Addis Ababa University

College of business and economics

Department of Accounting and finance
Risk management and insurance

Assignment 1

Biruk Bekele

BEE/4559/10

Section 1

To: Mr. Kibruyisfa

ObjectiveRisks 
Assume that an insurer has 100000 cars insured for a long period of time,
and on the average 10000 cars meet with at least one accident and claim for
damages each year. However, for a particular year, it is unlikely that there
will be exactly 10000 claims. Under certain assumptions, it can be proven
that over a long period of time, the deviation of the number of claim in a
year from 10000 will, on the average be 100. Thus there is a variation of
100 claims from the expected number of 10000 or a variation of 1%. This
relative variation of actual loss from expected loss is known as objective
risk. 

Objective risk will reduce as the number of exposure increases. In the

example above, 100000 cars were insured and the objective risk was 1%.
Instead, if 1000000 cars were insured, the expected number of claims will
increase from 10000 to 100000 (10% of 1000000 cars) by 10 times, but the
variation will only increase from 100 to 316 (approximately square root of
100000) by slightly more than 3 times. As a result, the relative variation or
the objective risk actually reduces from 1% (100/10000) to 0.316 %
( 316/100000). 

Since objective risk can be statistically measured, it is a very powerful

method for managing risk. As the number of exposure increases, the insurer
is able to predict its future loss experience more precisely. This phenomenon
is based on the law of large numbers. The law states that as the number of
exposeur increase, the variation reduces; therefore the actual loss
experience will approach the expected loss experience.

SubjectiveRisk
As the term suggests, subjective risk can be defined as the degree of
uncertainty perceived by an individual. It can therefore vary from one
person to another. For example, a person who has consumed a large
amount of alcohol at a party and intends to drive home will be uncertain if
he wil be booked by the police. This mental uncertainty is an instance of
subjective risk.

Two persons it the same situation may have different perceptions of the
risks and show markedly different attitudes and responses towards the risks.
Further, perceptions of risk can be affected by prior experience. If, in the
example above,
What is the difference between objective and subjective risk?
Subjective risk is what an individual perceives to be a possible unwanted event. ...
Objective risk (aka degree of risk) is the actual losses for a sample in a given
period, which can differ significantly from expected losses, and is inversely
proportional to the square root of the sample size — the law of large numbers
the drinker had been booked previously for driving under the influence of
alcohol, he will probably judge that the risk of being booked again is high
and may not attempt to drive home

q-2
In risk, you can guess the outcome but in uncertainty you can't. Risk can be said to be an
uncertain event which chances of occurrence can be predicted and measured whereas,
uncertainty can also be said to be an uncertain event which chances of occurrence cannot be
predicted and measured.

Key Differences between Risk and Uncertainty

The difference between risk and uncertainty can be drawn clearly on the following
grounds:

1. The risk is defined as the situation of winning or losing something worthy.

Uncertainty is a condition where there is no knowledge about the future
events.
2. Risk can be measured and quantified, through theoretical models.
Conversely, it is not possible to measure uncertainty in quantitative terms,
as the future events are unpredictable.
3. The potential outcomes are known in risk, whereas in the case of
uncertainty, the outcomes are unknown.
4. Risk can be controlled if proper measures are taken to control it. On the
other hand, uncertainty is beyond the control of the person or enterprise, as
the future is uncertain.
5. Minimization of risk can be done, by taking necessary precautions. As
opposed to the uncertainty that cannot be minimized.
6. In risk, probabilities are assigned to a set of circumstances which is not
possible in case of uncertainty.
Example

Jimmy owns a transport business. He drives trucks, moving commercial products

around Australia. Some of the hazards Jimmy faces each day include:

 contact with chemicals and fumes when refueling

 uncomfortable seating and fatigue, especially on long journeys
 no heating or air-conditioning to change the temperature inside the truck

Some steps Jimmy could take to reduce the risks in his daily work include:

 wearing appropriate clothing to reduce his exposure to chemicals

 taking regular breaks during his trips to stretch and walk around
 ensuring that he only works the legal hours for his industry to deal with fatigue
 installing fans or air-conditioning in his truck
 having suitable clothing and water for each trip

Example

Uncertainty connotes in everyday language in three different directions,

relating to the external world, to knowledge, and to the mind, respectively.
We may say that the out-come of a soccer match, or an election, or a
rescue operation is uncertain, meaning that the (future) state of affairs in
the external world is not fixed or determined. We may say that there is
considerable uncertainty in a weather forecast, in a fish stock assessment,
or in a molecular model. In this case, the “uncertainty” typically is not
thought to reside in the world itself, but in the imperfect quality of our
knowledge about that world: There is a determinate biomass of the fish
stock, it is just that we do not know this number. Finally, a common usage
of “uncertainty” and “uncertain” (in particular in Norwegian, with
“usikkerhet” and “usikker”) is the one that relates to our mind and our
emotions, intentions and actions. Hence, we may say that we are uncertain
about what to do or feel “usikker” – insecure in English, but also unsure,
perhaps bordering to feeling anxious, afraid or helpless
q-3

 Peril: Cause of loss. 

 Risk: Uncertainty arising from the possible occurrence of given events that
would result in loss with no opportunity for gain. 

 Hazard: Condition that increases the probability of loss.

