CHAPTER ONE

RISK AND RELATED

TOPICS
 Meaning of Risk
 Definition
 Risk is a condition in which there is a possibility
of an adverse deviation from a desired outcome
that is expected for or hoped for.
 Risk is uncertainty regarding loss. The
individual hopes that adversity will not occur,
and it is the possibility that this hope will not be
met that constitutes risk.
 If someone owns a house, she/he wishes that it
would not catch fire. The fact that the outcome
may be something other than what she/he hopes
constitutes the possibility of loss or risk.
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 Risk is potential deviation in outcomes. If a loss
is certain to occur, it may be planned for in
advance and treated as a definite, kwon expense.
It is when there is uncertainty about the
occurrence of a loss that risk becomes an
important problem.
 If only one outcome is possible, the variation
and hence the risk is 0. If the risk is 0, the future
is perfectly predictable.
 If many outcomes are possible, the risk is not 0.
The greater the variation, the greater the risk.

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 1.2 Uncertainty and its relationship to risk
 Uncertainty refers to a state of mind
characterized by doubt, based on a lack of
knowledge about what will or will not happen in
the future.
 Uncertainty is simply a psychological reaction to
the absence of knowledge about the future.
 Uncertainty is the doubt a person has concerning
his/her ability to predict which of the many
possible outcomes will occur.
 Unlike probability and risk, uncertainty cannot be
measured by commonly accepted yardstick/unit/.

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 1.3 Risk vs. Probability
 Probability refers to the long-run chance of
occurrence or relative frequency of some event.
 Risk, as differentiated from probability, is a
concept in relative variation. We are referring here
particularly to objective risk, which is the relative
variation of actual from probable or expected loss.
Objective risk can be measured meaningfully only
in terms of a group large enough to analyze
statistically.
 If the number of objects is too small, the range of
probable variation is so large that it is virtually
infinite as far as the insurer is concerned.
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 Objective probability: refers to the long-run
relative frequency of an event based on the
assumptions of an infinite number of observations
and of no chance in the underlying conditions.
Objective probabilities can be determined in two
ways.
 They can be determined by deductive reasoning.
These probabilities are called prior probabilities.
For example, the probability of getting a head from
the toss of a perfectly balanced coin is ½ because
there are two sides, and only one is a head.
Likewise, the probability of getting a 6 on upper
face of die with a single rolled die is 1/6, since
there are six sides and only one side has six
6
numbers on it.
 Objective probability can be determined by
inductive reasoning. For example, the
probability that a person age 21 will die before
age 26 cannot be logically deduced. However, by
a careful analysis of past mortality experience,
life insurance can estimate the probability of
death and sell a life insurance policy issued at age
21.

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 Subjective Probability
 Subjective probability is the individual’s
personal estimate of the chance loss. For example,
people who buy a lottery ticket on their birthday
may believe it is their luck day and overstate the
small chance of winning.
 A wide variety of factors can influence subjective
probability, including a person’s age, intelligence
and education.

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 Risk, Peril and Hazard

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 Peril
 Peril is defined as the cause of loss. It is a
contingency that may cause a loss. For example,
fire, windstorm, hail, theft etc. Each of these is
the cause of the loss that occurs. If someone’s
house burns because of a fire, the peril, cause of
loss, is the fire. Similarly, if your car is damaged
in a collision with another car, collision is the
peril or cause of loss.

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 Hazard
 A Hazard is a condition that may create or
increase the chance of a loss arising from a given
peril. It is a condition that introduces or increases
the probability of loss from a peril.
 For example, one of the perils that cause loss to
an auto is collision. A condition that makes the
occurrence of collisions more likely is icy street.
The icy street is the hazard and the collision is the
peril. Storing gasoline in a kitchen is another
example of a hazard.
 The storage of the gasoline generally will not
cause a loss. The gasoline, however, will make
fire losses occur more sever. 11
 Poor lighting in a crime-prone area is a hazard, in
that theft losses may be more frequent than would
be the case if better lighting were available.
 The poor lighting by itself would not cause the
loss, but to the extent that it makes theft more
frequent is a hazard.

 It is possible for something to be both a peril and

a hazard.
 For instant, sickness is a peril causing economic
loss, but it is also a hazard that increases the
chance of loss from the peril of premature death.

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 How many types of
hazards are there?

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There are three basic types of hazards:
 Physical hazard
 Moral hazard
 Morale hazard

Physical Hazard
 A physical hazard is a condition stemming from
the physical characteristics of an object that
increases the probability and severity of loss from
given perils. Physical hazards consist of those
physical properties that increase the chance of loss
from the various perils.
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 Physical hazards include such phenomenon as the
existence of dry forests (hazard for fire), earth
faults (hazard for earthquakes) and icebergs
(hazard to ocean shipping).
 Other examples of physical hazards are icy road
that increase the chance of an auto accident,
defective wiring in a building that increases the
chance of fire and a defective lock on a door that
increases the chance of theft.
 Such hazards may or may not be within human
control.

