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Yared B.
 CHAPTER ONE
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Risk And Related Topics

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Meaning of Risk
❖ There is no single definition of risk.
❖ Economists, behavioral scientists, risk theorists,
statisticians, each have their own concept of
risk.
❖ But all of them consider the following
definitions:
❖ Risk: Possibility of unfortunate occurrence.
✓ Is Combination of hazards(dangers)
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❖ Risk is unpredictability: tendency of actual

results may differ from predicted results.
❖ Risk is uncertainty of loss.
❖ Risk is possibility of loss.
❖ But, insurance theorists have not agreed on a
universal definition, there are common elements
in all definitions: indeterminacy**** & loss.

****Quality of being uncertain

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❖ Concept of an indeterminate outcome is implicit in all

definitions of risk:
✓ Outcome must be in question.
❖ If we know for certain that a loss will occur, there is
no risk.
❖ Risk is a condition in w/c there is a possibility of
unfavorable deviation from a desired outcome that is
expected or hoped for.
❖ Risk is uncertainty concerning occurrence of loss.
❖ Risk is said to exist, there must be always at least two possible outcomes.
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❖ If we know for certain that a loss will occur, there is no risk.

❖ At least one of possible outcomes is undesirable.
❖ Risk is potential variation in outcomes.
❖ If a loss is certain to occur, outcome is one & known in
advance, therefore, there is no risk. Why?
❖ Degree of risk is inversely related to ability to predict which
outcome will actually occur.
❖ Thus, as greater variation greater risk.

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Risk vs. uncertainty

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❑ Certainty is lack of doubt.

❑ Certainty is a state of being free from doubt

❑ Uncertainty w/c is doubt about our ability to

predict future outcome of current actions.

❑ Uncertainty refers to a feelings characterized by

doubt, based on:

✓ Lack of Knowledge About What Will Or Will Not

Happen In Future. Yared B.
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❑ Uncertainty is doubt about our ability to predict future.

❑ It is a subjective concept, so it can’t be measured
directly by any acceptable yardstick.
❑ Uncertainty varies across individuals b/c it is state of
mind.
❑ Risk refers to a condition of circumstances in w/c there
is a possibility of loss.
❑ Unlike uncertainty, risk can be measured.
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Risk Vs. Probability

❑ Risk (especially objective risk) is relative difference of actual &
expected loss.

❑ Objective risk can be measured meaningfully only in terms of a

group large enough to analyze statistically.

❑ Chance of loss may be identical for two different groups but

objective risk may be quite different.

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Risk Vs. Probability

❖ Probability (chance of loss) is closely related to concept of
risk, but distinguished from risk.

❖ Probability: long run chance of occurrence or relative

frequency of some event.

❖ It is probability that an event will occur.

❖ Insurers are particularly involved in probability or chance of

loss - probability that an even that causes a loss will occur to
one of a group of insured objects.
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Objective & Subjective Probability

❑ Objective Probability
❑ Is long-run relative frequency of an event based on:
✓ Assumptions of an infinite number of observations
✓ No change in underlying conditions.
❑ It can be determined in two ways.
❑ First, by deductive reasoning.

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Deductive Reasoning.
❑ These called a priori probabilities.
❑ For E.g. probability of getting a head from toss
of a fair coin is half as there are two sides, &
only one side is a head.
❑ Tossing of four/six side a die

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Inductive Reasoning
E.g. Probability that a 25 years old person will die
before age 30 cannot be logically deduced.
❖ But, by a careful analysis of:
✓ Past mortality experience life insurers can
estimate probability of death on sell a five year
term life insurance policy issued at age 25

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Subjective Probability
➢ Is individual’s personal estimate of chance of loss.
➢ It need not agree with objective probability.

E.g. people who buy a lottery ticket on their birthday may believe it is their
lucky day & overestimate small chance of winning.
› A wide variety of factors can influence subjective probability, including:

-Person’s Age
-Gender Intelligence

-Education and Use f Alcohol Etc.

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Risk, Peril and Hazard

➢ Peril is cause of loss that occurred.

❖ If a house burns b/c of a fire cause of loss is fire.

❖ If a car is damaged in a collision with another car, collision

is peril, or cause of loss.

❑ Hazard is a condition that creates or increases chance of

loss from a given peril.

