Week 1

Topic 1: Risk in Our Society

Subtopics Overview

• 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

Meaning of Risk

• Risk: Uncertainty concerning the occurrence of a loss.

• Loss Exposure: Any situation or circumstances where a loss is possible, regardless of whether a loss occurs.

• Objective Risk vs. Subjective Risk

  • Objective Risk: Defined as the relative variation of actual loss from expected loss, statistically calculated using a measure of dispersion (e.g., standard deviation).

  • Subjective Risk: Defined as uncertainty based on an individual’s mental condition or state of mind. Different perceptions can lead to varying assessments of risk, with high subjective risk often prompting conservative behavior.

Chance of Loss

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

• Objective Probability vs. Subjective Probability

  • Objective Probability: Long-run relative frequency of an event assuming infinite observations with no change in underlying conditions, determined by deductive or inductive reasoning.

  • Subjective Probability: The individual’s personal estimate of the chance of loss, which may differ from objective probability.

• Distinction Between Chance of Loss and Objective Risk:

  • Chance of loss refers to the likelihood of an event causing a loss, while objective risk is the relative variation of actual loss from expected loss.

Peril and Hazard

• Peril: The cause of the loss (e.g., a collision in an auto accident).

• Hazard: A condition that increases the chance of loss.

  • Types of Hazards:

    • Physical Hazards: Physical conditions increasing chance of loss (e.g., icy roads, defective wiring).

    • Moral Hazard: Dishonesty or character defects that increase chances of loss (e.g., faking accidents).

    • Morale/Attitudinal Hazard: Carelessness resulting from existence of insurance (e.g., leaving keys in an unlocked car).

    • Legal Hazard: Characteristics of legal systems that increase chance of loss (e.g., large damage awards in liability lawsuits).

Basic Categories of Risk

• Pure Risk vs. Speculative Risk

  • Pure Risk: Possibilities of loss or no loss (e.g., natural disasters).

  • Speculative Risk: Possibilities of profit or loss (e.g., gambling).

• Diversifiable vs. Nondiversifiable Risk

  • Diversifiable: Affects only individuals or small groups; can be reduced by diversification.

  • Nondiversifiable: Affects the entire economy or large groups.

• Fundamental vs. Particular Risk

  • Fundamental: Affects large numbers of persons (e.g., economic downturn).

  • Particular: Affects only the individual (e.g., car theft).

• Enterprise Risk: Encompasses all major risks faced by a business, including pure, speculative, strategic, operational, and financial risks.

• Systemic Risk: Risk of collapse of an entire system due to the failure of a single entity.

Types of Pure Risks

• Personal Risks: Possibility of loss/reduction in income, extra expenses, or depletion of financial assets.

  • Examples:

    • Premature death of family head

    • Insufficient retirement income

    • Poor health leading to catastrophic medical bills and loss of income

    • Involuntary unemployment

• Property Risks: Associated with destruction or theft of property.

  • Direct Loss: Financial loss from physical damage or theft (e.g., fire damage).

  • Indirect Loss: Loss resulting from inability to operate (e.g., lost profits after fire).

• Liability Risks: Possibility of being held liable for injury or property damage.

  • No maximum limit of loss, with potential for significant legal costs and liens on income/assets.

• Commercial Risks: Financial risks that can incapacitate or bankrupt firms.

  • Includes property, liability, loss of business income, cybersecurity issues.

Burden of Risk on Society

• Presence of risk leads to three key burdens:

  • Large emergency funds must be maintained without insurance.

  • Liability risks may hinder innovation, depriving society of goods/services.

  • Risk induces widespread worry and fear.

Methods of Handling Risk

• Risk Control:

  • Avoidance: Eliminating risk.

  • Loss Control:

    • Loss Prevention: Activities to reduce frequency of losses.

    • Loss Reduction: Activities to minimize severity of losses.

      • Techniques: Duplication, separation, diversification.

• Risk Financing:

  • Retention: Individual or firm retains some or all loss (active or passive).

  • Noninsurance Transfers: Risk can be transferred to others through contracts or mechanisms like hedging or incorporation.

  • Insurance: Traditional risk transfer method.