RI

SKMANAGEMENTANDI
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CHAPTERONE
RI
SKANDRELATEDTOPI
CS
MeaningofRi sk:
Ther eisnosi ngledef i
niti
onofr isk. Economi st
s,behav ioralsci enti
sts,risk
theor
ists,stat
isti
ci
ansandact uari
eseachhav etheirownconceptofr i
sk.Howev er
,
ri
sktraditi
onall
yhasbeendef inedint ermsofuncer tainty.Basedont hi
sconcept ,risk
i
sdef i
nedasuncer taintyconcer ni
ngt heoccur r
enceofal oss.Forexampl e,t
her isk
ofbeingki l
l
edi nacaracci dentispr esentbecauseuncer taintyispr esent.Ther i
skof
l
ungcancerf orsmoker sispr esentbecauseuncer taintyi spr esent.Andt her i
skof
fl
unki
ngacol l
egecour seispresentbecauseuncer t
ai ntyispr esent.
Althoughr i
skisdef i
nedasuncer tai
nty,employeesi nt heinsur anceindust r
yof ten
usethet ermr i
sktoi denti
fythepr oper t
yorl i
febei
ngi nsur ed.Thus,i ntheinsurance
i
ndustry,iti
scommont ohearst at
ement ssuchas“ thatdr iverisapoorr i
sk”or“ that
bui
ldi
ngi
sanunaccept
abl
eri
sk.
”
Writ
ers,par
ti
cul
arl
yintheUSAhav eproducedanumberofdefi
nit
ionsofr
isk.
Theseareusuall
yaccompaniedbylengt
hyargumentst
osuppor
ttheparti
cul
arv
iew
theyputf
orward.Consi
dert
hef ol
l
owingdef
ini
ti
ons:
 Ri
ski
st hepossi bil
it
yofanunfort
unateoccur
rence.
 Ri
ski
sacombi nat i
onofhazards.
 Ri
skisunpr edictabil
it
y– thetendencythatactualr
esul
tsmaydi
ff
erf
rom
pr
edi
ctedresults.
 Ri
ski
suncer tai
nt yofloss.
 Ri
ski
spossi bil
ityofloss.
Fi
nal
ly
,when r i
sk is def
ined as uncert
aint
y,some aut
hor
s make a car
eful
di
sti
nct
ionbetweenobject
iveri
skandsubj ect
iveri
sk.
Obj
ecti
veRisk:
Object
iver
iskisdefinedastherelat
ivevar
iat
ionofact
uall
ossfr
om expect
ed
l
oss.Forexample,assumethatapropert
yinsur
erhas10,
000housesi
nsur
edovera
l
ongperiodand, onav erage,1%, or100houses,bur
neachy ear.Howev er
,itwouldbe
rar
eforexactly100housest oburneachy ear
.I nsomey ears,asfew as90houses
mayburn; i
nothery ears, asmanyas110houses, mayburn.Thus, ther
eisav ari
ati
on
of10housesf rom t heexpect ednumberof100,orav ar
iationof10%.Thi srel
ati
ve
var
iat
ionofactuallossf rom expectedl
ossisknownasObject i
veRisk”.
Object
iveriskdecl inesast henumberofexposuresi ncreases. Obj
ecti
ver i
sk
var
iesi
nver
sel
ywi
tht
hesquar
erootoft
henumberofcasesunderobser
vat
ion.
Object i
veriskcanbest at i
sti
call
ycal cul
atedbysomemeasur eofdi spersion,suchas
thest andarddevi at
ionort hecoef fi
cientofvariation.Becauseobj ecti
ver iskcanbe
measur ed,i
tisanext r
emel yusefulconceptforani nsureroracor porateriskmanager .
As t he numberofexposur es increases,an i nsurercan pr edicti t
sf utur
el oss
exper i
encemor eaccur at el
ybecausei tcanr el
yont hel awofl argenumber .Thel aw
oflargenumber sstatest hatthenumberofexposur eunitsincr
eases, themor eclosely
theact uallossexper i
encewi l
lappr oachtheexpect edlossexper ience.Forexampl e:
ast henumberofhousesunderobser vati
onincr eases,t hegreateri sthedegr eeof
accur acyinpredicat
ingt hepr oporti
onofhousest hatwi llburn.

