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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.
All rights reserved. No part of the material protected by this copyright may be reproduced or utilized in any form or by any means, electronic or mechanical, including photocopying, recording, or by any information storage and retrieval system, without permission in writing from the copyright owner.
Requests for permission to make copies of any part of the work should be mailed to Copyright Permissions, Penn Foster, 925 Oak Street, Scranton, Pennsylvania 18515.
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
EXAMINATION—LESSON 2 51
LESSON 3: LOSS CONTROL AND LEGAL LIABILITY 55
EXAMINATION—LESSON 3 63
LESSON 4: PERSONAL INSURANCE ISSUES 67
EXAMINATION—LESSON 4 79
LESSON 5: EMPLOYEE-EMPLOYER RELATIONSHIPS 83
GRADED PROJECT 109
EXAMINATION—LESSON 5 115
LESSON 6: BUSINESS RISK MANAGEMENT— THEORY 119
EXAMINATION—LESSON 6 129
LESSON 7—BUSINESS RISK MANAGEMENT— TYPES OF CONTRACTS 133
EXAMINATION—LESSON 7 145
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Contentsiv
LESSON 8—BUSINESS RISK MANAGEMENT— ADDITIONAL TOPICS 149
EXAMINATION—LESSON 8 161
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
Instructions to Students4
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.
Instructions to Students6
Lesson 1: Introduction to Risk Management For: Read in this Read in
study guide: the textbook:
Assignment 1 Pages 12–14 Pages 1–14
Assignment 2 Pages 15–17 Pages 15–29
Assignment 3 Pages 19–21 Pages 30–53
Examination 50082100 Material in Lesson 1
Lesson 2: General Theory of Insurance Markets For: Read in this Read in
study guide: the textbook:
Assignment 4 Pages 28–30 Pages 54–74
Assignment 5 Pages 31–33 Pages 75–96
Assignment 6 Pages 35–36 Pages 97–114
Assignment 7 Page 37 Pages 115–133
Assignment 8 Pages 39–41 Pages 134–161
Assignment 9 Page 43 Pages 162–178
Assignment 10 Pages 46–47 Pages 179–200
Examination 50082200 Material in Lesson 2
Lesson 3: Loss Control and Legal Liability For: Read in this Read in
study guide: the textbook:
Assignment 11 Pages 56–57 Pages 201–214
Assignment 12 Pages 59–60 Pages 215–241
Examination 50082300 Material in Lesson 3
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Lesson Assignments8
Lesson 4: Personal Insurance Issues For: Read in this Read in
study guide: the textbook:
Assignment 13 Pages 68–69 Pages 242–275
Assignment 14 Pages 71–72 Pages 276–296
Assignment 15 Pages 74–77 Pages 297–333
Examination 50082400 Material in Lesson 4
Lesson 5: Employee-Employer Relationships For: Read in this Read in
study guide: the textbook:
Assignment 16 Pages 84–88 Pages 334–363
Assignment 17 Pages 90–93 Pages 364–387
Assignment 18 Pages 95–97 Pages 388–412
Assignment 19 Pages 98–106 Pages 414–440
Graded Project 50082900
Examination 50082500 Material in Lesson 5
Lesson 6: Business Risk Management—Theory For: Read in this Read in
study guide: the textbook:
Assignment 20 Pages 120–121 Pages 441–462
Assignment 21 Pages 123–124 Pages 463–483
Assignment 22 Page 126 Pages 484–499
Examination 50082600 Material in Lesson 6
Lesson 7: Business Risk Management—Types of Contracts For: Read in this Read in
study guide: the textbook:
Assignment 23 Pages 134–136 Pages 500–525
Assignment 24 Pages 138–139 Pages 526–549
Assignment 25 Pages 141–143 Pages 550–569
Examination 50082700 Material in Lesson 7
Lesson Assignments 9
Lesson 8: Business Risk Management—Additional Topics For: Read in this Read in
study guide: the textbook:
Assignment 26 Page 150 Pages 570–590
Assignment 27 Page 152 Pages 591–604
Assignment 28 Pages 154–156 Pages 605–624
Assignment 29 Pages 157–159 Pages 625–645
Examination 50082800 Material in Lesson 8
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 Read the following introduction. Then, read Chapter 2 in your textbook, Risk Management and Insurance.
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).
Now that you’ve finished Assignment 2, complete Self- Check 2. 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 2, move on to Assignment 3.
Self-Check 2
Indicate whether each of the following statements is True or 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
Select the one best answer to each question.
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.
Check your answers with those on page 165.
Lesson 1 19
ASSIGNMENT 3 Read the following introduction. Then, read Chapter 3 in your textbook, Risk Management and Insurance.
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.
Now that you’ve finished Assignment 3, complete Self- Check 3. Check your answers with those provided at the back of this study guide. When you’re sure that you completely understand the material from the first three assignments, move on to the examination for Lesson 1.
Self-Check 3
Indicate whether each of the following statements is True or 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
Indicate whether each of the following statements is True or 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.
Select the one best answer to each question.
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.
Textbook Questions and Problems
Complete Questions 1–4 on page 51 in the textbook.
Check your answers with those on page 165.
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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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%
Examination, Lesson 126
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 When you complete this lesson, you’ll be able to
� 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
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� 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 Read the following introduction. Then, read Chapter 4 in your textbook, Risk Management and Insurance.
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.
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Now that you’ve finished Assignment 4, complete Self- Check 4. 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 4, move on to Assignment 5.
Self-Check 4
Indicate whether each of the following statements is True or 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.
Select the one best answer to each question.
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 Read the following introduction. Then, read Chapter 5 in your textbook, Risk Management and Insurance.
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.
Check your answers with those on page 166.
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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
Now that you’ve finished Assignment 5, complete Self- Check 5. 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 5, move on to Assignment 6.
FIGURE 1—Agency Theory
Self-Check 5
Indicate whether each of the following statements is True or 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)
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Self-Check 5
Indicate whether each of the following statements is True or 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.
Select the one best answer to each question.
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.
Textbook Questions and Problems
Answer Questions 1 and 7 on page 96 in the textbook.
Check your answers with those on page 166.
Lesson 2 35
ASSIGNMENT 6 Read the following introduction. Then, read Chapter 6 in your textbook, Risk Management and Insurance.
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.
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Now that you’ve finished Assignment 6, complete Self- Check 6. 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 6, move on to Assignment 7.
Self-Check 6 Indicate whether each of the following statements is True or 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.
Select the one best answer to each question.
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.
Textbook Questions and Problems
Answer Questions 2, 7, and 9 on pages 113–114 in the textbook.
Check your answers with those on page 167.
Lesson 2 37
ASSIGNMENT 7 Read the following introduction. Then, read Chapter 7 in your textbook, Risk Management and Insurance.
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.
Now that you’ve finished Assignment 7, complete Self- Check 7. 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 7, move on to Assignment 8.
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Self-Check 7
Indicate whether each of the following statements is True or 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.
Select the one best answer to each question.
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 Read the following introduction. Then, read Chapter 8 in your textbook, Risk Management and Insurance.
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
Textbook Questions and Problems
Complete Questions 1, 2, 3, and 6 on pages 130–131 in the textbook.
Check your answers with those on page 167.
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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.
Now that you’ve finished Assignment 8, complete Self- Check 8. 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 8, move on to Assignment 9.
Self-Check 8
Indicate whether each of the following statements is True or 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)
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Self-Check 8
Indicate whether each of the following statements is True or 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.
Select the one best answer to each question.
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
Textbook Questions and Problems
Answer Questions 1, 2, 7, and 9 on page 159 in the textbook.
Check your answers with those on page 168.
Lesson 2 43
ASSIGNMENT 9 Read the following introduction. Then, read Chapter 9 in your textbook, Risk Management and Insurance.
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.
Now that you’ve finished Assignment 9, complete Self- Check 9. 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 9, move on to Assignment 10.
Risk Management44
Self-Check 9 Indicate whether each of the following statements is True or 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.
Select the one best answer to each question.
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
Select the one best answer to each question.
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.
Textbook Questions and Problems
Answer Questions 2, 3, and 5a on page 174 in the textbook.
Check your answers with those on page 169.
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ASSIGNMENT 10 Read the following introduction. Then, read Chapter 10 in your textbook, Risk Management and Insurance.
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.
Now that you’ve finished Assignment 10, complete Self- 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.
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Self-Check 10
Indicate whether each of the following statements is True or 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.
Select the one best answer to each question.
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.
Textbook Questions and Problems
Answer Question 1 on page 198 in the textbook.
Check your answers with those on page 170.
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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
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General Theory of Insurance Markets
When you feel confident that you have mastered the material in
Lesson 2, 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
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answers to the school, you must use the number above.
For the quickest test results, go to
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Examination, Lesson 252
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.
Examination, Lesson 2 53
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.
Examination, Lesson 254
NOTES
Loss Control and Legal Liability
INTRODUCTION Lesson 3 will introduce terminology relating to loss control and basic legal liability rules.
OBJECTIVES When you complete this lesson, you’ll be able to
� 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
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ASSIGNMENT 11 Read the following introduction. Then, read Chapter 11 in your textbook, Risk Management and Insurance.
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.
Now that you’ve finished Assignment 11, complete Self- Check 11. 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 11, move on to Assignment 12.
Self-Check 11
Indicate whether each of the following statements is True or 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
Select the one best answer to each question.
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
Textbook Questions and Problems
Answer Question 5 on page 214 in the textbook.
Check your answers with those on page 171.
Lesson 3 59
ASSIGNMENT 12 Read the following introduction. Then, read Chapter 12 in your textbook, Risk Management and Insurance.
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
Now that you’ve finished Assignment 12, complete Self- Check 12. 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 12, move on to the examination for Lesson 3.
Lesson 3 61
Self-Check 12
Indicate whether each of the following statements is True or 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.
Select the one best answer to each question.
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.
Textbook Questions and Problems
Complete Questions 1, 2, 6, 8, and 9 on pages 234–235 in the textbook.
Check your answers with those on page 172.
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.
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Loss Control and Legal Liability
When you feel confident that you have mastered the material in
Lesson 3, 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
50082300 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 364
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.
Examination, Lesson 3 65
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
Examination, Lesson 366
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 When you complete this lesson, you’ll be able to
� 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
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ASSIGNMENT 13 Read the following introduction. Then, read Chapter 13 in your textbook, Risk Management and Insurance.
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.
Now that you’ve finished Assignment 13, complete Self- Check 13. 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 13, move on to Assignment 14.
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
Select the one best answer to each question.
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
Textbook Questions and Problems
Answer Questions 2, 3, 6, 7, and 11 on pages 273–274 in the textbook.
Check your answers with those on page 173.
Lesson 4 71
ASSIGNMENT 14 Read the following introduction. Then, read Chapter 14 in your textbook, Risk Management and Insurance.
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.
Now that you’ve finished Assignment 14, complete Self- Check 14. 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 14, move on to Assignment 15.
Lesson 4 73
Self-Check 14
Indicate whether each of the following statements is True or 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
Select the one best answer to each question.
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 Read the following introduction. Then, read Chapter 15 in your textbook, Risk Management and Insurance.
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.
Textbook Questions and Problems
Answer Questions 1 and 3 on page 295 in the textbook.
Check your answers with those on page 174.
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.
Now that you’ve finished Assignment 15, complete Self- Check 15. 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 15, move on to the examination for Lesson 4.
Self-Check 15
Indicate whether each of the following statements is True or 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
Select the one best answer to each question.
6. Which of the following types of life insurance policies were sold the most in the United States during 2000?
a. Term life insurance c. Universal life insurance b. Whole life insurance d. Variable life insurance
7. In pricing a life insurance contract, which of the following is not necessary to determine the price per thousand dollars of coverage?
a. The age of the insured b. The time value of money c. The face amount of the policy d. The insurer’s expense and profit loading
8. Over the life of the policyholder, the face amount of a whole life policy remains fixed, but the death protection component _______ and the cash value component _______.
a. increases; decreases c. decreases; decreases b. increases; increases d. decreases; increases
Textbook Questions and Problems
Answer Questions 1, 2, 3, and 4 on page 329 in the textbook.
Check your answers with those on page 175.
79
1. The market for auto insurance that provides coverage to drivers who would otherwise not be able to buy insurance is called the _______ market.
A. residual C. prior approval B. voluntary D. reinsurance
2. Which of the following is not one of the main types of coverage provided under the personal auto policy?
A. Liability coverage for injuries caused by the negligence of the insured driver
B. Coverage for physical damage to the personal property of the negligent driver
C. Coverage for losses caused to the insured by a driver without liability insurance
D. Coverage for theft of the insured vehicle
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Personal Insurance Issues
When you feel confident that you have mastered the material in
Lesson 4, 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
50082400 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 480
3. Which one of the following is not an argument favoring no-fault personal injury protection (PIP) coverage?
A. Loss payments are generally made more quickly. B. Dispute resolution costs are lower. C. It provides increased incentives for auto safety. D. When fault is unclear, more people will still have first-party coverage.
4. Henry is driving Lisa’s automobile. He runs a stop sign and causes an accident. Henry and Lisa both have a personal automobile insurance policy. How will the liability cover- age between these two policies most likely be coordinated?
A. Henry’s policy is primary, while Lisa’s policy is excess. B. Lisa’s policy is primary, while Henry’s policy is excess. C. Henry’s and Lisa’s policy pay equal shares. D. Only Henry’s policy is obligated to provide liability coverage, since he is the at-fault
driver.
5. Insurance coverage for flood damage is available through the National Flood Insurance Program. How does the program operate?
A. Private insurers sell and service the policies, with the federal government bearing the risk.
B. Private insurers sell and service the policies while sharing the risk with the federal government.
C. Private insurers underwrite the risk, with the federal government acting as a reinsurer only in the event of a bad loss experience.
D. All polices are sold and serviced by the federal government, which also bears the risk.
6. Which of the following statements is true of compulsory automobile insurance?
A. It’s unconstitutional. B. It enjoys strong enforcement. C. It’s similar to a flat or sales tax in its impact on policyholders. D. It has a regressive impact on the distribution of income.
7. Driver classes may be based on which of the following factors?
A. Age C. Sexual orientation B. Race D. Religion
8. Which of the following losses is most likely to be excluded from coverage in a homeowner’s insurance policy?
A. Theft of personal property B. Damage from lightning strike C. Property loss due to an intentional act D. Fire loss
Examination, Lesson 4 81
9. What is the main reason that homeowner’s insurance policies commonly exclude coverage for earthquake and flood?
A. Not many people need this coverage. B. The losses tend to be correlated across policyholders. C. Moral hazard D. The government can provide this coverage more cost effectively.
10. When Kathy buys a single-premium whole life policy, she
A. makes the same premium payment each year of the policy period. B. makes the same premium payment each year for a limited number of years and is
then covered for her whole life. C. makes the same premium payment each year for her whole life and is covered for
her whole life. D. pays the entire premium in a lump sum when the policy is issued and is then
covered for her whole life.
11. In the context of life insurance policies, which of the following equations is incorrect?
A. Cash value policies = Term insurance + Savings plan B. Potentially taxable = Receipt – Net cost C. Death protection = Death benefit – Cash value D. Death protection = Death benefit
12. Which of the following is not a tax benefit of cash value life insurance?
A. Death benefits aren’t taxable income. B. Life insurance premiums paid are tax deductible in the United States. C. The annual increase in the cash value while the policy is in force isn’t taxed. D. Returns earned on the savings component are tax deferred until surrender.
