025

Thursday, November 20, 2

There is no single definition of risk. Economists, behavioral
scientists, risk theorists, statisticians and actuaries each have
CHAPTER ONE
RISK AND RELATED TOPICS
MEANING OF RISK:

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.
Although risk is defined as uncertainty, employees in the
insurance industry often use the term risk to identify the
property or
1 life being insured. Thus, in the insurance industry, it
is common to hear statements such as “that driver is a poor
risk” or “that building is an unacceptable risk.”
 0, 2025
Thursday, November 2
 From financial point of view, risk is defined as
uncertainty to the occurrence of financial
deficit/loss.
 From Economic point of view, risk can be

defined as a sudden occurrence of

individual/group economic crises.
 the following are some the basic examples of

risks which can result to uncertain able

losses.
 The risk of being killed in auto accident

 The risk of house damage as a result of

2
flooding or earth quick.
 The risk of car collision in ice road
 Writers, particularly in the USA have produced a

0, 2025
Thursday, November 2
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 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 3

objective risk and subjective risk.

 0, 2025
Thursday, November 2
 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”.
 Objective risk can be statistically calculated by some

measure of dispersion, such as the standard deviation

or the coefficient of variation.
 Because objective risk can be measured, it is an
4
extremely useful concept for an insurer or a corporate
risk manager.
 1 Subjective Risk:

0, 2025
Thursday, November 2
 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
5
and prudent behavior, while low subjective risk may
result in less conservative behavior.
 0, 2025
Thursday, November 2
 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.
 For complex activities, such as participating in a business

venture, some persons are very cautious, others are more

6
aggressive. Although risk aversion explains some of the
reluctance to participate,
 Probability (Chance of Loss):

0, 2025
Thursday, November 2
 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.
 Objective Probability:
 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.
 Objective probabilities can be determined in two ways. First, they can be
determined by deductive reasoning. These probabilities are called a priori
probabilities. For example: tossing a fair coin.
 Second, objective probabilities can be determined by inductive reasoning,
rather than by deduction. For example, the probability that a person age
21 will dies before age 26 cannot be logically deduced. However, by a
careful analysis of past mortality experience, life insurers can estimate the
probability of death an sell a five year term life insurance policy issued at
age 21.
 is the likelihood of occurrence of an event that is based on historical data.
 Instead of using personal opinion, analysts use data and mathematical
equations to derive the objective probability of an event. Since analysts7
use all kinds of measurements to predict the future, the objective
probability is considered more accurate and sophisticated for making
business decisions.
 Subjective Probability:

0, 2025
Thursday, November 2
 Subject probability is the individual’s personal estimate of
chance of loss. Subjective probability need not coincide with
objective probability.
 For example, people who buy a lottery ticket on their birthday
may believe it is their lucky day and overestimate the small
chance of winning. A wide variety of factors can influence
subjective probability, including a person’s age, gender
intelligence, education, and the use of alcohol.
 Subjective probability is personal, and they are not data-
driven.
 A person may think a certain incident to occur at certain
moments and hence form an opinion of their own. They may
act depending on the opinion and such an idea of an
occurrence of a certain event is known as subjective
probability. Most subjective probabilities are not facts.
 For example, a person may think that the BSE will gain 65%8
value the next day, while another person may think it will gain
50%. Both are examples of subjective probabilities.
 Probability distinguished from Risk:

0, 2025
Thursday, November 2
 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 both9
cities is the same.
 PERIL AND HAZARD

0, 2025
Thursday, November 2
 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, tornadoes, 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:
 Physical hazard
 Mortal hazard
10
 Morale hazard
 Legal hazard
 Physical hazard: A physical hazard is a physical condition

0, 2025
Thursday, November 2
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.
 Moral 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.
exaggeration of claims,
 Morale 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 insureds 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
11
without signaling. Careless acts like these increase the chance of loss.
 cigarette smoking around petrol sations.
 Legal hazard: Legal hazard refers to

0, 2025
Thursday, November 2
characteristics of the legal system or
regulatory environment that increase the
frequency or severity of losses. Examples include
adverse jury verdicts or large damage awards in
liability lawsuits, statutes that require insurers to
include coverage for certain benefits in health
insurance plans, such as coverage for alcoholism; and
regulatory action by state insurance departments
that restrict the ability of insurers to withdraw from
the state because of poor underwriting results.
 Categories of Risk:

 Risk can be classified into several distinct categories.

