Risk management and Insurance

CHAPTER 1: THE NATURE OF RISK

Definition of Risk
Risk is a condition in which there is a possibility of
an adverse deviation from a desired outcome.
If only one outcome is possible, the variation and
hence the risk is zero
If some one knows or certain the result of a
given outcome or if there is a positive deviation
from a desired out come, there is no risk.
If many outcomes are possible, the risk is not zero

Uncertainty and its relationship to risk

Uncertainty refers to a state of mind characterized by
doubt, based on lack of knowledge about what will or
will not happen in the future
Uncertainty is the doubt a person has concerning his/her
ability to predict which of the many possible outcomes
will occur
If there is uncertainty or dilemma about the outcome of
future events, there is risk
Hence , risk is highly related to uncertainty
But, uncertainty cannot be measured by commonly
accepted yardstick/unit.

Risk versus Probability

Probability refers to the long-run chance of
occurrence or relative frequency of some event
Risk and probability are similar in that :
the out come of the future events is not certain.
Both can be measured by commonly accepted
yardstick/unit
Where as the difference between probability and
risk is that a concept in relative variation

Cont
If the number of objects is too small, the range of
probable variation is large and vice versa
If the number of objects is too small, the risk will
be also minimum and vice versa
Probability has both objective and subjective
aspects
In case of objective probability, the chance of
happening an event depends upon a given
observation

Cont
Whereas in case of subjective probability, the
chance of happening an event depends upon
the individuals personal estimate of the
chance of loss.
Means some people may be risk taker
whereas others may be risk averter
Objective probability can be determined
either deductive(prior) or inductive (based on
past observation)reasoning.

Risk, Peril and Hazard

Peril is defined as the cause of loss or
It is a contingency that may cause a loss
Example: fire, flood, , windstorm, collisions ,
theft, lightning, earthquake , and soon
Hazard is a condition that may create or
increase or exaggerate the chance of a loss
arising from a given peril

Cont
For example: icy street increases the
occurrence of cars collisions; Storing gasoline
in a kitchen may create fire; Poor lighting in a
crime-prone area may increase theft, draught
may create windstorm, and so on

Types of Hazard
Physical Hazard: is a condition stemming from the
physical characteristics of an object that increases
the probability and severity of loss.
Physical hazards consist of those physical
properties that increase the chance of loss
For example: the existence of dry forests (hazard
for fire); earth faults (hazard for earthquakes)
;icebergs (hazard to ocean shipping); defective
wiring in a building that increases the chance of
fire and a defective lock on a door that increases
the chance of theft.

Cont
Moral Hazard: means dishonesty or character
defects in an individual that increases the
frequency or severity of loss.
Moral hazard refers to the increase in the
probability of loss that result from dishonest
tendencies in the character of the insured person
A dishonest person, in the hope of collecting from
the insurance company, may intentionally cause a
loss or may exaggerate the amount of a loss in an
attempt to collect more than the amount to which
he /she is entitled

Cont
For example: causing an accident to collect the
insurance, submitting a fraudulent claim, inflating
the amount of a claim and intentionally burning
unsold merchandise that is insured
Morale Hazard: refers to carelessness or
indifference to a loss because of the existence of
insurance.
When people have purchased insurance, they may
have a more careless attitude toward preventing
losses.

Cont.
For example: leaving car keys in the ignition of
an unlocked car and thus increasing the
chance of theft, leaving a door unlocked that
allows a burglar to enter, and changing way
suddenly on a congested road without
signaling.

Classification of risk
Financial and non-financial Risks: losses occurred
on property are called financial risks such as
financial crises; damage of building ,car, or other
financial assets whereas losses occurred on
human health are non-financial risks such as
injury, sickness, or death.
Static and dynamic risks: Dynamic risks are those
resulting from changes in the economy whereas
Static risks involve those losses that would occur
ever if there were no changes in the economy.

Cont
Examples of dynamic risks: Changes in the
price level, consumer tastes, income and
output and technology may cause financial
loss in the economy.
Examples of static risks include risks due to
random events such as fire, windstorm or
death

Cont
Fundamental and particular risks
. Fundamental risk is a risk that affects the
entire economy or large numbers of persons
or groups within the economy.
. Fundamental risks involve losses that are
impersonal in origin and consequence
. They are group risks, caused for the most part
by economic, social and political phenomenon

Cont
Examples of fundamental risks include high
inflation, war, drought, earthquakes, floods
and other natural disasters.
particular risk is a risk that affects only
individuals and not the entire community.
Examples of particular risks are the burning of
a house, the damage of a car, theft of
individual property etc.

Cont
Objective and subjective risks
Objective risk is defined as the relative variation
of actual from expected loss.
Objective risk is the variation that occurs when
actual losses differ from expected losses
Assume that a property insurer has 10,000 houses
insured over a long period and on average 100
houses burn each year. But in some year only 90
or in another year 110 houses may destroyed.

Cont
Thus, there is a variation of 10 houses from the
expected loss known as objective risk.
Objective risk can be statistically measured by
some measure of dispersion, such as variance,
standard deviation or coefficient of variation.
Subjective risk is defined as uncertainty based on
a persons mental condition or state of mind
subjective risk is a psychological uncertainty that
stems from the individuals mental attitude or
state of mind.

Cont
Pure and Speculative risks
Pure risk is defined as a situation in which
there are only the possibilities of loss or no
loss.
The only possible outcomes are adverse (loss)
and neutral (no loss).
A pure risk exists when there is a chance of
loss but no chance of gain.

Cont.
Examples of pure risks include premature death,
job-related accidents, damage to property from
fire, lighting, flood, earthquake etc
Speculative risk is defined as a situation in which
either profit or loss is possible.
Speculative risk exists when there is a chance of
gain as well as a chance of loss.
For example investment in a capital project ,
gambling a football match, going into business
etc.

Classifications of Pure Risk

Personal risks: are risks that consist of the
possibility of loss of income or assets as a result of
the loss of the ability to earn income.
Personal risks are risks that directly affect an
individual; they involve the possibility of the
complete loss or reduction of earned income,
extra expenses and the depletion of financial
asset.
Examples are risk of premature death ,risk of
insufficient income during retirement ,risk of poor
health and risk of unemployment.

Cont
Property Risks: Anyone who owns property faces
property risks simply because such possessions
can be destroyed or stolen.
Property loss may be direct or indirect.
A direct loss is a financial loss that results from
the physical damage, destruction or theft of the
property. For example if a house is destroyed by
fire, the owner losses the value of the house.
An indirect loss is a financial loss that results
indirectly from the occurrence of a direct physical
damage or theft loss.

Cont
when a firms facilities are destroyed the firm
losses not only the value of those facilities but
also the income that would have been earned
through their use.
Liability Risks: is the unintentional injury of other
persons or damage to their property through
negligence or carelessness
Legally you can be held liable if you do something
that result in bodily injury or property damage to
someone else

Cont.
Risks arising from Failure of others: this type of
risk may happen when someone agrees to
perform a certain service and fails to do so
this obligation would result in your financial
loss.
Examples of such risks include failure of a
contractor to complete a construction project
as scheduled or failure of debtors to make
payments as expected.