BONUS CHAPTER C MANAGING RISK

LEARNING GOALS
After you have read and studied this chapter, you should be able to:
1. Identify the environmental changes that have made risk management
important.
2. Explain the four ways of managing risk and distinguish between insurable
and uninsurable risk.
3. Define insurance policies and explain the law of large numbers and the
rule of indemnity.
4. Discuss the various types of insurance that businesses can buy to
manage risk.

LEARNING THE LANGUAGE

Listed here are important terms found in this chapter. Choose the correct term for
each definition below and write it in the space provided.
Claim
Law of large numbers
Rule of indemnity
Health maintenance
Mutual insurance company Self-insurance
organizations (HMOs)
Health savings accounts
Preferred provider
Speculative risk
(HSAs)
organizations (PPOs)
Insurable interest
Premium
Stock insurance company
Insurable risk
Pure risk
Uninsurable risk
Insurance policy
Risk
1.
A ______________________is a type of insurance company owned by
stockholders.
2.

A written contract known as a(n) _____________________ is between the insured

and an insurance company that promises to pay for all or part of a loss.

3.

The _____________________ says that an insured person or organization cannot

collect more than the actual loss from an insurable risk.

4.

The threat of loss with no chance of profit is called __________________________.

5.
The ______________________is a principle which states that if a large number of people are
exposed
to the same risk, a predictable number of losses will occur during a given period of time.
6.

A chance of either profit or loss is called ______________________.

7.

The chance of loss an entrepreneur takes of losing time and money on a business that may
not prove to be profitable is commonly called __________________.

8.

A _________________________is a type of insurance company owned by its policyholders.

9.

Health care organizations known as __________________________require members to choose

from

a restricted list of doctors.

10.

The fee charged by an insurance company for an insurance policy is a ___________________.

11.

A(n) _____________________is one that no insurance company will cover.

12.
The practice of setting aside money to cover routine claims and buying only catastrophe
policies
to cover big losses is called ____________________.
13.

A(n) ________________________is a risk that the typical insurance company will cover.

14.

Health care organizations similar to HMOs except that they allow members to choose their
own physicians for a fee are called _________________________.

15.

The possibility of the policyholder to suffer a loss is called __________________________.

16.

Tax-deferred accounts known as _________________ are linked to low-cost, high deductible

health insurance policies.

17.

The insured person sends a statement of loss called ____________ to the insurance company
to request payment.

ASSESSMENT CHECK
Learning Goal 1
Understanding Business Risks
1.

What is ERM?

2.

What are the goals of ERM?

a. ______________________________________________________
b. ______________________________________________________
c. ______________________________________________________
Learning Goa 2
Managing Risk
3.

Describe the two kinds of risk.

a.

__________________________________________________________________________

______________________________________________________________________________
b.

___________________________________________________________________________

______________________________________________________________________________

4.
The kind of risk of most concern to business people is:
______________________________
5.

List four methods businesses use to manage pure risk.

a. ________________________________ c. _______________________________
b. _______________________________

6.

d. _______________________________

What are of examples of how can a firm reduce risk?

a. ___________________________________________________________________
b. ___________________________________________________________________
c. ___________________________________________________________________

7.

_________________________ to threats is critical to risk management

8.

How do some companies avoid risk?

9.
Self-insurance is most appropriate when:
_________________________________________

10.

What does it mean for a company to go bare with self-insurance,

and what is the risk?

11.

What is a BOP?

12

Describe four kinds of uninsurable risk.

a. __________________________________________________________________________
b. __________________________________________________________________________
c. __________________________________________________________________________
d.

_________________________________________________________________________

13.

Identify the guidelines used to evaluate whether or not a risk is insurable.

a. _________________________________________________________________________
b. _________________________________________________________________________
c. _________________________________________________________________________
d. _________________________________________________________________________
e.
f.

________________________________________________________________________
________________________________________________________________________

Learning Goal 3
Understanding Insurance Policies
14.
What makes the acceptance of risk possible for insurance companies is:
_____________
___________________________________________________________________________
15.

How are appropriate premiums for each policy determined?

16.

Today, many insurance companies are charging high premiums not for
expected losses
but for ____________________________________________________________________

17.

Can a person purchase more than one policy to cover the same risk? Explain.

Learning Goal 4
Insurance Coverage for Various Kinds of Risk
18.

What are three types of insurance to cover losses?

a. _____________________________________________
b. _____________________________________________
c. _____________________________________________

19.

What are four major options for health insurance?

a. ________________________________

c. ________________________________

b. ________________________________

d. ________________________________

20.

