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Exam 1 chapter 1
risk management 4000 exam 1
Undergraduate 3

Additional Insurance Flashcards





defined as uncertainty concerncing the occurence of a loss.


*There is no single definition of risk.

ex: risk of dying in a car accident

"that driver is poor risk"

loss exposure

any situation or circumstance in which a loss is possible, regardless of whether a loss occurs. 

ex: manufacturing plants that may be damages by a flood or an earthquake. potential injury to workers because of unsafe working conditions. 

Objective Risk 

also called "degree of risk"

--is defined as the relative variation of actual loss from expected loss. 

ex: insurer has 10,000 houses. 1% or 100 houses burn each year. some years 90 burn, others 110 burn. therefore there is a variation of 10% or 10houses/100houses

Law of Large Numbers
As the number of exposure units increases, the more closely the actual loss experience will approach the expected loss experience. 
Subjective Risk

--defined as uncertainty based on a person's mental condition or state of mind. 


High subjective risk results in conservative and prudent behavior, while low subjective risk results in less conservative behavior. 

ex: been arrested before going out in other cities for being underage, now more cautious and less likely to do so. 

chance of loss

defined as the probability that an event will occur


*has both objective and subjective aspects just like risk

Objective probability

refers to the long-run relative frequency of an event based on the assumptions of an infinite number of obervations and of no chanfe in the underlying conditions. 

**can be determined in 2 ways:

1) by deductive reasoning (a priori probabilities)--ex: tossing a coin (50/50 chance of getting a head/tail), or rolling a die (1/6 chance of getting a certain # 1-6)

2)by inductive reasoning: ex: a person that is age 21 and the probability that they will die before  age 26 cannot be determined but based on past mortality experience we can estimate. 

Subjective Probability

is the individual's personal estimate of the chance of loss

**ex: people who buy lottery tickets on their birthday think that all of a sudden that are more likely to win. 

**a lot of factors can influence sujective probability such as age, gender, intelligence, education, and use of alcohol. 


Chance of loss vs. objective risk 



**chance of loss may be identical for two different groups but objective risk may be quite different. 

ex: LA and Philly both have a chance of fire 1% on 10,000 homes in each city but the range of variation (or objective risk) differs in each city. Philly has a range of 75 to 125 house burning while LA has only 90 to 110 houses burning range. Therfore the objective risk in bigger in Philly.


**cause of the loss.


ex: the fire, or collision, lightening, hail, tornado, earthquake, flood, burgarly, theft


a condition that creates or increases the frequency or severity of loss

4 types:

1)physical hazard

2) moral hazard

3) Attitudinal hazard

4) Legal hazard

physical hazard

physical condition that increases frequency or severity of loss

ex: icy roads, defective wiring in a building

moral hazard

dishonesty or character defects in an individual that increase the frequency or severity of loss

ex: faking an accident to collect from an insurer, submitting fraudlent claims, 

**to control this type of hazard, insurers implement various policy provisions, such as deductibles, waiting periods, exclusions, and riders

Attitudinal Hazards

carelessness or indifference to a loss, which increase the frequency or severity of a loss. 

ex: leaving your keys in an unlocked car, changing lanes suddenly and not looking.

legal hazard

refers to characteristics of the legal system or regulatory envirnoment that increase the frequency or severity of losses. 

ex: adverse jury verdicts or large damage awats in liability lawsuits. 

pure risk

defined as a situation in which there are only the possibilities of a loss or no loss. 

**only possible outcomes are adverse (LOSS) or neutral (NO LOSS).

ex: premature death, job-related accidents, major medical expenses, property damage from fire/flood/etc.


Speculative Risk

defined as a situation in which either profit or loss is possible.

ex: purchasing 100 shares of common stock, can ethier profit from it or loss money. betting on a horse race, investing in real estate.


Distinguishing between pure and speculative risks:

3 reasons


1) private insurers typically only insure pure risk. 

2) the law of large numbers can be applied more easily to pure risks than to speculative risks. 

--exception is the speculative risk of gambling.

3) society may benefit from a speculative risk even though a loss occurs, but it is harmed if a pure risk is present and a loss occurs.

--ex: if a firm develops a new technology for producing inexpensive computers other businesses may go out of business but consumers are benefitted becuase of cheaper price. 

However society doesnt benefit from a pure risk such as a flood or earthquake.

Diversifiable risk

a risk that affects only individuals or small groups and not the entire economy. 

--is a risk that can be reduced by DIVERSIFICATION!

ex: porfolio of just 100% investment in just stocks is very risky but diversifying your portfolio among bonds, CDs, stocks is less risky because if you lose money in one area you may profit in another area to offset any losses incurred.

Nondiversifiable risk

risk that affects the entire economy or a large # of people/groups within the economy.

**a risk that CANT be elminated by DIVERSIFICATION!

ex:rapid inflation, cyclical unemployment,war,hurricanes,floods,earthquakes

**also known as systematic risk or fundamental risk

Enterprise Risk

term that encompasses all major risks faced by a business firm. such risks include


1)pure risk

2)speculative risk

3) strategic risk

4) operational risk

5) financial risk

strategic risk

refers to uncertainty regarding the firms financial goals and objectives. 

ex: if a firm enters into a new line of business, the line may be unprofitable.

operational risk

results from the firms business operations

ex: online banking service bank, "hackers" may cause problems by breaking in and stealing customers information

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. 

ex: food company agrees to deliver cases of cereal for 6 months at a designated and agreed upon price but then grain prices rise and the company may lose money. 

personal risks

risks that directly affect an individual.

