184 BANKING AND INSURANCE

Risk in our Society

On September 11, 2001, foreign terrorists hijacked four commercial Jets.
Two jets crashed into the World Trade Centre towers; the third jet crashed
into the Pentagon in Arlington while the fourth plane crashed in a field in
Southwestern Pennsylvania. Thousands of people died due to the attack.
The shocking terrorist attack shows clearly that we live in a risky world.
Other tragic events occur daily. Motorists die or are severely injured in
auto accidents. House owners lose their homes and personal property
because of fires, floods, hurricanes, earthquake and other natural
disasters. Others incur catastrophic medical bills and the loss of earnings
because of heart disease, cancer, AIDS, or other diseases. Still others face
financial ruin because they negligently injure someone and cannot pay a
liability judgment.
In this chapter we discuss about the nature and treatment of risk in our
society. Topics discussed include the meaning of risk, the major types of
risk that threaten our financial security and the basic methods of handling
RISK IN OUR SOC IET Y risk.

MEANING OF RISK
Learning Objectives
After studying this chapter, you should be able to understand: There is no single or universal definition of risk. Economists, behavioral
Meaning of risk. scientists, risk theorists, statisticians and actuaries each have their own
Distinguish between pure risk and speculative risk. concept of risk. Risk traditionally has been defined in terms of uncertainty.
Identify the major pure risks that are associated with financial Based on this concept, defined have been defined as uncertainty concerning
insecurity. the occurrence of a loss. For example, the risk of being killed in an auto
How risk is a burden to society.
accident is present because uncertainty is present. The risk of lungs cancer for
Major methods of handling risk.
smokers is present because there is also uncertainty. And the risk of flunking
a college course is present because uncertainty is present. In a nutshell where
uncertainty is present, risk is present there and where risk is present
uncertainty is present there thus risk and uncertainty are connected to each
other.
Risk is defined in terms of uncertainty related with economical loss and
uncertainty is basic truth of daily life. In our society different kinds of risks
occur which can be directly seen or heard. For example, we hear death of
some body at the age of 18, damage of house by fire, Z was killed in accident
etc.
Such incidents have a great loss to an individual, society or even to the state.
“When we take a risk, we are betting on an outcome that will result It is always uncertain that when, where, how and why such incidents occur
from a decision we have made, though we do not know for certain and what are the reasons behind them. Such uncertainty about the loss is
what the outcome will be.” • Peter Berrstein
known as risk. There is risk if the financial loss is possible and if the financial
risk is absent, then there is no risk. For example, the machine producer
 RISK IN OUR SOCIETY
knows that after a constant use both the life and value of it decreases but
there is not risk since there is not uncertainty of loss. Similarly, if the machine
producer is sure that the machine won't be burnt on fire, there is no risk too.
It is because in this second example, there isn't surety about the loss. Thus,
the uncertainty regarding the loss has worrying impact on human life. That's
why each individual or society wants to become free from such risks.
Risk also has an opposite impact on society, either directly or indirectly. As a
result, it hinders the economic development of the society. Because of the
risk, nobody is excited for financial activities. In society, the tendency of
financing or funding in the areas where there is less risk is high and the vice
versa. For that reason, the society can't get as much benefited as it could be.
Because of the risk there is the tendency of low production, less supply, high
price and again low production. This tendency ultimately affects the whole
industrial activities. Finally, defining risk as an uncertain phenomenon
intellectual has divided it into objectives risk and subjective risk.
Figure 1
Meaning of Risk
Meaning of Risk.
Objective Risk Subjective Risk
1. Objective Risk
Objective risk is defined as the relative variation between the expected loss
and the actual loss. For example, suppose an insurance company has insured
some 10,000 houses in an extended period of time and one percent or 100
houses are burnt every year in an average. But it may not be possible that
actually 100 houses will burn each year. In some years, only some 90 houses
may burn and 110 houses in other years. Here thus, variation of 10 houses is
seen or the variation is of 10 percent. This relative variation between the
expected loss and the actual is known as the objective risk.
Objective risk declines as the number of exposures increases. More
specifically, objective risk varies with the square root of the number of cases
under observation. In our previous example, 10,000 houses were insured and
objective risk was 10/100, or 10 percent. Now assume that 10 lakh (1 million)
houses were insured. The expected number of houses that will burn is now
10,000 but the variation of actual loss from expected loss is only 100. Now,
the objective risk is 100/10000 or 1 percent. Thus, as the square root of the
number of houses increased from 100 in the first example to 1000 in the
second example (10 time), objective risk declined to one-tenth of its former
level.
185 186 BANKING AND INSURANCE
Objective risk can be statistically calculated by some measure of dispersion,
such as the standard deviation or the coefficient of variation. Since objective
risk can be measured, it is an extremely useful concept for an insurer or a
corporate risk manager. As the number of exposure increases, an insurer can
predict its future loss experience more accurately because it can rely on the
law of large numbers. The law of large numbers states that as the number of
exposure unit increase, the more closely the actual loss experience will
approach the expected loss experience. For example, as the number of homes
under observation increases, the greater is the degree of accuracy in
predicting the proportion of homes that get burnt. The low of large numbers
is discussed in greater detail in Chapter 9.
2. Subjective Risk
Subjective risk is defined as uncertainty based on a person's mental condition
or state of mind. For example, a customer who was drinking heavily in a bar
may foolishly attempt to drive home. The driver may be uncertain whether
he will arrive home safely without being arrested by the police for drunk
driving. This mental uncertainty is called the subjective risk.
