ASC172 – PRINCIPLES OF RISK MANAGEMENT
AND INSURANCE
Chapter 1 Part A:
Risk and Insurance
Week 1
Nur Haidar Binti Hanafi
Siti Nurasyikin Binti Shamsuddin
TABLE OF CONTENTS
Learning Objectives
1.1 Definition of Risk
1.2 Types of Risk
1.3 Methods of Handling Risk
Conclusions
Quiz
References
LEARNING OBJECTIVES
At the end of this lesson, you should be able to:
• Define the meaning of risk
• Understand the types of risk
• Explain the methods of handling risk
1.1Definition of Risk
• Risk: uncertainty regarding the loss occurrence
• Loss exposure: situation in which a loss is likely to
happen, regardless of loss occurs or not
• Types of risk:
Objective risk: relative variation of actual loss from
expected loss
Subjective risk: uncertainty which is based on an
individual’s mental condition
Chance of Loss
• Chance of loss: defined as the probability that an event
will occur
• Types of probability:
Objective probability: is a long-run relative frequency
of an event based on the assumptions of an infinite
number of observations and of no change in the
underlying conditions
Subjective probability: the chance of loss which is
based on an individual’s guess
Chance of Loss vs. Objective Risk
Even though the chance of loss may be the same for two
different groups, the objective risk may be different
City # homes Average # Range Chance Objective
fires of Fire Risk
Kuala 10,000 100 75 – 125 1% 25%
Lumpur
Perlis 10,000 100 90 - 110 1% 10%
Peril and hazard
Peril
Hazard
Physical
Moral
Attitudinal/Morale
Legal
Peril and Hazard
• Peril: cause of the loss
• Eg: In a fire incident, the gas leaking is the peril
• Hazard: condition that make the frequency and severity
of loss increases
i. Physical hazard: the increasing of the frequency or
severity of loss due to physical condition
ii. Moral hazard: the increasing of the frequency or
severity of loss due to dishonesty or character
defects in an individual
Cont. Peril and Hazard
iii. Attitudinal hazard (morale hazard): the increasing of
the frequency or severity of a loss due to carelessness or
indifference to a loss
iv. Legal hazard: the increasing of the frequency or
severity of a loss due to characteristics of the legal
system or regulatory environment
Classification of risk
Pure & Diversifiable &
Speculative Nondiversifiabl Enterprise Risk
Risk e Risk
Diversifiabl
Pure Risk
e Risk
Speculative Nondiversifi
Risk able Risk
Classification of Risk
• Pure and speculative risk
Pure risk: possibilities of loss or no loss
Eg: earthquake
Speculative risk: possibilities of profit or loss
Eg: gambling
Cont. Classification of Risk
• Diversifiable risk and nondiversifiable risk
Diversifiable risk is risk that affects only small
groups or individuals
Also called nonsystematic or particular risk. Eg: car theft
Nondiversifiable risk is risk that affects the entire
economy or groups within the economy or large
numbers of persons
Also called systematic risk or fundamental risk. Eg:
hurricane
To insure nondiversifiable risks, Government
assistance may be necessary.
Cont. Classification of Risk
• Enterprise risk: includes all major risks which is faced by
a business firm; pure risk, speculative risk, strategic
risk, operational risk, and financial risk
Strategic risk: uncertainty regarding the firm’s
financial goals and objectives.
Operational risk: results from the firm’s business
operations.
Financial risk: uncertainty of loss because of adverse
changes in commodity prices, interest rates, foreign
exchange rates, and the value of money.
1.2 Types of
Risk
1.
Propert
y risk
2. 3.
Types
Person Liabilit
of risk
al risk y risk
4.
