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Chapter One (1) 1. Risk and Related Topics
Chapter One (1) 1. Risk and Related Topics
Dear student, the starting point of any material on risk management and insurance has to be the
understanding of the concept of risk itself. Let you answer the question here under before you go
deep into the chapter.
The word risk is certainly used in ever day conversation and seems to be well understood by
those using it. For instance, you use the word risk quite often in your daily life. You often hear
people saying this is risky; do not take any risk, etc. So, what is your understanding of the word
risk? What impression does it give you when somebody mentions the word to you?
To most people, risk implies some form of uncertainty about outcome in a given situation. That
is, the listener understands in a given situation there is uncertainty about the outcome will be
unfavorable. This is loose intuitive notion of risk, which implies a lack of knowledge about the
future and the possibility of some adverse consequence, is satisfactory for conversational usage.
But as a student of risk management and insurance, you do not need to stop with this simple
understanding of the word risk. Rather, you shall explore more concepts incorporated in it.
Because risk is undesirable and its consequences are, at times, damaging to individual,
businesses and the society as a whole, mankind is constantly developing its predictive ability
through the constant upgrading and refinement of its knowledge. The more mankind is
knowledgeable about the future, the more certain it will be concerning future events. But, the
disappointing phenomenon is that perfect foresight about the future is something impossible.
Thus, risk becomes a fact of life that will remain side by side with the activities of mankind.
Every discipline has its own specialized terminology, which has very simple meanings in ever
day usage often take on different and complicated connotations when applied in a specialized
field. No comprehensive definition exists so far. It is defined in different forms by several
authors with some differences in the wordings used. The essence however is very similar. In
general, risk refers to exposure to adverse consequences.
There is no single definition of risk. Economists, behavioral scientists, risk theorists, statisticians
and actuaries each have their own concept of risk. Risk management is still in its infancy as a
body of theory. As a result, we find many contradictory definitions of risk throughout the
literature dealing with this phenomenon from the risk management or an insurance point of view.
However, risk traditionally has been defined in terms of uncertainty. Based on this concept, risk
is defined as uncertainty concerning the occurrence of a loss. For example, the risk of being
killed in a car accident is present because uncertainty is present. The risk of lung cancer for
smokers is present because uncertainty is present. And the risk of flunking/failing a college
course is present because uncertainty is present.
Although risk is defined as uncertainty, employees in the insurance industry often use the term
risk to identify the property or life being insured. Thus, in the insurance industry, it is common
to hear statements such as “that driver is a poor risk” or “that building is an unacceptable
risk.”
The term risk used in different ways; the following are some definitions given by different
scholars and practitioners in the different fields:
Risk is the chance of loss.
Risk is the possibility of loss.
Risk is uncertainty of loss.
Risk is the exposure to adverse consequence
Risk is the probability of any outcome different from the one expected.
Doubt
Worry
Undesirable events
Risk is a combination of hazards
Let’s see if some definition means approximately the same thing, or has a different connotation,
to decide the one which is relatively proper definition, and which, if any, is relatively suitable for
our purpose.
and ‘chance of loss’ (i.e. probability of loss) mean the same thing, the degree of risk and the
degree of probability should always be the same. Yet when the chance of loss (defined as the
probability of loss) is 100%, the loss is certain and there is no risk. Risk always has the
implication that outcome is how somehow in question. When the chance of loss (probability) is
either 100% or 0, the degree of risk is zero.
A contribution of major significance in the area of risk theory as it relates to insurance was
provided by Irving Pfeffer in his insurance and Economic Theory, Pfeffer draws a distinction
between risk and uncertainty. According to Pfeffer,
Uncertainty is a state of mind relative to a specific situation. It is measured by degree
of belief.
Risk is a combination of hazards and is measured by probability. Risk is state of real
world.
There are common elements in all definitions of risk: Indeterminacy and loss.
Indeterminacy: the notion of indeterminate outcome is implicit in all definitions of risk;
the outcome must be in question. When risk is said to exist, there must be at least two
possible outcomes. If we know for certain that loss will occur there is no risk.
