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Exam 1 study guide

by: JKJ

Exam 1 study guide FIN 3101 - 006


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Howard Keen (P)
Study Guide
Risk Management
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This 14 page Study Guide was uploaded by JKJ on Sunday January 31, 2016. The Study Guide belongs to FIN 3101 - 006 at Temple University taught by Howard Keen (P) in Spring 2016. Since its upload, it has received 32 views. For similar materials see FINANCIAL MANAGEMENT in Finance at Temple University.


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Date Created: 01/31/16
Topic 1 Risk  Uncertain outcome  Possibility of loss Uncertainty- about type and /or timing of outcome All losses in financial terms  Losses to individuals and organizations Ways to manage risk:  Loss mitigation (mitigate = lessen); loss control (train employees)  Avoid loss situation if possible  Budget for the loss Probability of Loss  Measurable  Between 0 and 1  Probability of 0% is impossible event; No risk  Probability of 100% is a certain event; No risk I. Risk Classifications  Pure vs. Speculative (both involve uncertainty) Pure Risk  Loss  No Loss  No chance of a gain EX:  Natural disasters  Illness, Injury.  Death  Focus of Traditional Risk Management (TRM) Speculative Risk  Chance of a loss or a gain  Loss  No loss/gain  Gain EX:  Gambling  Investments  Buying an apartment  Focus of Enterprise Risk Management (ERM) Major types of Pure Risk  Personal  Property  Liability 1. Personal  Human capital - Ability to make income - Subject to “life and health” exposures to loss What can happen? - Loss of income - Medical expenses - Unemployment/Retirement 2. Property  Ownership of physical or other assets - Damage/theft - Direct losses: cost of replacement or repair - Indirect losses: loss of income, extra expenses- business interruption losses 3. Liability - Legal liability based on tort or negligence - Financial consequences o Legal fees o Judgment o Reputation loss EX: GM faulty ignition switch; NFL head injuries II. Static vs. Dynamic Risk a. Static - Does not change significantly over time - Always present EX: Fire, Flood, Death, Theft  Traditional Risk Management b. Dynamic - Arise from economic or regulatory changes - New/emerging risks EX: Hover boards, Terrorism, Affordable care act, Cyber-attacks, Global warming Increase risk with dynamic in a global economy III. Subjective vs. Objective a. Subjective - Based on opinion/ attitude, not fact - May be very different than actual - Varies by person/organizations - Attitudes towards risk of key decision makers impacts risk management decision-making o Risk adverse o Risk lover o Risk neutral b. Objective - Measurable by relative variation of actual losses from expected losses - Greater variability means greater risk - AL = Actual losses that occur in a time period - EL = Expected losses (planned, average, anticipated) - Risk present if possible for AL to deviate from EL o AL less than EL  Good o Al greater than EL  Bad o Al = EL  Neutral - Objective risk measure (AL – EL)/ EL IV. Diversifiable vs. Non-Diversifiable a. Diversifiable - Affects only individuals or small groups and not entire economy - Can be managed through diversification EX: Dwelling fires- different locations b. Non-Diversifiable - Affects the entire economy or large number of individuals within the economy o Correlated o Cannot be reduced through diversification o May need government assistance EX: Natural disasters, Recession, high interest rates Systemic Risk - Potential for collapse of entire financial system Insurable risks are generally: o Pure o Objective o Diversifiable Factors affecting risk 1) Peril - Immediate cause of the loss - Rando event that causes losses to occur - Common perils causing loss to property: o Fire o Flood o Theft o Collision - Common perils causing personal loss: o Unemployment o Death 2) Frequency of loss - Number of losses in a given time period What is the likelihood of a loss? o Low frequency losses = low probability o High frequency losses = high probability 3) Severity of loss - Given a loss has occurred, how bad is it in $ - Property easier to estimate than liability 4) Hazards - A condition that lies behind the occurrence of a loss and serves to: o Raise frequency of loss o Raise severity of loss, or: o Raise both frequency and severity EX: Icy roads increase the chance of an auto accident - Ice is hazard, accident (Collison) is peril Classifications of Hazards 1. Physical hazards - Location o If peril is flood, then property located in a flood zone is a physical hazard - Construction o If peril is fire, faulty wiring is a physical hazard o If peril is fire, wood/frame is a physical hazard 2. Moral hazard - Moral hazard exists when the presence of insurance changes the behavior of the insured so as to increase the frequency of severity of loss EX: Building owner burns