Principles of Risk Management and

Insurance
Fourteenth Edition, Global Edition

Chapter 1

Risk and Its Treatment

1 1-1
Copyright © 2022 Pearson Education Ltd.
Get motivated
if you had a bad time last year

• https://www.youtube.com/watch?v=MRQizP
cZWBI

• http://www.youtube.com/watch?
v=0yetHqWODp0

2 1-2
Source: Internet
3 1-3
Then http://www.youtube.com/watch?v=obq5gJrO3z0 4 1-4
• FIERY BALLOON ACCIDENT KILLS 19 TOURISTS IN EGYPT
(U GOOGLE IT FOR 2014, ONE IN VIRGINIA)
• By MAGGIE MICHAEL
• — Feb. 26, 2013 9:11 PM EST
• LUXOR, Egypt (AP) — The terror lasted less than two minutes:
Smoke poured from a hot air balloon carrying sightseers on a
sunrise flight over the ancient city of Luxor, it burst in a flash of
flame and then plummeted about 1,000 feet to earth. A farmer
watched helplessly as tourists trying to escape the blazing
gondola leaped to their deaths.
• Nineteen people were killed Tuesday in what appeared to be the
deadliest hot air ballooning accident on record. A British tourist
and the Egyptian pilot, who was badly burned, were the sole
survivors.
• http://bigstory.ap.org/article/official-least-19-foreign-tourists-di
e-egypt-hot-air-balloon-crashes-near-luxor

5 1-5
How do you see the activity now?

6 1-6
Risk and Its Treatment
• Different Definitions of Risk
• Chance of Loss
• Peril and Hazard
• Classification of Risk
• Major Personal Risks and Commercial Risks
• Burden of Risk on Society
• Techniques for Managing Risk

Outcome
Understand the terms above and how they are
related to our daily lives and learn the
technique for risk management) 7 1-7
How do you see Risk?

A hot-air balloon burst into flames and crashed to the ground in

New Zealand on Saturday, killing all 11 people on board, after
hitting a power line. (January 7, 2012)
Similar accidents continue to happen every year.

2 tourists dead after hot air balloon carrying 30 people makes hard
landing in Turkey, OCTOBER 19, 2022 / 9:58 AM / CBS

8 1-8
Definition of RISK
webster.com
• 1: possibility of loss or injury : peril

• 2: someone or something that creates or suggests a hazard

• 3a : the chance of loss or the perils to the subject matter of an

insurance contract; also : the degree of probability of such loss
b : a person or thing that is a specified hazard to an insurer c :
an insurance hazard from a specified cause or source <war
risk>

• 4: the chance that an investment (as a stock or commodity)

will lose value

9 1-9
 Different Definitions of Risk
• Risk: Uncertainty concerning the occurrence of a loss
– Expected loss
• Riskier => greater frequency or severity of loss (any
examples?)
• Riskier => The expected loss will be higher
• E.g. higher risk of Earthquake: Japan, higher risk of car
accident: drunk driving
– Variability of loss (around expected value)
• Riskier => more difficult to predict
• E.g. Price change of stock vs price change of bonds

• Loss Exposure: Any situation or circumstance in which a loss

is possible, regardless of whether a loss occurs.
10 1-10
 Different Definitions of Risk
• Objective Risk vs. Subjective Risk
– Objective risk is defined as the relative variation of
actual loss from expected loss
• It can be statistically calculated using a measure of
dispersion, such as the standard deviation
• Remember any graphs of normal distribution & standard
deviation?
– How does the risk change with a larger units of exposure?
– Objective risk declines as the number of exposure increases
» claims: on average 10 out of 10,000 cases insured (from
experience)
» Actual claims can be say, 8 or 12 => 2/10 or 20%
variation
» How can we reduce the variation?
» If 100 x 10,000 cases insured => objective risk =20%
/sqrt(100) =2%
11 1-11
 Class exercise

The chance of loss may be identical for two different

groups, but objective risk may be quite different!