Loss: at least one of the outcomes is undesirable. This may be a loss in the generally
accepted sense, in which something the individual posses are loss, or it may be a gain
smaller than the gain that was possible.
In general, the following are some important concepts you should note from the above
definitions and discussions.
Risk is the reality of the real world, but not belief i.e. risk is an objective concept.
Risk refers to uncertainty as to the loss.
Risk becomes important if there is uncertainty as to the occurrence of the loss
If we are certain there is no risk
Under risky condition, the outcome is undesirable
The degree of risk is inversely related to the ability to predict the future.
The more the future is unpredictable and unmanageable, the greater will be the risk
If the probability of the occurrence is 1 or 0, the degree of risk is zero
If many outcomes are possible, the risk is not zero. The greater the variation, the greater
the risk.
Uncertainty is doubt about our ability to predict the future. Uncertainty arises when an
individual perceives risk. Uncertainty is a subjective concept, so it cannot be measured directly.
Since uncertainty is a state of mind, it varies across individuals.
For complex activities, such as participating in a business venture, some persons are very
cautious, others are more aggressive. Although risk aversion explains some of the reluctance to
participate, the level of risk perceived by individuals also plays a key role. The perceived level
of risk depends on information that an individual can use to evaluate the chance of outcomes
and, perhaps, on the individual’s ability to evaluate this information.
The level and type of information on the nature of a risky activity have an important effect on
uncertainty.
Level of Uncertainty Characteristics Examples
None (Certainty) Outcomes can be Physical laws, natural
predicted with precision. sciences.
The level of uncertainty arising from a given type of risk can depend on the entity facing the risk;
for example, an insurer or a governmental entity may regard the risk of earthquake as being at
level 2, while the individual may regard the earthquake as being at level 3. This difference in
perspective may be a consequence of an ability to estimate the likelihood of outcomes.
In general, the following important concepts can be noted from the definition.
o Uncertainty is the doubt as to the occurrence of certain desired outcome.
i. Objective Probability:
Objective probability refers to the long-run relative frequency of an event based on the
assumptions of an infinite number of observations and of no change in the underlying
conditions. Objective probabilities can be determined in two ways. First, they can be
determined by deductive reasoning. These probabilities are called a priori probabilities. For
example: tossing a fair coin. Second, objective probabilities can be determined by inductive
reasoning, rather than by deduction. For example, the probability that a person age 21 will dies
before age 26 cannot be logically deduced. However, by a careful analysis of past mortality
experience, life insurers can estimate the probability of death on a five-year term life insurance
policy issued at age 21.
in losses ranges from 75 to 125 in Hawassa, but only from 90 to 110 in Adama, objective risk is
greater in Hawassa even though the chance of loss in both cities is the same.
Peril: A Peril is a contingency, which may cause a loss. OR: it refers to the specific
cause of a loss. Peril is also called loss producing agent. It is the source of a specific loss.
Peril refers to prime source of specific loss. Most of time, it is beyond the control of
anyone involved in the situation. If your house burns because of a fire, the peril, or cause
of loss, is the fire. If your car is damaged in a collision with another car, collision is the
peril, or cause of loss. Common perils that cause property damage included fire,
lightning, windstorm, hail, tornadoes, earth quakes, theft and robbery.
Hazard: A hazard, on the other hand is that the condition which creates or increases the
probability of a loss arising from a given peril.
For example, one of the perils that can cause loss to automobile is collusion. A condition that
makes the occurrence of collusions more likely is an icy street. The icy street is the hazard and
the collusion is the peril. It is possible to establish the following relationship.
Hazard Peril Risk
Note: this relationship is not always true: because sometimes it is possible for something to be
both a peril and hazard. For instance, sickness is a peril causing economic loss, but it also a
hazard that increases the chance of loss from the peril of premature death.
? Can you think of some example of peril and hazard?
