Chapter 1

Words associated with risk? Loss, Uncertainty, gain,chance.

Components of the cost of risk: expenses to finance loss, unreimbursed losses, costs of loss reduction
techniques, opportunity cost.
Four ways to categorize risk
1- Pure VS Speculative
- Chance of loss or neutral outcome only Chance of loss, gain or neutral outcome
- Losses are unexpected Risk taken voluntarily
- Most are insurable risk Not insurable
- No possibility of gain, There’s uncertainty about an event that
only the potential for loss could produce either a profit or loss
Example of PURE risk: damage property by fire, flood land for, purchasing. Prospect of premature death
caused by accident or illness
Example of SPECULATIVE risk: there is uncertainty about an event that could produce either profit or loss. A
firm purchasing land for development is making a decision that entails speculative risk. However, if after
the purchase it discovers that the land contains a latent pollution problem, the firm would then face a new
pure risk.
The common source of PURE risk, which include property risks, liability risks, life, health, and loss of
income risks.
- Property risk: All businesses and individuals that own, rent, or use property are exposed to the
risk that the property may be damaged, destroyed, or stolen. For example, lightning may strike
a building, causing a fire that destroys the structure and the inventory, supplies, and equipment
inside. If property damage is extensive, a business may be forced to shut down temporarily,
thereby incurring a loss of income in addition to the expense of replacing the damaged
property.
- Liability risk: Liability judgments may result in payments made to compensate injured parties as
well as to punish those responsible for the injuries, with multimillion dollar awards no longer
rare. Even when an individual is eventually absolved of liability, the expenses involved in
defending a case often prove to be substantial. Consequently, both individuals and businesses
must be careful to identify all sources of liability risk that may affect them and then make
suitable arrangements for dealing with such exposures to loss. Another common liability risk
arises from automobile use. Drivers involved in accidents may be liable if their actions are
judged to be the cause of harm to someone else or to another person’s property. For example,
if customers are injured by a firm’s products or through the actions of a company’s employees,
the business may be held responsible for several million dollars worth of losses.
- Life, health, and loss of income risks: The possibility of the untimely death of star salesperson
Ann Costello exposes her employer to potential loss if a replacement with the same skills and
experience is not readily available. Even if Ann could be easily replaced, in many cases
employee deaths are disruptive for other workers and may result in temporarily reduced
productivity. This phenomenon is especially true if the death is due to job-related conditions.
Persons who become ill or who are injured in accidents will incur expenses for medical
treatment, and the cost of such treatment is becoming increasingly expensive.
- Financial risks: can impact on a firm’s earnings. Examples of these financial risks include credit
risk, foreign exchange risk, commodity risk, and interest rate risk.
 2- Fundamental VS Particular
- Affect large n° of people or society at once Affect individual,family,individual busine
- Not 100% insurable Generally insurable
- Government usually finance or partially finance
Losses
Example of FUNDAMENTAL risk: disaster such as hurricanes, earthquakes, and major terrorist attacks, as
well as economic phenomena like inflation, recession, and changes in interest rates.
Example of PARTICULAR risk: auto accidents, building fires, worker injures.

3- Statistic VS Dynamic
- Generally doesn’t change over time Produced bc of changes in society
- Often result from nature Often not insurable in the standard
- Can be part of a stable economy insurance market
Example of STATISTIC risk: random events as lightning, windstorm, death.
Example of DYMANIC risk: urban unrest, increasingly complex technology, changing attitudes of legislatures
and courts about a variety of issues.
4- Subjective VS Objective
- Attitudes towards risk; what you think about the risk Measurable risk
- Everyone is different Probable variation of actual from
- Not easily measurement average outcomes
Example of SUBJECTIVE risk: one person may look at a situation and conclude that it is low risk, while
another may look at an identical situation and conclude that it is high risk.
Example of OBJECTIVE risk: is the same in both cases, but neither a person may be able to determine the
true, objective risk.

