c2 - risk and its treatment

7/26/2019 c2 - Risk and Its Treatment

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CHAPTER 1: RISK AND ITS

TREATMENTPrinciples of Risk Management and InsuranceBy G.E. Rejda

(Class 2)


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AGENDA

Different Definitions of Risk Chance of Loss Peril and Hazard

Classification of Risk Major Personal Risks andCommercial Risks

Burden of Risk on Society Techniques for Managing Risk


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DIFFERENT DEFINITIONS

There is no single definition of risk. Risk is defined asuncertainty concerning the occurrence of a loss.

Because the term risk is ambiguous and have differentmeanings, many corporate risk managers use the term loss

exposure to identify potential loss. Loss exposure is anysituation or circumstance in which a loss is possible,regardless of whether a loss occurs.

Objective Risk vs. Subjective Risk Objective risk is defined as the relative variation of actual loss from

expected loss. For example It declines as the number of exposures increases;

It can be statistically calculated by some measure of dispersion, such asthe standard deviation or the coefficient of variation;

Law of large numbersas the number of exposure units increases, themore closely the actual loss experience will approach the expected lossexperience.


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DIFFERENT DEFINITIONS

Objective Risk vs. Subjective Risk Subjective riskis defined as uncertainty based on a persons

mental condition or state of mind. For example

The impact of subjective risk varies depending on the individual;

Two persons in the same situation may have different perception of

risk and their behavior may be altered accordingly; High subjective risk often results in conservative and prudent

behavior, while low subjective risk may result in less conservative

behavior. For example


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CHANCE OF LOSS

Chance of loss is closely related to the concept of risk.Chance of loss can be defined as the probability that anevent will occur.

Objective Probability vs. Subjective Probability

Objective probability refers to the long-run relative frequency of anevent based on the assumptions of an infinite number ofobservations and of no change in the underlying conditions It can be determined by deductive reasoning (priori) or inductive

reasoning. For example

Subjective probability is the individuals personal estimate of the

chance of loss. It need not coincide with objective probability. Forexample

The chance of loss may be identical for two different groups,but objective risk may be different. For example


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PERIL AND HAZARD

Peril is defined as the cause of loss Example: If your house burns because of a fire, the peril or cause of

loss, is the fire.

A hazard is a condition that creates or increases the

frequency or severity of loss. 4 major types: Physical hazard is a physical conditions that increases the frequency

or severity of loss (e.g. icy roads, defective wiring);

Moral hazard is dishonesty or character defects in an individual thatincrease the frequency or severity of loss (e.g. faking an accident,inflating claim amounts);

Morale Hazard / Attitudinal Hazard is carelessness or indifference toa loss, which increases the frequency or severity of a loss (e.g.leaving car keys in an unlocked car);

Legal Hazard refers to characteristics of the legal system orregulatory environment that increase the frequency or severity of

loss (e.g. large damage awards in liability lawsuits).


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CLASSIFICATION OF RISK

Pure and Speculative Risk Pure risk is defined as a situation in which there are only the

possibilities of loss or no loss (e.g. flood, earthquake etc.); Speculative risk is defined as a situation in which either profit or

loss is possible (e.g. invest into stock market); Three distinguish differences:-

Insurers typically insure pure risks; Law of large numbers can be applied more easily to pure risks than to

speculative risks (with an exception of gambling); Society may benefit from a speculative risk even though a loss occurs, but

it is harmed if a pure risk is present and a loss occurs. For example

Diversifiable and Non-diversifiable Risk Diversifiable risk (Particular risk) affects only individuals or small

groups and not the entire economy. It can be reduced or eliminatedby diversification (e.g. diversified investment portfolio);

Non-diversifiable risk (Fundamental risk) affects the entire economyor large numbers of persons or groups within the economy. Itcannot be eliminated or reduced by diversification (e.g. flood,earthquake etc.).


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CLASSIFICATION OF RISK

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 Strategic risk refers to uncertainty regarding the firms financial goals and

objectives (e.g. new line of business vs profit);

Operational risk results from the firms business operations (e.g. on-linebanking services vs computer hackers);

Financial riskrefers to the uncertainty of loss because of adverse changes incommodity prices, interest rates, foreign exchange rates and value of money.