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Subj
ect
iveRi
sk:
Subj
ect
iver
iski
sdefinedasuncer
tai
ntybasedonaperson’
smentalcondi
ti
onor
st
ateofmind. Forexampl
e,acustomerwhowasdrinki
ngheav
il
yi nabarmay
fool
i
shl
yatt
empttodr
ivehome.Thedri
vermaybeuncer
tai
nwhetherhewil
lar
ri
ve
homesafel
ywit
houtbei
ngarrest
edbythepol
icef
ordrunkdr
ivi sment
ng. Thi al
uncer
tai
ntyi
scal
ledsubj
ect
iver
isk.
I
mpactofsubj
ecti
veriskvari
esdependingontheindi
vidual.Twoper sonsinthe
samesi t
uati
oncanhav eadi ffer
entpercepti
onofrisk,andt hei
rbehav i
ormaybe
alt
eredaccordi
ngl
y.Ifanindiv
idualexper
iencesgr
eatment aluncert
aint
yconcer ni
ng
theoccur
renceofaloss,t
hatperson’
sbehav i
ormaybeaf f
ected.Highsubj ect
iveri
sk
oftenresul
tsinconser
vati
veandpr udentbehavi
or,whi
lelow subject
iveriskmay
resul
tinlessconser
vat
ivebehavi
or.Forexampleamot or
istpr
ev i
ouslyarr
estedf
or
drunkdr ivi
ngi sawar ethathehasconsumedt oomuchal cohol.Thedr i
vermayt hen
compensat efort hement aluncer t
aintybygetti
ngsomeoneel setodr i
vet hecarhome
orbyt akingat axi.Anot herdriverinthesamesi tuati
onmayper ceivet her i
skofbei ng
arrestedassl i
ght . Thisseconddr i
vermaydr iveinamor ecar elessandr eckless
manner ;
al owsubj ectiver i
skresultsinlessconservati
vedr i
vi
ngbehav ior.
Uncer tai
nty :
Certaintyislackofdoubt .InWebst er
’sNewCol legi
ateDi ct
ionar y,onemeani ng
oft heterm“ certainty”is“ astateofbei ngfreefr
om doubt ,
”adef initi
onwi l
lsuittothe
studyofr iskmanagement .Theant onym ofcertai
ntyis“uncertai
nt y”whi chis“ doubt
aboutourabi li
tyt opr edictthef utureoutcomeofcur rentact i
ons. ”Cl earl
y,thet er
m
“uncer t
aintydescr i
bes a st ate ofmi nd. Uncer t
aintyar i
ses when an i ndivi
dual
per
cei
vest
hatout
comescannotbeknownwi
thcer
tai
nty.
”
Uncer t
aintyi sdoubtaboutourabi l
ityt opr edictt hef uture.Uncer tai
nt yari
ses
whenani ndi vi
dualper cei vesr i
sk.Uncer t
ai ntyi sasubj ecti
v econcept ,soi tcannotbe
measur eddi rectly.Sinceuncer taintyisast ateofmi ne,itvariesacr ossi ndividuals.
Forcompl exact iv
ities, suchaspar t
icipat ingi nabusi nessv enture, someper sons
arev erycaut i
ous,ot her sar emor eaggr essi ve.Al thoughr iskav ersionexpl ainssome
ofther eluctancet opar ticipate,t helevelofr i
skper cei
v edbyi ndivi
dual sal sopl aysa
keyr ole.Theper ceivedl ev elofr i
skdependsoni nf ormat i
ont hatani ndi vidualcanuse
to ev aluat et he chance ofout comes and,per haps,on t he i ndividual’s abil
ityto
evaluat et hi
si nformat on.Thel
i evelandt ypeofi nformat i
onont henat ureofar i
sky
acti
vi t
yhaveani mpor tantef f
ectonuncer tainty.
LevelsofUncer tainty:
Lev el ofUncer t
ainty Char acteristics Exampl es
None( Cer tai
nty) Outcomes can be Phy si
cal l aws, nat ural
predictedwi thpr eci sion. sci ences.

