INSTRUCTOR'S RESOURCE MANUAL
PRINCIPLES OF RISK MANAGEMENT AND INSURANCE
14TH EDITION
CHAPTER NO. 01: RISK AND ITS TREATMENT
ANSWERS TO CASE APPLICATION
a. Retention. Because the car is old and has a limited market value, collision insurance should not be
purchased. Retention can be used to deal with the exposure.
b. Liability insurance. Because the exposure has the potential for causing a catastrophic loss, auto
liability insurance should be purchased.
c. Insurance. Property insurance could be purchased to deal with the property exposure of $10,000. The
policy should contain a deductible.
d. Retention. The dollar value of the loss of a disposable contact lens is small.
e. Loss control. The waterbed should be carefully checked for possible leaks to reduce the possibility of
damage to the apartment. As an alternative, an endorsement can be added to a homeowners policy to
cover the liability exposure.
f. Avoidance. Michael should pick a new running route.
g. Life insurance. Michael’s father should have purchased life insurance. The loss of tuition would have
been replaced by life insurance.
ANSWERS TO REVIEW QUESTIONS
1. (a) There is no single definition of risk. Historically, many insurance authors have defined risk in
terms of uncertainty. Risk is uncertainty concerning the occurrence of a loss.
(b) A loss exposure is any situation or circumstance in which a loss is possible, regardless of whether
a loss occurs.
(c) Objective risk is the relative variation of actual loss from expected loss. As the number of
exposure units under observation increases, objective risk declines. Subjective risk is uncertainty
based on one’s mental condition or state of mind. Accordingly, objective risk is measurable and
statistical; subjective risk is personal and not easily measured.
2. (a) Chance of loss can be defined as the probability that an event will occur.
, (b) Objective probability refers to the long-run relative frequency of an event based on the
assumption of an infinite number of observations and no change in the underlying conditions.
Subjective probability is the individual’s personal estimate of the chance of loss.
3. (a) Peril is the cause of loss. Hazard is a condition that creates or increases the chance of loss.
(b) Physical hazard is a physical condition that increases the chance of loss. Moral hazard is
dishonesty or character defects in an individual that increase the chance of loss. Attitudinal
hazard (morale hazard) is carelessness or indifference to a loss. Legal hazard refers to
characteristics of the legal system or regulatory environment that increase the frequency or
severity of losses.
4. (a) Pure risk is defined as a situation in which there are only the possibilities of loss or no loss.
Speculative risk is defined as a situation where either profit or loss is possible.
(b) Diversifiable risk is a risk that affects only individuals or small groups and not the entire
economy. It is a risk that can be reduced or eliminated by diversification. In contrast,
nondiversifiable risk is a risk that affects the entire economy or large numbers of persons or
groups within the economy. It is a risk that cannot be reduced or eliminated by diversification.
5. (a) Enterprise risk is a term that encompasses all major risks faced by a business firm, which include
pure risk, speculative risk, strategic risk, operational risk, and financial risk.
(b) Financial risk is the uncertainty of loss because of adverse changes in commodity prices, interest
rates, foreign exchange rates, and the value of money.
(c) Systemic risk is the risk of collapse of an entire system or entire market due to the failure of a
single entity or group of entities that can result in the breakdown of the entire financial system.
6. (a) Enterprise risk management combines into a single unified treatment program all major risks
faced by the firm. These risks include pure risk, speculative risk, strategic risk, operational risk,
and financial risk.
(b) Traditional risk management considered only major and minor pure risks faced by a corporation.
These risks were limited to property, liability, and personnel-related loss exposures. Enterprise
risk management considers all risks faced by a corporation as described in (a) above.
7. Personal risks associated with great financial and economic insecurity include the risks of premature
death, insufficient income during retirement, old age, poor health, unemployment, and alcohol and
drug addiction. In addition, persons owning property are exposed to the risk of having their property
damaged or lost from numerous perils. Finally, liability risks are also associated with great financial
and economic insecurity.
