Chapter 25 Introduction to Risk Management 25 1

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Chapter 25 Introduction to Risk Management 25. 1 Understanding Risk 25. 2 Managing Risk

Chapter 25 Introduction to Risk Management 25. 1 Understanding Risk 25. 2 Managing Risk © 2010 South-Western, Cengage Learning

Lesson 25. 1 Understanding Risk GOALS n Explain risk and the different types of

Lesson 25. 1 Understanding Risk GOALS n Explain risk and the different types of risk. n Explain the concept of insurance and how risks are spread. Chapter 25 © 2010 South-Western, Cengage Learning 2

Types of Risk n Pure risk n Speculative risk n Economic risk n Insurable

Types of Risk n Pure risk n Speculative risk n Economic risk n Insurable risk Chapter 25 © 2010 South-Western, Cengage Learning 3

Pure Risk n Pure risk is a chance of loss with no chance for

Pure Risk n Pure risk is a chance of loss with no chance for gain. n Pure risks are random (can happen to anyone) and result in loss (not gain). n Examples of pure risk include the following: n Accidents resulting in physical injury and damage to property n Illnesses that people get throughout life, as a part of aging n Acts of nature, resulting in damage to persons and property Chapter 25 © 2010 South-Western, Cengage Learning 4

Speculative Risk n A speculative risk may result in either gain or loss. n

Speculative Risk n A speculative risk may result in either gain or loss. n Because speculative risks are not “accidental” or random, and may result in either gain or loss, you cannot protect yourself from losses in a traditional manner. n While hedging (making an investment to help offset against loss) is a technique used to help reduce losses from such risky acts, it does not reduce the risk itself. Chapter 25 © 2010 South-Western, Cengage Learning 5

Economic Risk n Economic risk may result in gain or loss because of changing

Economic Risk n Economic risk may result in gain or loss because of changing economic conditions. n For example, when the business cycle is in a period of recovery or growth, most people and businesses are realizing gains in their financial position. n However, the economy can slow down. n During this time, people lose jobs and are unable to buy goods and services. n As a result, many businesses find themselves unable to meet their debts. Chapter 25 © 2010 South-Western, Cengage Learning 6

Insurable Risk n You can reduce negative consequences of a pure risk by purchasing

Insurable Risk n You can reduce negative consequences of a pure risk by purchasing insurance. n Insurance is a method for spreading individual risk among a large group of people to make losses more affordable for all. n An insurable risk is a pure risk that is faced by a large number of people and for which the amount of the loss can be predicted. Chapter 25 © 2010 South-Western, Cengage Learning 7

(continued) Insurable Risk n Insurance companies can make these predictions by examining the amount

(continued) Insurable Risk n Insurance companies can make these predictions by examining the amount of loss incurred from past events, such as flooding. n To purchase insurance, you must have an insurable interest to protect. n An insurable interest is any financial interest in life or property such that, if the life or property were lost or harmed, the insured would suffer financially. n There are three major insurable risks: personal, property, and liability. Chapter 25 © 2010 South-Western, Cengage Learning 8

Personal Risk n A personal risk is the chance of loss involving your income

Personal Risk n A personal risk is the chance of loss involving your income and standard of living. n You can protect yourself from personal risks by buying life, health, and disability insurance. n In addition, insurance against personal risks protects others who are depending on your income to provide food, clothing, shelter, and the comforts of life. Chapter 25 © 2010 South-Western, Cengage Learning 9

Property Risk n The chance of loss or harm to personal or real property

Property Risk n The chance of loss or harm to personal or real property is called property risk. n For example, your home, car, or other possessions could be damaged or destroyed by fire, theft, wind, rain, accident, and other hazards. n To protect against such risks, you can buy property insurance. Chapter 25 © 2010 South-Western, Cengage Learning 10

Liability Risk n A liability risk is the chance of loss that may occur

Liability Risk n A liability risk is the chance of loss that may occur when your errors or actions result in injuries to others or damages to their property. n For example, you could accidentally cause injury or damage to others or their property by your conduct while driving a car. n Or a person could fall because of your home’s crumbling front steps and break an arm. n Liability insurance will protect you when others sue you for injuring them or damaging their property. Chapter 25 © 2010 South-Western, Cengage Learning 11

Spreading the Risk n An insurance company, or insurer, is a business that agrees

Spreading the Risk n An insurance company, or insurer, is a business that agrees to pay the cost of potential future losses in exchange for regular fee payments. n When people buy insurance, they join a risk-sharing group by purchasing a written insurance contract (a policy). Chapter 25 © 2010 South-Western, Cengage Learning 12

(continued) Spreading the Risk n Under the policy, the insurer agrees to assume an

(continued) Spreading the Risk n Under the policy, the insurer agrees to assume an identified risk for a fee, called the premium, usually paid at regular intervals by the owner of the policy (the policyholder). n The insurer collects insurance premiums from policyholders under the assumption that only a few policyholders will have financial losses at any given time. Chapter 25 © 2010 South-Western, Cengage Learning 13

Indemnification n Insurance is not meant to enrich—only to compensate for actual losses incurred.