There are four major types of hazards:
1. Physical hazard
2. Moral hazard
3. Morale hazard
4. Legal hazard
1) Physical Hazard:
o A physical hazard is a physical condition that increases the chance of loss.
o A physical hazard is a condition stemming from the physical characteristics of the
exposure (object) and that increases the probability and severity of loss from given
perils.
o Examples of physical hazards include icy roads that increase the chance of a car
accident, defective wiring in a building that increases the chance of fire, and location of
property, (near burglar area, flood area, earthquake area).
o Such hazards may or may not be within human control.
2) Moral Hazards:
3) Morale Hazard:
Some insurance authors draw a subtle distinction between moral hazard and morale
hazard.
Moral hazard refers to dishonest by an insured that increases the frequency or severity of
loss.
Morale hazard is carelessness or indifference to a loss because of existence of
insurance. Some insureds are careless or indifferent to a loss because they have
insurance.
Examples of morale hazard include leaving car keys in an unlocked car, which increase
the chance of theft; leaving a door unlocked that allows a robber to enter; and changing
lanes suddenly on a congested interstate highway without signaling. Careless acts like
these increase the chance of loss.
4) Legal Hazard:
Legal hazard refers to characteristics of the legal system or regulatory environment that
increase the frequency or severity of losses.
Examples include adverse jury verdicts or large damage awards in liability lawsuits,
statutes that require insurers to include coverage for certain benefits in health insurance
plans, such as coverage for alcoholism; and regulatory action by state insurance
departments that restrict the ability of insurers to withdraw from the state because of poor
underwriting results.
b. Non-financial risks: those risks which do not have or expressed in financial terms.
Example: Agony one feels following the death of a person, personal injury and etc.
b. Static risks
Refers to those losses, which would occur even if there are no changes in the
overall economy. They are losses arising from causes other than changes in the
economy. Unlike dynamic risk, they are predictable and could be controlled to
some extent by taking loss prevention measures. Many of perils fall under this
category.
These are risks connected with losses caused by the irregular action of the forces of
nature/flood, earthquake or the mistakes and misdeeds of human beings (moral and
morale hazards).
are caused by perils which have no consequence on the national economy, like a
fire or theft or misappropriation.
Note:
o Static risks would be present in an unchanging economy. If we could hold consumer
taste, output and income and the level of technology constant, some individuals would
still suffer financial losses. These losses arise as a result of the perils of nature and the
dishonesty of other individuals.
o Dynamic risks benefit the society over the long run since they are the result of
adjustments to misallocation of resources.
o Unlike dynamic risk, static risks are not a source of gain to society. i.e. they usually
result in a loss to society. Static risks affect directly few individuals at most exhibit more
regularly over a specific period of time and are generally predictable.
o Static risk and dynamic risks are not independent; greater dynamic risks may increase
some type of static risks. E.g. Industrialization (technology) affects global weather
patterns.
o Dynamic risks are less likely to occur than static risks, but are also less predictable.
Static risks are more suited to management through insurance.
A. Pure Risk:
Pure risk is defined as a situation in which there are only the possibilities of loss or
not loss but no chance of gain/profit.
The only possible outcomes are adverse (loss) and neutral (no loss). For instance,
owner of automobile faces the risk of a collusion loss. If collusion occurs, he will
suffer financial loss. If there is no collusion, the owner does not gain.
Other examples of pure risk include premature death, industrial accidents, terrible
medical expenses, and damage to property from fire, lightning, flood, or earthquake.
Most pure risks are insurable. They are always undesirable and hence people take
steps to avoid such risks.
Pure risks that exist for individuals and business firms can be classified under one of
the following:
1) Personal Risk
Personal risks are risks that directly affect an individual
This refers to the possibility of loss to a person such as: death, disability,
loss of earning power, etc.
These consist of the possibility of the loss of income or assets as a result
of the loss of the ability to earn income. Both individual and business
face losses.
the property can be building, car, real estate and personal property can be damaged or
destroy because of fire, lightning, tornadoes, windstorms, and numerous other causes.
Property risks embrace two distinct types of loss:
i) Direct loss and ii) Indirect loss
a. Direct loss: A direct loss is defined as financial loss that results, from the physical
damage, destruction, or theft of the property. For example, if you own a hotel that is
damaged by a fire, the physical damage to the hotel is known as a direct loss.
b. Indirect loss or Consequential loss: is a financial loss that results indirectly from
the occurrence of a direct physical damage or theft loss OR it is the losses that are
going to be incurred because of direct loss. Thus, in addition to the physical damage
loss, the hotel would lose profits for several months while the hotel is being rebuilt.
