CHAPTER ONE

RISK AND RELATED TOPICS

Meaning of Risk:
There is no single definition of risk. Economists, behavioral scientists, risk
theorists, statisticians and actuaries each have their own concept of risk. However,
risk traditionally has been defined in terms of uncertainty. Based on this concept, risk
is defined as uncertainty concerning the occurrence of a loss. For example, the risk of
being killed in a car accident is present because uncertainty is present. The risk of
lung cancer for smokers is present because uncertainty is present. And the risk of
flunking a college course is present because uncertainty is present.
Although risk is defined as uncertainty, employees in the insurance industry
often use the term risk to identify the property or life being insured. Thus, in the
insurance industry, it is common to hear statements such as “that driver is a poor
risk” or “that building is an unacceptable risk.”
Writers, particularly in the USA have produced a number of definitions of risk.
These are usually accompanied by lengthy arguments to support the particular view
they put forward. Consider the following definitions:
Risk is the possibility of an unfortunate occurrence.
Risk is a combination of hazards.
Risk is unpredictability – the tendency that actual results may differ from
predicted results.
Risk is uncertainty of loss.
Risk is possibility of loss.
Finally, when risk is defined as uncertainty, some authors make a careful
distinction between objective risk and subjective risk.

Objective Risk:
Objective risk is defined as the relative variation of actual loss from expected
loss. For example, assume that a property insurer has 10,000 houses insured over a
long period and, on average, 1 %, or 100 houses, burn each year. However, it would
be rare for exactly 100 houses to burn each year. In some years, as few as 90 houses
may burn; in other years, as many as 110 houses, may burn. Thus, there is a variation
of 10 houses from the expected number of 100, or a variation of 10%. This relative
variation of actual loss from expected loss is known as Objective Risk”.
Objective risk declines as the number of exposures increases. Objective risk
varies inversely with the square root of the number of cases under observation.
Objective risk can be statistically calculated by some measure of dispersion, such as
the standard deviation or the coefficient of variation. Because objective risk can be
measured, it is an extremely useful concept for an insurer or a corporate risk manager.
As the number of exposures increases, an insurer can predict its future loss experience

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more accurately because it can rely on the law of large number. The law of large
numbers states that the number of exposure units increases, the more closely the
actual loss experience will approach the expected loss experience. For example: as
the number of houses under observation increases, the greater is the degree of
accuracy in predicating the proportion of houses that will burn.

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 subjective risk.
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 home
or by taking a taxi. Another driver in the same situation may perceive the risk of
being arrested as slight. This second driver may drive in a more careless and reckless
manner; a low subjective risk results in less conservative driving behavior.

Uncertainty:
Certainty is lack of doubt. In Webster’s New Collegiate Dictionary, one meaning
of the term “certainty” is “a state of being free from doubt,” a definition will suit to
the study of risk management. The antonym of certainty is “uncertainty” which is
“doubt about our ability to predict the future outcome of current actions.” Clearly,
the term “uncertainty describes a state of mind. Uncertainty arises when an
individual perceives that outcomes cannot be known with certainty.”
Uncertainty is doubt about our ability to predict the future. Uncertainty arises
when an individual perceives risk. Uncertainty is a subjective concept, so it cannot be
measured directly. Since uncertainty is a state of mind, it varies across individuals.
For complex activities, such as participating in a business venture, some persons
are very cautious, others are more aggressive. Although risk aversion explains some
of the reluctance to participate, the level of risk perceived by individuals also plays a
key role. The perceived level of risk depends on information that an individual can
use to evaluate the chance of outcomes and, perhaps, on the individual’s ability to

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evaluate this information. The level and type of information on the nature of a risky
activity have an important effect on uncertainty.
Levels of Uncertainty:
Level of Uncertainty Characteristics Examples
None (Certainty) Outcomes can be Physical laws, natural
predicted with precision. sciences.

Level 1 Outcomes are identified Games of chance, Cards,

(Objective and probabilities are Dies.
Uncertainty) known.

Outcomes are identified Fire, automobile

Level 2 but probabilities are accident, many
(Subjective unknown. investments.
Uncertainty)
Outcomes are not fully Space exploration,
identifies and genetic research.
Level 3 probabilities are
unknown.
The level of uncertainty arising from a given type of risk can depend on the
entity facing the risk; for example, an insurer or a governmental entity may regard the
risk of earthquake as being at level 2, while the individual may regard the earthquake
as being a at level 3. This difference in perspective may be a consequence of an ability
to estimate the likelihood of outcomes.

