RMI 1

Chapter 1: Risk and Its Treatment

Learning Objectives (1 of 2)

  • 1.1 Explain the historical definition of risk.

  • 1.2 Explain the meaning of loss exposure.

  • 1.3 Understand the following types of risk:

    • Pure risk

    • Speculative risk

    • Diversifiable risk

    • Nondiversifiable risk

    • Enterprise risk

    • Systemic risk

Learning Objectives (2 of 2)

  • 1.4 Identify the major pure risks that are associated with great economic insecurity.

  • 1.5 Show how risk is a burden to society.

  • 1.6 Explain the major techniques for managing risk.

Definitions of Risk (1 of 2)

  • Traditional Definition of Risk:

    • Defined as uncertainty concerning the occurrence of a loss.

    • In the insurance industry, the term "risk" also identifies the property or life being considered for insurance.

    • In economics and finance:

    • The term risk is utilized in scenarios where the probabilities of possible outcomes are known.

    • The term uncertainty is utilized when the probabilities cannot be estimated.

Definitions of Risk (2 of 2)

  • Loss Exposure:

    • Any situation or circumstance in which a loss is possible, regardless of whether the loss occurs.

  • Objective Risk:

    • Defined as the relative variation of actual loss from expected loss, which can be statistically calculated using measures of dispersion, such as the standard deviation.

  • Subjective (Perceived) Risk:

    • Defined as uncertainty based on a person’s mental condition or state of mind.

Chance of Loss (1 of 2)

  • Chance of Loss:

    • Refers to the probability that an event causing a loss will occur.

  • Objective Probability:

    • Describes the long-run relative frequency of an event based on assumptions of an infinite number of observations and of no change in the underlying conditions.

  • Subjective Probability:

    • Represents an individual’s personal estimate of the chance of loss.

Chance of Loss (2 of 2)

  • Example:

    • The chance of loss is the probability that an event causing a loss will occur.

    • Objective Risk:

    • Represents the relative variation of actual loss from expected loss.

    • Example Data:

      • Philadelphia:

      • Number of homes: 10,000

      • Chance of fire: 1%

      • Average number of fires: 100

      • Range: 75 – 125

      • Objective risk: 25%

      • Los Angeles:

      • Number of homes: 10,000

      • Chance of fire: 1%

      • Average number of fires: 100

      • Range: 90 – 110

      • Objective risk: 10%

Peril and Hazard (1 of 2)

  • Peril:

    • Defined as the cause of the loss. Examples include:

    • Property damage due to fire, windstorm, or lightning.

    • Damage to a vehicle from a collision with another vehicle.

  • Hazard:

    • A condition that increases the frequency or severity of a loss.

    • Physical Hazard:

      • A physical condition that increases the frequency or severity of loss.

    • Moral Hazard:

      • Dishonesty or character defects in an individual that heighten the frequency or severity of loss.

Peril and Hazard (2 of 2)

  • Attitudinal Hazard (Morale Hazard):

    • Carelessness or indifference to loss, which increases frequency or severity of loss.

  • Legal Hazard:

    • Refers to characteristics of the legal system or regulatory environment that increase the frequency or severity of loss.

Classification of Risk (1 of 5)

  • Pure Risk vs. Speculative Risk:

    • Pure Risk:

    • A situation with only possibilities of loss or no loss (e.g., earthquake).

    • Speculative Risk:

    • A situation with possibilities of profit or loss (e.g., gambling).

Classification of Risk (2 of 5)

  • Diversifiable vs. Nondiversifiable Risk:

    • Diversifiable Risk:

    • A risk that affects only individuals or small groups (e.g., car theft). It can be mitigated through diversification.

    • Nondiversifiable Risk:

    • Affects the entire economy or large groups (e.g., hurricane). Also referred to as fundamental risk.

    • Often requires government assistance for insurance coverage.

Classification of Risk (3 of 5)

  • Enterprise Risk:

    • Encompasses all major risks faced by a business, including:

    • Pure risk

    • Speculative risk

    • Strategic risk

    • Operational risk

    • Financial risk

    • Strategic Risk:

    • Refers to uncertainty regarding a firm’s financial goals and objectives.

    • Operational Risk:

    • Results from the business's operations.

