Chapter one part 1 Sheet one

Risk and Risk management

Risk Definition

➢ The concepts of risks have been discussed in different fields by many authors, the risk has many
definitions depending on the field and context (political- economics – statistics – health) all these
definitions have certain keywords in common: uncertainty and loss.
➢ uncertainty of outcome: all definitions of risk agreed on the indeterminacy of outcomes if risk exists
in certain situations there must be two or more possible outcomes and the unfavorable outcome
should not be neither a certain event (with probability of one nor zero) because that is no risk in
situations in which one is certain that the loss will occur or certain that the loss will never occur.

➢ risk is uncertainty and undesirable outcomes defined the risk as uncertaintyconcerning

the occurrences of a loss by this definition the risk has two characteristics:
o Uncertainty which is an event may or may not
happen
o Loss that is an event has unwanted
consequences.

➢ from individuals’ perspective Defined the risk as possibility of an adverse deviation from adesired
outcome that is hoped for

➢ from insurers perspective is possible deviation from what is expected since the amount of loss is
needed to be predicted (finding the expected loss) in order to determine the proper premium

➢ Another definition of risk is uncertainty concerning the occurrence of loss and this definition
distinguishes between objective risk and subjective risk.

subjective risk:
• is the uncertainty based on a person’s mental condition or state of mind and the degree of subjective
risk varies from one person to another if they are facing same situation each one would behave to the
same risk differently
• Individuals with high subjective risk usually behaves conservatively and wisely while those with low
subjective risk usually behaves less conservatively.
for example
suppose that a driver discovered the brake of his car has certain minor malfunction he is a aware that there is a
risk of making an accident if her drives his car back home in this situation one driver may perceive that risk as
a high risk (subjectively) and he may decide to go back home by taxi ( conservative behavior) whereas
another driver may perceive that risk as a low risk (subjectively) and he may decide to return home by his
care at a low speed (less conservative behavior)

‫خطرا لوقوع حادث إذا كانت تقود سيارته إلى‬

ً ‫ فهو يدرك أن هناك‬، ‫لنفترض أن السائق اكتشف أن فرامل سيارته بها عطل طفيف معين‬
‫ قد يرى أحد السائقين أن هذا الخطر يمثل مخاطرة عالية (بشكل شخصي) وقد يقرر العودة إلى المنزل بسيارة‬، ‫المنزل في هذه الحالة‬
‫أجرة (سلوك محافظ) بينما قد يرى سائق آخر أن هذا الخطر منخفض المخاطر (بشكل شخصي) وقد يقرر العودة إلى المنزل برعايته‬
ً ‫بسرعة منخفضة (سلوك أقل تحف‬
)‫ظا‬

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 Objective Risk:
Objective risk is defined as the relative variation of actual loss from expected loss.

For example
Suppose that an insurer has 100,000 houses insured against fire and 1% of houses (1000) are expected to burn
annually this expected value doesn’t mean that exactly 1000 houses would be burn each year it could be few
as 900 houses or as many as 1100 houses that may burn so we have variation of 100 from the expected
100
number of 1000 houses 1000 × 100 = 10% (relative risk & objective risk)

the difference between risk and uncertainty?

Risk is used in situations where the probabilities outcomes could be estimated but uncertainty is used in
situations where these probabilities could not be estimated.

What are the difference between risk, peril, hazard?

Risk is the chance of loss.

Peril is the cause of loss for example if an insured apartment against fire is burned, in this situation, the peril
is fire (cause of damage)
Hazard is the condition which increases the severity and probability of loss, and it can be.
1- physical hazard for example existence of defective wire or the existence of furniture being made of
wood in that apartment theses physical conditions increase the probability and severity of catching
fire.
2- moral hazard (dishonesty) for example insured who fakes or arranges for a fire accident for the
purpose of collecting insurance.
3- morale/ attitudinal (carelessness) an insured who carelessly smokes cigarettes or mother don’t care
about her children.

Classification of risk

1- Speculative risk
Is defined as the possibility of profit or loss and this type of risk is not insured
Examples:
1- if you purchase some shares of common stock you would lose if the price decreases
but would gain if the price increases
2- betting in a horse
race
3- investing in a real
estate
4- wagering

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2- pure risk
is defined as the only possibility loss or no losss

so the only possibilities are unfavorable or neutral

outcomes

some of pure risks can be insured.

examples:

death, accidents, damage to property from fire, flood ,or earthquake

pure risk are also classified into three categories as the following:

1- personal loss exposures

Are risks that effect an individual these risks involve the possibility of reduction of earned income
the complete loss and the extra expenses also risk of unemployment, risk of poor health, risk of
death, and risk of low-income during retirement.

