Study GuideRisk ManagementByA. J. CataldoAbo.docx

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.
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Requests for permission to make copies of any part of the work
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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
LESSON 3: LOSS CONTROL AND LEGAL LIABILITY 55
LESSON 4: PERSONAL INSURANCE ISSUES 67
LESSON 5: EMPLOYEE-EMPLOYER
RELATIONSHIPS 83
GRADED PROJECT 109

LESSON 6: BUSINESS RISK MANAGEMENT—
THEORY 119
LESSON 7—BUSINESS RISK MANAGEMENT—
TYPES OF CONTRACTS 133
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Contentsiv
LESSON 8—BUSINESS RISK MANAGEMENT—
ADDITIONAL TOPICS 149
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
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.

Lesson 1: Introduction to Risk Management
For: Read in this Read in
study guide: the textbook:
Assignment 1 Pages 12–14 Pages 1–14
Examination 50082100 Material in Lesson 1
Lesson 2: General Theory of Insurance Markets
Assignment 7 Page 37 Pages 115–133

Lesson 3: Loss Control and Legal Liability
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Lesson Assignments8
Lesson 4: Personal Insurance Issues
Lesson 5: Employee-Employer Relationships

Graded Project 50082900
Lesson 6: Business Risk Management—Theory
Lesson 7: Business Risk Management—Types of Contracts
Lesson Assignments 9

Lesson 8: Business Risk Management—Additional Topics
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
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).
Assignment 3.
Self-Check 2
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
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.
Lesson 1 19
ASSIGNMENT 3
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.
understand the material from the first three assignments,
move on to the examination for Lesson 1.
Self-Check 3
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
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.
7. Which type of risk would you expect to have the most skewed

probability distribution?
(Assume a time period of one year.)
a. Product liability claims for a drug manufacturer
b. Shoplifting losses for a small bookstore
c. Collision damage to vehicles for a delivery service
d. Employee injuries in a grocery store
8. Unidentified risk exposures will result in
a. reduced insurance premiums.
b. increased insurance premiums.
c. implicit retention.
d. purchasing too much insurance.
9. The expected loss per exposure is the
a. expected frequency per exposure.
b. expected severity per occurrence.
c. expected frequency per exposure times the expected severity
per occurrence all divided by
the number of exposures.
d. expected frequency per exposure times the expected severity
per occurrence.

Complete Questions 1–4 on page 51 in the textbook.
23
1. One situation is riskier than another if it has
A. a greater expected loss.
B. a lower uncertainty.
C. a lower expected loss.
D. no uncertainty.
2. Which of the following is not considered part of business
risk?
A. Price risk C. Pure risk
B. Credit risk D. Longevity risk
3. All of the following are types of price risk except

A. commodity price risk.
B. exchange rate risk.
C. stock market risk.
D. interest rate risk.
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Lesson 1
Introduction to Risk Management
When you feel confident that you have mastered the material in
Lesson 1, go to http://www.takeexamsonline.com and submit
your answers online. If you don’t have access to the Internet,
you can phone in or mail in your exam. Submit your answers for
this examination as soon as you complete it. Do not wait until
another examination is ready.
Questions 1–15: Select the one best answer to each question.

EXAMINATION NUMBER
50082100
Whichever method you use in submitting your exam
answers to the school, you must use the number above.
For the quickest test results, go to
http://www.takeexamsonline.com
Examination, Lesson 124
4. Which of the following is the definition of credit risk?
A. Uncertainties due to possible changes in input prices
B. The risk that parties to which the firm has lent money will
default
C. The risk that a firm won’t be able to get credit from lenders
D. The risk that a firm won’t have sufficient funds to make
payments to its creditors

5. Gallagher Winery is attempting to identify its pure risks.
Which of the following is an
example of an indirect loss for Gallagher?
A. Loss of grapevines due to hail
B. Employee health problems due to insecticide usage
C. Loss of profit due to bad publicity about a liability claim
D. Cost of replacing equipment after a fire
6. By increasing spending on safety equipment, Charley’s Meat
Packing has reduced total
worker injury costs by 15%. This is an example of the
A. tradeoff between loss control costs and loss financing.
B. importance of loss control.
C. tendency of business firms to spend too little on loss control.
D. tradeoff between loss control costs and expected direct
losses.
7. Which one of following is not a major method of managing
risk?
A. Loss identification C. Loss financing
B. Loss control D. Internal risk reduction

8. Which of the following is incorrect?
A. Value with risk = Value without risk – Cost of risk
B. Value without risk – Value with risk = Cost of risk
C. Less variability = More risk
D. Greater variability = Greater risk
9. Which of the following statements is correct?
A. There are no efficient or optimal levels of risk.
B. There are efficient or optimal levels of risk.
C. Risk is less costly than the cost associated with the
management of risk.
D. Risk can’t be effectively managed.
10. All of the following are important components of the cost of
risk for a pharmaceutical
company that’s developing a new prescription drug for the
treatment of AIDS, except
the cost of
A. testing the product for safety.
B. defending against and settling future liability claims.
C. product liability insurance.

D. marketing the product to doctors.
Examination, Lesson 1 25
11. Which of the following statements is true of book value?
A. It has little or no correspondence to economic value.
B. It’s often relevant for risk management purposes.
C. It’s often used for pricing insurance.
D. It’s based on historical cost.
12. Assume that the following probability distribution exists for
automobile damages:
What is the expected value for damages?
A. $12.40 C. $1,240
B. $124 D. $12,400
13. Which of the following statements is true of random
variables?
A. They have a certain outcome.

B. They have an uncertain outcome.
C. They may have a certain or an uncertain outcome.
D. Outcome certainty or uncertainty doesn’t apply to random
variability.
14. A listing of a random variable’s possible outcomes and the
respective probabilities of
those outcomes is called the
A. probability distribution. C. standard deviation.
B. expected value. D. correlation.
15. Which of the following statements is true about expected
value?
A. It’s used to determine the value of a company’s assets.
B. It uses the probability distribution to develop information
about where outcomes
are unlikely to occur, on average.
C. It focuses on providing information about where outlier or
extreme ranges of
outcomes may occur.
D. It provides information about where outcomes tend to occur,

on average.
Possible Outcomes
for Damages
Probability
$11,500 50%
,600 30%
2,000 10%
7,000 6%
$11,000 4%
NOTES

General Theory of
Insurance Markets
INTRODUCTION
Lesson 2 covers a relatively large number of chapters. In
Lesson 2, we focus on general theory, legal theory, regulatory
theory, agency theory, and the practice of insurance markets.
Pay particular attention to the boxed features and appen-
dices, which include terms like agent, principal, adverse
selection, and moral hazard. These are theoretical terms, but
particularly applicable in the insurance and risk assessment
markets and applications.
Much of the material contained in Assignment and Chapter 4
is very basic review of the concepts of business statistics.
OBJECTIVES
� Show how pooling arrangements provide the foundation
for insurance transactions
� Discuss how insurers reduce insolvency risk through
diversification of underwriting risk, reinsurance, and
investment choices

