Chapter 4 Advanced Topics in Risk Management 1.
All of the following are financial risks which may be faced by business organizations EXCEPT (a) interest rate risk. (b) commodity price risk. (c) product liability risk. (d) currency exchange rate risk. Answer: C
2.
Which of the following statements about the scope of risk management is (are) true? I. Traditionally, risk management was limited in scope to speculative loss exposures. II. In the 1990s, some businesses began to expand the scope of risk management to include financial risks. (a) I only (b) II only (c) both I and II (d) neither I nor II Answer: B
3.
Mid-States Beef is a commercial feedlot business. Currently, the company has over 10,000 cattle in feedlots. Mid-States is concerned that the price of corn, the grain fed to the cattle, will increase significantly. The risk that the price of corn may increase and harm the profitability of Mid-States Beef’s operations is a(n) (a) currency exchange rate risk. (b) property risk. (c) commodity price risk. (d) interest rate risk. Answer: C
4.
An integrated risk program is a risk management program which combines (a) pure and speculative risks. (b) property and liability risks. (c) interest rate risk and currency exchange rate risk. (d) commodity price risk and interest rate risk. Answer: A
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5.
Regional Airline (RA) is looking for an effective way of handling its risk exposures. The company spends millions of dollars on jet fuel. The company also has significant liability exposures. RA can retain a large portion of its liability exposure if fuel costs are low. The company can pay high fuel costs if retained liability losses are low. RA cannot, however, absorb both high fuel costs and high retained liability claims. RA’s insurer designed an insurance program that pays only if both contingencies (high fuel costs and high retained liability claims) occur. The contract the insurer designed is called a(n) (a) double indemnity rider. (b) double trigger option. (c) multiple protection policy. (d) other insurance provision. Answer: B
6.
Which statement is (are) true with respect to enterprise risk management programs? I. They address traditional property, liability, and personnel loss exposures. II. They do not address financial risks. (a) I only (b) II only (c) both I and II (d) neither I nor II Answer: A
7.
A comprehensive risk management plan that addresses an organization’s pure risks, speculative risks, strategic risks, and operational risks is called a(n) (a) risk management information system. (b) financial risk management plan. (c) speculative risk management plan. (d) enterprise risk management plan. Answer: D
8.
The property and liability insurance industry is characterized by a repetitive pattern of loose underwriting standards with low premiums followed by tight underwriting standards with high premiums. This repetitive pattern is called the (a) ratemaking oscillation. (b) business cycle. (c) underwriting cycle. (d) claims circulation. Answer: C
9.
Which statement is (are) true regarding property and liability insurance market conditions? I. Premiums are high when the insurance market is “hard.” II. Underwriting standards are tight when the insurance market is “soft.” (a) I only (b) II only (c) both I and II (d) neither I nor II Answer: A
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10.
Which of the following statements is true regarding insurance market conditions and underwriting results? (a) A combined ratio greater than one (or 100 percent) indicates profitable underwriting. (b) In a “soft” insurance market, more retention is used than in a “hard” insurance market. (c) Insurance rates are high and underwriting standards are tight when the insurance market is “hard.” (d) Property and liability insurance premiums and underwriting standards do not fluctuate over time. Answer: C
11.
The relative level of surplus in the insurance industry is called the industry’s (a) capacity. (b) liabilities. (c) reserves. (d) admitted assets. Answer: A
12.
Which of the following statements is (are) true regarding investment returns and the underwriting cycle? I. Investment returns have no impact upon the underwriting cycle. II. Investment returns can lengthen the duration of a soft market by offsetting underwriting losses. (a) I only (b) II only (c) both I and II (d) neither I nor II Answer: B
13.
A large property and liability insurance company merged with a bank and then acquired a stock brokerage company. This type of merger and acquisition activity is categorized as (a) insurance company consolidation. (b) cross-industry consolidation. (c) financial risk management. (d) insurance brokerage consolidation. Answer: B
14.
A risk manager has a fleet of 200 vehicles. On average, 50 vehicles per year experience property damage. What is the probability that any vehicle will be damaged in any given year? (a) 10 percent (b) 20 percent (c) 25 percent (d) 50 percent Answer: C
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15.
RST Company has production facilities in Salt Lake City and Cleveland. The probability that in any given year a fire will damage the production facility in Salt Lake City is 5 percent. The probability that in any given year a fire will damage the Cleveland production facility is 4 percent. What is the probability that BOTH production facilities will be damaged by fire in any given year? (a) 0.20 percent (b) 2.00 percent (c) 4.50 percent (d) 9.00 percent Answer: A
16.
RST Company has production facilities in Salt Lake City and Cleveland. The probability that in any given year a fire will damage the production facility in Salt Lake City is 5 percent. The probability that in any given year a fire will damage the Cleveland production facility is 4 percent. What is the probability that AT LEAST ONE of the production facilities will be damaged by fire in any given year? (a) 0.20 percent (b) 2.00 percent (c) 8.80 percent (d) 9.00 percent Answer: C
17.
Some events cannot occur together because the occurrence of one event makes the occurrence of the second event impossible. Such events are called (a) dependent events. (b) independent events. (c) conditional events. (d) mutually exclusive events. Answer: D
18.
Two buildings are located close together at a production facility. The probability that either of these buildings will experience a fire loss is 4 percent. However, if one building has a fire, the probability that the second building will have a fire is 60 percent. What is the probability that both buildings will have a fire? (a) 1.6 percent (b) 2.4 percent (c) 8.0 percent (d) 64.0 percent Answer: B
19.