13. As a rule of thumb, insurance coverage should equal
A. 6 to 10 times annual income. B. 6 to 10 times net worth. C. 6 to 10 times monthly income. D. 6% to 10% of expected annual retirement income.
14. An annuity that pays only until the annuitant dies is called a _______ annuity.
A. straight life C. whole life B. term D. universal
15. A policy that pays the face amount of the policy if the insured dies and also pays the face amount if the insured survives the policy term is called a/an _______ policy.
A. whole life C. endowment B. universal life D. term life
Examination, Lesson 482
NOTES
Employer-Employee Relationships
INTRODUCTION In Lesson 5 we’ll review a variety of employee benefits. Group medical and health care and retirement plans are covered in the first two assignments. These represent employer-provided plans to attract and retain employees. We’ll also review workers’ compensation and Social Security, which are required by state and/or federal law. Assignment 19 will form the foundation for your course project.
OBJECTIVES When you complete this lesson, you’ll be able to
� Explain major types of employee benefits and why firms provide them
� Describe, analyze, and summarize group medical expense coverage provisions and pricing issues, including HMOs and other forms of managed care
� Discuss the causes of high health care costs, why many remain uninsured, and proposals to control costs and increase the number of those insured
� Describe major types and features of employment-related retirement plans and their tax incentives, growth in defined contribution plans, and related government regulation and insurance
� Define IRAs, Roth IRAs, SEP, and Keogh plans
� Describe the basic history, features, and economic rationale of workers’ compensation laws and liability insurance
� Describe Social Security retirement, survivor, and disability and Medicare programs, benefits and their financing
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ASSIGNMENT 16 Read the following introduction. Then, read Chapter 16 in your textbook, Risk Management and Insurance.
Major Types of Employee Benefits The most common types of voluntary benefits offered by employers include
� Medical insurance
� Life insurance
� Disability insurance
� Dental insurance
� Retirement plans
Cafeteria benefit plans (also known as flexible benefit plans or, more formally, Section 125 plans, after the Internal Revenue Code section addressing them) provide some core benefits to all employees, while allowing them to select from a menu of optional benefits. Tax advantaged benefits include flexible spending accounts, which may be used to pay for medical, dental, or child care expenses using pre-tax dollars. The amount of money in this account must be decided ahead of time, and any unused portion is forfeited at the end of the period. Therefore, it’s important for employees to be some- what conservative in their estimated costs.
Why Firms Provide Employee Benefits Three reasons are commonly suggested to explain why firms provide employee benefits instead of simply paying higher cash wages:
1. Tax savings for both employer and employee (Employee benefits plans that receive preferential income tax treatment are called qualified plans.)
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2. Administrative expenses in group insurance premiums are lower as a percentage than for individual insurance (economies of scale lower the per-individual cost).
3. Employers sometimes find that employer-provided bene- fits promote employee productivity or retention. (How many times have your heard someone refer, favorably, to their employer’s superior benefits?)
Overview of Group Medical Expense Coverage One of the most common and important types of employee benefits is group medical expense coverage. With traditional fee-for-service arrangements, employees receive basic benefits (hospitalization, surgery, physician services, and specified diagnostic tests), and, typically, additional protection in the form of supplementary major medical coverage. Many plans contain a stop loss clause or place a ceiling on the out-of- pocket maximum costs to be incurred by the employee. The insurance company pays all qualifying expenses above this ceiling. Under this system, some basic services—such as routine checkups—may not be paid for by the insurance.
Some insurers play an active role in patient health care man- agement. This is called managed care. Health maintenance organizations (HMOs) represent one form of managed care, in which insureds must use doctors within the network or the insurance company won’t pay for the care. HMOs usually place a lot of emphasis on preventive care, providing more coverage for routine screenings than for specialist care. Efforts to control costs have led to requirements that participants select a primary care physician, who serves a gatekeeper function. The requirement that insureds see a pri- mary doctor first, to get permission to see a specialist, means that specialist utilization is lower under this type of plan.
Some providers have contracted with employers/insurers for price discounts. These arrangements are called preferred provider organizations.
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Group Medical Plan Provisions and Pricing Issues Fee-for-service group medical plans usually contain a preexisting conditions clause, excluding coverage for new employees for ailments for which the person received medical treatment during some period of time, often the prior 12 months. Preexisting clauses are relatively uncommon in HMOs.
Title I of the Health Insurance Portability and Accountability Act (HIPAA), enacted in 1996, limits preexisting condition exclusions to 12 months after enrollment (18 months in the case of those who don’t enroll as soon as they’re eligible). This means that preexisting conditions can’t be excluded forever; rather, they’re subject to a waiting period. Individuals may reduce or eliminate this exclusion period if they had health insurance (“creditable coverage”) prior to enrolling in the plan, without any “significant breaks” in coverage— defined as 63 days or more without creditable coverage. So, a person changing jobs that provide health insurance isn’t sub- ject to the exclusion. Insurance companies are required to provide a “certificate of creditable coverage” upon termination of coverage.
“Creditable coverage” includes nearly all group and individual health plans, Medicare, and Medicaid. To determine how much coverage can be credited against the exclusion period in the new plan, start at the enrollment date and count back- wards until you reach a significant break in coverage, or the 12-month period is exhausted. Essentially, the 12-month exclusion period is applied retroactively to the previous insurance the person had, so that someone who had insur- ance continuously for 13 months before enrolling in new employment coverage has no exclusion period; someone who had insurance for only 6 months faces a 6-month exclusion period; and someone who had no previous insurance faces the full 12-month exclusion period.
If the insurance has a waiting period before employees are eligible for health coverage, the “enrollment date” in the definition is the beginning of the waiting period. Any waiting period that applies to enrollment in the plan runs concur-
A preexisting condition is defined by HIPAA as a condition for which “medical advice, diagno- sis, care or treatment was recommended or received within the six- month period before the enrollment date.” For a person who had a medical condition in the past, but hasn’t received any medical advice, diagnosis, care or treatment for it within the six months prior to enrollment in the new plan, the old condition is not a pre- existing condition to which an exclusion can be applied.
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rently with the exclusion period, so that a 6-month waiting period can’t be added to a 12-month exclusion period to become an 18-month exclusion period. The waiting period also doesn’t count as a “significant break” in coverage.
Genetic information can’t be counted as a preexisting condition—so, for example, a woman who carries the breast cancer gene, but who has never had breast cancer, can’t be denied coverage if she develops breast cancer. Pregnancy also can’t be treated as a preexisting condition.
Health Care Reform The Health Insurance Accountability and Portability Act of 1996 permitted medical savings accounts (MSAs) (now referred to as health savings accounts, or HSAs) on an experi- mental basis. Congress later extended the program past the experimental stage. The original MSAs were limited to the self-employed and employers of 50 or fewer people; HSAs aren’t subject to these restrictions. These accounts accom- pany high-deductible health insurance plans ($1,100 or more for a single person) and, unlike flexible spending plans, aren’t a “use it or lose it” proposition—if the money in the account isn’t spent in one year, it can be rolled over and continue to grow and accumulate.
Note: Not all health plans with high deductibles meet the requirements for association with an HSA. By law, an HSA plan can’t include pre-deductible co-pays for routine care or treatment, except that optional co-pays may be included for preventive care. There are also maximum out-of-pocket costs that change annually.
A health savings account is funded with pre-tax dollars, and if withdrawals are made for the purposes of qualified medical expenditures, the withdrawals aren’t subject to federal income tax (many states also exempt this money from taxa- tion). If withdrawals aren’t used for medical expenses, they’re subject to a penalty tax, unless the person is of retirement age or disabled. Earnings in the account accumulate tax- deferred. The law limits how much can be contributed each year to the account—for 2008, those limits are $2,900/indi- vidual and $5,800/family.
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During the 2008 presidential election campaign, candidates Clinton and Obama proposed similar, one-provider plans to provide medical insurance at a lower cost to all Americans, and John McCain proposed a $5,000 per year refundable tax credit for medical insurance, to allow market forces to enter into the provider selection process.
Now that you’ve finished Assignment 16, complete Self- Check 16. 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 16, move on to Assignment 17.
Self-Check 16
Indicate whether each of the following statements is True or False.
______ 1. The most common types of voluntary benefits offered by employers include medical
insurance, life insurance, disability insurance, dental insurance, and retirement plans.
______ 2. Firms provide employee benefits instead of simply paying higher cash wages, in part,
to achieve tax savings for both employer and employee.
______ 3. One of the most common and important types of employee benefits is group medical
expense coverage.
______ 4. The Health Insurance Accountability and Portability Act of 1996 permitted medical
savings accounts (MSAs) on an experimental basis.
______ 5. Causes of increasing medical and health care costs include excessive utilization,
increased quality, higher costs associated with improved technologies and treatments,
and an aging population.
(Continued)
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Self-Check 16
Select the one best answer to each question.
6. Employee benefit plans that do not require workers to pay part of the cost of the benefits are known as
a. defined benefit plans. c. contributory plans. b. noncontributory plans. d. cafeteria plans.
7. Group insurance is usually cheaper than individual insurance for all of the following reasons except
a. lower claims cost. c. lower expense loading. b. reduced adverse selection. d. better predictability of losses.
8. Which of the following statements about medical savings accounts (MSAs) is true?
a. Healthier employees will opt for traditional insurance plans, thus causing the MSAs to lose money.
b. If a person has losses less than the deductible in a given year, he or she gets no benefit from the insurance.
c. MSAs will have no effect on the incentives for utilization of health care. d. The MSA provides catastrophic coverage.
Check your answers with those on page 176.
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ASSIGNMENT 17 Read the following introduction. Then, read Chapter 17 in your textbook, Risk Management and Insurance.
Overview of Retirement Plans There are three ways to provide for retirement income:
1. Defined benefit plans—An employer promises employees a monthly retirement benefit (called a pension) defined by a benefit formula. The retirement benefit as a percentage of the employee’s final salary is called the replacement rate. The replacement rate increases as the employee’s years of service increase.
Assuming that the employer honors its pension commit- ments, in this type of plan the employer assumes the investment risk—if the investments in the pension fund do poorly, the employer must make up the difference by increasing its contributions. In the long bull market of the late 1990s, many large companies didn’t make any pension fund contributions at all because of the growth in the pension funds’ investments. Then, when the market crashed in 1999–2000, suddenly the funds’ assets crashed also and they became badly underfunded. Many companies terminated their pension plans and left it to the government to pay the benefits, so the risk to the employee of this sort of plan has increased.
2. Defined contribution plans—An employer (and, often, the employee) makes a specific (defined) contribution to a fund up to a certain allowable amount. A 401(k) is an example of a defined contribution plan; the annual contribution limit for 2008 is $15,500. The employee generally has a choice of several funds to allocate the money to (commonly stock and bond mutual funds). The employee’s retirement benefit depends on the investment return. In this type of fund, the employee bears the risk of investment return. If the investments do poorly, the employer won’t add any money to the account, and the employee’s ability to cover costs in retirement will be compromised. The employee is always vested in his or
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her own contributions to the plan, while vesting in the employer’s portion works in much the same way as with pension plans.
3. Cash balance plans—During the 1990s, hybrid plans called cash balance plans evolved. Like defined benefit plans from a sponsor’s perspective and classified as defined benefit plans for regulatory purposes, cash bal- ance plans are similar to defined contribution plans from an employee’s perspective. The employer contributes money on behalf of each employee according to a formula; all the money is invested into an aggregate fund that isn’t directed by the employee. The employee, however, can roll over the funds in a lump sum to another account when he or she changes jobs. Increases and decreases in the value of the plan’s investments don’t directly affect the benefit amounts promised to partici- pants. Thus, the investment risks and rewards on plan assets are borne solely by the employer.
While both traditional defined benefit plans and cash balance plans are required to offer payment of an employee’s benefit in the form of a series of payments for life, traditional defined benefit plans define an employee’s benefit as a series of monthly payments for life to begin at retirement, but cash balance plans define the benefit in terms of a stated account balance. (These accounts are often referred to as “hypotheti- cal accounts” because they don’t reflect actual contributions to an account or actual gains and losses allocable to the account.) In addition, many cash balance plans allow the participant to choose (with consent from his or her spouse) instead to take a lump sum benefit equal to the account balance at retirement.
Companies are allowed to change their traditional pension plan formula to a cash balance plan formula. Federal law does place restrictions on plan changes of this type. For example, a plan amendment can’t reduce benefits that partic- ipants have already earned. Advance notification to plan participants is required if, as a result of the amendment, the rate that plan participants may earn benefits in the future is significantly reduced. There are other legal requirements that have to be satisfied, including prohibitions against age discrimination.
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Tax Advantages of Retirement Plans The widespread use of employment-related retirement plans is due to the preferential tax treatment granted through these qualified retirement plans. Generally, the tax deferral allows these monies to grow, without reduction by annual tax pay- ments. Even greater tax savings are enjoyed if the individual receives a tax deduction for the contribution during peak earnings years while in a relatively high tax bracket, and withdraws and pays the tax while in a lower tax bracket during retirement years.
Incentive Effects of Employer- Sponsored Pension Plans Retirement plans are used to
1. Increase employee productivity, effort, and retention
2. Promote retirement at an age when employee productivity declines
Many of these plans have participation requirements and vesting requirements. Vesting requirements may result in the forfeiture of all or a portion of the component contributed by the employer if the employee terminates employment with the employer on or before a predetermined vesting date. Vesting may take the form of cliff vesting (e.g., full benefits after a certain number of years, but none before then) or graded vesting (e.g., 20 percent after 2 years, 40 percent after 4 years, and so on). A plan’s normal retirement age determines the age at which a retiree receives full retirement benefits, and may used to induce retirement.
Retirement Plan Provisions and Regulations Regulation of retirement plans expanded with the Employee Retirement Income Security Act (ERISA) of 1974. To retain their tax-favored status, qualified plans must meet nondiscrimination rules, which means in essence that the
Lesson 5 93
retirement plan can’t be used as a disguised tax shelter for the CEO while the rank-and-file employees are discouraged from participating. The law also prohibits excessively long vesting periods.
ERISA requires minimum funding requirements for defined- benefit plans, and created the Pension Benefit Guaranty Corporation (PBGC) to ensure that some benefits are given to employees when a company’s pension fund is terminated while less than adequately funded. Companies with pension plans are charged an annual premium for this insurance. In recent years, due in part to gyrations in the stock and bond markets, many company pension plans have become under- funded and been turned over to the PBGC, whose ability to cover all the obligations is becoming more and more strained.
Now that you’ve finished Assignment 17, complete Self- Check 17. 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 17, move on to Assignment 18.
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Self-Check 17
Indicate whether each of the following statements is True or False.
______ 1. In a defined benefit plan, an employer promises employees a monthly retirement
benefit defined by a benefit formula.
______ 2. In a defined contribution plan, the employer and/or employee makes a specific
contribution to a fund.
______ 3. Vesting may take the form of cliff vesting or graded vesting.
______ 4. In a money purchase plan, the employer makes a contribution to the employee’s
account, but only if the firm profits.
______ 5. Only employees can establish Keogh plans.
Select the one best answer to each question.