� Describe different types of insurance company ownership
� Discuss the role of insurer capital and factors that affect
insurer capital decisions
� Briefly describe state insurance regulation and summa-
rize major activities that are regulated
� Discuss the normative view that regulation should serve
the public interest by mitigating market imperfections
and how political pressure may cause the practice of
regulation to deviate from the public interest view
27
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Risk Management28
� Summarize the historical record of insurance company
insolvencies,
� List the primary features and functions of solvency
regulation, including solvency monitoring, capital
requirements, and insurance guaranty funds

� Explain why and how insurers classify buyers into differ-
ent groups based on estimates of expected claim cost
� Explain how insurance premiums may be affected by
shocks to insurer capital
� Summarize the evidence and explanations for the
insurance underwriting cycle
� Define what it means to be risk averse and why
risk-averse individuals buy insurance
� Explain how business risk management differs from
individual risk management
� Identify, describe, and explain factors that can limit the
insurability of risk and the major provisions that limit
coverage in insurance contracts
� Explain the fundamental legal doctrines underlying
insurance contracts
ASSIGNMENT 4

Risk Reduction through Pooling
Independent Losses
Your text uses a two-person pooling arrangement example to
illustrate how pooling doesn’t reduce the expected cost, but
does reduce the standard deviation. Accident costs, therefore,
through this pooling process, have become more predictable,
or less uncertain. Uncertainty reduction is equated with risk
reduction, for each of the individuals involved in the pool.
Lesson 2 29
At the extreme, or as the number of people in the pooling
arrangement becomes very large, the standard deviation of
each participant’s cost becomes very close to zero and the
risk, therefore, becomes negligible for each participant. The
expected cost would, therefore, remain at $500, but the stan-
dard deviation would decline, so that the expected cost would
approach certainty. This law of large numbers leads to the
appropriate application of a normal distribution for large sam-
ples (n = 30), due to findings from statistical research and
based on the central limit theorem.

To reinforce, recall the following, which applies universally:
Higher Risk = Higher Variance = Higher Standard
Deviation = Higher Uncertainty
and
Lower Risk = Lower Variance = Lower Standard
Deviation = Lower Uncertainty
Pooling arrangements result in overall risk reduction for each
individual participant in the pool.
Insurers as Managers of Risk
Pooling Arrangements
The costs associated with marketing and specifying the terms
of agreements for risk pooling arrangements are referred to
as distribution costs. The procedures associated with identify-
ing (estimating) a potential risk pooling participant’s expected
loss is known as underwriting. The cost associated with
monitoring claims by members of the risk pool is a part of
the loss adjustment cost.
Other Examples of Diversification:

Stock Markets
Risk diversification examples are, perhaps, most evident in
the stock market, where shareholders represent pools of risk-
takers for new and existing business ventures.
Risk Management30
Assignment 5.
Self-Check 4
False.
______ 1. Pooling reduces the expected cost.
______ 2. Pooling doesn’t reduce the standard deviation.
______ 3. Accident costs, through pooling, become more

predictable.
______ 4. Higher risk = Higher variance = Higher standard
deviation = Higher uncertainty
______ 5. Lower risk = Lower variance = Lower standard
deviation = Lower uncertainty
______ 6. Pooling arrangements result in overall risk reduction
for each individual participant in
the pool.
7. Which of the following is not a type of contracting cost
associated with the creation and
operation of pooling arrangements?
a. Distribution costs c. Premiums
b. Underwriting expenses d. Loss adjustment expenses
8. Insurers that rely, to some degree, on exclusive agents to sell
their policies are known as

a. mutuals. c. independents.
b. direct writers. d. brokers.
(Continued)
Lesson 2 31
ASSIGNMENT 5
Insurer Capital
Economic capital is defined as the difference between the
market value of assets and the market value of liabilities, as
follows:
Economic Capital = Market Value of Assets –
Market Value of Liabilities
Ownership and Sources of Capital
A mutual insurer is the most common form of policyholder-
owned insurer. A stock insurer is an incorporated insurance
company, owned by investors who have purchased the stock

or equity of the company.
Lloyd’s of London is a different form of an investor-owned
insurer. Owners of insurance organizations that conduct
business at Lloyd’s are called names and have unlimited
liability.
Self-Check 4
9. The main (economic) reason for the existence of insurance
companies is
a. individuals’ need to diversify risk.
b. insurers’ ability to predict individual losses.
c. insurers’ ability to form efficient risk pools with minimal
contracting costs.
d. individuals’ inability to determine expected loss.
Risk Management32
Insurer Operations, Reinsurance,

and Insolvency Risk
Underwriting risk is the risk that an average claim cost will
differ from the amount expected when a policy is sold. Just
as businesses and individuals purchase insurance, insurers
also purchase insurance, referred to as reinsurance. The
buyer, known as the ceding insurer or primary insurer, pays
the reinsurer a premium. A reinsurance treaty covers multiple
policies written by the ceding insurer. An alternative to tradi-
tional catastrophe reinsurance is called a catastrophe bond.
Insurer value is maximized when the insurer is able to effi-
ciently and effectively balance higher returns from riskier
investments against the increased investment risk and the
need for capital.
Factors Affecting Insurer Capital
Decisions
When assets have greater value to one firm, when compared
to other firms, these assets are said to be specific assets.
Insurers retain capital to preserve the value of their specific
assets, referred to as the insurer’s franchise value.
Reductions in a firm’s value, resulting from the failure of
management to act in the best interest of stockholders, are
called agency cost (Figure 1).

Lesson 2 33
Assignment 6.
FIGURE 1—Agency Theory
Self-Check 5
False.
______ 1. Economic capital = Market value of assets – Market
value of liabilities
______ 2. A mutual insurer is an incorporated insurance
company, owned by investors who have
purchased the stock or equity of the company.

