Lecture 1

Definition of Risk and Its Types

Dr. Dina Abu Qamar

1. Definition of risk.
2. Risk Distinguished from Uncertainty.
3. Loss Exposure.
4. Objective Risk and Subjective Risk.
5. Chance of Loss.
6. Peril and Hazard.
7. Types of Hazard.
8. Classification of Risk

 Pure and Speculative risk.

 Diversifiable and Nondiversifiable Risk.
 Enterprise risk.
 Systematic Risk

9. Major Personal Risks and Commercial

Risks.
10. Burden of Risk on Society
Definition of Risk:
Risk is defined as uncertainty concerning the occurrence of
a loss. For example, the risk of being killed in an auto accident
is present because uncertainty is present. The risk of lung
cancer for smokers is present because uncertainty is present.

Risk Distinguished from Uncertainty:

According to the American Academy of Actuaries, the term
risk is used in situations where the probabilities of possible
outcomes are known or can be estimated with some degree of
accuracy, whereas uncertainty is used in situations where such
probabilities cannot be estimated. For example, the probability
of destruction of your home by a meteorite from outer space is
only a guess and generally cannot be accurately estimated.

Loss Exposure:

Corporate risk managers use the term loss exposure to

identify potential losses. A loss exposure is any situation or
circumstance in which a loss is possible, regardless of whether a
loss actually occurs. Examples of loss exposures include
manufacturing plants that may be damaged by an earthquake or
flood, defective products that may result in lawsuits against the
manufacturer, possible theft of company property because of
inadequate security, and potential injury to employees because
of unsafe working conditions.

Objective Risk and Subjective Risk:

Objective risk (also called degree of risk) is defined as the

relative variation of actual loss from expected loss. 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; in other
years, as many as 110 houses may 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.

Objective risk declines as the number of exposures

increases. More specifically, objective risk varies inversely
with the square root of the number of cases under observation.
In our previous example, 10,000 houses were insured, and
objective risk was 10/100, or 10 percent. Now assume that 1
million houses are insured. The expected number of houses
that will burn is now 10,000, but the variation of actual loss
from expected loss is only 100. Objective risk is now
100/10,000, or 1 percent. Thus, as the square root of the
number of houses increased from 100 in the first example to
1,000 in the second example (10 times), objective risk declined
to one-tenth of its former level.

Subjective Risk (perceived risk) is defined as uncertainty

based on a person’s mental condition or state of mind.
Another name for subjective risk is perceived risk For
example, assume that a driver with several convictions for
drunk driving is drinking heavily in a neighborhood bar and
foolishly attempts to drive home. The driver may be uncertain
whether he will arrive home safely without being arrested by
the police for drunk driving. This mental uncertainty or
perception is called subjective risk.
Chance of Loss: Chance of loss is closely related to the
concept of risk. Chance of loss is defined as the probability that
an event will occur.

Peril and Hazard:

Peril is defined as the cause of loss. If your house burns

because of a fire, the peril, or cause of loss, is the fire. If your
car is damaged in a collision with another car, collision is the
peril, or cause of loss. Common perils that cause loss to
property include fire, lightning, windstorm, hail, tornado,
earthquake, flood, burglary, and theft.

Hazard is a condition that creates or increases the

frequency or severity of loss. There are four major types of
hazards: Physical hazard, Moral hazard, Attitudinal hazard
(morale hazard), and Legal hazard.

1. Physical Hazard is a physical condition that increases

the frequency or severity of loss. Examples of physical hazards
include icy roads that increase the chance of an auto accident,
defective wiring in a building that increases the chance of fire,
and a defective lock on a door that increases the chance of
theft.

Moral Hazard is dishonesty or character defects in an

individual that increase the frequency or severity of loss.
Examples of moral hazard in insurance include faking an
accident to collect benefits from an insurer, submitting a
fraudulent claim, Murdering the insured to collect the life
insurance proceeds is another important example of moral
hazard.

Moral hazard is present in all forms of insurance, and it

is difficult to control. Insurers attempt to control moral hazard
by the careful underwriting of applicants for insurance and by
various policy provisions.

Attitudinal or Morale Hazard is carelessness or

indifference to a loss, which increases the frequency or severity
of a loss. Examples of attitudinal hazard include leaving car
keys in an unlocked car, which increases the chance of theft;
leaving a door unlocked, which allows a burglar to enter.
 Legal Hazard refers to characteristics of the legal system or
regulatory environment that increase the frequency or severity
of losses. Examples include adverse jury verdicts or large
damage awards in liability lawsuits; statutes that require
insurers to include coverage for certain benefits in health
insurance plans, such as coverage for alcoholism; and
regulatory action by state insurance departments that prevents
insurers from withdrawing from a state because of poor
underwriting results.

Classification of Risk:

Risk can be classified into several distinct classes. The

most important include the following: Pure and speculative
risk, Diversifiable risk and nondiversifiable risk, Enterprise
risk, Systemic risk.

1. Pure Risk and Speculative Risk:

Pure risk is defined as a situation in which there are only

the possibilities of loss or no loss. Examples of pure risks
include premature death, job-related accidents, catastrophic
medical expenses, and damage to property from fire, lightning,
flood, or earthquake.

