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CHAPTER 1

THE PROBLEM OF RISK

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CHAPTER OBJECTIVES
When you have finished this chapter, you should be able to
• Define and explain the meaning of the term risk
• Distinguish among the terms risk, peril, and hazard
• Identify and explain the classes of hazards
• Differentiate between pure risk and speculative risk
• Differentiate between fundamental and particular risk
• Describe the categories into which pure risk may be subdivided
• Identify and explain the principal methods of handling risk

You see the mangled metal of two cars that have col- understanding of the concept of risk is clear enough,
lided on an interstate highway. A fire engine with terms that have a simple meaning in everyday usage
its siren screaming roars down the street. A build- sometimes have a specialized connotation when
ing in your neighborhood burns, or you see an am- used in a particular field of study. In this chapter
bulance racing to the hospital. Such tragic events we will examine the concept of risk as the funda-
arouse your interest and emotions. After the noise mental problem with which insurance deals. In ad-
and excitement have died down, you are grateful dition, we will also examine several related con-
that the loss did not happen to you and you may cepts.
even feel sorry for whoever suffered the loss. But
you’re glad that it wasn’t you. Losses like these hap-
pen to some people, whereas others go along hap-
pily, free from misfortune. The fact that these losses THE CONCEPT OF RISK
or similar events could happen to you, and the fact
that you can’t tell for sure whether or not they will, It would seem that the term risk is a simple enough
is a condition we call risk. Risk is a pervasive con- notion. When someone states that there is risk in a
dition of human existence. Although our instinctive particular situation, the listener understands what is
1
2 SECTION ONE RISK, INSURANCE, AND RISK MANAGEMENT

