Chapter-one

RISK AND RELATED TOPICS

Overview

Dear student, as the starting point of any material on risk management

and insurance has to be the understanding of the concept of risk
itself let you answer the questions here under before you go deep in
to the chapter.

The word risk is certainly used in everyday conversation and seems to

be well understood by those using it. For instance, you use the word
risk quite often in your daily life. You often hear people saying this
is risky; do not take any risk, etc. So, what is your understanding of
the word risk? What impression does it gives you when somebody
mentions the word to you?

To most people, risk implies some form of uncertainty about outcome in

a given situation. That is, the listener understands in a given
situation there is uncertainty about the outcome, and the possibility
exists that the outcome will be unfavorable. This is loose intuitive
notion of risk, which implies a lack of knowledge about the future and
the possibility of some adverse consequence, is satisfactory for
conversational usage. But as a student of risk management and
insurance, you do not need to stop with this simple understanding of
the word risk. Rather, you shall explore more concepts incorporated in
it.

Section: 1 the concept of and definition of RISK

Due to imperfect knowledge about the future, our actions are likely to
result in outcomes, which are different from our expectations. This is
something that is not desirable. Risk exists because there is no
perfect foresight about the future.

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Because risk is undesirable and its consequences are, at times,
damaging to individual, businesses and the society as a whole, mankind
is constantly developing its predictive ability through the constant
upgrading and refinement of its knowledge. The more mankind is
knowledgeable about the future, the more certain it will be concerning
future events. But, the disappointing phenomenon is that perfect
foresight about the future is something impossible. Thus, risk becomes
a fact of life that will remain side by side with the activities of
mankind.

Every discipline has its own specialized terminology, which has very
simple meanings in every day usage often take on different and
complicated connotations when applied in a specialized field. This
section mainly emphasized on the concept of risk.

No comprehensive definition exists so far. It is defined in different

forms by several authors with some differences in the wordings used.
The essence however is very similar. In general, risk refers to
exposure to adverse consequences.

Before we define risk for our purpose, it would be advisable to

consider the various definitions given by different scholars and
practitioners to comprehend the basic concept of risk.

Economists, satiations, decision theorists and insurance theorists

have long discussed the concept of “risk” and “uncertainty” in an
attempt to arrive at a definition of risk.

Up to the present time, they have not been able to agree on a

definition that can be used in each field with the same facility, nor
does it appears likely that they will not do so in the near future.

Risk management is still in its infancy as a body of theory. As a

result, we find many contradictory definitions of risk throughout the
literature dealing with this phenomenon from the risk management or an
insurance point of view. One reason for these contradictions is that

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risk management or insurance theorists have attempted to borrow the
definition if risk used in other fields.

The term risk used in different ways; the following are some
definitions given by different scholars and practitioners in the
different fields:

 Risk is the chance of loss.

 Risk is the possibility of loss.

 Risk is uncertainly.

 Risk is the probability of any outcome different from the one

expected.

 Doubt

 Worry

 The exposure of adverse consequence

 Undesirable events

Let’s see if some definition means approximately the same thing, or

has a different connotation, to decide the one which is relatively
proper definition, and which, if any, is relatively suitable for our
purpose.

o Risk is the chance of loss

Many writers define risk as the “chance of loss” what exactly is meant
by this term chance of loss? Webster defines “chance of loss” in two
ways:

 As “a possibility or likelihood of something happening” and

 As “… a degree of probability”

One defect in the definition of risk as the “chance of loss” is that

we cannot always be certain which of these two meanings is intended.

On the other hand, “chance of loss” is often used to indicate a

degree of probability in a given situation, and many writers reject

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the definition of risk as the “chance of loss” because of the
possible connotation of probability.

When used to indicate a degree of probability the “chance of loss” is

most frequently expressed as a percentage or a fraction. In this
context the chance of loss is simply the probability of loss. It
indicates the probable number and severity of loss out of a given
number of exposures.

Example: if you are offered a prize for drawing a white ball out of a
box that contains nine black balls and one white ball, your chance of
loss is 9/10 or 90%.

