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12/16/2024
By Birhanu S.
CHAPTER ONE
RISK AND RELATED TOPICS
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Objectives

After completing this unit, students will be able to:

 Define and understand the concept of risk.

 Understand the difference between risk, uncertainty
and probability.
 Understand the word hazard and peril and its
relationship with risk.
 Identify the different types of risk.

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Introduction

 The future cannot be predicted. It is uncertain, and

no one has ever been successful in forecasting the
stock market, interest rates, or exchange rates
consistently—or credit, operational, and systemic
events with major financial implications or other
issues.
 Yet, the financial risk that arises from uncertainty
can be managed. Indeed, much of what
distinguishes modern economies from those of the
past is the new ability to identify risk, to measure it,
to appreciate its consequences, and then to take
action accordingly, such as transferring or
mitigating the risk.

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Meaning of risk

 Risk is the likelihood of losses resulting from events.

 Risk provides the basis for opportunity. The terms
risk and exposure have subtle differences in their
meaning.
 Risk refers to the probability of loss, while exposure
is the possibility of loss, although they are often
used interchangeably. Risk arises as a result of
exposure.

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Cont`d…

 It is impossible to escape all types of risk in today’s

world.
 For individuals, driving an automobile, investing in
stocks or bonds, and even jogging/pushing along a
country road are situations that involve some risk.
 For businesses, risk is a part of every decision. In
fact, the essence of business decision making is
weighing the potential risks and gains involved in
various courses of action.

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Cont`d…

 There is obviously a difference

between, say, the risk of losing money
one has invested and the risk of being
hit by a car while jogging.
 This difference leads to the
classification of risks as either
speculative or pure risks.

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1.2. RISK Vs UNCERTAINTY

 The dictionary meaning of risk is “the

possibility of meeting danger or
suffering harm or loss”.
 The dictionary meaning of uncertainty
is “the state of being uncertain”. Here,
uncertain means “feeling doubt
about”.

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Cont`d…

 Thus, uncertainty of meeting with a

loss or damage is known as risk.
Although risk is defined as uncertainty,
employees in the insurance industry
often use the term risk to identify the
property or life being insured.

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1.3 RISK & PROBABILITY

 Probability refers to the long run

chance of occurrence, or relative
frequency of some event.
 are generally assigned to events that
are expected to happen in the future.
 Chance of loss is closely related to the
concept of risk. “Chance of loss” is
defined as the probability that an
event will occur.

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Cont`d..

 Probability has both objective and

subjective aspects.
 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.

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Cont`d…

 Subjective probability is the individual’s personal

estimate of the chance of loss. It need not coincide
with objective probability.
 For example, people who buy a lottery ticket on
their birthday may believe that it is their lucky day
and over-estimate the small chance of winning.
 However, some may think that their wedding
anniversary day as a lucky day. Thus, a wide variety
of factors can influence subjective probability such
as age, sex, intelligence, education, etc.

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Cont`d…

 In subjective probability, a person’s

estimate of loss may differ from
objective probability because there
may be ambiguity in the way in which
the probability is perceived.

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1.4 Risk, peril and hazard

 Risk is uncertainty concerning the occurrence of a

loss or events which might produce a loss (an
event).
 Peril is defined as the cause of loss. If a house burns
because of fire, the peril (the cause of loss) is the
fire.
 Likewise, some common perils that cause damage
or loss to the property include lightening,
windstorm, tornadoes, earthquakes, theft and
burglary.

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Cont`d….

 Hazard- A condition which lies behind

the occurrence of a loss.

 Could increase frequency.

 Could increase severity.

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Cont`d…

 It classified as
 A physical hazard
 It is a physical condition that increases the
frequency or severity of loss.
 Moral hazard
 It is dishonesty or character defects in an individual
that increase the frequency or severity of loss. For
example, the dishonest persons may fake an
accident to collect the insurance or they
intentionally burn unsold merchandise that is
insured.

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Cont`d….

 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”. However, this view is incorrect because the
insurer can pay claims only by collecting premiums
from other insured. Because of moral hazard,
premiums are higher for everyone.

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Cont`d…

 Morale Hazard:
 Morale hazard is slightly different from the moral
hazard. Moral hazard refers to dishonesty by an
insured that increases the frequency or severity of
loss.
 Morale hazard is carelessness or indifference to a
loss because of the existence of insurance.
Examples of morale hazard include
 leaving a door unlocked that allows a burglar to enter,
 rash driving without proper signaling.
 Careless acts like these increase the chances of loss.

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Cont`d…

 Legal Hazard
 Refers to characteristics of the legal
system or regulatory environment that
increase the frequency or severity of
loss.

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Types of Risk

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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Cont`d..

 Static risks involve those losses that would occur

even if there were no changes in the economy.
 If we could hold consumer tastes, output and
income, and the level of technology constant, some
individuals would still suffer financial loss.
 These losses arise from causes other than the
changes in the economy, such as the perils of
nature and the dishonesty of other individuals.
Unlike dynamic risk, static risks are not a source of
gain to society.

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Cont`d..

 Examples of static risks include the uncertainties

due to random events such as fire, windstorm, or
death.
 Static losses involve either the destruction of the
asset or a change in its possession as a result
dishonesty or human failure.
 Static losses tend to occur with a degree of
regularity overtime and, as a result, are generally
predictable. Because they are predictable, static
risks are more suited to treatment by insurance
than are dynamic risks.

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Cont`d..

 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.