Risk aversion technical term for disliking risk. A person who’s risk averse prefers certainty to uncertainty.
Measurement of risk
- Chance of loss, chance of occurrence of a single event. Suppose that 1000 buildings are considered
to be susceptible to the risk of loss due to a tornado. If past experience indicates that 20 of these
buildings are likely to be damaged by a tornado, then the chance of loss is : (20/1000)x 100= 2%
- Expected loss,Example: 50% chance of no loss, 50% chance chance of a $10.000 loss
Expected loss. (0.5 x $0 + 0.5 x $10000), result will be very close to $5000, so 5000 would be the
expected loss.
- Degree of risk: is the range of variability around the expected losses.
- Objective Risk = Probable variation of actual from expected losses/Expected Losses
- Consider the possibility of fire losses to buildings in Acworth and Branson. There are 100,000
buildings in each city and, on average, each city has 100 fire losses per year. By looking at historical
data, statisticians are able to estimate that the actual number of fire losses in Acworth during the
next year will very likely range from 95 to 105. In Branson, however, the range probably will be
greater, with at least 80 fire losses expected and possibly as many as 120. The degree of risk for
each city is computed as follows:
RiskAcworth = (105 – 95) / 100 = 10 percent
RiskBranson = (120 – 80) / 100 = 40 percent
People who make risky financial decisions are risk averse. For example, the only reason people invest in
high risk stock is bc they are “compensated” for taking that risk through higher expected returns. No smart
investor would choose a high risk stock over a low risk stock if both offered the same expected return.
Peril  use to describe a specific contingency that may cause loss. For example, one of the perils that can
cause loss to an automobile is collision.
Hazard  nything that increases the frequency or severity of loss
Physical Hazard:
- a condition stemming from the environment or material characteristics of an object that increases
the frequency or severity of loss
- Icy roads increase the frequency of a collision
- Collision is the peril
- Icy roads are the physical hazard
Moral Hazard
- Steams from an insured’s mental attitude or immoral character
- Increases the frequency or severity of loss bc a person causes or fakes a loss in order to collect
insurance
- Results in insurance fraud
Morale Hazard
- Steams from an insured’s mental attitude or carelessness
- Increases the frequency or severity of loss bc a person is less careful to control loss knowing they
have insurance

Traditional Risk Management Vs Enterprise Risk Management

Traditional Risk Management
- Focuses only on “pure risk”, only a chance of loss
- Death, auto accident, damage to property, liability
Enterprise Risk Management
- Also know as INTEGRATED risk management
- Considers all aspects and types of risk in the risk management decision
- Another term is risk optimization
Frequency: how often smth is happening
4 steps in the risk management process
1) Identify your risk
2) Evaluate the risk
3) Select the risk treatment method or methods
4) Implement and review decisions

Low frequency/high severity = insurance (transfer)

High frequency/low severity= retained
Chapter 2
Risk identification Methods (6) is the most important element of the risk management process.
1- Loss exposures
Is potential loss that may be associated with a specific type of risk. Can be categorized as to
whether they result from: - property, liability, life, health, loss of income.
The user asks “is this a potential source of loss to me or my firm?”. Typically most useful when
designed for your specific industry, construction, retail, manufacturing, healthcare.

2- Financial statement Analysis

Balance sheet and budgets
Can help identify property values.
Weakness: - book value might not be the same as replacement cost
-doesn’t show where property is located and may not separate property values
Income statement and statement of cash flows
Helps to identify sources of cash for paying for losses and helps identify liquidity of assets.

3- Flow chart
Using this, ask: what could disrupt the flow of work?
Examples: manufacturing, online retail/delivery, transportation, service. Can identify potential
bottlenecks.

4- Contract Analysis
Contracts often specify who is liable if a loss occurs. Consider liability for Commercial
Transportation.
Who is liable for damage to property from an accident? The seller? The buyer? The trucking
company?

5- Onsite Inspection
Benefit are pretty obvious.
Weakness: what do people do when they are being watched? Don’t always do inspections when
most losses happen.

