Principles of Risk Management and Insurance - Chapter 1

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Risk and Its Treatment
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1

Traditionally, risk has been defined as

  1. A) any situation in which the probability of loss is one.
  2. B) any situation in which the probability of loss is zero.
  3. C) uncertainty concerning the occurrence of loss.
  4. D) the probability of a loss occurring.

Answer: C

2

Objective risk is defined as

  1. A) the probability of loss.
  2. B) the relative variation of actual loss from expected loss.
  3. C) uncertainty based on a person's mental condition or state of mind.
  4. D) the cause of loss.

Answer: B

3

An insurance company estimates its objective risk for 10,000 exposures to be 10 percent. Assuming the probability of loss remains the same, what would happen to the objective risk if the number of exposures were to increase to 1 million?

  1. A) It would decrease to 1 percent.
  2. B) It would decrease to 5 percent.
  3. C) It would remain the same.
  4. D) It would increase to 20 percent.

Answer: A

4

Uncertainty based on a person's mental condition or state of mind is known as

  1. A) objective risk.
  2. B) subjective risk.
  3. C) objective probability.
  4. D) subjective probability.

Answer: B

5

The long-run relative frequency of an event based on the assumption of an infinite number of observations with no change in the underlying conditions is called

  1. A) objective probability.
  2. B) objective risk.
  3. C) subjective probability.
  4. D) subjective risk.

Answer: A

6

Which of the following statements about a priori probabilities is correct?

  1. A) They are subjective probabilities based on ambiguity in the way probability is perceived.
  2. B) They are subjective probabilities that may vary among individuals because of factors such as age, gender, education, and the use of alcohol.
  3. C) They are objective probabilities that can be determined by deductive reasoning.
  4. D) They are objective probabilities that can be determined by subjective reasoning.

Answer: C

7

An individual's personal estimate of the chance of loss is a(n)

  1. A) objective probability.
  2. B) objective risk.
  3. C) subjective probability.
  4. D) a priori

Answer: C

8

A peril is

  1. A) a moral hazard.
  2. B) the cause of a loss.
  3. C) a condition that increases the chance of a loss.
  4. D) the probability that a loss will occur.

Answer: B

9

An earthquake is an example of a(n)

  1. A) moral hazard.
  2. B) peril.
  3. C) physical hazard.
  4. D) objective risk.

Answer: B

10

Dense fog that increases the chance of an automobile accident is an example of a

  1. A) speculative risk.
  2. B) peril.
  3. C) physical hazard.
  4. D) moral hazard.

Answer: C

11

Faking an accident to collect insurance proceeds is an example of

  1. A) physical hazard.
  2. B) objective risk.
  3. C) moral hazard.
  4. D) attitudinal hazard.

Answer: C

12

Carelessness or indifference to a loss is an example of

  1. A) physical hazard.
  2. B) objective probability.
  3. C) moral hazard.
  4. D) attitudinal hazard.

Answer: D

13

Some characteristics of the judicial system and regulatory environment increase the frequency and severity of loss. This hazard is called

  1. A) moral hazard.
  2. B) physical hazard.
  3. C) attitudinal hazard.
  4. D) legal hazard.

Answer: D

14

Taylor Tobacco Company is concerned that the company may be held liable in a court of law and ordered to pay a large damage award to a smoker harmed by the company’s cigarettes. The characteristics of the judicial system that increase the frequency and severity of loss are known as

  1. A) moral hazard.
  2. B) particular risk.
  3. C) speculative risk.
  4. D) legal hazard.

Answer: D

15

A name that encompasses all of the major risks faced by a business firm is

  1. A) financial risk.
  2. B) speculative risk.
  3. C) enterprise risk.
  4. D) pure risk.

Answer: C

16

Which of the following statements about financial risk is (are) true?

