CHAPTER ONE - RISK AND RELATED TOPICS

1.1. Risk defined

1.2. Risk vs. uncertainty
1.3. Risk and probability
1.4. Risk, peril and hazard
1.5. Classification of risk
Chapter Objectives
After completing this unit, students will be able to:
 Define and understand the concept of risk
 Understand the difference between risk, uncertainty and probability
 Understand the word hazard and peril and its relationship with risk
 Identify the different types of risk
INTRODUCTION

Due to imperfect knowledge about the future, our actions are likely to result in outcomes which
are different from our expectations. This is something that is not desirable. Risk exists because
there is no perfect foresight about the future.
Since risk is undesirable and its consequences are, at times, damaging to individuals, business
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.

Another sad thing is that when mankind gains technological advancement with the objective of
enhancing society’s development and timing to bring nature under its control, it creases an
associated risk. Some of these risks are extremely disastrous to society. Space technology,
nuclear plants, aerospace industry, chemical plants, oil rigs etc. all bring increased risk not only
to individuals and companies in particular but to the society as a whole. Thus, one can remember
the numerous incidents related to technological development which brought shocking tragedies
to people, companies and the Society.

Each new technological development creates its related risk. New risks are created whenever
new inventions are discovered.

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1.1. Definition of Risk/Meaning of Risk

There is no single comprehensive definition exists so far. Economists, behavioral scientists, risk
theorists, statistician, and actuaries each have their own concept of risk. Dear colleagues even if
it is defined in different forms by several authors with some differences in the wordings used, the
essence of the definition is very similar. In general, risk refers to exposure to adverse
consequences. Dear colleague some of the definitions given by different authors are given
allow:-

“Risk is a condition in which there is a possibility of an adverse deviation from a desired

outcome that is expected or hoped for”.

According this definition risk exists when there is a possibility for adverse (unfavorable)
deviation from expectation. In fact, deviations from expectations could be either favorable
(positive) or unfavorable (Negative). Favorable deviations are, in most cases, welcomed since
they have desirable (positive) effects. Therefore risk generally is associated with bad and harmful
incidents. Accordingly, some explain risk as a situation where there is unfavorable (harmful)
deviation from what has been expected.

“Risk is potential variation in outcomes”. If a loss is certain to occur, it may be planned for in
advance and treated as a definite known expense. Dear colleagues, it is then there is uncertainty
about the occurrence of a loss that risk becomes an important problem. If only one outcome is
possible, the variation and hence the risk is zero. If many outcomes are possible, the risk is not
zero. The greater the variation the greater the risk. The degree of risk is inversely related to the
ability to predict which outcome will actually occur. If the risk is zero, the future is perfectly
predictable and more manageable.

“Risk is the objectified uncertainty as to the occurrence of an undesirable event. It varies with
uncertainty and not with the degree of probability.” Dear colleague, the central theme is still
prevalent – the possibility of undesired event. More than explaining the essence, the definition
implies the existence of two types of uncertainties: Objective and subjective uncertainties
Moreover, the definition indicates the positive relationship of risk and uncertainty. It also implies
that risk and probability are two different concepts although they have functional relationship.

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The other definition of risk given by Athearn is that

“The possibility of an unfavorable deviation from expectations; it is the possibility that

something we do not want to happen will happen or that something we want to happen will fail
to do so.”

Athearn called the unfavorable deviation a loss; and this loss, although in most cases has
economic implications, may at times be difficult to describe in economic terms. For example, the
unexpected death of a pet could be a great loss to a family. But, the loss cannot be measured in
economic terms. The loss whether or not measurable in economic term is an incident to be
avoided. It is an unfavorable occurrence.

To summarize the concept of risk embodied in its definition let us look the following statements.

 The potential for unexpected events to occur or for expected events not to occur, either of
which can precipitate adverse outcomes.
 Risk is unpredictability – the tendency that actual results may differ from predicted.
 A condition in which there is a possibility of an adverse deviation from a desired outcomes
that is expected or hoped for.
 The possibility that a sentient entity will incur loss.
 The objectified uncertainty as to the occurrence of an undesired event.
1.2. Risk Vs. Uncertainty

We have used the word uncertainty several times already. In our first attempt at a working
definition at risk, we said that it was uncertainty about the outcome in a given situation.
Moreover, many text books use the terms risk and uncertainty interchangeably. However, the
distinction between the two terms must be noted.

