Lakhasly

Risk is a pervasive condition of human existence, defined as the uncertainty of an outcome where an unfavorable event is possible. While its intuitive meaning is clear, the term "risk" can have specialized insurance connotations, referring either to a peril or an insured entity. However, this text broadly defines risk as a situation involving exposure to loss. More specifically, risk is a condition of the real world characterized by the possibility of an adverse deviation from a desired outcome.

Despite a lack of universal agreement among insurance theorists, common elements in risk definitions include indeterminacy (the outcome must be in question, with at least two possibilities) and loss (at least one undesirable outcome). Other definitions encompass the chance of loss, possibility of loss, uncertainty, dispersion of actual from expected results, or probability of any outcome different from expected.

Uncertainty is a psychological state of doubt resulting from a lack of knowledge about future events, contrasting with certainty. The existence of risk, as a condition where loss is possible, creates this individual uncertainty, which varies based on personal knowledge and attitudes. Crucially, risk objectively exists regardless of whether an individual recognizes or feels uncertain about it; for example, stating 'I am uncertain what grade I will get' reflects this lack of knowledge.

The degree of risk relates to the likelihood of an adverse occurrence, measured by the probability of an adverse deviation. Risk is considered zero when the probability of loss is 0% (impossible) or 100% (certain), as the outcome is known. The expected value of a loss, calculated by multiplying the probability of loss by the potential loss amount, helps measure this degree. For example, a $10 risk with a 0.10 probability has an expected value of $1.

It's essential to distinguish risk from peril and hazard. A peril is the direct cause of a loss (e.g., fire, flood). A hazard is a condition that increases the chance or severity of a loss from a peril. Hazards are classified as:

• Physical hazards: Tangible properties increasing loss likelihood (e.g., building construction type).
• Moral hazards: Increased loss probability due to an insured's dishonest tendencies (e.g., attempting to defraud).
• Legal hazards: Increased loss frequency/severity due to legal doctrines or regulations (e.g., new environmental laws).

Risks are classified in several ways:

1. Static and Dynamic Risks:

   • Dynamic risks arise from economic changes (e.g., price level, technology shifts); they can cause financial loss but often benefit society long-term through resource reallocation.
   • Static risks would occur even without economic changes (e.g., natural perils, human dishonesty); they don't generate societal gain, involve asset destruction or possession change, and are generally predictable.

2. Fundamental and Particular Risks:

   • Fundamental risks are impersonal in origin and widespread in consequence, affecting large populations due to economic, social, political, or physical phenomena beyond individual control (e.g., earthquakes, unemployment). Society is typically responsible for addressing them.
   • Particular risks stem from individual events and impact individuals (e.g., a house fire). Individuals are typically responsible for managing these.

3. Pure and Speculative Risks:

   • Speculative risks involve both the possibility of loss and gain (e.g., investment, entrepreneurship).
   • Pure risks involve only the chance of loss or no loss (e.g., property damage). Crucially, only pure risks are insurable.

4. Classifications of Pure Risk:

   • Personal risks: Loss of income or assets due to inability to earn (e.g., premature death, disability, unemployment).
   • Property risks: Loss from destruction or theft of possessions, encompassing direct loss (value of asset) and indirect/consequential loss (loss of use, additional expenses like temporary housing).
   • Liability risks: Loss of assets/income due to legal liability or damages from torts or rights invasion.
   • Risks from failure of others: Financial loss due to another party's unfulfilled obligations (e.g., contractor delays, debtor defaults).

5. Diversifiable and Non-diversifiable Risks:

   • Diversifiable risk (nonsystematic or particular risk) affects individuals/small groups and can be reduced by diversification.
   • Non-diversifiable risk (systematic or fundamental risk) affects the entire economy or large populations and cannot be diversified away.

Firms face additional risks, including crime exposures (theft, fraud), human resources exposures (worker injuries, key employee loss), foreign loss exposures (terrorism, political risks), intangible property exposures (reputation, goodwill), and government exposures (new laws, regulations).

The relationship between the degree of risk and the probability of loss is non-linear. The degree of risk is zero when the probability of loss is 0% or 100%, as the outcome is certain. It increases as the probability of loss rises from 0% to 50%, where the degree of risk is double the probability (Degree = 2 * Probability). If the probability exceeds 50% and approaches 100%, the degree of risk decreases, calculated as double the complement of the probability (Degree = 2 * (1 - Probability)). For example, a 70% probability of loss yields a 60% degree of risk (2 * (1 - 0.70)).

Individuals adopt two primary risk management policies:

• The Positive Policy: Involves engaging in risky activities after careful data collection, analysis, and prediction of future risk tendencies.
• The Negative Policy: Involves avoiding activities due to perceived risks, even if manageable (e.g., not investing money for fear of loss).