  1. Enterprise risk does not include financial risk.
  2. Financial risk is easily addressed through the purchase of insurance.
  3. A) I only
  4. B) II only
  5. C) both I and II
  6. D) neither I nor II

Answer: D

17

One of the speculative financial risks considered in an enterprise risk management program is the risk of loss because of adverse changes in commodity prices, interest rates, foreign exchange rates, and the value of money. This risk is called

  1. A) property risk.
  2. B) financial risk.
  3. C) strategic risk.
  4. D) operational risk.

Answer: B

18

Katelyn was just named Risk Manager of ABC Company. She has decided to create a risk management program which considers all of the risks faced by ABC—pure, speculative, operational, and strategic—in a single risk management program. Such a program is called a(n)

  1. A) financial risk management program.
  2. B) enterprise risk management program.
  3. C) fundamental risk management program.
  4. D) consequential risk management program.

Answer: B

19

A pure risk is defined as a situation in which there is

  1. A) only the possibility of loss or no loss.
  2. B) only the possibility of profit.
  3. C) a possibility of neither profit nor loss.
  4. D) a possibility of either profit or loss.

Answer: A

20

The premature death of an individual is an example of a

  1. A) pure risk.
  2. B) speculative risk.
  3. C) nondiversifiable risk.
  4. D) physical hazard.

Answer: A

21

Which of the following statements about speculative risks is true?

  1. A) They are almost always insurable by private insurers.
  2. B) They are more easily predictable than pure risks.
  3. C) They may benefit society even though a loss occurs.
  4. D) They involve only a chance of loss.

Answer: C

22

An automobile that is a total loss as a result of a collision is an example of which of the following types of risk?

  1. Speculative risk
  2. Diversifiable risk
  3. A) I only
  4. B) II only
  5. C) both I and II
  6. D) neither I nor II

Answer: B

23

All of the following are programs to insure fundamental risks EXCEPT

  1. A) federally subsidized flood insurance.
  2. B) auto physical damage insurance.
  3. C) Social Security.
  4. D) unemployment insurance.

Answer: B

24

All of the following are examples of personal risks EXCEPT

  1. A) poor health.
  2. B) unemployment.
  3. C) premature death.
  4. D) loss of business income.

Answer: D

25

Which of the following is a reason why premature death may result in economic insecurity?

  1. Additional expenses associated with death may be incurred.
  2. The income of the deceased person's family may be inadequate to meet its basic needs.
  3. A) I only
  4. B) II only
  5. C) both I and II
  6. D) neither I nor II

Answer: C

26

Which of the following is (are) often consequences of long-term disability?

  1. Continuing medical expenses
  2. Loss or reduction of employee benefits
  3. A) I only
  4. B) II only
  5. C) both I and II
  6. D) neither I nor II

Answer: C

27

Which of the following is an example of consequential (indirect) loss?

  1. A) the theft of a person's jewelry
  2. B) the destruction of a firm's manufacturing plant by an earthquake
  3. C) the cost of renting a substitute vehicle while a collision-damaged car is being repaired
  4. D) the vandalism of a person's automobile

Answer: C

28

The extra expense incurred by a business to stay in operation following a fire is an example of a(n)

  1. A) fundamental risk.
  2. B) speculative risk.
  3. C) direct loss.
  4. D) indirect loss.

Answer: D

29

Which of the following statements about liability risks is (are) true?

  1. Future income and assets can be attached to pay judgments if inadequate insurance is carried.
  2. There is an upper limit on the amount of loss.
  3. A) I only
  4. B) II only
  5. C) both I and II
  6. D) neither I nor II

Answer: A

30

All of the following are burdens to society because of the presence of risk EXCEPT

  1. A) The size of an emergency fund must be increased.
  2. B) Risk provides an incentive for people to engage in loss control.
  3. C) Society is deprived of certain goods and services.
  4. D) Mental fear and worry are present.

Answer: B

31

Loss control includes which of the following?

