Risk and its treatment

Risk: the uncertainty concerning the occurrence of loss

Loss exposures: any situation or circumstance in which a loss is possible, regardless of whether a
loss occur.

When risk includes uncertainty, we have Objective risk VS. Subjective risk

Objective risk: is defined as the relative variation of actual loss from expected loss.

Law of large number: states that as the number of exposures units increases, the more closely the
actual loss experience will approach the expected loss experience.

Subjective risk: is defined as uncertainty based on a person’s mental condition or state of mind.

Chance of loss: The probability that an event will occur.

Chance of loss for two events might be the same but the objective risk might be different,

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 probability can be Deductive reasoning (Prior probability) or Inductive reasoning.

Subjective probability: is the individual’s personal estimate of the chance of loss.

A peril: is defined as the cause of the loss.

A hazard: is a condition that creates or increases the frequency or severity of loss.

There are four major types of Hazard:

 Physical Hazard: is a physical condition that increases the frequency or severity of loss
 Moral Hazard: is dishonesty or character defects in an individual that increase the
frequency or severity of loss
 Attitudinal Hazard: is carelessness or indifference to a loss, which increases the frequency
or severity of a loss.
 Legal Hazard: refers to characteristics of the legal system or regulatory environment that
increase the frequency or severity of loss.

Classification of risk

 Pure and speculative risk

Pure risk: is a situation in which there are only the possibilities of loss (adverse) or no loss
(Neutral) (earthquake)
Speculative risk: is a situation in which either profit or loss is possible (gambling)
We should distinguish between the two risks because:
 1. Private insurers concentrate on insuring certain pure risks and do not insure
speculative risks.
2. The law of large numbers can be applied easily to pure risks than speculative risks.
3. Society may benefit from a speculative risk even though a loss occurs, but it is
harmed if a pure risk is present though a loss occurs.
 Diversifiable risk and non diversifiable risk
Diversifiable risk: affects only individuals or small groups and not the entire economy (car
theft). It is also called nonsystematic or particular risk.
It is the risk that can be reduced or eliminated by diversification.
Non diversifiable risk: affects the entire economy or large numbers of persons or groups
within the economy (hurricane, flood, and earthquake). It cannot be reduced or eliminated by
diversification. It is also called systematic risk or fundamental risk.

Government assistance may be necessary to insure non diversifiable risks.

 Enterprise risk: encompasses all major risks faced by a business firm, which include pure
risk, speculative risk, strategic risk, operational risk, and financial risk
Where
– Strategic risk: refers to uncertainty regarding the firm’s financial goals and objectives.
– Operational risk: results from the firm’s business operations.
– Financial risk: refers to the uncertainty of loss because of adverse changes in
commodity prices, interest rates, foreign exchange rates, and the value of money.
 Enterprise Risk Management: combines into a single unified treatment program all major
risks faced by the firm include pure risk, speculative risk, strategic risk, operational risk, and
financial risk.
 As long as all risks are not perfectly correlated, the firm can offset one risk against another,
thus reducing the firm’s overall risk.
 Treatment of financial risks requires the use of complex hedging techniques, financial
derivatives, futures contracts and other financial instruments.

Major personal risks and commercial risks

Personal risks: are risks that directly affect and individual or family. They involve the
possibility of a loss or reduction in income, extra expenses or depletion of financial assets,
due to:

– Premature death of family head

– Insufficient income during retirement

– Poor health (catastrophic medical bills and loss of earned income)

– Involuntary unemployment
 Questions
1. How does objective probability differ from subjective probability?
Objective probability is a mathematical probability that can be determined by deduction or
through statistical analysis. For example, based on pooled mortality data, we can estimate the
probability that an individual will die before he or she reaches age 50. Subjective probability
is an individual’s personal estimate of the chance of loss. As subjective probabilities are
personal estimates, they are not identical across individuals and can be influenced by a
number of factors.
2. What is the difference between risk and chance of loss?
Chance of loss is a probability concept. Risk is uncertainty concerning the occurrence of loss.
The chance of loss (probability) may be the same for two events, but the risk could be very
different. For example, two stocks may have the same expected return, 10 percent, and the
distribution of their expected returns may be symmetric (50 percent probability of gain, 50
percent probability of loss). However, the standard deviation of the returns of the first stock
may be 25 percent, while the standard deviation of the returns of the second stock may be
only 10 percent. Thus, the chance of loss for both stocks is 50 percent, but the first stock is of
greater risk.
3. How do moral hazard and attitudinal (morale) hazard increase the chance of loss?
Attitudinal hazard increases the chance of loss because the individual is indifferent to loss
because of insurance. Thus proper loss control activities may not be undertaken. Moral
hazard is more severe. Here an individual commits dishonest acts in an effort to collect from
the insurer. Attitudinal hazard does not involve an action; moral hazard involves committing
dishonest acts.
4. Differentiate between the types of risk in the following pairs.

