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Midterm Study Guide (Stuff to Reference)

Q) What are the two main types of risk?


A) Pure risk: either the bad thing happens, or it doesn’t happen.
E.g. the house burns down, or it doesn’t.
Speculative risk: there is an upside to the risk… e.g. playing the lottery.
It’s not about luck per se… it’s about intelligent analysis of the pros and cons.
Q) What is the definition of risk?
There is no one definition, as risk is dependent on the situation.
The essence of risk is uncertainty… the chance for something (bad) to happen if
we follow a particular course of action.
Here are some definitions…
“Risk is the probability, in quantitative terms, of a defined hazard occurring”
Q) What are the factors to consider when determining probability?
All risk boils down to…
Frequency and severity.
We want to reduce either (or both) of these factors.
Q) How do we determine frequency?
We look at how often it’s happened in the past. Past occurrences are the best
predictor of future occurrences.
Q) What is objective risk?
The relative variation of actual loss from expected loss.
It’s basically how wrong we are when we try to determine what’s going to
happen.
Q) What is the Law of Large Numbers?
As the number of exposure units increase, the more closely the actual loss
experience will approach the expected loss experience.
If you want to be confident about the future, you need to collect as much past
data/test things as much as possible.
Q) What is subjective risk?
“Risk is all in the mind… a notion of observation”
Risk is heavily linked to a particular persons perception.
Subjective risk is uncertainty based on a person’s mental condition or state of
mind.
Two people can have very different perceptions of risk, even if in the same
situation.
Q) What is a peril?
Peril is defined as the cause of loss… it’s our identification of the risk.
Q) What is a hazard?
Hazard is a condition that creates or increases the chance of loss.
Q) What are the different types of hazards?
Physical hazard: faulty brakes, defective wiring
Moral hazard: e.g. fraudulent claim
Morale hazard: carelessness on the behalf of an individual/organization due to
the presence of insurance.
Legal hazard: Characteristics of the legal system or regulatory environment that
increases the frequency or severity of losses.
Risk implies a possible negative or uncertain outcome
Q) What are the components of systems safety?
 Build in safety, don’t try to fix a finished design.
 Deal with systems as a whole, not parts.
 Takes a larger view of hazard causes than just failures.
 Analysis & past experiences + codes of practice.
 Qualitative over quantitative factors.
 Must incorporate management and safety culture concerns.
What is decision theory?
Analyzing the cost of unexpected events.
The study of the reasoning underlying an agents choices.
History of Risk Management?
 Corporate insurance buyers came to realize that there might be *more
cost-effective ways of dealing with risk.
 Most effective approach would be to *prevent losses from occurring and
*minimize the economic consequences of the losses they were unable to
prevent.
 No longer acceptable for organisations to become exposed to unexpected
loss.
Risk management is all about embracing calculated risk.
What are the objectives of risk management?
Pre loss
We must understand how much we should spend on reducing the effects of a
potential loss.
Reduce stress – having a solid system in place for dealing with problems greatly
reduces stress and risk to the business.
Legal obligations – can be external (e.g. gov. legislation about waste disposal) or
internal (rules of the company)
Post loss
Survival – speed of contingency. How quickly can we get back up and running?
Continue operating – obvious one.
Earnings stability – a certain level of certainty that earnings and profits won’t drop
off dramatically.
Growth – secondary after survival.
Negative externalities – e.g. negative press. Any small incident can affect the
company as a whole.
What is the risk management process?
1. Identify the Loss exposures.
2. Analyse the Loss Exposures.
3. Choose the most efficient methods of controlling and financing loss
exposures and implementing them.
4. Monitor outcomes
Step 1: Identify and measure the loss exposures
Typically undertaken by in-house risk manager or outside risk analyst.
Risk manager – more common these days, as companies are avoiding outsourcing
the task.
Surveyor/analyst – outsourcing the assessment to someone who is expert in that particular
area.
They incentivise people reducing their own risk by offering to reduce premium dependent on
taking certain steps e.g. cheaper house insurance if there’s smoke alarms installed.

Where can loss exposures arise from?


Loss exposures arising from...
 Property – damage to the buildings of the business.
 Liability – someone suing the business based on harm that befell them by
following advice, getting injured on the premises, using faulty product, etc.
 Business income – anything that could negatively impact our income.
 HR – not getting the best people… or people getting injured on job/fired.
 Crime – theft, fraud…
 Employee benefit – you have to incentivize people to work for the company
via a good contract. Therefore you need to provide for whatever you
promised.
 Foreign – currency exchange, political unrest…
 Reputation – everything can impact your reputation
What are some useful sources of information for this step?
 Sources of information
 Risk analysis questionnaires...
 *Physical inspection...
 Flowcharts...
 Financial statements...
 *Historical loss data.
Information is key. We need all the info before we can do anything about it.
Questionnaires are the starting point. All employees in org get them. Ground staff may spot
risks that management miss.
Physical inspection – having experts examining machinery, premises, equipment, etc.
Flowcharts – visual representations can help to spot potential bottlenecks.
Financial statements – finding where the company is losing money.
Historical data – seeing what has happened before, how often, how bad was it, etc.

