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Study Guide

Risk Management By

A. J. Cataldo

About the Author

A. J. Cataldo is currently a professor of accounting at West Chester

University, in West Chester, Pennsylvania. He holds a B.S. degree

in accounting/finance and a master of accounting degree from

the University of Arizona. He earned a Ph.D. from the Virginia

Polytechnic Institute and State University. He is a certified public

accountant and a certified management accountant. He has worked

in public accounting, as a government auditor, controller, and

provided expert testimony in business litigation engagements. His

publications include three Elsevier Science monographs, and his

articles have appeared in Journal of Accountancy, National Tax

Journal, Research in Accounting Regulation, Journal of Forensic

Accounting, and Accounting Historians Journal, among others. He

has also published in and served on editorial review boards for

Institute of Management Accounting association journals, including

Management Accounting, Strategic Finance, and Management

Accounting Quarterly, since January 1990.

Copyright © 2009 by Penn Foster, Inc.

All rights reserved. No part of the material protected by this copyright may be reproduced or utilized in any form or by any means, electronic or mechanical, including photocopying, recording, or by any information storage and retrieval system, without permission in writing from the copyright owner.

Requests for permission to make copies of any part of the work should be mailed to Copyright Permissions, Penn Foster, 925 Oak Street, Scranton, Pennsylvania 18515.

Printed in the United States of America

All terms mentioned in this text that are known to be trademarks or service marks have been appropriately capitalized. Use of a term in this text should not be regarded as affecting the validity of any trademark or service mark.

INSTRUCTIONS 1

LESSON ASSIGNMENTS 7

LESSON 1: INTRODUCTION TO RISK MANAGEMENT 11

EXAMINATION—LESSON 1 23

LESSON 2: GENERAL THEORY OF INSURANCE MARKETS 27

EXAMINATION—LESSON 2 51

LESSON 3: LOSS CONTROL AND LEGAL LIABILITY 55

EXAMINATION—LESSON 3 63

LESSON 4: PERSONAL INSURANCE ISSUES 67

EXAMINATION—LESSON 4 79

LESSON 5: EMPLOYEE-EMPLOYER RELATIONSHIPS 83

GRADED PROJECT 109

EXAMINATION—LESSON 5 115

LESSON 6: BUSINESS RISK MANAGEMENT— THEORY 119

EXAMINATION—LESSON 6 129

LESSON 7—BUSINESS RISK MANAGEMENT— TYPES OF CONTRACTS 133

EXAMINATION—LESSON 7 145

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Contentsiv

LESSON 8—BUSINESS RISK MANAGEMENT— ADDITIONAL TOPICS 149

EXAMINATION—LESSON 8 161

SELF-CHECK ANSWERS 165

INTRODUCTION Welcome to Risk Management! This course will provide you with insights into how the insurance industry operates. All business decisions involve risk, and while all risks might not be quantified with a high degree of certainty, the objective of your business education is to learn how to minimize the sub- jective component and maximize the objective component of any business decision and the risks associated with it.

While there are quantitative components to risk management, the vast majority of this course requires you to master new terminology. Therefore, you’ll succeed in easily passing this course if you

� Proceed to a new assignment only after you’ve mastered the terminology and concepts from the prior assignment

� Proceed to take the lesson exam only after you’ve mas- tered the terminology and concepts from all assignments and related quizzes contained in that lesson

� Proceed to take the final exam only after you’ve mastered the terminology and concepts from all lessons and related lesson exams

This study guide focuses, primarily, on most of the terms that are in bold type in the body of the text. The study guide will prepare you for the questions in the Self-Checks that follow each assignment, for the lesson exams, and for the final exam. Many chapters and lessons don’t require home- work, so, in these cases, you should focus on mastering new terminology and concepts.

Lesson 4 covers automobile, homeowner’s, and life insurance; Lesson 5 covers employee benefits, retirement plans, workers’ compensation, and Social Security. These seven assignments will contain information likely to better prepare and benefit anyone taking this course, regardless of their field of expert- ise and/or area of professional employment.