    • Financial Risk:

    • Refers to the uncertainty of loss due to adverse changes in commodity prices, interest rates, foreign exchange rates, and the value of money.

Classification of Risk (4 of 5)

  • Enterprise Risk Management:

    • Combines all major risks faced by the firm into one unified treatment program.

    • This packaging allows firms to offset one risk against another, reducing overall risk if the risks are not perfectly correlated.

    • Treatment of financial risks often requires complex hedging techniques, financial derivatives, futures contracts, and other financial instruments.

Classification of Risk (5 of 5)

  • Systemic Risk:

    • The risk of an entire system or market collapsing due to the failure of a single entity or a group of entities, potentially leading to the breakdown of the entire financial system.

Major Personal and Commercial Risks (1 of 5)

  • Personal Risks:

    • Directly affect individuals or families and involve the possibility of loss in the following scenarios:

    • Premature death

    • Retirement risks

    • Poor health

    • Unemployment

    • Alcohol and drug addiction

Major Personal and Commercial Risks (2 of 5)

  • Property Risks:

    • Involve potential losses associated with the destruction or theft of property.

    • Direct Loss:

    • Financial loss resulting from physical damage, destruction, or theft of property (e.g., fire damage to a home).

    • Indirect (Consequential) Loss:

    • Financial loss that occurs indirectly due to direct physical damage or theft (e.g., additional living expenses after a fire).

Major Personal and Commercial Risks (3 of 5)

  • Liability Risks:

    • Involve the risk of being legally liable for bodily injury or property damage to others.

    • No maximum upper limit on the potential loss.

    • Legal defense costs can be extremely high.

Major Personal and Commercial Risks (4 of 5)

  • Firms face various pure risks that can have severe financial consequences:

    • Property risks: damage to buildings, furniture, office equipment.

    • Liability risks: lawsuits for defective products, pollution, sexual harassment.

    • Loss of business income due to shutdowns following physical damage.

    • Cybersecurity risks: identity theft and breaches of firms' computer systems.

Major Personal and Commercial Risks (5 of 5)

  • Other Risks for Business Firms:

    • Human resources exposures, such as job-related injuries.

    • Foreign loss exposures, like acts of terrorism.

    • Intangible property exposures: damage to market reputation and public image.

    • Government exposures, such as violations of safety standards.

Burden of Risk on Society

  • The presence of risk imposes three major burdens on society:

    • In the absence of insurance, individuals and businesses must maintain large emergency funds to cover unexpected losses.

    • Liability lawsuit risks may discourage innovation, which deprives society of certain goods and services.

    • Risk causes persistent worry and fear among individuals and entities.

Techniques for Managing Risk (1 of 4)

  • Risk Control:

    • Techniques to reduce the frequency or severity of losses.

    • Avoidance:

      • Engaging in actions to eliminate the risk completely.

    • Loss Prevention:

      • Activities aimed at reducing the frequency of losses.

    • Loss Reduction:

      • Activities focused on minimizing the severity of losses:

      • Duplication

      • Separation

      • Diversification

Techniques for Managing Risk (2 of 4)

  • Risk Financing:

    • Techniques that provide funding for losses.

    • Retention:

      • An individual or business firm retains part or all of the losses from a given risk.

      • Active Retention:

      • An individual is aware of the risk and intentionally plans to retain it.

      • Passive Retention:

      • Risks may be unknowingly retained due to ignorance or indifference.

Techniques for Managing Risk (3 of 4)

  • Self-Insurance:

    • A planned retention method where part or all of a loss exposure is retained by the firm.

  • Non-insurance Transfer:

    • Transfers risk to another party:

    • Contractual transfer (hold-harmless clause).

    • Hedging:

      • A technique to transfer unfavorable price fluctuations to a speculator.

    • Incorporation of a business transfers creditor risk regarding insufficient assets.

Techniques for Managing Risk (4 of 4)

  • For many individuals, insurance is the most practical method for addressing major risks:

    • Risk Transfer:

    • Pure risk is transferred to an insurer.

    • Pooling Technique:

    • Spreads the losses of a few over the entire group.

    • Law of Large Numbers:

    • A concept that helps to reduce risk by ensuring a stable result in large samples.