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IAI SP8 practice questions

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Question 1General insurance products and markets

Which type of policy is specifically designed to cover a business against losses arising from the dishonesty of its own employees?

  1. Business interruption insurance
  2. Employers' liability insurance
  3. Public liability insurance
  4. Fidelity guarantee insurance Correct answer.

Explanation

Fidelity guarantee insurance is a specialist cover designed to indemnify an employer for financial loss caused by fraud or dishonesty of employees. It differs from liability covers, which respond to injury or damage claims from third parties.

Question 2General insurance products and markets

In the London insurance market, which term describes a syndicate of individual underwriters operating within Lloyd's who each accept a share of a risk?

  1. Managing general agent
  2. Captive insurer
  3. Coverholder
  4. Lloyd's syndicate Correct answer.

Explanation

A Lloyd's syndicate is a group of members, often backed by corporate capital, that accepts risks under the Lloyd's umbrella. Each syndicate is managed by a managing agent and takes its own share of a risk.

Question 3General insurance products and markets

Which principle requires that an insured must have a legally recognised relationship with the subject matter of insurance?

  1. Indemnity
  2. Utmost good faith
  3. Insurable interest Correct answer.
  4. Proximate cause

Explanation

Insurable interest requires the insured to stand to suffer a financial or legal disadvantage if the insured event occurs. Without it, the contract would be a wager rather than a contract of indemnity.

Question 4General insurance products and markets

A householder's buildings policy typically covers which of the following as standard?

  1. The contents of the dwelling including furniture
  2. Personal accident benefits for the householder
  3. Legal expenses for employment disputes
  4. The structure of the dwelling and its permanent fixtures Correct answer.

Explanation

Buildings cover responds to damage to the structure and permanent fixtures of the home. Contents, personal accident, and legal expenses are usually separate sections or separate policies.

Question 5General insurance products and markets

Which motor insurance cover level provides the minimum legally required protection in the United Kingdom?

  1. Roadside assistance
  2. Third party, fire and theft
  3. Third party only Correct answer.
  4. Comprehensive

Explanation

Third party only cover is the statutory minimum required to drive on public roads, covering liability for injury or damage to others. Comprehensive and third party, fire and theft provide wider cover at the policyholder's option.

Question 6General insurance products and markets

Which market participant places business with insurers on behalf of clients and owes a duty of care to the client rather than the insurer?

  1. Underwriter
  2. Reinsurer
  3. Insurance broker Correct answer.
  4. Loss adjuster

Explanation

An insurance broker acts for the client, advising on cover and placing risks with insurers. The broker's duty is owed to the client, distinguishing it from an agent acting for the insurer.

Question 7General insurance products and markets

What is the primary purpose of reinsurance in the general insurance market?

  1. To calculate the premium tax payable
  2. To transfer risk from an insurer to another insurer Correct answer.
  3. To provide compulsory cover for motorists
  4. To regulate the conduct of brokers

Explanation

Reinsurance transfers part of the risk accepted by a primary insurer to a reinsurer, protecting the ceding insurer against large or accumulative losses. It also supports capital efficiency and underwriting capacity.

Question 8General insurance products and markets

Which of the following is a characteristic of a mutual insurer?

  1. It is owned by its shareholders
  2. It is owned by the government
  3. It is owned by its brokers
  4. It is owned by its policyholders Correct answer.

Explanation

A mutual insurer is owned by its policyholders, who may receive returns or benefits rather than dividends to external shareholders. This ownership structure distinguishes it from a proprietary company.

Question 9General insurance products and markets

A commercial property policy is written on a 'new for old' basis. What does this mean when a claim is settled?

  1. The insurer replaces the damaged item without deduction for wear and tear Correct answer.
  2. The insurer pays only the original purchase price
  3. The insurer pays the market value of the damaged property at the date of loss
  4. The insurer pays nothing if the property is more than five years old

Explanation

New for old settlement replaces damaged property with new equivalent items without deducting for depreciation or wear and tear. It is common in household contents cover and usually requires sums insured to reflect replacement cost.

Question 10General insurance products and markets

An insured suffers a fire loss. Under the doctrine of proximate cause, which cause is treated as the operative cause of loss?

  1. The cause nearest in time to the damage
  2. The cause most favourable to the insured
  3. The dominant and effective cause of the damage Correct answer.
  4. The cause recorded first in the claim report

Explanation

Proximate cause is the dominant, effective cause that sets the chain of events in motion, not simply the last event in time. Insurers apply it to determine whether the loss falls within the insured perils.