Level1 Outcomes areident

if
ied Gamesofchance,Car
ds,
(Object
iveUncer
tai
nty
) and pr obabi
li
ti
es ar e Di
es.
known.

Level2 Out
comes areident
if
ied Fi
re,
automobil
eaccident
,
(Subj
ecti
ve but probabi
l
iti
es ar e manyinvest
ments.
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Uncer
tai
nty
) unknown.
Space explor
ation,
Out comes ar e notf ull
y genet i
cr esear
ch.
Lev el3 identifi
es and
probabi li
ti
es are
unknown.
Thel evelofuncertaintyarisingfrom agivent ypeofr i
skcandependont heentit
y
facingt her i
sk;forexampl e,ani nsureroragov ernmentalentitymayr egardtheriskof
ear t
hquakeasbei ngatl evel2, whiletheindivi
dualmayr egar
dt heearthquakeasbei ng
aatl evel3. Thisdifferencei nper specti
v emaybeaconsequenceofanabi l
ityto
est i
mat et heli
keli
hoodofout comes.
Pr obabi li
ty(ChanceofLoss) :
Pr obabil
it
yiscloselyrelatedt otheconceptofr sk.Chanceofl
i ossisdef i
nedas
thepr obabili
tythataneventwi lloccur .Likeri
sk,“probabili
ty”hasbot hobjecti
veand
subj ectiveaspects.
Obj ect i
vePr obabi
li
ty:
Object
iveprobabi
li
tyr
eferstothelong-r
unrel
ati
vefrequencyofaneventbased
ontheassumpt i
onsofani nfi
nit
enumberofobser vati
onsandofnochangei nthe
under
lyi
ngconditi
ons.Objecti
veprobabil
it
iescanbedeterminedintwoways.First
,
theycanbedet erminedbydeduct iver easoni ng.Thesepr obabi l
itiesar ecal l
edapr i
ori
probabi l
iti
es.Forexampl e:t ossingaf aircoin.Second,obj ectivepr obabil
iti
escanbe
deter mi ned byi nduct iver easoni ng,r athert han bydeduct ion. Forexampl e,t he
probabi l
itythataper sonage21wi lldiesbef oreage26cannotbel ogicall
ydeduced.
Howev er,byacar efulanal ysi sofpastmor tali
tyexper ience,lifei nsur er
scanest imat e
thepr obabili
tyofdeat hansel lafivey eart erml i
feinsurancepol i
cyi ssuedatage21.
Subj ect i
v eProbabi l
ity:
Subjectpr obabi l
ityist he i ndividual’s per sonalest i
mat e ofchance ofl oss.
Subj ect i
ve pr obabi l
ityneed notcoi ncide wi th objective probabi l
ity. Forexampl e,
peopl ewhobuyal ot teryticketont heirbi rt
hdaymaybel ievei ti st heirluckydayand
over estimat et hesmal lchanceofwi nning. Awi dev ari
etyoff act orscani nfl
uence
subj ectivepr obabi li
ty,i ncl
udi ngaper son’sage,genderi ntel
ligence,educat ion,andt he
useofal cohol.
Probabi li
tydistingui shedf rom Ri sk:
Chanceofl osscanbedi stingui shedf r
om obj ectiverisk.Chanceofl ossi sthe
probabi l
itythatanev ent hatcausesal osswi lloccur .Obj ect i
ver i
ski sther el
at i
8v e
variat i
onofact uallossf r
om expect edl oss.Thechanceofl ossmaybei dent i
calf or
twodi f
ferentgr oupsbutobj ecti
ver i
skmaybequi t
edi f
ferent .Forexampl e,assume
thatapr opertyi nsur erhas10, 000homesi nsuredi nlossAngel esand10, 000homes
i
nsur edi nPhi l
adel phiaandt hatthechanceofl ossineachci tyis1%.Thus, onav erage,
100homesshoul dbur nannual l
yineachci t
y.Howev er,i
ftheannual v ar
iati
oni nlosses
rangesf rom 75t o125i nPhi l
adel phi a,butonl yfrom 90t o110i nLosAngel es,
object iver i
ski sgr eat erinPhi l
adel phiaev enthought hechanceofl ossi nbot hcit i
esi s
