Slide principles of risk management and insurance

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 Definitions of Risk • Traditional Definition of risk: – Risk is defined as uncertainty concerning the occurrence of a loss – In the insurance industry, risk is also used to identify the property or life that is being considered for insurance

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Chapter 1 Risk and Its Treatment

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• Major Personal Risks and Commercial Risks

• Burden of Risk on Society

• Techniques for Managing Risk

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Definitions of Risk

• Traditional Definition of risk:

– Risk is defined as uncertainty concerning the

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Definitions of Risk (cont.)

• Risk Distinguished from Uncertainty:

– The term risk is used in situations where the

probabilities of possible outcomes are known

– Uncertainty is used in situations where such

probabilities cannot be estimated

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• Loss Exposure:

– Any situation or circumstance in which a loss is

possible, regardless of whether a loss occurs

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• Objective risk

– It is defined as the relative variation of actual loss from expected loss

– It can be statistically calculated by some

measure of dispersion, such as the standard deviation

• Subjective (perceived) risk

– It is defined as uncertainty based on a person’s mental condition or state of mind

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Chance of Loss

• Chance of Loss:

– The probability that an event will occur

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Chance of Loss (cont.)

• Objective Probability

– It 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

– It is the individual’s personal estimate of the

chance of loss

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Chance of Loss vs Objective Risk

• 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

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Peril and Hazard

• A peril is defined as the cause of the loss.

– Examples include property damage because of fire, windstorm, or lightening, or damage to your car because of a collision with another vehicle

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Peril and Hazard (cont.)

• A hazard is a condition that increases the chance

of loss

– (i) Physical hazard

– (ii) Moral hazard

– (iii) Attitudinal hazard (morale hazard), and

– (iv) Legal hazard

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• Hazard

– (i) A physical hazard is a physical condition

that increases the frequency or severity of loss

– (ii) Moral hazard is dishonesty or character

defects in an individual that increase the

frequency or severity of loss

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• Hazard (cont.)

– (iii) Attitudinal Hazard (Morale Hazard) is

carelessness or indifference to a loss, which

increases the frequency or severity of a loss

– (iv) Legal Hazard refers to characteristics of the

legal system or regulatory environment that

increase the frequency or severity of losses

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Classification of Risk

• (1) Pure Risk and Speculative Risk

• (2) Diversifiable Risk and Nondiversifiable Risk

• (3) Enterprise Risk, and

• (4) Systemic Risk

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Classification of Risk (cont.)

• (1) Pure Risk 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)

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• (2) Diversifiable Risk and Nondiversifiable Risk

– A diversifiable risk affects only individuals or

small groups (car theft) It can be reduced or

eliminated by diversification

– A nondiversifiable risk affects the entire

economy or large numbers of persons or groups within the economy (hurricane) It is also called

fundamental risk.

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• (3) Enterprise 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

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• (3) Enterprise Risk (cont.)

– (i) Strategic risk refers to uncertainty regarding

the firm’s financial goals and objectives

– (ii) Operational risk results from the firm’s

business operations

– (iii) 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

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• (4) Systemic Risk

– Systemic risk is the risk of collapse of an entire

system or entire market due to the failure of a

single entity or group of entities that can result in the breakdown of the entire financial system

– Systemic risk is especially important with

respect to large financial institutions that are

considered too large to fail without doing major

financial harm to the economy

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• Major Personal Risks and Commercial Risks

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Major Personal Risks

• (1) Personal Risks

• (2) Property Risks

• (3) Liability Risks

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Major Personal Risks (cont.)

• (1) Personal Risks

– They are risks that directly affect an 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

▪ Inadequate retirement income

▪ Poor health, or

▪ Unemployment

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• (2) Property Risks

– They involve the possibility of losses associated with the destruction or theft of property

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• (2) Property Risks (cont.)

▪ 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)

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• (3) Liability Risks

– They 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, and

▪ Legal defense costs can be enormous

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Major Commercial Risks

• Definition

– Firms face a variety of pure risks that can have

serious financial consequences if a loss occurs These risks include:

▪ (1) Property risks

▪ (2) Liability risks

▪ (3) Loss of business income

▪ (4) Cybersecurity and identity theft, and

▪ (5) Other risks

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Major Commercial Risks (cont.)

• Classification

– (1) Property risks, such as damage to buildings,

furniture and office equipment

– (2) Liability risks, such as suits for defective

products, pollution, and sexual harassment

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• Classification (cont.)

– (3) Loss of business income, when the firm

must shut down for some time after a physical damage loss

– (4) Cybersecurity and identity theft by thieves

breaking into a firm’s computer system

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‒ (5) Other risks faced by business firms include:

▪ (i) Human resources exposures, such as

job-related injuries

▪ (ii) Foreign loss exposures, such as acts of

terrorism

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▪ (iii) Intangible property exposures, such as

damage to the market reputation and public image of the company

▪ (iv) Government exposures, such as violation

of safety standards

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• Burden of Risk on Society

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Burden of Risk on Society

• Three Burdens on Society

– (1) The size of an emergency fund must be

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Burden of Risk on Society (cont.)