Those writers argue that if “risk” and “chance of loss” (i.e.

probability of loss) mean the same thing, the degree of risk and the
degree of probability should always be the same. Yet when the chance
of loss (defined as the probability of loss) is 100%, the loss is
certain and there is no risk. Risk always has the implication that the
outcome is somehow in question. When the chance of loss (probability)
is either 100% or 0, the degree of risk is zero.

o Risk is the possibility of loss

Another way of defining risk is to say that it is simply the

possibility of loss. Note that when we define risk the possibility of
loss, no attention is given to the probability as long as it is not
zero or one. The term “possibility” means that the probability of
event is between zero and one, and the very notion of risk implies
that the outcome is in question. This definition probably comes
closer to the notion of risk used in everyday conversation. However,
it is a rather loose definition, and does not tend itself to
quantitative analysis.

oRisk is Uncertainty
Some writers have carried the relationship (risk and uncertainty) to
its ultimate degree and maintain the risk as uncertainty.
Unfortunately, like the term “chance of loss” the term uncertainty is
ambiguous, it has several possible meanings.
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The first scholarly treatment of the area of risk in relation to
insurance was The Economic Theory of Risk and Insurance by Alan
H.Willett originally published in 1901.Willett recognized that risk is
commonly used in an ambiguous manner and sought to construct a more
precise definition. He arrived at the conclusion that the
uncertainties of the world are an illusion based on people’s imperfect
knowledge.

A contribution of major significance in the area of risk theory as it

relates to insurance was provided by Irving Pfeffer in his Insurance
and Economic Theory, for Pfeffer draws a distinction between risk and
uncertainty. According to Pfeffer, “uncertainty is a state of mind
relative to a specific fact situation.”

On the other hand, According to Irving Pfeffer risk is a combination

of hazards and is measured by probability. Uncertainty is measured by
degree of belief. Risk is a state of the real world; uncertainty is a
state of mind. More than any other writer, Pfeffer focused on the
contradiction inherent in defining risk as uncertainty.

From the definitions we could find a general lack of agreement

concerning the definition of risk. Even though, the insurance
theorists have not agreed on universal definition there are common
elements in all definitions: indeterminacy and loss.

o Indeterminacy: the notion of indeterminate outcome is

implicit in all definitions of risk: the outcome must be in
question. When risk is said to exist, there must always be
at least two possible outcomes. If we know for certain that
loss will occur there is no risk.

o Loss: at least one of the outcomes is undesirable. This may

be a loss in the generally accepted sense, in which some
thing the individual posses are loss, or it may be a gain
smaller than the gain that was possible.

In general, as a single definition would not sufficiently capture the

comprehensive flavor of the term risk, it is apparent that we would
not stick to one or more definition of risk. However, the following
are some important concepts you should note from the above definitions
and discussions.
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  Risk is the reality of the real world, but not belief. i.e risk
is an objective concept.

 Risk refers to uncertainty as to the loss.

 Risk becomes important if there is uncertainty as to the

occurrence of the loss.

 If we are certain, there is no risk

 Under risky situation, the outcome is undesirable.

 The degree of risk is inversely related to the ability to

predict the future.

 The more the future is unpredictable and unmanageable, the

greater will be the risk.

 If the probability of the occurrence is 1 or 0, the degree of

risk is zero.

 If many outcomes are possible, the risk is not 0. The greater

the variation, the greater the risk

Section: 2 Risk Versus uncertainty

In the first section you have dealt at length with the concept of
risk. But you are not clear as to what uncertainty actually means
and how it differs from risk. Getting clear idea here therefore,
will help you much to have proper understanding of the concept of
risk.

? What do you mean by uncertainty? Is uncertainty similar to risk?

Many textbooks use the terms risk and uncertainty interchangeably.

Although the two are closely related, quite many authors make a
distinction between the two terms.

A writer named Irving Pfeffer noted the difference between risk and
uncertainty a follows:

 “Risk is a combination of hazards and is measured by

probability; uncertainty is measured by the degree of belief.
Risk is a state of the world; uncertainty is a state of mind”.

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 You can see from the definition above that risk is objective
concept and can be measured (chapter-2 discuss in detail), where as
uncertainty is subjective concept.

Uncertainty refers to the doubt as to the occurrence of a certain

desired outcome. It is more of a subjective belief.

