RMI 3011 Professor McHugh Test 1 Review Risk definition uncertainty concerning the occurrence of a loss Objective v subjective risk o Objective Risk is defined as the relative variation or difference of actual loss from expected loss o Subjective Risk is defined as uncertainty based on a person s mental condition or mental state o Which one is harder to assess Subjective Peril definition the cause of the loss i e in an auto accident the collision is the peril 4 types of Hazards A hazard is a condition that increases the chance of loss o Physical Hazard is a physical condition that increases the frequency or severity of loss o Moral Hazard is dishonesty or character defects in an individual that increase the frequency or severity of loss or severity of a loss o Attitudinal or Morale Hazard is carelessness or negligence to a loss which increases the frequency o Legal Hazard refers to the characteristics of the legal system or regulatory environment that increase the frequency or severity of loss Pure v speculative risk o Pure risk INSURABLE is a situation in which there are only the possibilities of loss or no loss i e an earthquake Burdens of risk on society o Speculative Risk is a situation in which either profit or loss is possible i e gambling o The presence of risk results in three major burdens on society In the absence of insurance individuals and business firms would have to maintain large emergency funds to pay for unexpected losses The risk of a liability lawsuit may discourage innovation depriving society of certain goods and services Risk causes worry and fear Techniques for managing risk retention v avoidance v non I xfer v Insurance o Risk Control refers to techniques that reduce the frequency or severity of losses Avoidance Loss Prevention which refers to activities to reduce the frequency of losses Loss Reduction which refers to activities to reduce the severity of losses o Risk Financing refers to techniques that provide for payment of losses after they occur Retention means that an individual is aware of the risk and deliberately plans to retain all of part of it Active Retention means that an individual is aware of the risk and deliberately plans to retain all of part of it Passive Retention means risks may be unknowingly retained because of ignorance indifference or laziness Self Insurance is a special form of planned retention by which part or all of a given loss exposure is retained by the firm o Non Insurance Transfers transfers a risk to another party other than an insurance company A transfer of risk by contract such as through a service contract or a HOLD HARMLESS in a contract Hedging is a technique for transferring the risk of unfavorable price fluctuations to a speculator by purchasing and selling future contracts on an organized exchange Incorporation of business firm transfers to the creditors the risk is having o For more people INSURANCE is the most practical method of handling major risks Risk Transfer is used because a pure risk is transferred to the insurer The pooling technique is used to spread the losses of the few over an entire group The risk may be reduced by application of the law of large numbers Risk financing o Retention paying for losses o Non Insurance Transfer service contract o Insurance Indemnification insurance definition o Insurance definition Insurance is the pooling of fortuitous happening by accident losses by transfer of such risks to insurers who agree to indemnify insured s for such losses to provide other pecuniary benefits on their occurrence or to render services connected with the risk o Indemnification return the insured person back to their position before the loss Law of large numbers and insurance o 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 o Pooling meaning lots of inputs involves spreading losses incurred by the few over the entire group o RISK REDUCTION IS BASED ON THE LAW OF LARGE NUMBERS 6 characteristics of ideally insurable risks know this cold VERY IMPORTANT o Large Numbers of Exposure Activity Units To predict average loss based on the law of large numbers o Accidental and Unintentional Loss To assure random occurrence of events o Determinable and Measureable Loss To determine how much should be paid o No Catastrophic Loss Reinsurance To allow the pooling technique to work Exposures to catastrophic loss can be managed by using reinsurance dispersing coverage over a large geographic area or using financial instruments such as catastrophe bonds o Calculable Chance of Loss To establish a premium that is sufficient to pay all claims and expenses and yields a profit during the policy period o Economically Feasible Premium So people can afford to purchase the policy For insurance to be an attractive purchase the premiums paid must be substantially less than the face value or amount of the policy o Other Considerations Most personal property and liability risks can be insured Market risks financial risks production risks and political risks are difficult to insure Adverse selection is the tendency of persons with a higher than average chance of loss to seek insurance at standard rates o If not controlled by under write adverse selection results in higher than expected loss levels 5 Social benefits of insurance o Indemnification of loss being financially restored to your status before the loss o Reduction of worry and fear o Source of investment funds o Loss prevention o Enhancement of credit Expense loading is the amount needed to pay all expenses including commissions general administrative expenses state premium taxes acquisition expenses and an allowance for contingencies and profit Risk Management is the process that identifies loss exposures faced by an organization and selects the most appropriate techniques for treating such exposures 4 steps of risk management process o Identify potential losses o Measure and analyze the lose exposures o Select the appropriate combination of techniques for treating the loss exposures o Implement and monitor the risk management program Risk Financing methods pro s and con s of each retention payment options o Retention means that the firm retains part of all of the losses that can result from a given loss As Professor McHugh would say Eats the losses Retention is effectively used when No other method of treatment is available The
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