The term uncertainty refers to the double as to the occurrence of a certain desired outcomes. It
refers to a state of mind characterized by doubt. Based on a lack of knowledge about what will
happen or will not happen in the future. It is simply a psychological reaction to the absence of
knowledge about the future. It is more of subjective belief subjective in the sense that “It is based
on the knowledge and attitudes of the person viewing the situation and different subjective
uncertainties are possible for different individuals under identical circumstances of the external

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world. This means for a given state of real world Situation, different people would express
different intensity of uncertainty.

The distinction between risk and uncertainty is expressed as follows by Peffer.

“Risk is a combination of hazards and is measured by probability, uncertainty is measured by the

degree of belief. Risk is a state of the world, whereas uncertainty is the state of the mind.

The confusion that may arise in this definition is that whether or not risk is measured by
probability rather than by variability. A clear explanation made above is that risk is largely
objective while uncertainty is subjective.

Uncertainty is the doubt a person has concerning his or her ability to predict which of the many
possible outcomes will occur. Uncertainty is a person’s conscious awareness of the risk in a
given situation. Uncertainty depends up on the person’s estimated risk what that person believes
to be the state of the world and the confidence he or she has in this belief. A person may be
extremely uncertain about the future in a situation where in reality the risk is small; on the other
hand, this person may have great confidence in his or her ability to predict the future when in
fact the future is highly uncertain. Unlike probability and risk, uncertainty cannot be measured
by any commonly accepted yardstick.

Of course, risk and uncertainty may have some relationship, uncertainty results from the
imperfection of knowledge of individual in predicting the future. The higher the lack of
knowledge about the future, the higher the uncertainty. But, it is debatable to say that higher
uncertainty leads to higher risk. Crowe and Horn described four situations to underline the
distinction between risk and uncertainty.

1. Both risk and uncertainty are present

 A person may be exposed to risk of disability and may experience uncertainty.
Here since the person know the risk of disability he experience uncertainty. That
means the awareness of the existence of risk lead to uncertainty in the mind of the
individual.
2. Both risk and uncertainty are absent.

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  Modern Sailors know that the world is not flat; there is no possibility of falling off the
edge of the world, therefore, they would experience no uncertainty about such a
contingency. Here, the knowledge that the world is not flat assure the person that
there is no possibility of falling off the edge of the world consequently the person fell
certain about the event i.e. no uncertainty here.
3. Risk is present and uncertainty absent
 The possibility of less due to interruption of operation by fire. There may be no
uncertainty because of failure to recognize the existence of such risk, understatement
of the situation or because of preoccupation with other problems.
4. Risk absent but uncertainty present.
 An hour ago, a man learned that a plan departing from the airport crashed. The man
knows that his wife was scheduled to fly from the airport earlier today, but he does
not know whether she was on the plane crashed. Here, there is no risk as risk refers to
future outcomes. However, there is uncertainty since it relates to past, present and
future situations.
Risk exist whether or not a person is aware of it because it is a state of the world rather than the
state of mind. However, uncertainty exists only with awareness; it is a state of mind. For
example, the risk of cancer from cigarette smoking. This risk existed the moment cigarette are
produced. However, the uncertainty did not arise until the relationship between cigarette
smoking and cancer is established through scientific and empirical research.

Sometimes risk may create uncertainty. Thus, the relationship between risk and uncertainty is
established in terms of cause and effect. That means knowledge of the existence of risk and
appreciation of its significance creates a feeling of uncertainty. Risk, when we aware of it causes
uncertainty.

In general, uncertainty results in a feeling of insecurity. This insecurity, leads one to worry
giving considerable thought for the uncertain situation. Worry leads a person to take the
necessary action so that the possible loss is avoided. For example, the moment one joins
university he faces the risk of dismissal. This is an objective situation of the university system.
The existence of this risk creates uncertainty in the student’s psychological make-up which was
totally absent prior to university enrollment. The student starts to worry and makes every effort

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to work hard so that he/she would avert the risk. The intensity of uncertainty varies from one
student to another depending on his/her background, confidence, intelligence, caliber and the
like.

Uncertainty, therefore, refers to the doubt a person expresses as to which of the many possible
future outcomes will take place. It is essentially different from risk. A person’s uncertainty
concerning future outcomes may be high; where in fact the associated risk is small and vice
versa.