meant: that in the given situation there is uncertainty the definition of risk.1 Although the insurance theo-
about the outcome, and the possibility exists that rists have not agreed on a universal definition, there
the outcome will be unfavorable. This loose, intui- are common elements in all the definitions: indeter-
tive notion of risk, which implies a lack of knowl- minacy and loss.
edge about the future and the possibility of some
adverse consequence, is satisfactory for conversa-
• The notion of an indeterminate outcome is im-
plicit in all definitions of risk: the outcome must
tional usage, but for our purpose a somewhat more
be in question. When risk is said to exist, there
rigid definition is desirable.
must always be at least two possible outcomes. If
Economists, statisticians, decision theorists, and
we know for certain that a loss will occur, there is
insurance theorists have long discussed the con-
no risk. Investment in a capital asset, for example,
cepts of risk and uncertainty in an attempt to con-
usually involves a realization that the asset is sub-
struct a definition of risk that is useful for analy-
ject to physical depreciation and that its value will
sis in each field of investigation. So far, they have
decline. Here the outcome is certain and so there
not been able to agree on a single definition that
is no risk.
can be used in each field. A definition of risk that
is suitable for the economist or statistician may be • At least one of the possible outcomes is undesir-
worthless as an analytic tool for the insurance the- able. This may be a loss in the generally accepted
orist. Because each group treats a different body sense, in which something the individual pos-
of subject matter, each requires a different con- sesses is lost, or it may be a gain smaller than the
cept of risk. Although the statistician, the deci- gain that was possible. For example, the investor
sion theorist, and the insurance theorist all use the who fails to take advantage of an opportunity
term risk, each may mean something entirely dif- “loses” the gain that might have been made. The
ferent. investor faced with the choice between two stocks
Insurance is still in its infancy as a body of may be said to “lose” if he or she chooses the one
theory. As a result, we find contradictory defini- that increases in value less than the alternative.
tions of risk throughout the literature dealing with
this phenomenon from an insurance point of view.
One reason for these contradictions is that insur- Our Definition of Risk
ance theorists have attempted to borrow the def- We define risk as a condition of the real world in
initions of risk used in other fields. Surprising as which there is an exposure to adversity. More specif-
it may seem, insurance text writers have not been ically,
able to agree on a definition of this basic con-
cept. Risk is a condition in which there is a possibility of
To compound the problem, the term risk is used an adverse deviation from a desired outcome that
is expected or hoped for.
by people in the insurance business to mean either
a peril insured against (e.g., fire is a risk to which Note first that in this definition risk is a condi-
most property is exposed) or a person or property tion of the real world; it is a combination of circum-
protected by insurance (e.g., many insurance com- stances in the external environment. Note also that
panies feel that young drivers are not good risks). in this combination of circumstances, there is a pos-
In this text, however, we will use the term in its gen- sibility of loss. When we say that an event is possi-
eral meaning, to indicate a situation in which an ble, we mean that it has a probability between zero
exposure to loss exists. and one; it is neither impossible nor definite. Note
also that there is no requirement that the possibil-
ity be measurable—only that it must exist. We may
or may not be able to measure the degree of risk,
Current Definitions of Risk
1 The term risk is variously defined as (1) the chance of loss, (2)
If we were to survey the best-known insurance text-
the possibility of loss, (3) uncertainty, (4) the dispersion of actual
books used in colleges and universities today, we from expected results, or (5) the probability of any outcome
would find a general lack of agreement concerning different from the one expected.
 CHAPTER 1 THE PROBLEM OF RISK 3
but the probability of the adverse outcome must be a particular situation. A student says “I am certain I
between zero and one.2 will get an A in this course,” which means the same
The undesirable event is described as “an adverse as “I am positive I will get an A in this course.” Both
deviation from a desired outcome that is expected or statements reflect a conviction about the outcome.
hoped for.” The reference to a desired outcome that Uncertainty, on the other hand, is the opposite men-
