UNIT 1: CONCEPTS IN RISK AND INSURANCEUNIT 1: CONCEPTS IN RISK AND INSURANCE

ContentContent

1.0 Aims and Objectives 1.0 Aims and Objectives

1.11.1 Introduction Introduction

1.21.2 Meaning of Risk Meaning of Risk

1.31.3 Risk and Uncertainty Risk and Uncertainty

1.41.4 Risk, Peril and Hazard Risk, Peril and Hazard

1.51.5 Chance of Loss Distinguished from Risk Chance of Loss Distinguished from Risk

1.61.6 Classification of Risk Classification of Risk

1.6.11.6.1 Objective and Subjective RiskObjective and Subjective Risk

1.6.21.6.2 Financial and Non-Financial RiskFinancial and Non-Financial Risk

1.6.31.6.3 Pure and Speculative RisksPure and Speculative Risks

1.6.41.6.4 Static and Dynamic RisksStatic and Dynamic Risks

1.6.51.6.5 Fundamental and Particular RisksFundamental and Particular Risks

1.71.7 Risk Related to Business Activities Risk Related to Business Activities

1.81.8 Burden of Risk on the Society Burden of Risk on the Society

1.91.9 SummarySummary

1.101.10 Answer to Check Your Progress ExerciseAnswer to Check Your Progress Exercise

1.0 AIMS AND OBJECTIVES1.0 AIMS AND OBJECTIVES

Dear student, in this section, you will learn about the fundamental concepts in risk andDear student, in this section, you will learn about the fundamental concepts in risk and

insurance and the classifications of risk based on various criteria. insurance and the classifications of risk based on various criteria.

After studying this unit, you should be able to:After studying this unit, you should be able to:

summarize why the study of risk management is important;summarize why the study of risk management is important;

outline the ideas incorporated in the meanoutline the ideas incorporated in the meaning of risk;ing of risk;

classify risk according to various criteria; and classify risk according to various criteria; and

describe the extent of risk in various areas (for example: at work, crime, road accidescribe the extent of risk in various areas (for example: at work, crime, road acci--

dents, fire).dents, fire).

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1.1 INTRODUCTION1.1 INTRODUCTION

In your earlier courses, you have discussed some important concepts in business. Business,In your earlier courses, you have discussed some important concepts in business. Business,

which refers to all those activities there are connected with production or purchase of goodswhich refers to all those activities there are connected with production or purchase of goods

and services with the object of selling them at profit, has some essential characteristics andand services with the object of selling them at profit, has some essential characteristics and

one of these is the fact that it involves an element of risk and uncertainty. Because the adverseone of these is the fact that it involves an element of risk and uncertainty. Because the adverse

effects of risk have affected mankind since the beginning of time, individuals groups andeffects of risk have affected mankind since the beginning of time, individuals groups and

societies have developed various methods for managing risk. Since no one knows the futuresocieties have developed various methods for managing risk. Since no one knows the future

exactly, every one is a risk manager not by choice, but by sheer necessity. The purpose of thisexactly, every one is a risk manager not by choice, but by sheer necessity. The purpose of this

course is then to examine how businesses and families might effectively mange a major classcourse is then to examine how businesses and families might effectively mange a major class

of exposures to loss through a process called risk management, which is the identification,of exposures to loss through a process called risk management, which is the identification,

measurement, and treatment of exposures to potential accidental losses.measurement, and treatment of exposures to potential accidental losses.

1.2 THE MEANING OF RISK1.2 THE MEANING OF RISK

Dear student, the starting point for any reading material on risk and insurance must be theDear student, the starting point for any reading material on risk and insurance must be the

concept of risk itself and our understanding of it. What exactly is meant by the word risk? Theconcept of risk itself and our understanding of it. What exactly is meant by the word risk? The

word is certainly used freword is certainly used frequently in everyday conversation and seems to be well understoodquently in everyday conversation and seems to be well understood

by those using it.by those using it.

What is your understanding when the term ‘risk’ is mentioned? Do you have any idea? PleaseWhat is your understanding when the term ‘risk’ is mentioned? Do you have any idea? Please

write your response in the space provided below.write your response in the space provided below.

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Dear student, there is no single definition of risk. Many writers have produced a number ofDear student, there is no single definition of risk. Many writers have produced a number of

definitions of risk. These are usually accompanied by lengthy arguments to support thedefinitions of risk. These are usually accompanied by lengthy arguments to support the

particular view they put forward. Economists, behavioral scientists, risk theorists, statisticians,particular view they put forward. Economists, behavioral scientists, risk theorists, statisticians,

and actuaries each have their own concept of risk. Some of these definitions are forwarded forand actuaries each have their own concept of risk. Some of these definitions are forwarded for

your consideration. your consideration.

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A.A. Risk is potential variation in outcomes. When risk is present, outcomes cannot beRisk is potential variation in outcomes. When risk is present, outcomes cannot be

forecasted with certainty. William, Smith and Youngforecasted with certainty. William, Smith and Young

B.B. Risk is the variation in out comes that could accrue over a specified period in aRisk is the variation in out comes that could accrue over a specified period in a

given situation. William’s and Heinsgiven situation. William’s and Heins

C.C. Risk is the condition in which there is a possibility of adverse deviant from desiredRisk is the condition in which there is a possibility of adverse deviant from desired

outcome that is expected or hoped for. Vaughen outcome that is expected or hoped for. Vaughen

Wiliams and Heins did not focus only on the negative side as variation could beWiliams and Heins did not focus only on the negative side as variation could be

both positive and negative. The emphasis is then on both negative and positiveboth positive and negative. The emphasis is then on both negative and positive

feelings of risk. But Vaughen focuses on the negative felling of risk. feelings of risk. But Vaughen focuses on the negative felling of risk.

Dear student, could you identify the defining elements of the concept of risk? Please itemizeDear student, could you identify the defining elements of the concept of risk? Please itemize

them down, in your own words, in the space provided below.them down, in your own words, in the space provided below.

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However, looking at the definitions, there does seem to emerge some kind of common threadHowever, looking at the definitions, there does seem to emerge some kind of common thread

running through each of them. running through each of them.

Firstly, there is the underlyFirstly, there is the underlying idea of uncertainty, what we have referred to as doubt abouting idea of uncertainty, what we have referred to as doubt about

the future. the future.

Secondly, there is the implication that there are differing levels or deSecondly, there is the implication that there are differing levels or degrees of risk. The use ofgrees of risk. The use of

words such as possibility and unpredictability, do seem to indicate some measure ofwords such as possibility and unpredictability, do seem to indicate some measure of

variability in the effect of this doubt. variability in the effect of this doubt.

Thirdly, there is the idea of a result having been brought about by a cause or causes. This doesThirdly, there is the idea of a result having been brought about by a cause or causes. This does

seem to tie in nicely with the working definition we used earlier of uncertainty about theseem to tie in nicely with the working definition we used earlier of uncertainty about the

outcome in a given situation.outcome in a given situation.

The value of having a single definition is questionThe value of having a single definition is questionable because it is likely to be limited in itsable because it is likely to be limited in its

ability to capture the comprehensive flavor of risk. It is more valuable to dissect the idea ofability to capture the comprehensive flavor of risk. It is more valuable to dissect the idea of

risk and conrisk and consider its component parts.sider its component parts.

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Dear student, in the forthcoming discussions, we will look at the common concepts in riskDear student, in the forthcoming discussions, we will look at the common concepts in risk

management. In doing this, we may be able to move towards a more comprehensive andmanagement. In doing this, we may be able to move towards a more comprehensive and

practipractical understanding of the meaning and nature of risk than would be the case if we stuckcal understanding of the meaning and nature of risk than would be the case if we stuck

rigidly to one or two definitions.rigidly to one or two definitions.

