Financial Markets and Institutions Questions With Answers (University of Technology Jamaic, Exams of Nursing

Download Financial Markets and Institutions Questions With Answers (University of Technology Jamaic and more Exams Nursing in PDF only on Docsity! lOMoARcPSD|8617767 lOMoARcPSD|8617767 Financial Markets and Institutions Questions With Answers (University of Technology Jamaica) Chapter 1 Risk and Its Management Multiple Choice 1. The major types of business risk include all of the following except: a. price risk b. diversification risk c. pure risk d. credit risk Answer: b Type: K 2. Credit risk is: a. the risk that a firm’s borrowers will not make promised payments. b. the risk that a firm will not be able to get credit from lenders. c. the risk that a firm will not have sufficient funds to make payments to their creditors. d. the risk due to changes in output and input prices. Answer: a Type: K 3. All of the following are types of price risk except: a. commodity price risk b. exchange rate risk c. stock price risk d. interest rate risk Answer: c Type: K 4. Which of the following is not an example of a direct loss from pure risk? lOMoARcPSD|8617767 a. loss of profit b. damage to assets c. cost of paying and defending liability claims d. employee turnover Answer: a Type: A 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. Answer: c Type: A 6. Which of the following is not a method of loss financing? a. diversification b. retention c. insurance d. hedging Answer: a Type: K 7. Driving at lower speeds in order to reduce the probability of having an automobile accident is an example of: a. loss financing b. loss control c. internal risk reduction d. hedging Answer: b Type: A 8. 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. eliminate airplane crashes d. no impact on risk of airplane crashes Answer: a Type: A lOMoARcPSD|8617767 4. Three methods of financing losses are: retention , insurance , and hedging . (Answer could also include other contractual risk transfers.) 5. The major types of risk that produce fluctuations in cash flows and business value are price risk, credit risk, and pure risk. II. Problems and Short Answer Questions 1. What are the most important characteristics of pure risk as compared to other types of risk? Answer: The most important characteristics of pure risk include: a) the losses have the potential to be large relative to the business’ resources; b) the underlying causes are company-specific and the firm can take actions to reduce frequency and severity; c) they are often insurable; and d) there are not usually any offsetting gains to other parties. Type: K 2. Provide a brief outline of the steps in the risk management process. Answer: The key steps in the risk management process are: a) identify the risks; b) evaluate the potential frequency and severity of the losses; c) select the risk management methods to be used; d) implement the risk management methods; and e) monitor the risk management program on a regular basis. Type: K 3. Rocky’s Bagels, Inc. is a small bagel sandwich restaurant. Rocky is concerned about the risk of employees cutting themselves on the job. Assuming that Rocky has no interest in expanding his operation, which of the major risk management methods are likely to be most important to Rocky? Which will not be appropriate for Rocky? Explain. Answer: Rocky will need to focus on loss control. He can take increased precautions such as providing employees with instruction on cutting bagels or he can invest in equipment that does not require employees to be near the blades. Loss financing through insurance or retention can be used to cover the cost of losses that do occur but generally insurance for small regular losses will be too expensive. Internal risk reduction will be the least useful, since Rocky cannot diversify away this risk and additional information is not likely to reduce the losses. Type: A lOMoARcPSD|8617767 4. Explain how the two major approaches to loss control (reducing the risky activity and increasing precautions) could reduce McDonald’s risk of customer burns due to hot coffee. Answer: Although McDonalds would not want to reduce coffee sales, they could reduce the risk by reducing the temperature of the coffee they serve. Increased precautions could include warning labels on cups and on coffee urns. Type: A 5. Fraternities on college campuses are exposed to significant risks from serving alcohol at social functions. What are some of the direct and indirect costs of this risk? Answer: Direct costs include damage to fraternity property or guests during parties, potential liability for injuries caused by party attendees, costs of fines imposed. Indirect costs include potential loss of charter from national fraternity or the sponsoring university, reduced membership if reputation of fraternity is damaged. Type: A 131 lOMoARcPSD|8617767 Chapter 2 Objective of Risk Management I. Multiple Choice 1. The fundamental objective of risk management is: a. diversification b. minimize the cost of risk c. hedging d. loss control Answer: b Type: K 2. If unexpected increases in losses from price risk are not offset by cash inflows from insurance contracts, hedging arrangements or other contractual risk transfers, they will result in: a. an increased stock price b. a reduced stock price c. bankruptcy d. increased diversification Answer: b Type: K 3. Johnson Incorporated, located in California, had a $1 million uninsured loss due to an earthquake in 1997. What impact is this likely to have on the firm’s value? a. It will have no impact. b. The firm value will increase by $1 million. c. The firm value will decrease by $1 million. d. The firm value will probably decrease, but the amount of decline will depend on other factors such as the firm’s level of diversification of risk. Answer: d Type: A lOMoARcPSD|8617767 12. By increasing spending on safety equipment Charly’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. tradeoff between loss control costs and expected direct losses c. tendency of business firms to spend too little on loss control d. importance of loss control Answer: b Type: A 13. Which one of the following is not a determinant of value of a business firm? a. expected magnitude of the firm’s future cash flows b. expected timing of the firm’s future cash flows c. expected variability of the firm’s future cash flows d. all of the above are determinants of a firm’s value Answer: d Type: K 14. JoPro Inc. and Thron Company both have the same level of expected cash flows, with JoPro’s cash flows subject to greater variability. Which of the following statement best describes how risk adverse investors will view these shares? a. The investors will only be willing to purchase the shares of Thron Company. b. The investors will be willing to purchase all of the shares of Thron Company but only a few of the shares of JoPro Inc. c. The investors will pay a lower price for the shares of JoPro Inc. than they will for Thron Company’s shares, thereby increasing the expected return on the dollars invested in JoPro shares. d. The investors will pay a higher price for the shares of JoPro Inc. than they will for Thron Company’s shares, thereby increasing the expected return on the dollars invested in JoPro shares. Answer: c Type: A 135 lOMoARcPSD|8617767 15. 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. transactions costs involved with making hedging arrangements d. opportunity cost of maintaining self-insurance loss reserves Answer: a Type: A II. Fill-Ins 1. The overall objective of risk management for “for-profit” businesses is to minimize the cost of risk . 2. The costs incurred by shareholders in monitoring managerial behavior are known as a gency costs. 3. The cost of risk includes the expected cost of losses, the cost of loss control , the cost of loss financing , and the cost of internal risk reduction , and the cost of any residual uncertainty after the other risk reduction methods have been implemented. 4. In estimating the cost of risk, tradeoffs will normally exist between the expenditures on loss control and the cost of direct and indirect losses . 5. If a person facing two risky alternatives, whose expected outcomes are the same, chooses the alternative with less variability, this person is risk adverse . III. Problems and Short Answer Questions 1. Managers may have incentives to take action that benefit themselves at the expense of the shareholders. What factors give them incentives to act consistently with shareholder value maximization? Answer: Factors that give managers incentives to act consistently with shareholder value maximization include: compensation linked to performance; takeover risk for firms that are undervalued; the potential for lower product prices when costs are not adequately controlled by management; monitoring by other stakeholders; and potential fiduciary liability. Type: K lOMoARcPSD|8617767 2. When will minimizing the cost of risk also maximize the value of the firm. Answer: If the firm's cost of risk is defined to include all of the effects of risk and risk management on firm value - minimizing the cost of risk will maximize shareholder value. Type: K 3. Describe the most important components of the cost of risk that apply to the risk of shoplifting at a convenience store. Answer: The most important components of the cost of risk for the convenience store are: a) the expected cost of lost inventory; b) the expected cost of indirect losses such as reduction in profits; c) cost of loss control such as extra expenses of inventory management, mirrors, additional personnel; d) the cost of insurance or retention to cover lost inventory. Type: A 4. How does the overall objective of risk management differ for a non-profit organization, such as your local food bank, which does not have shareholders? Answer: Since non-profits do not have shareholders, they generally will be attempting to maximize the value of products or services provided to their customers or constituents. The cost of risk for such a firm will be the reduction in value of the firm’s activities to their constituents. The food bank will be trying to provide the largest amount of food to the largest number of people at the lowest cost they can. Minimizing the risk of losses due to food spoilage, theft, or liability claims will help to achieve this goal. Type: A 5. If all for-profit firms act to minimize the cost of risk and thereby maximize shareholder value, will this also minimize the societal cost of risk? Why or why not? Answer: If risk management decisions reflected all the costs that risk creates for other parties, then the individual firms’ risk management activities would also minimize societal risks. However, there are many risks that are imposed on society but are not reflected in the cost of risk for the individual firms. Since 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. Type: K 137 140 lOMoARcPSD|8617767 d. There is not enough information to answer this question. Answer: b Type: A 7. Which distribution(s) exhibit(s) skewness? a. Distribution X only b. Distribution Y only c. Both X and Y are skewed. d. Neither distribution is skewed. Answer: c Type: A 8. 