is either expected or hoped for contemplates both tal state. If one says “I am uncertain what grade I
individual and aggregate loss exposures. The indi- am going to get in this course,” the statement re-
vidual hopes that adversity will not occur, and it is flects a lack of knowledge about the outcome. Un-
the possibility that this hope will not be met that con- certainty, then, is simply a psychological reaction
stitutes risk. If you own a house, you hope that it will to the absence of knowledge about the future.3 The
not catch fire. When you make a wager, you hope existence of risk—a condition or combination of cir-
that the outcome will be favorable. That the out- cumstances in which there is a possibility of loss—
come in either event may be something other than creates uncertainty on the part of individuals when
what you hope for constitutes the possibility of loss that risk is recognized.
or risk. The individual’s conviction or lack thereof (cer-
In the case of an insurer, actuaries predict some tainty or uncertainty) about a specific fact or situa-
specified number and amount of losses and charge tion may or may not coincide with the conditions of
a premium based on this expectation. The amount the real world. The student who says “I am certain
of predicted losses is the desired outcome that is ex- I will get an A in this course” may actually get a B,
pected by the insurer. For the insurer, risk is the pos- a C, a D, or even an F. Uncertainty varies with the
sibility that losses will deviate adversely from what knowledge and attitudes of the person. Different at-
is expected. titudes are possible for different individuals under
identical conditions of the real world. It is possible,
for example, for a person to experience uncertainty
Uncertainty and Its Relationship to Risk in a situation in which he or she imagines that there
Because the term uncertainty is often used in con- is a chance of loss but where no chance of loss ex-
nection with the term risk (sometimes even inter- ists. Similarly, it is possible for an individual to feel
changeably), it seems appropriate to explain the re- no uncertainty regarding a particular risk when the
lationship between the two terms. exposure to loss is not recognized. Whether or not
The most widely held meaning of uncertainty a risk is recognized, however, does not alter its exis-
refers to a state of mind characterized by doubt, tence. When there is a possibility of loss, risk exists
based on a lack of knowledge about what will or whether or not the person exposed to loss is aware
will not happen in the future. It is the opposite of of the risk.4
certainty, which is a conviction or certitude about

3 In addition to its meaning as a psychological phenomenon, a

second possible meaning of the term uncertainty relates to prob-
2 We measure probability on an imaginary ruler, marked at one ability and is contrasted with a second meaning of certainty: a
end with a zero and unity at the other. The high end of the situation in which the probability of an event is 100 percent. An
scale, marked unity, represents absolute certainty. Any proposi- event may be said to be impossible (probability = 0), certain
tion about which there is no doubt whatsoever finds its place (probability = 1), or uncertain. Used in reference to the likeli-
at this point on the scale. For example, the probability that the hood of an event, uncertain simply means that the probability is
reader will eventually die is equal to 1, because it is absolutely judged to be between 0 and 1.
certain that we will all die some day. Using the letter p to stand for 4 Some authors equate our notion of uncertainty with subjective
probability, we would write p = 1. The bottom end of the scale, risk, which is a person’s perception of risk. An individual may
marked zero, represents absolute impossibility. The probability perceive risk where it does not exist. (Navigators in Columbus’s
that the reader could run a mile in 30 seconds is zero, because day perceived a risk of falling off the edge of the world.) They
failure would be absolutely certain. The statistician here would may also fail to perceive risk when it does exist. The distinction
write p = 0. Events that are neither certain nor impossible lie between objective risk and subjective risk (i.e., between risk and
between the two ends of our imaginary ruler and are assigned uncertainty) is important because subjective risk affects the de-
values that vary with the likelihood of their occurrence. Thus, cisions people make. Ideally, they should make decisions based
the probability of drawing the ace of spades from a deck of cards on actual risk (i.e., objective risk). Better information reduces un-
is 1/52, or .019. The probability of drawing any ace is 1/13; the certainty (improves subjective risk estimates) and leads to better
probability of drawing a black card is 1/2, or .5. decisions.
4 SECTION ONE RISK, INSURANCE, AND RISK MANAGEMENT

