CHAPTER ONE

RISK AND RELATED TOPICS

1.1. MEANING OF RISK

There is no single definition of risk. Economists, behavioral scientists, risk theorists, statisticians
and actuaries each have their own concept of risk. Writers have produced a number of definitions
which are usually accompanies by lengthy arguments to support the particular view they put
forward. Consider the following definitions:

 Risk is the possibility of an unfortunate occurrence.

 Risk is a combination of hazards.
 Risk is unpredictability – the tendency that actual results may differ from predicted
results.
 Risk is uncertainty of loss.
 Risk is possibility of loss.

Although the insurance theorists have not agreed on a universal definition, there are common
elements in all the definitions: indeterminacy and loss.

 The notion of an 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 a loss will occur, there is no risk.
 At least one of the possible outcomes is undesirable. May be a loss or profit less than the
expected.

Risk is a condition in which there is a possibility of an unfavorable deviation from a desired

outcome that is expected or hoped for. Risk is uncertainty concerning the occurrence of loss.

The individual hopes that adversity will not occur, and it is the possibility that this hope will not
be met that constitutes risk.

Risk is potential variation in outcomes. If a loss is certain to occur, the outcome is one and
known in advance, therefore, there is no risk. It is when many outcomes are possible and when
there is uncertainty about the occurrence of a loss that the notion of risk is to exist. The degree
of risk is inversely related to the ability to predict which outcome will actually occur. The greater
the variation, the greater the risk.

1.2. RISK VERSUS UNCERTAINTY

The term uncertainty is often used in connection with the term risk. So, it is apparent to deal with
the relationship of these words.

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Certainty is lack of doubt. In Webster‟s New Collegiate Dictionary, one meaning of the term
“certainty” is “a state of being free from doubt,” a definition will suit to the study of risk
management. The antonym of certainty is “uncertainty” which is “doubt about our ability to
predict the future outcome of current actions.” Clearly, the term “uncertainty describes a state of
mind. Uncertainty arises when an individual perceives that outcomes cannot be known with
certainty.”

Uncertainty refers to a feelings characterized by doubt, based on the lack of knowledge about
what will or will not happen in the future. Uncertainty is doubt about our ability to predict the
future. It is doubt a person has concerning his/her ability to predict which of the possible
outcomes to occur. Uncertainty arises when an individual perceives risk. Uncertainty is a
subjective concept, so it cannot be measured directly - cannot be measured by any acceptable
yardstick. Since it is a state of mind, uncertainty varies across individuals.

Levels of Uncertainty:

The level of uncertainty arising from a given type of risk can depend on the entity facing the risk;
for example, an insurer or a governmental entity may regard the risk of earthquake as being at

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level 2, while the individual may regard the earthquake as being at level 3. This difference in
perspective may be a consequence of an ability to estimate the likelihood of outcomes.

On the other hand, risk refers to a condition or combination of circumstances in which there is a
possibility of loss. It is what a person believes to be the state of the world and the confidence
he/she has in this belief. Unlike uncertainty, risk can be measured.

1.3. RISK VERSUS PROBABILITY

Probability (chance of loss) is closely related to the concept of risk. But it should be
distinguished from risk. Probability is the long run chance of occurrence, or relative frequency
of some event. It is the probability that an event will occur. Insurers are particularly interested in
the probability or chance of loss - the probability that an even that causes a loss will occur to one
of a group of insured objects.

Risk (especially objective risk) is relative variation of actual loss from expected loss. Objective
risk can be measured meaningfully only in terms of a group large enough to analyze statistically.
The chance of loss may be identical for two different groups but objective risk may be quite
different. For example, assume that a property insurer has 10,000 homes insured in Addis Ababa
and 10,000 homes insured Hawassa and that the chance of loss in each city is 1%. Thus, on
average, 100 homes should burn annually in each city. However, if the annual variation in losses
ranges from 75 to 125 in Hawassa, but only from 90 to 110 in Addis Ababa, objective risk is
greater in Hawassa even though the chance of loss in both cities is the same.

Probability has both objective and subjective aspects.

Objective Probability

Objective probability refers to the long-run relative frequency of an event based on the
assumptions of an infinite number of observations and of no change in the underlying conditions.

Objective probabilities can be determined in two ways.

First, they can be determined by deductive reasoning. These probabilities are called a priori
probabilities. For example, the probability of getting a head from the toss of a fair coin is half as
there are two sides, and only one side is a head. Similarly, the probability of rolling a 6 dotted
side in a die is 1/6, as there is only one side has six dots.

