CHAPTER 1

RISK IN OUR SOCIETY

1
WE LIVE IN A RISKY WORLD,,

• Terrorists
• Accidents
• Home-loss
• Medical Bills
• Natural Catastrophes
How can we avoid/ mitigate risk?

2
MEANING OF RISK ,
• Different definitions by economist, behavioral
scientists, risk theorists, etc.
• However, they all agree that;

Risk  Uncertainty

Page 20
3
MEANING OF RISK ,
• Generally defined as: “The uncertainty
concerning the occurrence of a loss”

• Or “The variability in future outcomes”

• And also “The chance of loss”

Examples?

4
 RISK

Risk

Subjectiv
Objective
e

Page 21

5
 OBJECTIVE RISK

Risk

Subjectiv
Objective
e

6
OBJECTIVE RISK

• Also called : Degree of Risk

• It is defined as “ The relative variation of actual

loss from expected loss”
• Objective Risk=
• Difference between Actual Loss and Expected
Loss = Objective Risk

7
OBJECTIVE RISK EXAMPLE
- An insurance company has been in business for
50 years.
- According to the statistics, it insures 10,000
houses in the long run.
- On average, it expects 1% of houses (100
houses) to burn each year
- However, actual records showed the following:
2009: 90 houses burnt
2010: 110 houses burnt

8
ANSWER
Actual loss variation =
110 - 100 = 10 Houses
100 - 90 = 10 Houses

Average Actual Loss Variation =(10+10)/ 2 = 10

Houses

Expected loss = 100 Houses

Degree of risk = objective risk = 10/100 = 10%

9
EXERCISE ON OBJECTIVE RISK
• An insurance company insures 50,000 cars each
year
• Expect 1000 to be involved in accidents each
year
• Actual records shows:
2010: 1200 cars were damaged
2011: 800 cars were damaged
Objective risk?

10
OBJECTIVE RISK

• Standard deviation, coefficient of variation

• Objective Risk=

• Law of large numbers: As the number of exposure units

increases, the more closely the actual loss experience will
approach the expected loss experience.
• Accuracy of predictions

11
SUBJECTIVE RISK

Risk

Subjectiv
Objective
e

12
SUBJECTIVE RISK

• “Uncertainty based on a person’s mental

condition or state of mind”
• Two persons in the same situation will have:
1. Different perception of risk
2. Behave differently
3. Different experience

- High subjective risk  more conservative behavior

13
SUBJECTIVE RISK EXAMPLE

• A young man has had a lot to drink

• He decides to carelessly drive back home.

• Although he realizes that there is a certain level of

uncertainty about him arriving home safely.

• Or being arrested by the police.

• What if someone else with greater mental

uncertainty (high subjective risk) was in his place?

14
 SUBJECTIVE RISK

• Driving 140km/hr

• Riding a roller costar

• Climbing a mountain

• Missing a class

15
IMPORTANT NOTE,,

Risk ≠ Chance of Loss

• Chance of loss might be identical for two groups, but

objective risk might be different.
• Risk is basically defined as an uncertain event and the
occurrence of that event would disrupt the flow of the
processes which are aligned with the objectives set. On
the other hand, Calculated Risk revolves around the
concept of Prudence which signifies that the loss of
carrying out an objective would already be estimated
and reckoned with, before laying down the processes to
actually carry it out. Page 22

16
CHANCE OF LOSS

• “The probability that an event will occur”

Chance of
Loss

Objective Subjective
Probability Probability

Page 21
17
CHANCE OF LOSS

A. Objective Probability:
- Long run relative frequency
- Has two assumptions:
1. Infinite number of observations
2. No change in underlying conditions

- Meaning: The probability that an event will occur

based on an analysis in which each measure is
based on a recorded observation, rather than a
subjective estimate.