thesame.
PERI LANDHAZARD
Thet ermsper ilandhazar dshoul dnotbeconf usedwi t
ht heconceptofr i
sk
discussedear li
er.
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Per
il
:
Per
ili
sdef
inedast
hecauseofl
oss.I
fyourhousebur
nsbecauseofaf
ir
e,t
he
per
il
,orcauseofloss,i
sthefir
e.I
fyourcarisdamagedinacolli
sionwit
hanot hercar
,
col
l
isi
onist heperi
l,orcauseofloss.Commonper i
lsthatcausepropertydamage
i
ncl
udedfire,l
i
ght
ning,windst
orm,
hail,
tor
nadoes,ear
thquakes,t
heftandrobbery.
Hazar
d:
Ahazar
disacondi
ti
ont
hatcr
eat
esori
ncr
easest
hechanceofl
oss.Ther
ear
e
fourmaj ort ypesofhazar ds:
 Phy sical hazar d
 Mor tal hazar d
 Mor al ehazar d
 Legal hazar d
Physicalhazar d: A physi calhazar di sa physi calcondi tion t hati ncr easest he
chanceofl oss. Exampl esofphy si
calhazar dsi ncl udei cyr oadst hati ncr easet he
chanceofacaracci dent ,def ect i
v ewi ringi nabui ldingt hatincr easest hei ncr easesof
fi
re,andadef ect ivel ockondoort hati ncr easest hechanceoft hef t.
Mor alhazar ds:Mor alhazar di sdi shonest yorchar act erdef ect sinani ndi vi dualt hat
i
ncr easet hef requencyorsever ityofl oss.Exampl esofmor alhazar di ncl udef aking
anacci dentt ocol lectf rom ani nsur er,submi tti
ngaf raudul entcl aim,i nf latingt he
amountofacl aim, andi ntent i
onal lybur ningunsol dmer chandi set hatisi nsur ed.
Mor alehazar d: Somei nsur anceaut hor sdr aw asubt l
edi st i
nct i
onbet weenmor al
hazardandmor alehazar d. Mor alhazar dr ef erst odi shonestbyani nsur edt hat
i
ncreases t he f requencyorsev er ityofl oss. Mor ale hazar di s car elessness or
i
ndif f
er encet oal ossbecauseofexi stenceofi nsur ance.Somei nsuredsar ecar eless
orindi fferentt oal ossbecauset heyhav ei nsur ance. Exampl esofmor al ehazar d
i
ncludel eav ingcarkey si nanunl ockedcar ,whi chi ncr easet hechanceoft hef t;leav ing
adoorunl ockedt hatal l
owsar obbert oent er;andchangi ngl anessuddenl yona
congest edi nter statehi ghwaywi thoutsi gnal ing.Car elessact sl i
ket hesei ncr easet he
chanceofl oss.
Legalhazar d: Legalhazar dr ef er st o char acter i
st i
cs oft he legalsyst em or
regulator yenvi ronmentt hati ncr easet hef requencyorsever ityofl osses.Exampl es
i
ncludeadv er sej ur yv erdi ctsorl ar gedamageawar dsi nl i
abi l
ityl awsui ts, stat ut est hat
requirei nsur erst oi ncl udecov eragef orcer tainbenef i
tsi nheal thi nsurancepl ans, such
ascov eragef oral cohol ism; andr egul atoryact ionbyst at einsur ancedepar tment st hat
restri
ctt heabi lityofi nsur erst owi thdr awf rom t hest atebecauseofpoorunder wr i
ting
results.
Categor i
esofRi sk:
Riskcanbecl assi f i
edi nt osev eraldi stinctcat egor i
es.Thet womaj orcat egor i
es
areasf oll
ows:
 Pur eandSpecul ativeRi sks.
 Fundament alandPar ti
cul arRi sks.
PureandSpecul ativeRi sks:
PureRi sk: Pur er iski sdef inedasasi tuationi nwhi cht her ear eonl ythepossi bili
ties
oflossornotl oss.Theonl ypossi bleout comesar eadv er se( loss)andneut ral( no
l
oss) . Exampl esofpur er iski ncl udepr emat uredeat h,indust r
ialacci dent s,t erri
ble

