CPCU 500 Assignment 1

Transcript
Welcome to the CPCU 500 video series. My name is Jim Sherlock. During my career in the insurance industry,
I’ve taught CPCU classes for over thirty years, both in the classroom and over the Internet. As we go through
this course material, I’ll summarize the key ideas in each assignment and share a few tips with you that I’ve
picked up along the way.

In the interest of full disclosure, I am not an employee of the Institutes. And, I have no inside knowledge
about the questions that are on the CPCU 500 exam. The videos in this series are based on the information
the Institutes provide to all CPCU candidates. These videos are intended to be a supplement to the CPCU 500
study materials.
A successful exam-preparation strategy includes:
- Carefully reading and studying the textbook or online study materials,
- Working through the course guide, and
- Using the SMART exam-prep material.
These resources, along with the videos, provide you several ways of interacting with and reinforcing the
course material. The more ways in which you can interact with the course material, the better you will
remember it.
Each of the videos is based on the educational objectives listed in the study materials.
As you go through the material in CPCU 500, you'll see that there are a lot of lists. My suggestion is to write-
out these lists in a handy place, like the blank pages of the textbook, so you can review them frequently and
commit them to memory.

Assignment 1, provides an introduction to risk management, examines several ways of classifying risk,
discusses the purposes and benefits of risk management, and examines the steps in the risk management
process. Later assignments develop the risk management process in more detail and closely examine
insurance as a risk management technique.

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The educational objective is to describe each of the following in the context of risk: uncertainty, possibility,
and possibility compared with probability.

In the context of risk management, risk is the uncertainty about future outcomes. There is a possibility that a
particular future outcome will either occur or not occur. In contrast, the probability of the risk occurring is
expressed more precisely as a value between 0 and 1.

As a final comment. . . Note the distinction between the possibility of an event and the probability of an
event. Possibility tells us if something will or will not occur; whereas, probability tells us the likelihood of an
event occurring and is valued from zero (meaning the event will not happen) and one (meaning the event is
certain to happen).
CPCU 500 Assignment 1

Let's try a practice question. Pause the video, read the question, and select the best answer. Write the letter
of your selected answer on a piece of paper. When you are ready, continue the video to check your answer.
Which of the following statements about the differences between possibility and probability is most accurate?

“A” is the correct answer. Probability is measurable and has a value from 0 to 1.

“B” is incorrect. Probabilities can be quantified while possibilities cannot be quantified.

“C” is also incorrect. The possibility of an event occurring only indicates that it may or may not happen. It does
not quantify the likelihood of it happening.

“D” is incorrect. Probability has a value from 0 to 1. For example, if an event is likely to happen, it may have a
value of .9. Or, if an event is unlikely to happen, it may have a value of .1.

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The educational objective is to explain the following classifications of risk and how they apply in risk
management:
- Pure versus speculative risk
- Subjective versus objective risk
- Diversifiable versus nondiversifiable risk, and
- The quadrants of risk, which are: hazard risks, operational risks, financial risks, and strategic risks.

There are several ways in which risk can be classified.

- A risk can be identified as pure or speculative. A pure risk produces either a loss or no loss while a
speculative risk produces a loss, no loss, or a gain. The risk of windstorm damage to your home is a pure risk
since you will either have a loss or you will not have a loss. In contrast, the risk concerning how much money
you will make when you sell your house next year is speculative risk. These risks have three possible
outcomes. You may lose money on the sale (that is, have a loss), break even (that is, have no loss), or sell the
house for a profit (that is, have a gain).

- Next, a risk can be identified as subjective or objective. Subjective risks are based on opinion. As an example,
you may evaluate the risk of your home being destroyed by fire during the next year based on your gut
feeling. Alternatively, you may determine the risk of fire damage to your house during the next year by
examining the data on fire damage to similar homes in your area over the past 20 years. This is an example of
an objective risk, which is based on facts.

