Risk, exposure, hazard, peril, and loss, and the methods of handling risk

Correct answer: Uncertainty about whether a loss will occur

Risk is uncertainty concerning loss. Where a loss is certain there is no risk, only a cost, so insurance deals with the uncertainty of whether a loss will happen.

Correct answer: A homeowner may or may not suffer damage from a kitchen fire

Pure risk has only two outcomes: loss or no loss. A house fire either happens or it does not, and the owner cannot profit from it. The other choices all carry a chance of gain, which makes them speculative.

Correct answer: Exposure

Exposure is the state of being subject to loss, and insurers express it in exposure units, such as the number of vehicles, the size of a payroll or the value of a building, to predict and price losses.

Correct answer: The cause of a loss

A peril is the immediate cause of loss, such as fire, windstorm, theft, collision, illness or death. Policies typically describe their coverage in terms of the perils they insure against.

Correct answer: A condition that increases the chance of a loss or the severity of a loss

A hazard is not the cause of a loss. It is a condition, physical, moral or morale, that makes a peril more likely to occur or makes the resulting loss larger.

Correct answer: Physical hazard

A physical hazard is a tangible characteristic of property or a person that increases the chance or size of a loss. Frayed wiring and oily rags near a furnace are physical conditions that make fire more likely.

Correct answer: Moral hazard involves dishonesty, while morale hazard involves carelessness or indifference

Moral hazard stems from dishonesty, such as intentionally causing a loss or exaggerating a claim. Morale hazard stems from an indifferent attitude toward loss because insurance is in place, with no intent to defraud.

Correct answer: Lightning and the fire it caused

The peril is the cause of loss. Here lightning, and the fire it started, caused the destruction. The dry hay is a hazard that increased severity, and the destroyed barn is the loss.

Correct answer: a physical hazard

Grease buildup is a tangible condition that increases the chance and severity of a kitchen fire, which makes it a physical hazard. Fire would be the peril.

Correct answer: a direct loss

A direct loss is the immediate physical damage to property caused by a peril. Repairing the fire-damaged building is the direct loss; costs flowing from it are indirect.

Correct answer: an indirect, or consequential, loss

Indirect or consequential losses arise as a result of a direct loss. Lost business income while a damaged property is repaired is a classic indirect loss.

Correct answer: Avoidance

Avoidance means refusing to take on the activity or property that creates the exposure. It is the only method that removes the risk entirely.

Correct answer: Avoidance

By declining to own a motorcycle, Raj has eliminated the exposure entirely. That is avoidance.

Correct answer: Reduction

Reduction, or loss control, lowers the probability or the severity of a loss without eliminating the activity. Smoke detectors and sprinklers reduce both how often fires become serious and how much damage they do.

Correct answer: Retention

A deductible is planned retention: the insured agrees to pay that portion of each loss personally. Raising the deductible increases the amount retained in exchange for a lower premium.

Correct answer: Transfer

Insurance transfers the financial consequences of covered losses from the insured to the insurer in exchange for a premium.

Correct answer: risk sharing

Sharing spreads the cost of a loss among members of a group so each bears a portion. The partners split any judgment, which is sharing.

Correct answer: Avoidance

Only avoidance eliminates the exposure itself. Every other method accepts that a loss may happen and deals with its frequency, its severity or who pays for it.

Correct answer: Transfer the risk by buying insurance

Low-frequency, high-severity risks are best handled by transfer. The premium is affordable because losses are rare, and the insured is protected from a loss they could not absorb.

Correct answer: Reduce the losses with driver training and retain the remaining small costs

High-frequency, low-severity losses are predictable and affordable. They are best handled by reducing their frequency through loss control and retaining what remains, rather than paying an insurer to process many small claims.

Correct answer: retention of a low-frequency, low-severity risk

Rare, low-cost losses are best retained. Insuring items that are cheap to replace would cost more in premium and effort than the expected loss.

Correct answer: retention

Self-insurance is planned retention. The organization accepts the risk and funds expected losses itself, often because its large number of exposure units makes losses predictable.

Correct answer: a transfer of risk by contract

Transfer is not limited to insurance. A hold-harmless or indemnity clause shifts the financial consequences of a loss from one party to another by contract.

Correct answer: An automatic sprinkler system that limits how far a fire spreads

Loss reduction can work on frequency, which is loss prevention, or on severity, which is loss minimization. A sprinkler does not stop fires from starting; it limits the damage once a fire begins.

Correct answer: As a substandard risk who pays an additional premium

Impaired health and a hazardous occupation are hazards that raise the probability of loss. An applicant who does not meet the standards for normal premium rates is a substandard risk and is charged an additional premium.

Correct answer: exposure

Exposure is measured in units appropriate to the coverage. For workers' compensation, payroll measures how much of the workforce is open to injury, so it serves as the exposure base.

Correct answer: A tornado

A peril is the cause of loss, and a tornado directly causes damage. The other choices are conditions, physical or moral, that make a loss more likely or larger.

Correct answer: A deductible keeps the insured paying part of each loss, which discourages carelessness and eliminates small claims

A deductible is planned retention by the insured. Because the insured bears part of every loss, it counters morale hazard and removes the cost of processing many small claims, which helps keep premiums lower.

Correct answer: unplanned, or passive, retention

Retention can be planned or unplanned. When a person fails to recognize a risk, any loss from it is retained by default. That is unplanned, or passive, retention.

Correct answer: Legal hazard

Some texts identify legal hazard as a fourth hazard: features of the legal environment, such as generous court awards, that increase the frequency or severity of claims.

Correct answer: An unintended, unexpected reduction in value

A loss is an unintended, unforeseen decrease in value resulting from a peril. Deliberate destruction and expected depreciation are not losses in the insurance sense.

Correct answer: physical hazards

A physical hazard can be a condition of a person as well as of property. Smoking and high blood pressure increase the likelihood of illness, the peril, so they are physical hazards.

Correct answer: Retention of the first $1,000 and transfer of the remaining $19,000

A deductible is retention: the insured keeps that portion of every covered loss. The rest of the loss is transferred to the insurer through the policy. Most insurance arrangements combine the two.