CHAPTER ONE

RISK AND RELATED TOPICS

OBJECTIVES
At the end of this chapter you should e able to:
 Define and understand the concept of risk

 Understand the difference between risk, uncertainty and probability

 Understand the word hazard and peril and its relationship with risk

 Identify the different types of risk

1.1 Meaning of Risk

There is no single definition of risk. Economists, behavioral scientists, risk theorists, statisticians and actuaries
each have their own concept of risk. 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. For example, the
risk of being killed in a car accident is present because uncertainty is present. The risk of lung cancer for
smokers is present because uncertainty is present. And the risk of flunking a college course is present because
uncertainty is present.
Employees in the insurance industry often use the term risk to identify the property or life being insured.
Thus, in the insurance industry, it is common to hear statements such as uncertainty
Writers, particularly in the USA have produced a number of definitions of risk. These are usually accompanied
by lengthy arguments to support the particular view they put forward. Consider the following definitions:
Risk is a possibility of an adverse deviation from a desired outcome that is expected or hoped for

Risk is the possibility of an unfortunate occurrence.

Risk is a combination of hazards.

Risk is unpredictability – the tendency that actual results may differ from predicted results.

Risk is uncertainty of loss.

Risk is possibility of loss.

Finally, when risk is defined as uncertainty, some authors make a careful distinction between objective risk
and subjective risk.

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  Objective Risk
Objective risk is defined as the relative variation of actual loss from expected loss. For 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; 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%. This relative variation of actual loss from expected loss is
known as Objective Risk”.
 Subjective Risk
Subjective risk is defined as uncertainty based on a person’s mental condition or state of mind. For example,
a customer who was drinking heavily in a bar may foolishly attempt to drive home. 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.
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 subjective risk often results in conservative and prudent behavior, while low subjective risk may result
in less conservative behavior. For example a motorist previously arrested for drunk driving is aware that he
has consumed too much alcohol. The driver may then compensate for the mental uncertainty by getting
someone else to drive the car home or by taking a taxi. Another driver in the same situation may perceive the
risk of being arrested as slight. This second driver may drive in a more careless and reckless manner; a low
subjective risk results in less conservative driving behavior.

1.2. Risk Vs uncertainty

Certainty is lack of doubt. In Webster‟s New Collegiate Dictionary, one meaning of the term “certainty” is “a
state of being free from doubt,” a definition will suit to the study of risk management. The antonym of
certainty is “uncertainty which is “doubt about our ability to predict the future outcome of current actions.”
Clearly, the term “uncertainty describes a state of mind. Uncertainty arises when an individual perceives
that outcomes cannot be known with certainty.”

Uncertainty is doubt about our ability to predict the future. Uncertainty arises when an individual perceives
risk. Uncertainty is a subjective concept, so it cannot be measured directly. Since uncertainty is a state of mind,
it varies across individuals.

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For complex activities, such as participating in a business venture, some persons are very cautious, others are
more aggressive. Although risk aversion explains some of the reluctance to participate, the level of risk
perceived by individuals also plays a key role. The perceived level of risk depends on information that an
individual can use to evaluate the chance of outcomes and, perhaps, on the individual’s ability to evaluate this
information. The level and type of information on the nature of a risky activity have an important effect on
uncertainty.

Levels of Uncertainty

Level of Uncertainty Characteristics Examples

None (Certainty) Outcomes can be predicted with Physical laws, natural

precision. sciences.

Outcomes are identified and Games of chance, Cards,

Level-1
probabilities are known. Dies.
(Objective Uncertainty)

Outcomes are identified but

probabilities are unknown.
Fire, automobile accident,
Level-2 many investments.

(Subjective Uncertainty) Outcomes are not fully

identifies and probabilities are
Space exploration, genetic
unknown.
research.

Level-3

The level of uncertainty arising from a given type of risk can depend on the entity facing the risk; for
example, an insurer or a governmental entity may regard the risk of earthquake as being at level-2, while the
individual may regard the earthquake as being a at level-3. This difference in perspective may be a
consequence of an ability to estimate the likelihood of outcomes.