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medical expenses, anddamaget opr oper tyf rom f

ire, l
ight ning, fl
ood, orear t
hquake.
SpeculativeRi sk: Specul ativer i
ski sdef i
nedasasi tuat ioni nwhi cheitherprofitor
l
ossi spossi bl e. Forexampl e,ify oupur chase100shar esofcommonst ock,y ou
wouldpr ofitift hepr i
ceofst ocki ncreasesbutwoul dl ossi fthepr icedecl i
nes.Ot her
examples,ofspecul ati
v er i
ski ncludebet ti
ngonhor ser ace,car dgames,i nvesti
ngi n
realestate,andgoi ngi ntobusi nessf ory oursel f
.I nt hesesi tuati
ons,bot hprofi
tand
l
ossar epossi ble.
Disti
nguishbet weenpur eandspecul at i
ver isks:
 First,privatei nsurersgener all
yi nsur eonl ypur er isk.
Wi thcer tainexcept i
ons,specul ativer iskgener al lyi snotconsi deredinsurable,
andot hert echniquesf ormanagi ngwi thspecul ativ er i
skmustbeused.
 Second,t helawofl ar genumber scanbeappl iedmor eeasilyt opur eri
skst han
tospecul ativer i
sks. Thel awofl argenumber si si mpor tantbecausei tenables
i
nsur erst opredictf ut urel ossexper i
ence.
In cont rast,i ti s gener all
ymor e diffi
cul tt o applyt he law ofl arge
number s t ospecul ativer iskst opr edictfuturel ossexper i
ence.Anexcept i
on
ist hespecul at i
ver iskofgambl i
ngwher enightcl uboper ator scanappl ythel aw
ofl argenumber sinamostef ficientmanner .
 Finally,Soci etymaybenef itfrom aspecul ativer iskev ent houghal ossoccur s,
buti tishar medi fapur er i
ski spr esentandal ossoccur s.
Exampl e, afirm maydev elopnewt echnologyf orpr oducingl owpr icecomput ers.
Asar esultsomecompet it
orsmaybef orced t o bankr upt cy. Despitet he
bankr upt cy,soci etybenef i
tsbecauset hecomput er sarepr oducedatal owcost .
Howev er ,soci etynor mal l
ydoesnotbenef itwhenasl ossf rom apur er i
sk
occur s, suchasf l
ood, orear thquake.
Fundament alandPar ticularRi sks.
Fundament alRi sk:
Afundamentalr
iski
sari
skthataf
fect
stheenti
reeconomyorlar
genumber sof
per
sonsorgr oupswithi
ntheeconomy. Exampl
esi ncl
uderapi
dinf
lat
ion,cy
clical
unemployment,andwarbecauselargenumbersofindiv
idual
sareaf
fected.
Theri
skofanat ur
aldisasterisanot
herimportantri
sk.Hurri
canes,tornadoes,
eart
hquakes,fl
oods,andforestandgr assfir
escanr esul
tinbil
l
ionsofdol l
arsof
propert
ydamageandnumer ousdeat hs.Morerecentl
y,theri
skofaterror
istattacki
s
rapi
dlyemergi
ngasfundament al
risk.
Par
ti
cul
arRisk:
A part
icularr
iskisar i
skthataf f
ects onl
yi ndi
vi
dual
s and notthe ent
ire
community. Examplesi
ncl
udecarthef
ts,gol
dt hef
ts,bankrobber
ies,anddwell
i
ng
fi
res.Onlyindivi
dualsexper
ienci
ngsuchlossesareaff
ected,nottheent
ir
eeconomy
Typesofpur erisk:
Themaj ortypesofpureri
skthatcancreat
egreatfi
nanciali
nsecur
it
yincl
ude
 PersonalRisks.
 Propert
yRi sks.
 Li
abili
tyRisks.
Per
sonalRisks:
Personalri
sksar
eri
skst
hatdi
rect
lyaf
fectani
ndi
vi
dual
. Theyi
nvol
vet
he

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possi
bil
i
tyoft
hecompl et
el ossorr
educt
ionofearnedincome,extr
aexpenses,
andt
he
depl
eti
onoffi
nanci
alassets.Therear
efourmajorpersonalr
isks.