The loss of profits would be consequential loss. Other examples of a consequential
loss would be the loss of rents, the loss of the use of building, and the loss of a local
market.
3) Liability Risk:
Refers to the intentional or unintentional injury or damage made to other persons or to their
property.
Under our legal system, you can be held legally liable if you do something that result in
bodily injury or property damage to someone else. A court of law may order you to pay
substantial damages to the person you have injured.
Example: A given pastry may face product liability if the cake it makes create health
problem on customer due to sanitation problem and people suffer from that act and demand
compensation by the court of law.
B. Speculative Risk:
Speculative risk is defined as a situation in which either profit or loss is possible.
For example, if you purchase 100 shares of common stock, you would profit if the price of
stock increases but would loss if the price declines.
Other examples, of speculative risk include betting on horse race, card games, investing in
real estate, and going into business for yourself, keeping dollar gambling. In these
situations, both profit and loss are possible.
First, private insurers generally insure only pure risk. With certain exceptions, speculative
risk generally is not considered insurable, and other techniques for managing with
speculative risk must be used.
Pure risks are distasteful (involuntarily accepted), but speculative risks posse some
attractive features (voluntarily accepted).
Second, the law of large numbers can be applied more easily to pure risks than to
speculative risks. The law of large numbers is important because it enables insurers to
predict future loss experience.
In contrast, it is generally more difficult to apply the law of large numbers to speculative
risks to predict future loss experience. An exception is the speculative risk of gambling
where nightclub operators can apply the law of large numbers in a most efficient manner.
Finally, Society may benefit from a speculative risk even though a loss occurs, but it is
harmed if a pure risk is present and a loss occurs. Example, a firm may develop new
technology for producing low price computers. As a result, some competitors may be
forced to bankruptcy. Despite the bankruptcy, society benefits because the computers are
produced at a low cost. However, society normally does not benefit when as loss from a
pure risk occurs, such as flood, or earth quake.
B) Objective Risk
Is “the variation that exists in nature and is the same for all persons facing the same
situation.” It is the state of nature.
It is measurable by using statistical measures like standard deviation, variation and etc.
It differs from subjective risk primarily in the sense that is more precisely observable
and therefore measurable.
For example, assume that a property insurer has 10,000 houses insured over a long
period and, on average, 1 %, or 100 houses, burn each year. However, it would be rare
for exactly 100 houses to burn each year. In some years, as few as 90 houses may
burn; in other years, as many as 110 houses, may burn. Thus, there is a variation of 10
houses from the expected number of 100, or a variation of 10%. This relative variation
of actual loss from expected loss is known as Objective Risk.
Objective risk declines as the number of exposures increases. Objective risk varies
inversely with the square root of the number of cases under observation.
As the number of exposures increases, an insurer can predict its future loss experience
more accurately because it can rely on the law of large number.
The law of large numbers states that the number of exposure units’ increases, the more
closely the actual loss experience will approach the expected loss experience. For
example: as the number of houses under observation increases, the greater is the
degree of accuracy in predicating the proportion of houses that will burn.
i. Fundamental Risk:
A fundamental risk is a risk that affects the entire economy or large numbers of
persons or groups within the economy.
Involve losses that are impersonal in origin and consequence
They are group risks caused for the most part by economic, social and political
phenomena.
They affect a large number of society and they are not the fault of anyone.
Generally speaking, fundamental risks are uninsurable
Examples include rapid inflation, deflation, cyclical unemployment, and war because
large numbers of individuals are affected.
The risk of a natural disaster is another important risk such as hurricanes, tornadoes,
earthquakes, floods, and forest and grass fires can result in billions of dollars of property
damage and numerous deaths. More recently, the risk of a terrorist attack is rapidly
emerging as fundamental risk.
Z End Of Ch01
Wish U A Nice Study!!!