Risk and Its Treatment - RMIN 4000 Lecture Notes

Risk and Its Treatment

RMIN 4000 – Chapter 1

  • Instructor: Daniel Brown

  • Year: 1785

  • Institution: Terry College of Business, University of Georgia

Risk of Driving a Car

  • Conceptual Overview:

    • Assets: Things of Value that could be lost.

    • Example: Car

    • Exposures: Things that could happen to these assets.

    • Example: Car accident, theft, vandalism

    • Perils: Specific threats to assets.

    • Example: Acts of God, breakdown

    • Risk Management: Steps taken to protect assets and reduce potential losses.

    • Example activities:

      • Drive safely

      • Insurance

      • Maintenance

      • Obey laws

      • Use car alarms

      • Park in safe areas

      • Wear seat belts

      • Take driver’s education

What is Risk?

  • Textbook Definition:

    • Uncertainty concerning the occurrence of a loss.

  • Refined Definition:

    • A calculated possibility of a negative outcome.

Calculated Possibility

  • Definition:

    • A probabilistic outcome that refers to the chance of loss or likelihood of loss.

  • Probabilistic Range:

    • Ranges from 0 to 1 (0% to 100%).

    • 0: Impossible event (No Risk)

    • 0.5: Indicating moderate risk

    • 1: Certain event (No Risk)

Negative Outcome

  • Definition:

    • Refers to a quantifiable loss in monetary terms, expressed as ($).

Frequency and Severity

  • Frequency:

    • The number of losses that occur over a specified time period.

    • Expressed as the probability of a loss occurring.

    • Example: Probability of a fire is $0.0071$ per loss exposure per year.

  • Severity:

    • The dollar amount of loss that occurs when a specific peril transpires.

    • Example: Average fire loss per house is $32,547$.

Frequency & Severity Equations

  • Equations:

    • Frequency: ext{Frequency} = rac{ ext{Number of Losses}}{ ext{Number of Exposures}}

    • Severity: ext{Severity} = rac{ ext{Incurred Losses} ext{(in dollars)}}{ ext{Number of Losses}}

Frequency & Severity – Example

  • Scenario: Lannister Insurance Company's wind damage case:

    • Insures 100,000 homes; incurred $30,000,000 in wind damage losses for 5,000 homes in 2024.

    • Calculations Required:

    • Determine wind loss frequency in 2024.

    • Determine average wind loss severity in 2024.

Peril vs. Hazard

  • Peril:

    • Definition: Cause of loss.

    • Examples: Fire, tornado, collision, burglary.

  • Hazard:

    • Definition: A condition that creates or increases the frequency or severity of a loss but does not cause a loss.

    • Types of Hazards:

    • Physical Hazard: Physical condition increasing the risk.

    • Moral Hazard: Dishonesty increasing risk; behavior changes due to insurance.

      • Examples:

      • Creating fake hail damage.

      • Exaggerating insured property value.

    • Morale (Attitudinal) Hazard: Carelessness increasing risk.

      • Examples:

      • Leaving car keys in an unlocked vehicle.

      • Ignoring maintenance issues like tree limbs.

    • Legal Hazard: Legal/regulatory elements increasing loss risk.

      • Examples:

      • Favorable jury attitudes leading to larger compensation.

      • Requirements like Diminution in Value in Georgia property losses.

Risk Classifications

  • Types of Risk:

    • Pure vs. Speculative Risk:

    • Pure Risk: Only entails loss or no loss.

      • Example Perils: Fire, cancer, dog bites.

    • Speculative Risk: Involves loss, no loss, or gain.

      • Example Activities: Investments, gambling.

    • Diversifiable Risk:

    • Affects small groups, can be mitigated through diversification; risks were not correlated (e.g., fire, theft).

    • Nondiversifiable Risk:

    • Affects the whole economy, cannot be mitigated through diversification, may require governmental intervention; risks are correlated (e.g., inflation).

    • Systemic Risk:

    • The risk of a complete breakdown of the financial system due to failures in a single entity or group of entities affecting the entire market.

Major Types of Pure Risks

  1. Personal Risk:

    • Affects individuals/families; involves loss of income or financial resources.

    • Potential Perils: Death, unemployment, disability.

  2. Property Risk:

    • Addresses the potential for property damage or theft.

    • Direct Loss: Direct costs of repairing/replacing damaged property.

    • Indirect Loss: Financial losses arising from the direct loss; for instance, paying for temporary housing post-fire damage.

  3. Liability Risk:

    • Legal financial responsibilities arising from causing harm to others.

    • Unlimited potential for financial loss; includes defense costs associated with lawsuits.

  4. Loss of Business Income:

    • Occurs when businesses cannot generate income due to physical damage; classified as direct loss.

  5. Cyber-security:

    • Risks associated with the protection of digital assets and information.

Techniques for Managing Risks

  • Risk Control:

    • Techniques aimed at reducing either frequency or severity of losses.

    • Examples:

    • Loss Prevention: Techniques to prevent losses from occurring.

      • Example: Implementing airport security; cannot eliminate all risks but can mitigate.

    • Loss Reduction: Mitigates the severity of losses.

      • Example: Fire sprinklers in buildings.

    • Duplication, Separation, & Diversification: Methods to manage risk effectively.

  • Risk Financing:

    • Techniques to fund losses that may occur.

    • Includes:

    • Retention: Retaining some or all of the risks (active or passive).

    • Noninsurance transfer: Transfer of risk through contracts.

    • Insurance: Protection against specified risks.