ANSWERS TO THE QUESTIONS IN THE COURSE GUIDE ARM 56. 6th Edition CONTENTS. Assignment Title Page. 1 Introduction to Risk Financing 7

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1 ANSWERS TO THE QUESTIONS IN THE COURSE GUIDE ARM 56 6th Edition 2016 CONTENTS Assignment Title Page 1 Introduction to Risk Financing 7 2 Estimating Hazard Risk 17 3 Transferring Hazard Risk Through 29 Insurance 4 Self-Insurance Plans 50 5 Retrospective Rating Plans 59 6 Reinsurance 68 7 Captive Insurance 82 8 Contractual Risk Transfer 91 9 Transferring Financial Risk 103 Published by: KEIR EDUCATIONAL RESOURCES 4785 Emerald Way Middletown OH FAX customerservice@keirsuccess.com 10 Transferring Hazard Risk to the 108 Capital Markets 11 Allocating Costs of Managing Hazard Risk Keir Educational Resources

2 Assignment 1 Introduction to Risk Financing Educational Objective 1 Risk financing is the method or methods used by organizations to finance the cost of losses or to offset the variability in cash flows that may take place over time. are: There are essentially two risk financing techniques. They Transfer shifting the responsibility to pay losses and loss-related expenses to another party. This can be an insurance technique (purchasing an insurance policy) or a noninsurance technique (enforcing a hold-harmless agreement). Retention retaining the loss exposure and generating funds within the organization to pay for losses. Transfer is the most common method that organizations use to pay for losses. Insurance is a transfer of the potential financial consequences of a loss to an insurer. However, it is a transfer of only the exposures delineated in the insurance contract. With a traditional insurance transfer, the organization pays a set cost (the premium) to the insurer against the possibility of a large financial loss. Besides the promise to pay losses, the insurer agrees to provide claim-related services, such as loss adjustment and legal defense services. Contract (Noninsurance) risk transfer is a risk financing technique that transfers all or part of the financial consequences of a loss to a third-party not an insurer. This is done through a contract or agreement. Only the exposures covered by the contract or agreement are transferred. Common types of noninsurance transfers include hold-harmless agreements (or indemnity, agreements) are contracts in which one party (indemnitor) agrees to assume the liability of another party (indemnitee). Hedging agreements are financial transactions where one asset is held to offset the risk associated with another asset. An example of hedging is the purchase of a futures contract. A futures contract is an agreement to buy or sell a commodity or security at some future date for a price fixed at the time of the agreement. For example, a national rental car company agrees to purchase a sixmonth supply of gasoline from a petroleum company at the current price. If the price of gasoline rises above the agreed price, the rental company benefits from the agreement. Retention, as previously noted, occurs when an organization retains a loss exposure (or exposures) and generates funds within the organization to pay for losses. Risk financing experts believe that over time, retention is the most economical risk financing technique. For some organizations, particularly in a hard insurance cycle, retention may be the only option. There are three aspects to consider about retention. Retention can be: Planned or unplanned: Planned retention is a calculated retention of a loss exposure that has been identified and analyzed. Unplanned retention is the unintended assumption of a loss exposure. In some cases, it can be an inadvertent assumption by an organization. For example, many main street organizations retain the organization s environmental exposures since they do not anticipate environmental claims or litigation. Complete or partial: Just like it sounds Funded or unfunded: Funded retention contains a pre-event arrangement to ensure that funding is available for the consequences of the event Unfunded retention involves no pre-event plan as to how to fund the consequences of the event 2016 Keir Educational Resources

3 Key Words and Phrases 1. Risk financing is a conscious act or decision not to act that generates funds to pay for the consequences of risk. 2. Transfer is a risk financing method where the financial consequences of risk are shifted to another party. 3. Retention is a risk financing technique where an organization uses its own resources to pay for its losses. 4. Hazard risk is risk where the only possible outcomes are loss or no loss. 5. Speculative risk is risk where the possible outcomes are loss, no loss, or gain. 6. Insurance is the transfer of the potential financial consequences of specific loss exposures to an insurer. 7. Risk is the uncertainty of outcomes that can be either positive or negative. insurance policy or employing a noninsurance technique, such as a hold-harmless agreement. Retention assuming financial responsibility for loss exposures by means of a party s or organization s own assets or resources Both insurance and noninsurance techniques transfer the potential financial consequences of risk. 1-3 Hedging is practical when it is used to offset the consequences of risk which are inevitable to the operation of an organization. Application Question 1-4. One advantage to the transference of the financial consequences of liability exposures is that it eliminates the uncertainty of how a liability event would impact the organization financially. It is a trade of the certainty of a small, regular payment (the premium) for the uncertainty of a potentially major loss. Additionally, the involvement of an insurer would give the organization services such as claim handling and defense. 8. Hold-harmless agreement (or indemnity agreement) a contractual provision that obligates one of the parties to assume the legal liability of another party. 9. Hedging is a financial strategy where one asset is used to offset the risk associated with another asset. 10. A futures contract is an agreement to buy or sell a commodity or security at some future date for a price fixed at the time of the agreement. Review Questions 1-1. The two categories of risk financing techniques are transfer and retention, which are defined as follows: Transfer shifting the responsibility to pay losses and lossrelated expenses to another party, for example, by purchasing an 2016 Keir Educational Resources

