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FIN 3440- Midterm Exam Guide - Comprehensive Notes for the exam ( 83 pages long!)


Department
Finance
Course Code
FIN 3440
Professor
J.Boyd
Study Guide
Midterm

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LSU
FIN 3440
MIDTERM EXAM
STUDY GUIDE

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Finance 3440; Date: Spring 2013
RISK MANAGEMENT OVERVIEW AND PROCESS
We can define risk in our course as the possibility of an unfavorable variation from a desired
result. An individual, for example, hopes that his house will not burn down, or that he will not
die prematurely. The insurer hires professionals (actuaries) to predict losses and to develop
insurance pricing (premiums) so that the company is profitable; the insurer hopes that actual
losses will not vary unfavorably from forecasted losses.
The concept of expected value that you learned in statistics is also useful in assessing risk for our
purposes because it captures the probability and severity of a loss in the calculation. For
example, if the potential severity of a loss $1,000,000 but its probability of occurrence is 1%, the
expected value of the loss is only $10,000. Conversely, if the potential severity were quite low,
say $1, and the probability of loss were high at 95%, the expected value of the loss would be
quite low at 95 cents. We will discover later in the lecture that probability and severity of loss are
useful concepts to develop a risk management framework and to determine when the use of
insurance for risk management is most appropriate.
BURDEN OF RISK
Some risks involve possibility of gain/loss (investment in stocks, bonds, and other securities)
Others risks involve possibility of loss only (loss of home, life, health)
This course deals primarily with loss/no loss type of uncertainties, not gain/loss
Services judged too risky can be withdrawn from society (malpractice, big business exposure)
Businesses/individuals may try to reduce the negative consequences of risk by transfer or
retention of the risk, or in extreme cases, avoidance of the risk entirely.
Cost of risk = outlay to reduce + opportunity cost of activities foregone due to risk + expenses of
strategies to finance potential losses + cost of losses not reimbursed
DEFINITIONS OF RISK
Pure vs. Speculative
Pure risk is uncertainty of loss only (fire or flood to property, premature death by accident or
illness). Normally only pure risks are insurable, but not all pure risks are insurable..
Speculative risk is uncertainty of loss or gain (business ventures, gambling), where a voluntary
choice of risk is assumed because of the possibility of gain.
Static vs. Dynamic
Static derives from perils in nature or dishonesty of people (random events such as lightning,
windstorms, and death), do not benefit society, and tend to occur with predictable regularity such
that they are more appropriate to the use of insurance than dynamic risks.
Dynamic risks are produced by changes in the economy (price levels, increasing technology, and
changing legal systems), usually benefit society over time, and are generally less predictable than
static risks.
Subjective vs. Objective
Subjective risk is psychological assessment of outcome.
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Objective is more precisely observable and measurable (probable variation of actual from
expected)
SOURCES OF PURE RISK
Property Risks (Business/Personal: “First-Party Insurance”)
Businesses/individuals that own, rent, or use property
Exposed to risk of property damage, destruction, theft
Examples: lightning and fire
Other examples: theft, tornadoes, hurricanes, explosions, riots, collisions, falling objects,
floods, earthquakes, and freezing.
Recent: Hurricane Isaac, Hurricane Sandy
Extensive damage leads to business shutdown (income loss, expense of repair)
Related businesses (customers/suppliers) also exposed to risks of loss (raw
material interruption)
Summary: Property risks involve loss of property and loss of use (lost income/added
expenses)
Personal Risks (“First-Party Insurance”)
Premature death
Illness
Disability
Unemployment
Retirement
Summary: The five personal risks above are a result of one’s inability to earn an income.
Liability Risks (Intentional/Negligent: “Third-Party Insurance”)
More litigation today
Businesses and individuals financially liable
Judgments may be payments to compensate injuries or to punish those responsible
Multimillion awards no longer rare
Legal expenses often substantial even if absolved of liability
Therefore careful ID of liability risk exposures is prudent
Examples:
Injury of customer on property
Car accidents
Product liability
Environmental pollution
Employee rights violations
Recent: BP Oil Spill, Penn State Scandal, Colorado Shootings, Bayou Corne
Sinkhole, Sandy Hook Shooting
Summary: Intentional or negligent harm to other people (“third-party) by an insured
policyholder (“first-party) can result in significant financial claims in a liability lawsuit
against the policyholder.
MEASUREMENT OF RISK
Chance of Loss
How is risk measured after it's identified?
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