? When we say uncertainty is subjective, does it mean that the

intensity of uncertainty differs among people? Of course! Since
uncertainty based on the knowledge and attitudes of person viewing
the situation; and different subjective uncertainties are possible
for different individuals under identical circumstances of the
external world. E.g. two people working on the same business could
feel uncertain about the future loss with varying degree.

In general the following important concepts can be noted from the

definition.

 Uncertainty is the doubt as to the occurrence of certain desired

outcome.
 Uncertainty is the doubt that a person is aware of it or conscious
as to the existence of the risk.
 Risk is the possible of adverse deviation from a desired outcome
that is expected or hoped for.
 Uncertainty exists when the individual is aware of it. But risk
exists when a person is aware of it or not.

 Uncertainty depends upon the person’s estimated risk.

 Unlike probability and risk, we cannot measure uncertainty by a

commonly accepted yardstick.

Section: 3 Risk versus Probability

There exists also some confusion as to the difference between risk and
probability. Part of the confusion arises due to definitional
problems. Where one defines risk as a chance of loss, it would be very
difficult to make significant difference between risk and probability.
The other difficulty is whether or not probability measures risk. For
example, Pfeffer in his definition of risk stated that risk is
measured by probability.

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? What is probability? Probability is the chance of occurrence of
particular event or Probability is the long run chance/possibility of
an occurrence.

We use the word probability to refer to the likelihood of occurrence

of a given event. Specifically it is mathematical rate expressing the
chance that a certain event will occur.

Probabilities are generally assigned to events that are expected to

happen in the future. There may be a number of possible events that
will take place under given set of conditions; and these events may
occur in equal or different chance of occurrence. The weights given to
each possible event may depend on prior knowledge, toss of a coin,
past experience, statistical or mathematical estimation of relevant
data (objective probabilities) or psychological belief (subjective
probabilities).

Probability varies between 0 and 1. If the probability is 0, that

outcome will not occur. If the probability is 1, that outcome will
occur. The closer the probability is to 1, the more likely it will
occur.

Risk, on the other hand, refers to the variation in the possible

outcomes. This means that risk depends on the entire probability
distribution (Williams and Heins).It indicates the concept of
variability. The concepts of risk and probability are, therefore, two
different things. We are referring here particularly to objective
risk-which is the relative variation of actual from probable or
expected loss.

Risk is a characteristic of the entire probability distribution,

where as there is a separate probability for each outcome.

The following example illustrates the distinction between risk and

probability. Suppose the occurrence of a particular event is to be
considered. One extreme is that this event is certainly to take place.
Thus, the probability that this event will take place is 1.There is
certainty as to the occurrence of this event with perfect foresight in
this regard. Accordingly, there is no risk. The other extreme is that
the event will not take place at all .Hence; the probability of
occurrence is zero. Here, too, there is certainty and therefore, there
is no risk. In between these two extremes there could be several
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occurrences of the events with the corresponding probabilities of
occurrence. This puts us in a situation of uncertainty because it is
difficult to exactly tell which of the many possible events will take
place. Under this situation there is risk. This is graphically
depicted as follows:

Risk

0 0.5 1 Probability

Fig: Risk versus Probability graph / Probability Distribution/

? What else do you note from the above graph? Is the risk necessarily
high when probability is high? People wrongly think that risk is
necessarily high when probability is high. But this is not always
true; rather the graph shows risk is zero when probability is as high
as one.

Section: 4: Risk, Peril and Hazard

It is common for the terms “Peril” and “hazard” to be used inter
changeably / synonymously with each other and with “risk”. However,
to be precise, it is important to distinguish these terms. All of them
transmit bad taste or feeling.

Peril: A peril is a contingency, which may cause a loss. Or: it

refers to the specific cause of a loss. Peril is also called as a
loss producing agent. It is the source of a specific loss.

Peril refers to prime source of specific loss. Most of time, it is

beyond the control of anyone involved in the situation.

Hazard: A hazard, on the other hand is that the condition which

creates or increases the probability of a loss arising from a
given peril.

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For example, one of the perils that can cause loss to automobile is
collision. A condition that makes the occurrence of collisions more
likely is an icy street. The icy street is the hazard and the
collision is the peril.