The impact of subjective risk varies depending on the individual. Two
persons in the same situation can have a different perception of risk and their
behavior may be altered accordingly. If an individual experiences great
mental uncertainty concerning the occurrence of a loss, that person's
behavior may be affected. High subjective risk often results in conservative
and prudent behavior, while low subjective risk may result in less
conservative behavior. For example, a motorist previously arrested for drunk
driving is aware that he has consumed too much alcohol. The driver may
then compensate for the mental uncertainty by getting someone else to drive
the car to the house or can take a cab.
Another driver in the same situation may perceive the risk of being arrested
as slight. This second driver may drive more carelessly and in reckless
manner; a low subjective risk results in less conservative driving behavior.
CHANCE OF LOSS
The long-term chance of occurrence, or relative frequency of loss, is defined
to be the chance of loss. The concept has little meaning if applied to the
chance of occurrence of a single event. Rather, it is meaningful primarily
when applied to the chance of a loss occurring among a large number of
possible events. Thus, chance of loss is expressed as the ratio of the number
of losses that are likely to occur compared to the large number of possible
losses in a given group. For example, suppose 1,000 buildings in a particular
city are considered to be susceptible to the risk of loss due to a tornado. If
 RISK IN OUR SOCIETY
past experience indicates that 20 of these buildings are likely to be damaged
by a tornado during a given time period, then the chance of loss due to a
tornado is 2 percent. This number is determined by dividing the probable
number of losses (20) by the number of buildings exposed to loss (1,000).
Chance of loss is closely related to the concept of risk. Like risk, "probability"
has both objective and subjective aspects.
Chance of Loss
Figure 2
Chance of Loss.
Objective Probability Subjective Probability
Deductive reasoning
Inductive reasoning
or a priori probability
1. Objective Probability
Objective probability refers to the long-run relative frequency of an event
based on the consumptions of an infinite number of observations and of no
change in the underlying conditions. Objective probabilities can be
determined in two ways:
a. Deductive Reasoning or a priori Probability: Priories probabilities are
determined on the basis of general principles or laws. In other words, they
can be determined by deductive reasoning. For example, the probability of
getting a head from the toss of perfectly balanced coin is 1/2 because there
are two sides, and head is only one. Likewise, the probability of rolling a six
with a single side is 1/6, since there are six sides and only one side has six
dots on it.
b. Inductive Reasoning: If a general principle or law is propagated (made)
on the basis of some specific events, it is known as inductive reasoning. For
example, the probability that a person aged 21 will die before age 26 cannot
be logically deducted. However, by a careful analysis of past mortality
experience, life insurance company can estimate the probability of death and
sell a five years term life insurance policy issued at age 21.
2. Subjective Probability
Subjective probability is the individual's personal estimate of the chance of
loss. Subjective probability need not coincide with objective probability. For
example, people who buy a lottery ticket on their birthday may believe that it
is their lucky day and over estimate the small chance of winning. A wide
variety of factors can influence subjective probability, including a person's
187 188 BANKING AND INSURANCE
age, gender, intelligence, education, and the use of alcohol. In addition, a
person's estimate of a loss may differ from objective probability because there
may be ambiguity in the way in which the probability is perceived.
PERIL AND HAZARD
We have looked at the nation of uncertainty, the fact that there are different
levels of risk, and the final component of risk will be looked as it is the cause
of the eventual loss.
We often use the word risk to mean both the event that will give rise to some
loss and the factors that may influence the outcome of a loss. When we think
about cause we must be clear that there are at least these two aspects to it. We
can see this if we think back to the two houses on the river bank and the risk
of flood. The risk of flood does not really make sense, what we mean is the
risk of flood damage. Flood is the cause of the loss and the fact that one of the
houses we right on the bank of the river influences the outcome. Flood is the
peril and the proximity of the house to the river is the hazard. There should
not be confusion about the terms 'peril' and 'hazard' with the concept of risk
discussed earlier.
1. Peril
Peril is defined as the cause of loss. For example, if someone's house burns
because of a fire, the peril or cause of loss is the fire. If your car is damaged in
a collision with another car, collision is the peril or cause of loss. Common
perils that cause property damage include fire, lightning, windstorm, hail
tornadoes, earthquakes, theft and burglary.
2. Hazard
Factors that may influence the outcome are referred to as hazards. These
hazards are not themselves the cause of the loss, but they can increase or
decrease the effects that a peril operates. The consideration of hazard is
important when an insurance company is deciding whether or not it should
insure some risk and what premium to charge.
A hazard is a condition that creates or increases the chance of loss. There are
four major types of hazards:
Figure 3
Types of Types of Hazard
Hazards.
Physical Hazard Moral Hazard Morale Hazard Legal Hazard
 RISK IN OUR SOCIETY 189
a. Physical hazard: A physical hazard is a physical condition that increases
the chance of loss. In other words, a physical hazard is a condition stemming
from the material characteristics of an object. Consider the peril of collision,
which may cause the loss to an automobile. A physical condition that makes
the occurrence of collision more likely is an icy street. The icy street is the
hazard, and the collision is the peril. The chance of loss due to collision may
be higher in winter than at other times of the year because of the greater
incidence of the physical hazard of icy streets.
Physical hazards include such phenomena as the existence of dry forests
(hazard affecting the peril of fire), earth faults (a hazard of earthquakes), and
the existence of oily rags in a firm’s storage closet (a hazard for fire). Other
examples of physical hazards include defective wiring in a building that
increases the chance of fire, and a defective lock on a door that increases the
chance of theft. Such hazard may or may not be within human control. For
example, the oily rag hazard can easily be eliminated. Other physical
hazards, such as weather condition, usually cannot be controlled, although
their existence often may be observed.