2- property loss exposures

Are risks of having property damaged or lost from the different types of causes.

for example, personal property or real estate can be destroyed because of tornadoes, fire,
windstorms, and lightning.
There are direct loss and indirect loss of this risk.

Direct loss: is defined as a financial loss that results from physical damage or theft of the property.
such as restaurants may be damaged by a fire.
Indirect loss: is defined as a financial loss that results indirectly from the occurrenceof a direct theft
or physical damage loss such as the loss of profits for some months while the restaurant is being
rebuilt after a fire.

3- liability loss exposures

if you do something which results in property damage or in bodily injury to someoneelse you can be held
legally liable under our legal system
for example

the responsibility of the owner of the car for injuries and losses suffered by others ina car crash.
business firm may be held legally liable for defective products that harm or injury customers.

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(Classification of risk based on origin of consequences of the risk occurrence)
According to the nature the risks can be divided into two major types the fundamental risks.

and the risks

a) fundamental risks (non-diversifiable)

The fundamental risk affects the entire economy or large groups within the economy and non-insurable
Examples
Rapid inflation, pollution, earthquake, war, cyclical unemployment
The risk of a natural disaster can result in billions dollars of property damage and deaths

b) particular risks (diversifiable)

The particular risk affects only individuals and not the entire community most of particular risks are
insurable.
Examples:
1- Bank robberies 2- factories fires 3- car thefts.

Risk management
risk management as the scientific approach for dealing with risks.
the objective of risk management

1- Before loss occurrence

2- After loss occurrence

Before loss occurrence

designing procedures that minimize the potential losses by reducing the frequency or the severity.

After loss occurrence

How to finance different losses by least possible cost or reduce or eliminate the financial

burden of the loss

The basic steps in risk management are:

1- Identify all possible risks (major or minor)

2- Quantify (measure) the degree of risk and evaluate the frequency and severity of
losses.
3- Select suitable techniques to reduce the risk.
4- Implement the selected technique.
5- Monitor the result of risk management decisions (all performance of theprocess

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 Quantify (measure) the degree of risk (step 2) in details
➢ The process of quantifying risk is based on the frequency/ probability distribution in which the risk
manager estimates all possible losses and their corresponding frequency or probability (relative
frequency)
➢ Construct the probability distribution of certain losses which is estimated from frequency distribution
Probability = frequency / N ( total number)
➢ In order to say this is probability distribution the sum of all probabilities should equal to 1 Probability
between 0 and 1

probabilities of loss is presentation of two factors

1- Frequency of losses (how many times certain losses happen during specific period)
2- Severity of loss (value of loss) or magnitude value of loss

For example, probability distribution of losses for one year

Loss ( x ) Zero 500 1000 2000 5000 10000 Total
Severity of
loss
Probability of 0.4 0.20 0.19 0.12 0.06 0.03 1
loss (px)

priority risk according to loss severity and loss frequency

according to severity of loss
1- Unbearable loss (critical loss) the losses which can’t bear the burden of it (very critical loss such as
bankrupt) (higher severity loss)
2- Difficult to bear risks (important loss) (you need to borrow to cover (finance) the loss the existence
income of company is not sufficient to cover the loss you need to borrow or for example make the
insurance policy to transfer the risk
3- Unimportant loss risks you can bear this loss (no bankrupt and no borrowing) you can cover this loss
from the profit of the company or the existing assets and income.

based on loss frequency

1- Almost zero (not going to happen in the future) unlikely to occur.
2- Slight frequency possible loss (rare loss) probability to happen in the future once and doesn’t repeat
again.
3- Moderate Possible loss sometimes happened in the past and possible to happen in the future.
4- Definite loss happing in the past and possible to happen in the future and keep occurring for example
car accident.

Based on probability distribution losses the risk manager can obtain useful measurement about
the risk
1- Some useful probabilities such as probabilities of certain value of losses or no loss

For example the probability of loss severity 2000 is 0.12 which mean we would expect that
12% of all events would yield $2000 loss

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 2- Expected loss (mean) (average loss)

the expected loss indicates the average amount of loss that should be anticipated during the specified time
interval, and it is a major factor when insurer determine the proper pricing of an insurance policy

3- The variability of losses from expected loss the increase or decrease from expected loss
(standard deviation)
‫انحراف عن متوسط الخسائر بالزياده او النقصان‬
‫التفاوت في متوسط الخسائر‬
We have to find the variance to get standard deviation

4- Coefficient of variation (objective risk) (relative risk)

Relative variation of actual loss from expected loss the higher the relative variability (c.v) the higher the risk

Notes
- If you want to compare risk between two groups, we use CV to know which group have higher risk
also.