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

instance, sickness is a peril causing economic loss, but it also a
hazard that increases the chance of loss from the peril of premature
death.

? Can you think of some example of peril and hazard?

Hazards are normally classified into three basic types:

1) Physical Hazards

- Physical hazards consist of those physical properties that

increase the chance of loss from the various perils.

- A physical hazard is a condition stemming from the physical

characteristics of the exposure (object) and that increases the
probability and severity of loss from given perils.

For example:

- Type of construction,(wood, bricks)

 A building made of bricks is more strong than the

one made up of wood

- Working condition,(personal accidents)

 A person who works in mining fields is more exposed

to risk than a person working in an office.

- Location of property,(near burglar area, flood area,

earthquake area)

- Occurrence of building,(dry cleaning, chemicals, super

market)

Such hazards may or may not be within human control.

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2) Moral Hazard

- A moral hazard stems from the mental attitude of the insured

person.

- It refers to the increase of the probability of loss which

results from evil tendencies in the character of the insured
person.

- It origins from the evil character of that insured person.

- Arises due to dishonest and fraudulent acts of the individual. A

dishonest person, in the hope of collecting from the insurance
company, may internationally cause a loss, or may exaggerate the
amount of a loss. Example: Arson

? What other example of moral hazard can you mention?

You may point out the following as possible answer:

 Faking an accident to collect money from insurance companies

 Dishonesty, fraudulent intention, exaggeration of claims,
etc.

3) Morale Hazard

- Results from a careless attitude on the part of insured persons

toward the occurrence of losses.

- The purchase of insurance may create a morale hazard, since the

realization that the insurance company will bear the loss.

- It doesn’t involve dishonestly, but less concern on the matter,

or indifference to loss.

Example:

 The tendency of physicians to provide more expensive levels

of care when costs are covered by insurance,

 Leaving car keys in unlocked car-increases the chance of

theft,

 Leaving a house unlocked that allows burglar to enter,

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  The inclination of juries to make larger awards when the
loss is covered by insurance the so-called “deep pocket”
syndrome, and etc.

? In this section (section-4) you have studied about risk peril and
hazard. But, is it possible to establish a specific cause- effect
relationship between these concepts?

Yes! Though it does not always work that way, we can conclude that
peril which is prime cause of risk is by itself caused or
influenced by hazard. Accordingly, it is possible to establish the
following relationship.

Hazard Peril Risk

Note: this relationship is not always true; because sometimes it is

possible for something to be both a peril and hazard at a time.

Section: 5 CLASSIFICATION OF RISK

- Risk may be classified in several ways according to their cause,

their economic effect, or some other dimension.

1. Financial Versus Non-Financial Risks

Financial risks are one where the loss occurred has some financial
implication; or where loss occurred can be measured in monetary
terms.
Examples of financial risks include:

- Credit risk

- Foreign exchange risk

- Commodity risk and

- Interest rate risk.

Non–Financial risks - those risks which do not have or expressed

in financial terms.

Example: Agony one feels following the death of a person,

personal injury and etc

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 2. Static Risks Versus Dynamic Risks

This is classification of risk based on its degree of intensity and

its predictability.

Dynamic risks

 are those risks originates / resulting from changes in the

overall economy such as price level changes, changes in consumer
taste, income distribution, technological changes, political
changes and the like. They are less predictable and hence beyond
the control of risk managers and hence are not usually covered by
insurance policies.

 Risk type which its effect is felt widely, and its effect is more
serious compared to static risk (discussed latter).

For example:

o Changes in the price level, consumer tastes, income and

output, and technology.
o Urban unrest, increasingly complex technology, and
changing attitude of legislatures and courts about a
Varity of issues.
Static risks:
Refers to those losses, which would occur even if there
are no changes in the overall 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 extent by taking loss prevention
measures. Many of the perils fall under this category.
These are risks connected with losses caused by the
irregular action of the forces of nature or the mistakes
and misdeeds of human beings.
Risks related to losses because of forces of
nature/Flood, earthquake/, dishonesty, mistakes, both
moral and morale hazards are an examples.