1.3 RISK AND 1.3 RISK AND UNCERTAINTYUNCERTAINTY

We have used the word uncertainty several times already. In our first attempt at a workingWe have used the word uncertainty several times already. In our first attempt at a working

definition of risk, we said that it was uncertainty about the outcome in a given situation.definition of risk, we said that it was uncertainty about the outcome in a given situation.

Uncertainty is at the very core of the concept of risk itself, but are we clear what we mean byUncertainty is at the very core of the concept of risk itself, but are we clear what we mean by

it when we use the word?it when we use the word?

We could take rather the philosophical view and say that uncertainty is, like beauty, in theWe could take rather the philosophical view and say that uncertainty is, like beauty, in the

eye of the beholder. We could go a step further than this and say that there is no realeye of the beholder. We could go a step further than this and say that there is no real

uncertainty in the natural order of things in our world. This point is worth exploring a littleuncertainty in the natural order of things in our world. This point is worth exploring a little

further as part of our confurther as part of our consideration of the nature of risk.sideration of the nature of risk.

An argument can be put which says that there is no uncertainty, that it does not exist in theAn argument can be put which says that there is no uncertainty, that it does not exist in the

natural order of things. You may well respond to this by saying that there are a number ofnatural order of things. You may well respond to this by saying that there are a number of

outcomes which are uncertain. For example: a risk of a rain, the possibility of being madeoutcomes which are uncertain. For example: a risk of a rain, the possibility of being made

redunredundant, the risk of having an accident. There is surely uncertainty surrounding all of thesedant, the risk of having an accident. There is surely uncertainty surrounding all of these

events - or is there?events - or is there?

We may say that there is a risk of rain, a risk of being made redundant or a risk of being in anWe may say that there is a risk of rain, a risk of being made redundant or a risk of being in an

accident. We use the phrase almost suggesting that the event may or may not happen. The factaccident. We use the phrase almost suggesting that the event may or may not happen. The fact

is that the event will or will not occur, there is no doubt about that. What we are reallyis that the event will or will not occur, there is no doubt about that. What we are really

expressing is the fact that we have some doubt as to whether the event will occur or not. Weexpressing is the fact that we have some doubt as to whether the event will occur or not. We

have imperfect inforhave imperfect information about the future, and this imperfection in our knowledge is whatmation about the future, and this imperfection in our knowledge is what

leads to the doubt and hence to the uncertainty which we express.leads to the doubt and hence to the uncertainty which we express.

This rather places the idea of uncertainty, and conThis rather places the idea of uncertainty, and consequently risk, with the individual andsequently risk, with the individual and

supports the view that uncertainty is in the eye of the besupports the view that uncertainty is in the eye of the beholder. holder.

Consider a child playing in the middle of a busy road; a workman using a machine whileConsider a child playing in the middle of a busy road; a workman using a machine while

being unabeing unaware that it is faulty and dangerous; pedestrians unaware that a wall runningware that it is faulty and dangerous; pedestrians unaware that a wall running

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alongside a pavement is in a dangerous condition and about to collapse. In each of thesealongside a pavement is in a dangerous condition and about to collapse. In each of these

situations there is an element of risk. However, uncertainty will only be created when thesituations there is an element of risk. However, uncertainty will only be created when the

individuals recognize the existence of the risks. The child may escape free of injury, theindividuals recognize the existence of the risks. The child may escape free of injury, the

machine may hold out until the workmachine may hold out until the workman has finished using it and the wall may not collapseman has finished using it and the wall may not collapse

and injure passers by. Alternatively, there could be serious injury in each case.and injure passers by. Alternatively, there could be serious injury in each case.

The people involved in each of these examples are unaware of the risk, but it does not meanThe people involved in each of these examples are unaware of the risk, but it does not mean

that there is no risk. Most people would agree that risk is present, even if it is not recognizedthat there is no risk. Most people would agree that risk is present, even if it is not recognized

by the people who could be affected. We conclude that risk can exist in the abby the people who could be affected. We conclude that risk can exist in the abstract; it is notstract; it is not

dependent on being recognized as existing by those who may be most directly independent on being recognized as existing by those who may be most directly involved. Riskvolved. Risk

is linked more to the event itself, rather than to any personal perception of the existence ofis linked more to the event itself, rather than to any personal perception of the existence of

uncertainty. Unlike risk, uncertainty dependent on being recognized.uncertainty. Unlike risk, uncertainty dependent on being recognized.

To bring this philosophical discussion to some conTo bring this philosophical discussion to some conclusion, we could say that the concept ofclusion, we could say that the concept of

unceruncertainty implies doubt about the future based on a lack of knowledge, or imperfection intainty implies doubt about the future based on a lack of knowledge, or imperfection in

knowledge. Risk exists regardless of whether this doubt has been recognized by those whoknowledge. Risk exists regardless of whether this doubt has been recognized by those who

may be most directly involved.may be most directly involved.

The reason for looking at uncertainty was that it formed one of the components of the conceptThe reason for looking at uncertainty was that it formed one of the components of the concept

of risk. Going back to the broader idea of risk, and using our understanding of uncertainty, weof risk. Going back to the broader idea of risk, and using our understanding of uncertainty, we

could say that the basis of risk is lack of knowledge, recould say that the basis of risk is lack of knowledge, regardless of whether the state of lack ofgardless of whether the state of lack of

knowledge is recognized. If we always knew what was going to happen there would be noknowledge is recognized. If we always knew what was going to happen there would be no

risk. We would know for certain if our house was to burn down this year, if we were to haverisk. We would know for certain if our house was to burn down this year, if we were to have

an accident, if the buran accident, if the burglars were to select our house, if our car was to be stolen, and so on. Weglars were to select our house, if our car was to be stolen, and so on. We

do not have this knowledge and hence operate in an uncertain or risky envido not have this knowledge and hence operate in an uncertain or risky environment.ronment.

We can therefore say that risk exists outside the individual, it may be recognized as existingWe can therefore say that risk exists outside the individual, it may be recognized as existing

but this is not a pre-requisite. In this sense, it is objecbut this is not a pre-requisite. In this sense, it is objective and not dependent on any onetive and not dependent on any one

individual. In chapter two we will see that people very often do place their own subjectiveindividual. In chapter two we will see that people very often do place their own subjective

assessments on the existence and level of risk in given situations. assessments on the existence and level of risk in given situations.

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1.4 RISK, 1.4 RISK, PERIL AND HAZARDPERIL AND HAZARD

We often use the word risk to mean both the event, which will give rise to some loss and theWe often use the word risk to mean both the event, which will give rise to some loss and the

factors which may influence the outcome of a loss. When we think about cause, we must befactors which may influence the outcome of a loss. When we think about cause, we must be

clear that there are at least these two aspects to it. We can see this if we think of a house on aclear that there are at least these two aspects to it. We can see this if we think of a house on a

riverbank and the risk of flood. The risk of flood does not really make sense, what we mean isriverbank and the risk of flood. The risk of flood does not really make sense, what we mean is

the risk of flood damage. Flood is the cause of the loss and the fact that one of the houses wasthe risk of flood damage. Flood is the cause of the loss and the fact that one of the houses was

right on the bank of the river influences the outcome.right on the bank of the river influences the outcome.