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 Answer: a Type: A 9. Which of the following pairs of random variables are likely to be uncorrelated? a. total health care costs in New York City for 1997; total health care costs in New York City for 1998 b. total property damage due to wildfires in Colorado in 1997; total property damage due to wildfires in California in 1998. c. number of people who die from cancer in the US in 1997; number of people who die from cancer in the US in 1998. d. worker injuries at a shoe manufacturing plant owned and managed by Exodus Incorporated; worker injuries at a different shoe manufacturing plant owned and managed by Exodus Incorporated. Answer: b Type: A 10. Unidentified risk exposures will result in: a. reduced insurance premiums b. increased insurance premiums c. implicit retention lOMoARcPSD|8617767 d. purchasing too much insurance Answer: c Type: K 11. When estimating property loss exposure, which of the following methods for valuing property is the least relevant measure for risk managers? a. book value b. market value c. firm specific value d. replacement cost Answer: a Type: K 12. The number of losses in a given period of time is known as: a. loss severity b. loss frequency c. total losses d. the loss distribution Answer: b Type: K 13. The magnitude of loss per occurrence is known as: a. loss severity b. loss frequency c. total losses d. the loss distribution Answer: a Type: K 14. The expected loss per exposure is: a. the expected frequency per exposure. b. the expected severity per occurrence. c. the expected frequency per exposure times the expected severity per occurrence all divided by the number of exposures. d. the expected frequency per exposure times the expected severity per occurrence. Answer: d Type: K 141 142 lOMoARcPSD|8617767 15. Darunee Inc. has estimated that ½ of their twenty workers will be injured in the coming year. The expected severity per occurrence is $1,000. What is the expected loss per exposure? a. $1,000 b. $10 c. $10,000 d. $500 Answer: d Type: K 16. Which of the following is not a key feature of loss distributions that would be considered by risk managers? a. expected value b. standard deviation c. maximum probable loss d. least probable loss Answer: d Type: K II. Fill-Ins 1. A random variable is a variable whose outcome is uncertain. 2. A probability distribution identifies all the possible outcomes for a random variable and the probability of each outcome. 3. A common statistical measure of the risk of a random variable is the standard deviation (or variance) . 4. If a probability distribution is not symmetrical, as in the case of liability losses, the distribution is said to be skewed . 5. A firm that is concerned about losses due to temporary shut-down of its manufacturing facility following a fire can purchase business interruption insurance. III Problems and Short Answer Questions 1. Jack Sprat Wholesale Meats, Inc. is faced with the following probability distribution for losses due to meat spoilage: lOMoARcPSD|8617767 5. Fill-in the second column of the following table to indicate if the specific variables, or exposures, for the identified group(s) or context are most likely positively correlated, negatively correlated, or uncorrelated. Variables or Exposure Correlation Unemployment amongst a group of factory workers The number of auto accidents, in a given year, for each resident of Omaha Natural gas demand and winter temperatures in Minnesota Total damage from house fires in South Dakota and total damage from house fires in Arizona Number of days with rainfall and volume of paying customers at a public outdoor swimming pool. Flood damages to homes in Southern Louisiana. Answer: Variables or Exposure Correlation Unemployment amongst a group of factory workers positive The number of auto accidents, in a given year, for each resident of Omaha uncorrelated Natural gas demand and winter temperatures in Minnesota positive Total damage from house fires in South Dakota and total damage from house fires in Arizona uncorrelated Number of days with rainfall and volume of paying customers at a public outdoor swimming pool. negative Flood damages to homes in Southern Louisiana. positive Type: A 145 lOMoARcPSD|8617767 146 Chapter 4 Pooling Arrangements and the Diversification of Risk I. Multiple Choice 1. Which of the following is not a type of contracting cost associated with the creation and operation of pooling arrangements: a. distribution costs b. underwriting expenses c. premiums d. loss adjustment expenses Answer: c Type: K 2. Insurers that rely, to some degree, on exclusive agents to sell their policies are known as: a. mutuals b. direct writers c. independents d. brokers Answer: b Type: K 3. The process of identifying (or estimating) a potential insurance buyer’s expected loss is known as: a. underwriting b. risk management c. loss adjusting d. insurance distribution Answer: a Type: K 4. Insurance distribution costs may include all of the following except: a. advertising and marketing expenses b. agent commissions c. mailing costs d. underwriting expenses lOMoARcPSD|8617767 Answer: d Type: A 5. Under what circumstance will a pooling arrangement result in reduced risk (standard deviation) to the participants in the pool? a. only when losses are perfectly positively correlated b. when losses are high c. only when losses are negatively correlated d. whenever losses are less than perfectly positively correlated Answer: d Type: K 6. According to the effect of the law of large numbers on a pooling arrangement, the greater the number of participants in the risk pool, a. the less likely the actual average loss will approach the expected (per participant) loss b. the more closely the actual average loss will approach the expected (per participant) loss c. the greater will be the skewness of the pool’s loss distribution d. the greater will be the pool’s correlation Answer: b Type: K 7. Bilbo has just purchased an insurance policy (and thereby joined a risk-pool). Bilbo paid an ex ante premium and did not give the insurer ex post assessment rights. These means a. Bilbo does not have the right to collect losses greater than his ex ante premium b. The insurer does not have the right to deny claims that are less than the agreed upon ex post amount. c. Bilbo is not required to assess the insurer. d. The insurer cannot request further premium from Bilbo should the risk-pool experience a bad loss. Answer: d Type: K 8. Risk-pooling arrangements a. reduce the risk faced by each member of the risk-pool b. increase the likelihood of small loss events c. are used only for liability exposures 147 150 lOMoARcPSD|8617767 II. Fill-Ins 1. The process of estimating a potential insured’s expected loss is known as underwriting . 2. Insurers that rely on exclusive agents, employees, or direct response methods are known as direct writers . 3. A pooling arrangement is less effective at reducing participants risk exposure if the participant losses are positively correlated. 4. Their ability to operate with an efficient level of contracting costs are the main reason that insurers exist and specialize in the formation of pooling arrangements. 5. The amount of risk reduction increases as more participants are added to a pooling arrangement, provided the losses are uncorrelated across participants. III Problems and Short Answer Questions 1. Explain the main economic functions of insurance institutions. Answer: The main economic function of insurance institutions is to provide an efficient mechanism for economizing on contracting costs associated with pooling of losses. Type: K 2. Compare insurer pooling arrangements with a well-diversified portfolios of stock shares. Answer: Insurance pools and well diversified stock portfolios are, in principle, nearly similar. Both are mechanisms for reducing risk. Predicting the outcome of a set of pooled (and uncorrelated) risks can be done more reliably than predicting the outcome of a single risk. The larger the number of risks in the pool, the smaller is the variance of expected outcomes. 3. Use the following table of information. Probability of Loss Outcomes Chayanee Yanisa Loss Outcome #1 .15 $1,500 $1,000 Loss Outcome #2 .85 $0 $100 lOMoARcPSD|8617767 (1,500  225)2 (.15)  (0  225)2 (.85) (1,000  235)2 (.15)  (0  235)2 (.85) a. What is Chayanee’s expected loss and standard deviation of expected loss? b. What is Yanisa’s expected loss and standard deviation of expected loss? c. Chayanee’s and Yanisa’s outcomes are independent of one another, so they decide to form a risk pool and share the losses equally. Construct a table displaying the Chayanee’s portion of the possible outcomes of the sharing arrangement and the probabilities thereof. What is the expected loss and standard deviation of expected loss for Chayanee’s outcome from the sharing arrangement? Answer: a. For Chayanee : Expected Losses  1,500(.15)  0(.85)  225 Standard Deviation of Losses   $535.61 b. For Yanisa : Expected Losses  1,000(.15)  100(.85)  235 Standard Deviation of Losses   $321.36 c. For the pooling arrangement: Possible Loss Outcomes of Pooling Arrangement Chayanee’s Portion of the Pooled Outcome Probabilities of Loss Outcomes 0 + 100 = $100 $50 (.85)(.85) = .7225 0 + 1000 = $1,000 $500 (.85)(.15) = .1275 1,500 + 100 = $1,600 $800 (.15)(.85) = .1275 1,500 + 1,000 = $2,500 $1,250 (.15)(.15) = .0225 Chayanee’s expected loss from the pooling arrangement: 50(.7225)  500(.1275)  800(.1275)  1,250(.0225)  $230 Chayanee’s standard deviation of expected loss from the pooling arrangement: (50  230) 2 (.7225) (500  230) 2 (.1275) (800  230) 2 (.1275) (1,250  230) 2 (.0225)  $312.31 4. Suppose that Peter Piper has a wholesale meat business similar to Jack Sprat and is exposed to an identical loss distribution from meat spoilage as defined in Problem 1. If Jack and Peter enter into a pooling agreement whereby they agree to split the costs of any losses that occur. a. Make a table that shows the possible total