6. The tax advantages of qualified retirement plans include all of the following except
a. contributions to the plan aren’t subject to income tax until received as benefits. b. contributions paid by employers are tax deductible in the year they’re made. c. earnings on assets in qualified retirement plans are subject to lower capital gains tax
rates. d. dividend and interest earnings in the retirement plan aren’t subject to income tax until
received as benefits.
7. Which of the following investments makes the least sense for a qualified pension plan?
a. Tax-free municipal bonds c. Corporate bonds b. Dividend-paying stocks d. Growth stocks
8. A defined contribution plan that’s invested entirely in the sponsoring firm’s stock
a. is violating the law because employer stock is limited to no more than 10% of plan assets. b. has been shown to increase employee productivity by 10%. c. makes a firm more likely to be a takeover target. d. may be bad for participants because it forces them to have a relatively undiversified
portfolio.
Check your answers with those on page 176.
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ASSIGNMENT 18 Read the following introduction. Then, read Chapter 18 in your textbook, Risk Management and Insurance.
Overview of Workers’ Compensation Laws Workers’ compensation laws have two important features:
1. Employers pay benefits without regard to employer fault or negligence.
2. Employees aren’t allowed to sue employers for injuries under tort law.
The economic rationale for workers’ compensation rests on whether it can minimize the cost of risk by maximizing the welfare of workers when compared to alternatives.
Employers are required by law to either purchase workers’ compensation insurance or prove that they have the ability to self-insure and pay claims. Some states run their own insurance companies for workers’ compensation; all states regulate insurance prices to some extent. Workers’ compen- sation payments may be made for temporary total disability, permanent total disability, or permanent partial disability.
Workers’ Compensation Insurance and Self-Insurance Workers’ compensation insurance has two main coverage parts:
1. Workers’ compensation insurance
2. Employers’ liability insurance
Generally, employees are classified based on their position in the firm for purposes of workers’ compensation. Some positions embody greater risk and some are less risky. For example, a white-collar worker in an office has little risk of harm in the normal course of his or her duties, while a demolition expert is placed at great risk during the ordinary
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course of a day’s activities. For this reason, the prospective loss cost and therefore the advisory rate (cost of insurance per $100 of gross salary) for the latter is far greater than that for the former. The advisory rate is adjusted, up or down, based on a firm’s experience rating (costs of claims in the previous three years) and schedule rating (rating based on the insurer’s estimate of future claim costs, based on things like safety programs). Therefore, a firm with few accidents result- ing in claims is likely to reduce their workers’ compensation costs, which provides an economic incentive to improve worker safety.
Adverse selection and moral hazard can occur in an employ- ment setting as well as in an insurance setting (Figure 4).
Government Safety Regulation The most significant government safety regulations include the Occupational Safety and Health Act (OSHA), which became effective in 1971, and the Americans with Disabilities Act (ADA), which became effective in 1992. OSHA provides safety requirements for employers and allows employees to anonymously report violations. Employers can be fined for violations, and managers can even be subject to criminal penalties in extreme cases. The ADA made it illegal to
FIGURE 4—Moral Hazard and Employment
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discriminate against disabled workers, and requires employers to make “reasonable accommodations” to help disabled workers perform their jobs.
Now that you’ve finished Assignment 18, complete Self- Check 18. 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 18, move on to Assignment 19.
Self-Check 18
Indicate whether each of the following statements is True or False.
______ 1. Workers’ compensation payments may be made for temporary total disability,
permanent total disability, or permanent partial disability.
______ 2. The economic rationale for workers’ compensation rests on whether it can minimize the
cost of risk by maximizing the welfare of workers when compared to alternatives.
______ 3. Workers’ compensation insurance has two main coverage parts: workers’ dental
insurance and employers’ litigation insurance.
______ 4. The advisory rate can be adjusted up or down based on a firm’s experience rating and
schedule rating.
______ 5. One of the most significant government safety regulations is the Occupational Safety
and Health Act.
Select the one best answer to each question.
6. If the 2002 prospective loss cost per $100 of payroll for Colorado restaurants is $.80 and the ABC Insurance Company’s loading for expenses and profit is 20% of the class rate, what is the ABC class rate for a Colorado restaurant in 2002?
a. $0.16 per $100 payroll c. $0.96 per $100 payroll b. $0.80 per $100 payroll d. $1.00 per $100 payroll
(Continued)
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ASSIGNMENT 19 Read the following introduction. Then, read Chapter 19 in your textbook, Risk Management and Insurance.
Overview of Social Security The U.S. Social Security program, enacted in 1935, is more formally known as the Old-Age, Survivors, Disability, and Health Insurance (OASDHI) program. As shown in Figure 5, it includes
1. Old-Age, Survivors, and Disability Insurance (OASDI)
2. Medicare (the health insurance component)
Self-Check 18
7. Yasmina works as an accountant for MyTown Medical clinic. One of the clinic’s physician/ owners has given Yasmina some medical advice that she feels has severely exacerbated an old work-related back injury. As a result of this situation, what kind of lawsuit might Yasmina be able to file against her employer?
a. Employment practices lawsuit b. Dual capacity lawsuit c. Employee compensation lawsuit d. Yasmina won’t be able to file any lawsuit because the injury is work related.
8. The original rationale for second injury funds was to
a. increase employment opportunities for workers who have sustained some type of permanent injury.
b. hold a worker’s employer responsible for funding second-injury costs. c. eliminate second-injury lawsuits. d. reduce the incentive of insurers to investigate questionable claims.
Check your answers with those on page 177.
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Generally, OASDI represents 6.2 percent (12.4 percent, combined) and Medicare represents 1.45 percent (2.9 per- cent, combined) of the 7.65 percent of salary or wages that the employer and employee each contribute to the U.S. Social Security system (7.65 + 7.65 = 15.3 percent, in total).
FIGURE 5—The FICA Tax
Tax Wage Year Base
Tax Wage Year Base
Tax Wage Year Base
Tax Wage Year Base
1937–50 $3,000
1951–54 $3,600
1955–58 $4,200
1959–65 $4,800
1966–67 $6,600
1968–71 $7,800
1972 $9,000
1973 $10,800
1974 $13,200
1975 $14,100
1976 $15,300
1977 $16,500
1978 $17,700
1979 $22,900
1980 $25,900
1981 $29,700
1982 $32,400
1983 $35,700
1984 $37,800
1985 $39,600
1986 $42,000
1987 $43,800
1988 $45,000
1989 $48,000
1990 $51,300
1991 $53,400
1992 $55,500
1993 $57,600
1994 $60,600
1995 $61,200
1996 $62,700
1997 $65,400
1998 $68,400
1999 $72,600
2000 $76,200
2001 $80,400
2002 $84,900
2003 $87,000
2004 $87,900
2005 $90,000
2006 $94,200
2007 $97,500
2008 $102,000
2009 $106,500
Social Security Wage Base through the Years
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OASDI Benefits Old-Age, Survivors, and Disability Insurance (OASDI) benefits include retirement, survivors, and disability benefits. These benefits are summarized in Table 19.1 on page 416 of your text.
OASDI benefits provide monthly benefits to a worker retiring at normal retirement age, known as the primary insurance amount (PIA). This is calculated in two steps, including the computation of the worker’s average indexed monthly earnings (AIME). OASDI benefits are adjusted to keep up with inflation through annual cost-of-living adjustments (COLA).
Social Security benefits aren’t subject to a means test, but are subject to an earnings test. This means that people don’t have to prove they have few assets to collect Social Security; benefits are reduced, however, if wage income (not investment income) exceeds a certain level after retirement.
Tax FICA SECA Year(s)
Tax FICA SECA Year(s)
1937–49 1.00% NA
1950 1.50% NA
1951–53 1.50% 2.25%
1954–56 2.00% 3.00%
1957–58 2.25% 3.38%
1959 2.50% 3.75%
1960–61 3.00% 4.50%
1962 3.13% 4.70%
1963–65 3.63% 5.40%
1966 4.20% 6.15%
1967–68 4.40% 6.40%
1969–70 4.80% 6.90%
1971–72 5.20% 7.50%
1973 5.85% 8.00%
1974–77 5.85% 7.90%
1978 6.05% 8.10%
1979-80 6.13% 8.10%
1981 6.65% 9.30%
1982–83 6.70% 9.35%
1984 6.70% 11.30%
1985 7.05% 11.80%
1986–87 7.15% 12.30%
1988–89 7.51% 13.02%
1990– 7.65% 15.30%
FICA Tax (1937– ), SECA Tax (1951– ), SECA tax subsidy phase-out completed & SECA taxes adjusted & partially deductible (1990– )
Social Security Taxes through the Years
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OASDI Financing OASDI benefits are financed almost exclusively from payroll (also called Federal Insurance Contribution Act, or FICA) taxes. The OASDI tax rate, as previously discussed, is 6.2 percent of an annually inflation-adjusted maximum taxable wage base ($102,000 for 2008). The tax for Medicare doesn’t have a maximum wage base.
Social Security is largely financed using what’s called pay-as- you-go financing. This means that payroll taxes on current workers fund payment of benefits to current retirees. Workers’ contributions aren’t set aside in a fund to pay their later benefits—which is why the demographic trend of increasing average age of the population is worrisome from the perspec- tive of Social Security. The number of workers supporting each beneficiary has declined dramatically since the program began. In addition, as lifespans have increased, people have been collecting benefits for longer, which of course costs more.
The pay-as-you-go system is often referred to by legislators and politicians as PAYGO. Average benefits are expressed as follows:
Average benefit = Tax rate ✕ Average taxable wage ✕ Ratio of workers to beneficiaries
Alternatively:
Tax rate = Average benefits ÷ (Average taxable wage ✕ Ratio of workers to beneficiaries)
While a worker’s payroll taxes aren’t invested to fund his or her future benefits, an implicit rate of return on payroll taxes can be calculated.
Why Have Social Security? Social Security represents what economists refer to as an intergenerational contract. The younger generation funds Social Security for older generations, with the expectation that the same will be done for them, and so on.
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Presently, we face a crisis in the United States as the popula- tion ages. There will continue to be a smaller base of younger workers to fund the Social Security benefits for older benefici- aries under the PAYGO system. Unless a change is made, the system is projected to become insolvent by around 2040.
Proposed Changes and Alternatives to Social Security During the 2008 Presidential campaign, Senators Obama and Clinton recommend lifting the wage base ceiling, at various levels, to ensure adequate funding for Social Security, well into the future. Other proposals, including those made by President George W. Bush, included a partial privatization of Social Security, both to generate higher returns from stocks and to prevent politicians from spending Social Security net cash inflows. This privatization component represents a departure from the PAYGO system.
Medicare Since your textbook was published, the Medicare law has been modified to include prescription drugs. Medicare now has three main parts:
� Part A: Hospital Insurance (abbreviated as HI in your textbook)
� Part B: Supplementary Medical Insurance (abbreviated as SMI in your textbook)
� Part D: Prescription drug plan
There’s also a Part C, the Medicare Advantage plan. Parts A and B are often referred to as the Original Medicare plan. Most people get their coverage through the Original Medicare plan, which is a fee-for-service plan. Beneficiaries are always free to get noncovered services on their own if they choose to pay for the service. For people with other insurance besides Medicare, sometimes that other insurance pays health care bills first, and Medicare pays what’s left. Examples include liability insurance (including automobile insurance), black- lung benefits, and workers’ compensation.
Lesson 5 103
Medicare Part A
Medicare Part A covers hospitalization and inpatient care in skilled nursing facilities, hospice, and also home health care under certain conditions. People usually don’t pay a monthly premium for Part A coverage if they or their spouse paid Medicare taxes while working.
Medicare Part B
Medicare Part B helps cover medically necessary services like doctors’ services and outpatient care. It also helps cover some preventive services to help maintain patients’ health and to keep certain illnesses from getting worse. Part B is subject to a monthly premium (the standard amount is $96.40 in 2008; higher-income people pay more). There’s also a deductible. For anyone who doesn’t sign up for Part B when first eligible, the cost may go up 10% for each full 12-month period that he or she could have had Part B, but didn’t sign up for it. If the delay in taking Part B is because the person is covered by group health plan coverage based on employment, the higher premium may not apply.
Medigap (Medicare Supplement Insurance) Policies
The Original Medicare Plan pays for many, but not all, health care services and supplies. To help pay out-of-pocket costs, many people buy a Medigap policy sold by private insurance companies. A Medigap policy is private health insurance designed to supplement the Original Medicare Plan. This means it helps pay some of the health care costs (“gaps”) that the Original Medicare Plan doesn’t cover, like copayments, coinsurance, and deductibles. Some Medigap policies cover extra benefits for an extra cost. For people in the Original Medicare Plan who buy a Medigap policy, both plans will pay their share of Medicare-approved amounts for covered health care costs.
Medicare doesn’t pay any of the costs for a Medigap policy. Medigap policies work only with the Original Medicare Plan, and they can’t be used to pay copayments or deductibles for Medicare Advantage Plans. In fact, it’s illegal for anyone to
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sell a Medigap policy to someone who has a Medicare Advantage Plan. Every Medigap policy must be clearly identified as “Medicare Supplement Insurance.”
Medigap insurance companies can sell only a “standardized” Medigap policy. Standardized Medigap policies are identified by letters (Medigap plans A through L). In Massachusetts, Minnesota, and Wisconsin, Medigap policies are standardized in a different way. Some states have another type of Medigap policy called Medicare SELECT, which requires beneficiaries to use specific hospitals and in some cases, specific doctors, to get full benefits. Each standardized Medigap policy must offer the same basic benefits, no matter which insurance company sells it. Usually the only difference between Medigap policies sold by different insurance companies is the cost.
Medicare Part C
With the passage of the Balanced Budget Act of 1997, Medicare beneficiaries were given the option to receive their Medicare benefits through private health insurance plans (HMOs or PPOs), instead of through the Original Medicare plan. These programs were known as Medicare+Choice or Part C plans. With the Medicare Prescription Drug, Improvement, and Modernization Act of 2003, the compensa- tion and business practices changed for insurers that offer these plans, and they became known as Medicare Advantage (MA) plans.
Medicare has a standard benefit package for care that mem- bers can receive from nearly any hospital or doctor in the country. Medicare Advantage plans must cover at least all of the medically necessary services that the Original Medicare plan provides. For people who choose to enroll in a Medicare private health plan, Medicare pays the private health plan a set amount every month for each member. Members may have to pay a monthly premium in addition to the Medicare Part B premium, and generally pay a fixed amount (a copay- ment of $20, for example) every time they see a doctor. Medicare Advantage Plans may offer extra benefits, such as vision, hearing, dental, and/or health and wellness programs. They generally have provider networks, meaning beneficiaries
Lesson 5 105
must go to certain providers to get covered services. Only during certain times of the year is it possible to join or switch plans.
Medicare Part D
Medicare Part D was created by the Medicare Prescription Drug, Improvement, and Modernization Act, and went into effect on January 1, 2006. Anyone with Part A or B is eligible for Part D; in fact, anyone on the Original Medicare plan must also choose a Part D plan. To receive this benefit, a per- son with Medicare must enroll in a stand-alone Prescription Drug Plan (PDP) or Medicare Advantage plan with prescription drug coverage (MA-PD). These plans are approved and regu- lated by the Medicare program, but are actually designed and administered by private health insurance companies. People who decide not to join a Medicare drug plan when they are first eligible may pay a late-enrollment penalty if they choose to join later.
