United States
Hong KongThe risk management process, and the four responses
Identify exposures, evaluate them by frequency and severity, select a response - avoid, retain, transfer or reduce - implement, and monitor. High severity with low frequency is what insurance is for.
This is the framework the whole domain hangs on, and questions use it directly.
The four responses
| Response | When it applies |
|---|---|
| Avoid | Do not engage in the activity at all |
| Retain | Accept the loss yourself - deductibles, self-insurance |
| Transfer | Shift it to someone else - usually insurance |
| Reduce | Lower frequency or severity - sprinklers, safety measures, diversification |
Insurance is one of four. A question offering insurance for every scenario is not testing the framework, and the exam knows that.
Frequency and severity decide it
| Low severity | High severity | |
|---|---|---|
| Low frequency | Retain | Transfer - this is what insurance is for |
| High frequency | Retain and reduce | Avoid |
Four cells and they answer a great many questions on their own.
A house fire is rare and catastrophic - transfer. A cracked phone screen is common and cheap - retain. Driving without a license is frequent risk with severe consequences - avoid.
Insuring high-frequency low-severity risk is bad economics, because you pay the expected loss plus the insurer's costs and margin. That is the reasoning behind choosing a higher deductible, and questions test it.
The steps
- Identify and analyze exposures - personal, property, liability.
- Evaluate each by frequency and severity.
- Select the appropriate response.
- Implement it.
- Monitor and review as circumstances change.
Step five is the one people skip. A new baby, a house move, a business start, a large inheritance - each changes exposures, and each is a scenario the exam uses.
Insurable risk
Not everything can be insured. An insurable risk generally requires a large number of similar exposure units, a loss that is definite in time and place, accidental from the insured's perspective, not catastrophic to the insurer, and a calculable probability with an economically feasible premium.
Which is why flood and earthquake are handled separately from standard homeowners cover, and why some risks are simply uninsurable.
Adverse selection and moral hazard
Adverse selection: people more likely to claim are more likely to buy. Insurers respond with underwriting, exclusions and waiting periods.
Moral hazard: having cover changes behavior. Insurers respond with deductibles and coinsurance. Knowing which term applies to a described situation is a straightforward mark.
Dollar limits here are indexed annually and several were changed by recent legislation. Confirm the current figure before relying on it, and expect the exam to test the rule rather than the number.
Common questions
What are the four risk management responses?
Avoid, retain, transfer and reduce. Insurance is the transfer option and only one of the four, which is what framework questions test.
How do frequency and severity decide the response?
Low frequency with high severity is transferred through insurance. Low severity is retained. High frequency with high severity is avoided. High frequency with low severity is retained and reduced.
Why not insure small frequent losses?
Because you pay the expected loss plus the insurer's costs and margin. That reasoning is why a higher deductible is often the right recommendation.
What makes a risk insurable?
A large number of similar exposure units, a loss definite in time and place, accidental from the insured's perspective, not catastrophic to the insurer, and a calculable probability with a feasible premium.
What is the difference between adverse selection and moral hazard?
Adverse selection is people more likely to claim being more likely to buy, addressed by underwriting. Moral hazard is cover changing behavior, addressed by deductibles and coinsurance.