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The Concept of Risk
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What would be your reaction after the excitementsettles down?
Risk is a pervasive condition of humanexistence
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R I S K ??
Economists
Statisticians
Decisiontheorists
Insurance
theorists
All have
different
meanings for
RISK
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The concept of Risk
Insurance is still in its infancy as a body oftheory.contradictions regarding the definition
One reason could be that the insurancetheorists have attempted to borrow thedefinitions of risk from other fields
Even the insurance text writers have beenunable to agree on a definition of this basicconcept
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Usage of the term risk in Insurance
The term Risk is used varyingly in
insurance:
An insured object e.g. a house, factor, ship or car
A peril e.g. Fire, storm, collision, AOG disasters A hazard or a set of hazardous conditions which
may cause a loss e.g. storage of inflammable
materials near to a source of heat
A person or property protected by insurance e.g.Many insurers feel young drivers are not good
risks
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Various definitions of Risk
o The chance of losso Likelihood of something happening
o The possibility of losso The probability lies between 0 and 1
o Uncertaintyo A state of mind, characterized by doubt - subjective
o The dispersion of actual from expected results ORo Risk exists because the actual results always differ from expected
o The probability of any outcome different from the oneexpected or probability of a loss occurring.
o Expected outcomes are assigned a probability based on pastexperience
In the context of Risk management, it is the last usage whichis nearest to an acceptable definition of risk; a phenomenonclosely associated with uncertain events.
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Definition of risk
The condition of the real world is a Combination of circumstances + the
external environment.
Risk is a
condition of the
real world in
which there isan exposure to
adversity
Risk is a condition in
which there is a
possibility of an
adverse deviation
from which a desired
outcome that is
expected or hoped
for.
OR
In the combination of circumstances there is a possibility of
loss
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Possibility/ Probability of loss
i.e. it has a probability between zero and one.
So it neither impossible nor definite.
Also there is no requirement that the possibility be
measurable
We may not be able to measure the degree of risk, butthe probability of the adverse outcome must be
between zero and one
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Probability a concept of average
It is an average concept as it indicates the number of timesa
particular outcome can be expected to occur Tossing of a coin:
o Toss a coin --- it can land on its head or tail
o So probability of getting a head is 1:2 or 0.5o Toss a coin 6 times --- getting 3 heads is a small probability
o But the more number of times you toss a coin, there is a possibility of
the ratio of outcomes approaching 1:2
The probability of a particular outcome is defined as the
proportion of times that such an outcome is observed to
occur in an infinitely large number of independent events.
http://www.youtube.com/watch?feature=en
dscreen&NR=1&v=AY3O_qsSnbE
http://www.youtube.com/watch?feature=endscreen&NR=1&v=AY3O_qsSnbEhttp://www.youtube.com/watch?feature=endscreen&NR=1&v=AY3O_qsSnbEhttp://www.youtube.com/watch?feature=endscreen&NR=1&v=AY3O_qsSnbEhttp://www.youtube.com/watch?feature=endscreen&NR=1&v=AY3O_qsSnbE7/31/2019 3. the Concept of Risk
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Stack of cards
The possibility of drawingthe ace of spades from adeck of cards = 1/52 or.019
drawing any ace (4 suits) = 1/13
OR
drawing a black card (2 black
suits) = or 0.5
A deck = 52 cards
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Vehicle(s) involved in an accident
If the probability of a vehicle
being involved in an accident
in any one year = 0.2
Then, a firm with One vehicle
can expect it to have an
accident once in five years.
But if the accident does
happen, there is no certainty
that the vehicle will not soon
be involved in another.
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So, a firm has 5000 vehicles
Can safely plan on having to deal
with 1000 (5000 x 0.2) accidentsor so each year
These are e.gs. of the operation of
the law of large numbers, a lawwhich essentially predicts that as
the number of events increases,
the relative variation in actual
outcomes from the expected
outcomes decreases.
Risk can be thought of as:
the degree of variation in the possible outcomes from an uncertain
event, OR as the variation in actual from expected outcomes.
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THE DEGREE OF RISK
Also called the Objective Risk (OR)
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Risk can be thought of as:
the degree of variation in the possible outcomes from an uncertain
event, OR as the variation in actual from expected outcomes.
The Degree of Risk
Precisely what is meant when we say that one alternative involves more risk
or less riskthan another?
The commonly accepted meaning of the Degree of Riskis relatedto the likelihood of its occurrence.
By instinct, we consider those events with higher probability of
loss to be riskier, than those with lesser probability.
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The Degree of Risk contd
E.g. For an Individual, the hope is NO loss will occur.
Here, we measure risk in terms of the probability of the
adverse deviation from what is hoped for.
Actuarial tables will tell us that the probability of death at the age
of :
52 is 1 percent 79 is 10 percent
97 is 50 percent
Using the probability of adverse deviation from the outcome that
is hoped for, we view the risk of death-
At the age of 79 as > that at age 52, but less than at the age of
97.
The higher the probability that an event will occur, the greater the
likelihood of the deviation from the outcome hoped for.
