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Introduction to Risk Management and Insurance, 10e (Dorfman/Cather)
Chapter 1 Introduction to Enterprise Risk Management and Insurance
1) A Pure Risk is defined as:
A) an event that offer no opportunity for financial gain
B) the chance a loss will occur
C) a diversifiable risk
D) a contingency that increases the chance of a loss
2) All the following are direct losses except:
A) a car is stolen
B) a house suffers flood damage
C) an apartment must be rented after a house is destroyed by fire
D) a business loses $100,000 in a law suit
3) All the following are direct losses except:
A) a house is burglarized
B) a store loses $200,000 in sales because a fire closes it down for two weeks
C) a corporation must pay $1 million in ransom when its CEO is kidnapped
D) an delivery truck needs $15,000 in repairs after a collision
4) Which of the following is not an example of a Catastrophic Loss Event?
A) Hurricane Katrina
B) Death of Michael Jackson
C) September 11, 2001 terror attacks
D) 2004 Tsunami in the Indian Ocean
5) Which of the following is not a method of protection of risk?
A) Group insurance plans
B) Employee benefits
C) Social insurance
D) Humanitarian aid
6) Defective electrical wiring that may lead to a fire is an example of a:
A) pure risk
B) non-diversifiable risk
C) speculative risk
D) physical hazard
7) Risk Pooling is an example of:
A) a Catastrophic Loss Event
B) diversifying risk
C) a speculate risk
D) applying the risk-return trade-off
8) Which of the following is a false statement?
A) Risk averse people will pay an insurance premium that is greater than the mathematically fair
chance of loss in order to relieve themselves of uncertainty.
B) A risk seeker is willing to assume risk.
C) The mathematically fair price for insurance is the objective risk for the insurer multiplied by
the maximum possible loss.
D) Insurance is never a mathematically fair trade because the insurer adds several operating and
other costs to loss costs when it calculates the premium.
9) Which of the following is not a hazard?
A) Storing one ton of dynamite in a garage
B) Bad diet (eating lots of junk food)
C) Skating on thin ice
D) Getting shot accidentally while deer hunting
10) The correct order of the steps in the Risk Management Process is:
A) Establish Goals, Identify Potential Loss Exposure, Measure Potential Loss Exposure, Choose
Risk Handling Techniques, Implement Techniques and Monitor Effectiveness
B) Establish Goals, Choose Risk Handling Techniques, Identify Potential Loss Exposure,
Measure Potential Loss Exposure, Implement Techniques and Monitor Effectiveness
C) Establish Goals, Choose Risk Handling Techniques, Measure Potential Loss Exposure,
Identify Potential Loss Exposure, Implement Techniques and Monitor Effectiveness
D) Establish Goals, Measure Potential Loss Exposure, Identify Potential Loss Exposure, Choose
Risk Handling Techniques, Implement Techniques and Monitor Effectiveness
11) Assume that 1000 students, all healthy, all age 22, and all male, form a life insurance pool to
pay $500 to the beneficiaries of any member who dies in the next 365 days. The chance of loss
or probability of death for the members of this group is .002. To join the pool a member must
pay: (Disregard interest earnings and reserves and assume expenses of operating the insurance
pool are 30% of losses).
A) $1
B) $1.30
C) $3
D) $2.28
12) Which of the following is not a type of risk when identifying a pure risk?
A) Retention Risk
B) Property Risk
C) Liability Risk
D) Human Resource Risk
13) Which of the following is a true statement?
A) Liability risks are risks associated with building calamities.
B) Theft is a diversifiable risk.
C) Most individuals in the industrialized countries carry no insurance.
D) The Law of Large Numbers is used in Risk Pooling.
14) Loss Transfer means:
A) shifting the financial consequences of a loss to a third party
B) shifting the financial consequences of a loss to a self-insurance program
C) shifting the financial consequences of a loss to a well-diversified portfolio
D) shifting the financial consequences of a loss to more wealthy group of people
15) Which of the following is not a risk handling technique?
A) Loss control
B) Loss diversification
C) Loss transfer
D) Loss financing
16) Which of the following potential losses is not an example of a pure risk?
A) Loss of a home by fire
B) Theft of a car
C) Loss of $10,000 in the stock market
D) Theft of your wallet containing $100
17) Enterprise Risk Management:
A) is only applicable to insurance firms
B) is an outdated method of dealing with risk
C) works best when evaluating risks is distinct company silos
D) is a process that examines all risks collectively
18) Which of the following is not a direct social benefit of the insurance mechanism?
