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Chapter 1

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30 views17 pages

Chapter 1

Uploaded by

Negash adane
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
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Download as PPTX, PDF, TXT or read online on Scribd
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CHAPTER ONE

RISK AND RELATED TOPICS


Definition
 Risk is a condition in which there is a possibility
of an adverse deviation from a desired outcome.
 Risk is potential variation in outcomes.

 However, risk traditionally has been defined in


terms of uncertainty. Based on this concept, risk
is defined as uncertainty concerning the
occurrence of a loss.
Risk vs uncertainty

• Uncertainty refers to a state of mind


characterized by doubt, based on a lack of
knowledge about what will or will not happen in
the future.
• Where as risk- is a condition or combination of
circumstances in which there is a possibility of
loss.
Risk and probability
• Probability refers to the long-run chance of
circumstance, or relative frequency of some
event.
• Objective probability refers to the long-run
relative frequency of an event based on the
assumption of an infinite numbers of
observations.
• Subjective probability
• The individual's personal estimate of the
chance of loss. Subjective probability need not
coincide with objective probability.
Risk, peril and hazard
 Peril-is defined as the cause of loss. It is a contingency that may
cause a loss.
 Common perils that cause property damage include fire, lighting,
windstorm, hail, tornados, earthquakes, theft, burglary and others
• Hazard-is a condition that may create or increase the chance of
loss arising from the given peril.
• Example: Ice roads that increase the chance of an auto accident,
inappropriate wiring system cases fire .
• There are four major types of hazards
 Physical hazard: is a physical condition that
increases the chance of loss
• Example:
• Ice roads that increase the chance of an auto accident,
Defective wiring in a building that increase the
chance of fire.
 Moral /mental hazard: is dishonesty or character
defects in an individual that increase the frequency
or severity of loss.
• Example:
• Faking an accident to collect from an insurer
• Submitting a fraudulent claim
• Inflating the amount of claim
 Morale hazard: is carelessness or indifference
to a loss because of the existence of insurance
• Example: Leaving car keys in an unlocked car,
which increase the chance of theft
• Leaving a door unlocked that allows a burglar to
enter
 Legal hazard: refers to characteristics of the
legal systems or regulatory environment that
increase the frequency or severity of loss.
• Example:
• Adverse jury verdicts or large damage awards in
liability lawsuits.
Classification of risk
• Financial and non-financial risks
• There is some element of risk in every aspect of
human endeavor, and many of these risks have no
(or only incidental) financial consequences.

• Financial risk; market value risk( interest rate


risk, exchange prices, equity prices, commodity
prices)
 non-financial risk model risk, operational risk
(fraud, misconduct, failure of internal controls or
audit systems, natural disasters)
• Static and dynamic risks
• Dynamic risks: are those resulting from
changes in the economy. E.g. Changes in the
price level, consumer tastes, income and output,
and technology may cause financial loss to
members of the economy.

• Generally dynamic risks are the result of


adjustments to misallocation of resources. In the
long run, dynamic risks are beneficial to the
society
• Static risks: involves those losses that would occur
even if there were no changes in the economy
• Static losses involve destruction of assets or
change in their possession as a result of dishonesty.
Static losses seem to appear periodically and as a
result of these they are generally predictable
• Example:

• Uncertainties due to random events such as fire,


windstorm, or death
• Fundamental and particular risks

• A fundamental risk: is a risk that affects the entire


economy or large numbers of persons or groups within
the economy. Example: high inflation, war, droughts,
earthquakes, floods and other natural disasters
• particular risk: is a risk that affects only individuals
and not the entire economy. Example: burning of a
house, the robbery of a bank, and the damage of a car.
• Objective and subjective risks

 Objective risk: is defined at the relative variation of actual from expected

loss. It can be measured by standard deviation and coefficient of variation.

• Subjective risk: is defined as uncertainty based on a persons mental condition

or state of mind

• Degree of risk: is the range of variability around the expected losses, which are

calculated using the chance of loss concepts by means of

• Objective risk=probable variation of actual from expected losses/expected

losses

• Chance of loss=probable number of losses/number objects exposed to losses


• Pure 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), a pure risk exists when there is
a chance of loss but no chance of gain. Car
accident, premature death, job-related accidents
• Speculative risk: is defined as 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: Investment
In Capital Project
Classification of pure risks
 Personal risk: Are risks that consist of the possibility of loss of
income or assets as a result of the loss of the ability to earn
income. They are risks that directly affect an individual; Risks of
premature death, Risk of insufficient income during retirement,
Risk of poor health, Risk of unemployment
 Property risks: Any one who owns property faces property risks
simply because such possessions can be destroyed or stolen.
There are two types of loss associated with the destruction or
theft of property, direct loss(loss of the property), indirect
loss(loss of the use of the property).
 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.
 Risks arising from failure of others

• When another person agrees to perform a service for


you, he or she undertakes an obligation that you hope
will be met.
• Burden of risks on society

 Large emergency fund In the absence of insurance,

individuals and business firms would have to increase

the size of their emergency fund in order to pay for

unexpected losses

 Worry and fear The uncertainty connected with risk

usually produces a feeling of frustration and mental

unrest. This is perfectly true in the case of pure risk.

Speculative risk is attractive to many individuals.


Thank you!!!

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