18
CHANCE OF LOSS
A. Objective Probability:
Determined by:
- Deductive Reasoning (priori probabilities): cutting
down options
- Inductive Reasoning: Analysis of past experience

Example: the probability of getting a head from the

toss of a perfectly balanced coin is 1/2 because
there are two sides, and only one is a head.

19
CHANCE OF LOSS
B. Subjective Probability
- “Individual personal estimate of the chance of
loss”
- Buying a lottery ticket on your birthday?
- Factors effecting the estimate: Age, Gender,
Intelligence, Education, etc.

- Example: Multiple Choice Test

20
 IMPORTANT NOTE,,

Example: Takaful International, has

the following

City # homes Average # Range Chance Objective

fires of Fire Risk
Manama 10,000 100 75 – 125 1% 25%
Riffa 10,000 100 90 - 110 1% 10%

Page 22

21
IMPORTANT TO REMEMBER

• Insurer  Insurance company

• Insured  person, property, or
liability being insured.

22
 The Distinction between risk,
peril, and Hazard is important

Page 22 - 23 23
PERIL,,

“ it is the cause of loss”

Examples: Fire, Collision, Theft, Earthquake, etc.

24
HAZARD ,,

• “ A condition that creates or

increases the chance of loss”
• Types of Hazard:
1. Physical
2. Moral
3. Morale (Attitudinal)
4. Legal

25
HAZARD

1. Physical Hazard: “a physical condition that

increases the chance of loss” ( icy roads,
defective wiring)
2. Moral Hazard: “ Dishonesty, character defect
in an individual that increase frequency or
severity of loss” (Faking an accident, burn unsold
merchandise)
- Difficult to control
- Careful underwriting and policy provision

26
HAZARD

3. Morale Hazard: “carelessness, indifference to

a loss because of the existing insurance”
(leaving keys in an open car, changing lanes without
signaling)
4. Legal Hazard: “Characteristics of legal
system that increase the chance loss” (Adverse
jury verdicts or large damage awards in lawsuits)

27
 HAZARD EXERCISE

Give an example of each, concerning one case

28
BASIC CATEGORIZE OF RISK

1. Pure
2. Speculative
3. Fundamental (Non-diversifiable Risk)
4. Specific (Diversifiable Risk)
5. Enterprise

Page 23-24

29
 HOMEWORK QUESTION

Define each type of the risk

categorize (one line is enough)

30
PURE & SPECULATIVE RISK

• Usually, defined by the comparison between each

two categorize.

• Pure and Speculative Risk:

- Pure Risk: is one in which there are only the
possibilities of loss or no loss (earthquake)

- Speculative Risk: is one in which both profit or

loss are possible (gambling)

- Examples?
31
WHY DO WE DISTINGUISH?

• It is important to distinguish between pure risk and

speculative risks for these reasons:

1. Private insurers typically insure only pure risks

(Exceptions sometimes with portfolio investment).

2. The law of large numbers can be applied more easily to

pure risks than speculative risks(Exceptions with
casinos).

3. Society might benefit from a speculative risk even

though a loss occurs, but it is harmed if a pure risk is
present and a loss occurs.
32
FUNDAMENTAL & PARTICULAR RISK

Fundamental Risk: affects the entire economy or

large numbers of persons or groups (hurricane).

Particular Risk: affects only the individual (car

theft).

33
ENTERPRISE RISK

Enterprise Risk: Encompasses all major risks faced

by a business firm, which include: pure risk,
speculative risk, strategic risk, operational risk,
and financial risk.