loss outcomes that Jack and Peter will have to split, with their associated probabilities. b. What is the expected value of each person’s loss share? c. Will the standard deviation of expected losses for each person in the pool be the same? Why or why not? 151 lOMoARcPSD|8617767 152 Answer: a. Possible Outcomes Probability Total Loss Loss to Each J($0) P($0) .2 x .2 = .04 $0 $0 J($0) P($100) .2 x .6 = .12 $100 $50 J($0) P($1,000) .2 x .2 = .04 $1,000 $500 J($100) P($0) .6 x .2 = .12 $100 $50 J($100) P($100) .6 x .6 = .36 $200 $100 J($100) P($1,000) .6 x .2 = .12 $1,100 $550 J($1,000) P($0) .2 x .2 = .04 $1,000 $500 J($1,000) P($100) .2 x .6 = .12 $1,100 $550 J($1,000) P($1,000) .2 x .2 = .04 $2,000 $1,000 b. Expected value for each participant = .04(0) + .12(50) + .04(500) + .12(50) + .36(100) + .12(550) + .04(500) + .12(550) + .04(1000) = $260 c. The standard deviation will be lower than $372 as long as Jack Sprat’s and Peter Pipers loss distributions are not perfectly correlated with each other. Type: A 5. Pooling arrangements are designed to reduce the risk to members of the pool. Explain the impact on risk reduction as the number of participants in the pool increase, all other factors equal. What happens to the expected cost of risk per participant as the pool size increases? Answer: The amount of risk that can be reduced through pooling arrangements increases as the number of participants increases, all other factors equal. The expected cost of risk per participant will stay the same. Type: K lOMoARcPSD|8617767 8. (Use information from Question #7) If Jennifer believes that her true probabilities for each possible loss outcome are half as high as the insurer has estimated, what is the percentage loading on the policy from her perspective? (Note: This means Jennifer believes her probability for $0 loss is .60) a. 10% b. 20% c. 120% d. 200% Answer: c Type: A 9. The main reason that diversified shareholders might not want their corporate managers to purchase insurance is that: a. they like risk b. they have already diversified away the risk that is being insured c. they are risk averse d. cash flow variability increases their return on investment Answer: b Type: A 10. The main tax benefit of insurance from a corporate shareholder’s perspective is due to: a. the tax deductibility of insurance payments b. the different treatment of gains and losses under the tax code c. the progressive nature of the corporate tax schedule d. the double taxation of corporate profits Answer: c Type: K 11. What is the risk premium of a gamble whereby the participant has a .55 chance of winning $1,000 or a .45 chance of losing $1,000. a. $10 b. $15 c. $100 d. $150 Answer: c Type: A 155 lOMoARcPSD|8617767 156 12. Due to premium loading, people generally pay insurance premiums that are greater than their expected claim costs. A risk adverse individual may be willing to pay this additional amount because insurance reduces risk. This ‘additional amount’ that a person is willing to pay to reduce risk is an example of a a. gamble b. risk premium c. down payment d. risk neutral transaction Answer: b Type: A 13. As a person’s wealth increases it is likely that their degree of risk aversion will a. decline b. stay the same c. increase d. cannot tell since wealth and risk aversion are not related Answer: a Type: K 14. Law of Demand: As price increases, the quantity demanded decreases. In the context of fair insurance premiums, the relevant ‘price’ that determines quantity demanded is a. premium loading b. present value of expected claims costs c. expected loss amount d. discount rate Answer: a Type: A 15. Which one of the following is not a reason for a publicly held, widely traded, business to purchase insurance? a. to provide efficient claims processing and loss control services b. reduce the expected cost of loss financing c. reduce expected tax payments d. reduce the owners’ risk Answer: d Type: K lOMoARcPSD|8617767 II. Fill-Ins 1. If Mary has a preference for a definite payment of $100 over a risky gamble that has an expected value of $100, she is risk averse . 2. Even a risk averse person may choose not to buy insurance if the premium loading is too high relative to the expected loss. 3. People who have greater income (or wealth) may be less likely to purchase insurance. 4. If Rocky Road, Inc.’s shareholders all have diversified portfolios, they may not want the firm’s managers to buy insurance. 5. Even if corporate insurance does not reduce the shareholders’ risk, it may provide other benefits such as more efficient claims processing , lower cost financing of losses , and reduced tax payments . (Other answers include: reduced likelihood of financial distress and better contract terms with the firm’s stakeholders.) III. Problems and Short Answer Questions 1. “The purchase of insurance is not value-maximizing for firms with well-diversified corporate shareholders.” Explain the logic of this statement. Answer: Diversification of the portfolio is a mechanism whereby a shareholder can reduce the variability of returns due to pure risks. Therefore, since insurance and diversification achieve the same outcome, the use of both may be redundant and may impose unnecessary costs on the shareholders. Type: A 2. Explain why a corporation might still want to purchase insurance despite the fact that its shareholders are well-diversified. Answer: Business insurance purchases can: a) be an efficient method of purchasing claims processing and loss control services; b) reduce the expected cost of financing losses; c) reduce the likelihood that the firm will have to raise costly external capital for new investment projects and thereby increase the likelihood that it will adopt good investment projects; d)reduce the likelihood of financial distress and thereby improve the terms on which the firm contracts with other claimants, such as employees, suppliers, lenders, and customers; and e) reduce expected tax payments. Type: A 157 lOMoARcPSD|8617767 160 Answer: b Type: A 5. The conditions necessary for moral hazard to arise in insurance contracts include all of the following except: a. The expected losses must depend in part on the insured’s behavior b. The insurer must have some ability to impact the insured’s behavior c. It must be costly for the insurer to observe policyholder behavior d. It must be costly for the insurer to measure the impact of policyholder behavior on expected claim costs Answer: b Type: K 6. Which of the following is not a method of reducing the impact of moral hazard on expected claim costs? a. deductibles b. experience rating c. careful risk classification d. careful investigation of claims Answer: c Type: K 7. Insurers use deductibles to: a. reduce claims processing costs b. reduce moral hazard problems c. mitigate adverse selection problems d. all of the above Answer: d Type: K 8. Health insurance policies often have coinsurance provisions that require the policyholder to pay a. a minimum amount of claims in a given year before the insurance company will be responsible for payment. b. the first $500 of all claims c. all of the claims that exceed the policy limits d. a specified proportion of every loss Answer: d lOMoARcPSD|8617767 Type: A 9. The primary limiting factor on the insurability of a high frequency, low severity loss exposure is a. high administrative costs b. high capital costs c. the moral hazard problem d. adverse selection Answer: a Type: A 10. Thom 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 Thom has knee surgery that costs $5,000, he can recover a. $5,000 from each insurer since the full premium has been paid for that coverage. b. $5,000 from his own insurer only. c. $2,500 from each insurer. d. $5,000 from his own insurer who will then try to collect $2,500 from Judy’s insurer. Answer: c Type: A 11. An insurance contract which specifies that the insurer pay a pre-set amount upon the occurrence of a loss is called: a. a valued contract b. an indemnity contract c. a coinsurance contract d. an insurance-to-value contract Answer: a Type: K 12. The legal principle which states that an insurance policy cannot pay more than the financial loss suffered is called the principle of: a. insurable interest b. moral hazard c. adhesion d. indemnity Answer: d 161 lOMoARcPSD|8617767 162 Type: K 13. Since insurance contracts are generally standard forms with many detailed provisions drawn up by the insurer, they are considered to be: a. contracts of adhesion b. unenforceable if the insured cannot negotiate terms c. insurable interests d. contrary to the indemnity principle Answer: a Type: K 14. If an insurance buyer has intentionally concealed information from the insurer, the legal remedy in most states is that: a. the policyholder can be sued for bad faith b. the insurer can void the contract c. the insured can void the contract d. both b and c Answer: b Type: K 15. Janet needs to purchase property coverage on her downtown business building. The building is worth $150,000. The insurer has an insure-to-value (coinsurance) requirement of 80%. If Janet purchases $80,000 of property coverage what proportion of each loss (should one occur) will the insurer pay? a. 3/4 b. 2/3 c. 8/10 d. 10/12 Answer: b Type: A II. Fill-Ins 1. The three major factors that limit insurability of risk in private insurance markets are: premium loadings , moral hazard , and adverse selection . 2. John has full insurance on his car. John’s tendency to leave his car unlocked when he goes to the mall is an example of moral hazard . lOMoARcPSD|8617767 Use the following information to answer questions 5-8. Happy Time Day Camp has the following distribution for its annual liability costs: Loss = $2,000,000 with probability .0001 $100,000 with probability .001 $5,000 with probability .1 $0 with probability .8989 5. What are the expected claim costs for Happy Time? Answer: ($2,000,000)(.0001) + ($100,000)(.001) + ($5,000)(.1) = $800 Type: A 6. If an insurer offered Happy Time a policy with 50% coinsurance, what are the expected claim costs on this policy? Answer: ($1,000,000)(.0001) + ($50,000)(.001) + ($2,500)(.1) = $400 Type: A 7. If an insurer offered Happy Time a policy with a $5000 annual deductible, what are the expected claim costs on this policy? Answer: ($1,995,000)(.0001) + ($95,000)(.001) = $294.50 Type: A 8. If an insurer offered Happy Time a policy with a $500,000 limit, what are the expected claim costs on this policy? Answer: ($500,000)(.0001) + ($100,000)(.001) + ($5,000)(.1) = $650 Type: A 165 lOMoARcPSD|8617767 166 Chapter 11 Loss Control I. Multiple Choice 1. 