CHAPTER 1

RISK AND RELATED TOPICS

1.1. Definition of risk: It is a condition in which there is a

possibility of an adverse deviation from a desired outcome. Or

 Risk is defined as uncertainty concerning the occurrence of

loss.
E.g. The risk of being killed in an auto accident for a truck driver is
present b/c uncertainty is present.
Like wise, the risk of lung cancer for smokers is present b/c
uncertainty is present.

 Therefore, risk is uncertainty regarding the occurrence of a loss.

This means that the loss may or may not happened. If the loss is
certain to occur, it may planned in advance and treated as definite.
 1.2. Risk Vs uncertainty
 The dictionary meaning of risk is “the possibility of meeting
danger or suffering harm/ loss”

 The dictionary meaning of uncertainty is “ the state of being

uncertain” here, uncertain means “feeling of doubt about some
thing”

 Generally, uncertainty is a state of mind characterized by

doubt, based on lack of knowledge about what will or will not
happen in the future.

 The existence of uncertainty creates risk. Therefore

uncertainty is a pre-condition for risk.
 1.3. Risk Vs Probability
Probability: is the long-run chance of occurrence,
or relative frequency of some events.

Risk: is relative variation/deviation of items.

 Therefore, probability is expectation of

outcomes but risk is deviation (variation) of
outcomes from expectation.
 1.5 Risk, Peril and Hazard
Peril: - is the prime cause; it is what will give rise to the loss.
Often it is beyond the control of anyone who may be involved.

E.g. storm, fire, theft, motor accident and drought are all perils.

Hazard: - refers to the condition that may create or increase

the chance of a loss arising from a given peril.

 There are 3 major types of hazards:

1.Physical hazards
2. Moral hazard
3. Morale hazard
 Cont…

1. Physical hazards: - This is related with the physical

properties of the thing exposed to risk, such as the nature
of construction of a building, the nature of the road.

 Examples are:
 Icy, rough roads that increase the likelihood of an auto
accident

 Type of construction material such as wood, bricks,

 Location of property such as near to fuel station, near to

flood area, near to earthquake area, etc.
 Cont..

2. Moral hazard: - is a dishonesty, a fraudulence or

character fault in an individual that increases the
frequency or severity of loss.

 E.g. dishonesty, fraudulent intention, exaggeration of

claims, etc

3. Morale hazard: it initiated from act of carelessness

which leading to the occurrence of a loss.

 E.g. leaving car keys in an unlocked car,, leaving a

door unlocked that allows a burglar to enter,, etc.
  
1.6 Classification of Risk

1.6.1 Objective and Subjective Risk

 Objective risk- is defined as the relative variation of the
actual loss from expected loss.

 Objective risk can be statistically measured by some

measure of dispersion, such as the standard deviation or
the coefficient of variation. Since objective risk can be
measured, it is an extremely useful concept for an insurer
or a corporate risk manager

 Subjective risk- is defined as uncertainty based on a

person’s mental condition or state of mind.
 1.6.2 Financial and Non-Financial Risk

 A financial risk is one where the outcome can be measured in

monetary terms.
 Non-financial risk if the risk does not have financial
implication (if the outcomes is not related with money)

1.6.3 Pure and Speculative Risks

 Pure risks refer to the situation in which the outcomes of any
activity is only a loss or no loss would occur.
E.g. premature death, job related with accident.

 Speculative risk is defined as a situation in which the possible

outcomes of any activities are either profit or loss.
E.g. betting on football match, going into business (being
investor).
 1.6.4. Static and Dynamic Risks

 Dynamic risk originates from changes in the

overall economy.
 E.g. price level changes, changes in consumer
taster, income distribution, technological changes,
political changes etc.

 Static risk refers to those losses that can take

place if there were no changes in the overall
economy. They are losses arising from causes
other than changes in the economy.
 E.g. fire, theft, drought, war, collision etc
 1.6.5. Fundamental and Particular Risks

 Fundamental risk is a risk that affects the entire economy or

large numbers of persons or groups within the economy.
Examples include rapid inflation, natural disaster, cyclical
unemployment, and war because large numbers of individuals
are affected. Thus, fundamental risks affect the entire society
or a large group of the population.

 Particular risk is a risk that affects only individuals and not

the entire community. Examples include car thefts, bank
robberies, property losses, death, disability and burning house
by fires. Only individuals experiencing such losses are
affected, not the entire economy or large groups of people.
Therefore, particular risks affect each individual separately.
 Classification of pure risk
 The major types of pure risk that create the great
financial insecurity (shortage of money):
1. Personal risk
2. property risk
3. Liability risk
4. Risk arising out of the failure of the other.
1. Personal risk: are risk that consist of possibility of loss income
as a result of loss of ability to participate in some activity.
 There are 4 major personal risks:
A. Risk of prematured-death
B. Risk of insufficient income during retirement
C. Risk of poor health
D. Risk of unemployment
 Cont…

A. Risk of prematured-death: it is the death of

bread winner (header of family) without satisfied
financial obligation such as dependent to support,
Child to educate, liability to be paid etc.
 cost that resulting from premature death:
 human life value is lost
 Extra cost may incur (e.g. funeral expense)
 Reduction of living standard
B. Risk of insufficient income during retirement
is cause of financial insecurity because of old age.
 Cont…

C. Risk of poor health

 medical expenses
 loss of earned income.
 The above 2 expenses causes financial
insecurity (shortage of money)
D. Risk of unemployment if you are
unemployment you loss your income. This is risk
for you.
 Cont…

2. Property risk: are risks associated with defect

(change or destroy) in possession of property.
 The loss from property can be categorized into
two: A) Direct loss and B) Indirect loss
A) Direct loss: is financial loss that result from the
physical damage of property.
B) Indirect loss: is financial loss that result from due
to the occurrence of Direct damage of property.
E.g. when the rent house is damaged we loss the
rent house, in addition to this we also loss income
from the rent house.
 Cont…

3. Liability risk: are risk result from injury of other

person or damage to their property. (intentionally or
unintentionally)

4. Risk arising from failure of other: it is a risk

arise when person’s fail to meet an obligation that
you hope will be meet.

E.g. Failure of a contractor to complete a contraction

project as scheduled program, which result failure of
income to make payment as expected.
 Cont…

The end!!