6- Statistical Analysis of Past Losses

Probably they way most losses are identified and later analyzed.
Often use Risk Management Information Systems to collect and analyze loss data.
Potential weaknesses: - just because a loss hasn’t happened before, doesn’t mean it wont happen!
-history doesn’t always repeat itself
-must account for changing externalities
Risk management Information System
Are not just used to collect and analyze loss data; other uses:
- Claims management (especially large, self-insurance company)
- Safety monitoring
- Creation of better risk management tools by analyzing accident causes
The following are examples of the successful use of RMIS by risk managers:
Reporting: Creation of reports that summarize loss payments and estimates of future losses. Accounting
and finance departments use these reports in preparing the organization’s financial statements.
Examination of the causes of accidents: by identifying the reasons for accidents, risk managers can
determine where safety and loss prevention expenditures would be most helpful. A large number of
employees or customers slipping and falling in a certain area may warrant a review of cleanup procedures
or a study of the costs for installing special carpet.
Review of claims adjustment process: risk managers use RMIS to evaluate the performance of claims
adjusters by comparing actual results to standards. Typical evaluation areas are promptness of initial
contact, case settlement time, amount paid for type of injury, and accuracy of the adjuster’s case value
estimate.
Evaluate Frequency and Severity
Frequency: is most often expressed as a probability in risk management
Severity: size of loss or cost of loss
How big is the loss? How big could it get? Fairly easy to estimate with property exposures, not so much
with other exposures.
Example: group of 30 men (21-30)
2 accidents over 5 years
Averall cost $2000
20 accident /5 years= 4 accident per year
4 accident/30 men= 0.13 or 13%
20 accidents/30 men= 67% chance in a year
0.67/5 years=13%
Inherent Risk or Residual Risk?
Residual: the frequency and severity of risk left over after risk management actions are taken
Inherent: the frequency and severity of risk before any actions are taken to manage the risk
Risk mapping or Profiling
Inputting the frequency and severity of each risk a business faces into a matrix array.
Also indicates whether or not the risk is covered by insurance. Allows businesses to identify the risks that
are most likely to seriously affect their ability to achieve their goals.
Central tendency measures: Mean, Expected Value ( probability of each outcome times size of outcome),
Median, Mode.

Measures of variation or dispersion: Standard deviation ( a number that measures how close a group of
individual measurements is to its expected value) and variance (the mean of the squared deviations from
the mean), Coefficient of variation (the standard deviation expressed as a percentage mean).
Probability
Maximum possible loss
The maximum severity a loss can be, Total loss for property, Very difficult to determine liability and health
insurance.
Maximum probable loss
Maximum loss with different levels of confidence, can be determined with a value at risk analysis.
Value at risk analysis
Constructs probability distributions of the risks alone and in various combinations, to obtain estimates of
the risk of loss at various probability levels.
Great for enterprise risk management bc it considers correlation between different categories of risk.
Law of large numbers
The law of large numbers, which can be derived and proven mathematically, states that as the number of
exposure units (in other words, persons or objects exposed to risk) increases, the more likely it becomes
that actual loss experience will equal probable loss experience. Hence, the degree of objective risk
diminishes as the number of exposure units increases.
The more risks in the loss pool, the more predictable the outcomes.
Objective risk= range /expected
Chapter 3
Non insurance Risk Management Techniques
1- Risk Avoidance
Conscious decision not to expose oneself or one-s firm to a particular risk of loss. Decrease one’s chance of
loss to zero. Some risks are just too <risky> so they should be avoided. For example, the eccentric chief
executive of a multibillion dollar firm may decide not to fly to avoid the risk of dying in an airplane crash.
2- Loss Control
Taking conscience steps to reduce the frequency or severity of losses that might occur. Heinrich’s Domino
Theory became famous in 1959. He recommends to remove the third domino to reduce the chance of
injury.
Types of loss control
- Severity// loss reduction : Accepts that some losses will occur but attempts to reduce the size of
loss.
Two special form of severity reduction: 1. Separation 2. Duplication
Separation: Separation involves the reduction of the maximum probable loss associated with some kinds of
risks. For example, a firm may disperse work operations in such a way that an explosion or other
catastrophe will not injure more than a limited number of persons. Through such separation, the firm is
reducing the likely severity of overall firm losses by reducing the size of the exposure in any one location.
- Timing/ consider reputation risks: 1. Pre-loss 2. Concurrent loss 3. Post-loss
Potential loss of Loss Control: purchase and installation, maintenance and other ongoing expense,
and in a firm, loss control techniques are only as good as management-s commitment to them.
3- Risk Retention
- Planned divided into Funded and Unfunded
- Unplanned / Unfunded
Planned retention involves a conscious and deliberate assumption of recognized risk. Sometimes
planned retention occurs because it is the most convenient risk treatment technique or because there
are simply no alternatives available short of ceasing operations.
Unplanned, when a firm or individual does not recognize that a risk exists and unwittingly believes that
no loss could occur.
If a loss occurs, an individual or firm will pay for it out of whatever funds are available at the time.
Retention can be planned or unplanned, and losses that occur can either be funded or unfunded in
advance.
Unfunded retention: absorbing the expense of losses as they occur, rather than making any special advance
arrangements to pay for them.
Funded retention: pre-loss arrangement to ensure that money is readily available to pay for losses that
occur.
Funded risk retention methods:
1.Credit 2.Reserve Funds 3.Self-insurance
4. Captive insurers, which combines the technique of risk retention and risk transfer

