Chapter One: Risk and Related Topics

CHAPTER ONE
RISK AND RELATED TOPICS
1.1 MEANING OF RISK

There is no single definition of risk. Economists, behavioral scientists, risk theorists, statisticians,
and actuaries each have their own concept of risk. There are common elements in all the
definitions: Indeterminacy and loss

 The notion/idea of an indeterminate outcome is implicit in all definitions of risk: the

outcome must be in question. When risk is said to exist, there must always be at least two
possible outcomes. If we know for certain that a loss will occur, there is no risk.
 At least one of the possible outcomes is undesirable. This may be a loss in the generally
accepted sense, in which something the individual possesses is lost, or it may be a gain
smaller than the gain that was possible.

Risk is a condition in which there is a possibility of an adverse deviation from a desired outcome
that is expected or hoped for. Risk is uncertainty regarding loss. The individual hopes that
adversity will not occur, and it is the possibility that this hope will not be met that constitutes
risk. If you own a house, you hope that it will not catch fire.

1.2 RISK VS. UNCERTAINTY

Uncertainty refers to a state of mind characterized by doubt, based on a lack of knowledge about
what will or will not happen in the future. Uncertainty is simply a psychological reaction to the
absence of knowledge about the future. The existence of risk creates uncertainty on the part of
individuals when that risk is recognized.

Uncertainty is the doubt a person has concerning his or her ability to predict which of the many
possible outcomes will occur. Uncertainty is a person’s conscious awareness of the risk in a
given situation.

 Unlike probability and risk, uncertainty cannot be measured by commonly accepted

yardstick/unit/.

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Chapter One: Risk and Related Topics

1.3 RISK VS. PROBABILITY

Probability refers to the long-run chance of occurrence, or relative frequency of some event.
Insurers are particularly interested in the probability or chance of loss, or accurately, the
probability that a loss will occur to one of insured objects. Actually, probability has little
meaning if applied to the chance of occurrence of a single event. It has meaning only when
applied to the chance of occurrence among a large number of events.

Risk, as differentiated from probability, is a concept in relative variation. We are referring here
particularly to objective risk, which is the relative variation of actual from probable or expected
one. Objective risk can be measured meaningfully only in terms of a group large enough to
analyze statistically.

Probability has both objective and subjective aspects.

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, the probability of getting a head from
the toss of a perfectly balanced coin is ½ because there are two sides, and only one is a head.
Second, objective probability can be determined by inductive reasoning. For example, the
probability that a person age 21 will die before age 26 cannot be logically deductive. However,
by a careful analysis of past mortality experience, life insurers can estimates the probability of
death and sell a five year term insurance policy issued at age 21.

Subjective probability

It is the individual’s personal estimate of the chance of loss. 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,
intelligence and education.

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Chapter One: Risk and Related Topics

1.4 RISK, PERIL AND HAZARD

It is common for the terms peril and hazard to be used interchangeably with each other and with
“risk”. However, to be precise, it is important to distinguish these terms.

Peril

Peril is defined as a cause of loss. It is a contingency that may cause a loss. Example, if your
house is 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 the cause of the loss.

Hazard

A hazard is a condition that may create or increase the chance of a loss arising from a given peril.
A hazard is a condition that introduces or increases the probability of loss from a peril. For
example, one of the perils that can cause loss to an auto is collision. A condition that makes the
occurrence of collisions more likely is an icy street. The icy street is the hazard and the collision
is the peril.

There are basic types of hazards

Physical hazard

A physical hazard is a condition stemming from the physical characteristics of an object that
increases the probability and severity of loss from given perils. For example, the existence of dry
forests (hazard for fire), earth faults (hazard for earthquakes), icy road (hazard for auto accident).

Moral hazard

Moral hazard is dishonesty or character defects in an individual that increase the frequency or
severity of loss. Moral hazard refers to the increase in the probability of loss that result from
dishonest tendencies in the character of the insured person. Example of moral hazard includes
intentionally burning unsold merchandise that is insured.

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Chapter One: Risk and Related Topics

Morale hazard

Morale hazard is carelessness or indifference to a loss because of the existence of insurance.

Some insured are careless or indifferent to a loss because they have insurance. Examples of
morale hazard include leaving car keys in the ignition of an unlocked car and thus increasing the
chance of theft, leaving a door unlocked that allows a burglar, etc.

1.5 CLASSIFICATION OF RISK

1. Static and Dynamic Risks

Dynamic risks are those resulting from changes in the economy. Changes in the price level,
consumer tastes, income and output, and technology may cause financial loss to members of the
economy. These dynamic risks normally benefit society over the long run, since they are the
result of adjustments to misallocation of resources. Although these dynamic risks may affect a
large number of individuals, they are generally considered less predictable than static risks, since
they do not occur with any precise degree of regularity.