1.3. Risk and Probability

Chance of loss is closely related to the concept of risk. “Chance of loss” is defined as the
probability that an event will occur. Probability has both objective and subjective aspects.

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 either by deductive reasoning or by inductive
reasoning. In case of deductive reasoning, it is called a priori probabilities. For example, the
probability of getting a head from the toss of a perfectly balanced coin is ½ because there are two
sides and only one is a head.

The example of inductive reasoning is that the probability that a 21-year old person die before
the age 26 cannot be logically deduced. However, by a careful; analysis of past mortality
experience, life insurers can estimate the probability of death.

Subjective Probability:

Subjective probability is the individual’s personal estimate of the chance of loss. It need not
coincide with objective probability. For example, people who buy a lottery ticket on their
birthday may believe that it is their lucky day and over-estimate the small chance of winning.
However, some may think that their wedding anniversary day as a lucky day. Thus, a wide
variety of factors can influence subjective probability such as age, sex, intelligence, education,
etc.

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In subjective probability, a person’s estimate of loss may differ from objective probability
because there may be ambiguity in the way in which the probability is perceived. For example,
assume that a slot machine in a gambling casino requires triple zero (“000”) to win. The person
playing the machine may perceive the probability of winning to be quite high. But if there are
numbers from 0 to 9 on each reel and only one zero in each reel. Thus, the objective probability
of hitting the jackpot with three zeros (“000”) is quite small. Assuming that each reel spins
independently of the others, the probability that all three will simultaneously show zero (“0”) is
the product of their individual probabilities, i.e., 1/10x 1/10x 1/10 = 1/1000. Thus, this
knowledge is advantageous to casino owners, who know that most gamblers are not trained
statisticians and therefore likely to overestimate the objective probabilities of winning.

Chance of loss Vs. Risk: Chance of loss is the probability that an event will occur. Objective
risk is the relative variation of actual loss from expected loss. “The chance of loss may be same
for two different groups, but objective risk may be different. For example, Africa Insurance
Company (AIC) has 10000 homes insured in Addis Ababa and 10000 homes insured in Jimma
and that the chance of loss in each city is 1%. Thus, on an average 100 homes should burn
annually in each city. However, if the annual variation in losses ranges from 70 to 120 in Addis,
but only from 90 to 110 in Jimma, objective risk is greater in Addis even though the chance of
loss in both cities is the same.

1.4. Risk, Peril and Hazard

Peril:-

Peril is defined as the specific cause of a loss. It is a contingency that may cause a loss. Such as
fire, windstorm, theft, explosion, flood etc. Each of these is the cause of the loss that occurs. 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.

Hazard:-

A hazard is a condition that may create or increase the chance of loss arising from a given peril.
A hazard is a condition that introduces or increases the probability of loss from a peril. For
example, one of the perils that can cause loss to an auto is collision. A condition that makes the
occurrence of Collisions more likely is an icy street or muddy street. The icy (muddy) street is
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the hazard and the collision is the peril. Hazard, in general, affect the magnitude and frequency
of a loss. The more hazardous conditions are, the higher the chance of loss. Storing gasoline in a
kitchen is another example of a hazard. The storage of the gasoline generally will not cause a
loss. The gasoline, however, will make fire losses that otherwise occur more sever. From this
you can understand that the consideration of hazard is important when an insurance company is
deciding whether or not it should insure some risk and what premium to charge. There are three
basic types of hazards:-

 Physical hazard
 Moral hazard
 Morale hazard
Physical Hazard

A physical hazard is a condition stemming from the physical characteristics of an object that
increase the probability and severity of loss from given perils. Physical hazard is associated with
the physical properties of the item exposed to risk. Examples of physical hazard includes such
phenomenon as the existence of dry forests (hazard for fire), earth faults (hazard for earth
quakes), and icebergs (hazard to ocean shipping). Other examples of physical hazards are icy
roads that increase the chance of an auto accident, defective wiring in a building that increases
the chance of fire, and a defective lock on a door that increase the chance of theft.

Such hazard may or may not be within human control. For example, some hazards for fire can be
controlled by planning restrictions on building, campfires in forest during the dry seasons. Some
hazards, however, cannot be controlled little can be done to prevent or control air masses that
products ocean storms.