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OBJECTIVES When you complete this course, you’ll be able to

� Discuss different meanings of the term risk, including business risk, personal risk, pure risk, and other types of risk

� Describe major risk management methods and organiza- tion of the risk management function within business

� Explain how minimizing the cost of risk maximizes busi- ness value and the possible conflicts between business and societal objectives

� Describe how pooling of independent loss exposures reduces risk

� Discuss the role of insurer capital and factors that affect insurer capital decisions

� Explain the fundamental legal doctrines underlying insurance contracts

� Discuss the circumstances in which the assignment of legal liability affects safety incentives

� Explain compulsory and no-fault automobile insurance laws and their rationale and effect

� Analyze the impact of catastrophes on property insur- ance and the market’s response to large catastrophes

� Describe the tax benefits associated with life insurance and annuity products

� Analyze the pricing of basic life insurance policies and annuities

� Explain major types of employee benefits and why firms provide them

� Describe the basic history, features, and economic rationale of workers’ compensation laws and liability insurance

Instructions to Students2

� Describe Social Security retirement, survivor, and disability and Medicare programs, benefits, and their financing

� Identify major types of property-casualty insurance contracts purchased by businesses and describe the negotiation of commercial insurance programs

� Explain basic derivative contracts (options, forwards, futures, and swaps) commonly used for hedging, and distinctions between insurance and derivatives contracts

� Describe major types of risk typically hedged using derivatives

YOUR TEXTBOOK Successfully completing your course depends heavily on the knowledge and understanding you acquire from your primary textbook, Risk Management and Insurance. So, please take some time to look through it to see what’s in the book and how the material is arranged. Here are some of the important features of that text. It’s a good idea to become familiar with them.

The Brief Contents, on page xiv, gives you a quick overview of the chapters in the text. The contents, on pages xv–xxiv, give you a detailed outline of the content for each chapter, includ- ing main topic headings. A preface begins on page ix. It gives you the key concepts that inform the authors’ approach to insurance, as well as text updates. A subject index begins on page 646.

Each chapter begins with an outline of major and minor top- ics to be covered. Scan it to orient yourself to the material ahead. Within the text, topics are divided by major headings and subheadings devoted to particular ideas or concepts. Tables, figures, and boxed features appear throughout the text. All of these provide data that’s essential to mastering the text material. Don’t skip over them. The chapter end matter provides you with key terms, a chapter summary, questions to challenge your capacity for critical thinking, and

Instructions to Students 3

suggested readings. Use these features to further master the chapter material. Pay special attention to the chapter sum- mary as an aid to reviewing the material.

The textbook used for this course, as is frequently the case for university courses in risk management, has been designed for a two-semester course. Generally, the same text would be used for the second or more advanced course, but by those pursuing a degree in finance or risk management. Therefore, this risk management course has been designed to be and is comparable to any undergraduate, third, or junior year course at any undergraduate university program.

COURSE MATERIALS The course includes the following materials:

1. This study guide, which contains an introduction to your course, plus

� A lesson assignments page with a schedule of study assignments

� Assignment introductions emphasizing the main points in the textbook

� Self-checks and answers to help you assess your understanding of the material

� An examination for each of the lessons in this course

� A graded project to allow you to put your learning into practice

2. Your course textbook, Risk Management and Insurance, Second Edition, by Scott Harrington and Gregory Niehaus, which contains the assignment reading material

Instructions to Students4

A STUDY PLAN Think of this study guide as a blueprint for your course. You should read it carefully. Use the following procedures to receive the maximum benefit from your studies:

1. Set aside a regular time for study.

2. Write down your reading and study schedule. You might want to use a wall calendar—the kind with space to write in—to show what you need to do and when. Check off assignments as you complete them to see your progress.

3. Read everything twice—or at least review it after reading it carefully. No one gets everything on the first reading.

4. Don’t look up answers in the key before you do the self- checks at the end of a chapter. That defeats the purpose of the exercises. However, do make sure you correct any errors.