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 Answer: c Type: K 2. Loss Prevention activities are aimed at reducing the a. frequency of losses b. size of a loss (for if and when a loss occurs) c. probability of loss to zero d. all of the above Answer: a Type: K 3. FunFun Toys produces assorted toy rockets. It has discovered that its water pressure rockets have a tendency to tip over just before take off thereby flying parallel, and low, to the ground. FunFun has decided to quit producing this toy rocket. This is an example of a. loss control b. loss prevention c. loss avoidance d. all of the above Answer: d Type: A 4. Loss Reduction activities are aimed at reducing the a. frequency of losses b. size of a loss (for if and when a loss occurs) c. probability of loss to zero d. all of the above lOMoARcPSD|8617767 Answer: b Type: K 5. 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 Answer: b Type: K 6. Insurance coverage can reduce the incentives to undertake loss control activities if insurers a. help pay for the loss control b. don’t reduce insurance premiums to reflect the effects of the loss control activities c. pay for losses anyway d. lower premiums after loss control is implemented Answer: b Type: K Use the following information to answer questions 7-10. PTM Inc. is evaluating a loss control plan. The costs and benefits are as follows; (Ignore the implications of possible reduced insurance premiums.) Today End of Year 1 End of Years 2-5 Loss Control Expenditures $10,000 $4,000 0 Reduction in Expected Losses 0 $3,400 $3,400 7. Using a cost of capital of 6%, what is the present value of the loss control expenditures (rounded to the nearest dollar)? a. $14,000 b. $13,774 c. $12,994 d. $12,755 Answer: b 167 lOMoARcPSD|8617767 Downloaded by Ashraf Nader (muntahashams51@gmail.com) 170 Answer: d Type: A 15. What is the economically efficient level of loss control spending? a. $160,000 b. $240,000 c. $320,000 d. $400,000 Answer: b Type: A II. Fill-ins 1. Loss control refers to efforts that reduce expected losses . 2. Loss prevention activities attempt to reduce the expected frequency of losses. 3. Loss reduction activities attempt to reduce the size of a loss should one occur. 4. The installation of a sprinkler system is an example of activity . pre-loss (loss reduction) 5. Segregation of exposure units is an example of risk diversification that will reduce the expected severity of losses. 6. The value of a human life can be computed implicitly from assorted decisions made by individuals and other organization. III. Problems and Short Answer Questions 1. Describe the similarities between ‘segregation of exposures units’ and risk pooling. Answer: Both of these activities are a form of risk diversification. Both methods will typically not reduce expected losses, but will reduce the expected severity of losses by lowering the probability of very large losses. Segregation of exposure units will divide what might otherwise be a very large loss exposure into several smaller exposures. Type: K lOMoARcPSD|8617767 Downloaded by Ashraf Nader (muntahashams51@gmail.com) 2. BigTime manufacturing has substantial warehousing needs for raw materials. It currently faces the choice of building a single $12 million facility or three separate $4 million facilities. Each facility faces the following loss distribution. (The separate facilities are statistically independent.) Probability of Loss Percent of Value Lost .03 100 .02 50 .95 0 a) What is the expected loss for each warehousing choice? b) What is the probability of a $12 million loss for warehousing choice? c) Having the three separate facilities will reduce the expected severity of losses. What are some disadvantages to this segregation of loss exposures? Answer: a) Expected loss for the $12 million facility is (.03)$12,000,000+(.02)$6,000,000+(.95)0 = $480,000 Expected loss for each of the $4 million facilities is (.03)$4,000,000+(.02)$2,000,000+(.95)0 = $160,000 Since $4 million facilities are independent, their total expected loss is (3)$160,000 = $480,000 b) The probability of a $12 million loss for the $12 million facility is .03. Whereas the probability of a $12 million loss for the three segregated facilities is (.03)(.03)(.03) = .00003. c) Some disadvantages to having the three separate facilities might be duplication of labor efforts, increased transportation cost of moving supplies and materials, decreased effectiveness of communication, etc. Type: A 3. What effect can insurance have on loss control activities? Answer: Insurance, by itself, can reduce the incentive to undertake loss control efforts. If the risk is effectively transferred to an insurer, the business firm will think it has little to gain with loss control. This moral hazard aspect of insurance can be mitigated if the insurer reduces the business firm’s insurance premium to reflect the improved loss probabilities. Type: K 171 lOMoARcPSD|8617767 Downloaded by Ashraf Nader (muntahashams51@gmail.com) 172 4. Using the following data determine what level of loss control spending should be undertaken? Loss Control Number of Expenditures $0 $50,000 $100,000 Worker Injuries 200 170 148 Average Injury Severity $150,000 $200,000 130 122 $8,000 $250,000 118 Answer: Loss Control Number of Worker Total Cost Marginal Marginal Expenditures Injuries of Injuries Benefit Cost $0 200 $1,600,000 $50,000 170 $1,360,000 $240,000 $50,000 $100,000 148 $1,184,000 $176,000 $50,000 $150,000 130 $1,040,000 $144,000 $50,000 $200,000 122 $976,000 $64,000 $50,000 $250,000 118 $944,000 $32,000 $50,000 The economically efficient level of loss control spending is $200,000. The next marginal increase of $50,000 only brings $32,000 in benefits. Type: A 5. Most people probably agree that it is very difficult to place a dollar value on human life. Explain what it means to implicitly place a dollar value on human life in ordinary decisions. Answer: Everyday decisions can affect the probabilities of death. Examples of such decisions are an individual’s choice of automobile, some employers’ decision regarding safety equipment, and governmental regulations regarding safety standards. The implicit valuation of human life is found by comparing the amount of money that one spends to reduce the probability of a death. For instance, spending $50,000 to reduce the probability of a death by the increment of .005 implies a value of life equal to ($50,000)/(.005) = $10,000,000. Type: A lOMoARcPSD|8617767 Downloaded by Ashraf Nader (muntahashams51@gmail.com) Answer: b Type: A 9. According to the collateral source rule: a. you cannot get compensation from more than one source for the same injury. b. you must try to mitigate your own damages by requesting compensation from all possible sources c. courts are precluded from reducing damages by the amount of coverage provided by a plaintiff’s life, health, or property insurance. d. none of the above. Answer: c Type: K 10. Which one of the following liability rules frequently applies to products liability cases? a. no liability b. negligence c. strict liability d. absolute liability Answer: c Type: K 11. When the U.S. legal system assigns a liability rule for a general type of loss the system is essentially a. assessing fault b. protecting consumers c. allocating risk d. measuring damages Answer: c Type: K 12. In business liability cases, courts may apply an economic standard for negligence – cost-justified precautions. This standard is met if the business firm a. spent at least 10% of it 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 175 lOMoARcPSD|8617767 Downloaded by Ashraf Nader (muntahashams51@gmail.com) 176 d. has purchased adequate insurance Answer: b Type K 13. 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 Answer: a Type: K 14. Which of the following statements is/are true regarding the objective(s) of the U.S. tort system? a. the system attempts to provide the rights incentives for safety b. the system attempts to provide the right amount of compensation for accident victims c. the system attempts to minimize the cost of risk to society d. all of the above Answer: d Type: K 15. 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) Answer: b Type: K lOMoARcPSD|8617767 Downloaded by Ashraf Nader (muntahashams51@gmail.com) II. Fill-Ins 1. From an economic perspective, the two fundamental objectives of the tort system are to provide incentives for people to engage in the optimal level of safety and to provide optimal compensation to victims 2. The liability rule that is most often used in defective product cases is strict liability. 3. An example of a non-monetary loss is pain and suffering . 4. Compensatory damages in tort liability cases compensate victims for monetary losses such as medical expenses and lost pay . 5. Common law is the body of law that has evolved over time as a result of previous court decisions and not the result of specific legislative actions. 6. The burden of proof under a negligence rule is on the plaintiff . 7. A person or firm is said to be judgment proof if they have insufficient wealth to pay for damages III. Problems and Short Answer Questions 1. What are the main suggestions that have been made for reforming the tort liability system? Answer: Some of the proposals for tort reform are designed to reduce the incentive to bring lawsuits, e.g. limits on contingency fees charged by lawyers, requiring the loser to pay the winner’s legal fees. Other proposals are directed at reducing damage awards, e.g. caps on pain and suffering awards, limits on punitive damages, restrictions on the collateral source rule. Elimination of the joint and several liability rule has been proposed on the grounds that it does little to encourage safety. Type: K 2. Explain how a) consumer information and b) transactions costs imply that the private marketplace will not provide optimal incentives in the absence of a system of legal liability. Answer: Without a legal liability system, transactions would be designed to ensure that each party engages in the optimal level of loss control and payment to injured parties. If one party to the transaction is not fully informed, then there will be insufficient incentives. Similarly, if the transactions costs of contracting with all parties who might cause you injury are too high, then the market will not allocate the 177 lOMoARcPSD|8617767 Downloaded by Ashraf Nader (muntahashams51@gmail.com) 180 Chapter 20 Risk Management and Shareholder Wealth I. Multiple Choice 1. The value of a firm is: a. the present value of the firm’s expected future cash flows. b. impossible to estimate. c. dependent on its capital structure. d. all of the above. Answer: a Type: K 2. Which of the following risks faced by a business firm is most likely to be nondiversifiable? a. explosion at the firm’s plant b. worker injury c. reduced earnings due to poor economic conditions d. a product liability claim Answer: c Type: A 3. 