# Chance of Average # Objective

City homes Fire fires Range Risk
Philadelphia 10,000 1% 100 75 – 125 25%

Los Angeles 10,000 1% 100 90 – 110 10%

12 1-12
Subjective risk is defined as uncertainty based on a
person’s mental condition or state of mind (hot air
balloon => more risky now! How about travelling by
plane after the disappearance of the Malaysia Airlines
Flight 17) Two persons in the same situation may have
different perceptions of risk (you may have no fear if
you are being gun pointed if….)
High subjective risk often results in conservative
behavior
Think about buying stocks

13 1-13
 Chance of Loss
• Chance of loss: The probability that an event will occur

• Objective Probability vs. Subjective Probability

– Objective probability refers to the long-run relative frequency
of an event assuming an infinite number of observations and
no change in the underlying conditions
• It can be determined by deductive or inductive reasoning
– E.g. probability of getting a head from coin tossing vs
probability of a person having car accident in a year.
– Subjective probability is the individual’s personal estimate of
the chance of loss
• A person’s perception of the chance of loss may differ from
the objective probability
– E.g. before and after global financial crisis
– 2012 Mayan Calendar Doomsday, End-of-the-World
14 1-14
 Peril and Hazard
• A peril is defined as the cause of the loss
– In an auto accident, the collision is the peril
• A hazard is a condition that increases the chance of loss
– Physical hazards are physical conditions that increase the chance
of loss
• icy roads, defective wiring
– Moral hazard is dishonesty or character defects in an individual,
that increase the chance of loss
• faking accidents, inflating claim amounts
– Attitudinal Hazard (Morale Hazard) is carelessness or indifference
to a loss, which increases the frequency or severity of a loss
• leaving keys in an unlocked car
– Legal Hazard refers to characteristics of the legal system or
regulatory environment that increase the chance of loss
• large damage awards in liability lawsuits

15 1-15
Questions (take out a paper)

• Given the following scenario, state which is the

hazard, the peril, and the exposure, respectively?
• You recently moved from Beijing to Taiwan and
bought a home. A typhoon destroys your home.

• True or False? Twin towers burn to the ground

resulting in a complete loss. The fact that the
construction material is steel is the peril involved in
this loss.

16 1-16
 Classification of Risk
• Pure and Speculative Risk
– A pure risk is one in which there are only the possibilities of
loss or no loss
• earthquake
– A speculative risk is one in which both profit or loss are
possible
• gambling
• Diversifiable Risk and Nondiversifiable Risk
– A diversifiable risk affects only individuals or small groups
(car theft). It is also called nonsystematic or particular risk.
– A nondiversifiable risk affects the entire economy or large
numbers of persons or groups within the economy
(hurricane). It is also called systematic risk or fundamental
risk.
– Government assistance may be necessary to insure
nondiversifiable risks. 17 1-17
 Classification of Risk

• Enterprise risk encompasses all major risks faced by a

business firm, which include: pure risk, speculative risk,
strategic risk, operational risk, and financial risk
– 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.
• China's Tsingshan fires nickel rally as it cuts costly exposure-sources
• https://www.reuters.com/business/chinas-tsingshan-fires-nickel-rally-it-cuts-cos
tly-exposure-sources-2022-03-08/

• Enterprise Risk Management combines into a single unified

treatment program all major risks faced by the firm:
– Pure risk
– Speculative risk
– Strategic risk
– Operational risk
– Financial risk
18 1-18
Major Personal Risks and Commercial Risks
• Personal risks involve the possibility of a loss or
reduction in income, extra expenses or depletion of
financial assets:
– Premature death of family head
– Insufficient income during retirement
• Most workers are not saving enough for a comfortable
retirement
• More Americans Say 80 Is The New Retirement Age – Forbes
(I bet the situation is getting worse given the market dropped
more than 20% in 2022)
• http://www.youtube.com/watch?v=8t1cBn7Vnns
• https://www.youtube.com/watch?v=_cPLrEAqgDc
– Poor health (catastrophic medical bills and loss of earned income)
– Involuntary unemployment

