RISK MANAGEMENT AND INSURANCE

CHAPTER ONE

BASIC CONCEPTS OF RISK

Objectives
After completing this chapter, you
would be able to:
Understand what risk means in general
Explain the relationship between risk and
probability
Describe types of risks commonly faced by
businesses
Understand the relationship between risk,
peril and hazard
Identify the different classification of risks
that individuals and organizations face
 Meaning 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

the likelihood of an unfortunate occurrence
Unpredictable
uncertainty about the future
possibility of adverse deviation from
expected outcomes
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 and Subjective Risks
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.
 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.
 Cont…
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 Four basic types of hazards:
Physicalhazard
Moral hazard

Morale 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.
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.
 Cont…
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.
 Cont…
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 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
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.
 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
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
Dynamic risks are those resulting from:
Static and Dynamic Risks

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.
 Cont…
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
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
 Cont…
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.
 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, - War,
- Drought, - Earthquakes,
- Floods and - Other natural disaster
 A particular Risk
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 risk
Is defined as the relative variation of actual
from expected loss.
Objective risk is a statistical risk,
Objective Risk = Probable Variation of
Actual Loss
Probable Losses
Example:
Assume that a property insurer has 10,000 houses
insured over a long period and, on average, 1%, 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
 Effects of Numbers Exposed on Objective Risk
The Law of Large Numbers
States that as the number of exposure units
increases, the more certain it becomes that
actual loss experience will equal probable loss
experience. Hence, the risk diminishes as the
number of exposure units increases.
Objective risk varies inversely with the
probability for any constant number of
exposures.
However, in general, the rate of
decrease in objective risk is less than
proportionate to the rate of increase in
probability of loss.
 Subjective 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
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).
exists when there is a chance of loss but no
chance of gain.
 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.
 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.
 Cont…
Costs that result from the premature death of a
household dead include:
The human life value of the family head is lost
forever.
Additional expenses may be incurred because
of funeral expenses, uninsured medical bills
and others.
Because of insufficient income, some families
will experience a reduction in their standard
of living.
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 payment of catastrophic medical bills and
 the loss of earned income.
Risk of unemployment:
 major threat to financial security.
 Unemployment can cause financial insecurity in at
least
three ways.
The worker losses his or her earned income.
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.
If the duration of unemployment is extended over a
 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.
 Cont…
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 may be:
Loss of additional benefits other than the
property itself resulting from, destruction,
or theft
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.
 Cont…
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.
 Cont…
It is important to distinguish between pure and
speculative risks for three reasons:
1. Normally only pure risks are insurable.
2. The law of large numbers can be applied
more easily to pure risk than to a speculative
risk.
3. 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.
 Cont…
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:
1. business risk
2. financial risk
3. interest rate risks
4. purchasing power risks and
5. market risks.
Each of these is briefly discussed below.
 1. Business Risk

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.
is independent of the company’s financial structure.
2. Financial Risk:
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.
 Cont…
Other financial risks include;
1. bankruptcy,
2. stock price decline,
3. insolvency.
 Bond holders are less exposed to financial
risk than common stock holders because
they have a priority claim against the assets
of an insolvent firm.
 Government securities, however, bear very
low risk.
 3. Interest Rate Risk:
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.
4. 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.
 5. 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.
Market risk is also called systematic or non-
diversifiable risk.
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