  1. Loss reduction
  2. Loss prevention
  3. A) I only
  4. B) II only
  5. C) both I and II
  6. D) neither I nor II

Answer: C

32

Following good health habits can be categorized as

  1. A) loss prevention.
  2. B) risk retention.
  3. C) noninsurance transfer.
  4. D) personal insurance.

Answer: A

33

From the insured's perspective, the use of deductibles in insurance contracts is an example of

  1. A) risk transfer.
  2. B) risk control.
  3. C) risk avoidance.
  4. D) risk retention.

Answer: D

34

The use of fire-resistive materials when constructing a building is an example of

  1. A) risk transfer.
  2. B) risk control.
  3. C) risk avoidance.
  4. D) risk retention.

Answer: B

35

All of the following statements about risk retention are true EXCEPT

  1. A) It may be used intentionally if commercial insurance is unavailable.
  2. B) It may be used passively because of ignorance.
  3. C) Its use is most appropriate for low-frequency, high-severity types of risks.
  4. D) Its use results in cost savings if losses are less than the cost of insurance.

Answer: C

36

Which of the following is an example of a noninsurance risk transfer?

  1. A) not engaging in dangerous activities
  2. B) entering into a hold-harmless agreement
  3. C) installing smoke detectors in your home
  4. D) using nonflammable building material when constructing a house

Answer: B

37

Curt borrowed money from a bank to purchase a fishing boat. He purchased property insurance on the boat. Curt had difficulty making loan payments because he did not catch many fish, and fish prices were low. Curt intentionally sunk the boat, collected from his insurer, and paid off the loan balance. This scenario illustrates the problem of

  1. A) adverse selection.
  2. B) moral hazard.
  3. C) nondiversifiable risk.
  4. D) attitudinal hazard.

Answer: B

38

Jenna opened a successful restaurant. One night, after the restaurant had closed, a fire started when the electrical system malfunctioned. In addition to the physical damage to the restaurant, Jenna lost profits that could have been earned while the restaurant was closed for repairs. The lost profits are an example of

  1. A) direct loss.
  2. B) nondiversifiable risk.
  3. C) speculative risk.
  4. D) indirect loss.

Answer: D

39

Brad started a pest control business. To protect his personal assets against liability arising out of the business, Brad incorporated the business. Brad's use of the corporate form of organization to shield against personal liability claims illustrates

  1. A) fundamental risk.
  2. B) noninsurance transfer.
  3. C) risk retention.
  4. D) objective risk.

Answer: B

40

ABC Insurance Company plans to sell homeowners insurance in five Western states. ABC expects that 8 homeowners out of every 100, on average, will report claims each year. The variation between the rate of loss that ABC expects to occur and the rate of loss that actually occurs is called

  1. A) objective probability.
  2. B) subjective probability.
  3. C) objective risk.
  4. D) subjective risk.

Answer: C

41

Williams Company installed smoke detectors, a sprinkler system, and fire extinguishers in its new manufacturing facility. These devices are all examples of

  1. A) risk control.
  2. B) noninsurance transfer.
  3. C) risk avoidance.
  4. D) risk retention.

Answer: A

42

Which of the following statements about hedging is (are) true?

  1. Hedging is a form of risk transfer.
  2. Hedging is used to address the risk of unfavorable price fluctuations.
  3. A) I only
  4. B) II only
  5. C) both I and II
  6. D) neither I nor II

Answer: C

43

Cathy's car hit a patch of ice on the road. The car skidded off the road and hit a tree. The presence of ice on the road is best described as a(n)

  1. A) peril.
  2. B) subjective risk.
  3. C) physical hazard.
  4. D) indirect loss.

Answer: C

44

Jim and Paula Franklin started a dry cleaning business. The business may be successful or it may fail. The type of risk that is present when either a profit or loss could occur is called

  1. A) pure risk.
  2. B) subjective risk.
  3. C) nondiversifiable risk.
  4. D) speculative risk.

Answer: D

45

Ben is concerned that if he injures someone or damages someone's property he could be held legally responsible and required to pay damages. This type of risk is called a

  1. A) speculative risk.
  2. B) liability risk.
  3. C) nondiversifiable risk.
  4. D) property risk.

Answer: B

46

MLX Drug Company would like to market a new hypertension drug. While the Food and Drug Administration (FDA) was testing the drug, it discovered that the drug produced a harmful side effect. When MLX learned of the FDA's test result, MLX abandoned its plan to produce and distribute the drug. MLX's reaction illustrates

