Chapter one

1. Introduction
 Facts about the world we live in:

 Imperfect knowledge about the future.

 Continuous technological advancement.
 There are enormous benefits accruing to the society as a result of
technological advancement.
 There are costs related with the advancement of technology.
 Aerospace - Air bus 320 disaster in 1985
- September 11, 2000 terror attack
 Oil industry - Exxon Valdez
- Piper Alpha oil 1988
 Chemical industry - Bhopal incident
 Space Exploration - Challenger
 Electronics Exploration - Computer virus
 Pharmaceutical Industry - Product liability
 It is not advisable to curtail the development of technology.
 Risk is everywhere for people as well as organizations

 Thus, people have to accept it as fact of life.

 Risk itself forces us to devise ways & means of escaping the damage.
 All this calls for sound management of risk.

2. Concepts in Risk and Insurance

2.1 The Meaning of Risk

 As applied in everyday life:
i. Risk as a cause.
ii. Risk as the likelihood - 'the risk of something happening'
iii. Risk as the object - 'going to see a risk'

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 iv. Risk as loss - 'Taking a risk'.

 As reflected in the literature:

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

 Defining Elements of the Meaning of Risk:

i. The idea of uncertainty/doubt about the future.

ii. Differing levels or degrees of risk.
iii. It is causes.

2.2 Risk, Uncertainty, and Probability

2.2.1 Risk versus Uncertainty

 Risk and uncertainty are distinct concepts.

 Uncertainty is:
 The doubt as to the occurrence of a certain desired outcome.
 A state of mind whereby a sentient entity experience doubt.
 A subjective phenomenon - one of the possible reactions of an entity to its
interpretation of reality.

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  Risk is:
 An objective phenomenon that can be measured mathematically or
statistically.
 Independent of the individual's beliefs.
 Exists whether or not person is aware of it.
 It is the state of the world.

 Four further situations that illustrate the distinction between the two concepts:

 Both risk & uncertainty are present:

 An individual may be exposed to risk of disability and may experience
uncertainty.

 Both risk & uncertainty are absent:

 Modern sailors know that the world is not flat; there is no possibility of falling of
the edge of the world, therefore, they would experience no uncertainty about such
a contingency.

 Risk is present & uncertainty is absent:

 A businessman may be exposed to the possibility loss of due to interruption of
operations by fire.

 Risk is absent but uncertainty is present:

 When Columbus sailed there was no possibility that he would fall of the edge of
the world. Never the less, presumably he was uncertain about his possibility.

2.2.2 Risk versus Probability

 Probability is:
 The long-run chance of occurrence, or relative frequency of some event.
 Risk is:

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  The relative variation of actual loss from expected loss.

2.3 Level of Risk

 All risks aren’t equally likely.
 There are different levels of risk.
 e.g., a house by the side of a river.
 a 2nd house which is further form the river bank and on a slight hill.

2.3.1 Frequency and Severity

 Two components in risk measurement.
 Important for Risk handling decisions.
Frequency

Frequency

Severity Severity

2.4 Risks, Peril, & Hazard

2.4.1 Peril

 The prime cause: it is what will give rise to the loss.

 e.g., Storm, Flood, Fire, Thefts, collusion, etc.

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2.4.2 Hazards

 Hazards are:
 factors which may influence the outcome.
 conditions that tend to increase the probability & severity of loss.
 conditions that increase the effect should a peril operate

2.4.2.1 Physical Hazard:

 Conditions stemming form the physical characteristics of an object.
 Physical condition that increases the probability and severity of loss form a given
peril.
 Examples may include:
 Existence of dry forest - for fire
 Earth faults - for earth quakes
 Icebergs - ocean shipping
 Icy roads - for auto accident

2.4.2.2 Moral Hazard:

 Stems from dishonesty or character defects of an individual that increases the

probability as well as the severity of loss.
 Stems from the mental attitude of the individual
 Examples may include:
 Faking an accident to collect insurance money
 Submitting a fraudulent claim
 Inflating the size of a claim.
 Intentionally burning unsold merchandise that is insured.

2.4.2.3 Morale Hazard

 Carelessness or indifference to a loss because of the existence of insurance.

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  Includes the mental attitude that characterizes accident-prone person.
 This type of individual does not appear to deliberately cause the accident to
happen, but the psychologist would probably diagnose the cause of excessive and
repeated accidents as subconscious problem of morale.
 Examples may include:
 leaving key in an unlocked car.
 leaving a door unlocked.

2.5 Classification of Risks

2.5.1 Objective versus Subjective Risk

2.5.1.1 Objective Risk

 The relative variation of actual loss form probable or expected loss.

 Is concerned with the range of variability of economic losses about some long-run
average (most probable) loss in a group large enough to analyse significantly in a
statistical sense.

