Syllabus

Concept of Risk and Insurance

Definition of Risk
Degree of Risk
Risk Vs Profitability
Objective Risk and the law of large numbers
Hazard and Perils
State vs Dynamic Risk
Pure Risk vs Speculative Risk
 Concept of Risk and Insurance

In simple terms, risk is the possibility of something bad happening.

Risk, as defined in Insurance, is the possibility of a loss. 

The Probability that actual results will differ from expected results

Not taking any risk is also a part of risk.

"When we take a risk, we are betting an outcome that will result from a decision we have
made, though we do not know for certain what the outcome will be “ Peter L Bernstein
Based on above concept Risk is defined as uncertainty concerning the occurrence of a loss.
 Degree of Risk
Degree of Risk : It refers to the intensity of objective risk, which is assessed by finding
the difference between expected looses with that of the actual looses.

Degree of Risk = Difference between Expected and Actual losses

Actual losses
 Risk with Certainty and Uncertainty
The Term Risk is used in situation where the probabilities of possible outcomes are
known or can be estimated with some degree of accuracy, whereas

Uncertainty is used in situation where such probabilities cannot be estimated .

Making decisions under certainty is easy. The cause and effect are known, and the risk
involved is minimal.

Most significant decisions made in today’s complex environment are formulated under
a state of uncertainty. Conditions of uncertainty exist when the future environment is
unpredictable
Objective Risk ( Degree of Risk ) and the law of large Numbers
Objective risk ( Degree of Risk ) is the relative variation of actual loss from expected
loss,
In other word, is the actual losses for a sample in a given period, which can differ
significantly from expected losses, and is inversely proportional to the square root of
the sample size — the law of large Numbers
For example, a coin 10 times, it is expected that 5 of those flips will yield heads and
the other 5 will yield tails.
However, in most sets of 10 flips the actual number of heads and tails will differ from
this expectation.
It's possible that all will be heads, for instance.
However, as the number of flips is increased, the number of heads and tails tends
toward equality. In 1,000,000 flips, it is highly unlikely that they will all be heads or all
tails, and, in fact, the number of both will be closer to the mean.
 Contd……
The law of large numbers, in probability and statistics, states that as a sample size grows, its
mean gets closer to the average of the whole population

The law of large numbers states that an observed sample average from a large sample will
be close to the true population average and that it will get closer the larger the sample.

Insurance companies rely on the law of large numbers  to help estimate the value and
frequency of future claims they will pay to policyholders.

When it works perfectly, insurance companies run a stable business, consumers pay a fair
and accurate premium, and the entire financial system avoids serious disruption.
 Contd…
Subjective risk is what an individual perceives to be a possible unwanted event.

Somebody who has lost a lot of money in the stock market will probably feel more
risk investing in the market than someone who has profited handsomely.

Subjective risk , also known as perceived risk is defined as uncertainty based on

Person’s state of mind.
 Peril and Hazard

Peril ( Cause )
Hazard ( Condition )
A peril is something that can cause a financial loss. Examples include falling,
crashing @ bike, fire, wind, tornado,lightning, water, volcanic eruptions, illness etc
etc

A hazard is a condition that increase the frequency of losses.

For examples : industrial pollution, nuclear radiation, toxic wastes, factory

explosionns, fires and chemical spills.
Notes : A peril is any event that can cause a financial loss. A hazard is something that increases the
probability that a peril will occur.
 Contd…..

Risk = A probability or threat of damage, injury, or any other negative occurrence.

Peril = Cause of loss.
Hazard = Condition that increases the probability of loss.

In the world of insurance, there are four different types of hazards:

a)Physical Hazard
b)Legal Hazard
c)Moral Hazard
d)Morale Hazard ( Attitudinal Hazard )
 Contd……

Physical Hazards - A physical hazard is a physical condition that increases the frequency
of loss .
For example , Icy roads that increases the chances of auto accident, defective wire in
building which increases the chances of fire .

Legal Hazards - A legal hazard is a rise in the chance of a loss due to legal action or
Hazards that could cause a loss due to legal issues, like a court notice about a property,
 Contd…..
Moral Hazards - A moral hazard, comes about because of fraud committed by an
insured person. It is dishonesty in an individual that increases the frequency of
looses.
For example faking an accident to collect benefits from insurance company.
Submitting a fraudulent claim etc

Morale Hazard ( Attitudinal Hazard ) : Not to be mistaken for moral hazards, it

comes because act of negligence. It is carelessness or indifference to a loss, which
increases frequency of looses.

For instance, leaving a car key in an unlocked car which increases the chance of theft
 Classification of Risk
The four major classicization of Risk are as follows.