, 8. Risk is a burden to society in at least three ways:
(a) The size of an emergency fund must be increased.
(b) Society may be deprived of needed goods and services.
(c) Worry and fear are present.
9. A direct loss is a financial loss that results from the physical damage, destruction, or theft of property.
Indirect loss results from or is the consequence of a direct loss. For example, if a student’s car is
stolen (direct loss), he or she will lose the use of the car until it is replaced or recovered (indirect
loss).
10. Major risks faced by business firms include property risks, liability risks, loss of business income,
cyber security and identity theft, crime exposures, human resources exposures, foreign loss
exposures, intangible property exposures, and government exposures.
11. (a) Risk control techniques refer to techniques that reduce the frequency or severity of losses. They
include the following:
(1) Avoidance. This means a certain loss exposure is never acquired, or an existing loss exposure
is abandoned. For example, a drug manufacturer can avoid lawsuits associated with a
dangerous drug by not producing the drug.
(2) Loss prevention. Certain activities are undertaken that reduce the frequency of a particular
loss. One example of loss prevention is periodic inspection of steam boilers to prevent an
explosion.
(3) Loss reduction. This refers to measures that reduce the severity of a loss after it occurs. One
example of loss reduction is an automatic sprinkler system in a department store that can
reduce the severity of a fire loss.
(4) Duplication. This technique refers to have back-up or duplicate copies of important
documents or property in the event a loss occurs.
(5) Separation. The assets exposed to loss are separated or divided to minimize the financial loss
from a single event.
(6) Diversification. This technique reduces the chance of loss by spreading the loss exposure
across different parties.
(b) Risk financing refers to techniques that provide for the payment of losses after they occur. They
include the following
(1) Retention. This means that an individual or business firm retains part or all of the losses that
can result from a given loss exposure. For example, a motorist may retain the first $500 of a
, physical damage loss to his or her automobile by purchasing an auto insurance collision
policy with a $500 deductible.
(2) Noninsurance transfers. This means that a risk is transferred to another party other than an
insurance company. For example, the risk of a defective television set can be shifted or
transferred to the retailer by the purchase of a service contract by which the retailer is
responsible for all repairs after the warranty expires.
(3) Insurance. Insurance transfers risk to an insurer that pays if a loss occurs. An auto insurance
policy can be purchased covering liability arising from the negligent operation of an
automobile.
ANSWERS TO APPLICATION QUESTIONS
1. Objective risk is the relative variation of actual loss from expected loss. Although the chance of loss
may be identical for two different groups, the relative variation of actual from expected loss may be
quite different. For example, if a company has a fleet of 1,000 trucks, the expected number of
collision losses each year may be 30. However, actual losses may vary each year from 25 to 35. In
contrast, another fleet of 1,000 trucks may have the same number of expected losses (30), but the
annual variation may be considerably higher, such as 20 to 40. Thus, objective risk is greater for the
second fleet.
2. (a) This is a nondiversifiable risk because the entire nation can be affected by a terrorist attack.
(b) This is a pure risk. The insured rarely profits if his or her house is damaged in a fire.
(c) This is pure risk because of the loss of earned income. You usually do not profit if you
are totally disabled.
(d) This is a speculative risk. Profit or loss is possible.
(e) This is a nondiversifiable risk because large numbers of people can lose their homes in
a major flood.
(f) This is a nondiversifiable risk because large numbers of home buyers will be adversely affected
by higher interest rates and higher monthly mortgage payments. From the viewpoint of home
builders and realtors, a rise in interest rates is also a financial risk that can slow down the sale of
new and used homes.
(g) This is a speculative risk because both profit and loss are possible.
3. (a) Risk control such as exercise, losing weight, and following a healthy diet can reduce the chance
of dying prematurely from a heart attack. Life insurance can also be used, which reduces or
eliminates the financial consequences to surviving family members if a family head dies
prematurely.