The distinction is important because in modeling there is a difference between modeling risk
and modeling a peril. Hazards are built into all models as a modifier to the chance of something
happening.  

Risk, peril, and hazard are terms used to indicate the possibility of loss, and are often used
interchangeably, but the insurance industry distinguishes these terms. A risk is simply the
possibility of a loss, but a peril is a cause of loss. A hazard is a condition that increases the
possibility of loss. For instance, fire is a peril because it causes losses, while a fireplace is a
hazard because it increases the probability of loss from fire. Some things can be both a peril and
a hazard. Smoking, for instance, causes cancer and other health ailments, while also increasing
the probability of such ailments. Many fundamental risks, such as hurricanes, earthquakes, or
unemployment, that affect many people are generally insured by society or by the government,
while particular risks that affect individuals or specific organizations, such as losses from fire or
vandalism, are considered the particular responsibilities of those affected.

q-4

Moral Hazards are concerned with the attitude and conduct of people. They
indicate those dangers which relate to character, integrity and mental attitude of
the insured. They are losses that result from dishonesty or indifference. Insurance
Companies suffer losses because of fraudulent or inflated claims. These are not
visible and cannot be identified by mere inspection of the risk or subject of
insurance. In every risk, an element of moral hazard may be to some degree,
always present.

 
Examples of Moral Hazard:

1. An employer’s indifference to Health and Safety regulations increases the

chances of claims and is an example of poor moral hazard.
2. A moral hazard exists when a person wants to take out a policy with the
intent to make a profit – fraud.
3. Shabby maintenance of a property and bad administration is an example of
poor moral hazard. This can also be considered a physical hazard as untidy
premises is a sign of bad maintenance and can lead to claims.
4. Excessive over insurance is another poor moral hazard.

 Physical Hazards are physical conditions that increase the possibility of a loss.
They indicate the dangers of the subject of insurance which can be identified by
inspection of the risk.

Examples of Physical Hazard:

1. Fire policy – nature and construction of the building and whether materials
used are of a combustible or non-combustible nature.

Nature of occupation of the premises – storage of hazardous materials etc.

Maintenance and upkeep of the premises.

System of heating and lighting – electrical wiring checked on a regular basis and
up to date.

2. Burglary policy – construction, security, nature of contents, reputation of

area etc. are all examples of physical hazard.
3. Liability policy – nature of construction, occupation of premises, history of
past liabilities, health and safety awareness, properly maintained plant and
equipment, untidy and poorly controlled or over-congested premises.
4. moralehazard.
Circumstance that increases the probability of occurrence of a loss, or a
larger than normal loss, because of an insurance-policy applicant's
 indifferent attitude after the issuance of policy. For example, he or she
might be careless in locking the doors and windows when leaving home. In
common usage, morale hazard indicates that the insured party
unconsciously changes their actions or behaviors, as opposed to a
deliberate change in order to cheat the system or benefit from his or her
circumstances. Compare with moral hazard.

Legal hazard can also result from laws or regulations that force insurance companies to cover
risks that they would otherwise not cover, such as including coverage for alcoholism in health
insurance.

q-5

Pure Risk: There are only two possibilities; something bad happening or nothing
happening. It is unlikely that any measurable benefit will arise from a pure risk.
The house will enjoy a year with nothing bad occurring or there will be damage
caused by a covered cause of loss (fire, wind, etc.). Predicting the outcomes of a
pure risk is accomplished (sometimes) using the law of large numbers, a priori
data or empirical data. Pure risk, also known as absolute risk, is insurable.

Speculative Risk: Three possible outcomes exist in speculative risk: something

good (gain), something bad (loss) or nothing (staying even). Gambling and
investing in the stock market are two examples of speculative risks. Each offers a
chance to make money, lose money or walk away even. Again, do not equate
gambling and investing on any other level than as both being a speculative risk.
Gambling is designed to enrich one party (the house); the odds are always in its
favor. Investing is designed to enrich all involved, the house that set up the "game"
AND those that chose to place money in the game - all participants with "skin in
the game" win or lose together. Speculative risk is not insurable in the traditional
insurance market; there are other means to hedge speculative risk such as
diversification and derivatives.

Both speculative risk and pure risk involve the possibility of loss. However, speculative risk also
involves the possibility of gain as well - even if there is no loss. ... Speculative risks involve the
possibility of loss and gain. Pure risks involve the possibility of loss only.
q-6
Personal risk is anything that exposes you to the risk of losing something of
value. Usually, personal risk is associated with your financial investments and
insurance. ... Whenever you take on any of these investments, you stand a certain
amount of risk in losing your money.

Alex went snowboarding at snowshoe and broke his leg. The hospital bill was
$1400.

property risk. The possibility of financial loss occurring as the result of owing a
real estate investment. Property risk might arise from such things as liability,
legal issues, partner problems that can force a sale, fire or theft, loss of rental
income and purchasing property with an imperfect title

Harding invested in stock market and lost money when his stock’s value dropped.

A liability risk is a vulnerability that can cause a party to be held responsible for
certain types of losses. Many businesses face various types of liability risk, the
losses for which can be quite substantial. Liability coverage is, therefore,
extremely important for companies

A customer slipped on spilled water in the store aisle before an employee cleaned
the spill.