- we can use standard deviation to compare between two groups but if means of two groups are equal
so be careful, we use standard deviation in comparison between two groups only if means of two
groups are Equal.

- If the two means not equal between two groups, we can’t use standard deviation in comparison.

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 - Example

1- How likely it is to incur a critical / unbearable loss?

2- How likely it is that loss will be difficult to bear?
3- find the probability of incurring no loss.
4- find the probability of incurring loss.
5- find the expected value of loss.
6- measure the risk and relative risk.
7- assume that expected loss due to robbery is 45,000 with standarddeviation of 62.000 which
peril is risker (fire or robbery)?
Answer
i Xi amount Px
of loss
severity of
loss
1 o 0.22 Unimportant loss
2 5 0.240 Unimportant loss
3 10 0.210 Unimportant loss
4 50 0.180 Important loss (difficult to
bear)
5 100 0.118 Important loss (difficult to
bear)
6 200 0.022 Important loss (difficult to
bear)
7 400 0.007 Unbearable loss (critical
loss)
8 500 0.002 Unbearable loss(critical
loss)
9 700 0.001 unbearable loss(critical
loss)
Make sure total = 1

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1- How likely it is to incur a critical / unbearable loss ?

Probabilities of critical loss (unbearable loss) = 0.007 + 0.002 + 0.001 = 0.01

2- How likely it is that loss will be difficult to bear ?

Probabilities of loss difficult to bear (important loss)

0.180 + 0.118 + 0.022 = 0.32

3- find the probability of incurring no loss

0.22
4- find the probability of incurring loss
1 – 0.22 = 0.78
5- find the expected value of loss

i Xi amount of loss Px X * Px
severity ofloss

1 o 0.22 Zero
2 5 0.240 1.2
3 10 0.210 2.1
4 50 0.180 9
5 100 0.118 11.8
6 200 0.022 4.4
7 400 0.007 2.8
8 500 0.002 1
9 700 0.001 0.7
Make sure Sum total
total = 1 33

µ = ∑ x. p(x) = 33

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 6- measure the risk and relative risk

risk means standard deviation and relative risk means coefficient of variation
i Xi amountof Px X * Px X2 * px
loss severity
of
loss
1 o 0.22 Zero 0
2 5 0.240 1.2 6
3 10 0.210 2.1 21
4 50 0.180 9 450
5 100 0.118 11.8 1180
6 200 0.022 4.4 880
7 400 0.007 2.8 1120
8 500 0.002 1 500
9 700 0.001 0.7 490
Make sure Sum total 4647
total = 1 33

Standard deviation (risk ) = √𝑥 2 . 𝑝(𝑥 ) − µ2

4647 – (33) = 3358

√3358=59.6489

Relative risk C.v (objective risk)

59.6489
× 100 = 180.754242 %
33
7- assume that expected loss due to robbery is 45,000 with standard deviation of 62.000
which peril is risker (fire or robbery)?

C.V fire = 180.75 %

62.000
C.V robbery × 100 = 137.78 %
45.000

So risk of fire is more risky because of higher C.V

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 Example 2

Example 3

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MCQ Questions

Answer A

Answer b

5- the speculative risk is possibility of

a) Gain
b) Loss
c) Gain or loss
d) Loss or no loss

Answer C

6- pure risk is possibility of

a) Gain
b) Loss
c) Gain or loss
d) Loss or no loss
Answer D

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7- the chance of loss due to reduction in your income
a) Personal loss exposure
b) Property loss exposure
c) Liability loss exposure
d) All of the above
Answer A
8- the loss of your house because of tornado
a) Personal loss exposure
b) Property loss exposure
c) Liability loss exposure
d) All of the above
Answer B
9- if you do something result to property damage or bodily damage to someone else
a) Personal loss exposure
b) Property loss exposure
c) Liability loss exposure
d) All of the above
Answer C
11-Which among the following is not a pure risk?
a) Personal risk
b) Property risk
c) Loss of income risk
d) Strategic

risk
Answer D

Ans A

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Answer A

Answer C

22- Risk refer to the uncertainty and undesirable outcomes

a) True
b) False true

23- Wagering is an example of speculative risk

a) True
b) False
True

24- Fundamental risk effects on small scale on society

a) True
b) False false

Ans C

Answer D

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 29- The contract of insurance is usually applicable only to pure risks.
a) True
b) False

True

30- The contract of insurance is usually applicable only to speculative risks.

a) True
b) False

False

Answer D

Answer D

Answer B

Prepared By Dr Zayan Ahmed

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