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Principles of Insurance
Chapter-01: Risk In Our Society
Prepared By:
Tasneema Khan
Assistant Professor
Department of Banking and Insurance
University of Dhaka
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Topics to be Covered

■ Definition of Risk

■ Peril and Hazard

■ Basic Categories of Risk

■ Types of Pure Risk

■ Burden of Risk on Society

■ Methods of Handling Risk

+ Definition Of Risk
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.

■ Risk refers to the possibility or chance of meeting

danger, suffering loss or injury or exposure to
adversity or danger.

■ Traditionally Risk is defined in terms of

uncertainty.

■ Risk is defined as the uncertainty concerning the

occurrence of a loss.
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Risk Distinguished From
Uncertainty
■ Risk is used in a situation where the probabilities of possible
outcomes are known or can be estimated with some degree
of accuracy.

Measurable, controllable and can be minimized.

■ Uncertainty is used in situations where such probabilities can

not be estimated.
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Loss Exposure

■ Because risk is a ambiguous term and has different

meaning, many authors use the term loss
exposure to identify potential loss.

■ Loss exposure is any situation or circumstance in

which a loss is possible, regardless of whether a
loss actually occurs.
+ Peril and Hazard
The term Peril and Hazard should not be confused
with the concept of risk.

■ Peril is defined as the causes of loss.

Ex: fire, lightning, windstorm, earthquake, theft.

■ Hazard is a condition that creates or increases the

frequency or severity of loss.
■ Physical Hazard
■ Moral Hazard
■ Morale Hazard
■ Legal Hazard
+ Types of Hazard
1. Physical Hazard:

A physical hazard is a physical condition that increases the

frequency or severity of loss.
■ It can be inspected. It is visible and apparent.
■ For ex: Defective wiring, Icy road, Defective lock.

2. Moral Hazard:

Moral hazard is dishonesty or character defects in an individual

that increases the frequency or severity of loss.

■ It is present in all sort of insurance.

■ It is difficult to control.
■ Because of moral hazard, premium is higher.
■ Insurance companies try to control moral hazard by several means.
■ Ex: faking an accident, intentionally burning, submitting fraudulent
claim, inflating the amount of claim, murdering the insured to collect
the life insurance proceeds
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Types of Hazard (Cont.)
3. Morale Hazard or Attitudinal Hazard:

Morale hazard is carelessness or indifference to a loss, which increases

the severity and frequency of loss.

Because of existence of insurance, people may become careless or

indifferent to loss.
■ Different from moral hazard.
■ Ex: Leaving car key in an unlocked car, leaving door unlocked, changing
lanes suddenly

4. Legal Hazard:

Refers to characteristics of the legal system or regulatory environment

that increases the severity or frequency of losses.

■ Legal hazard results 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.
 Loss Peril Hazard
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Physical Moral Morale
Hazard Hazard Hazard

House burns Fire Defective Intentional Leaving the

because of wiring burning stove open
Fire

Car is Collision Icy road Damaging Suddenly

damaged in own car changing the
a Collision lane

Car lost by Theft Defective lock Faking the Leaving the

Theft in the car theft key in the car
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Basic Categories of Risk
1. Pure and Speculative Risk

2. Fundamental and Particular Risk

3. Enterprise Risk
■ Strategic
■ Operational
■ Financial
+ Basic Categories of Risk (Cont.)
1. Pure and Speculative Risk:

“Pure risk” is defined as a situation in which there are only the

possibilities of loss or no loss.
■ The only possible outcomes are adverse (loss) and neutral (no
loss)
■ Ex: premature death, catastrophic medical expense, damage to
property from fire, lightening etc.

Types of Pure Risk:

■ Personal
■ Property
■ Liability

“Speculative risk” is defined as a situation in which either

profit or loss is possible.
Ex: Investment, Betting, Business
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Basic Categories of Risk (Cont.)
2. Fundamental and Particular Risk/

“Fundamental risk” is a risk that affects the entire economy

or large number of persons or groups within the economy.
Ex: War, inflation, cyclical unemployment, natural disaster, terrorist
attack.

“Particular Risk” is a risk that affects only individuals and not

the entire community.

Ex: Car theft, Bank robbery, dwelling fire.

3. Enterprise Risk:

A term that encompasses all major risks faced by a business firm.

