3. the Concept of Risk

7/31/2019 3. the Concept of Risk

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The Concept of Risk


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What would be your reaction after the excitementsettles down?

Risk is a pervasive condition of humanexistence


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R I S K ??

Economists

Statisticians

Decisiontheorists

Insurance

theorists

All have

different

meanings for

RISK


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The concept of Risk

Insurance is still in its infancy as a body oftheory.contradictions regarding the definition

One reason could be that the insurancetheorists have attempted to borrow thedefinitions of risk from other fields

Even the insurance text writers have beenunable to agree on a definition of this basicconcept


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Usage of the term risk in Insurance

The term Risk is used varyingly in

insurance:

An insured object e.g. a house, factor, ship or car

A peril e.g. Fire, storm, collision, AOG disasters A hazard or a set of hazardous conditions which

may cause a loss e.g. storage of inflammable

materials near to a source of heat

A person or property protected by insurance e.g.Many insurers feel young drivers are not good

risks


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Various definitions of Risk

o The chance of losso Likelihood of something happening

o The possibility of losso The probability lies between 0 and 1

o Uncertaintyo A state of mind, characterized by doubt - subjective

o The dispersion of actual from expected results ORo Risk exists because the actual results always differ from expected

o The probability of any outcome different from the oneexpected or probability of a loss occurring.

o Expected outcomes are assigned a probability based on pastexperience

In the context of Risk management, it is the last usage whichis nearest to an acceptable definition of risk; a phenomenonclosely associated with uncertain events.


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Definition of risk

The condition of the real world is a Combination of circumstances + the

external environment.

Risk is a

condition of the

real world in

which there isan exposure to

adversity

Risk is a condition in

which there is a

possibility of an

adverse deviation

from which a desired

outcome that is

expected or hoped

for.

OR

In the combination of circumstances there is a possibility of

loss


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Possibility/ Probability of loss

i.e. it has a probability between zero and one.

So it neither impossible nor definite.

Also there is no requirement that the possibility be

measurable

We may not be able to measure the degree of risk, butthe probability of the adverse outcome must be

between zero and one


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Probability a concept of average

It is an average concept as it indicates the number of timesa

particular outcome can be expected to occur Tossing of a coin:

o Toss a coin --- it can land on its head or tail

o So probability of getting a head is 1:2 or 0.5o Toss a coin 6 times --- getting 3 heads is a small probability

o But the more number of times you toss a coin, there is a possibility of

the ratio of outcomes approaching 1:2

The probability of a particular outcome is defined as the

proportion of times that such an outcome is observed to

occur in an infinitely large number of independent events.

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Stack of cards

The possibility of drawingthe ace of spades from adeck of cards = 1/52 or.019

drawing any ace (4 suits) = 1/13

OR

drawing a black card (2 black

suits) = or 0.5

A deck = 52 cards


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Vehicle(s) involved in an accident

If the probability of a vehicle

being involved in an accident

in any one year = 0.2

Then, a firm with One vehicle

can expect it to have an

accident once in five years.

But if the accident does

happen, there is no certainty

that the vehicle will not soon

be involved in another.


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So, a firm has 5000 vehicles

Can safely plan on having to deal

with 1000 (5000 x 0.2) accidentsor so each year

These are e.gs. of the operation of

the law of large numbers, a lawwhich essentially predicts that as

the number of events increases,

the relative variation in actual

outcomes from the expected

outcomes decreases.

Risk can be thought of as:

the degree of variation in the possible outcomes from an uncertain

event, OR as the variation in actual from expected outcomes.


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THE DEGREE OF RISK

Also called the Objective Risk (OR)


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Risk can be thought of as:

the degree of variation in the possible outcomes from an uncertain

event, OR as the variation in actual from expected outcomes.

The Degree of Risk

Precisely what is meant when we say that one alternative involves more risk

or less riskthan another?

The commonly accepted meaning of the Degree of Riskis relatedto the likelihood of its occurrence.

By instinct, we consider those events with higher probability of

loss to be riskier, than those with lesser probability.


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The Degree of Risk contd

E.g. For an Individual, the hope is NO loss will occur.

Here, we measure risk in terms of the probability of the

adverse deviation from what is hoped for.

Actuarial tables will tell us that the probability of death at the age

of :

52 is 1 percent 79 is 10 percent

97 is 50 percent

Using the probability of adverse deviation from the outcome that

is hoped for, we view the risk of death-

At the age of 79 as > that at age 52, but less than at the age of

97.

The higher the probability that an event will occur, the greater the

likelihood of the deviation from the outcome hoped for.

The greater the risk, as longer as the probability of loss is < 1.


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Russian Roulette

o There is more risk when there are two bullets in a

revolvers six chambers than when there is one bullet.

o Adding a third bullet, increases the chances of risk.

o Adding a fourth and fifth bullet increases the probability

of a deviation from the hoped-for outcome.o If a sixth bullet is added, the player can no longer

expect or even hope that the outcome will be

favourable.

o The sixth bullet makes the outcome certain and risk no

longer exists.

