Chapter 4

Question 1

Risk Financing Goals

Answer 1

1. Pay for losses
2. Manage the cost of risk
3. Manage cash flow variability
4. Maintain an appropriate level of liquidity
5. Comply with legal requirements

Question 2

Transfer Costs

Answer 2

costs paid in order to transfer responsibility for losses to another party

Question 3

Cost of Risk

Answer 3

1. Administrative Expenses
2. Risk Control Expenses
3. Risk Financing Expenses
4. Managing Expenses

Question 4

Administrative Expenses

Answer 4

Cost of internal administration and the cost of purchased services, such as claim admin or risk management consulting

Question 5

Risk Control Expenses

Answer 5

Incurred to reduce frequency, reduce the severity of losses that do occur, or increase the predictability of future losses

Question 6

Risk Financing Expenses

Answer 6

Incurred to manage the risk financing measures used to meet risk financing goals

Question 7

Maximum Cash Flow Variability

Answer 7

depends on the organization’s tolerance for risk, depends on factors such as the organization’s size, its financial strength, and management’s own degree of risk tolerance, depends on the degree to which the organization’s other stakeholders, suppliers, or customers are willing to accept risk

Question 8

Liquid Asset

Answer 8

can easily be converted into cash. Property is not usually a liquid asset.

Question 9

Appropriate Level of Liquidity

Answer 9

determination of the appropriate level of liquidity for retained losses and consideration of both internal and external sources of capital to meet those needs

Question 10

Comply With Legal Requirements

Answer 10

depends on the individual requirements imposed by the applicable statutory or contractual obligations.

Question 11

Retention

Answer 11

A risk financing technique by which losses are retained by generating funds within the organization to pay for the losses

Question 12

Transfer

Answer 12

In the context of risk management, a risk financing technique by which the financial responsibility for losses and variability in cash flows is shifted to another party

Question 13

Planned Retention

Answer 13

allows the risk management professional to choose the most appropriate retention funding measure

Question 14

Unplanned Retention

Answer 14

occurs when either losses cannot be insured or otherwise transferred or an individual or organization fails to correctly identify or assess a loss exposure

Question 15

Retention Funding Measures

Answer 15

rely on funds that originate within the organization
Current expenses of losses (relies on current cash flow); Using an unfunded reserve (relies on an accounting entry that does not specificy the assets that are to pay); Using a funded reserve (relies on a reserve that is supported with allocated cash, securities, or other liquid assets); Borrowing funds (uses an organization’s own resources to pay for losses and in time uses it own earnings to repay the loan).

Question 16

Current Expensing of Losses

Answer 16

relies on current cash flow to cover the cost of losses

Question 17

Unfunded Loss Reserve

Answer 17

appears as an accounting entry denoting potential liability to pay for a loss, the reserve recognizes in advance that the organization may suffer a loss but the organization does not support that potential for loss with any specific assets, based on an estimation of the portion of accounts receivable that will not be paid

Question 18

Funded Loss Reserve

Answer 18

appears as an accounting entry denoting potential liability to pay for a loss, supported with cash, securities, or other liquid assets allocated to meet the obligations that the reserve represents

Question 19

Advantages of Retention

Answer 19

1. Cost Savings
2. Control of Claims Process
3. Timing of Cash Flows
4. Incentives for Risk Control

Question 20

Limitations of Retention

Answer 20

1. restrictions so that the individual or organization pays at least some portion of the loss
2. Ultimate responsibility for paying for the loss remains with the individual or organization

Question 21

Advantages of Transfer

Answer 21

1. Reducing exposure to large losses
2. Reducing cash flow variability
3. Provided ancillary services
4. Avoiding adverse employee and public relations

Question 22

Reducing Exposure to Large Losses

Answer 22

retaining large loss exposures increases the probability that an individual or organization will incur financial distress

Question 23

Reducing Cash Flow Variability

Answer 23

reducing the effect of losses associated with retaining large loss exposure, can increase an organization’s attractiveness to investors and thereby potentially increase the overall value of the organization

