Study 2 – The Risk Management Process
1. What are the steps of the risk management process? (p. 2)
1. Identify and Analyze
2. Formulate Options
3. Select the Best Technique
4. Implement the Plan
5. Monitor and Modify
2. How are client needs determined? (p. 2)
Client’s needs are determined by identifying loss exposures. Thus, by using risk management techniques, a needs-based sales approach is achieved.
3. What outside sources can be helpful to identify and treat loss exposures? (p. 3)
Both full-time risk managers and insurance personnel may seek help from outside resources. Lawyers and accountants can help to estimate amounts subject to loss and determine the resources available to handle the loss costs. In addition, there are many consultants, safety service companies and others ready to help identify exposures.
4. What are four methods commonly used to identify exposures? (p. 4)
1. Surveys
2. Flow Charts
3. Financial Statements
4. Inspections
5. Review the Insurance Checklist for Commercial Accounts. (p. 6-7)
6. Review the Contents Schedule. (p. 8-9)
7. What are the drawbacks of checklist forms? (p. 4)
The checklist describes subject of insurance, highlights the perils these exposures are subject to and lists the types of insurance policies appropriate for the exposures mentioned. Loss exposures are not described in detail.
8. What do flow charts identify? (p. 5)
A flow chart of a business process may help in identifying exposure to loss. It maps the sequence of business activity in its basic components using graphic representation. A flow chart reveals the bottlenecks in production.
9. What information is revealed in financial statements? (p. 5)
Company financial statements help to identify loss exposures through examination of the company balance sheet, the methods of valuation used for accounting purposes and the income statement.
10. What are the drawbacks of on-site inspections? (p. 11)
Site inspections are expensive, especially when an independent professional inspection is required.
11. What are the advantages of on-site inspections? (p. 11)
First-hand impressions are much more useful than third-hand information such as flow charts, questionnaires and financial statements. The producer will get a better understanding of the operation which increases the ability to better serve the client.
12. What factors are considered in the analysis of loss exposures? (p. 11)
1. Likelihood of the loss occurring (loss frequency)
2. Seriousness of the loss (loss severity)
3. Financial effect of all losses in any given period of time (frequency times severity)
4. Reliability of the predictions of frequency and severity.
13. What are the Prouty classifications for measuring loss frequency and severity? (p. 12)
Frequency and severity can be classified in down-to-each nonmathematical terms using Prouty Measures developed by Richard Prouty.
Frequency:
· Almost nil
· Slight
· Moderate
· Definite
Severity:
· Maximum possible loss – the worst that can happen
· Maximum probably loss – the worst that is likely to happen
· Annual expected dollar loss – the expected average severity times expected frequency
14. What type of changes must be considered when predicting the frequency and severity of losses? (p. 13)
The objective is to predict with as much certainty as possible what the probabilities are of future losses (both frequency and severity) so as to better analyze the exposure to loss. Calculations based on the past can reliably predict the probabilities of future events only If everything else remains unchanged.
15. What are the two major classifications used in treating loss exposures? (p. 15)
1. Loss control techniques: to control the exposure to prevent losses or reduce their severity.
2. Loss financial techniques: to pay for losses which do occur.
16. What are the two basic theories of loss control? (p. 15)
1. Domino Theory: The first theory was conceived by H.W. Heinrich. He concludes that all losses are the result of unsafe acts of persons – accidents are the fault of people. It held that unsafe acts begin the chain of events which ultimately lead to accidents.
2. Energy Release Theory: Dr. William Haddon stated that accidents result from mechanical failures.
17. Name the five loss control techniques. (p. 16)
1. Avoidance
2. Loss prevention
3. Loss reduction
4. Separation or diversification
5. Noninsurance risk transfer
18. Given an example of each loss control technique. (p. 10)
Avoidance: It is more likely that a decision to avoid a certain risk exposure will lead to newly created exposures that require attention and perhaps another risk treatment as they are impractical or impossible to avoid.
Loss prevention: Regular inspection and testing of machinery and equipment is a loss prevention activity. Such routine inspections conducted at regular intervals have been so effective in preventing losses that the probability of elevator losses approaches zero.
Loss reduction: are used to lessen the severity of those losses which do occur. Installing automatic sprinklers or other fire suppression devices designed to slow or stop the spread of fires are example of loss reduction.
Separation or diversification: Costly as it is difficult to implement. Items subject to loss can be moved to separate locations to reduce the concentration of value should a loss occur at one location. The potential of one loss wiping out the entire operation becomes less likely.