A) Increased business and social stability
B) Better allocation of society’s resources
C) Better choice of optimum size of business operations
D) Lower federal and state income taxes
19) The ideal insurance system:
A) reduces the probability of accidental and fortuitous losses due to increased predictability
B) requires the transfer of a large number of exposures to loss to a pool, where a fund exists in
advance of losses having to be paid
C) works best when a large proportion of the participants in the pool submits a claim
D) eliminates all hazards
20) Catastrophic losses are not insured by the private insurance industry because:
A) if a truly catastrophic loss occurs, it can threaten the solvency of the insurer
B) catastrophic losses can result from an individual’s moral hazard
C) the federal government wants to insure catastrophic losses
D) the losses require foreign reinsurance companies to operate in the U.S.
21) Which one of the following losses is an indirect loss?
A) Damage to a car when a tree falls on it
B) Loss caused by an arsonist who burns down a building to collect insurance proceeds
C) Monetary losses due to the inability to produce and sell goods when a machine is destroyed
D) Monetary losses due to a legal liability claim
22) Diversifiable risk is defined as:
A) risk with two possible outcomes
B) risk with three possible outcomes
C) an individual’s perception of risk
D) none of the above
23) Why is a large number of exposure units generally required for a risk to be insurable?
A) It allows the insurer to accurately predict the aggregate dollar amount of loss.
B) It allows for at least some losses to occur.
C) It reduces speculative risk.
D) It reduces both the speculative risk and pure risk.
24) Why is a large number of exposure units generally required for a risk to be insurable?
A) It prevents the insurer from losing money.
B) It guarantees that losses will be unintentional and measurable.
C) It enables the insurer to better predict the frequency and severity of losses (moderate).
D) It minimizes physical hazards.
25) Examine the following list of “risks.” Determine which of these are “pure risks.”
I. The risk that your antique Corvette will depreciate in market value
II. The risk that you will have a collision in your Corvette, thus causing you to spend thousands
of dollars in repair costs
III. The risk that someone will steal your Corvette
IV. The risk that you will buy a house and lightning will strike your roof, thus causing you to
have to purchase a new roof
V. The risk that you will invest your life savings in a business venture that fails, thus causing
you to lose your entire investment
A) I, II, III, IV, and V
B) I, II, and IV
C) I, II, III, and IV
D) II, III, and IV
26) The law of large numbers states that as the number of exposure units increases:
A) accuracy of predictions should improve
B) the chance of loss declines
C) Speculative risk increases
D) the number of accidents decreases
27) Which of the following is an accurate definition of “insurance”?
A) A savings account designed to protect you in the event of a rainy day
B) A financial arrangement that redistributes the costs of unexpected losses among a pool of
insureds
C) A communist plot to destroy capitalist enterprise
D) A contractual agreement in which the insurer agrees to pay the insured only if the insured
requests the money
28) An insurance applicant dying from cancer is not likely to be insured because:
A) the loss is not definite as to time and place
B) the probability of loss varies daily, ultimately reaching 1.0
C) the loss would be catastrophic for the insurer
D) the loss is certain to occur and the price for coverage would be uneconomical
29) What is the fundamental function of the insurance company—in other words, what is it the
insurance company does that makes the insurance mechanism work?
A) It pools those insureds having similar risks, and predicts the losses that those in the pool will
suffer.
B) It pools any insureds who wish to purchase insurance, and attempts to predict the losses that
those in the pool will suffer.
C) It redistributes government subsidies to those who have suffered catastrophes.
D) It eliminates the process of underwriting in order to sell insurance to as many people as
possible, thus providing insureds with a huge quantity discount.
30) There are four basic components of an insurance premium. Which of the following is not one
of those components?
A) Losses suffered by the members of the insurance pool
B) Law of large numbers
C) An allowance for unexpected losses
D) Earnings on investments
31) Enterprise Risk Management is typically described as having the following characteristics,
except:
A) a top-down corporate focus
B) a broad scope of loss exposures
C) a portfolio perspective
D) a loose approach to risk identification, assessment, and treatment
32) In the context of ERM, hazard risk is defined as:
A) being associated with the strategic direction of a firm
B) being associated with the operations of a firm
C) adverse financial losses associated with diversifiable risks.
D) adverse financial losses associated with pure risks.
33) In the context of ERM, which of the following is an example of hazard risk?
A) Human Resource losses
B) Property losses
C) Liability losses
D) Supply Chain interruption losses
34) Arthur is driving home from work when he runs off the road and hits a telephone pole. These
are the losses he suffers: $12,000 to repair the damage to his car, and, $800 to rent a car while his
car is being repaired. What is the correct name for each of these losses?