occurrence or loss; it is the probability of some out-

The Degree of Risk
come different from that predicted or expected. In-
It is intuitively obvious that there are some situations surance companies make predictions about losses
in which the risk is greater than in other situations. that are expected to occur and charge a premium
Just as we should agree on what we mean when we based on this prediction. For the insurance com-
use the term risk, we should agree on the way(s) pany, then, the risk is that its prediction will not be
in which risk can be measured. Precisely what is accurate. Suppose that based on past experience, an
meant when we say that one alternative involves insurer estimates that 1 out of 1000 houses will burn.
“more risk” or “less risk” than another? If the company insures 100,000 houses, it might pre-
It would seem that the most commonly accepted dict that 100 houses will burn out of the 100,000
meaning of degree of risk is related to the likelihood insured, but it is highly unlikely that 100, and only
of occurrence. We intuitively consider those events 100, houses will burn. The actual experience will
with a high probability of loss to be “riskier” than undoubtedly deviate from the expectation, and in-
those with a low probability. This intuitive notion of sofar as this deviation is unfavorable, the insurance
the degree of risk is consistent with our definition company faces risk. Therefore, the insurance com-
of risk. When risk is defined as the possibility of an pany not only predicts the number of houses that
adverse deviation from a desired outcome that is will burn but also estimates the range of error. The
expected or hoped for, the degree of risk is mea- prediction might be that 100 losses will occur and
sured by the probability of the adverse deviation. that the range of possible deviation will be plus or
In the case of the individual, the hope is that no minus 10. Some number of houses between 90 and
loss will occur, so that the probability of a deviation 110 are expected to burn, and the possibility that
from what is hoped for (which is the measure of the number will be more than 100 is the insurer’s
risk) varies directly with the probability that a loss risk. Students who have studied statistics will note
will occur. In the case of the individual, we measure that when one of the standard measures of disper-
risk in terms of the probability of an adverse devia- sion (such as the standard deviation) is used, risk is
tion from what is hoped for. Actuarial tables tell us, measurable, and we can say that more risk or less
for example, that the probability of death at age 60 risk exists in a given situation, depending on the
is approximately 1 percent and that at age 83 it is standard deviation.
about 10 percent. At age 96, the probability of death At times we use the terms more risk and less risk
increases to nearly 30 percent. Using the probabil- to indicate a measure of the possible size of the
ity of an adverse deviation from the outcome that loss. Many people would say that there is more risk
is hoped for, we view the risk of death at age 83 as involved in a possible loss of $1000 than in that of
greater than that at age 60, but less than that at age $1, even though the probability of loss is the same
96. The higher the probability that an event will oc- in both cases. The probability that a loss may oc-
cur, the greater the likelihood of a deviation from the cur and the potential severity of the loss if it does
outcome that is hoped for and the greater the risk, occur contribute to the intensity of one’s reaction
as long as the probability of loss is less than one. to risk. It seems, therefore, that a measurement of
If the probability of loss is 1.0, there is no chance risk should recognize the magnitude of the poten-
of an outcome other than that which is expected tial loss. Given two situations, one involving a $1000
and, therefore, no hope of a favorable result. Simi- exposure and the other a $1 exposure, and assuming
larly, when the probability of loss is zero, there is no the same probability in each case, it seems appro-
possibility of loss and therefore no risk. priate to state that there is a greater risk in the case of
In the case of a large number of exposure units, the possible loss of $1000. This is consistent with our
estimates can be made about the likelihood that definition of risk, since the loss of $1000 is a greater
a given number of losses will occur, and predic- deviation from what is hoped for (i.e., no loss) than
tions can be made on the basis of these estimates. is the loss of $1. On the other hand, given two sit-
Here the expectation is that the predicted number of uations in which the amount exposed is the same
losses will occur. In the case of aggregate exposures, (e.g., $1000), there is more risk in the situation with
the degree of risk is not the probability of a single the greater probability of loss.
 CHAPTER 1 THE PROBLEM OF RISK 5
While it may be difficult to relate the size of the • Morale hazard, not to be confused with moral
potential loss and the probability of that loss in the hazard, acts to increase losses where insurance
measurement of risk, the concept of expected value exists, not necessarily because of dishonesty but
may be used to relate these two facets of a given risk because of a different attitude toward losses that
situation. The expected value of a loss in a given will be paid by insurance. When people have pur-
situation is the probability of that loss multiplied by chased insurance, they may have a more careless
the amount of the potential loss. If the amount at attitude toward preventing losses or may have a
risk is $10 and the probability of loss is 0.10, the different attitude toward the cost of restoring dam-
expected value of the loss is $1. If the amount at age. Morale hazard is also reflected in the attitude
risk is $100 and the probability is 0.01, the expected of persons who are not insureds. The tendency
value is also $1. This is a very useful concept, as we of physicians to provide more expensive levels
will see later. of care when costs are covered by insurance is
a part of the morale hazard. Similarly, the inclina-
tion of juries to make larger awards when the loss is
Risk Distinguished from Peril and Hazard covered by insurance—the so-called deep-pocket
It is not uncommon for the terms peril and hazard to syndrome—is another example of morale hazard.
be used interchangeably with each other and with In short, morale hazard acts to increase both the
risk. However, to be precise, it is important to distin- frequency and severity of losses when such losses
guish these terms. A peril is a cause of a loss. We are covered by insurance.
speak of the peril of fire, or windstorm, or hail, or In addition to these three traditional types of haz-
theft. Each of these is the cause of the loss that oc- ard, a fourth hazard—the legal hazard—should be
curs. A hazard, on the other hand, is a condition that recognized. Legal hazard refers to the increase in
may create or increase the chance of a loss arising the frequency and severity of loss that arises from
from a given peril. It is possible for something to be legal doctrines enacted by legislatures and created
both a peril and a hazard. For instance, sickness is by the courts. Jurisdictions in which legal doctrines
a peril causing economic loss, but it is also a haz- favor a plaintiff represent a hazard to persons or
ard that increases the chance of loss from the peril organizations who are sued at tort. Although legal
of premature death. Hazards are normally classified hazard is greatest in the field of legal liability, it also
into three categories: exists in the case of property exposures. In jurisdic-
• Physical hazards consist of those physical prop- tions where building codes require that new build-
erties that increase the chance of loss from the ings conform to statutory requirements, the destruc-
various perils. Examples of physical hazards that tion of a building that does not meet the require-
increase the possibility of loss from the peril of ments may force an owner to incur additional costs
fire are the type of construction, the location of in reconstruction, thereby increasing the exposure
the property, and the occupancy of the building. to loss.
• Moral hazard refers to the increase in the proba-
Classifications of Risk
bility of loss that results from dishonest tendencies
in the character of the insured person. More sim- In its broadest context, the term risk includes all sit-
ply, it is the dishonest tendencies on the part of an uations in which there is an exposure to adversity.
insured that may induce that person to attempt Risks may be classified in many ways; however, cer-
to defraud the insurance company. A dishonest tain distinctions are particularly important for our
person, in the hope of collecting from the insur- purposes. These include the following.
ance company, may intentionally cause a loss or Static and Dynamic Risks An important dis-
may exaggerate the amount of a loss in an attempt tinction is between static and dynamic risks.5
to collect more than the amount to which he or
she is entitled. Fraud is a significant problem for 5 The dynamic–static distinction was made by Willett. See Alan
insurance companies and increases the cost of H. Willett, The Economic Theory of Risk and Insurance (Philadel-
insurance. phia: University of Pennsylvania Press, 1951), pp. 14–19.
6 SECTION ONE RISK, INSURANCE, AND RISK MANAGEMENT

