Basic Risk and Insurance Concepts

Subjective Probability
Risk Management Individual’s personal estimate of the chance
Risk of loss (ex: lottoe bets); need not coincide
- Uncertainty with objective probability
- May result in deviation from an expected
outcome, whether positive or negative Peril
- AS LONG AS THERE IS DEVIATION - Cause of loss
- Fire, storm, robbery
Loss Exposure
- Any situation or circumstance in which a loss Hazard
is possible, regardless of whether a loss - Condition that creates or increases the
actually occurs frequency or severity of loss
- Types:
Types of Risks o Physical
a. Objective Risk o Moral
- Degree of risk o Attitudinal
- Relative variation of actual loss from o Legal
ex: "echo expected loss
chamber" during
the election -->- Declines as the number of exposures Pure Risk
we thought that
Leni's going to increases - Only possibilities are loss (averse) or no loss
win because we
are just (neutral)
surrounded by
Leni supporters; Law of Large Numbers - NO CHANCE OF GAIN
basically, we
didn't consider the o As the number of exposure units - Insurers generally concentrate on pure risks
whole population
increases, the more closely the actual - Law of large numbers can be applied more
the more units
you get, the more loss experience will approach the easily
you see the
bigger picture expected loss experience - Society may be harmed
- Ex: fire
- If you limit you sample size, your exposure to
being mistaken is high Speculative Risk
- As you approach a larger number, you are - Either profit or loss is possible
more able to determine the risk
Diversifiable Risk
b. Subjective Risk - Non-systematic or particular risk
- Perceived risk - Affects only individuals or small groups
- Uncertainty based on a person's mental - Don’t put your eggs in one basket
condition
- Affects a person's behavior Non-diversifiable
- Risk Taker VS Risk Averse - Fundamental risk
- High subjective risk → conservative and - Affects the entire economy or large numer of
prudent behavior persons
- Ex: pandemic (you have no choice or control)
Chance of Loss - Government assistance may be necessary to
- Probability that a loss event will occur insure against non-diversifiable risk
- Chance of loss may be the same, but
objective risk may be different Systemic Risk
- Based on estimates - Risk of collapse of an entire system or market
due to the failure of a single entity or group of
Objective Probability (expected vs actual) entities, resulting in the breakdown of an
Long-run relative frequency of an event based entire financial system
on the assumptions of an infinite number of
observations and no change in underlying Enterprise Risk
conditions
 - Encompasses all major risks faced by a - Risk-distributing scheme
business firm
- Includes pure, speculative, strategic, Pooling of Losses
operational, financial risk, etc. - Spreading of losses incurred by the few over
- Combines into a single unified treatment the entire group such that average loss is
program all major risks faced by a firm substituted for actual loss
- Involves the prediction of future losses with
Risk Control some accuracy based on the law of large
• Avoidance numbers
• Loss Prevention - Goal is to reduce the variation in possible
• Loss Reduction outcomes as measured by the standard
o Duplication deviation
o Separation → physical separation of
assets Payment of Fortuitous Losses
o Diversification → diversify between - A fortuitous loss is unforeseen and
govt bonds and stocks unexpected by the insured and occurs as a
Risk Financing result of chance
• Retention → you recognize that there is a loss - The loss must be accidental and random
o Active → you are absorbing the loss
(ex: depreciation) Risk Transfer
o Passive → wrongly estimated which - A pure risk is transferred from the insured to
would result to manifestation in other the insurer, who is typically in a stronger
records or the production itself; ex: financial position to pay the loss than the
you forgot to recognize the warranty insured
expense
• Non-insurance transfers Indemnification
o By contract - The insured is restored to his/her approximate
o Hedging → volatile price of goods (ex: financial position prior to the occurrence of
as seller, you sold an item for locked the loss compensated for the loss

in for P100 but it was originally at

P200. As seller, you have a loss of Concept of Adverse Selection
P100) - If not controlled by underwriting and policy
o Incorporation provisions, this would result in higher-than-
• Insurance expected loss levels and unprofitable
business
Risk Appetite
- Risk you are willing to take Underwriting
Risk Tolerance - Process of selecting and classifying
- Risk that you can take applicants for insurance
Risk Capacity
- Maximum level of risk you can be exposed

Risk is a CASE-TO-CASE basis

Insurance Concepts
Insurance
- Pooling of fortuitous losses by transfer of
such risks to insurers who agree to:
o Indemnify the insured for such losses
o Provide other pecuniary benefits on
their occurrence
o Render services connected with the
risk