(a) Pure and speculative risks

Pure risks have two possible outcomes: a loss or no loss. Speculative risks have three
possible outcomes: loss, no loss, and gain. Pure risks are readily insurable, while most
speculative risks are not privately insurable.
(b) Diversifiable and non diversifiable risks

Diversifiable risk is risk that affects individuals or small groups, and not the entire
economy. It is risk that can be reduced or eliminated through diversification.
Nondiversifiable risk is risk that affects the entire economy or large numbers of persons or
groups within the economy. It is risk that can’t be eliminated or reduced through
diversification.

5. What are “enterprise risk” and “enterprise risk management”?

Enterprise risk encompasses all major risks faced by a business firm, including pure risks,
speculative risks, strategic risks, and operational risks. Enterprise risk management combines
treatment of this broad range of risks into a single, unified, risk treatment program.
6. Explain why, from an economic standpoint, the impact of long-term disability can be
more severe than the impact of premature death.
 From an economic standpoint, the consequences of long-term disability can be more severe
than premature death. In either case, the income stream provided to the family by the family
breadwinner is interrupted. In the case of long-term disability, however, there are additional
expenses that must be incurred by the disabled individual and his/her family.
7. What are the major costs of risk to society?
There are three major costs of risk to society. First, emergency funds must be set aside to pay
for losses when they occur. Second, because of risk, society may be deprived of needed
goods and services. Finally, because of risk, society must bear the burden of fear and worry.
8. What is the difference between active and passive retention? Provide an example of
each.
Active retention involves a conscious decision to use retention to handle a risk after analysis
of the risk. An example would be a business deciding to retain the risk of physical damage to
vehicles in its delivery fleet rather than purchasing insurance. Passive retention occurs when
risks are unknowingly retained. For example, a business may start to offer off-site day care as
an employee benefit. The company may assume that its liability insurance will cover liability
claims associated with the day care center. However, the coverage may include a “premises
only” definition of insured locations. Thus, the risk is passively retained because the
company thought it was covered.
9. What are the potential advantages and disadvantages of using (a) retention and (b)
avoidance to handle risk exposures?

(a) The potential advantage of retention is that if the loss level is low, the expenditure to
transfer the risk would not have been incurred. The potential disadvantage is that if the loss
level is high, you will be responsible for all of the loss.
(b) With avoidance, the probability of loss is reduced to zero. However, there may be some
benefit that is foregone if avoidance is used. For example, the fear of liability may force
discontinuation of operations and avoiding an exposure may mean the loss of profits that
could have been earned if operations had continued.
10. What are the major characteristics of the risk handling technique called insurance?
Insurance has a number of important characteristics. First, insurance involves the transfer of
risk. Second, insurance uses pooling to spread the cost of losses over the entire group that is
insured. Third, insurance applies the law of large numbers to reduce objective risk.

True or False

T F 1. The risk associated with the purchase of common stock is a pure risk.

T F 2. Indifference to loss because of the presence of insurance is called moral hazard.

T F 3. Liability risks can be more severe than property risks.

T F 4. As the sample size increases, the deviation between actual losses and expected losses also
increases.

T F 5. The presence of risk leads to a less than perfect allocation of productive resources.

T F 6. Direct losses are the only type of losses associated with property risks.
T F 7. Hedging price risks is an example of risk retention.

T F 8. The subjective probability associated with an event is the same for all individuals.

T F 9. There are both property risks and liability risks associated with operating an automobile.