Dynamic risks are those resulting from changes in Since fundamental risks are caused by conditions
the economy. Changes in the price level, consumer more or less beyond the control of the individuals
tastes, income and output, and technology may who suffer the losses and since they are not the fault
cause financial loss to members of the economy. of anyone in particular, it is held that society rather
These dynamic risks normally benefit society over than the individual has a responsibility to deal with
the long run, since they are the result of adjustments them. Although some fundamental risks are dealt
to misallocation of resources. Although these dy- with through private insurance,7 usually, some form
namic risks may affect a large number of individu- of social insurance or government transfer program
als, they are generally considered less predictable is used to deal with fundamental risks. Unemploy-
than static risks, since the former do not occur with ment and occupational disabilities are fundamental
any precise degree of regularity. risks treated through social insurance. Flood dam-
Static risks involve those losses that would occur age or earthquakes make a district a disaster area
even if there were no changes in the economy. If we eligible for federal funds.
could hold consumer tastes, output and income, In the final analysis, whether a risk is considered
and the level of technology constant, some individ- fundamental or particular depends on current pub-
uals would still suffer financial loss. These losses lic opinion concerning the responsibility for the
arise from causes other than the changes in the causes and consequences of the risk. In the after-
economy, such as the perils of nature and the dis- math of the terrorist attack on the World Trade Cen-
honesty of other individuals. Unlike dynamic risks, ter on September 11, 2001, Congress and the in-
static risks are not a source of gain to society. Static surance industry debated the question of whether
losses involve either the destruction of the asset or terrorist attacks are a fundamental or particular risk.
a change in its possession as a result of dishonesty Reinsurers—the insurers that provide insurance to
or human failure. Static losses tend to occur with a insurance companies—announced their intent to
degree of regularity over time and, as a result, are exclude acts of terrorism from the coverage they pro-
generally predictable. Because they are predictable, vide to other insurers. Faced with the loss of backup
static risks are more suited to treatment by insurance coverage, the insurers that deal with the public
than are dynamic risks. developed an endorsement for their policies ex-
cluding loss from terrorist acts. In response to these
Fundamental and Particular Risks The distinc-
developments, Congress established a federal ter-
tion between fundamental and particular risks is
rorism reinsurance program in November 2002.8
based on the difference in the origin and conse-
Particular risks are considered to be the individ-
quences of the losses.6 Fundamental risks involve
ual’s own responsibility, inappropriate subjects for
losses that are impersonal in origin and conse-
action by society as a whole. They are dealt with
quence. They are group risks, caused for the most
by the individual through the use of insurance, loss
part by economic, social, and political phenomena,
prevention, or some other technique.
although they may also result from physical occur-
rences. They affect large segments or even all of the Pure and Speculative Risks One of the most
population. Particular risks involve losses that arise useful distinctions is that between pure risk and
out of individual events and are felt by individuals
rather than by the entire group. They may be static 7 For example, earthquake insurance is available from private
or dynamic. Unemployment, war, inflation, earth- insurers in most parts of the country, and flood insurance is fre-
quakes, and floods are all fundamental risks. The quently included in contracts covering movable personal prop-
erty. Flood insurance on real property is available through private
burning of a house and the robbery of a bank are insurers only on a limited basis.
particular risks. 8 The original Terrorism Risk Insurance Act (TRIA) created a ter-
rorism risk insurance program that was scheduled to expire on
December 31, 2005. However, the program was extended, with
some changes, in the Terrorism Risk Insurance Extension Act of
6 The distinction between fundamental and particular risks is 2005 and is now scheduled to expire on December 31, 2007. In
based on C. A. Kulp’s discussion of risk (which he referred to as mid-2007, it seemed likely that federal involvement in terrorism
“hazard”). See C. A. Kulp, Casualty Insurance, 3rd ed. (New York: insurance would continue past 2007, either by renewal of TRIEA
