CHAPTER ONE

RISK AND RELATED TOPICS

1.1. Risk defined
There is no single definition of risk. Economists, behavioral scientists, risk theorists, statisticians,
and actuaries each have their own concept of risk.
Risk is a condition in which there is a possibility of an adverse deviation from a desired outcome
that is expected or hoped for. However, risk traditionally has been defined in terms of
uncertainty. Based on this concept, risk is uncertainty concerning the occurrence of a loss.
For example, the risk of being killed in auto accident is present because uncertainty is present.
The risk of lung cancer for smokers is present because uncertainty is present. The risk of
flunking a college course is present because uncertainty is present.
1.2. 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.
It is simply a psychological reaction to the absence of knowledge about the future. Uncertainty is
a person’s conscious awareness of the risk in a given situation. Unlike probability and risk,
uncertainty can’t be measured by any commonly accepted yardstick.
1.3. Risk and probability
Probability refers to the long-run chance of circumstance, or relative frequency of some event. It
is necessary to distinguish carefully between risk and probability.
Objective and subjective aspects probability .
A. Objective probability
Objective probability refers to the long-run relative frequency of an event based on the
assumption of an infinite numbers of observations.
Objective probabilities can be determined in two ways
I. Deductive reasoning: priori probabilities-tossing a coin, side of dies
II. Inductive reasoning: determined by past experience and data
B. Subjective probability
It refers the individual’s personal estimate of the chance of loss. Subjective probability need not
coincide with objective probability.

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For example, people who buy a lottery ticket on their birthday may believe, it is their lucky day
and over estimate the small chance of winning.
Peril and hazard
I. Peril-is defined as the cause of loss. It is a contingency that may cause a loss.
Example:
 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, lighting, windstorm, hail,
tornados, earthquakes, theft, burglary and others
III. Hazard-is a condition that may create or increase the chance of loss arising from
the given peril.
Example:
 One of the perils that can cause loss to an auto is collision. Condition that makes the
occurrence of collisions more likely is an icy street.
 Sickness is a peril causing economic loss, but it is also a hazard that increases the chance
of loss from the peril of premature death.
Types of hazards
1. 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
 A defective lock on a door that increase the chance of theft.
2. 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
 Intentionally burning the unsold merchandize that is insured

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3. 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
 Changing lanes suddenly on a congested interstate high way without signaling
Careless acts like these increase the chance of loss
4. 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.
1.4. Classification of risk
1.4.1. 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.
1. Examples of financial risk;
 market value risk( interest rate risk, exchange prices, equity prices, commodity prices)
 credit risk (downgrade, default, credit spread risk)
 liquidity risk
2. Examples of non-financial risk

 model risk  legal risk

 operational risk settlement risk  tax risk
 accounting risk  sovereign risk and political risk
 regulatory risk

1.4.2. Static and dynamic risks

1. Dynamic risks: are those resulting from changes in the economy.
Example:
 Changes in the price level, consumer tastes, income and output, and technology may cause
financial loss to members of the economy.

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  Dynamic risk normally affects a large number of individuals, but because they do not occur
regularly, they are more difficult to predict than static risk
2. Static risks: involves those losses that would occur even if there were no changes in the
economy
Example:
 Uncertainties due to random events such as fire, windstorm, or death
Unlike dynamic risks, static risks are not a source of gain to society. Because they are
predictable, static risks are more suited to treatment by insurance than dynamic risks.

Static risks are risks that involve losses brought about by irregular action of nature or by
dishonest misdeeds and mistakes of man. Static losses involve destruction of assets or change in
their possession as a result of dishonesty.

Examples of static risk include theft, arson assassination and bad weather. Static risks are pure
risks.

1.4.3. Fundamental and particular risks

Their difference is based on the origin and consequence of the losses
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
B. Particular risk: is a risk that affects only individuals and not the entire economy. It involves
losses that a rise out of individual events and are felt by individuals rather than by the entire
group. They may be static or dynamic
Example: burning of a house, the robbery of a bank, and the damage of a car
1.4.4. Objective and subjective risks
A. Objective risk: is defined at the relative variation of actual from expected loss.
 Statistical risk is applicable mainly to groups of objects exposed to loss, refers to the
variation that occurs when actual losses differ from expected losses.
 It can be measured by standard deviation and coefficient of variation
B. Subjective risk: is defined as uncertainty based on a person’s mental condition or state of
mind

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  Is a psychological uncertainty that stems from the individual mental attitude or state of
mind
 It is difficult to measure these attitudes scientifically and predict risk-taking behavior,
such as insurance buying behavior, from test of risk-taking attitudes
 Subjective risk may affect a decision when the decision-maker is interpreting objective
risk
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
Generally, high subjective risk produces very conservative conduct and low subjective risks
tends to produce less conservative conduct
Objective risk varies according to the ratio of probable variation of actual from probable loss. If
a loss has already occurred, the probable variations as zero and thus objective risk is also zero.
Similarly, if it is impossible for the loss to happen, the probable variation is zero and the
objective risk is still zero.
1.4.5. Pure and speculative risk
A. 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
Example: Car accident, premature death, job-related accidents, and damage of property from fire,
lighting, flood, or earth quake
B. 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
Example: investment in capital project, purchase of stocks, a football match, investing in real
estate, and going in to business for yourself. In these situations both profit and loss are possible.
Classification of pure risks
1. 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.
 Risks of premature death:
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 Premature death is defined as the death of a household head with unfulfilled financial
obligations.
Risk of insufficient income during retirement
This a major risk associated with old age.
Risk of poor health
Includes both the payment of catastrophic medical bills and the loss of earned income
 Risk of unemployment
Is another major threat to financial security.
2. 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 :
A direct loss: is defined as a financial loss that results from the physical damage, destruction, or
theft of the property
An indirect loss: is a financial loss that results indirectly from the occurrence of a direct physical
damage or theft loss.
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.
4. Risks arising from failure of others
When the person’s failure to meet his / her obligation would result in your financial loss, risk
exists. For example, failure of a contractor to construction project as scheduled, failure of debtors
to make payments as expected.
Burden of risks on society
When a house destroyed by a fire, or money is stolen, or a wage earner dies, there is a financial
loss. These losses are the primary burden of risks and the primary reason that individuals attempt
to avoid risk or alleviate its impact. In addition to the losses themselves
 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
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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.