INTRODUCTION:
Losses like these happen to some people, whereas others go along happily, free from
misfortune. The fact that these losses or similar events could happen to you, and the fact
that you can’t tell for sure whether or not they will, is a condition we call risk. Risk is a
pervasive condition of human existence. Although our instinctive understanding of the
concept of risk is clear enough, terms that have a simple meaning in everyday usage
sometimes have a specialized connotation when used in a particular field of study. In this
chapter we will examine the concept of risk as the fundamental problem with which
insurance deals. In addition, we will also examine several related concepts.3
2. THE CONCEPT OF RISK:
It would seem that the term risk is a simple enough notion. When someone states that
there is risk in a particular situation, the listener understands what is meant: that in the
given situation there is uncertainty about the outcome, and the possibility exists that
the outcome will be unfavorable. This 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 for our purpose a somewhat more rigid definition is desirable.
To compound the problem, the term risk is used by people in the insurance business to
mean either a peril insured against (e.g., fire is a risk to which most property is exposed) or a
person or property protected by insurance (e.g., many insurance companies feel that young
drivers are not good risks).
In this text, however, we will use the term in its general meaning, to indicate a situation in
which an exposure to loss exists. 4
3. CURRENT DEFINITIONS OF RISK:
If we were to survey the best-known insurance textbooks used in colleges and universities
today, we would find a general lack of agreement concerning the definition of risk.
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. Investment in a
capital asset, for example, usually involves a realization that the asset is subject
to physical depreciation and that its value will decline. Here the outcome is certain and so
there is no risk
• At least one of the possible outcomes is undesirable. This may be a loss in the generally
accepted sense, in which something the individual possesses is lost, or it may be a gain
smaller than the gain that was possible. For example, the investor who fails to take
advantage of an opportunity “loses” the gain that might have been made. The investor
faced with the choice between two stocks may be said to “lose” if he or she chooses the
one that increases in value less than the alternative.5
Our Definition of Risk:
We define risk as a condition of the real world in which there is an exposure to adversity. More
specifically, Risk is a condition in which there is a possibility of an adverse deviation from a desired
outcome that is expected or hoped for.
The term risk is variously defined as:
(1) the chance of loss
(2) the possibility of loss
(3) uncertainty
(4) the dispersion of actual from expected results
(5) the probability of any outcome different from the one expected.6
Uncertainty and Its Relationship to Risk:
Because the term uncertainty is often used in connection with the term risk (sometimes even
interchangeably), it seems appropriate to explain the relationship between the two terms.
The most widely held meaning of uncertainty refers to a state of mind characterized by doubt
based on a lack of knowledge about what will or will not happen in the future. It is the opposite of
certainty, which is a conviction or certitude about a particular situation.
For example, a student says “I am certain I will get an A in this course,” which means the same
as “I am positive I will get an A in this course.” Both statements reflect a conviction about the
outcome.
Uncertainty, on the other hand, is the opposite mental state. If one says “I am uncertain what
grade I am going to get in this course,” the statement reflects a lack of knowledge about the
outcome. Uncertainty, then, is simply a psychological reaction to the absence of knowledge about
the future. The existence of risk—a condition or combination of circumstances in which there is a
possibility of loss— creates uncertainty on the part of individuals when
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that risk is recognized.Uncertainty varies with the knowledge and attitudes of the person. Different attitudes are possible
for different individuals under identical conditions of the real world. It is possible, for example, for
a person to experience uncertainty in a situation in which he or she imagines that there is a chance
of loss but where no chance of loss exists.
Similarly, it is possible for an individual to feel no uncertainty regarding a particular risk when the
exposure to loss is not recognized. Whether or not a risk is recognized, however, does not alter its
existence.
When there is a possibility of loss, risk exists whether or not the person exposed to loss is aware
of the risk.8
The Degree of Risk:
It is intuitively obvious that there are some situations in which the risk is greater than in other
situations. It would seem that the most commonly accepted meaning of degree of risk is related to
the likelihood of occurrence. We intuitively consider those events with a high probability of loss to