Which of the following statements is (are) true with regard to probability analysis? I. Independent events cannot occur together. II. If events are dependent, the occurrence of one event affects the occurrence of the second event. (a) I only (b) II only (c) both I and II (d) neither I nor II Answer: B
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20.
Jane is risk manager of ABC Manufacturing Company. She is trying to decide whether to self-insure her company’s workers compensation exposure or to purchase insurance. Jane would like to use regression analysis to predict the number of workers compensation claims that will occur next year. The number of claims will be the dependent variable in the regression. All of the following would be reasonable independent variables to use EXCEPT (a) number of employees. (b) number of hours worked. (c) total assets. (d) payroll. Answer: C
21.
A method of characterizing the relationship between two or more variables and then using the characterization to make a prediction is called (a) loss analysis. (b) time value of money analysis. (c) regression analysis. (d) capital budgeting. Answer: C
22.
A distribution showing losses that could occur and the corresponding chance that each loss could occur is called an (a) underwriting cycle. (b) capital budget. (c) loss distribution. (d) risk map. Answer: C
23.
Which of the following statements is (are) true with respect to the time value of money? I. Money received today is worth more than the same amount of money received in the future. II. The present value of a future amount is greater than the future amount. (a) I only (b) II only (c) both I and II (d) neither I nor II Answer: A
24.
Calculating the present value of a future amount is called (a) interpolating. (b) discounting. (c) compounding. (d) regression analysis. Answer: B
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25.
The process of determining which set of investments in plant and equipment to undertake is called (a) regression analysis. (b) loss forecasting. (c) time value of money. (d) capital budgeting. Answer: D
26.
Which of the following statements is (are) true regarding the net present value of a capital investment? I. Net present value does not consider time value of money. II. A positive net present value represents an increase in value to the firm. (a) I only (b) II only (c) both I and II (d) neither I nor II Answer: B
27.
Millie is risk manager of JKL Company. She is considering an investment in a loss control project. The project will cost $40,000. Assuming a 10 percent discount rate, the present value of the future cash flows that this project will generate is $60,000. What is the net present value (NPV) of this project? (a) $20,000 (b) $26,000 (c) $60,000 (d) $100,000 Answer: A
28.
A computerized data base that permits risk managers to store and analyze risk management data is called a (a) risk management information system. (b) risk management Intranet. (c) risk management web site. (d) risk map. Answer: A
29.
A grid charting the potential frequency and severity of losses is called a (a) risk management information system. (b) risk management Intranet. (c) risk management web site. (d) risk map. Answer: D
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Which of the following statements is (are) true with regard to the use of technology in risk management programs? I. Risk management Intranets are web sites with search capabilities designed for an internal audience. II. Risk management information systems can be used to store and track workers compensation claims data. (a) I only (b) II only (c) both I and II (d) neither I nor II Answer: C
31.
Terrorists attacked the World Trade Center on September 11, 2001. The attack simultaneously created large losses for life insurers, property insurers, workers compensation insurers, health insurers, and liability insurers. What name is given to an event that simultaneously creates large losses in several lines of insurance? (a) speculative loss (b) clash loss (c) retroactive loss (d) consequential loss Answer: B
32.
Which of the following was a consequence of passage of the Financial Modernization Act (GrammLeach-Bliley)? (a) Formation of insurers was made easier because capital requirements were reduced. (b) It became easier for insurers to conduct business as they were no longer required to be licensed in each state where they operate, but only in the state where they are domiciled. (c) Insurers were required to prepare financial statements using generally accepted accounting principles (GAAP) instead of statements prepared using statutory accounting. (d) Depression-era barriers between underwriting risk, depository functions, and securities underwriting were eliminated. Answer: D
33.
The transfer of insurable risk to the capital markets through the creation of a financial instrument is called (a) coefficient of risk. (b) securitization of risk. (c) financial risk management. (d) enterprise risk management. Answer: B
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34.
LMN Insurance Company is concerned about its exposure to hurricane losses for property risks it insured on the Gulf Coast. LMN borrowed money from investors by issuing financial securities. LMN promised to repay the money it borrowed with interest provided hurricane losses do not exceed a specified level. If hurricane losses exceed the specified level, LMN will repay less than it borrowed and use the extra money to fund hurricane losses. The securities that LMN issued are (a) call options. (b) futures contracts. (c) weather options. (d) catastrophe bonds. Answer: D
35.
Hedge Fund Company offers a mutual fund to investors. Fund managers are concerned about fund volatility. They analyzed the fund to determine the worst loss likely to occur in a calendar quarter, assuming a 90 percent level of confidence. The worst probable loss is known as the fund’s (a) unrealized capital gain. (b) value at risk. (c) beta coefficient. (d) surrender value. Answer: B
36.
Reasons to adopt an enterprise risk management plan include all of the following EXCEPT (a) to increase earnings volatility. (b) to treat risks facing the business in a more holistic way. (c) to increase net income. (d) to gain an advantage over competitors. Answer: A
37.
Which of the following statements concerning the securitization of risk is (are) true? I. Securitization increases the capacity of the insurance industry. II. Securitization can be used to protect against catastrophic loss. (a) I only (b) II only (c) both I and II (d) neither I nor II Answer: C