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. Answer: b Type: K 4. Corporate insurance purchases can affect expected cash flows by: a. increasing net cash flows due to premium loadings. b. increasing net cash flows by providing cheaper claim processing. c. decreasing net cash flows by reducing the likelihood of financial distress. d. decreasing net cash flows by reducing expected tax payments. Answer: b lOMoARcPSD|8617767 Downloaded by Ashraf Nader (muntahashams51@gmail.com) Type: K 5. Which of the following is a likely result of the risk of bankruptcy for an airline? a. Managers and employees demand higher levels of compensation. b. The cost of borrowing will be higher. c. Some potential customers will choose to do business with other airlines. d. All of the above. Answer: d Type: A 6. 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. Answer: d Type: K 7. Corporate risk reduction increases shareholder wealth by: a. increasing expected net cash flows. b. decreasing the corporate cost of capital. c. increasing the corporate cost of capital. d. none of the above. Answer: a Type: K 8. When deciding how much insurance to purchase, a firm must compare the insurance premium loading to: a. the cost of capital b. the expected loss c. the expected cost of raising new funds following a loss d. the costs of financial distress Answer: c Type: K 181 lOMoARcPSD|8617767 Downloaded by Ashraf Nader (muntahashams51@gmail.com) 182 9. Financial distress: a. always results in bankruptcy. b. requires that a firm be legally reorganized to restructure the terms of its obligations. c. often imposes costs on parties who have contractual relationships with the firm. d. will not affect the firm’s expected cash flows unless it results in an actual bankruptcy. Answer: c Type: K 10. Watergate Inc. has a main office that is located in a flood plain. How will its lenders react if Watergate does not purchase flood insurance, a. its lenders will be indifferent b. its lenders will probably charge a lower interest rate c. its lenders will structure any loans to reflect the cost of a potential underinvestment problem d. none of the above. Answer: c Type: A 11. Which one of the following is a fundamental factor in determining the value of a firm? a. level of expected future cash flows b. timing of expected future cash flows c. opportunity cost of capital d. all of the above factors are fundamental determinants of a firm’s value Answer: d Type: K 12. The difference between a firm’s opportunity cost of capital and the risk-free rate is a. the firm’s risk premium b. always greater (in magnitude) than the risk-free rate c. always less (in magnitude) than the risk-free rate d. diversifiable risk Answer: a Type: A lOMoARcPSD|8617767 Downloaded by Ashraf Nader (muntahashams51@gmail.com) Type: A 5. If Bogie’s Stogies Inc., in question #4 above, purchases insurance to cover its product liability risk, what impact will this have on the cost of capital? Explain. Answer: The purchase of insurance will not impact the cost of capital since product liability risk is a diversifiable risk. Type: A 6. If Bogie’s Stogies Inc., in question #4 above, hedges their currency risk exposure, what impact will this have on the cost of capital. Explain. Answer: Currency risk is diversifiable, so the hedging activity will likely reduce the firm’s cost of capital. However, the hedge will reduce corporate cash flows so that the benefits and costs may offset each other. Type: A 7. Shaky Bakey is a restaurant supply company that is experiencing financial distress. Without insurance, what impacts will the risk of bankruptcy have on Shaky’s contracts with other claimholders? Answer: Customers will be concerned about Shaky’s quality and reliability and may seek other sources for their supplies. Employees will demand higher compensation for the risk of losing their jobs. Shaky’s suppliers will demand higher prices to compensate for the risk of not being paid. Lenders will demand higher interest rates. Type: A 185 lOMoARcPSD|8617767 Downloaded by Ashraf Nader (muntahashams51@gmail.com) 186 Chapter 21 Tax, Regulatory, and Accounting Factors Affecting Corporate Risk Management I. Multiple Choice 1. A tax benefit: a. always accrues to the party who receives the tax deduction. b. sometimes accrues to a party other than the one who receives the tax deduction. c. will always increase the wealth of the shareholders of the firm receiving the tax benefit. d. all of the above Answer: b Type: K 2. The tax benefits of insurance, as compared to retention, arise from several factors including: a. regressive tax rates b. hedging c. tax treatment of unpaid losses d. none of the above Answer: c Type: K 3. Premium taxes and excise taxes: a. increase the premium loading on insurance b. decrease the present value of expected losses c. cannot be passed on to insurance buyers in the form of higher premiums d. do not affect the choice between insurance and retention Answer: a Type: K 4. The tax treatment of uninsured losses: a. is the same as the financial reporting of uninsured losses. b. allows for a firm to choose when the loss will be deducted – either when the loss is incurred or when it is paid c. is the same for insurance companies and non-insurance companies. d. requires that the loss be deducted in the year it is paid. lOMoARcPSD|8617767 Downloaded by Ashraf Nader (muntahashams51@gmail.com) Answer: d Type: K 5. The financial reporting requirements for uninsured losses require firms to recognize losses: a. when they occur b. when they are paid c. when they become probable and can be reasonably estimated. d. none of the above. Answer: a Type: K 6. A foreign insurer is: a. domiciled in the state. b. domiciled outside the U.S. c. domiciled in another state in the U.S. d. the same as an alien insurer. Answer: c Type: K 7. An admitted insurer in a particular state: a. can be domestic, foreign or alien. b. is always a domestic insurer. c. is not always licensed to sell insurance in the state. d. faces stricter regulation than non-admitted insurers. Answer: a Type: K 8. Which of the following statements is true regarding the relationship between a firm’s risk management decisions and its capital structure decisions? a. The risk management decisions should be made independently from the capital structure decisions. b. Risk management has no affect on a firm’s capital structure. c. Strategic decisions about a firm’s capital structure and risk management should not be made independently. d. None of the above. Answer: c 187 lOMoARcPSD|8617767 Downloaded by Ashraf Nader (muntahashams51@gmail.com) 190 5. The federal government excise tax on primary insurance transactions is four percent. III. Problems and Short Answer Questions 1. Explain why a tax benefit might not necessarily result in an increase in shareholder wealth for the firm receiving the benefit. Answer: If the product market is competitive, the firm that receives the tax break may be forced to pass on the benefit to their customers in the form of lower output prices. Type: K 2. Ellis Manufacturing, Inc. is considering whether to buy property insurance for their fully depreciated warehouse or to retain the risk. Explain how each of the following factors might make the insurance option more attractive than retention. a. progressive corporate income tax rates b. tax treatment of depreciated property. Answer: a. Tax payments with insurance will be based on certain level of income whereas without insurance, the firm will pay a higher tax rate when the loss does not occur than when it does occur. As a result of progressive tax rates, the reduction in after tax income in the years without a loss is less than the increase in after tax income in the years with a loss; b. Ellis be able to deduct the insurance premium whether or not a loss occurs. If a loss occurs, Ellis will have to recognize a capital gain equal to the insurance indemnity payment.. If the income tax rate exceeds the capital gains tax rate, the income tax savings from deducting the premium will exceed the capital gains tax payment. Type: A 3. Explain how less volatile financial accounting numbers due to the purchase of insurance can influence the magnitude or variability of cash flows. Answer: Purchase of insurance will cause less volatile earnings which will: a) allow investors to predict earnings and cash flows more accurately which may reduce the investor’s estimate of the riskiness of the firm (although this is non-systematic risk); b) reduces the likelihood of default on debt contracts; c) make it less costly for shareholders and other stakeholders to monitor management behavior. Type: K lOMoARcPSD|8617767 Downloaded by Ashraf Nader (muntahashams51@gmail.com) 4. Explain the tax treatment and financial accounting treatment for each of the following: a. insurance premiums b. uninsured losses Answer: a. premiums paid are a deductible expense in the year in which coverage is provided (both for taxes and financial accounting) b. uninsured losses are reported as an expense in the year in which they occur but are deducted for tax purposes in the year in which they are paid. Type: K 5. Explain the reasons for “fronting”. Answer: Fronting is used to comply with regulations that restrict the choice of insurers, to reduce excise taxes, and to satisfy third party demands that insurance be provided by a particular set of insurers. Type: K 191 lOMoARcPSD|8617767 Downloaded by Ashraf Nader (muntahashams51@gmail.com) 192 Chapter 22 Risk Retention/Reduction Decisions I. Multiple Choice 1. Which of the following is not a potential benefit to a firm from increasing retention? a. savings on premium loadings b. increased moral hazard c. avoiding implicit taxes that arise from insurance price regulation d. reduced exposure to insurance market volatility Answer: b Type: K 2. Which one of the following firms is more likely to use retention? a. closely held firm b. publicly traded and widely held firm c. a firm with a high level of financial leverage d. a small firm Answer: b Type: K 3. 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 Answer: d Type: A 4. A disaggregated risk management approach will generally result in a. lower transactions costs b. higher transactions cost c. lower expected losses d. higher expected losses Answer: b lOMoARcPSD|8617767 Downloaded by Ashraf Nader (muntahashams51@gmail.com) 12. A basic guideline for the retain/insure decision is ‘Insure those exposures that… a. have reasonably predictable losses.’ (This makes for stable premiums.) b. can potentially result in large, disruptive losses c. have high frequency and high severity d. are measurable Answer: b Type: K 13. Firms concerned with their probability of insolvency will tend to a. retain more risks so as to keep use of funds otherwise spent on premiums b. retain more risks to avoid increasing their debt financing c. insure more risks in order to decrease their reliance on debt financing d. insure more risk to stabilize their cash flows Answer: d Type: A 14. A bundled insurance policy with a single overall retention limit can help a firm a. avoid purchasing unnecessary coverage b. avoid the problem of two contracts providing duplicate coverage c. develop simpler contracts d. understand the disaggregated loss distributions Answer: a Type: K 15. Newly designed bundled contracts will face the uncertainty of legal interpretation and the settling of disputes thereof. This uncertainty, relative to established separate contracts, is an example of a. minimal risk transfer b. ‘bundled’ contract law c. moral hazard d. increased transactions costs (for a bundled policy) Answer: d Type: K 195 lOMoARcPSD|8617767 Downloaded by Ashraf Nader (muntahashams51@gmail.com) 196 II. Fill-Ins 1. Optimal retention for many firms involves the retention of predictable losses and buying insurance against large, potentially disruptive losses. 2. Reducing exposure to insurance market volatility is a benefit of retaining a risk exposure. 3. A firm who very actively seeks out new investment opportunities is most likely to use risk retention when evaluating the retention/reduction decision. 4. The complexity of the contract is a disadvantage to the aggregate approach to the risk retention/reduction decision. 5. A firm with a high level of financial leverage is less likely to use retention. III. Problems and Short Answer Questions 1. The development and selection of alternative risk management methods involves a fundamental tradeoff between the benefits of retention and the increased costs from greater risk. What are the benefits of increased retention? Answer: The potential savings from increased retention include: a) savings on premium loadings; b)reduced exposure to insurance market volatility; c) reduced moral hazard; d) avoiding high premiums that may accompany asymmetric information; e) avoiding implicit taxes that arise from insurance price regulation; and f) maintaining the use of funds until losses are paid. Type: K 2. Consider two firms: Firm A has 2,000 workers in twenty different states. Firm B has 500 workers at a single plant. All else equal, which firm would be more likely to retain their workers compensation losses? Explain. Answer: Firm A would be more likely to retain because the lower correlation among workers reduces the variability of losses compared to Firm B where many workers could be hurt in a single accident. Type: A 3. Killebrew Inc. has historically purchased separate policies for property insurance and liability insurance. Each of the policies had $4 million retention. The company is now considering the purchase of a bundled policy which covers both property and liability exposures. The retention of the bundled policy is to be $8 million. Draw a lOMoARcPSD|8617767 Downloaded by Ashraf Nader (muntahashams51@gmail.com) 8 4 4 8 graph illustrating the areas of unnecessary coverage that will exist if Killebrew continues with separate policies. Answer: Unnecessary Coverage Property Loss Type: K 4. Why does a firm which is very active in seeking out new investment opportunities, e.g. a technology research firm, have less incentive to use retention? Answer: A firm which is engaged in cutting-edge technology will desire a steady flow source of investment funds. If such a firm suffers a loss on a retained risk exposure some investment opportunities may have to be foregone as the funds will not be available for the investment or the cost of raising funds externally may be too great. Type: K 5. Detail some of the difficulties in the aggregated approach to risk management. Answer: The primary difficulty of the aggregate approach to risk management is the complexity of the undertaking. Detailed knowledge of the individual risk exposures and their correlations must be obtained. Given the breadth of some corporations this might be quite difficult. The insurer (or whoever is assuming the risk under a bundled policy) must understand how to price such an amalgamation of risks. All of this complexity gives rise to higher transactions costs. Additional issue that exists once a contract is established is how any disputes will be resolved. These new types of contract will not have a established set of laws governing interpretation of the contracts. Type: A 197 L ia bi lit y L os s lOMoARcPSD|8617767 Downloaded by Ashraf Nader (muntahashams51@gmail.com) 200 8. The type(s) of risk that is (are) very frequently hedged with derivatives are: a. foreign exchange risk b. interest rate risk c. commodity price risk d. all of the above Answer: d Type: K 9. Factors that have contributed to the use of interest rate derivatives to hedge against changes in value due to interest rate changes include: a. low interest rates in the 1990s b. volatility of interest rates in the 1970s and 1980s c. the Federal Reserve policy of trying to stabilize interest rates directly instead of targeting monetary aggregates d. all of the above Answer: b Type: K 10. Which of the following is not a determinant of forward or futures prices? a. the current price of the underlying asset b. the time to expiration c. the premium charged by the broker d. the risk free rate of interest Answer: c Type: K 11. Basis risk exists when the hedging instrument a. is likely to increase in value b. is likely to decrease in value c. differs in value from the item (or variable) being hedged d. has a high level of volatility Answer: c Type: K 12. The notional principle for swap contracts is a. an accurate measure of the amount of money at risk b. usually double the amount of money at risk lOMoARcPSD|8617767 Downloaded by Ashraf Nader (muntahashams51@gmail.com) c. usually an inaccurate measure of the amount of money at risk d. the expected value of the payout of the contract Answer: c Type: K 13. When compared to derivative contracts, insurance contracts a. have greater basis risk b. are used to hedge losses that are more specific to a firm c. are more liquid d. tend to have lower transactions (or contracting) costs Answer: b Type: K 14. Miker wants to protect his company from the increased costs it would face if the price of corn exceeds $5 per bushel. Which of the following instruments will generate value if the price per bushel of corn should exceed $5? a. call option b. put option c. either a call option or a put option because both will suit his needs d. swap option Answer: a Type: A 15. Which of the following is not true about call options contracts? a. The potential payoff of a call options is asymmetrical. b. The underlying asset is a market variable or some other aggregate economic variable. c. Call option contracts are nonstandard. d. Call option contract can be settled without physical delivery. Answer: c Type: K II. Fill-Ins 1. A contract whose payoff or value is derived from the value of an underlying asset is known as a derivative contract. 201 lOMoARcPSD|8617767 Downloaded by Ashraf Nader (muntahashams51@gmail.com) 202 2. A derivative contract in which the buyer of the contract receives a positive payoff when the value of the underlying asset is above the exercise price is called a call option . 3. A derivative contract in which the buyer of the contract receives a positive payoff when the value of the underlying asset is below the exercise price is called a put option . 4. The basis for a hedge is the difference between the value of what’s being hedged and the value of the hedging instrument . 5. An option that can be exercised at any time up to the expiration date is called a(n) American option. 6. A measure commonly used to denote the value of outstanding swap contracts is called the notional principal . 7. Synergy exists when the combination of the parts has greater value than the sum of the individual values. 8. By purchasing a put option on an underlying asset which is positively correlated with a firm’s revenue (and thus positively correlated with profits), a firm can hedge against losses due to lower than expected revenue. III. Problems and Short Answer Questions 1. Explain how an insurance contract is similar to an option contract. Answer: Both types of contracts can be used to generate cash when events occur that otherwise would have caused a loss in firm value. Firms must pay a premium for either type of contract. In both types of contracts, the firm will not make a claim or exercise the contract rights if the negative event does not occur. Type: K 2. Anacott Steel uses oil in its production process and is therefore exposed to the risk of changing oil prices. If it uses derivatives to hedge this risk, what are the types of basis risk may it be exposed to? Answer: There may be differences between the factors that affect the oil costs for Anacott and the factors that affect the value of the derivative contract for Anacott These differences create basis risk and could include;  The derivative contract may be based on a different grade of oil than the one that Anacott needs for production. lOMoARcPSD|8617767 Downloaded by Ashraf Nader (muntahashams51@gmail.com) Chapter 25 Alternative Risk Transfer I. Multiple Choice 1. All of the following are examples of loss sensitive policies except: a. retrospectively rated policies b. experience rated policies c. investment credit program d. excess policies Answer: d Type: K 2. Experience-rated policies are beneficial to the insurer because they help to reduce: a. adverse selection b. moral hazard c. fraud d. insurer insolvency Answer: b Type: K 3. An insurance company that is set up as a subsidiary of a parent for the sole purpose of providing insurance to the parent corporation is: a. a subsidiary insurance company b. an offshore insurance company c. a pure captive insurance company d. operating illegally Answer: c Type: K 4. Captive insurance companies in the U.S. which only insure a single parent corporation: a. will not necessarily result in reduced taxes for the parent since the tax laws tend to treat them as self-insurance funds. b. will always reduce the risk of the parent corporation. c. will reduce loss costs to the parents as compared to buying insurance from a different insurer. d. all of the above. 