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The Meaning of Risk

Chapter · January 1998

DOI: 10.1007/978-1-4615-6187-3_1

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 THE MEANING OF RISK 1

Risk is the foundation of insurance but a brief survey of insurance text books
reveals differences of opinion among authors concerning the definition of "risk".
The article by Robert M. Crowe and Ronald C. Horn "The Meaning of Risk " that
was published in the September 1967 issue of the Journal of Risk and Insurance
focused attention on the frustrated victim: the student.
We have replicated here their article by updating the definitions. It is a
sincere tribute to the major textbooks and their authors that have largely inspired
our text:
Joe College is an undergraduate in the College of Business
Administration at Typical U. He has enrolled recently in an elective course
entitled "Principles of Risk and Insurance." Being that rare conscientious
student, Joe decides that, prior to the first class meeting of this course, it
would be well for him to do a bit of background reading on the subject.
After all, nothing impresses (or surprises) a professor more than a student
who has done some exploratory work on the subject before the semester
begins.
Joe assumes from the title of the course that the subject of risk will
be taken up first. That one should be duck soup. Everyone knows what
risk is! It looks like the early part of this course will be a snap!
Just to be sure, however, Joe decides to check the Webster's New
International Dictionary, where he learns that risk is "the possibility of loss,
injury, disadvantage, or destruction." Just what Joe figured! . The Concise
Oxford Dictionary refers to "the chance of hazard, bad consequences,
loss,"
Well!
 2

Now to be doubly sure, Joe heads for the library! There he pores
through a few textbooks designed for an introductory course in risk and
insurance. His research reveals the following:
1. "Risk is defined as uncertainty as to a loss." 1 Hmm! doesn’t sound quite
the same as the dictionary definition. Maybe insurance people use "risk"
in a very technical sense to mean something different from the dictionary
definition.
2. "Risk is uncertainty of financial loss."2
3. "Risk is defined as uncertainty concerning the occurrence of a loss. 3
4. "For our purpose the term risk usually refers to perils to which the
individual is objectively exposed at any time."4 Joe's confidence in his
understanding of risk now is a bit shaken.
5. "Risk is defined as the variation in the outcomes that could occur over a
specified period. If only one outcome is possible, the variation and hence
the risk is zero. If many outcomes are possible the risk is not null." 5 Joe
notes that there is nothing "objective" about risk in this definition and his
uncertainty (risk?) mounts.
6. "The lack of predictability of outcomes may be termed risk. Risk in this
sense, does not imply that outcome are adverse, only that they are not
known in advance"6 and the author indicates in his text that it is a
"temporary definition of risk".
7. "Risk is a state in which losses are possible... Risk has no meaning
without loss being the outcome of concern."7 Joe is starting to panic now.
8. "Risk is a condition in which there is a possibility of an adverse
deviation from a desired outcome that is expected or hoped for." 8 Sounds
plausible, but man! I'm confused.
If Joe College were to look further into texts on risk and insurance,
he would find that risk is also defined as a chance of loss or a combination
of hazards. Joe's next move is toward the Registrar's Office, where he
transfers out of Principles of Risk and Insurance and into Principles of
Management. Good luck Joe!

The word "risk" may originate from the Arabic word "risq" or the Latin word
"risicum". The Greek word "rhiza" is refering to the hazards of sailing around a
cliff.
The french word "risque" has a speculative connotation in "qui risque rien n'a
rien" (nothing ventured, nothing gained). In English, it is used in many nuances
in different contexts, often leading to confusion and misunderstanding. In 1966,
the Commission on Insurance Terminology of the American Risk and Insurance
Association approved the following definition of risk: "Uncertainty as to the
outcome of an event when two or more possibilities exist." 9 The disagreement or
confusion still persists today. The need for agreement on a common risk
 3

vocabulary was recognized by the Society for Risk Analysis when it established
its Committee for Definitions. Thirteen definitions were considered by the
Committee, none even close to the one adopted by the American Risk and
Insurance Association.10

The Classification of Risks

Willett recognized that risk is commonly used in an ambiguous manner and
sought to construct a more precise definition. He first proposed to classify risks
in two categories, economic risks, because their existence is due to participation
in economic life, and in contrast extra-economic risks, the existence of which is
not the result of economic activity. He mentioned that such risks may also affect
economic activity but he was only concerned by economic risk.