- Lastly, the risk can be either diversifiable or non-diversifiable. An example of a diversifiable risk is the chance
of an auto accident causing injury to a passenger. This auto accident is a random event; that is, the chance of
an auto accident is ordinarily uncorrelated and independent from other auto accidents that may happen at
CPCU 500 Assignment 1

another time and place and involve other people. Losses from auto accidents are suitable for pooling, that is,
this risk can be shared with a large group of people who have a similar risk of an automobile accident. By
contrast, a non-diversifiable risk can produce many losses that occur simultaneously and are correlated rather
than independent events. As an illustration, consider the damage to homes in a large geographic area caused
by a single earthquake. This type of risk produces a catastrophic event with damage to a large number of
homes simultaneously.

The quadrants of risk are a framework for categorizing four types of risk: hazard, operational, financial, and
strategic. Let’s examine each risk quadrant . . .

Hazard risks are those risks traditionally covered by insurance, and they are both pure and diversifiable risks.
Examples of hazard risks include the possibility of a building being damaged by a fire or of a customer suing a
retailer after slipping and falling in its store.

We shift the focus to operational risks, which are risks that result from people or a failure in processes,
systems, or controls A few examples of operational risk are listed. Like hazard risks, operational risks are
classified as pure and diversifiable, and they can often be transferred to an insurer or another party.

Financial risks arise from the effect of market forces on financial assets or liabilities and include market risk,
credit risk, liquidity risk, and price risk These risks are speculative, meaning they can produce one of three
discreet outcomes: a loss, no loss, or a gain. Financial risk can be either diversifiable or nondiversifiable.

The final quadrant of risk is strategic risks, which arise from trends in the economy and society, including
changes in the economic, political, and competitive environments, as well as from demographic shifts. More
specifically, these risks can affect current or future earnings arising from adverse business decisions, improper
implementation of decisions, or lack of responsiveness to changes in the industry or changes in demand. The
graphic identifies some loss exposures related to strategic risk. Most of these risks are speculative and
diversifiable.

Here’s another practice question. Pause the video, read the question, and select the best answer. Write the
letter of your selected answer on a piece of paper. When you are ready, continue the video to check your
answer.

Which one of the following statements about risk classification is most accurate?

“A” is incorrect. An investment in commercial real estate would be considered a speculative risk since this
investment can produce a gain, a loss, or breakeven for the investor.

“B” is also incorrect. Probabilities can be valued from 0 to 1. Possibilities, on the other hand, cannot be
quantified.
CPCU 500 Assignment 1

“C” is correct. Insurance deals primarily pure risks rather than speculative risks. A pure risk involves an event
that produces either a loss or no loss.

“D” is incorrect. The risk of inflation affects most, if not all, individuals, governments and businesses entities.
This risk is non-diversifiable
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The educational objective is to describe the concept of enterprise risk management.

Enterprise risk management is an approach to managing all of an organization's key business risk and
opportunities with the goal of maximizing shareholder value. This concept emerged in the 1990s following the
failure of several large corporations and subsequent regulatory mandates enacted to correct these problems.

Prior to that time, most organizations followed a traditional risk management approach to managing the risks
of the organization. With traditional risk management the focus was primarily on managing hazard risk. These
are pure risk, which either produce a loss or no loss. Risk management was treated as an isolated function
within the organization and usually involved only the purchase of insurance, the management of property or
liability claims made against the organization, and loss prevention activities.

Any risks involving other activities were managed by separate departments within the organization. As
examples, the human resources department managed personnel and employee-benefits risks; finance
managed credit, investment, and capital-acquisition risks; and operating departments managed
manufacturing and distribution risks.

In contrast, enterprise risk management manages all of an organization's risk, such as hazard, operational,
financial, and strategic risks. These risk are both pure and speculative. Enterprise risk management integrates
the treatment of the organization's risks in concert with the organization’s strategies and goals.