building, collects property insurance - Raise frequency Person claims to have had golf clubs in trunk of stolen car, collects insurance - Raise severity (trying to claim more than what was actually stolen) Two common threads - The presence of an insurance contract - Change in behavior (people act differently with insurance than without it) Topic 2 The risk management process Six steps: 1. Identify Loss Exposure  most crucial step  Failure to properly identify can lead to bankruptcy 2. Measure and Analyze Loss Exposure Measure:  Frequency/Probability of loss  Severity -Involves looking at past information and making projections about the future EX, easy for large firms to predict:  Workers compensation losses  Health Insurance losses EX, harder to predict:  More rare events: Natural disasters 3. Examine feasibility of RM techniques a) Risk control options -Decrease frequency  Training programs, safety measures -Decrease severity  Rehabilitation programs for injured workers b) Risk financing options  Insurance  Self-insurance/ budget for losses 4. Select the appropriate RM options -Select one or more -Decision rule to choose among the various options -Financial considerations- choose those with greatest effect on organization’s value -Subjective Risk (non-financial)  Attitudes toward risk of key decision makers are important  Peace of mind 5. Implement the chosen option EX:  Begin the safety program  Purchase insurance  Set up self-insured pool 6. Periodically Re-evaluate the chosen strategies -Is the safety program working? -Cost-benefit analysis -Does the loss exposure still exist in the same form? -Is insurance still the best option? Continuous cycle/Process Insurance Markets Underwriting cycle:  Soft Market o Easy underwriting- readily available insurance o Low premiums  Hard Market o Tight underwriting o High premiums RM program goals (text pp. 2.18-2.24)  Pre-loss goals  Post-loss goals Elements of a Loss Exposure Loss exposure: Situations or conditions present possibility of loss  Faced by individuals and organizations Three Elements: 1. A particular thing of value (asset) exposed to loss EX: Property; Human capital 2. As a result of a particular peril (cause of loss) 3. Possibility of a financial loss EX:  Property loss exposure faced by a firm  Assets- Property: building, furniture, contents…  Perils- fire, flood, theft  Financial loss- value of property damaged Identifying loss exposures- Step 1 in RM process 1. Share information with other firms in the same industry  RIMS-Risk and Insurance Management Society 2. One-site inspection/Walk arounds 3. Surveys/Questionnaires 4. Ask managers and employers 5. Contract analysis/Document analysis  Leases  Hold harmless agreements  Policy and procedures manual 6. Look at past information  Cannot be used to identify all types of loss exposures EX: low frequency; new/emerging loss exposures-dynamic risks 7. Financial statement approach  Balance sheet: assets and liabilities  Income statement  Budgets  Mergers and acquisitions 8. Flow chart approach Topic 3 Traditional and Enterprise Management TRM Loss Exposures: ERM Loss Exposures: - Property Loss Exposure - Hazard Risk - Liability Loss Exposure - Operational Risk - Net Income Loss Exposure - Financial Risk - Personnel Exposure - Strategic Risk - Personal Loss Exposure Property Loss Exposures -Legal “interest” in property “Interest”- Financial stake in property (If there is a loss to the property, you also suffer a loss) Some Sources of Legal Interest in Property 1. Ownership Interest  Present ownership interest (most common type)  Future ownership interest 2. Secured Creditors - Borrow money from the bank to buy a house  Bank is the secured creditor o It holds the title to the house o Has legal interest in the property o Bank insists that the buyer get insurance -There are two parties to a contract:  The insurer  The named insured 3. Lease Agreements  “Use interest”: Use the property for a specified purpose o Right to continued use - Usually have an obligation to return property without damage - May have a leasehold interest on the property EX: Renting property: 10 year lease at $10,000/month - 4 years into the lease a fire destroys the building - Current fair market value (FMV) is $12,000/month - Tenant has a leasehold interest if the FMV is greater than the rent (2,000/month for 6 years = 24,000 x 6= $144,000) - Leasehold interest coverage pays for the difference between old rent and new rent If FMV is less than rent, no leasehold interest 4. Bailee Interest  Bailee- Someone who has temporary possession of a property that belongs to another  Bailor- Owner of the property Contract of Bailment - Involves delivery of property to Bailee for a specific reason - And will be returned to Bailor EX: Car repair; Valet; Dry Cleaning What about losses to the property while in possession of the Bailee?  