A ) Pure and Speculative Risk

B) Diversifiable Risk and Non Diversifiable Risk

C) Enterprise Risk

D ) Systemic Risk
 Contd….
Pure and Speculative Risk
Pure risk is defined as a situation in which there are only the possibilities of loss or no loss . The only
possible outcomes are adverse (loss) and neutral (no loss).
Examples of pure risks include premature death, job-related accidents, damage to property from fire,
lightning, flood,or earthquake.

Speculative risk is defined as a situation in which either profit or loss is possible . For example,
purchasing 100 shares in secondary market menas there would be profit if the price of the stock
increases and lose if the price declines.
In these situations, both profit and loss are possible.

Notes :
First, private insurers generally concentrate on insuring certain pure risks.
Second, the law of large numbers can be applied more easily to pure risks than to speculative risks
Third, Businessman 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.
 Contd….
Diversifiable Risk and Non diversifiable Risk

Diversifiable risk is a risk that affects only individuals or small groups and not the entire
economy. It is a risk that can be reduced or eliminated by diversification.
For example, a diversified portfolio of stocks,bonds, and certificates of deposit (CDs) is
less risky than a portfolio that is 100 percent invested in stocks.

Non diversifiable risk is a risk that affects the entire economy or large numbers of
persons or groups within the economy. Examples are rapid inflation, cyclical war,
hurricanes, floods, and earthquakes.
it is also called systematic risk or fundamental risk.
 Contd……
Enterprise Risk
Enterprise risk is a term that encompasses all major risks faced by a business firm.
Such risks include pure risk, speculative risk, strategic risk, operational risk,and financial risk.
global crises, IT systems failure, data breaches, fraud,

Strategic risk refers to uncertainty regarding the firm’s financial goals . for example, if a firm
enters a new line of business, the line may be unprofitable.

Operational risk results from the firm’s business operations. For example, a bank that offers
online banking services may incur losses if “hackers” break into the bank’s computer.
Financial risk refers to the uncertainty of loss because of adverse changes in commodity
prices, interest rates, foreign exchange rates, and the value of money.

So Enterprise risk management means identifying, analyzing and treating the exposures an

organization faces as seen by the executive levels of management. 
 Contd…

In recent days, Enterprise risk is becoming more important in commercial risk

management, which is a process that organizations use to identify and treat major and
minor risks.
In the evolution of commercial risk management, some risk managers are now
considering all types of risk in one program.
Enterprise risk management combines into a single unified treatment program all
major risks faced by the firm. As explained earlier, these risks include
 Pure risk,
 Speculative risk,
 Strategic risk,
 Operational risk,
 Financial risk
 Systemic Risk
It is risk of collapse of an entire system or entire market due to the failure of a single entity of group of
entities that can result in the breakdown of entire financial system.

The most important feature of systemic risk is that the risk spreads from unhealthy institutions to
relatively healthier institutions through a transmission mechanism.

Systemic risks refer to a situation sparked by a single event that in turn potentially leads to wider collapse
whereas Systematic risk impacts the full market caused by undiversificable factor like global
recession ,war.

Systemic risks cannot be predicted however, systematic risks, once identified, can be somewhat
predictable in their path. 

A prime example of systemic risk would be the collapse of Lehman Brothers in 2008. Which had affected
worldwide economy.

For systematic risk examples, we can take example of Covid-19 pandemic. Pandemic risk is something
that’s always a possibility but difficult to predict.
 Technique for Managing Risk

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 Manager use both of these tools while managing Risk.

 Risk Control
Risk Control
Risk control is a generic term to describe techniques for reducing the frequency of
losses.

Major risk-control techniques include the following:

 ■ Avoidance

 ■ Loss prevention

 ■ Loss reduction
 Contd….
Avoidance : Avoidance is one technique for managing risk but not the perfect one.
However it is one of the best strategy.
For example, To avoid the risk of being hurt, Soembody staying at home all day..

Loss Prevention :It aims at reducing the probability of loss so that the frequency of
losses is reduced.
For example, The number of heart attacks can be reduced if individuals control their
weight, stop smoking, and eat healthy diets.

Loss Reduction : Some losses will inevitably occur so loss control is to reduce the
severity of a lost after it occurs.
For example, a Manufacturing factory can install a sprinkler system so that a fire will be
promptly extinguished, thereby reducing the severity of loss;
 Risk Financing
Risk Financing
Risk financing refers to techniques that provide for the payment of losses after they
occur.

Major risk-financing techniques include the following:

 ■ Retention

 ■ Noninsurance transfers

 ■ Insurance
 Contd……
Retention :
Active risk retention means that an individual is consciously aware of the risk and
deliberately plans to retain all or part of it.

Noninsurance Transfers : It is another technique for managing risk. The risk is

transferred to a party other than an insurance company.

For example Forward contract with banks while dealing with foreign currency.

Insurance : In almost all cases, insurance is the most practical method for handling major
risks.