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1.3. Risk and probability
Probability:-a numerical measure ranging from 0-1 expressing the relative occurrence or non- occurrence of
the future event.
Probability is closely related to the concept of risk. Chance of loss is defined as the probability that an event
will occur. Like risk, “probability” has both objective and subjective aspects.
Probability distinguished from Risk:
Chance of loss can be distinguished from objective risk. Chance of loss is the probability that an even that
causes a loss will occur. Objective risk is the relative variation of actual loss from expected loss. The chance of
loss may be identical for two different groups but objective risk may be quite different. For example, assume
that a property insurer has 10,000 homes insured in loss Angeles and 10,000 homes insured in Philadelphia and
that the chance of loss in each city is 1%. Thus, on average, 100 homes should burn annually in each city.
However, if the annual variation in losses ranges from 75 to 125 in Philadelphia, but only from 90 to 110 in
Los Angeles, objective risk is greater in Philadelphia even though the chance of loss in both cities is the same.

1.4 Risk, Peril and Hazard

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 property damage included fire, lightning, windstorm, hail, tornado,
earth quakes, theft and robbery.
 Hazard: A hazard is a condition that creates or increases the chance of loss. There are four major
types of hazards:
1. Physical hazard

2. Moral hazard

3. Morale hazard

[Link] hazard: A physical hazard is a physical condition that increases the chance of loss. Examples of
physical hazards include icy roads that increase the chance of a car accident, defective wiring in a building that
increases the increases of fire, and a defective lock on door that increases the chance of theft.
[Link] hazards: Moral hazard is dishonesty or character defects in an individual that increase the
frequency or severity of loss. Examples of moral hazard 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.
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[Link] hazard: Some insurance authors draw a subtle distinction between moral hazard and morale hazard.
Moral hazard refers to dishonest by an insured that increases the frequency or severity of loss. Morale hazard
is carelessness or indifference to a loss because of existence of insurance.

Some insured are careless or indifferent to a loss because they have insurance. Examples of morale hazard
include leaving car keys in an unlocked car, which increase the chance of theft; leaving a door unlocked that
allows a robber to enter; and changing lanes suddenly on a congested interstate highway without signaling.
Careless acts like these increase the chance of loss.

1.5 Classifications of Risks

There are many ways of classifying risks. However, the following groups of classifications are important in the
context of Risk Management and Insurance:
(1) Financial and Non-Financial Risks

(2) Static and Dynamic Risks

(3) Fundamental and Particular Risks

(4) Objective and Subjective Risks

(5) Pure and Speculative Risks

1) Financial and Non-Financial Risks

Risk generally involves all situations in which there is an exposure to adversity. However, the adversity may
result into certain financial losses in some cases, while in others it may not be the result. For instance, every
aspect of human endeavor involves certain risk, which at times may not have any financial consequences. Such
of those risks which result into financial losses are known as Financial Risks. Those who do not have any
financial consequence are known as Non-Financial Risks.
2) Static and Dynamic Risks
Dynamic risks are those resulting from changes in the economy. Changes in price level, changes in consumer
tastes and preferences, changes in income and output, and changes in technology may cause financial loss to
members of the economy, and such risks are Dynamic risks. However, the dynamic risks do not occur with any
precise degree of regularity and therefore, they are less predictable than static risks.
Static risks involve those losses that would occur even if there were no changes in the economy. Even if there
is no change in price level, or consumer tastes and preferences, or income and output, or in technology, still

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some people would incur financial loss. Here, the causes for such losses are not the changes in the economy,
but may be due to perils of nature and the dishonesty of individuals. Static losses tend to occur with a degree of
regularity over time, and therefore are generally predictable. And as such, static risks are more suitable for
coverage by insurance.
3) Fundamental and Particular Risks
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 factors, though occasionally they may arise out of physical
happenings. Unemployment, war, inflation, earthquake, storms, and floods are all fundamental risks and are
felt by larger groups of people.
Particular risks involve loses that arise out of individual events. They are felt by individuals rather than by the
entire group. They may be static or dynamic. For instance, the burning of a house and the robbery of a bank are
particular risks.
4) Subjective and Objective Risks
The risks which are perceived (but not really exist) by individuals are known as Subjective risks. For instance,
navigators in Columbus‟s day perceived a risk of falling off the edge of the world – since they then had a
wrong notion that the world was flat and not a globe. An individual may perceive risk when it does not exist.
Similarly, they may also fail to perceive risk when it does exist.

