Risk and Related Topics Chapter One
Risk and Related Topics Chapter One
Risk and Related Topics Chapter One
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.
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 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.”
Writers, particularly in the USA have produced a 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.
Theorists have no agreed in universal definition but there are common
elements in the definition i.e. Indeterminacy and loss
Indeterminacy: - means the outcome must be in question. When risk is said
to exist there must be at least two possible outcomes. If we know for certain
that a loss occurs, there is no risk.
Loss: - at least one of the possible outcomes is undesirable may be loss.
110 in Nazareth, objective risk is greater in Addis Ababa even though the
chance of loss in both cities is the same.
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, 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.
Subjective Probability:
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.
1.4 RISK, PERIL AND HAZARD
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. For
example one of the perils that can cause loss to a house is fire. The fire can be
cause while we go out of home leaving the cylinder switched on in the kitchen.
Using the cylinder properly will not cause a loss; rather poor handling does.it
is possible for something to be both a peril and hazard. For instance, sickness
is a peril causing economic loss, but it is also a hazard that increases the
chance of loss from the peril of earlier death. There are four major types of
hazards:
Physical hazard
Mortal hazard
Morale hazard
Legal hazard
Physical hazard: A physical hazard is a physical condition 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.
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
The major risk associated with old age is insufficient income during retirement.
The vast majority of workers in the world are retired 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 poor health includes
both the payment of terrible medical bills and the loss of earned income.
Risk of Unemployment:
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, and imperfections in the
labor market.
Property 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 indirect
loss or consequential loss.
Direct loss: A direct loss is defined as financial loss 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.
Indirect 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.
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 you to pay substantial damages to the person you
have injured.
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, and going into business for your
self. In these situations, both profit and loss are possible.
Distinguish between pure and speculative risks:
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 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 bankruptcy.
Despite the bankruptcy, society benefits because the computers are
produced at a low cost. However, society normally does not benefit when as
loss from a pure risk occurs, such as flood, or earth quake.
not source of gain for society. Examples includes uncertainty due to random
events such as fire, windstorm, or death, etc. static losses do involve either the
destruction of the asset or a change in its possession as a result of dishonesty
or human failure. These types of losses tend to occur with a degree of
regularity overtime and are generally predictable-which makes static risk more
suitable for treatment by insurances.
Dynamic risks
Dynamic risks are those resulting from change in the economy. Change in the
price level, consumer test, income and output and technology may cause
financial loss the member of society. Normally benefit the society over a long
run, since they are the results of adjustments to misallocation of resources.
Although they may affect a large number of individuals, dynamic risks are
generally considered less predictable than static risks, as they do not occurred
with any precise degree of regularity.
BURDEN OF RISKS ON SOCIETY
When a house destroyed by a fire, or money is stolen, or a wage earner dies,
there is a financial loss. These losses are the primary burden of risks and the
primary reason that individuals attempt to avoid risk or alleviate its impact. In
addition to the losses themselves
Large 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.
(One greater danger of this approach is the possibility that a loss may occur
before a sufficient fund has been accumulated)
Worry and fear
The uncertainty connected with risk usually produces a feeling of frustration
and mental unrest. This is perfectly true in the case of pure risk. Speculative
risk is attractive to many individuals.
The finance literature considers five types of risks that business organizations
face in the course of their normal operation. These are: business risk, financial
risk, interest rate risks, purchasing power risks, and market risks. Those are
briefly discussed below.
Business Risk - This is the risk associated with the physical operation of the
firm. Variations in the level of sales, costs, profits are likely to occur due to a
number of factors inherent in the economic environment. Business risk is
independent of the company’s financial structure.
Purchasing Power Risk - This risk arises under inflationary situations (general
price rise of goods and services) leading to a decline in the purchasing power of
the asset held.
Market Risk - Market risk is related to stock market. It refers to stock price
variability caused by market forces. It is the result of investors’ reactions to
real or psychological expectations. For example, some forecasts may convince
investors that the economy is heading towards a recession. The market index
would decline accordingly.
“THERE IS NO TIME AND PLACE WHICH IS FREE FROM RISK, AND VERY
DIFFICULT TO AVOID IT, SO WHAT WOULD BE BETTER?”
“MANAGING”