Flood is the peril and the proximity of the house to the river is the hazard. The Flood is the peril and the proximity of the house to the river is the hazard. The peril peril is theis the

prime cause; it is what will give rise to the loss. Often it is beyond the control of anyone whoprime cause; it is what will give rise to the loss. Often it is beyond the control of anyone who

may be involved. In this way we can say that storm, fire, theft, motor accident and explosionmay be involved. In this way we can say that storm, fire, theft, motor accident and explosion

are all perils.are all perils.

Factors, which may influence the outcome are reFactors, which may influence the outcome are referred to as ferred to as hazardshazards. Hazards refer to the. Hazards refer to the

conditions that create or increase the chance of loss. These hazards are not themconditions that create or increase the chance of loss. These hazards are not themselves theselves the

cause of the loss, but they can increase or decrease the effect should a peril operate. In fact,cause of the loss, but they can increase or decrease the effect should a peril operate. In fact,

hazards would facilitate the occurrence of perils. The consideration of hazard is importanthazards would facilitate the occurrence of perils. The consideration of hazard is important

when an inwhen an insurance company is deciding whether or not it should insure some risk and whatsurance company is deciding whether or not it should insure some risk and what

premium to charge. premium to charge.

There are four major types of hazards:There are four major types of hazards:

Physical hazardsPhysical hazards

Moral hazardMoral hazard

Morale hazardMorale hazard

Legal hazardLegal hazard

Physical hazardPhysical hazard is a physical condition that increases the likelihood of loss. It relates to the is a physical condition that increases the likelihood of loss. It relates to the

physical characteristics of the item or the property exposed to the risk, such as the nature ofphysical characteristics of the item or the property exposed to the risk, such as the nature of

construction of a buildconstruction of a building, the nature of the road (e.g. Icy, rough roads that increase theing, the nature of the road (e.g. Icy, rough roads that increase the

likelihood of an auto accident, etc) loose security protection at a shop or factory, or thelikelihood of an auto accident, etc) loose security protection at a shop or factory, or the

proximity of houses to a riverbank. proximity of houses to a riverbank.

Moral hazMoral hazardard is dishonesty or character defects in an individual that increases the frequency is dishonesty or character defects in an individual that increases the frequency

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or severity of loss. It is related with the human aspects which may influor severity of loss. It is related with the human aspects which may influence the outcome.ence the outcome.

This usually refers to the attiThis usually refers to the attitude of the insured person. Examples of moral hazard includetude of the insured person. Examples of moral hazard include

taking an accident to collect from an insurer, submitting a fraudulent claim, inflating thetaking an accident to collect from an insurer, submitting a fraudulent claim, inflating the

amount of the claim, and intentionally burning unsold merchandise that is insured.amount of the claim, and intentionally burning unsold merchandise that is insured.

Morale hazard Morale hazard refers to the carelessness or indifference to a loss because of the existence ofrefers to the carelessness or indifference to a loss because of the existence of

an insurance. Some insureds are careless or indifferent to a loss because they have insurance.an insurance. Some insureds are careless or indifferent to a loss because they have insurance.

Examples of morale hazard include leaving car keys in an unlocked car, which increases theExamples of morale hazard include leaving car keys in an unlocked car, which increases the

chance of theft; leaving a door unlocked that allows a burglar to enter, etc…. chance of theft; leaving a door unlocked that allows a burglar to enter, etc….

Legal hazardLegal hazard refers to characteristics of the legal system or regulatory environment that refers to characteristics of the legal system or regulatory environment that

increase the frequency or severity of losses. Examples include adverse jury verdicts or largeincrease the frequency or severity of losses. Examples include adverse jury verdicts or large

damage awards in liability lawsuits, statutes that require insurers to include coverage fordamage awards in liability lawsuits, statutes that require insurers to include coverage for

certain benefits in health insurance plans, such as coverage for alcoholism; and restrict thecertain benefits in health insurance plans, such as coverage for alcoholism; and restrict the

ability of insurers to withdraw from the state because of poor underwriting results. ability of insurers to withdraw from the state because of poor underwriting results.

1.5 1.5 CHANCE OF LOSS DISTINGUISHED FROM RISKCHANCE OF LOSS DISTINGUISHED FROM RISK

Chance of loss is closely related to the concept of risk. Chance of loss is closely related to the concept of risk. Chance of loss Chance of loss is defined as theis defined as the

probability that an event will occur. Chance of loss should not be confused with objectiveprobability that an event will occur. Chance of loss should not be confused with objective

risk. Chance of loss is the probability that an event will occur. Objective risk is the relativerisk. Chance of loss is the probability that an event will occur. Objective risk is the relative

variation of actual loss from the expected loss. The chance of loss may be for two differentvariation of actual loss from the expected loss. The chance of loss may be for two different

groups, but objective risk may be quite different. For example, assume that a fire insurer hasgroups, but objective risk may be quite different. For example, assume that a fire insurer has

10,000 homes insured in Addis Ababa and 10,000 homes in Mekelle and that the chance of10,000 homes insured in Addis Ababa and 10,000 homes in Mekelle and that the chance of

loss in each city is 1 per cent. Thus, on average, 100 homes should burn annually in each city.loss in each city is 1 per cent. Thus, on average, 100 homes should burn annually in each city.

However, if the annual variation in losses ranges from 75 to 125 in Addis Ababa, but onlyHowever, if the annual variation in losses ranges from 75 to 125 in Addis Ababa, but only

from 90 to 110 in Mekelle, objective risk is greater in Addis Ababa even the chance of loss infrom 90 to 110 in Mekelle, objective risk is greater in Addis Ababa even the chance of loss in

both cities is the same.both cities is the same.

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1.6 THE CLASSIFICATION OF RISK1.6 THE CLASSIFICATION OF RISK

We turn our attention now to the classes into which risk can be placed. This is different fromWe turn our attention now to the classes into which risk can be placed. This is different from

scrutinizing the actual idea of risk; we are now looking at the whole concept of risk andscrutinizing the actual idea of risk; we are now looking at the whole concept of risk and

grouping together similar classes of risk. Of the many classes, we will look at five.grouping together similar classes of risk. Of the many classes, we will look at five.

1.6.1 Objective and Subjective Risk1.6.1 Objective and Subjective Risk

Some authors make a careful distinction between objective risk and subjective risk. We shallSome authors make a careful distinction between objective risk and subjective risk. We shall

briefly discuss the distinction between the two in the forthcoming paragraphs. briefly discuss the distinction between the two in the forthcoming paragraphs.

Objective riskObjective risk – – is defined as the relative variation of the actual loss from expected loss. For is defined as the relative variation of the actual loss from expected loss. For

example, assume that a fire insurer has 10,000 houses insured over a long period and, onexample, assume that a fire insurer has 10,000 houses insured over a long period and, on

average, 1 percent, or 100 houses burn each year. However, it would be rare for exactly 100average, 1 percent, or 100 houses burn each year. However, it would be rare for exactly 100

houses to burn each year. In some years as few as 90 houses may burn, while in other years,houses to burn each year. In some years as few as 90 houses may burn, while in other years,

as many as 110 houses may burn. Thus, there is a variation of 10 houses from the expectedas many as 110 houses may burn. Thus, there is a variation of 10 houses from the expected

number of 100, or a variation of 10 percent. This relative variation of actual loss fromnumber of 100, or a variation of 10 percent. This relative variation of actual loss from

expected loss is known as objective risk. expected loss is known as objective risk.

Objective risk declines as the number of exposures increases. More specifically, objective riskObjective risk declines as the number of exposures increases. More specifically, objective risk

varies inversely with the square root of the number of cases under observation. In ourvaries inversely with the square root of the number of cases under observation. In our

previous example, 10,000 houses were insured, and objective risk was 10/100, or 10 per cent.previous example, 10,000 houses were insured, and objective risk was 10/100, or 10 per cent.

