The Concept of Risk

• Basic problem with which insurance deals

• Insurance theorists have not been able to

agree on a definition

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 Common Elements in Definitions of Risk

• Indeterminancy - at least two possible

outcomes are possible.

• Adversity - at least one of the outcomes is

undesirable and results in a loss.

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 The Text’s 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.”

– Risk not subjective - a state of the real

world where the probability of an adverse
event is between 0 and 1.

– Risk can exist whether or not it is perceived

– The probability of an adverse event may not

be measurable, but still exist.
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 Uncertainty and its Relationship to Risk

• The most widely held meaning of uncertainty

refers to a state of mind characterized by a
lack of knowledge or doubt about the future.
• It is contrasted with certainty, as in

– I am certain I will get an A in this course.”

– “I am uncertain what grade I will get.”

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 The Degree of Risk

• What is more risk or less risk?

• 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

A fourth type of hazard--legal hazard

should also be recognized.

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 Classifications of Risk

• Static and dynamic

• Fundamental and particular

• Pure and speculative

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 Static and Dynamic Risks

• 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

• 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

• 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.
• 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

• Speculative risks involve the possibility of

loss or gain. They are voluntarily accepted
because of the possibility of gain.
• Pure risks involve the possibility of loss or
no loss only.
• In general, insurance deals with pure risks
only.

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 Classifications of Pure Risk

1. Personal risks

2. Property risks

3. Liability risks

4. Risks arising out of failure of others

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 Personal Risks

Personal risks consist of the possibility of loss

of income or assets as a result of the loss of
the ability to earn income.
In general, earning power is subject to four
perils:
– premature death,
– dependent old age,
– sickness or disability, and
– unemployment.

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 Property Risks

Property risks embrace two types of loss: direct

loss and indirect or “consequential” loss.
 Direct loss is the loss of the property itself,
and is measured by the value of the
property or the cost of repairing the
property.
 Indirect loss results from the loss of use of
the asset that is damaged or destroyed, for
the period required to repair or replace the
property.

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 Liability Risks

Liability risks therefore involve the possibility

of loss of present assets or future income as a
result of damages assessed or legal liability
arising out of either intentional or unintentional
torts, or invasion of the rights of others

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 Risks Arising from Failure of Others

When a person who has agreed to meet an

obligation might fail to do so and such failure
would produce financial loss, risk exists.

Examples of risks in this category include

failure of a contractor to complete a
construction project as scheduled, or failure of
debtors to make payments as expected.

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 The Burden of Risk

• Some losses will occur

• The cost of accumulated reserves

• Deterrent effect on capital accumulation

• Higher cost of capital

• Feeling of frustration and mental unrest

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 Increasing Variety of Risks

The earliest risks were exposure to the

ravages of nature and predators.
Advances in technology produced new risks
 industrialization
 power sources
 legal system

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 Risks of the Modern Environment

Many risks facing individuals and organizations

today were unknown a generation ago.
 Liability for environmental damage,
discrimination in employment, sexual
harassment, and violence in the workplace.
 Hazards of the nuclear age
 Terrorism — bombings
 Risks related to information technology

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 Increasing Severity of Losses

Although earthquakes, floods, and storms occur

at about the same rate as in the past, each new
catastrophe seems to exceed previous losses.
 There is simply more wealth, more assets
and more investment exposed to loss.
 As business has become more capital
intensive, capital investment increases and
with it, the risk of financial loss.

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 Managing Risk

There is no escape from risk and humanity

must seek ways of dealing with it.
• Some risks--fundamental in nature--are met
through collective action of society and
government.
• E.g., Municipal police and fire departments
and countless other approaches.

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 Managing Risk

Although society and government can help

alleviate the burden of some risks, there are
other risks that are individual responsibilities.
A systematic approach is desirable for dealing
with these risks.
• What can we do about various risks?
• Which should be addressed first and what
should be done about them?

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