insurance, they are insuring against financial risks. For example, an individual who purchases car insurance is acquiring financial protection against physical damage or bodily harm that can result from traffic incidents. 20. Social insurance-Social insurance programs are government insurance programs with certain characteristics that distinguish them from other government insurance plans. These programs are financed entirely or in large part by mandatory contributions from employers, employees, or both, and not primarily by the general revenues of government. The contributions are usually earmarked for special trust funds; the benefits, in turn, are paid from these funds. In addition, the right to receive benefits is ordinarily derived from or linked to the recipient’s past contributions or coverage under the program; the benefits and contributions generally vary among the beneficiaries according to their prior earnings, but the benefits are heavily weighted in favor of low-income groups. Major social insurance programs in the United States include the following: Old-Age, Survivors, and Disability Insurance (Social Security) Medicare Unemployment insurance Workers compensation Compulsory temporary disability insurance Railroad Retirement Act Railroad Unemployment Insurance Act 21. Surety bonds provide for monetary compensation in the case of failure by bonded persons to perform certain acts, such as failure of a contractor to construct a building on time. There are two main categories of surety bond: Contract Bonds and Commercial Bonds. Contract bonds guarantee a specific contract. Examples include Performance Bonds, Bid Bonds, Supply bonds, Maintenance Bonds, and Subdivision Bonds. Commercial Bonds guarantee per the terms of the bond form. 22. Underwriting refers to the process of selecting and classifying applicants for insurance. For example, an underwriter may assume the risk of the cost of a fire in a home in return for a premium or a monthly payment. QUESTIONS FOR REVIEW 1. Explain each of the following characteristics of a typical insurance plan. a. Pooling of losses Losses incurred by the few are spread over the entire group so that in the process, average loss is substituted for actual loss. b. Payment of fortuitous losses Insurance plans provide for the payment of fortuitous losses. A fortuitous loss is one that is unforeseen and unexpected and occurs as a result of chance. c. Risk transfer In private insurance, a pure risk is transferred from the insured to the insurer, which is typically in a better financial position to pay the loss than the insured. d. Indemnification Compensation is given to the victim of a loss, in whole or in part, by payment, repair, or replacement. 2. Explain the law of large numbers The law of large numbers states that the greater the number of exposures, the more closely the actual results will approach the probable results expected from an infinite number of exposures. As the number of exposures increases, the relative variation of actual loss from expected loss will decline. Thus, the insurer can predict future losses with a greater degree of accuracy as the number of exposures increases. This is important, since an actuary must charge a premium that is adequate for paying all losses and expenses during the policy period. The lower the degree of objective risk, the more confidence an insurer has that the actual premium charged will be sufficient to pay all claims and expenses and leave a margin for profit. 3. Pure risks ideally should have certain characteristics to be insurable by private insurers. List the six characteristics of an ideally insurable risk. There are several requirements of an ideally insurable risk: (a) There must be a large number of exposure units. (b) The loss must be accidental and unintentional. (c) The loss must be determinable and measurable. (d) The loss should not be catastrophic. (e) The chance of loss must be calculable. (f) The premium must be economically feasible 4. Identify the approaches that insurers can use to deal with the problem of catastrophic loss exposures. The following are some of the measures that are used by the insurance company to deal with catastrophic loss: 1. Reinsurance. This is the condition where an insurance company takes an insurance cover from another insurance company to be indemnified in case of the occurrence of loss. 2. An insurance company can increase their coverage to a wide geographical area. 3. Insurance companies can use financial available financial instruments to cover catastrophic risk exposures; use of certain financial instruments in the capital markets, such as catastrophe bonds. 5. Why are most market risks, financial risks, production risks, and political risks considered difficult to insure by private insurers? These risks are generally uninsurable for several reasons. First, many of these risks are speculative risks, which are difficult to insure privately. Second, the potential for a catastrophic loss is great; this is particularly true for political risks, such as the risk of war. Finally, calculation of the correct premium may be difficult because the chance of loss cannot be accurately estimated. The possibility of deviation is very high and it is difficult to estimate. There are numerous factors on which the outcome depends. Moreover, considerable number of people are involved. 6. a. What is the meaning of adverse selection? Adverse selection is the tendency of persons with a higher-than-average chance of loss to seek insurance at standard (average) rates, which, if not controlled by underwriting, results in higher-than-expected loss levels. b. Identify some methods that insurers use to control for adverse selection. Adverse selection can be controlled by careful underwriting, by charging higher premiums to substandard applicants for insurance, and by certain policy provisions. 