Probability (Chance of Loss):

Probability is closely related to the concept of risk. Chance of loss is defined as
the probability that an event will occur. Like risk, “probability” has both objective
and subjective aspects.

Objective Probability:
Objective probability refers to the long-run relative frequency of an event based
on the assumptions of an infinite number of observations and of no change in the
underlying conditions. Objective probabilities can be determined in two ways. First,
they can be determined by deductive reasoning. These probabilities are called a priori
probabilities. For example: tossing a fair coin. Second, objective probabilities can be
determined by inductive reasoning, rather than by deduction. For example, the
probability that a person age 21 will dies before age 26 cannot be logically deduced.
However, by a careful analysis of past mortality experience, life insurers can estimate
the probability of death an sell a five year term life insurance policy issued at age 21.

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Subjective Probability:
Subject probability is the individual’s personal estimate of chance of loss.
Subjective probability need not coincide with objective probability. For example,
people who buy a lottery ticket on their birthday may believe it is their lucky day and
overestimate the small chance of winning. A wide variety of factors can influence
subjective probability, including a person’s age, gender intelligence, education, and the
use of alcohol.

Probability distinguished from Risk:

Chance of loss can be distinguished from objective risk. Chance of loss is the
probability that an even that causes a loss will occur. Objective risk is the relative
variation of actual loss from expected loss. The chance of loss may be identical for two
different groups but objective risk may be quite different. For example, assume that a
property insurer has 10,000 homes insured in loss Angeles and 10,000 homes insured
in Philadelphia and that the chance of loss in each city is 1%. Thus, on average, 100
homes should burn annually in each city. However, if the annual variation in losses
ranges from 75 to 125 in Philadelphia, but only from 90 to 110 in Los Angeles, objective
risk is greater in Philadelphia even though the chance of loss in both cities is the same.

PERIL AND HAZARD

The terms peril and hazard should not be confused with the concept of risk
discussed earlier.

Peril:
Peril is defined as the cause of loss. If your 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
included fire, lightning, windstorm, hail, tornadoes, earth quakes, theft and robbery.

Hazard:
A hazard is a condition that creates or increases the chance of loss. There are
four major types of hazards:
Physical hazard
Mortal hazard
Morale hazard
Legal hazard

Physical hazard: A physical hazard is a physical condition that increases the

chance of loss. Examples of physical hazards include icy roads that increase the

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chance of a car accident, defective wiring in a building that increases the increases of
fire, and a defective lock on door that increases the chance of theft.
Moral hazards: Moral hazard is dishonesty or character defects in an individual that
increase the frequency or severity of loss. Examples of moral hazard include faking an
accident to collect from an insurer, submitting a fraudulent claim, inflating the amount
of a claim, and intentionally burning unsold merchandise that is insured.

Morale hazard: Some insurance authors draw a subtle distinction between moral
hazard and morale hazard. Moral hazard refers to dishonest by an insured that
increases the frequency or severity of loss. Morale hazard is carelessness or
indifference to a loss because of existence of insurance. Some insureds are careless or
indifferent to a loss because they have insurance. Examples of morale hazard include
leaving car keys in an unlocked car, which increase the chance of theft; leaving a door
unlocked that allows a robber to enter; and changing lanes suddenly on a congested
interstate highway without signaling. Careless acts like these increase the chance of
loss.
Legal hazard: Legal hazard refers to characteristics of the legal system or
regulatory environment that increase the frequency or severity of losses. Examples
include adverse jury verdicts or large damage awards in liability lawsuits, statutes 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.

Categories of Risk:
Risk can be classified into several distinct categories. The two major categories
are as follows:
Pure and Speculative Risks.
Fundamental and Particular Risks.

Pure and Speculative Risks:

Pure Risk: Pure risk is defined as a situation in which there are only the possibilities
of loss or not loss. The only possible outcomes are adverse (loss) and neutral (no loss).
Examples of pure risk include premature death, industrial accidents, terrible medical
expenses, and damage to property from fire, lightning, flood, or earthquake.