4 MULTIPLE CHOICE QUESTIONS WORKBOOK ARM 56 6th Edition 2016 TABLE OF CONTENTS Assignment Title Ques Ans 1 Introduction to Risk Financing Estimating Hazard Risk Transferring Hazard Risk Through Insurance 4 Self-Insurance Plans Retrospective Rating Plans Reinsurance Captive Insurance Contractual Risk Transfer Transferring Financial Risk Transferring Hazard Risk to the Capital Markets Published by: KEIR EDUCATIONAL RESOURCES 4785 Emerald Way Middletown, OH FAX customerservice@keirsuccess.com 11 Allocating Costs of Managing Hazard Risk Keir Educational Resources

5 Assignment 1 Introduction to Risk Financing 1. Risk financing occurs when an organization: (Text 1.3) (A) Diversifies its asset portfolio through the purchase of stocks and bonds (B) Transfers its risk through the purchase of insurance (C) Analyzes its loss exposures (D) Acts or makes a decision that generates funds to pay losses 2. The basic difference between hazard risk and speculative risk is: (Text 1.4) (A) Hazard risk involves only natural perils, where speculative risk involve the acts of man. (B) Size of loss. Hazard risk generally presents much more costly losses than speculative risk. (C) Hazard risk presents the possibility of either loss or no loss, where speculative risk can turn out to result in loss, no loss, or gain. (D) Hazard risk can be insured, where speculative risk cannot. 3. Which of the following is NOT an example of the risk financing technique of transfer? (Text ) (A) Self-insured retentions (B) Indemnification, or hold-harmless, agreements (C) Insurance policies (D) Hedging 4. The funds used to pay for losses under a retention program are generated from: (Text ) (A) The organization s cash flow (B) Raised capital, such as from a bank (C) Financial reserve accounts (D) All of these 5. An organization develops a retention plan whereby it establishes a fund to pay for losses under $5,000. Considering the three dichotomies of how risks are retained, how would this situation be described? (Text ) (A) Unplanned, complete, and funded (B) Planned, partial, and funded (C) Planned, complete, and funded (D) Unplanned, partial, and funded 6. Which of the following is true about the risk financing goal of paying for the negative consequences of an event? (Text 1.7) (A) Negative financial consequences can be either sudden or gradual (B) (C) (D) It is traditionally applicable mainly to sudden events An important element of why it is important to pay for losses is the capability to resume or maintain operations All of the above 7. The need for greater liquidity occurs when an organization s retention program has which of the following characteristics? (Text ) (A) High retention levels and high loss variability (B) Lower than expected retention levels (C) Stable loss experience that matches actuarial predictions (D) Greater overall retention of property, as opposed to liability, loss exposures 8. Which of the following is NOT a risk financing goal? (Text ) (A) Paying for losses (B) Maintaining an appropriate level of liquidity (C) Managing the uncertainty of loss outcomes (D) Increasing the possibility of gain from investments 2016 Keir Educational Resources

6 Assignment 1 Introduction to Risk Financing 1. D is the answer. Risk financing is a conscious (voluntary) act or a decision not to act that generates the funds needed to pay for losses. Risk financing also helps offset the variability in cash flows that may occur. 2. C is the answer. With hazard risk, organizations seek to avoid or to finance the possible negative outcome. With speculative risk, organizations can, besides figuring out how to deal with the possible downside occurrence, position themselves to be able to exploit a possible upside occurrence. 3. A is the answer. Indemnification, or hold-harmless agreements; insurance policies; and hedging are all examples of risk transfer techniques. As its name suggests, a self-insured retention is a cost of loss which is borne by the injured party. 4. D is the answer. These are all viable sources of funds for an organization s retention program. 5. B is the answer. The organization planned ahead of time, it decided to retain only part of its exposure, and set aside money to fund the plan. 6. D is the answer. Additionally, public reputation/goodwill can be damaged if an organization doesn t pay its liability losses. 7. A is the answer. The higher an organization s retention level and loss variability, the greater are its liquidity needs. A sudden, devastating loss for a firm with a large retention could create an immediate and significant need for liquid assets. 8. D is the answer, as profitable investing is not, in and of itself, a goal of risk financing Keir Educational Resources