CHAPTER 1

RISK AND ITS TREATMENT

SCOPE OF THIS CHAPTER

Definition of risk

Explain the meaning of loss exposure

Distinction between peril and hazard

Types of risk

Major types of personal risk and commercial risk

The effects of risk on society

RISK DEFINITION

There is no single definition of Risk; however,

historically risk is defined in terms of uncertainty.

“Risk is an uncertainty concerning the occurrence of loss”

Examples:

Risk of being killed in the auto accident

Risk of lung cancer for smokers

Risk of failing in examination or college course

Examples of presence of risks in our society:

-A gunman kills 10 customers in a local department store

-A small town is wiped out by tornado.

-A drunk driver kills 5 people in a van on a expressway.

The definition of risk in the insurance industry is different.

Employees in insurance industry use risk to identify the

property or life that is being insured.

Example:

“ that driver is a poor/high risk” or “that building is an unacceptable risk”.

LOSS EXPOSURE

“Loss exposure” is used instead of risk due to ambiguity and different meaning in risk definition.

Any situation or circumstance in which a loss is possible, regardless of whether a loss occurs.

Example: If you drink when you are in a party and then you drive home, there is the possibility of making accident, killing somebody or heavy bodily injured because of less consciousness and willing to drive in high speed.

Possible theft of company property because of inadequate security

OBJECTIVE RISK VS. SUBJECTIVE RISK

Objective risk is relative variation of actual loss from expected loss.

Example: A property insurer has 10,000 houses to insure for a long period and on average it expects 1 percent or 100 houses burn each year; however, it would be rare for exactly 100 houses to burn each year. The actual loss is between 90 to 110 over a period with variation of 10 houses from the expected number of 100, or a variation of 10 percent.

10 percent is known as objective risk.

Objective risk declines as the number of exposure increases.

Assume 1 million houses are insured and expected number of houses will burn is now 10,000, but the variation of actual loss from expected loss is only 100.

Objective risk is now 100/10,000 or 1 percent.

“ Objective loss is inversely related to squared root of number of exposure units”.

LAW OF LARGE NUMBER Objective risk is measurable and it is used by insurer

and corporate risk managers.

If the number of exposure units increases, an insurer can predict its future loss experience more accurately due to “law of large number”.

What dose law of large number explain ?

If number of exposure units increases, the actual loss experience will approach more closely to expected loss experience.

If number of homes insured by property insurer increases, the proportion of homes will burn is more accurately predictable.

SUBJECTIVE RISK Subjective risk is defined as uncertainty based on a

person’s mental condition or state of mind.

Example : A drunk driver may be uncertain whether he will arrive home without being caught by the police.

The mental uncertainty is called subjective risk.

The higher subjective risk the more conservative and prudent behavior while low subjective risk may result in less conservative behavior.

Example : A motorist previously arrested for drunk driving is aware that he has consumed too much alcohol (high subjective risk) versus another driver in the same situation but not being arrested(low subjective risk).

CHANCE OF LOSS AND TYPES OF PROBABILITY

Chance of loss is defined as the probability that an event will occur. Two Types are probabilities:

Objective probability is related to frequency of observations

based on infinite number of observations and of no change in assumptions.

Example: The probability that a person age 21 will die before age 26 cannot be logically deduced; however, the insurers analyze the past mortality tables and sell a five-year term life insurance issued at age 21 based on the mortality tables.

Subjective probability is the individual‘s personal estimate of the chance of loss.

Example : Buying a lottery ticket on birthday and overestimate the chance of winning because you think it is your lucky day.

DIFFERENCE BETWEEN CHANCE OF LOSS AND OBJECTIVE RISK

Chance of loss = Probability that an event causes a loss will occur

Objective risk= Deviation of actual loss from expected loss

Example: A property insurer insured 10,000 homes in Philadelphia and 10,000 homes in Los Angeles and chance of fire in each city is 1 percent.

100 homes , on average will burn annually in each city.

Annual variation in losses ranges :

75 to 125 in Philadelphia

90 to 110 in Los Angeles

Objective risk is greater in Philadelphia compared to Los Angeles though the chance of loss is same for both.

PERIL AND HAZARD

Peril : The cause of loss e.g. cause of burning of house is fire or the cause of damaging your car is collision with another cars.

Other cause of loss to property: Fire, lightening, tornado, flood, burglary.

Hazard: A condition that creates or increases the frequency or severity of loss.

Examples : Icy roads, defective wiring, faking an accident

Increase the chance of auto accident Increase the chance of fire Moral Hazard

PERIL AND HAZARD

A physical hazard is a physical condition that increases the frequency or severity of loss.

Example: Icy road, defective wiring

Moral hazard is dishonesty or character defects in an individual that increase the frequency or severity of loss.

Example : Faking an accident to collect an insurer, submitting the fraudulent claim, inflating the amount of a claim, intentionally burning the unsold merchandise, murdering the insured to collect the proceeds.

Attitudinal Hazard (Morale Hazard) is carelessness or indifference to a loss, which increases the frequency or severity of a loss.

Example: Leaving car keys in an unlocked car, leaving the door unlocked, changing the lanes in a highway without signaling.