What are the features of an HMO?

21.

What are some complaints about HMOs?

22.

What are some characteristics of a PPO?

23.

Why do most businesses and individuals choose to join an HMO or a PPO?

24.

Describe the features of a health savings account.

25.
A major benefit to you of health saving accounts
is__________________________________
______________________________________________________________________________
26.

Describe disability insurance.

27.

Who provides workers compensation and what does it guarantee?

28.

Who does professional liability insurance cover?

What is another name for this type of insurance?

29.

What is product liability insurance?

30.
To ensure those left behind will be able to continue the business,
entrepreneurs often
buy _______________________________________________________________________

31.
What should you do about insurance coverage if you have a home-based
business?

32.

What are the issues involved in risk management and the environment?

CRITICAL THINKING EXERCISES

Learning Goal 1
1.

The environment changes so rapidly that it is difficult to identify all the

changes that could affect a business in terms of risk management. Evaluate
the company for which you work, or a company with which you are familiar.
What is happening today in the environment (you remember this from
chapter 1 - the economic and legal, technological, competitive, social, global
business environments)? How do the changes you have identified increase
the necessity for risk management for this firm? What actions can the firm
take to minimize the risk of loss from these changes?

Learning Goal 2
2.
Businesses have four options to avoid losses stemming from pure risk
situations.
Reduce the risk
Avoid the risk

Buy insurance to cover the risk

Self-insure against the risk

Read the following situations, and determine which option the firm is choosing in each case.
Use each option only once.
a. ____________

The president of an asbestos removal firm in Merriam, Kansas closed his

firm for four months.

b. ____________

A group of 27 accounting firms formed its own insurance company to

insure themselves.

c. ____________

Workers and visitors on construction sites are required to wear hard hats.

d. ____________

Senoret Chemical Company experienced a 1600% increase in its liability

coverage premium.

3.

Many variables determine which risks are insurable. Using your text, determine which
of the following situations would constitute an insurable risk.
a. ____________
equipment

TNG Enterprises would like to buy insurance to cover loss of computer

from power surges and possible spills.

b. ____________
losses occurring

Gilmores, Inc. a retail store in Kalamazoo, wanted to insure against

when a competitor, Hudsons, implemented an aggressive marketing

campaign.
c. ____________
d. ____________
losses created

MEMC wants to buy insurance to cover losses created by a breakdown of

their robotic and computer driven manufacturing systems.
PPI, a small manufacturing firm, wants to insure themselves against
by damage from a fire set accidentally.

e. ____________
Park,

Residents in Morgan City, Louisiana, East Lansing, Michigan and Valley

Missouri want to buy flood insurance.

f. ____________

g. ____________
planes.

Residents of Morgan City, Louisiana, however, face a high risk of flooding,

because the Mississippi River is cutting a new tributary through that city,
and floods regularly.
Boeing has extensive contracts with the government to build fighter
The company wants insurance to cover losses that may occur if Congress

cuts
the defense budget by over 20%.
Learning Goal 3
4.
Eric owns a company that makes self-darkening windshields for vehicles, Sun-2-Shade. He
is aware of the risks of owning a business, and is considering various insurance plans. Eric
would like to make sure that he wont incur any losses, and so is thinking about buying
policies from two different companies just to make sure that not only will he be covered, but
could make money while the company was down. Eric figures that he will be able to make
claims on both policies if something happens, and even make money when both companies
pay on the claim. As Erics advisor, what would you tell him about this plan?

Learning Goal 4
5.
You are a small business owner, currently working out of your home and you are concerned
about the kinds of insurance that you should carry for your business. Currently, your
business
consists of yourself, and 3 employees. You have turned to a small business consultant to
advise you. What do you think the consultant will say about the need for insurance?

PRACTICE TEST
MULTIPLE CHOICE Circle the best answer
Learning Goal 1
1.
Risk management has become an important concern for businesses today
because:
a.
insurance companies have done such a good job of marketing their
products
b.
rapid environmental changes are becoming a major source of risk for
companies..
c.
companies want to insure themselves against potential losses.
d.
lawyers have made insurance claims a part of a companys legal strategic
plan.
2.

An enterprise risk management program has as one of its goals:

a.
define which risks the program will manage.
b.
eliminate the risk of doing business.
c.
insure the company from environmental disasters.
d.
spread the risk of doing business over time.

Learning Goal 2
3.
When Macys orders inventory for the Christmas season, the company has to
predict what their customers will want to buy that season. The kind of risk
being described is
a. speculative risk.
b. pure risk.
.
c. insurable risk.
d. self-insurance
4.

