Q.

1:

Ramu is a university senior who is who is studying finance. He owns a car that has
a current market value of Rs 20,50,000. The current replacement value of his
clothes, TV, stereo, mobile phone, and other personal property in a rented
apartment totals Rs. 1,00,000. He uses disposable contact lenses, which cost Rs
20,000 for a seven-month supply. He also has a waterbed in his rented apartment
that has leaked in the past. A passionate runner, Ramu runs six miles daily in a
nearby public park that has the reputation of being extremely hazardous because
of drug traders, many attacks and robberies, and drive-by shootings. Shyamu’s
parents both work to help him pay his tuition.

For each of the following risks or loss exposures, identify an appropriate risk
management technique that could have been used to deal with the exposure.
Explain your answer.

a) Physical damage to the car because of a collision with another motorist

Retention: Since, there is less chance of having large damage to the car. So, it
is better to retain such type of risk by ourself.
b) Liability lawsuit against Ramu as a consequence of neglectful operation of his
car
Liability insurance: Liability insurance should be taken to prevent from any
liability claim arising due to injury to somebody along with damage to
someone’s property.
c) Total loss of clothes, television, stereo, and personal property because of a
grease fire in the kitchen of his rented apartment
 Loss Prevention: Appropriate measure to manage risk from fire such as
installation of sprinkler system and utilization of fire-resistant materials
should be adopted.
Insurance: Fire insurance should be taken to prevent from damage if could
not be controlled by risk prevention technique adopted.
d) Disappearance of one contact lens.
Retention: Since, the monetary value of one single contact lens is less. It is
better to retain such type of risk.
e) Waterbed leak that causes property damage to the apartment
Loss Prevention: Since, the waterbed leak occurred previously in the
apartment. So, it is better to allow for regular inspection of the water supply
to the waterbed.
f) Physical assault on Ramu by gang members who are dealing drugs in the park
where he runs
Avoidance: Ramu can avoid route during the morning exercising time in the
nearby public park
g) Loss of tuition assistance from Ramu’s father who is killed by a drunk driver in
an auto accident

Insurance: Ramu’s father should take life insurance along with accidental
death benefit as rider benefit. So, in the case of such accidental death the
amount from the insurance would offset the loss of his father’s death.

Q.2:
Several types of risk are present in the American economy. For each of the
following, identify the type of risk that is present. Explain your answer.

a) The Department of Homeland Security alerts the nation of a possible attack

by terrorists.
Systematic risk: The terrorist attack would affect the entire nation not just
single individual and industry/corporation.
b) A house may be severely damaged in a fire.
Pure risk: There may be a situation of occurrence of loss or not occurrence of
loss from fire.
c) A family head may be totally disabled in a plant explosion.
Non-Systematic risk: Disability of family head of any particular family result in
the financial difficulty within the particular family.
d) An investor purchases 100 shares of Microsoft stock.
Speculative risk: Following the price fluctuation in the Microsoft shares profit
or loss would result. The risk of going the share price in either direction is
present.
e) A river that periodically overflows may cause substantial property damage to
thousands of homes in the floodplain.
Systematic or fundamental risk: Because flood affects the overall geographical
area.
f) Home buyers may be faced with higher mortgage payments if the Federal
Reserve raises interest rates at its next meeting.
Non-Diversifiable risk: Since, the increase in the interest rate on mortgage
increases the total interest amount than previously paid on loan of all types.
g) A worker on vacation plays the slot machines in a casino.
 Speculative risk: There is a possibility of gaining profit or occurrence of loss
while playing slot machines in a casino.

Q.3:

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.

Health insurance: The family head should take health insurance from any
government or private insurance company. So, on occurrence of such risk the
financially dependent are provided with enough cash amount to sustain until
they are financially independent.
Loss Prevention: Appropriate healthy practices such as adoption of regular
exercise practices, control of cholesterol in diet, healthy food habits, limit
alcohol consumption.
b) An individual’s home may be totally destroyed in a hurricane.
Home insurance: Home insurance should be taken to avoid from the
catastrophic damage
Active Retention: Insurance with deductible should be taken to retain the part
of total risk.
c) A new car may be severely damaged in an auto accident.
 Auto insurance: Insurance policy with deductible should be purchased to
prevent from damage done to car.
Retention: Part of the total loss should be retained.
Loss Prevention: He/she should drive defensively.
d) A negligent motorist may be ordered to pay a substantial liability judgment to
someone who is injured in an auto accident.
Liability insurance: Liability insurance should be taken to prevent from any
liability claim arising due to injury to somebody during its operation.
e) A surgeon may be sued for medical malpractice.

