Risk Management & Insurance Chapter -1- Risk & Related Topics

CHAPTER ONE

1. RISK AND RELATED TOPICS

1.1. MEANING OF RISK

There is no comprehensive definition exists for Risk so far. It is defined in different terms by

several authors with some differences in the wordings used. The essence, however, is very

similar. However, risk historically has been defined in terms of uncertainty. Based on this

concept, risk is defined as uncertainty concerning the occurrence of a loss.

In the economics and finance literature, authors often make a distinction between risk and

uncertainty. The term “risk” is often used in situations where the probability of possible

outcomes can be estimated with some accuracy, while “uncertainty” is used in situations where

such probabilities cannot be estimated. As such, many authors have developed their own

concept of risk, and numerous definitions of risk exist in the professional literature.

Because the term risk is ambiguous 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 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.

When the definition of risk includes the concept of uncertainty, some authors make a careful

distinction between objective risk and subjective risk.

Objective Vs. Subjective Risk

These two types of risk are also mentioned as Measurable and Non-measurable Risk.

A. Objective Risk

Also called degree of risk is defined as the relative variation of actual loss from expected loss.

The characteristic of objective risk is that it is measurable. In other words, it can be quantified

using statistical or mathematical techniques.

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For example, the variance or standard deviation is used as a measure of risk in finance. In some

situations, the coefficient of variation is used as a measure of risk. In security market the BETA is

used to measure the risk associated with security returns, (measure of systematic risk). Under

such circumstances risk is quantified or measured which leads us to consider such risk as

objective risk.

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 declines as the number of exposures increases. More specifically, objective risk

varies inversely with the square root of the number of cases under observation. In our previous

example, 10,000 houses were insured, and objective risk was 10/100, or 10 percent. Now assume

that 1 million houses are insured. The expected number of houses that will burn is now 10,000,

but the variation of actual loss from expected loss is only 100. Objective risk is now 100/10,000,

or 1 percent. Thus, as the square root of the number of houses increased from 100 in the first

example to 1000 in the second example (10 times), objective risk declined to one-tenth of its

former level.

B. Subjective Risk

Subjective 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, the driver may be

uncertain whether he will arrive home safely without being arrested by the police for drunk

driving. This mental uncertainty 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

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subjective risk often results in conservative and prudent behavior, while low subjective risk may

result in less conservative behavior.

[Link] vs. Uncertainty

Many Risk Management textbooks use the terms risk and uncertainty interchangeably. The

distinction between the two must be noted, however. Although the two are closely related, quite

many authors make a distinction between the two terms. Uncertainty refers to the doubt as to

the occurrence of a certain desired outcome. It is more of a subjective belief. Subjective in the

sense that “it is based on the knowledge and attitudes of the person viewing the situation and

different individuals under identical circumstances of the external world”.

Uncertainty can be view as “a state of mind whereby a sentient entity experience doubt”. The

argument here is that for a given state of real world situation, different people would express

different intensity of uncertainty.

The following difference between risk and uncertainty can be noted:

Risk is a combination of hazards and is measured by probability but Uncertainty is measured by

the degree of belief. Risk is a state of the world but Uncertainty is a state of the mind. A clear

explanation made above is that risk is largely objective while uncertainty subjective.

[Link] and Probability

There exists also some confusion as to the difference between risk and probability. Part of the

confusion arises due to definitional problems. Where one defines risk as a chance of loss, it

would be very difficult to make significant difference between risk and probability. The other

difficulty is whether or not probability measures risk.

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; and these

events may occur in equal or different chance of occurrence. The weights given to each possible

event may depend on prior knowledge, (toss of a coin), past experience, statistical or

mathematical estimation of relevant data or possible event is assigned a corresponding

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probability of occurrence that leads to probability distribution. This means that probability

relates to a single possible event.