7. What are the two major differences between insurance and gambling? Insurance differs from gambling in two ways. First, gambling creates a new speculative risk that did not exist before, while insurance is a technique for handling an already existing pure risk (Thus, if you bet $500 on a horse race, a new speculative risk is created, but if you pay $500 to an insurer for a homeowners policy, which includes coverage for a fire, the risk of fire is already present. No new risk is created by the transaction). Second, gambling is socially unproductive, since the winner's gain comes at the expense of the loser. Insurance is always socially productive, since both the insured and insurer win if the loss does not occur. 8. What are the two major differences between insurance and hedging? First, an insurance transaction typically involves the transfer of pure risks because the characteristics of an insurable risk generally can be met. However, 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. A second difference between insurance and hedging is that moral hazard and adverse selection are more severe problems for insurers than for speculators who buy or sell futures contracts. Purchasers of insurance contracts can directly influence the profit or loss on the transaction because of intentional losses, fraudulent claims, or inflated claims. In contrast, individual entities, such as corn or wheat producers, generally cannot directly influence the financial outcome of the transaction when a futures contract is used to hedge a potential price decline. 9. a. Identify the major fields of private insurance. The major fields of private insurance are life insurance, health insurance, and property and liability insurance (also called property and casualty insurance). b. Identify several property and casualty insurance coverages. Property and casualty coverages can be divided into personal lines and commercial lines. Personal lines include private passenger auto insurance, homeowners insurance, personal umbrella liability insurance, earthquake insurance, and flood insurance. (Commercial lines include fire and allied lines insurance, commercial multiple peril insurance, general liability insurance, products liability insurance, workers compensation insurance, commercial auto insurance, accident and health insurance, inland marine and ocean marine insurance, professional liability insurance, directors and officers liability insurance, boiler and machinery insurance (also known as equipment breakdown insurance), fidelity and surety bonds, and crime insurance.) 10. a. Explain the basic characteristics of social insurance programs. Social insurance programs are government insurance programs with certain characteristics. The programs are enacted into law to deal with social and economic problems. The programs generally are compulsory and financed by contributions from covered employers and employees; benefits are paid from specifically earmarked funds; benefits are skewed or weighted in favor of lower income groups; benefit amounts generally are related to the covered individual's earnings; and eligibility requirements and benefit rights are prescribed by statute. b. Identify the major social insurance programs in the United States. Major social insurance programs are the following: • Old-age, survivors, and disability insurance (Social Security) • Medicare • Unemployment insurance • Workers compensation • Compulsory temporary disability insurance • Railroad Retirement Act CHAPTER 3 KEY TERMS 1. Association or group captive is an insurer owned by several parents. For example, corporations that belong to a trade association may jointly own a captive insurer. 2. Avoidance means a certain loss exposure is never acquired or undertaken, or an existing loss exposure is abandoned. For example, flood losses can be avoided by building a new plant on high ground, well above a floodplain. A pharmaceutical firm that markets a drug with dangerous side effects can remove the drug from the market to avoid possible legal liability. 3. Captive insurer. Losses can also be paid by a captive insurer. A captive insurer is an insurer owned by a parent firm for the purpose of insuring the parent firm’s loss exposures. There are different types of captive insurers. A single-parent captive, and an association or group captive. 4. Cost of risk. The cost of risk is reduced, which may increase the company’s profits. The cost of risk is a risk management tool that measures the costs associated with treating the organization’s loss expo- sures. These costs include insurance premiums paid, retained losses, loss control expenditures, outside risk management services, financial guarantees, internal administrative costs, and taxes, fees, and other relevant expenses. 5. Deductible is a provision by which a specified amount is subtracted from the loss payment otherwise payable to the insured. A deductible is used to eliminate small claims and the administrative expense of adjusting these claims. As a result, substantial premium savings are possible. In essence, a deductible is a form of risk retention. The risk manager must determine if a deductible is needed and the size of the deductible. In determining the size of the deductible, the firm may decide to retain a relatively small part of the maximum possible loss. The insurer normally adjusts any claims, and only losses in excess of the deductible are paid. 6. Diversification refers to reducing the chance of loss by spreading the loss exposure across different parties (e.g., customers and suppliers), securities (e.g., stocks and bonds), or transactions. Having different customers and suppliers reduces risk. For example, if the entire customer base consists of four domestic purchasers, sales will be impacted adversely by a domestic recession. If there are foreign and domestic customers, this risk is reduced. 