Static and Dynamic Risks

Willett considered that a fundamental classification of economic risks is based on
the distinction between static and dynamic losses. A similar classification was
suggested by Von Mangold between technical and economic losses. 11 An
alternative classification was presented by Hardy and distinguished the
followings: (1) risks of destruction through physical hazard, (2) uncertainties in
the production process, (3) risks resulting from market changes, (4) risks caused
by "abnormal" social conduct and, (5) risks arising from the failure to use
available knowledge.12
Dynamic risks are those involved in the possibility of dynamic changes.
They are resulting from changes in the economic conditions such as price levels,
consumer’s tastes, saving behaviour and technology. They usually benefit the
entire society in the long run.
Static risks involve losses that would occur even if there were no changes in
the economy such as accidents, fires and other perils of nature. These losses are
also caused by irregular action or mistakes of human beings. They could be the
source of gain for an individual but usually static losses involve the destruction
of assets and are not a source of gain for the society.

Pure and Speculative Risks

The distinction between pure and speculative risks is usually attributed to
Mowbray. 13 In the first publication of the American Economic Association,
Professor Emery distinguished risks of production from speculative risks. 14
Risks of production were not defined but speculative risks were "the risks of price
fluctuations affecting the whole market."
 4

Speculative risks describe a situation where there is a possibility of a loss as

well as a gain. The activities generating such risks are usually undertaken in the
hope of a gain. Gambling is a good example of a speculative risk. Investments
in risky assets are voluntary accepted although price fluctuations can either
benefit or deprive the owner.
Pure risks are those that offer only the prospect of a loss. Therefore, perils
of nature or consequences of human errors are usually only pure risks.
There are some borderline examples where it is difficult to classify the risk
because the process is dynamic and the result may be a short term loss which
could result in a gain in the long term. A strike results in losses for the workers
and the firm but in fact the outcome is a new labor contract which carries the
prospect of improved work conditions and/or salaries and higher expected
productivity and profits for the firm. The consequences of a war can also be
appreciated in different ways. A nationalization results in the loss of property due
to a dynamic change in the country but in fact the decision of investment usually
incorporates a premium for such a risk in the required rate of return on the
investment.

Fundamental and Particular Risks

The distinction between fundamental and particular risks is based on the concept
of hazard defined by Kulp.15
Particular risks involve losses that arise out of individual events and are felt
by individuals rather than a group. Fundamental risks involve losses that affect a
large segment of the population. The later are caused for the most part by
economic, social, climatic, health and/or political phenomena. Examples are
wars, earthquakes, health diseases, and economic recessions leading to
unemployment. Fundamental risks may be static or dynamic.

Systematic and Unsystematic Risks

This is a basic principle in financial management: risk can be eliminated through
diversification. Diversification reduces risks if all the outcomes of risky events
do not produce the same result or do not arise all at the same time. The convention
in finance is to interpret risk in the spirit of Willet and Knight. A risky outcome
is one that can assure a number of values. It is interesting to note that Knight in
1921 defined profit as a reward for assuming risk and claimed that only
uncertainties create an economic problem and are the source of economic profit.
In 1952, Markowitz, known as the father of modern portfolio theory,
published an article showing the exact relationship between stock return
correlation and risk reduction.16 He recognized that a set of securities can be
combined into an infinite number of portfolios with a wide range of risk-return
combinations. Risk that is eliminated through diversification is risk that is unique
 5

to the stock or group of stocks in the portfolio. Unique risk is known as

diversifiable or unsystematic risk. Because it can be eliminated, it should have
no value.
No matter how well diversified a portfolio is, there is some unavoidable
component of risk that exists because certain factors systematically affect all
firms in the economy to a greater or lesser extent. This risk is known as market
or systematic risk. This leads to one of the most important insights of modern
finance theory: because the risk of a well-diversified portfolio depends only on
the market risk of its components securities, the relevant risk of any security is its
sensitivity to general market movements.