Moral Hazard

Moral hazard is originated from evil tendencies in the character of the insured person. It is
associated with human nature, qualities, reputation, and attitudes etc.

Moral hazard can also be defined as dishonesty or character defects in an individual that increase
the frequency or severity of loss. Moral hazard refers to the increase in the probability of loss
that results from dishonest tendencies in the character of the insured person. A dishonest person,

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in the hope of collecting from the insurance company, any intentionally cause a loss or may
exaggerate the amount of a loss in an attempt to collect more than the amount to which he or she
is entitled. Examples of moral hazard are taking an accident to collect from an insurer,
submitting a fraudulent claim, inflating the amount of the claim, and intentionally bringing
unsold merchandise that is insured.

Moral hazards may exist in situation where excessive amounts of fire insurance are requested on
“white elephant” properties (Properties that are no longer profitable), where an incentive might
exist to “sell” the building to the fire insurance company”. Moral hazard is present in all forms of
insurance, and it is difficult to control. Dishonest individuals often rationalize their actions on the
grounds that” the insurer has plenty of money”. This view is incorrect because the insurer can
pay claims only by collecting premium from other insured’s. Because of moral hazard, premiums
are higher for everyone.

Morale Hazard:

Morale hazard is carelessness or indifference to a loss because of the existence of insurance.

Morale hazard is originated from acts of carelessness leading to the occurrence of a loss. It does
not involve dishonesty but it occurs due to lack of concern for events. Some insured’s are
careless or indifferent to a loss because they have insurance where people have purchases
insurance, they may have a more careless attitude towards preventing losses. Examples of morale
hazard include leaving car key 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 cigarette smoking around
petrol station increase the chance of fire. Careless acts like these increase the chance of loss.

Usually insurer try to eliminate the moral hazard and minimize the morale hazard by carefully
selecting their insured’s and by including contractual provisions causing the insured to regret the
loss despite the insurance coverage. For example some contracts require insured to pay the first
certain amount of loss, and others require insured’s to pay a percentage of each loss. In both
cases, the insured’s have reason to regret the losses while still receiving insurance compensation.

1.5. Classification of risk

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Risk may be classified in many ways; however, there are certain distinctions that are particularly
important for our propose. The major categories or risk are:

 Financial and non-financial risks

 Static and dynamic risks
 Fundamental and particular risks
 Objective and subjective risks
 Pure and speculative risks
1.5.1 Financial and Non-financial risks

This classification is self-explanatory. Financial risk results in losses that can be expressed in
financial terms, where as non-financial risk does not have financial implication.

In its broadest content, the term risk includes all situations in which there is an exposure to
adversity. In some cases this adversity involves financial loss, while in others it does not. There
is some element of risk in every aspect of human endeavor, and many of these risks have no
financial consequences. For example, material damage to property, theft of property or lost
business profit following a fire are financial risk because the outcome can be measured in
monetary terms, whereas the selection of a career, the choice of a marriage partner or having
children are some non-financial risk, b/c they outcome may not be measured in monetary terms.

In the world of business we are primarily concerned with risks which have a financially
measurement outcome.

1.5.2 Static and dynamic Risks

Dynamic risks originate /resulting/ from change in the overall economy such as price level
changes, changes in consumer test, change in income designation and output, technological
change political changes and the like. These changes may cause financial loss to members of the
economy. These dynamic risks normally benefits society over the long run, since they are the
result of adjustments to misallocation of resources. Although these dynamic risks man affect a
large number of individuals, they are generally considered less predictable and hence beyond the
control of risk managers, since they do not occur with any precise degree of regularity. Static

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risks, on the other hand, refer to those losses that can take place (occur) even if there were no
changes in the overall economy. If we could hold consumer testes.

Output and income, and the level of technology constant, some individuals would still suffer
financial loss. These losses arise from causes other than the damages in the economy, Such as the
perils of nature and the dishonesty of other individuals. Unlike dynamic risks, static risks are not
a sources of gain to society. Examples of static risks include the uncertainties due to random
events such as fire, windstorm, or death. Static loss involves either the destruction of the asset or
a change in its possession as a result of dishonesty or human failure. Unlike dynamic risk, they
are predictable and could be controlled to some extent by taking loss prevention measures and
purchasing insurance.

1.5.3 Fundamental and particular Risks

The distinction b/n fundamental and particular risks is based on the difference in the origin and
consequences of the losses.