7. Duplication refers to having back-ups or copies of important documents or property available in case a loss occurs. Examples include back-up copies of key business records (e.g., accounts receivable) in case the original records are lost or destroyed. Back- ups of important property may also be kept on hand. For example, if a key part of an assembly breaks down, having the part available immediately will prevent the assembly line from shutting down until the part can be obtained. 8. 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. A firm may be financially strong and may wish to retain a relatively larger proportion of the maximum possible loss. The retention limit may be set at the probable maximum loss (not maximum possible loss). For example, a retention limit of $1 million may be established for a single fire loss to a plant valued at $25 million. The $1 million would be viewed as the probable maximum loss. In the unlikely event of a total loss, the firm would absorb the first $1 million of loss, and the commercial insurer would pay the remaining $24 million. 9. Loss exposure is any situation or circum- stance in which a loss is possible, regardless of whether a loss actually occurs. For example, an individual's belongings could be destroyed by a flood, or a family's home and its contents could be destroyed by a tornado. 10. Loss frequency refers to the probable number of losses that may occur during some given time period. An example is loss frequency for water damage if your business is located on a flood plain is likely high. 11. Loss prevention refers to measures that reduce the frequency of a particular loss. For example, measures that reduce truck accidents include driver training, zero tolerance for alcohol or drug abuse, and strict enforcement of safety rules. Measures that reduce lawsuits from defective products include installation of safety features on hazardous products, placement of warning labels on dangerous products, and use of quality-control checks. 12. Loss reduction refers to measures that reduce the severity of a loss after it occurs. Examples include installation of an automatic sprinkler system that promptly extinguishes a fire; first-aid boxes in production areas; rehabilitation of workers with job-related injuries; and limiting the amount of cash on the premises. 13. Loss severity refers to the probable size of the losses that may occur. An example of loss severity is the business that is located on the flood plain will suffer property damage during a rising water claim and also some business interruption while clean up is being performed. 14. Manuscript policy is written for the firm, the language and meaning of the contractual provisions must be clear to both parties. The manuscript policy is custom made for a particular person or purpose, and has been negotiated by the insurer and the insured. This type of policy is more common among large commercial accounts or people exposed to special types of risk. 15. Maximum possible loss is the worst loss that is likely to happen. For example, if a plant is totally destroyed by a flood, the risk manager estimates that replacement cost, debris removal, demolition costs, and other costs will total $50 million. Thus, the maximum possible loss is $50 million. The risk manager also estimates that a flood causing more than $40 million of damage to the plant is so unlikely that such a flood would not occur more than once in 100 years. The risk manager may choose to ignore events that occur so infrequently. Thus, for this risk manager, the probable maximum loss is $40 million. 16. Noninsurance transfers are methods other than insurance by which a pure risk and its potential financial consequences are transferred to another party. Examples of noninsurance transfers include contracts, leases, hold-harmless agreements, and incorporation of a business. For example, a publishing firm may insert a hold-harmless clause in a contract, by which the author, not the publisher, is held legally liable if the publisher is sued for plagiarism. Finally, a business may incorporate to provide limited liability for the owners of the business. 17. Personal risk management refers to the identification and analysis of pure risks faced by an individual or family, and to the selection and implementation of the most appropriate technique(s) for treating such risks. A personal risk management program involves four steps: (1) identify loss exposures, (2) measure and analyze the loss exposures, (3) select appropriate techniques for treating the loss exposures, and (4) implement and review the risk management program periodically. 18. Probable maximum loss is the worst loss that could happen to the firm during its lifetime. Example, 15 key term 19. Retention means that the firm retains part or all of the losses that can result from a given loss. Retention can be either active or passive. Active risk retention means that the firm is aware of the loss exposure and consciously decides to retain part or all of it. For example, a risk manager may decide to retain physical damage losses to a fleet of company cars. Passive retention, however, is the failure to identify a loss exposure, failure to act, or forgetting to act. For example, a risk manager may fail to identify all company assets that could be damaged in an earthquake. 