Chapter One

General Overview of Risk Management and Insurance

1.1. INTRODUCTION

 Ever since, the human race came to this planet, its livelihood

has been surrounded by diverse risks ranging from those

that are controllable to those that are uncontrollable.

 Since no one knows the future exactly, everyone is a risk

manager not by choice, but by sheer necessity.

 Risk exists whenever the future is unknown.

 CONT….
 An anonymous person clearly stated this fact of life as
follows:
 The whole of life is the management of risk, but not its
elimination.
 People understand risk from different perspective.
o For example a system analysts views risk from the point of
view of system failure or breakdown.
o Insurers on the other hand, view it interms of suffering
losses due to accidental misfortunes.
 CONT…

o While in the field of finance,Security investors view it in terms

of fluctuation in the performance of the investment portfolio.
o These different perspective, however, have one thing in
common is deviation from expectation.
o The term risk is generally associated with an unfortunate
incident that leads to undesirable outcome.
o It denotes something unpleasant and harmful.
o The undesirable incident could lead to a loss -financial or
non-financial.
 1.1 Concept and Meaning of risk

There is no single definition of risk.

Economists, behavioral scientists and risk theorists have
their own concept of risk.
BASIC CONCEPT
1.Risk implies future uncertainty about deviation from
expected earnings or expected outcome.
 Traditionally risk has been defined interms of uncertainty.
 Based on this concept risk is defined as uncertainty
concerning the occurance of a loss.
 CONT…
 Modern scholars define risk as the variability in future outcomes
or the deviation of actual from expected (probable) outcome.
 Risk is then perceived as a deviation from what is expected or
anticipated.
 Risk is the possibility of an unfavorable deviation from
expectations;that is the occurrence of an undesirable
contingency.

o The greater the variation is the greater the risk .

 It is the possibility that something we do not want to happen will
happen or that something we want to happen will fail to do so.
 The term “risk”is when used by people in the insurance
business to mean a peril insured against, fire, Earthquake,
flood , Crop loss, livestock loss.
 The word “risk”will indicate a situation where an exposure
to loss exists.
Risk is the potential for adverse outcomes to:
o human health , safety, business activities and
o the environment from those dealings.
 Risk is uncertainty regarding loss.
 2. PROBABILITY AND CHANCE OF LOSS
 probablity is understood as a measure of the likelihood for
the occurrence of an event.
 Probability is an estimate of the proportion of outcomes in
which a specific condition is expected to occur.
 Probability refers to the long-run chance of occurrence.
 ‘’Chance of loss’’ is relative frequency occurring among a
large numbers of possible events.
 As per the definition ‘’chance of loss’’is similar to
‘’probability of loss.’’.
 PROBABILITY….

 There are three types of probability

A.prior probability (insurable)
 it is objective from the nature of the event (e.g the
probability of getting a head or a tail in a toss of coin or the
probability of getting a number in rolling a die).

B. Statistical probability (insurable).

 determined empirically by examining and analyzing large
observations from experience (e.g probability of motor
vehicle accident in a given geographical area in a given time
period).
 PROBABILITY…..

C. Estimated (judgment) probability (non-insurable):-which

cannot be established objectively, but estimated intuitively.
 The first two probability fall under the definition of risk
while the third one is described under uncertainty for
which there is no valid basis of any kind for classifying
instance.
D.Peril : is defined as a cause of loss.

 Example, if your house is 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 the cause of loss.
 Some common perils that cause property damage or loss
include fire, lightning, windstorm, hail, tornadoes,
earthquakes, theft and burglary.
 CONT…

E.Hazard: is a condition that may create or increase the

chance of a loss arising from a given peril.

 A hazard is a condition that introduces or increases the

probability of loss from a peril.

 For example, one of the perils that can cause loss to an auto
is collision.
 There are four major types of hazards:
 Physical hazard
 Moral hazard
 Morale hazard
 Legal hazard
 A.PHYSICAL HAZARD
 is physical condition that increase the chance of loss.
 is a condition stemming from the physical characteristics of
an object that increases the probability and severity of loss
from given perils.
Example
 icy roads that increase the chance of an auto accident or the road
of Abay desert that increase the chance of car accident is the
cause of the death of many people,
 defective wiring in a building that increase the chance of fire, and
a defective product that increase the loss of customer.
 B. MORAL HAZARD
 is dishonesty of character defects in an individual that increase the
frequency or severity of loss.
 stems from the mental attitude of the insured.
 is a condition that increases the chance that some person will
intentionally (1) cause a loss or (2) increase its severity.
o Example; faking an accident to collect insurance money, submitting a
fraudulent claim, inflating the size of claim, and intentionally burning
house that insured.
o Insurers attempt to control moral hazard by careful underwriting of
applicants for insurance and by various policy provisions, such as
deductable, waiting periods (elimination), exclusions and riders.
 C.MORALE HAZARD
o is carelessness or indifference of the insured to a loss
because the existence of insurance.
o includes the mental attitude that characterizes an accident-
prone person.
 Example
 leaving a key 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
drinking alcohol and deriving.
 CONT….