4. Risk transfer
Hold-Harmless Agreements:Purpose
Specifies the party that will be responsible for paying for a loss. For example, when a landlord makes a
tenant sign a “hold-harmeless” agreement making the tenant promise to pay for injures to guests.
Hold=harmeless types
1. Limited. Each party is responsible for specific losses
2. Intermediate. One part agrees to pay for losses when both are partially at
fault
3. Broad. One party agrees to be responsible for all losses, regardless of fault
Incorporation: another way for a business to transfer is to incorporate. In this way, the most that an
incorporated firm can ever lose is the total amount of its assets.
Diversification: process of spreading risk through a firm’s involvement in various businesses or through the
location of its operations in different geographic areas.
Hedging: a third party to which the risk of price fluctuations is transferred during hedging.
Surety bonds purpose: a risk transfer mechanism used primarily for contractual risk transfer. Provides
monetary compensation if the bonded party fails to perform.
Surety bonds: parties
Principal: agrees to perform certain acts
Obligee: party who id reimbursed if principal fails to perform
Surety: agrees to answer for the debt, default or obligation of another
Surety bonds types:
- Contract bonds
- License and permit bonds: guarantees the bonded person will comply with regulations
- Public official ponds: guarantees that public officials will faithfully perform their duties
- Judicial bond: guarantees bonded person will fulfill legal obligations
- Federal surety bonds: guarantees compliance with federal standards
Surety Contract Bonds
Bid Bond: guarantees winner of bid perform
Performance Bond: owner is guaranteed that work will be completed according to specifications
Payment Bond: guarantees bills for labor and materials used in the building will paid by the contractors
when bills are due
Maintenance Bond: guarantees that poor workmanship bu the principal will be corrected or defective
materials will be replaced

Other risk transfer (non insurance) methods

Incorporation
Diversification, whenever a business try to spread out the risk
Hedging

Enterprise risk management

- taking a holistic view of risk
- requires consideration of the entire portfolio of risks
- New position, chief risk officer, reflect s realization of
- Can also be called risk optimization

Exam review
Chapter 1
Type of risk easily measured  objective
Can be part of stable equilibrium bc they ae predictable statistic risk
Investing in stock market would best fit speculative risk
Types of risk cannot typically be insured in the standard markerdynamic risk s
Not adding a new desk to your restaurant because of added riskopportunity cost
The chance of loss of neutral incomePure risk
Risk of losing money un the stock market best describes which type of riskFinancial risk
Main focus is primarily pure risk traditional risk management
Affect large number of people or society at once fundamental risk
Being careless with your phone bc you know its insuredMorale hazard
The reason these risk are typically not insurable bc they are taken voluntarily speculative risk
A car accident that was your fault which result in back injuresLiability
War best falls into which category riskfundamental risk
All of the following are examples of peril exceptSmoking in a forest
Also called diversifiable risk bc they happen to one person or a few at times particular risk
What components of risk would installing safety features in vehiclecost of loss reduction technique
Is not an example of hazardcollision
chapter 2
The fewer risk in the loss pool, the more predictable the outcomeslaw of large number
Can help identify typical items of property and activities in a specific industryloss exposure checklist
Not a measure of central tendencyprobability
coefficient of vaiation= standard deviation/ mean
Guarantees the winner bid will performbid bond
Conscious decision not to expose yourself to a particular lossavoidance
An airbag in the vcar is a good example of which of the following risk treatments technique loss
reduction
Chance of loss to zero avoidance
Making two copies of keysduplication
is a judicial bond Bail bond