Question 11General insurance products and markets

An insured's buildings sum insured is £300,000, but the reinstatement value is £400,000. A partial loss of £40,000 occurs. Assuming average applies, what amount is payable?

  1. £26,667
  2. £40,000
  3. £10,000
  4. £30,000 Correct answer.

Explanation

Under average, the claim is reduced in proportion to the underinsurance: £40,000 × (£300,000 ÷ £400,000) = £30,000. The insured bears the shortfall caused by insuring for less than the full value.

Question 12General insurance products and markets

Which policy condition requires the insured to take reasonable steps to prevent further damage after a loss has occurred?

  1. Contribution condition
  2. Subrogation condition
  3. Mitigation condition Correct answer.
  4. Cancellation condition

Explanation

The mitigation condition obliges the insured to act as though uninsured and take reasonable steps to limit further loss. Insurers may reduce or decline a claim if the insured fails to mitigate.

Question 13General insurance products and markets

An insured holds two property policies covering the same building, each with a sum insured of £500,000. A loss of £200,000 occurs. Under the principle of contribution, how is the loss shared?

  1. The first policy pays £200,000 and the second pays nothing
  2. Each insurer pays £100,000 Correct answer.
  3. The insured selects one insurer to pay the full amount
  4. Each insurer pays £200,000, giving the insured a profit

Explanation

Contribution requires insurers covering the same interest to share the loss rateably, preventing the insured from recovering more than the loss. With equal sums insured, each insurer pays half.

Question 14General insurance products and markets

Which type of liability policy would respond to a claim from a member of the public injured by slipping on a wet floor in a shop?

  1. Product liability
  2. Public liability Correct answer.
  3. Professional indemnity
  4. Employers' liability

Explanation

Public liability covers the insured's legal liability for injury or property damage caused to third parties in connection with the business. A slip in a shop affects a member of the public, so public liability applies.

Question 15General insurance products and markets

In a coinsurance clause on a commercial property policy, what is the effect of insuring for less than the required percentage of value?

  1. The insurer pays the claim in full regardless
  2. Claims are reduced in proportion to the shortfall Correct answer.
  3. The policy is void from inception
  4. The premium is automatically refunded

Explanation

A coinsurance clause requires the insured to insure for a specified percentage of value and reduces claims proportionately if the sum insured falls short. It operates similarly to average but is set out as a contractual requirement.

Question 16General insurance products and markets

Which of the following best describes the role of a loss adjuster in the claims process?

  1. To underwrite complex commercial risks
  2. To set premium rates for new business
  3. To investigate and quantify claims on behalf of the insurer Correct answer.
  4. To sell policies to prospective insureds

Explanation

A loss adjuster investigates the circumstances of a claim, verifies the loss and recommends settlement to the insurer. The role is claims-focused rather than sales, pricing or underwriting.

Question 17General insurance products and markets

An insured deliberately fails to disclose a previous declined application when applying for property cover. What is the likely consequence under the duty of fair presentation?

  1. The insurer must pay all future claims in full
  2. The insurer may have remedies including avoiding the policy Correct answer.
  3. The policy automatically renews at the same terms
  4. The insured is entitled to a reduced premium

Explanation

A deliberate or reckless breach of the duty of fair presentation entitles the insurer to avoid the policy and retain premiums. The remedies reflect the seriousness of the non-disclosure.

Question 18General insurance products and markets

Which of the following is typically excluded from a standard household contents policy?

  1. Television sets
  2. Clothing and personal effects
  3. Business stock kept at home Correct answer.
  4. Domestic furniture

Explanation

Household contents policies generally exclude business stock and equipment used for commercial purposes, as these present different risks. Domestic items such as furniture and clothing are normally covered.

Question 19General insurance products and markets

What distinguishes a 'claims-made' liability policy from an 'occurrence' policy?

  1. Occurrence policies respond to claims reported during the policy period only
  2. Claims-made policies respond to claims reported during the policy period Correct answer.
  3. Claims-made policies only cover property damage
  4. Occurrence policies never cover injury claims

Explanation

A claims-made policy responds to claims notified during the policy period, regardless of when the incident occurred, subject to any retroactive date. An occurrence policy responds to incidents occurring during the policy period.

Question 20General insurance products and markets

An insured under a commercial combined policy has a fire loss and also suffers loss of profit while the premises are rebuilt. Which cover responds to the loss of profit?

