Agenda
• Definitions of Risk
• Chance of Loss
• Peril and Hazard
• Classification of Risk
• Major Personal Risks and Commercial Risks
• Burden of Risk on Society
• Techniques for Managing Risk
Chapter 1
Risk and Its Treatment
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Risk: Uncertainty concerning the occurrence of a loss
Loss Exposure: Any situation or circumstance in which a loss is possible, regardless of whether a loss occurs
Objective Risk vs. Subjective Risk
Objective risk is defined as the relative variation of actual
loss from expected loss
Subjective risk is defined as uncertainty based on a
person’s mental condition or state of mind
Chance of Loss
Chance of loss: The probability that an event will occur
Objective Probability vs. Subjective 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
Subjective probability is the individual’s personal estimate of the chance of loss
Different Definitions of Risk
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Chance of loss is the probability that an event that causes a loss will occur.
Objective risk is the relative variation of actual loss from expected loss
The chance of loss may be identical for two different groups, but objective risk may be quite different!
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A peril is defined as the cause of the loss In an auto accident, the collision is the peril
A hazard is a condition that increases the
chance of loss
A physical hazard is a physical condition that
increases the frequency or severity of loss Moral hazard is dishonesty or character defects
in an individual that increase the frequency or severity of loss
Chance of Loss vs. Objective Risk
City
Philadelphia Los Angeles
# homes
10,000 10,000
Average # fires 100
100
Range
75 – 125 90 – 110
Chance Objective of Fire Risk 1% 25%
1% 10%
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Peril and Hazard
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Attitudinal Hazard (Morale Hazard) is carelessness or indifference to a loss, which increases the frequency or severity of a loss
Legal Hazard refers to characteristics of the legal system or regulatory environment that increase the frequency or severity of loss
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Classification of Risk
Pure and Speculative Risk
A pure risk is a situation in which there are only
the possibilities of loss or no loss (earthquake) A speculative risk is a situation in which either
profit or loss is possible (gambling)
Peril and Hazard
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Diversifiable Risk and Nondiversifiable Risk A diversifiable risk affects only individuals or
small groups (car theft). It is also called nonsystematic or particular risk.
A nondiversifiable risk affects the entire economy or large numbers of persons or groups within the economy (hurricane). It is also called systematic risk or fundamental risk.
Government assistance may be necessary to insure nondiversifiable risks.
Classification of Risk
Enterprise risk encompasses all major risks faced by a business firm, which include: pure risk, speculative risk, strategic risk,
operational risk, and financial risk
Strategic Risk refers to uncertainty regarding the
firm’s financial goals and objectives. Operational risk results from the firm’s business
operations.
Financial Risk refers to the uncertainty of loss
because of adverse changes in commodity prices, interest rates, foreign exchange rates, and the value of money.
Classification of Risk
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Enterprise Risk Management combines into
a single unified treatment program all major
risks faced by the firm: Pure risk
Speculative risk Strategic risk Operational risk Financial risk
Classification of Risk
As long as all risks are not perfectly correlated, the firm can offset one risk against another, thus reducing the firm’s overall risk.
Treatment of financial risks requires the use of complex hedging techniques, financial derivatives, futures contracts and other financial instruments.
Classification of Risk
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Personal risks are risks that directly affect and individual or family. They involve the possibility of a loss or reduction in income, extra expenses or depletion of financial assets, due to:
Premature death of family head
Insufficient income during retirement
Poor health (catastrophic medical bills and loss of earned income)
Involuntary unemployment
Exhibit 1.1 Total Savings and Investments Reported by Retirees, Among Those Responding
(not including value of primary residence or defined benefit
plans)
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Major Personal Risks
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Property risks involve the possibility of losses associated with the destruction or theft of property
Direct loss vs. indirect loss
A direct loss is a financial loss that results from the physical damage, destruction, or theft of the property, such as fire damage to a home
An indirect or consequential loss is a financial loss that results indirectly from the occurrence of a direct physical damage or theft loss, e.g., the additional living expenses after a fire
Major Personal Risks
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Major Personal Risks
Liability risks involve the possibility of being
held legally liable for bodily injury or
property damage to someone else
There is no maximum upper limit with respect to
the amount of the loss
A lien can be placed on your income and
financial assets
Legal defense costs can be enormous
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Major Commercial Risks
Firms face a variety of pure risks that can
have serious financial consequences if a loss
occurs:
Property risks, such as damage to buildings, furniture and office equipment
Liability risks, such as suits for defective products, pollution, and sexual harassment
Loss of business income, when the firm must shut down for some time after a physical damage loss
Other risks to firms include crime exposures, human resource exposures, foreign loss exposures, intangible property exposures, and government exposures
Burden of Risk on Society
The presence of risk results in three major
burdens on society:
In the absence of insurance, individuals and
business firms would have to maintain large emergency funds to pay for unexpected losses
The risk of a liability lawsuit may discourage innovation, depriving society of certain goods and services
Risk causes worry and fear
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Risk Control refers to techniques that
reduce the frequency or severity of losses: Avoidance
Loss prevention refers to activities to reduce the frequency of losses
Loss reduction refers to activities to reduce the severity of losses
Techniques for Managing Risk
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Techniques for Managing Risk
Risk Financing refers to techniques that
provide for payment of losses after they occur: Retention means that an individual or business firm
retains part or all of the losses that can result from a given risk.
Active retention means that an individual is aware of the risk and deliberately plans to retain all or part of it
Passive retention means risks may be unknowingly retained because of ignorance, indifference, or laziness
Self Insurance is a special form of planned retention by which part or all of a given loss exposure is retained by the firm
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A Noninsurance transfer transfers a risk to
another party.
A transfer of risk by contract, such as through a
service contract or a hold-harmless clause in a contract
Hedging is a technique for transferring the risk of unfavorable price fluctuations to a speculator by purchasing and selling futures contracts on an organized exchange
Incorporation of a business firm transfers to the creditors the risk of having insufficient asset to pay business debt
Techniques for Managing Risk
For most people, insurance is the most
practical method for handling major risks Risk transfer is used because a pure risk is
transferred to the insurer.
The pooling technique is used to spread the
losses of the few over the entire group
The risk may be reduced by application of the
law of large numbers
Techniques for Managing Risk
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Copyright ©2014 Pearson Education, Inc. All rights reserved. 1-0