Chapter 1

Risk and Its Treatment

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Learning Objectives
After studying this chapter, you should be able to
• Explain the historical definition of risk.
• Explain the meaning of loss exposure.
• Understand the following types of risk:
• Pure risk
• Speculative risk
• Diversifiable risk
• Enterprise risk
• Identify the major pure risks that are associated with
financial insecurity.
• Show how risk is a burden to society.
• Explain the major techniques for managing risk.
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Agenda
• Definitions of Risk
• Chance of Loss
• Peril and Hazard
• Classification of Risk
• Major Personal Risks and Commercial Risks
• Burden of Risk on Society
• Techniques for Managing Risk
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Different Definitions of Risk

• Risk: Uncertainty concerning the occurrence of a loss
• Examples: auto accident, smoking
• Different manner in insurance industry
• In economics and finance about Risk and Uncertainty

• Loss Exposure: Any situation or circumstance in which a

loss is possible, regardless of whether a loss occurs
• Objective Risk vs. Subjective Risk
• Objective risk is defined as the relative variation of actual loss from
expected loss
• Subjective risk is defined as uncertainty based on a person’s
mental condition or state of mind
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Objective Risk
• The relative variation of actual loss from expected loss.
• Example: property insurer on 10,000 houses and 1% of
loss is expected (100 houses). The variation is 10 houses.
• When the number of exposures increases, risk declines.
The insured houses are increased to 1million and 1% is
the expected loss. If the variation of actual loss from
expected loss is 100, the objective risk is now 1%
(100/10,000).
• Risk can be statistically calculated by some measure of
dispersion such as standard deviation or the coefficient of
variation. So it is extremely useful concept for an insurer
or a corporate risk manager.
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Objective Risk
• As the number of exposures increases, an insurer can
predict its future loss experience more accurately because
it can rely on the law of large numbers.
• Law of Large Numbers: the number of exposure units
increases, the more closely the actual loss experience will
approach the expected loss experience.
• Example: as the number of homes under observation
increases, the greater is the degree of accuracy in
predicting the proportion of homes that will burn.
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Subjective Risk
• Uncertainty based on person’s mental condition or state of
mind.
• The impact subjective risk varies depending on the
individual.
• Two persons in the same situation can have a different
perception of risk, and their behavior may be altered
accordingly. If an individual experiences great mental
uncertainty concerning the occurrence of a loss, that
person’s behavior may be affected.
• High subjected risk often results in conservative and prudent
behavior, while low subjective risk may result in less
conservative behavior.
• Example: Motorist to drive or to take taxi.
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Chance of Loss
• Chance of loss: The probability that an event will occur

Objective Probability vs. Subjective Probability

• 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 change in the underlying conditions.
• Deductive reasoning as a priori probabilities (head or toe for a
coin, or rolling a die)
• Inductive reasoning: the probability that a person age 21 will die
before age 26 cannot be logically deduced. However, by a careful
analysis of past mortality of experience, life insurers can estimate
the probability of death and sell a five-year term life insurance
policy issued at age 21.
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Chance of Loss
• Subjective probability is the individual’s personal estimate of
the chance of loss.
• Lottery as a lucky day
• Factors to influence: age, gender, education, intelligence and
the use of alcohol or drugs.
• There may be ambiguity in the way in which the probability is
perceived (different from the objective probability).
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Chance of Loss vs. Objective Risk

• Chance of loss is the probability that an event that causes
a loss will occur.
• Objective risk is the relative variation of actual loss from
expected loss

The chance of loss may be identical for two different

groups, but objective risk may be quite different!
City # homes Average # Range Chance Objective
fires of Fire Risk
Philadelphia 10,000 100 75 – 125 1% 25%
Los Angeles 10,000 100 90 - 110 1% 10%
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Peril and Hazard

• A peril is defined as the cause of the loss
• In an auto accident, the collision is the peril
• Common perils to property: fire, lightning, windstorm, hail, tornado,
earthquake, flood, burglary and theft.

• A hazard is a condition that increases the chance of loss

• Physical hazard
• Moral hazard
• Attitudinal hazard (morale hazard)
• Legal hazard
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Peril and Hazard

• Physical hazard is a physical condition that increases the
frequency or severity of loss
• Icy roads for the chance of an auto accident
• Defective wiring in a building for the chance of fire
• Defective lock on a door for the chance of theft

• Moral hazard is dishonesty or character defects in an

individual that increase the frequency or severity of loss
• Faking an accident to collect from an insurer, submitting a fraudulent
claim, inflating the amount of a claim, intentionally burning unsold
merchandise that is insured, murdering the insured to collect the life
insurance
• Moral hazard is present in all forms of insurance and it is difficult to
control. So, insurance premiums are higher for everyone. Careful
underwriting of applicants and various policy provisions (deductibles,
waiting periods, exclusion)
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Peril and Hazard

• Attitudinal Hazard (Morale Hazard) is carelessness or
indifference to a loss, which increases the frequency or
severity of a loss
• Leaving car keys in an unlocked car (the chance of theft)
• Leaving a door unlocked (the chance of burglary)
• Changing lanes suddenly on a congested expressway without signaling (the
chance of an accident)

• Legal Hazard refers to characteristics of the legal system

or regulatory environment that increase the frequency or
severity of loss
• Adverse jury verdicts or large damage awards in liability lawsuits
• Statutes that require insurers to include coverage for certain benefits in
health insurance plans (alcoholism)
• Regulatory action to prevents insurers from withdrawing from a state
because of poor underwriting results
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Classification of Risk
• Pure and speculative risk

