CFP - Risk Management and Insurance Planning (11% of the exam) - Section C.18

Analysis and evaluation of risk exposures

Identifying a client's personal, property, liability and business exposures, ranking them by frequency and severity, and deciding which to insure, retain or mitigate. Items present a household and ask which exposure is most under-protected or which coverage gap matters most.

Risk exposure analysis

Practice question for this objective

Free sampleRisk Management and Insurance Planningmedium

A client aged 52 owns a coastal holiday house with a replacement cost of 900,000 dollars and no mortgage. Local records show a storm surge severe enough to destroy a house on that street happens roughly once every 40 years, and the client has no other liquid assets beyond an emergency fund of 60,000 dollars. Applying the frequency and severity framework of the risk management process, which treatment should the planner recommend for the storm surge exposure?

ARetain the exposure and fund it from the emergency reserve, because a once in 40 years event is an infrequent loss
BAvoid the exposure by selling the holiday house and renting comparable accommodation each season
CTransfer the exposure to an insurer through a policy covering storm surge damage to the dwelling Correct
DReduce the exposure by fitting storm shutters and raising the foundations, with no insurance purchased

Match a risk treatment to the exposure's frequency and severity: low frequency with high severity calls for transfer. The risk management process classifies each exposure by how often a loss occurs and how large it would be. Retention works where the client can pay the loss from resources on hand, and reduction lowers severity without capping it. Here the loss is rare but would exceed the client's liquid resources fifteen times over, so transferring it to an insurer for a comparatively small premium is the treatment that fits the quadrant.

Why A is wrong: Retention is tempting because the frequency really is low, but retention is appropriate only when the severity is also low enough that the client can absorb the loss; a 900,000 dollar loss against a 60,000 dollar reserve would be financially ruinous.

Why B is wrong: Avoidance does eliminate the exposure completely, but it also destroys the client's stated objective of owning the property, and avoidance is reserved for exposures that cannot be economically insured or reduced.

Why C is correct: Low frequency combined with high severity is the classic quadrant for risk transfer, because the premium is small relative to a loss the client could not absorb, and the insurer can pool the exposure across many similar properties.

Why D is wrong: Loss reduction is a sensible supplement and may earn a premium credit, but on its own it lowers the size of a loss rather than removing the catastrophic tail, so the client is still exposed to a loss far beyond the reserve.

See more CFP practice questions, answers explained.

Exam traps in Risk Management and Insurance Planning

Answers that look right on this material and are not. Each one is a distractor from a different question in the CFP bank for this domain.

A neighbour who slips on her icy front steps while delivering a parcel and sues her for 400,000 dollars of bodily injury damages.
Why it is wrong: Tempting because the demand exceeds the 300,000 dollar homeowners personal liability limit, but this is an ordinary premises liability claim: the homeowners policy pays to its limit and the umbrella pays the balance, so the exposure is funded.
Bind the umbrella at the current underlying limits, because an umbrella drops down and pays from the first dollar whenever the underlying policy limit is smaller than the umbrella requires.
Why it is wrong: Tempting because umbrellas do drop down for a loss the underlying policy does not cover at all, subject to a self insured retention, but they do not fill a gap created by underlying limits below the required amount.
The bodily injury liability cover of her own personal auto policy, once the at fault driver's own limit has been exhausted by payment.
Why it is wrong: Tempting because the limit is large enough, but liability cover pays third parties whom the insured injures; it never pays the named insured her own damages, so it cannot respond here.

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