Note:

Static risks would be present in an unchanging economy. If

we could hold consumer taste, output and income and the

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 level of technology constant, some individuals would still
suffer financial losses. These losses arise as a result of
the perils of nature and the dishonesty of other
individuals.
Dynamic risks normally benefit society over the long run
since they are the result of adjustments to misallocation of
resources.
Dynamic risks usually affect a large number of individuals
and are generally considered less predictable, since they
occur with any precise degree of irregularity, i.e. they
don’t have regularity.
Unlike to Dynamic risks, static risks are not a source of
gain to society. I.e. they usually result in a loss to
society.
Static risks affect directly few individuals at most exhibit
more regularly over a specific period of time and are
generally predictable.
Static and dynamic risks are not independent; greater
dynamic risks may increase some type of static risks.

Example:

 Uncertainty due to weather-related losses. This

risk is usually considered to be static. Increased
industrialization (technology) may be affecting
global weather patterns and thereby increasing this
source of static risk.

1. Pure Risks versus Speculative Risks

The distinction between pure and speculative risks, rest primarily on

profit/loss structure of the underlying situation in which the event
occurs.

Pure Risk

 A pure risk exists when there is a chance of loss but no

chance of gain/profit. Hence there are two possibilities
in the case of pure risk: the person facing the risk will
either be left in the same position he has been before

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 the incidence occurred or the outcome will be unfavorable
to him. i.e. Loss or no loss.

 Refers a situation in which only loss or no loss would

occur.

Example:

 Owner of an automobile faces the risk of a

collusion loss. If collusion occurs, he will suffer
a financial loss. If there is no collusion, the
owner does not gain.

Most pure risks are insurable (discussed in unit 3). They are always
undesirable and hence people take steps to avoid such risks.

While it would impossible to list all the risks confronting an

individual or business organization, we can briefly outline the nature
of various pure risks that we can face. Pure risks that exist for
individuals and business firms can be classified under one of the
following:

A. Personal Risk

This refers to the possibility of loss to a person such as; Death,

disability, loss of earning power, etc…

These consist of the possibility of the loss of income or assets as a

result of the loss of the ability to earn income. Both individual and
business face losses.

In general, earning power is subject to four perils:

I. Premature death

- Danger in person results in death

Example: A known engineer may die because of accident-

results in loss of income.

ii. Dependent old age

Example: If a person is retired, his income may

decrease.
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 iii. Sickness or Disability

- For instance, if a person is sick, he may not generate

income. This will result in a loss in income.

iv. Unemployment

- Example: When a person is unemployed, he will not generate

income.

Unemployment can be classified in different ways.

a. Aggregate unemployment

- Which affect the entire economy

b. Selective /unstructured/ type of unemployment

- It affects a particular business organization

- For instance if the business organization is unable to

compete the market, it will result unemployment.

c. Personal unemployment

- It affects the worker/individual

Example: If a person is unemployed because of

o Disciplinary measures

o Preferring other jobs

o Lack of interest

B. Property risks

- Refers to losses associated with ownership of the property,

such as destruction of property by fire. The property can be
building, car, etc.

- Property risks embrace two distinct types of loss:

i. Direct Loss
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 - It is the simplest to understand

- It refers to the loss with the actual/equivalent to the

property.

Example: If a house is destroyed by fire, the owner of the

property losses the value of the house. This is a
direct loss.

ii. Indirect Loss or Consequential Loss

- Are losses that are going to be incurred because of the

direct loss

- Is additional loss besides to direct loss

Example: If a house is destroyed by fire, the owner of the

property losses the value of the house. This is a
direct lose. In addition to losing the value of the
building itself, the owner of the property no
longer has a place to live during the time required
to rebuild the house. Thus, the owner will incur
additional expenses. This loss of use of the
destroyed asset is an “indirect” or “consequential”
loss.

C. Liability Risks

- Refers to the international or unintentional injury or

damage made to other persons or to their property. We will be
responsible for the risk. i.e.: One would be legally obliged to
pay for the damages he inflicted upon other persons or their
property.

E.g. A given pastry may face product liability if the cake it

makes create health problem on customer due to sanitation problem
and people suffer from that act and demand compensation by the
court of law.

D. Risk arising from failure of others

- When another person agrees to perform a service for you, he/she

undertakes an obligation which you hope is met. When the person’s

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 failure to meet this obligation, you will incur financial loss.
Therefore, risk exists.