Unlike Original Medicare, Part D coverage isn’t standardized. Plans choose which drugs they wish to cover, at what level they wish to cover them, and may choose not to cover some drugs at all. The plan has been criticized for being overly complicated, especially relating to the “Donut Hole,” officially known as the Coverage Gap. Here’s a rough example of how it works:
In 2008, the standard benefit requires payment of a $275 deductible. The beneficiary then pays 25% of the cost of a covered prescription drug up to an initial coverage limit of $2,510. (Only 10 percent of plans for 2008 offer the defined standard benefit. Most eliminate the deductible and use tiered drug co-payments rather than coinsurance.) Once the initial coverage limit is reached, the beneficiary is subject to another deductible, referred to commonly as the “Donut Hole,” in which he or she must pay the full cost of medicine. When total out-of-pocket expenses on formulary drugs for the year, including the deductible and initial coin- surance, reach $4,050, the beneficiary then reaches “catastrophic coverage,” and pays $2.25 for a generic or preferred drug and $5.65 for other drugs, or 5%
Risk Management106
coinsurance, whichever is greater. The $4,050 amount is calculated on a yearly basis, so a beneficiary who amasses $4,050 in out-of-pocket costs by December 31 of one year will start a new deductible on January 1.
In some cases, people who have prescription drug coverage from a former or current employer or union who join a Medicare drug plan might lose all of their employer or union coverage (along with their dependents). In other cases, they may still be able to use the employer or union coverage along with the plan they join. Employers and unions that provide prescription drug coverage must notify beneficiaries each year about how their current coverage compares to Medicare’s basic prescription drug coverage. These notices may be used later as proof of creditable prescription drug coverage if the beneficiary joins a Medicare drug plan.
Now that you’ve finished Assignment 19, complete Self- Check 19. 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 19, move on to the examination for Lesson 5.
The Part D Late-Enrollment Penalty
If you don’t join a Medicare drug plan when you’re first eligible for
Medicare Part A and/or B and you go without creditable prescription
drug coverage (prescription drug coverage that’s at least as good as
Medicare’s drug coverage) for 63 continuous days or more, you may
have to pay a late-enrollment penalty to join a plan later. This penalty
amount changes every year, and you’ll have to pay it as long as you
have Medicare prescription drug coverage. Your late-enrollment
penalty is calculated when you join a Medicare drug plan. To estimate
your penalty amount, multiply 1% of the national base beneficiary
premium ($27.93 ✕ 1% = $.28 in 2008) by the number of full
months you were eligible to join a Medicare drug plan but didn’t.
Round this to the nearest ten cents. This penalty amount is added
each month to your Medicare drug plan’s premium for as long as you
have a plan.
Lesson 5 107
Self-Check 19
Indicate whether each of the following statements is True or False.
______ 1. The U.S. Social Security program is more formally known as the Old-Age, Survivors,
Disability, and Health Insurance (OASDHI) program.
______ 2. Generally, OASDI represents 6.2 percent and Medicare represents 1.45 percent
of the 7.65 percent of salary or wages that employer and employee each contribute to
the U.S. Social Security system (7.65 + 7.65 = 15.3 percent, in total).
______ 3. OASDI benefits include retirement, survivors, and disability benefits.
______ 4. OASDI benefits provide monthly benefits to a worker retiring above normal retirement
age, known as the primary insurance amount (PIA).
______ 5. Average benefits are expressed as follows: Maximum benefit = Tax rate ✕ Minimum
taxable wage ✕ Ratio of workers to beneficiaries
______ 6. Presently, a worker’s payroll taxes are invested in the stock market to fund his or her
future benefits.
Select the one best answer to each question.
7. The basic monthly Social Security retirement benefit payable to a worker who retires at normal retirement age is called the
a. AIME. c. replacement rate. b. PIA. d. earnings test.
8. Implicit rates of return on Social Security payroll taxes are highest for
a. the lowest-paid workers. b. the highest-paid workers. c. workers who have fewer than 40 quarters of coverage. d. workers who entered the system after 1985.
(Continued)
Risk Management108
Self-Check 19
9. Blanche was a stay-at-home mother and homemaker for nearly her entire adult life. Her Social Security retirement benefit (when she reaches the normal retirement age and assuming her husband is alive) will be ________ of her husband’s primary insurance amount.
a. 50% c. 75% b. 60% d. 100%
Check your answers with those on page 177.
Graded Project
BACKGROUND Social Security solvency has been a topic of significant debate in recent years. As the population ages, life expectancy increases, and fewer workers fund the PAYGO system, this topic is likely to remain important until it’s solved. This project is designed to increase the depth of your understand- ing of how Social Security taxes are imposed and how to research Social Security insurance and retirement benefits.
Take a moment to review the tables below, which you studied in Assignment 19. These are the wage bases to which the OASDI component of Social Security applies—for the 2009 calendar and tax year, 6.2% of $106,500 (7.65%, up to this wage base ceiling, for both OASDI and Medicare).
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Tax Wage Year Base
Tax Wage Year Base
Tax Wage Year Base
Tax Wage Year Base
1937–50 $3,000
1951–54 $3,600
1955–58 $4,200
1959–65 $4,800
1966–67 $6,600
1968–71 $7,800
1972 $9,000
1973 $10,800
1974 $13,200
1975 $14,100
1976 $15,300
1977 $16,500
1978 $17,700
1979 $22,900
1980 $25,900
1981 $29,700
1982 $32,400
1983 $35,700
1984 $37,800
1985 $39,600
1986 $42,000
1987 $43,800
1988 $45,000
1989 $48,000
1990 $51,300
1991 $53,400
1992 $55,500
1993 $57,600
1994 $60,600
1995 $61,200
1996 $62,700
1997 $65,400
1998 $68,400
1999 $72,600
2000 $76,200
2001 $80,400
2002 $84,900
2003 $87,000
2004 $87,900
2005 $90,000
2006 $94,200
2007 $97,500
2008 $102,000
2009 $106,500
Social Security Wage Base through the Years
Remember, the 7.65% for 1990– represents the 6.2 percent OASDI plus the 1.45 percent Medicare tax.
PROCEDURE
Step 1 Combine the wage base and FICA tax rates applied to these wage bases into a single Excel file. In the process, compute the maximum employee (and employer) contribution to Social Security, based only on the maximum wage base. Here’s an example of a portion of the table:
Graded Project110
Tax FICA SECA Year(s)
Tax FICA SECA Year(s)
1937–49 1.00% NA
1950 1.50% NA
1951–53 1.50% 2.25%
1954–56 2.00% 3.00%
1957–58 2.25% 3.38%
1959 2.50% 3.75%
1960–61 3.00% 4.50%
1962 3.13% 4.70%
1963–65 3.63% 5.40%
1966 4.20% 6.15%
1967–68 4.40% 6.40%
1969–70 4.80% 6.90%
1971–72 5.20% 7.50%
1973 5.85% 8.00%
1974–77 5.85% 7.90%
1978 6.05% 8.10%
1979-80 6.13% 8.10%
1981 6.65% 9.30%
1982–83 6.70% 9.35%
1984 6.70% 11.30%
1985 7.05% 11.80%
1986–87 7.15% 12.30%
1988–89 7.51% 13.02%
1990– 7.65% 15.30%
FICA Tax (1937– ), SECA Tax (1951– ), SECA tax subsidy phase-out completed & SECA taxes adjusted & partially deductible (1990– )
Tax Wage Percent Maximum Year Base FICA
1937 $3,000 1.00% $30.00
1938 $3,000 1.00% $30.00
——BREAK IN SEQUENCE——
2008 $102,000 7.65% $7,803.00
2009 $106,500 7.65% $8,147.25
Social Security Taxes
Step 2
Introduction
FICA (Federal Insurance Contributions Act) and SECA (Self- Employment Contributions Act) represent the employer/ employee contributions to OASDI and Medicare and contribu- tions for the self-employed or sole proprietor. Notice that a self-employed individual didn’t have to contribute to Social Security from 1937 through 1950.
Before the 1980s, self-employed taxpayers made a contribu- tion to Social Security that was less than the employee’s and employer’s contributions, combined. However, one of the solutions to the Social Security shortfall at that time was to phase in a catch-up provision, where, starting in 1990, the employer (7.65%) and employee (7.65%) and the self- employed (15.3%) make equivalent contributions. Effectively, the self-employed taxpayer makes both employer and employee contributions.
Procedure
Into the Excel file you completed in Step 1, add columns for the SECA tax rates applied to these wage bases. In the process, compute the maximum self-employed taxpayer’s con- tribution to Social Security, based only on the maximum wage base. Also add a column for both employer and employee FICA components, so that we can compare the combined employer and employee contributions to FICA to the SECA contribu- tions. Here’s an example of a portion of the table:
Graded Project 111
Tax Wage FICA Maximum 2 Times SECA Maximum Year Base Percent FICA Maximum Percent SECA
FICA
1937 $3,000 1.00% $30.00 $60.00 0.00% $ — 1938 $3,000 1.00% $30.00 $60.00 0.00% $ — 1939 $3,000 1.00% $30.00 $60.00 0.00% $ —
—————BREAK IN SEQUENCE————— 1989 $48,000 7.51% $3,604.80 $7,209.60 13.02% $ 6,249.60 1990 $51,300 7.65% $3,924.45 $7,848.90 15.30% $ 7,848.90
—————BREAK IN SEQUENCE————— 2008 $102,000 7.65% $7,803.00 $15,606.00 15.30% $15,606.00 2009 $106,500 7.65% $8,147.25 $16,294.50 15.30% $16,294.50
Notice that the employee and employer contributions to FICA became equivalent to the self-employed taxpayer’s contribu- tion to SECA in 1990.
Step 3 Prepare a simple Excel graphic to illustrate the combined dollar contributions of employee and employer to FICA compared to those for the self-employed taxpayer to SECA from 1937 through 2009.
Step 4 Under current law, a taxpayer with a salary of $110,000 for 2009 would pay only 7.65% on the first $106,500. The same would be said for the employer. However, also under current law, any amount in excess of the $106,500 wage base and earned income amount for 2009 would continue to be subject to the 1.45% Medicare contribution by both employer and employee, for a total of 2.9%.
Separately compute the amounts, in addition to the $16,294.50 from the above table, that the employee and employer would have to pay for Medicare, assuming a salary level of $110,000 for the 2009 calendar and tax year. Show your calculations.
SUBMITTING YOUR ASSIGNMENT Follow this procedure to submit your assignment:
1. On your computer, save a revised and corrected version of your assignment. Be sure it includes all of the infor- mation listed in your assignment.
2. Go to http://www.takeexamsonline.com and log onto the site.
3. At your homepage, click on Take an Exam.
4. In the box provided, enter the project number: 50082900.
Graded Project112
Graded Project 113
5. Click on Submit.
6. On the next screen, enter your e-mail address.
7. If you wish to tell your instructor anything specific regarding this assignment, enter it in the Comments box.
8. Attach your file or files as follows:
� Click on the first Browse box.
� Locate the file you wish to attach.
� Double-click on the file.
� If you have more than one file to attach, click on the next Browse box and repeat the above steps for each file.
9. Click on Submit.
Important
After you submit the assignment for evaluation, you should receive a
confirmation e-mail with a tracking number. If you don’t receive this
number within 24 hours, you must resubmit the assignment.
NOTES
Graded Project114
115
1. The most common types of voluntary benefits offered by employers include all of the following, except
A. medical insurance. B. life insurance. C. disability insurance. D. automobile insurance.
2. Cafeteria benefit plans are also known as
A. flexible spending accounts. B. Section 125 plans. C. noncontributory plans. D. “free lunch” plans.
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Employee-Employer Relationships
When you feel confident that you have mastered the material in
Lesson 5, 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
50082500 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 5116
3. Which of the following is not one of the reasons commonly suggested explaining why firms provide employee benefits instead of simply paying higher cash wages?
A. Employers don’t have enough cash to pay higher wages. B. Employer-provided benefits promote employee productivity. C. Percentage loadings for administrative expenses in group insurance premiums are
lower than for individual insurance. D. They provide tax savings for both employer and employee.
4. The cost of employee benefits represents, on average, _______ of private employers’ total compensation costs.
A. 5%–10% C. 20%–25% B. 10%–15% D. 35%–40%
5. Many group medical expense coverage and medical plans contain a stop loss clause, which places a ceiling on the
A. amount a hospital or physician can charge the insurance provider. B. amount the provider will pay for any given medical problem or condition. C. out-of-pocket maximum costs to be incurred by the employee. D. out-of-pocket maximum costs to be incurred by the employer.
6. Monica works for a firm that has a pension plan. Her employer’s contributions vary from year to year depending on how well the firm is doing. For example, in 2007 when the firm had net income of $1,000,000, it contributed $2,000 to her pension. In 2008 when the firm had net income of $2,000,000, they contributed $4,000 to her pension. What kind of plan does Monica have?
A. Profit sharing plan C. 401(k) plan B. Money purchase plan D. ESOP
7. A retirement plan in which the employer promises to pay the employees a retirement benefit equal to 2% of their final salary for every year of service is an example of a
A. defined contribution plan. C. contributory plan. B. 401(k) plan. D. defined benefit plan.
8. Workers’ compensation laws have which two important features?
A. (1) Employers pay benefits unless there was employer fault or negligence, and (2) employees aren’t allowed to sue employers for injuries under tort law.
B. (1) Employers pay benefits without regard to employer fault or negligence, and (2) employees are required to sue employers for injuries under tort law.
C. (1) Employers pay benefits unless there was employer fault or negligence, and (2) employees can choose to sue employers for injuries under tort law.
D. (1) Employers pay benefits without regard to employer fault or negligence, and (2) employees aren’t allowed to sue employers for injuries under tort law.
Examination, Lesson 5 117
9. If an employer decides to use cliff vesting, what is the maximum length of service that can be required of an employee before vesting occurs?
A. 3 years C. 7 years B. 5 years D. 10 years
10. Which of the following categories of workers is not eligible for Social Security (OASDI) benefits?
A. Retired persons age 62 and over who have 40 quarters of coverage B. Unmarried children age 18 and under of deceased participants who had at least 6
quarters of coverage during the 13 quarters preceding death C. Spouses, under age 60, of deceased, fully insured workers with no dependent
children D. Disabled workers with at least 20 quarters of coverage during the 40 quarters
preceding the onset of disability
11. Medicare Part A provides which of the following benefits?
A. Inpatient hospital services C. Pharmaceutical expenses B. Physicians’ services D. Free homeopathic remedies
12. Due in large part to _______, workers’ compensation costs continue to increase.
A. undocumented workers B. rising medical costs C. inflation D. the declining value of the U.S. dollar
13. Which of the following is not one of the main types of workers’ compensation benefits?
A. Pain and suffering compensation B. Payment of medical expenses C. Payment for lost income due to disability D. Death benefits
14. Under workers’ compensation laws, injured workers who are unable to work can typically receive benefits equal to
A. 100% of their pre-injury wage. B. 100% of the state’s average weekly wage. C. 2/3 of their pre-injury wage, capped at 100% of the state’s average wage. D. 3/4 of their pre-injury wage, capped at 100% of the state’s average wage.
