FIN 463: Insurance and Banking Mustafa Hayat

Module 1
Risk and Its Treatment
Definitions of Risk

There is no single definition of risk. Economists, behavioral scientists, risk theorists, statisticians, actuaries,
and historians each have their own concept of risk.

Traditional Definition of Risk

Risk traditionally has been defined in terms of uncertainty. Based on this concept, 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.

Risk Distinguished from Uncertainty

In the economics and finance literature, authors and actuaries often make a distinction between risk and
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 dying at each attained age can be estimated with considerable accuracy. In contrast, 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

Because risk is an ambiguous term and has different meanings, many authors and 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.

Finally, when the definition of risk includes the concept of uncertainty, some authors make a careful
distinction between objective risk and subjective risk.

Objective 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 can be statistically calculated by some measure of dispersion, such as the standard deviation
or the coefficient of variation. Because objective risk can be measured, it is an extremely useful concept for
an insurer or a corporate risk manager. As the number of exposures increases, an insurer can predict its
future loss experience more accurately because it can rely on the law of large numbers. The law of large
numbers states that as the number of exposure units increases, the more closely the actual loss experience
will approach the expected loss experience. For example, as the number of homes under observation
increases, the greater is the degree of accuracy in predicting the proportion of homes that will burn.

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Subjective Risk (Perceived Risk)

Subjective risk (perceived risk) is defined as uncertainty based on a person’s mental condition or state of
mind. 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.

The impact of subjective risk varies depending on the individual. Two persons in the same situation can
have a different perception of risk, and their behavior may be altered accordingly. If an individual
experiences great mental uncertainty concerning the occurrence of a loss, that person’s behavior may be
affected. High subjective risk often results in conservative and prudent behavior, whereas low subjective risk
may result in less conservative behavior.

Peril and Hazard

The terms peril and hazard should not be confused with the concept of risk discussed earlier.

Peril

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

A 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)
➢ Legal hazard

Physical Hazard: A 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: 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, inflating the amount of a claim, and intentionally
burning unsold merchandise that is insured.

Attitudinal Hazard (Morale Hazard): Attitudinal 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: 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
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Classification of Risk

Risk can be classified into several distinct classes. The most important include the following:

➢ Pure and speculative risk

➢ Diversifiable risk and non-diversifiable risk
➢ Enterprise risk
➢ Systemic risk

Pure Risk and Speculative Risk

Pure risk is defined as 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). Examples of pure risks include premature death,
job related accidents, catastrophic medical expenses, and damage to property from fire, lightning, flood, or
earthquake.

In contrast, 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.

It is important to distinguish between pure and speculative risks for three reasons. First, private insurers
generally concentrate on pure risks and do not emphasize the insurance of speculative risks.

Second, the law of large numbers can be applied more easily to pure risks than to speculative risks. The law
of large numbers is important because it enables insurers to predict future loss experience. In contrast, it is
generally more difficult to apply the law of large numbers to speculative risks to predict future loss
experience.

Finally, society may benefit from a speculative risk even though a loss occurs, but is harmed if a pure risk is
present and a loss occurs.

Diversifiable Risk and Non-diversifiable 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. Because diversifiable risk affects only specific
individuals or small groups, it is also called nonsystematic risk or particular risk. Examples include car
thefts, robberies, and dwelling fires. Only individuals and business firms that experience such losses are
affected, not the entire economy.

In contrast, non-diversifiable 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, and war. Because non-diversifiable risk affects the entire
economy or large numbers of persons in the economy, it is also called as fundamental risk.

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. We have already explained the
meaning of pure and speculative 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.
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Enterprise risk also includes financial risk, which is becoming more important in a commercial risk
management program. 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. For example, a food
company that agrees to deliver cereal at a fixed price to a supermarket chain in 6 months may lose money if
grain prices rise.

Systemic Risk

Systemic 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. 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.

Burden of Risk on Society

The presence of risk results in certain undesirable social and economic effects. Risk entails three major
burdens on society:

➢ The size of an emergency fund must be increased.