The Bailee can often limit their liability  Bailee is often limited to repairing/replacing the cost of the property 5. Buyers and Sellers - If there is a loss to goods in transit, who is financially responsible?  That depends on the terms of the shipping agreement  Freight on Board (FOB) point –Indicates the point at which financial responsibility shifts from seller to buyer EX: If the contract says: Who is financially responsible? - FOB Denver - Seattle (Buyer destination) - FOB Seattle -Denver Liability Loss Exposure - Possibility of a claim alleging legal liability for injury or damage suffered by another EX: Defective products; Property; Company vehicles; Premises and general liability Financial consequences of loss  Legal fees (even if no settlement or damages are paid)  Court costs  Damages to plaintiffs  Settlement costs if claim is settled out of court Net Income Loss Exposure - Business Interruption losses  Net Income = Revenue – Expenses Two stage process: st 1 stage: A firm suffers a loss of some land (primary or direct loss- property, liability, or personnel loss) nd 2 stage: As result of a primary loss, also suffers a loss in net income (indirect loss) - Decrease in Net Income arises from:  Decrease in Revenue  Increase in Expenses  Both a decrease in Revenue and increase in Expenses - Net Income losses are ALWAYS the result of another loss occurring first  Usually from a property loss  May also be from a liability or personnel loss Events causing Net Income losses 1. Loss to property you own EX: Fire completely destroys building (property loss exposure – value: repair or replacement cost of building) May also have:  Loss of presence in the marketplace  Loss of client records o Both lead to decrease in revenue, which decreases Net Income - May have to rent another place  Leads to increased expenses, which decrease Net Income 2. Loss to property owned by others - Contingent net income EX: Loss to key supplier  Shutdown in your operations  Go into marketplace, buy from another supplier at a higher price 3. Loss to property owned by others J&J- Tylenol liability issue  Product liability issue  Liability loss exposure  Value the liability loss  Legal fees  Judgement/payments to families 4. Personnel Loss Exposure - A firm has a key employee (key decision maker, key salesperson) - The key employee suffers a personal loss EX: Death; Illness/Injury  Loss of income  Medical expenses o Borne by key employee and/or their family - The firm suffers a personnel loss - The firm may also have a Net Income loss -Increased Expenses  Cost of replacement  Training costs  Search costs -Decrease Expenses  Sales down; may lose customers  Decisions not made, or not making good decisions - Each leads to decreased Net Income - Are personnel loss exposures a “special case” of Net Income loss exposures? -Yes TRM V. ERM - TRM- Losses/risks are evaluated in a silo or isolated approach - Has four types of loss Exposure - Risks – Pure - Most risks are insurable Every firm faces: Who manages these risks?  Hazard risks -Risk Management  Personnel risks -Human Resources  Operational risks -Business units, COO  Financial risks -CFO, Treasurer  Strategic risks -CEO, Board - ERM- Looks at all risk in a firm; may have a chief risk officer (CRO) C-suite: CEO, CFO, COO, CRO  Pure and speculative risk  Uses integrated approach to managing risk  Breaks down the silos  First manages risks that threaten long run viability of an organization  Combination should decrease risk Types of Risk under ERM - Hazard - Operational - Financial - Strategic Focus on: - Source of risk - Who has traditionally managed it - Pure or Speculative? - Diversifiable or Non-Diversifiable? Hazard Risks - Arise from property, liability or personnel loss exposures  Pure  Most are diversifiable  Most can be handled with insurance  Small part of risk portfolio Operational Risks - Risks that arise from business operations  Failure in processes, systems or controls EX: - Manufacturing products:  Product recall  Supply chain issues - Customer service issues - Employment practices  Turnover  Discrimination  Workplace violence - Most are Pure Risks - Most are Diversifiable Financial Risks - Normally Speculative Risks - Traditionally handled by CFO function - Arise from effect of market forces on financial assets or liabilities  Interest rates  Exchange rates  Market risk  Liquidity risk - Sometimes managed by financial tools such as:  Futures, options, hedging Strategic Risks - Risks regarding a firm’s strengths, weaknesses, opportunities, and threats (SWOT analysis) - Arise from trends in economy and society - Industry and market change May also arise from: - Adverse management decisions  Ethics  Union Relations  Intellectual property  Media coverage  Product design - Speculative - Most are Diversifiable Risk Maps - Compares all risks an organization faces - Helps identify risks that need to be managed first - Helps break down departmentalization (silos) of risks under TRM


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