205 lOMoARcPSD|8617767 Downloaded by Ashraf Nader (muntahashams51@gmail.com) 206 Answer: a Type: K 5. Which one of the following is not a characteristic of retrospectively rated policies? a. retro premium is a function of the actual losses sustained during the policy period b. retro premium is subject to a minimum and a maximum c. retrospectively rated policies transfer more risk to the insurer than traditional insurance policies d. while the insurer fully settles all claims, it may subsequently require additional premium from the insured Answer: c Type: K 6. Alternative risk transfer (ART) is difficult to define. ART transactions though, do tend to have certain characteristics. Which one of the following is not a common characteristic of ART? a. low level of retention b. involvement with capital market institutions and securities c. contracts that span multiple years d. contracts that cover multiple sources of risk Answer: a Type: K 7. An oil refinery has recently suffered an explosion. The refinery has estimated its cost from this explosion to be approximately $50 million dollars. 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 a. retrospectively rated policy b. loss portfolio transfer c. premium financing arrangement d. incurred loss retro Answer: b Type: A 8. Which one of the following in not a characteristic of finite risk insurance? a. transfers relatively little risk from insured to insurer b. provides protection against the timing of insured’s loss payments lOMoARcPSD|8617767 Downloaded by Ashraf Nader (muntahashams51@gmail.com) c. the typical contract length is no more than two years d. all of the above are characteristics of finite risk insurance Answer: c Type: K 9. Regarding captives, ‘unrelated business’ refers to a. insurance lines outside the captive’s scope b. independent loss exposures c. noninsurance activities d. selling insurance coverage to entities not related to the parent corporation Answer: d Type: K 10. When a captive insurer writes coverage on a sister corporation the transaction is a. considered ‘risk-reducing’ b. not treated as insurance for tax purposes c. counted as related business d. all of the above Answer: a Type: K 11. Multiline insurance policies a. provide coverage for losses generated from different risk exposures b. provide coverage against an aggregate measure of losses c. can potentially allow the insured to save on transactions cost d. all of the above Answer: d Type: K 12. 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 Answer: b Type: K 207 lOMoARcPSD|8617767 Downloaded by Ashraf Nader (muntahashams51@gmail.com) 210 Complete the following table. Year 1 Year 2 Year 3 Previous Year Balance Premium $1,500,000 $1,500,000 $1,500,000 Insurer’s Fee Beginning Balance Claim Payments -$850,000 -$2,400,000 -$1,200,000 Interest End of Year Balance Answer: Year 1 Year 2 Year 3 Previous Year Balance $0 916,000 -52,200 Premium $1,500,000 $1,500,000 $1,500,000 Insurer’s Fee -180,000 -180,000 -180,000 Beginning Balance 1,320,000 2,236,000 1,267,800 Claim Payments -$850,000 -$2,400,000 -$1,200,000 Interest 66,000 111,800 63,390 End of Year Balance 916,000 -52,200 131,190 Type: A 4. What are two reasons a firm may want use an incurred loss retro policy instead of an excess policy with a high attachment point? Answer: a. The firm can gain a tax advantage with the incurred loss retro. Since additional retro premium is paid when the losses are incurred, the firm is able to get an earlier tax deduction. If the losses were retained via a high attachment point the tax deduction could be taken until the losses were paid. b. The incurred loss retro policy allows the firm to effectively retain the risk, yet contract with the insurer to process claims. Type: K 5. What risks are transfer to the insurer with a loss portfolio transfer? Answer: Since the actual loss event(s) has already occurred, the risk transferred with a loss portfolio transfer is the uncertainty regarding the ultimate amount of the loss(es) and the timing of when the loss payment(s) will ultimately be made. Type: K lOMoARcPSD|8617767 Downloaded by Ashraf Nader (muntahashams51@gmail.com) Chapter 28 Corporate Liability to Customers, Third Parties, and Shareholders I. Multiple Choice 1. Product manufacturers are usually sued for product-related injuries based on: a. strict liability b. negligence c. contributory negligence d. all of the above Answer: a Type: K 2. Which of the following is not one of the primary types of product defects? a. manufacturing defect b. design defect c. hidden defect d. warning defect Answer: c Type: K 3. 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. Answer: b Type: K 4. A statute of repose is: a. a product liability reform proposal that would require product liability lawsuits be brought within a certain number of years after the product was purchased. b. a common law rule for product liability that is similar to a statute of limitations. c. a statute that requires that the case be closed if there is no action on it within ten years. 211 lOMoARcPSD|8617767 Downloaded by Ashraf Nader (muntahashams51@gmail.com) 212 d. None of the above. Answer: a Type: K 5. 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. Answer: d Type: A 6. 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. Answer: b Type: K 7. Critics of the Superfund law argue that: a. the EPA has spent excessive resources on cleaning up sites that have little chance of posing harm to area residents. b. the law provides incentives for excessive investment in safety. c. the clean-up efforts have increased the exposure to toxic substances in some cases because these efforts have freed some of the substances into the environment. d. All of the above. Answer: d Type: K 8. If the directors and officers of a corporation cause the shareholders to suffer a loss they: a. are personally liable for the losses. b. are not liable if they can show that they acted with good business judgment. c. can never be held personally liable because of the limited liability rule. d. can only be liable up to the limit of their investment in the corporation. lOMoARcPSD|8617767 Downloaded by Ashraf Nader (muntahashams51@gmail.com) 2. The most recent CGL policies exclude coverage for environmental liability. 3. Insurance coverage for pollution liability is often offered in a separate environmental impairment liability (EIL ) policy. 4. If a director of a corporation makes a decision, using all available information and in reasonable consideration of the pros and cons of that decision, he or she will not be held personally liable in the event of a loss to shareholders because the business judgment rule will be applied by the courts. 5. Directors and officers of a corporation owe a duty of loyalty or care to the shareholders of the corporation. 6. A suit that is brought by a shareholder on behalf of the corporation is called a derivative suit. III. Problems and Short Answer Questions 1. For each of the following examples of product liability cases, explain what type of defect is being alleged. a. liability of an off-road auto manufacturer for failing to install a rollbar to minimize injuries if the vehicle overturns. b. liability of a babyfood manufacturer for pieces of glass found inside some of the jars. c. liability of a pharmaceutical company for side-effects of a drug. Answer: a) design defect, b) manufacturing defect, and c) warning defect Type: A 2. Kristopher is an avid bicycle enthusiast. He participates in Ride the Rockies, a popular bike race in the Colorado mountains. During the race, he slips on some gravel when going down a hill at 50 miles per hour and is thrown from his bike. His bike helmet cracks and he has serious head injuries. If he survives, under what theories can he sue the bike helmet manufacturer? Answer: He can claim that the helmet is defective. It may be a design defect if he can show that all the helmets have the same problem. If it can be shown to be peculiar to his particular helmet, it might be a manufacturing defect, such as a bad batch of plastic. It could also be a warning defect if the helmet was known by the manufacturer to be able to resist impacts but not sufficient to protect him from this type of road injury. An alternative possibility is to claim a breach of warranty since the implied warranty is that the helmet is suitable for what it is intended. 215 lOMoARcPSD|8617767 Downloaded by Ashraf Nader (muntahashams51@gmail.com) 216 Type: A 3. If the courts routinely hold manufacturers liable for injuries when the manufacturer could not have foreseen the danger or when the danger is caused by the consumer’s misuse of the product, what impact will this have on the incentives for product safety and victim compensation? Answer: This will likely result in too much investment in safety. Manufacturers will provide excessive warnings and may withdraw products from the market that actually might have a beneficial impact on risk. Two examples are drugs with rare but dangerous side-effects and small airplanes. On the other hand, holding the manufacturers liable in these cases makes it more likely that victims will be compensated. Type: A 4. In what way is the current system of product liability regressive? Answer: The current system is regressive because the cost of product liability is spread among all consumers equally (since prices of products are unrelated to the wealth of the purchaser), but the liability awards are generally higher for wealthy plaintiffs. Type: K 5. Name and briefly explain the types of product liability reforms that have been adopted by individual states and proposed at the federal level. Answer: These reforms include measures that would (1) reduce the potential liability of producers (e.g. by curtailing joint and several liability, capping pain and suffering damages, imposing limitations on punitive damages, and altering the collateral source rule); (2) reduce incentives of plaintiff’s attorneys to file marginal cases (e.g. by loser pays rule and reduced contingency fees for plaintiff’s attorneys); statute of repose (requiring that suits be brought within a certain time after purchase of the product). Type: K 6. Andy owns 100 shares of stock in XYZ Corporation. He believes that XYZ’s management has been guilty of mismanagement. What possible remedies does he have? Answer: He can bring a derivative suit on behalf of the