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FSU RMI 3011 - Ch. 1- Risk

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Used in situations where the probability of possible outcomes can be estimated with some accuracya.Ex. How many houses burn down each year i.Objective: aka degree of risk, the relative variation of actual loss from expected loss b.Ex. Drunk driving i.Subjective: uncertainty based on a person's mental condition or state of mind c.Risk: uncertainty concerning the occurrence of a loss A.Uncertainty: used in situations where such probabilities can not be estimatedB.Loss exposure: any situation or circumstance in which a loss is possible, regardless of whether a loss occursC.Objective probability: 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 conditiona.Subjective probability: the individual's personal estimate of the chance of lossb.Chance of Loss: the probability that an event will occurD.Chance of loss is the probability that an event that causes a loss will occura.Objective risk is the relative variation of actual loss from expected lossb.Chance of loss vs. Objective riskE.Risk and Uncertainty Ex. If your house burns because a fire, the peril is the firea.Peril: the cause of loss A.Ex. Icy roads, defective lock on a door1)Physical: a physical condition that increases the frequency or severity of lossi.Ex. Fraudulent claim, faking an accident/fire to collect insurance1)Moral: dishonesty or character defects in an individual that increase the frequency or severity of lossii.Ex. Leaving keys in an unlocked car increases chance of theft; changing lanes suddenly without signaling 1)Attitudinal (Morale): carelessness or indifference to a loss, which increases the frequency or severity of a lossiii.Legal: characteristics of the legal system or regulatory environment that increases the frequency or severity of losses iv.Four major areas: a.Hazard: a condition that creates or increases the frequency or severity of lossB.Peril and HazardEx. Premature death, flood, earthquakei.Pure risk: situations where there is only loss (adverse) or no loss (neutral)a.Ex. Stock market investing, going into business for yourself i.Speculative risk: either profit or loss is possible b.Pure and Speculative RiskA.Diversifiable: risk that affects only individuals or small groups and not the entire economy a.A risk that cannot be eliminated or reduced by diversification i.Nondiversifiable: a risk that affects the entire economy or large numbers of persons or groups within the economy b.Diversifiable and Nondiversifiable RiskB.Enterprise Risk: encompasses all major risks faced by a business firm. Such risks include pure risk, speculative risk, strategic risk, operational risk and financial risk C.Classification of RiskCh. 1- RiskSaturday, August 31, 20139:58 PM RMI Page 1speculative risk, strategic risk, operational risk and financial risk Ex. Mortgage, credit card loansi.Premature death: the death of a family head with unfulfilled financial obligationsa.Insufficient income during retirementb.Poor health: can lead to payment of medical bills and the loss of earned incomec.Unemploymentd.Personal Risks: risks that directly affect and individual or familyA.Ex. Physical damage to the home caused by a fire is a direct lossi.Direct loss: a financial loss that results from the physical damage, destruction or theft of the propertya.Ex. If your house burns down in a fire, you may incur additional living expenses to maintain your normal standard of living i.Indirect/consequential loss: a financial loss that results indirectly from the occurrence of a direct physical damage or theft loss b.Property Risks: risks of having property damaged or lost from numerous causesB.Major Personal and Commercial Risks The size of an emergency fund must be increasedA.Society is deprived of certain goods and servicesB.Worry and fear are present C.Burden of Risk on SocietyAvoidance- not always practical a.Ex. Auto accidents can be reduced by driving defensively i.Loss prevention- aims at reducing the probability of loss so that the frequency of losses is reduced b.Ex. Installing a sprinkler in case of firei.Loss reduction- aims to reduce the severity of the lossc.Risk control: techniques that reduce the frequency or severity of losses. Includes the following:A.Self insurance- a special form of planned retention by which part or all of a given loss exposure is retained by the firm i.Retention- means that an individual or business firm retains part of all of the losses that can result from a given risk a.Transfer of risk by contractsi.Hedging price risksii.Incorporation of a business firm iii.Noninsurance transfers- the risk is transferred to a party other than an insurance companyb.Insurance-c.Risk financing: techniques that provide for the funding of lossesB.Techniques for Managing Risk RMI Page 2Insurance: the pooling of fortuitous losses by transfer of such risks to insures who agree to indemnify insured for such losses, to provide other pecuniary benefits on their occurrence, or to render services connected with the risk A.Reduces variation in possible outcomes, thus reducing risk i.Pooling of losses: spreading of losses incurred by the few over the entire group, so that in the process, average loss is substituted for actual lossa.Fortuitous losses: one that is unforeseen and unexpected by the insured and occurs as a result of chance. Aka, must be accidentali.Ex. A person may slip on an icy sidewalk and break a legii.Payment of Fortuitous Losses: b.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 than the insuredc.Ex. If you are sued because of negligent operations of your car, your car insurance will pay those sums that you are legally obligated to payi.Indemnification: means that the insured is restored to his or her approximate financial position prior to the occurrence of the loss d.Basic Characteristics of Insurance:B.Purpose: to enable the insurer to predict loss based on the law of large numbersi.There must be a large number of exposure unitsa.A deliberately caused loss is not a random event because the insured knows when the loss will occur i.The lost must be accidental and unintentionalb.Cause, time, place and amount should all be known i.The loss must be determinable and measurablec.A large portion of exposure units should not incur losses at the same timei.Can result from natural disasters, terrorism, etc. ii.They are then


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