Second, objective probabilities can be determined by inductive reasoning, rather than by

deduction. For example, the probability that a 25 years old person will die before age 30 cannot
be logically deduced. However, by a careful analysis of past mortality experience, life insurers
can estimate the probability of death on sell a five year term life insurance policy issued at age
25.

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Subjective Probability

Subject probability is the individual’s personal estimate of chance of loss. Subjective probability
need not coincide with objective probability. For example, people who buy a lottery ticket on
their birthday may believe it is their lucky day and overestimate the small chance of winning. A
wide variety of factors can influence subjective probability, including a person’s age, gender
intelligence, education, the use of alcohol and etc.

1.4. RISK, PERIL AND HAZARD

The terms peril and hazard should not be confused with the concept of risk discussed earlier.

Peril

Peril is defined as the cause of loss that occurred. If a house burns because of a fire, the peril, or
cause of loss, is the fire. If a car is damaged in a collision with another car, collision is the peril,
or cause of loss. Common perils that cause property damage included fire, lightning, windstorm,
hail, tornadoes, earth quakes, theft and robbery.

Hazard

A hazard is a condition that creates or increases the chance of loss from a given peril. It is a
condition that boosts up the probability of loss from a peril. For example, one of the perils that
can cause loss to a house is fire. The fire can be caused while we go out of home leaving the
cylinder switched on in the kitchen. Using the cylinder properly will not cause a loss, rather
poor handling does. It is possible for something to be both a peril and a hazard. For instance,
sickness is a peril causing economic loss, but it is also a hazard that increases the chance of loss
from the peril of early death.

There are four major types of hazards:

 Physical hazard
 Moral hazard
 Morale hazard
 Legal hazard

Physical hazard

A physical hazard is a physical condition that increases the chance of loss. It is a condition
stemming from the physical characteristics of an object that increases the probability and
severity of loss from given perils. Examples of physical hazards include ice covered roads that
increase the chance of a car accident, defective wiring in a building that increases the extent of
fire, and a defective lock on door that increases the chance of theft.

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Such hazards may or may not be with in human control. Some hazards for fire can be controlled
by placing restrictions on buildings or taking care while operating. In contrary, some are not
controllable – little can be done to prevent or reduce their impact. Example, ocean storms.

Moral hazards

Moral hazard is deceitfulness or character defects in an individual that increase the frequency or
severity of loss. Examples of moral hazard include forged or calculated car accident, submitting
a fraudulent claim, intentionally burning unsold insured merchandise and etc.

Moral hazard may exist where there is corrupt intention to claim excessive amount of insurance
for properties that are no longer profitable. Moral hazard may happen in all forms of insurance,
and it is difficult to control.

Morale hazard

Some insurance authors draw a subtle distinction between moral hazard and morale hazard.
Moral hazard refers to dishonest by an insured that increases the frequency or severity of loss.
Morale hazard is carelessness or indifference to a loss because of existence of insurance. Some
insured persons are careless or indifferent to a loss because they have insurance. Examples of
morale hazard include leaving car keys in an unlocked car, which increase the chance of theft;
leaving a door unlocked that allows a robber to enter; and changing tracks suddenly on a
congested interstate highway without signaling. Careless acts like these increase the chance of
loss.

Morale hazard is also reflected in the attitude of persons who are not insured. This includes the
tendency of physician to provide expensive examinations or tests when costs are to be covered
by insurance. Insurers try to control or reduce both moral and morale hazard by carefully
selecting their insured and/or by providing contractual provisions that oblige the insurer to pay
some percentage of the loss.

Legal hazard

Legal hazard refers to characteristics of the legal system or regulatory environment that increase
the frequency or severity of losses. Examples include adverse jury decisions or large damage
awards in liability lawsuits, orders that require insurers to include coverage for certain benefits in
health insurance plans, such as coverage for alcoholism; and regulatory action by state insurance
departments that restrict the ability of insurers to withdraw from the state because of poor
underwriting results.

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1.5. CLASSES OF RISK

Risk can be classified into several distinct categories. The major categories are as follows:

 Objective and Subjective risks

 Pure and Speculative risks
 Fundamental and Particular risks
 Financial and Non- Financial risks
 Static and Dynamic risks

1.5.1. Objective Risk and Subjective Risk

Objective Risk

Objective risk, also called statistical risk, is defined as the relative variation of actual loss from
expected loss. It is applicable to groups of objects exposed to loss. For example, assume that a
property insurer has 10,000 houses insured over a long period and, on average, 1 %, 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; in other years, as 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%.
This relative variation of actual loss from expected loss is known as Objective Risk.

