Topic 2 Insurance Risk and Uncertainty in Human Life

UCSB Bren School of Environmental Management

Risk and Uncertainty in Human Life

Human activities involve a great circumstances full of hazard and uncertainty Risk can define as the probability of an unfavorable events and its consequences. Risk and uncertainty are accompanied by the fear of financial loss or hope of gain or both thus heightening our awareness of

Uncertainty vs. Risk Risk we sort of understand the probabilities (eg, hurricanes in the Gulf) Uncertainty we dont really even understand how likely or unlikely things are (eg, shut down of Gulf Stream). Most climate

Consider some of these definitions:

Risk is the possibility of an unfortunate occurrence. Risk is a combination of hazards Risk is unpredictably the tendency that actual results may differ from predicted results Risk is uncertainty of loss Risk is the possibility of loss

Cont:

Risk is referring to a
POTENTIAL CAUSE

HIGH RISK? LOW RISK? E.G. leaving the keys in a car locking the car in a garage Which signifies higher risk?

Concept of Risk
Risk is the chance of loss. Loss - reduction or disappearance of economic value Peril - a direct cause of loss Hazard condition that increases the chance of loss.

Imperfect information and knowledge will leads to the doubt and hence to the UNCERTAINTY

Concept of Risk
3 Types of Hazards
1.

(ctd)

Physical hazard Physical condition that increases the possibility of a loss. Smoking is a physical hazard that increases the likelihood of a house fire and illness.

Cont:
2.

Moral/Legal Behavior / Character defect Losses that results from dishonesty. Insurance companies suffer losses because of fraudulent or inflated claims. Laws or regulations that force insurance companies to cover risks that they would otherwise not cover,

Cont:

American legal system is a moral hazard in that it motivates many people to sue simply for financial profit because of the enormous amount of money that can sometimes be won, and because there is little cost to the plaintiff even if he loses.

Morale - Feelings Insurance can be regarded as a morale hazard because it increases the possibility of a loss that results from the insured worrying less about losses.
3.

Insured take fewer precautions and may engage in riskier activitiesbecause they have insurance.

Concept of Risk

(ctd)

Peril great danger / risk

e.g. property: destroyed or loss e.g. lives : injured or killed

How to manage/anticipate with the risk??

3 Types of Probability :
1. A Priority Probability possible events are known 2. Empirical Probability based on historical data 3. Judgmental Probability based on judgment

Business Risk and Uncertainty

The types of risk that company may faces: I. Strategic risks competitor / not meeting organizations agenda. II. Compliance risks responding to rules and regulations III. Financial risks Non payment or increases in interest rates IV. Operational risks non-functioning of equipment, theft Every businesses will possess risks that could become a threat to a business success. Risk can be categorized as to why the risk exists, and to whom it affects

Every risk is not insured?

PURE SPECULATIVE

Insurable

Not insurable

How to be?

Occur by chance

Must be definite

Rate of loss must be predictable

Must not be catastrophic

Pure Risk
Situation where there is ONLY a chance of either loss or no loss, but no chance of gain. Also called as an Absolute risks Example: The owner of an automobile faces the risk associated with a potential collision loss. If a collision occurs, the owner will suffer a financial loss. If no collision occurs, the owner does not gain.

Other example, the possibility that a person's house will be destroyed due to a natural disaster is pure risk. In this example, it is unlikely that there would be any potential benefit to this risk.

Cont:
Pure risk can be categorized as personal, property, or legal risk. Personal risks are risks that affect someone directly, such as illness, disability, or death.

Property risk affects either personal or real property. Thus, a house fire or car theft are examples of property risk.

Cont:
A property loss often involves both a direct loss and consequential losses. A direct loss is the loss or damage to the property itself.

A consequential loss (aka indirect loss) is a loss created by the direct loss. Thus, if your car is stolen, that is a direct loss; if you have to rent a car because of the theft, then you have some financial lossa consequential lossfrom renting a car.