10

no chance of an

outcome other

than that which is

expected, so, no

hope of a

favourable result.

when the

probability of loss

is zero, there is no

possibility of loss

and therefore no

risk.


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In case oflarge no. of exposure units, estimates can be made

about the likelihood of the no. of losses that will occur and

predictions made on the basis of these estimates.

Here the expectation is that the predicted number of losses

will occur.

In case of aggregate exposures, the degree of risk is not the

possibility of a single occurrence or loss; it is the probability of

some outcome different from the predicted or expected.

Insurance companies make predictions about the losses that

are expected to occur and charge a premium based on this

prediction.

For the insurance company, the risk is that its prediction will

not be accurate.


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Say there

are 10,000

houses

Based on past experience an

insurer estimates that 1 out

of these 100 houses will burn(1 %). Rare for all houses to

burn down at the same time

If the company insures 10,000

houses, it might predict 100

houses will burn from this.

Actual experience may

deviate from this

expectation


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So, Insurer will predict not only the number of

houses, but will also predict a range of error.

Say possible deviation will be + or 10.

Say, between 90 and 110 houses ..can be

expected to burn. The relative of actual loss from expected loss is

known as Objective risk (OR = 10/100 or 10%)

The possibility that the number will be > 100 is

the Insurers risk.

Objective risk varies inversely with the square

root of the number of cases under observation


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Objective risk declines as the number of exposuresincreases.

E.g. If 10,00,000 (1 million) houses are insured, expectedno. of houses that will burn is 10,000.

But variation of actual loss from expected loss is only 100.Objective Risk is now 100/10,000 or 1 percent

As the square root of the no. of houses increased from 100

in the first example to 1000 in the second example,objective risk declined to one-tenth of its former level

OR can be statistically calculated by some measureof dispersion standard deviation or coefficient of

variation Because of this feasibility, this is a very useful

concept for an insurer or a corporate risk manager.


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RISK DISTINGUISHED FROM

PERIL AND HAZARD

The terms peril and hazard are used interchangeably with

each other and with risk.

It is important to distinguish these terms


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Peril Vs Hazard

Peril Hazard

A peril is the cause of loss

E.g. fire, collision,

windstorm, hail, theft etc. Each of these is the cause

of the loss that occurs.

A hazard is a condition, that

creates or increases the

chance of a loss arisingfrom a given peril.

It is possible for something to be both a peril and a hazard.

For E.g. sickness---is a peril causing economic loss.

But if this sickness persists, It becomes a hazard that increases the

chance of loss if it results in premature death (peril).


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Three

traditional

Hazards

Physical

Physical properties that increasethe chance of loss from variousperils. For. E.g. fire

Type of construction; Location ofthe property; Occupancy of thebuilding.

Moral

Increase in probability of lossdue to : Dishonest tendenciesof insured ; Indifferentattitude; Indulge in fraud

Morale

Not to be confused with Moral H.Reflected in attitude of persons whoare not the insured . E.g. Physicians,Service Stations, etc. have a tendencyto increase both frequency andseverity of losses when covered byinsurance.


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Legal hazard

Fourth hazard which should be recognised.

Refers to the increase in the frequency and

severity of loss that arises from legal doctrines

enacted by legislatures and created by the

courts.

E.gs. Include - Jurisdictions in which legal

doctrines favour a plaintiff present a hazard to

persons or organisations who are sued at tort. It also exists in case of property exposures


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CLASSIFICATION OF RISK


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Financial and Non-financial risks

Static and Dynamic risks

Fundamental and Particular risks

Pure and Speculative risks


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Financial Risk Non-financial Risk

The term risk includes all

situations in which there

is an exposure to

adversity. In some cases this

adversity involves

financial loss.

Insurance is concernedwith risks that involve a

financial loss.

There is some element of

risk in every human

endeavour.

Many of these risks donot have any financial

consequences; at times it

may be almost negligible.


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Static RiskDynamic Risk

Exist even if there were no

changes in the economy. These losses arise from causes

other than changes in theeconomy e.g. perils of nature,dishonesty of other individuals,fire accidents, sickness etc.

Static risks are not a source of gainto society.

Losses involve either destructionof asset or a change in itspossession as a result of acts of

nature, dishonesty or humanfailure.

Tend to occur with a degree ofregularity over time and aregenerally predictable.

More suitable for insurance.

Result from the changes in the

economy. E.gs. Changes in the price level,

consumer tastes, income andoutput and technology maycause financial loss to membersof the economy.

Normally benefit society in thelong run, though individuals maysuffer loss. These are the resultof adjustments to misallocationof resources.

Less predictable than static risks,as they do not occur with anyprecise degree of regularity.

Not suitable for insurance due totheir non-predictability.