Comm
ercial
risk
1. Property Risks
• Property risks: possibility of losses associated with the
destruction or theft of property
• Direct loss vs. Indirect loss
A direct loss is a financial loss that results from the
physical damage, destruction, or theft of the property
• Eg: fire damage to a home
An indirect or consequential loss is a financial loss
that results indirectly from the occurrence of a direct
physical damage or theft loss
• Eg: the additional living expenses after a fire
2. Personal Risks
• Personal risks: risks that directly affect an individual or
family which involve the possibility of a loss or reduction in
income, extra expenses or depletion of financial assets,
due to:
Premature death of family head
Insufficient income during retirement
Poor health (catastrophic medical bills and loss of
earned income)
Involuntary unemployment
3. Liability Risks
• Liability risks involve the possibility of being held
legally liable for bodily injury or property damage to
someone else
There is no maximum upper limit with respect to the
amount of the loss
A lien can be placed on your income and financial
assets
Legal defense costs can be enormous
4. Commercial Risks
• Firms face a variety of pure risks that can have serious
financial consequences if a loss occurs:
Property risks: damage to buildings, furniture and office
equipment
Liability risks: suits for defective products, pollution, and
sexual harassment
Loss of business income: after a physical damage loss,
the firm must shut down for some time
Other risks : crime exposures, human resource
exposures, foreign loss exposures, intangible property
exposures, and government exposures
1.3 Methods of Handling Risk
• Risk control: techniques that reduce the frequency or
severity of losses:
Avoidance: shying away from possible loss
Loss prevention: activities to reduce the frequency
of losses
Loss reduction: activities to reduce the severity of
losses
Cont. Methods of Handling Risk
• Risk financing: techniques that provide for payment of
losses after they occur:
Retention means that an individual or business firm
retains part or all of the losses that can result from a
given risk.
• Active retention means that an individual is aware of
the risk and intentionally plans to retain all or part of it
• Passive retention means risks may be unintentionally
retained because of ignorance, indifference, or laziness
Self insurance is a special form of intentional retention by
which part or all of a given loss exposure is retained by
the firm
Cont. Methods of Handling Risk
• A noninsurance transfer transfers a risk to another party.
A transfer of risk by contract, such as through a service
contract or a hold-harmless clause in a contract
Hedging is a technique for transferring the risk of
unfavorable price fluctuations to a speculator by
purchasing and selling futures contracts on an
organized exchange
Incorporation of a business firm transfers to the
creditors the risk of having insufficient assets to pay
business debts
Cont. Methods of Handling Risk
• Insurance is the most practical method for handling
major risks for most people
Risk transferpure risk is transferred to the insurer
The pooling techniquespread the losses of the
few over the entire group
The risk may be reduced by application of the law
of large numbers
CONCLUSIONS
Now, the students are able to
• Give the definition of risk
• Understand the types of risk
• Further explain the methods of handling risk
QUIZ
1. Objective risk can be defined as
A) uncertainty based on a person's mental condition or
state of mind
B) the cause of loss.
C) the relative variation of actual loss from expected
loss.
D) the probability of loss.
Answer: C
2. Risk is defined as
A) any situation in which the probability of loss is zero.
B) uncertainty concerning the occurrence of loss.
C) any situation in which the probability of loss is one.
D) the probability of a loss occurring.
Answer: B
QUIZ
3. Uncertainty based on a individual's mental condition or state of mind is
known as
A) subjective probability.
B) objective risk.
C) subjective risk.
D) objective probability.
Answer: C
4. An insurance company estimates its objective risk for 10,000 exposures
to be 10 percent. What would happen to the objective risk if the number of
exposures were to increase to 1 million, assuming the probability of loss
remains the same?
A) It would remain the same.
B) It would decrease to 1 percent.
C) It would decrease to 5 percent.
D) It would increase to 20 percent.
Answer: B
QUIZ
5. An individual's personal estimate of the chance of
loss is
A) an objective risk.
B) a subjective probability.
C) an objective probability.
D) an a priori probability.
Answer: B
REFERENCE
• Redja, G.E. (2008). Principles of Risk Management and
Insurance, tenth edition, Addison-Aesley
• Redja, G.E. (2014). Principles of Risk Management and Insurance,
twelfth edition, Pearson Education Limited