■ Strategic
■ Operational
■ Financial
 Types of Pure Risk
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Personal Risk: Risks that directly affects an individual involving the possibility of the loss or reduction of
earned income, extra expenses and the depletion of financial assets
■ Risk of premature death
■ Risk of insufficient income during retirement
■ Risk of poor health
■ Risk of unemployment
■ Alcohol or drug addiction
Risk of premature death:
“Death of a child at early age” is not premature death in economic sense.
Premature death is defined as the death of a family head with unfulfilled financial obligations.
Four costs that result from the premature death:
2. Human life value of the family is lost forever.
3. Additional expenses may be incurred.
4. Families may have trouble covering expenses.
5. Non economic costs are also incurred.
Risk of insufficient income during retirement:
The major risk associated with old age is insufficient income during retirement which can result in
reduced standard of living unless they have sufficient assets to support.
Risk of poor health:
■ The risk of poor health includes both the payment of catastrophic medical bills and the loss of
earned income.
■ It affects earning and savings .
Risk of unemployment
■ The risk of unemployment is another major threat to financial security.
■ Workers lose their income and benefits, savings may be exhausted, reduction of income may not
be sufficient.
 Types of Pure Risk (cont.)
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Property Risk: Persons owning property are exposed to property risk. It is the
risk of having property damaged or lost from numerous causes.

■ Real estate or personal property can be damaged for numerous reasons.

■ Two major types of losses are associated destruction or theft of property.

■ Direct loss: Direct loss is defined as a financial loss that results from the
physical damage, destruction or theft of the property.
■ Indirect/ Consequential loss: An indirect loss is a financial loss that
results indirectly from the occurrence of a direct physical damage or
theft.
Extra expenses are another type of indirect loss.

Liability Risk: The risk of legally held liable for doing something that results
bodily injury or property damage to third party. The court of law may order to pay
substantial damages to the person you have injured.
2. There is no upper limit with resect to the amount of the loss. You can be sued
for any amount.
3. A lien can be placed on your income and financial assets to satisfy the legal
judgment.
4. Legal defense cost can be enormous.
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Burden Of Risk In Society
The presence of risk results in certain undesirable social and
economic effects.

Three major burdens are:

■ Larger emergency fund

■ Loss of certain goods and services

■ Worry and fear

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Methods Of Handling Risk

Risk is a burden not only to the individual but also to the

society as well.

Five major methods of handling risk:

1. Avoidance

2. Loss control- Loss prevention and loss reduction

3. Retention

4. Noninsurance transfer

5. Insurance
 Methods Of Handling Risk (cont.)
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1. Avoidance:
■ Avoidance is one method for handling risk.
■ However, not all risk can be avoided.
■ Sometimes this seems undesirable and impractical.

2. Loss control:
■ Another important method for handling risk is loss control.
■ Loss control consists of certain activities that reduce both the frequency and
severity of losses.
■ Therefore, loss control has two major objectives: Loss prevention and Loss
reduction.

Loss prevention: Loss prevention aims at reducing the probability of loss so

that the frequency of losses is reduced.

■ The goal of loss prevention is to prevent the loss form occurring.

Ex: safe driving course, stop smoking, eating healthy diets.

Loss reduction: Loss reduction is all about reducing the severity of a loss
after it occurs.

Ex: installing sprinkle system, fire resistant materials, community warning,

fire doors/fire walls.
+ Loss Control Loss Prevention Loss Reduction

Fire Risk Checking the wirings on Installing sprinkle

regular basis, Restricting system, Fire resistant
smoking, Periodic materials, Fire doors
inspection

Car Theft Risk Security check, Safe Installing alarm system

locking

Loss control is significant and highly desirable because:

■ It controls both direct and indirect costs. Sometimes indirect costs are
huge in amount.
■ Social cost can be reduced.
 3. Retention:
+ ■ Retention is third method of handling risk.
■ Retention means that an individual or business firm remains all or part of a given
risk.
■ Risk retention can be active or passive.
■ Applicable for high frequency-low severity loss.

Active risk retention:

Active risk retention means that an individual is consciously aware of the risk and
deliberately plans to retain all or part of it.
It is applicable :
1. When commercial insurance is unavailable.
2. To Save money

Passive risk retention:

Certain risk can be unknowingly retained because of ignorance, indifference or
laziness. Passive retention can be very much dangerous.
It is very dangerous if the retained risk has the potential for destroying you financially.
Ex: the risk of being permanently disabled.

4. Noninsurance transfer:

The risk is transferred to a party other than the insurance.

■ Transfer of risk by contract: Service contract, Hold-harmless clause, Price Contract,
■ Hedging price risks
■ Incorporation of business firm
+ 5. Insurance:
Insurance is the equitable transfer of the risk of a loss, from one
entity to another in exchange for payment.

■ The most practical method for handling risk.

Three major characteristics should be emphasized:

1. A pure risk is transferred to the insurer.

2. Pooling technique is used to spread the losses of the few over

the entire group.x

3. The risk may be reduced by application of law of large numbers

by which an insurer can predict future loss experience with
greater accuracy.
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Thanks