Today’s Outline
• What is Risk
• Chance of Loss
• Peril vs. Hazard
• Basic Categories of Risk
• Types of Pure Risk
• Burden of Risk on Society
• Methods of Handling Risk
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What is risk?
Risk: Uncertainty concerning the occurrence of a loss
- A possibility of a loss
Chance of a loss – a measurable probability of a loss (number
between 0 and 1)
Ex:
Objective Risk vs. Subjective Risk
– Objective risk - the relative variation of actual loss from
expected loss
• Can be statistically calculated using a measure of
dispersion such as the standard deviation and the
coefficient of variation.
– Subjective risk - uncertainty based on a person’s mental
condition or state of mind
Note: Two persons in the same situation may have
different perceptions of risk
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Also note: High subjective risk often results in
conservative behavior
. Loss - the undesired, unplanned reduction of economic value.
Note: A loss is different from planned expenses.
Expenses are the planned reduction of economic value
Ex: depreciation
Expenses are not the proper subject of insurance.
Chance of loss: The probability of a loss occurring
Objective Probability vs. Subjective Probability
Objective probability - the long-run relative frequency of an event
assuming an infinite number of observations and no change in the
underlying conditions
- Can be determined by deductive reasoning or statistical
analysis
Ex: Use mortality data to determine the probability that an
individual will die before age 50.
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Subjective probability –an individual’s personal estimate of the
chance of loss
• Note: A person’s perception of the chance of loss
may differ from the objective probability
Peril vs Hazard
• peril - the cause of the loss
Ex: In an auto accident, the collision is the peril
Ex: fire is the peril in a house burning down
Ex: Peril of property damage include: lightning,
windstorm tornado
• hazard - a condition that increases the chance of loss
• 4 types of hazards:
1. Physical hazards - physical conditions that increase the
chance of loss
Ex: icy roads, defective wiring, defective lock
2. Moral hazard – individual dishonesty or character
defects that increase the chance of loss
Ex: faking an accident, inflating claim amount
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3. Morale Hazard -carelessness or indifference to a loss
because of the existence of insurance (someone else
will have to pay for it)
Ex: leaving keys in an unlocked car
Ex
Because of Morale hazards, the insured need some
incentive to prevent loss
→ insurance contracts seldom provide full coverage
(has deductible).
4. Legal Hazard - characteristics of legal system or
regulatory environment that increase the chance of loss
Ex: large damage awards in liability lawsuits
Ex: WV and medical malpractice lawsuits
Ex Increasing inability of juries to understand details of a
case
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Basic Categories of Risk
A. Pure vs. Speculative Risk
- pure risk - risk in which there are only the possibilities of loss
or no loss
- outcome is either adverse or neutral
- something tragic happens or it doesn’t
Ex: earthquake, job-related accident, lightning, flood,
property damage due to a fire
- speculative risk - risk in which profit, breaking even or loss are
possible
Ex: gambling, buying stock
Notes:
1) The law of large numbers-
The law or large numbers- can be readily applied to pure
risk
Not so easily applied to speculative risk
Pure risk → the ability to predict future loss experience
Speculative risk → difficult to predict future loss experience
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2) Private insurance covers pure risk not speculative risk
3) Society can actually benefit from loss of a speculative risk.
Society never benefits from the occurrence of a pure risk
Ex: Advance in technology drives some firms out of business
Society benefits because of the lower cost production of a
product
B. Fundamental vs. Particular Risk
– fundamental (nondiversifiable) risk - affects the entire
economy or large numbers of persons or groups
Ex: hurricane, tornado, a successful terrorist plot
Note: Often considered the responsibility of government
– particular risk - affects only the individual
Ex: car theft, your house catches fire
Note: In many cases government insurance or social insurance
programs may be necessary to cover fundamental risks
Ex: FEMA and flood insurance, State unemployment
compensation programs
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C. Enterprise Risk
– Enterprise risk encompasses all major risks faced by a
business firm.
Includes:
- pure risk
- speculative risk
- strategic risk
- operational risk- risks from business operation
- financial risk- uncertainty of loss because of
adverse changes in commodity prices, interest rates,
foreign exchange rates and the value of money.
Types of Pure Risks
Recall: Pure risks have the possibilities of loss or no loss. Private
insurance is useful because the law or large numbers can be
readily applied.
Major types of pure risks that can create great financial insecurity:
1) Personal risks
2) Property risks
3) Liability risks
Personal risks – risks that directly affect an individual.
- involve the possibility of a loss or reduction in income, extra
expenses or depletion of financial assets:
– Premature death of family head
Life insurance needed
– Insufficient income during retirement
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• Most workers are not saving enough for a
comfortable retirement
Retirement planning needed
– Poor health (catastrophic medical bills and loss of
earned income)
Health Insurance needed
– Involuntary unemployment
Unemployment insurance programs and social
insurance needed
• Property risks involve the possibility of losses associated
with the destruction or theft of property:
– Physical damage to home and personal property from
fire, tornado, vandalism, or other causes
Home, auto and commercial property insurance needed
– 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 restaurant
• An indirect loss results indirectly from the
occurrence of a direct physical damage or theft
loss, such as lost profits due to inability to operate
after a fire
Note: insurance companies differentiate
between direct and indirect loss in insurance
contracts.
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• Liability risks involve the possibility of being held 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
- Defense costs can be enormous
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• The presence of risk results in three major burdens on
society:
1. In the absence of insurance, individuals would have to
maintain large emergency funds
2. The risk of a liability lawsuit may discourage
innovation, depriving society of certain goods and
services
3. Risk causes worry and fear
Methods of Handling Risks:
• Avoidance
• Loss control
– Loss prevention - activities to reduce the frequency of
losses
– Loss reduction - activities to reduce the severity of
losses
• Retention
– An individual or firm retains all or part of a loss
– Loss retention may be active or passive
• Noninsurance transfers
– A risk may be transferred to another party through
contracts, hedging, or incorporation
• Insurance
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