Speculative risk is defined as a situation in which either

profit or loss is possible. For example, 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.

2. Diversifiable Risk and Nondiversifiable Risk:

Diversifiable risk is a risk that affects only individuals or

small groups and not the entire economy. It is a risk that can
be reduced or eliminated by diversification. For example, a
diversified portfolio of stocks, bonds, and certificates of
deposit (CDs) is less risky than a portfolio that is 100 percent
invested in common stocks. Losses on one type of investment,
say stocks, may be offset by gains from bonds and CDs.
Likewise, there is less risk to a property and liability insurer if
different lines of insurance are underwritten rather than only
one line. Losses on one line can be offset by profits on other
lines. Because diversifiable risk affects only specific
individuals or small groups, it is also called nonsystematic risk
or particular risk.

Nondiversifiable risk is a risk that affects the entire

economy or large numbers of persons or groups within the
economy. It is a risk that cannot be eliminated or reduced by
diversification. Examples include rapid inflation, cyclical
unemployment, war, hurricanes, floods, and earthquakes
because large numbers of individuals or groups are affected. It
is also called Fundamental risk.

3. Enterprise Risk:

Enterprise Risk is a term that encompasses all major risks

faced by a business firm. Such risks include pure risk,
speculative risk, strategic risk, operational risk, and financial
risk.

Strategic Risk refers to uncertainty regarding the firm’s

financial goals and objectives; for example, if a firm enters a
new line of business, the line may be unprofitable.
 Operational Risk results from the firm’s business
operations. For example, a bank that offers online banking
services may incur losses if “hackers” break into the bank’s
computer.

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.

4. Systemic risk

Systematic risk is the risk of collapse of an entire system or

entire market due to the failure of a single entity or group of
entities that can result in the breakdown of the entire financial
system. Ex: the severe 2008– 2009 business recession in the
United States was the second-worst economic downswing in
U.S. history which was caused largely by systemic risk.

Systemic risk is an economic risk that is extremely

important in the monetary policy of the Federal Reserve, fiscal
policies of the federal government, and government regulation
of the economy.
Major Personal Risks and Commercial Risks (Pure risk):

Certain pure risks are associated with great economic

Insecurity for both individuals and families, as well as for
commercial business firms.

Major Personal Risks: are risks that directly affect individual

or family. They involve of the loss or reduction of earned
income, extra expenses, and depletion of financial asset.
Major personal risks that can cause great economic insecurity
include

1. Premature Death: Premature death is defined as the

death of a family head with unfulfilled financial
obligations. These obligations include dependents to
support, a mortgage to be paid off, children to educate,
and credit cards or installment loans to be repaid.
2. Inadequate retirement income.
3. Poor Health.
4. Unemployment.
5. Property risk: persons owing property are exposed to
property risk- the risk of having property damaged or
 destroyed from numerous causes. Ex: real estate can be
destroyed by fire, or windstorm.
6. Liability risk: you can be held legally liable if you do
something that results in bodily injury or property
damage to someone else (legal system). A court of law
may order you to pay substantial damages to the person
you have injured.

Major Commercial Risks: Firms also face a variety of pure

risks that can bankrupt the firm if loss occurs. These risks
include the following:

1- Property Risk: Business firms own valuable business

property that can be destroyed by numerous perils. Business
property includes plants and other buildings; furniture, office
equipment, and supplies; computers and computer software
and data; inventories of raw materials and finished products.

2- Liability Risks: Firms are sued for numerous reasons,

including defective products that harm others, pollution of the
environment, damage to the property of others, violation of
copyrights and intellectual property, and numerous. In
addition, directors and officers may be sued by stockholders
and other parties because of financial losses.

3- Loss of Business Income: The firm may be shut down for

several months because of a physical damage loss to business
property due to a fire, tornado, or other perils.

During the shutdown period, the firm would lose business

income, which includes the loss of profits, and the loss of local
markets. In addition, certain expenses may still continue, such
as rent, utilities, interest, taxes, some salaries, and insurance
premiums.

4- Cybersecurity and Identity Theft: Cybersecurity and

identity theft by thieves breaking into a firm’s computer system
and database are major problems for many firms.

5- Other risks: other risks include human resources exposures,

foreign loss exposures, intangible property exposures, and
government exposures.

• Human Resources Exposures: disease of workers,

disability of employee, and retirement.
 • Foreign Loss Exposures: terrorism, political risk, and
foreign currency risk.
• Intangible Property Exposures: These include damage to
the market reputation and public image of the company,
the loss of goodwill, and loss of intellectual property. For
many companies, the value of intangible property is
greater than the value of tangible property

• Government Exposures: state governments may pass

laws and regulations that have a significant financial
impact on the company. Examples include laws that
increase safety standards, laws that require reduction in
plant emissions and contamination, and new laws to
protect the environment that increase the cost of doing
business.

Burden of Risk on Society:

• The size of an emergency fund must be increased.

• Society is deprived of certain goods and services.
• Worry and fear are present.