5. Give yourself credit for completing each assignment. Your work and self-discipline will take you through this course. You deserve the credit. So give yourself a pat on the back as you complete each assignment.

6. Note the pages for each assignment and read the assign- ment in the textbook to get a general idea of its content. Then study the assignment, paying attention to all details, especially definitions and main concepts.

7. Read the corresponding lesson in the study guide to reinforce what you learned in the text and learn additional tips.

8. Answer the questions provided in the self-checks in the study guide. This will serve as a review of the material covered.

9. After answering the self-checks, check your answers with those given at the back of the study guide.

10. Complete each assignment in this way. If you miss any questions, review the pages of the textbook covering those questions. The self-checks are designed to reveal

Instructions to Students 5

weak points that you need to review. Don’t send your self-check answers to the school. They’re for you to evaluate your understanding of the material.

11. After you’ve completed the assignments for Lesson 1, turn to the first examination and complete it.

Follow this procedure for all eight lessons. You’re now ready to begin. Good luck with your studies. Remember, if you have any questions during your studies, you should e-mail your instructor.

Instructions to Students6

Lesson 1: Introduction to Risk Management For: Read in this Read in

study guide: the textbook:

Assignment 1 Pages 12–14 Pages 1–14

Assignment 2 Pages 15–17 Pages 15–29

Assignment 3 Pages 19–21 Pages 30–53

Examination 50082100 Material in Lesson 1

Lesson 2: General Theory of Insurance Markets For: Read in this Read in

study guide: the textbook:

Assignment 4 Pages 28–30 Pages 54–74

Assignment 5 Pages 31–33 Pages 75–96

Assignment 6 Pages 35–36 Pages 97–114

Assignment 7 Page 37 Pages 115–133

Assignment 8 Pages 39–41 Pages 134–161

Assignment 9 Page 43 Pages 162–178

Assignment 10 Pages 46–47 Pages 179–200

Examination 50082200 Material in Lesson 2

Lesson 3: Loss Control and Legal Liability For: Read in this Read in

study guide: the textbook:

Assignment 11 Pages 56–57 Pages 201–214

Assignment 12 Pages 59–60 Pages 215–241

Examination 50082300 Material in Lesson 3

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Lesson Assignments8

Lesson 4: Personal Insurance Issues For: Read in this Read in

study guide: the textbook:

Assignment 13 Pages 68–69 Pages 242–275

Assignment 14 Pages 71–72 Pages 276–296

Assignment 15 Pages 74–77 Pages 297–333

Examination 50082400 Material in Lesson 4

Lesson 5: Employee-Employer Relationships For: Read in this Read in

study guide: the textbook:

Assignment 16 Pages 84–88 Pages 334–363

Assignment 17 Pages 90–93 Pages 364–387

Assignment 18 Pages 95–97 Pages 388–412

Assignment 19 Pages 98–106 Pages 414–440

Graded Project 50082900

Examination 50082500 Material in Lesson 5

Lesson 6: Business Risk Management—Theory For: Read in this Read in

study guide: the textbook:

Assignment 20 Pages 120–121 Pages 441–462

Assignment 21 Pages 123–124 Pages 463–483

Assignment 22 Page 126 Pages 484–499

Examination 50082600 Material in Lesson 6

Lesson 7: Business Risk Management—Types of Contracts For: Read in this Read in

study guide: the textbook:

Assignment 23 Pages 134–136 Pages 500–525

Assignment 24 Pages 138–139 Pages 526–549

Assignment 25 Pages 141–143 Pages 550–569

Examination 50082700 Material in Lesson 7

Lesson Assignments 9

Lesson 8: Business Risk Management—Additional Topics For: Read in this Read in

study guide: the textbook:

Assignment 26 Page 150 Pages 570–590

Assignment 27 Page 152 Pages 591–604

Assignment 28 Pages 154–156 Pages 605–624

Assignment 29 Pages 157–159 Pages 625–645

Examination 50082800 Material in Lesson 8

Lesson Assignments10

NOTES

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Introduction to Risk Management

INTRODUCTION Lesson 1 introduces many new terms that you haven’t been exposed to in earlier courses. You should spend a significant amount of time and effort learning and becoming very com- fortable with these new terms.