______ 3. Reductions in a firm’s value, resulting from the
failure of management to act in the
best interest of stockholders, are called agency cost.
(Continued)
Risk Management34
Self-Check 5
False.
______ 4. Underwriting risk is the risk that an average claim
cost will differ from the amount
expected when a policy is sold.
______ 5. The reinsurer pays the ceding insurer a premium.
______ 6. A reinsurance treaty covers multiple policies written

by the ceding insurer.
7. The difference between an insurer’s market value of assets
and its market value of liabilities is
called
a. economic capital. c. reported capital.
b. economic profit. d. expected losses.
8. An insurance company which is owned by its policyholders is
called a
a. stock insurer. c. mutual insurer.
b. life insurer. d. Lloyd’s association.
9. Which one of the following is not a reason for insurers to
hold “adequate” economic capital?
a. To protect against the loss of franchise value
b. To provide a cushion for meeting unexpected claims costs
c. To achieve higher premium volume
d. To eliminate any chance of insolvency

10. Lloyd’s of London is a/an
a. stock insurance company.
b. mutual insurance company.
c. marketplace for transacting insurance business.
d. unincorporated mutual.
Answer Questions 1 and 7 on page 96 in the textbook.
Lesson 2 35
ASSIGNMENT 6
Scope and Operation of State
Insurance Regulation
Each state has a state insurance department or commission
and a state insurance commissioner. A voluntary organization

of state commissioners, the National Association of Insurance
Commissioners (NAIC), conducts regular meetings to discuss
insurance regulatory issues and develop model laws.
Objectives of Regulation: The
Public Interest View
The public interest view of regulation suggests that regulation
exists when the characteristics of a market differ significantly
from those of a competitive market, characterized by
1. Large numbers of sellers with relatively low market
shares and low cost of entry by new firms
2. Low-cost information to firms with respect to the cost of
production and to consumers concerning prices and
quality
3. An absence of spillovers (i.e., all costs are internalized to
sellers or buyers)
Regulation and Political Pressure
An alternative to the public interest view is the theory of
economic regulation, suggesting that regulators seek to serve
their own interest by maximizing political support. Movement
within and between industry and the regulatory structure

suggests that regulators may fail to act in the best interests
of the consuming public. This is known as capture theory,
regulatory capture theory, the capture hypothesis, or the
producer protection hypothesis.
Risk Management36
Assignment 7.
Self-Check 6
False.
______ 1. Few states have a state insurance department or
commission and a state insurance
commissioner.
______ 2. A voluntary organization of state commissioners has

been recommended, but doesn’t
presently exist.
______ 3. A competitive market is characterized by a small
numbers of sellers with relatively high
market shares and high cost of entry by new firms.
______ 4. The theory of economic regulation suggests that
regulators seek to serve their own
interest by maximizing political support.
______ 5. The following are equivalent or comparable terms:
capture theory, regulatory capture
theory, the capture hypothesis, and/or the producer protection
hypothesis.
6. The main criticism of the McCarran-Ferguson Act is that it
a. causes heterogeneity in prices.

b. makes it more difficult for insurers to adequately price
policies.
c. increases the cost of entry into a particular market or line of
business.
d. facilitates collusion among insurers to increase prices.
7. In most states, insurance regulation covers all of the
following areas except
a. “free riders.” c. insurer sales practices.
b. policy forms. d. compulsory insurance.
Answer Questions 2, 7, and 9 on pages 113–114 in the textbook.
Lesson 2 37
ASSIGNMENT 7

Solvency Ratings and Regulation
Financial rating agencies provide solvency ratings of insur-
ance companies. Examples include A.M. Best Company,
Moody’s, Standard and Poor’s, and Duff and Phelps.
Regulatory monitoring of insolvency risk is a form of
delegated monitoring. The NAIC Insurance Regulatory
Information System (IRIS) has been used by state regulators
since the 1970s. Historically, insurers have been required to
meet or exceed fixed minimum capital requirements to
continue to operate in a state. The NAIC has developed
risk-based capital requirements for adoption by states.
All states have guaranty funds or guaranty associations.
These guaranty systems provide substantial protection to
consumers covered by an insolvent insurer.
Generally, post-insolvency assessments are levied or imposed
on surviving insurers, to acquire the necessary economic
resources to pay claims against insolvent insurers.

Assignment 8.
Risk Management38
Self-Check 7
False.
______ 1. Financial rating agencies provide solvency ratings of
insurance companies.
______ 2. Regulatory monitoring of insolvency risk is a form of
delegated monitoring.
______ 3. There are no requirements that insurers meet or
exceed fixed minimum capital
requirements.
______ 4. The NAIC hasn’t yet, but is considering, the
development of risk-based capital

requirements for adoption by states.
______ 5. Very few states have guaranty funds or guaranty
associations.
______ 6. Generally, post-insolvency assessments are never
levied or imposed on surviving
insurers.
7. All of the following factors have contributed to insurance
company insolvencies except
a. catastrophe losses. c. general business cycle factors.
b. inadequate rates. d. inadequate capital.
8. What is meant by a “flight to quality” in insurance markets?
a. Policyholders withdraw funds from insurance companies and
invest in low-risk securities.
b. Policyholders cancel policies with high-risk insurers and buy
insurance from better-rated

companies.
c. Low-risk policyholders decide to go uninsured because rates
are too high.
d. Insurers decide to invest funds only in low-risk assets.
(Continued)
Lesson 2 39
ASSIGNMENT 8
Insurance Costs and Fair Premiums
A fair premium is one that’s sufficient to fund the insurer’s
costs and provide a fair return on invested capital, as follows:
Fair premium = Cost + Fair return
Expected Claim Costs
Adverse selection is defined as the tendency of buyers with
high expected losses to buy more coverage than buyers with

low expected losses when charged the same premium
(Figure 2).
Self-Check 7
9. Suppose that Quality-Is-Us Insurance Company (QIU) has
been evaluated against risk-based
capital (RBC) standards and has too little capital. Which of the
following choices is not a
method that QIU could use to reduce its ratio of capital to RBC?
a. Sell more insurance
b. Reinsure more of its business
c. Raise more capital
d. Move its investments from stocks to bonds
Complete Questions 1, 2, 3, and 6 on pages 130–131 in the
textbook.

Risk Management40
Competition between insurance providers leads to cost-based
prices, based on the insured’s risk classification. When low-
risk and high-risk buyers are forced to pay the same
insurance rates, a cross-subsidy is said to have taken place,
benefiting high-risk buyers and penalizing low-risk buyers.
Insurers employ selection standards to determine whether an
applicant in a given class will be offered coverage at the
insurer’s class rate. The overall process of assessing expected
claim costs for buyers, determining the applicant rate, and
deciding whether to offer coverage is known as underwriting.
Class rates may be modified by experience ratings (or merit
ratings) to reflect the prior loss experience of the applicant.
Some may qualify for a bonus-malus or no-claims discount.
A fair premium must include a recovery of cost, known as
expense loading.
Investment Income and the
Timing of Claim Payments
Insurers must plan cash flows for claims costs and coordi-
nate these cash flows with investment activities. The amount
of money needed to fund expected claim costs after taking

into consideration investment income earned by the insurer
might be referred to as discounted expected claim costs.
FIGURE 2—Adverse Selection
Lesson 2 41
Price Regulation
Historically, insurance rates were subject to prior approval
laws by rating bureaus. Beginning in the late 1960s, many
states began replacing these with competitive rating laws.
When regulation of rate changes or risk classification lowers
rates below levels required to cover expected costs and
provide a reasonable profit, insurers won’t voluntarily sell
coverage. Supply shortages may occur, but are prevented by
state residual market systems. These systems force insurers
to participate in the residual market if they wish to sell cover-
age in the voluntary market.