Fundamental risks are essentially group risks; the condition which caused them have no relation
to any particular individual. It is a risk that affects the entire economy or large number of persons
or groups wish in the economy. Fundamental risks involve losses that are impersonal in origin
and consequences. Most fundamental risks are economic, political or social phenomena. They
affect large segments or even all of the population. Examples of fundamental risks include high
inflation unemployment war, drought, earth quakes, floods, and other natural disasters. They are
general any uninsurable.

A particular risk is a risk that affects only individuals and not the entire community. They are
usually personal in causes, almost always personal in their application. Because they are so
largely personal in their nature; the individual has a certain degree of control over their causes.
They involve losses that arise out of individual events and are felt by individual rather than by
the entire group. They may be static or dynamic. Example of particular risks are the burning of a
house, the robbery of a bank, and the damage of a car.

Since fundamental risks are caused by conditions more or less beyond the control of the
individuals who suffer the losses and since they are not the fault of anyone in particular it is held

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that society rather than the individual has a it is held that society rather than the individual has a
responsibility to deal with them. Although some fundamental risks are dealt with through private
insurance, it is an inappropriate tool for dealing with most fundamental risks. For example,
earthquake insurance is available from private insurers, and flood insurance is frequently
included in contracts covering movable personal property.

Particular risks are considered to be the individual’s own responsibility, in appropriate subjects
for action by society as a whole. They are dealt with by the individual through the use of
insurance, loss prevention, or some other techniques.

1.5.4. Objective and subjective risks

Some authors make a careful distinction between objective risk and subjective risk. We shall
briefly discuss the distinction between the two in the following paragraphs.

Objective risk – is defined as the relative variation of the actual loss from expected loss
objective risk, or statistical risk, applicable mainly to groups of objects exposed to loss, refers to
the variation that occurs when actual loss differ from expected. For example, assume that a fire
insurer has 10,000 houses insured over a long period and, on average, 1 percent, 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, while 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
percent. This relative variation of actual loss from expected loss is known as objective risk.

Objective risk declines as the number of exposures increases. More specifically, objective risk
varies inversely with the square root of the number of cases under observation. In our previous
example, 10,000 houses were insured, and objective risk was 10/100, or 10 per cent. Now
assume that 1 million houses are insured. The expected loss is only 100. Objective risk now is
100/10,000, or 1 per cent. Thus, as the square root of the number of houses increased from 100 in
the first example to 1000 in the second example (ten times), objective risk; declined to one-tenth
of its former level. (This is discussed in detail in the next chapter).

Objective risk can be statistically measured by some measure of dispersion, such as the standard
deviation or the coefficient of variation. Since objective risk can be measured, it is an

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extremely useful concept for an insurer or a corporate risk manager. 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 numbers. The law of large numbers states that as the number of exposure units
increases, the more closely will the actual loss experience approach the probable loss experience.
For example as the number of homes under observation increases, the greater is the degree of
accuracy in predicting the proportion of homes that will burn.

Subjective risk – is defined as uncertainty based on a person’s mental condition or state of

mind. For example, an individual is drinking heavily in a bar and attempts to drive home. The
driver may be uncertain whether he or she will arrive home safely without being arrested by the
police for drunk driving. This mental uncertainty is called subjective risk. Often subjective risk is
expressed in terms of the degree of belief.

The impact of subjective risk varies depending on the individual. Two persons in the same
situation may have a different perception of risk, and their conduct may be altered accordingly. If
an individual experiences great mental uncertainty concerning the occurrence of a loss, that
person’s conduct may be affected. High subjective risk often results in less conservative conduct,
while low subjective risk may result in less conservative conduct. A driver may have been
previously arrested for drunk driving and is aware that he or she has consumed too much alcohol.
The driver may then compensate for mental uncertainty by getting someone else to drive him or
her home or by taking a cab. Another driver in the same situation may perceive the risk of
arrested as slight. The second driver may drive in more careless and reckless manner; a low
subjective risk results in less conservative driving behavior.

A subjective risk is a psychological uncertainty that stems from the individual’s mental attitude
or state of mind. Some writers have used the word “uncertainty” to be synonymous with
subjective risk as defined here. Subjective risk has been measured by means of different
psychological tests, but no widely accepted or uniform tests of proven reliability have been
developed. Thus although we recognize different degrees of risk taking willingness in persons, it
is difficult to measure these attitudes scientifically and to predict risk-taking behavior, such as
insurance-buying behavior, from test of risk –taking attitudes.