The majority of the material contained in Chapter 3 is very basic review material from business statistics. This is rela- tively easy material, but very important for later lessons and assignments, so the time you spend reviewing this material will pay off later.

OBJECTIVES When you complete this lesson, you’ll be able to

� Discuss different meanings of the term risk, including business risk, personal risk, pure risk and other types of risk

� Describe major risk management methods and organiza- tion of the risk management function within business

� Define and explain the overall objective of risk manage- ment and the cost-of-risk concept

� Explain how minimizing the cost of risk maximizes busi- ness value and the possible conflicts between business and societal objectives

� Discuss frameworks for identifying business and individual risk exposure

� Review concepts from probability and statistics, applying mathematical concepts to understand the frequency and severity of losses, and the concepts of maximum proba- ble loss and value at risk

Risk Management12

ASSIGNMENT 1 Read the following introduction. Then, read Chapter 1 in your textbook, Risk Management and Insurance.

Risk There are two meanings of risk, as defined in Figure 1.1 on page 2 of the text:

1. One situation is riskier than another if it has greater expected loss.

2. One situation is riskier than another if it has greater uncertainty.

Types of Risk Facing Businesses and Individuals Business risk is comprised of (1) price risk, (2) credit risk, and (3) pure risk (see Figure 1.3). Price risk refers to cash flow uncertainties arising from uncertainties due to possible changes in output and input prices (e.g., commodities, exchange rates, and interest rates). For example, as this course is being written, in mid-2008, oil is approaching $140 per barrel, and droughts and floods within the United States are reducing inputs available for a substitute product, ethanol. These factors have led both directly and indirectly to increased energy and food prices.

Credit risk refers to the risk that the firm’s customers and parties to which it has lent money will default, failing to make promised payments. For example, as this course is being written, in mid-2008, foreclosures continue in the housing market, as what has been characterized as “sub- prime issues” remain problematic and depress housing prices.

Pure risk refer to the risk of reduction in business assets due to factors such as

� Physical damage

� Theft

Lesson 1 13

� Expropriation, where the government seizes company assets (examples include Mexico’s PEMEX, created from foreign oil industry facilities in the 1930s, and Venezuela in recent years)

� Legal liability for damages or harm to customers, suppliers, shareholders, and other parties

� Injuries to employees (not covered by workers’ compensation insurance)

� Death, illness, and disability to employees and/or family members, for which employer benefit plans may require- ment payments, including obligations under pension or other retirement savings plans

Personal risk (see Figure 1.4) includes

� Loss of earnings (i.e., death, disability, aging, and unemployment)

� Medical expenses

� Liability (auto and home)

� Loss of physical assets (auto, home and other) or financial assets (stocks and bonds)

� Longevity

Risk Management Risk management involves

1. Identification of all significant risks

2. Evaluation of the potential frequency and severity of losses

3. Development and selection of methods for managing risks

4. Implementation of one or more of these methods

5. Ongoing monitoring of the performance and suitability of the risk management methods and strategies undertaken

Risk Management14

Major risk management methods include

1. Loss control—reduce risky activity and increase precautions

2. Loss financing—retention and self-insurance, insurance, hedging and other contractual risk transfers

3. Internal risk reduction—diversification and information investments

In most firms, the director of risk management is subordi- nate to and reports to finance or treasury executives.

Make sure you completely understand the contents of Figures 1.1, 1.3, and 1.4 in the textbook. This material represents the foundation for the remainder of the course.

Now that you’ve finished Assignment 1, complete Self- Check 1. Check your answers with those provided at the back of this study guide. When you’re sure that you completely understand the material from Assignment 1, move on to Assignment 2.

Self-Check 1

At the end of each section of Risk Management, you’ll be asked to pause and check

your understanding of what you’ve just read by completing a “Self-Check” exercise.

Answering these questions will help you review what you’ve studied so far. Please

complete Self-Check 1 now.