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 Moral Hazard
 Moral hazard is dishonesty or character defects
in an individual the increase the frequency or
severity of loss. Moral hazard refers to the
increase in the probability of loss that result from
dishonest tendencies in the character of the
character of the insured person. A dishonest
person, in the hope of collecting from the
insurance company, may intentionally cause a
loss or may exaggerate the amount of a loss in an
attempt to collect more than the amount to which
he /she is entitled.

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 Examples of moral hazard are causing an accident
to collect the insurance, submitting a fraudulent
claim, inflating the amount of a claim and
intentionally burning unsold merchandise that is
insured.
 Moral hazards may exist in situations where
excessive amount of fire insurance are requested
on “white elephant” properties (properties that are
no longer profitable); where an incentive might
exist to “sell the building to fire insurance
company”. Moral hazard is present in all forms of
insurance and it is difficult to control. Dishonest
individuals often rationalize their actions on the
ground that “the insurer has plenty of money”.
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 Morale Hazard
 Morale hazard is carelessness or indifference to a
loss because of the existence of insurance. Some
insured are careless or indifferent to a loss because
they have insurance. When people have purchased
insurance, they may have a more careless attitude
toward preventing losses.
 Examples of morale hazard include leaving car
keys in the ignition of an unlocked car and thus
increasing the chance of theft,
 leaving a door unlocked that allows a burglar to
enter and changing way suddenly on a congested
road without signaling.
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 Morale hazard is also reflected in the attitude of
persons who are not insured. The tendency of
physicians to provide more expensive levels of
care when costs are covered by insurance is a part
of the morale hazard.
 Similarly, the inclination of courts to make larger
awards when the loss is covered by insurance- the
so-called “deep pocket” syndrome- is another
example of morale hazard.

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 Classifications of Risk

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Risks may be classified into many ways; however,
there are certain distinctions that are particularly
important for our purposes. The major categories
of risk are:
 Financial and non-financial risks
 Static and dynamic risks
 Fundamental and particular risks
 Objective and subjective risks
 Pure and speculative risks

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 Financial and non-financial risks
 In general, the term risk includes all situations in
which there is an exposure to adversity. In some
cases, this adversity involves financial loss,
while in others it does not. There is some
elementof risk in every aspect of human
endeavor and many of these risks have no (or
only incidental) financial consequences.
 Static and dynamic risks
 Dynamic risks are those resulting from changes
in the economy. Changes in the price level,
consumer tastes, income and output and
technology may cause financial loss to members
of the economy.
 Static risks involve those losses that would occur
ever if there were no changes in the economy.
These losses arise from causes other than the
changes in the economy, such as the perils of
natural and dishonesty of other individuals.
 Unlike dynamic risks, static risks are not a source
of gain to society.
Fundamental and particular risks
 The distinction between fundamental and particular
risks is based on the difference in the origin and
consequences of the losses.
 A Fundamental risk is a risk that affects the entire
economy or large numbers of persons or groups
within the economy. Fundamental risks involve losses
that are impersonal in origin and consequence. They
are group risks, caused for the most part by economic,
social and political phenomenon, although they may
also result from physical occurrences.
 They affect large segments or even all of the
population. Examples of fundamental risks include
high inflation, war, drought, earthquakes, floods and
other natural disasters.
 A particular risk is a risk that affects only
individuals and not the entire community.
Particular risks involve losses that arise out of
individual events and are felt by individuals
rather than by the entire group.
 Examples of particular risks are the burning of a
house, the damage of a car, theft of individual
property etc.
 Pure and Speculative
risks

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 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). A pure risk exists when there is
a chance of loss but no chance of gain.
 For example, the owner of an automobile faces
the risk associated with a potential collision loss.
If a collision occurs, the owner will suffer a
financial loss.
 If there is no collision, the owner does not gain.
The owner’s position remains unchanged. Other
examples of pure risks include premature death,
job-related accidents and damage to property
from fire, lighting, flood, earthquake etc.
 Speculative risk is defined as a situation in which
either profit or loss is possible. A speculative risk
exists when there is a chance of gain as well as a
chance of loss. For example, investment in a
capital project might be profitable or it might
prove to be failure.
 Other example of speculative risks are betting a
football match, going into business etc. in these
situations, both profit and loss are possible.
 Pure risks are always distasteful, but speculative
risks possess some attractive features.
 Classifications of Pure Risk
 Even though it would be impossible to list all the
risks facing an individual or business, the nature
of various pure risks an individual or business
faces are outlined briefly below and most of them
are static risks.
The major types of pure risk that can create great
financial insecurity include:
 Personal risks
 Property risks
 Liability risks and
 Risks arising from failure of others
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1. Personal Risks
 Personal risks are risks that consist of the
possibility of loss of income or assets as a result of
the loss of the ability to earn income.
 Personal risks are risks that directly affect an
individual; they involve the possibility of the
complete loss or reduction of earned income, extra
expenses and the depletion of financial asset.
There are four major personal risks:
 Risk of premature death
 Risk of insufficient income during retirement
 Risk of poor health and
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Risk of unemployment 30
A. Risk of premature death
 Premature death is the death of a family head
(breadwinner) with outstanding unfulfilled
financial obligations, such as dependents to
support, children to educate and other debt.
Premature death can cause serious financial
problems to the surviving family members,
unless they have other source of fund, since their
share of the deceased/dead/ breadwinner’s
earning is lost forever.
 Premature death can cause financial problems
only if the deceased has dependents to support or
dies with unsatisfied financial obligations. Thus,
the death of a child age 10 is not “premature”
in the economic sense.
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 There are at least four costs that resulting from
the premature death of a family head. These are:
 The human life value of the family head is lost
forever. The human live value is the present value
of the family’s share of the deceased breadwinner’s
future earnings.
 Addition expanses may be incurred because of
funeral expenses, uninsured medical bills and others.
 Because of insufficient income, some families will
experience a reduction in their standard of living.
 Certain non-economic costs are also incurred
including emotional grief, loss of a role model and
counseling and guidance for the children.