Now assume that 1 million houses are insured. The expected number of houses that will burnNow assume that 1 million houses are insured. The expected number of houses that will burn

is now 10,000, but the variation of actual loss from expected loss is only 100. Objective riskis now 10,000, but the variation of actual loss from expected loss is only 100. Objective risk

now is 100/10,000, or 1 per cent. Thus, as the square root of the number of houses increasednow is 100/10,000, or 1 per cent. Thus, as the square root of the number of houses increased

from 100 in the first example to 1000 in the second example (ten times), objective risk;from 100 in the first example to 1000 in the second example (ten times), objective risk;

declined to one-tenth of its former level. (this is discussed in detail in the next chapter) declined to one-tenth of its former level. (this is discussed in detail in the next chapter)

Objective risk can be statistically measured by some measure of dispersion, such as theObjective risk can be statistically measured by some measure of dispersion, such as the

standard deviation or the coefficient of variation. Since objective risk can be measured, it is anstandard deviation or the coefficient of variation. Since objective risk can be measured, it is an

extremely useful concept for an insurer or a corporate risk manager. As the number ofextremely useful concept for an insurer or a corporate risk manager. As the number of

exposures increases, an insurer can predict its future loss experience more accurately becauseexposures increases, an insurer can predict its future loss experience more accurately because

it can rely on the it can rely on the law of large numbers.law of large numbers. The law of large numbers states that as the number The law of large numbers states that as the number

of exposure units increases, the more closely will the actual loss experience approach theof exposure units increases, the more closely will the actual loss experience approach the

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probable loss experience. For example as the number of homes under observation increases,probable loss experience. For example as the number of homes under observation increases,

the greater is the degree of accuracy in predicting the proportion of homes that will burn. the greater is the degree of accuracy in predicting the proportion of homes that will burn.

Subjective riskSubjective risk – – is defined as uncertainty based on a person’s mental condition or state ofis defined as uncertainty based on a person’s mental condition or state of

mind. For example, an individual is drinking heavily in a bar and attempts to derive home.mind. For example, an individual is drinking heavily in a bar and attempts to derive home.

The driver may be uncertain whether he or she will arrive home safely without being arrestedThe driver may be uncertain whether he or she will arrive home safely without being arrested

by the police for drunk driving. This mental uncertainty is called by the police for drunk driving. This mental uncertainty is called subjective risksubjective risk. Often. Often

subjective risk is expressed in terms of the degree of belief.subjective risk is expressed in terms of the degree of belief.

The impact of subjective risk varies depending on the individual. Two persons in the sameThe impact of subjective risk varies depending on the individual. Two persons in the same

situation may have a different perception of risk, and their conduct may be alteredsituation may have a different perception of risk, and their conduct may be altered

accordingly. If an individual experiences great mental uncertainty concerning the occurrenceaccordingly. If an individual experiences great mental uncertainty concerning the occurrence

of a loss, that person’s conduct may be affected. High subjective risk often results in lessof a loss, that person’s conduct may be affected. High subjective risk often results in less

conservative conduct, while low subjective risk may result in less conservative conduct. Aconservative conduct, while low subjective risk may result in less conservative conduct. A

driver may have been previously arrested for drunk driving and is aware that he or she hasdriver may have been previously arrested for drunk driving and is aware that he or she has

consumed too much alcohol. The driver may then compensate for mental uncertainty byconsumed too much alcohol. The driver may then compensate for mental uncertainty by

getting someone else to drive him or her home or by taking a cab. Another driver in the samegetting someone else to drive him or her home or by taking a cab. Another driver in the same

situation may perceive the risk of arrested as slight. The second driver may drive in moresituation may perceive the risk of arrested as slight. The second driver may drive in more

careless and reckless manner; a low subjective risk results in less conservative drivingcareless and reckless manner; a low subjective risk results in less conservative driving

behavior. behavior.

1.6.21.6.2 Financial and Non-Financial RiskFinancial and Non-Financial Risk

We have already said that risk implies a situation where there is uncertainty about theWe have already said that risk implies a situation where there is uncertainty about the

outcome. A financial risk is one where the outcome can be measured in monetary terms. Thisoutcome. A financial risk is one where the outcome can be measured in monetary terms. This

is easy to see in the case of material damage to property, theft of property or lost businessis easy to see in the case of material damage to property, theft of property or lost business

profit following a fire. In cases of personal injury, it can also be possible to measure financialprofit following a fire. In cases of personal injury, it can also be possible to measure financial

loss in terms of a court award of damages, or as a result of negotiation between lawyers andloss in terms of a court award of damages, or as a result of negotiation between lawyers and

insurers. In any of these cases, the outcome of the risky situation can be measured financially.insurers. In any of these cases, the outcome of the risky situation can be measured financially.

There are other situations where this kind of measThere are other situations where this kind of measurement is not possible. Take the case of theurement is not possible. Take the case of the

choice of a new car, or the selection of an item from a restaurant menu. These could be takenchoice of a new car, or the selection of an item from a restaurant menu. These could be taken

as risky situations, not because the outcome will cause fias risky situations, not because the outcome will cause financial loss, but because the outcomenancial loss, but because the outcome

could be uncomfortable or disliked in some other way. We could even go as far as to say thatcould be uncomfortable or disliked in some other way. We could even go as far as to say that

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the great social decisions of life are examples of non-financial risks: the selection of a career,the great social decisions of life are examples of non-financial risks: the selection of a career,

the choice of a marriage partner, having children. There may or may not be financialthe choice of a marriage partner, having children. There may or may not be financial

implications, but in the main the outcome is not measurable financially but by other, moreimplications, but in the main the outcome is not measurable financially but by other, more

human, criteria.human, criteria.

In the world of business we are primarily conIn the world of business we are primarily concerned with risks which have a financiallycerned with risks which have a financially

measurmeasurable outcome.able outcome.

1.6.3 Pure and Speculative Risks1.6.3 Pure and Speculative Risks

This classification also concerns the outcome. It distinguishes between those situations whereThis classification also concerns the outcome. It distinguishes between those situations where

there is only the possibility of loss and those where a gain may also result.there is only the possibility of loss and those where a gain may also result.

Pure risksPure risks involve two possible outcomes a loss or, at best, no loss. The outcome can only be involve two possible outcomes a loss or, at best, no loss. The outcome can only be

unfavorable to us, or leave us in the same position as we enunfavorable to us, or leave us in the same position as we enjoyed before the event occurred.joyed before the event occurred.

The risk of a moThe risk of a motor accident, fire at a factory, theft of goods from a store, or injury at work aretor accident, fire at a factory, theft of goods from a store, or injury at work are

all pure risks with no element of gain. It is a loss or no loss that can result from such risks.all pure risks with no element of gain. It is a loss or no loss that can result from such risks.

The major types of pure risks that are associated with great financial and economic insecurityThe major types of pure risks that are associated with great financial and economic insecurity

include personal risks, property risks, and liability risks.include personal risks, property risks, and liability risks.

Personal riskPersonal risk is chiefly concerned with death and the time of its occurrence. And apart from is chiefly concerned with death and the time of its occurrence. And apart from

death, there is incapacity through accident, injury, illness or old age – loss of earning power. death, there is incapacity through accident, injury, illness or old age – loss of earning power.

