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risk management 4000 exam 1
Undergraduate 2

Additional Insurance Flashcards




risk management

a process that identifies loss exposures faced by an organization and selects the most appropriate techniques for treating such exposures

**new forms of risk management are constantly emerging that consider both pure and speculative loss exposures. 

what are the 2 objectives of risk management?

1) pre-loss objectives: important objectives before a loss occurs include economy, reduction of anxiety, and meeting legal obligations. First, the firm should prepare for potential losses in the most economical way. Second objective is the reduction of anxiety. certain loss exposures such as defective product causing a major lawsuit can cause greater anxiety than a small fire. Final objective is to meet any legal obligations--

Companies have to follow govt regulations. 


2) post-loss objectives: certain objectives AFTER a loss occurs.  These objectives include survival, continued operation, stability of earnings, continued growth, and social responsibility. 

What are the four steps in the risk management process: 

1) identify loss exposures

2) measure and analyze the loss exposures

3) select the appropriate combination of techniques for treating loss exposures

4) implement and monitor the risk management program. 

Identifying Loss exposures:

--involves an analysis of ALL potential losses. 

1. property loss exposures

2. liability loss exposures income loss exposures

4. human resources loss exposures

5. crime exposures

6. employee benefit loss exposures

7. foreign loss exposures

8. intangible property loss exposures

9. failure to comply with government laws and regulations. 


Measure and Analyze the Loss exposures:

*it is important to measure and quantify the loss exposures in order to manage them properly. 

*this step requires an estimation of the frequency and severity of the loss.


Loss frequency: refers to the probable number of losses that may occur during some given time period. 

Loss severity: refers to how severe the losses are that may occur

**once they are ranked in an order of importance then certain risk management techniques can be applied. 

**severity of a loss is MORE important then frequency. 



Analyzing risks

Maximum probable loss vs probably maximum loss


maximum possible loss: is the worst loss that could happen to the firm during its lifetime.

Probable maximum loss: the worst loss that is likely to happen

Select the appropriate combination of techniques for treating the loss exposures

* these techniques can be classified broadly as either risk control or risk financing. 

risk control:refers to techniques that reduce the frequency or severity of the losses. 

risk financing: refers to techniques that provide for the funding of losses. 


risk control:

3 major risk control techniques


1) Avoidance

-major advantage of this technique is that the chance of loss is reduced to zero if the loss exposure is never acquired. 

--two major disadvantages. first, the firm may not be able to avoid all losses. ex: cannot avoid the premature death of a key executive. Second, it may not be practicle to avoid theexposure. ex: if you are a paint company, you cannot avoid making paint.


2) Loss Prevention: trying to reduce the frequency of a loss. ex: to reduce accidents caused by the elderly, implement screening tests to make sure they are still eligible to drive.


3) Loss Reduction: refers to reducing the severity of a loss. ex: installing a sprinkler system to reduce damage by a fire.


Risk Financing:

3 major techniques


1) Retention: means that a firm retains all or part of the losses that result from a loss.

can be active or passive.

2) Non-insurance transfers

3) insurance

Retention levels

determining the dollar amount of losses that a firm will retain.

2 methods:

1) a corporation can determine the maximum uninsured loss it can absorb without adversely affecting the company's earnings. (rule is that max retention should be set at 5% of the company's annual earnings)

2) a company can determine the max ret as a % of the firm's net working capital-between 1 and 5%.

If Retention is used, what are 4 methods that firms use to pay for losses?

1) Current net income: the firm can treat the losses as expenses for the year and pay for it out of its current net income.

2) Unfunded reserve: is a bookkeeping account that is charged with actual or expecteed losses from a given exposure.

3) Funded Reserve: the setting aside of liquid funds to pay losses. however, most companies do not do this because the money set aside in the reserve could have better usage for running the company.

4) credit line: can establish a credit line with the bank and borrowed funds may be usedto pay losses as they occur. interest is payed on the loan.

Captive insurer

*losses can be paid by a captive insurer. 

--it is an insurer owned by a parent firm for the purpose of insuring the parent firm's loss exposures. 


single parent captive (pure captive) : is an insurer only owned by ONE parent company. 


Association or group captive: is an insurer owned by several parents. 

reasons captive insurers form:

1)Difficulty in obtaining insurance

2) Favorable regulatory environment

3) Lower costs

4) Easier access to reinsurer

5) Formation of a profit center

Income Tax Treatment of Captives:

the IRS earlier took a position that premiums paid to a single parent captive are NOT income-tax deductible. 

Now, they MAY BE tax deductible but only if certain requirements are met.


risk retention groups
is a group captive that can write any type of liability coverage except employers liabilty, workers compensation, and personal lines. 
advantages and disadvantages of retention:


1) save on loss costs

2) save on expenses

3) encourage loss prevention

4) increase cash flow



1) possible higher losses

2) possible higher expenses

3) possible higher taxes

Non-insurance transfers:

in which a pure risk and its potential financial consequence are transferred to a third party. 

ex: contracts, leases, hold-harmless agreements

advantages and disadvantages of non-insurance transfers


  • the risk manager can transfer some potential losses that are not commercially insurable
  • noninsurance transfers often cost less than insurance
  • the potential loss may be shifted to someone  who is in a better position to exercise loss control
  • the transfer of potential loss may fail because the contract language is so ambiguous.
  • if the party to whom the potential loss is transferred is unable to pay the loss , the firm is still responsible for the claim.
  • an insurer may not give credit for transfers an insurance costs may not always be reduced.

*commercial insurance is appropriate for loss exposures that have a low probability of loss but the severity of loss is high. 


**must pay attention to :

  • selection of insurance coverages
  • selection of an insurer
  • negotiation of terms
  • dissemination of information concerning insurance coverages
  • periodic review of the program

 is the amount of expenses that must be paid out of pocket before an insurer will pay any expenses.

It is normally quoted as a fixed quantity and is a part of most policies covering losses to the policy holder. The deductible must be paid by the insured, before the benefits of the policy can apply. 

Typically, a general rule is: the higher the deductible, the lower the premium, and vice versa.

excess insurance

a plan in which the insurer does NOT participate in theloss until the actual loss exceeds the amount a firm has decided to retain. 

ex: a firm takes the initiative to retain against a fire  by setting a $1,000,000 limit as a probably maximum loss but if a total loss of $25 mill occurs then the insurer would pay $24 mill of it. 

which technique should be used?

**look at the matrix for various loss exposures.

 1) low frequency and low severity 

ex: office supplies theft (use retention)

2) high frequency, low severity

ex: minor car accidents, shoplifting, food spoilage (use Loss prevention, and retention)

3) Low frequency, high severity

ex: floods, earthquakes (use insurance)

4) high frequency, high severity

ex: truck driver has many DUIs, it would be best to avoid him by firing him/not hiring him (use avoidance)

hard vs. soft market conditions

hard market: profitability is declining, industry is experiencing underwriting losses. as a result underwriting standards tighten, premiums increase, and insurance becomes more expensive. might retain more loss exposures and cut back on buying insurance.


soft market: profitability is improving, premiums decline, insurance easier to obtain. buy more insurance and retain less loss exposures.

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