• Diversifiable risk and non-diversifiable risk

• Enterprise risk
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Classification of Risk
Pure and Speculative Risk

• A pure risk is a situation in which there are only the

possibilities of loss or no loss (earthquake)
• Premature death, job-related accidents, catastrophic medical
expenses and damage to property from fire, lightning, flood or
earthquake

• A speculative risk is a situation in which either profit or

loss is possible (gambling)
• Stock (price changes), horse race, real estate, business operation
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Classification of Risk
• Three reasons to distinguish between pure and
speculative risks:
• Insurers on insuring certain pure risks, not speculative risks (but
some exceptions such as institutional portfolio investments and
municipal bonds against loss, and enterprise risk management)
• Law of large number more easily to pure risks than speculative
risks
• Benefits for the society from a speculative risk even though a loss
occurs
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Classification of Risk
Diversifiable Risk and Non-diversifiable Risk
• A diversifiable risk affects only individuals or small groups (car
theft). It is also called nonsystematic or particular risk.
• Risk can be reduced or eliminated by diversification.
• A diversified portfolio of stocks, bonds and CDs
• Different lines of insurance to be underwritten.

• A non-diversifiable risk affects the entire economy or large

numbers of persons or groups within the economy (hurricane).
It is also called systematic risk or fundamental risk.
• inflation, unemployment, war, hurricanes, floods and earthquakes

• Government assistance may be necessary to insure non-

diversifiable risks (social insurance, government insurance
programs, government guarantees or subsidies).
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Classification of Risk
• Enterprise risk encompasses all major risks faced by a
business firm, which include: pure risk, speculative risk,
strategic risk, operational risk, and financial risk
• Strategic Risk refers to uncertainty regarding the firm’s financial
goals and objectives.
• Operational risk results from the firm’s business operations.
• Financial Risk refers to the uncertainty of loss because of adverse
changes in commodity prices, interest rates, foreign exchange
rates, and the value of money.
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Classification of Risk
• Enterprise Risk Management combines into a single
unified treatment program all major risks faced by the
firm:
• Pure risk
• Speculative risk
• Strategic risk
• Operational risk
• Financial risk
• By packaging major risks into a single program, the firm
can offset one risk against another.
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Classification of Risk
• As long as all risks are not perfectly correlated, the firm
can offset one risk against another, thus reducing the
firm’s overall risk.
• Treatment of financial risks requires the use of complex
hedging techniques, financial derivatives, futures
contracts and other financial instruments.
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Major Personal Risks

• Personal risks are risks that directly affect and individual
or family. They involve the possibility of a loss or reduction
in income, extra expenses or depletion of financial assets,
due to:
• Premature death of family head
• Insufficient income during retirement
• Poor health (catastrophic medical bills and loss of earned income)
• Involuntary unemployment
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Major Personal Risks

• Property risks involve the possibility of losses associated
with the destruction or theft of property
• Direct loss vs. indirect loss
• A direct loss is a financial loss that results from the physical
damage, destruction, or theft of the property, such as fire damage
to a home
• An indirect or consequential loss is a financial loss that results
indirectly from the occurrence of a direct physical damage or theft
loss, e.g., the additional living expenses after a fire
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Major Personal Risks

• Liability risks involve the possibility of being held legally
liable for bodily injury or property damage to someone
else
• There is no maximum upper limit with respect to the amount of the
loss
• A lien can be placed on your income and financial assets
• Legal defense costs can be enormous
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Major Commercial Risks

• Firms face a variety of pure risks that can have serious
financial consequences if a loss occurs:
• Property risks, such as damage to buildings, furniture and office
equipment
• Liability risks, such as suits for defective products, pollution, and
sexual harassment
• Loss of business income, when the firm must shut down for some
time after a physical damage loss
• Other risks to firms include crime exposures, human resource
exposures, foreign loss exposures, intangible property exposures,
and government exposures
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Burden of Risk on Society

• The presence of risk results in three major burdens on
society:
• In the absence of insurance, individuals and business firms would
have to maintain large emergency funds to pay for unexpected
losses
• The risk of a liability lawsuit may discourage innovation, depriving
society of certain goods and services
• Risk causes worry and fear
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Techniques for Managing Risk

• Risk Control refers to techniques that reduce the
frequency or severity of losses:
• Avoidance
• Loss prevention refers to activities to reduce the frequency of
losses
• Loss reduction refers to activities to reduce the severity of losses
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Techniques for Managing Risk

• Risk Financing refers to techniques that provide for payment
of losses after they occur:
• Retention means that an individual or business firm retains part or all
of the losses that can result from a given risk.
• Active retention means that an individual is aware of the risk
and deliberately plans to retain all or part of it
• Passive retention means risks may be unknowingly retained
because of ignorance, indifference, or laziness
• Self Insurance is a special form of planned retention by which
part or all of a given loss exposure is retained by the firm
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Techniques for Managing Risk

• A Noninsurance transfer transfers a risk to another party.
• A transfer of risk by contract, such as through a service contract or
a hold-harmless clause in a contract
• Hedging is a technique for transferring the risk of unfavorable price
fluctuations to a speculator by purchasing and selling futures
contracts on an organized exchange
• Incorporation of a business firm transfers to the creditors the risk of
having
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Techniques for Managing Risk

• For most people, insurance is the most practical method
for handling major risks
• Risk transfer is used because a pure risk is transferred to the
insurer.
• The pooling technique is used to spread the losses of the few over
the entire group
• The risk may be reduced by application of the law of large numbers
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The End of the Chapter!