1. Several types of risk are present in the Malaysian economy.

y. For each of the following, identify the type of risk

that is present. Explain your answer.

a) The Ministry of Home Affairs and Internal Security alerts the nation of a possible attack by terrorists.

ASW: This is a nondiversifiable risk because the entire nation can be affected by a terrorist attack.

b) A family head may be totally disabled in a plant explosion.

ASW: This is pure risk because of the loss of earned income. You usually do not profit if you are totally
disabled.

c) An investor purchases 100 shares of MTouche Technology Bhd stock.

ASW: This is a speculative risk. Profit or loss is possible.

d) A river that periodically overflows may cause substantial property damage to thousands of homes in the
floodplain.

ASW: This is a nondiversifieable risk because large numbers of people can lose their homes in a major
flood.

e) Home buyers may be faced with higher mortgage payments if Bank Negara Malaysia raises interest rates at
its next meeting.

ASW: 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.

f) A worker on vacation plays the slot machines in a casino.

ASW: This is a speculative risk because both profit and loss are possible.
2. There are several techniques available for managing risk. For each of the following risks, identify an
appropriate technique, or combination of techniques, that would be appropriate for dealing with the risk.

a) A family head may die prematurely because of a heart attack.

ASW: 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.

b) An individual’s home may be totally destroyed in a hurricane.

ASW: Property insurance is an appropriate technique for dealing with the risk of a hurricane. Retention can
also be used by purchasing the policy with a deductible.

c) A new car may be severely damaged in an auto accident.

ASW: Collision insurance on the new car is an effective way to deal with this exposure. Retention can also
be used by purchasing the policy with a deductible for collision losses. The insured can also drive
defensively, which is a form of risk control.

d) A negligent motorist may be ordered to pay a substantial liability judgment to someone who is injured in an
auto accident.

ASW: A catastrophic loss exposure is present. Auto liability insurance should be purchased to deal with the
exposure.
 e) A surgeon may be sued for medical malpractice.

ASW: Professional liability insurance should be purchased to deal with malpractice suits. The surgeon could
also use risk control to reduce the possibility of injuring a patient.

3. Chong Hwa owns a jewellery shop in a high crime rate area. The store does not have a camera surveillance
system. The high cost of burglary and theft insurance has substantially reduced his profits. A risk management
consultant points out that several methods other than insurance can be used to handle the burglary and theft exposure.
Identify and explain TWO (2) noninsurance methods that could be used to deal with the burglary and theft exposure.
ASW:
(a) Avoidance. CH can avoid the risk of burglary or robbery by going into a different line of business. However,
this is not a practical solution and may not be feasible.
(b) Risk control. Risk control efforts can be undertaken to reduce both the frequency and severity of losses. A
burglar alarm system can be installed. The pawn shop can be relocated to another part of the city where crime
rates are lower. Losses also can be prevented by hiring a guard or patrol service to protect the property.
(c) Retention. CH may decide to retain all losses, thereby eliminating the need for burglary insurance. However,
since a large loss could result in financial ruin, he may decide to retain losses only up to a certain amount, such
as RM1000. Excess insurance can be purchased for losses exceeding the retention limit.

4. Risk managers use a number of methods for managing risk. For each of the following, what method for
handling risk is used? Explain your answer.

a) The decision not to carry earthquake insurance on a firm’s main manufacturing plant.

ASW: Retention. The firm is retaining the earthquake exposure.

b) The installation of an automatic sprinkler system in a hotel.

ASW: Risk control. If a fire occurs, the sprinkler system will operate automatically to extinguish the fire,
thereby reducing the size of the loss.

c) The decision not to produce a product that might result in a product liability lawsuit.

ASW: Avoidance. The firm is avoiding a lawsuit by not manufacturing products that could injure customers
who use the product.

d) Requiring retailers who sell the firm’s product to sign an agreement releasing the firm from liability if the
product injures someone.

ASW: Noninsurance transfer. The firm manufacturing the product has transferred the risk of a liability suit
to the retailers by such an agreement. This agreement is often called a hold-harmless agreement. For
example, a manufacturer may insert a hold-harmless clause in a contract with a retailer by which the retailer
agrees to hold the manufacturer harmless if a scaffold collapses and someone is injured.

5. A business firm is planning to acquire another company through merger. In the acquisition, a manufacturing
plant in another state is being transferred to the firm. Give examples of (a) pure risk, and (b) speculative risk
which might be involved in this transaction.

ASW:

(a) Pure risk: E.g. Fire, windstorm, explosion, flood, earthquake, riot & civil commotion.
(b) Speculative risk: E.g. Marketing, production & financial decisions.

6. Discuss why insurance is more commonly used as a risk-handling technique by smaller firms than by bigger
corporations.

ASW:

Insurers often hold a comparative advantage over their smaller customers in bearing such losses because they
can use risk pooling to better predict the mean losses across all pool members & thus charge lower premiums.
As a result, it is often less expensive for many consumers to transfer their risks to an insurer for a premium than
to bear the risks themselves. Insurance is, therefore, the foundation of the risk management programmes of most
individual consumers as well as most small & medium-sized businesses & non-business organisations.