The greater the risk, as longer as the probability of loss is < 1.
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Russian Roulette
o There is more risk when there are two bullets in a
revolvers six chambers than when there is one bullet.
o Adding a third bullet, increases the chances of risk.
o Adding a fourth and fifth bullet increases the probability
of a deviation from the hoped-for outcome.o If a sixth bullet is added, the player can no longer
expect or even hope that the outcome will be
favourable.
o The sixth bullet makes the outcome certain and risk no
longer exists.
10
no chance of an
outcome other
than that which is
expected, so, no
hope of a
favourable result.
when the
probability of loss
is zero, there is no
possibility of loss
and therefore no
risk.
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In case oflarge no. of exposure units, estimates can be made
about the likelihood of the no. of losses that will occur and
predictions made on the basis of these estimates.
Here the expectation is that the predicted number of losses
will occur.
In case of aggregate exposures, the degree of risk is not the
possibility of a single occurrence or loss; it is the probability of
some outcome different from the predicted or expected.
Insurance companies make predictions about the losses that
are expected to occur and charge a premium based on this
prediction.
For the insurance company, the risk is that its prediction will
not be accurate.
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Say there
are 10,000
houses
Based on past experience an
insurer estimates that 1 out
of these 100 houses will burn(1 %). Rare for all houses to
burn down at the same time
If the company insures 10,000
houses, it might predict 100
houses will burn from this.
Actual experience may
deviate from this
expectation
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So, Insurer will predict not only the number of
houses, but will also predict a range of error.
Say possible deviation will be + or 10.
Say, between 90 and 110 houses ..can be
expected to burn. The relative of actual loss from expected loss is
known as Objective risk (OR = 10/100 or 10%)
The possibility that the number will be > 100 is
the Insurers risk.
Objective risk varies inversely with the square
root of the number of cases under observation
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Objective risk declines as the number of exposuresincreases.
E.g. If 10,00,000 (1 million) houses are insured, expectedno. of houses that will burn is 10,000.
But variation of actual loss from expected loss is only 100.Objective Risk is now 100/10,000 or 1 percent
As the square root of the no. of houses increased from 100
in the first example to 1000 in the second example,objective risk declined to one-tenth of its former level
OR can be statistically calculated by some measureof dispersion standard deviation or coefficient of
variation Because of this feasibility, this is a very useful
concept for an insurer or a corporate risk manager.
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RISK DISTINGUISHED FROM
PERIL AND HAZARD
The terms peril and hazard are used interchangeably with
each other and with risk.
It is important to distinguish these terms
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Peril Vs Hazard
Peril Hazard
A peril is the cause of loss
E.g. fire, collision,
windstorm, hail, theft etc. Each of these is the cause
of the loss that occurs.
A hazard is a condition, that
creates or increases the
chance of a loss arisingfrom a given peril.
It is possible for something to be both a peril and a hazard.
For E.g. sickness---is a peril causing economic loss.
But if this sickness persists, It becomes a hazard that increases the
chance of loss if it results in premature death (peril).
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Three
traditional
Hazards
Physical
Physical properties that increasethe chance of loss from variousperils. For. E.g. fire
Type of construction; Location ofthe property; Occupancy of thebuilding.
Moral
Increase in probability of lossdue to : Dishonest tendenciesof insured ; Indifferentattitude; Indulge in fraud
Morale
Not to be confused with Moral H.Reflected in attitude of persons whoare not the insured . E.g. Physicians,Service Stations, etc. have a tendencyto increase both frequency andseverity of losses when covered byinsurance.
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Legal hazard
Fourth hazard which should be recognised.
Refers to the increase in the frequency and
severity of loss that arises from legal doctrines
enacted by legislatures and created by the
courts.
E.gs. Include - Jurisdictions in which legal
doctrines favour a plaintiff present a hazard to
persons or organisations who are sued at tort. It also exists in case of property exposures
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CLASSIFICATION OF RISK
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Financial and Non-financial risks
Static and Dynamic risks
Fundamental and Particular risks
Pure and Speculative risks
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Financial Risk Non-financial Risk
The term risk includes all
situations in which there
is an exposure to
adversity. In some cases this
adversity involves
financial loss.
Insurance is concernedwith risks that involve a
financial loss.
There is some element of
risk in every human
endeavour.
Many of these risks donot have any financial
consequences; at times it
may be almost negligible.
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Static RiskDynamic Risk
Exist even if there were no
changes in the economy. These losses arise from causes
other than changes in theeconomy e.g. perils of nature,dishonesty of other individuals,fire accidents, sickness etc.
Static risks are not a source of gainto society.
Losses involve either destructionof asset or a change in itspossession as a result of acts of
nature, dishonesty or humanfailure.
Tend to occur with a degree ofregularity over time and aregenerally predictable.
More suitable for insurance.
Result from the changes in the
economy. E.gs. Changes in the price level,
consumer tastes, income andoutput and technology maycause financial loss to membersof the economy.
Normally benefit society in thelong run, though individuals maysuffer loss. These are the resultof adjustments to misallocationof resources.
