Chapter 4: Advanced Topics in Risk Management

1. Which of the following is a financial risk that may be faced by a business organization?
A) injuries suffered by employees at the workplace
B) lost income after a fire loss
C) product liability risk
D) currency exchange rate risk

2. Which of the following statements about the scope of risk management is (are) true?
I. Traditionally, risk management was limited in scope to speculative loss exposures.
II. In the 1990s, some businesses began to expand the scope of risk management to include
financial risks.
A) I only
B) II only
C) both I and II
D) neither I nor II

3. Mid-States Beef is a commercial feedlot business. Currently, the company has over 10,000
cattle in feedlots. Mid-States is concerned that the price of corn, the grain fed to the cattle, will
increase significantly. The risk that the price of corn may increase and harm the profitability of
Mid-States Beef's operations is a(n)
A) currency exchange rate risk.
B) property risk.
C) commodity price risk.
D) interest rate risk.

4. An integrated risk management program is a risk management program which combines

A) pure and speculative risks.
B) property and liability risks.
C) personnel-related risk and property risk.
D) direct and indirect loss risk.

5. Regional Airline (RA) spends millions of dollars each year on jet fuel. The company also has
significant liability exposures. RA can retain a large portion of its liability exposure if fuel costs
are low. The company can pay high fuel costs if retained liability losses are low. RA cannot,
however, absorb both high fuel costs and high retained liability claims. RA's insurer designed an
insurance program where the insurer pays only if both contingencies (high fuel costs and high
retained liability claims) occur. The contract the insurer designed is called a(n)
A) double indemnity rider.
B) double trigger option.
C) multiple protection policy.
D) other insurance provision.

6. Which statement is (are) true with respect to enterprise risk management programs?
I. They address traditional property, liability, and personnel loss exposures.
II. They do not address financial risks.
A) I only
B) II only
C) both I and II
D) neither I nor II

7. A comprehensive risk management program that addresses an organization's pure risks,

speculative risks, strategic risks, and operational risks is called a(n)
A) risk management information system.
B) financial risk management plan.
C) speculative risk management plan.
D) enterprise risk management plan.

8. The property and liability insurance industry is characterized by a repetitive pattern of loose
underwriting standards with low premiums followed by tight underwriting standards with
high premiums. This repetitive pattern is called the
A) underwriting by exception method.
B) business cycle.
C) underwriting cycle.
D) account underwriting method.

9. Which statement is (are) true regarding property and liability insurance market conditions?
I. Premiums are high when the insurance market is "hard."
II. Underwriting standards are tight when the insurance market is "soft."
A) I only
B) II only
C) both I and II
D) neither I nor II

10. Which of the following statements is true regarding insurance market conditions and
underwriting results?
A) A combined ratio greater than one (or 100 percent) indicates profitable underwriting. =>
unprofitable
B) In a "soft" insurance market, more retention is used than in a "hard" insurance market. => less
C) Insurance rates are high and underwriting standards are tight when the insurance market is
"hard."
D) Property and liability insurance premiums and underwriting standards do not fluctuate over
time.

11. The relative level of surplus in the insurance industry is called the industry's
A) capacity.
B) liabilities.
C) reserves.
D) admitted assets.
12. Which of the following statements is (are) true regarding investment returns and the
underwriting cycle?
I. Investment returns have no impact upon the underwriting cycle.
II. Investment returns can lengthen the duration of a soft market by offsetting underwriting
losses.
A) I only
B) II only
C) both I and II
D) neither I nor II

13. A large property and liability insurance company merged with a bank and then acquired a
stock brokerage company. This type of merger and acquisition activity is categorized as
A) insurance company consolidation.
B) cross-industry consolidation.
C) financial risk management.
D) insurance brokerage consolidation.