Objective risks are real risks that exist. The risk of falling on a slippery floor if one runs fast is a real risk and
it is objective.

5) Pure and Speculative Risks

Speculative risk involves a situation in which there is a possibility of loss, but also a possibility of gain.
Gambling and betting involve speculative risk. If a student bets on the winning of football team, he will run a
risk of losing the bet-amount if the specified team loses in the game, yet he has a chance of winning the bet-
amount if the team wins the game. The hope of gain is the crux of the matter in speculative risk.
Pure risks involve those situations in which there is a chance of loss or no loss. In case of a house, there is a
chance of it getting burnt which will result into a loss – or it may not burn at all which may result into „no
losses‟. Thus, pure risks result either into a loss or no loss, but never result into a gain. Obviously, pure risks
are the major subject matter for insurance. Since there is no question of avoiding losses in pure risks when they
really occur, there is a need for insuring pure risks against.
Classifications of Pure Risks
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Listing all the risks confronting an individual or a business is near impossibility. Yet, we may try to classify
and state the most important and frequent categories of pure risks for insurance purposes, in the following
manner:

(1) Personal risks

(2) Property risks
(3) Liability risks
(4) Risks arising from failure of others
1. Personal Risks
Personal risks consist of the possibility of loss of income or assets as a result of loss of the ability to earn
income. On account of one of four perils, the ability to earn income may suffer:
 Risk of premature death.
 Risk of insufficient income during retirement.
 Risk of poor health.
 Risk of unemployment.
 Risk of premature death: Premature death is defined as 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. If the surviving family members receive an insufficient amount of
replacement income from other
 Risk of Insufficient Income during the Retirement

The major risk associated with old age is insufficient income during retirement. The vast majority of workers
in the world are before age 65. When they retire, they lose their earned income. Unless they have sufficient
financial assets on which to draw, or have access to other sources of retirement income, such at social security
or a private pension, they will be exposed to financial insecurity during retirement.

 Risk of Poor Health

Poor health is another important personal risk. The risk of poor health includes both the payment of terrible
medical bills and the loss of earned income.

 Risk of Unemployment

The risk of unemployment is another major threat to financial security. Unemployment can result from
business cycle downswings, technological and structure changes in the economy, seasonal factors, and
imperfections in the labor market.

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 sources or have insufficient financial assets to replace the lost income, they may be financially insecure.

2. Property Risks
The risk of property being destroyed or stolen by somebody is known as the property risk. Property risks may
result into two types of losses, viz., direct loss and indirect loss. If a house is destroyed by fire, the owner loses
the value of the house. This is a direct loss.
During the period in which the house is rebuilt, the owner has to spend towards lodging expenses. This is
indirect loss, arising as a consequence of the destroyed house. Thus, property risks can involve (a) the loss of
property itself (direct loss) and (b) loss of use of the property resulting in lost income or additional expenses
(indirect loss).
3. Liability Risks

Liability risks 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 civil wrongs, or invasion of the rights of
others. The basic peril in the liability risk is the unintentional (or sometimes intentional) injury of other persons
or damage to their property through negligence or carelessness.
4. Risks arising from failure of others
Risks exist when a person (who agreed to perform) fails to meet his agreed obligations, thereby resulting into
financial loss. For example, when a building contractor fails to complete the construction work as scheduled,
there is a risk of suffering financial loss (due to continued stay in rented house). Similarly, when debtors fail to
pay their dues on time as expected, the risk of financing for those debts does exist.