Risk, on the other hand, refers to the variation in the possible outcomes. This means that risk

depends on the entire probability distribution. It indicates the concept of variability. The

concepts of risk and probability are, therefore, two different things.

[Link], Peril and Hazard

Risk has already been defined above. 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.

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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 from an insurer, submitting a fraudulent claim, inflating the amount of a claim, and

intentionally burning unsold merchandise that is insured. Murdering the insured to collect the

life insurance proceeds is another important example of moral hazard.

Moral hazard is present in all forms of insurance, and it is difficult to control. Dishonest

individuals often rationalize their actions on the grounds that “the insurer has plenty of

money.” This view is incorrect because the insurer can pay claims only by collecting premiums

from other insured’s. Because of moral hazard, insurance premiums are higher for everyone.

Insurers attempt to control moral hazard by the careful underwriting of applicants for insurance

and by various policy provisions, such as deductibles, waiting periods, exclusions, and riders.

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; and changing lanes suddenly on a congested expressway without signaling,

which increases the chance of an accident. Careless acts like these increase the frequency and

severity of loss.

The term morale hazard has the same meaning as attitudinal hazard. Morale hazard is a term

that describes someone who is careless or indifferent to a loss. However, the term attitudinal

hazard is more widely used today and is less confusing to students and more descriptive of the

concept being discussed.

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; statutes that require insurers to include coverage for certain benefits

in health insurance plans, such as coverage for alcoholism; and regulatory action by state

insurance departments that prevents insurers from withdrawing from a state because of poor

underwriting results.
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[Link] of Risk

Risk can be classified into several distinct classes. They include the following:

I. Financial Vs. Non-Financial Risks

This classification is self-explanatory. Financial risk results in losses that can be expressed in

financial terms. Non-financial risk does not have financial implication.

II. Statistic Vs. Dynamic Risks

Dynamic risks originate from changes in the overall economy such as: Price level changes,

changes in consumer taste, income distribution, technological changes, political changes and

the like. They are less predictable and hence beyond the control of risk managers.

Static risks on the other hand, refer to those losses that can take place even though there were no

changes in the over –all economy. They are losses arising from causes other than changes in the

economy. Unlike dynamic risks, they are predictable and could be controlled to some extent

by taking loss prevention measures. Many of the perils fall under this category.

III. Fundamental Vs. Particular Risks

Fundamental risks are essentially group risks: the conditions which cause them have no

relation to any particular individual. Most fundamental risks are economic, political or

social< Thus, fundamental risks affect the entire society or a larger segment of the

population, which are usually, beyond the control of individuals. The responsibility for

tackling these risks is, therefore, left to the society itself. Examples include; unemployment,

Famine, flood; inflation, war, etc < they are generally uninsurable.

Particular risks are those due to particular conditions, which obtain in particular causes.

They affect each individual separately< They are usually personal in cause, almost always

personal in their application. Because they are so largely personal in their nature, the

individual has a certain degree of control over their causes. Particularly risks are the

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responsibility of individuals. They are dealt with by purchasing insurance policies and other

techniques. Examples include: property losses, death, disability, etc<.

IV. Pure Vs. Speculative risks

The distinction between pure and speculative risks rests primarily on profit or loss structure of

the underlying situation in which the event occurs.

Pure risks refer to the situation in which only a loss or no loss would occur. The only possible outcomes

are adverse (loss) and neutral (no loss). Most pure risks are insurable. They are always undesirable

and hence people take steps to avoid such risks. Examples of pure risks include premature

death, job-related accidents, catastrophic medical expenses, and damage to property from fire,

lightning, flood, or earthquake.

Speculative risks, on the other hand, provide favorable or unfavorable consequences.

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.

People are more adverse to pure risks as compared to speculative risks. In speculative risk

situation, people may deliberately create the risk when they realize that the favorable outcome

is, indeed, so gain or promising. Speculative risks are generally uninsurable. They are dealt with

hedging and other commercial techniques. Examples include foreign exchange risk, gambling,

etc<

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.