14. A company has a fleet of 200 vehicles. On average, 50 vehicles per year experience property
damage. What is the probability that any vehicle will be damaged in any given year?
A) 10 percent
B) 20 percent
C) 25 percent
D) 50 percent

15. RST Company has production facilities in Salt Lake City and Cleveland. The probability that
in any given year a fire will damage the production facility in Salt Lake City is 5 percent. The
probability that in any given year a fire will damage the Cleveland production facility is 4
percent. What is the probability that BOTH production facilities will be damaged by fire in any
given year?
A) 0.20 percent
B) 2.00 percent
C) 4.50 percent
D) 9.00 percent

16. RST Company has production facilities in Salt Lake City and Cleveland. The probability that
in any given year a fire will damage the production facility in Salt Lake City is 5 percent. The
probability that in any given year a fire will damage the Cleveland production facility is 4
percent. What is the probability that AT LEAST ONE of the production facilities will be
damaged by fire in any given year?
A) 0.20 percent
B) 2.00 percent
C) 8.80 percent
D) 9.00 percent

17. Some events cannot occur together because the occurrence of one event makes the
occurrence of the second event impossible. Such events are called
A) dependent events.
B) independent events.
C) conditional events.
D) mutually exclusive events.

18. Two buildings are located close together at a production facility. The probability that either of
these buildings will experience a fire loss is 4 percent. However, if one building has a fire, the
probability that the second building will have a fire is 60 percent. What is the probability that
both buildings will have a fire?
A) 1.6 percent
B) 2.4 percent
C) 8.0 percent
D) 64.0 percent

19. Which of the following statements is (are) true with regard to probability analysis?
I. If two events are independent, the occurrence of one event does not affect the occurrence of the
second event.
II. If two events are dependent, the occurrence of one event affects the occurrence of the second
event.
A) I only
B) II only
C) both I and II
D) neither I nor II

20. Jane is risk manager of ABC Manufacturing Company. She is trying to decide whether to
self-insure her company's workers compensation exposure or to purchase insurance. Jane would
like to use regression analysis to predict the number of workers compensation claims that will
occur next year. The number of claims will be the dependent variable in the regression. All of the
following would be reasonable independent variables to use EXCEPT
A) number of employees.
B) number of hours worked.
C) total assets.
D) payroll.

21. A method of characterizing the relationship between two or more variables and then using
the characterization to make a prediction is called
A) loss analysis.
B) time value of money analysis.
C) regression analysis.
D) capital budgeting analysis.

22. A table showing losses that could occur and the corresponding chance that each loss could
occur is called a(n)
A) underwriting cycle.
B) capital budget.
C) loss distribution.
D) risk map.

23. Which of the following statements is (are) true with respect to the time value of money?
I. Money received today is worth more than the same amount of money received in the future.
II. The present value of a future amount is greater than the future amount.
A) I only
B) II only
C) both I and II
D) neither I nor II

24. Calculating the present value of a future amount is called

A) interpolating.
B) discounting.
C) compounding.
D) regression analysis.

25. The process of determining which set of investments in plant and equipment to
undertake is called
A) regression analysis.
B) loss forecasting.
C) time value of money analysis
D) capital budgeting.

26. Which of the following statements is (are) true regarding the net present value of a capital
investment?
I. Net present value does not consider time value of money.
II. A positive net present value represents an increase in value to the firm.
A) I only
B) II only
C) both I and II
D) neither I nor II

27. Millie is risk manager of JKL Company. She is considering an investment in a loss control
project. The project will cost $40,000. Assuming a 10 percent discount rate, the present value of
the future net cash flows that this project will generate is $60,000. What is the net present value
(NPV) of this project?
A) $20,000
B) $26,000
C) $60,000
D) $100,000

28. A computerized data base that permits risk managers to store and analyze risk management
data is called a
A) risk management information system.
B) risk management Intranet.
C) risk management web site.
D) risk map.

29. A grid charting the potential frequency and severity of losses is called a
A) risk management information system.
B) risk management Intranet.
C) risk management web site.
D) risk map.

31. Terrorists attacked the World Trade Center on September 11, 2001. The attack simultaneously
created large losses for life insurers, property insurers, workers compensation insurers, health
insurers, and liability insurers. What name is given to an event that simultaneously creates
large losses in several lines of insurance?