15. Which one of the following programs is not financed with OASDHI payroll taxes?
A. Social Security disability benefits C. Medicare Part A B. Social Security survivor benefits D. Medicare Part B
Examination, Lesson 5118
NOTES
Business Risk Management—Theory
INTRODUCTION Lesson 6 includes three chapters on business risk manage- ment and theory. The first two of the three will represent review material typically covered in corporate finance courses.
OBJECTIVES When you complete this lesson, you’ll be able to
� Analyze corporate risk management using modern accounting rules and financial management tools
� Explain firm valuation, using expected cash flows and cost of capital
� Describe how investor diversification affects cost of capital, why corporate risk reduction doesn’t affect cost of capital, and how corporate risk reduction affects expected cash flows
� Show how progressive tax rates induce firms to reduce risk, provide tax benefits to insurance, tax benefits from depreciation, and debt financing
� Describe how insurance premium taxes and excise taxes increase premium loadings
� Describe government regulation that requires business insurance
� Identify firm characteristics that influence risk retention/ reduction decisions and where firms should focus their risk reduction activities
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ASSIGNMENT 20 Read the following introduction. Then, read Chapter 20 in your textbook, Risk Management and Insurance.
Principles of Business Valuation Generally, businesses are valued based on the present value of net cash inflows. Therefore, the same concepts and mechanics relating to discounted cash flow (DCF), net pres- ent value (NPV), and internal rate of return (IRR) would apply when establishing the fair market value of a firm, where the discount rate is referred to as the opportunity cost of capital and includes a profit component, and risk-free rates and risk premiums are included for consideration and in the computa- tional formulas.
Recall that there are two types of risk:
1. Diversifiable risk, which has no effect on the opportunity cost of capital
2. Nondiversifiable risk, which increases the opportunity cost of capital as follows:
Total risk = Diversifiable risk + Nondiversifiable risk
Diversifiable risk can be eliminated in a carefully constructed portfolio; nondiversifiable risk can’t be eliminated. Just as a mutual fund or investor might seek to diversify the compo- nents of a portfolio to eliminate diversifiable risk, and insurer can construct a diversified portfolio of insureds or policy holders to achieve a comparable objective.
Risk Management and the Opportunity Cost of Capital The discount rate equals the risk-free rate plus a risk premium. Risk management must focus on a reduction of the risk premium component of the discount rate. The risk premium is dependent only on nondiversifiable risk.
Lesson 6 121
Risk Management and Expected Cash Flows Net present value (NPV) is the present value of a project’s net cash flow. The cost of issuing securities to finance a project reduces the NPV of the project, resulting in an adjusted NPV, as follows:
Adjusted NPV = NPV – Cost of issuing securities
Now that you’ve finished Assignment 20, complete Self- Check 20. 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 20, move on to Assignment 21.
Self-Check 20
Indicate whether each of the following statements is True or False.
______ 1. Generally, businesses are valued based on the present value of net cash inflows.
______ 2. Diversifiable risk increases the opportunity cost of capital.
______ 3. Nondiversifiable risk decreases the opportunity cost of capital.
______ 4. Total risk = Diversifiable risk + Nondiversifiable risk
______ 5. Discount rate = Risk-free rate + Risk premium
______ 6. Adjusted NPV = NPV + Cost of issuing securities
(Continued)
Risk Management122
Self-Check 20
Select the one best answer to each question.
7. Which of the following is not an advantage of purchasing insurance as compared to retaining the risk?
a. Insurers can provide cheaper claim processing and loss control services. b. The price of the insurance is often less than the expected claim cost. c. Insurance reduces the likelihood of financial distress. d. Insurance can reduce a firm’s expected tax payments.
8. In estimating the net present value of a firm’s cash flows, the appropriate discount rate will be the risk-free rate plus a risk premium that takes into account
a. all the risk that the firm is subject to. b. firm-specific and market risk that the firm is subject to. c. diversifiable risk only. d. nondiversifiable risk only.
9. When deciding how much insurance to purchase, a firm must compare the insurance premium loading to the
a. cost of capital. b. expected loss. c. expected cost of raising new funds following a loss. d. costs of financial distress.
Textbook Questions and Problems
Complete Questions 1, 2, and 5 on pages 456–457 in the textbook.
Check your answers with those on page 178.
Lesson 6 123
ASSIGNMENT 21 Read the following introduction. Then, read Chapter 21 in your textbook, Risk Management and Insurance.
Taxes A transaction provides a tax benefit if it lowers the aggregate present value of tax payments for all parties involved in the transaction. Tax rate progressivity simply means that tax rates rise as taxable income rises.
Tax Treatment of Insurers versus Noninsurance Companies Insurance companies can deduct the discounted value of incurred losses, which equals losses paid during the year plus the change during the year in the discounted value of its liability for unpaid claims (loss reserve), as follows:
Tax deductible losses = Losses paid + Discounted change in losses expected
A tax shield is the amount by which tax payments are reduced by an expense when computing taxable income. For example, for a firm in a 34 percent federal income tax bracket (T = 34%), the tax shield for an additional $100 in deductions is $34, as follows:
Tax shield = 1 ✕ T
Tax shield = $100 ✕ 34% = $34
Insurance and Interest Tax Shields on Debt A firm’s capital structure refers to the composition and types of debt and equity used to finance its assets. Recall that A = L + OE. Dividends must be paid from after-tax dollars, but interest expense is tax deductible. Deductible interest, therefore, represents an interest tax shield.
Risk Management124
All states impose premium taxes on insurance transactions. These approximate 2 percent, on average. The federal govern- ment imposes excise taxes on insurance purchased from insurers domiciled outside of the United States (known as alien insurers).
Regulatory Effects on Loss Financing Admitted insurers are licensed and providing insurance in a particular state. A nonadmitted insurer can also sell insur- ance covering a risk in a state in which it’s not licensed, so long as it’s licensed in some state and uses an approved insurance agent. Nonadmitted insurance coverage often represents excess coverage. The market for nonadmitted insurance is called the excess and surplus (E&S) lines market.
Now that you’ve finished Assignment 21, complete Self- Check 21. 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 21, move on to Assignment 22.
Self-Check 21
Indicate whether each of the following statements is True or False.
______ 1. A transaction provides a tax benefit if it lowers the aggregate present value of tax
payments for all parties involved in the transaction.
______ 2. Tax rate progressivity simply means that tax rates rise as taxable income rises.
______ 3. Interest expense must be paid from after-tax dollars, but dividends are tax deductible.
(Continued)
Lesson 6 125
Self-Check 21
Indicate whether each of the following statements is True or False.
______ 4. Insurance companies can deduct the discounted value of incurred losses, which equals
losses paid during the year plus the change during the year in the discounted value of
its liability for unpaid claims (loss reserve).
______ 5. All states impose excise taxes on insurance transactions approximating 2 percent, on
average. The federal government imposes premium taxes on insurance purchased from
an insurer domiciled outside of the United States (known as an alien insurer).
______ 6. A tax shield is the amount by which tax payments are reduced by an expense when
computing taxable income.
Select the one best answer to each question.
7. Premium taxes and excise taxes
a. increase the premium loading on insurance. b. decrease the present value of expected losses. c. can’t be passed on to insurance buyers in the form of higher premiums. d. don’t affect the choice between insurance and retention.
8. A tax benefit should be defined (or stated) in terms of
a. actual tax payments. c. expected tax payments. b. actual tax deductions. d. expected loss financing.
9. This year’s deduction for incurred losses for CPT Insurance Company is equal to the
a. present value of losses that were incurred this year. b. value of losses that were paid this year. c. dollar value of losses that incurred this year, no matter when they’re expected to be paid. d. value of losses that were paid this year plus any change in the discounted value of
incurred losses that will be paid in the future.
Textbook Questions and Problems
Complete Questions 1, 2, and 7 on pages 481–482 in the textbook.
Check your answers with those on page 179.
Risk Management126
ASSIGNMENT 22 Read the following introduction. Then, read Chapter 22 in your textbook, Risk Management and Insurance.
Firm Characteristics Affecting Risk Retention (Reduction) Decisions Risk retention refers to the decision to accept the uncertainty (variability) associated with a particular risk exposure. Risk reduction refers to the decision to reduce uncertainty and variability.
Increasing risk retention may potentially lead to
� Savings on premium loadings
� Reduced exposure to insurance market volatility
� Reducing moral hazard
� Avoiding high premiums that may accompany asymmetric information
� Avoiding implicit taxes arising from insurance price regulation
Aggregated or Disaggregated Risk Management A policy that bundles multiple exposures is referred to as a bundled policy. Advantages of purchasing a bundled policy include the reduction in fixed costs of arranging multiple insurance contracts and the reduction in proportional load- ing costs on policies as a result of reducing the purchase of unnecessary coverage. Disadvantages include greater com- plexity and, therefore, greater costs associated with arranging the policy.
Now that you’ve finished Assignment 22, complete Self- Check 22. 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 22, move on to the examination for Lesson 6.
Lesson 6 127
Self-Check 22
Indicate whether each of the following statements is True or False.
______ 1. Risk retention refers to the decision to reduce uncertainty (variability).
______ 2. Risk reduction refers to the decision to accept the uncertainty (variability) associated
with a particular risk exposure.
______ 3. Increasing risk retention may lead to potential savings on premium loadings.
______ 4. Increasing risk retention may lead to potential savings through reduced exposure to
insurance market volatility.
______ 5. Increasing risk retention may lead to potential savings from reduced moral hazard.
______ 6. A policy that bundles multiple exposures is referred to as a bundled policy.
Select the one best answer to each question.
7. Bilbo Industries is a technology company that prides itself on the ability to react quickly to new product developments. It maintains a significant research and development budget. Regarding risk-reducing activities, Bilbo Industries is
a. more likely to retain risks thereby retaining use of more funds. b. more likely to retain risk because of their ability to react to changing developments. c. less likely to retain risks to concentrate on what they do best. d. less likely to retain risk to help ensure they have a steady supply of investment funds.
8. Residual markets regulation can create an incentive to self-insure
a. when residual premiums are higher than those in the voluntary market. b. because firms that self-insure don’t participate in residual market financing. c. because self-insured firms are subsidized by the residual markets. d. whenever residual markets provide coverage for compulsory coverages.
9. A basic guideline for the retain/insure decision is “Insure those exposures that . . .
a. are measurable.” b. have high frequency and high severity.” c. can potentially result in large, disruptive losses.” d. have reasonably predictable losses.” (This makes for stable premiums.)
Check your answers with those on page 179.
Risk Management128
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129
1. Which of the following statements is true of diversifiable risk?
A. It can be eliminated in a carefully constructed portfolio. B. It can’t be eliminated. C. It affects the opportunity cost of capital. D. It increases the opportunity cost of capital.
2. Which of the following risks faced by a business is most likely to be nondiversifiable?
A. An explosion at the firm’s plant B. Worker injury C. Reduced earnings due to poor economic conditions D. A class-action product liability claim
3. Which of the following equations is correct?
A. Discount rate = Risk-free rate – Risk premium B. Discount rate = Risk-free rate ✕ Risk premium C. Discount rate = Risk-free rate ÷ Risk premium D. Discount rate = Risk-free rate + Risk premium
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Business Risk Management—Theory
When you feel confident that you have mastered the material in
Lesson 6, 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
50082600 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 6130
4. Which of the following equations is correct?
A. Adjusted NPV = NPV + Cost of issuing securities B. Adjusted NPV = NPV – Cost of issuing securities C. Adjusted NPV = NPV ÷ Cost of issuing securities D. Adjusted NPV = NPV ✕ Cost of issuing securities
5. Corporate risk reduction increases shareholder wealth by
A. increasing expected net cash flows. B. decreasing expected net cash flows. C. decreasing the corporate cost of capital. D. increasing the corporate cost of capital.
6. Which of the following statements is true of the tax treatment of uninsured losses?
A. It’s the same as the financial reporting of uninsured losses. B. It allows for a firm to choose when the loss will be deducted. C. It’s the same for insurance companies and non-insurance companies. D. It requires that the loss be deducted in the year it’s paid.
7. The main advantage of using debt financing is the
A. effect on cost of capital. B. availability of interest tax shields. C. lower probability of financial distress. D. reduced variability of earnings.
8. The federal government imposes _______ taxes on insurance purchased from insurers domiciled outside of the United States.
A. sin C. excise B. premium D. non-patriot
9. U.S. corporations can carry losses _______ years forward and 2 years backwards.
A. 10 C. 22 B. 20 D. 25
10. An admitted insurer in a particular state
A. can be domestic, foreign, or alien. B. is always a domestic insurer. C. isn’t always licensed to sell insurance in the state. D. faces stricter regulation than nonadmitted insurers.
11. Which of the following refers to the decision to accept the uncertainty (variability) associated with a particular risk exposure?
A. Risk retention C. Risk sharing B. Risk reduction D. Risk mitigation
Examination, Lesson 6 131
12. Which one of the following firms is more likely to use retention?
A. A closely held firm B. A firm with a high level of financial leverage C. A publicly traded and widely held firm D. A small firm
13. Which one of the following is an example of an aggregated approach to risk management?
A. Hedging exchange rate risk B. Hedging interest rate risk C. Purchasing a high level of liability insurance D. Using derivatives to stabilize fluctuations in revenue
14. A bundled insurance policy with a single overall retention limit can help a firm
A. avoid the problem of two contracts providing duplicate coverage. B. develop simpler contracts. C. avoid purchasing unnecessary coverage. D. understand the disaggregated loss distributions.
15. A disaggregated risk management approach will generally result in
A. higher transaction costs. C. lower expected losses. B. lower transaction costs. D. higher expected losses.
Examination, Lesson 6132
NOTES
Business Risk Management— Types of Contracts
INTRODUCTION Lesson 7 includes three chapters on business risk manage- ment and types of contracts. Chapter 24 is a review of basic corporate finance concepts.
OBJECTIVES When you complete this lesson, you’ll be able to
� Identify major types of property-casualty insurance contracts purchased by businesses and describe the negotiation of commercial insurance programs
� Explain the operation of deductibles and self-insured retentions, policy limits, primary coverage, excess coverage, and umbrella liability coverage in commercial insurance programs
� Describe key provisions of insurance coverage for damage to business property, including associated loss of income and extraordinary operating expenses
� Describe key provisions of commercial general liability insurance, including occurrences and claims-made coverage
� Highlight differences between commercial and personal insurance pricing and underwriting
� Explain basic derivative contracts (options, forwards, futures, and swaps) commonly used for hedging, and distinctions between insurance and derivatives contracts
� Distinguish between exchange-traded and over-the- counter derivative markets
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� Describe major types of risk typically hedged using derivatives
� Define alternative risk transfer, provide examples of products (finite risk plans and captive insurance companies), and explain why these products are used
ASSIGNMENT 23 Read the following introduction. Then, read Chapter 23 in your textbook, Risk Management and Insurance.
Overview of Contracts and Markets There are four major types of property-casualty insurance contracts sold to business buyers:
1. First-party coverage for policyholders’ losses from property damage and associated loss of income
2. Liability and related coverage for injury to third parties
3. Multiple-peril contracts, which, analogous to home- owner’s insurance, cover both property and liability losses in a single contract
4. Surety bonds and financial guarantees
Deductibles and Self-Insured Retentions An exposure diagram is a tool useful in displaying how an insurance contract apportions insurance between the insurer and the insured. With a per occurrence deductible, the insurance buyer or customer pays up to the deductible amount on each covered loss. With an aggregate deductible, the insurance buyer or customer pays until the aggregate amount paid equals the aggregate deductible, and the insur- ance company pays all amounts in excess of the aggregate deductible. The deductible amount may be referred to as a self-insured retention (SIR).