Property riskProperty risk refers to losses associated with ownership of property such as destruction of refers to losses associated with ownership of property such as destruction of

property by fire, lightening, windstorm, flood and other forces of nature. Property risk leads toproperty by fire, lightening, windstorm, flood and other forces of nature. Property risk leads to

direct loss and consequential loss. For example, when the New York twin towers weredirect loss and consequential loss. For example, when the New York twin towers were

destroyed, the direct loss is the building itself and the consequential loss is the benefitdestroyed, the direct loss is the building itself and the consequential loss is the benefit

generated from it including the rent income. generated from it including the rent income.

Losses to property may be classified as either Losses to property may be classified as either direct loss or indirect loss. direct loss or indirect loss. Each of this groupEach of this group

is discussed below. is discussed below.

Direct loss –Direct loss – a direct loss is defined as a financial loss that results from the physical a direct loss is defined as a financial loss that results from the physical

damage, destruction, or theft of the property. For example, assume that you own adamage, destruction, or theft of the property. For example, assume that you own a

restaurant, and the building is insured by a property insurance policy. If the building isrestaurant, and the building is insured by a property insurance policy. If the building is

10

damaged by a fire, the physical damage to the property is known as damaged by a fire, the physical damage to the property is known as a direct loss. a direct loss. In otherIn other

words, property suffers a direct loss when the property itself is directly damaged orwords, property suffers a direct loss when the property itself is directly damaged or

destroyed or disappears because of contact with a physical or social peril. destroyed or disappears because of contact with a physical or social peril.

Indirect or consequential loss – Indirect or consequential loss – an indirect loss is a financial loss that results indirectlyan indirect loss is a financial loss that results indirectly

from the occurrence of a direct physical damage, destruction, or theft. Thus, in addition tofrom the occurrence of a direct physical damage, destruction, or theft. Thus, in addition to

the physical damage loss, the restaurant would lose profits for several months while it isthe physical damage loss, the restaurant would lose profits for several months while it is

being rebuilt. The loss of profits would be a consequential loss. Other examples ofbeing rebuilt. The loss of profits would be a consequential loss. Other examples of

consequential loss would be the loss of the use of the building, the loss of rents, and theconsequential loss would be the loss of the use of the building, the loss of rents, and the

loss of a market. loss of a market.

Extra expenses are another type of indirect, or consequential loss. For example, supposeExtra expenses are another type of indirect, or consequential loss. For example, suppose

you own a newspaper, bank, or dairy. If a loss occurs, you must continue to operateyou own a newspaper, bank, or dairy. If a loss occurs, you must continue to operate

regardless of cost; otherwise, you will lose customers to your competitors. It may beregardless of cost; otherwise, you will lose customers to your competitors. It may be

necessary to set up a temporary operation at some alternative location, and substantialnecessary to set up a temporary operation at some alternative location, and substantial

extra expenses would then be incurred.extra expenses would then be incurred.

Property refers to a bundle of rights that form part of the tangible physical assets, but whichProperty refers to a bundle of rights that form part of the tangible physical assets, but which

independently possess certain economic value. The exposures that result from these interestsindependently possess certain economic value. The exposures that result from these interests

may be property including net income or liability exposures. Only the direct and indirectmay be property including net income or liability exposures. Only the direct and indirect

property loss exposures are considered below.property loss exposures are considered below.

Liability Risk Liability Risk

Liability risk is the possibility of loss arising from intentional or unintentional damage madeLiability risk is the possibility of loss arising from intentional or unintentional damage made

to other persons or to their property. One would be legally obliged to pay for the damages heto other persons or to their property. One would be legally obliged to pay for the damages he

inflicted upon other persons or their property. A court of law may order you to pay substantialinflicted upon other persons or their property. A court of law may order you to pay substantial

damages to the person you have injured. damages to the person you have injured.

Liability risks are of great importance for several reasons. First, there is no maximum upperLiability risks are of great importance for several reasons. First, there is no maximum upper

limit with respect to the amount of the loss. You can be sued for any amount. In contrast, iflimit with respect to the amount of the loss. You can be sued for any amount. In contrast, if

you own a property, there is a maximum limit on the loss. For example, if your automobileyou own a property, there is a maximum limit on the loss. For example, if your automobile

has an actual cash value of Br. 10,000, the maximum physical damage loss is Br. 10,000. Buthas an actual cash value of Br. 10,000, the maximum physical damage loss is Br. 10,000. But

if you are negligent and cause and accident that results in serious bodily injury to the otherif you are negligent and cause and accident that results in serious bodily injury to the other

driver, you can be sued for any amount – Br. 50,000, Br. 500,000, or Br.1 million or more –driver, you can be sued for any amount – Br. 50,000, Br. 500,000, or Br.1 million or more –

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by the person you have injured. by the person you have injured.

Second, although the experience is painful, you can afford to lose your present financialSecond, although the experience is painful, you can afford to lose your present financial

assets, but you can never afford to lose your future income and assets. Assume that you areassets, but you can never afford to lose your future income and assets. Assume that you are

sued and are required by the court to pay a substantial judgment to the person you havesued and are required by the court to pay a substantial judgment to the person you have

injured. If you do not carry liability insurance or are underinsured, your future and assets caninjured. If you do not carry liability insurance or are underinsured, your future and assets can

be attached to satisfy the judgment. If you declare bankruptcy to avoid payment of thebe attached to satisfy the judgment. If you declare bankruptcy to avoid payment of the

judgment, your ability to obtain credit will be severely impaired. judgment, your ability to obtain credit will be severely impaired.

Finally, legal defense costs can be enormous. If you are sued and have no liability insurance,Finally, legal defense costs can be enormous. If you are sued and have no liability insurance,

the cost of hiring an attorney to defend you and represent you in a court of law can bethe cost of hiring an attorney to defend you and represent you in a court of law can be

staggering. staggering.

Speculative RiskSpeculative Risk `̀ The alternative to pure risks is speculative risk, where there are two The alternative to pure risks is speculative risk, where there are two

possible outcomes – gain or loss. Speculative risk is defined as a situation in which eitherpossible outcomes – gain or loss. Speculative risk is defined as a situation in which either

profit or loss is possible. Investing money in shares is a good example. The investment mayprofit or loss is possible. Investing money in shares is a good example. The investment may

result in a loss or possibly a break-even position, but the reason it was made was the prospectresult in a loss or possibly a break-even position, but the reason it was made was the prospect

of gain. People are more adverse to pure risks as compared to speculative risks. In speculativeof gain. People are more adverse to pure risks as compared to speculative risks. In speculative

risk situation, people may deliberately create the risk when they realize that the favorablerisk situation, people may deliberately create the risk when they realize that the favorable

outcome is, indeed, so promising. outcome is, indeed, so promising.

Dear student, it is important to distinguish between pure and speculative risks for threeDear student, it is important to distinguish between pure and speculative risks for three

reasons. First, private insurers generally insure only pure risks. With some exceptions,reasons. First, private insurers generally insure only pure risks. With some exceptions,

speculative risks are not considered insurable and other techniques for coping with risk mustspeculative risks are not considered insurable and other techniques for coping with risk must

be used. (one exception is that some insurers will insure institutional portfolio investmentsbe used. (one exception is that some insurers will insure institutional portfolio investments

and municipal bonds against loss.)and municipal bonds against loss.)

Second, the law of large numbers can be applied more easily to pure risks than to speculativeSecond, the law of large numbers can be applied more easily to pure risks than to speculative

risks. The law of large numbers is important since it enables insurers to predict losses inrisks. The law of large numbers is important since it enables insurers to predict losses in

advance. In contrast, it is generally more difficult to apply the law of large numbers toadvance. In contrast, it is generally more difficult to apply the law of large numbers to

speculative risks in order to predict future loss experience. speculative risks in order to predict future loss experience.

