Principles of Risk Management and

Insurance
Thirteenth Edition

Chapter 1
Risk and Its
Treatment

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Agenda
• Definitions of Risk
• Chance of Loss
• Peril and Hazard
• Classification of Risk
• Major Personal Risks and Commercial Risks
• Burden of Risk on Society
• Techniques for Managing Risk

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Definitions of Risk (1 of 2)
• Traditional Definition of Risk: Uncertainty concerning the
occurrence of a loss
• In the insurance industry, risk is also used to identify the
property or life that is being considered for insurance
• In economics and finance:
– The term risk is used in situations where the
probabilities of possible outcomes are known
– Uncertainty is used in situations where such
probabilities cannot be estimated

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Definitions of Risk (2 of 2)
• Loss Exposure: Any situation or circumstance in which a
loss is possible, regardless of whether a loss occurs
• Objective risk is defined as the relative variation of actual
loss from expected loss
– It can be statistically calculated by some measure of
dispersion, such as the standard deviation
• Subjective (perceived) risk is defined as uncertainty
based on a person’s mental condition or state of mind

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Chance of Loss
• Chance of loss: The probability that an event will occur
• Objective probability refers to the 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 is the individual’s personal
estimate of the chance of loss

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Chance of Loss vs. Objective Risk
• Chance of loss is the probability that an event 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!

Average # Chance of Objective

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Peril and Hazard (1 of 2)
• A peril is defined as the cause of the loss.
– Examples include property damage because of fire,
windstorm, or lightening, or damage to your car
because of a collision with another vehicle.
• A hazard is a condition that increases the chance of loss
– A physical hazard is a physical condition that
increases the frequency or severity of loss
– Moral hazard is dishonesty or character defects in an
individual that increase the frequency or severity of
loss

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Peril and Hazard (2 of 2)
– Attitudinal Hazard (Morale Hazard) is carelessness
or indifference to a loss, which increases the frequency
or severity of a loss
– Legal Hazard refers to characteristics of the legal
system or regulatory environment that increase the
frequency or severity of losses

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Classification of Risk (1 of 6)
• Pure Risk and Speculative Risk
– A pure risk is a situation in which there are only the
possibilities of loss or no loss (earthquake)
– A speculative risk is a situation in which either profit
or loss is possible (gambling)

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Classification of Risk (2 of 6)
• Diversifiable Risk and Nondiversifiable Risk
– A diversifiable risk affects only individuals or small
groups (car theft). It can be reduced or eliminated by
diversification.
– A nondiversifiable risk affects the entire economy or
large numbers of persons or groups within the
economy (hurricane). It is also called fundamental risk.
– Government assistance may be necessary to insure
nondiversifiable risks.

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Classification of Risk (3 of 6)
• Enterprise risk encompasses all major risks faced by a
business firm, which include: pure risk, speculative risk,
strategic risk, operational risk, and financial risk
– Strategic Risk refers to uncertainty regarding the
firm’s financial goals and objectives.
– Operational risk results from the firm’s business
operations.
– 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.

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Classification of Risk (4 of 6)
• Enterprise Risk Management combines into a single
unified treatment program all major risks faced by the firm:
– Pure risk
– Speculative risk
– Strategic risk
– Operational risk
– Financial risk

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Classification of Risk (5 of 6)
• As long as all risks are not perfectly correlated, the firm
can offset one risk against another, thus reducing the firm’s
overall risk.
• Treatment of financial risks requires the use of complex
hedging techniques, financial derivatives, futures contracts
and other financial instruments.

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Classification of Risk (6 of 6)
• Systemic risk is the risk of collapse of an entire system or
entire market due to the failure of a single entity or group
of entities that can result in the breakdown of the entire
financial system
• Systemic risk is especially important with respect to large
financial institutions that are considered too large to fail
without doing major financial harm to the US economy

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Major Personal Risks (1 of 3)
• Personal risks are risks that directly affect an individual or
family. They involve the possibility of a loss or reduction in
income, extra expenses or depletion of financial assets,
due to:
– Premature death
– Inadequate retirement income
– Poor health
– Unemployment

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Exhibit 1.1 Total Savings and Investments
Reported by Retirees, Among Those
Responding

*Have retirement plan defined as respondent or spouse having at least one of the following IRA, defined
contribution plan or defined benefit plan.

(not including value of primary residence or defined benefit plans)

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Major Personal Risks (2 of 3)
• Property risks involve the 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,
such as 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 (e.g., the additional living
expenses after a fire).

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Major Personal Risks (3 of 3)
• 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

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Major Commercial Risks (1 of 2)
• Firms face a variety of pure risks that can have serious
financial consequences if a loss occurs:
– Property risks, such as damage to buildings, furniture
and office equipment
– Liability risks, such as suits for defective products,
pollution, and sexual harassment
– Loss of business income, when the firm must shut
down for some time after a physical damage loss
– Cybersecurity and identity theft by thieves breaking
into a firm’s computer system

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Major Commercial Risks (2 of 2)
• Other risks faced by business firms include:
‒ Human resources exposures, such as job-related
injuries
‒ Foreign loss exposures, such as acts of terrorism
‒ Intangible property exposures, such as damage to
the market reputation and public image of the company
‒ Government exposures, such as violation of safety
standards

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Burden of Risk on Society
• The presence of risk results in three major burdens on
society:
– In the absence of insurance, individuals and business
firms would have to maintain large emergency funds to
pay for unexpected losses
– The risk of a liability lawsuit may discourage innovation,
depriving society of certain goods and services
– Risk causes worry and fear

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Techniques for Managing Risk (1 of 4)
• Risk Control refers to techniques that reduce the
frequency or severity of losses:
– Avoidance
– Loss prevention refers to activities to reduce the
frequency of losses
• Loss reduction refers to activities to reduce the severity
of losses:
– Duplication
– Separation
– Diversification

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Techniques for Managing Risk (2 of 4)
• Risk Financing refers to 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 deliberately plans to retain all or part of it
– Passive retention means risks may be unknowingly
retained because of ignorance, indifference, or laziness

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Techniques for Managing Risk (3 of 4)
• Self Insurance is a special form of planned retention by
which part or all of a given loss exposure is retained by the
firm
• A Noninsurance transfer transfers a risk to another party.
– A transfer of risk by contract, such as through a hold-
harmless clause in a contract
– Hedging is a technique for transferring the risk of
unfavorable price fluctuations to a speculator
Incorporation of a business firm transfers to the
creditors the risk of having insufficient assets

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Techniques for Managing Risk (4 of 4)
• For most people, insurance is the most practical method
for handling major risks:
– Risk transfer is used because a pure risk is transferred
to the insurer.
– The pooling technique is used to spread the losses of
the few over the entire group
– The risk may be reduced by application of the law of
large numbers

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Copyright

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