Question 24

Provide Ancillary Services

Answer 24

the level of efficiency and expertise that some organizations have developed in risk assessment & control services, and claims administration makes the risk transfer agreement very appealing to organizations that cannot provide these services efficiently

Question 25

Avoiding Adverse Employee and Public Relations

Answer 25

as well as transferring responsibility for the loss itself, the organization can transfer responsibility for the claims administration process, any issues with claims admin are less likely to harm the reputation of the organization and consequently are less likely to generate adverse employee and public relations

Question 26

Risk Tolerance

Answer 26

the level of risk an organization is willing to assume directly affects its optimal balance between retention and transfer The higher the organization's willingness to accept risk, the higher the likelihood that more risk will be retained

Question 27

Financial Condition

Answer 27

the more financially secure an individual or organization is, the more loss exposures can be retained without causing liquidity or cash flow variability problems

Question 28

Core Operations

Answer 28

the organization knows and understands its core operations and the loss exposures associated with them better than any outside party

Question 29

Ability to Diversify

Answer 29

ability to gain the advantage of offsetting losses that occur to one loss exposure with the absence of losses associated with the other loss exposures

Question 30

Ability to Control Losses

Answer 30

risk control reduces loss frequency and/or loss severity, the more risk control an organization is able to undertake, the more loss exposures it is typically able to retain

Question 31

Ability to Administer the Retention Plan

Answer 31

Organizations that have a better ability to fulfill claims admin, risk management consulting, or retention fund accounting are able to use retention more efficiently

Question 32

Guaranteed Cost Insurance

Answer 32

Insurance policies that are designed to cover property, liability, and net income exposures from various causes. The insured transfers the potential financial consequences of certain loss exposures to the insurer for a premium. In exchange, the insurer agrees to pay for all losses covered by the policy, subject to a deductible and policy limit, and agrees to provide necessary claim and litigation services.

Question 33

Primary Layer

Answer 33

The first level of insurance coverage above any deductible

Question 34

Excess Layer

Answer 34

A level of insurance coverage abouve the primary layer

Question 35

Umbrella Policy

Answer 35

A liability policy that provides excess coverage above underlying policies and may also provide coverage not available in the underlying policies, subject to a self-insured retention

Question 36

Buffer Layer

Answer 36

A level of excess insurance coverage etween a primary layer and an umbrella policy

Question 37

Self-Insurance

Answer 37

A form of retention under which an organization records its losses and maintains a formal system to pay for them.

Question 38

Claims Administration Services

Answer 38

1. Recordkeeping 2. Claim Adjustment 3. Loss Reserving 4. Litigation Management 5. Regulatory Requirements 6. Excess Coverage Insurance

Question 39

Recordkeeping

Answer 39

A self-insured organization needs this system to trak its self-insured claims

Question 40

Claims Adjustment

Answer 40

As with an insured plan, claims must be investigated, evauated, negotiated, and paid

Question 41

Loss Reserving

Answer 41

A self-insured organization must determine reserve amounts needed for estimated future payments on self-insured losses that have occurred. The reserves for self0insured loss payments can be funded or unfunded

Question 42

Litigation Management

Answer 42

involves controlling the cost of legal expenses for claims that are litigated. This includes evaluating and selecting defense lawyers, supervising them during litigation, and keeping records of their costs. It also involves specific techniques such as auditing legal bulls and experimenting with alternative fee-billing strategies

Question 43

Regulatory Requirements

Answer 43

n most states, an orgnization must qualify as a self-insurer in order to self-insure workers compensation or auto liabilit loss exposures. The qualification requirements specify items such as financial security requirements that the organization must submit to the regulatory body to qualify as a self-insurer

Question 44

Excess Coverage Insurance

Answer 44

Many states require a self-insurer to purchase, some state specify conditions for the purchase of this coverage