4 major personal risks:

1)risk of premature death

2) risk of insufficient retirement income

3) risk of poor health

4) risk of unemployment

Risk of premature death

defined as the death of a family head with unfulfilled financial obligations

--can cause financial problems if still have dependents to support, or have insufficient financial assets to replace lost income


**human life value: defined as the present value of the family's share of the deceased breadwinner's furture earnings. 

risk of insufficient retirement income

**vast majority of workers retire before the age of 65.

--experience a substantial reduction in their money incomes when they retire. 

2008, median income for retired people 65 and over was $29,744

--workers are not saving enough for retirement:

53% of workers have total savings less than $25,000. only 12% have savings $250,000 or more. 

Risk of poor health

includes risk of payment of catastrophic medical bills and loss of earned income from disability.

-costs of surgerys are rising.

-the probability of becoming disabled for 90 days or more before age 65 is 21% for a male age 22 and 33% for women age 22.

risk of unemployment

unemployment can result from business cycle downswings, technological and structural changes in the economy, seasonal factors, and imperfections in the labor market. 

-workers lose their employee benefits, and if duration of unemployment extends for a long period of time, past savinds may become depleted.

property risks

the risk of having property damaged or lost from numerous cases.

**can be damaged because of fire/flood/etc.

2 major types of loss:

1) direct loss: defined as financial that results from the physical damage, destruction or theft of the property. ex: if you own a home that is directly damage from fire, the damge that is caused is a direct loss

2) Indirect or Consequential loss: a financial loss that results immediately from the occurence of a direct physical damage or theft loss. 

ex: because of fire damage you may have to rent a home while it is getting fixed/eat out at restaurants

liability risks

another important type of pure risk that most people face. you can be held legally liable if you do something that results in bodily injury or property damage to someone else. 

ex: homeowners can be held legally liable for injury of someone else on their property, dog owners can be held legally liable if their dog bites someone.



Liability Risks are important for 3 main reasons:



1) there is NO MAXIMUM upper limit with respect to the amount of the loss. you can be sued for any amount. 

--however if you own property, there is a maximum limit on the loss. ex: the car you have an accident in has an actual cash value of $20,000, you can only be sued for $20,000.

2) A lien can be placed on your income and financial assets to satisfy a legal judgement.

--your property or income can be taken away to pay off what you owe.

3) legal defense costs can be enormous. 

--if you have no liablity insurance, the cost of hiring an attorney to defend you can be staggering. 

Commercial Risks

business firms face a wide variety of pure risks that can financially cripple or bankrupt a firm if a loss occurs. 

1) property risks--any type of property that could be damaged such a office equipment to important documents

2) liability risks--lawsuits range from small claims to multimillion dollar demands. sued for defective products that harm/injure somebody,discrimination,pollution,violation of copyrights

3) loss of business income--firm may be shut down from fire damage for several months, expenses may still continue.

4) other risks--crime exposures such as robbery, human resourcesexposures such as job related injuries and death or disability of key employees, foreign loss exposures such as acts of terrorism or kidnapping of employees, intagible property exposures such as demage to market reputation and public image of the company, government exposures such as laws that are passed that have financial impact on the company.

What are the the 3 major burdens on society that risk causes

1) the size of an emergency fund must be increased: in the absence of insurance, business firms would have to increase theire emergency funds in case there is an unexpected loss. 

2) society is deprived of certain goods and services: because of risk of liability lawsuits. ex: a lot more companies back in the day manufactured childrens vaccines but because of lawsuits only a few companies do so today. same goes for companies that manufacture football helmets and silicone breast implants.

3) worry and fear are present: flying on an airplane during turbulence, trying to pass a class to graduatem etc. 


5 Techniques for managing risk 

1) avoidance: ex: you can avoid the risk of being mugged in a high crime rate area by staying out of the are.

2) Loss Control: consists of certain activities that reduce frequency or severity of losses. Has 2 major objectives: **Loss prevention (auto accidents can be reduced if motorists take a safe driving course) **Loss reduction (can install a sprinkler system so that in case of fire the damage is not as severe)

3) Retention: an individual or a business firm retains part of all of the financial consequences. can be ACTIVE or PASSIVE. Active (ex: a motorist wants to retain the risk of collision loss and purchases an auto insurance policy with a $500 deductible or higher) Passive (certain risks may be unknowingly retained because of ignorance, indifference or laziness. ex: many workers are not insured against risk of disability). Self insurance is a special form of planned retention by which part or all of a given loss exposure is retained by the firm. Losses are funded and paid for by the firm. Risk retention is used for high frequency and low severity cases. 

4) Noninsurance transfers:the risk is transferred to a party other than an insurance company.

5) insurance: most practical method for handling major risks. Risk transfer--a pure risk is transferred to the insurer. Pooling technique is used to spread the losses of the few over the entire group so that average loss is substituted for actual loss. Law of large numbers reduces risk because an insurer can predict future loss experience with greater accuracy. 

Risk can be transferred by 3 methods for noninsurance transfers:

1) Transfer of Risk by contracts: unwanted risks can be transferred by contracts. ex: risk of defective tv set can be transferred to the retailer by purchasing a service contract. risk can be transferred by a hold-harmless clause (ex: a manufacturer of  scaffolds inserts the this clause into a contract with a retailer; the retailer agrees to hold the manufacturer HARMLESS if a scaffold collapses and someone is injured.

2) Hedging Price Risks: Hedging is a technique for transferring the risk of unfavorable price flucuations to a speculator by purchasing and selling futures contracts on an organzied exchange. 

3) Incorporation of a Business Firm:if a firm is a sole proprietorship the owner's personal assets can be attached by creditors for satisfaction of debts. If a firm incorporates personal assets cannot be attached by creditorsfor payment of the firms debts. So liability of the stockholders is limited and the risk of the firm having insufficient assets to pay business debts is shifted to the creditors. 

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