19 1-19
Insight
• About half of all personal bankruptcy cases are (at
least in part) due to medical reasons
• 2000-2007 June: 5 million families filed for
bankruptcy due to medical reasons
• 20% of people who reported having medical bill
problems considered filing for bankruptcy (bills too
expensive)
• More than half of adults with inadequate insurance:
didn’t fill in prescription, skipped recommended
tests, treatment or didn’t go to doctor for medical
advices. $$ problem
• 40% of Americans don’t have $400 in the bank for
emergency expenses: Federal Reserve
• https://abcnews.go.com/US/10-americans-struggle-cover-400-emergency-expense-federal/story?id=63253846, may 2019

20 1-20
Exhibit 1.1 Reported Total Savings and
Investments among Those Responding, by Age

What can you tell from the figures above?

(not including value of primary residence or defined benefit plans)

21 1-21
Major Personal Risks and
Commercial Risks
• 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
• 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 home
– An indirect loss results indirectly from the occurrence of a direct
physical damage or theft loss, such as the additional living
expenses after a fire to a home. These additional expenses would
be a consequential loss.

e.g. 花園街火警 Fire at Fa Yuen Street killed 9 and injured 34 (Nov. 2011)
Rally over 'photo ban' shuts retailer Dolce & Gabbana in Tsim Sha Tsui, Jan 10, 2012
22 1-22
 http://www.youtube.com/watch?v=
00ZmGa8Q42E

http://www.youtube.com/watch?
v=O4rSiUPGt3A

http://www.youtube.com/watch?fea
ture=player_embedded&v=VdeyQ
aQNckA

Amazon testing drones for deliveries

Write down the types of risk involved

23 1-23
Major Personal Risks and
Commercial Risks
• 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

Have you ever played golf, remote control (rc) toys, etc ?
Women killed by rc-aeroplane in Mainland.
Man got hit by a golf ball.
Man paralyzed by rc-helicopter accident in H.K.
The owner of the heli that hit him was only fined HK$5000 (US$642).
A civil suit then followed, and the victim was awarded HK $8.8M (U$1.13
M).
24 1-24
Brain surgery for man hit by wayward toy copter
PatsyMoy and CarolChung
Monday, January 14, 2008,, http://www.thestandard.com.hk

A 44-year-old man underwent emergency brain surgery after he was hit by a remote-
controlled toy helicopter yesterday. Law Kwok-wah was rushed by ambulance to Queen
Elizabeth Hospital with a 20-centimeter-long wound to the back of his head. Law, who
works in a travel company, was said to have over 10 years of experience flying toy
helicopters and had won in local competitions. Police said the accident happened at
1.48pm when Law and his friend, surnamed Wong and over 40 years old, were flying a
remote-control helicopter at an open space on Chun Wang Street in Tseung Kwan O.
Police said the man was a friend of the toy owner. Law asked to try the toy and
accidentally hit a button on
the remote control, causing the helicopter to crash into his head.
The blades of the 1.5-meter-long helicopter broke off in the accident. The helicopter,
weighing six kilograms, can fly up to 90 kilometers an hour. Police are still investigating.
The Civil Aviation Department said it will follow up the case, adding that licensing is not
required for helicopters weighing less than seven kilograms. The accident happened at a
government site with a warning sign prohibiting flying remote-control toys. But some
aficionados said they simply ignored the warning due to lack of other places in urban
districts for their activities. A Mr Tong, who has been flying remote-control helicopters
for the past three years, estimated there were 50,000 to 80,000 players in Hong25Kong.
1-25
遙控直升機撞癱友人 麵包師傅罰 5000 元
( 明報 )2 月 6 日 星期五 05:05
【明報專訊】中年麵包師傅去年初偕友到將軍澳空地玩遙控直升
機，惟樂極生悲，直升機撞向友人致其右邊部分頭 骨遭螺旋槳削
去，至今半身癱瘓及失去案發時記憶。麵包師傅昨被裁定危害他
人或 財物安全罪成，裁判官稱事件非 常不幸，但只能按控罪最高
刑罰，判被告罰款 5000 元。

