Risk Management and Insurance PDF

Risk Management and Insurance: Definition of Risk ​ Risk - uncertainty concerning the occurrence of a loss ○​ If the probability of an event occurring is either zero or one, there is no risk since there is no uncertainty ​ Loss Exposure - any situation or circumstan...

Risk Management and Insurance: Definition of Risk ​ Risk - uncertainty concerning the occurrence of a loss ○​ If the probability of an event occurring is either zero or one, there is no risk since there is no uncertainty ​ Loss Exposure - any situation or circumstance in which a loss is possible, regardless of whether a loss occurs Categories of Risk ​ Pure Risk - is one in which there are only the possibilities or loss of no loss ○​ Premature death ​ Speculative Risk - is one in which both profit or loss are possible ○​ Investments or business ventures ​ Static Risk - from unchanging society ○​ Ex: Pure static risk could be tornado, lightning wildfires ​ Dynamic Risk - produced by changes in society ○​ Ex: increasingly complex technology ​ Ex: Pandemic ​ Ex: changes in attitude due to legislation ​ Fundamental Risk - affects the entire economy or large number of persons or groups within the economy ○​ Ex: Hurricane Helena or wildfires in California ​ Particular Risk - affects only the individual and not the entire community ○​ Ex: Car theft, bank robberies, dwelling fires ​ Objective Risk - relative variation of actual loss from expected loss ○​ Measurable and statistical ○​ If a loss in certain to occur, objective is zero ​ Subjective Risk - uncertainty based on a person’s mental condition or state of mind ○​ Ex: two persons in the same situation may have different perceptions of risk ○​ Difficult to measure Classifications of Risk ​ Enterprise Risk - encompasses all major risks faced by a business firm ○​ Which include: pure risk, speculative risk, strategic risk, operational risk, and financial risk ​ Financial risk refers to the uncertainty or loss bec of adverse changes in commodity prices, interest rates, foreign exchange rates, and the value of money  ○​ Enterprise Risk Management (ERM) - combines into a single unified treatment program all major risk faced by the firm ​ Pure risk, speculative risk, strategic risk, operational risk, financial risk Sources of Pure Risk → possibility of loss or no loss ​ Property Risk ○​ Business property ○​ Individually owned property ○​ Property owned by others ​ Liability Risk ○​ Business Liability Exposure (injury from a product) ○​ Liability exposure experienced by individuals ○​ Liability exposures is big in corporate finance ​ Personal Risk - Life, Health, & Loss of Income ○​ Premature death ○​ Poor health - medical expenses ○​ Disability - loss of earned income and medical expenses ○​ Unemployment - depletion of financial assets Major Personal Risk and Commercial Risk ​ Personal risks - involve the possibilities of a loss or reduction in income, extra expenses or depletion of financial assets ○​ Ex: Premature death of family head ○​ Ex: Insufficient income during retirement ​ Most workers are not saving enough for a comfortable retirement ​ Put away 15% of pre-tax income ○​ Poor health (catastrophic medical bills and loss of earned income) ○​ Involuntary unemployment ​ Property risk - involve the possibility of losses associated with the destruction or theft of property ○​ Physical damage to home and personal property from fire, tornado, hurricane, vandalism, or other causes Direct loss vs. indirect loss: ○​ Direct loss - is a financial loss that results from the physical damage, destruction or theft of the property ○​ Indirect loss - results indirectly from the occurrence of a direct physical damage or theft loss, such as the additional living expenses after a fire to a home ​ Liability Risk - involve the possibility of being held liable for bodily injury or property damage to someone else ○​ No maximum upper limit with respect to the amount of the loss ○​ A lien can be placed in your income and financial assets ○​ Defense costs can be enormous  ○​ Ex: Car insurance Commercial Risks - firms face a variety of pure risks that can have serious financial consequences if a loss occurs ​ Property risks - such as damage to buildings, furniture and office equipment ​ Liability risks - suits for defective products, pollution of the environment and sexual harassment ​ Loss of business income - when the firm must shut down for some time after a physical damage loss ​ Other risks - to firms include crime exposures, human resource exposures, foreign loss exposures, intangible property exposures, and government exposures Chance of Loss - the probability that an event will occur ​ Objective probability - refers to the long-run relative frequency of an event assuming an infinite number of observations and no change in the underlying conditions ​ Subjective probability - is the individual's personal estimate of the chance of loss ○​ A person's perception of the chance of loss may differ from the objective probability Hazards vs. Perils: ​ Peril - specific contingency that may cause loss ○​ Ex: fires in Cali ​ Hazard - a condition that increases the chance of loss due to a peril ○​ Ex: the dry brush that has not been cleared Perils: ​ Natural Perils - generally insurable ○​ Windstorms ○​ Lightning ○​ Heart attack ​ Natural Perils - generally difficult to insure ○​ Flood ○​ Earthquake ○​ Epidemic ○​ Volcanic eruption ○​ Mold ​ Human Perils - generally insurable ○​ Theft ○​ Vandalism ○​ Negligence ○​ fire/smoke ​ Human Perils - generally difficult to insure ○​ War  ○​ Radioactive materials ○​ Civil unrest Hazards: - a condition that increase the chance of loss ​ Physical Hazard - a physical condition that increases the chance of loss ○​ Ex: icy roads, defective wiring ​ Moral Hazards - is dishonesty or character defects in an individual, that increases the chance of loss ○​ Ex: faking accidents, inflating claim amounts ​ Morale - Hazards - carelessness or indifference to a loss, which increases the frequency or severity of a loss ○​ Ex: leaving keys in an unlocked car ​ The Peril here would the theft Burden of Risk on Society: ​ The presence of risk results in three major burdens on society ○​ The absence of insurance, individuals would have to maintain large emergency funds ○​ The risk of liability lawsuits may discourage innovation, depriving society of certain goods and services ○​ Risk causes worry and fear Techniques for Managing Risk: 1.​ Avoidance - a drug manufacturer can avoid producing a dangerous drug that may result in a lawsuit 2.​ Loss Control - certain activities are undertaken to reduce both the frequency and severity of losses a.​ Loss prevention - refers to activities to reduce the frequency of losses b.​ Loss reduction - refers to activities to reduce the severity of losses i.​ Ex: tall buildings in Cali sway so they can withstand earthquakes ii.​ Duplication iii.​ Separation iv.​ Diversification 3.​ Retention - a individual or firm retains all or part of a given risk a.​ Active retention - that an individual is consciously aware of the risk and deliberately plans to retain all or part of it i.​ Ex: an individual is responsible for the $500 deductible on an auto policy (first $500 of physical damage comes out of pocket) b.​ Passive retention - risks may be unknowingly retained bec of ignorance, indifference, or laziness c.​ Self insurance - a special form of planned retention by which part or all of a given loss exposure is retained by the firm 4.​ Noninsurance transfers - A risk may be transferred to another party  a.​ Transfers of risk by contract such as through a service contract or a hold-harmless agreement in a contract i.​ The risk of defective flat screen tv can be shifted to the retailer by the purchase of a survive contract by which the retailer is responsible for all repairs after the warranty expires b.​ Hedging - a technique for transferring the risk of unfavorable price fluctuations to a speculator by purchasing and selling future contracts on an organized exchange c.​ Incorporation - of a business firm transfers risk to the creditors having insufficient assets to pay business debts 5.​ Insurance a.​ Risk transfer is used because a pure risk is transferred to the insurer i.​ Ex: an automobile insurance policy can be purchases covering the negligent operations of an automobile b.​ The pooling technique is used to spread the losses of the few over the entire group c.​ The risk may be reduced by application of the law of large numbers