Risk Management &

Insurance

Chapter One: Risk and Related

Topics

2015
 1.1 Definition of Risk
 There is no single definition of risk.

 Different disciplines were defining risk on the

bases of perspective tendency and working
condition of the subject matter.

 Financial point of view, risk is defined as

uncertainty to the occurrence of financial
deficit/loss.

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 Economic point of view, risk can be defined
as a sudden occurrence of individual/group
economic crises.

 Generally, Economists, behavioral scientists,

risk theorists and statisticians each have their
own concept of risk.

 Some of these definitions are forwarded for your

consideration.
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 Cont…
 Risk is the variations in the outcomes that
could occur over a specified period in a given
situation.

 The greater the variability, the greater the risk.

 Risk is unpredictability – the tendency that

actual results may differ from predicted
results.

 Risk is the uncertainty of loss.

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 Cont…
 Risk is the possibility of loss.

 Risk is condition in which there is a possibility

of an adverse (unfavorable) deviation from a
desired outcome that is expected or hoped for.

 Outcome must be in question

 If we know for certain that a loss will occur,

there is no risk.

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 1.2 Risk Vs Uncertainty
 Risk is exposure to loss.
 It has two components:
 The probability of failing to achieve a particular
outcome.
 The consequences/impacts of failing to achieve
that outcome.

 Certainty is lack of doubt. Everything is known.

 It is a state of being free from doubt.

 Uncertainty is the indefiniteness or variance

of an event.
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 Cont…
 Uncertainty is 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 subjective concept, so it can’t be measured

directly by any acceptable yardstick.

 It varies across individuals b/c it is a state of mind.

 Risk refers to a condition of circumstances in

which there is a possibility of loss.

 Unlike uncertainty, risk can be measured.

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 1.3 Risk and probability
 Probability is closely related to concept of risk ,
but distinguished from risk.

 Probability: Long run chance of occurrence or

relative frequency of some event.

 Probability refers to a chance that an event will

occur in a single possible event.
 Insurer’s main concern is to minimize risk by
predicting the probability of occurrence or
chance of loss. 8
 1.4 Risk, Peril and Hazard
 Risk mean both the event, which will give rise
to some loss and the factors, which may
influence the outcome of a loss.

 Peril is cause of loss that occurred.

 Anything that causes a loss is a peril.
 Peril is the prime cause; it is what will give rise
to the loss.
 If a house burns b/c of a fire, cause of loss is
fire.
 If a car is damaged in a collision with another
car, collision is peril, or cause of loss.
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 Cont…
 Common perils that cause property damage include
fire, wind storm, theft, explosion, flood, collision,
earthquake etc.
 Hazard is a condition that creates or increases
chance of loss from a given peril.
 Hazards are not themselves the cause of the loss,
but they can increase the effect should a peril
operates.
 It facilitates the occurrence of perils.

Activity: Mr. Yokahum built a house near by jema

River; a flood came and destroyed the house.
What is the peril? And
what is the hazard? 10
 Types of hazards
1) physical hazard is a physical condition that
increases the likelihood of loss.
 It relates to the physical characteristics of the item
or the property exposed to the risk.

 May or may not be with in human control.

 Rough/curvy/icy roads that increase the likelihood of
an auto-accident,
 loose security protection at a shop or factory,
 the proximity of houses to a riverbank,
 defective wiring in a building that increases fire, and
 a defective lock on door that increases the chance of
theft,
 Ocean storms.
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 Cont…

2) Moral hazard is dishonesty or character defects

in an individual that increases the frequency or
severity of loss.
 This usually refers to the attitude of the insured
person.

Example:
 Making an accident to collect from an insurer,
 Submitting a fraudulent claim,
 Inflating the amount of the claim, and
 Intentionally burning unsold merchandise that is
insured.
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 Cont…

3) Morale hazard: refers to the carelessness or

unresponsiveness to loss because of the
existence of insurance.
 Careless acts to increase chance of loss.
 Some insured persons are careless to a loss
because they have insurance.
 Examples:
 Leaving car keys in an unlocked car, which
increase chance of theft,
 Leaving a door unlocked that allows the robber
to enter,
 Failing to follow safety rule properly. 13
 1.5 The classification of risk
I. Pure & Speculative Risk-Based on Outcome
1.Pure risk is a situation there are only a
possibilities of loss or no loss.
The only possible outcomes are adverse(loss) &
neutral(no loss)
It occurs when there is a chance of loss but no
chance of gain.
If a collision occurs, the owner will suffer a
financial loss.
If there is no collision, the owner's position
remains unchanged.
E.g.: Fire at a factory, accident, flood, theft, etc.
Pure risk includes; 14
 Cont…
A. Personal risk
B. Property risk and
C. Liability risk
A. Personal risks: Directly affect an individuals.
 Includes possibility of complete loss or
reduction of earned income , extra expenses &
depletion of financial assets.
There are four major personal risks
 Risk of Premature death,
 Risk of Insufficient income during
retirement (risk of old age),
 Risk of Poor health, and
 Risk of Unemployment.
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 Cont…
 Risk of Premature death: Death of a household
head with unfulfilled financial obligation.
 E.g. Dependents to support, a mortgage to be
paid off, or children to educate.

 Risk of Insufficient income during retirement:

 Risk associated with old age is Insufficient income
during retirement.
 When employees retire, they lose their earned
income.