Assignment 9.
Self-Check 8
False.
______ 1. Fair premium = Cost + Fair return
______ 2. Adverse selection is defined as the tendency of
buyers with low expected losses to buy
more coverage than buyers with low expected losses when
charged the same premium.
______ 3. When low-risk and high-risk buyers are forced to pay
different insurance rates, a
cross-subsidy is said to have taken place.
(Continued)

Risk Management42
Self-Check 8
False.
______ 4. The overall process of assessing expected claim costs
for buyers, determining the
applicant rate, and deciding whether to offer coverage is known
as underwriting.
______ 5. A fair premium must include a recovery of cost,
known as profit loading.
______ 6. Supply shortages may occur due to state residual
market systems.
7. A hard insurance market is characterized by
a. increasing prices. c. falling prices.
b. stable prices. d. readily available coverage.

8. Which of the following is not a common (short-term)
outcome of temporary rate suppression?
a. Insurers suffer losses c. Insurers curtail investments
b. Insurers reduce supply d. Insurers raise premiums
9. Which of the following types of insurance will have the
longest claim tail?
a. Homeowner’s
b. Automobile physical damage (collision)
c. Auto liability
d. Employee medical coverage
Answer Questions 1, 2, 7, and 9 on page 159 in the textbook.
Lesson 2 43

ASSIGNMENT 9
Risk Aversion and Demand
for Insurance
A person who is risk averse prefers certainty to a risky or
uncertain alternative. A person who is risk neutral cares only
about expected wealth and wouldn’t expect a risk premium to
accept risk.
Diversification reduces risk to individuals (see Chapter 4).
The same may be said for individual shareholders, in ways
similar to the application of insurance pools. If business own-
ers aren’t well-diversified, the purchase of business
insurance will reduce the business owners’ risk. Business
insurance coverage will preserve capital in the event of a
business loss.
Assignment 10.

Risk Management44
Self-Check 9
False.
______ 1. A person who is risk averse cares only about
expected wealth and wouldn’t expect a
risk premium to accept risk.
______ 2. A person who is risk neutral prefers certainty to a
risky or uncertain alternative.
______ 3. Nonmonetary losses include pain, suffering, and
grief.
______ 4. Diversification reduces risk to individuals.
______ 5. If business owners aren’t well-diversified, the
purchase of business insurance will
reduce the business owners’ risk.

______ 6. Business insurance coverage will preserve capital in
the event of a business loss.
7. An individual’s demand for insurance depends on all of the
following factors except
a. income. c. premium loading.
b. wealth. d. portfolio return.
(Continued)
Lesson 2 45
Self-Check 9
8. Suppose that you have $20,000 in wealth and face a 20%
chance of losing $10,000. What is
the expected value of your wealth without insurance?

a. $10,000 c. $18,000
b. $16,000 d. $20,000
9. The main reason that diversified shareholders might not want
their corporate managers to
purchase insurance is that
a. they like risk.
b. they’ve already diversified away the risk that’s being insured.
c. they’re risk averse.
d. cash flow variability increases their return on investment.
Answer Questions 2, 3, and 5a on page 174 in the textbook.
Risk Management46
ASSIGNMENT 10

Factors That Limit the
Insurability of Risk
Parameter uncertainty exists when insurers are uncertain
about the true expected losses of those insured. Moral hazard
refers to the effect of insurance on the insured’s incentives to
reduce expected losses. Adverse selection refers to that situa-
tion in which consumers have different expected losses, but
the insurer is unable to distinguish between the two types of
consumers and charge them different premiums (Figure 3).
Contractual Provisions That
Limit Coverage
Contractual provisions that limit coverage include deductibles,
coinsurance, policy limits, and policy exclusions. Deductibles
eliminate coverage for relatively small losses by making the
insured pay the first several hundred dollars, for example, of
a claim. Coinsurance requires an insured to pay a specified
FIGURE 3—Asymmetric
Information

Lesson 2 47
portion of the loss, often a percentage. An upper limit or
ceiling on a policy is referred to as a policy limit. If an insur-
ance policy contains exclusions, these items are excluded from
coverage. Pro rata clauses and excess clauses may also
involve the coordination of benefits and/or reduce the risk of
recovery in excess of loss.
There are two types of insurance policies: (1) indemnity
contracts require that the insurer pay the claim after a loss
and (2) valued contracts establish the amount at the time of
insurance contract initiation. Insurance-to-value (coinsurance)
clauses specify the percentage of the property’s value that the
insurer requires to be purchased to receive a full reimburse-
ment in the event of loss.
Legal Doctrine
The indemnity principle states that an insurance policy can’t
pay more than the financial loss suffered. Furthermore, the
insurance policyholder must have an insurable interest—for
example, you can’t insure your neighbor’s house, because it’s
not yours. Both the insurer and the policyholder must dis-
close all relevant information and negotiate with utmost good
faith. Failure to do so may constitute a misrepresentation or

concealment of a material or significant, relevant variable
that could have led to very different terms in the agreement.
When disputes arise, rules pertaining to contracts of adhesion
(a policy offered for acceptance or rejection but not negotia-
tion) apply. Some courts have adopted what’s known as a
doctrine of reasonable expectations, which holds that policies
will be interpreted in a fashion consistent with the expecta-
tions of a reasonable person without legal training. Bad-faith
suits arise in cases where insurers have failed to act in a
manner consistent with reasonable policyholder expectations.
Check 10. Check your answers with those provided at the
back of this study guide. When you’re sure that you com-
pletely understand the material from Assignment 10, move
on to the examination for Lesson 2.
Risk Management48
Self-Check 10

False.
______ 1. Parameter uncertainty exists when insurers are
certain about the true expected losses
of those insured.
______ 2. Moral hazard refers to the effect of insurance on the
insured’s incentives to reduce
expected losses.
______ 3. Adverse selection refers to that situation in which
consumers have different expected
losses, but the insurer is unable to distinguish between the two
types of consumers
and charge them different premiums.
______ 4. Contractual provisions that limit coverage include
deductibles, coinsurance, policy
limits, and policy exclusions.

______ 5. The indemnity principle states that an insurance
policy can pay more than the financial
loss suffered.
______ 6. The doctrine of reasonable expectations holds that
policies will be interpreted in a
fashion consistent with the expectations of a reasonable person
with legal training.
7. The reason that higher premium loadings generally lead to
lower demand for insurance
coverage is that
a. the fair premium becomes too large relative to the expected
cost of not purchasing
insurance.
b. people don’t like insurers to make too much profit.
c. exposures with low severity always have high administrative
costs.
d. exposures with high frequency are less likely to be insurable.