T F 10. Risk is the probability that a loss will occur.

T F 11. Financial risk refers to the uncertainty of loss because of adverse price movements, changing
interest rates, and similar exposures.

Ans.

1. F This risk is a speculative risk because there are three possible outcomes: loss, breaking even,
and gain. Loss and no loss are the possible outcomes with pure risks.
2. F Indifference to loss because of the presence of insurance is called attitudinal (morale) hazard.
3. T
4. F When the sample size increases, the deviation between actual losses and expected losses
declines. Private insurers rely on this principle, known as the law of large numbers.
5. T
6. F Indirect losses, such as continuing expenses and the loss of profits also are associated with
property risks.
7. F Hedging price risks illustrate the transfer of risk, not risk retention.
8. F Subjective probability is an individual’s personal assessment of the chance of loss. Individuals
may perceive the same situation differently, depending on their risk aversion, prior experience,
age, education, and other factors.
9. T
10. F Chance of loss is the probability that a loss will occur. Risk is uncertainty concerning the
occurrence of loss.
11. T

Multiple Choices

1. Ben purchased fire insurance on his antique desk. While the desk was being moved, it was
damaged. As “damage in transit” was not an insured peril, Ben set fire to the damaged desk.
The desk was completely destroyed and Ben collected the insured value of the desk from his
fire insurer. This scenario illustrates:
(a) Moral hazard
(b) Subjective probability
(c) Speculative risk
(d) Attitudinal hazard
Answer: (a)
2. Which statement is true with regard to risk and insurance?
I. Most speculative risks can be insured.
II. Insurance is a form of risk transfer.
(a) I only
(b) II only
(c) Both I and II
(d) Neither I nor II
Answer: (b)

3. The probability of drawing an “ace” from a thoroughly shuffled deck of playing cards is one-
thirteenth (there are 4 aces out of 52 cards). This type of probability is known as:
(a) Subjective probability
(b) Objective risk
(c) Chance of loss
(d) Objective probability
Answer: (d)

4. When an earthquake occurred in California, a studio was filming a number of movies. In

addition to the physical damage the studio sustained, the studio was forced to delay or cancel
release of some films. The profits lost because of delay or cancellation illustrate:
(a) Consequential loss
(b) Direct loss
(c) Subjective probability
(d) Objective probability
Answer: (a)

5. Beth was late for work. As she drove around a curve, she hit a patch of oil that had been
spilled on the road. She slid across the road and hit a guard rail. Beth was not hurt; however,
her car was severely damaged. The presence of oil on the road is best described as a(n):
(a) Attitudinal hazard
(b) Objective risk
(c) Moral hazard
(d) Physical hazard
Answer: (d)

6. In the preceding question, the collision between Beth’s car and the guard rail is an example of
a:
(a) Peril
(b) Physical hazard
(c) Legal hazard
(d) Speculative risk
Answer: (a)

7. All of the following are diversifiable risks EXCEPT:

(a) Damage from hurricanes
(b) Theft of your car
 (c) A fire at your home
(d) Investment risk
Answer: (a)
8. Collins Van Lines requires each of their moving van drivers to complete a driver safety
course each year. Requiring drivers to complete a driver safety course is an example of:

(a) Retention
(b) Noninsurance transfer
(c) Avoidance
(d) Loss control
Answer: (d)
9. Jack started a construction company. To protect his personal assets from the claims of
creditors and claimants, he decided to incorporate the business. Incorporating the business
illustrates which method of risk treatment?
(a) Retention
(b) Noninsurance transfer
(c) Avoidance
(d) Loss control
Answer: (b)
10. The variation between actual and expected results is known as:
(a) Objective risk
(b) Objective probability
(c) Subjective probability
(d) Subjective risk
Answer: (a)
11. Which statement is true about hazard?
I. Attitudinal hazard is a more severe problem than moral hazard.
II. Peril and hazard is the same thing.
(a) I only
(b) II only
(c) Both I and II
(d) Neither I nor II
Answer: (d)
12. Traditionally, risk has been defined as
A) Any situation in which the probability of loss is zero.
B) The probability of a loss occurring.
C) Uncertainty concerning the occurrence of loss.
D) Any situation in which the probability of loss is one.