RMI 3011 EXAM 1 STUDY GUIDE FUNDAMENTALS OF RISK I Risk uncertainty regarding a loss A Objective Risk vs Subjective Risk 1 Objective degree of risk valuation of actual loss from expected loss Decreases when the number of insured items rises due to the Law of large numbers more exposed units causes actual loss to more closely resemble expected loss 2 S ubjective Uncertainty based on a person s mental condition or state of mind Based on mental uncertainty A higher subjective risk usually results in a more conservative approach B Chance of loss probability that am event will occur 1 objective probability long run relative frequency of an event based on the assumption of an infinite number of observations with no change in underlying conditions i A priori determined by deductive reasoning ii inductive determination assumption based on past experience cannot be determined with pure logic 2 Subjective Probability personal estimate of loss slot machine odds increase due to it being a lucky day C Chance of loss over all probability objective risk individual valuation D Peril vs Hazard 1 Peril cause of loss a fire caused a house to burn 2 Hazard condition that creates or increases severity of loss i physical hazard gas can next to a fireplace ii Moral starting a fire to collect insurance money iii morale attitudinal disregard or lack of care leaving a stove burning while going to work iv legal unfair bias in the courtroom II CLASSIFICATION OF RISK A Pure vs Speculative risk 1 Pure 2 Speculative there only exists a possibility of loss no profit floods fires profit is possible buying stock i pure is more likely to be insurable than speculative because it is easier to apply the law of large numbers to pure risk ii society can benefit from speculative risk if loss occurs difference between speculative loss and gambling B Diversifiable vs Non Diversifiable 1 diversifiable affects small groups and not the whole economy Also called nonsystematic or particular risk 2 Nondiversifiable affects entire economy or a large group inside of the economy Systematic fundamental risk Inflation hurricanes unemployment Government help is usually required to insure 3 Enterprise Risk encompasses all major risks faced by a business firm i pure risk speculative strategic operational financial ii enterprise risk management combines all risks of i into a single treatment program iii financial risks often require hedging techniques III MAJOR PERSONAL RISKS AND COMMERCIAL RISKS A Personal Risk Risks that directly affect an individual or family 1 Premature death death of an individual with unfulfilled financial obligations Costs include i loss of human life value ii additional expenses funeral med bills iii loss of family ability to generate income iv non economical losses sadness 2 Poor Health economic insecurity from increased medical bills inability to work 3 Unemployment 2012 rate 8 2 i current income loss cut hours long periods of time can extinguish unemployment benefits B Property Risk destruction or theft 1 Direct Loss financial loss resulting from physical damage 2 Indirect Loss consequential loss additional losses resulting indirectly from property damage eating out instead of cooking because of a fire C Liability Risk 1 No maximum upper limit with respect to loss 2 lien can be placed to garnish wages if a person cannot pay Financial assets can be seized 3 Legal defense costs can be large D Commercial Risk 1 include property risks liability risks loss if business income extra expenses crime human resource exposure foreign loss intangible property exposures etc BURDEN OF RISK ON SOCIETY 1 Need for a large emergency fund 2 Loss of certain goods and services due to fear of lawsuit 3 Worry and Fear RISK PROFILES 1 risk adverse does not take risks 2 Risk neutral kind of in between adverse and seeker 3 risk seeker likes to take risks INTRO TO RISK MANAGEMENT IV V I RISK MANAGEMENT The process that identifies loss exposures faced by an organization and selects the most appropriate techniques for treating the exposures Loss Exposure any situation or circumstance where loss is possible regardless of actual loss occurrence 1 The firm should prepare for potential losses in the most economical A Pre Loss Objectives way 2 reduction of anxiety 3 meet all legal obligations B Post Loss Objectives 1 Survival of the firm most important 2 Continue operations 3 stability of earnings keep making the same amount of money as pre loss 4 keep growing 5 Minimize effect of loss on other persons and society C Steps of Risk Management 1 Identify loss exposure i review all potential loss liability property crime etc through risk analysis techniques questionnaires physical inspection financial statement analysis etc ii Measure and analyze loss exposure a estimate loss frequency and severity b estimate probable maximum loss and maximum possible loss c Rank risks in order of importance 3 Select appropriate combination of techniques for treating loss exposure II RISK MANAGEMENT TECHNIQUES frequency probable number of losses severity probable size of loss to occur Most important one catastrophic loss can be way worse than many small losses DON T RISK MORE THAN YOU CAN AFFORD TO LOSE A Risk Control reduce frequency and severity of loss 1 Avoidance avoiding or abandoning a loss exposure completely reducing chance of loss to 0 i may be impossible to avoid risks completely ii may be impractical to avoid all risk 2 prevention reduce frequency of a particular loss safety measures on the job 3 Reduction reduce severity of loss after occurrence Sprinkler systems turn on after fire starts B Risk Financing implemented after risk control technique to pay for losses after they occur 1 Retention purposefully retaining part of a loss from a given risk i active retention knowingly retaining loss such as purchasing insurance for an unlikely occurrence with a high deductible the deductible amount is the amount retained ii passive retention ignorance laziness iii retention should only be used when losses are not predictable or severe Last resort 2 Non Insurance Transfers Contracts separate entities i pros transfers commercially uninsurable losses Can cost less than insurance ii cons ambiguous contracts can cause payment failure may not receive cost reduction failure to pay still results in liability of party at risk 3 Commercial Insurance C When to Use What 1 Low frequency low severity retain 2 Low frequency high severity transfer insurance 3 High frequency
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