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 Financial impact of premature death in
different types of families
 Single people
 Premature death of single people with no
dependents to support or other financial
obligations is not likely to create a financial
problem for other.
 Single-parent families
 Premature death of the single parent can cause
great economic insecurity for the surviving
children. The need for large amount of insurance
on the family head is great.

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 Two income-earners with children
 In two-income families with children, the death
of one income earner can cause considerable
economic insecurity for the surviving family
members, because both incomes are necessary to
maintain the family’s standard of living.
However, in two income families without
children, premature death of one income earner
is not likely cause economic insecurity for the
surviving spouse.

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 Traditional families
 Traditional families are families in which only
one parent is income earner and other parent
stays at home to take care of dependent children.
Premature death of income earner can cause
great economic insecurity for the surviving
family members.
 Sandwiched families
 A sandwiched family is one in which a son or
daughter with children provides financial support
or other service to one or both parents. Thus, the
son or the daughter is “sandwiched” between the
younger and older generation.
 Premature death of income earner can cause
great economic insecurity for the surviving
family members. A working spouse in a
sandwiched family needs a substantial amount of
life insurance

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B. Risk of insufficient income during retirement
 The major risk associated with old age is
insufficient income during retirement. Unless
retired workers have sufficient financial assets on
which to draw or have access to other sources of
retirement income, they will be exposed to
financial insecurity during retirement.

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 C. Risk of poor health
 The risk of poor health includes both the payment
of medical expenses and the loss of earned
income. Unless a person has adequate health
insurance, private savings and financial assets or
other sources of income to meet medical
expenditures, he or she will be financially
insecure.
 D. Risk of unemployment
 The risk of unemployment is another major threat
to financial security. Unemployment can cause
financial insecurity in at least three ways.
 The worker losses his / she earned income. Unless
there is adequate replacement income or past
savings on which to draw, the unemployed worker
will be financially insecure.
 Because of economic conditions, the worker may
be able to work only part time. The reduced
income may be insufficient in terms of the
worker’s needs.
 If the duration of unemployment is extended over
a long period, past savings may be exhausted.
2. Property Risks
 Anyone who owns property faces property risks simply
because such possessions can be destroyed or stolen.
There are two major types of loss associated with the
destruction or theft of property:
 Direct loss and
 Indirect or consequential loss
 A direct loss is a financial loss that results from the
physical damage, destruction or theft of the property.
Direct loss is the simplest to understand: if a house is
destroyed by fire, the owner losses the value of the house.
This is direct loss.
 However, in addition to losing the value of the
building itself, the property owner no longer has a
place to live and during the time required to rebuild
the house, it is likely that the owner will incur
additional expenses living somewhere else. This loss
of use of the destroyed asset is an “indirect” or
“consequential” loss.
 Another example, when a firm’s facilities are
destroyed the firm losses not only the value of those
facilities but also the income that would have been
earned through their use. Thus, property risks can
involve two types of losses:
 The loss of the property and
 Loss of use of the property resulting in lost income or
additional expenses
3. Liability Risks
 The basic peril in the liability risk is the
unintentional injury of other persons or damage
to their property through negligence or
carelessness. However, liability may also result
from intentional injuries or damage. Legally you
can be held liable if you do something that
result in bodily injury or property damage to
someone else. 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
other.
 Risks arising from Failure of others
 When another person agrees to perform a service
for you, he/she undertakes an obligation that you
hope will be met. When the person’s failure to
meet this obligation would result in your
financial loss, risk exists. Examples of risks in
this category would include failure of a
contractor to complete a construction project as
scheduled or failure of debtors to make payments
as expected.
 Burden of Risk on Society
 Regardless of the manner in which risk is
defined, the greatest burden in connection with
risk is that some losses will actually occur, when
a house is destroyed by fire or money is stolen, or
a wage earner dies, there is a financialloss. These
losses are the primary burden of risk and the
primary reason that individuals attempt to avoid
risk or alleviate its impact.
 In addition to the losses themselves, there are
other detrimental aspects of risk. Risk entails two
major burdens on society:
 Large emergency fund and
 Worry and fear
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