Chapter 1

Risk in
Our Society

Dr. Aram Massoudi

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Agenda
• Meaning of Risk
• Chance of Loss
• Peril and Hazard
• Basic Categories of Risk
• Types of Pure Risk
• Burden of Risk on Society
• Methods of Handling Risk

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Meaning of Risk
• Risk: Uncertainty concerning the occurrence of a loss

• Objective Risk vs. Subjective Risk

– Objective risk is defined as the relative variation of actual loss from
expected loss
• It can be statistically calculated using a measure of dispersion, such
as the standard deviation
– Subjective risk is defined as uncertainty based on a person’s
mental condition or state of mind
• Two persons in the same situation may have different perceptions of
risk
• High subjective risk often results in conservative behavior

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Loss exposure

• A loss exposure is any situation or circumstance in

which a loss is possible, regardless of whether a loss
actually occurs. Examples of loss exposures include:
1. manufacturing plants that may be damaged by an earthquake or
flood,
2. defective products that may result in lawsuits against the
manufacturer,
3. Possible theft of company property because of inadequate
security,
4. and potential injury to employees because of unsafe working
conditions.

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Chance of Loss
• Chance of loss: The probability that an event will occur

• Objective Probability vs. Subjective Probability

– Objective probability refers to the long-run relative frequency of an
event assuming an infinite number of observations and no change
in the underlying conditions
– Subjective probability is the individual’s personal estimate of the
chance of loss
• A person’s perception of the chance of loss may differ from the
objective probability

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Peril and Hazard
• A peril is defined as the cause of the loss
– In an auto accident, the collision is the peril
• A hazard is a condition that increases the chance of loss
– Physical hazards are physical conditions that increase the chance
of loss (icy roads, defective wiring)
– Moral hazard is dishonesty or character defects in an individual,
that increase the chance of loss (faking accidents, inflating claim
amounts)
– Morale Hazard is carelessness or indifference to a loss because of
the existence of insurance (leaving keys in an unlocked car)
– Legal Hazard refers to characteristics of the legal system or
regulatory environment that increase the chance of loss (large
damage awards in liability lawsuits)

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Basic Categories of Risk
• Pure and Speculative Risk
– A pure risk is one in which there are only the possibilities of loss or
no loss (earthquake)
– A speculative risk is one in which both profit or loss are possible
(gambling)
• Fundamental and Particular Risk
– A fundamental risk affects the entire economy or large numbers of
persons or groups (hurricane)
– A particular risk affects only the individual (car theft)
• Enterprise Risk
– Enterprise risk encompasses all major risks faced by a business
firm, which include: pure risk, speculative risk, strategic risk,
operational risk, and financial risk

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Types of Pure Risks
• Personal risks involve the possibility of a loss or
reduction in income, extra expenses or depletion
of financial assets:
– Premature death of family head
– Insufficient income during retirement
• Most workers are not saving enough for a comfortable
retirement
– Poor health (catastrophic medical bills and loss of
earned income)
– Involuntary unemployment

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Types of Pure Risks
• Property risks involve the possibility of losses
associated with the destruction or theft of
property:
– Physical damage to home and personal property from
fire, tornado, vandalism, or other causes
• Direct loss vs. indirect loss
– A direct loss is a financial loss that results from the physical
damage, destruction, or theft of the property, such as fire damage
to a restaurant
– An indirect loss results indirectly from the occurrence of a direct
physical damage or theft loss, such as lost profits due to inability to
operate after a fire

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Types of Pure Risks

• Liability risks involve the possibility of being held

liable for bodily injury or property damage to
someone else
– There is no maximum upper limit with respect to the
amount of the loss
– A lien can be placed on your income and financial
assets
– Defense costs can be enormous

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Burden of Risk on Society

• The presence of risk results in three major

burdens on society:
– In the absence of insurance, individuals would
have to maintain large emergency funds
– The risk of a liability lawsuit may discourage
innovation, depriving society of certain goods
and services
– Risk causes worry and fear

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Methods of Handling Risk
• Avoidance
• Loss control
– Loss prevention refers to activities to reduce the frequency of
losses
– Loss reduction refers to activities to reduce the severity of losses
• Retention
– An individual or firm retains all or part of a loss
• Noninsurance transfers
– A risk may be transferred to another party through contracts,
hedging, or incorporation
• Insurance

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Definition of Insurance

• Insurance is the pooling of fortuitous losses

by transfer of such risks to insurers, who
agree to indemnify insured for such losses,
to provide other pecuniary benefits on their
occurrence, or to render services connected
with the risk

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Basic Characteristics of Insurance

• Pooling of losses
– Spreading losses incurred by the few over the entire group
– Risk reduction based on the Law of Large Numbers
• Payment of fortuitous losses
– Insurance pays for losses that are unforeseen, unexpected, and
occur as a result of chance
• Risk transfer
– A pure risk is transferred from the insured to the insurer, who
typically is in a stronger financial position
• Indemnification
– The insured is restored to his or her approximate financial position
prior to the occurrence of the loss

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Adverse Selection and Insurance

• Adverse selection is the tendency of persons with

a higher-than-average chance of loss to seek
insurance at standard rates
• If not controlled, adverse selection result in higher-
than-expected loss levels
• Adverse selection can be controlled by:
– careful underwriting (selection and classification of
applicants for insurance)
– policy provisions (e.g., suicide clause in life insurance)

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Private Insurance
• Life and Health
– Life insurance pays death benefits to beneficiaries when
the insured dies
– Health insurance covers medical expenses because of
sickness or injury
– Disability plans pay income benefits
• Property and Liability
– Property insurance indemnifies property owners against
the loss or damage of real or personal property
– Liability insurance covers the insured’s legal liability
arising out of property damage or bodily injury to others
– Casualty insurance refers to insurance that covers
whatever is not covered by fire, marine, and life insurance

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Social Benefits of Insurance
• Indemnification for Loss
– Contributes to family and business stability
• Reduction of Worry and Fear
– Insureds are less worried about losses
• Source of Investment Funds
– Premiums may be invested, promoting economic growth
• Loss Prevention
– Insurers support loss-prevention activities that reduce direct and
indirect losses
• Enhancement of Credit
– Insured individuals are better credit risks than individuals without
insurance

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