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Fundamental Risk Particular Risk

Involve losses impersonal in

origin and consequence.

Group risks caused by social,

economic and political

phenomena. May also result

from physical occurrences.

Caused by conditions beyond thecontrol of the affected

individuals

Effect large segments or even all

of the population.

Responsibility of society.

Unemployment, War, inflation,

earthquakes, floods are all

fundamental risks

Involves losses that arise out ofindividual events

Felt by individuals rather than theentire group.

They may be static or dynamic.

E.gs. The burning of a house, therobbery of a bank, infidelity of an

employee etc. Individuals own responsibility as

losses are within the control ofindividuals. E.g. faulty electricalwiring leading to a fire

They are dealt with by theindividual through the use ofinsurance, loss prevention or someother technique.


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Speculative Risk Pure Risk

Situation where there is a

possibility of loss OR gain. E.g. In Gambling risk is

deliberately created in thehope of gain. Wager out of amatch.

Investment of Entrepreneuror VC may be lost if theproduct is not accepted bythe market at a pricesufficient to cover costs; butrisk is borne in return for

possibility of a profit. Insurance does not cover

speculative risks because ofits two-dimensional nature ofloss or gain

Situations where there is a

chance of LOSS or NO LOSS.

E.g. loss of property. A car

owner may face the risk of his

car meeting with an accident.

Possible outcomes are lossor no loss.

An outbreak of fire may not

cause substantial damage, but

would definitely not lead to a

gain.

Pure risks are preferred for

insurance.


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CLASSIFICATION OF PURE

RISKS

Brief outline of the nature of various pure risks faced by

individuals. Mostly, these are also static risks


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1. Personal risks

Consist of the possibility of loss of incomeor assets resulting from loss of ability to

earn income.

Earning power is subject to four perils:a. Premature death

b. Dependent old age

c. Sickness or disabilityd. unemployment


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2. Property Risks

Property owners face risk of losing property asthey can be destroyed or stolen

2 distinct types of loss

Direct loss - e.g. burning of a house / business firm

Indirect loss resulting from the house burning

Property risks, can involve the following types

of losses:

a. The loss of the property

b. Loss of use of property

c. Additional expenses occasioned by the loss of the

property


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Liability Risks

Basic peril in liability is the unintentional injury of otherpersons or damage to their property through

negligence or carelessness

Liability may also result from intentional injuries or

damage Law provides that if anyone has injured or damaged

anothers property, through negligence or otherwise

can be held responsible for the harm caused; so legal

liability exists. Liability risks therefore involve possibility of loss of

present assets or future income as a result of legal

liability arising out of intentional or unintentional

actions or invasion of rights of others.


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Risks arising from failure of others

When another person agrees to perform aservice for you, he / she undertakes an

obligation that you hope will be fulfilled.

When that persons failure to meet thisobligation results in your financial loss, risk

exists.

E.g.

Failure of a contractor to complete a construction

project as scheduled

Failure of debtors to make payments as expected

Eff t f U t i t i di id l d


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Effects of Uncertainty on individuals and

families

diseaseAccidental injury &

deathunemployment

Loss ofpossessions due toperils floods, fire

Liability for injurycaused to others

Other eventswhich may reduce

welfare

Events that cause a loss

On the brighter side unexpected gains may occur:Large wins on football pools

Chance encounter leading to better job or happy marriage etc.


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Effects of Uncertainty faced by an

Organisation

Loss or damageto property /

assets

Liability lossesto TP (Public /

Product)

Production risks- disruption by

fire, flood,strikes

Marketing &distribution

risksFinancial risks Personnel risks

Environmentalrisks


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The Burden of Risk

The greatest burden in connection with riskis that some losses actually occur.

There is financial loss when:

A house destroyed by fire.

Money stolen.

Wage earner of family dies.

When someones negligence leads to injury ordamage to property.

These losses are the primary burden of riskand the primary reason that individualsattempt to avoid risk or alleviate its impact.


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Other detrimental aspects of risk

Uncertainty of loss occurring Prudent individual - Absence of insurance

accumulation of reserve fund opportunitycost

Existence of risk detrimental to growth ofeconomy

Investment risks - only if there are highreturns

Uncertainty connected with pure risksproduces feeling of frustration and mentalunrest.


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Discussion

Two 9-year-old boys are watching atelevision replay of a boxing match betweenMuhammad Ali and Joe Frazier on a programcalled Great Fights of the Century. Since

the fight took place before they were oldenough to remember the outcome, neitherknows who won and they bet on theoutcome. Tom bets on Ali and Tim bets onFrazier.

Does risk exist in this situation? If yes, whatis this risk called?

Risk - For Tim? For Tom?


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Discussion

Mike says, The possibility that my housemay burn is a pure risk for me, but if I

buy insurance, it is a speculative risk for

the insurance company. Do you agree? Why? Or why not?

Documents

3. the Concept of Risk