A) The $12,000 is an indirect loss, and the $800 is a direct loss.
B) The $12,000 is a direct loss, and the $800 is also a direct loss.
C) The $12,000 is a direct loss, and the $800 is an indirect loss.
D) The total loss of $12,800 is a direct loss.
35) Which of the following is not an example of a speculative risk?
A) Purchase of an insurance policy
B) Investment in common stocks
C) Operating a business for profit
D) Investment in banana futures
36) The most difficult and important step in the risk management process generally is:
A) evaluating risk
B) reviewing the program
C) selecting the best method(s) to handle the risk
D) identifying the risk
37) A “pure risk” is defined as a situation where there is the possibility:
A) of loss or no change
B) of profit or no change
C) of profit or loss
D) that actual losses will deviate from expected losses
38) Loss prevention and control:
A) eliminate risk
B) are an alternative to self insurance
C) reduce the probability and severity of loss
D) directly minimize the probability of a natural disaster occurring
39) Loss prevention is the best risk management tool when the chance of loss is ________ and
the potential loss severity is ________.
A) high, high
B) high, low
C) low, low
D) low, high
40) Risk retention is not a good idea if:
A) the risk is unimportant
B) you did not identify the risk
C) the frequency is so low it almost will never happen
D) the exposure is potentially catastrophic
41) Which of the following would not normally be identified in the risk management process?
A) Property exposures
B) Speculative exposures
C) Indirect loss exposures
D) Operations exposures
42) The primary reason the insurance mechanism functions successfully is the:
A) existence of hazard risks
B) ease with which losses can be measured
C) predictability of losses via the law of large numbers
D) existence of many non-industrial nations
43) If the chance of loss is high and loss severity is high, generally the most appropriate risk
management tool is:
A) risk transfer
B) risk reduction
C) risk assumption
D) risk avoidance
44) The Chief Risk Officer is concerned primarily with the management of:
A) operational risks
B) financial risks
C) strategic risks
D) all of the above
45) Which of the following best describes a pure risk?
A) An uncontrollable risk that cannot be insured
B) The outcome will either be a loss or no change
C) The outcome will be either a loss or a gain
D) A risk with three possible outcomes
46) When faced with a risk of loss that is low frequency-high severity in nature, a prudent risk
manager would choose which of the following methods for handling the loss exposure?
A) self-insure
B) avoidance
C) transfer
D) mediate
47) If you were the risk manager of the World Trade Center buildings, what loss prevention or
reduction technique could you have implemented before the 9/11/01 tragedy that might have
made a significant difference in the number of lives lost?
A) Guards on the roof of each building
B) Evacuation procedures that required everyone to leave after any sign of loss
C) Stronger exterior building materials
D) Better background screening of all who were allowed to work in the building
48) Risk diversification is based on the principle that:
A) one should not be exposed to only one event
B) one should put all her “eggs in one basket”
C) risk can be measured subjectively
D) pure risk seldom happens
49) Which of the following is not a goal of the government, employer or employee in providing
employee benefits?
A) Raise tax revenue
B) Provide security for employees
C) Retain, attract and compensate employees
D) Encourage savings for retirement
50) If a person installs an automatic sprinkler system to prevent serious fire damage, this action
can be considered “insurance” as defined in the text.
51) Hazards may increase either the frequency or the severity of losses.
52) A flood is an example of a non-diversifiable risk.
53) In general, aggregate losses must be predictable in advance for an insurance system to work
properly.
54) Risk averse people have a tendency to shy away from insurance.
55) “Loss” and “chance of loss” are terms with the same meaning.
56) Volcanoes have catastrophic loss potential because they are limited in geographic impact.
57) The law of large numbers allows the insurer to predict aggregate dollar losses in advance of
their occurrence.
58) Insurance companies utilize the law of large numbers to reduce the chance of loss for their
insureds.
59) Most speculative risks are insurable.
60) One reason catastrophes are difficult to insure is because the damage is so unpredictable.
61) Speculative risks refer to those events which can only result in loss.
62) Employee benefits have been strengthened in the last few years.
63) Enterprise Risk Management is a comprehensive approach to corporate risk.
64) The first step in the Risk Management Process is choosing appropriate risk handling
techniques.
65) Enterprise Risk Management is the response of the accounting profession to corporate fraud.
66) Explain the financial definition and the legal definition of “insurance.”
67) Why is Enterprise Risk Management so important for firms?
68) Explain briefly the law of large numbers.
69) Describe the Risk Management Process.
70) Discuss risk reduction through diversification.
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71) What are the three basic methods of dealing with risk in the risk management process?