Objective Risk = Probable Variation of Actual Loss

Probable Losses
Example 1:

Consider the possibility of fire losses to buildings in towns A and B. There are 100,000 buildings
in each town and, on average each town has 100 fire losses per year. By looking at historical data
from the towns, statisticians are able to estimate that in town A, the actual number of fire losses
during the next year will very likely range from 95 to 105. In town B, however, the range
probably will be greater, with at least 80 fire losses expected and possibly as many as 120.

Objective Risk town A = (105 – 95)/100 = 10%

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 Objective Risk town B = (120 – 80)/100 = 40%

 Effects of Numbers Exposed on Objective Risk

 The Law of Large Numbers

States that as the number of exposure units increases, the more certain it becomes that
actual loss experience will equal probable loss experience. Hence, the risk diminishes as
the number of exposure units increases.

Example 2:

Suppose that Company A and Company B own 100 and 900 automobiles, respectively. These
cars are used by the sales personnel of each firm and are driven in the same geographical
territory. The chance of loss in a given year due to accident is 20%.

The expected number of losses is:

For Company A = 0.20 * 100 = 20

For Company B = 0.20 * 900 = 180

Suppose further that statisticians have computed that the likely range in the number of losses in
one year is 8 for Company A and 24 for Company B. thus, the objective risk is:

Objective Risk Company A = 8/20 = 40%

Objective Risk Company B = 24/180 = 13.3%

 By increasing the number of exposed units by nine times, the risk was reduced
to a third.

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 Objective risk varies inversely with the square root of the number of exposed units.

 Effects of Probability on Objective Risk

 The higher the probability of loss, the lesser the objective risk would be.

Example 3:

Assume that employers A and B, each with 10,000 employees, are concerned about occupational
injuries to workers. Employer A is in a “safe” industry with the chance of loss of a disabling
injury in its plate being equal to 0.01. Employer B is in a more dangerous industry, with the
chance of loss equal to 0.25. It has been determined that the probable variation in injuries in
employer A’s plant will be no more than 20, whereas in employer B’s plant that the probable
variation will not exceed 87. Thus, the objective risk is:

Objective Risk Employer A = 20/(0.01 * 10,000) = 20%

Objective Risk Employer B = 87/(0.25 * 10,000) = 3.5%

 Objective risk varies inversely with the probability for any constant number of exposure
units. However, in general, the rate of decrease in objective risk is less than proportionate
to the rate of increase in probability of loss.

2.5.1.2 Subjective Risk

 Psychological uncertainty that stems from the individual’s mental attitude or state
of mind.
 May be measured by means of different psychological tests but no widely
accepted or uniform tests of proven reliability have been developed.
 The impact of subjective risk varies depending on the individual.

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  Subjective risk may affect a decision when the decision maker is interpreting
objective risk.

2.5.2 Financial Versus Non-Financial Risk

 This classification is based on the nature of the outcome.

2.5.2.1 Financial Risk
 The outcome is measurable in monetary terms.
 e.g., material damage to property
theft of property
2.5.2.2 Non-Financial Risk
 The outcome is not possible to measure in monetary terms.
 e.g., selection of an item from a restaurant menu
great many decisions of life, such as marriage partner.
2.5.3 Pure Versus Speculative Risks
 This classification as well is concerned with the outcome.
 It distinguishes between those situations where there is only the possibility of breaking
even, at best and those where a gain may also result.

2.5.3.1 Pure Risks

 Pure risks involve only two possible outcomes: a loss or, at best, no loss.
 Examples may include:

 The risks of a motor accident, fire at a factory, theft of goods from a store, or
injury at work are all pure risks with no element of gain.
2.5.3.1.1 Personal Risk
 Are risks that directly affect an individual?
 Involve the possibility of the complete loss or reduction of earned income, extra
expenses, and the depletion of financial assets.

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 i. Risk of premature death – this refers to the death of a household head with
unfulfilled financial obligations.

 Premature death can cause financial problems only if the deceased has
dependents to support or dies with unsatisfied financial obligations.
 Costs related to the premature death of a household head.

 The human life value of the family head is lost forever.

 The additional expenses may be incurred.
 The family’s income from all sources may be inadequate just in terms of its basic needs.
 non-economic costs
ii. Risk of old age – the major risk associated with old age is insufficient income
during retirement.
iii. Risk of poor health –includes both catastrophic medical bills and the loss of
earned income.
iv. Risk of unemployment –Unemployment can result from a business cycle
downsizing, from technological and structural changes in the economy, from
seasonal factors, and from fluctuations in the labour market.
2.5.3.1.2 Property Risk

 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
Property risk stems from diverse perils Risk by different hazards: physical, moral
accompanied
or morale.