❑ There are four major types of hazards

1. Physical hazard 3. Morale hazard
2. Moral hazard 4. Legal hazard

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Physical hazard
✓ A physical condition that increases chance of loss.
✓ a Condition stemming from physical characteristics of object that
increases probability & severity of loss from given perils.
✓ May or may not be with in human control.
❖ Some hazards for fire can be controlled by placing restrictions on
buildings or taking care while operating.
❖ In contrary, some are not controllable – little can be done to
prevent or reduce their impact.
✓ Example, ocean storms.
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Moral hazard
❑ Character faults in an individual that increase frequency
or severity of loss.
❑ Dishonest by an insured that increases frequency or
severity of loss.
E.g. It may exist where there is corrupt intention to claim
excessive amount of insurance for properties that are no
longer profitable.
❑ Include forged or calculated car accident, submitting a
fraudulent claim, intentionally burning unsold insured
merchandise.
❑ It may happen in all forms of insurance& it is difficult to
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Morale hazard
❖ Carelessness to a loss b/c of existence of
insurance & Careless acts to increase chance of
loss.
❖ Some insured persons are careless or
indifferent to a loss because they have
insurance.
E.g. Morale hazard include leaving car keys in an
unlocked car, w/c increase chance of theft, leaving a
door unlocked that allowsYared a
B.
robber to enter
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❖ Insurers try to control or reduce both moral &

morale hazard by:
✓ Carefully selecting their insured &/or
✓ Providing contractual provisions that assist

insurer to pay some percentage of loss.

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Legal hazard
❑Characteristics of legal system
or regulatory environment that
increase frequency or severity
of losses.

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Classes of Risk
❑ Objective risk (statistical risk) is relative variation of actual
loss from expected loss.

❑ Applicable to groups of objects exposed to loss.

❑ Statistically calculated by measure of dispersion (standard

deviation or coefficient of variation)

❑ As number of exposures increases, an insurer can predict its

future loss experience more accurately b/c it can rely on law
of large number.
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➢ Subjective risk: Uncertainty based on a person's mental

condition or state of mind.

➢ Psychological uncertainty that stems from individual's

mental attitude or state of mind.

E.g. Driver may be uncertain whether he will

arrive home safely without being arrested by
police for drunk driving.

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❑ Impact of subjective risk varies depending on individual.

❑ Two persons in the same situation can have d/t

perception of risk & their behavior may be changed
accordingly.

❑ If an individual experiences great mental uncertainty

concerning occurrence of a loss, that person's behavior
may be affected.

❑ High subjective risk often results in conservative &

prudent behavior

❑ Low subjective risk may result in less conservative

behavior.
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❖ E.g. a driver previously arrested for drunk driving is aware

that he has taken too much alcohol.

❖ Driver may then compensate for mental uncertainty by

getting someone else to drive car home or by taking a taxi.

❖ Another driver in same situation may perceive

risk of being arrested as minor.

❖ This second driver may drive in a more careless &

irresponsible manner; a low subjective risk results in less
conservative driving behavior.

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❑ Pure risk is situation in w/h there are only possibilities of

loss or not loss.
❑ The only possible outcomes are adverse (loss) & neutral
(no loss).
❑ It occurs when there is a chance of loss but no chance of
gain.
❑ E.g. a shop owner will suffer financial loss if shop is burnt
in fire, but no gain if there is no fire.
❑ Pure risk include premature death, industrial accidents,
terrible medical expenses & damage to property from fire,
lightning, flood, or earthquake.
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Types of pure risk

1. Personal risks: Directly affect an individual.
❑ Includes possibility of complete loss or reduction of
earned income, extra expenses & 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. Yared B.
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❑ Risk of premature death: Death of a household head with

unfulfilled financial obligations.

E.g. Dependents to support, a mortgage to be paid off, or

children to educate
❑ Risk of insufficient income during retirement
✓ Risk associated with old age is insufficient income during
retirement.
❖ Majority of workers in world are before age 65. When they
retire, they lose their earned income

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❑ Risk of Poor Health

❖ Poor health is another important personal risk.
❖ Risk of poor health includes both payment of poor
medical bills & loss of earned income.
➢ Risk of Unemployment: Major threat to
financial security.
➢ Unemployment can result from business cycle
downswings, technological & structure changes in
economy, seasonal factors & imperfections in labor
market.
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2. Property Risks: Risk of having property damaged or lost

from numerous causes.
✓ Real estate & personal property can be damaged or destroy
b/c of fire, lightning, tornadoes, windstorms, & numerous
other causes.
➢ There are two major types of loss associated with
destruction or theft of property:
➢ Direct loss & indirect loss or consequential loss

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❖ Direct loss: Financial loss that results, from

physical damage, destruction, or theft of property.
❖ E.g. Assume a hotel that is damaged by a fire,
physical damage to hotel is known as direct loss.
❖ Indirect loss: Financial loss results indirectly from
occurrence of a direct physical damage or theft loss.
❖ In addition to physical damage loss, hotel lose
profits for several months while hotel is being
rebuilt.
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3.Liability risk: Pure risk that most persons face.

❖ One can be held legally liable if he/she does
something that result in bodily injury or property
damage to someone else.
❖ A court of law may order him/her to pay
substantial damages to the person he/she has
injured.

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❖ Speculative risk: Defined as a situation

in which either profit or loss is possible.
❖ For Eg. If you purchase 100 shares of
common stock, you would profit if price of
stock increases but would loss if price
declines.

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Distinguish between pure and speculative risks

❖ First, private insurers generally insure only pure risk.