Legal Hazard refers to characteristics of the legal system or regulatory environment that increase the frequency or severity of loss.

Example : Adverse jury verdicts or large damage awards in liability lawsuits, adding some special coverage to health insurance such as alcoholism coverage

CLASSIFICATION OF RISK

1-Pure and speculative risk 2-Diversifiable risk and nondiversifiable risk 3-Enterprise risk

CLASSIFICATION OF RISK

Pure and Speculative RiskA pure risk is a situation in which there are only

the possibilities of loss or no loss (earthquake)A speculative risk is a situation in which either

profit or loss is possible (gambling)

DIFFERENCES BETWEEN PURE RISK AND SPECULATIVE RISK

Private insurers typically insure only pure risk - Other techniques to deal with speculative risk

Law of large number can be applied to pure risks than to speculative risks

- More difficult to apply the law of large numbers to predict the future loss experience for speculative risk

Society may benefit from a speculative risk even though a loss occurs but it is harmed if a pure risk is present.

- New technology for producing inexpensive computers

CLASSIFICATION OF RISK Diversifiable risk and nondiversifiable risk

Diversifiable Risk(Nonsystematic Risk) Affects only the individuals or firms and not the entire economy and can be reduced or eliminated by diversification.

Example: A diversified portfolio of stocks, bonds, and certificate of deposit(CDs) is less risky than a portfolio of 100 percent stocks.

Nondiversifiable Risk(Systematic Risk) Affects the entire economy or large number of persons or groups within the economy and can not be reduced or eliminated by diversification.

Example : Cyclical unemployment, rapid Inflation, war, floods, earthquakes.

How do you distinct the diversifiable and nondiversifiable risk?

Government assistant such as social insurance or

government insurance programs as well as government

subsidies may be necessary to insure nondiversifiable

risk.

CLASSIFICATION OF RISK

Enterprise risk encompasses all major risks faced by a business firm, which include: pure risk, speculative risk, strategic risk, operational risk, and financial risk

Strategic Risk refers to uncertainty regarding the firm’s financial goals and objectives.Example: Launch a new line of business by a firm

Operational risk results from the firm’s business operations. 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.

Example: A food company that agrees to deliver cereal at a fixed price to a supermarket chain in 6 months may lose money if grain prices rise.

MAJOR PERSONAL RISKS AND COMMERCIAL RISKS

Certain pure risks are associated with great financial insecurity for both individuals and families, as well as for commercial business firms.

1- Personal risks Types of pure risks that

2- Property risks can threaten an individual’s

3- Liability risks financial security

4- Commercial risks Types of pure risks

that can financially

threaten or bankrupt the firm

MAJOR PERSONAL RISKS

Personal risks are risks that directly affect an individual or family. They involve the possibility of a loss or reduction in income, extra expenses or depletion of financial assets, due to:

Premature death of family head

Insufficient income during retirement

Poor health (catastrophic medical bills and loss of earned income)

Involuntary unemployment

MAJOR PROPERTY RISKS

Property risks involve the possibility of losses associated with the destruction or theft of property

Direct loss vs. indirect loss

A direct loss is a financial loss that results from the physical damage, destruction, or theft of the property, such as fire damage to a home

An indirect or consequential loss is a financial loss that results indirectly from the occurrence of a direct physical damage or theft loss, e.g., the additional living expenses after a fire

MAJOR LIABILITY RISKS

Liability risks involve the possibility of being held legally liable for bodily injury or property damage to someone else

There is no maximum upper limit with respect to the amount of the loss

A lien can be placed on your income and financial assets

Legal defense costs can be enormous

Example:

If your car has a cash value of $20,000 , the maximum physical damage to your car is $20,000. But, if your negligence results in bodily injury or physical damage to someone else, you can be sued for any amount $50,000,$500,000 ,or $1million or more by the person you have injured.

MAJOR COMMERCIAL RISKS

Firms face a variety of pure risks that can have serious financial consequences if a loss occurs:Property risks, such as damage to buildings, furniture

and office equipmentLiability risks, such as suits for defective products,

pollution, and sexual harassmentLoss of business income, when the firm must shut down

for some time after a physical damage lossOther risks to firms include crime exposures, human

resource exposures, foreign loss exposures, intangible property exposures, and government exposures

BURDEN OF RISK ON SOCIETY

The presence of risk results in three major

burdens on society: 1-In the absence of insurance, size of emergency

funds must be increased.

Example: you purchase a $300,000 home and want to accumulate a fund for repairs if it is damaged by fire, hail, wind-storm . Without the insurance you need at least $50,000 annually to build up an adequate fund.

What if an early loss occur?

2-Loss of Certain Goods and Services Society is deprived of certain goods and services.

Example: Many manufacturing firms have discontinued the manufacture of childhood products, football helmets, and certain birth-control devices due to the threat of liability suit. - Consequence of September 11, 2001 on companies that manufactured anti-terrorism technologies.

3-Worry and Fear As a result of risk presence, fear and worry is present.

Example: Parents may be fearful if son or daughter teenage departs on a skiing trip during a blinding snowstorm because of the threat of being killed on an icy road

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