(Continued)
Lesson 2 49
Self-Check 10
8. The primary limiting factor on the insurability of highly
correlated loss exposures is
a. high administrative costs. c. the moral hazard problem.
b. high capital costs. d. adverse selection.
9. Tom and Judy, a married couple, are employed at different
companies, and both of their
employers provide complete family health insurance with pro
rata clauses, no deductibles,
and no coinsurance. If Tom has knee surgery that costs $5,000,
he can recover
a. $5,000 from each insurer since the full premium has been
paid for that coverage.
b. $5,000 from his own insurer only.

c. $2,500 from each insurer.
d. $5,000 from his own insurer, who will then try to collect
$2,500 from Judy’s insurer.
Answer Question 1 on page 198 in the textbook.
Risk Management50
NOTES
51
1. Which of the following is incorrect?
A. Higher risk = Higher variance
B. Higher variance = Higher standard deviation
C. Higher standard deviation = Higher uncertainty

D. Higher uncertainty = Lower risk
2. Which of the following represents a correct definition for
underwriting?
A. The costs associated with marketing and specifying the
terms of agreements for risk pooling arrangements
B. The procedures associated with estimating a potential risk
pooling participant’s expected loss
C. The cost associated with monitoring claims by members
of the risk pool
D. The process of writing an insurance contract
E
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Lesson 2
General Theory of Insurance Markets

EXAMINATION NUMBER
50082200

3. Which of the following statements is true of pooling
arrangements?
A. They result in overall risk reduction for each individual
participant in the pool.
B. They increase the risk for each individual participant in the
pool.
C. They result in overall risk reduction for selected participants
in the pool.
D. They increase the risk for selected participants in the pool.
4. Complete the following equation:
Economic capital =
A. Historical cost of assets – Historical cost of liabilities
B. Replacement cost of assets – Replacement cost of liabilities
C. Market value of assets – Market value of liabilities
D. Depreciated cost of assets – Historical cost of liabilities
5. Reduction of a firm’s value resulting from the failure of
management to act in the best
interest of stockholders is called

A. agency cost. C. monitoring cost.
B. adverse selection. D. moral hazard.
6. The major underlying force that motivates individuals to
purchase insurance even
though insurance premiums exceed expected claim costs is
A. profit. C. expected losses.
B. risk aversion. D. premium loadings.
7. The public interest view of regulation suggests that
regulation exists when the
characteristics of a market differ significantly from those of a
competitive market,
characterized by all of the following except
A. an absence of spillovers (i.e., all costs are internalized to
sellers or buyers).
B. large numbers of sellers with relatively low market shares
and low cost of entry by
new firms.
C. low-cost information to firms with respect to the cost of
production and to

consumers concerning prices and quality.
D. small numbers of sellers with relatively high market shares
and high cost of entry
by new firms.
8. Which area of insurance regulation includes risk-based
capital requirements, guaranty
funds, and financial reporting requirements?
A. Licensing regulation C. Solvency regulation
B. Rate regulation D. Regulation of sales practices
9. Regulatory monitoring of insolvency risk is a form of
A. fixed minimum capital requirements.
B. delegated monitoring.
C. guaranty funds or guaranty associations.
D. post-insolvency assessments.
10. The tendency of buyers with high expected losses to buy

more coverage than buyers
with low expected losses when charged the same premium is
referred to as
A. principal cost. C. moral hazard.
B. agency cost. D. adverse selection.
11. Risk-based capital formulas for property-liability insurers
encompass which of the
following main risk categories?
A. Asset risk, credit risk, underwriting risk, and off-balance
sheet risk
B. Asset risk, credit risk, and underwriting risk
C. Asset risk, interest rate risk, credit risk, and off-balance
sheet risk
D. Credit risk, interest rate risk, underwriting risk, and off-
balance sheet risk
12. The legal principle which states that an insurance policy
can’t pay more than the
financial loss suffered is called the principle of
A. insurable interest. C. indemnity.
B. moral hazard. D. adhesion.

13. A cross-subsidy in insurance occurs in which situation?
A. When different lines of insurance (e.g., auto and
homeowner’s) are priced so that
those with higher administrative costs subsidize those with
lower administrative
costs
B. When each risk class pays a premium that’s appropriate for
their level of risk
C. When buyers in different risk groups pay the same premium,
so that lower-risk
buyers subsidize the higher-risk buyers
D. When insurance is designed to encourage a change in
behavior of risky buyers
14. Nonmonetary losses include
A. pain and suffering. C. agency cost.
B. lost income. D. principal cost.
15. The doctrine of reasonable expectations holds that insurance
policies will be interpreted

in a fashion
A. consistent with the expectations of a reasonable person with
legal training.
B. consistent with the expectations of a reasonable person
without legal training.
C. consistent with the expectations of a reasonable person with
at least a sixth grade
reading level.
D. that provides the greatest benefit to the insurance company.
NOTES
Loss Control and Legal
Liability
INTRODUCTION
Lesson 3 will introduce terminology relating to loss control

and basic legal liability rules.
OBJECTIVES
� Define and describe the various types of loss control
� Derive optimal levels of loss control using information on
the costs and benefits
� Discuss the rationale for government safety programs
� Provide background on the general structure of U.S. law
� Describe basic legal liability rules and procedures,
including negligence law
� Describe the economic functions of the legal liability
system
� Explain the circumstances in which the assignment of
legal liability affects safety incentives and discuss rela-
tionships between liability law and safety regulation
� Briefly describe various proposals for tort reform

3
Risk Management56
ASSIGNMENT 11
Types of Loss Control
� Loss control refers to strategies used to reduce expected
losses.
� Loss prevention is associated with the reduction of the
frequency of losses.
� Loss reduction is associated with the reduction of the
magnitude of a loss.
� Loss avoidance is a form of loss prevention, reducing the
probability of loss to zero.
� Pre-loss activities precede a loss and are designed to

reduce the magnitude of the loss.
� Post-loss activities follow a loss and are, typically,
designed to prevent additional losses.
� Segregation (separation) of exposure units describes the
process of risk diversification through the segregation of
loss exposures into smaller exposure units.
Examples of Identification
of Benefits and Costs
Examples of costs and benefits associated with loss control
are included in your text on pages 207–209, and include
installation of automatic sprinkler systems, installation of
safety guards, and child-resistant packaging of nonprescrip-
tion drugs.
Lesson 3 57
Cost-Benefit Analysis of Safety
Regulation
Government regulation is costly and may not be able to
operationalize adequate incentives to effectively implement

safety programs.
Pages 210–212 of your text illustrate how the value of a
life can be computed. Table 11.3 on page 213 of your text
summarizes some examples of the costs associated with esti-
mates of the number of lives saved from a variety of safety
regulations.
on to Assignment 12.
Self-Check 11
False.
______ 1. Loss prevention is associated with the reduction of
the magnitude of a loss.
______ 2. Loss reduction is associated with the reduction of the
frequency of a loss.