Overseeing the enterprise risk management function is the chief risk officer, which is an executive-level
position reporting directly to the chief executive officer or the board of directors. The chief risk officer’s
responsibilities include the following:

- Overseeing the enterprise risk management program by gathering, learning and sharing the best ERM
practices with managers;
- Obtaining the support of senior management for the enterprise risk management process by linking it
to the strategic goals of the organization;
- Empowering managers to become risk owners, who: are aware of the organization’s strategic goals;
can identify and manage risk in their areas; and, through the partnership with the ERM, can improve
the organization’s overall performance.
- Facilitating the flow of necessary data to and from managers to improving the organization’s overall
CPCU 500 Assignment 1

results.

The foundation of enterprise risk management is built on three pillars.

The first of these is interdependency. Unlike traditional risk management, which assumes the probability of a
risk occurring is independent of another risk occurring, enterprise risk management considers the
interdependencies among risk. For example, an unexpected rise in interest rates can increase and
organization’s cost of borrowing. Rising interest rates may result in an economic slowdown and increased
unemployment. This may cause a decrease in organization's sales during the next quarter.

The second pillar is correlation. Risk are uncorrelated when the occurrence of one risk-related event has no
impact on the occurrence of another event. When two or more risk are uncorrelated, they can act as a hedge
against each other.

The third pillar is portfolio theory. Risk analysis includes both the individual risks as well as the interactions
with other risks. As an illustration, let’s return to the earlier example of an unexpected rise in interest rates.
While this may increase the organization's cost of future borrowing, the higher interest rates may partially
offset this by the higher returns produced from some of the organization’s financial investments.

To give you some practice differentiating traditional risk management from enterprise risk management, let's
try another practice question.

Pause the video, read the question, and select the best answer. Write the letter of your selected answer on a
piece of paper. When you are ready, continue the video to check your answer.

The key difference between the traditional risk management approach and the enterprise risk management
approach is that . . .

“A” is the correct answer. Enterprise risk management encompasses a greater variety of risks, including both
pure risk and speculative risk. ERM involves hazard risk, operational risk, financial risk, and strategic risk.

“B” is incorrect since enterprise risk management focuses on both speculative risk and insurable risk. Most
insurable risk are hazard risks.

“C” is incorrect. Enterprise risk management may use insurance where it is appropriate. Traditional risk
management uses insurance, as well as several other techniques, to manage risk.

“D” is incorrect. Enterprise risk management and traditional risk management are both practiced in
international and domestic organizations.

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CPCU 500 Assignment 1

The educational objective is to describe the following elements for property, liability, personnel, and net
income loss exposures:
- The assets exposed to loss
- The causes of loss, including associated hazards, and
- The financial consequences of loss

For insurance and risk management purposes, loss exposures are categorized as follows:
1. Property loss exposures, which present the possibility that an entity will sustain a loss resulting
from damage, destruction, theft, or loss of use of property in which the entity has a financial
interest.
2. Liability loss exposures, which present the possibility that an entity will sustain a loss resulting
from a claim by another party.
3. Personnel loss exposures, which present the possibility of a loss due to a key person’s death,
disability, retirement, or resignation, depriving an organization of the person's special skills or
knowledge that the organization cannot readily replace.
4. Net income loss exposures, which is a condition that presents the possibility of loss caused by a
reduction in net income. This is caused either by a decrease in revenue or increase in expenses.

In a property loss exposure, the asset exposed to loss is property in which the entity has an interest. Property
can be categorized as either tangible property or intangible property. Tangible property (such as a building or
an automobile) has a physical form, while intangible property (such as a patent or copyright) does not have a
physical form.

There are many possible causes of property loss. Fire, windstorm, theft, hacker attack, and war are examples.

The main financial consequence of damage to or destruction or theft of property is a reduction in its value.
The loss of value can be partial or total, depending on the amount of damage. Damage to property can also
result in a loss of the property owner's income because the property cannot be used to generate income.