Other examples of physical hazards include defective wiring in a building
that increases the chance of fire, and a defective lock on a door that increases
the chance of theft.
b. Moral hazard: Moral hazard is dishonesty or character defects in an
individual that increases the frequency or severity of loss. In other words, the
condition known as moral hazard also stems from an individual's mental
attitude. It is associated with intentional actions designed either to cause a
loss or to increase its severity. Moral hazards often are typified by individual
with known records of dishonesty. Other examples of moral hazard include
faking an accident to collect from an insurer, submitting a fraudulent claim,
inflating the amount of claim and intentionally burning unsold merchandise
that is insured.
c. Morale hazard: The mental attitude of a careless or accident-prone person
is known as morale hazard. Some times a subconscious desire for a loss may
exist, even though the individual is not fully aware of this desire. In other
cases, circumstances may cause someone to be indifference to the possibility
of a loss, thus causing that person to behave in a careless manner. For
example, suppose the managers of XYZ Company believe that the federal
government will provide disaster assistance that will fully compensate XYZ
for all earthquake losses it may incur. In making plans for a new building
near a major fault line, XYZ’s management may be tempted to ignore more
expensive construction designs and procedures that can lessen the damage
from earthquakes. In essence, XYZ’s assumption regarding the potential for
federal disaster aid makes its management indifferent to the prospect of loss
and therefore, more prone to make unmindful decisions.
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Some insurance authors draw a subtle distinction between moral hazard and
morale hazard. Moral hazard refers to dishonesty by an insured that
increases the frequency or severity of loss. Morale hazard is carelessness or
indifference to a loss because of the existence of insurance. Some insured are
careless or indifferent to a loss because they have insurance. Examples of
morale hazard include leaving car keys in an unlocked car, which increases
the chance of theft; leaving a door unlocked that allows a burglary to enter;
and changing lanes suddenly on a congested interstate highway without
signaling. Such careless acts increase the chance of loss.
d. Legal hazard: Legal hazard refers to characteristics of the legal system or
regulatory environment that increases the frequency or severity of losses.
Examples include adverse jury verdicts or large damage a ward in liability
lawsuits, statues that require insurers to include coverage for certain benefits
in health insurance plans, such as coverage for alcoholism; and regulatory
action by state insurance departments that restrict the ability of insurers to
withdraw from the state because of poor underwriting results.
Basic Categories of Risk
Risk can be classified into several distinct categories. The two major
categories are as follows:
Figure 4
Basic Categories Basic Categories of Risk
of Risk.
Pure and Speculative Risk Fundamental and Particular Risk
1. Pure and Speculative Risk
a. Pure risk: A pure risk exists when there is a chance of loss but no chance of
gain. In other words, 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, catastrophic medical expenses, and
damage to property from fire, lightning, flood or earthquake etc. Such risks
are also called static risks. It is because these risks can be measured. They can
be measured, and the indemnity can be obtained.
b. Speculative risk: Speculative risk is defined as a situation in which either
profit or loss is possible. In other words, a speculative risk exists when there
is a chance of gain as well as a chance of loss or there is a possibility of either
profit or loss. For example, if you purchase 100 shares of common stock, you
would get profit if the price of the stock increases but would lose if the price
decreases. Other examples of speculative risks include betting on a horse
 RISK IN OUR SOCIETY 191
race, investing in real state and going into business. In these situations, both
profit and loss are possible.
Distinguish Between Pure and Speculative Risk
Pure risks are always distasteful but speculative risks possess some attractive
features. There are three reasons that distinguish pure risk from speculative
risk. They are:
a. Insurable interest: Except some speculative risks generally there is no
insurable interest. Hence private insurers generally insure only pure risks
with certain expectations, speculative risks generally are not considered
insurable and other techniques for coping with speculative risk must be used.
b. Predict Future loss experience: The law of large numbers can be applied
more easily to pure risks than to speculative risks. The law of large numbers
is important because it enables insurers to predict future loss experience. In
contrast, it is generally more difficult to apply the law of large numbers to
speculative risk of gambling, where casino operators can apply the law of
large numbers in a most efficient manner.
c. Benefit: Society 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. For
example, a firm may develop new technology for producing inexpensive
computers. As a result, some competitors may be forced into bankruptcy.
Despite the bankruptcy, society benefits because the computers are produced
at a lower cost. However, society normally does not benefit when a loss from
a pure risk occurs, such as a flood or earthquake that devastates an area.
2. Fundamental and Particular Risk
a. Fundamental Risk: A fundamental risk is a risk that affects the entire
economy or large numbers of persons or groups within the economy. Rapid
inflation, cyclical unemployment, and war are some of the examples of
fundamental risk because large numbers of individuals are affected by them.
Such risk affects the whole society or nation or the larger part of the world
rather than affecting the individuals. Fundamental or pure risk is related to
the social catastrophes such as famine, war etc. and the insurance of such
catastrophic events are not possible. Compensation of such losses is possible
only in the government or international level.
b. Particular risk: Particular risk is a risk that affects only individuals and not
entire community. Examples include car thefts, bank robberies and dwelling
fires. Only individual experiencing such losses are affected, not the entire
economy. It is because these risks have their effects on relatively small areas,
such losses can be measured. That's why; most particular risks can be
insured.
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Distinction between Fundamental and Particular Risk
The distinction between a fundamental and a particular risk is important
because government assistance may be necessary to insure a fundamental
risk. Government insurance programs, as well as government guarantees and
subsidies may be necessary to insure certain fundamental risks even in the
developed countries like USA. For example, the risk of unemployment
generally is not insurable by private insurers but can be insured publicly by
state unemployment compensation programs. In addition, flood insurance
subsidized by the federal government is available to business firms and
individuals in flood prone areas.
