RMI 270 Study Guide Exam #1
RMI 270 Study Guide Exam #1 RMI 270
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This 7 page Study Guide was uploaded by Danielle Notetaker on Monday February 1, 2016. The Study Guide belongs to RMI 270 at Ball State University taught by Dr. Fitzgerald in Spring 2016. Since its upload, it has received 59 views. For similar materials see in Risk Management And Insurance at Ball State University.
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Date Created: 02/01/16
RMI 270 Study Guide Ch.1-3 Chapter 1 Risk- uncertainty concerning the occurrence of a loss Economics defines risk & uncertainty differently Risk- used in situations where the probability of possible outcomes can be estimated with some accuracy Uncertainty- used in situations where such probabilities cannot be estimated Risk is an ambiguous term (many different meanings). Loss exposure- any situation or circumstance in which a loss is possible, regardless of whether a loss occurs o Ex: factories may be damaged by flood or earthquake, defective products may result in lawsuits Objective risk vs. Subjective Risk Objective – (degree of risk) the relative variation of actual loss from expected loss o Objective risk declines as the number of exposures increase o Ex: 10,000 houses insured = variation of 10% of houses that burn 1 million houses insured = variation of 1% of houses that burn o Objective risk can be measured! As the number of exposures increases, an insurer can predict its future loss experience by relying on the law of large numbers Law of large numbers – states that as the number of exposure units increases, the more closely the actual loss experience will approach the expected loss experience Subjective – uncertainty based on a person’s mental condition or state of mind o Ex: Driver has several convictions for drunk driving and is drinking heavily at the bar. He then decides to drive home, but is uncertain if will make it home without getting arrested for drunk driving. (the mental uncertainty = subjective risk) Chance of loss – the probability that an event will occur o Probability can be objective or subjective Peril & Hazard Peril – the cause of loss o If your house burns down because of a fire the peril is the fire o If your car is damaged in a collision, the collision is the peril Hazard – a condition that creates of increases the frequency or severity of loss 4 Major Types of Hazards: 1. Physical- physical condition that increases the frequency or severity of loss a. Ex: icy roads that increase the chance of car accident b. Ex: defective lock that increases the chance of theft 2. Moral- dishonesty or character defects in an individual that increases the frequency or severity of loss a. Ex: faking an accident to collect from an insurer b. Ex: submitting a fraudulent claim c. Ex: intentionally burning merchandise that is insured 3. Morale- carelessness or indifference to a loss, which increases the frequency or severity of a loss a. Ex: leaving car keys in an unlocked car, which increases the chance of theft b. Ex: changing lanes on crowed highway with no turn signal, increases chance of accident 4. Legal- characteristics of the legal system or regulatory environment that increases the frequency of losses Classification of Risk 1. Pure and Speculative Risk 2. Diversifiable Risk and Nondiversifiable Risk 3. Enterprise Risk Pure Risk – a situation in which there are only the possibilities of loss or no loss o Ex: premature death, job-related accidents, catastrophic medical expenses, damages to property from fire Speculative Risk – situation in which either profit or loss is possible o Ex: buying shares of stock, betting on horse race, investing in real estate *The law of large numbers can be applied more easily to pure risk than speculative risk Diversifiable risk –a risk that affects only individuals or small groups not the entire economy. It can be reduced or eliminated by diversification o Ex: diversified portfolio of stocks, bonds, and CDs Nondiversifiable risk – affects the entire economy or large numbers of persons or groups o Ex: rapid inflation, cyclical unemployment, war, hurricanes, floods Enterprise Risk – encompasses all major risks faced by a business firm, includes pure, speculative risk, strategic, operational, and financial risk o Financial risk: the uncertainty of loss because of adverse changes in commodity prices, interest rates, foreign exchange rates, and the value of money Major Personal and Commercial Risks Personal risks – risks that are directly affect an individual or family Major Personal Risks: 1. Premature death 2. Insufficient income during retirement 3. Poor health 4. Unemployment Property Risks – the risk of having property damaged or lost from numerous causes (maximum limit on the loss) Direct loss – a financial loss that results from the physical damage, destruction, or theft of the property o Ex: if you owe a home that is damaged by a fire, the physical damage to the home is a direct loss Indirect loss or Consequential loss– a financial loss that results indirectly from the occurrence of a direct physical damage or theft loss o Ex: If your house burns down, you may incur additional living expenses Liability Risk – (type of pure risk) you can be held legally liable if you do something that results in bodily injury or property