RISK MANAGEMENT AND INSURANCE

CHAPTER ONE

1.1 BASIC CONCEPTS OF RISK

Meaning of Risk
There is no single definition of risk. Risk traditionally has been defined in terms of uncertainty.
Based on this concept, risk can be defined as:

Potential variation in outcomes where outcomes cannot be forecasted with certainty

Variation in outcomes that could occur over a specified period in a given situation

A condition in which there is a possibility of an adverse deviation from a desired outcome

that is expected or hoped for.
What are the characteristics of risk?
The following are the characteristics of risk

 Risk is the likelihood of an unfortunate occurrence

 Risk is unpredictable

 Risk is uncertainty about the future

 Risk is possibility of adverse deviation from expected outcomes

 Risk is an outcome that is not favorable
Risk vs. uncertainty

 Risk refers to something that is state of nature or environment.

 Uncertainty refers to the doubt, dilemma or wornness that a person has regarding the
occurrence of undesired event.

 Uncertainty is a person’s conscious awareness of the risk in a given situation.

Risk vs. Probability

 Probability refers to the long run chance of occurrence of event.

 Probabilities are generally assigned to events that are expected to happen in the future

 There may be a number of possible events that will take place under given set of conditions

 Objective risk is defined as the relative variation of actual loss from expected loss.

 Subjective risk is defined as uncertainty based on person’s mental condition or state of mind.

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Peril and Hazard
Peril is defined as the cause of loss. It is a contingency that may cause a loss. Examples are:

 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 property damage include fire, lightning, windstorm, hail,
tornados, earthquakes, theft, and burglary.

Hazard is a condition that may create or increase the chance of a loss arising from a given peril.

 Hazard is conditions that aggravate, accelerate or facilitate the magnitude/severity of loss.

 Example: drinking and driving, existence of icy street, poorly constructed roads/highways.

 There are three basic types of hazards:

Physical hazard Morale hazard
Moral hazard Legal hazard
Physical hazard

 A physical condition that increases the chance of loss from specific perils.

 Physical hazards include such phenomena as:

Existence of dry forests (hazard for fire),

Earth faults (hazard for earthquakes),

Icebergs (hazard to ocean shipping).

Icy roads that increase the chance of an auto accident,

Defective wiring in a building that increases the chance of fire, and

Defective lock on a door that increases the chance of theft.

 Such hazards may or may not be within human control.

Moral Hazard

 Moral Hazard is dishonesty or character defects in an individual that increase the frequency
or severity of loss.

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 A dishonest person, in the hope of collecting from the insurance company, may intentionally
cause a loss or may exaggerate the amount of a loss in an attempt to collect more than the
amount to which he or she is entitled.

 Examples of moral hazard are:

Faking an accident to collect the insurance,

Submitting a fraudulent claim,

Inflating the amount of a claim, and

Intentionally burning unsold merchandise that is insured.

 Moral hazards may exist in situations where excessive amounts of fire insurance are request
on “white elephant” properties (properties that are no longer profitable); where an incentive
might exist to “sell the building to the fire insurance company.”

 Moral hazard is present in all forms of insurance, and it is difficult to control.

Morale Hazard

 It is carelessness or indifference to a loss because of the existence of insurance.

 When people have purchased insurance, they may have a more careless attitude toward
preventing losses.
Examples of morale hazard include:

 Leaving car keys in the ignition of an unlocked car and thus increasing the chance of theft,

 leaving a door unlocked that allows a burglar to enter, and

 Changing lane suddenly on a congested road without signaling. Careless acts like these
increase the chance of loss.

 Morale hazard is also reflected in the attitude of persons who are not insured.

The tendency of physicians to provide more expensive levels of care when costs are
covered by insurance.

The inclination of courts to make larger awards when the loss is covered by
insurance-the so-called “deep pocket”

 Insurers try to eliminate the moral hazard and minimize the morale hazard by carefully
selecting their insured and by including contractual provisions causing the insured to regret
the loss despite the insurance coverage. For example, some contracts require insured to pay

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the first certain amount of a loss, and others require insured’s to pay a percentage of each
loss. In both cases, the insured’s have reason to regret the losses while still receiving
insurance compensation.

Legal Hazard

 Legal hazard refers to the characteristics of the legal system or regulatory environment that
increase the frequency or severity of the loss.
Examples include:

Adverse jury verdicts or large damage awards in liability law suits or Statutes that
require insurers to include coverage for certain benefits in health insurance plans such as
coverage for alcoholism and restrict the ability of insured to withdraw from the state
because of poor underwriting results.

1.2 Classifications of Risk

Risks may be classified in many ways; however, there are certain distinctions that are particularly
important for our purposes. The major categories of risk are:
 Financial and non-financial risks
 Static and dynamic risks
 Fundamental and particular risks
 Objective and subjective risks
 Pure and speculative risks
Financial and non-financial risks

Financial risk is one where the outcome can be measured in monetary item. This risk results in
losses that can be expressed in financial terms. Example

 Damage of property by earth quake,

 Theft of property or Loss of property by fire

 like car accident,

 loss of building

Non Finical Risk refers to risks that do not have financial implication. The loss is not easily
measurable in terms of money. Example

 Loss of human life

Static and Dynamic Risks

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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.
 Dynamic risks may affect a large number of individuals and have no regularity.

Static risks involve those losses that would occur even if there were no changes in the economy.
Unlike dynamic risks, static risks are not a source of fain to society. 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 of dishonesty or human failure.

Static losses tend to occur with:

 A degree of regularity overtime and,
 They are predictable,
Static risks are more suited to treatment by in insurance than are dynamic risks.