PRINCIPLES OF RISK MANAGEMENT AND INSURANCE
14TH EDITION
CHAPTER NO. 01: RISK AND ITS TREATMENT
ANSWERS TO CASE APPLICATION
a. Retention. Because the car is old and has a limited market value, collision insurance should not be
purchased. Retention can be used to deal with the exposure.
b. Liability insurance. Because the exposure has the potential for causing a catastrophic loss, auto
liability insurance should be purchased.
c. Insurance. Property insurance could be purchased to deal with the property exposure of $10,000. The
policy should contain a deductible.
d. Retention. The dollar value of the loss of a disposable contact lens is small.
e. Loss control. The waterbed should be carefully checked for possible leaks to reduce the possibility of
damage to the apartment. As an alternative, an endorsement can be added to a homeowners policy to
cover the liability exposure.
f. Avoidance. Michael should pick a new running route.
g. Life insurance. Michael’s father should have purchased life insurance. The loss of tuition would have
been replaced by life insurance.
ANSWERS TO REVIEW QUESTIONS
1. (a) There is no single definition of risk. Historically, many insurance authors have defined risk in
terms of uncertainty. Risk is uncertainty concerning the occurrence of a loss.
(b) A loss exposure is any situation or circumstance in which a loss is possible, regardless of whether
a loss occurs.
(c) Objective risk is the relative variation of actual loss from expected loss. As the number of
exposure units under observation increases, objective risk declines. Subjective risk is uncertainty
based on one’s mental condition or state of mind. Accordingly, objective risk is measurable and
statistical; subjective risk is personal and not easily measured.
2. (a) Chance of loss can be defined as the probability that an event will occur.
, (b) Objective probability refers to the long-run relative frequency of an event based on the
assumption of an infinite number of observations and no change in the underlying conditions.
Subjective probability is the individual’s personal estimate of the chance of loss.
3. (a) Peril is the cause of loss. Hazard is a condition that creates or increases the chance of loss.
(b) Physical hazard is a physical condition that increases the chance of loss. Moral hazard is
dishonesty or character defects in an individual that increase the chance of loss. Attitudinal
hazard (morale hazard) is carelessness or indifference to a loss. Legal hazard refers to
characteristics of the legal system or regulatory environment that increase the frequency or
severity of losses.
4. (a) Pure risk is defined as a situation in which there are only the possibilities of loss or no loss.
Speculative risk is defined as a situation where either profit or loss is possible.
(b) Diversifiable risk is a risk that affects only individuals or small groups and not the entire
economy. It is a risk that can be reduced or eliminated by diversification. In contrast,
nondiversifiable risk is a risk that affects the entire economy or large numbers of persons or
groups within the economy. It is a risk that cannot be reduced or eliminated by diversification.
5. (a) Enterprise risk is a term that encompasses all major risks faced by a business firm, which include
pure risk, speculative risk, strategic risk, operational risk, and financial risk.
(b) Financial risk is the uncertainty of loss because of adverse changes in commodity prices, interest
rates, foreign exchange rates, and the value of money.
(c) Systemic risk is the risk of collapse of an entire system or entire market due to the failure of a
single entity or group of entities that can result in the breakdown of the entire financial system.
6. (a) Enterprise risk management combines into a single unified treatment program all major risks
faced by the firm. These risks include pure risk, speculative risk, strategic risk, operational risk,
and financial risk.
(b) Traditional risk management considered only major and minor pure risks faced by a corporation.
These risks were limited to property, liability, and personnel-related loss exposures. Enterprise
risk management considers all risks faced by a corporation as described in (a) above.
7. Personal risks associated with great financial and economic insecurity include the risks of premature
death, insufficient income during retirement, old age, poor health, unemployment, and alcohol and
drug addiction. In addition, persons owning property are exposed to the risk of having their property
damaged or lost from numerous perils. Finally, liability risks are also associated with great financial
and economic insecurity.