Lesson 7 135
Policy Limits and Primary/Excess/Umbrella Policies Both property and liability policies typically have per occurrence limits. Liability policies also have an annual aggregate limit. Excess policies provide coverage if losses are in excess of some relatively large threshold, referred to as the attachment point. A policy attaching immediately above the firm’s retention is commonly referred to as primary coverage. Some firms purchase insurance coverage in layers from different insurers. This is referred to as layering coverage.
An umbrella policy is similar to excess coverage in that the policy provides excess coverage over other policies or self- insured retentions, and covers liability losses from multiple exposures or perils. A coverage chart, like that provided in Figure 23.6 on page 511 of your text, may be used to sum- marize and depict layers and participating insurers.
Property Insurance Loss of income associated with a curtailment or cessation of operations following physical damage to property can be insured with business interruption coverage, and may be combined with or provided separately from extra expense coverage, which insures the buyer against extraordinary expenses that might be incurred to maintain operation fol- lowing damage to facilities. A causes of loss form is used to specify causes of loss (perils) in business property insurance contracts.
Commercial General Liability Insurance The standard commercial general liability (CGL) insurance policy places a duty to defend the policyholder and pay defense costs on the insurer. Business risk exclusions exclude the insurer from liability for damage to the insured’s product, work, and impaired property. CGL buyers may choose cover- age that’s triggered by an occurrence of injury (occurrences coverage) or coverage that’s triggered by a claim being made (claims-made coverage).
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For personal injury applications, if the date of injury can’t be reasonably determined, the date that the injury manifests itself to the plaintiff triggers coverage (manifestation trigger). Alternatively, the court (fact-finder) attempts to estimate when the injury actually occurred based on expert testimony and other evidence (injury-in-fact trigger).
Now that you’ve finished Assignment 23, complete Self- Check 23. 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 23, move on to Assignment 24.
Self-Check 23
Indicate whether each of the following statements is True or False.
______ 1. Surety bonds and financial guarantees are a type of property-casualty insurance
contracts sold to business buyers.
______ 2. With a per occurrence deductible, the insurance buyer pays up to the deductible
amount on each covered loss.
______ 3. CGL buyers may choose coverage that’s triggered by an occurrence of injury, referred
to as claims-made coverage.
______ 4. For personal injury applications, if the date of injury can’t be reasonably determined,
the date that the injury manifests itself to the plaintiff triggers coverage and is referred
to as the injury-in-fact trigger.
______ 5. With an aggregate deductible, the insurance buyer pays until the aggregate amount
paid equals the aggregate deductible, and the insurance company pays all amounts in
excess of the aggregate deductible.
(Continued)
Lesson 7 137
Self-Check 23
Select the one best answer to each question.
6. Large businesses often purchase highly customized insurance contracts. These contracts are frequently called
a. personal policies. c. manuscript policies. b. special needs policies. d. commercial forms.
7. Your commercial liability policy has the following terms: $10,000 per occurrence deductible; $50,000 stop loss provision; and $200,000 policy limit. How much will you pay if the covered losses during the policy period are as follows: $10,000; $25,000, $50,000, $5,000, $8,000; $20,000; and $100,000?
a. $10,000 c. $168,000 b. $50,000 d. $218,000
8. An occurrence policy
a. covers claims that are filed during the policy period. b. is the least common type of commercial property and liability insurance policy. c. covers claims for losses that occurred during the policy period if the claim is also made
during the policy period. d. covers claims for losses that happened during the policy period regardless of when the
claim is filed.
Check your answers with those on page 180.
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ASSIGNMENT 24 Read the following introduction. Then, read Chapter 24 in your textbook, Risk Management and Insurance.
Introduction to Derivatives and Hedging Call and put option contracts, often covered in corporate finance courses, are covered again in this course, as these options are derived from underlying financial assets and represent a relatively simple hedging strategy that firms of any size might employ to reduce risk.
A derivative contract has a payoff or value derived from the value of some underlying asset, as follows:
� The buyer of a call option contract receives a positive pay- off only if their cost for the option (option price) for the underlying asset value exceeds some threshold, or exercise price.
� The buyer of a put option contract receives a positive pay- off only if the cost for the option for the underlying asset value falls below the exercise price.
Cash-settled derivative contacts are purely financial and don’t involve physical delivery of the underlying asset.
Hedging with Forward/ Futures Contracts A forward contract or a futures contract generates a payoff equal to the difference between the actual price of the under- lying asset and some predetermined price called the forward price or the futures price. The cost of carry relationship is illustrated on page 538 of your text, as follows:
Forward (future) price = Spot price at time t + Cost of carry
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Markets for Derivatives An over-the-counter (OTC) derivative contract is tailor-made to the needs of the contract participants. An exchange-traded derivative is standardized. Performance bonds, called a margin, must be posted by those taking futures positions.
An entertaining way to learn about derivatives and the magnitude of the risks associated with these financial instru- ments is to watch the film Trading Places, where the Dukes are faced with a margin call.
Now that you’ve finished Assignment 24, complete Self- Check 24. 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 24, move on to Assignment 25.
Self-Check 24
Indicate whether each of the following statements is True or False.
______ 1. A derivative contract has a payoff or value derived from the value of some underlying
asset.
______ 2. The buyer of a call option contract receives a positive payoff only if the option price
falls below the exercise price.
______ 3. The buyer of a put option contract receives a positive payoff only if the cost for the
option for the underlying asset value exceeds the exercise price.
______ 4. Determinants of call option prices include the price of the underlying asset, the
exercise price, the volatility in the return of the underlying asset, the time to maturity
for the underlying asset, and interest rates.
______ 5. An over-the-counter (OTC) derivative contract is standardized.
(Continued)
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Self-Check 24
Select the one best answer to each question.
6. Which of the following is not a factor that influences the price of a call option at a given point in time (t)?
a. The date that the option was first created b. The price of the underlying asset at time t c. The exercise price of the option d. The interest rate on government bonds (risk free rate)
7. Option X and Option Y have the same underlying security and the same exercise price. If Option X has three months to maturity and Option Y has six months to maturity, which option will have a higher price?
a. Option X will have a higher price. b. Option Y will have a higher price. c. Since Options X and Y are on the same underlying security, they must have the same
price. d. The answer can’t be determined from the information given.
8. The current spot price of oil is $12 per barrel, the interest rate is 8%, and the cost of storing and insuring oil for one year is 1% of the value of the oil. What would be the no-arbitrage futures price today on a contract that expires one year from now?
a. $12 c. $13.09 b. $12.96 d. $13.20
Check your answers with those on page 180.
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ASSIGNMENT 25 Read the following introduction. Then, read Chapter 25 in your textbook, Risk Management and Insurance.
Description of Alternative Risk Transfer (ART) Although alternative risk transfer (ART) transactions doesn’t have a generally accepted definition, characteristics include the following:
1. They involve a high level of retention.
2. They span multiple years.
3. They include multiple sources of cash.
4. They cover sources of risk not normally covered by insurance contracts.
5. They involve capital market institutions and securities.
Generally, ART transactions have increased in recent decades.
Loss Sensitive Contracts Loss sensitive insurance contracts involve premium adjust- ments dependent on the losses that occur or are paid during the policy period. Large-deductible policies involve the reten- tion of a significant amount of the risk by the policyholder, with the insurer temporarily financing the losses.
A retrospectively rated policy (retro) is a loss sensitive contract with an up-front premium and an additional premium that’s paid after the loss (or, if losses were less than expected, part of the up-front premium may be refunded). As with large deductible policies, the insurer settles all claims.
An investment credit program is one where the insured pays the insurer an amount expected to cover loss payments up to the desired deductible amount and the insurer, after deduct- ing for expenses, places the remaining funds in a trust account to earn interest while awaiting a claim. A premium
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financing arrangement is one where a policyholder borrows the funds deposited with the insurer, for tax purposes. A loss portfolio transfer occurs when a firm transfers a loss to an insurer by paying the present value of expected future claims in one lump sum or installments. The insurer takes on the risk of the future claims being different than expected, and the insured can write off its loss all at once for tax and finan- cial statement purposes.
Finite Risk Contracts Insurers (and reinsurers) offer multiple-year loss sensitive plans referred to as finite risk insurance or financial insurance. These plans don’t transfer much of the risk of loss to the insurer from the insured, but rather allow for smoothing of the loss payments over the policy period.
Captive Insurers Captive insurers are wholly owned subsidiaries. They’re called a pure captive if they insure only their parent or its subsidiaries. Brother-sister transactions may occur between subsidiaries with the same parent as the captive. Many captives have unrelated business, selling insurance to non- insurance corporations not owned by the captive parent. Others are group captives, where the insurance corporation has multiple parents. These relations are shown in Figure 25.3 on page 558 in your text. Captives are usually formed for tax purposes. Risk retention groups are similar to group captives.
Multiline/Multitrigger Insurance Policies Multiline insurance policies provide coverage against an aggregate measure of losses from different risk exposures. Multitrigger insurance policies specify multiple conditions or contingencies that must occur before payments are made.
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Contingent Financing Arrangements Contingent debt and contingent equity (or new stock) is debt or equity contingent upon an event or events. The benefit to the company of this sort of arrangement is that its finance rate, or the price it will get for new equity shares, is known up-front. The risk taken on by the bank or investors is that interest rates will be higher than the agreed rate (thus the bank is forgoing profits), or the company’s stock price will be lower (thus the investors are overpaying). Because all assets are financed with debt and/or equity, these represent contin- gent financing arrangements. In addition, many large insurance companies have lines of credit with banks or financial institutions.
Now that you’ve finished Assignment 25, complete Self- Check 25. 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 25, move on to the examination for Lesson 7.
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Self-Check 25
Indicate whether each of the following statements is True or False.
______ 1. Alternative risk transfer (ART) transactions typically involve a high level of retention.
______ 2. Loss sensitive insurance contracts involve premium adjustments dependent on the
losses that occur or are paid after the policy period.
______ 3. Large-deductible policies involve the retention of a significant amount of the risk by the
policyholder, with the insurer temporarily financing the losses.
______ 4. A retrospectively rated policy is a loss sensitive contract with an up-front premium.
______ 5. Captive insurers are wholly owned subsidiaries.
______ 6. Multiline insurance policies specify multiple conditions or contingencies that must occur
before payments are made.
Select the one best answer to each question.
7. All of the following are examples of loss sensitive policies except
a. retrospectively rated policies. c. investment credit programs. b. experience rated policies. d. excess policies.
8. A multitrigger insurance policy
a. provides coverage for losses generated from different risk exposures. b. is triggered by multiple conditions or contingencies. c. is triggered only when two losses of the same type occur. d. requires two insurers provide payment of large losses.
9. Regarding captives, what does “unrelated business” refer to?
a. Selling insurance coverage to entities not related to the parent corporation b. Insurance lines outside the captive’s scope c. Independent loss exposures d. Noninsurance activities
Check your answers with those on page 180.
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1. An insurance contract provision that stipulates the policy- holder will pay the first $100,000 of each loss is an example of a/an
A. aggregate deductible. B. stop loss provision. C. per occurrence deductible. D. loss cap.
2. Which of the following is a tool useful in displaying how a particular insurance contract apportions losses between the insurer and the insured?
A. Exposure diagram C. Aggregation graph B. Coverage chart D. Occurrence diagram
3. Both property and liability policies typically have
A. annual aggregate limits. C. layering coverage. B. per occurrence limits. D. excess policies.
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Business Risk Management—Types of Contracts
When you feel confident that you have mastered the material in
Lesson 7, 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
50082700 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 7146
4. The portion of a property insurance policy that summarizes the types and locations of covered property, policy limits, and premiums rates is called the
A. coverage form. C. policy conditions. B. policy package. D. policy declarations.
5. Loss of income associated with a curtailment or cessation of operations following physical damage to property can be insured with which of the following?
A. Extra expense coverage C. Business interruption coverage B. Causes of loss form D. Umbrella policy
6. LT properties has four excess policies covering a large building it owns. Each policy is from a different insurer and has a policy limit of $10 million. The first policy has an attachment point of $5 million, the second policy attachment point of $15 million, the third policy has an attachment point of $25 million, and the fourth policy has an attachment point of $35 million. This type of insurance purchasing is referred to as _______ coverage.
A. attachment C. blanket B. layering D. umbrella
7. Call option A has an exercise price of $20. Call option B has an exercise price of $15. If all other characteristics of these options are identical and they are on the same underlying asset, which option will have a higher price?
A. Call option A will have a higher price. B. Call option B will have a higher price. C. Call option A and call option B will have the same price. D. It’s impossible for two options on the same underlying asset to have different
exercise prices.
8. Which of the following statements is true about a futures contract?
A. The payoff is equal to the difference between the price of the underlying asset and the futures price.
B. The payoff is the same as that of a call option. C. Futures contracts always require delivery of the underlying asset to complete the
contract. D. The futures price is paid by the buyer at the outset of the contract.
9. Basis risk exists when the hedging instrument
A. is likely to increase in value over time. B. is likely to decrease in value over time. C. has a high level of volatility. D. differs in value from the item being hedged.
Examination, Lesson 7 147
10. When there’s an increase in a put option price, the
A. price of the underlying asset increases. B. volatility in return of the underlying asset increases. C. time to maturity decreases. D. interest rates decrease.
11. Which of the following statements is true about the notional principal for swap contracts?
A. It’s an accurate measure of the amount of money at risk. B. It’s usually double the amount of money at risk. C. It’s usually an inaccurate measure of the amount of money at risk. D. It’s the expected value of the payout of the contract.
12. The cost of carry relationship is illustrated by which of the following equations?
A. Forward price = Spot price at time t + Cost of carry B. Forward price + Spot price at time t = Cost of carry C. Forward price ✕ Spot price at time t = Cost of carry D. Forward price = Spot price at time t ✕ Cost of carry
13. A.J. Manufacturing has an agreement with the Bank of St. Croix whereby A.J. can borrow up $3.5 million should the manufacturing plant suffer a severe fire or wind- storm. The interest rate on the loan is guaranteed to not be greater than 7 percent. This is an example of
A. contingent debt. C. a letter of credit. B. contingent equity. D. a line of credit.
14. Experience-rated policies are beneficial to the insurer because they help to reduce
A. adverse selection. C. fraud. B. moral hazard. D. insurer insolvency.
15. An oil refinery has recently suffered an explosion. The refinery has estimated its cost from this explosion to be approximately $50 million. Uncertainty still exists, though, regarding the actual amount and timing of the loss payments. An insurer has agreed, for a price, to assume all responsibility for the payment of this loss. This is an example of a/an
A. retrospectively rated policy. C. incurred loss retro policy. B. premium financing arrangement. D. loss portfolio transfer.
Examination, Lesson 7148
NOTES
Business Risk Management— Additional Topics
INTRODUCTION Lesson 8 begins with Chapter 26. The majority of the material contained in Chapter 26 is a review of business statistics concepts. Chapter 27 is devoted to a case study: United Grain Growers is a case that integrates many of the concepts and tools presented in previous chapters. Chapters 28 and 29 introduce and provide coverage of additional terms and con- cepts, completing the textbook coverage of this course in Risk Management.