Ronald Press, 1956), pp. 3, 4. or an alternative mechanism.
 CHAPTER 1 THE PROBLEM OF RISK 7
speculative risk.9 Speculative risk describes a situ- ing power is subject to four perils: (a) premature
ation in which there is a possibility of loss, but also death, (b) dependent old age, (c) sickness or
a possibility of gain. Gambling is a good example of disability, and (d) unemployment.
a speculative risk. In a gambling situation, risk is de- 2. Property risks. Anyone who owns property faces
liberately created in the hope of gain. The student property risks simply because such possessions
wagering $10 on the outcome of Saturday’s game can be destroyed or stolen. Property risks em-
faces the possibility of loss, but this is accompanied brace two distinct types of loss: direct loss and
by the possibility of gain. The entrepreneur or cap- indirect or “consequential” loss. Direct loss is the
italist faces speculative risk in the quest for profit. simplest to understand: If a house is destroyed
The investment made may be lost if the product is by fire, the owner loses the value of the house.
not accepted by the market at a price sufficient to This is a direct loss. However, in addition to los-
cover costs, but this risk is borne in return for the ing the value of the building itself, the property
possibility of profit. The term pure risk, in contrast, owner no longer has a place to live, and during
is used to designate those situations that involve only the time required to rebuild the house, it is likely
the chance of loss or no loss. One of the best exam- that the owner will incur additional expenses liv-
ples of pure risk is the possibility of loss surround- ing somewhere else. This loss of use of the de-
ing the ownership of property. The person who buys stroyed asset is an indirect, or “consequential,”
an automobile, for example, immediately faces the loss. An even better example is the case of a
possibility that something may happen to damage business firm. When a firm’s facilities are des-
or destroy the automobile. The possible outcomes troyed, it loses not only the value of those facil-
are loss or no loss. ities but also the income that would have been
The distinction between pure and speculative earned through their use. Property risks, then,
risks is an important one, because normally only can involve two types of losses: (a) the loss
pure risks are insurable. Insurance is not concerned of the property and (b) loss of use of the property
with the protection of individuals against those resulting in lost income or additional expenses.
losses arising out of speculative risks. Speculative
risk is voluntarily accepted because of its two- 3. Liability risks. The basic peril in the liability risk is
dimensional nature, which includes the possibility the unintentional injury of other persons or dam-
of gain. Not all pure risks are insurable, and a fur- age to their property through negligence or care-
ther distinction between insurable and uninsurable lessness; however, liability may also result from
pure risks may also be made. A discussion of this intentional injuries or damage. Under our legal
difference will be delayed until Chapter 2. system, the laws provide that one who has injured
another, or damaged another’s property through
Classifications of Pure Risk Although it would negligence or otherwise, can be held responsi-
be impossible in this book to list all the risks ble for the harm caused. Liability risks therefore
confronting an individual or business, we can briefly involve the possibility of loss of present assets or
outline the nature of the various pure risks that we future income as a result of damages assessed
face. For the most part, these are also static risks. or legal liability arising out of either intentional
Pure risks that exist for individuals and business or unintentional torts, or invasion of the rights of
firms can be classified under one of the following: others.
4. Risks arising from failure of others. When an-
1. Personal risks. These consist of the possibility of
other person agrees to perform a service for
loss of income or assets as a result of the loss
you, he or she undertakes an obligation that
of the ability to earn income. In general, earn-
you hope will be met. When the person’s fail-
ure to meet this obligation would result in your
9 Although the distinction between pure and speculative risk had financial loss, risk exists. Examples of risks in
been introduced earlier, Albert H. Mowbray formalized the dis- this category would include failure of a contrac-
tinction. See Albert H. Mowbray and Ralph H. Blanchard, Insur-
ance, Its Theory and Practice in the United States. 5th ed. (New tor to complete a construction project as sched-
York: McGraw-Hill, 1961), pp. 6, 7. uled, or failure of debtors to make payments as
8 SECTION ONE RISK, INSURANCE, AND RISK MANAGEMENT