A) speculative loss
B) clash loss
C) retroactive loss
D) consequential loss

32. Which of the following was a consequence of passage of the Financial Modernization Act
(Gramm-Leach-Bliley)?

A) Formation of insurers was made easier because capital requirements were reduced.
B) It became easier for insurers to conduct business as they were no longer required to be
licensed in each state where they operate, but only in the state where they are domiciled.
C) Insurers were required to prepare financial statements using generally accepted accounting
principles (GAAP) instead of using statutory accounting.
D) Depression-era barriers between underwriting risk, depository functions, and securities
underwriting were eliminated.

33. The transfer of insurable risk to the capital markets through the creation of a financial
instrument is called

A) coefficient of risk.
B) securitization of risk.
C) financial risk management.
D) enterprise risk management.

34. LMN Insurance Company is concerned about its exposure to hurricane losses for property
risks it insured on the Gulf Coast. LMN borrowed money from investors by issuing financial
securities. LMN promised to repay the money it borrowed with interest if hurricane losses do
not exceed a specified level. If hurricane losses exceed the specified level, LMN will repay
less than it borrowed and use the extra money to fund hurricane losses. The securities that
LMN issued are
A) call options.
B) futures contracts.
C) weather options.
D) catastrophe bonds.

35. Hedge Fund Company offers a mutual fund to investors. Fund managers are concerned about
fund volatility. They analyzed the fund to determine the worst loss likely to occur in a calendar
quarter, assuming a 90 percent level of confidence. The worst probable loss is known as the
fund's
A) unrealized capital gain.
B) value at risk.
C) beta coefficient.
D) surrender value.

36. Reasons to adopt an enterprise risk management plan include all of the following
EXCEPT
A) to increase earnings volatility. (deviation)
B) to treat risks facing the business in a more holistic way.
C) to increase net income.
D) to gain an advantage over competitors.

37. Which of the following statements concerning the securitization of risk is (are) true?
I. Securitization increases the capacity of the insurance industry. (surplus)
II. Securitization can be used to protect against catastrophic loss.
A) I only
B) II only
C) both I and II
D) neither I nor II
38. Insurance Brokerage Company uses a computer-based method of estimating the losses its
clients will suffer if a severe storm or earthquake occurs. This method of estimating losses is
called
A) capital budgeting.
B) securitization of risk.
C) risk mapping.
D) catastrophe modeling.

39. Uncertainty pertaining to the organization's goals and objectives and the organization's
strengths, weaknesses, opportunities, and threats is called
A) operational risk.
B) strategic risk.
C) subjective risk.
D) pure risk.

40. Consolidation in the insurance industry is a continuing trend. One area where mergers and
acquisitions frequently occur is between marketing intermediaries who represent insurance
purchasers. These intermediaries are called
A) insurance adjusters.
B) insurance agents.
C) insurance underwriters.
D) insurance brokers.

41. Five Below Zero is a new ski resort in Colorado. Five Below Zero is concerned that an
abnormally warm winter will prevent the accumulation of snow needed to have a profitable ski
season. Five Below Zero purchased a contract that will pay a lump sum if the daily high
temperature exceeds 30 degrees for more than 12 days between January 1st and March 31st. The
contract Five Below Zero purchased is called a(n)
A) catastrophe bond.
B) weather option.
C) interest rate swap.
D) convertible bond.

42. Which statement is (are) true concerning catastrophe models?

I. Businesses other than insurance companies use catastrophe models.

II. Catastrophe models are able to precisely predict disaster occurrences and loss values.
A) I only
B) II only
C) both I and II
D) neither I nor II

43. Which of the following is a financial derivative that derives value from specific insurable
losses or from an index of values?
A) commodity futures contract
B) corporate bond
C) catastrophe bond
D) insurance option

44. An emerging concern for risk managers is the greater volatility that has been observed in
weather patterns—higher high temperatures, lower low temperatures, record rainfall, drought,
etc. Collectively, this risk is called
A) seismic risk.
B) hurricane risk.
C) speculative risk.
D) climate change risk.

