Principles of Insurance Exam 1 Chapter 1 Risk and Its Treatment Risk Uncertainty concerning the occurrence of a loss Loss Exposure Any situation or circumstance in which a loss is possible regardless of whether a loss occurs Objective Risk The relative variation of actual loss from expected loss Subjective Risk Uncertainty based on a person s mental condition or state of mind Chance of loss Probability that an event will occur Objective Probability Long run relative frequency of an event based on the assumptions of an infinite number of observations and no change in the underlying conditions Subjective Probability Individual s personal estimate of the chance of loss Peril Cause of the loss Ex In auto accident the collision is the peril Hazard Condition that increases the chance of loss Physical Hazard Physical condition that increases the frequency or severity of loss Moral Hazard Dishonesty or character defects in an individual that increase the frequency or severity of loss Attitudinal Hazard Morale Hazard Carelessness or indifference to a loss which increases the frequency or severity of loss Legal Hazard Refers to characteristics of the legal system or regulatory environment that increase the frequency or severity of loss Pure Risk Situation in which there are only the possibilities of loss or no loss earthquake Speculative Risk Situation in which either profit or loss is possible gambling Diversifiable Risk Affects only individuals or small groups car theft It is also called a particular risk Nondiversifiable Risk Affects the entire economy or large numbers of persons or groups within the economy hurricane also called a fundamental risk Government assistance may be necessary to insure nondiversifiable risks Enterprise Risk Encompasses all major risks faced by a business firm which include Strategic Risk Uncertainty regarding the firm s financial goals and objectives Operational Risk Results from a firm s operations Pure Risks Property risks liability risks loss of business income crime Financial Risk Refers to the uncertainty of loss because of adverse changes in commodity prices interest rates foreign exchange rates and the value of money Enterprise Risk Management Combines all of the above risks into a single unified treatment program Personal Risks Directly affect the individual or family They involve a loss of income or depletion of financial assets due to Insufficient income during retirement Premature death of family head Poor health catastrophic medical bills and loss of earned income Property Risks Liability Risks Involuntary Unemployment Property Risks Involve the possibility of losses associated with the destruction or theft of property Direct Loss Financial loss that results from the physical damage destruction or theft of the property such as fire damage to a home Indirect consequential Loss Financial loss that results indirectly from the occurrence of a direct physical damage or theft loss Ex Additional living expenses after a fire Liability Risks Involve the possibility of being held legally liable for bodily injury or property damage to someone else No max upper limit with respect ot the amount of the loss A lien can be placed on your income and financial assets Legal defense costs can be enormous Commercial Risks Firms face a variety of pure risks that can have serious financial consequences if a loss occurs o Property Risk Such as damage to buildings furniture and office equipment o Liability Risks Such as suits for defective products pollution and sexual o Loss of Business Income When the firm must shut down for some time after a harassment physical damage loss o Other Risks Include crime exposures human resource exposures foreign loss exposures intangible property exposures and government exposures Three Major Burdens Risk Places on Society In absence of insurance individuals and business firms would have to maintain large emergency funds to pay or unexpected losses Risk of liability lawsuit may discourage innovation depriving society of certain goods and services Risk causes worry and fear Techniques for Managing Risk Risk Control Refers to techniques that reduce the frequency or severity of losses o Avoidance o Loss Prevention Activities to reduce the frequency of losses o Loss Reduction Activities to reduce the severity of losses Risk Financing Techniques that pay for losses after they occur o Retention When an individual or business firm retains part or all of the losses that can result from a given risk Active Retention When an individual is aware of the risk and deliberately plans to retain all or part of it Passive Retention Means that risks may be unknowingly retained because of ignorance indifference or laziness Self Insurance Special form of planned retention by which part or all of a given loss exposure is retained by the firm o Noninsurance Transfer Transfers risk to another party Hold harmless clause in a contract Hedging Technique for transferring the risk of unfavorable price fluctuations to a speculator by purchasing and selling futures contracts on an organized exchange Incorporation of a business transfers to creditors the risk of having insufficient assets to pay them o Insurance For most people insurance is the most practical method for handling major risks entire group Risk transfer is used because a pure risk is transferred to the insurer The pooling technique is used to spread the losses of a few over the The risk may be reduced by application of the law of large numbers Chapter 2 Insurance and Risk Insurance pooling of fortuitous losses by transfer of such risks to insurers who agree to indemnify insureds for such losses Basic Characteristics of Insurance Pooling of Losses involves spreading of losses incurred by a few over the entire group Law of Large Numbers 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 Payment of Fortuitous Losses A loss that is unforeseen unexpected and occurs as a result of chance is a fortuitous loss Risk Transfer A pure risk is transferred from the insured person or business to the insurer Indemnification The insured person is restored to what his approximate financial position was prior to experiencing the loss Characteristics of an Ideally Insurable Risk Large number of exposure units exist Accidental and Unintentional losses Determinable and Measurable Losses No Catastrophic Loss