  1. A) risk avoidance.
  2. B) hedging.
  3. C) risk transfer.
  4. D) risk retention.

Answer: A

47

ABC Insurance Company sells auto insurance in one state. Recently, the state legislature passed a law that limits the use of an individual’s credit history by insurers when selecting applicants to insure. This change in law will increase the possibility of unprofitable results for ABC. This type of hazard is an example of

  1. A) physical hazard.
  2. B) legal hazard.
  3. C) moral hazard.
  4. D) attitudinal hazard.

Answer: B

48

All of the following are characteristics of the liability risk that most people face EXCEPT

  1. A) a lien may be placed on your income and assets to satisfy a legal judgment.
  2. B) substantial legal expenses may be incurred defending the claim.
  3. C) there is no upper limit on the amount of the loss.
  4. D) owning liability insurance eliminates the possibility of being held legally liable.

Answer: D

49

Which of the following statements about chance of loss and risk is (are) true?

  1. If the chance of loss is identical for two groups, the objective risk must be the same.
  2. Two individuals may perceive differently the risk inherent in a given activity.
  3. A) I only
  4. B) II only
  5. C) both I and II
  6. D) neither I nor II

Answer: B

50

A risk that affects only individuals or small groups and not the entire economy is called a

  1. A) diversifiable risk.
  2. B) pure risk.
  3. C) speculative risk.
  4. D) nondiversifiable risk.

Answer: A

51

Which of the following is an example of a commercial risk?

  1. A) the risk of insufficient retirement income
  2. B) the loss of business income
  3. C) the risk of premature death
  4. D) the risk of being unemployed

Answer: B

52

A special form of planned retention by which part or all of a give loss exposure is retained by the firm is called

  1. A) hedging.
  2. B) self-insurance.
  3. C) passive retention.
  4. D) noninsurance transfer.

Answer: B

53

The production facility for ABC Manufacturing is located in a flood plain. Although the risk of flood is low, ABC's risk manager is concerned that a flood could damage the plant and equipment. He received bids on flood insurance from two insurance agents, but decided the cost of coverage was too high relative to the risk. So he did not purchase flood insurance. Which risk management technique is ABC using with respect to the risk of flood?

  1. A) active retention
  2. B) noninsurance transfer
  3. C) passive retention

D) avoidance

Answer: A

54

A student who has skipped many classes and not studied the course material was surprised to learn there was a test when he showed-up for class. The student's mental uncertainty about whether or not he will pass the test is called

  1. A) objective risk.
  2. B) objective probability.
  3. C) subjective probability.
  4. D) subjective risk.

Answer: D

55

Rapid inflation, cyclical unemployment, war, hurricanes, and floods are all examples of

  1. A) diversifiable risks.
  2. B) physical hazards.
  3. C) nondiversifiable risks.
  4. D) speculative risks.

Answer: C

56

Five years ago, Shannon decided to start investing monthly in the common stock of ABC Telecom Company. Her financial well-being will be harmed if the price of ABC Telecom stock drops significantly. The risk of investment loss can be reduced if she invests in other companies and other types of financial assets. The risk Shannon faces with regard to her investments is a(n)

  1. A) enterprise risk.
  2. B) diversifiable risk.
  3. C) pure risk.
  4. D) nondiversifiable risk.

Answer: B

57

Frazier Electric keeps a paper copy of business records at the company’s headquarters. The company also has two back-up copies of business records stored in electronic files. The electronic files are kept in the event the paper records are damaged or destroyed. The back-up files illustrate which of the following risk control techniques?

  1. A) loss prevention
  2. B) loss reduction
  3. C) diversification
  4. D) duplication

Answer: D

58

Rather than storing all of its finished goods in a single location, Davis Company divides the finished goods between two warehouses. This simple risk control technique which is designed to limit losses should a warehouse fire occur is called

  1. A) duplication.
  2. B) risk transfer.
  3. C) separation.
  4. D) loss prevention.

Answer: C

59

Some members of Congress are concerned that if one or two large U.S. banks fail, it could lead to the collapse of the entire U.S. financial sector. This risk is called

  1. A) objective risk.
  2. B) systemic risk.
  3. C) enterprise risk.
  4. D) subjective risk.

Answer: B