34
TYPES OF PURE RISK

Pure Risk

Personal Property Liability

Premature
Direct Loss
Death

Insufficient Indirect/
Income During Consequential
Retirement Risk

Poor Health

Unemployment Page 25-29

35
TYPES OF PURE RISK - PERSONAL

• Personal Risk: risks that directly affect an

individual
1. Premature Death: the death of a family
head with unfulfilled financial obligations

2. Insufficient Income During Retirement:

reduction in income, not enough savings

36
TYPES OF PURE RISK

3. Poor Health: catastrophic medical bills and loss

of earned income

4. Involuntary Unemployment: financial insecurity,

business cycle downswings, technological and
structural changes. Loosing the job, working part
time, extended period of unemployment

37
TYPES OF PURE RISK - PROPERTY

• Property risks: The Risk of having a property

damaged or lost from numerous causes

1. Direct Loss: involve the possibility of losses

associated with the destruction or theft of
property (i.e. a fire damaging a house).

2. Indirect Loss: results indirectly from the

occurrence of a direct physical damage or theft
loss (i.e. renting an apartment to stay at until
property is repaired).
38
EXAMPLE OF PROPERTY RISK

If you own a candy store and it caught on fire.

Direct or Indirect Loss?

39
TYPES OF PURE RISK - LIABILITY

• Liability risks: involve the possibility of being

held liable for bodily injury or property
damage to someone else
- You have to pay an amount for the person you
injured
- There is no maximum upper limit with respect to the
amount of the loss. A line can be placed on your income
and financial assets. Defense costs can be enormous
•Pharmaceutical company that has released a
- Examples?
medicine with harmful side effects.
•Polluting the environment.

40
BURDEN OF RISK ON SOCIETY

• The presence of risk results in three major

burdens on society:

1. Larger Emergency Fund

2. Loss of Certain Goods and Services
3. Risk causes worry and fear

Page 30
41
BURDEN OF RISK ON SOCIETY

1. Larger Emergency Fund

Maintain large emergency funds to pay for
unexpected losses.
Without insurance:

Consumption Lower Living

Higher Saving
Reduced Standard

42
Example?..
BURDEN OF RISK ON SOCIETY

2. Loss of Certain Goods & Services

- The risk of a liability lawsuit may discourage innovation,
depriving society of certain goods and services

- Example:

 Vaccination

 Terrorism

43
BURDEN OF RISK ON SOCIETY

3. Risk Causes Worry and Fear

- Parents won’t allow their children to drive a

motorbike.

- Student entering the test feeling tense.

44
 METHODS OF HANDLING RISK

Methods

Risk
Risk Control
Financing

Noninsuranc
Avoidance Loss Control Retention Insurance
e Transfers

Page 30 - 33
45
RISK CONTROL METHODS - AVOIDANCE

• Avoidance:
Desirable choice.. One can chose practicality in
decision making.
Just don’t do it.
Example?

46
RISK CONTROL METHODS – LOSS
CONTROL
• Loss Control:
Before and after occurrence of loss.

a) Loss Prevention: refers to activities to reduce the

frequency of losses.
Example?

b) Loss Reduction: refers to activities to reduce the

severity of losses.
Example?

47
RISK FINANCING METHODS -
RETENTION

• Retention:
• An individual or firm retains all or part of a loss, it can
be passive or active.

a. Active: An individual consciously aware of the risk and

deliberately plans to retain all or part of it. (Auto
Insurance)

b. Passive: Unknowingly retained because of ignorance,

indifference, or laziness.

48
RISK FINANCING METHODS –
NONINSURANCE TRANSFERS
• Noninsurance Transfers: The risk is transferred to a
party other than an insurance company.
a. Transfer of Risk by Contracts: Agreeing on a
contract that will remove part or all of the risk
(Service contract, warranties, rents).
Example?
b. Hedging Price Risks: transferring risk of unfavorable
price fluctuations (Future and option contracts) .
Example?
c. Incorporation of a Business Firm: Sole Proprietorship
Vs. Corporation (limit liability).
Example?

49
RISK FINANCING METHODS -
INSURANCE
• Insurance: More practical
• Three Characteristics:
1. Risk Transfer
2. Pooling technique  Spread Risk
3. Low of large number  Reduce Risk

[Link]
>> How insurance works

[Link]
>> Islam and insurance

50
END OF CHAPTER 1

51