D.Legal hazard:- Legal hazard refers to characteristics of

the legal system or
 regulatory environment that increase the frequency or
severity of losses.
 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.
 Uncertainty is imperfect ability to assign a character state to an
entity or activity; a form or source of doubt.
 It has no probability.
 Risk is the relative variation of actual from probable or expected
one.
 It can refer to general uncertainty, doubt, an insured object, or
chance of loss.
 It has probability
 THE PRACTICAL DIFFERENCE BETWEEN RISK AND
UNCERTAINTY

 Risk is a combination of hazards

 It is measured by probability or the distribution of the
outcome in a group of instances is known (either through
calculation of a priori or from statistics of past experience).
 However, uncertainty is measured by a degree of belief or it
is impossible to form a group of instance (assign
probability).
 Unlike probability and risk, uncertainty cannot be measured
by any commonly accepted yardstick
 CONT…
o Risk is a state of the world (i.e objective phenomenon) but
uncertainty is the state of the mind (i.e subjective
phenomenon).
o Risk relates only future outcomes, while, uncertainty can
relate to the past event, present realities and future outcomes.
o When risk is said to be exist there must always be at least two
possible outcomes.
o If we know in advance what the outcome will be, there is no
risk.
 CLASSIFICATION OF RISK
 Risks may be classified in several ways according to their
cause, their economic effect, or some other dimension.
 Financial Versus Non Financial Risks
 The term risk includes all situations in which there is an
exposure to adversity.
 In some cases this adversity involves financial loss, while in
others it does not.
 There is some element of risk in every aspect of human
endeavor and many of these risks have no (or only incidental)
financial consequences.
 

 Dynamic Risks (generally less predictable)

 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

Risk as a result from changing circumstances, laws, or conditions
Examples: terrorism, tax laws, exchange rates, political risk,
cultural change, they are generally considered less predictable
than static risks.
Dynamic Risks normally benefit society over the long-run since
they are the result of adjustments to misallocation of resources.
 Static risks doesn't change over time( generally more
predictable).
 These are risks connected with losses caused by the
irregular action of the forces of nature or the mistakes and
misdeeds of human beings.
 These losses arise from causes other than the changes in the
economy, such as; the perils of nature and the dishonesty of
other individuals.
Examples of static risks include the uncertainties due to
random events such as fire, flood, theft, natural disasters,
death similar from year to year.
 Pure risks(insurable) versus Speculative risks

 A pure risk exists when there is a chance of loss but no

chance of gain.
 For 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's position remains
unchanged.
 CONT…
 A speculative risk exists when there is a chance of gains as well as a
chance of loss.
 For instance, expansion of an existing plant involves a chance of
loss and chance of gain
 Pure risks are always distasteful, but speculative risks possess some
attractive features.
 Speculative risk is voluntarily accepted because of its two
dimensional nature, which includes the possibility of gain and loss.
 Gambling is also a good example of speculative risk.
 In a gambling situation risk is deliberately created in the hope of
gain.
 CLASSIFICATION OF PURE RISKS

1. Personal Risks:These consist of the possibility of the loss

of income or assets as a result of loss the ability to earn
income.
 In general earning power is subject to four basic perils
 premature death
 dependent old age
 sickness or disability
 unemployment
 CONT…

2.Property risks Anyone who owns property faces risks

simply because such possession can be destroyed or stolen.
Property risks embrace two distinct types of loss:direct
loss and indirect or consequential loss.
 Direct loss is the simplest to understand.
 If a house is destroyed by fire, the property owner loses the
value of the house.
 in addition to this owner no longer has a place to live and
the owner will incur additional expenses living somewhere
else(indirect loss).
 CONT…
 Property risks, then, can involve three types of losses.
o the loss of the property
o loss of use of the property or its income and
o Additional expenses occasioned by the loss of the property.
3.Liability Risk: the basic peril in the liability risk is the
unintentional injury of property of others through negligence
or carelessness.
 involve the possibility of loss of present assets or future
income as a result of damages assessed or legal liability
arising out of either intentional or unintentional torts or
invasion of the rights.
  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.
 Fundamental risks involve losses that are impersonal in
origin and consequence.
 They are group risks, caused for the most part by
economic, social and political phenomena.
 Examples of fundamental risks include high inflation, war,
drought, earthquakes, floods and other natural disasters.
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.