Static risks involve those losses that would occur even if there were no changes in the
economy. If we could hold consumer tastes, output and income, and the level of technology
constant, some individuals would still suffer financial loss. These losses arise from causes other
than the changes in the economy, such as the perils of nature and the dishonesty of other
individuals. Unlike dynamic risk, static risks are not a source of gain to society. Examples of
static risks include the uncertainties due to random events such as fire, windstorm, or death.
Static losses involve either the destruction of the asset or a change in its possession as a result
dishonesty or human failure. Static losses tend to occur with a degree of regularity overtime and,
as a result, are generally predictable. Because they are predictable, static risks are more suited
to treatment by insurance than are dynamic risks.

2. Fundamental and Particular Risks

The distinction between fundamental and particular risks is based on the difference in the origin
and consequences of the losses.

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A fundamental risk is a risk that affects the entire economy or large numbers of persons or
groups within the economy. Fundamental risks involve losses that are impersonal in origin and
consequence. They are group risks, caused for the most part by economic, social and political
phenomena, although they may also result from physical occurrences. They affect large segments
or even all of the population. Examples of fundamental risks include high inflation, war, drought,
earthquakes, floods and other natural disasters.

A particular risk is a risk that affects only individuals and not the entire community. Particular
risks involve losses that arise out of individual events and are felt by individuals rather than by
the entire group. They may be static or dynamic. Examples of particular risks are the burning of
a house, the robbery of a bank, and the damage of a car.

 Since Particular risks are considered to be the individual’s own responsibility, they can be
treated with by the individual using insurance, loss prevention or some other technique.
3. Objective and Subjective Risks

Objective risk is defined as the relative variation of actual from expected loss. Objective risk, or
statistical risk, applicable mainly to groups of objects exposed to loss, refers to the variation that
occurs when actual losses differ from expected losses. For example assume that a property
insurer has 10,000 houses insured over a long period and, on average, 1 percent, 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, while in other years, as many as 110 house my burn. Thus,
there is a variation of 10 houses from the expected number of 100, or a variation of 10 percent.
This relative variation of actual loss from expected loss is known as objective risk.

Subjective risk is defined as uncertainty based on a person’s mental condition or state of mind.
A subjective risk is a psychological uncertainty that stems from the individual’s mental attitude
or state of mind. Some writers have used the word “uncertainty” to be synonymous with
subjective risk as defined here. Subjective risk has been measured by means of different
psychological tests, but no widely accepted or uniform tests of proven reliability have been
developed. Thus, although we recognize different degrees of risk-taking willingness in persons,
it is difficult to measure these attitudes scientifically and to predict risk-taking behavior, such as
insurance-buying behavior, from test of risk-taking attitudes.

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4. Pure and Speculative Risks

Pure risk is defined a situation in which there are only the possibilities of loss or no loss. The
only possible outcomes are adverse (loss) and neutral (no loss). A pure risk exists when there is a
chance of loss but not chance of gain. For example, the owner of an automobile faces the risk
associated with a potential collision loss. If a collision occurs, the owner will suffer a financial
loss. If there is no collision, the owner does not gain. The owner’s position remains unchanged.
Other examples of pure risks include premature death, job-related accidents, and damage to
property from fire, lighting, flood, or earthquake.

Speculative Risk is defined as a situation in which either profit or loss is possible. A speculative
risk exists when there is a chance of gain as well as a chance of loss. For instance, investment in
a capital project might be profitable or it might prove to be a failure. If you purchase 100 shares
of common stock, you would profit if the price of the stock increases but would lose if the price
declines. Other examples of speculative risks are betting on a football match, investing in real
estate, and going into business. In these situations, both profit and loss are possible.

 Pure risks are always distasteful, but speculative risks possess some attractive features.
 The distinction between pure and speculative risks is an important one, because normally
only pure risks are insurable. Insurance is not concerned with the protection of individuals
against those losses arising out of speculative risks. Speculative risk is voluntarily accepted
because of its two- dimensional nature, which includes the possibility of gain.

Classifications of Pure Risk

The major types of pure risk that can create great financial insecurity include personal risks,
property risks, liability risks, and risks arising from failure of others.

A. Personal Risks

Personal risks are risks that consist of the possibility of loss of income or assets as a result of the
loss of the ability to earn income. 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 asset. There are four major personal risks:

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Chapter One: Risk and Related Topics

i. Risk of premature death

ii. Risk of insufficient income during retirement
iii. Risk of poor health
iv. Risk of unemployment
i. Risk of premature death

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.