Example: Failure of a contractor to complete a construction

project as scheduled or failure of debtors to make
payments as expected.

B. Speculative risk

A speculative risk exists when there is a chance of gain as well as a

chance of loss. i.e. there is a possibility of loss and gain.

Example: Gambling, Smuggling, keeping, dollar…… is a good

example of a speculative risk.

? Can you note some more important distinction between pure and
speculative risk?

You may note the following:

Pure risks are always distasteful, but speculative risks posses

some attractive features,

In a situation involving a speculative risk, society may benefit

even though the individual is injured. For instance, the
introduction of a socially beneficial product may cause a firm
manufacturing the product it replaces to go bankrupt; But in a
pure-risk-situation society suffers (or share the risk) if any
individual experiences a loss.

Normally only pure risks are insurable (exception are there).

Insurance is not concerned with the protection of individuals
against those losses arising out of speculative risks. That is,
speculative risks are generally uninsurable. They are dealt with
hedging and other commercial techniques .Examples include,
foreign exchange risk, gambling, etc.

Speculative risk is voluntarily accepted because of its two

dimensional nature, which includes the possibility of gain and
loss; but pure risk are involuntarily accepted.

2. Subjective Versus Objective Risk

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Some authors classify risk into objective and subjective, (Green,
Williams and Heins).These two types of risk are also mentioned as
measurable and non-measurable risk.

A. Subjective risk

 It is also called as psychological uncertainty.

 Refers to the mental state of an individual as to the occurrence
of certain event in a specific period of time.
 Refers to the mental state of an individual who experiences doubt
or worry as to the outcome of a given event.
 It is the psychological uncertainty that arises from an
individual’s mental attitude or state of mind.

B. Objective Risk

 Is” the variation that exists in nature and is the same for
all persons facing the same situation” It is the sate of
nature. However, each individual’s estimate of the objective
risk varies due to a number of factors. Thus, the estimate
of objective risk which depends on the person’s
psychological belief is the subjective risk. The problem,
however, is that it is difficult to obtain the true
objective risk in most business situation.

 It is measurable. In other words, it can be quantified

using statistical techniques. For example, the variance or
standard deviation is used as a measure of risk in finance.
In some situations, the coefficient of variation is used as
a measure of risk.

 Refers to the variation when actual loss differs from

expected loss. The objective risk can be measured by the
concepts of variation; the concepts of variation are
variance and standard deviation.

 It can be quantified or it can be expressed numerically.

 It differs from subjective risk primarily in the sense that

is more precisely observable and therefore measurable.

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 In general, objective risk is the probable variation of actual
from expected experience. Applicable mainly to groups of
objects exposed to loss. Because objective risk is measured it
is an extremely useful concept for an insurer or a corporate
risk manager.

3. Fundamental risks Versus Particular Risk

The distinction between fundamental and particular risks is

based on the differences in origin and consequences of the
losses.

(a) Fundamental Risk

- Involve those losses that are impersonal in origin and

consequence.

- They are group risks caused for the most part by economic,
social and political phenomena.

- They affect a large number of society

- Since these are group risks, impersonal in origin and

effect, they are unpreventable at least for the individual.

- They are not the fault of anyone.

- Generally speaking fundamental risks are uninsurable.

Example: Risk associated with uncertainties,

inaccuracies, and disharmonies, in the economic
system will result:

o Unemployment

o Inflation They Are Fundamental Risks

o Deflation

o War

- Risk associated with extraordinary natural disturbances such

as:

o Drought

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 o Earthquakes Are Fundamental risks

o Flood

b) Particular Risks

- Involve losses that arise out of individual events and that

are felt by individuals rather than by the entire group.

- Particular risks are risks personal in origin and effect.

That is, they are personal in nature and affect each
individual separately.

- Are more readily controlled, because they are so largely

personal in nature.

Example:

- The risk of death or disability from non-occupational

causes.

- The risk of legal liability for personal injury or property

damage to others.

Note:

 Particular risks are always pure risks, where as fundamental

risks include pure and speculative risks.

 Unlike fundamental risk particular risks are insurable.

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