There is no single definition of risk.

Economists, behavioral scientists, risk theorists,

statisticians, and actuaries each have their own concept of risk. However, risk historically
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
an auto accident is present because uncertainty is present. The risk of lung cancer for
smokers is present because uncertainty is present. The risk of flunking a college course is
present because uncertainty is present. Employees in the insurance industry often use the
term risk in a different manner to identify the property or life that is being considered for
insurance. For example, 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.” Finally, in the
economics and finance literature, authors often make a distinction between risk and
uncertainty. The term “risk” is often used in situations where the probability of possible
outcomes can be estimated with some accuracy, while “uncertainty” is used in situations
where such probabilities cannot be estimated. As such, many authors have developed
their own concept of risk, and numerous definitions of risk exist in the professional
literature.
Personal risks are risks that directly affect an individual or family. They involve the
possibility of the loss or reduction of earned income, extra expenses, poor health or
employment, etc.
Persons owning property are exposed to property risks—the risk of having property
damaged or lost from numerous causes. Homes and other real estate and personal
property can be damaged or destroyed because of fire, lightning, tornado, windstorm, and
numerous other causes. There are two major types of loss associated with the destruction
or theft of property: direct loss and indirect or consequential loss.
Direct Loss: A direct loss is defined as a financial loss that results from the physical
damage, destruction, or theft of the property. For example, if you own a home that is
damaged by a fire, the physical damage to the home is a direct loss.
Indirect or Consequential Loss: An indirect loss is a financial loss that results indirectly
from the occurrence of a direct physical damage or theft loss. For example, as a result of
the fire to your home, you may incur additional living expenses to maintain your normal
standard of living. You may have to rent a motel or apartment while the home is being
repaired. You may have to eat some or all of your meals at local restaurants. You may
also lose rental income if a room is rented and the house is not habitable. These
additional expenses that resulted from the fire would be a consequential loss.
Liability risks are another important type of pure risk that most persons face. Under our
legal system, you can be held legally liable if you do something that results 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.
Techniques for managing risk can be classified broadly as either risk control or risk
financing. Risk control refers to techniques that reduce the frequency or severity of
losses. Risk financing refers to techniques that provide for the funding of losses. Risk
managers typically use a combination of techniques for treating each loss exposure.
Risk Control: As noted above, risk control is a generic term to describe techniques for
reducing the frequency or severity of losses. Major risk-control techniques include the
following:
Avoidance is one technique for managing risk. For example, you can avoid the risk of
being mugged in a high crime area by staying out of the vicinity; you can avoid the risk
of divorce by not marrying; and a business firm can avoid the risk of being sued for a
defective product by not producing the product. Not all risks should be avoided, however.
For example, you can avoid the risk of death or disability in a plane crash by refusing to
fly. But is this choice practical or desirable? The alternatives—driving or taking a bus or
train—often are not appealing. Although the risk of a plane crash is present, the safety
record of commercial airlines is excellent, and flying is a reasonable risk to assume.
Loss prevention aims at reducing the probability of loss so that the frequency of losses is
reduced. Several examples of personal loss prevention can be given. Auto accidents can
be reduced if motorists take a safe-driving course and drive defensively. Loss prevention
is also important for business firms. For example, strict security measures at airports and
aboard commercial flights can reduce acts of terrorism. Boiler explosions can be
prevented by periodic inspections by safety engineers; occupational accidents can be
reduced by the elimination of unsafe working conditions and by strong enforcement of
safety rules; and fires can be prevented by forbidding workers to smoke in a building
where highly flammable materials are used. In short, the goal of loss prevention is to
reduce the probability that losses with occur.
Strict loss prevention efforts can reduce the frequency of losses; however, some losses
will inevitably occur. Thus, the second objective of loss control is to reduce the severity
of a loss after it occurs. For example, a department store can install a sprinkler system so
that a fire will be promptly extinguished, thereby reducing the severity of loss; a plant
can be constructed with fire-resistant materials to minimize fire damage; fire doors and
fire walls can be used to prevent a fire from spreading; and a community warning system
can reduce the number of injuries and deaths from an approaching tornado.

Payment of Fortuitous Losses: A fortuitous loss is one that is unforeseen and unexpected
by the insured and occurs as a result of chance. In other words, the loss must be
accidental. The law of large numbers is based on the assumption that losses are accidental
and occur randomly. For example, a person may slip on an icy sidewalk and break a leg.
The loss would be fortuitous.
Indemnification means that the insured is restored to his or her approximate financial
position prior to the occurrence of the loss. Thus, if your home burns in a fire, a
homeowner’s policy will indemnify you or restore you to your previous position. If you
are sued because of the negligent operation of an automobile, your auto liability
insurance policy will pay those sums that you are legally obligated to pay. Similarly, if
you become seriously disabled, a disability-income insurance policy will restore at least
part of the lost wages.
There are ideally six characteristics of an insurable risk:
There must be a large number of exposure units: The first requirement of an insurable
risk is a large number of exposure units. Ideally, there should be a large group of roughly
similar, but not necessarily identical, exposure units that are subject to the same peril or
group of perils. For example, a large number of frame dwellings in a city can be grouped
together for purposes of providing property insurance on the dwellings. The purpose of
this first requirement is to enable the insurer to predict loss based on the law of large
numbers. Loss data can be compiled over time, and losses for the group as a whole can be
predicted with some accuracy.
The loss must be accidental and unintentional: A second requirement is that the loss
should be accidental and unintentional; ideally, the loss should be unforeseen and
unexpected by the insured and outside of the insured’s control. Thus, if an individual
deliberately causes a loss, he or she should not be indemnified for the loss.
The loss must be determinable and measurable: A third requirement is that the loss
should be both determinable and measurable. This means the loss should be definite as to
cause, time, place, and amount. Some losses, however, are difficult to determine and
measure. For example, under a disability-income policy, the insurer promises to pay a
monthly benefit to the disabled person if the definition of disability stated in the policy is
satisfied. Some dishonest claimants may deliberately fake sickness or injury to collect
from the insurer.
The loss should not be catastrophic: The fourth requirement is that ideally the loss
should not be catastrophic. This means that a large proportion of exposure units should
not incur losses at the same time. Insurers ideally wish to avoid all catastrophic losses. In
reality, however, that is impossible, because catastrophic losses periodically result from
floods, hurricanes, tornadoes, earthquakes, forest fires, and other natural disasters.
Catastrophic losses can also result from acts of terrorism. (Event of Force Majeure).
The chance of loss must be calculable: A fifth requirement is that the chance of loss
should be calculable. The insurer must be able to calculate both the average frequency
and the average severity of future losses with some accuracy. This requirement is
necessary so that a proper premium can be charged that is sufficient to pay all claims and
expenses and yields a profit during the policy period.
The premium must be economically feasible: A final requirement is that the premium
should be economically feasible. The insured must be able to afford the premium. In
addition, for the insurance to be an attractive purchase, the premiums paid must be
substantially less than the face value, or amount, of the policy.