Objective risk declines as the number of exposures increases. Objective risk varies inversely with
the square root of the number of cases under observation. Objective risk can be statistically
calculated by some measure of dispersion, such as the standard deviation or the coefficient of
variation. Because objective risk can be measured, it is an extremely 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 because it can rely on the law of large number.
The law of large numbers states that the number of exposure units increases, the more closely the
actual loss experience will approach the expected loss experience. For example: as the number
of houses under observation increases, the greater is the degree of accuracy in predicting the
proportion of houses that will burn.

Subjective Risk

Subjective risk is defined as uncertainty based on a person’s mental condition or state of mind. It
is a psychological uncertainty that stems from the individual’s mental attitude or state of mind.
For example, a customer who was drinking heavily in a bar may foolishly attempt to drive home.
The driver may be uncertain whether he will arrive home safely without being arrested by the
police for drunk driving. This mental uncertainty is called subjective risk.

Impact of subjective risk varies depending on the individual. Two persons in the same situation
can have a different perception of risk, and their behavior may be altered accordingly. If an

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individual experiences great mental uncertainty concerning the occurrence of a loss, that
person’s behavior may be affected. High subjective risk often results in conservative and prudent
behavior, while low subjective risk may result in less conservative behavior. For example a
driver previously arrested for drunk driving is aware that he has taken too much alcohol. The
driver may then compensate for the mental uncertainty by getting someone else to drive the car
home or by taking a taxi. Another driver in the same situation may perceive the risk of being
arrested as slight. This second driver may drive in a more careless and reckless manner; a low
subjective risk results in less conservative driving behavior.

Subjective risk can be measured by means of different psychological tests, but no widely
accepted or uniform tests of proven reliability have been developed. Thus though there are
different degrees of risk taking willingness in persons, it is difficult to measure these attitudes
scientifically and to predict risk taking behavior.

Subjective risk may affect a decision when the decision maker is interpreting objective risk. A
risk manager may determine some given level of risk as high, while another may interpret small.
A customer rejected by one bank may be accepted by the other. These different interpretations
come from the subjective attitudes of the decision makers towards risk.

1.5.2. Pure and Speculative Risks

Pure Risk

Pure risk is defined as a situation in which there are only the possibilities of loss or not loss. The
only possible outcomes are adverse (loss) and neutral (no loss). A pure risk occurs when there is
a chance of loss but no chance of gain. For example a shop owner will suffer financial loss if the
shop is burnt in fire, but no gain if there is no fire. Examples of pure risk include premature
death, industrial accidents, terrible medical expenses, and damage to property from fire,
lightning, flood, or earthquake.

Types of pure risk

The major types of pure risk that can create great financial insecurity include

 Personal Risks
 Property Risks
 Liability Risks

Personal Risks

Personal risks are risks that directly affect an individual. They involve the possibility of the
complete loss or reduction of earned income, extra expenses, and the depletion of financial
assets. There are four major personal risks.

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  Risk of premature death
 Risk of insufficient income during retirement
 Risk of poor health
 Risk of unemployment.

Risk of premature death

Premature death is defined as the death of a household head with unfulfilled financial
obligations. These obligations can include dependents to support, a mortgage to be paid off, or
children to educate. If the surviving family members receive an insufficient amount of
replacement income from other sources or have insufficient financial assets to replace the lost
income, they may be financially insecure.

Risk of insufficient income during the retirement

The major risk associated with old age is insufficient income during retirement. The vast
majority of workers in the world are before age 65. When they retire, they lose their earned
income. Unless they have sufficient financial assets on which to draw, or have access to other
sources of retirement income, such as social security or a private pension, they will be exposed to
financial insecurity during retirement.

Risk of Poor Health

Poor health is another important personal risk. The risk of poor health includes both the payment
of terrible medical bills and the loss of earned income.

Risk of Unemployment

The risk of unemployment is another major threat to financial security. Unemployment can
result from business cycle downswings, technological and structure changes in the economy,
seasonal factors, and imperfections in the labor market.