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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.

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.

MAJOR PERSONAL RISKS AND COMMERCIAL RISKS

The preceding discussion shows several ways of classifying risk. Certain pure risks are

associated with great economic insecurity for both individuals and families, as well as for

commercial business firms. This section discusses (1) important personal risks that affect

individuals and families and (2) major commercial risks that affect business firms.

Personal Risks

Personal risks are risks that directly affect an individual or family. They involve the possibility

of the loss or reduction of earned income, extra expenses, and the depletion of financial assets.

Major personal risks that can cause great economic insecurity include the following:

Premature death

Insufficient income during retirement

Poor health

Unemployment

Property Risks

Persons owning property are exposed to property risks—the risk of having property damaged

or lost from numerous causes. Homes and other real estate and personal property can be

damaged or destroyed because of fire, lightning, tornado, windstorm, and numerous other

causes. There are two major types of loss associated with the destruction or theft of property:

direct loss and indirect or consequential loss.

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Direct Loss A direct loss is defined as a financial loss that results from the physical

damage, destruction, or theft of the property. For example, if you own a home that is

damaged by a fire, the physical damage to the home is a direct loss.

Indirect or Consequential Loss An indirect loss is a financial loss that results indirectly

from the occurrence of a direct physical damage or theft loss. For example, as a result of

the fire to your home, you may incur additional living expenses to maintain your normal

standard of living. You may have to rent a motel or apartment while the home is being

repaired. You may have to eat some or all of your meals at local restaurants. You may

also lose rental income if a room is rented and the house is not habitable. These additional

expenses that resulted from the fire would be a consequential loss.

Liability Risks

Liability risks are another important type of pure risk that most persons face. Under our legal

system, you can be held legally liable if you do something those results in bodily injury or

property damage to someone else. A court of law may order you to pay substantial damages to

the person you have injured.

Commercial Risks

Business firms also face a wide variety of pure risks that can financially cripple or bankrupt the

firm if a loss occurs. These risks include (1) property risks, (2) liability risks, (3) loss of business

income, and (4) other risks.

Property Risks Business firms own valuable business property that can be damaged or

destroyed by numerous perils, including fires, windstorms, tornadoes, hurricanes, earthquakes,

and other perils. Business property includes plants and other buildings; furniture, office

equipment, and supplies; computers and computer software and data; inventories of raw

materials and finished products; company cars, boats, and planes; and machinery and mobile

equipment. The firm also has accounts receivable records and may have other valuable business

records that could be damaged or destroyed and expensive to replace.

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Liability Risks Business firms today often operate in highly competitive markets where

lawsuits for bodily injury and property damage are common. The lawsuits range from small

nuisance claims to multimillion-dollar demands. Firms are sued for numerous reasons,

including defective products that harm or injure others, pollution of the environment, damage

to the property of others, injuries to customers, discrimination against employees and sexual

harassment, violation of copyrights and intellectual property, and numerous other reasons. In

addition, directors and officers may be sued by stockholders and other parties because of

financial losses and mismanagement of the company.

Loss of Business Income Another important risk is the potential loss of business income when a

covered physical damage loss occurs. The firm may be shut down for several months because of

a physical damage loss to business property because of a fire, tornado, hurricane, earthquake, or

other perils.

During the shutdown period, the firm would lose business income, which includes the loss of

profits, the loss of rents if business property is rented to others, and the loss of local markets.

In addition, during the shutdown period, certain expenses may still continue, such as rent,

utilities, leases, interest, taxes, some salaries, insurance premiums, and other overhead costs.

Fixed costs and continuing expenses that are not offset by revenues can be sizeable if the

shutdown period is lengthy.

Finally, the firm may incur extra expenses during the period of restoration that would not have

been incurred if the loss had not taken place. Examples include the cost of relocating

temporarily to another location, increased rent at another location, and the rental of substitute

equipment.

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