CHAPTER 1
Introduction to Risk
THE BURDEN OF RISK
DEFINITIONS OF RISK
Pure versus Speculative Risk
Static versus Dynamic Risk
Subjective versus Objective Risk
SOURCES OF PURE RISK
Property Risks
Liability Risks
Life, Health, and Loss of Income Risks
Financial Risk
MEASUREMENT OF RISK
Chance of Loss
Physical Hazard
Morale Hazard
Moral Hazard
Degree of Risk
MANAGEMENT OF RISK
KEY TERMS AND CONCEPTS
Chance of loss
Chief risk officer
Cost of risk
Degree of risk
Dynamic risks
Enterprise risk
management
Financial risks
Frequency
Hazards
Integrated risk management
Moral hazard
Morale hazard
Objective risk
Peril
Pure risk
Risk
Risk management
Risk management process
Risk manager
Severity
Speculative risk
Static risks
Subjective risk
ANSWERS TO QUESTIONS FOR REVIEW AND DISCUSSION
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2.
Risk can be defined as uncertainty as to loss. Risk can create an economic burden by requiring
reserve funds to pay for contingent losses and price increases of some goods and services. Risk
may deprive society of some goods and services that are determined to involve too much risk to
justify their production.
a. Pure risk involves uncertainty as to whether loss will occur. It does not involve a possibility
of gain. Speculative risk involves uncertainty about an event that could produce either a
profit or loss.
b. Static risks are those that would exist in an unchanging society that is in stable equilibrium.
Dynamic risks are caused by societal changes.
c. Subjective risks arise from psychological uncertainty that is based on an individual’s mental
attitude or state of mind. Objective risk is more precisely observable and measurable.
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Chapter 1: Introduction to Risk
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Windstorm, flood, and other natural disasters are examples of risks that are both pure and static.
A peril is a specific contingency that may cause loss. A hazard is a condition that introduces or
increases the chance of loss from the existence of a given peril. Examples of perils include fire,
windstorm, collision, war, etc. Examples of hazards include oily rags, icy roads, a dishonest
employee, a careless driver, etc.
a Morale
b. Moral
c. Morale
d. Moral
e. Physical
Risk management is the process used to systematically manage exposures to pure risk. The four
steps are: (1) identify risks, (2) evaluate risks, (3) select risk management techniques, and (4)
implement and review decisions. Traditionally, risk management has dealt primarily with pure
risks. Enterprise risk management considers all of an entity’s risks together, both pure and
speculative.
As a loss becomes more and more certain to happen, there is less and less uncertainty that it will
not happen. If a point is finally reached when an event is certain to occur, then there is no risk at
all.
Company ABC: (70 - 60) / 65 = 15 percent
Company XYZ: (80 - 50) / 65 = 46 percent
a. Collision or oil spill
b. Flood
c. Fire or explosion
d. Death
e. Theft or vandalism
Answers will vary. It can be pointed out that the mathematical value of the game is (0.90 ×
$1,000) + (0.10 × $100,000) = $10,900, and a “gambler” should choose the game. Most students
will probably choose the cash. Since most persons are risk-averting and will take the certain
amount, ventures like the game, similar to real-life investments bearing considerable risk and low
probabilities for hitting it big (e.g., oil drilling), are not widely sought. Hence, the capital cost of
such ventures must be high in order to overcome risk. This high cost is the economic burden
imposed by risk because it will produce higher consumer prices for the final product.
A has the greater risk. B has the greater probability of loss. Using the objective risk formula
(Probable Variation of Loss / Probable Losses), we get 3 / 2 = 150% for A and 12 / 30 = 40% for
B. The probable loss is 2 / 100 = 2% for A and 30 / 1,000 = 3% for B.
This question opens an opportunity to discuss subjective risk and its effect on economic or buyer
behavior. Information and explanation is a major industry today, and much of its effort is
designed to smooth the course of commerce by reducing perceived risk in the minds of customers.
Information reduces perceived risk by making it easier for the buyer to understand the product and
the ways in which the product will solve problems for the buyer. The purpose, of course, is to
make it easier for the buyer to come to an intelligent buying decision.
Risk is defined as uncertainty as to loss, and variation is a measure of uncertainty. Expected
annual loss is not a measure of uncertainty. There is a higher degree of risk when there is a lower
probability of occurrence because as a loss becomes more certain to occur there is less uncertainty
that it will not occur. Risk would totally disappear only when the probability of occurrence is 0%
and 100%.
Property losses would be easiest to estimate because the value of the property concerned can help
in estimating the maximum possible loss. Liability risks would be difficult to estimate because
they are subject to wide variation and are contingent on several factors both within and outside of
the company’s direct control. Personal risks are also difficult to estimate because evaluation
Chapter 1: Introduction to Risk
involves such problems as placing a value on human life or health, which can be a very difficult
undertaking.
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