Free Financial Management For Project Managers Risk Management Questions and Answers — Questions and Answers

Question 1: Retention comes in a variety of forms, known as .

none of the above
3; required, primary and excess
2; diversified and undiversified
2; active and passive (Correct answer)

Correct answer: 2; active and passive

In risk management, retention refers to the strategy of accepting the financial burden of a risk rather than transferring it to another party. The two primary forms of retention are active retention, where a company consciously decides to bear a known risk, and passive retention, where a company unknowingly or unintentionally retains a risk due to oversight or lack of awareness.

Question 2: Which of the following describes the spreading of losses suffered by a select few across the entire group, replacing actual loss with average loss as a result?

underwriting
insurance
pooling (Correct answer)
indemnification

Correct answer: pooling

Pooling is a fundamental principle of insurance where the losses of a few are shared among many. This mechanism replaces the actual, potentially large, loss for an individual with an average loss, making it more manageable and predictable for all participants. It's the core idea behind how insurance works to mitigate individual financial risk.

Question 3: The _____________ level is largely responsible for regulating insurance.

none of the above
state (Correct answer)
both a and b
federal

Correct answer: state

In the United States, insurance regulation is primarily handled at the state level, not federal. Each state has its own department of insurance responsible for licensing insurers, approving policy forms, regulating rates, and ensuring solvency to protect policyholders. This decentralized approach allows for regulations tailored to local market conditions and consumer needs.

Question 4: A(n) ____________ insurer is one that is owned by a parent company with the intention of covering the loss exposures of the parent company.

contract
passive
retained
captive (Correct answer)

Correct answer: captive

A captive insurer is an insurance company established and owned by a parent company or group of companies, primarily to insure the risks of its owner(s). Instead of purchasing insurance from commercial insurers, the parent company essentially self-insures through its captive. This allows for greater control over coverage, claims, and potentially lower costs for specific risks.

Question 5: What qualifies as a feature of an insurance contract and which of the following does not?

equal value exchange (Correct answer)
consideration
legally competent parties
offer and acceptance

Correct answer: equal value exchange

Insurance contracts are characterized by an unequal exchange of values, making 'equal value exchange' not a feature. The insured pays a relatively small premium, but the insurer promises to pay a much larger sum if a covered event occurs, or nothing at all if it doesn't. This aleatory nature, where the outcome depends on an uncertain event, distinguishes it from typical commercial contracts.

Question 6: Atlanta and Memphis both have 100,000 vehicles that are covered by an insurance. Each city has a 3% chance of having an accident. Atlanta recorded 350, 300, and 250 accidents from 2006 to 2009, compared to 300, 280, and 320 accidents in Memphis. Which city carries more risk?

additional information is required to answer this question
Memphis
the risk is equal between the two cities
Atlanta (Correct answer)

Correct answer: Atlanta

Risk is often associated with the variability or dispersion of outcomes around an expected value. While both cities have a 3% chance of an accident (expected 300 accidents), Atlanta's accident numbers (350, 300, 250) show greater fluctuation from the expected 300 compared to Memphis's (300, 280, 320). This higher variability in Atlanta's actual losses indicates greater risk.

Question 7: Which of the following are instances of retention, transfer, and commercial insurance?

none of the above
risk financing (Correct answer)
both a and b
risk control

Correct answer: risk financing

Risk financing refers to the methods used to pay for losses that occur. Retention (keeping the risk and paying for losses out of pocket) and transfer (shifting the financial burden of risk to another party, like an insurer through commercial insurance) are both primary strategies within risk financing. They address how an organization funds potential losses, rather than controlling the likelihood or severity of the loss itself.

Question 8: In an insurance contract, the values transferred may not be equal and instead depend on an uncertain event. Due to this, the insurance contract is

personal
unilateral
conditional
aleatory (Correct answer)

Correct answer: aleatory

An insurance contract is considered aleatory because the values exchanged by the parties are unequal and depend on the occurrence of an uncertain event. The insured pays a fixed premium, but the insurer's payout is contingent upon a covered loss occurring, which may or may not happen. This contrasts with commutative contracts where parties exchange items of relatively equal value.