  1. Engineering inspection
  2. Business interruption Correct answer.
  3. Public liability
  4. Fidelity guarantee

Explanation

Business interruption cover indemnifies the insured for loss of gross profit and increased cost of working following an insured incident. It typically follows the same perils as the property section.

Question 21General insurance products and markets

Which of the following best explains why insurers use excesses on liability policies?

  1. To eliminate all claims below £10,000
  2. To avoid the need for underwriting
  3. To increase the premium charged
  4. To share small losses with the insured and encourage risk management Correct answer.

Explanation

An excess requires the insured to bear a small part of each loss, sharing the cost and discouraging small claims. It also reduces administration costs and encourages risk management.

Question 22General insurance products and markets

An insured's commercial property policy includes a 'removal of debris' clause. What is the practical effect of this clause?

  1. It transfers clean-up liability to the public authority
  2. It covers the cost of clearing debris following an insured loss Correct answer.
  3. It covers the cost of removing the insured's business waste generally
  4. It excludes all clean-up costs from the policy

Explanation

Removal of debris clauses extend cover to include the cost of clearing debris after an insured event, within stated limits. They address a cost that would otherwise fall on the insured and complicate reinstatement.

Question 23General insurance products and markets

An insured holds a policy with a 'claims cooperation' condition. Which scenario best illustrates its purpose?

  1. The insured must assist the insurer in investigating and defending a claim Correct answer.
  2. The insured must pay the premium in instalments
  3. The insured must appoint a broker
  4. The insured must renew the policy annually

Explanation

Claims cooperation conditions require the insured to provide information and assistance to enable the insurer to investigate or defend a claim. Breach may entitle the insurer to reduce or decline cover.

Question 24General insurance products and markets

Under the principle of subrogation, when does the insurer's right to pursue a third party arise?

  1. Before any claim is notified
  2. When the policy is cancelled
  3. Only if the insured consents in writing
  4. Once the insurer has paid the claim Correct answer.

Explanation

Subrogation allows the insurer, having indemnified the insured, to step into the insured's shoes and pursue recovery from the responsible third party. The right arises on payment of the claim.

Question 25General insurance products and markets

Which best explains the concept of 'utmost good faith' in modern general insurance contracts?

  1. The duty ends once the policy is issued
  2. Only the insured owes duties of disclosure to the insurer
  3. Both parties owe duties of fair dealing and disclosure, with remedies for breach Correct answer.
  4. The insurer may avoid the policy for any inaccuracy, however minor

Explanation

Modern law and regulation impose duties of fair presentation and fair dealing on both parties, with proportionate remedies for breach. The duty continues throughout the contract, not only at inception.

Question 26General insurance products and markets

Under the Financial Services and Markets Act regime, which body is responsible for prudential regulation of general insurers and for authorising firms to carry on insurance business in the UK?

  1. The Financial Ombudsman Service
  2. The Prudential Regulation Authority Correct answer.
  3. The Financial Conduct Authority's retail conduct division
  4. The Association of British Insurers

Explanation

The Prudential Regulation Authority, part of the Bank of England, authorises and supervises insurers for financial soundness, while conduct is handled separately by the Financial Conduct Authority. The Ombudsman resolves individual disputes and the ABI is a trade body with no regulatory powers.

Question 27General insurance products and markets

A broker is remunerated by an insurer through a commission arrangement disclosed to the client. Which regulatory concern does this arrangement most directly raise?

  1. That the client loses any right to complain to the Financial Ombudsman Service
  2. That the broker may be influenced to recommend a product that pays higher commission rather than one best suited to the client Correct answer.
  3. That the policy is automatically void for lack of insurable interest
  4. That the insurer becomes liable for the broker's advice under the policy terms

Explanation

Commission-based remuneration creates a potential conflict of interest, which is why disclosure and fair treatment of customers rules require transparency about how intermediaries are paid. Insurers are not made liable for broker advice simply by paying commission, and Ombudsman access and insurable interest are unaffected.

Question 28General insurance products and markets

An insurer wishes to write a large commercial property risk that exceeds its own appetite for a single exposure. Which market mechanism allows several insurers to each accept a defined share of the same risk under one policy?

  1. A binding authority, where a coverholder issues policies on the insurer's behalf
  2. A coinsurance placement, where each subscribing insurer bears its stated percentage of every loss Correct answer.
  3. A facultative reinsurance treaty, where the reinsurer automatically accepts all risks written by the cedant
  4. A protected cell company, where each cell's liabilities are ring-fenced from the others

Explanation

In a coinsurance or subscription placement, several insurers each sign for a percentage of the risk and pay that same percentage of any claim, which spreads a large exposure across the market. Reinsurance, delegated authority and protected cells serve different purposes and do not create shared direct participation on a single policy.