______ 3. Post-loss activities precede a loss; they’re designed
to reduce the magnitude of a loss.
______ 4. Pre-loss activities follow a loss; they’re typically
designed to prevent additional losses.
______ 5. Loss avoidance is a form of loss prevention, reducing
the probability of loss to zero.
______ 6. Segregation of exposure units describes the process
of risk diversification through the
segregation of loss exposures into smaller exposure units
(Continued)
Risk Management58
Self-Check 11
7. A particular loss control effort will be undertaken if

a. the expected frequency of losses is reduced.
b. the expected severity of losses is reduced.
c. expected losses are reduced by an amount greater than the
cost of the loss control effort.
d. All of the above
8. Loss prevention activities are aimed at reducing the
a. frequency of losses.
b. size of a loss, if and when a loss occurs.
c. probability of loss to zero.
d. None of the above
Answer Question 5 on page 214 in the textbook.
Lesson 3 59
ASSIGNMENT 12

Tort Liability Rules
Damages take a variety of forms:
� Compensatory damages are meant to compensate the
plaintiff for some injury or loss he or she has suffered.
➢ Special damages—compensation for economic losses
➢ General damages—compensation for noneconomic
losses (i.e., pain and suffering)
� Punitive damages aren’t compensatory, but are designed
to punish the defendant and deter future injurious
behavior.
Joint and several liability refers to cases (e.g., partnerships)
where each defendant can be separately held responsible for
the entire amount of damages.
Liability from Negligence
Generally, negligence is proved when there’s a

� Legal duty by the defendant
� Breach of that duty (firms must take cost-justified
precautions to prevent harm)
� Proximate cause
� Injury to the plaintiff
Defenses to negligence include the following:
� Assumption of risk defense—the plaintiff knew the risks
and proceeded anyway.
� Contributory negligence—the plaintiff’s own negligence
contributed to his or her injury, and the defendant
doesn’t have to pay anything.
Risk Management60
� Comparative negligence—the plaintiff’s own negligence
contributed to his or her injury, and the defendant has
to pay an amount in proportion to his or her contribu-

tion to the injury.
Economic Objectives of the
Tort Liability System
The U.S. tort system attempts to compensate victims fully for
their losses. The collateral source rule precludes courts from
reducing damages awarded by the amount of coverage pro-
vided by a plaintiff’s first-party life, health, or property
insurance.
A defendant who has a judgment imposed on him or her, but
has insufficient wealth to pay the entire judgment, is said to
be judgment proof for damages in excess of his or her wealth.
Proposals for Tort Reform
Contemporary tort reform proposals include
1. Modifying incentives to bring suits
2. Limits on contingency fees
3. Reducing damages by placing caps or ceilings on pain
and suffering awards and punitive damages
4. Limits on punitive damages

5. Limiting the application of joint and several liability
Lesson 3 61
Self-Check 12
False.
______ 1. Common law has evolved over time and includes
judicial precedent.
______ 2. Statutory law refers to laws passed by legislative
bodies.
______ 3. Criminal law is usually the result of common law.

______ 4. Damages take a variety of forms, including
compensatory damages and punitive
damages.
______ 5. Compensatory damages include special damages and
general damages.
6. From an economic perspective, the tort system would not be
necessary if consumers were
a. uninformed about a product’s risk and transaction costs were
low.
b. fully informed about a product’s risk and transaction costs
were low.
c. fully informed about a product’s risk and transaction costs
were high.
d. partially informed about a product’s risk and transaction
costs were high.
7. John was speeding into an intersection when Mary
negligently was making a left turn.

Their cars collided, and Mary sued John for her injuries. The
jury determined that John was
negligent and that Mary was 30% responsible for her own
injuries. Mary’s actual damages
were $25,000. If the comparative negligence rule applies in that
jurisdiction, how much will
Mary get?
a. Nothing c. $17,500
b. $7,500 d. $25,000
8. When the U.S. legal system assigns a liability rule for a
general type of loss, the system is
essentially
a. assessing fault. c. allocating risk.
b. protecting consumers. d. measuring damages.
Complete Questions 1, 2, 6, 8, and 9 on pages 234–235 in the
textbook.

Risk Management62
NOTES
63
1. Which of the following best defines strategies used to reduce
expected losses?
A. Loss control C. Loss reduction
B. Loss prevention D. Loss avoidance
2. Which of the following is associated with the reduction of the
frequency of losses?
A. Loss control C. Loss prevention
B. Loss reduction D. Loss avoidance
3. Insurance coverage can reduce the incentives to undertake
loss control activities if insurers

A. help pay for the loss control.
B. pay for losses anyway.
C. reduce insurance premiums after loss control is
implemented.
D. don’t reduce insurance premiums after loss control is
implemented.
E
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Lesson 3
Loss Control and Legal Liability

EXAMINATION NUMBER
50082300
4. Segregation of exposure units can reduce
A. the expected frequency of losses.
B. the expected severity of losses.
C. both the expected frequency and expected severity of losses.

D. only those losses that result from natural disasters.
5. Billy Bob earns $45,000 and faces a .007 probability of dying
in a workplace accident.
Jim Bob earns $41,000 and faces a .0038 probability of dying in
a workplace accident.
The two require the same level of skill and training. From this
information, what is the
implicit value of a person’s life?
A. $315,000 C. $1,052,631
B. $571,428 D. $1,250,000
6. Which one of the following is not a potential benefit of loss
control efforts to improve
workplace safety?
A. Reduced expected losses
B. Increased worker productivity
C. Improved marginal cost of safety
D. Reduced insurance premiums
7. In business liability cases, courts may apply an economic
standard for negligence
called cost-justified precautions. This standard is met if the

business
A. spent at least 10% of its revenue on safety efforts.
B. undertook safety costs whenever the marginal benefit of the
safety effort was
greater than the marginal cost.
C. undertook safety costs whenever the marginal benefit of the
safety effort was less
than the marginal cost.
D. has purchased adequate insurance.
8. Which of the following refers to laws passed by legislative
bodies?
A. Statutory law C. Criminal law
B. Common law D. Tort law
9. Which one of the following liability rules frequently applies
to products liability cases?
A. No liability C. Strict liability
B. Negligence D. Absolute liability

10. Under joint and several liability,
A. a defendant’s spouse is equally liable for the defendant’s
negligence.
B. a defendant has no defenses against the charge of negligence.
C. a defendant can’t be held fully responsible for losses he or
she only partially
caused.
D. a defendant can be held fully responsible for losses he or she
only partially caused.
11. Which one of the following is not a potential source of
limited liability (or being
judgment proof)?
A. Bankruptcy laws
B. Being elderly
C. Lack of wealth
D. Being incorporated (as a business)