Property Risks

Persons owning property are exposed to property risks – the risk of having property damaged or
lost from numerous causes. Real estate and personal property can be damaged or destroy
because of fire, lightning, tornadoes, windstorms, and numerous other causes. There are two
major types of loss associated with the destruction or theft of property: direct loss and indirect
loss or consequential loss.

Direct loss: A direct loss is defined as financial loss that results, from the physical damage,
destruction, or theft of the property. For example, assume a hotel that is damaged by a fire, the
physical damage to the hotel is known as a direct loss.

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Indirect loss: An indirect loss is a financial loss that results indirectly from the occurrence of a
direct physical damage or theft loss. Thus, in addition to the physical damage loss, the hotel
would lose profits for several months while the hotel is being rebuilt. The loss of profits would
be consequential loss. Other examples of a consequential loss would be the loss of rents, the loss
of the use of building, and the loss of a local market.

Liability Risk

Liability risks are another important type of pure risk that most persons face. One can be held
legally liable if he/she does something that result in bodily injury or property damage to
someone else. A court of law may order him/her to pay substantial damages to the person he/she
has injured.

Speculative Risk

Speculative risk is defined as a situation in which either profit or loss is possible. For example, if
you purchase 100 shares of common stock, you would profit if the price of stock increases but
would loss if the price declines. Other examples, of speculative risk include betting on horse
race, card games, investing in real estate, and going into business for oneself. In these situations,
both profit and loss are possible. Distinguish between pure and speculative risks:

 First, private insurers generally insure only pure risk. With certain exceptions, speculative
risk generally is not considered insurable, and other techniques for managing with
speculative risk must be used.
 Second, the law of large numbers can be applied more easily to pure risks than to
speculative risks. The law of large numbers is important because it enables insurers to
predict future loss experience. In contrast, it is generally more difficult to apply the law
of large numbers to speculative risks to predict future loss experience. An exception is
the speculative risk of gambling where nightclub operators can apply the law of large
numbers in a most efficient manner.
 Finally, 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. Example, a firm may develop new
technology for producing low price computers. As a result some competitors may be
forced to bankruptcy. Despite the bankruptcy, society benefits because the computers are
produced at a low cost. However, society normally does not benefit when as loss from a
pure risk occurs, such as flood, or earth quake.

1.5.3. Fundamental and Particular Risks

Fundamental Risk

A fundamental risk is a risk that affects the entire economy or large numbers of persons or
groups within the economy. Fundamental risks involve losses that are impersonal in origin and

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consequence. They are group risks for the most part by economic, social and political
phenomena, although they may also result from physical occurrences. They affect large segments
or even all of the population. Examples include rapid inflation, cyclical unemployment, and war
because large numbers of individuals are affected.

The risk of a natural disaster is another important risk. Hurricanes, tornadoes, earthquakes,
floods, and forest and grass fires can result in billions of dollars of property damage and
numerous deaths. More recently, the risk of a terrorist attack is rapidly emerging as fundamental
risk.

Particular Risk

A particular risk is a risk that affects only individuals and not the entire community. Particular
risk involves losses that arise out of individual events and are felt by individuals rather than by
the entire group. Examples include car thefts, gold thefts, bank robberies, and dwelling fires.
Only individuals experiencing such losses are affected, not the entire economy.

1.5.4. Financial and Non- Financial Risk

In its broadest context, the term risk includes all situations in which there is an exposure to
adversity. In some cases this adversity involves financial loss, while in the others it does not.
There is some element of risk in every aspect of human endeavor, and many of these risks have
no financial consequences.

1.5.5. Static and Dynamic Risks

Static Risk

Static risks involve those losses that would occur even if there were no changes in the economy.
If we could hold consumer tastes, output and income, and the level of technology constant, some
individuals would still suffer financial loss. These losses arise from causes other than the change
in the economy. These risks are not source of gain to society. Examples include uncertainty due
to random events such as fire; windstorm, or death, etc. static losses do involve either the
destruction of the asset or a change in its possession as a result of dishonesty or human failure.
These types of losses tend to occur with a degree of regularity overtime and are generally
predictable – which make static risks more suitable for treatment by insurances.

Dynamic Risks

Dynamic risks are those resulting from changes in the economy. Change in the price level,
consumer tastes, income and outputs and technology may cause financial losses to members of
the society. Dynamic risks normally benefit the society over a long run, since they are the results
of adjustments to misallocation of resources. Although they may affect a large number of

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individuals, dynamic risks are generally considered less predictable than static risks, as they do
not occur with any precise degree of regularity.

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