 Risk of Poor health:

 Includes both payment of poor medical bills & loss
of earned income. 16
 Cont…
 Risk of Unemployment.
 Unemployment can result from business cycle
downswings, technological and structural
changes in economy, seasonal factors & from
fluctuations in the labor market.
B. Property risks: Risk of having property
damaged or lost from numerous causes.
 This refers to losses associated with
ownership of property.
 Real estate and personal property can be
damaged or destroyed because of fire,
lightening, tornadoes, windstorms, and
numerous other causes. 17
 There are two major types of loss associated with
destruction or theft of property:
 Direct loss : a financial loss that results, from physical
damage, destruction, or theft of the property.
E.g. Assume a Hotel that is damaged by a fire, physical
damage to Hotel is known as direct loss.
 Indirect loss(consequential loss): loss that results
indirectly from the occurrence of a direct physical
damage or theft loss.
 In addition to physical damage loss, Hotel lose
profits for several months while Hotel is being
rebuilt.
 Other examples would be the loss of rents, the loss
of the use of building, and the loss of a local market.
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 Cont…
C. Liability risk is the possibility of loss arising from
intentional or unintentional damage made to other
persons or to their property.
 In general usage, the term has become
synonymous with “responsibility” and involves the
concept of penalty when a responsibility may not
have been met.
 One can be held legally liable if he/she does
something that result in bodily injury or property
damage to someone else.
 A court of law may order him/her to pay substantial
damages to the person he/she has injured.
2. Speculative Risk: defined as a situation in w/c
either profit or loss is possible. 19
 Cont…
 It can be horse racing, lottery, gambling, expansion of
plant, introduction of new product to the market etc..
 E.g. If you purchase 100 shares of common stock, you
would profit if price of stock increases but would loss if
price declines.
 People are more adverse to pure risks as compared to
speculative risks.
 In speculative risk situation, people may deliberately
create the risk when they realize that the favorable
outcome is, indeed, so promising.
 Speculative risks are not considered insurable and
other techniques for coping with risk must be used.
 The law of large numbers can be applied more easily to
pure risks than to speculative risks.
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 Cont…

II. Fundamental & Particular Risk-Based on Cause

and Effect
1. Fundamental risk is a risk that affects the entire
economy or large number of persons or groups within
the economy.
 are essentially group risks; the conditions, which cause
them, have no relation to any particular individual.
 are economic, political or social.
 are those which involve losses that are impersonal in
origin and consequences.
 affect large segments or even all of the population.
 are beyond the control of individual/group.
E.g. High inflation, social change, political intervention,
war, famine, volcanoes and other natural ‘disasters’..
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 Cont…

2. Particular risk refers to a risk that affects

only individuals and not the entire community.
 Particular risks are much more personal both

in their cause and effect.

 Examples: burning of a house, car theft, gold
thefts, bank robberies, risk of legal liability &
dwelling fires.
 Particular risks are insurable while
fundamental risks are not insurable.
 Hence they can be controlled by purchasing

insurance policies and other risk handling

tools. 22
 Cont…

III. Financial & Non-Financial Risk-Based on

Monetary measurement
1. Financial risk is a risk that results in losses
that can be expressed in financial terms.
 Examples of financial risk include physical
damage to a property, theft of property or lost
business profit following a fire.
2. Non-financial risk refers to a loss that does
not have financial implications.
 Examples: choice of a marriage partner, the
selection of an item from a restaurant menu,
the selection of a career, having children, death
of relatives, choice of a new car. 23
 Cont…

IV. Dynamic & Static Risk-Based on Economy

1. Dynamic risk refers to losses originates from
changes in the overall economy such as:
 price level changes,
 changes in consumer tastes,
 income distribution,
 technological changes,
 political changes and the like.
 Dynamic risks are:
 less predictable and
 hence beyond the control of risk
managers.
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 Cont…

2. Static risks refer to those losses that can take

place even though there were no changes in the
overall economy.
Static risks:
 are predictable and could be controlled to some
extent by taking loss prevention measures.

 are insurable, because they are predictable

whereas dynamic risks are not insurable.

 arise from causes other than the changes in

economy, such as perils of nature & dishonesty.
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 Cont…

V. Objective and Subjective Risk

1. Objective Risk: is defined as the relative
variation of the actual loss from expected loss.
Objective Risk:
 Applicable mainly to groups of objects exposed to
loss.
 It can be statistically measured by some measure of
dispersion, such as the SD or the coefficient of
variation.
 It declines as the number of exposures/experience
increases.
 As the number of exposure units increases, an
insurer can predict its future loss experience more
accurately because it can rely on the law of large26
numbers.
 Cont…

 The law of large numbers states that the number

of exposure units increases, the more closely the
actual loss experience will approach the expected
loss experience.
 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”. 27
 Cont…
 As the number of homes under observation
increases, the greater is the degree of accuracy in
predicting the proportion of homes that will burn.
 Since objective risk can be measured, it is an
extremely useful concept for an insurer or a
corporate risk manager.

2. Subjective Risk: is defined as uncertainty based

on a person’s mental condition or state of mind.
 Subjective risk is expressed in terms of the degree
of belief.
 Two persons in the same situation may have a
different perception of risk, and their conduct may
be altered accordingly. 28
 Cont…

Example:
An individual is drinking heavily in a bar and
attempts to drive home. The driver may be
uncertain whether he or she will arrive home
wisely without being arrested by the police for
drunk driving.
This mental uncertainty is called subjective
risk.

 High subjective risk often results in high

conservative conduct, while low subjective risk
may result in less conservative conduct.
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 Risk related to business activities
A. Business risk: associated with physical operation of
risk including variation in sales, costs, profits, etc.

B. Financial risk: associated with debt financing

including debt payment, bankruptcy, stock price
decline, etc.

C. Interest rate risk: results from change in interest

rate.

D. Purchasing power risk: arises under inflationary

situation.

E. Market risk: refers to stock price variability caused by

market forces. 30
 Cont…

Thank
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