TYPES OF PURE RISK
Pure risks may be of different types, but the major types of pure risk that can
create great economical insecurity include:
Figure 5
Types of Pure Risk
Types of Pure
Risk.
Personal Risk Property Risk Liability Risk
Risk of Premature Date Direct Loss
Risk of Insufficient Income Indirect or
during Retirement Consequential Loss
Risk of Poor Health
Risk of Unemployment
1. Personal Risk
Personal risks are risks that directly affect an individual. They involve the
possibility of the complete loss or reduction of earned income, extra expenses
and the depletion of financial assets. There are four major personal risks.
a. Risk of premature death: It is defined as the death of a household head
with unfulfilled financial economical obligations. These obligations can
include dependents to support, a mortgage to be paid off or children to
educate. If the surviving family members receive an insufficient amount of
replacement income from other sources or have sufficient financial assets to
replace the lost income, they may be financially unsecured.
Premature death can cause financial problems only if the diseased has
dependents to support or dies with unsatisfied financial obligations. Thus,
the death of a child aged seven is not "premature" in the economic sense
 RISK IN OUR SOCIETY 193
because here the principle of insurable interest does not apply. There are at
least four costs that result from the premature death of a household head.
(i) Human life value: When the household head dies prematurely his human
life value is lost forever. The human life value is defined as the present value
of the family's share of the deceased breadwinner's future earnings. This loss
can be substantial; the actual or potential human life value of most college
graduate can easily exceed $500,000.
(ii) Additional expenses: Additional expenses may be incurred because of
funeral expenses, uninsured medical bills, probate and estate and settlement
cost and inheritance taxes for larger estate. Because all these expenses incur
when the household dies, these expenses are called additional expenses.
(iii) Insufficient income: Because of insufficient income, some families may
have trouble of meeting the needs or covering expenses. Such a situation is
created if the household head, supporting his family dies prematurely. As a
result, rest of the family may suffer because of insufficient income.
(iv) Certain non-economic costs: After an untimely demise of the household
head certain non-economic costs are also incurred, which may include:
emotional grief, loss of a role model, counseling and guidance for the
children.
b. Risk of Insufficient Income during Retirement: The major risk associated
with old age is insufficient income during retirement. The vast majority of
workers in the United States retire before age 65, when they retire, they lose
their earned income. Unless they have sufficient financial assets or have
access to other sources of retirement income, such as, social security or a
private pension, they will be exposed to financial insecurity during
retirement. The majority of workers experience a substantial reduction in
their income when they retire, which can result in a reduction of standard of
living.
c. Risk of poor health: Poor health is another important personal risk. The
risk of poor health includes both the payment of catastrophic medical bills
and the loss of earned income. The costs of major surgery have increased
substantially in recent years. For example, an open heart surgery takes more
than $200,000; kidney or heart transplant can cost more than $400,000, and
the costs of crippling accident requiring several major operations, plastic
surgery, and rehabilitation can exceed $500,000. In addition, long-term care
in a nursing home can cost $50,000 or more each year (these examples are in
the American context). Unless these persons have adequate health insurance,
private savings and financial assets or other sources of income to meet these
expenditures, they will be financially insecure. Particularly, there is the
inability of some persons to pay catastrophic medical bills in an important
course of person bankruptcy.
194 BANKING AND INSURANCE
The loss of earned income is another major cause of financial insecurity if the
disability is severs. In cases of long-term disabilities, there is a substantial
loss of earned income, medical bills are incurred, employee benefits may be
lost or reduced, savings are often depleted, and someone must take care of
the disabled person. The loss of earned income during an extended disability
can be financially very painful.
d. Risk of Unemployment: The risk of unemployment is another major
threat to financial security. Unemployment can result from business cycle
down swings, technological and structural changes in the economy, seasonal
factors, and imperfection in the labour market.
Several important trends have challenged to the problem of employment. To
hold down labour costs, large corporations have downsized, and their work-
force has been permanently reduced, employers are increasingly hiring
temporary or part-time workers to reduce labour costs; and millions of jobs
have been lost to foreign nations because of global competition. Regardless of
the reason, unemployment can cause financial insecurity in at least three
ways.
(i) Workers lose their earned income and employee benefit: Workers lose
their earned income and employee benefits. Unless there is adequate
replacement income or past saving there will be financial insecurity to
workers.
(ii) The worker may be able to work only part time: Because of economic
conditions of the country the worker may be able to work only part time. The
reduced income may be insufficient in terms of the worker's needs. So
workers can not drive their life and they will be financially unsecured.
(iii) The duration of unemployment is extended over a long time: If the
duration of unemployment is extended over a long period, past savings and
unemployment benefits may be exhausted. Thus workers may experience
great financial insecurity.
2. Property Risks
Persons owning property are exposed to property risks. That is risk of having
property damaged or lost from numerous causes. Real estate and personal
property can be damaged or destroyed due to the fire, lightening, tornadoes,
wind storms and numerous other causes. There are two major types of losses
associated with the destruction or theft of property. These losses are
discussed below.
a. Direct loss: A direct loss is a financial loss that results from the physical
damage, destruction or theft of the property. For example, if we own a sport
shop that is damaged by a fire, the physical damage to the sport shop is
known as a direct loss.
 RISK IN OUR SOCIETY 195
b. 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. Thus in addition to the loss due to physical damage, the sport shop
would lose profits for several months while the sport shop is being rebuilt.