12. Ted was injured in an accident that was caused by Judy’s
negligence. As a result of the
accident, Ted incurred $8,000 in medical bills. He filed and won
a lawsuit against Linda,
and the medical bills were paid by the judgment. These medical
bills are what type of
damages?
A. Special compensatory damages
B. General compensatory damages
C. Special punitive damages
D. General punitive damages
13. The conditions necessary for a plaintiff to show that a
defendant was negligent include
all of the following except which one?
A. The defendant had a duty to the plaintiff and breached the
duty.
B. The defendant’s breach of duty was the proximate cause of
the plaintiff’s injury.
C. The defendant intended to cause harm to the plaintiff.
D. The plaintiff suffered a loss.
14. In which of the following cases is the defendant always

liable?
A. No liability C. Strict liability
B. Absolute liability D. Negligence
15. John was speeding into an intersection when Mary
negligently was making a left turn.
Their cars collided, and Mary sued John for her injuries. The
jury determined that John
was negligent and that Mary was 30% responsible for her own
injuries. Mary’s actual
damages were $25,000. If the contributory negligence rule
applies in that jurisdiction,
how much will Mary get?
A. $25,000 C. $7,500
B. $17,500 D. Nothing
NOTES

Personal Insurance Issues
INTRODUCTION
Lesson 4 has great potential for applicability in your personal
insurance planning needs. The assignments and chapters in
this lesson will provide you with insights into automobile,
homeowner’s, and life insurance and annuities.
OBJECTIVES
� Describe personal auto insurance coverage (and expo-
sure to loss) arising from automobile ownership and use
and explain major features of pricing and underwriting
� Explain compulsory and no-fault automobile insurance
laws and their rationale and effect
� Describe homeowner’s insurance and personal umbrella
liability insurance policies, as well as property insurance
arrangements for catastrophic perils, including FAIR
plans and National Flood Insurance Program
� Analyze the impact of catastrophes on property insur-

ance and the market’s response to large catastrophes
� Provide a brief overview of major life insurance and
annuity products
� Describe key features and uses of term, endowment,
whole life (compared to universal and variable) life
insurance policies and annuity products
� Describe the tax benefits associated with life insurance
and annuity products
� Analyze the pricing of basic life insurance policies and
annuities
� Describe methods for comparing the cost of life insur-
ance policies across insurers
67
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4
Risk Management68
ASSIGNMENT 13

Overview of Auto Loss Exposures
and Insurance
Your personal auto policy provides auto liability coverage. It
consists of predetermined coverage based on state compulsory
liability insurance laws, which require drivers to be insured
for minimum amounts. All states have financial responsibility
laws that penalize those found to have negligently caused
accidents, if they’re unable to pay for certain minimum
amounts of damages. Some of the acronyms used in the
insurance industry, and likely to be detailed on your personal
auto insurance policy billing statement, include
� PDL—property damage liability
� BIL—bodily injury liability
� PIP—personal injury protection
� UM—uninsured motorist
� UIM—underinsured motorist
� FR—financial responsibility law

Your personal auto policy may include auto medical payments
coverage, which acts independently from health insurance. In
states with no-fault or related laws, your personal auto policy
includes personal injury protection coverage instead. Your
policy may also include uninsured and/or underinsured
motorist coverage. This covers you if the cause of the accident
is someone who can’t pay and has no insurance. There are
two optional types of coverage for vehicle damage and theft:
collision coverage and other-than-collision (also called
comprehensive) coverage.
Lesson 4 69
Auto Insurance Pricing and
Underwriting
Different insurance rates are charged to different groups of
consumers, depending on
� Driver class (for example, age group)
� Territorial ratings (for example, city or rural area)

Driver classes include those based on age, gender, automobile
use, number of automobiles and accompanying homeowner’s
coverage, and other factors. The insured’s driving record in
also an important factor. The nonstandard insurance market is
the specialty insurance market, which exists to serve drivers
with characteristics that suggest significantly above-average
expected claim and/or administrative costs.
Self-Check 13
Match the abbreviations on the left with the terms on the right.
______ 1. PDL
______ 2. BIL
______ 3. PIP
______ 4. UM

______ 5. UIM
______ 6. FR
(Continued)
a. ____Bodily insured liability
b. ____Underinsured motorist
c. ____Personal damage liability
d. ____Financial responsibility law
e. ____Uninsured motorist
f. ____Personal insurance protection
Risk Management70
Self-Check 13

7. Jodi, age 25, is single, lives by herself, and drives a Subaru.
Which one of the following
statements most completely describes persons insured under her
personal automobile policy?
a. Only her, when she is driving her car
b. Only her, when she is driving her car or a rental car
c. Her and anyone else who is driving her car with her
permission
d. Her, when she is driving any car with permission, and anyone
else who is driving her car
with her permission
8. Which of the following is the most common type of residual
market mechanism for auto
liability insurance?
a. Assigned risk plan c. Reinsurance facility
b. Joint underwriting association d. ARC plan
9. If a person’s past accidents and driving violations didn’t
result in higher auto insurance
premiums, what impact would this have on incentives?

a. Increased incentive for insurers to provide low-priced
coverage
b. Decreased incentive for people to buy insurance
c. Decreased incentive to drive safely
d. Increased incentive for excessive coverage
Answer Questions 2, 3, 6, 7, and 11 on pages 273–274 in the
textbook.
Lesson 4 71
ASSIGNMENT 14
Homeowner’s Insurance
The basic contents from Tables 14.2 and 14.3 on pages 278
and 282, respectively, have been merged below. The most

common form of homeowner’s policy is HO3:
Homeowner’s insurance dwelling coverage (A) covers the main
residence and attached structures. Coverage for medical
payments to others pays medical expenses for nonresidents
injured while on the premises. Guaranteed replacement cost
will pay the like-kind replacement cost even if it exceeds the
policy limit. The majority of homeowner policies cover
Policy
Form
Perils Covered Type of Settlement
Percent of
Homeowner’s Policies
A & B & D
Dwelling &
Other

Structures
C
Personal
Property
A & B
Dwelling &
Other
Structures
C
Personal
Property
1977 1995
HO1 Basic Basic LKRC ACV 14% <1%

HO2 Expanded Expanded LKRC
ACV or
LKRC
41% 6%
HO3 Open peril Expanded
LKRC or
GRC
ACV or
LKRC
45% 93%
HO4
(Renter)
NA
Expanded NA
ACV or
LKRC

NA NA
HO5 Open peril Open peril GRC LKRC NA NA
HO6
(Condo)
Expanded
Expanded ACV
ACV or
LKRC
NA NA
HO8 Basic Basic FRC or ACV ACV 0% <1%
LK = like-kind, GRC = guaranteed replacement cost, RC =
replacement cost, ACV = actual cash
value, and NA = not applicable.
Risk Management72

dwellings and other structures up to their like-kind replace-
ment cost. The actual cash value is defined as replacement
cost less depreciation:
ACV = RC – Depreciation
Policies that pay functional replacement cost (FRC) pay the
cost of replacement for damaged property using the same
functional materials, but not necessarily the same exact
materials.
Personal umbrella policies usually provide excess coverage of
at least $1 million for liabilities arising from multiple sources.
Coverage of High Risk/
Catastrophic Perils
Insurance against flood losses can be purchased through the
government-subsidized National Flood Insurance Program
(NFIP). The program attempts a delicate balancing act—
covering flood losses while not encouraging excessive
development (and therefore repeat losses) in flood-prone
areas. In some cases, the government purchases and con-
demns properties that are flooded multiple times.
Following large losses caused by urban riots in 1967 and