The two major categories are as follows:

 Pure and Speculative Risks.
12
 Fundamental and Particular Risks.
 Pure and Speculative Risks:

0, 2025
Thursday, November 2
 Pure Risk: Pure risk is defined as a situation in

which there are only the possibilities of loss or

not loss. The only possible outcomes are adverse
(loss) and neutral (no loss). Examples of pure risk
include premature death, industrial accidents,
terrible medical expenses, and damage to property
from fire, lightning, flood, or earthquake.
 Speculative Risk: Speculative risk is defined as

a situation in which either profit or loss is

possible. For example, if you purchase 100 shares
of common stock, you would profit if the price of
stock increases but would loss if the price declines.
 Other examples, of speculative risk include betting

on horse race, card games, investing in real estate,

13
and going into business for your self. In these
situations, both profit and loss are possible.
 Distinguish between pure and speculative risks:

0, 2025
Thursday, November 2
 First, private insurers generally insure only pure risk.
 With certain exceptions, speculative risk generally is not considered
insurable, and other techniques for managing with speculative risk
must be used.
 Second, the law of large numbers (Insurance companies must
determine what premium to charge that will cover losses, and be
competitive with other insurance companies). can be applied more
easily to pure risks than to speculative risks. The law of large
numbers is important because it enables insurers to predict future loss
experience.
 In contrast, it is generally more difficult to apply the law of large
numbers to speculative risks to predict future loss experience. An
exception is the speculative risk of gambling where nightclub
operators can apply the law of large numbers in a most efficient
manner.
 Finally, Society may benefit from a speculative risk even though a loss
occurs, but it is harmed if a pure risk is present and a loss occurs.
 Example, a firm may develop new technology for producing low price
computers. As a result some competitors may be forced to 14
bankruptcy. Despite the bankruptcy, society benefits because the
computers are produced at a low cost. However, society normally
 Fundamental and Particular Risks.

0, 2025
Thursday, November 2
Fundamental Risk:
 A fundamental risk is a risk that affects the entire
economy or large numbers of persons or groups
within the economy. Examples include rapid inflation,
cyclical unemployment, and war because large numbers of
individuals are affected.
 The risk of a natural disaster is another important risk.
Hurricanes, tornadoes, earthquakes, floods, and forest and
grass fires can result in billions of dollars of property
damage and numerous deaths. More recently, the risk of a
terrorist attack is rapidly emerging as fundamental risk.
Particular Risk:
 A particular risk is a risk that affects only individuals
and not the entire community. Examples include car
thefts, gold thefts, bank robberies, and dwelling fires. Only
individuals experiencing such losses are affected, not the15
entire economy.
 Types of pure risk:

0, 2025
Thursday, November 2
 The major types of pure risk that can create great
financial insecurity include
 Personal Risks.
 Property Risks.
 Liability Risks.
 Personal Risks:
 Personal risks are risks that directly affect an
individual. They involve the possibility of the complete
loss or reduction of earned income, extra expenses, and
the depletion of financial assets. There are four major
personal risks.
 Risk of premature death.
 Risk of insufficient income during
retirement.
16
 Risk of poor health.
 Risk of unemployment.
 Risk of premature death:

0, 2025
Thursday, November 2
 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
sources or have insufficient financial assets to replace the lost
income, they may be financially insecure.
 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
17
poor health includes both the payment of terrible medical
bills and the loss of earned income.
 Risk of Unemployment:

0, 2025
Thursday, November 2
 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, an imperfections in the labor market.
[Link] Risks:
 Persons owning property are exposed to

property risks – the risk of having property

damaged or lost from numerous causes. Real
estate and personal property can be damaged or
destroy because of fire, lightning, tornadoes,
windstorms, and numerous other causes. There are
two major types of loss associated with the
destruction or theft of property direct loss and 18
indirect loss or consequential loss.

 [Link] loss: A direct loss is defined as financial loss

0, 2025
Thursday, November 2
that results, from the physical damage, destruction, or
theft of the property. For example, if you own a hotel that
is damaged by a fire, the physical damage to the hotel is
known as a direct loss.
 [Link] loss: An indirect loss is a financial loss that
results indirectly from the occurrence of a direct
physical damage or theft loss. Thus, in addition to the
physical damage loss, the hotel would lose profits for several
months while the hotel is being rebuilt. The loss of profits
would be consequential loss. Other examples of a
consequential loss would be the loss of rents, the loss of the
use of building, and the loss of a local market.
3. Liability Risk:
 Liability risks are another important type of pure risk that
most persons face. Under our legal system, you can be held
legally liable if you do something that result in bodily injury or
property damage to someone else. A court of law may order 19
you to pay substantial damages to the person you have
injured.
Thursday, November 2
20

0, 2025
THE END