be “riskier” than those with a low probability. This intuitive notion of the degree of risk is
consistent with our definition of risk. When risk is defined as the possibility of an adverse deviation
from a desired outcome that is expected or hoped for, the degree of risk is measured by the
probability of the adverse deviation.
If the probability of loss is 1, there is no chance of an outcome other than that which is expected
and, therefore, no hope of a favorable result. Similarly, when the probability of loss is zero, there is
no possibility of loss and therefore no risk.
The concept of expected value may be used to relate to relate the size of the potential loss and the
probability of that loss in the measurement of risk. The expected value of a loss in a given situation
is the probability of that loss multiplied by the amount of the potential loss. For example, if the
amount at risk is $10 and the probability of loss is 0.10, the expected value of the loss is $1. If the
amount at risk is $100 and the probability is 0.01, the expected value is also $1. 9
Risk Distinguished from Peril and Hazard:
It is not uncommon for the terms peril and hazard to be used interchangeably with each other and
with risk. However, to be precise, it is important to distinguish these terms. A peril is a cause of a
loss. A hazard, on the other hand, is a condition that may create or increase the chance of a loss
arising from a given peril. Hazards are normally classified into three categories:
• Physical hazard: consist of those physical properties that increase the chance of loss from the
various perils. Examples of physical hazards that increase the possibility of loss from the peril of
fire are the type of construction, the location of the property, and the occupancy of the building.
• Moral hazard: refers to the increase in the probability of loss that results from dishonest
tendencies in the character of the insured person. More simply, it is the dishonest tendencies on
the part of an insured that may induce that person to attempt to defraud the insurance company.
• Legal hazard: refers to the increase in the frequency and severity of loss that arises from
legal doctrines enacted by legislatures and created by the courts.10
4.CLASSIFICATIONS OF RISK:
Risks may be classified in many ways. These include the following;
Static and Dynamic Risks:
Dynamic risks are those resulting from changes in the economy. Changes in the price level,
consumer tastes, income and output, and technology may cause financial loss to members of the
economy. These dynamic risks normally benefit society over the long run, since they are the result
of adjustments to misallocation of resources.
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 changes in
the economy, such as the perils of nature and the dishonesty of other individuals. Unlike dynamic
risks, static risks are not a source of gain to society. Static losses involve either the destruction of
the asset or a change in its possession as a result of dishonesty or human failure. Static losses tend
to occur with a degree of regularity over time and, as a result, are generally predictable.11
Fundamental and Particular Risks:
Fundamental risks involve losses that are impersonal in origin and consequence. They are group
risks, caused 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.
Fundamental risks are caused by conditions more or less beyond the control of the individuals
who suffer the losses and since they are not the fault of anyone in particular, it is held that society
rather than the individual has a responsibility to deal with them.
Particular risks involve losses that arise out of individual events and are felt by individuals rather
than by the entire group. They may be static or dynamic. Unemployment, war, inflation,
earthquakes, and floods are all fundamental risks. The burning of a house and the robbery of a
bank are particular risks.
Particular risks are considered to be the individual’s own responsibility, inappropriate subjects for
action by society as a whole. They are dealt with by the individual through the use of insurance,
loss prevention, or some other technique.12
Pure and Speculative Risks:
Speculative risk describes a situation in which there is a possibility of loss, but also a possibility of
gain. For example, the entrepreneur or capitalist faces speculative risk in the quest for profit.
The investment made may be lost if the product is not accepted by the market at a price sufficient
to cover costs, but this risk is borne in return for the possibility of profit.
Pure risk is used to designate those situations that involve only the chance of loss or no loss. One
of the best examples of pure risk is the possibility of loss surrounding the ownership of property.
The person who buys an automobile, for example, immediately faces the possibility that
something may happen to damage or destroy the automobile. The possible outcomes are loss or
no loss.
Note:
Only pure risks are insurable. Insurance is not concerned with the protection of individuals against
those losses arising out of speculative risks.13
Classifications of Pure Risk:
Pure risks that exist for individuals and business firms can be classified under one of the following:

1. Personal risks: These consist of the possibility of loss of income or assets as a result of the loss
   of the ability to earn income. In general, earning power is subject to four perils: (a) premature
   death, (b) dependent old age, (c) sickness or disability, and (d) unemployment.


2. Property risks: Anyone who owns property faces property risks simply because such possessions
   can be destroyed or stolen. Property risks embrace two distinct types of loss: direct loss and
   indirect or “consequential” loss. Direct loss is the simplest to understand: If a house is destroyed
   by fire, the owner loses the value of the house. However, in addition to losing the value of the
   building itself, the property owner no longer has a place to live, and during the time required to
   rebuild the house, it is likely that the owner will incur additional expenses living somewhere else.
   This loss of use of the destroyed asset is an indirect, or “consequential,” loss.
   Property risks, then, can involve two types of losses: (a) the loss of the property and (b) loss of use of the
   property resulting in lost income or additional expenses.14


3. Liability risks: Liability risks involve the possibility of loss of present assets or future income as a
   result of damages assessed or legal liability arising out of either intentional or unintentional torts,
   or invasion of the rights of others.


4. Risks arising from failure of others: When another person agrees to perform a service for
   you, he or she undertakes an obligation that you hope will be met. When the person’s failure
   to meet this obligation would result in your financial loss, risk exists. Examples of risks in this
   category would include failure of a contractor to complete a construction project as scheduled, or
   failure of debtors to make payments as expected.15
   Diversifiable Risk and Non-diversifiable Risk:
   Diversifiable risk: is a risk that affects only individuals or small groups and not the entire economy.
   It is a risk that can be reduced or eliminated by diversification. Diversifiable risk affects only specific
   individuals or small groups, it is also called nonsystematic risk or particular risk.
   Non-diversifiable risk: is a risk that affects the entire economy or large numbers of persons or
   groups within the economy. It is a risk that cannot be eliminated or reduced by diversification.
   Because non-diversifiable risk affects the entire economy or large numbers of persons in the
   economy, it is also called systematic risk or fundamental risk.16
   Other Risks:
   Firms must cope with a wide variety of additional risks, summarized as follows:
   ■ Crime exposures . These include robbery and burglary; shoplifting; employee theft and
   dishonesty; fraud and embezzlement; computer crimes and Internet-related crimes; and the piracy
   and theft of intellectual property.
   ■ Human resources exposures . These include job related injuries and disease of workers; death or
   disability of key employees; group life and health and retirement plan exposures; and violation of
   federal and state laws and regulations.
   ■ Foreign loss exposures . These include acts of terrorism, political risks, kidnapping of key
   personnel, damage to foreign plants and property, and foreign currency risks.
   ■ Intangible property exposures . These include damage to the market reputation and public image
   of the company, the loss of goodwill, and loss of intellectual property. For many companies, the
   value of intangible property is greater than the value of tangible property.
   ■ Government exposures . Federal and state governments may pass laws and regulations that
   have a significant financial impact on the company. Examples include laws that increase safety
   standards, laws that require reduction in plant emissions and contamination, and new laws to
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   protect the environment that increase the cost of doing business.5. The relationship between the degree of risk and the probability of loss:
   There is a strong relationship between the degree of risk and the probability of loss. To illustrate
   this relationship, consider the following diagram:18
   From the previous figure, we can see a set of relationships:


5. The degree of risk equals zero when the probability of loss is zero (the case of the impossibility
   of the accident occurring), and here the person proceeds to make the decision. The degree of risk
   also equals zero when the probability of loss value is 100% (the case of the certainty of the
   accident), because the person will not proceed to make the decision.


6. The degree of risk increases with the increase in probability of loss, and the relationship
   between them is represented by the degree of risk being double the value of the probability of
   loss when the probability of loss takes any value from zero to 50%. If the probability of loss equals
   50%, then the degree of risk equals 100%. Therefore, the relationship between probability of loss
   and the degree of risk when the probability of loss takes values from zero to 50% becomes as
   follows:
   Degree of risk = 2*Probability of loss


7. If the probability value exceeds 50%, the degree of risk decreases until it reaches zero when the
   probability of loss reaches 100%. The relationship between the probability of loss and the degree
   of risk when the probability of loss exceeds 50% and until it reaches 100% is as follows:
   Degree of risk = 2*(1 - Probability of loss)19
   Example:
   If the probability of loss is 70%, then the risk degree = 30% x 2 = 60%
   If the probability of loss is 85%, then the risk degree = 15% x 2 = 30%
   If the probability of loss is 100%, then the risk degree = 0% = 2 x 0%20


8. RISK MANAGEMENT POLICIES:
   The presence of risk has resulted in varying attitudes toward the future, whether optimistic or
   pessimistic. In both cases, the presence of risk has led individuals to adopt one of two policies:
   The Positive Policy:
   This policy involves individuals engaging in a variety of risky areas, but only after data on risky
   behavior over the past period has been collected, analyzed, and used to predict the future
   tendencies of the risk, both in terms of its frequency and its magnitude.
   The Negative Policy:
   This policy involves individuals avoiding certain areas of activity due to the risks involved, which
   can be managed. Examples of this are numerous, including: keeping money without investing it for
   fear of losing it; not buying a car for fear of it being involved in an accident.21
   IMPORTANT CONCEPTS TO REMEMBER
   risk
   uncertainty
   subjective risk
   degree of risk
   peril
   hazard
   physical hazard
   moral hazard
   morale hazard
   deep-pocket
   syndrome
   static risk
   dynamic risk
   fundamental risk
   particular risk
   pure risk
   speculative risk
   personal risk
   property risk
   direct loss
   indirect loss
   liability risk
   probability of loss
   expected value