Premature death can cause financial problems only if the deceased has dependents to support or
dies with unsatisfied financial obligations. Thus, the death of a child age 10 is not “premature” in
the economic sense.

ii. Risk of insufficient income during retirement

Risk of insufficient income during the retirement is another major risk associated with old age.
The majority of workers in America retire before age 65. When they retire, they lose their earned
income. Unless they have sufficient financial assets, or have access to other sources of
retirement, they will be exposed to financial insecurity during retirement

iii. Risk of poor health

The risk of poor health includes both the payment of catastrophic medical bills and the loss of
earned income. Unless a person has adequate health insurance, private saving and financial
assets, or other sources of income to meet medical expenditures, he or she will be financially
insecure.

The loss of earned income is another major cause of financial insecurity if the disability is
severe. In cases of long-term disability, there is a substantial loss of earned income, medical bills
are incurred, employee benefits may be lost, or reduced, savings are often depleted/exhausted
sand someone must take care of the disabled person. The loss of earned income during an
extended disability can be financially very painful.

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iv. Risk of Unemployment

The risk of unemployment is another major threat to financial security. Unemployment can cause
financial insecurity in at least three ways.

 The worker losses his / she earned income. Unless there is adequate replacement income
or past savings on which to draw, the unemployed worker will be financially insecure.
 Because of economic conditions, the worker may be able to work only part time. The
reduced income may be insufficient in terms of the worker’s needs.
 If the duration of unemployment is extended over a long period, past savings may be
exhausted.
B. Property Risks

Anyone who owns property faces property risks simply because such possessions can be
destroyed or stolen. There are two major types of loss associated with the destruction or theft of
property: direct loss and indirect or consequential loss.

i. Direct Loss

A direct loss is defined as a financial loss that results from the physical damage, destruction, or
theft of the property. Direct loss is the simplest to understand; if a house is destroyed by fire, the
owner loses the value of the house. This is a direct loss.

ii. Indirect Loss

However, in addition to losing the value of the building itself, the property owner no longer has a
place to live, and during the time required to rebuild the house, it is likely that the owner will
incur additional expenses living somewhere else. This loss of use of the destroyed asset is an
“indirect,” or “consequential,” loss. An indirect loss is a financial loss that results indirectly from
the occurrence of a direct physical damage or theft loss.

An even better example is the case of a business firm. If a firm’s facilities are destroyed, it losses
not only the value of those facilities but also the income that would have been earned through
their use. Property risks, then, can involve two types of losses: (a) the loss of the property and
(b) loss of use of the property resulting in lost income or additional expenses.

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C. Liability Risks

The basic peril in the liability risk is the unintentional injury of other persons or damage to their
property through negligence or carelessness; however, liability may also result from intentional
injuries or damage. 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. Liability risks therefore involve
the possibility of loss of present assets or future income as a result of damages assessed or legal
liability arising out of either intentional or unintentional torts, or invasion of the rights of others.

D. Risks Arising from Failure of Others

When another person agrees to perform a service for you, he or she undertakes an obligation that
you hope will be met. When the person’s failure to meet this obligation would result in your
financial loss, risk exists. Examples of risks in this category would include failure of a contractor
to complete a construction project as scheduled, or failure of debtors to make payments as
expected.

BURDEN OF RISK ON SOCIETY

Regardless of the manner in which risk is defined, the greatest burden in connection with risk is
that some losses will actually occur. When a house is destroyed by fire, or money is stolen, or a
wage earner dies, there is a financial loss. These losses are the primary burden of risk and the
primary reason that individuals attempt to avoid risk or alleviate its impact.

In addition to the losses themselves, there are other detrimental aspects of risk, Risk entails two
major burdens on society.

 The size of an emergency fund must be increased

 Worry and fear are present.

Larger emergency fund

In the absence of insurance, individuals and business firms would have to increase the size of
their emergency fund in order to pay for unexpected losses. Accumulation of such a reserve fund

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carries an opportunity cost, for funds must be available at the time of the loss and must therefore
be held in a highly liquid state. The return on such funds will presumably be less than if they
were put to alternative uses.

Worry and fear

The uncertainty connected with risk usually produces a feeling of frustration and mental unrest.
This is particularly true in the case of pure risk. Speculative risk is attractive to many individuals.
In case of pure risk, where there is no compensating chance of gain, risk is distasteful. Some
examples can illustrate the mental unrest and fear caused by risk. Parents may be fearful if a
teenage son or daughter departs on a hiking trip. Some passengers in bus may become extremely
nervous and fearful if the bus encounters severe turbulence during the drive. A college student
who needs a grade C in a course in order to graduate may enter the final examination room with
a feeling of anxiety and fear.

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