expected. With the development of the Internet, Finally, the uncertainty connected with risk usu-
the rapid evolution of e-commerce, and the in- ally produces a feeling of frustration and mental
creased trend toward outsourcing by big busi- unrest. This is particularly true in the case of pure
nesses, a variety of new risks relating to the failure risk. Speculative risk is attractive to many individu-
of others have emerged. als. The gambler obviously enjoys the uncertainty
connected with wagering more than the certainty
of not gambling—otherwise he or she would not
THE BURDEN OF RISK gamble. But here it is the possibility of gain or profit,
which exists only in the speculative risk category,
Regardless of the manner in which risk is defined, that is attractive. In the case of pure risk, where there
the greatest burden in connection with risk is that is no compensating chance of gain, risk is distaste-
some losses will actually occur. When a house is de- ful. Most people hope that misfortunes will not be-
stroyed by fire, or money is stolen, or a wage earner fall them and that their present state of well-being
dies, there is a financial loss. When someone is neg- will continue. While they hope that no misfortune
ligent and that negligence results in injury to a per- will occur, people are nevertheless likely to worry
son or damage to property, there is a financial loss. about possible mishaps. This worry, which induces
These losses are the primary burden of risk and the a feeling of diminished well-being, is an additional
primary reason that individuals attempt to avoid risk burden of risk.
or alleviate its impact.
In addition to the losses themselves, there are
other detrimental aspects of risk. The uncertainty as THE GROWING NUMBER AND
to whether the loss will occur requires the prudent VARIETY OF PURE RISKS
individual to prepare for its possible occurrence. In
the absence of insurance, one way this can be done From the dawn of civilization, humans have faced
is to accumulate a reserve fund to meet the losses the possibility of loss. Our ancestors confronted an
if they do occur.10 Accumulation of such a reserve environment characterized by incredible perils and
fund carries an opportunity cost, for funds must be hazards. The earliest perils giving rise to risk were
available at the time of the loss and must therefore those of nature and predators (including not only
be held in a highly liquid state. The return on such savage beasts but human predators as well). Hu-
funds will presumably be less than if they were put mans learned to anticipate and prepare for adversity,
to alternative uses. If each property owner accumu- both collectively and individually. They built shelter
lates his or her own fund, the amount of funds held and they saved for the future. This provided pro-
in such reserves will be greater than if the funds are tection from the elements and savage beasts, but it
amassed collectively. created new risks. Structures constructed for protec-
Furthermore, the existence of risk may have a de- tion were vulnerable to damage, and saving meant
terrent effect on economic growth and capital ac- accumulation of wealth, which inevitably created
cumulation. Progress in the economy is determined new risks. Those who saved were exposed to the
to a large extent by the rate of capital accumulation, predatory inclinations of those who did not (an ex-
but the investment of capital involves risk that is dis- posure that continues to the present day). Despite
tasteful. Investors as a class will incur the risks of a progress in learning how to deal with risks, the chal-
new undertaking only if the return on the investment lenge of dealing with risk continued to grow. As new
is sufficiently high to compensate for both the dy- ways of addressing risk are found, new risks appear,
namic and static risks. The cost of capital is higher in often as a result of progress.
those situations in which the risk is greater, and the Harnessing energy has made life easier, but it has
consumer must pay the resulting higher cost of the created new risks. Until about 200 years ago, the ma-
goods and services or they will not be forthcoming. jor sources of energy were muscle (both human and
animals), wind, and water, and the risks associated
with energy sources were modest. Since the early
10 One great danger of this approach is the possibility that a loss 1800s, advances in technology have increased the
may occur before a sufficient fund has been accumulated. sources of energy available to humankind, and with
 CHAPTER 1 THE PROBLEM OF RISK 9
each new source have come new risks. For exam- identity theft is the fastest growing white-collar crime
ple, the industrial revolution witnessed the applica- in the nation.11
tion of steam to the production process, and with With each advance in technology, new risks arise.
steam came new risks. The early steam engines were Because many of the old risks remain, the inventory
hazardous mechanisms and explosions were com- of risks that must be addressed increases geometri-
mon. Not only did steam power produce the risk cally. Daily newspapers indicate the simultaneous
of explosion, it created other risks as well. Steam threat of new-age hazards and age-old perils of na-
engines were far less prone to stoppage by obstruc- ture. The hazards posed by the nuclear age were
tions than human-powered devices; they continued demonstrated by the incident at the Three Mile Is-
to grind away, oblivious to the hands and arms that land nuclear facility in Pennsylvania in 1979 and
got entangled in gears. As with the application of the accident at the Soviet Union’s Chernobyl plant
steam, the introduction of electric power, the inter- in April 1987. The destruction that can be wreaked
nal combustion engine, and nuclear power have all by nature are evidenced by Hurricane Katrina’s es-
created new risks. timated $80 billion in damages, by the floods of
One can argue that the invention of the legal sys- near-biblical proportions that ravaged the midwest-
tem was an effort to address risk. By defining indi- ern United States in 1993, and by earthquakes in
vidual rights and responsibilities, the legal system California and Kobe, Japan, in 1993 and 1994. The
created a framework whose basic function was to bombings of the World Trade Center and the Ok-
protect those rights. At the same time, the legal sys- lahoma City Federal Building in 1993 and 1995, re-
tem itself became a source of risk, by creating a spectively, and the terrorist attack on the World Trade
system in which those who are injured or damaged Center and the Pentagon on September 11, 2001, are
by others may seek compensation. As the concept stark reminders that not only nature can cause death
of rights and responsibilities has developed, new and destruction, but people as well. Although other
causes of action have emerged. Many of the current losses are less momentous, it is only because they
legal risks were unknown a generation ago. These in- affect a single individual or firm. For the party suf-
clude potential liability for a profusion of new trans- fering the loss, they are no less devastating.
gressions: environmental damage, discrimination in
employment, sexual harassment, and violence in
the workplace.
The most recent expansion of risks we face, like
INCREASING SEVERITY OF LOSSES
many previous expansions, is traceable to advances
As might be expected, with the increasing array
in technology. The information age in which we are
of risks, the dollar amount of losses arising from
now immersed embodies a variety of new expo-
accidents has also increased. Interestingly, how-
sures. Information has value, and as such, its ex-
ever, the increasing dollar amount of losses is not
posure to loss represents risk. Information has, of
solely a function of the increasing number of risks.
course, always had value. What has changed is the
Even those losses that arise from the perils of
way that information is collected, sorted, and com-
nature—windstorms, earthquakes and floods—
municated electronically. In an earlier era, when
have exhibited an increasing severity. Nor is the
information was recorded on hard media, it was
easier to protect. Equally important, it was easy to
detect when the information security system had
been breached. The interconnectivity of the Internet 11 In 2003, Congress enacted amendments to the Fair Credit Re-
and electronic communication generally exposes porting Act to provide consumers with some protection against
valuable information to loss in ways not previously indentity theft. Nonetheless, identity theft continues to be a prob-
imagined. Pirates and thieves have been a constant lem, and it is estimated that millions of Americans are victims
each year. In early 2005, a number of firms reported their data
source of potential loss throughout history. Hackers had been stolen or misplaced, heightening concerns about pos-
who commit vandalism and electronic larceny have sible identity theft. In February 2005, ChoicePoint disclosed that
replaced the bandits and pirates who threatened it had sold sensitive information on at least 166,000 people to a
Nigerian con artist posing as a debt collector. The Federal Trade
early traders. Modern thieves steal not only assets Commission fined ChoicePoint $10 million and ordered it to set
but sometimes one’s identity. According to the FBI, aside $5 million to aid the victims of its error.
10 SECTION ONE RISK, INSURANCE, AND RISK MANAGEMENT