 Riskofprematuredeath.
 Riskofinsuf
fi
cienti
ncomedur
ing
reti
rement.
 Riskofpoorhealth.
 Riskofunemploy ment
.
Ri
skofprematuredeath:
Pr
emat
uredeathisdefi
nedasthedeathofahousehol
dheadwi t
h unf ulf
il
led
f
inanci
alobl
igat
ions. These obl
i
gati
ons can i
ncl
ude dependent
st o support
,a
mortgaget obepai doff
,orchi
ldrent oeducate. Ifthesurvi
vingfami
lymember s
r
eceiveani nsuf
fi
cientamountofr eplacementincomefrom othersour
cesorhav e
i
nsuffi
cientfi
nanci
alassetstor eplace the l
ostincome,theymaybe f inanci
all
y
i
nsecure.
Ri
skofi
nsuf
fici
enti
ncomeduringt
her
eti
rement:
Themajorri
skassoci
atedwit
hol
dageisinsuf
fi
cienti
ncomedur
ingr
eti
rement
.
Thev astmaj
or i
tyofworkersinthewor l
darebef or
eage65.Whent heyr et
ir
e,they
l
oset hei
rearnedincome.Unl esst heyhavesuffi
cientf
inanci
alassetsonwhi cht o
draw,orhav
eaccesst oothersourcesofret
irementincome,suchatsocialsecuri
tyor
apriv
atepension,t
heywil
lbeexposedt ofi
nancial
insecuri
tydur
ingret
ir
ement .
RiskofPoorHealth:
Poorheal
thisanotherimpor
tantpersonalr
isk.Theriskofpoorhealt
hincl
udes
boththepaymentofter
ribl
emedicalbi
ll
sandt helossofearnedi
ncome.
RiskofUnemployment:
The ri
sk ofunempl oymentis anothermaj orthreattof inanci
alsecuri
ty.
Unemploymentcan r
esul
tfrom business cycl
e downswi
ngs,technol
ogi
caland
st
ructur
echangesi
ntheeconomy,seasonalfact
ors,andi
mperf
ecti
onsinthelabor
market.
Propert
yRisks:
Personsowni
ngpropert
yar eexposedtopr oper
tyri
sks– theri
skofhaving
pr
oper
tydamagedorl
ostfrom numerouscauses.Realest
ateandper
sonalpr
opert
y
canbedamagedordest roybecauseoff i
re,li
ght ning,t ornadoes,wi ndst orms,and
numer ousot hercauses. Ther ear etwomaj ort y pesofl ossassoci atedwi t
ht he
destructi
onort hef
tofpr opertydir
ectlossandi ndirectlossorconsequent ial l
oss.
Directloss: A directl ossisdef inedasf i
nanci all osst hatr esults,f r
om t he
physicaldamage,dest r
uct i
on,ort heftoft hepr oper ty.Forexampl e,ify ouowna
hotelthatisdamagedbyaf i
re,t
hephy sicaldamaget othehot elisknownasadi r
ect
l
oss.
Indir
ectloss: Ani ndirectlossisaf i
nanciallosst hatr esultsindirect l
yf rom the
occurrenceofadi rectphysicaldamageort heftloss.Thus, inaddi t
iont ot hephy si
cal
damagel oss,t
hehot elwoul dloseprofitsforsever almont hswhi l
et hehot elisbeing
rebuil
t. Thel ossofpr ofit
swoul dbeconsequent i
all oss. Ot herexampl esofa
consequent i
allosswouldbet helossofr ents,thel ossoft heuseofbui lding,andt he
l
ossofal ocalmarket.

Fr
ewB.
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 RI
SKMANAGEMENTANDI
NSURANCE

Li
abi
li
tyRi
sk:
Li
abili
tyri
sksar eanotherimpor
tanttypeofpur eri
skthatmostpersonsf ace.
Underourlegalsystem,youcanbeheldlegal
lyl
iabl
eifyoudosomethi
ngthatresulti
n
bodi
lyinj
uryorpr opert
ydamaget osomeoneel se.Acour tofl
aw mayordery outo
paysubstanti
aldamagest otheper
sonyouhav einj
ured.

Fr
ewB.
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