Finally, society may benefit from a speculative risk even though a loss occurs, but it isFinally, 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, a firm may develop a newharmed if a pure risk is present and a loss occurs. For example, a firm may develop a new

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technological process for producing computers more cheaply and, as a result, may force atechnological process for producing computers more cheaply and, as a result, may force a

competitor into bankruptcy, society benefits since the computers are produced morecompetitor into bankruptcy, society benefits since the computers are produced more

efficiently and at a lower cost. However, society will not benefit when most pure risks occur,efficiently and at a lower cost. However, society will not benefit when most pure risks occur,

as for example, if a flood occurs or an earthquake devastates an area.as for example, if a flood occurs or an earthquake devastates an area.

The reason for stressing the difference between pure and speculative risks is to highlight theThe reason for stressing the difference between pure and speculative risks is to highlight the

fact that pure risks are normally insurable while specufact that pure risks are normally insurable while speculative risks are not normally insurable.lative risks are not normally insurable.

It is difficult to be dogmatic about this, as practice is changing and the division between pureIt is difficult to be dogmatic about this, as practice is changing and the division between pure

and speculative is becoming more blurred as time passes. Take the case of the credit risk,and speculative is becoming more blurred as time passes. Take the case of the credit risk,

which we listed under the heading of speculative risks. The goods have been sold on credit inwhich we listed under the heading of speculative risks. The goods have been sold on credit in

the hope that a gain will result but a form of credit insurance is available which will meetthe hope that a gain will result but a form of credit insurance is available which will meet

some of the consequences should the debtor default.some of the consequences should the debtor default.

However, insurance is not normally available for those risks where the outcome can be a gainHowever, insurance is not normally available for those risks where the outcome can be a gain

and it is easy to see why this should be so. Speculative risks are entered into voluntarily, inand it is easy to see why this should be so. Speculative risks are entered into voluntarily, in

the hope that there will be gain. There would be very little inthe hope that there will be gain. There would be very little incentive to work towardscentive to work towards

achieving that gain if it was known that an insurance company would pay up, regardless of theachieving that gain if it was known that an insurance company would pay up, regardless of the

effort expended by the individual. Using the terminology of hazard, we could say that thereeffort expended by the individual. Using the terminology of hazard, we could say that there

would be a very high risk of moral or morale hazard.would be a very high risk of moral or morale hazard.

However, we should be clear that the pure risk consequences of speculative risks can beHowever, we should be clear that the pure risk consequences of speculative risks can be

insured against and that more and more people involved in risk and insurance are being askedinsured against and that more and more people involved in risk and insurance are being asked

to handle speculative risks.to handle speculative risks.

1.6.4 Static and Dynamic Risks1.6.4 Static and Dynamic Risks

Dynamic risk originates from changes in the overall economy such as price level changes,Dynamic risk originates from changes in the overall economy such as price level changes,

changes in consumer taster, income distribution, technological changes, political changes andchanges in consumer taster, income distribution, technological changes, political changes and

the like. They are less predictable and hence beyond the control of risk managers. Static risks,the like. They are less predictable and hence beyond the control of risk managers. Static risks,

on the other hand, refer to those losses that can take place even though there were no changeson the other hand, refer to those losses that can take place even though there were no changes

in the over all economy. They are losses arising from causes other than changes in thein the over all economy. They are losses arising from causes other than changes in the

economy. Unlike dynamic risks, they are predictable and could be controlled to some extenteconomy. Unlike dynamic risks, they are predictable and could be controlled to some extent

by taking loss prevention measures. Many of the perils fall under this category. by taking loss prevention measures. Many of the perils fall under this category.

1.6.5 Fundamental and Particular Risks1.6.5 Fundamental and Particular Risks

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The final classification relates to both the cause and effect of risk. Fundamental risks areThe final classification relates to both the cause and effect of risk. Fundamental risks are

those, which arise from causes outside the control of any one individual or even a group ofthose, which arise from causes outside the control of any one individual or even a group of

individuals. In addition, the effect of fundamental risks is felt by large numbers of people.individuals. In addition, the effect of fundamental risks is felt by large numbers of people.

This classification would include earthquakes, floods, famine, volcanoes and other naturalThis classification would include earthquakes, floods, famine, volcanoes and other natural

‘disasters’. However it would not be accurate to limit fundamental risk to naturally oc‘disasters’. However it would not be accurate to limit fundamental risk to naturally occurringcurring

perils. Social change, political intervention and war are all capable of being interpreted asperils. Social change, political intervention and war are all capable of being interpreted as

fundamental risks.fundamental risks.

In contrast to this form of risk, which is impersonal in origin and widespread in effect, weIn contrast to this form of risk, which is impersonal in origin and widespread in effect, we

have parhave particular risks. Particular risks are much more perticular risks. Particular risks are much more personal both in their cause and effect.sonal both in their cause and effect.

This would include many of the risks we have already menThis would include many of the risks we have already mentioned such as fire, theft, worktioned such as fire, theft, work

related injury and motor accidents. All of these risks arise from indirelated injury and motor accidents. All of these risks arise from individual causes and affectvidual causes and affect

individuals in their conseindividuals in their consequences.quences.

What is interesting is the way in which risks can change classification. This does support theWhat is interesting is the way in which risks can change classification. This does support the

view that risk is a dynamic concept and that our view of it can be modified as time passes.view that risk is a dynamic concept and that our view of it can be modified as time passes.

Much of this movement in classification has been from particuMuch of this movement in classification has been from particular to fundamental.lar to fundamental.

Unemployment was regarded as a particular risk for much of the early part of this century,Unemployment was regarded as a particular risk for much of the early part of this century,

there was almost the implication that being unemployed was the fault of the individual.there was almost the implication that being unemployed was the fault of the individual.

However, the techHowever, the technological unemployment of the seventies and eightnological unemployment of the seventies and eighties has changed thaties has changed that

view, and we now talk about people suffering unemployment. As a consequence of changes inview, and we now talk about people suffering unemployment. As a consequence of changes in

our industrial and commercial world, the emphasis has moved away from the individual toour industrial and commercial world, the emphasis has moved away from the individual to

society as a whole. The evidence of this is seen in the financial provision made for those whosociety as a whole. The evidence of this is seen in the financial provision made for those who

are unemployed, in almost all industrialized countries.are unemployed, in almost all industrialized countries.

A similar move has taken place concerning injury in motor accidents, injury at work andA similar move has taken place concerning injury in motor accidents, injury at work and

injury caused by faulty products. In each of these cases society has decided that those who areinjury caused by faulty products. In each of these cases society has decided that those who are

injured should be able to receive financial compensation. It does this by passing legislation,injured should be able to receive financial compensation. It does this by passing legislation,

which ensures either that suitable insurance is in force, or that those who are injured need notwhich ensures either that suitable insurance is in force, or that those who are injured need not

have the burden of proving fault.have the burden of proving fault.

In the main, particular risks are insurable while fundamental risks are not, but it is difficult toIn the main, particular risks are insurable while fundamental risks are not, but it is difficult to

14

generalize as views in the insurance market place change from time to time. We could say thatgeneralize as views in the insurance market place change from time to time. We could say that

funfundamental risks are normally so uncontrollable, widespread and indiscriminate that it is feltdamental risks are normally so uncontrollable, widespread and indiscriminate that it is felt

they should be the responsibility of society as a whole. The geographical factor is oftenthey should be the responsibility of society as a whole. The geographical factor is often

important, particuimportant, particularly for natural hazards such as flood and earthlarly for natural hazards such as flood and earthquake. In many parts of thequake. In many parts of the

world these risks would be regarded as fundamental and not insurable, but in the Unitedworld these risks would be regarded as fundamental and not insurable, but in the United

Kingdom they are insurable.Kingdom they are insurable.

