RISK

MANAGEMENT
AND
INSURANCE

CHAPTER ONE
RISK AND RELATED TOPICS
Indeterminacy and loss
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WHAT IS RISK?
 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 s/he
hopes constitutes the possibility of loss or risk.
 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.
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 If only one outcome is possible, the variation and
hence the risk is 0. If many outcomes are possible, the
risk is not 0. The greater the variation, the greater the
risk.
 The degree of risk is inversely related to the ability to
predict which outcome will actually occur. If the risk
is 0, the future is perfectly predictable.
 If the risk in a given situation can be reduced, the
future becomes more predictable and more
manageable.
 In a two-outcome situation for which the probability of
one outcome is 1 and the probability of the second
outcome is 0, the risk is 0 because the actual outcome
is known.

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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. Uncertainty is a
person’s conscious awareness of the risk in a given
situation.
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Itdepends upon the person’s estimated risk- what
that person believes to be the state of the world-
and the confidence he/she has in this belief.
Unlike probability and risk, uncertainty cannot be
measured by commonly accepted yardstick/unit/.

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 Risk vs. Probability
Itis necessary to distinguish carefully between risk
and 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.
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 Types of Probability
Probability has both objective and subjective
aspects.
Objective 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 chance in the underlying conditions.
Objective probabilities can be determined in two
ways.

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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
numbers on it.

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Cont’d…
 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.
 For example, assume that there are 1,000,000
persons age 25 and it is predicted from past
experience that 3,000 of them will die in a given
time period. The probability of loss is thus 0.003.

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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
Itis common for the
terms peril and hazard to
be used interchangeably
with each other and with
“risk”. However, to be
precise, it is important to
distinguish these terms.
Peril : is defined as the
cause of loss. It is a
contingency that may
cause a loss.

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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. 05/07/2024 12
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. 05/07/2024 13
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.
There are three basic types of hazards:
Physical hazard
Moral hazard
Morale hazard

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 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.
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
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 Suchhazards may or may not be within human control.
For example, some hazards for fire can be controlled
by placing restrictions on building campfires in forests
during the dry season. Some hazards, however, cannot
be controlled- little can be done to prevent.

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05/07/2024 17
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”.
 This view is incorrect because the insurer can pay claims
only by collecting premium from other insured. Because of
moral hazard, premiums are higher than for everyone.
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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.
 Careless acts like these increases the chance of loss.
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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
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 element of risk in every aspect of
human endeavor and many of these risks have no
(or only incidental) financial consequences.

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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.
These dynamic risks normally benefit society over
the long run, since they are the result of
adjustments to misallocation of resources.
Although these dynamic risks may affect a large
number of individuals, they are generally
considered less predictable than static risks, since
they do not occur with any precise degree of
regularity.
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 Static risks involve those losses that would occur
even if there were no changes in the economy. With
constant (no change in) consumer tastes, output and
income and the level of technology, some individuals
would still suffer financial loss.
 Unlike dynamic risks, static risks are not a source of
gain to society. Examples of static risks include risks
due to random events such as fire, windstorm or
death. Because they are predictable, static risks are
more suited to treatment by insurance than are
dynamic risks.

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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.
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05/07/2024 27
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.
They may be static or dynamic. Examples of
particular risks are the burning of a house, the
damage of a car, theft of individual property etc.

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 Objective and subjective risks
Objective risk or statistical risk, applicable mainly
to groups of objects exposed to loss, refers to the
variation that occurs when actual losses differ from
expected losses.
Example, assume that a property insurer has 10,000
houses insured over a long period and on average
100 houses burn each year. However, it would be
rare for exactly 100 houses to burn each year. In
some year, as few as 90 houses may burn, while in
other years, as many as 110 houses may burn.
Thus, there is a variation of 10 houses from the
expected loss is known as objective risk.
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 Objective and subjective risks
Objective Risk = Probable Variation of Actual Loss

Probable Losses

 Example 1:
 Consider the possibility of fire losses to buildings in towns A and B.
There are 100,000 buildings in each town and, on average each town has
100 fire losses per year. By looking at historical data from the towns,
statisticians are able to estimate that in town A, the actual number of fire
losses during the next year will very likely range from 95 to 105. In
town B, however, the range probably will be greater, with at least 80 fire
losses expected and possibly as many as 120.
 Objective Risk town A = (105 – 95)/100 =
10%
 Objective Risk town B = (120 – 80)/100 =
40%
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 Objective and subjective risks
The Law of Large Numbers
States that as the number of exposure units
increases, the more certain it becomes that
actual loss experience will equal probable
loss experience. Hence, the risk diminishes
as the number of exposure units increases.