Question 29General insurance products and markets

A UK household policyholder wants independent confirmation of the scope of cover and exclusions before buying a high-value home policy. Which statement best describes the role of the policy wording and the Insurance Product Information Document in that decision?

  1. Both documents are legally binding in full and any inconsistency between them is resolved in the insurer's favour
  2. The IPID gives a short standardised summary of the main features and exclusions, while the full policy wording contains the binding terms and conditions Correct answer.
  3. The IPID replaces the need for a policy wording for all personal lines products
  4. The IPID is the binding contract and the policy wording is merely promotional material

Explanation

The Insurance Product Information Document is a short, standardised summary designed to help customers compare products, whereas the full policy wording sets out the contractual terms, conditions and exclusions. Where the summary and the wording differ, the wording governs the contract.

Question 30General insurance products and markets

A new Lloyd's syndicate wishes to accept business in a class where it has no historical data of its own. Which feature of the Lloyd's market most directly supports its ability to do so while managing capital exposure?

  1. Access to the Lloyd's central guarantee arrangements and the ability to reinsure risk through the market's extensive reinsurance capacity Correct answer.
  2. The obligation to cede all accepted risk to the Corporation of Lloyd's
  3. The statutory immunity of Lloyd's members from solvency regulation
  4. The requirement that every syndicate writes only one class of business

Explanation

Lloyd's operates a chain of security including central assets, and syndicates can lay off exposure through the depth of reinsurance capacity available in the market, which supports entry into unfamiliar classes. Syndicates are not restricted to a single class, members are not immune from regulation, and risk is not ceded to the Corporation.

Question 31Risk and insurance: risk identification, measurement and management

In enterprise risk management, which term describes the residual exposure that remains after controls have been applied to a risk?

  1. Inherent risk
  2. Residual risk Correct answer.
  3. Risk appetite
  4. Risk capacity

Explanation

Residual risk is the level of exposure remaining once existing controls and mitigation measures are in place. It is contrasted with inherent risk, which is the exposure before controls are considered. Risk appetite and risk capacity describe tolerances rather than a remaining exposure level.

Question 32Risk and insurance: risk identification, measurement and management

An insurer's underwriting team is assessing a large petrochemical facility. Which risk identification technique would best reveal how a single equipment failure could cascade into business interruption and liability losses?

  1. A claims triangle development analysis
  2. A checklist of standard policy exclusions
  3. A review of the reinsurance treaty wording
  4. A hazard and operability study (HAZOP) Correct answer.

Explanation

HAZOP is a structured, systematic technique that examines deviations in process parameters to identify failure pathways and their consequences, including cascading effects. It is designed for complex process plant where interdependencies matter. Checklists and treaty reviews do not model causal chains, and claims triangles are reserving tools.

Question 33Risk and insurance: risk identification, measurement and management

Which statement best describes the role of risk appetite within an insurer's risk management framework?

  1. It defines the amount and type of risk the insurer is willing to accept in pursuit of its objectives. Correct answer.
  2. It sets the maximum premium volume the insurer can write in a year.
  3. It records the losses the insurer has already incurred in the current period.
  4. It specifies the solvency capital requirement imposed by the regulator.

Explanation

Risk appetite expresses the quantum and categories of risk an insurer chooses to pursue or retain, aligned with its strategy. It is a forward-looking tolerance statement, not a historical record or a regulatory calculation. Limits and tolerances are then derived from it.

Question 34Risk and insurance: risk identification, measurement and management

A property portfolio has two independent risks. Risk A has a 5% annual probability of a £2m loss; Risk B has a 10% annual probability of a £1m loss. What is the expected annual loss from these two risks combined?

  1. £100,000
  2. £150,000
  3. £200,000 Correct answer.
  4. £300,000

Explanation

Expected loss for each risk equals probability multiplied by severity: Risk A is 0.05 × £2m = £100,000 and Risk B is 0.10 × £1m = £100,000. Because expectation is additive regardless of dependence, the combined expected loss is £200,000.

Question 35Risk and insurance: risk identification, measurement and management

Which measure of risk captures the potential size of losses in the tail of a distribution beyond a chosen confidence level?

  1. Tail value at risk Correct answer.
  2. Mean expected loss
  3. Loss frequency
  4. Standard deviation

Explanation

Tail value at risk (also called expected shortfall) measures the average loss conditional on losses exceeding a specified confidence threshold. It therefore describes severity in the tail, which standard deviation and mean loss do not. Frequency counts how often losses occur rather than their tail size.