Dear student, the discussion up to this point has been intended to give a rounded view of theDear student, the discussion up to this point has been intended to give a rounded view of the

nature of the connature of the concept of risk itself. It may have seemed rather philocept of risk itself. It may have seemed rather philosophical at times, but it hassophical at times, but it has

been useful to explore ideas rather than simply accept definitions. We now move on to thebeen useful to explore ideas rather than simply accept definitions. We now move on to the

much more practical and objecmuch more practical and objective question of the cost of risktive question of the cost of risk

1.7 RISKS RELATED TO BUSINESS ACTIVITIES1.7 RISKS RELATED TO BUSINESS ACTIVITIES

Most risks in business environment are speculative in nature. The finance literature considersMost risks in business environment are speculative in nature. The finance literature considers

five types of risks that business organizations face in the course of their normal operation.five types of risks that business organizations face in the course of their normal operation.

These are: business risk, financial risk, interest rate risks, purchasing power risks, and marketThese are: business risk, financial risk, interest rate risks, purchasing power risks, and market

risks. Each of these are briefly discussed below. risks. Each of these are briefly discussed below.

Business Risk - Business Risk - This is the risk associated with the physical operation of the firm. VariationsThis is the risk associated with the physical operation of the firm. Variations

in the level of sales, costs, profits are likely to occur due to a number of factorsin the level of sales, costs, profits are likely to occur due to a number of factors

inherent in the economic environment. Business risk is independent of theinherent in the economic environment. Business risk is independent of the

company’s financial structure.company’s financial structure.

Financial Risk - Financial Risk - This is associated with debt financing. Borrowing results in the payment ofThis is associated with debt financing. Borrowing results in the payment of

periodic interest charge and the payment principal upon maturity. There is aperiodic interest charge and the payment principal upon maturity. There is a

risk of default by the company if operations are not profitable. Otherrisk of default by the company if operations are not profitable. Other

financial risks include; bankruptcy, stock price decline, insolvency.financial risks include; bankruptcy, stock price decline, insolvency.

Bondholders are less exposed to financial risk than common stockholdersBondholders are less exposed to financial risk than common stockholders

because they have a priority claim against the assets of an insolvent firm.because they have a priority claim against the assets of an insolvent firm.

Government securities, however, bear very low risk.Government securities, however, bear very low risk.

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Interest Rate Risk - Interest Rate Risk - This is a risk resulting from changes in interest rates. Changes in interestThis is a risk resulting from changes in interest rates. Changes in interest

rates affect the prices of financial securities such as the prices of bonds etc.rates affect the prices of financial securities such as the prices of bonds etc.

for interest rate rise depresses bond prices and vice, versa.for interest rate rise depresses bond prices and vice, versa.

Purchasing Power Risk - Purchasing Power Risk - This risk arises under inflationary situations (general price rise ofThis risk arises under inflationary situations (general price rise of

goods and services) leading to a decline in the purchasing power of the assetgoods and services) leading to a decline in the purchasing power of the asset

held. Financial assets lose purchasing power if increased inflationaryheld. Financial assets lose purchasing power if increased inflationary

tendencies prevail in the economy.tendencies prevail in the economy.

Market Risk - Market Risk - Market risk is related to stock market. It refers to stock price variabilityMarket risk is related to stock market. It refers to stock price variability

caused by market forces. It is the result of investors’ reactions to real orcaused by market forces. It is the result of investors’ reactions to real or

psychological expectations. For example, some forecasts may convincepsychological expectations. For example, some forecasts may convince

investors that the economy is heading towards a recession. The market indexinvestors that the economy is heading towards a recession. The market index

would decline accordingly. In other situation investors erroneously overreactwould decline accordingly. In other situation investors erroneously overreact

to events and affect the market by making abnormal transactions. Theto events and affect the market by making abnormal transactions. The

market, in many cases, is also affected by such events as: presidentialmarket, in many cases, is also affected by such events as: presidential

elections, trade balances, balance of payment figures, wars, new inventions,elections, trade balances, balance of payment figures, wars, new inventions,

etc...Market risk is also called systematic or non-diversifiable risk. Alletc...Market risk is also called systematic or non-diversifiable risk. All

investors are subject to this risk. It is the result of the workings of theinvestors are subject to this risk. It is the result of the workings of the

economy; and cannot be eliminated through portfolio diversification.economy; and cannot be eliminated through portfolio diversification.

However, investors are paid for this risk.However, investors are paid for this risk.

1.8 BURDEN OF RISK ON SOCIETY1.8 BURDEN OF RISK ON SOCIETY

The presence of risk results in certain undesirable social and economic effects. Risk entailsThe presence of risk results in certain undesirable social and economic effects. Risk entails

three major burdens on society:three major burdens on society:

i.i. The size of an emergency fund must be increased. The size of an emergency fund must be increased.

ii.ii. Society is deprived of certain goods and services.Society is deprived of certain goods and services.

iii.iii. Worry and fear are present.Worry and fear are present.

i.i. Larger Emergency FundLarger Emergency Fund

It is prudent to set aside funds for emergency purposes. However, in the absence of insurance,It is prudent to set aside funds for emergency purposes. However, in the absence of insurance,

individuals and business firms must increase the size of their emergency funds in order to payindividuals and business firms must increase the size of their emergency funds in order to pay

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for unexpected losses. For example, assume you have purchased a Br. 300,000 home andfor unexpected losses. For example, assume you have purchased a Br. 300,000 home and

want to have money for repairs if the home is damaged from fire, hail, windstorm, or somewant to have money for repairs if the home is damaged from fire, hail, windstorm, or some

other peril. Without insurance, you would have to save some big lump-sum annually to buildother peril. Without insurance, you would have to save some big lump-sum annually to build

up an adequate fund within a relatively short period of time. Even then, an early loss couldup an adequate fund within a relatively short period of time. Even then, an early loss could

occur, and your emergency fund would be insufficient to pay the loss. If you are a middle-occur, and your emergency fund would be insufficient to pay the loss. If you are a middle-

income wage earner, you would find such saving difficult. In any event, the higher the amountincome wage earner, you would find such saving difficult. In any event, the higher the amount

that must be saved, the more consumption spending must be reduced, which results in a lowerthat must be saved, the more consumption spending must be reduced, which results in a lower

standard of living. standard of living.

ii.ii. Loss of Certain Goods and ServicesLoss of Certain Goods and Services

A second burden of risk is that society is deprived of certain goods and services. For example,A second burden of risk is that society is deprived of certain goods and services. For example,

because of the risk of a liability lawsuit, many corporations have discontinued manufacturingbecause of the risk of a liability lawsuit, many corporations have discontinued manufacturing

certain products. Numerous examples can be given. Some 250 companies in the world used tocertain products. Numerous examples can be given. Some 250 companies in the world used to

manufacture childhood vaccines; today, only a few firms manufacture vaccines, due in part tomanufacture childhood vaccines; today, only a few firms manufacture vaccines, due in part to

the threat of liability suits. Other firms have discontinued the manufacture of certain products,the threat of liability suits. Other firms have discontinued the manufacture of certain products,

including single-engine airplanes, asbestos products, football helmets, silicon-gel breastincluding single-engine airplanes, asbestos products, football helmets, silicon-gel breast

implants, and certain birth control devices. implants, and certain birth control devices.

iii.iii. Worry and fearWorry and fear

A final burden of risk is that worry and fear are present. Numerous examples can illustrate theA final burden of risk is that worry and fear are present. Numerous examples can illustrate the

mental unrest and fear caused by risk. A college student who needs a grade of C in a course inmental unrest and fear caused by risk. A college student who needs a grade of C in a course in

order to graduate may enter the final examination room with a feeling of apprehension andorder to graduate may enter the final examination room with a feeling of apprehension and

fear. Parents may be fearful if a teenage son or daughter departs on a skiing trip during afear. Parents may be fearful if a teenage son or daughter departs on a skiing trip during a

blinding snowstorm since the risk of being killed on an icy road is present. Some passengersblinding snowstorm since the risk of being killed on an icy road is present. Some passengers

in a commercial jet may become extremely nervous and fearful if the jet encounters severein a commercial jet may become extremely nervous and fearful if the jet encounters severe

turbulence during the flight.turbulence during the flight.