It is when a company has several widely distributed facilities that

________________ is the most appropriate.
a. reducing the risk
b. avoiding the risk
c. self-insurance

d. finding another company to take the risk

5.

An
a.
b.
c.
d.

insurable risk is one in which:

the loss is a specific amount.
the loss is not accidental.
the risk is dispersed.
the policyholder has no insurable interest.

Learning Goal 3
6.
The law of large numbers states that:
a. a large number of people must make claims before an insurance company
will begin to pay out.
b. if a large number of people are exposed to the same risk, a predictable
number of losses will occur during a given period of time.
c. items that will be covered by an insurance policy must not be above a
certain amount, i.e. the large number which is set by actuaries.
d. if losses from an occurrence are large enough, and insurance company will
turn the policies over to a reinsurance company.
7.

The idea that an insured person or organization cannot collect more than the
actual loss from an insurable risk is called the:
a. law of large numbers.
b. rule of indemnity.
c. disability insurance
d. insurable interest.

Learning Goal 4
8.
A type of insurance that requires members to choose from a restricted list of
doctors is called a:
a. health maintenance organization.
b. preferred provider organization.
c. disability insurance.
d. medical savings account.
9.

Disability insurance
a. replaces all your income if you become disabled.
b. starts immediately after your disability.
c. is required from employers.
d. replaces a portion of your income.

10.

If a person is injured when using a product and sues the manufacturer, the
company is covered by
a. workers compensation.
b. disability insurance.
c. product liability insurance.
d. business interruption insurance.

10

11.

Which of the following is true of workers compensation insurance?

a. It guarantees payment of wages, medical care, and rehabilitation services for
employees who are injured on the job.
b. Only employers in right to work states are required to provide workers
compensation insurance.
c. The insurance does not provide benefits to the survivors of workers who die as a
result of work-related injuries.
d. The cost of insurance is standard in any industry.

12.

Business concern about damage to the environment:

a. is primarily restricted to companies in the United States.
b. is declining as companies add more insurance coverage as part of their strategic

plans.
c. has become a global issue because of concerns over issues such as climate
changes.
d. is primarily a concern of companies in the European Union and Eastern Europe.
TRUE-FALSE
Learning Goal 1
1. _____
An enterprise risk management system includes determining how risk
management efforts will be coordinated across the firm.
2. _____

New legislation is being passed in some areas which aims to lessen some risk so
companies can obtain insurance coverage at a reasonable price.

Learning Goal 2
3. _____
A firm can reduce risk by establishing loss prevention programs such as fire
drills, health education and accident prevention programs.
4. _____

Pure risk is the threat of loss with no chance for profit.

5. _____

When a company goes bare in terms of insurance, the company is getting the
bare minimum insurance coverage from its insurance provider.
One type of risk that cannot be covered is loss from accidental injury.

6. _____

Learning Goal 3
7. _____
The rule of indemnity states that you can have two insurance policies to cover
the same risk of loss.
8. _____
A stock insurance company is one that insures the risk of being a
stockholder.
Learning Goal 4
9. _____
doctors.

One of the complaints about an HMO is that members cant choose their own

10. _____

Health savings accounts are tax-deferred accounts that allow you to save
money for future medical expenses.

11. ____

Many professionals other than doctors and lawyers are buying malpractice
insurance which is also known as professional liability insurance.

11

12. ____
Most homeowners insurance policies have adequate protection for a home
based business.
13. ____

Workers compensation insurance guarantees payment of wages for employees

injured on the job, but will not cover medical expenses, as those should be
covered by medical insurance programs.

14. ____

Concerns about the environment stem from issues such as global warming and
hazards from nuclear power plants.

You Can Find It on the Net

Visit the website http://www.rmmag.com/ which is the website for Risk Management
magazine.
What are the major concerns addressed in the current issue of the magazine? How
do those concerns reflect what we have discussed in this chapter?
What is the RIMS?
Visit the home page of the insurance company you currently use for car,
homeowners, or other insurance policies. What types of products does this
company offer? Use this companys website to determine if you have adequate
insurance to cover your needs.
Can this company insure your small business? What kinds of business insurance do
they offer for your small business?