The loss of profits would be a consequential loss. Other examples of a
consequential loss would be the loss of rents, the loss of the use of the
building and the loss of a local market.
Extra expenses are another type of indirect or consequential loss. For
example suppose we own a newspaper bank or diary. If a loss occurs we
must continue to operate regardless of cost otherwise, we will lose customers
to our competitors. It may be necessary to set up a temporary operation at
some alternative location and substantial extra expenses would be then
incurred.
3. Liability Risks
Liability risks as another important type of pure risk that most persons face.
Under our legal system, we can be held legally liable if we do something that
result in bodily injury or property damage to someone else. A court of law
may order us to pay substantial damages to the person we have injured
which risk is called liability risk.
USA is a ligitious society believes on law, and lawsuits are common.
Motorists can be held legally liable if they drive their vehicles on the road
negligently. The liability exposure can be especially high for teenage drivers.
Operators of boats and lake owners also can be held legally liable because of
bodily in Jury to boat occupants' swimmers and water skiers. Business firms
can be held legally liable for defective products that harm or injure
customers. Physicians' attorneys, accountants, engineers and other
professionals can be sued by patients and clients because of alleged acts of
mal-practice. Thus we can say that liability risks are of greater importance
because of several reasons as follows.
a. There is no maximum upper limit with respect to the amount of the loss:
If any person's property gets damaged by us then he may sue case for asking
compensation of any amount. In contrast if we own property there is a
maximum limit on the loss. For example, assume that if your car has an
actual cash value of 10,00,000, the maximum physical damage loss is not
more than Rs. 10,00,000. But if we are negligent and cause an accident that
results in serious bodily injury to the other driver, you can be sued for any
amount Rs. 5,00,000, Rs. 10,00,000 or Rs. 50,00,000 or more by the person we
have injured.
b. A lien can be placed on our income and financial assets to satisfy a legal
judgment: A lien can be placed on our income and financial assets to satisfy a
196 BANKING AND INSURANCE
legal judgment. For example assume that we injure someone and court of law
orders us to pay damages to the injured party. If we cannot pay the judgment
a lien may be placed on our income and financial assets to satisfy the
judgment. If we declare bankruptcy to avoid payment of the judgment, our
credit rating will be impaired.
c. Legal defense costs can be enormous: Legal defense cost can be enormous.
If we have no liability insurance, if we injure some one, if we damage other's
property, we will have to contact with lawyers in higher rate. Then the cost
of hiring an attorney to defend us can be staggering. If the suit goes to trial
attorney fees and other legal expenses can be substantial. Thus attorney fees
unless decision of lawsuit and other legal expenses are included under the
legal defense costs.
BURDEN OF RISK ON SOCIETY
The presence of risk results in certain undesirable social and economic
effects. Risk entails three major burdens on society. These burdens are
discussed below:
Figure 6
Burden of Risk Burden of Risk on Society
on Society.
Larger Emergency Loss of Certain Worry & Fear
Fund Goods and Services
1. Larger Emergency Fund
When individual, society or business firm insure their personal property or
business firm, they will not have to increase the size of their emergency fund
to pay for unexpected losses. But if business firms or individual property are
not insured or if there is absence of insurance they would have to increase
the size of their emergency funds to pay for unexpected losses. For example,
Ram has purchased a one lakh fifty thousand home and he wants to
accumulate a house worth fund for repairs if the house is damaged by fire,
hail, windstorm or some other peril. Without insurance Ram would have to
save at least two lakh twenty five thousands annually to build up an
adequate fund within a relatively short period of time. Even than an early
loss could occur and Ram's emergency fund may be insufficient to pay the
loss. If Ram is a middle income wage earner, he would find such saving
difficult. In any event the higher the amount that must be saved, the more
current consumption spending must be reduced, which results in a lower
 RISK IN OUR SOCIETY 197
standard of living. So, social and economic burden on society are emerged.
Thus we can say freely that it will be better to avoid the emergency fund.
2. Loss of Certain Goods and Services
A second burden of risk is that society is deprived of certain goods and
services. For example, because of the risk of a liability lawsuit, many
corporations have discontinued manufacturing certain products. Numerous
examples can be given. Some 250 companies in the world once manufactured
childhood vaccines; today, only a small number of firms manufacture
vaccines, due in part to the threat of liability suits. Other companies have
discontinued the manufacture of certain products including asbestos
products football helmets, silicone - gel-breast implants and certain birth
control devices because of fear of legal liability. Thus, due to the risk certain
goods and services on the society are reduced. By the result of reduction of
certain goods and services, peoples on the society can not consume the
products produced by the company. The burden of risk emerges on the
society because of loss of certain goods and services.
3. Worry and Fear
A final burden of risk is that worry and fear are present. For example,
assume that parents may be fearful if a teenage son or daughter departs on a
skiing trip during a blinding snowstorm because the risk of being killed on
an icy road is present. Some passengers in a commercial jet may become
extremely nervous and fearful, if the jet encounters severe turbulence during
the flight. A college student who needs grade of 'A' result in a course to
graduate may enter the final examination room with a feeling of
apprehension and fear. Such types of worry and fear on the society are being
resulted everyday. By the result of worry and fear burden of risk on the
society is increased.
METHODS OF HANDLING RISK
As we stated earlier, risk is a burden not only to the individual but to the
society as well. Thus, it is important to examine some techniques for
handling the problem of risk. If the quantity of risk increases in the society,
society and individuals also have to face with economic and financial
problem. Finally, person and society are affected badly due to the economic
and financial problem. So to solve the problem of risk, it is necessary to
examine some techniques. There are five major methods of handling risks.