Check Your Progress ExerciseCheck Your Progress Exercise

1.1. Give any three common elements in the definition of risk.Give any three common elements in the definition of risk.

………………………………………………………………………………………………………………………………………………………………………………………………

………………………………………………………………………………………………………………………………………………………………………………………………

……………………………………………………………………………………………….……………………………………………………………………………………………….

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2.2. "Risk is the state of mind". Argue on this."Risk is the state of mind". Argue on this.

………………………………………………………………………………………………………………………………………………………………………………………………

………………………………………………………………………………………………………………………………………………………………………………………………

……………………………………………………………………………………………….……………………………………………………………………………………………….

3.3. What are the basic differences between moral and morale hazards?What are the basic differences between moral and morale hazards?

………………………………………………………………………………………………………………………………………………………………………………………………

………………………………………………………………………………………………………………………………………………………………………………………………

……………………………………………………………………………………………….……………………………………………………………………………………………….

4.4. Identify the risk, peril and hazards of the September 11 incidents of the twin towers inIdentify the risk, peril and hazards of the September 11 incidents of the twin towers in

the United States of America.the United States of America.

………………………………………………………………………………………………………………………………………………………………………………………………

………………………………………………………………………………………………………………………………………………………………………………………………

……………………………………………………………………………………………….……………………………………………………………………………………………….

5.5. Which of the following is not true about risk.Which of the following is not true about risk.

a.a. It is a potential variation in outcome.It is a potential variation in outcome.

b.b. Being an inherent element in business it cannot be managed.Being an inherent element in business it cannot be managed.

c.c. It has something to do with future uncertainty.It has something to do with future uncertainty.

d.d. All of the aboveAll of the above

e.e. None of the aboveNone of the above

1.9 SUMMARY1.9 SUMMARY

There is no single definition of risk. Risk has been defined in a number of ways byThere is no single definition of risk. Risk has been defined in a number of ways by

different authors. different authors.

Objective risk is the relative variation of actual loss from expected loss. SubjectiveObjective risk is the relative variation of actual loss from expected loss. Subjective

risk is uncertainty based on an individual’s mental condition or state of mind. Chance ofrisk is uncertainty based on an individual’s mental condition or state of mind. Chance of

loss is defined as the probability that an event will occur; it is not the same thing as risk. loss is defined as the probability that an event will occur; it is not the same thing as risk.

Peril is defined as the prime cause of the loss. Hazard is any condition that creates orPeril is defined as the prime cause of the loss. Hazard is any condition that creates or

increases the chance of loss. There are four major types of hazards. Physical hazard is aincreases the chance of loss. There are four major types of hazards. Physical hazard is a

physical condition present that increases the likelihood of loss. Moral hazard is dishonestyphysical condition present that increases the likelihood of loss. Moral hazard is dishonesty

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or character defects in an individual that increases the likelihood of loss. Morale hazard isor character defects in an individual that increases the likelihood of loss. Morale hazard is

carelessness or indifference to a loss because of the existence of insurance. Legal hazardcarelessness or indifference to a loss because of the existence of insurance. Legal hazard

refers to characteristics of the legal system or regulatory environment that increase therefers to characteristics of the legal system or regulatory environment that increase the

frequency or severity of losses. frequency or severity of losses.

The basic categories of risk include the following:The basic categories of risk include the following:

oo Objective and subjective riskObjective and subjective risk

oo Pure and speculative riskPure and speculative risk

oo Fundamental and particular riskFundamental and particular risk

oo Static and dynamic riskStatic and dynamic risk

oo Financial and non-financial risk. Financial and non-financial risk.

A pure risk is a risk where there are only the possibilities of loss or no loss. AA pure risk is a risk where there are only the possibilities of loss or no loss. A

speculative risk is a risk where either profit or loss is possible. speculative risk is a risk where either profit or loss is possible.

A fundamental risk is a risk that affects the entire economy or large number of personsA fundamental risk is a risk that affects the entire economy or large number of persons

or groups within the economy, such as inflation, war, or recession. A particular risk is aor groups within the economy, such as inflation, war, or recession. A particular risk is a

risk that affects only the individual and not the entire community or country. risk that affects only the individual and not the entire community or country.

The following kinds of pure risk can threaten an individual’s financial security:The following kinds of pure risk can threaten an individual’s financial security:

oo Personal risksPersonal risks

oo Property risksProperty risks

oo Liability risksLiability risks

-- Personal risks are those risks that directly affect an individual. Personal risks are those risks that directly affect an individual.

-- Property risk affects persons who own property. Property risk affects persons who own property.

-- A direct loss is a financial loss that results from the physical damage,A direct loss is a financial loss that results from the physical damage,

destruction, or theft of the property. An indirect, or consequential, lossdestruction, or theft of the property. An indirect, or consequential, loss

is a financial loss that result indirectly from the occurrence of a directis a financial loss that result indirectly from the occurrence of a direct

physical damage or theft loss. Examples of indirect losses are the lossphysical damage or theft loss. Examples of indirect losses are the loss

of use of property, loss of profits, loss of rents, and extra expenses. of use of property, loss of profits, loss of rents, and extra expenses.

-- Liability risks are extremely important because there is no maximumLiability risks are extremely important because there is no maximum

upper limit on the amount of the loss, and if a person must payupper limit on the amount of the loss, and if a person must pay

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damages, future incomes and assets can be attached to pay andamages, future incomes and assets can be attached to pay an

unsatisfied judgment; substantial legal defense costs and attorneys feesunsatisfied judgment; substantial legal defense costs and attorneys fees

may also be incurred. may also be incurred.

Risk entails three major burdens on society:Risk entails three major burdens on society:

-- The size of an emergency fund must be increased.The size of an emergency fund must be increased.

-- Society is deprived of needed goods and services.Society is deprived of needed goods and services.

-- Worry and fear are present.Worry and fear are present.

1.101.10 CHECK YOUR PROGRESS QUESTION CHECK YOUR PROGRESS QUESTION

1.1. Refer to Section 1.2Refer to Section 1.2

2.2. Refer to Section 1.3Refer to Section 1.3

3.3. Refer to Section 1.4Refer to Section 1.4

4.4. Hint: Risk is unexpected losses of exposures (property and person).Hint: Risk is unexpected losses of exposures (property and person).

Peril is the specific cause for the occurrence of the loss.Peril is the specific cause for the occurrence of the loss.

Hazard is any condition that facilitates the occurrence of loss from the perilHazard is any condition that facilitates the occurrence of loss from the peril

element.element.

5.5. BB

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