In a liability loss exposure, the asset exposed to loss is money paid to defend against a claim made against the
entity by another party. Payments that may be required include legal fees, courts costs, and damages paid to
the claimant either because of a court decision in favor of the claimant or through an out-of-court settlement.

The cause of a liability loss is the making of a claim or suit against the entity by another party seeking damages
or some other legal remedy. When this happens, the entity incurs defense costs. If the claim or suit prevails,
the entity will also have to pay damages.

In theory the financial consequences of a liability loss exposure are limitless. In practice, financial
consequences are limited to the total wealth of the entity.
CPCU 500 Assignment 1

In a personnel loss exposure, the asset exposed to loss is the value that a key person adds to an organization.

The cause of a personnel loss is the key person's death, disability, retirement, resignation, or any other event
that deprives the organization of the key person's special skill or knowledge that the organization cannot
readily replace.

The financial consequences of a personnel loss vary based on the cause of loss. The death of a key employee
is a total, permanent loss. The disability of a key employee may be partial or total, as well as temporary or
permanent.

In a net income loss exposure, the asset exposed to loss is the organization's future stream of net income cash
flows. Net income equals revenues minus expenses and income taxes in a given time period.

The cause of a net income loss can be a property loss, a liability loss, or a personnel loss, all of which are
considered to be direct losses. Net income losses, therefore, are considered to be indirect losses. Net income
losses can also result from business risks, such as poor strategic planning or obsolesence of the organization's
products or services.

The financial consequences of a net income loss vary based on the cause of loss. The worst case scenario for a
net income loss is a decrease in revenues to zero and a significant increase in expenses for a prolonged
period.

Here is another practice question. Pause the video, read the question, and select the best answer. Write the
letter of your selected answer on a piece of paper. When you are ready, continue the video to check your
answer.

An organization's exposure to loss to its patents or trade secrets would be classified as . . .

“A” is incorrect. The loss of an organization's patents or trade secrets is a pure loss, not a speculative loss. The
organization does not stand to gain from the loss of a patent or trade secret.

“B” is also incorrect. The loss of patents and trade secrets does not produce a third-party liability loss for the
organization.

“C” is incorrect. This situation does not describe a personnel loss.

“D” is correct. The loss of patents or trade secrets represents a loss of intellectual property, which is a
property loss.
CPCU 500 Assignment 1

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The educational objective is to describe the benefits of risk management and how it reduces the financial
consequences of risk for individuals, organizations and society.

The table examines the benefits of risk management for three separate entities who are impacted by risk:
individuals, organizations, and society as a whole. Overall, risk management lowers expected losses and
reduces residual uncertainty.

Take some time to study the cells in the table and think of examples of the ways in which you feel risk
management is beneficial.

Let's try another practice question. Pause the video, read the question, and select the best answer. Write the
letter of your selected answer on a piece of paper. When you are ready, continue the video to check your
answer.

Which one of the following statements most accurately describes the benefits of risk management efforts to
society as a whole?

“A” is incorrect since risk management does not eliminate risk from the economy.

“B” is also incorrect. Risk management is not a significant source of global employment.

“C” is correct. Risk management efforts benefit society by lowering expected losses, reducing residual
uncertainty, and improving the application of productive resources.

“D” is incorrect. Quantifying the elements of risk faced by individuals and organizations is not a risk
management benefit for society.

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The educational objective is to summarize the pre-loss and post-loss risk management goals and the conflicts
that can arise as they are implemented.

A risk management plan begins with establishing goals.

The pre-loss goals of a risk management program include these:
1. Economy of operations, meaning a risk management program should operate economically and
efficiently. That is, generally, an entity should not incur substantial costs in exchange for a slight
benefit.
2. Tolerable uncertainty, meaning that the risk management program should be consistent with the
company’s tolerance for risk. How much can the company afford to lose?
3. The risk management program should meet all of the company’s legal obligations.
CPCU 500 Assignment 1

4. Social responsibility, meaning that the company is acting ethically and is fulfilling its obligations to
the community and society as a whole.