These methods are discussed below.
198 BANKING AND INSURANCE
Figure 7
Methods of
Handling Risk.
Methods of Handling Risk
Risk Loss
Retention
Non-insurance
Insurance
Avoidance Control Risk Transfers
1. Risk Avoidance
The meaning of avoidance is that a certain loss exposure is never acquired or
an existing loss exposure is abandoned. Avoidance is one method of
handling risk. So, avoidance means that any things is far from the place or in
that place no person goes ever or never buys something or nobody involves
in the activities of risk. A technique of pre-planning of avoidance already
arising from the risk is called avoidance. For example, we can avoid the risk
of being mugged in a high-crime rate area by staying out of the area, we can
avoid the risk of divorce avoiding marriage and a business firm can avoid the
risk of being sued for a defective product by not producing the product.
From above mentioned example it is clear that any person can face risk. And
all of there possible risks creates difficult situation in our life. So, to stay
separately or to live avoiding all possible risk or to reject the activities of
possible risk is called avoidance.
However, it is no possible to avoid all the risks. For example, we 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 airline is excellent and flying is a reasonable risk
to assume. Thus the simplest way of being safe risk is avoidance of risk or to
avoid cause of risk earlier.
2. Loss Control
Loss control is another important method for handling risk. Loss control
consists of certain activities that reduce both the frequency and severity of
loss. When particular risks cannot be avoided, actions may often be taken to
reduce the losses associated with them. This method of dealing with risk is
known as loss control. It is different than risk avoidance, because the firm or
individual is still engaging in operations that give rise to particular risks
rather than abandoning specific activities. Loss control involves making
conscious decisions regarding the manner in which those activities will be
conducted. Common goals are either to reduce the probability of losses or to
decrease the cost of losses that do occur. Thus loss control has two major
objectives. These major objectives are:
 RISK IN OUR SOCIETY 199
a. Loss prevention: Loss prevention aims at reducing the probability of loss
so that the frequencies of losses are reduced. Several examples of personal
loss prevention can be illustrated. Auto accidents can be reduced if motorists
take a safe driving course and drive defensively. The number of heart attacks
can be reduced if individuals control their weight, give up smoking and eat
healthy diets.
Loss prevention is also important for business firms. For example strict
security measures at airports and aboard commercial flights can reduce
hijacking by terrorists. 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 prevent the loss from occurring.
b. Loss reduction: Strict loss prevention efforts can reduce the frequency of
losses yet some losses will inevitably occur. Inevitable losses can not be
controlled totally but these losses can be reduced partially or 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,
there by reducing the loss; a plant can be constructed with fire-resistant
materials to minimize fire damage; fire door 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. From the
point of view of society loss control is highly desirable because of two
reasons.
(i) The indirect cost of losses may be larger, and in some instances can
easily exceed the direct cost: The indirect costs of losses may be large and in
some instances can easily exceed the direct cost. For example assume that a
worker may be injured on the job. In addition to being responsible for the
workers medical expenses and a certain percentage of earnings, the firm may
incur sizable indirect cost; a machine may be damaged and must be repaired;
the assembly line may have to be shut down; costs are incurred in training a
new worker to replace the injured worker; and a contract may be cancelled
because goods are not shipped on time. By preventing the loss from
occurring both indirect costs and direct costs are reduced.
(ii) The social costs of losses and reduced: For example assume that the
worker in the preceding example dies in an accident. Society is deprived
forever of the goods and services the decreased worker could have produced.
The worker's family losses its share of the worker's earnings and may
experience considerable grief and financial insecurity. And the worker may
personally experience great pain and suffering before dying. In short these
social costs can be reduced through an effective loss control program.
200 BANKING AND INSURANCE
3. Retention
Retention means that the firm retains part or all of the losses that can result
from a given loss. Retention is a third method of handling risk. An individual
or a business firm retains all or part of a give risk. Risk retention can be either
active or passive. These are discussed below.
a. Active risk retention: Active risk retention means that an individual is
consciously aware of the risk and deliberately plans to retain all or part of it.
For example, a motorist may wish to retain the risk of a small collision loss
by purchasing an auto insurance policy with a Rs. 250,000 or higher
deductible. A house-owner may retain a small part of the risk of damage to
the house by purchasing a house-owners policy with a substantial
deductible. A business firm may deliberately retain the risk of petty thefts by
employees, shoplifting or the spoilage of perishable goods. In these cases
conscious decision is made to retain part or all of a given risk. Active risk
retention is used for two major reasons.
(i) Money can be saved. Insurance may not be purchased at all or it may be
purchased with a deductible. In both ways there is often a substantial saving
in the cost of insurance.
(ii) The risk may be deliberately. The risk may be deliberately retained
because commercial insurance is either unavailable or unaffordable.
b. Passive risk retention: Risk also can be retained passively. Certain risks
may be unknowingly retained because of ignorance, indifference or laziness.
Passive retention is very dangerous if the risk retained has the potential for
destroying us financially. For example, many workers with earned income
are not insured against the risk of total and permanent disability under either
an individual or group disability income plan. However, the adverse
financial consequences of total and permanent disability generally are more
severe than the financial consequences of premature death. Therefore, people
who are not insured against this risk are using the technique of risk retention
in a most dangerous and in appropriate manner.
In a nutshell risk retention is an important method for handling risk. Risk
retention however, is appropriate primarily for high frequency low -severity
risks where potential losses are relatively small. Except under unusual
circumstances risk retention should not be used to retain low frequency, high
severity risks such as the risk of catastrophic medical expenses long-term
disability or legal liability.