• (1) Larger Emergency Fund

– In the absence of insurance, individuals and business firms would have to maintain large

emergency funds to pay for unexpected losses

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• (2) Loss of Certain Goods and Services

– The risk of a liability lawsuit may discourage

innovation, depriving society of certain goods

and services

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• (3) Worry and Fear

– Risk causes worry and fear

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• Techniques for Managing Risk

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Techniques for Managing Risk

• (1) Risk Control

• (2) Risk Financing

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Techniques for Managing Risk (cont.)

▪ (ii) Loss prevention, and

▪ (iii) Loss reduction

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Risk Control

• (i) Avoidance

– It is one technique for managing risk

– For example, you can avoid the risk of being mugged in a high-crime area by staying

away from the high-crime rate area

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Risk Control (cont.)

• (ii) Loss Prevention

– It is a technique that reduces the probability of loss so that the frequency of losses is reduced

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• (iii) Loss Reduction

– It refers to activities to reduce the severity of losses:

▪ Duplication

▪ Separation

▪ Diversification

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• (iii) Loss Reduction (cont.)

– Duplication: It refers to having back-ups or

copies of important documents or property

available in case a loss occurs

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•(3) Loss Reduction (cont.)

– Separation: The assets exposed to loss are

separated or divided to minimize the financial

loss from a single event

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• (3) Loss Reduction (cont.)

– Diversification: It reduces the chance of loss

by spreading the loss exposure across different

parties.

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Techniques for Managing Risk (cont.)

• (2) Risk Financing

– It refers to techniques that provide for payment

of losses after they occur

– They include the following:

▪ (i) Retention

▪ (ii) Noninsurance transfers, and

▪ (iii) Insurance

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Risk Financing

• (i) Retention

– It means that an individual or business firm

retains part of all of the losses that can result from a given risk

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Risk Financing (cont.)

• (i) Retention (cont.)

– Risk retention can be active or passive

▪ 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

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• (i) Retention (cont.)

– 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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Risk Financing

• (ii) Noninsurance transfer

– A Noninsurance transfer transfers a risk to

another party

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• (ii) Noninsurance transfer (cont.)

– A risk can be transferred by several methods,

including:

▪ A transfer of risk by contract, such as through

a hold-harmless clause in a contract

▪ Hedging is a technique for transferring the risk

of unfavorable price fluctuations to a speculator

▪ Incorporation of a business firm transfers to

the creditors the risk of having insufficient assets

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• (iii) Insurance

– It is the most practical method for handling

major risks

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• (iii) Insurance (cont.)

– Three major characteristics:

▪ 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

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Thank You!

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Chapter 2 Insurance and Risk

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▪ Definition and Basic Characteristics of

Insurance

▪ Characteristics of An Ideally Insurable Risk

▪ Adverse Selection and Insurance

▪ Insurance and Gambling Compared

▪ Insurance and Hedging Compared

▪ Types of Insurance

▪ Benefits and Costs of Insurance to Society

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Definition and Basic Characteristics of Insurance

▪ Definition of Insurance

▪ Basic Characteristics of Insurance

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Definition of Insurance

▪ Insurance

– It is the pooling of fortuitous losses by transfer

of such risks to insurers, who agree to

indemnify insureds for such losses, to provide other pecuniary benefits on their occurrence, or

to render services connected with the risk.

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Basic Characteristics of Insurance

▪ (1) Pooling of losses

▪ (2) Payment of fortuitous losses

▪ (3) Risk transfer, and

▪ (4) Indemnification

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(cont.)

▪ (1) Pooling of losses

– Pooling involves spreading losses incurred by

the few over the entire group

– Risk reduction is based on the Law of Large

Numbers

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Definition of Insurance

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(cont.)

▪ (2) Payment of fortuitous losses

– A fortuitous loss is one that is unforeseen,

unexpected, and occur as a result of chance

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(cont.)

▪ (4) Indemnification

– The insured is restored to his or her

approximate financial position prior to the

occurrence of the loss

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Agenda

▪ Definition and Basic Characteristics of Insurance

▪ Characteristics of An Ideally Insurable Risk

▪ Adverse Selection and Insurance

▪ Insurance and Gambling Compared

▪ Insurance and Hedging Compared

▪ Types of Insurance

▪ Benefits and Costs of Insurance to Society

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Characteristics of an Ideally Insurable Risk

▪ (1) Large number of exposure units

▪ (2) Accidental and unintentional loss

▪ (3) Determinable and measurable loss

▪ (4) No catastrophic loss

▪ (5) Calculable chance of loss, and

▪ (6) Economically feasible premium

Tiêu đề	slide principles of risk management and insurance
Trường học	Pearson Education, Inc.
Chuyên ngành	Risk Management and Insurance
Thể loại	lecture notes
Năm xuất bản	2017

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Số trang	324
Dung lượng	1,67 MB