Question 45

Large Deductible Plan

Answer 45

A workers compensation plan with a deductible of at least $100,000 that allows the insured to self-insure most of its workers compensation claims without establishing a qualifying self-insurance plan. The insurer provides administrative and claim services, and the employer reimburses the insurer for any losses under the deductible

Question 46

Captive Insurer

Answer 46

A subsidiary formed to insure the loss exposures of its parent company and the parent's affiliates

Question 47

Group Captive

Answer 47

owned by multiple parents typically operate as formalized pools in which several organizations group together to share the financial consequenses associated with their collective loss exposures

Question 48

Single Parent Captive

Answer 48

Typically operate as a formalized retention plan and only provde insurance coverage for thier parent or sibling organizations

Question 49

Selecting a Domicile for a Captive

Answer 49

1. Initial capital requirements, taxes, and annual fees. 2. Reputation and regulatory environment 3. Premium and investment restrictions 4. Support of infrastructure in terms of accountants, bankers, lawyers, captive managers, and other third-party service providers within the domicile

Question 50

Risk Retention Group

Answer 50

A group capitve formed under the requirements of the Liability Risk Retention Acto of 1986 to insure the parent organizaitons

Question 51

Rent-a-Captive

Answer 51

An arrangement under which an organization rents capital from a captive to which it pays premiums and receives reimbursement for its losses

Question 52

Protected Cell Company

Answer 52

A corporate entity serprated into cells so that each participating company owns an entire cell but only a portion of the overall company

Question 53

Finite Risk Insurance Plan

Answer 53

A risk financing plan that transfers a limited (finite) amount of risk to an insurer. It is often used for especially hazardous loss exposures for which insurance capacity is limited or unavaialble (such as environmental liability and earthquake damage). The premium is a very high percentage of the policy limits.

Question 54

Pool

Answer 54

A group of organitzations that band together to insure each other's loss exposures

Question 55

Retrospective Rating Plan

Answer 55

A Risk Financing plan that increases or reduces an insured's premium during a policy period based on the insured's own losses during the same period. They are used to finance low to medium severity losses and are usually combined with other risk financing plans to cover high severity losses. The insured must have a substantial insurance premium to benefit from this plan and cash flow uncertainty can

Question 56

Retrospective Rating Plan Design

Answer 56

The insured pays premium at the beginning of the policy period and the insurer issues an insurance policy and agrees to pay covered losses up to the policy limits. The insured's losses during the policy period are considered in calculating a major portion of the premium

Question 57

Loss Limit

Answer 57

The level at which a loss occurrence is limited for the purpose of calculating a retrospectively rated premium

Question 58

Hold Harmless Agreement

Answer 58

A noninsurance risk transfer measure commonly used to assign the responsibility for losses arising out of a particular relationship or activity

Question 59

Capital Market

Answer 59

A financial market in which long-term securities are traded

Question 60

Securitization

Answer 60

The process of creating a marketable investment security based on a financial transaction's expected cash flows

Question 61

Insurance Securitization

Answer 61

The process of creating a marketable insurance-linked security based on the cash flows that arise from the transfer of insurable risks. Example: The insurer sells insurance policies that cover losses related to natural disaster. They transfer that risk to capital markets where investors holding diversified portfolios have a larger pool of assets to absorb catastophic losses. It reduces the insurer's overall risk.

Question 62

Catastrophe Bond

Answer 62

Policies that cover losses related to natural disasters, repayments are made using the savings in interest and principal to the insurer who uses the cash to offset its hurricane losses

Question 63

Hedging

Answer 63

A financial transaction in which one asset is held to offset the risk associated with another asset. It is well suited to business risks created by price changes. Example: oil prices are volatile. A business can enter into a contract to buy oil at a certain price and time at some pont in the future. It is a speculative business risk that allow organizations to protect itself agains possible price-level losses by sacrificing possible price-level gains.

Question 64

Derivative

Answer 64

A financial contract that derives its value from the value of another asset

Question 65

Contingent Capital Agreement

Answer 65

An agreement, entered into before any losses occur, that enables an organization to raise cash by selling stock or issuing debt at prearranged terms after a loss occurs that exceeds a certain threshold. An organization does not transfer its risk of loss to investors. It receives captial injection in the form os debt or equity after the a loss occurs to help it pay for the loss.