Direct Loss
Real Estate & Physical Cause Owners
Attachments
Social Cause Secured creditors
Personal Indirect Loss
Property
Economic Cause Bailee

Figure 2 Classifications of Property Risks

2.5.3.1.3 Liability Risk

 Liability risk is the possibility of loss arising from intentional or unintentional damage
made to other persons or to their property.

2.5.3.2 Speculative Risks

 There are three possible outcomes – loss, breakeven, and gain situation.
 Examples may include: Investing in a venture; gambling transactions.
 People may deliberately create speculative risks.

2.5.4 Static and Dynamic Risks

2.5.4.1 Dynamic Risk

 Originates from changes in the overall economy such as price level changes, changes in
consumer tastes, income distribution, technological changes, political changes and the
like.
 Are less predictable and hence beyond the control of risk managers.

2.5.4.2 Static Risks

 Losses that can take place even though there were no changes in the overall economy.
 Are losses arising from causes other than changes in the economy.
 Are predictable and could be controlled to some extent by taking loss prevention
measures. Many of the perils fall under this category.

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2.5.5 Fundamental vs. Particular Risks

 This classification relates to both the cause and effect of risk.

2.5.5.1 Fundamental Risk

 Are those which arise from causes outside the control of any one individual or even a
group of individuals.
 Impersonal in origin and widespread in effect.
 The effect of such risks is felt by large numbers of people.
Examples would include earthquakes, floods, famine, volcanoes and other natural
‘disasters’, social change, political intervention, war, etc
2.5.5.2 Particular Risks

 Are much more personal both in their cause and effect.

 Examples would include fire, theft, work related injury and motor accidents.
 Arise from individual causes and affect individuals in their consequences.

2.5.6 Risks Related to Business Activities

2.5.6.1 Business Risk

 Is the risk associated with the physical operation of the firm.

 Variations in the level of sales, costs, profits, etc.
 Is independent of the company’s financial structure.

2.5.6.2 Financial Risk

 Is associated with debt financing.

 Examples may include: risk of default, bankruptcy, stock price decline, insolvency.

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2.5.6.3 Interest Rate Risk

 Is a risk resulting from changes in interest rates.

 Changes in interest rates affect the prices of financial securities such as the prices of
bonds etc. for interest rate rise depresses bond prices and vice, versa.

2.5.6.4 Purchasing Power Risk

 Arises under inflationary situations (general price rise of goods and services) leading to a
decline in the purchasing power of the asset held.
 Financial assets lose purchasing power if increased inflationary tendencies prevail in the
economy.

2.5.6.5 Market Risk

 Market risk is related to stock market.

 Unexpected changes in market-determined asset prices, indices, reference rates, etc.
 Refers to stock price variability caused by market forces. It is the result of investors’
reactions to real or psychological expectations.
 The market, in many cases, is also affected by such events as: presidential elections, trade
balances, balance of payment figures, wars, new inventions, etc...
 Market risk is also called systematic or non-diversifiable risk.
 All investors are subject to this risk.
 It is the result of the workings of the economy; and cannot be eliminated through
portfolio diversification.
 Investors are paid for this risk.

2.5.7 Risks Related to International Business

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  IB is an organization that buys and/or sells goods and services across two or more
countries, even if management is located in a single country.
 IB operates in a highly uncertain turbulent environment.
 IB operates in a multi-currency environment.

2.5.7.1 Transaction Exposure

 Refers to the potential gains/losses in cash flows resulting from business transactions
denominated in a foreign currency.

2.5.7.2 Translation Exposure

 Is related to a balance sheet, it is sometimes called Balance Sheet Exposure.

 The accounting convention requires that the assets and liabilities of foreign affiliates
should be translated into home currency at the time of preparation of the consolidated
financial statements using the current exchange rate prevailing on the balance sheet date.

2.5.7.3 Economic Exposure

 Tend to affect a business’s future cash flow.

 Concerned with the impact of exchange rates on the NPV of the global company’s future
cash flows.

2.6 Burden of Risk on Society

 The presence of risk results in certain undesirable social and economic effects:

 In the absence of insurance, the size of emergency funds must be increased.

 Deterrent effect on capital accumulation.
 The risk of a liability lawsuit may discourage innovation, depriving the
society of certain goods and services.

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  Higher Cost of Capital—higher expected rate of return
 Worry and fear are present.
2.7 Beneficial Functions of Risk
 Risk enables wealth to be created. It does so in a number of ways:
 It creates the hope for profit.
 It is a bar to entry into the market place for ventures which are unsound, or likely
to be short-lived.
 It encourages a safety culture.

 ‘Health Warning! Risks can be positive or negative!’

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