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Cont`d…

 They are group risks, caused for the most

part by economic, social and political
phenomena, 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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Cont`d…

 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 robbery of a
bank, and the damage of a car.
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Cont`d…

 Objective and Subjective

Risks
 Objective risk is defined as the
relative variation of actual from
expected loss. 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.
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Cont`d…

 For example assume that a property insurer has

10,000 houses insured over a long period and, on
average, 1 percent, or 100 houses, burn each year.
However, it would be rare for exactly 100 houses to
burn each year. In some years, as few as 90 houses
may burn, while in other years, as many as 110
house my burn. Thus, there is a variation of 10
houses from the expected number of 100, or a
variation of 10 percent. This relative variation of
actual loss from expected loss is known as objective
risk.

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Cont`d…

 Subjective risk is defined as

uncertainty based on a person’s
mental condition or state of mind. A
subjective risk is a psychological
uncertainty that stems from the
individual’s mental attitude or state of
mind. Some writers have used the
word “uncertainty” to be synonymous
with subjective risk as defined here.

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Cont`d…

 Subjective risk has been measured by

means of different psychological tests,
but no widely accepted or uniform tests
of proven reliability have been developed.
 Thus, although we recognize different
degrees of risk-taking willingness in
persons, it is difficult to measure these
attitudes scientifically and to predict risk-
taking behavior, such as insurance-
buying behavior, from test of risk-taking
attitudes.
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Cont`d…

 Speculative and Pure risk

• A speculative risk is a risk that accompanies
the possibility of earning a profit.
• Most business decisions, such as the decision to
market a new product, involve speculative risks.
• If the new product succeeds in the marketplace,
there are profits; if it fails, there are losses.
• For example, PepsiCo repeatedly gambles on the
introduction of new products to compete with
Coca-Cola and reach the intangible top spot. But
the gamble does not pay off when the product
fails.

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Cont`d…

 Pure risk is defined 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 not 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.
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Cont`d…

 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, or
earthquake.

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Types of pure risk

 A. Personal risks: - Personal risks are risks

that directly affect an individual. Examples of
personal risks are possibility of the complete loss or
reduction of earned income, extra expenses, etc.
 There are four major personal risks.
 Risk of premature death:
 Risk of insufficient income during retirement:
 Risk of poor health
 Risk of unemployment

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Risk of premature death:

 is defined as the death of a household head with

unfulfilled financial obligations. The obligations may
be dependents to support, a mortgage to be paid off
or children to educate.
 If the surviving family members receive an
insufficient amount of replacement income from
other sources, they may be financially insecure.
 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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Risk of insufficient income during
retirement

 risk associated with old age.

 The majority of workers retire before
age 65.
 When they retire, they lose their
earned income. Unless they have
sufficient financial assets, or have
access to other sources of retirement,
they will be exposed to financial
insecurity during retirement.

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Risk of poor health

 includes both the payment of medical bills and the

loss of earned income.
 The costs of major surgery have increased
substantially in recent years.
 Unless these persons have adequate health
insurance, private savings, and financial assets, or
other sources of income to meet these
expenditures, they will be financially insecure.

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Risk of unemployment

 Unemployment can result from business cycle

downswings, technological & structural changes in
the economy, etc. Unemployment can cause
financial insecurity in three ways;
 First, the worker loses his or her earned income.
 Second, because of economic conditions, the worker
may be able to work only part time.
 Finally, if the duration of the unemployment is
extended a long period, past savings may be
exhausted.

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B. Property risks

 Persons owning property are exposed to the risk of

having their property damaged or lost from
numerous causes like fire, lightning, windstorms etc.
 There are two major types of loss in the damage of
property;
 Direct :- results from the physical damage,
destruction, or theft of the property, such as fire
damage to a home.

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Cont`d…

 Indirect loss:- also called

consequential loss.
 It 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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C. Liability risks

 involve the possibility of being held legally liable for

bodily injury or property damage to someone else.
 The court of law may order that person to pay
substantial damages to the person who is injured.
 Motorists are being held legally liable for the negligent
operation of their vehicles.
 Producers are also being sued because of defective
products that harm or injure customers.

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Cont`d..

 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 instance, investment in a capital
project might be profitable or it might prove to be a
failure.
 If you purchase 100 shares of common stock, you
would profit if the price of the stock increases but
would lose if the price declines.
 Other examples of speculative risks are betting on a
football match, investing in real estate, and going
into business for yourself. In these situations, both
profit and loss are possible.

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Cont`d..

 For example, if Mr X. Purchases 100 shares of a

company, he would gain if the price of that share
increases but would lose if the price declines. Thus,
here there are possibilities of both profit and loss.

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Difference Between
Speculative and Pure Risk
 Private insurers generally insure only
pure risks. Speculative risks are not
considered insurable and other
techniques must use to cope with risk.
 One exception is that some insurers
will insure institutional portfolio
investments and municipal bonds
against loss.

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Cont`d….

 The law of large numbers can be applied more

easily to pure risks than to speculative risks.
 Society may benefit from a speculative risk even
though a loss occurs, but it is harmed if a pure risk
is present and loss occurs.
 For example, a firm may develop new technology
for producing cheaply. As a result, some competitors
may fail. Despite the failures, society benefits since
the computers are produced at a lower cost.
However, society does not benefit when a loss from
the pure risk occurs, such as floods, earthquakes,
etc.

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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 Fundamental 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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1.6 Burden of risk on society

 The size of an emergency fund will be

increased.
 Worry and fear are present
 Loss of certain goods and services.
 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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THE END

By Birhanu S. 12/16/2024