20. Retention level which is the dollar amount of losses that the firm will retain. A financially strong firm can have a higher retention level than one whose financial position is weak. Example, 19 key term 21. Risk control refers to techniques that reduce the frequency or severity of losses. Major risk-control techniques include the following: ■ Avoidance ■ Loss prevention ■ Loss reduction ■ Duplication ■ Separation ■ Diversification 22. Risk financing refers to techniques that provide for the payment of losses after they occur. Major risk-financing techniques include the following: ■ Retention ■ Noninsurance transfers ■Commercial insurance - also used in a risk management program. Insurance is appropriate for loss exposures that have a low probability of loss but the severity of loss is high. If the risk manager uses insurance to treat certain loss exposures, five key areas must be emphasized: 1) Selection of insurance coverages 2) Selection of an insurer 3)Negotiation of terms 4)Dissemination of information concerning insurance coverages 5)Periodic review of the insurance program 23. Risk management is a process that identifies loss exposures faced by an organization and selects the most appropriate techniques for treating such exposures. 24. Risk management manual may be developed and used in the program. A risk management manual often includes a list of insurance policies, agent and broker contact information, who to contact when a loss occurs, emergency contact numbers, and other relevant information. The manual describes in some detail the risk management program of the firm and can be a very useful tool for training managers, supervisors, and new employees who will be participating in the program. Writing the manual also forces the risk manager to state precisely his or her responsibilities, objectives, available techniques, and the responsibilities of other parties. 25. Risk management policy statement is necessary to have an effective risk management program. This statement outlines the risk management objectives of the firm, as well as company policy with respect to treatment of loss exposures. It also educates top-level executives in regard to the risk management process; establishes the importance, role, and authority of the risk manager; and provides standards for judging the risk manager’s performance. 26. Risk retention group is a group captive that can write any type of liability coverage except employers’ liability, workers compensation, and personal lines. For example, a group of physicians may find medical malpractice liability insurance difficult to obtain or too expensive to purchase. The physicians can form a risk retention group to insure their medical malpractice loss exposures. 27. Self-insurance (self-funding) is a special form of planned retention by which part or all of a given loss exposure is retained by the firm. It is widely used in workers compensation. Self-insurance is also used by employers to provide group health, dental, vision, and prescription drug benefits to employees. Firms often self-insure their group health insurance benefits because they can save money and control healthcare costs. Advantages • The self-funded plan has lower fixed costs than a fully insured plan. Most expenses are variable based on the actual claims. •The self-funded employer may use the independent, managed-care measures, such as preferred provider organizations, pre-certification, and utilization review, that save the most money, rather than simply those the carrier offers. •Any leftover funds in the claim account may be reconciled against future contributions. •Interest earned on the claim account is considered income to a nonqualified plan. A qualified plan may use this interest for future benefit payment. •Benefit plan administration through a professional third-party administrator is reasonably and competitively priced. Only slightly more involvement by the employer is required, such as verifying eligibility, printing employee communication materials, and distributing claim checks. •Self-funding with stop-loss coverage simplifies budgeting because the employer always knows its maximum expenditure for group health coverage. •Administrative services such as claims handling are often simpler, faster, and performed on a more personal and professional basis. Bureaucratic red tape is eliminated. 28. Separation means dividing the assets exposed to loss to minimize the harm from a single event. For example, a manufacturing company may divide the production area of a plant into four quadrants by using 6-foot-thick concrete walls. A fire may damage production in one quadrant, but the thick concrete walls prevent the fire from spreading. Similarly, a manufacturer may store finished goods in two warehouses in different cities. If one of the warehouses is damaged or destroyed, the finished goods in the other warehouse are unharmed. 29. Single parent captive (pure captive) is an insurer owned by only one parent, such as a corporation. An association or group captive is an insurer owned by several parents. For example, corporations that belong to a trade association may jointly own a captive insurer. Example, key term 3 QUESTIONS FOR REVIEW 1. What is the meaning of risk management? Systematic process for the identification and evaluation of loss exposures faced by an organization or individual, and for the selection and implementation of the most appropriate techniques for treating such exposures 2. Explain the objectives of risk management both before and after a loss occurs. Pre- Loss First Objective: the firm should prepare for potential losses in the most economical way Second Objective: reduction of anxiety Final Objective: meet any legal obligations. Post Loss First Objective: survival of the firm Second Objective: continue operating Third Objective: stability of earnings Fourth Objective: is continued growth of the firm Objective of social responsibility: minimize the effects that a loss will have on other persons and on society. 