Enterprise risk is becoming more important in commercial riskmanagement, which is the process that organizations use toidentify and treat major and minor risks

Some risk managers are now considering all types of risk in 1program

Enterprise risk management (ERM) combines into a singleunified treatment program all major risks faced by the firm, byoffsetting one risk against another i.e. overall risk can be reduced


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MAJOR PERSONAL RISKS AND

COMMERCIAL RISKS Personal risks are risks that directly affect an

individual. They involve the possibility of the loss orreduction in earned income, extra expenses ordepletion of financial assets.

There are 4 major personal risks: Risk of premature death of family head with unfulfilled

financial obligations;

Risk of insufficient retirement income;

Most workers are not saving enough for a comfortable

retirement Risk of poor health;

Payment of catastrophic medical bills and loss of earned income

Risk of unemployment;

Result from business cycle downswings, changes in economy etc.


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COMMERCIAL RISKS Property risks involve the risk of having

property damaged or lost from numerouscauses. The possibility of losses associated withthe destruction or theft of property:

Physical damage to home and personal property fromfire, lightning, tornado, vandalism, or other causes

2 major types of loss associated with this:

A direct loss is a financial loss that results from the physical

damage, destruction, or theft of the property, such as firedamage to a restaurant;

An indirect loss (consequential loss ) results indirectly fromthe occurrence of a direct physical damage or theft loss, suchas loss of profits due to inability to operate after a fire.


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COMMERCIAL RISKS Liability risks are another important type of

pure risk that most people face. It involve the

possibility of being held liable for bodily injury

or property damage to someone else.

Is of great importance for several reasons:

There is no maximum upper limit with respect to the

amount of the loss;

A lien (legal claim) can be placed on your income andfinancial assets to satisfy a legal judgment;

Legal defense costs can be enormous.


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COMMERCIAL RISKS Commercial risks basically when a business

firms face wide variety of pure risks that canfinancially cripple or bankrupt the firm if a lossoccurs. These includes:

Property risksproperty that can be damaged ordestroyed by numerous perils;

Liability riskslawsuits for bodily injury and propertydamage;

Loss of business income;

Other risks, such as crime, human resources, foreignloss, intangible property, government exposures.Examples are


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BURDEN OF RISK ON SOCIETY

The presence of risk results in certainundesirable social and economic effects.Risk entails 3 major burdens on society:

In the absence of insurance, individuals andbusiness firms would have to have or maintainlarger emergency funds;

The risk of a liability lawsuit may discourage

innovation, depriving society of certain goodsand services;

Worry and fear caused by risk. For example


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TECHNIQUES FOR MANAGING

RISK

It is important to examine some techniques fordealing with risk. There are 5 major methods formanaging risk: Avoidancefor example, you can avoid the risk of being

mugged in high-crime rate area by staying out of thearea or you can avoid the risk of divorce by notmarrying

Loss control Loss prevention refers to activities to reduce the frequencyof

losses. For example, strict security measure at airport, periodicinspections of boiler, enforcement of safety rules etc.;

Loss reduction refers to activities to reduce the severityoflosses. For example, installation of sprinkler system etc.;


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RISK

There are 5 major methods for managing risk: Retention

An individual or a business firm retains all or part of all of thefinancial consequences of a given risk;

Risk retention may be active (consciously aware of the risk) orpassive (unknowingly retained because of ignorance etc.);

Self-insurance: a special form of planned retention by which partor all of a given loss exposure is retained by the business firm


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RISK

There are 5 major methods for managing risk: Noninsurance transfers

A risk may be transferred to another party other than insurancecompany, such as through contracts, hedging of price orincorporation of a business firm

Insurance For most people, insurance is the most practical method for

handling major risks;

3 major characteristics are risk transfer (pure risk is transferredto the insurer), pooling technique (spread losses of the few overthe entire group so that average loss is substituted for actualloss) and the application law of large numbers (can predict futureloss experience with greater accuracy)

c2 - risk and its treatment

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