Less predictable than static risks,as they do not occur with anyprecise degree of regularity.
Not suitable for insurance due totheir non-predictability.
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Fundamental Risk Particular Risk
Involve losses impersonal in
origin and consequence.
Group risks caused by social,
economic and political
phenomena. May also result
from physical occurrences.
Caused by conditions beyond thecontrol of the affected
individuals
Effect large segments or even all
of the population.
Responsibility of society.
Unemployment, War, inflation,
earthquakes, floods are all
fundamental risks
Involves losses that arise out ofindividual events
Felt by individuals rather than theentire group.
They may be static or dynamic.
E.gs. The burning of a house, therobbery of a bank, infidelity of an
employee etc. Individuals own responsibility as
losses are within the control ofindividuals. E.g. faulty electricalwiring leading to a fire
They are dealt with by theindividual through the use ofinsurance, loss prevention or someother technique.
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Speculative Risk Pure Risk
Situation where there is a
possibility of loss OR gain. E.g. In Gambling risk is
deliberately created in thehope of gain. Wager out of amatch.
Investment of Entrepreneuror VC may be lost if theproduct is not accepted bythe market at a pricesufficient to cover costs; butrisk is borne in return for
possibility of a profit. Insurance does not cover
speculative risks because ofits two-dimensional nature ofloss or gain
Situations where there is a
chance of LOSS or NO LOSS.
E.g. loss of property. A car
owner may face the risk of his
car meeting with an accident.
Possible outcomes are lossor no loss.
An outbreak of fire may not
cause substantial damage, but
would definitely not lead to a
gain.
Pure risks are preferred for
insurance.
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CLASSIFICATION OF PURE
RISKS
Brief outline of the nature of various pure risks faced by
individuals. Mostly, these are also static risks
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1. Personal risks
Consist of the possibility of loss of incomeor assets resulting from loss of ability to
earn income.
Earning power is subject to four perils:a. Premature death
b. Dependent old age
c. Sickness or disabilityd. unemployment
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2. Property Risks
Property owners face risk of losing property asthey can be destroyed or stolen
2 distinct types of loss
Direct loss - e.g. burning of a house / business firm
Indirect loss resulting from the house burning
Property risks, can involve the following types
of losses:
a. The loss of the property
b. Loss of use of property
c. Additional expenses occasioned by the loss of the
property
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Liability Risks
Basic peril in liability is the unintentional injury of otherpersons or damage to their property through
negligence or carelessness
Liability may also result from intentional injuries or
damage Law provides that if anyone has injured or damaged
anothers property, through negligence or otherwise
can be held responsible for the harm caused; so legal
liability exists. Liability risks therefore involve possibility of loss of
present assets or future income as a result of legal
liability arising out of intentional or unintentional
actions or invasion of rights of others.
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Risks arising from failure of others
When another person agrees to perform aservice for you, he / she undertakes an
obligation that you hope will be fulfilled.
When that persons failure to meet thisobligation results in your financial loss, risk
exists.
E.g.
Failure of a contractor to complete a construction
project as scheduled
Failure of debtors to make payments as expected
Eff t f U t i t i di id l d
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Effects of Uncertainty on individuals and
families
diseaseAccidental injury &
deathunemployment
Loss ofpossessions due toperils floods, fire
Liability for injurycaused to others
Other eventswhich may reduce
welfare
Events that cause a loss
On the brighter side unexpected gains may occur:Large wins on football pools
Chance encounter leading to better job or happy marriage etc.
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Effects of Uncertainty faced by an
Organisation
Loss or damageto property /
assets
Liability lossesto TP (Public /
Product)
Production risks- disruption by
fire, flood,strikes
Marketing &distribution
risksFinancial risks Personnel risks
Environmentalrisks
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The Burden of Risk
The greatest burden in connection with riskis that some losses actually occur.
There is financial loss when:
A house destroyed by fire.
Money stolen.
Wage earner of family dies.
When someones negligence leads to injury ordamage to property.
These losses are the primary burden of riskand the primary reason that individualsattempt to avoid risk or alleviate its impact.
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Other detrimental aspects of risk
Uncertainty of loss occurring Prudent individual - Absence of insurance
accumulation of reserve fund opportunitycost
Existence of risk detrimental to growth ofeconomy
Investment risks - only if there are highreturns
Uncertainty connected with pure risksproduces feeling of frustration and mentalunrest.
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Discussion
Two 9-year-old boys are watching atelevision replay of a boxing match betweenMuhammad Ali and Joe Frazier on a programcalled Great Fights of the Century. Since
the fight took place before they were oldenough to remember the outcome, neitherknows who won and they bet on theoutcome. Tom bets on Ali and Tim bets onFrazier.
Does risk exist in this situation? If yes, whatis this risk called?
Risk - For Tim? For Tom?
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Discussion
Mike says, The possibility that my housemay burn is a pure risk for me, but if I
buy insurance, it is a speculative risk for
the insurance company. Do you agree? Why? Or why not?
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