12

ANSWERS
LEARNING THE LANGUAGE
1. Stock insurance company7. Risk
13. Insurable risk
2. Insurance policy
8. Mutual insurance company 14. Preferred Provider
Organization (PPO)
3. Rule of indemnity
9. Health maintenance
15. Insurable interest
organizations (HMOs)
4. Pure risk
10. Premium
16. Medical savings accounts
(MSAs)
5. Law of large numbers
11. Uninsurable risk
17. Claim
6. Speculative risk
12. Self insurance

ASSESSMENT CHECK
Learning Goal 1
Understanding Business Risks
1.

ERM is an enterprise risk program, designed by executives for their companies.

2.

The goals of an ERM can include:

a. defining which risks the program will manage.
b. what risk management processes, technologies, and investments will be required.
c. how these efforts will be coordinated across the firm.

Learning Goal 2
Managing Risk
3.
firm

a. Speculative risk involves a chance of either profit or loss. It includes the chance the

takes to make extra money by buying new machinery, acquiring more inventory
and making
other decisions in which the probability of loss may be relatively low and the
amount of loss is
known. An entrepreneur takes speculative risk on the chance of making a profit.
b. Pure risk is the threat of loss with no chance for profit. It involves the threat of fire,
accident or loss. If such events occur, a company loses money, but if the events do
not occur,
the company gains nothing.
4.

The kind of risk of most concern to business-people is pure risk.

5.

Firms can manage risk by

a. Reducing the risk
b. Avoiding the risk
c. Self-insure against the risk
d. Buy insurance against the risk

6.

Examples of reducing risk include:

13

7.

a. A firm can reduce risk by establishing loss-prevention programs such as fire drills,
health
education, safety inspections, equipment maintenance, and
accident prevention programs.
b. Retail stores use mirrors, video cameras, and other devices to prevent shoplifting.
c. Manufacturers have safety devices to protect workers from injury.
Quick response is critical to risk management.

8.

Companies avoid risk by not accepting hazardous jobs and by outsourcing shipping and
other functions. For example, the threat of lawsuits has driven away some drug
companies from manufacturing vaccines, and some consulting engineers refuse to
work on hazardous sites. Some companies are losing outside members of their boards
of directors for lack of liability coverage. Many companies have cut back on their
investments to avoid the risk of financial losses.

9.

Self insurance is most appropriate when a firm has several widely distributed facilities.

10.

When a company goes bare the company is paying claims straight out of its budget.
This is a very risky strategy for a company. The risk is that the whole firm could go
bankrupt over one claim if the damages are high enough.

11.

A BOP is a business ownership policy. This is a package that includes

property and liability insurance, and reduces the cost of insurance.

12.

Four kinds of uninsurable risk include:

a. Market risks (from price changes, style changes, new products)
b. Political risks (from war or government restrictions)
c. Personal risks (from loss of job)
d. Risks of operation (strikes or inefficient machinery)

13.

An
a.
b.
c.
d.
e.
f.

insurable risk is evaluated using the following criteria

The policyholder must have an insurable interest.
The loss must be measurable.
The chance of loss should be measurable.
The loss should be accidental.
The risk should be dispersed.
The insurance company can set standards for accepting risk.

Learning Goal 3
Understanding Insurance Policies
14.

What makes the acceptance of risk possible for insurance companies is the
law of large numbers.

15.

Appropriate premiums for insurance policies are determined by using the law
of large numbers. Once the insurance company predicts the number of
losses likely to occur, it can determine the appropriate premiums for each
policy it issues against that loss.
The premium is supposed to be high enough to cover expected losses and
still earn a profit for the firm.

16.

Today many insurance companies are charging higher premiums not for
expected losses but for the costs they anticipate from the increasing number
of court cases and high damage awards.

14

17.

A person cant buy two insurance policies and collect from both for the same
loss. You cannot gain from risk management you can only minimize losses

Learning Goal 4
Insurance Coverage for Various Kinds of Risk
18.

Three types of insurance include:

a. property and liability
b. health
c. life insurance

19.

Four major options for health insurance are:

a. health care providers, such as Blue Cross/Blue Shield,
b. health maintenance organizations (HMOs)
c. preferred provider organizations (PPOs)
d. medical savings accounts (MSAs)

20.

HMOs offer a full range of health care benefits. Emphasis is on helping

members stay healthy instead of on treating illnesses. Members do not
receive bills and do not have to fill out claim forms for routine service. HMOs
employ or contract with doctors, hospitals and other systems of health care
and members must use those providers. HMOs are less expensive than
comprehensive health insurance providers.

21.

Members complain about not being able to choose doctors or to get the care
they want or need. Some physicians complain that they lose some freedom
to do what is needed to make people well and that they often receive less
compensation than they feel is appropriate for the services they provide.

