A Definition of Risk

Risk is a condition in which there is a

possibility of an adverse deviation from a
desired outcome that is expected or hoped for.

1. Risk not subjective - a state of the real

world

2. Risk can exist whether or not it is

perceived

3. Risk can be imagined where possibility of

loss does not exist (subjective)
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 The Degree of Risk

1. What is more risk or less risk?

2. Varies with the probability of deviation

• from what is expected in case of

aggregate data

• from what is hoped for (no loss) in case

of individual

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 Risk Distinguished From Peril and Hazard

Peril: the cause of

loss

Hazard: a condition that creates

or increases the chance
of loss

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Classifications of Hazards

Physical

Moral

Morale

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 Classifications of Risk

1. Financial and non-financial

2. Static and dynamic

3. Fundamental and particular

4. Pure and speculative

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 Static and Dynamic Risks

1. Dynamic risks result from changes in the

economy (e.g., changes in price levels,
consumer taste, income, and output).
• benefit society in the long run, by
adjusting misallocations of resources

2. Static risks would exist even in the absence

of economic change (from perils of nature
or human dishonesty).
• not a source of gain to society

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 Fundamental and Particular Risks

1. Fundamental risks are impersonal in origin

and consequences. They are societal risks.
• It is held that society (rather than the
individual) should deal with them.

2. Particular risks involve losses that arise out

of individual events and are felt by
individuals rather than the entire group.
• Particular risks are considered the
individual’s own responsibility that are
properly addressed by the individual.
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 Pure and Speculative Risks

1. Speculative risks involve the possibility of

loss or gain. They are voluntarily accepted
because of the possibility of gain.

2. Pure risks involve the possibility of loss or

no loss only.

3. In general, insurance deals with pure risks

only.

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 Classifications of Pure Risk

1. Personal risks(premature death, retirement

income, poor health,unemployment)

2. Property risks

3. Liability risks

4. Risks arising out of failure of others

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 The Burden of Risk

1. Some losses will occur

2. The cost of accumulated reserves

3. Deterrent effect on capital accumulation

4. Higher cost of capital

5. Feeling of frustration and mental unrest

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 Methods of Dealing With Risk

1. Avoidance

2. Reduction(loss control)

3. Retention (active or passive)

4. Transfer

5. Sharing

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 Nature & Functions of Insurance

In its simplest aspect, insurance has two

fundamental characteristics:

1. Transfer of risk from the individual to the

group.

2. Sharing of losses on some equitable basis.

(unstated but important third characteristic is

that of INDEMNIFICATION)

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 Insurance Defined: Individual Perspective

Insurance is an economic device whereby the

individual substitutes a small certain cost (the
premium) for a large uncertain financial loss
(the contingency insured against) which would
exist if it were not for the insurance.

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 Risk Reduction Through Pooling

1. The risk an insurer faces is not merely a

summation of risks transferred to it by
individuals.
2. Insurer can predict within narrow limits the
amount of losses that will occur.
3. If insurer could predict future losses with
absolute precision, it would have no risk.
4. Accuracy of insurer’s prediction is based
on the law of large numbers.

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 Probability Theory and Law of Large Numbers

Probability theory is the body of knowledge

concerned with measuring the likelihood that
something will happen and making predictions
based on this likelihood.

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 Insurance Defined Social Perspective

Insurance is an economic device for reducing

and eliminating risk through the process of
combining a sufficient number of homogeneous
exposures to make the losses predictable for
the group as a whole.

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 Insurance: Transfer or Pooling?

1. The view that the essence of insurance is

risk transfer emphasizes the individual’s
substitution of a small small certain cost for
large uncertain loss.

2. Emphasis on pooling or risk sharing

emphasizes the role of reducing risk in the
aggregate.

3. Insurance can exist without pooling, but not

without transfer.

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 Insurance and Gambling

1. In gambling, there is no chance of loss (and

therefore no risk) prior to the wager.

2. In the case of insurance, the chance of loss

exists whether or not insurance is
purchased.

3. Gambling creates risk, while insurance

provides for the transfer of existing risk.

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 Economic Contribution of Insurance

1. Creates certainty about burden of loss

2. Spreading losses that do occur

3. Provides for an optimal utilization of capital

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 Elements of an Insurable Risk

1. Large numbers of exposure units

2. Definite and measurable loss

3. The loss must be fortuitous

4. The loss must not be catastrophic

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 The Fields of Insurance

1. Private insurance
voluntary programs designed to protect
individual against financial loss

2. Social Insurance
compulsory insurance programs
generally operated by government

3. Public Benefit Guarantee Programs

quasi-social coverages usually
associated with regulation

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 Private (Voluntary) Insurance

1. Usually (but not always) voluntary.

2. Usually (but not always) offered by private

insurers.

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 Private (Voluntary) Insurance

1. Life insurance

2. Accident and health insurance

3. Property and liability

• fire
• marine
• casualty
• fidelity and surety bonds

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 Casualty Insurance

accident and health insurance

automobile
liability
workers compensation
boiler and machinery
plate glass
burglary, robbery, theft
credit insurance
title insurance

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 Social Insurance

Based on the notion that there are some people

in society who face fundamental risks that they
cannot deal with themselves.

Social insurance programs rest on the premise

that if an individual cannot provide for a
reasonable standard of living through personal
efforts, society should assist.

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 Social Insurance Definition

1. Coverage is compulsory

2. Eligibility derived from contributions:

no requirement to demonstrate need

3. Method of determining benefits prescribed

by law

4. Benefits not directly related to

contributions

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 Social Insurance Definition

5. Definite long-range plan for financing

6. Cost borne primarily by contributions

7. Plan administered or supervised

by government

8. Plan not established solely for government

employees

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 Social Insurance Programs in the U.S.

1. Old-Age, Survivors and Disability Insurance

2. Railroad Retirement, Disability and

Unemployment Insurance

3. Unemployment Insurance

4. Medicare

5. State Compulsory Temporary Disability

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 Public Guarantee Insurance Programs

1. Quasi social insurance programs, mainly in

connection with financial institutions

2. Public Guarantee Insurance Programs are

usually allied with the function of regulation

3. Insurance principle is used to protect

lenders, depositors, or investors against
loss resulting from failure of a financial
institution

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 Federal Public Guarantee Programs

1. Federal Deposit Insurance Corporation

2. National Credit Union Administration

3. Securities Investor Protection Corporation

4. Pension Benefit Guarantee Corporation

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