45. Which of the following statements regarding terrorism insurance is (are) true?
I. There is a federal backstop if terrorism claims are catastrophic.
II. Private insurers market terrorism insurance.
A) I only
B) II only
C) both I and II
D) neither I nor II

46. The terrorism risk in the United States

A) is of no concern to private companies.
B) is limited to attacks by foreign nationals.
C) can be addressed through risk control and insurance.
D) is an uninsurable risk.

47. Which of the following is a demographic factor that has increased losses from climate change
in the United States?
A) The increasing life expectancy in the United States.
B) The increasing population in Southern states such as Florida, Texas, and South Carolina.
C) The declining fertility rate (live births per women of child-bearing age) in the United States.
D) The growth in the number of families living below the poverty line in the United States.

48. Last year, XYZ Insurance Company had a combined ratio of 102.4 and lost $10.2 million
on the insurance that it sold. The company, however, was required to pay income taxes. The best
explanation for this apparent contradiction is that XYZ offset its underwriting loss with
A) increased loss reserves.
B) investment income.
C) increased loss adjustment expenses.
D) unearned premiums.

49. ABC Company in considering a loss control investment. The project will cost $100,000. It
will generate an after-tax net cash flow of $60,000 one year after investment and an after-tax net
cash flow of $60,000 two years after investment. The present value of $1 received one year from
today assuming a 6 percent rate is .9434. The present value of $1 received two years from today
assuming a 6 percent interest rate is .8900. Assuming a discount rate of 6 percent, what is the net
present value (NPV) of this project?
A) $10,004
B) $13,195
C) $16,604
D) $20,000

50. Which of the following statements about the risk of terrorism in the United States is (are)
true?
I. Congress created a federal backstop for terrorism claims.
II. Coverage for losses attributable to terrorism is not marketed by private insurers in the U.S.
A) I only
B) II only
C) both I and II
D) neither I nor II

51. When announcing that an enterprise risk management program would be implemented at
XYZ Company, the president of the company observed, “We must overcome the silo mentality
for the program to be successful.” The “silo mentality” refers to
A) over-emphasis on pure risks and ignoring speculative risks.
B) using too much of one risk treatment measure and ignoring other risk treatment methods.
C) focusing narrowly on one area and not viewing risk holistically.
D) everyone assuming someone else is responsible for managing a risk and no one taking
leadership.

52. The first step in the enterprise risk management process is

A) risk analysis.
B) implementing and monitoring the program.
C) risk identification.
D) selection of risk treatment measures.
53. A bank stores depositor data electronically. The data include financial account values, social
security numbers, and other information. An outside party was able to gain access to the bank’s
customer data through unauthorized access to the bank’s computer system. The outside party
was able to steal money from the accounts and to sell customer data, including social security
numbers, to others. This scenario illustrates
A) terrorism risk.
B) climate change risk.
C) speculative financial risk.
D) cyber-liability risk.

54. A risk manager analyzed fleet accident data to help determine which loss control measures
would provide the greatest safety incentives for drivers. Examining data to generate
information that will help make more informed decisions is called
A) predictive analytics.
B) catastrophe modeling.
C) sensitivity analysis.
D) data mining.

55. West Coast Insurance writes property and liability insurance in California, Oregon, and
Washington. These states are all susceptible to earthquakes. To help determine how much
reinsurance to purchase, West Coast Insurance hired an organization to use a computer algorithm
to estimate what its insured losses would be if a severe earthquake occurred. West Coast
Insurance based its purchase of reinsurance on the loss estimates. This scenario illustrates using
A) value-at-risk analysis.
B) catastrophe modeling.
C) risk mapping.
D) a risk management information system.

56. Palmer Polymers is changing from a traditional risk management program to an enterprise
risk management program. As a first step, the risk manager determined all the risks that the
organization faces. Next, she created a grid with loss frequency on the x-axis and loss severity
on the y-axis. Then she plotted all of the loss exposures based on frequency and severity. The
grid and the plotted loss exposures are called a
A) probability distribution.
B) catastrophe model.
C) risk map.
D) risk management information system.