4. Non-Insurance Transfers
Non-insurance transfers are other techniques for handling risk. Non-
insurance transfers are methods other than insurance by which a pure risk
and its potential financial consequences are transferred to another party. Of
course, the risk is transferred to a party other than on insurance company. A
 RISK IN OUR SOCIETY 201
risk can be transferred by several techniques. Example of non-insurance
transfer is that a businessman can transfer the burden of economic loss of his
goods to customer by increasing value of goods. The businessman assumes
that his property may be damaged by any causes. The risk is transferred to
another party. Some techniques of transferring risk are discussed here:
a. Transfer of risk by contracts: Unwanted risks can be transferred by
contracts. For example, the risk of a defective television or stereo set can be
transferred to the retailer by purchasing a service contract, which makes the
retailer responsible for all repairs after the warranty expires. The risk of a
rent increase can be transferred to the landlord by a long-term lease. The risk
of a price increase in construction costs be transferred to the builder by
having a fixed price in the contract.
Finally, a risk can be transferred by a holder harmless clause. For example, if
a manufacturer of scaffolds inserts a hold harmless clause in a contract with
retailer, the retailer agrees to hold the manufacturer harmless incase a
scaffold collapse and someone is injured.
b. Hedging price risks: Hedging involves the transfer of a speculative risk. It
is a business transaction in which the risk of price fluctuations is transferred
to a third party, which can be either a speculator or another hedger. For
example, an airline faces significant price risk from fluctuation in the price of
the jet fuel that it buys. The airline sells tickets well in advance of the date on
which it promises to transport its passengers. The price that the airline pays
for jet fuel on the day that it transports its passengers may either increase or
decrease relative to the price on the date that it set its ticket prices, causing
either profit or loss. The airline prefers to avoid the price risk and concentrate
on its main business operation: transporting goods and passengers.
Therefore, on the basis of the quantity of jet fuel it expects to buy, the airline
enters into an equal and opposite transaction in the oil futures market
whereby a speculator, in effect, assumes the price risk. The speculator agrees
to take the price risk in the hope of making a profit on the total transaction. In
other words, the speculator hopes to make the right guesses about price
trends more often than not. The speculator is the risk transferee, and the
transferor is usually a businessperson wishing to pass on a price risk to
someone who is more willing and able to bear it. Alternatively, the third
party opposite the transaction made by the airline may itself be a hedger. For
example, because an oil company benefits from increases in the price of oil,
its risk exposure with respect to oil prices is the mirror image of an airline’s
exposure to oil price risk. That means the oil company could hedge its
exposure to oil price risk by taking a position in the futures market exactly
opposite to that of the airline. In this case, both the oil company and the
airline reduce their risk by investing on opposite sides of this futures market
202 BANKING AND INSURANCE
transaction. In addition to futures contracts, forwards, swaps, and options
are other commonly used tools for hedging speculative risk.
c. Incorporation of business firm: Incorporation is another important
example of risk transfer. For example, if a firm is a sole proprietorship, the
owner's personal assets can be attached by creditors for satisfaction of debts.
If a firm incorporates, personal assets can not be attached by creditors for
payment of the firm's debts. In essence, by incorporation, the liability of the
stock holders is limited and the risk of the firm having insufficient assets to
pay business debts is shifted to the creditors.
Finally, another way for a business to transfer risk is to incorporate. In this
way, the greatest loss that an incorporated firm can ever lose is the total
amount of its assets. Personal assets of the owners can not be attached to help
pay for business losses, and can be the case with sole proprietorships and
partnerships. Through this act of incorporation, a firm transfers to its
creditors the risk that might not have sufficient assets to pay for losses and
other debts.
d. Diversification: While risk management might not be the primary
motivation then many of the production decisions that a firm makes can
serve to transfer risk. Diversification across various business or geographic
locations, while frequently justified by business synergies or economies of
scale, also results in the transfer of risk across business units. Additionally,
this combining of business or geographic locations in one firm can even
result in a reduction in total risk through the portfolio effect of pooling
individual risks that have different correlations. For example, a firm with two
production facilities may sustain windstorm damage to its facility in
Nepalgunj resulting from a tornado. However, it is unlikely that the same
storm would cause damage to its facility in Kathmandu.
5. Insurance
As an economic institution, insurance involves not only risk transfer but also
pooling and risk reduction. Pooling is the sharing of total losses among a
group. Pooling within a large group facilitates risk reduction, which is a
decrease in the total amount of uncertainty present in a particular situation.
Insurance accomplishes risk reduction by combining under one
management; a group of objects are situated so that the aggregate losses to
which the insured are subject become predictable within narrow limits. Thus,
overall risk for the group is reduced, and losses that result are pooled,
usually through the payment of an insurance premium. Thus, through the
insurance mechanism, insured's transfer various risks to the group and
exchange a potentially large, uncertain loss for relatively smaller certain
premium.
 RISK IN OUR SOCIETY 203
Insurance is usually implemented through legal contracts or policies, in
which the insurer promises to, reimburse the insured for losses suffered
during the term of the agreement. Implicit in insurance transfers is the
assumption that the insurer will indeed be able to pay what ever losses may
occur. Sometimes, however, insurers become insolvent and are unable to
keep their promises to pay insured losses. In such cases, insured may have to
bear the cost of losses that they had assumed, had been adequately
transferred through the purchase of insurance policies. Thus, when using
insurance as a risk management technique, it is important to consider the
financial condition of the insurer and the probability that it will be able to
pay for all insured losses that may occur.