曾在巴士公司任職的事主羅國華（ 45 歲）昨沒有到庭，其代表律
師 在庭外透露，羅至今仍要靠輪椅代步，已喪失 工作能力，
稍後會入稟高等法院向被告索償，相信金額以百萬元計。
被告面臨百萬元計索償

http://www.daddyhobby.com 06-02-2009

26 1-26
9/11/2004

The High Court ordered the Incorporated Owners Association of Albert House
in Aberdeen to wind up, ten years after a fatal canopy collapse there, in which
a woman was killed and 13 others injured. It could not repay more than
25 million dollars in compensation and legal fees within a reasonable
period.
高等法院頒令香港仔添喜大廈業主立案法團清盤，
認為法團未能在合理時間內，籌得二千五百萬元，
支付十年前在上址發生，導致一死十三傷塌簷篷意外的賠償及律師費。

Be aware of the above case when you become a property owner

27 1-27
 添喜大廈簷篷慘劇法團清盤業主上身

高等裁定十年前酒樓簷篷奪命意外的大廈業主立案法團清盤，大廈
小業主每戶可能要分擔十多萬元賠償。
法庭作出今次裁決後，香港仔添喜大廈業主將要負上賠款責任，無
力償還者有可能會被入稟追討賠償或被「釘契」 encumbrance
。大廈有許多小業主都是長者，有小業主擔心無力償還賠償，亦有
在事發後才買入單位的業主覺得非常不公平。
法官表示，同情添喜大廈業主立案法團的處境，但相信法團無力在
合理時間內籌足 2500 萬元賠款及訴訟費，所以頒令清盤。
大廈業主立案法團主席今日出庭時表示，法團上月已經開會通過每
戶科款 6 萬元，原本計劃在本月 22 日再開會，希望每戶再科款 10
萬元還款。

28 1-28
• 這宗糾纏近十年的法律訴訟，始於 94 年 8 月 1 日，當日添喜大
廈新好酒樓拆卸一樓簷篷上的魚缸時，簷篷突倒塌，導致 1 死
13 傷。其後法庭裁定簷篷鋼筋錯亂兼日久失修，判新好酒樓、持
牌人何永恆、業主立案法團、酒樓業主公司「香港仔長勝置業」
、屋宇管理有限公司及恒安拆卸工程 6 名被告疏忽，須向苦主賠
償逾 3000 萬元。
由於業主立案法團沒有購買公眾責任保險， 136 名小業主要攤分
賠償。業主立案法團在 2001 年已分擔了 15% 的賠款，不過，
因為新好酒樓、屋宇管理及何永恆等四名被告先後破產及被清盤
。向受害人墊支賠償的「香港仔長勝置業」轉而控告添喜大廈業
主立案法團，要其承擔賠償。
如法團無能力承擔賠償金額，要由各小業主負責，債權人有權申
請個別小業主破產，拍賣物業償還。有小業主說，要他們承擔其
他人的責任，並不公平。
有保險界人士估計，訴訟案中勝方會「釘契」阻止敗訴的業主賣
樓，但若要強行要求小業主賣樓還債，將會牽涉複雜訴訟。
• 參考資料 : 明報
http://www.gaforum.org/archive/index.php/t-101471.html
29 1-29
Indirect loses

• 2008 年 08 月 18 日
http://hk.apple.nextmedia.com
• 香港仔添喜大廈 14 年前發生塌簷篷壓死人事件，
有小業主疑不堪要承擔約 25 萬元的巨額賠償，以
致精神失常，早前因為噪音問題向上層住客投擲易
燃液體 ……… ..

30 1-30
Major Personal Risks and
Commercial Risks

• Commercial Risks
– Firms face a variety of pure risks that can have serious
financial consequences if a loss occurs:
• Property risks, such as damage to buildings, furniture and office
equipment (flooding in Thailand)
• Liability risks, such as suits for defective products, pollution of
the environment, and sexual harassment
• Loss of business income, when the firm must shut down for
some time after a physical damage loss
• Other risks to firms include crime exposures, human resource
exposures (Steve Jobs), foreign loss exposure (Citic Pacific’s
$2bn in forex losses, FX, heads kidnapped, overseas
construction of water dam), intangible property exposures, and
government exposures (e.g. new environmental protection laws,
labor laws in mainland, laws related to raising product prices
affecting inflation)
31 1-31
Have you heard about the BP oil spill 2010? Not yet settled in 2014

What is the direct loss?