Question 36Risk and insurance: risk identification, measurement and management

An insurer uses a reinsurance treaty that transfers losses above £5m per event up to £25m. Which risk treatment category does this represent?

  1. Risk retention
  2. Risk reduction through engineering controls
  3. Risk transfer Correct answer.
  4. Risk avoidance

Explanation

Reinsurance shifts a defined layer of loss to a counterparty in exchange for premium, which is a transfer treatment. Retention would leave the loss with the insurer, avoidance would mean not writing the risk, and engineering controls reduce the physical hazard itself.

Question 37Risk and insurance: risk identification, measurement and management

In a risk register, which pair of attributes is most important for prioritising which risks to address first?

  1. Claim handler and settlement date
  2. Currency and payment method
  3. Likelihood and impact Correct answer.
  4. Policy number and broker name

Explanation

Prioritisation in a risk register typically combines an estimate of how likely a risk event is with the severity of its impact, often through a risk score or matrix. These two dimensions allow risks to be ranked for treatment. Administrative fields do not inform risk priority.

Question 38Risk and insurance: risk identification, measurement and management

An underwriter is measuring the risk of a single large industrial fire. Which combination of frequency and severity best characterises this exposure?

  1. Low frequency and low severity
  2. Low frequency and high severity Correct answer.
  3. High frequency and low severity
  4. High frequency and high severity

Explanation

A single large industrial fire is an event that occurs rarely but produces very substantial loss when it does, so it sits in the low frequency, high severity quadrant. This profile is typically handled through retention limits and catastrophe or facultative reinsurance. High frequency exposures are better managed through pricing and deductibles.

Question 39Risk and insurance: risk identification, measurement and management

Which of the following is a key limitation of using historical loss data alone to measure future risk?

  1. It may understate emerging or unobserved risks not present in the data. Correct answer.
  2. It removes the need for expert judgement in setting assumptions.
  3. It guarantees that tail events are fully captured.
  4. It automatically incorporates forward-looking scenario analysis.

Explanation

Historical data can only reflect risks that have already occurred and been recorded, so genuinely new or emerging exposures may be invisible in it. This is why scenario analysis and expert judgement supplement experience data. Historical data does not guarantee tail capture or eliminate judgement.

Question 40Risk and insurance: risk identification, measurement and management

A risk manager classifies risks by their source. Which of the following is best described as an operational risk rather than a financial or strategic risk?

  1. Failure of an internal claims processing system Correct answer.
  2. Changes in corporate tax legislation
  3. Entry of a new competitor into a core market
  4. Adverse movements in interest rates affecting asset values

Explanation

Operational risk arises from inadequate or failed internal processes, people, systems, or external events, and a system failure fits squarely within that definition. Interest rate movements are financial risk, while competitor entry and tax changes are strategic or external environment risks.

Question 41Risk and insurance: risk identification, measurement and management

An insurer calculates a 99.5% one-year value at risk of £40m. Which statement correctly interprets this figure?

  1. The maximum possible loss in any year is £40m.
  2. The expected loss over one year is £40m.
  3. Losses will exceed £40m in one year out of every two.
  4. There is a 0.5% probability that losses over one year will exceed £40m. Correct answer.

Explanation

Value at risk at 99.5% means that in 99.5% of years losses are expected to stay at or below the threshold, leaving a 0.5% chance of exceeding it. It is not a maximum loss and is not the mean. The exceedance probability is 0.5%, not 50%.

Question 42Risk and insurance: risk identification, measurement and management

Which control activity is an example of a detective control rather than a preventive control?

  1. Password protection on the policy administration system
  2. Reconciliation of the claims ledger to bank records Correct answer.
  3. Segregation of underwriting and claims duties
  4. Dual authorisation of large claim payments

Explanation

Detective controls identify errors or irregularities after they occur, and reconciliation of the ledger to bank records does exactly that. Dual authorisation, segregation of duties, and password protection all act to stop problems arising in the first place and are preventive.

Question 43Risk and insurance: risk identification, measurement and management

An insurer's board is reviewing its risk management framework. Which element most directly demonstrates that risk oversight is embedded at the highest level of governance?

  1. An annual fire drill at the head office
  2. A monthly newsletter on risk awareness for staff
  3. A claims triage procedure for small losses
  4. A board risk committee that reviews the risk appetite and top exposures regularly Correct answer.