Country and International Risks

In its broader sense, country risk can be defined as potential financial losses due
to problems arising from macro-economic and/or political events in a particular
country.
At the country level, business risks are essentially classified as operating
risks, socio-political risks and financial risks. Operating risks are those
concerning the local economic, technical, infrastructural and cultural
environment while socio-political risks are those concerning the host government
and its policies, programs and practices. For example, changes in Governments
may result in changes of behavior or attitudes towards nationalistic interests.
Financial risks reflect the possibility that even though the investment is
generating a cash flow in local currency, foreign exchange controls or problems
may limit the transfer of funds. This is often referred as sovereign risk or transfer
risk.
Country risk by nature is a dynamic risk. Unexpected events play against a
background of shifting trends. Country risk is also mainly a diversifiable risk.
However, external factors and mainly international factors too can alter
unexpectedly and transform perception of a country risk. In the 1970s oil played
a major role in the international scene. Perception of risks, therefore, is inevitably
subject to change depending on the way the world economy and international
policies unfold.

Risk and Uncertainty

The Committee on Insurance Terminology proposed in 1966 the definition of risk
as "Uncertainty as to the outcome of an event when two or more possibilities
exist".17 It is easy to conclude that the greater the uncertainty, the greater the risk.
Willett (1901), argued in page 5, that "the uncertainty is the greatest when chances
are even," that is when the degree of probability is 1/2. However, he also stated
in page 9 that risk "varies with the uncertainty and not with the degree of
probability."
 6

Vaughan (1989, p.5) gives the counter example of the dangerous game of
Russian roulette. If a revolver has 3 cartridges, leaving 3 of the chambers in the
cylinder empty, the chance of loss is 1/2. If there are 4 cartridges then the chance
of loss is higher and it is difficult to admit that the risk declines because there is
less uncertainty. It seems more logical to state that adding one cartridge increases
rather than decreases the risk. In this particular case the lack of information about
the number of cartridges in the cylinder may increase the level of uncertainty
while at the same time the real risk may be low if there is only one cartridge or
even null if there is no cartridge. 18

Level of uncertainty
________________________________________________
CERTAINTY IGNORANCE

Perfect information Objective Subjective Lack of

Probability = 0 (or 1) Probability Probability information

___________|___________
Large Small
Sample Sample

The Economic Costs of Risks

Regardless of the manner in which risk is defined, its existence affects the
economic performance of agents and therefore imposes constraints on the
optimum allocation of resources and on the economic development of all nations.
Individual as well as business decisions are not made under conditions of
certainty. Although the idea of risk may be difficult to conceptualize, all
economic agents are taking decisions they consider beneficial to them.
In 1901, A.H. Willet refers to the costs of uncertainty arising out of (1) the
unexpected losses that do occur and (2) the uncertainty itself even if no losses
occurs. He also refers to uncertainty as a disutility. The prudent individual
response to uncertainty (as to whether a loss will occur) is to engage in safe
actions rather than risky ones. At the society level this behaviour may cause
distortions in the optimal allocation of productive resources.
These economic costs are the primary reason why economic agents attempt
to avoid risk or alleviate its impact. "The existence of risk in an approximate
static state causes an economic loss. The assumption of risk, on the other hand, is
a source of gain to the society as a whole." 19
 7

Risk and Return

Risk is the common denominator of all decisions made by human being. The
objective in taking these decisions is not to avoid risk but to recognize its
existence and ensure that compensation is adequate for the risks being borne. The
presence of uncertainty about future income or future return from an investment
means that there is a risk to be evaluated by the economic agent which is bearing
the risk. Investors, for example, must be compensated (receive a reward) for
giving up present consumption and bearing the risk of the investment. Almost all
financial decisions including insurance involve some sort of risk-return tradeoffs.
Each individual economic agent regards each action he takes as being in
some way or another, beneficial to him, and he regards all actions when
combined, as yielding some maximum present and future level of satisfaction. As
a general rule it can still be said that most individuals prefer higher returns to
lower returns. Similarly they prefer lower risk to higher risk.
About a century ago, Marshall in "The Principles of Economics" recognized
the existence of a net premium for risk-taking. The most important development
in the field of Finance in the past 30 years has been the ability to quantify the
meaning of risk for business decisions. This has led in turn to new theoretical and
empirical work relating to the relation between risk and expected return.