Speculative Risk: Speculative risk is defined as a situation in which either profit or

loss is possible. For example, if you purchase 100 shares of common stock, you would
profit if the price of stock increases but would loss if the price declines. Other
examples, of speculative risk include betting on horse race, card games, investing in

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real estate, and going into business for your self. In these situations, both profit and
loss are possible.

Distinguish between pure and speculative risks:

First, private insurers generally insure only pure risk.
With certain exceptions, speculative risk generally is not considered insurable,
and other techniques for managing with speculative risk must be used.

Second, 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 risks to predict future loss experience. An exception is
the speculative risk of gambling where nightclub operators can apply the law
of large numbers in a most efficient manner.

Finally, 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.
Example, a firm may develop new technology for producing low price
computers. As a result some competitors may be forced to bankruptcy. Despite
the bankruptcy, society benefits because the computers are produced at a low
cost. However, society normally does not benefit when as loss from a pure risk
occurs, such as flood, or earth quake.

Fundamental and Particular Risks.

Fundamental Risk:
A fundamental risk is a risk that affects the entire economy or large numbers of
persons or groups within the economy. Examples include rapid inflation, cyclical
unemployment, and war because large numbers of individuals are affected.
The risk of a natural disaster is another important risk. Hurricanes, tornadoes,
earthquakes, floods, and forest and grass fires can result in billions of dollars of
property damage and numerous deaths. More recently, the risk of a terrorist attack is
rapidly emerging as fundamental risk.

Particular Risk:
A particular risk is a risk that affects only individuals and not the entire
community. Examples include car thefts, gold thefts, bank robberies, and dwelling
fires. Only individuals experiencing such losses are affected, not the entire economy.
Types of pure risk:
The major types of pure risk that can create great financial insecurity include

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 Personal Risks.
Property Risks.
Liability Risks.

Personal Risks:
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.

Risk of premature death.

Risk of insufficient income during
retirement.
Risk of poor health.
Risk of unemployment.

Risk of premature death:

Premature death is defined as the death of a household head with unfulfilled
financial 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
insufficient financial assets to replace the lost income, they may be financially
insecure.
Risk of insufficient income during the retirement:
The major risk associated with old age is insufficient income during retirement.
The vast majority of workers in the world are before age 65. When they retire, they
lose their earned income. Unless they have sufficient financial assets on which to
draw, or have access to other sources of retirement income, such at social security or a
private pension, they will be exposed to financial insecurity during retirement.

Risk of Poor Health:

Poor health is another important personal risk. The risk of poor health includes
both the payment of terrible medical bills and the loss of earned income.

Risk of Unemployment:
The risk of unemployment is another major threat to financial security.
Unemployment can result from business cycle downswings, technological and
structure changes in the economy, seasonal factors, and imperfections in the labor
market.
Property Risks:

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 Persons owning property are exposed to property risks – the risk of having
property damaged or lost from numerous causes. Real estate and personal property
can be damaged or destroy because of fire, lightning, tornadoes, windstorms, and
numerous other causes. There are two major types of loss associated with the
destruction or theft of property direct loss and indirect loss or consequential loss.

Direct loss: A direct loss is defined as financial loss that results, from the
physical damage, destruction, or theft of the property. For example, if you own a
hotel that is damaged by a fire, the physical damage to the hotel is known as a direct
loss.

Indirect 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 physical
damage loss, the hotel would lose profits for several months while the hotel is being
rebuilt. The loss of profits would be consequential loss. Other examples of a
consequential loss would be the loss of rents, the loss of the use of building, and the
loss of a local market.

Liability Risk:
Liability risks are another important type of pure risk that most persons face.
Under our legal system, you can be held legally liable if you do something that result
in bodily injury or property damage to someone else. A court of law may order you
to pay substantial damages to the person you have injured.

Review Questions:

1. Explain briefly the meaning of risk.

2. How does objective risk differ from subjective risk?
3. Define chance of loss.
4. Distinguish between an objective probability and a subjective probability.
5. Define peril, hazard, physical hazard, moral hazard, morale hazard, and legal hazard.
6. Explain the difference between pure and speculative risk.
7. Identify the major types of pure risk that are associated with great financial insecurity.
8. Why is pure risk harmful to society?
9. What is the difference between a direct loss and an indirect or consequential loss?