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

Larger Emergency Fund

It is prudent to set aside funds for an emergency. However, in the absence of insurance, individuals and
business firms would have to increase substantially the size of their emergency fund to pay for unexpected
losses. Even then, an early loss could occur, and your emergency fund may be insufficient to pay for the
loss. If you are a middle- or low-income earner, you would find such saving difficult. In any event, the
higher the amount that must be saved, the more current consumption spending must be reduced, which
results in a lower standard of living.

Loss of Certain Goods and Services

A second burden of risk is that society is deprived of important goods and services. For example, because of
the risk of a liability lawsuit, many corporations have discontinued manufacturing certain products.
Numerous examples can be given. Some 250 companies in the world once manufactured childhood
vaccines; today, only a small number of firms manufacture vaccines, due in part to the threat of liability
suits.

Worry and Fear

The final burden of risk is that of worry and fear. Numerous examples illustrate the mental unrest and fear
caused by risk. Some passengers in a commercial jet may become extremely nervous and fearful if the jet
encounters severe turbulence during the flight.

Techniques for Managing Risk

Techniques for managing risk can be classified broadly as either risk control or risk financing. Risk control
refers to techniques that reduce the frequency or severity of losses. Risk financing refers to techniques that
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provide for the funding of losses. Risk managers typically use a combination of techniques for treating each
loss exposure.

Risk Control

Risk control is a generic term to describe techniques for reducing the frequency or severity of losses. Major
risk-control techniques include the following:

➢ Avoidance
➢ Loss prevention
➢ Loss reduction
▪ Duplication
▪ Separation
▪ Diversification

Avoidance: Avoidance is one technique for managing risk. For example, you can avoid the risk of being
mugged in a high-crime area by staying away from high-crime rate areas.

Loss Prevention: Loss prevention is a technique that reduces the probability of loss so that the frequency of
losses is reduced. Several examples of personal loss prevention can be given. Auto accidents can be reduced
if motorists take a safe-driving course and drive defensively. The number of heart attacks can be reduced if
individuals control their weight, stop smoking, and eat healthy diets. Loss prevention is also important for
business firms. For example, strict security measures at airports and aboard commercial flights can reduce
acts of terrorism

Loss Reduction: Strict loss prevention efforts can reduce the frequency of losses; however, some losses will
inevitably occur. Thus, another objective of loss control is to reduce the severity of a loss after it occurs. For
example, a department store can install a sprinkler system so that a fire will be promptly extinguished,
thereby reducing the severity of loss.

Duplication: Losses can also be reduced by duplication. This technique refers to having back-ups or
copies of important documents or property available in case a loss occurs. For example, back-up copies of
key business records (e.g., accounts receivable) are available in case the original records are lost or
destroyed.

Separation: Another technique for reducing losses is separation. The assets exposed to loss are separated
or divided to minimize the financial loss from a single event. For example, a manufacturer may store
finished goods in two warehouses in different cities. If one warehouse is damaged or destroyed by a fire,
tornado, or other peril, the finished goods in the other warehouse are unharmed.

Diversification: Finally, losses can be reduced by diversification. This technique reduces the chance of
loss by spreading the loss exposure across different parties. Risk is reduced if a manufacturer has a
number of customers and suppliers. For example, if the entire customer base consists of only four
domestic purchasers, sales will be impacted adversely by a domestic recession. However, if there are
foreign customers and additional domestic customers as well, this risk is reduced. Similarly, the risk of
relying on a single supplier can be minimized by having contracts with several suppliers.

Risk Financing

As stated earlier, risk financing refers to techniques that provide for the payment of losses after they occur.
Major risk-financing techniques include the following:

❖ Retention
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❖ Noninsurance transfers
❖ Insurance

Retention: Retention is an important technique for managing risk. Retention means that an individual or a
business firm retains part of all of the losses that can result from a given risk. Risk retention can be active or
passive.

