CHAPTER ONE: Meaning of Risk

• Although the insurance theorists have not agreed on a universal definition, there are
common elements in the definitions: indeterminacy and loss.
The notion of an indeterminate outcome is implicit in all definition of risk. The outcome
must be in question.
• When risk is said to exist, there must be at least two possible outcomes.
• If we know for certain that a loss will occur, there is no risk.
• Investment in a capital asset, for example, usually involves a realization that the asset is
subject to physical depreciation and that its value will decline.
• Here the outcome is certain and so there is no risk.
At least one of the possible outcomes is undesirable.
• This may be a loss in the generally accepted sense, or it may be a gain smaller than the
gain that was possible.
• Risk implies future uncertainty about deviation from expected earnings or expected
outcome.
 Cont…
• 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, known expense.
• It is when there is uncertainty about the occurrence of a loss that risk becomes a
problem.
 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.
• It depends 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.
• A person may be extremely uncertain about the future in a situation
where in reality the risk is small; on the other hand, this person may have
a great confidence in his or her ability to predict the future when in fact
the future is highly uncertain.
 Risk and Probability
• Probability refers to the long-run chance of occurrence or relative frequency of some
event.
• Probability has both objective and subjective aspects.
a. 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.
• It is based on empirical evidence uising statistics experiment and mathematical
measurements
• 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.
• 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.
b. 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.
• Subjective probability refers to the probability of something happening based on
an individual’s own experience or personal judgment.
• A subjective probability is not based on market data or historical information and
differs from person to person.
• In other words, it is created from the opinion of an individual and is not based on
fact.
Risk, Peril and Hazard
• It is 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.
a. Peril 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 or 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.
b. 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.
Cont…
• The icy street is the hazard and the collision is the peril.
• Storing gasoline in a kitchen is another example of a hazard.
• Poor lighting in a crime-prone area is a hazard,
• It is possible for something to be both a peril and 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.
Types of hazards
1 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 dry forests (hazard for fire), earth faults (hazard for
earthquakes) and icebergs (hazard to ocean shipping), icy road, defective wiring
and a defective lock on a door that increases the chance of theft.
 Cont…
2. Moral hazard is dishonesty or character defects in an individual that
increase the frequency or severity of loss.
• 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.
• 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”.
3. Morale hazard
• Morale hazard is carelessness or indifference to a loss because of the
existence of insurance.
• When people have purchased insurance, they may have a more careless
attitude toward preventing losses.
• Examples of morale hazard include leaving car keys, leaving a door
unlocked
• Insurers try to eliminate the moral hazard and minimize the morale hazard
by carefully selecting their insured and by including contractual provisions
causing the insured to regret the loss despite the insurance coverage.
• For example, some contracts require insured to pay the first certain
amount of a loss and others require insured to pay a percentage of each
loss.
• In both cases, the insured have reason to regret the losses while still
receiving insurance compensation.
 Classifications of Risk

1. 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.
• A non-financial loss does not have a direct monetary value
• Eg. distress or inconvenience caused by a firm's maladministration or error.
2. 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.
• With constant (no change in economy)consumer tastes, output and income and the
level of technology, some individuals would still suffer financial loss.
• These losses arise from causes other than the changes in the economy, such as the
perils of natural and dishonesty of other individuals.
3. Fundamental and particular risks

• The distinction between fundamental and particular risks is based on the

difference in the origin and consequences of the losses.
• Fundamental risks involve losses that are impersonal in origin and
consequence.
• 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.
• Since fundamental risks are more or less beyond the control of the individuals
who suffer the losses, and they are not the fault of anyone in particular,
4. 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, 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.
• Gambling and investing in the stock market are two examples of speculative risks. Each
offers a chance to make money, lose money or walk away even.
Cont….
• Other example of speculative risks are betting a football match, going into
business etc. in these situations, both profit and loss are possible.
• 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.
Classifications of Pure Risk
The major types of pure risk that can create great financial insecurity include:
1. Personal risks
2. Property risks
3. Liability risks and
4. Risks arising from failure of others
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
Risk of unemployment
A. Risk of premature death
• Premature death is the death of a family head (breadwinner) with outstanding
unfulfilled financial obligations,
• Premature death can cause serious financial problems to the surviving family
members, unless they have other source of fund
Cont…
• 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.
• 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.
• 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.
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.
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.
Cont…
• 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.
• 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
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.
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.
• 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.
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.
Cont…
• 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.
 Cont…

• An indirect loss is a financial loss that results indirectly from the occurrence of a direct
physical damage or theft loss.
• 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.
4. Risks arising from Failure of others
• he risks arising from the failure of others refer to the potential negative consequences
that an individual, company, or organization faces when a third party (such as a supplier,
business partner, or contractor) fails to meet their obligations or performs poorly.
• 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.
• Example: Supply Chain Disruption
• Scenario: A company that manufactures smartphones relies on a supplier in another
country to provide key components, such as microchips.
• If that supplier experiences a production issue, such as a factory shutdown due to a
natural disaster, labor strike, or financial insolvency, the smartphone manufacturer could
face significant delays in production.
 Cont…
Risks:
• Operational Delays: The failure of the supplier to deliver the components on time can
delay the entire production process, resulting in missed deadlines, slower time-to-
market for new products, or inability to meet customer demand.
• Financial Losses: If the company cannot meet its sales targets or fulfill orders, it might
experience reduced revenues, lost profits, or even penalties for breach of contract.
• Reputational Damage: Consumers or business partners may lose confidence in the
company’s ability to deliver on time, harming the brand’s reputation and potentially
leading to long-term customer attrition.
• Legal Risks: If the supply chain disruption causes the company to breach contractual
obligations with clients or other stakeholders, it could lead to lawsuits or claims for
damages.
• Increased Costs: The company might need to find alternative suppliers quickly, which
can result in higher prices for components or expedited shipping fees, increasing
operational costs.
Burden of Risk on Society

• 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
a. Large emergency fund
• In the absence of insurance, individuals and business firms would have
to increase the size of their emergency fund in order to pay for
unexpected losses.
• Funds will presumably be less than if they were put to alternative uses.
Cont…

b. Worry and fear

• The uncertainty connected with risk usually produces a feeling of frustration and
mental unrest.
• In case of pure risk, where there is no compensating chance of gain, risk is
distasteful.
• Some examples can illustrate the mental unrest and fear caused by risk. Parents
may be fearful if a teenage son or daughter departs on a hiking trip.
• Some passengers in bus may become extremely nervous and fearful if the bus
encounters severe turbulence during the drive.
• A college student who needs a grade C in a course in order to graduate may enter
the final examination room with a feeling of anxiety and fear.