What are some recent business trends that bring exposures with them?
 Increased use of *outsourcing of manufacturing and *R & D to suppliers;
 Globalization of *supply chains;
 *Reduction of supplier base;
 More intertwined and *integrated processes between companies;
 Reduced *buffers, e.g. inventory and lead time;
 Increased demand for on-time deliveries in shorter time windows, and
shorter lead times;
 Shorter product *life cycles and compressed time-to-market
Businesses have pushed aggressively, getting closer to maximum business loss – things that would destroy them.

Arbitrage – looking for opportunity somewhere else.

Outsourcing – avoids big capital outlay for setup, but you lose control over the process.

Reduction of suppliers – big companies swallow up small ones.


What are our major risk control techniques?
We can try to avoid it. If it’s not economically feasible to take a loss (having
minimized it as much as possible), then back off.
Loss prevention: ex-anti management – how to reduce the probability of the
event.
Loss reduction: ex-post management – how to reduce the severity after it’s
already happened.
What are our major risk financing techniques?
Retention: shouldering the burden ourselves.
Insurance: paying someone to take on risk for you.
Risk transfer: basically like insurance.
What is a direct loss?
Any loss caused directly by the particular event e.g. flood damage to premises
after a flood.
What is an indirect loss?
Any financial loss resulting from circumstances caused by an event e.g. lost
business due to moving premises due to flood.
What is a maximum probable loss event?
This is generally defined as the maximum likely value of loss caused by an event
(e.g. a house fire) assuming passive safety systems don’t fail (e.g. fire doors) and
our active suppression systems work (e.g. sprinklers).
What is a maximum possible loss event?
This is the max loss we can take in the event where all of our protective systems
fail (e.g. in the case of house fire, our smoke alarms don’t work, sprinklers don’t
activate, and fire doors are left open).
What is risk retention?
Two types…
Active retention: This is when we’ve determined the risk, quantified it, decided
it’s manageable and predictable, and have decided we’re willing to take the
consequences – the max probable loss is something we can deal with.
Passive retention: This happens when we fail to fully analyze the situation, leaving
ourselves exposed to blindsiding financial loss.
What is loss prevention?
Also known as ex-anti. We attempt to avoid the risk by reducing the
probability/frequency of it occurring.
What is loss reduction?
Also known as ex-post. This happens after the event has occurred – we try to
reduce the severity of the consequences.
What is insurance?
It’s one method of risk transfer. The business transfers the financial fallout of a
particular risk occurring from themselves to a third party insurer, in exchange for
a premium.
What is risk transfer?
Different types apart from just insurance…
Indemnity: The options a company takes to transfer potential financial obligations
to another party without the need for insurance e.g. a shipping company taking
responsibility for the cargo it carries.
Non-insurance transfer = e.g. hold harmless agreement. The shippers are
responsible for cargo while they are in possession of it.
Hedging = transferring the risk of volatility
What is pure risk?
Pure risk is the insurable kind. There’s no positive, only an absence of the
negative. An example is home insurance. Either your home is damaged or it isn’t –
you don’t have the opportunity to make money.
What is speculative risk?
It means there’s uncertainty about the outcome of a particular event… there
could be a loss, and there could be a gain. An example of this is buying stocks or
gambling. This is generally not insurable.
What is fundamental risk?
Fundamental risk is exposure via a situation affecting a large group of
people/firms due to a common circumstance e.g. we all live in an earthquake
zone, so we’re at risk from earthquakes.
What is risk creep?
Risk creep is essentially starting out with something that’s pretty safe, then
gradually stepping it up over time until you end up doing something that’s far
riskier, with no perceptible change in perceived risk level.
Who analyses loss exposures?
 Risk Manager/Risk Management Team (Company/Institution)
 Actuary/Risk Underwriter (Insurance/Reinsurance Company)
What’s the function?
To predict the major part of your costs – losses and related expenses, using
historical data and past judgement.
What are the two key components of risk analysis?
Frequency: how often/how many loss events will we face?
Severity: how bad are these loss events going to be?
What is de-bounding of risk?
We’re not necessarily exposed to new risks... They’re the same risks, just more
uncontrollable.
Temporal de-bounding = we’re exposed to risk now that may not manifest for
years to come.
Spatial = we’re exposed to risk without borders… events in Pakistan impact
Ireland.
Social = people unwilling to take responsibility for loss events e.g. global warming.
How do we price risk?
More frequent events (e.g. motor accidents) are easier to price than
novel/uncommon events.
What is the actuarially fair premium?
Actuarially fair = spreading the value of expected claims out across the whole
population.
Reasons to charge more than actuarially fair premium?
Uncertainty – afraid of it being higher.
Trying to do more than just cover costs.
Reasons to charge around actuarially fair premium?