The value of insurance as a loss-financing mechanism is especially apparent in light of the uncertain timing of
large losses. E.g. Consider a highly profitable small business that faces a 1% chance each year of suffering a
RM500,000 fire loss. While in theory the firm could plan to save RM100,000 per year over 5 years to build a
fund to pay for the loss (ignoring interest), it would not have enough cash, in spite of its high profitability, if the
100-to-1 fire event occurred in year 2 of the savings campaign. Such financing considerations are even more
important to less-profitable organisations that are unable to save large sums of money for such losses.

Insurance is an especially appropriate risk-management tool for a firm when its loss frequency is low & the
severity of a potential loss is high. When the frequency of looses within a firm is low, its risk manager generally
has insufficient data with which to forecast losses, making risk reduction through pooling infeasible. High
severity means that firms are also less likely to have enough funds available internally to bear the risk of
suffering a large loss. Many situations facing both smaller firms & individuals meet these 2 criteria of low
frequency & high severity, & thus insurance is widely purchased. Even large firms will face certain risks that
can be characterised by low-frequency, high-severity loss exposures & thus require insurance. Meanwhile,
under certain conditions, medium-sized to large organisations are less dependent on insurance & often have a
wider variety of non-insurance risk-handling alternatives available to them.

Having said that, firms & individuals also buy insurance for reasons that are unrelated to risk pooling. In some
cases, the law may require them to do so. E.g. Employers are required to provide workers’ compensation
benefits to employees & drivers must purchase auto liability insurance. Lending institutions often require
consumers to buy insurance on autos or real estate as a condition of borrowing money to purchase such items; in
these cases, the insurance protects the lender’s collateral interest in the items should they be damaged /
destroyed. A large firm may need certain services that the insurer offers, e.g. loss-control inspections / loss-
settlement expertise. Finally, exposure to any extremely large potential losses generally requires insurance
protection. The combined effect of these forces creates a fairly consistent level of demand for insurance
products.

7. The Selection of Risk-Handling Techniques, Based on Frequency and Severity

Low Severity High Severity

High Self-insurance (for larger firms) & Avoidance (if possible) & loss
Frequency loss control control
Low Risk assumption & loss control Insurance & loss control
Frequency

Referring to the table above, unlike the other 2 categories of risk-handling techniques, loss control is used across
all 4 quadrants of the table. Discuss why loss control is appropriate across such a wide spectrum of losses.

ASW:
 Low-frequency, low-severity losses are commonly assumed / retained by many organisations because their cost
generally can be paid from cash accounts without causing financial issues. If the organisation is concerned that
larger than expected losses may occur, it can choose to arrange for supplemental internal loss funding to provide
an additional means of financing. Because the organisation is bearing the cost of retained losses internally, it
also will use loss control whenever the cost is lower than resulting reduction in loss costs.

Low-frequency, higher severity losses are incurred by many organisations. Insurers generally can use risk
pooling to reduce risk by combining a large number of exposure units. Loss-control efforts, especially loss-
reduction techniques, are also useful, & insurers often reward a reduction in losses with a reduction in
premiums.

High-frequency, low-severity losses are often self-insured by large organisations that possess enough exposure
units to reduce risk effectively through pooling. Self-insurance also requires that the organisation prearrange
financing to cover the cost of expected self-insured losses. Because the firm is paying for losses internally, it
also will use loss control to reduce losses when its cost is offset by the reduction in losses. Loss prevention is
especially advisable to reduce the frequency of losses. Unlike large organisations, however, smaller firms may
choose to insure high-frequency, low-severity losses because they do not have enough exposure units to reduce
risk effectively through pooling or they lack the financial resources to self-fund these losses.

High-frequency, high-severity losses are potentially catastrophic. As a result, most organisations attempt to
avoid such risks if they can anticipate them with sufficient lead time. Loss-reduction & loss-prevention
activities are also advised. Corporations dealing with high-frequency, high-severity losses face direct & indirect
costs that can force them to restructure their operations dramatically in an effort to generate enough cash to pay
for their mounting losses. In the worst-case scenario, the troubled firm may be forced into bankruptcy, where it
attempts to reorganise & pay for its loss obligations without defaulting on its existing financial obligations to
employees, bondholders & other corporate stakeholders.

8. Is a purchase of insurance a gamble? Discuss.

ASW:

Insurance is the exact opposite of gambling. In gambling, 2 or more persons deliberately set about creating some
hazard for pleasure / profit; they introduce the element of risk where it did not previously exist. Insurance,
however, is designed as a hedge against risks that are already present, or are indissolubly associated with some
purpose other than merely risk creation, the object being to neutralize the existing risk. Thus, a person who buys
property assumes the chance that it will burn, & takes out a policy of insurance to eliminate the financial
consequences of this risk. Without insurance, all persons run the financial risk attached to premature death;
every person in foreign trade assumes the chance that his goods will be lost at sea; every manufacturer takes the
chance that some person will be injured on his premises & that he will be held responsible; every buyer of
property takes the chance that his title will prove to be defective. Insurance is designed to reduce these existing
financial risks, not to create new ones. Insurance & gambling both involve chances. But chances are created by
gambling & are counterbalanced by insurance.