Question 66

SPV

Answer 66

an intermediary that a mortgage company might securitize its mortgage receivable through

Question 67

Advantages of Retention

Answer 67

1. Lowers long-run costs 2. Increases control over the claim process 3. Improves timing of cash flows 4. Encourages risk control

Question 68

Funding Resources for Retained Losses

Answer 68

1. Current expensing of losses 2. Unfunded loss reserve 3. Funded Loss retention plan 4. Borrowing

Question 69

Factors When Choosing a Risk Financing Measure

Answer 69

1. Compatibility with risk financing goals 2. Loss exposure characteristics 3. Organization specific characteristics

Question 70

Risk Financing Measures (list)

Answer 70

1. Guaranteed cost insurance 2. Self Insurance 3. Large Deductible Plan 4. Captive Insurer 5. Finite Risk Insurance Plan 6. Pool 7. Retrospective Rating Plan 8. Hold Harmless Agreement 9. Capital market Solutions

Question 71

What expenses constitute an organization's Cost of Risk regardless of whether loss are retained or transferred?

Answer 71

Administrative, Risk Control, Risk Financing, and Managing.

Question 72

What does Administrative Expenses include when managing the Cost of Risk?

Answer 72

The cost of internal administration and the cost of purchased services, such as claim administration or risk management consulting.

Question 73

Self Insurance

Answer 73

A form of rention under which an organization records its losses and maintains a formal system to pay for them. The organization is responsible for recordkeeping, claims adjustment, loss reserving, litigation management, regulatory requirements, and may be required to purchase excess insurance above the planned retention.

Question 74

Identify the factors that affect an organization's maximum cash flow variability level?

Answer 74

Organization's size , financial strength, management's degree of risk tolerance, organization's degree in which stakeholders will accept the risk.

Question 75

Limitations of Risk Management Measures

Answer 75

Risk transfer measures (including nsurance) are not typically pure transfers, but are some combination of retention and transfer. Most, if not all, risk transfer easures involve some type of limitation on the potential loss amounts that are being transferred. These limitations can be deductibles, limits, or other restrictions so that the individual or organization (transferor) pays at least some portion of the loss. The ultimate responsibility for paying for the loss remains with the individual or organization. Risk financing does not eliminate the transferor’s legal responsibility for the loss if the transferee fails to pay.

Question 76

What conditions can lead to more retention?

Answer 76

High risk tolerance. Secure financial condition Core operations Well diversified risks Having effective loss control to reduce frequency and severity Having ability to administer a retention plan

Question 77

Explain the difference between a self-insurance LAN and a large deductible plan.

Answer 77

A self insurance plan is a retention measure. All claims administration is done by the organization. (up to attachment point of excess coverage) A large deductible plan is a transfer measure with some properties of self-nsurance. The insurance carrier handles all claims by the organization reimburses the carrier for losses under the deductible.

Question 78

How do organizations benefit from pools?

Answer 78

Pools reduce the cost of risk and keep uncertainty of the cos associated with its retained losses at a tolerable level. This is usually used by organizations that are too small o form a captive.

Question 79

How do organizations benefit from retrospective rating plans?

Answer 79

If the loss limit and maximum premium are set at proper levels they can provide financial stability. If the plan covers more than one type of exposure, the insured benefits from the stability provided through diversification by retaining losses from differen types of exposures under a single plan.

Question 80

What are the advantages of using hedging as a risk financing measure?

Answer 80

Hedging against possible net income losses from price changes can reduce business risk loss exposures and reduce its dependence on traditional financial and insurance markets.

Question 81

Way are the disadvantages of using hedging as a risk financing measure?

Answer 81

Can destabilize an organization's general risk financing plan and it's entire structure if earnings and surpluses are seriously jeopardized by speculative investments in hedging instruments.