FIN138 – Exam 1 Study Guide (Completed)
Principles of Risk Management & Insurance
Chapter 1 – Basic Concepts
- Definitions of Insurance
* Financial: A mechanism for pooling funds to pay for unexpected losses. Transfers risk from individuals
to insurers.
* Legal: A contractual arrangement where the insurer promises compensation for losses in exchange
for premium payments.
- Types of Risk
* Risk: Uncertainty regarding a possible loss.
* Objective Risk: The measurable variation between expected and actual outcomes.
* Relative Objective Risk: Objective risk compared to expected outcomes, often expressed as a ratio.
* Pure Risk: Only chance of loss (e.g., fire, illness).
* Speculative Risk: Possibility of gain or loss (e.g., investments, gambling).
- Chance of Loss: Probability a loss will occur.
- Peril vs Hazard
* Peril: The cause of loss (e.g., fire, theft).
* Physical Hazard: A condition increasing loss likelihood (e.g., faulty wiring).
- Law of Large Numbers (LLN): Predicts future outcomes more accurately when more exposure units
are pooled.
- Risk Aversion: Preference for avoiding risk, explains why individuals buy insurance.
- Mathematically Fair Price: Expected loss without loading costs.
- Cash Flow Underwriting: Practice of writing policies at lower premiums to generate investment
income.
* Combined Ratio = (Incurred Losses + Expenses) ÷ Premiums Earned.
Chapter 2 – Insurance and Risk
- Characteristics of Insurance: Pooling, transfer of risk, indemnification, and legal contract.
- Six Requirements of Insurable Risk: Large group, accidental loss, determinable loss, no catastrophic
loss, calculable chance, feasible premium.
- Expected Loss = Probability × Magnitude of loss.
- Adverse Selection: High-risk individuals are more likely to seek insurance.
* Controlled with underwriting, exclusions, deductibles.
- Reinsurance: Insurance purchased by insurers to spread risk (protect capacity, profits, and against
catastrophes).
- Insurance Premium Components (MFP + expenses): Pure premium, risk charge, loading, profit
margin.
Chapter 3 – Risk Management
- Risk Management: Identifying, analyzing, and responding to risk.
- Steps: Identify, measure, select method, implement, monitor.
- Direct vs Indirect Loss: Direct = immediate damage, Indirect = consequential losses.
- Risk Matrix: Compares frequency vs severity.
- Handling Methods: Avoidance, Prevention, Reduction, Insurance, Retention.
- Captive Insurer: Insurance company owned by a parent firm (pros: cost savings, cons: high startup).
Chapters 5 & 6 – Insurance Institutions
- GLB Act: Removed barriers between banks, securities, insurers.
- Glass-Steagall Act: Separated banking and investments.
- Stock Insurer vs Mutual Insurer: Stock owned by shareholders, Mutual owned by policyholders.
- Lloyd’s of London: Marketplace for specialized risks.
- Demutualization: Conversion to stock company (pros: capital, cons: loss of control).
- Distribution: Direct marketing, agency-principal, agent vs broker, direct writer vs independent agent.
- Key Jobs: Underwriter, Loss Adjuster, Actuary.
- Investments: Bonds, stocks, real estate.
Chapter 8 – Insurance Regulation
- Reasons for Regulation: Consumer protection, stability, fair competition.
- NAIC: Coordinates state insurance regulation.
- Rating Agencies: AM Best, Moody’s, S&P;, Fitch.
- AM Best: Specializes in insurer ratings.
- State Insurance Commissioners: Regulate insurers, enforce laws.
- Status: State-regulated, debate over federal role.
- Complaint Ratios: Ratio = justified complaints ÷ total; Index compares to industry (1 = average).