OBJECTIVES When you complete this lesson, you’ll be able to
� Explain how historical data is used to compute a proba- bility distribution of future losses and how correlation coefficients and regression is applied in the context of risk management
� Define enterprise risk management
� Describe legal liability rules, insurance coverage, and public policy issues as they relate to product, environ- mental, and directors and officers’ (D&O) liability
� Explain how limited liability assists businesses in limited tort liability risk reduction, and how businesses are liable for the actions of agents, employees, and independent contractors
� Define hold harmless and indemnity agreements and their impact on the cost of risk
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ASSIGNMENT 26 Read the following introduction. Then, read Chapter 26 in your textbook, Risk Management and Insurance.
Risk Management Tools This material is a review of business statistics and corporate finance. Use this chapter as an opportunity to review this material, but as applied to risk management.
Calculating Frequency and Severity of Losses from Historical Data Recall, from earlier coursework, that regression seeks to develop a cost equation, where total cost is a function of fixed costs and variable costs, as follows:
Y = αα + ββX
or
Total cost = Fixed cost + Variable cost
or
Dependent variable = Y-axis intercept + Slope
Using Entire Probability Distributions The risk of loss can be estimated using the normal distribu- tion. Frequently, a computer simulation of loss distribution will prove useful for risk estimation. The Poisson distribution is frequently used for these applications, as is the lognormal distribution. Both of these are complicated statistical calculations that you don’t need to delve into further for our purposes.
Now that you’ve finished Assignment 26, complete Self- Check 26. 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 26, move on to Assignment 27.
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Self-Check 26
Indicate whether each of the following statements is True or False.
______ 1. Regression seeks to develop a cost equation, where
Dependent variable = Y-axis intercept – Slope
______ 2. The risk of loss can be estimated using the normal distribution.
______ 3. Discounted cash flow analysis and the net present value method are applied with
projections of cash flows to compute risk estimates.
Select the one best answer to each question.
4. A probability distribution that is often used to approximate the severity of property and liability losses is the _______ distribution.
a. Poisson c. gamma b. normal d. lognormal
The following table contains loss data from Smith Corporation. Use this data to answer
questions 5–8.
5. What is the average loss severity in Year 1?
a. $6,588 c. $8,137 b. $7,714 d. $9,450
(Continued)
Year 1 Year 2 Year 3
Loss Severity Loss Severity Loss Severity
#1 $ 4,000 #1 $ 7,000 #1 $ 3,000
#2 2,000 #2 27,000 #2 9,500
#3 8,000 #3 5,000 #3 17,000
#4 5,500 #4 14,000 #4 12,000
#5 19,000 #5 3,500 #5 5,000
#6 11,000 #6 31,000
#7 4,500 #7 21,000
#8 6,000
#9 8,500
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ASSIGNMENT 27 Read the following introduction. Then, read Chapter 27 in your textbook, Risk Management and Insurance.
Enterprise Risk Management Enterprise risk management (ERM) refers to the identification and measurement of all risk exposures and their manage- ment within a unified framework. This chapter is dedicated to a real-life case study of a company and its risk management strategies. The United Grain Growers case integrates many of the concepts and tools presented in previous chapters.
Now that you’ve finished Assignment 27, complete Self- Check 27. 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 27, move on to Assignment 28.
Self-Check 26
6. What is the average loss severity over the three years?
a. $8,137 c. $11,300 b. $10,643 d. $11,751
7. Using the three-year average frequency and average severity, what is the expected total loss amount for the next year (Year 4)?
a. $81,951 c. $74,501 b. $79,261 d. $65,891
8. In Year 3, Smith Corporation had an insurance policy to help finance its losses. The policy had a $5,000 per occurrence deductible, a $25,000 stop-loss provision, and a $75,000 policy limit. What amount did Smith Corporation pay for these losses?
a. $25,000 c. $38,000 b. $35,000 d. $42,000
Check your answers with those on page 181.
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Self-Check 27
Select the one best answer to each question.
1. Which risk exposure was identified as United Grain Growers’ main source of unmanaged risk?
a. Counterparty risk c. Environmental liability b. Commodity price and basis risk d. Weather effects on grain volume
2. Why was it appropriate for the UGG analysts to use a time trend variable in a regression equation modeling crop yields?
a. Because crop yields vary from year-to-year b. To capture productivity increases over time c. To measure the length of the growing season d. To adjust for annual crop quality
3. Analysts for UGG performed regression analysis with assorted dependent variables, e.g. wheat from Alberta. In addition to a time trend variable, what other two variables were used as explanatory variables?
a. Average June temperature and average July precipitation b. Average June temperature and average fertilizer application in May c. Average July precipitation and average fertilizer application in May d. Average fertilizer application in May and average length of the growing season
4. If average temperature and average precipitation variables in Alberta are highly correlated with the respective variables in Saskatchewan, geographic diversification will
a. do little to reduce the exposure to weather risk. b. provide some reduction in the exposure to weather risk. c. effectively eliminate the exposure to weather risk. d. Correlation doesn’t impact the effects of diversification.
Textbook Questions and Problems
Complete Questions 1–2 on page 603 in the textbook.
Check your answers with those on page 181.
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ASSIGNMENT 28 Read the following introduction. Then, read Chapter 28 in your textbook, Risk Management and Insurance.
Products Liability There are three general types of product defects:
1. Manufacturing defect—a product deviates from what the manufacturer intended.
2. Design defect—foreseeable risks of harm presented by the product could have been prevented.
3. Warning defect—the product hasn’t been properly labeled or risks associated with use haven’t been previously explained.
Defenses against the above include
1. Assumed risk
2. Engaging in unforeseeable misuse
In addition to the above, contract law provides for the following warranties:
1. Express warranty—an explicit statement or promise of performance
2. Implied warranty—the product is reasonably designed for its intended use
Environmental Liability The Comprehensive Environmental Response, Compensation, and Liability Act (CERCLA) of 1980, also known as the Superfund law, was passed, in part, because of the Love Canal incident described on page 614 of your text.
Although your text makes light of the environmental impact of the Love Canal toxins, there was a signifi- cant number of children with birth defects in the town before the population was evacuated. Pictures of chemicals bubbling up to the surface, and decayed
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chemical drums emerging from the ground in residents’ backyards, shocked people into demanding government action. The site was officially declared “closed” (cleanup completed) in 2004, 21 years after it was declared an environmental disaster. For a contemporary account of the site by then–EPA Administrator Eckardt C. Beck, go to http://www.epa.gov/history/topics/lovecanal/ 01.htm
Beginning in 1973, many commercial general liability (CGL) policies included a sudden and accidental clause, offering a separate policy to cover other environmental areas, including gradual pollution.
Frequently, disputes over environmental claims arise from the trigger of coverage—which insurance policies are triggered by the event and how claim costs are to be divided among and covered by multiple policies. In 1986, insurers responded to tendencies by some courts to require coverage by changing the exclusion in the standard CGL policy from all but sudden and accidental pollution to absolute pollution exclusion.
Directors’ and Officers’ Liability Corporate directors and officers (abbreviated D&O) are required to make informed decisions (called the duty of care). Generally, courts apply the business judgment rule, where they won’t question informed decisions, even if they turned out poorly. However, the post-Enron era has led to many lawsuits against directors and officers when publicly traded stock prices decline, and dramatic increases in the price charged to these corporations for D&O insurance. Corporate indemnification of officers and directors refers to reimburse- ment by the corporation for director and officer legal costs and losses from settlements, judgments, and fines.
Shareholder suits fall into two classes:
� Derivative suits are brought by shareholders on behalf of the corporation, where damages awarded are received by the corporation.
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� Direct action suits against directors and/or officers are initiated by shareholders, where damages awarded are received by the plaintiffs and their attorneys.
The duty of loyalty means that the directors must act in the best interests of the shareholders when a corporate decision involves a potentially material conflict of interest between shareholders, officers, and directors.
Now that you’ve finished Assignment 28, complete Self- Check 28. 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 28, move on to Assignment 29.
Self-Check 28
Indicate whether each of the following statements is True or False.
______ 1. There are three general types of product defects: manufacturing defect, design defect,
and warning defect.
______ 2. Contract law provides for express warranties, but not implied warranties.
______ 3. Direct action suits are brought by shareholders on behalf of the corporation, and
damages awarded are received by the corporation.
______ 4. Corporate directors and officers are bound by a duty of loyalty.
______ 5. A strike suit is a frivolous lawsuit.
(Continued)
Lesson 8 157
ASSIGNMENT 29 Read the following introduction. Then, read Chapter 29 in your textbook, Risk Management and Insurance.
Risk Shifting through Limited Liability One of the advantages of incorporating is to limit liability to corporate assets. However, there have been cases where courts have forced shareholders to pay claims that the corporation can’t pay (known as piercing the corporate veil),
Self-Check 28
Select the one best answer to each question.
6. The court case MacPherson v. Buick (1916) established which one of the following legal precedents?
a. Negligence needed to be proved in product liability cases b. A contractual relationship between the injured party and the manufacturer is not needed
to recover damages. c. The strict liability standard for products liability cases. d. The “unreasonably dangerous” standard for products liability
7. Strict liability for all consumer losses due to product-related injuries
a. provides inadequate incentives for manufacturers to invest in safety. b. provides inadequate compensation for victims. c. provides appropriate incentives for consumers to take safety precautions. d. helps correct the problem of uninformed consumers who overconsume risky products in
the absence of such a liability rule.
8. A manufacturer is subject to liability resulting from express and implied warranties. This is an example of what kind of liability?
a. Tort c. Strict b. Contractual d. Imputed
Check your answers with those on page 181.
Risk Management158
effectively nullifying the risk shifting intended through use of these limited liability provisions. These cases are rare, however, and almost always involve either closely held corporations or parent-subsidiary situations.
Liability for Actions of Employees and Other Parties Vicarious liability (also known as imputed negligence) repre- sents a fundamental provision of tort law, where the principal (usually the employer) is responsible for the actions of the agent (usually the employee) and his or her related torts (e.g., any strict liability). This may be applied in employee-employer arrangements, but may not apply in independent contractor cases, because they’re supposed to be “independent” and not under the company’s direct control. However, protecting the public safety constitutes a nondelegable duty—one that can’t be delegated to an independent contractor. In such cases, the business hiring the contractor may be held to be vicariously liable.
Hold Harmless and Indemnity Agreements A hold harmless agreement is a contract between two parties in which one party agrees to hold the other party harmless (in other words, pay any damages) for losses arising from some specified activity. An indemnity agreement is one where one party (the indemnitee) pays an injured party and is then reimbursed by the other party (the indemnitor). One type of evidence of indemnity is a certificate of insurance, issued by the insurer.
Lesson 8 159
Claims Management and Administration Insurance payments are often accompanied or combined with the signing of a release, which releases the payer from future claims. In other words, the plaintiff can’t decide to sue again for some other injury arising from the incident. Advance payments may also be made by an insurer (defendant) in a case involving litigation. While the vast majority of liability suits are settled with lump sum settlements, a structured settlement represents an alternative, where the settlement is paid in installments, usually through an annuity.
Now that you’ve finished Assignment 29, complete Self- Check 29. 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 29, move on to your last lesson examination.
Self-Check 29
Indicate whether each of the following statements is True or False.
______ 1. One of the advantages of incorporating is to limit liability to corporate assets and
protect personal assets.
______ 2. There have been no cases where courts have allowed the corporate veil to be pierced.
______ 3. Vicarious liability represents a fundamental provision of tort law, where the principal is
responsible for the actions of the agent and his or her related torts.
______ 4. The vast majority of liability suits are settled with structured settlements.
(Continued)
Risk Management160
Self-Check 29
Select the one best answer to each question.
5. Under a system of limited liability, corporations do not bear all of the costs of tort liability claims. This might cause firms to
a. fail to provide optimal safety incentives. b. take excessive risk. c. fail to consider all of the costs that they impose on others. d. All of the above
6. Under common law, a worker will be deemed to be an employee (as opposed to an independent contractor) if the
a. hiring firm doesn’t control hours worked. b. hiring firm supervises and directs the worker in how the work should be done. c. worker provides his or her own tools and equipment. d. worker has complete control over how and when the work is completed.
7. A lawsuit in which the plaintiff’s case is known by both parties to be weak is called a
a. nuisance suit. c. judgment-proof suit. b. test case. d. subsidiary suit.
8. Vicarious liability is also known as
a. strict liability. c. imputed negligence. b. contractual liability. d. acquired negligence.
Check your answers with those on page 182.
161
1. Regression seeks to develop a cost equation. Which of the following represents a cost equation based on linear regression?
A. Y = α + βX C. Y = α ✕ βX B. Y = α – βX D. Y = α ÷ βX
2. The _______ distribution is often used to approximate the frequency of accident losses.
A. normal C. Poisson B. gamma D. lognormal
3. If the normal distribution is used to estimate losses when the true loss distribution is in fact positively skewed, which of the following errors will occur?
A. The maximum probable loss will be overestimated. B. The maximum probable loss will be underestimated. C. The standard deviation will be underestimated. D. The standard deviation will be overestimated.
E x
a m
in a
t io
n E
x a
m in
a t io
n Lesson 8
Business Risk Management—Additional Topics
When you feel confident that you have mastered the material in
Lesson 8, 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
50082800 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 8162
4. The correlation coefficient is always within the range between
A. –2.0 and +1.0. C. 0 and +1.0. B. –1.0 and 0. D. –1.0 and +1.0.
5. When a risk manager is choosing between two alternative, mutually exclusive methods of financing losses that have different patterns of expenditures, but don’t materially affect the variability of any of the firm’s cash flows, the appropriate cost of capital for discounting these expenditures is the
A. risk free rate. B. opportunity cost. C. opportunity cost of capital, adjusted upward to reflect additional risk. D. opportunity cost of capital, adjusted downward to reflect reduced risk.
6. A hold harmless agreement is a contract between two parties in which
A. both parties agree to indemnify each other for any losses incurred. B. both parties agree to buy insurance against any potential losses that might arise
out of the activity they are engaged in. C. one party agrees not to make the other party pay for any losses that might arise
out of some activity. D. one party agrees to reimburse the other party for any losses that might arise out of
some activity.
7. If a group of shareholders file a lawsuit on behalf of the corporation against the directors and officers of the corporation, it’s called a/an _______ lawsuit.
A. direct action C. indemnity B. nuisance D. derivative
8. Roaster Coaster Inc. manufactures rolling hotdog vending stands. One of the hotdog vending stands comes off the production line defective. It eventually starts a fire at an amusement park. The fire causes a minor panic that results in a few children being injured as the crowd runs away from the fire. This is an example of a _______ defect.
A. hidden C. manufacturing B. design D. warning
9. When foreseeable risks of harm presented by a product could easily have been prevented, it’s said to have a _______ defect.
A. design C. warning B. manufacturing D. strict
Examination, Lesson 8 163
10. Under the most recent commercial general liability policies, environmental damage is
A. covered only if it was “sudden and intentional.” B. excluded from coverage under the policy. C. covered if the pollution was gradual. D. covered if the policyholder was unaware that it was occurring.
