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BU353 Midterm Review.docx

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Richard Reiner

Midterm Review Application Questions: Risk pooling, risk control spending, deductible selection 1. Steps in the Risk Management Process a) Identify Potential Losses b) Evaluate Potential Losses c) Select the Appropriate Technique for Treating Loss Exposures d) Implement and Administer the Plan e) Monitor 2. Types of Losses from Pure Risks a) Direct Losses - damage to assets, injury/illness to employees, liability claims and defence costs b) Indirect Losses - loss of normal profit (net cash flow), higher costs of funds & foregone investment, bankruptcy costs 3. Distinguish between Risk Control and Risk Financing a) Risk/Loss Control involves decisions to invest or forego resources to reduce expected losses - loss prevention – reduces the frequency of loss (an extreme example is loss avoidance) - loss reduction – reduces the severity of the loss (pre or post loss) b) Risk/Loss Financing refers to decisions about how to pay for losses if they occur - retain costs of losses (through reserves, issuing debt/equity or obtaining loans) - transfer cost of losses (through insurance, hedging such as futures/forwards/options/swaps) 4. Methods of Risk Identification -checklists, financial statements, discussions with managers, employee surveys, insurance professionals, risk management consultants 5. Qualitative Analysis of Risk Control Strategies - compare the benefits to the costs of the loss control strategy - trade-off: cost of increased precautions vs. benefit of reduced expected losses - large losses can cause indirect losses: lost profits, clean-up costs, cost of raising capital etc. - directing resources towards safety measures that are the most cost-effective saves lives and reduces the total cost of risk 6. Define the following: i) Indemnity – an insured is fully compensated for the actual cash value (ACV) of what they lost up to the limit of the policy - an insurance policy cannot pay more than the financial loss suffered ii) moral hazard – insurance changes a person’s incentive to take precautions; a party will have a tendency to take risks knowing that the potential costs of taking risk will be borne by others iii) adverse selection – when policyholders are better informed about expected claim costs than insurers; consumers have different expected losses but the insurer is unable to distinguish between the two types of consumers or charge different premiums iv) insurable interest – the policy-holder must suffer adverse financial consequences if the event causing the insurance company to pay a claim occurs v) valued policies – establishes the amount that the insurer pays at the time the contract is initiated without regard to the amount of the loss caused by the insured event 7. Risk Retention and Firm Characteristics a) Ownership structure - private firms retain less losses b) Firm tolerance to risk - firms whose management are more risk averse retain less risk c) Firm size - small firms retain less losses d) Correlation of losses - retain losses that are least correlated e) Investment opportunity - purchase insurance if many future investment opportunities exist 8. The role of OSFI and FSCO a) OFSI – Federal Overseer – Office of the Superintendent of Financial Institutions - regulates and monitors Federally chartered and foreign insurance companies - supervises institutions to determine whether they are in sound financial condition
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