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 Objective and subjective risks
 Example 2:
 Suppose that Company A and Company B own 100 and 900 automobiles,
respectively. These cars are used by the sales personnel of each firm and are
driven in the same geographical territory. The chance of loss in a given year due
to accident is 20%.
 The expected number of losses is:
 For Company A = 0.20 * 100 =
20
 For Company B = 0.20 * 900 =
180
 Suppose further those statisticians have computed that the likely range in the
number of losses in one year is 8 for Company A and 24 for Company B. thus,
the objective risk is:
 Objective Risk Company A = 8/20 = 40%
 Objective Risk Company B = 24/180 = 13.3%
 Objective risk varies inversely with the square root of the number of
exposed units.
 Effects of Probability on Objective Risk
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 Objective and subjective risks
 Example 3:
 Assume that employers A and B, each with 10,000 employees, are
concerned about occupational injuries to workers. Employer A is in a
“safe” industry with the chance of loss of a disabling injury in its plate
being equal to 0.01. Employer B is in a more dangerous industry, with
the chance of loss equal to 0.25. It has been determined that the probable
variation in injuries in employer A’s plant will be no more than 20,
whereas in employer B’s plant that the probable variation will not
exceed 87. Thus, the objective risk is:
 Objective Risk Employer A = 20/(0.01 * 10,000) = 20%
 Objective Risk Employer B = 87/(0.25 * 10,000) = 3.5%
 Objective risk varies inversely with the probability for any
constant number of exposure units. However, in general, the
rate of decrease in objective risk is less than proportionate
to the rate of increase in probability of loss.

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Objective Risk = Probable Variation of
Actual Loss
 Probable Losses

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Subjective risk is defined as uncertainty based
on a person’s mental condition or state mind. A
subjective risk is a psychological uncertainty that
stems from the individual’s mental attitude or
state of mind.
Subjective risk may affect a decision when the
decision-maker is interpreting objective risk.
One manager may determine that some given
level of risk is “high” while another may interpret
this same level as “low”. These different
interpretations depend on the subjective attitudes
of the decision makers toward risk
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 Pure and Speculative risks
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,
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flood, earthquake 36
05/07/2024 37
 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.

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Pure risks are always distasteful, but speculative
risks possess some attractive features.
The distinction between pure and speculative risks
is an important one, because normally only pure
risks are insurable. Insurance is not concerned
with the protection of individuals against those
losses arising out of speculative risks. Speculative
risk is voluntarily accepted because of its two-
dimensional nature, which includes the possibility
of gain.

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 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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 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
 Risk of unemployment
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 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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Cont’d
 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 05/07/2024 46
 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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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.
The loss of earned income is another major cause of
financial insecurity if the disability is severe. In cases of
long-term disability, there is a substantial loss of earned
income, medical bills are incurred, and employee benefits
may be lost or reduced, savings are often depleted and
someone must take care of the disabled person. The loss
of earned income during an extended disability can be
financially very painful. 05/07/2024 48
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.

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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.
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Contd
An indirect loss is a financial loss that results
indirectly from the occurrence of a direct physical
damage or theft 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
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 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.
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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.

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Risks Related to Business Activities

 Business Risk –
 - is the risk associated with the physical operation
of the firm.
 e.g. variations in the level of sales, costs, profits,
etc
 -is independent of the company’s financial
structure.
 Financial Risk
 Is associated with debt financing.
 Examples may include: risk of default,
bankruptcy, stock price decline, insolvency.
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Risks Related to Business Activities
 Interest Rate Risk
 is a risk resulting from changes in interest rates.
 changes in interest rates affect the prices of financial
securities such as the prices of bonds etc. for interest
rate rise depresses bond prices and vice, versa.
 Purchasing Power Risk
 Arises under inflationary situations (general price
rise of goods and services) leading to a decline in
the purchasing power of the asset held.
 Financial assets lose purchasing power if increased
inflationary tendencies prevail in the economy.
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Risks Related to Business Activities
 Market Risk
 Market risk is related to stock market.
 Unexpected changes in market-determined asset prices, indices,
reference rates, etc.
 Refers to stock price variability caused by market forces. It is the
result of investors’ reactions to real or psychological expectations.
 The market, in many cases, is also affected by such events as:
presidential elections, trade balances, balance of payment figures,
wars, new inventions, etc...
 Market risk is also called systematic or non-diversifiable risk.
 All investors are subject to this risk.
 It is the result of the workings of the economy; and cannot be
eliminated through portfolio diversification.
 Investors are paid for this risk.
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Risks Related to International Business

IB is an organization that buys and/or sells

goods and services across two or more
countries, even if management is located in
a single country.
IB operates in a highly uncertain turbulent
environment.
IB operates in a multi-currency
environment.

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Risks Related to International Business

 Transaction Exposure
 Refers to the potential gains/losses in cash flows resulting from
business transactions denominated in a foreign currency.
 Translation Exposure
 Is related to a balance sheet, it is sometimes called Balance Sheet
Exposure.
 The accounting convention requires that the assets and liabilities
of foreign affiliates should be translated into home currency at the
time of preparation of the consolidated financial statements using
the current exchange rate prevailing on the balance sheet date.
 Economic Exposure
 Tend to affect a business’s future cash flow.
 Concerned with the impact of exchange rates on the NPV of the
global company’s future cash flows.
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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 financial loss. 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 05/07/2024 59
End of Chapter
One
Thank you for your attention.

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