Explanation

Board-level oversight is evidenced by a dedicated committee that regularly reviews risk appetite and the largest exposures and reports to the board. This places risk decision-making at the top of the governance structure. Staff communications, claims procedures, and drills are operational activities lower in the organisation.

Question 44Risk and insurance: risk identification, measurement and management

Two risks are perfectly positively correlated. How does the risk of the combined portfolio compare with the sum of the individual risks measured by standard deviation?

  1. It equals the sum of the individual standard deviations. Correct answer.
  2. It is lower than the sum of the individual standard deviations.
  3. It is higher than the sum of the individual standard deviations.
  4. It is zero regardless of the individual risks.

Explanation

With perfect positive correlation the standard deviation of the sum equals the sum of the individual standard deviations, because there is no diversification benefit. Any correlation below one produces a combined standard deviation below the simple sum. Correlation cannot drive the result to zero or above the sum.

Question 45Risk and insurance: risk identification, measurement and management

Which statement correctly distinguishes risk tolerance from risk appetite?

  1. Tolerance is the total capital the organisation holds against all risks.
  2. Tolerance is the same concept as risk capacity and can be used interchangeably.
  3. Tolerance is the historical loss experience used to calibrate appetite.
  4. Tolerance is the specific variation around appetite that the organisation will accept in practice. Correct answer.

Explanation

Risk appetite sets the overall level of risk the organisation seeks, while tolerance defines the acceptable variation or boundaries around that appetite for specific activities. Capacity is the maximum risk bearable, which is a different concept. Historical experience informs calibration but is not tolerance.

Question 46Risk and insurance: risk identification, measurement and management

An insurer has identified a risk of regulatory change affecting its product terms. Which response is most consistent with a risk reduction strategy?

  1. Ceasing to sell the affected product line entirely
  2. Building a compliance monitoring process that tracks regulatory consultations early Correct answer.
  3. Accepting the risk with no further action and monitoring it
  4. Purchasing a financial derivative to hedge interest rate exposure

Explanation

Risk reduction lowers either the likelihood or the impact of an event, and early regulatory monitoring reduces the chance of being caught unprepared by change. Exiting the line is avoidance, derivatives address market risk, and passive acceptance is retention.

Question 47Risk and insurance: risk identification, measurement and management

In scenario analysis for operational risk, why do insurers construct extreme but plausible scenarios rather than rely solely on observed losses?

  1. Because regulators prohibit the use of internal loss data
  2. Because scenario analysis eliminates the need for capital modelling
  3. Because observed losses may never have reached the severity levels that the insurer could face Correct answer.
  4. Because extreme scenarios are easier to quantify than historical data

Explanation

Scenario analysis explores severe events that may be absent or underrepresented in the loss history, giving insight into tail exposure. It complements rather than replaces historical data and capital modelling. Scenarios are generally harder, not easier, to quantify than observed data.

Question 48Risk and insurance: risk identification, measurement and management

Which of the following best describes a key person risk in an insurance operation?

  1. The risk that a reinsurer becomes insolvent
  2. The risk that a single indispensable individual leaves and disrupts critical activities Correct answer.
  3. The risk that interest rates rise sharply
  4. The risk that a new regulation increases reporting costs

Explanation

Key person risk is a people-related operational risk where the loss of a critical individual disrupts essential functions. Reinsurer insolvency is counterparty credit risk, interest rate movements are financial risk, and new regulation is an external or compliance risk.

Question 49Risk and insurance: risk identification, measurement and management

An insurer's gross loss from an event is £12m. It has a per-risk reinsurance cover of £8m excess of £4m. What is the insurer's net retained loss from the event?

  1. £0m
  2. £4m Correct answer.
  3. £8m
  4. £12m

Explanation

The reinsurance layer covers losses between £4m and £12m, so the reinsurer pays £8m and the insurer retains the £4m deductible. The retention is the amount below the attachment point, which here is £4m. The full loss is not retained and the loss is not eliminated.

Question 50Risk and insurance: risk identification, measurement and management

Which statement best explains why diversification reduces portfolio risk?

  1. It combines exposures whose losses are less than perfectly correlated. Correct answer.
  2. It removes all risk from the portfolio regardless of correlation.
  3. It increases the expected return of each individual exposure.
  4. It guarantees that no single loss can exceed a fixed amount.

Explanation

Diversification works because imperfect correlation between exposures means individual adverse outcomes do not all occur simultaneously, lowering aggregate variability. It does not raise individual expected returns, eliminate all risk, or cap any single loss.