The post-loss goals of a risk management program include these:

1. Survival. At the most basic level, the company should be able to survive a loss.
2. Continuity of operations. Not only should the company be able to survive a loss, but it should be
able to continue its business operations.
3. Profitability. Not only should the company strive to continue its operations after a loss, but it
should be able to do so profitably.
4. Earnings stability. Not only should the company be able to continue profitable operations
following a loss, but its profitability level should be stable.
5. Growth. Not only should the company have stable, profitable earnings following a loss, but it
should have access to sufficient financial resources to support increasing growth.
6. The last post-loss goal is social responsibility. After a loss has occurred, the company continues to
act ethically and fulfill its obligations to the community and society as a whole.

As you can see, the first five post-loss goals are in ascending order from the most basic (surviving a loss) to the
most ambitious (growing after a loss has occurred).

Sometimes risk management goals conflict with each other. For example, spending money to reduce risk to a
tolerable level, to meet legal obligations, or to assure profitable growth can come at the expense of
economizing operations.

Here is another practice question for you to try. Pause the video, read the question, and select the best
answer. Write the letter of your selected answer on a piece of paper. When you are ready, continue the video
to check your answer.

Following a severe loss, the basic post-loss goal for an organization should be . . .

“B” is the correct answer. Having experienced a severe loss, the organization is most concerned with their
survival.

Social responsibility, growth, and earnings stability are secondary to the organization’s survival.
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The educational objective is to describe each of the steps in the risk management process.

The steps in the risk management process are shown here. These steps are as follows:
- First, identify the organization's loss exposures using methods such as document analysis, compliance
reviews, inspections, or expertise within or outside the organization.
CPCU 500 Assignment 1

- Second, analyze the loss exposures by considering the frequency of losses, the severity of losses, the
total dollar amount of losses for all occurrences during a specific period of time, and the timing of
when losses occur and when losses are paid.

- Third, examine the feasibility of risk management techniques, which can be categorized as either risk
control or risk financing. Risk control techniques alter the estimated frequency and severity of loss,
and risk financing techniques pay for losses that occur despite the controls.
- Fourth, select the best technique for treating the loss exposure.
- Fifth, implement the selected risk management techniques.
- And last, monitor the results and revise the risk management program accordingly. Risk management
is an ongoing process to determine if risk management goals are being met and to identify new loss
exposures.

On the bottom of the exhibit I added a sentence, which is a trick to help you remember the steps in the risk
management process. I am examined, study I must. The first letter of each of the bullet points help you recall
the steps of the risk management process.
- I am examined. The letter ‘I’ helps you remember “identifying the loss exposures.”
- . . . am examined. The letter “a” in “am” helps you remember “analyze the loss exposures.”
- . . . examined. The letter “e” in “examined” helps you remember “examining the risk management
alternatives.”
- Study. The “S” in “study helps you remember “selecting the best technique for treating the loss
exposure.”
- I. The letter “I” helps you remember “implementing the selected technique.”
- Must. The letter ”M” in “must” helps you remember “monitoring the results.”

Here is another practice question. Pause the video, read the question, and select the best answer. Write the
letter of your selected answer on a piece of paper. When you are ready, continue the video to check your
answer.

When examining the feasibility of alternative risk management techniques, organization should consider risk
control techniques, the purpose of which can best be described as . . .

"A" is incorrect since selecting the limits of insurance is a risk financing technique, not a risk control
technique.

In a similar way, “B” is also incorrect. Transferring a risk is not a risk control technique.

“C” is incorrect because generating funds is a risk financing technique, not risk control technique.
CPCU 500 Assignment 1

“D” is the correct response. The purpose of risk control techniques is to minimize the frequency and severity
of losses or make losses more predictable.