damage to someone else. A court of law may order you to pay substantial damages (no maximum upper limit with respect to the amount of loss) Commercial Risks: Businesses can face a wide variety of pure risks that can cripple the firm, for example: property, liability, loss of business income, and other risks Techniques for Managing Risk Risk Control – techniques that reduce the frequency or severity of losses Includes: o Avoidance o Loss prevention – reduces probability of loss o Loss reduction – reduces severity of loss Chapter 2 Insurance – 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 risks Basic Characteristics of Insurance 1. Pooling of losses 2. Payment of fortuitous losses 3. Risk transfer 4. Indemnification o Pooling – the spreading of losses incurred by the few over the entire group, so that in the process, average loss is substituted for actual loss Primary purpose of pooling: to reduce variation in possible outcomes, which reduces risk Pooling the loss of a large number of exposure units, helps the insurer to predict future losses with greater accuracy o Fortuitous loss – one that is unforeseen and unexpected by the insured and occurs as a result of chance (The loss must be accidental) 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 o Indemnification – the insured is restored to their financial position prior to the occurrence of the loss Private insurers generally only insure pure risks! 6 Characteristics of Insurable Risk: 1. Must be a large number of exposure units 2. Loss must be accidental and unintentional (unforeseen & unexpected) 3. Loss must be determinable and measurable a. Loss should be definite as to cause, time, place, and amount i. Ex: life insurance- cause & time of death are easily determined 4. The must should NOT be catastrophic a. Catastrophic events include: flood, hurricane, earthquake b. If there is a catastrophic loss, reinsurance can be used or disperse insurance geographically i. Reinsurance = the primary insurer writes the insurance transfer to another insurer 5. Chance of loss must be calculable a. Insurer must be able to calculate the average frequency & the average severity so that they can charge the proper premium 6. The premium must be economically feasible Adverse selection – the tendency of people with a higher than average chance of loss to seek insurance at a standard rate o Ex: high-risk drivers who seek auto-insurance at a standard rate o Can be controlled with underwriting Underwriting – the process of selecting and classifying applicants for insurance Insurance vs. Gambling Gambling creates a new speculative risk, while insurance is a technique for handling already existing pure risk Types of Insurance 1. Private Insurance a. Life Insurance – pays death benefits b. Health Insurance c. Property & Liability Insurance 2. Government Insurance a. Social Insurance i. Social Security, Medicare, Unemployment, Workers Comp, ect. Benefits of Insurance to Society 1. Indemnification for loss – families are restored to their prior financial position 2. Reduction of worry and fear 3. Source of investment funds 4. Loss prevention 5. Enhancement of credit Costs of Insurance to Society 1. Cost of doing business 2. Fraudulent claims 3. Inflated claims Chapter 3 Risk management – a process that identifies loss exposures faced by an organization and selects the most appropriate techniques for treating such exposures Loss exposure – any situation or circumstance in which a loss is possible, regardless of whether a loss actually occurs Steps in the Risk Management Process: 1. Identify loss exposures – review ALL potential losses (property, liability, crime, income, HR, employee benefit, foreign, intangible property, ect.) 2. Measure and analyze the loss exposures a. Requires an estimation of the frequency and severity of the loss i. Loss frequency: probable number of losses ii. Loss severity: probable size of losses b. Then the loss exposures can be ranked according to their importance i. Maximum Possible Loss: the worst loss that could happen to the firm during its lifetime ii. Probable Maximum Loss: the worst loss that is likely to happen 3. Select the appropriate combination of techniques for treating the loss exposures a. Risk Control: reduce the frequency or severity of losses i. Avoidance = no loss at all 1. Ex: No flood loss if move your business to higher grounds ii. Loss prevention – reduces the frequency of loss 1. Ex: reduces truck driving accidents by driver training & zero tolerance for alcohol iii. Loss reduction – reduces severity of loss after it occurs 1. Ex: install sprinkler system b. Risk Financing: provide for the funding of losses i. Retention – firm retains part or all of the losses 1. Ex: collision losses to cars ii. Noninsurance transfers – methods other than insurance where a pure risk is transferred to another party 1. Ex: transfers of contracts, leases iii. Commercial insurance – insurance is appropriate for loss exposures that have low probability of loss but the severity is high 5 key Areas must be emphasized: 1. Selection of insurance coverage 2. Selection of an insurer 3. Negotiation of terms 4. Dissemination of information concerning insurance coverages 5. Periodic review of the insurance program 4. Implement and monitor the risk management program
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