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Subjective risk may affect a decision when the decision-maker is interpreting objective risk. One
risk manager may determine that some given level of risk is “high” while another may interpret
this same level as “two”. These different interpretations depend on the subjective attitudes of the
decision makers toward risk. Thus, it is not enough to know only the degree of objective risk; the
risk attitude of the decision maker who will act on the basis of this knowledge must also be
known. A person who knows that there is only one chance in a million that a loss will occur may
still experience worry and doubt, and thus would buy insurance, while another would not. One
can appreciate the importance of studying subjective risk. However, by studying several
examples illustrating different mental attitudes toward risk in different situations.

Banker A refuses a loan proposition that banker B accepts easily and under equivalent
conditions. Student B graduates and accepts a position paying a low initial salary but offering an
opportunity for a large income for a few who succeed in the company. Student A graduates and
accepts a position paying a higher and more secure salary than B’s position pays, but under
conditions limiting the opportunities for advancement. Consumer A is offered certain types of
goods over the telephone but refuses to buy; Consumer B, offered the same goods, buys even
without full information. Business A insures the plant against fire even though the premium may
be very high, while business B, a neighbor operating under similar conditions, refuses the
insurance.

1.5.5 Pure and Speculative Risks

Pure Risks

Pure risks involve two possible outcomes: a loss or, at best no loss. The outcome can only be
unfavorable to us, or leave us in the same position as we enjoyed before the event occurred. The
risk of a motor accident, fire at a factor, theft of goods from a store, or injury at work are all pure
risks with no element of gain. It is a loss or no loss that can result from such risks.

The major types of pure risks that are associated with great financial and economic insecurity
include personal risks, property risks, and liability risks.

A) Personal Risk

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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
assets. In other words, they refer to the possibility of loss to a person such as: death, disability,
loss of earning power etc. There are four major personal risks.

 Risk of premature death – this refers to the death of a household head with unfulfilled
financial obligations. These can include dependents to support, a mortgage to be paid off,
or children to educate. If the surviving family members lack additional sources of income
or have insufficient financial assets to replace the lost income, financial hardship can
result.
Premature death can cause financial problems only if the deceased has dependents to
support or dies with unsatisfied financial obligations. This the death of a child age ten is
not “premature” in the economic sense.

There are at least four costs that results from the premature death of a household head.
First, the human life value of the family head is lost forever. The human life value is
defined as the present value of the family’s share of the deceased bread winner’s future
earnings. This loss can be substantial. Second, the additional expenses may be incurred
because of burial and probate costs, estate and inheritance taxes, and any remaining
medical expenses. Third, the family’ income from all sources may be inadequate just in
terms of its basic needs. Finally, certain non-economic costs are also incurred, such as the
emotional grief of the surviving spouse and the loss of guidance and a role model for the
children.

Risk of insufficient income during retirement

 Risk of old age – the major risk associated with old age is insufficient income during
retirement. When older workers retire, they lose their normal work earnings. Unless they
have accumulated sufficient financial assets on which to draw, or have access to other
sources of retirement income, such as social security or a private pension, they will be
confronted with a serious problem of economic insecurity.
 Risk of poor health – poor health is another important personal risk. The risk of poor
health includes both catastrophic medical bills and the loss of earned income. Unless

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 persons have adequate health insurance or other sources of income to meet these
expenditures, they will be financially insecure. In particular, the inability of some persons
to pay catastrophic medical bill s is a major cause of personal bankruptcy.
The loss of earned income is another major cause of financial insecurity if the disability
is severe. In cases of long-term disability, there is a substantial loss of earned income,
medical bills are incurred, employee benefits may be lost or reduced, savings are often
depleted, and someone must take care of the disabled person.

 Risk of unemployment- the risk of unemployment is another major threat to financial

security. Unemployment can result for a business cycle downsizing, from technological
and structural changes in the economy, from seasonal factors, and from fluctuations in
the labor market.
Regardless of the cause, unemployment can cause financial insecurity in at least three
ways. First, the worker loses his or her earned income. Unless there is adequate
replacement income or past savings on which to draw, the unemployed worker will be
financially insecure. Second, because of economic conditions, the worker may be able to
work only part-time. The reduced income may be insufficient in terms of the workers’
needs. Finally, if the duration of unemployment is extended over a long period, past
savings may be exhausted.