Indicate whether each of the following statements is True or False.

______ 1. Business risk includes price risk, credit risk, and pure risk.

______ 2. Price risk includes the risk of customer loan default.

______ 3. Personal risk includes risk of loss of earnings through disability.

(Continued)

Lesson 1 15

ASSIGNMENT 2 Read the following introduction. Then, read Chapter 2 in your textbook, Risk Management and Insurance.

Understanding the Cost of Risk Risk is costly, and so is the management of risk. Just as the cost of an accounting system and financial statement accuracy shouldn’t exceed the benefit, the cost of risk management shouldn’t exceed the benefit.

Self-Check 1

Select the one best answer to each question.

4. Which of the following is not a method of loss financing?

a. Diversification c. Insurance b. Retention d. Hedging

5. What impact does routine inspection of aircraft for mechanical problems have on the risk of airplane crashes for United Airlines?

a. Reduced frequency of crashes b. Reduced magnitude of loss if the crash occurs c. Elimination of airplane crashes d. It has no impact on the risk of airplane crashes.

6. Ted’s Brewery imports beer from Thailand to the United States. To facilitate the transactions Ted’s Brewery holds large amounts of Thai currency. The uncertainty that Ted faces regarding the U.S. dollar value of his holdings of Thai currency is an example of

a. credit risk. c. pure risk. b. international risk. d. price risk.

Check your answers with those on page 165.

Risk Management16

There are five primary components to the cost of risk (see Figure 2.1):

1. Expected losses (direct and indirect)

2. Cost of loss control (increased precautions and reduced activity)

3. Cost of loss financing (retention, insurance, and hedging)

4. Cost of internal risk reduction (diversification in informa- tional investment)

5. Cost of residual uncertainty (impact on shareholders and other stakeholders)

Firm Value Maximization and the Cost of Risk A firm’s value is determined by future net cash inflows. Firm value maximization occurs when the cost of risk is minimized, as follows:

Value with risk = Value without risk – Cost of risk

or

Value without risk – Value with risk = Cost of risk

Individual Risk Management and the Cost of Risk An individual is risk averse if, when deciding between two risky alternatives that have the same expected outcome, the person chooses the alternative with less risk or variability.

Greater variability = Greater risk

or

Less variability = Less risk

Lesson 1 17

Risk Management and Societal Welfare There are efficient or optimal levels of risk. Private cost of risk refers to the cost to a business; social cost of risk refers to the cost to society. When the private cost of risk differs from the social cost of risk, business value maximization will generally not minimize the total cost of risk to society. For example, if the fine or penalty and for an individual’s illegal activity is modest, when compared to the profitability and risks associated with detection of the illegal activity, we could expect more of the illegal activity (e.g., cheating on your indi- vidual income tax return or paying the maid under the table).

Now that you’ve finished Assignment 2, complete Self- Check 2. Check your answers with those provided at the back of this study guide. When you’re sure that you completely understand the material from Assignment 2, move on to Assignment 3.

Self-Check 2

Indicate whether each of the following statements is True or False.

______ 1. Firm value maximization occurs when the cost of risk is minimized.

______ 2. Value with risk = Value without risk + Cost of risk

______ 3. Greater variability = Greater risk

______ 4. Private cost of risk refers to the cost to society.

______ 5. Social cost of risk refers to the cost to a business.

(Continued)

Risk Management18

Self-Check 2

Select the one best answer to each question.

6. The cost of loss control for potential fire damage to a firm’s warehouses would include the

a. cost of fire insurance. b. cost of damage to goods in the building. c. cost of installing sprinklers. d. potential loss of business that would occur if goods couldn’t be shipped on time due to the

fire.

7. If unexpected increases in losses from price risk aren’t offset by cash inflows from insurance contracts, hedging arrangements, or other contractual risk transfers, they’ll result in

a. an increased stock price. b. a reduced stock price. c. bankruptcy. d. increased diversification.