Cont:

Legal risk (aka liability risk) is a particular type of personal risk that you will be sued because of neglect, malpractice, or causing willful injury either to another person or to someone else's property. Legal risk is the possibility of financial loss if you are found liable, or the financial loss incurred just defending yourself, even if you are not found liable. Most personal, property, and legal risks are insurable.

Speculative Risk
Speculative risk are normally taken in the hope of some gain and the provision of insurance may act as a distinct disincentive to effort. This characterizes most financial investments.

Possibilities of gain, loss or no loss Most speculative risks are uninsurable, because they are undertaken willingly for the hope of profit.

Cont:

Example: A person hoped to gain from an enterprise Investment in stocks market Betting in a horse race

Speculative risk will generally involve a greater frequency of loss than a pure risk.

Cont:
Why the speculative risk cannot be insurable? i.e Market risks such as price changes and/or changes in the exchange rate of currency are not insurable.

These risks are not subject to advance calculation, hence the insurer would have no realistic basis for computing his premium. The speculative risks are handled businessmen by way of hedging, whereby a speculator assumes the price risk.

Cont:

Pure risk is insurable, because the law of large numbers can be applied to forecast future losses, and, thus, insurance companies can calculate what premium to charge based on expected losses.
Speculative risks have more varied conditions that make estimating future losses difficult or impossible.

Taking one example of new line clothing business enterprise, identify the pure risk and speculative risk that may exists in this business activity?

Level of Risk
We cannot make the assumptions that all risks are equally likely to occur. Some will be more or less risky than others.

Example: Consider there is a house by the side of river which is known for the tendency to overflow its banks compares for the house on the hill.

thus, we may say that the prospect that damage will occur to the house by the side of river is high.

Cont: Frequency and Severity

Shoplifting high-frequency risk, number of occurrence is high but low severity. Airplanes crash and ships accident low-frequency risk but high severity

A person may be willing to fund losses which are frequent and not too severe rather than doing the same for rare events which have the potential for very high costs

Cont: The Utility Theory

This relates more to the measure of risk to which an individual is exposed. The Utility Theory attempts to represent the probability of loss and the COST of loss in one measurement. The value which a person attaches to a risky situation is a function of the probability of the loss occurring and the severity should it occur. Example: A person who only possesses RM10 would view the risk of losing RM8 as extremely serious, while millionaire would not even think twice about a potential loss of such a small amount.

Risk-Averse

Risk-Seeking

Risk-Neutral

Cont:

Hence, we can look at the cost of risk the perspectives of:-

Frequency of risk

Monetary cost of financial severity

Human cost in terms of pain and suffering

Law of Large Numbers

The operation of the common pool is very much based on the successful application of the Law of large numbers. Definition: The law states that the larger the group of similar risks, the closer the actual losses experienced by the group will approach the expected losses.
Measure of probability of the incidence of a particular result during one experiment. Also known as a law of averages.

Gambling

Uncertainties which are not a necessary part of everyday living and working. Also called a game of chance which is a result of voluntarily choice. Such risks entail both loss and gain and the hope of gain motivating the taking of risk. For instances, betting in casino.

Economic Importance of Risk Reduction

1. To smooth flow of business activity and production process. 2. Large-scale supply of capital

3. Cost estimation and cost reduction

Economic Importance of Risk Reduction (ctd)

1. To smooth flow of business activity and production process.
o o Capacity to minimize the financial losses and relieve the burden of losses. It will facilitate the conduct of business and more people are willing to engage in business activity.

Economic Importance of Risk Reduction (ctd)

2. Large-scale supply of capital
o Organization of industrial and commercial requires a vast scale availability of huge capital. Capital is thus raised by numbers of investors not depending on single individual.

Insurance then will encourage the investor to venture into a business because they have a protection mechanism.

Economic Importance of Risk Reduction (ctd)

3. Cost estimation and cost reduction
o Under the circumstances of uncertainty, it is impossible for producer to have an accurate idea of total cost. By taking an insurance, the producer can minimize the risk against uncertainties such as in the event of loss incurred from accidents.

In the context of cost reduction, the amount of premium that producer has to pay to insurer is lower compare when producer has to bear much

Thank You