Addis Ababa University

College of Business and Economics

Department of Accounting and Finance
Individual Assignment of Risk Management and Incurrences

Name ID Section
Dawit Terefe BEE/6912/11 1

Instructors: Mr. Kibruyesfa

1. Briefly discuss the difference between Objectives vs. Subjective Risk by using different
examples.

Objective versus Subjective Risk

Objective risk refers to risks that can be statistically measured by some measure of
description, such as the standard deviation or coefficient of variation etc.
 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 units increases, an insurer can predict its future loss
experience more accurately because it can rely on law of large numbers.
 The law of large numbers states that as the number of exposure units increases, the
more closely will the actual loss experience approach the probable loss experience.
 Objective risk varies inversely with the probability for any constant number of
exposures unties.

• The relative variation of actual loss form probable or expected loss.

• Is concerned with the range of variability of economic losses about some long-run average
(most probable) loss in a group large enough to analyses significantly in a statistical sense.

Objective Risk = Probable Variation of Actual Loss / Probable Losses

Example 1:

Consider the possibility of fire losses to buildings in towns A and B. There are 100,000 buildings
in each town and, on average each town has 100 fire losses per year. By looking at historical data
from the towns, statisticians are able to estimate that in town A, the actual number of fire losses
during the next year will very likely range from 95 to 105. In town B, however, the range
probably will be greater, with at least 80 fire losses expected and possibly as many as 120.

Objective Risk town A = (105 – 95)/100 = 10%

Objective Risk town B = (120 – 80)/100 = 40%

• Effects of Numbers Exposed on Objective Risk

The Law of Large Numbers

States that as the number of exposure units increases, the more certain it becomes that actual loss
experience will equal probable loss experience. Hence, the risk diminishes as the number of
exposure units increases.
Subjective Risk

• Psychological uncertainty that stems from the individual’s mental attitude or state of mind.

• May be measured by means of different psychological tests but no widely accepted or uniform
tests of proven reliability have been developed.

• The impact of subjective risk varies depending on the individual.

• Subjective risk may affect a decision when the decision maker is interpreting objective risk.

2. Briefly discuss the difference between risk and uncertainty using different examples

Risk versus Uncertainty

• Risk and uncertainty are distinct concepts.

• Uncertainty is: The doubt as to the occurrence of a certain desired outcome.

A state of mind whereby a sentient entity experience doubt.

A subjective phenomenon one of the possible reactions of an entity to its interpretation of reality.

• Risk is: an objective phenomenon that can be measured mathematically or statistically.

Independent of the individual's beliefs. Exists whether or not person is aware of it. It is the
state of the world.

• Four further situations that illustrate the distinction between the two concepts:

Both risk & uncertainty are present:

• An individual may be exposed to risk of disability and may experience uncertainty.

Both risk & uncertainty are absent:

• Modern sailors know that the world is not flat; there is no possibility of falling of the edge of
the world, therefore, they would experience no uncertainty about such a contingency.

Risk is present & uncertainty is absent:

• A businessman may be exposed to the possibility loss of due to interruption of operations by

fire.

Risk is absent but uncertainty is present:

• When Columbus sailed there was no possibility that he would fall of the edge of the world.
Never the less, presumably he was uncertain about his possibility
 3. Using real examples discuss the difference between risk, Peril and hazard.
Risks, Peril, & Hazard

Peril:

• The prime cause: it is what will give rise to the loss.

• E.gs Storm, Flood, Fire, Thefts and collusion, etc.

Hazards:

• Hazards are: factors which may influence the outcome.

Conditions that tend to increase the probability & severity of loss.

Conditions that increase the effect should a peril operate

4. By using real cases examples discuss in detail the four major types of hazard.

 They are four major types of hazard.

 Physical hazard
 Moral Hazard
 Morale Hazard
 Legal Hazard

Physical Hazard:

• Conditions stemming from the physical characteristics of an object.

• Physical condition that increases the probability and severity of loss form a given peril.

• Examples may include: Existence of dry forest - for fire Earth faults - for earth quakes
Icebergs - ocean shipping Icy roads - for auto accident

Moral Hazard:

• Stems from dishonesty or character defects of an individual that increases the probability as
well as the severity of loss.

• Stems from the mental attitude of the individual

• Examples may include: Faking an accident to collect insurance money submitting a

fraudulent claim inflating the size of a claim.

Intentionally burning unsold merchandise that is insured.

Morale Hazard
• Carelessness or indifference to a loss because of the existence of insurance.

• Includes the mental attitude that characterizes accident-prone person.

• This type of individual does not appear to deliberately cause the accident to happen, but the
psychologist would probably diagnose the cause of excessive and repeated accidents as
subconscious problem of morale.

• Examples may include: leaving key in an unlocked car. Leaving a door unlocked.

Legal hazard:

Legal hazards refer to characteristics of the legal system or regulatory environment that increases
the frequency or severity losses.

Examples include adverse jury verdicts or large damage award in liability lawsuits; statutes tha
required insurers to includes coverages for certain benefits in health insurances plan such as
coverage for alcoholism; and regulatory action by state insurances department that prevent
insurers from withdrawing from states because of poor understanding results.

5. Make a detail distinction between Pure vs. Speculative risks. In your discussion you must use
examples.

Pure Versus Speculative Risks

• This classification as well is concerned with the outcome.

• It distinguishes between those situations where there is only the possibility of breaking even, at
best and those where a gain may also result.

Pure Risks

• Pure risks involve only two possible outcomes: a loss or, at best, no loss.

• Examples may include:

The risk of a motor accident, fire at a factory, theft of goods from a store, or injury at work is all
pure risks with no element of gain

6. Discuss the following terms and show examples of each case.

I. Personal risk
II. Property risk
III. Liability risk
Personal Risk

• are risks that directly affect an individual.

• involve the possibility of the complete loss or reduction of earned income, extra expenses, and
the depletion of financial assets.

I. Risk of premature death – this refers to the death of a household head with unfulfilled financial
obligations.

• Premature death can cause financial problems only if the deceased has dependents to support
or dies with unsatisfied financial obligations.

• Costs related to the premature death of a household head.

The human life value of the family head is lost forever. The additional expenses may be
incurred.

The family’s income from all sources may be inadequate just in terms of its basic needs.

Non-economic costs

ii. Risk of old age – the major risk associated with old age is insufficient income during
retirement.

iii. Risk of poor health –includes both catastrophic medical bills and the loss of earned income.
iv. Risk of unemployment –Unemployment can result from a business cycle downsizing, from
technological and structural changes in the economy, from seasonal factors, and from
fluctuations in the labor market.

Property Risk:

• Refers to losses associated with ownership of property.

• Persons owning property are exposed to the risk of having their property damaged or lost from
numerous causes.

• Property risk stems from diverse perils accompanied by different hazards: physical, moral or
morale.

Liability Risk:

• Liability risk is the possibility of loss arising from intentional or unintentional damage made to
other persons or to their property