Question 9: Which of the following describes uncertainty based on a person's mental state or state of mind?

none of the above
subjective risk (Correct answer)
uncertainty
objective risk

Correct answer: subjective risk

Subjective risk refers to an individual's perception of risk, which is based on their mental state or attitude. It can influence how a person behaves in the face of uncertainty, even if the objective probability of an event remains the same. For example, someone might perceive flying as riskier than driving, despite statistical evidence suggesting the opposite.

Question 10: Which of the following claims about the difference between insurance and gambling is untrue?

insurance aligns the incentives between insurer and insured
gambling creates a new risk
gambling creates a situation where one party gains at another's expense
insurance creates a new risk (Correct answer)

Correct answer: insurance creates a new risk

The claim that 'insurance creates a new risk' is untrue. Insurance deals with existing risks that are inherent in life and business, such as the risk of fire, theft, or illness. In contrast, gambling creates a new, artificial risk where none existed before, simply for the purpose of a wager. Insurance aims to mitigate or transfer existing risks, not to generate new ones.

Question 11: What phrase best captures the phenomena where the real loss experience will resemble the expected loss experience the more exposure units there are?

risk transfer
law of large numbers (Correct answer)
indemnification
underwriting

Correct answer: law of large numbers

The law of large numbers states that as the number of exposure units increases, the actual loss experience will more closely approximate the expected (or theoretical) loss experience. This principle is fundamental to insurance, allowing insurers to predict future losses with greater accuracy when they have a large pool of similar policyholders. It enables them to set appropriate premiums and maintain solvency.

Question 12: Which is not an insurance benefit?

enhancement of credit
source of investment funds
expense loadings (Correct answer)
indemnification for loss

Correct answer: expense loadings

Expense loadings are a component of an insurance premium that covers the insurer's operating costs, such as administrative expenses, marketing, and commissions. While necessary for the insurer's operation, they represent a cost to the policyholder, not a benefit. Benefits of insurance include indemnification for loss, enhancement of credit, and providing a source of investment funds.

Question 13: Which of the following is not a prerequisite for a risk that can, in theory, be insured?

losses should be catastrophic in nature (Correct answer)
losses must be determinable and measurable
premiums should be economically feasible
losses must be accidental and unintentional

Correct answer: losses should be catastrophic in nature

For a risk to be insurable, losses should generally NOT be catastrophic in nature for a large number of insureds simultaneously. If many policyholders suffer losses from the same event (e.g., a widespread natural disaster), it could bankrupt the insurer. Instead, insurable losses should ideally be accidental, measurable, determinable, and not catastrophic to the insurer's entire portfolio.

Question 14: In order to persuade Rex to buy the coverage, Rex's insurance agent offers him a discount on the premium. This is an illustration of the unethical behavior referred to as .

reducing
rebating (Correct answer)
coercing
twisting

Correct answer: rebating

Rebating is an illegal practice where an insurance agent offers a portion of their commission or something else of value not specified in the policy as an inducement for a client to purchase insurance. This practice is prohibited because it can lead to unfair discrimination among policyholders and undermine the integrity of the insurance market.

Question 15: _____________ is excellent for high-frequency, low-severity losses.

loss prevention/loss reduction (Correct answer)
retention
transfer
avoidance

Correct answer: loss prevention/loss reduction

Loss prevention and loss reduction strategies are excellent for high-frequency, low-severity losses because they aim to reduce the occurrence or impact of these common, but individually small, events. Implementing measures like safety training or regular maintenance can significantly decrease the total cost of these frequent losses, making it a cost-effective approach. These methods directly address the frequency and severity of such risks.

Question 16: Which of the following is not a risk management pre-loss goal?

preparing for losses in an economical way
survival of the firm (Correct answer)
reducing anxiety
meeting legal obligations

Correct answer: survival of the firm

Survival of the firm is a crucial post-loss goal, meaning it's what the firm aims to achieve *after* a loss has occurred to continue operations. Pre-loss goals, on the other hand, focus on preparing for losses before they happen. These include reducing anxiety, meeting legal obligations, and preparing for losses in an economical way.

Free Financial Management For Project Managers Risk Management Questions and Answers

Retention comes in a variety of forms, known as .