corporation, in which case any damages would be awarded to the corporation. Alternatively, he could bring a direct suit and win damages directly. A class action could be brought be a group of shareholders. With only 100 shares, it is doubtful that this would be financially lOMoARcPSD|8617767 Downloaded by Ashraf Nader (muntahashams51@gmail.com) worthwhile to Andy and the management might be covered under the business judgment rule. Type: A 7. The 500 residents of Teenytown USA have heard that a section of their town has been declared a Superfund cleanup site. They are concerned that the costs of the cleanup will outweigh the benefits. The cleanup of their town is estimated to cost $5-10 million. The dump is 5 miles from town and the contaminants are not currently affecting groundwater. What other information would be necessary for them to conduct a cost benefit analysis? How would you suggest that Teenytown residents present their argument? Answer: Teenytown will need to estimate any other costs that may arise, including the potential for the cleanup to release toxins into the ground, air and water. In the absence of any other costs, the benefit to the community would have to be $10,000 per resident to make the cleanup worth the cost to taxpayers. Answers will vary. Type: A 217 B) They are more easily predictable than pure risks. C) Their occurrence may benefit society. D) They involve only a chance of loss. Answer: C Question Status: Previous Edition 22) An automobile that is a total loss as a result of a collision is an example of which of the following types of risk? I. Speculative risk II. Fundamental risk A) I only B) II only C) both I and II D) neither I nor II Answer: D Question Status: Revised 23) All of the following are programs to insure fundamental risks EXCEPT A) federally subsidized flood insurance. B) auto physical damage insurance. C) Social Security. D) unemployment insurance. Answer: B Question Status: Revised 24) All of the following are examples of personal risks EXCEPT A) poor health. B) unemployment. C) premature death. D) flood. Answer: D Question Status: Previous Edition 25) Which of the following is a reason why premature death may result in economic insecurity? I. Additional expenses associated with death may be incurred. II. The income of the deceased persons family may be inadequate to meet its basic needs. A) I only B) II only C) both I and II D) neither I nor II Answer: C Question Status: Previous Edition 26) Which of the following are often consequences of long-term disability? I. Continuing medical expenses II. Loss or reduction of employee benefits A) I only B) II only C) both I and II D) neither I nor II Answer: C Question Status: Previous Edition 27) All of the following are examples of direct property losses EXCEPT A) the theft of a persons jewelry. B) the destruction of a firms manufacturing plant by an earthquake. C) the cost of renting a substitute vehicle while a collision-damaged car is being repaired. D) the vandalism of a persons automobile. Answer: C Question Status: Revised 28) The extra expense incurred by a business to stay in operation following a fire is an example of a(n) A) fundamental risk. B) speculative risk. C) direct loss. D) indirect loss. Answer: D Question Status: Previous Edition Chapter 1 Risk in Our Society 7 8 Rejda · Principles of Risk Management and Insurance, Tenth Edition 29) Which of the following statements about liability risks is (are) true? I. Future income and assets can be attached to pay judgments if inadequate insurance is carried. II. There is an upper limit on the amount of loss. A) I only B) II only C) both I and II D) neither I nor II Answer: A Question Status: Previous Edition 30) All of the following are burdens to society because of the presence of risk EXCEPT A) The size of an emergency fund must be increased. B) Individuals may profit from accepting a speculative risk. C) Society is deprived of certain goods and services. D) Mental fear and worry are present. Answer: B Question Status: Previous Edition 31) Loss control includes which of the following? I. Loss reduction II. Loss prevention A) I only B) II only C) both I and II D) neither I nor II Answer: C Question Status: Previous Edition 32) Following good health habits can be categorized as A) loss prevention. B) loss retention. C) noninsurance transfer. D) personal insurance. Answer: A Question Status: Previous Edition 33) From the insureds perspective, the use of deductibles in insurance contracts is an example of A) risk transfer. B) loss control. C) risk avoidance. D) risk retention. Answer: D Question Status: Previous Edition 34) The use of fire-resistive materials when constructing a building is an example of A) risk transfer. B) loss control. C) risk avoidance. D) risk retention. Answer: B Question Status: Previous Edition 35) All of the following statements about risk retention are true EXCEPT A) It may be used intentionally if commercial insurance is unavailable. B) It may be used passively because of ignorance. C) Its use is most appropriate for low-frequency, high-severity types of risks. D) Its use results in cost savings if losses are less than the cost of insurance. Answer: C Question Status: Revised 36) All of the following are methods of noninsurance transfer EXCEPT A) entering into a hold- harmless agreement. B) avoiding dangerous activities. C) hedging risk using futures contracts. D) incorporating a business. Answer: B Question Status: Revised Chapter 1 Risk in Our Society 9 10 Rejda · Principles of Risk Management and Insurance, Tenth Edition 37) Curt borrowed money from a bank to purchase a fishing boat. He purchased property insurance on the boat. Curt had difficulty making loan payments because he did not catch many fish, and fish prices were low. Curt intentionally sunk the boat, collected from his insurer, and paid off the loan balance. This scenario illustrates the problem of A) adverse selection. B) moral hazard. C) fundamental risk. D) morale hazard. Answer: B Question Status: Previous Edition 38) Jenna opened a successful restaurant. One night, after the restaurant had closed, a fire started when the electrical system malfunctioned. In addition to the physical damage to the restaurant, Jenna also lost profits that could have been earned while the restaurant was closed for repairs. The lost profits are an example of A) direct loss. B) fundamental risk. C) speculative risk. D) indirect loss. Answer: D Question Status: Revised 39) Brad started a pest control business. To protect his personal assets against liability arising out of the business, Brad incorporated the business. Brads use of the corporate form of organization to shield against personal liability claims illustrates A) fundamental risk. B) noninsurance transfer. C) risk retention. D) objective risk. Answer: B Question Status: Previous Edition 40) ABC Insurance Company plans to sell homeowners insurance in five Western states. ABC expects that 8 homeowners out of every 100, on average, will report claims each year. The variation between the rate of loss that ABC expects to occur and the rate of loss that actually does occur is called A) objective probability. B) subjective probability. C) objective risk. D) subjective risk. Answer: C Question Status: Previous Edition 41) Williams Company installed smoke detectors, a sprinkler system, and fire extinguishers in its new manufacturing facility. These devices are all examples of A) loss control. B) noninsurance transfer. C) risk avoidance. D) risk retention. Answer: A Question Status: Previous Edition 42) Tyndal Products Company produces cereal. The company has entered into contracts to deliver 500,000 boxes of cereal during the next 18 months. The company is concerned that the prices of two ingredients, corn and wheat, may increase over the next 18 months. The company used grain futures contracts to hedge the price risk associated with these commodities. Tyndals use of hedging illustrates which risk management technique? A) noninsurance transfer B) risk avoidance C) risk retention D) risk assumption Answer: A Question Status: Revised 43) Cathys car hit a patch of ice on the road. The car skidded off the road and hit a tree. The presence of ice on the road is best described as a(n) A) peril. B) subjective risk. C) physical hazard. D) indirect loss. Answer: C Question Status: Previous Edition Chapter 1 Risk in Our Society 11 12 Rejda · Principles of Risk Management and Insurance, Tenth Edition 44) Jim and Paula Franklin started a dry cleaning business. The business may be successful or it may fail. The type of risk that is present when either a profit or loss could occur is called A) pure risk. B) subjective risk. C) fundamental risk. D) speculative risk. Answer: D Question Status: Previous Edition 45) Ben is concerned that if he injures someone or damages someones property he could be held legally responsible and required to pay damages. This type of risk is called a A) speculative risk. B) liability risk. C) fundamental risk. D) property risk. Answer: B Question Status: Previous Edition 46) MLX Drug Company would like to market a new hypertension drug. While the Food and Drug Administration (FDA) was testing the drug, it discovered that the drug produced a harmful side effect. When MLX learned of the FDAs test result, MLX abandoned its plan to produce and distribute the drug. MLXs reaction illustrates A) risk avoidance. B) hedging. C) risk transfer. D) risk retention. Answer: A Question Status: Previous Edition 47) ABC Health Insurance Company sells health insurance in one state. Recently, that states legislature passed a law forbidding health insurers from considering an individuals health history when selecting applicants to insure. This change in law will increase the possibility of unprofitable results for ABC. This type of hazard is an example of A) physical hazard. B) legal hazard. C) moral hazard. D) morale hazard. Answer: B Question Status: Revised 48) All of the following are characteristics of the liability risk that most people face EXCEPT A) a lien may be placed on your income and assets to satisfy a legal judgment. B) substantial legal expenses may be incurred defending the claim. C) there is no upper limit on the amount of the loss. D) owning liability insurance eliminates the possibility of being held legally liable. Answer: D Question Status: New 49) Which of the following statements about chance of loss and risk is (are) true? I. If the chance of loss is identical for two groups, the objective risk must be the same. II. Two individuals may perceive differently the