Indirect losses?

A US judge has given final approval to

BP’s $7.8bn (£4.8bn) part settlement with
businesses and individuals who suffered
losses following its disastrous Gulf of
Mexico oil spill.
The settlement resolves most private
individual’s claims for economic loss and
property damage, but it doesn’t cover
lawsuits brought by the US government or
those brought by the states of Alabama
and Louisiana.
http://www.telegraph.co.uk 22 Nov 2012
32 1-32
 Burden of Risk on Society

• The presence of risk results in three major

burdens on society:
– In the absence of insurance, individuals would
have to maintain large emergency funds
– The risk of a liability lawsuit may discourage
innovation, depriving society of certain goods
and services
– Risk causes worry and fear

33 1-33
 Techniques for Managing Risk

• There are five major methods for managing risk

1. Avoidance
2. Loss control
Loss prevention refers to activities to reduce the frequency of
losses
Loss reduction refers to activities to reduce the severity of
losses
3. Retention
An individual or firm retains all or part of a given risk
Active retention means that an individual is consciously aware
of the risk and deliberately plans to retain all or part of it
Passive retention means risks may be unknowingly retained
because of ignorance, indifference, or laziness
Self Insurance is a special form of planned retention by which
part or all of a given loss exposure is retained by the firm
34 1-34
 Techniques for Managing Risk

4. Noninsurance transfers
A risk may be transferred to another party by several methods:
A transfer of risk by contract, such as through a service contract
or a hold-harmless clause in a contract
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 transfers to the creditors the risk
of having insufficient assets to pay business debts
5. Insurance
– For most people, insurance is the most practical method for
handling a major risk

35 1-35
Concept check

• Fog that increases the chance of an

automobile accident is an example of a

• A) speculative risk.
• B) peril.
• C) physical hazard.
• D) moral hazard.

• Why not peril?

36 1-36
Concept check

• the cause of a loss is called________

37 1-37
Chapter 1 CASE APPLICATION

• Mike is a college senior who is majoring in BBA.

• He owns a high-mileage 2000 Ford with current
market value of $2,500.
• The current replacement value of his personal
property in a rented apartment totals $10,000.
• He wears disposable contact lenses, which cost
$300 for a six-month supply.
• He also has a waterbed in his rented apartment that
has leaked water in the past.
• As avid runner, Mike run five miles daily in a nearby
public park that has reputation of being extremely
dangerous due to drug dealers.
• Mike’s parents both work to help him pay for his
tuition.
38 1-38
Mike’s Methods of Handling
Risks
For each of the following risks and loss
exposures, identify an appropriate RM
technique that could have been used to
deal with the exposure. (use the same
paper to answer the questions)

• Physical damage to the 2000 Ford due to

a collision with another motorist.

39 1-39
Mike’s Methods of Handling
Risks
• Liability lawsuit against Mike arising out of
the negligent operation of his car.

• Total loss of personal property due to a

fire in the kitchen of his rented
apartment.

40 1-40
Mike’s Methods of Handling
Risks
• Disappearance of one contact lens.

• Waterbed leak that cause property damage to

the apartment.

41 1-41
Mike’s Methods of Handling
Risks
• Physical assault on Mike by gang members who are
dealing drugs in the park where he runs.

• Loss of tuition assistance from Mike’s father who is

killed by a drunk driver in an auto accident.

42 1-42
In class exercise, take out a paper
• 10000 car insurance
• Chance of car accident in a year 1%
• Kowloon: 80 to 120
• Hong Kong: 75 to 125

• Are the chances of loss in Kln different from that in HK?

• What type of risk should be considered?
• Note: the chance of loss is the probability that an event
will occur)
• Ans: No, Objective

43 1-43