Professional Liability insurance: Professional Liability insurance should be

taken to prevent from any liability claim arising due to injury to somebody
along with damage to someone’s property. Also, he should adopt risk
prevention methods.

Q.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
Retention: The firm wants to retain earthquake exposure on its main
manufacturing plant.
b) The installation of an automatic sprinkler system in a hotel
Loss Prevention: Upon installation of automatic sprinkler system in a hotel, it
reduces the possibility of damage due to fire.
c) The decision not to produce a product that might result in a product liability
lawsuit
Avoidance: The firm is avoiding the lawsuit of customer by not producing the
product which injury consumers.
d) Requiring retailers who sell the firm’s product to sign an agreement releasing
the firm from liability if the product injures someone

Transfer of risk by contract: The firm manufacturing the product transfer

liability risk to its retailer by signing this contract.

Q.5:

Andrew owns a gun shop in a high crime 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 noninsurance methods that could be
used to deal with the burglary and theft exposure.

Ans: Andrew can indulge in following noninsurance methods to deal with burglary
and theft exposure:

Avoidance: Andrew can start a new line of business. Hence, avoiding the risk of
burglary and theft exposure. However, this is not a feasible or practical solution.

Loss Prevention: Andrew can install burglary alarm system in his shop. He can shift
the shop location to a place where there is low crime rate. Also, he can hire
armed guards to safeguard the shop from such incident.
Retention: Andrew can retain part of the loss to some threshold limit. After the
loss exceeding retention limit, he can buy an insurance contract which covers the
loss related to burglary and theft.

Match each term with a statement

1. Premium A fee that is charged for insurance coverage.

2. Risk The possibility that a loss will occur.
3. Insurance Policy A contract between two parties.
4. Risk management The purpose is to minimize the costs of a loss or injury.
5. Speculative risk A decision to market a new product is an example of this type
of risk.
6. Insurer The party that assumes financial responsibility for losses.
7. Insurable risk Insurance companies are willing to assume this type of risk.
8. Pure risk An example of this risk is the possibility of an automobile accident.
9. Insurance It provides protection through a contract against loss.
10.Self-insurance A monetary fund established to cover the cost of a loss.

Risk; Speculative risk; Pure risk; Risk management; Self-insurance; Insurer;

Premium; insurance policy; insurance; insurable risk.

True-False Questions
1. T Driving an automobile carries a potential pure risk.
2. F Businesses use smoke alarms, security guards, and safety equipment
to avoid
risk.
3. T A premium is a fee charged by the insurer.
4. F Auto accidents are classified as speculative risks.
5. F Generally, the greater the risk and the amount to be paid, the smaller
the
premium.
6. T The probability of a loss must be predictable for a risk to be
insurable.
7. T Risk exists where there is uncertainty.
8. F Risk exists where there is certainty of loss.

Multiple Choice Questions

1. When a jewelry store locks its merchandise in a vault at the end of the day, it is
practicing
a) risk reduction.
b) risk avoidance.
c) risk assumption.
d) risk shifting
e) none of the above.
Answer: b)
2. Risks that insurance firms will not assume are called
a) Uninsurable risks
b) insurable risks.
c) endorsements.
d) pure risks
e) avoidable risks
Answer: a)
3. Which of the following is not a condition for an insurable loss?
a) Losses must be under the control of the insured.
b) The insured hazard must be geographically widespread.
c) The probability of a loss should be predictable.
d) Losses must result from an intentional action by the insured person.
e) Losses must be measurable.
Answer: d)
Q.6:
Short answer Questions:
1. Compare a speculative risk with a pure risk and give an example of each.
Ans:
Pure risk or absolute risk is a type of risk that cannot be controlled and has only
two possible outcomes: complete loss or no loss, therefore there are no
opportunities for gain or profit. Pure risk is divided into three categories:
personal, property, and liability. Pure risk can be avoided, accepted or
transferred to an insurance company. Therefore, it is usually insurable.
For e.g.: Car in perfect condition results in nothing bad occurring while the
damage to car due to collusion results in financial cost of replacing the car and
results in loss to the owner.

Speculative risk is controlled risk as it involves moral hazard that makes people
seek out some risks rather than avoid them, thus it’s a choice and not the result
of uncontrollable circumstances. Speculative risk can result in either profit or
loss. Gambling transactions and financial investment activities are two common
examples of speculative risk.
2. Explain why speculative risks are generally not insurable.
Ans:
Speculative risks are not insurable because the lure of the possible reward
causes people to take these risks upon themselves willingly. The possibility of
gain is a moral hazard (more on that later) that makes people seek out the
risk, rather than avoid it. With certain exception (such as institutional
portfolio investments and municipal bonds against loss), private insurers
generally concentrate on insuring certain pure risk. Secondly, the law of large
number can be applied more easily to pure risk than to speculative risk. The
law of large numbers is important because it enables insurers to predict
future loss experience. Thirdly, society may benefit from the speculative risk
even though the loss occurs, but it is harmed if a pure risk is present and a
loss occurs. For example, a firm may develop new technology for producing
inexpensive computers. As a result, some competitors may be forced into
bankruptcy. Despite the bankruptcy, social benefits because the computers
are produced at a lower cost. However, society normally does not benefit
when a loss from a pure risk occurs, such as flood or earthquake that
devastates an area (Rejda, 2016).