Indemnification n Insurance is not meant to enrich—only to compensate for actual losses incurred. n This principle is called indemnification. n Indemnification means putting the policyholder back in the same financial condition he or she was in before the loss occurred. Chapter 25 © 2010 South-Western, Cengage Learning 14

Insurance Terminology n n n Actuarial table Actuary Beneficiary Benefits Cash value Claim Coverage

Insurance Terminology n n n Actuarial table Actuary Beneficiary Benefits Cash value Claim Coverage Deductible Exclusions Face amount Grace period n n n n n Hazard Insurance agent Insured Insurer Loss Peril Probability Proof of loss Standard policy Unearned premium Chapter 25 © 2010 South-Western, Cengage Learning 15

Lesson 25. 2 Managing Risk GOALS n Discuss the risk-management process. n Explain how

Lesson 25. 2 Managing Risk GOALS n Discuss the risk-management process. n Explain how to create a risk-management plan. n Discuss ways to reduce the costs of insurance. Chapter 25 © 2010 South-Western, Cengage Learning 16

Risk Management Is a Process n While you cannot eliminate risk, you can manage

Risk Management Is a Process n While you cannot eliminate risk, you can manage it so that a loss does not become financially devastating. n Risk management is an organized strategy for controlling financial loss from pure risks and insurable risks. Chapter 25 © 2010 South-Western, Cengage Learning 17

Risk Assessment n Risk management begins with a systematic study of the risks that

Risk Assessment n Risk management begins with a systematic study of the risks that you face. n It begins with risk assessment, or understanding the types of risk you will face and their potential consequences. n Risk assessment is a three-step process: n Step 1: Identify risks of loss n Step 2: Assess seriousness of risks n Step 3: Handle risks Chapter 25 © 2010 South-Western, Cengage Learning 18

Techniques for Handling Risks n Risk shifting n Risk avoidance n Risk reduction n

Techniques for Handling Risks n Risk shifting n Risk avoidance n Risk reduction n Risk assumption Chapter 25 © 2010 South-Western, Cengage Learning 19

Risk Shifting n Risk shifting, also called risk transfer, occurs when you buy insurance

Risk Shifting n Risk shifting, also called risk transfer, occurs when you buy insurance to cover financial losses caused by damaging events, such as fire, theft, injury, or death. n By making premium payments, you shift the risk of major financial loss to the insurance company. Chapter 25 © 2010 South-Western, Cengage Learning 20

Risk Avoidance n Risk avoidance lowers the chance for loss by not doing the

Risk Avoidance n Risk avoidance lowers the chance for loss by not doing the activity that could result in the loss. n Examples: n Instead of having a party at your house and risking damage, you could reserve a section of a restaurant. n Instead of participating in a dangerous sport, you could go camping. Chapter 25 © 2010 South-Western, Cengage Learning 21

Risk Reduction n Risk reduction lowers the chance of loss by taking measures to

Risk Reduction n Risk reduction lowers the chance of loss by taking measures to lessen the frequency or severity of losses that may occur. n For example, you may put studded snow tires on your car, install fire alarms or sprinklers in your home, or use seat belts. n All these steps would lessen the financial risk of potential losses. Chapter 25 © 2010 South-Western, Cengage Learning 22

Risk Assumption n Risk assumption is the process of accepting the consequences of risk.

Risk Assumption n Risk assumption is the process of accepting the consequences of risk. n To help cushion your financial burden, you could establish a monetary fund to cover the cost of a loss. n People who self-insure plan to absorb the costs of some risks themselves. n This strategy can reduce the cost of insurance. Chapter 25 © 2010 South-Western, Cengage Learning 23

The Risk-Management Plan n List identified risks. n List assessment of risks’ financial impact.

The Risk-Management Plan n List identified risks. n List assessment of risks’ financial impact. n List techniques to manage each risk. Chapter 25 © 2010 South-Western, Cengage Learning 24

Reducing Insurance Costs n Increase deductibles. n A deductible is the specified amount of

Reducing Insurance Costs n Increase deductibles. n A deductible is the specified amount of a loss that you must pay. n Generally, the higher the deductible, the lower the insurance premium. n Purchase group insurance. n The premiums for group plans are usually considerably lower than for an individual plan. Chapter 25 © 2010 South-Western, Cengage Learning 25

(continued) Reducing Insurance Costs n Consider payment options. n Monthly payments usually contain an

(continued) Reducing Insurance Costs n Consider payment options. n Monthly payments usually contain an extra charge, while semiannual payments do not. n Having premiums automatically deducted from your checking account or paying electronically may reduce your costs. Chapter 25 © 2010 South-Western, Cengage Learning 26

(continued) Reducing Insurance Costs n Look for discount opportunities. n Many insurance companies offer

(continued) Reducing Insurance Costs n Look for discount opportunities. n Many insurance companies offer discounts for special conditions. n Comparison shop. n Get quotes from several insurers. n Be sure to give each one the same information so you can compare exact coverage and costs. Chapter 25 © 2010 South-Western, Cengage Learning 27