Other Definitions
Along with many other fields of activities, insurance has its own language. While
the definition of "risk" as inspired many authors, some other words are often
confused in the insurance jargon.

Accident: An unexpected, undesired event arising from a peril and

resulting in a loss of resources.
Peril: A peril is a situation that may cause a personal or property loss.
Perils are natural, human-made or economic.
Hazard: A hazard is something that increases the chance that a loss will happen
because of a specific peril (see appendix 2).
Exposure: An exposure is a defined asset (human or physical) subject to a
defined peril.
Loss Exposure: The potential financial loss or the monetary amount that is
involved in the exposure.
 8

Summary: Important Concepts to Remember

Each chapter introduces a number of important concepts that will be used

throughout the rest of the book.

Organization of this Text

The author of an introductory text in insurance faces a problem in choosing a
beginning point as several ideas need to be presented at once. On the one hand, it
is desirable to set out theoretical structures first. On the other hand, it is easier to
understand the theoretical concepts if one have a working knowledge of certain
institutional details.

_______________________________________________________
DISCUSSION:
Examples will be developed in this text to provide a basis
for discussions on technical issues. The proposed answers or
solutions are only suggested and opened to critical ideas.
_______________________________________________________

The optimal structure of a textbook must include a number of theoretical and

applied factors. This book is divided into the following parts:
Part I describes the development of insurance activities (Chapter 2) and the
importance of insurance in the world economy today (Chapter 3).
Part II includes the basic tools of risk management, i.e., risk management
concepts (Chapter 4), Risk analysis tools (Chapter 5), and Risk financing
decisions (Chapter 6).
It provides a foundation for Part III, which covers all aspects of insurance
concepts, i.e., the attitudes toward risk and risk aversion (Chapter 7), the concept
of insurance contract (Chapter 8), the pricing of insurance (Chapter 9), and the
concepts of retention, self-insurance and captive insurance companies (Chapter
10).
Part IV turns to the decisions and operations of the insurance companies. It
covers the organization of insurance markets (Chapter 11), the operations of an
insurance company (Chapter 12), the reserves and investment decisions of
insurance companies (Chapter 13) and the role of reinsurance (Chapter 14).
Finally, Part V takes up the financial perspectives of insurance operations. It
covers the financial analysis and performance of insurance companies (Chapter
15), and the regulation of insurance companies (Chapter 16).
 9

Notes
 10

Appendix 1.1
The Classification of Risks

Risk and Uncertainty in Business

Dynamic Risks:
Human Safety and health conditions at work.

Technological Failure of new technology.

Product innovation.
Lack of technical knowledge, expertise.

Managerial Marketing errors, changes in consumer tastes.

Market competition.
Financial management losses.
Poor human resources management.

Social Change in social policy and behavior.

Labour Unions relations.
Change in fashions and tastes.

Economic Change in level of economic activity.

Inflation, monetary and fiscal policies.
Foreign exchange rates, terms of trade.

Political Change in government, regulations.

Nationalization..
Coup d'Etat, war, terrorism.

Static Risks:
Human Death, injury, sickness.
Theft, fraud.

Technical Breakdown of equipment.

Accident.

Legal Tort liability, Product liability.

Environmental Fire, flood, windstorm, earthquake,

rainfalls, hurricane.
 11

Adapted from Carter R.L. and N.A. Doherty, Handbook of Risk

Management, London: Kluwer-Harrap Handbooks.