3. Describe how a firm can use each risk management technique to manage risk.
Include examples.
Ans: Technique of managing risk can broadly classified as:
a) Risk control techniques refer to techniques that reduce the frequency or
severity of losses. They include the following:
  Avoidance: This means a certain 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.
 Loss prevention: Certain activities are undertaken that reduce the
frequency of a particular loss. Examination of aero plane by flight
safety engineer can help to reduce the possibility of occurrence of
loss.
 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.
 Duplication: This technique refers to have back-up or duplicate
copies of important documents or property in the event of loss
occurs.
 Diversification: This technique reduces the chance of loss by
spreading the loss exposure across parties.
 Separation: The assets exposed to loss are separated or divided to
minimize the financial loss from a single event.
b) Risk financing refers to techniques that provide for the payment of losses
after they occur. They include the following:
 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 firm Rs.1000 of a physical
 damage loss to his or her automobile by purchasing an auto
insurance with accidental damage of Rs. 1000 deductible.
 Non-insurance transfer: 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.
 Insurance: An auto insurance policy can be purchased covering the
negligent operation of an automobile.
4. Discuss a situation where self-insurance may be practical.
Ans:
A large corporation may self-insure or fund part or all of the group health
insurance benefits paid to employees. The culture of high rates of self-
insurance among large corporation is that their risk pools are large and
actuarially enable them to better predict their employees’ health expenses.
They basically retain the expenses paid to employee up to certain dollar value
and beyond that rupee value they purchase excess-loss insurance from the
insurance company. So, that they can insure themselves if the claim amount
exceeds the certain rupee value.

Q.7:
Questions for Discussions:
1. Mike says, “The possibility that my house may burn is a pure risk form, but if I
buy insurance, it is a speculative risk for the insurance company.” Do you
agree? Why or why not?
 Ans: Yes, I agree with the Mike’s statement “The possibility that my house
may burn is a pure risk but if I buy insurance, it is speculative risk for the
insurance company.” For Mike the occurrence of the loss due to fire results in
financial loss to him, whereas the building in perfect condition results in no-
profit or no-loss situation. So, we can say that it is a pure risk for Mike. For the
insurance company where Mike insured his property, the occurrence of fire
on his home results in loss whereas the building in perfect condition results in
profit from the premium earned. So, we can say that it is a speculative risk for
the insurance company where Mike insured his property.

2. What risks do you face as an individual? Which, of these risks have you
elected to retain and which have you transferred? (Harrington book)
Ans:
The risks that individual face is listed below:
i) Earning risk
ii) Medical expenses risk
iii) Liability risk
iv) Physical asset risk
v) financial asset risk
vi) longevity risk

 Earning risk refers to the potential fluctuation in family’s earnings,

which can occur as a result of a decline in the value of an individual
earner’s productivity due to death, disability, aging, or a change in
technology(unemployment). My family have taken life insurance
 contract with the accidental death benefit, disability benefit and
unemployment benefit as rider in the policy.
 Health care cost may sometimes arise large unexpected cashflow.
Since, overall health of our parents and brother are satisfactory, so we
have decided to retain medical expenses.
 Liability suits can cause large unexpected expenses. Since, my parents
and brother ride bike often, so we have done third party insurance
from the private insurance company.
 Physical assets such as Automobile, homes and computer can be lost
stolen, or damaged. We have taken insurance for homes and
automobile and retained computer related risk.
 Financial assets values also are subject to fluctuation due to change in
inflation, and changes in real value of stocks and bonds. We have
decided to retain such risks as insurance against investments are not
prevalent right now.
 Longevity risk refers to the possibility that retired people will outlive
their financial resources. Brother and me have decided to take proper
care of our parents and have retained risk from the longevity of
parents.

3. Describe loss control measures that you could take to reduce your risk of
being insured in an automobile accident.
Ans: The risk of being injured in an automobile can be reduced by driving:

i) Less often
ii) More safely
iii) During times that have a lower likelihood of accidents (For example,
day time during non-rush hour period)
iv) Less often on dangerous roads
v) A safer car
vi) At lower speeds
vii) Using seat belts
viii) without distractions (For example, not using a phone)