increasing severity merely a reflection of inflation;

the dollar total from these losses continues to in-
MANAGING RISK
crease even when adjusted for inflation. Although
There is no escape from the presence of risk, and hu-
earthquakes, floods, and windstorms occur at essen-
manity must accordingly seek ways of dealing with
tially the same rate as in the past, each new catastro-
it. Some risks—generally of a fundamental nature—
phe seems to exceed previous losses. The reason, of
are met through the collective efforts of society and
course, is that there is simply more wealth, more in-
government. Municipal police and fire departments
vestment, and more assets exposed to loss. As busi-
are good examples of the collectively financed ap-
ness becomes more capital intensive as the tech-
proaches to dealing with risk, but countless others
nology of production equipment becomes more
might be suggested. Although society and govern-
costly, capital investment increases. With the growth
ment can help alleviate the burden of risks in many
in capital investment, the risk of financial loss also
areas, some risks are considered the responsibility
increases.12
of the individual.
12 The San Francisco earthquake of 1906 caused an estimated
Given the vast array of risks faced by individuals
$400 million in damage from earthquake and fire. The cost in and businesses and the variety of possible ways to
2007 dollars would have been about $9 billion. Damage from a deal with them, a systematic approach is needed in
quake of the same intensity as the 1906 earthquake would likely dealing with risks. What can we do about the various
exceed $100 billion; San Francisco today is a dramatically differ-
ent place from the San Francisco of 1906. Buildings are taller and risks we face? Which risks require attention first and
more expensive to build and there are more of them. There are how should they be addressed? In Chapter 2 we will
more people, more cars, and more “stuff’’ today than in 1906. As begin our discussion of risk management and con-
population and wealth increase, the exposure to loss is magni-
fied. The richer we become as a society, the more wealth that is sider a systematic approach for dealing with pure
exposed to loss. risks faced by individuals and firms.

IMPORTANT CONCEPTS TO REMEMBER

risk morale hazard personal risk
uncertainty deep-pocket syndrome property risk
subjective risk static risk direct loss
degree of risk dynamic risk indirect loss
peril fundamental risk liability risk
hazard particular risk probability of loss
physical hazard pure risk expected value
moral hazard speculative risk

QUESTIONS FOR REVIEW

1. Define risk. In your definition, state the relationship 4. Explain how pure risk has an adverse effect on eco-
between risk and uncertainty. nomic activity.
2. Risk may be subclassified in several ways. List the 5. List the four types of pure risk facing an individual or
three principal ways in which risk may be categorized, and an organization and give an example of each.
explain the distinguishing characteristics of each class. 6. The text discusses the “burden of risk.” What are the
3. The distinction between “pure risk” and “speculative two principal ways in which the impact of risk may be felt
risk” is important because only pure risks are normally by an individual or an organization?
insurable. Why is the distinction between “fundamental 7. Distinguish between “perils” and “hazards” and give
risk” and “particular risk” important? two specific examples of each.