If it’s part of a package deal – make profit on other insurance.
If it’s a competitive market.
How do we go about pricing and transferring risk?
Risk Management (During Transfer)
Risk analysis
H&S recommendations – wear a hard hat, make everyone take a lifting course,
etc.
Insurance contract – the exact terms that have to be fulfilled before the insurance
company will make a payout.
Risk Management (After Transfer)
Monitoring recommendations – insurance company has to check up and make
sure their advice is being taken.
Asset-Liability management – making sure that assets = liabilities, as this is
literally what insurance companies do for a living.
Morbidity vs mortality?
Mortality – risk of death.
Morbidity – risk of severe injury.
Pricing major injury is more hassle… it depends on stuff – nature of injury,
litigation, health care costs, etc.
How do we get variance?
Find the mean of all values… minus the mean from each value and square to
insure it’s positive… add these values up and then get the average of that sum.
How do we calculate standard deviation?
Get the square root of your average variance figure.
This is then used to rank risks based on inherent volatility.
Important standard deviation figures…
1 = 68% confidence interval (covering 84% of possible values)
1.645 = 90% confidence interval (covering 95% of possible values)
2.33 = 98% confidence interval (covering 99% of possible values)
What is probable maximum loss?
The max amount you’re likely to lose at some point (so anything up to a once a
century loss event).
Solvency 2 regulation makes companies hold enough capital to cover 99% of all
losses.
What is risk pooling?
When a group of people come together in order to share their losses… all paying
less as a result.
How can we make our risk calculations more accurate?
- Work to a 99% confidence level…. 10 + 2.33(2) = 14.66 houses
- Use more historical data. E.g. expand to include all 10 years of data… so 95%
confidence level = 10 + 1.645(3.16) = 15.21 houses
Portfolio effects
A correlation between risks in a company’s portfolio can have significant impact
on their profits/losses.
Negative correlation: as one goes up, the other goes down e.g. as oil prices go
down, airline shares go up.
Positive correlation: both go up and down together.
Zero correlation: no connection.
What happens when there’s a strong correlation between two items in the risk
portfolio?
The company should either transfer risk to reduce double exposure, or factor it
into the premium.
Why does the correlation coefficient matter?
Creating a portfolio with assets that are less than perfectly positively correlated
should reduce portfolio risk.
What is retention policy?
Retention policy – how much of the risk insured with us that we keep at our
company. This is known as reinsurance.
What is the Bernoulli Principle?
When insurance is offered at the actuarially fair premium, the expected utility of
insuring is always greater than the expected utility of not insuring.
What is a soft insurance market?
Lower premiums, broader coverage, more policies w/ higher limits...
This happens in strong, competitive markets.
What is a hard insurance market?
Premiums go up, insurance capacity goes down.
This happens in troubled markets  trying to return to profitability.
A risk averse person will pay more than the actuarially fair premium in order to
eliminate downside risk.
A risk taker is indifferent to buying insurance at the actuarially fair premium.
What is moral hazard?
It’s an assumption that insured people will overuse services they feel they’re
entitled to due to their insurance e.g. medical care.
Moral hazard occurs when individual behaviour changes under conditions of
insurance.
How does it arise?
Asymmetrical information – imbalance in who knows what.
This is particularly prevalent in the medical insurance industry, as insurers can’t
ask much.
How can we reduce moral hazard?
Ex-anti: frequency. People behave in a way that makes loss events more likely to
occur. Affected by deductibles.
Ex-post: severity. There is no incentive for people to reduce the severity of a loss
event e.g. house fire. Affected by coinsurance.
What are deductibles?
An exclusion of a certain amount of expense from coverage – an excess. People
are less likely to make small frequent claims if they have to pay for them.
What is coinsurance?
The claimant has to pay a certain percentage of the cost e.g. 20%. This
encourages people to reduce the severity of loss events, as it costs them money.
When is insurance more likely to be provided?
Insurance more likely to be provided against those events
a) against which people have a greater risk aversion
b) for which the quantity demanded at a zero price does not greatly
exceed the quantity demanded at a positive price
c) for which the extent of randomness is greater
What are some other problems posed by asymmetrical information?
Adverse selection: when the insurer can’t get an accurate picture of the real risk
the consumer poses.
Adverse selection death spiral: When the insurance pool suffers a greater than
expected level of claims, all premiums are increased across the board.
Increasing premiums across the board will force the “good risks” (people who are
safer) to leave, as they don’t believe their premium is matched to their level of
risk.
The government has to intervene to prevent this from happening… makes
insurance companies offer community ratings  same price for everyone,
regardless of risk.
This leads to cross-subsidization: infrequent claimants paying for frequent
claimants.

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