1968, many insurers withdrew or raised premiums signifi-
cantly, so a number of states created fair access to insurance
requirements (FAIR) plans to provide coverage in these areas.
Seven states on the East and Gulf costs of the United States
have beach and windstorm insurance plans to cover hurri-
cane losses. Even with this plan, Florida residents have
found it increasingly difficult to purchase insurance because
of the severe hurricanes that have hit the state in recent
years. Increased development in the state has caused hurri-
cane losses to increase each year, leading many insurers to
stop writing homeowner’s insurance in Florida, or to exclude
certain types of damage from their coverage.
Lesson 4 73
Self-Check 14

False.
______ 1. The most common form of homeowner’s policy is
HO7.
______ 2. Homeowner insurance dwelling coverage covers the
main residence and attached
structures.
______ 3. Coverage for medical payments to others pays
medical expenses for nonresidents
injured while on the premises.
______ 4. ACV = annual cost value
______ 5. RC = repair cash
6. Which of the following losses is normally included in
homeowner’s insurance coverage?

a. Normal wear and tear on the dwelling
b. Property loss caused by a pet
c. Damage to motor vehicles
d. Loss or damage to the homeowner’s personal property while
staying at a hotel in Las
Vegas
7. Under most homeowner’s insurance policies, if the coverage
meets the coinsurance
requirement, dwellings and other structures will be insured up
to
a. their actual cash value.
b. their like-kind replacement cost.
c. their replacement cost less accumulated depreciation.
d. 80% of their actual cash value.
8. The primary reason for the low profitability of homeowner’s
insurance companies in the 1990s
was
a. losses from catastrophes. c. mismanagement.
b. poor underwriting. d. unexpected inflation.

(Continued)
Risk Management74
ASSIGNMENT 15
Life Insurance Product Overview
Term insurance provides pure insurance or death protection
without a savings plan. Cash value policies contain a term
insurance component plus a savings plan:
Cash value policies = Term insurance + Savings plan
In the case of a cash value policy, the amount of savings
accumulated at any point in time is referred to as the cash
value of the policy.
If a policyholder terminates or surrenders the policy, he or
she is entitled to at least a portion of the policy’s cash value.
Early policy surrenders are referred to as lapses. The cash

Self-Check 14
9. Governmental entities (such as the CAT Fund in Florida) may
have an advantage at insuring
correlated loss exposures because
a. correlated loss exposures affect a large number of people.
b. pooling across time requires consideration of the time value
of money.
c. governments are in a better position than private insurers to
enforce intertemporal pooling
contracts.
d. governments are better at determining the price of correlated
risks.
Answer Questions 1 and 3 on page 295 in the textbook.
Lesson 4 75

surrender value is less than the cash value with universal life
and variable life policies, as a surrender charge is often
applied.
The death benefit is the amount of money received by the
beneficiary when the insured dies, and equals the policy’s
face amount. Death protection is the amount of the death
benefit less the cash value, as follows:
Death protection = Death benefit – Cash value
Traditional Products: Term,
Endowment, and Whole Life
Nearly all term policies are guaranteed renewable—that is,
although they may last only five years, they can be renewed
after that time, and then renewed again and again. An
endowment policy is insurance where the insurer pays the
face amount of the policy either at the insured’s death or at
the end of the policy. This type of insurance is uncommon in
the United States, because it doesn’t get favorable tax treat-
ment. A whole life policy is an endowment policy with a very
long term. The fundamental aspect of a whole life policy can
be summarized, as follows:

Death protection = Death benefit (or Face amount) – Cash
value
Illustrated dividends for whole life policies, which salesmen
use to sell the policies, tend to reflect what the insurer is
currently paying, which isn’t guaranteed for the future. This
can lead to claims of deceptive marketing when the interest
rates have been particularly high and assumptions about
future rates are based on that anomaly.
Extended term insurance uses a single premium to purchase
a paid-up term policy. Usually this large premium comes
from the cash value of a whole life policy that’s converted to a
term policy.
Most whole life policies allow the policyholder to obtain a
large portion of the cash value of the policy without surren-
dering the policy (policy loan). This amount then decreases
the amount of the death benefit if the insured dies before
repaying the loan.
Risk Management76

Product Innovation: Universal
and Variable Life
Universal life policies, like whole life policies, provide perma-
nent death protection and savings accumulation. However,
these policies offer greater flexibility with respect to premium
payments, and the cash value varies explicitly over time. The
cash value is based on premium payments, less expense and
mortality charges, plus credited interest.
A variable life policy generates a return earned on a
portfolio of assets—usually stocks or bonds—chosen by
the policyholder.
Tax Benefits from Life
Insurance Policies
Cash value life insurance policies may represent a tax-
advantaged financial vehicle, when compared to alternatives.
� Death benefits aren’t taxable (but they may be subject to
estate tax).
� No income tax is paid on increases in cash value while
the policy remains in force, unlike a savings account
where the interest is taxed every year.

� If surrendered, the policyholder pays income tax on the
surrender value minus the premiums paid (even though
only part of those premiums went to the cash value).
Annuity Contracts
An annuity is associated with an accumulation period—
when the insurance company receives payments from the
annuitant, or policyholder—and a payout period—when the
insurance company makes payments to the annuitant. An
annuity that pays only until the annuitant dies is called a
straight life annuity. A deferred annuity (about 95 percent of
all annuities purchased) is usually purchased before retire-
ment, to be used as income after retirement. A fixed annuity
usually guarantees some minimum rate of return, whereas a
variable annuity doesn’t.
Lesson 4 77
Life Insurance Pricing and
Cost Comparisons
Net premiums and mortality tables are examined in pages 314
through 323 of your text, where the authors compare a
sequence of one-year life insurance policies to a two-year

term policy. Term insurance policies are commonly compared
using the interest adjusted cost index. Whole life policies are
commonly compared using the estimated implicit rate of
return.
Rules of thumb suggest that insurance coverage should
equal 6 to 10 times annual income.
Self-Check 15
False.
______ 1. Term insurance provides an insurance component
plus a savings plan.
______ 2. Cash value policies provide pure insurance or death
protection without a savings plan.

______ 3. Death protection = Death benefit – Cash value
______ 4. Whole life insurance policies are commonly
compared using the interest adjusted cost
index. Term life policies are commonly compared using the
estimated implicit rate of
return.
______ 5. Term life insurance provides a death benefit equal to
the face amount of the policy if
the insured dies during the policy period.
(Continued)
Risk Management78
Self-Check 15

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