❖ With certain exceptions, speculative risk generally is not
considered insurable & other techniques for managing with
speculative risk must be used.
❖ Second, law of large numbers can be applied more easily to pure
risks than to speculative risks.

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❖ 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 law of large numbers to
speculative risks to predict future loss
experience.

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❖ 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.

❖ E.g. Firm may develop new technology for producing

low price computers. As a result some competitors may
be forced to bankruptcy.
❖ Despite bankruptcy, society benefits because
computers are produced at a low cost.
❖ But, society normally does not benefit when as loss

from a pure risk occurs, such as flood /earthquake .

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Fundamental & Particular Risks

❖ Fundamental risk
❖ Risk that affects entire economy or large
numbers of persons or groups within
economy.
❖ Involve losses that are impersonal in
origin & consequence.
❖ Affect large segments /even all of population.
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❖ E.g. Rapid inflation, cyclical unemployment &

war because large numbers of individuals are
affected.
❖ Risk of a natural disaster is another important
risk. Storms, tornadoes, earthquakes, floods, and
forest and grass fires can result in billions of
dollars of property damage and numerous deaths.
❖ Recently, risk of a terrorist attack is rapidly
emerging as fundamental risk.

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❖ A particular risk: Affects only individuals & not

entire community.
❖ Involves losses that arise out of individual events & are
felt by individuals rather than by entire group.
❖ E.g. Car thefts, gold thefts, bank robberies &
dwelling fires.
❖ Only individuals experiencing such losses are
affected, not entire economy
❖ Is Financial & Non Financial Risk
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Static and Dynamic Risk

❖ Static risks: losses that would occur even if there
were no changes in economy
❖ Generally predictable which make static risks more
suitable for treatment by insurances.
❖ Dynamic risks: Resulting from changes in economy.
❖ Change in price level, consumer tastes, income & outputs &
technology may cause financial losses to members of society.
❖ Generally considered less predictable than static risks

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Risk Related to Business Activities

❑ Most risks in business env’t are speculative in nature.
› Five types of risks that business organizations face in
course of their normal operation.
1. Business Risk
➢ Risk associated with physical operation of firm.
➢ Variations in level of sales, costs, profits are likely to
occur due to a number of factors inherent in economic
environment.
› Business risk is independent of company’s financial
structure.

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2.Financial Risk
› Risk associated with debt financing.
› Borrowing results in payment of periodic interest charge & payment
principal upon maturity.
› There is a risk of default by company if operations are not profitable.
› Other financial risks include; bankruptcy, stock price decline,
insolvency.
3. Interest Rate Risk
› Risk resulting from changes in interest rates.
› Changes in interest rates affect prices of financial securities such as
prices of bonds
› For interest rate rise depresses bond prices and vice, versa.

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4. Purchasing Power Risk

› Risk arises under inflationary situations leading to
a decline in purchasing power of the asset held.
› Financial assets lose purchasing power if increased
inflationary tendencies prevail in economy.
5. Market Risk
› Risk is related to stock market.
› Refers to stock price variability caused by market
forces.
› It is result of investors’ reactions to real or
psychological expectations.
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› Market, in many cases, is also affected by such

events as: presidential elections, trade BOP
figures, wars, new inventions, etc.
› Market risk is also called systematic or non-
diversifiable risk.
› All investors are subject to this risk.
› It is result of workings of economy
› Cannot be eliminated through portfolio
diversification.
› However, investors are paid for this risk.
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Burden of Risk On Society

› Presence of risk results in certain undesirable social
and economic effects.
➢ Risk entails three major burdens on society:

1. Size of an emergency fund must be increased.

➢ It is prudent to set aside funds for emergency
purposes.
➢ However, in absence of insurance, individuals &
business firms must increase size of their emergency
funds in order to pay for unexpected losses. Yared B.
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› For example, assume you have purchased a Br.

300,000 home and want to have money for
repairs if the home is damaged from fire, hail,
windstorm, or some other peril.
› Without insurance you would have to save
some big lump-sum annually to build up an
adequate fund within a relatively short period
of time

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2. Society is deprived of certain goods & services

➢ Because of risk of a liability lawsuit, many
corporations have discontinued manufacturing
certain products.
E.g. Some 250 companies in world used to manufacture
childhood vaccines; today, only a few firms manufacture
vaccines, due in part to the threat of liability suits.
Other firms have discontinued the manufacture of certain
products, including single-engine airplanes, asbestos
products, football helmets, silicon-gel breast implants, and
certain birth control devices Yared B.
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3. Worry & fear are present

› A final burden of risk is that worry and fear are
present.
› e.g. mental unrest & fear caused by risk.
› A college student who needs a grade of C in a
course in order to graduate may enter the final
examination room with a feeling of worry & fear.
› Some passengers in a commercial jet may
become extremely nervous & fearful if jet
encounters severe turbulence during flight.
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End of chapter one

Yared B.