Active Retention Active risk retention means that an individual is consciously aware of the risk and
deliberately plans to retain all or part of it. For example, a business firm may deliberately retain the risk of
petty thefts by employees, shoplifting, or the spoilage of perishable goods by purchasing a property
insurance policy with a sizeable deductible. In these cases, a conscious decision is made to retain part or all
of a given risk. Active risk retention is used for two major reasons. First, it can save money. Insurance may
not be purchased, or it may be purchased with a deductible; either way, there is often substantial savings in
the cost of insurance. Second, the risk may be deliberately retained because commercial insurance is either
unavailable or unaffordable.

Passive Retention Risk can also be retained passively. Certain risks may be unknowingly retained because of
ignorance, indifference, laziness, or failure to identify an important risk. Passive retention is very dangerous
if the risk retained has the potential for financial ruin. For example, many workers with earned incomes are
not insured against the risk of total and permanent disability. However, the adverse financial consequences
of total and permanent disability generally are more severe than the financial consequences of premature
death.

Self-Insurance: Our discussion of retention would not be complete without a brief discussion of self-
insurance. Self-insurance is a special form of planned retention by which part or all of a given loss
exposure is retained by the firm. Another name for self-insurance is self-funding, which expresses more
clearly the idea that losses are funded and paid for by the firm. For example, a large corporation may self-
insure or fund part or all of the group health insurance benefits paid to employees.

Noninsurance Transfers Noninsurance transfers are another technique for managing risk. The risk is
transferred to a party other than an insurance company. A risk can be transferred by several methods,
including:

❖ Transfer of risk by contracts

❖ Hedging price risks
❖ Incorporation of a business firm

Transfer of Risk by Contracts: Undesirable risks can be transferred by contracts. For example, the risk
of a defective television or stereo set can be transferred to the retailer by purchasing a service contract,
which makes the retailer responsible for all repairs after the warranty expires. The risk of a rent increase can
be transferred to the landlord by a long-term lease.

Hedging Price Risks: Hedging price risks is another example of risk transfer. Hedging is a technique for
transferring the risk of unfavorable price fluctuations to a speculator by purchasing and selling futures
contracts on an organized exchange.

Incorporation of a Business Firm: Incorporation is another example of risk transfer. If a firm is a sole
proprietorship, the owner’s personal assets can be attached by creditors for satisfaction of debts. If a firm
incorporates, personal assets cannot be attached by creditors for payment of the firm’s debts. In essence, by
incorporation, the liability of the stockholders is limited, and the risk of the firm having insufficient assets to
pay business debts is shifted to the creditors.

Insurance For most people, insurance is the most practical method for dealing with major risks. Although
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private insurance has several characteristics, three major characteristics should be emphasized. First, risk
transfer is used because a pure risk is transferred to the insurer. Second, the pooling technique is used to
spread the losses of the few over the entire group so that average loss is substituted for actual loss. Finally,
the risk may be reduced by application of the law of large numbers by which an insurer can predict future
loss experience with greater accuracy.

Review Questions

1. Define the following terms:

i) Traditional Definition of Risk ix) Hazard
ii) loss exposure x) Pure Risk
iii) Objective risk xi) speculative risk
iv) The law of large numbers xii) Diversifiable Risk
v) Subjective risk xiii) Non-diversifiable Risk
vi) Objective probability xiv) Enterprise risk
vii) Subjective probability xv) Systemic Risk
viii) Peril

2 a) Explain the historical definition of risk.

b) What is a loss exposure?
c) How does objective risk differ from subjective risk?

3 a) Define chance of loss.

b) What is the difference between objective probability and subjective probability?
c) How objective probability can be determined?

4 What is the difference between peril and hazard? Describe the types of hazard.

5 Elaborately describe the different cases of risk.

6 Explain how risk impose burden on Society.

7 Define risk control. Illustrate the major risk control techniques.

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8 Describe the loss reduction techniques.

9. Define risk financing. Illustrate the major risk financing techniques.

10 Describe the non-insurance risk transfer methods.

Reference

Rejda, GE & McNamara, MJ, 2017, Principles of Risk Management and Insurance, 13th edn, Pearson
Education Limited, Essex, England

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