RISK AND INSURANCE

The Nature of Risks

CONCEPT OF RISK

• Risk is a situation in which some kind of loss is possible. Risk is a part of life.

•  Insurance protects against risk, in the sense that people who buy insurance are financially compensated in case of loss.

• Purchasing insurance does not remove risk. It merely provides compensation for the loss and spreads the cost of sharing the risk.  

CONCEPT OF RISK

• Because insurance is intangible, you do not actually see what you are getting which some people cannot bring themselves to spend money on something they cannot see and might not need.

• Risk is intangible too, until you experience a loss, or survive a close call.

CONCEPT OF RISK

• Dealing with risk– There are several ways to handle risk.

• Avoid risk for example, decided not to smoke• Reduce risk, by limiting the number of

cigarettes you smoke if you are a smoker• Ignore risk• Transfer risk

PROBABILITY THEORY

• A Priori Probability– Determined when the total number of possible

events are known.– Example: the probability of getting a six on a

roll of dice is 1/6.– This concept has a limited practical

application in the study of risk because situations where a number of possible outcome are known are very rare.

PROBABILITY THEORY

• Empirical Probability– Determined on the basis of historical data– Example: road accidents.– The underlying concept that makes it possible

for empirical probability to be measured accurately is that as the number of observations increases, the predicted loss tends to approach the actual loss (the law of large numbers)

PROBABILITY THEORY – Empirical Probability

• Law of large numbers is a concept with the following requirements:– Large number of similar loss exposures– Loss exposures must be independent– Random occurrence of losses.

PROBABILITY THEORY

• Judgemental Probability– Determined based on the judgement of the

person predicting the outcome.– It is used when there is lack of historical data

or credible statistics.– Example: Astronaut program by Malaysia.

The insurance company in Malaysia uses judgemental probability due to lack of credible statistics.

RELATED CONCEPT

• Loss – A reduction or

disappearance of economic value

• Peril– Is a cause of loss

• Hazard– A condition that increases the

chance of loss– Physical Hazard

• Physical condition that increases the condition of loss

– Moral Hazard• A character defect in an

individual that increases the chance of loss

– Morale Hazard• A character defect in an

individual that increases the chance of loss with the knowledge that insurance exists

BASIC CATEGORIES OF RISKS

• Fundamental and Particular Risks– Fundamental risk

• Affects the entire economy or large number of persons/groups within the economy

• Affects the society in general and cannot be controlled

• Example: flood or inflation

– Particular risk• Those future outcomes that we can partially control

• Arises from individual decisions

• Example: to further study or to drive a car

BASIC CATEGORIES OF RISKS

• Pure and Speculative Risks– Pure Risk

• There are possibility of loss or no loss

• Example: to pass or to fail the exam

– Speculative Risk• Possibility of loss, no loss or profit

• Example: investment

TYPES OF PURE RISKS

• PERSONAL RISKS

• PROPERTY RISKS

• LIABILITY RISKS

TYPES OF PURE RISKS

• Personal Risks– Risk of premature death

• Significant losses: loss of human value and additional expenses

– Risk of old age• Significant loss: insufficient income during retirement

– Risk of poor health• Significant losses: Expensive medical charges and loss of

earned income

– Risk of unemployment• Significant losses: loss of earned income and depletion of

accumulation financial assets.

TYPES OF PURE RISKS

• Direct Loss– Damage to property by a peril.– Example: house destroyed by fire

• Indirect loss– Loss in consequence of a direct loss– Example: loss of profit

• Extra expenses– Extra costs incurred as a result of the loss– Example: owner have to rent another building to

continue operation/ living.

TYPES OF PURE RISKS

• Liability risks– Anybody is exposed to liability risk as you can

be held legally liable if you do something that results in bodily injury or property damage to someone else.

– A court of lay may order you to pay substantial damage to the person whom you have injured.