Insurance is the most practical method for handling a major risk for most
people. Although, private insurance has several features, three major features
are emphasized here. These features are:
a. Risk transfer: Risk transfer is used because a pure risk is transferred to the
insurer.
b. Pooling technique: In insurance money from different persons is collected
in a place to manage risk. The pooling technique is used to spread the losses
of the few over the entries group so that average loss is substituted for actual
loss.
c. Law of large numbers: The risk may be reduced by application of the law
of large numbers by which an insurer can predict future loss experience with
greater accuracy. Each of these characteristics is discussed in chapter 9.
Summary
1. There is no single definition of risk. Risk traditionally has been defined as
uncertainty concerning the occurrence of a loss.
2. Objective risk is the relative variation of actual loss from expected loss.
Subjective risk is uncertainty based on an individual's mental condition or
stage of mind. Chance of loss is defined as the probability that an event
will occur; it is not the same thing as risk.
3. Peril is defined as the cause of loss. Hazard is any condition that creates or
increase the chance of loss. There are four major types of hazards.
(a) Physical Hazard: Physical hazard is physical conditions present that
increase the chance of loss.
(b) Moral Hazard: Moral hazard is dishonesty or character defects in a
individual that increase the chance of loss.
(c) Morale Hazard: Morale hazard is carelessness or indifference to a
loss because of the existence of insurance.
204 BANKING AND INSURANCE
(d) Legal Hazard: Legal hazard refers to characteristics of the legal
system or regulatory environment that increase the frequency or
severity of losses.
4. The basic categories of risk include the following:
(a) Pure and speculative risk
(b) Fundamental and particular risk
(i) Pure risk: A pure risk is a risk where there are only the
possibilities of loss or no loss.
(ii) Speculative risk: A speculative risk is a risk where either profit
or loss is possible.
(iii) Fundamental risk: A fundamental risk is a risk that affects the
entire economy or large numbers of persons or groups within the
economy, such as inflation, war, or recession
(iv) Particular risks: A particulars risk is a risk that affects only the
individual and not the entire community or country.
5. The following types of pure risk can threaten an individual's financial
security:
(a) Personal risks
(b) Property risks
(c) Liability risks
6. Personal risks are those risks that directly affect an individual. Major
personal risks include the following:
(a) Risk of premature death
(b) Risk of insufficient income during retirement
(c) Risk of poor health
(d) Risk unemployment
7. Property risks affect persons who own property. If property is damaged or
lost, two principal types of losses may result:
(a) Direct loss to property: A direct loss is a financial loss that results
from the physical damage, destruction, or theft of the property.
(b) Indirect, or consequential loss: An indirect or consequential loss is a
financial loss that results indirectly from the occurrence of a direct
physical damage or theft loss. Examples of indirect losses are the loss
of use of the property, loss of profits, loss of rent and extra expenses.
8. Liability risks are extremely important because there is no maximum
upper limit on the amount of the loss, and if a person must pay damages, a
lien can be placed on income and assets to satisfy a legal judgment;
substantial legal defense costs and attorney fees may also be incurred.
9. Risk entails three major burdens on society
(a) The size of an emergency fund must be increased.
(b) Society is deprived of needed goods and services.
(c) Worry and fear are present.
10. There are five major methods of handling risk:
(a) Avoidance
(b) Loss control
(c) Retention
 RISK IN OUR SOCIETY 205 206 BANKING AND INSURANCE

(d) Non-insurance risk transfers 3. Identify the types of financial losses likely to be incurred by each of the
(e) Insurance following parties.
a. A person who negligently injures another motorist in an auto
accident.
b. A restaurant that is shut down for six months because of a tornado.
c. A family whose family head dies prematurely.
Theoretical Questions d. A tenant whose apartment burns in a fire.
4. Several methods are available for handling risk. However, certain
1. Explain briefly the meaning of risk. techniques are more appropriate than others in a given situation.
2. How does objective risk differ from subjective risk? a. (i) should retention be used in those situations where both loss
3. Define chance of loss. frequency and loss severity are high? Explain your answer.
4. Explain the basic categories of risk. [TU 2063] (ii) Explain why loss control is a highly desirable method for handling
5. Distinguish between an objective probability and a subjective risk.
probability. b. Explain why chance of loss and risk are not the same thing.
6. Define peril, hazard, physical hazard, moral hazard, morale hazard and 5. Sarah operates a pawn-shop in a large city. Her shop is in a high-crime
legal hazard. area and the high cost of burglary insurance is threatening the existence
of her business. A trade association points out that several methods
7. Explain the difference between pure and speculative risk and between
other than insurance can be used to handle the burglary exposure.
fundamental and particular risk.
Identify and illustrate three different non-insurance methods that might
8. Identify the major types of pure risk that are associated with great be used to deal with this exposure.
financial insecurity.
9. Why is pure risk harmful to society?
10. What is the burden of risk?
11. What is the difference between a direct losses an indirect, or
consequential loss?
12. Describe briefly the five major methods of handling risk. Give an
example of each method.
13. Write notes on method of handling risks. [TU 2064]

Application Questions
1. Union Insurance received an application to provide property insurance
on a frame dwelling located near an oil refinery in an industrial section
of the city. In considering this property for insurance, the property
insurance underwriter is concerned with risk, hazard, and chance of loss.
a. Describe several risks to which the frame dwelling is exposed.
b. Compute and contrast moral hazard and morale hazard with respect
to property insurance on the frame dwelling. Give an example of
each.
2. Assume that chance of loss is 3 percent for two different fleets of trucks.
Explain how it is possible that objective risk for both fleets can be
different even though the chance of loss is identical.