22.

Preferred provider organizations contract with hospitals and doctors, but do

not require members to choose only from those physicians. Members can use
outside provides, for which they pay more. Members pay a deductible before
the PPO will pay any bills. When the plan does pay, members usually have to
pay part of the bill. This payment is called co-insurance.

23.

Most individuals and businesses choose to join a PPO or an HMO because

they can cost as much as 80 percent less than individual health insurance
policies.

24. With a health savings account, you or your employer put part of the money
currently spent on health insurance into a health savings account. You would
use the money only for needed health care services. At the end of the year
you get to keep the money you dont spend in the account for future medical
coverage.
25.

One major benefit to you of a health saving account is that the money grows
tax-free until you take it out.

26.

Disability insurance replaces part of your income if you become disabled and
unable to work. Usually, before you can begin collecting there is a period of
time you must be disabled. The premiums for such insurance vary depending
on your age, occupation, and income.

27.

Workers compensation insurance guarantees payment of wages, medical

care, and rehabilitation services for employees who are injured on the job.

15

28.

Employers in all states are required to provide this type of insurance. This
insurance also provides benefits to the survivors of workers who die as a
result of work-related injuries.
The cost of the insurance varies by the category of business; higher risk jobs
cost more to insure than lower risk types of jobs.
Professional liability insurance covers people who may be found liable for
professional negligence, such as lawyers, doctors, dentists, mortgage
brokers, and real estate appraisers.
This is also known as malpractice insurance.

29.

Product liability insurance provides coverage against liability arising out of

products sold.

30.
To ensure those left behind will be able to continue the business,
entrepreneurs often
buy life insurance that will pay partners and others what they need to keep
the firm going.
31.

Homeowners policies usually dont have adequate protection for a homebased business, so you may need to add an endorsement, or rider, to
increase the coverage.
If clients visit your office and or if you receive deliveries regularly, you may
need home-office insurance, which protects you from slip and fall lawsuits
and other risks associated with visitors. More elaborate businesses may need
other kinds of insurance.

32.

Risk management goes beyond the protection of individuals and businesses

from known risk. It now means evaluating the worldwide risks and prioritizing
these risks so that international funds can be spent where they will do the
most good.

CRITICAL THINKING EXERCISES

Learning Goal 1
1.
Your answers to this question will vary. However, some suggestions as to how to
minimize risk may include developing an enterprise risk management program for the
company, to determine what risks pose the greatest danger to the company, and how
to manage those risks.

Learning Goal 2
2.
a. Avoid risk
b. Self-insure against the risk
c.
Reduce the risk

16

d. Buy insurance to cover the risk.

3.

a. Yes, companies can buy insurance against the loss of computer equipment.
b. No, this would be an uninsurable risk.
c. No, a company cannot insure against inefficient machinery or machinery
that breaks down or doesnt work.
d. Yes you can insure against fire damage.
e. Yes, probably, unless the occurrence of loss has been too high.
f. No, most likely because the probability of flooding in Morgan City is too
high.
g. No this would be a political risk and is uninsurable.

Learning Goal 3
4.

While it is understandable that Eric would be concerned about taking care of

losses his business may experience, the rule of indemnity will prevent Eric
from filing claims with two different insurance companies for the same
incident. The rule of indemnity states that an insured person or organization
cant collect more than the actual loss from an insurable risk. If a company
carries two policies, the two insurance companies would calculate any loss
and divide the reimbursement.

Leaning Goal 4
5.
As a small business owner located in your home, you will need to have a
regular homeowners policy, but there will be additional coverage that you
should consider.
You may need a rider to cover business equipment, and if customers or
clients call on you, you may need home office insurance. If you manufacture
items at your home business, you should consider a business owner policy.
Depending upon the type of business you own, you may want to consider
professional liability insurance or product liability insurance.
Since you have employees, you may want to check into offering other
insurance coverage for them. Employers often offer life insurance, disability
insurance, retirement plans, and health insurance.
You will probably be required to offer workers compensation insurance. The
cost of workers compensation insurance will be determined by your
companys safety record, its payroll and the types of hazards faced by your
workers.

PRACTICE TEST
MULTIPLE CHOICE

TRUE-FALSE

1.
2.
3.
4.
5.
6.

1.
2.
3.
4.
5.
6.
7.

a
b
a
c
c
b

7. b
8. a
9. d
10. c
11. b
12. c

T
T
T
T
F
F
F

17

8. F
9. T
10. T
11. T
12. F
13. F
14. T

18