Fundamental and particular risks

The distinction between fundamental and particular risks is based on the difference in the origin and
consequences of the losses.

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.
 Involve losses that are impersonal in origin and consequence.
 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.

Example
High inflation, Other natural disaster
War,
Drought,
Earthquakes,
Floods and

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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:
Burning of a house,
Robbery of a bank, and
Damage of a car.
Objective and Subjective Risks

Objective risk:
 Is defined as the relative variation of actual from expected loss.
 Objective risk is a statistical risk,

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
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.

Subject 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.

Pure and Speculative Risk

Pure risk is
 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 no chance of gain.

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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. 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,
 Damage to property from fire, lighting, flood, or earthquake.

Types of Pure Risk

The major types of pure risk that can create great financial insecurity include personal risks,
property risks, liability risks and risks arising from failure of others.

1. Personal Risks
Personal risks are risks that directly affect an individual. They involve the possibility of the
complete loss or reduction of earned income, extra expenses, and the depletion of financial asset.

There are four major types of personal risks:

 Risk of premature death
 Risk of insufficient income during retirement
 Risk of poor health
 Risk of unemployment

Risk of Premature death:

Premature death is the death of a household head with unfulfilled financial obligations. These
obligations can include dependents to support, a mortgage to be paid off, or children to educate.

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.
Costs that result from the premature death of a household dead include:
1. The human life value of the family head is lost forever.

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2. Additional expenses may be incurred because of funeral expenses, uninsured medical

bills and others.
3. Because of insufficient income, some families will experience a reduction in their
standard of living.
4. Certain non-economic costs are also incurred, including emotional grief, loss of a role
model, and counseling and guidance for the children.

Risk of insufficient income during retirement: The major risk associated with old age is
insufficient income during retirement.

Risk of poor health: The risk of poor health includes both the payment of catastrophic medical
bills and the loss of earned income.

Risk of unemployment: The risk of unemployment is another major threat to financial security.
Unemployment can cause financial insecurity in at least three ways.
1. The worker losses his or her earned income.
2. Because of economic conditions, the worker may be able to work only part-time. The
reduced income may be insufficient in terms of the worker’s needs.
3. If the duration of unemployment is extended over a long period, past savings may be
exhausted.

2. Property Risks
Refers to losses associated with ownership of property such as destruction of property by fire,
lightening, windstorm, flood and other forces of nature. Losses to property may be classified as
either direct loss or indirect loss.

Direct loss is defined as a financial loss that results from the physical damage, destruction, or
theft of the property. If a house is destroyed by fire, the owner loses the value of the house.

Indirect loss is a financial loss that results indirectly from the occurrence of a direct physical
damage or theft. Example when a firm’s facilities are destroyed, it loses not only the value of
those facilities but also the income that would have been earned through their use. Indirect loss
bay be:
 Loss of additional benefits other than the property itself resulting from, destruction, or
theft

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 Incurrence of additional expenses

3. Liability Risks
The basic peril in the liability risk is the unintentional injury of other persons or damage to their
property through negligence or carelessness; however, liability may also result from intentional
injuries or damage.

Speculative risk is:

 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.

It is important to distinguish between pure and speculative risks for three reasons:
 Normally only pure risks are insurable. Insurance is not concerned with the protection of
individuals against those losses arising out of speculative risks.
 The law of large numbers can be applied more easily to pure risk than to a speculative
risk.
 Society may benefit from a speculative risk even though a loss occurs, but it is harmed if
a pure risk present and a loss occur.
Both pure and speculative risks commonly exist at the same time. For example, the ownership of
a building exposes the owner to both pure risks (for example, accidental damage to the property)
and speculative risks (for example, rise or fall in property values caused by general economic
conditions)

Risks Related to Business Activities

Most risks in business environment are speculative in nature. The finance literature considers
five types of risks that business organizations face in the course of their normal operation. These
are: business risk, financial risk, interest rate risks, purchasing power risks, and market risks.
Each of these is briefly discussed below.

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Business Risk:
This is the risk associated with the physical operation of the firm. Variations in the level of
sales, costs, profits are likely to occur due to a number of factors inherent in the economic
environment. Business risk is independent of the company’s financial structure.
Financial Risk:
This is associated with debt financing. Borrowing results in the payment of periodic interest
charge and the payment of principal upon maturity. There is a risk of default by the company if
operations are not profitable. Other financial risks include; bankruptcy, stock price decline,
insolvency. Bondholders are less exposed to financial risk than common stockholders because
they have a priority claim against the assets of an insolvent firm. Government securities,
however, bear very low risk.
Interest Rate Risk:
This is a risk resulting from changes in interest rates. Changes in interest rates affect the prices
of financial securities such as the prices of bonds etc. for interest rate rise depresses bond prices
and vice, versa.
Purchasing Power Risk:
This risk arises under inflationary situations (general price rise of goods and services) leading
to a decline in the purchasing power of the asset held. Financial assets lose purchasing power if
increased inflationary tendencies prevail in the economy.
Market Risk:
Market risk is related to stock market. It refers to stock price variability caused by market forces.
It is the result of investors’ reactions to real or psychological expectations. For example, some
forecasts may convince investors that the economy is heading towards a recession. The market
index would decline accordingly. In other situation investors erroneously overreact to events and
affect the market by making abnormal transactions. The market, in many cases, is also affected
by such events as: presidential elections, trade balances, balance of payment figures, wars, new
inventions, etc...Market risk is also called systematic or non-diversifiable risk. All investors are
subject to this risk. It is the result of the workings of the economy; and cannot be eliminated
through portfolio diversification. However, investors are paid for this risk

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