11. The principle that product liability suits must be brought within a certain number of years is called
A. assumed risk. C. regressivity. B. unforeseeable misuse. D. the statute of repose.
12. If the directors and officers of a corporation cause the shareholders to suffer a loss,
A. they’re personally liable for the total amount of the losses. B. they aren’t liable if they can show that they acted with reasonable business
judgment. C. they can never be held personally liable because of the limited liability rule. D. they can be liable only up to the limit of their investment in the corporation.
13. When a corporation has debt financing and limited liability, a liability claim in excess of the equity value of the firm will
A. expose shareholders to claims on their personal assets. B. result in shareholders losing only part of their investment in the firm, since
bondholders will pay some of the cost. C. result in shareholders losing all of their investment in the firm. D. be paid only after the shareholders have paid back their debt to the bondholders.
14. Which of the following statements about the liability of businesses for actions of independent contractors is true?
A. A business that hires an independent contractor can always be held vicariously liable for the negligent actions of the contractor.
B. A business that hires an independent contractor will never be held vicariously liable for the negligent actions of the contractor.
C. A business that hires an independent contractor can be held liable for the actions of the contractor if the contractor is acting as an employee.
D. A business can avoid liability by delegating to an independent contractor the duty to keep the public safe.
15. Protecting the public safety constitutes a/an
A. hold harmless agreement. C. indemnity agreement. B. certificate of insurance. D. nondelegable duty.
Examination, Lesson 8164
NOTES
Self-Check 1
1. True
2. False
3. True
4. a
5. b
6. d
Self-Check 2
1. True
2. False
3. True
4. False
5. False
6. c
7. b
8. a
Answers to Textbook Problems
1. The cost of achieving zero risk is too high.
Self-Check 3
1. True
2. True
3. True
4. True
5. True
6. False
7. a
165
A n
s w
e r
s A
n s
w e
r s
8. c
9. d
Answers to Textbook Problems
1. Expected Value of Losses = ($90,000 ✕ 0.02) + ($10,000 ✕ 0.06) + ($0 ✕ 0.92) = $2,400
2. Expected Value of Profits = ($70,000 ✕ 0.05) + ($50,000 ✕ 0.25) + ($30,000 ✕ 0.35) + ($10,000 ✕ 0.2) + (–$10,000 ✕ 0.15) = $27,000
3. Expected Value = ($3,000,000 ✕ 0.004) + ($1,500,000 ✕ 0.01) + ($800,000 ✕ 0.026) = $47,800
4. Expected Value = ($5,000,000 ✕ 0.004) + ($1,500,000 ✕ 0.025) + ($500,000 ✕ 0.03) = $72,500
Self-Check 4
1. False
2. False
3. True
4. True
5. True
6. True
7. c
8. b
9. c
Self-Check 5
1. True
2. False
3. True
4. True
5. False
6. True
Self-Check Answers166
Self-Check Answers
7. a
8. c
9. d
10. c
Answers to Textbook Problems
1. $200 – $175 = $25 million
7. The major investments held by property-liability insurers are municipal bonds, corporate bonds, government bonds, and common stock. The major investment held by life-health insurers is corporate bonds.
Self-Check 6
1. False
2. False
3. False
4. True
5. True
6. d
7. a
Answers to Textbook Problems
2. See pages 105–106 of the text.
7. To the extent that consumers can interpret information and that the Internet information is trustworthy, then a case might be made for less regulation.
9. The NAIC is an association of state insurance commis- sioners. Its role is to facilitate and coordinate state regulation of insurance.
Self-Check 7
1. True
2. True
3. False
167
4. False
5. False
6. False
7. c
8. b
9. a
Answers to Textbook Problems
1. In some cases (although it’s difficult to identify when), insurers may simply have had really bad luck.
2. Insurer insolvencies can occur as a result of sudden unexpected events. In addition, insurers can sometimes hide their financial difficulties for some time from out- side observers. Thus, insolvency doesn’t necessarily imply that regulators failed to perform their jobs.
3. Businesses are more likely to use solvency ratings of insurers because of the larger amount of insurance cov- erage they typically purchase and because guaranty funds typically won’t provide complete coverage if their insurer becomes insolvent.
6. Insurers might be reluctant to reduce their capital because the insurer has significant franchise value, which would be lost if the insurer failed.
Self-Check 8
1. True
2. False
3. False
4. True
5. False
6. False
7. a
8. d
9. c
Self-Check Answers168
Answers to Textbook Problems
1. Expected claim cost = ($100,000 ✕ 0.005) + ($60,000 ✕ 0.01) + ($20,000 ✕ 0.02) + ($10,000 ✕ 0.05) = $500 + $600 + $400 + 500 = $2,000
b. Present value of expected claim cost = $2,000 ÷ 1.06 = $1,886.79
c. Fair premium = $1,886.79 + $100 + $50 = $2,036.79
2. Expected loss adjustment expenses = 0.12 ✕ $2,000 = $240
Present value of expected loss adjustment expenses = $240 ÷ 1.06 = $226.42
Fair premium = $2,036.79 + 226.42 = $2,263.21
7. When interest rates increase, insurance premiums should decrease, all else equal. The farther into the future that claims are paid, the lower are insurance premiums, all else equal.
9. If capital shocks cause insurance prices to increase above the present value of expected costs, then policy- holders implicitly bear part of the risk associated with losses that deplete insurers’ capital.
Self-Check 9
1. False
2. False
3. True
4. True
5. True
6. True
7. d
8. c
9. b
Self-Check Answers 169
Answers to Textbook Problems
2. A risk-averse person would purchase policy c because the premium is equal to the expected claim cost, i.e., there’s no premium loading. A risk-averse person wouldn’t necessarily purchase policy d.
3. Poor people may simply not have sufficient income to purchase insurance. In addition, poor people have limited wealth to protect from lawsuits. Therefore, they’ll likely purchase little liability insurance coverage.
5 Expected claim cost = (0.02 ✕ $20,000) + (0.04 ✕ $5,000) + (0.01 ✕ $1,000) = $400 + $200 + $100 = $700
Fair premium = $700 ✕ 1.15 = $805
Loading from the insurer’s perspective = $105
Self-Check 10
1. False
2. True
3. True
4. True
5. False
6. False
7. a
8. b
9. c
Answers to Textbook Problems
1. a. As legal costs increase, the premium loading will increase, which will likely lead to a decrease in the amount of insurance coverage purchase by risk-averse people.
b. As regulatory compliance costs decrease, the premium loading will decrease, which will likely lead to an increase in the amount of insurance coverage purchased by risk-averse people.
Self-Check Answers170
c. As the tax on investment earnings increase, the premium loading will increase, which will likely lead to a decrease in the amount of insurance coverage purchased by risk-averse people.
d. As the variability of claim costs increase, the insurer will likely need to hold more capital to keep its likeli- hood of insolvency constant. Capital costs will cause the premium loading to increase, which will likely lead to a decrease in the amount of insurance coverage purchased by risk-averse people.
e. As the criminal penalties for fraud increase, insurers will need to spend less to verify that claims are legiti- mate. Therefore the premium loading will decrease, which will likely lead to an increase in the amount of insurance coverage purchased by risk-averse people.
Self-Check 11
1. False
2. False
3. False
4. False
5. True
6. True
7. c
8. a
Answers to Textbook Problems
5. Generally, the cost of eliminating the possibility of a death at a worksite is too costly.
Self-Check 12
1. True
2. True
3. False
Self-Check Answers 171
4. True
5. True
6. b
7. c
8. c
Answers to Textbook Problems
1. a. If the automobile driver is found negligent, then he or she would be liable for Ms. Schmit’s medical expenses and noneconomic losses.
b. If the automobile driver is found negligent, but suc- cessfully argues that Ms. Schmit also was negligent for crossing the street between intersections, then under a contributory negligence standard, Ms. Schmit would have to pay her own medical expenses and she wouldn’t be reimbursed for her noneconomic losses.
c. If the automobile driver is found negligent, but successfully argues that Ms. Schmit also was negli- gent for crossing the street between intersections, then under a comparative negligence standard, the driver might be liable for only a portion (correspon- ding to how the responsibility for the accident was apportioned by the court) of Ms. Schmit’s medical expenses and noneconomic losses. Under some states’ comparative negligence rules, if the defendant is less than 50 percent responsible, however, the defendant could escape liability completely.
d. Under an absolute liability standard, the driver would be liable even if Ms. Schmit was largely responsible for the accident.
2. a. If physicians were always liable, then they would probably exercise more care in the delivery of medical services. An absolute liability standard could provide physicians with excessive incentives for safety, i.e., they might practice defensive medicine that increased the cost and safety of medical care beyond the point that consumers would be willing to pay for (if con- sumers paid the full cost of services). The expected
Self-Check Answers172
liability cost associated with providing care also could lead some physicians to stop practicing or switching to specialties with less liability risk.
b. Victims would receive more compensation since they would receive compensation for injuries even when the physician wasn’t negligent. From a compensation (insurance) perspective, this might be advantageous as people would bear less risk, although the impor- tance of this effect is reduced to the extent people have medical expense insurance that would cover additional medical costs due to injuries from previous medical treatments.
c. Legal costs would likely decrease because courts wouldn’t have to incur the costs of determining whether physicians were negligent.
6. A profit-maximizing producer would spend the optimal amount ($4,000).
8. The producer would spend $2,000.
9. Each additional level of safety expenditures lowers the firm’s insurance premium by the amount of expected consumer losses. Therefore, the profit-maximizing firm will spend the optimal amount ($4,000).
Self-Check 13
1. c
2. a
3. f
4. e
5. b
6. d
7. d
8. a
9. c
Self-Check Answers 173
Answers to Textbook Problems
2. Underinsured and uninsured motorist coverage might be improved by eliminating any mandatory coverage for pain and suffering. Many people would prefer not to purchase insurance against noneconomic losses, and thus the mandatory coverage forces some people to pur- chase insurance they don’t desire.
3. The main rating factors are driving record, location of residence (territory), and characteristics of the driver, such as age and gender.
5. Insurers will be willing to sell coverage provided they can cover their costs, including their cost of capital. Consequently, the people that are insured in residual markets are typically people who have higher expected costs than the premium that insurers are allowed to charge. Not surprisingly, residual markets typically lose money.
6. People who violate compulsory insurance laws and drive without insurance may have greater incentives to avoid accidents so as not to incur the penalties associated with violating the compulsory insurance law.
7. Repeal of compulsory liability insurance and limits on tort liability would likely decrease drivers’ incentives for safety. The government could counteract this effect by increasing fines for traffic violations and accidents and by increasing enforcement efforts.
11. Personal injury lawyers benefit from lawsuits and there- fore generally would be hurt by the limitations on legal liability of no-fault laws. To the extent that legislators are still practicing law or plan to practice law after their term in office, voting on no-fault legislation could represent a conflict of interest.
Self-Check 14
1. False
2. True
3. True
Self-Check Answers174
4. False
5. False
6. d
7. b
8. a
9. c
Answers to Textbook Problems
1. Assuming the homeowner is determined to be liable, then the insurer would pay all of the damages. If the homeowner isn’t negligent, then the insurer would pay $1,000 of medical payments.
b. Since all of these items would be covered up to $10,000 under the other structures coverage, the insurer would pay $10,000.
c. The insurer would pay the entire damage of $75,000.
3. Premium = 0.005 ✕ $100,000 ✕ 1.2 = $600.
Self-Check 15
1. False
2. False
3. True
4. False
5. True
6. b
7. c
8. d
Answers to Textbook Problems
1. It would probably be a good idea for Jane to purchase term insurance. In this way, she can purchase a rela- tively large amount of coverage. In contrast, a whole life policy with the same premium would provide much lower coverage.
Self-Check Answers 175
2. The curve would shift down.
3.
4. People who expect to die early are more likely to buy life insurance, and people who expect to live longer than the average person tend to buy annuities.
Self-Check 16
1. True
2. True
3. True
4. True
5. True
6. b
7. a
8. d
Self-Check 17
1. True
2. True
3. True
4. False
Self-Check Answers176
Year 1 Year 2 Year 3
Cash Value at beginning of year $10,000 $10,971 $11,887
Premium payments made at beginning of year $1,000 $1,000 $1,500
Mortality cost $550 $600 $675
Expense cost $100 $50 $50
Interest rate used for crediting cash value 6.0% 5.0% 5.0%
Credited interest* 621 566 633
Cash Value at end of year 10,971 11,887 13,295
* (Cash value at beginning of year + premium payments – mortality cost – expense cost ) ✕ Interest rate.
5. False
6. c
7. a
8. d
Self-Check 18
1. True
2. True
3. False
4. True
5. True
6. d
7. b
8. a
Self-Check 19
1. True
2. True
3. True
4. False
5. False
6. False
7. b
8. a
9. a
Self-Check Answers 177
Self-Check 20
1. True
2. False
3. False
4. True
5. True
6. False
7. b
8. d
9. c
Answers to Textbook Problems
1. Price = $20 ÷ 1.08 + $20 ÷ 1.082 = $18.52 + $17.15 = $35.66.
2.
5. Opportunity cost of capital = 0.07 + 0.05 = 0.12 = 12%. Since investors can diversify this risk on their own, Thistle’s risk premium won’t change if it purchases insurance.
Self-Check Answers178
Year 1 Year 2
Revenue $100.00 $100.00
Costs $85.00 with prob. 0.1 $85.00 with prob. 0.1
$79.445 with prob. 0.9 $79.445 with prob. 0.9
Net Cash Flow $15.00 with prob. 0.1 $15.00 with prob. 0.1
$20.56 with prob. 0.9 $20.56 with prob. 0.9
(a) Expected net cash flow = $15 ✕ 0.1 + $20.56 ✕ 0.9 = $20
(b) $35.66
(c) The opportunity cost of capital shouldn’t change as a result of introducing the risk of workplace injuries, because this risk is firm specific and should be readily diversified by shareholders.
Self-Check 21
1. True
2. True
3. False
4. True
5. False
6. True
7. a
8. c
9. d
Answers to Textbook Problems
1. False—transactions might reduce expected tax payments, but they also reduce expected cash flows to shareholders.
2. False—the definition of a tax benefit considers the tax payments of all the parties involved in a transaction. The policyholder could receive the benefits of the tax break through a lower insurance premium.
3. Under tax accounting, a loss is recorded when it’s paid. Under financial reporting accounting, a loss is recorded when it becomes probable and can be reasonably estimated.
Self-Check 22
1. False
2. False
3. True
4. True
5. True
6. True
Self-Check Answers 179
7. d
8. b
9. c
Self-Check 23
1. True
2. True
3. False
4. False
5. True
6. c
7. b
8. d
Self-Check 24
1. True
2. False
3. False
4. True
5. False
6. a
7. b
8. c
Self-Check 25
1. True
2. False
3. True
4. True
Self-Check Answers180
5. True
6. False
7. d
8. b
9. a
Self-Check 26
1. False
2. True
3. True
4. d
5. b
6. b
7. c
8. c
Self-Check 27
1. d
2. b
3. a
4. a
Answers to Textbook Problems
1. Correlation coefficient = 0.94
2. Correlation coefficient = 0.88
Self-Check 28
1. True
2. False
3. False
Self-Check Answers 181
4. True
5. True
6. b
7. d
8. b
Self-Check 29
1. True
2. False
3. True
4. False
5. d
6. b
7. a
8. c
Self-Check Answers182
