RISK
1
Objectives
In this chapter, we will explore four major points:
1- The concept of risk, especially those areas
particular to risk management
2- Why risk matters in our lives
3- How risk can be measured and evaluated
4- Methods to manage risk, including
insurance
2
Outline
‹ Nature
of Risk
‹ Attitudes Toward Risk
‹ Measurement of Risk
‹ Elements of Pure Risk
‹ Methods of Handling Pure Risk
3
Nature of Risk
A. Definition: variability in future outcomes
B. Speculative Risk: possibility of gain as well as loss or
no loss
C. Pure Risk: only loss or no loss
D. Loss, which is disappearance or reduction in an
economic value, is the outcome of concern
E. For risk to exist, it must be possible for loss to occur,
which implies unpredictability
F. A risk manager’s job is to minimize the negative
aspects of not knowing the future.
4
Attitudes Toward Risk
A. Many people are risk averse – willing to pay in excess
of the expected return in exchange for some certainty
about the future
B. Risk aversion is important because it may result in lost
opportunities
5
Measurement Of Risk
A. Specific Measurement Techniques
1. Average value: best guess of the future
2. Variability: can be measured using range,
variance, standard deviation and coefficient of
variation
3. Data sources: often events under consideration are
rare, making data collection difficult
6
Measurement Of Risk…
B.
Law of Large Numbers:
As a sample of observations is increased in size, the
relative variation about the mean declines
1. There is greater confidence in estimates that use
larger samples
2. Used by risk managers to estimate future
outcomes for planning purposes
7
Elements of Pure Risk
A. Exposure: opportunity for loss
1. Personal loss exposures: death, disability, sickness,
unemployment, and old age
2. Property loss exposures: direct loss is the cost to
repair or replace property; consequential loss is the
loss of use during repair or replacement
3. Liability loss exposure: legal suits claiming damage
to others
8
Elements of Pure Risk…
B. Perils: immediate causes of loss such as death and fire
1. Natural: people have little control over i.e.
hurricanes, lightning
2. Human: people have control over i.e. suicide, theft
3. Economic: recessions, employee strikes, arson for
profit
9
Elements of Pure Risk…
C. Hazards: conditions that increase the probability
and/or severity of loss
1. Physical: tangible conditions of the environment
that affect the frequency and\or severity of loss i.e.
slippery roads
2. Intangible: attitudes and cultures affecting
probability and severity of loss
a. Moral: dishonesty on the part of insureds
b. Morale: attitudes of carelessness and lack of
concern
10
Methods of Handling Pure Risk
A. Avoidance
1. Avoid activities that may lead to loss
2. Avoid ownership or responsibility that may be lost
11
Methods of Handling Pure Risk…
B. Loss Prevention and Reduction
1. Definition: prevention reduces loss frequency;
reduction lessens loss severity
2. Goal: reduce losses to the minimum level that is
compatible with a reasonable degree of human activity
and expense; a standard which will change through
time
12
Methods of Handling Pure Risk…
C. Retention
1. Definition: when losses are paid from an
individual’s or organization’s own funds
2. Why it occurs:
a. Ignorance of risk
b. Significance of risk underestimated
c. Maximum dollar losses small
d. Able to predict losses
13
Methods of Handling Pure Risk…
D. Transfer
1. Definition: shift risk to someone else
2. Modes of Transfer:
a. Formation of a corporation
b. Contractual arrangements
(i). Guarantee
(ii). Bailment
(iii). Lease and rental agreements
(iv). Contracts of suretyship
c. Insurance: the most important transfer
mechanism used by risk managers
14
Methods of Handling Pure Risk…
E. Combination
Use a combination of avoidance, loss prevention and
control, retention, and transfer techniques, as the most
feasible and efficient way to manage risk
15