8. Which one of the following is not an example of the cost of loss financing?

a. Expected direct/indirect losses b. The loading in insurance premiums c. Transaction costs involved with making hedging arrangements d. The opportunity cost of maintaining self-insurance loss reserves

Textbook Questions and Problems

Answer Question 1 on page 28 in the textbook. This should be a one-sentence response. Devote the remainder of your time to the development of a complete understanding of the contents of the chapter. This material represents the foundation for the remainder of the course.

Check your answers with those on page 165.

Lesson 1 19

ASSIGNMENT 3 Read the following introduction. Then, read Chapter 3 in your textbook, Risk Management and Insurance.

Risk Identification The first step in the risk management process is risk identification. The need to quantify property loss exposure leads us to consider alternative valuation methods, as follows:

� Book value = Cost – Accounting depreciation

� Market value = Highest valued use

� Firm-specific value = Value in current use

� Replacement cost new = Cost of replacing with a new comparable

Book value has little or no correspondence to economic value and is seldom relevant for risk management purposes. If there are no firm-specific benefits, firm-specific value will equal market value. Alternatively, firm-specific value may exceed market value. Replacement cost will often exceed the market value of a property.

If an event results in an interruption of business operations, profits are lost, in addition to the cost of physical property replacement, despite the fact that some operating expenses may continue. For example, if a fire results in a plant or facil- ity shutdown, salaries for certain employees continue. This is referred to as business income exposure. The insurance for this component of risk is referred to as business interruption insurance.

Extra expense exposure may also apply. For example, the shutdown of a facility may require the temporary use of a more costly facility. This may be the case, for example, when a complete shutdown would result in higher costs when com- pared to those associated with the temporary use of a more costly facility. Insurance purchased to reimburse the firm for these higher costs is referred to as extra expense coverage.

Risk Management20

Basic Concepts from Probability and Statistics This material is review of the basic concepts of business statistics. Chapter 26 also represents a review of quantitative applications from prior coursework. Review these terms and materials.

A random variable is one with an uncertain outcome. Information about a random variable is summarized by the random variable’s probability distribution, which identifies all possible outcomes for the random variable and the probability of outcomes. The expected value of a probability distribution provides information about where the outcomes tend to occur, on average.

Example: Assume that the following probability distribution exists for automobile damage (see Table 3.3 on page 36 of your text):

Solution: The computation of the expected value of damages follows:

Possible Outcomes

for Damages Probability

$11,500 50%

,500 30%

1,000 10%

5,000 6%

$10,000 4%

Possible Outcomes

for Damages Probability

Expected Value

of Damages

$11,500 50% $ 0

500 30% 150

1,000 10% 100

5,000 6% 300

$10,000 4% 400

Total 100% $ 950

Lesson 1 21

The variance of a probability distribution provides informa- tion about the likelihood and magnitude by which a particular outcome from the distribution will differ from the expected value. The square root of this variance is the standard deviation. Higher variances and standard deviations are associated with higher risk.

Evaluating the Frequency and Severity of Losses The frequency of loss measures the number of losses in a given time period. Frequency and probability are comparable, in the above table. The severity of loss measures the magni- tude of loss per occurrence. Severity and possible outcomes for damages are comparable, in the above table.

Now that you’ve finished Assignment 3, complete Self- Check 3. Check your answers with those provided at the back of this study guide. When you’re sure that you completely understand the material from the first three assignments, move on to the examination for Lesson 1.

Self-Check 3

Indicate whether each of the following statements is True or False.

______ 1. Book value has little or no correspondence to economic value and is seldom relevant

for risk management purposes.

______ 2. A random variable is one with an uncertain outcome.

______ 3. Information about a random variable is summarized by the random variable’s

probability distribution.

(Continued)

Risk Management22

Self-Check 3

Indicate whether each of the following statements is True or False.

______ 4. The expected value of a probability distribution provides information about where the

outcomes tend to occur, on average.

______ 5. Higher variances and standard deviations are associated with higher risk.

______ 6. The square root of the standard deviation is the variance.

Select the one best answer to each question.

7. Which type of risk would you expect to have the most skewed probability distribution? (Assume a time period of one year.)

a. …