3. Describe the steps in the risk management process. Step 1: Identify Loss Exposers Step 2: Measure and analyze the loss exposures Step 3 Select and Appropriate combination of techniques for treating the loss exposures Step 4: Implement and monitor the risk management program. 4. a. Identify the sources of information that a risk manager can use to identify loss exposures. Questionaire/Checklist-Pre-designed checklist enabling a business or individual to answer a series of questions regarding their assets and activities to determine potential exposure Financial Statement Analysis-an analysis of the firm's B/S and I/S to determine exposures Flowcharts- helps to identify exposures related to the production process Contract Analysis-helps to identify exposure resulting from the involvement with others parties in a contractual agreement On-Site Inspections- visiting the various business locations, observing and interviewing various employees regarding the activities taking place Statistical Analysis of Past Losses-Use past losses to identify and protect future losses b. What is the difference between the maximum possible loss and probable maximum loss? -Maximum possible loss is the worst loss that could possibly happen to the firm during its lifetime. -Maximum probable loss: is the worst loss that is likely to happen. 5. a. Explain the meaning of risk control. Risk control refers to techniques that reduce the frequency or severity of losses. Major risk-control techniques include the following: ■ Avoidance ■ Loss prevention ■ Loss reduction ■ Duplication ■ Separation ■ Diversification b. Explain the following risk-control techniques. 1. Avoidance --means a certain loss exposure is never acquired, or an existing loss exposure is abandoned --the chance of loss is decreased to zero --it is not always possible, or practical, to avoid all losses 2. Loss prevention refers to the measure that REDUCES the FREQUENCY of a particular loss -implemented BEFORE a loss occurs Ex: installing safety features on hazardous products 3. Loss reduction -a risk control technique that REDUCES THE SEVERITY of a particular loss ex. sprinkler systems, automatic burglar alarms 4. Duplication -dispersion of an asset over 2 locations, keeping on in reserve -use of backups, spares, or copies in reserve for use in the event of accident affecting primary asset -duplication is not used unless primary asset/activity is damaged/destroyed ex. an organization may make arrangements with more than one supplier of key raw material (just in case primary supplier could not provide materials because of a loss) 5. Separation -dispersion of asset or activity over several locations to avoid dependence on a single location -this technique is appropriate if organization can operate with only a portion of these separate units left intact (organization must be able to continue operations even if one unit suffers a total loss) *REDUCE SEVERITY of an individual loss at a single location (multiple locations = increase loss frequency) ex. maintaining several warehouses at different locations 6. Diversification -spread of loss exposures over numerous projects, products, markets, or regions -prevents single event or series of events from destroying a large % of assets -potential to increase loss frequency by increasing loss exposures -REDUCES SEVERITY and make loss exposures more predictable 6. a. Explain the meaning of risk financing. risk management techniques that provide for the funding of losses after they occur, such as retention, non insurance transfers, and commercial insurance. b. Explain the following risk-financing techniques. 1. Retention Risk management technique in which an individual or a firm retains part or all of the losses resulting from a given loss exposure. Used when no other method is available, the worst possible loss is not serious, and losses are highly predictable. 2. Noninsurance transfers Various methods other than insurance by which a pure risk and its potential financial consequences can be transferred to another party, for example, contracts, leases, and hold-harmless agreements. 3. Insurance is appropriate for loss exposures that have a LOW PROBABILITY of loss but for which the SEVERITY of loss is HIGH 7. What conditions should be fulfilled before retention is used in a risk management program? --No other method of treatment is available --The worst possible loss is not serious --Losses are fairly predictable. 8. a. What is a captive insurer? Insurance company established and owned by a parent firm in order to insure its loss exposures while reducing premium costs, providing easier access to a reinsurer, and perhaps easing tax burdens. b. Explain the advantages of using a captive insurer in a risk management program. -Favorable regulatory environment -lower costs -easier access to a reinsurer. 9. a. What is self-insurance? Retention program in which the employer self-funds or pays part or all of the losses. b. What is a risk retention group? is a group captive that can write any type of liability coverage except employers' liability, workers compensation, and personal lines 10. a. Explain the advantages of using insurance in a risk management program. -The firm will be indemnified after a loss occurs -Uncertainty is reduced -can provide valuable risk management services, such as risk-control services, loss exposure analysis, and claims adjusting b. Explain the disadvantages of using insurance in a risk management program -The payment of premiums is a major cost -Considerable time and effort must be spent in negotiating the insurance coverages -Risk manager may have less incentive to implement loss control measures because the insurer will pay the claim if a loss occurs.