Noninsurance transfers: passes any financial responsibility for a loss to someone else. Probably of a loss remains the same, but the asset or activity from which the exposure to loss arises is transferred to another party.
19. How is retention defined in risk management? (p. 19)
Retention is absorbing all or part of the loss and is sometimes the only risk management technique available. A plan to retain risk works best for losses that are not too serious and fairly predictable. In other words, they should be low in severity and high in frequency.
20. What is the difference between active and passive decisions in risk retention? (p. 19)
An active decision is one made consciously, whether it involves doing something or not doing something.
When an exposure is retained because it was never identified, it is known as a passive retention. This is an unwelcome situation since no plan will exist to deal with the unexpected loss.
21. What are the five sources of funds to pay for retained losses? (p. 19)
1. Current expenses
2. Unfunded reserves
3. Funded reserves
4. Borrowing
5. Captive insurers
22. Review the advantages of disadvantages of loss retention. (p. 21)
For larger organizations that potentially spend large sums of money to purchase insurance, retention is a method to gain control of the premium dollars and possibly improve a company’s work flow. An appropriate blend of retention and transfer techniques should maximize the potential for a healthy cash flow within an organizing.
For small anticipated losses, a retention program may reduce the cost of the risk management program. The company will fix an appropriate level of retention based on corporate needs and objectives. When companies must pay for at least part of their own losses it encourages them to actively practice loss prevention, since a loss prevented is money saved. If more losses occur than expected, the retention program may cost the company more than what it saved by purchasing a larger deductible. If losses are modest, the company may improve cash flow because losses are only paid when they occur and not in advance. However, if losses are heavy and come early, retention could be more a drain on cash flow than paying an insurance premium in advance.
23. What are the benefits of large deductibles? (p. 23)
Large retention levels can only be justified if adequate loss history is available to reasonably predict future losses and the company has the financial resources to pay for losses that do occur. Retention is best practiced for smaller, predictable losses.
Commercial insurance purchased with larger deductibles will result in savings that can be applied towards the purchase of higher limits of insurance. It is better to protect against a single large loss that might impair a company’s survival than to save a few dollars to maintain low limits of insurance.
24. What are unbundled services? (p. 23)
Larger organizations may want to pick and choose the services they purchase from an insurer. It is viewed by clients as a way to reduce premium costs. It is a way to customize the services they need. Not all insurers offer this service and it is not generally used.
25. What are the two methods used to transfer responsibility for paying losses? (p. 25)
1. Transfer of loss to other entities by business contract
2. Transfer of loss to an insurer through an insurance policy
26. What do hold-harmless agreements and indemnification clauses achieve? (p. 25)
Contracts often include Hold-harmless agreements and indemnification clauses to transfer the financial sequences of losses. Any type of contract may include these provisions:
· A lease of premises or equipment
· Construction agreements
· A bailment contract
· Contacts of sale and supply
· Purchase order agreements
· Service contracts
27. What other safeguards are used to strengthen the reliability of hold-harmless agreements and indemnification clauses? (p. 26)
When hold-harmless agreements and indemnifications clauses are drafted, the requirements for liability insurance should be part of the contract. The policy should include a waiver of subrogation against the indemnitee. The insurance should also include the indemnitee as an additional insured. In this way, the indemnitee has the right to report a claim directly to the insurer when the indemnitor is unable or unwilling to do so. The indemnitee will be more secure in the fact that the promise to pay is strengthened with an insurance policy.
28. Review the advantages and disadvantages of noninsurance transfers. (p. 27)
Advantages:
· Exposure may not be insurable
· Transfer may be less expensive than insurance
· Agreement may be tailored to meet individual needs
· Exposure can be controlled by the party in the best position to do so
Disadvantages:
· Transfer may not be as complete as intended
· Agreements subject to litigation and reinterpretation by courts of law
· Indemnitor may be unable to pay the loss
· Strength of agreement susceptible to economic environment
29. How does insurance transfer risk? (p. 27)
Insurance is a mechanism by which insureds exchange, which is transfer, the uncertainty of future losses for the certainty of a fixed sum (the premium).
Insurance differs from hold-harmless agreements since the contract of insurance deals principally with the transfer of risk. Insurance is available to cover many exposures whether they arise from potential damage to physical assets, the potential loss of use of physical assets, third-party liabilities or the human-asset exposures of sickness, disability and death.
30. What must a potential client consider when selecting a producer and an insurer? (p. 28)
First the financial strength of the insurer must be considered. A second consideration is the willingness of the insurer to provide the required coverages. A third consideration is the range of additional services offered by the insurer and producer. Finally, the cost of the coverage must be considered.
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