Chapter 6 Quiz

Twenty questions to check your grasp of risk, hazard, frequency and severity, exposure, and the underwriter's mental move. Fifteen multiple choice and five short answer. Answers are in the collapsed block at the bottom — work the question before you open it. All figures are constructed teaching examples.

Multiple choice

1. Which of the following is a pure risk? - A. Launching a new product line - B. Buying shares of a company - C. The chance that a warehouse burns down - D. Planting a crop hoping prices rise

2. A peril is best described as: - A. A condition that makes a loss more likely - B. The actual cause of a loss - C. The deductible the insured retains - D. The standardized unit the insurer charges for

3. Oil-soaked rags stored next to a furnace are an example of a: - A. Peril - B. Physical hazard - C. Moral hazard - D. Legal hazard

4. An owner whose failing business is worth more burned than sold represents a: - A. Physical hazard - B. Morale hazard - C. Moral hazard - D. Legal hazard

5. A jurisdiction known for runaway jury verdicts increases loss severity on every liability account written there. This is an example of a: - A. Physical hazard - B. Morale hazard - C. Moral hazard - D. Legal hazard

6. The expected loss for a risk is equal to: - A. Frequency plus severity - B. Frequency divided by severity - C. Frequency times severity - D. Severity minus the deductible

7. A fleet averages 5 collision claims a year at \$20,000 each. Its expected annual collision loss is: - A. \$25,000 - B. \$100,000 - C. \$4,000 - D. \$400,000

8. Two risks have the identical \$80,000 expected annual loss. Risk one is 32 small claims; risk two is one rare catastrophic claim. Compared with risk one, risk two is primarily a problem of: - A. Housekeeping and maintenance - B. Limits and catastrophe - C. Premium audit - D. Adverse selection

9. Which dimension of loss is generally the more stable, predictable, and trustworthy from a risk's own short history? - A. Severity - B. Frequency - C. They are equally stable - D. Neither carries any signal

10. The typical exposure base for workers' compensation is: - A. Per vehicle - B. Per \$1,000 of building value - C. Per \$100 of payroll, by class code - D. Per \$1,000 of face amount

11. A good exposure base should be all of the following EXCEPT: - A. Proportional to expected loss - B. Practical to measure and verify - C. Hard for the insured to manipulate - D. As large a number as possible to raise the premium

12. Risk classification is best understood as: - A. The cause of adverse selection - B. Sorting risks into groups of similar expected loss so each can be rated consistently - C. A list of the perils a policy covers - D. The setting aside of money for unpaid losses

13. Which is the underwriter's core mental move, in order? - A. Price → bind → inspect - B. Exposure → hazard → controls → frequency × severity - C. Peril → premium → profit - D. Severity → frequency → decline

14. Insuring a building for far less than its true value is dangerous chiefly because: - A. It violates the law against unfair discrimination - B. A partial loss triggers the coinsurance penalty and a total loss exceeds the limit - C. It is a speculative risk - D. It increases the legal hazard

15. The chapter argues that insurability is best understood as: - A. A fixed yes/no property of the risk alone - B. A function of the risk plus the terms, the price, and the machinery brought to it - C. Determined entirely by the peril involved - D. Whatever the predictive model outputs

Short answer

16. In one or two sentences, explain why insurance addresses pure risk but leaves speculative risk to the market.

17. Give one example each of a hazard that primarily raises the frequency of loss and one that primarily raises the severity, and name the family of each.

18. Two accounts post the same expected loss; one is high-frequency/low-severity and the other is low-frequency/high-severity. Name one underwriting tool you would reach for in each case, and say why they differ.

19. Harbor Steel strains exactly one of the six insurability criteria. Name it, and name two things the underwriter brings to the account that make the strained exposure writable anyway.

20. Why does the chapter say risk classification is both the underwriter's primary tool and the place where the legal and ethical stakes run highest? Name the line it must not cross.

Answer key (work the questions first) **1. C** — Only loss or no loss is possible; A, B, and D all carry a chance of gain (speculative). **2. B** — A peril is the cause of loss; the condition that makes loss more likely is a *hazard* (A). **3. B** — A tangible, observable condition that raises the chance of a fire loss. **4. C** — Dishonesty/incentive to cause or exaggerate a loss is moral hazard. **5. D** — The judicial environment, not anything physical, drives the worse outcome: legal hazard. **6. C** — Expected loss = frequency × severity. **7. B** — $5 \times \$20{,}000 = \$100{,}000$. **8. B** — A rare catastrophic claim is a limits-and-catastrophe problem, managed with structure and reinsurance, not housekeeping. **9. B** — Frequency is the more stable dimension; severity is fat-tailed and dragged by rare large losses. **10. C** — Workers' comp rates on payroll per \$100, by NCCI class code (owned by Ch. 22). **11. D** — A base is chosen to *track the risk*, not to inflate the premium; manipulating the base up to raise price is not a property of a *good* base. **12. B** — Classification sorts risks into groups of similar expected loss; it is the cure for adverse selection, not its cause. **13. B** — Exposure → hazard → controls, then frequency × severity to a grade. **14. B** — Undervaluation triggers the coinsurance penalty on a partial loss and leaves the limit short of the rebuild cost on a total loss. **15. B** — Insurability is a relationship between the risk and the apparatus (terms, price, reinsurance, capital), not a verdict on the risk alone. **16.** Insurance covers *pure* risk because the loss must be fortuitous and the upside must not be retained by the insured; a speculative risk's chance of gain would let insureds keep the upside and transfer only the downside, turning the pool into a subsidized one-sided bet (pure adverse selection), so the market — not the insurer — bears it. **17.** *Frequency:* worn wiring or hot-work near combustibles (physical hazard) raises how *often* a fire starts. *Severity:* an aging roof in a named-storm zone (physical hazard), or a plaintiff-friendly venue (legal hazard), raises how *bad* the loss is when it occurs. (Any defensible pairing earns credit.) **18.** High-frequency/low-severity is an operations problem — a safety/maintenance program plus a per-claim deductible to screen nuisance losses. Low-frequency/high-severity is a structure problem — adequate limits, excess/umbrella, and reinsurance. They differ because housekeeping reduces *counts* but does nothing about the rare enormous claim, while limits and reinsurance cap *size* but do nothing about routine frequency. **19.** The strained criterion is *not catastrophic to the insurer* — the coastal, named-storm exposure means one event can strike Harbor Steel and many other insureds at once (the independence assumption fails for the catastrophe peril). The underwriter makes it writable with adequate catastrophe pricing, a percentage named-windstorm deductible that shares the severity, and cession of the catastrophe risk to reinsurance (Ch. 27) — plus adequate capital behind it (Ch. 28). **20.** Classification is the primary tool because it is how the insurer charges by risk and corrects adverse selection; it is also where the stakes are highest because the law permits classifying by *risk* but forbids classifying by *protected class* (race, religion, national origin, and — variably — gender and credit). The line it must not cross is *unfair discrimination*, including through a *proxy* — a permissible-seeming factor that stands in for a prohibited one (owned by Ch. 4 and developed in Ch. 35).