, 8. Risk is a burden to society in at least three ways:
(a) The size of an emergency fund must be increased.
(b) Society may be deprived of needed goods and services.
(c) Worry and fear are present.
9. A direct loss is a financial loss that results from the physical damage, destruction, or theft of property.
Indirect loss results from or is the consequence of a direct loss. For example, if a student’s car is
stolen (direct loss), he or she will lose the use of the car until it is replaced or recovered (indirect
loss).
10. Major risks faced by business firms include property risks, liability risks, loss of business income,
cyber security and identity theft, crime exposures, human resources exposures, foreign loss
exposures, intangible property exposures, and government exposures.
11. (a) Risk control techniques refer to techniques that reduce the frequency or severity of losses. They
include the following:
(1) Avoidance. This means a certain loss exposure is never acquired, or an existing loss exposure
is abandoned. For example, a drug manufacturer can avoid lawsuits associated with a
dangerous drug by not producing the drug.
(2) Loss prevention. Certain activities are undertaken that reduce the frequency of a particular
loss. One example of loss prevention is periodic inspection of steam boilers to prevent an
explosion.
(3) Loss reduction. This refers to measures that reduce the severity of a loss after it occurs. One
example of loss reduction is an automatic sprinkler system in a department store that can
reduce the severity of a fire loss.
(4) Duplication. This technique refers to have back-up or duplicate copies of important
documents or property in the event a loss occurs.
(5) Separation. The assets exposed to loss are separated or divided to minimize the financial loss
from a single event.
(6) Diversification. This technique reduces the chance of loss by spreading the loss exposure
across different parties.
(b) Risk financing refers to techniques that provide for the payment of losses after they occur. They
include the following
(1) Retention. This means that an individual or business firm retains part or all of the losses that
can result from a given loss exposure. For example, a motorist may retain the first $500 of a
, physical damage loss to his or her automobile by purchasing an auto insurance collision
policy with a $500 deductible.
(2) Noninsurance transfers. This means that a risk is transferred to another party other than an
insurance company. For example, the risk of a defective television set can be shifted or
transferred to the retailer by the purchase of a service contract by which the retailer is
responsible for all repairs after the warranty expires.
(3) Insurance. Insurance transfers risk to an insurer that pays if a loss occurs. An auto insurance
policy can be purchased covering liability arising from the negligent operation of an
automobile.
ANSWERS TO APPLICATION QUESTIONS
1. Objective risk is the relative variation of actual loss from expected loss. Although the chance of loss
may be identical for two different groups, the relative variation of actual from expected loss may be
quite different. For example, if a company has a fleet of 1,000 trucks, the expected number of
collision losses each year may be 30. However, actual losses may vary each year from 25 to 35. In
contrast, another fleet of 1,000 trucks may have the same number of expected losses (30), but the
annual variation may be considerably higher, such as 20 to 40. Thus, objective risk is greater for the
second fleet.
2. (a) This is a nondiversifiable risk because the entire nation can be affected by a terrorist attack.
(b) This is a pure risk. The insured rarely profits if his or her house is damaged in a fire.
(c) This is pure risk because of the loss of earned income. You usually do not profit if you
are totally disabled.
(d) This is a speculative risk. Profit or loss is possible.
(e) This is a nondiversifiable risk because large numbers of people can lose their homes in
a major flood.
(f) This is a nondiversifiable risk because large numbers of home buyers will be adversely affected
by higher interest rates and higher monthly mortgage payments. From the viewpoint of home
builders and realtors, a rise in interest rates is also a financial risk that can slow down the sale of
new and used homes.
(g) This is a speculative risk because both profit and loss are possible.
3. (a) Risk control such as exercise, losing weight, and following a healthy diet can reduce the chance
of dying prematurely from a heart attack. Life insurance can also be used, which reduces or
eliminates the financial consequences to surviving family members if a family head dies
prematurely.