Appendix 1.2
Sources of Hazards

Human Hazards: Ignorance, negligence, carelessness, boredom.

Fatigue, stress, physical limitations.
Incorrect training or supervision.
Alcohol, drugs, smoking.

Environmental Hazards: Weather, temperature, noise, light.

Mechanical Hazards: Weight, speed or acceleration, rotation, vibration.

Stored energy , stability, shape.

Energy Hazards: Electrical (short circuit, arcing, explosion,

overheating, etc.)
Radiation (electrical, medical, thermal, etc.)
Water, gas, wind.

Chemical Hazards: Corrosiveness, Oxidability, Toxicity.

Flammability, explosiveness, etc.
 12

1 Several text books agree with this definition:

Mark R. Greene and James Trieschman, Risk and Insurance, 7th ed., Cincinnati, Ohio: South-Western Pub. Co., 1988, p. 1.
Robert I. Mehr, Fundamentals of Insurance, 2nd ed., Homewood, Illinois: R.D. Irwin, 1986, p. 24.
Herbert S. Denenberg et al., Risk and Insurance, 2nd ed., Englewood Cliffs, NJ: Prentice Hall Inc., 1974, p. 4.
2
David L. Bickelhaupt, General Insurance, 9th ed.,Homewood, Illinois: R.D. Irwin, 1974, p. 2. and also S.S. Huebner, Kenneth
Black Jr. and Robert S. Cline, Property and Liability Insurance, 3rd ed., Englewood Cliffs, NJ: Prentice Hall Inc., 1982, p. 3.
3
George E. Rejda, Principles of Insurance, 3rd ed., Glenview, Illinois: Scott, Foresman and Co., 1989.
4
Irving Pfeffer and David R. Klock, Perspectives on Insurance, Englewood Cliffs, NJ: Prentice Hall Inc., 1974, p. 209.
5
C.Arthur Williams, Jr. and R.M. Heins, Risk Management and Insurance, 6th ed., New York: McGraw-Hill Book Co., 1989, p.
8.
6
Neil A. Doherty, Corporate Risk Management: A Financial Exposition, New York: McGraw-Hill Book Co., 1985, p. 1.
7
J.L. Athearn, S.T. Pritchett and J.T. Schmit, Risk and Insurance, 6th ed., St Paul: West Pub. Co., 1989, p. 1.
8
Emmett J. Vaughan, Fundamentals of Risk and Insurance, 5th ed., New York: John Wiley & Sons, 1989, P. 4.
9
Bulletin of the Commission of Insurance Terminology of the American Risk and Insurance Association, vol. 2, no. 1, March
1966.
10
L.B. Gratt , "The Definition of Risk and Associated Terminology for Risk Analysis," Proceedings of the Society for Risk
Analysis 1987 Meeting. Also published in Bonin, J.J. and D.E. Stevenson, (Eds.) Risk Assessment in Setting National Priorities,
New York: Plenum Press, 1989.
11
H. Von Mangold, Volkswirthschaftslehre, Stuttgart, 1868, p. 184.
12
C.O. Hardy, Risk and the Risk Bearing, Chicago: The University of Chicago Press, 1923, pp 2-3.
13
Albert H. Mowbray and Ralph H. Blanchard, Insurance, Its Theory and Practice in the United States, New York: McGraw Hill,
1st ed., 1930.
14
H.C. Emery, "The Place of the Speculator in the Theory of Distribution," Publications of the American Economic Association,
vol.1, no.1, p.104.
15
C.A. Kulp, Casualty Insurance, New York: Ronald Press, 3rd ed. , 1956, pp 3-4.
16
Harry Markowitz, "Portfolio Selection," Journal of Finance, March 1952, pp 77-91.
17
American Risk and Insurance Association, Bulletin of the Commission on Insurance Terminology, vol. II, no.1, March 1966.
18
In I. Fisher's view ( 1930, p.221 ) "risk varies inversely with knowledge." In The Theory of Interest, New York: MacMillan
Co., 1930.
19
A.H.,Willet, p. 32.

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