Particular risks are considered to be the individual's own

responsibility, inappropriate subjects for action by society as a
whole.
Examples of particular risks are the risk of death or disability
from non-occupational causes, the risk of property losses by such
perils as fire, explosion, theft, and vandalism, and the risk of legal
liability for personal injury or property damage to others,the
burning of a house, the robbery of a bank, and the damage of a car.
 CONT…
 Since fundamental risks are caused by conditions more or less
beyond the control of the individuals who suffer the losses and since
they are not the fault of anyone in particular,
 it is held that society rather than the individual has a responsibility
to deal with them.
 Although some fundamental risks are dealt with through private
insurance (for example, earthquake insurance is available from
private insurers in many countries, and flood insurance is frequently
include in all risk contracts covering movable personal property)
 some form of social insurance or other transfer program may be
necessary to deal with particular risk.
 3. Objective and Subjective Risks
Objective risk is defined as the relative variation of actual
from expected loss.
 Objective risk, or statistical risk
o applicable mainly to groups of objects exposed to loss;
 refers to the variation that occurs when actual losses differ
from expected losses.
 The relative variation of actual loss from expected loss is
known as objective risk.
 It may be measured statistically by some concept in
variation, such as the standard deviation.
Subjective risk is defined as uncertainty based on a person’s
mental condition or state of mind.
Subjective risk measured by means of different psychological
tests,
but no widely accepted or uniform tests of proven reliability
have been developed.
refers to the mental state of individual who experiences doubt
or worry as to the outcome of a given event.
 It is a psychological uncertainty that stems from the
individual's mental attitude or state of mind.
 CONT…

 Subjective risk may affect a decision when the decision-

maker is interpreting objective risk.
 One risk manager may determine that some given level of
risk is "high" while another may interpret this same level as
"low".
 Thus it is not enough to know only the degree of objective
risk;
 the risk attitude of the decision maker who will act on the
basis of this knowledge must also be know.
Degree of Risk: is the range of variability around the expected
losses, which are calculated using the chance of loss concept by
means of the following formula:
Objectiverisk=

 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.
 1.2. Producers‟ Attitude towards Risk
Farmers may be divided into three types: risk-neutral; risk-takers
and risk-averse.
The risk-averse farmers try to avoid taking risks.
They tend to be more cautious individuals with preferences for
less risky sources of income.
They will sacrifice some amount of income to reduce the chance
of low income and losses.
A risk averter does not accept any risk at all.
 However,the risk averse farmer would seek to be compensated
for the risk taken by receiving a higher return than would
normally be obtained if there were no risk.
 RISK-TAKERS

 Risk-takers are people who are open to more risky business

options.
 The risk-takers prefer to take a chance to make more profit.
 A risk –taker does accept any risk at all.
Farmers are often willing to accept higher risks to obtain
higher incomes.
 Unlike the risk-averse, risk takers choose the alternative that
gives some chance of a higher outcome, even though they may
have to accept a lower outcome
 CONT…

 risk-taking farmers tend to prefer to take the chance to

make gains rather than protecting themselves from
potential losses.
 Even so,risk-taking farmers are still influenced by the
return they could receive.
 It is useful for the farmers and those who provide support
services to know their attitudes towards risk.
 Risk-neutral lies between the risk-averse and risk-taking positions.
There are some factors that may influence a farmer’s attitude
towards risk
 A person without family commitments may be more willing to take
risks.
 Family commitments and responsibilities can also play a role in
attitudes toward risk.
 Similarly, older people are likely to take less risk.
 Past experience may also influence a farmer’s decisions.
 Again, this may be related to age; a younger person may not yet
have had many experiences on which to base decisions.
 1.3. Quantifying Risk
Quantifying risk is a process to evaluate identified risks to
produce data that can be used in deciding a response to
corresponding risks.
 The objective of risk quantification is
 to prepare contingencies in terms of costs, time, or human
resources and prioritize them in terms of their severity and
likelihood,
 so that appropriate action can be taken accordingly.
 In order to quantify risk, risk needs to be identified first.
o Some key indicators of risk taking ability are:
oGross margin: is the difference between the income of an
enterprise or farm and the variable costs.
oThe higher the gross margin, the more income the farmer
can generate and the greater the risk-taking ability.
oCash flow: All farmers need cash to meet family living
expenses, loan repayments and other expenses requiring
cash payment.
oCash flow is the expected sales minus expenses.
oThe smaller the cash flow, the lower the cash reserve and
the risk-taking ability of the farmer
 An example of cash flow
Assume there are three farmers each operating 20-hec farms
with the same type of machinery.
 All three farmers have outstanding debt from a purchase of
improved seed and fertilizer.
Farmer 3 borrowed $100 to cover the cost of hired labor
when the farmer was in hospital.
 A comparison of the three respective financial situations is
outlined below.
 Farmer 1 Farmer 2 Farmer 3
Gross income 220 180 210
Variable cost 80 60 80
Gross margin
Inflow
Loan - - 100
Income
Total in flow
Outflow
Debt 10 10 80
repayment
Rent - 100 100
Expense 80 60 80
Total out flow
Net cash flow
Calculate gross margin and net cash flow?
 Which farmer is more risk taker or has risk taking ability?
 Here we see that Farmer 1 has the highest gross margin
and the largest cash flow.
 Farmer 1 can assume more risk than either Farmers 2 or
3 and has higher risk-taking ability.
 Risk management” an organized approach to identify
possible or probable financial harm and
 take steps to minimize the financial impact to acceptable
levels.
 is a systematic process for the identification and evaluation
of pure loss exposures faced by an organization and
individuals.
 and for the selection and implementation of more
appropriate techniques for treating such exposures
 Risk management refers to actions farmers take to increase
the chances of success of the farm business.