B) Property Risk

This refers to losses associated with ownership of property. Persons owning property are exposed
to the risk of having their property damaged or lost from numerous causes. Property risk stems
from diverse perils accompanied by different hazards: physical, oral or morale. Real estate and
personal property can be damaged or destroyed because of fire, lightening, tornadoes,
windstorms, and numerous other causes. Generally speaking, property losses can be classified in
at least four ways, based on:

i. The class of property affected

ii. The cause of the loss
iii. Whether the loss is direct or indirect, and
iv. The nature of the firm’s interest in the property

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i. Classification Based on Property class

Extra expenses are another type of indirect, or consequential loss. For example, suppose
you own a newspaper, bank, or dairy. If a loss occurs, you must continue to operate
regardless of cost; otherwise, you will lose customers to your competitors. It may be
necessary to set up a temporary operation at some alternative location, and substantial
extra expenses would then be incurred.

iv. Classification based on the nature of the firm’s interest in the property

Property refers to a bundle of rights that form part of the tangible physical assets, but which
independently possess certain economic value. The exposures that result from these interests
may be property including net income or liability exposures. Only the direct and indirect
property loss exposures are considered below.

 Owners. The clearest property interest is sole ownership. An ownership interest may
result from a purchase, a foreclosure on a mortgage, a conditional sales contract, a gift, or
from some other event. If the property suffers a direct or indirect loss, the owner bears the
amount of that loss. If a business owns only part of the property, it bears only part of the
loss.
 Secured creditors. A secured creditor has an interest in property pledged as security for
the loan, because the creditor’s ability to collect from the debtors diminishes if the
property is damaged or destroyed. The potential loss is the unpaid balance of the loan.
C) Liability Risk

Liability risk is the possibility of loss arising from intentional or unintentional damage made
to other persons or to their property. One would be legally obliged to pay for the damages he
inflicted upon other persons or their property. A court of law may order you to pay
substantial damages to the person you have injured.

Liability risks are of great importance for several reasons. First, there is no maximum upper
limit with respect to the amount of the loss. You can be sued for any amount. In contrast, if
you own a property, there is a maximum limit on the loss. For example, if your automobile
has an actual cash value of Br. 10,000, the maximum physical damage loss is Br. 10,000. But

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 if you are negligent and cause an accident that results in serious bodily injury to the other
driver, you can be sued for any amount –Br. 50,000, Br. 5000,000, Br.1 million or more – by
the person you have injured.

Second, although the experience is painful, you can afford to lose your present financial
assets, but you can never afford to lose your future income and assets. Assume that you are
sued and are required by the court to pay a substantial judgment to the person you have
injured. If you do not carry liability insurance or are underinsured, your future and assets can
be attached to satisfy the judgment. If you declare bankruptcy to avoid payment of the
judgment, your ability to obtain credit will be severely impaired.

Finally, legal defense costs can be enormous. If you are sued and have no liability insurance,
the cost of hiring an attorney to defend you and represent you in a court of law can be
staggering.

Speculative Risk

The alternative to pure risks is speculative risk, where there are two possible outcomes – gain
or loss. Speculative risk is defined as a situation in which either profit or loss is possible.
Investing money in shares is a good example. The investment may result in a loss or possibly
a break-even position, but the reason it was made was for its prospect of gain. People are
more adverse to pure risks as compared to speculative risks. In speculative risk situation,
people may deliberately create the risk when they realize that the favorable outcome is,
indeed, so promising.

It is important to distinguish between pure and speculative risks for three reasons. First,
private insurers generally insure only pure risks. With some exceptions, speculative risks are
not considered insurable and other techniques for coping with risk must be used. (One
exception is that some insurers will insure institutional portfolio investments and municipal
bonds against loss.)

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 since it enables insurers to predict losses in

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 advance. In contrast, it is generally more difficult to apply the law of large numbers to
speculative risks in order to predict future loss experience.

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. For example, a firm may develop a new
technological process for producing computers more cheaply and, as a result, may force a
competitor into bankruptcy, society benefits since the computers are produced more
efficiently and at a lower cost. However, society will not benefit when most pure risks occur,
as for example, if a flood occurs or an earthquake devastates an area.

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