Unit 1 Introduction to Risk

The meaning of risk Uncertainty vs. risk Classification of risk The degree of risk

Meaning of Risk
Risk is the possibility of an unfortunate occurrence. Risk is a combination of hazards. Risk is unpredictability the tendency that actual results may differ from predicted results. Risk is uncertainty of loss. Risk is the possibility of loss. Risk is a condition in which there is a possibility of an adverse deviation from a desired outcome that is expected or hoped for.

(1) Objective risk - It is defined as the relative variation of actual loss from expected loss. - It varies inversely with the square root of the no. of cases under observation. - It is measured as the standard deviation or the coefficient of variation. - It declines as the numbers of exposures increases. - According to law of large no.s as the number of exposure increases the more closely the actual loss experience will approach the expected loss experience.

(2) Subjective risk - It is defined as uncertainty based on a persons mental condition or state of mind. - The impact of subjective risk varies with individual to individual. - High subjective risk results in conservative and prudent behaviour - Low subjective risk results in less conservative risk.

Uncertainty vs risk
Uncertainty refers to a situation where the outcome is not certain or unknown & a state of mind characterised by doubt. The existence of risk creates uncertainty on the part of individuals when that risk is recognised. Risk refers to a situation where there is a possibility of a loss. The chances of loss can be found out by objective and subjective probability.

(1) Objective probability - It refers to the long run relative frequency of an event based on the assumptions of an infinite no. of observations and of no change in conditions underlying. - It is determined by deductive & inductive reasoning. - for ex. The probability of getting a head from the toss of a coin is as there are two sides and only one head. - The probability that a person of age 21 will die before 26 can not be deduced. But on the basis of mortality rate the insurance company can estimate the probability of death and sell a 5 year policy. (2) Subjective probability - It is the individuals personal estimate of the chance of loss. It needs to coincide with objective probability. - Factors like persons age, gender, intelligence, education can influence the subjective probability.

Hazards
Hazards are the conditions that increase the severity of loss or the conditions affecting perils. Types of Hazards : Physical Hazard It is a condition stemming from the material characteristics of an object. They are not under control of human being Morale hazard It refers to the mental attitude of a careless or accident prone person. - In some cases a subconscious desire for a loss may exist. - while in some cases circumstances cause a person to behave in a careless manner. Moral hazard It relates to the mental attitude of a person. - It is associated with intentional actions designed to cause a loss - They are caused by the dishonesty of individuals.

Classification of Risk
(1) Financial and Non financial risk : - It involves the relationship between an individual or an organisation and an asset or expectation of income that may be lost or damaged. - It involves three elements: (i) The individual or organization exposed to risk (ii) Asset or income whose destruction cause financial loss (iii) A peril which can cause the loss - Non financial risk relates to aspect of human endeavour. - Individual having no value faces no financial risk.

(2) Static and dynamic risk :

- Dynamic risk is related to changes in the economy like changes in price level, consumer taste, income & output etc. - It benefit society over the long run since they are the result of adjustments to misallocation of resources. - Static risk : It involves those losses which occur even if there were no changes in the economy. - If all factors related to change in economy are constant, there are persons who suffer financial loss because of perils of nature or dishonesty of some individuals. - It tends to occur with a degree of regularity so they are predictable so it is more suited to insurance.

(3) Acceptable & unacceptable risk - The degree of risk aversion tends to increase with the potential size of loss. - The maximum size of loss that can be tolerated depends on the status of the organization or individual. - The maximum amount the organization can control is known as acceptable risk while the amount which it can not control is known as unacceptable risk. - The distinction between these two is not possible because of time factor and ability to overcome the risk.

(4) Fundamental & particular risk - It affects the entire economy or large no. of persons or groups within the economy. eg. Rapid inflation, unemployment, war, tornado, earthquake, flood etc. - A particular risk is a risk that affects only individual and not entire economy. Eg. Car theft, bank robberies, fire etc. - Government assist only in fundamental risk as it affects the entire economy.

(5) Pure & speculative risk - Pure risk is defined as a situation in which there are only the possibilities of loss or no loss.eg. premature death, job related accidents, damage to property. - Speculative risk is defined as a situation in which either profit or loss is possible.eg.share trading, horse race. - Private insurers insure only pure risk & not speculative. - The law of large no. can be applied to pure risk than speculative risk. - Speculative risk is beneficial to society evenif some loss occurs.

Types of pure risk

(A) Personal risk - Risk of premature death - Risk of insufficient income during retirement - Risk of poor health - Risk of unemployment (B) Property risk - Direct loss - Indirect or consequential loss (C) Liability risk

Degree of Risk
It is related to the likelihood of occurrence of an event which may have more risk or less risk. In the case of large no.s of exposure predictions can be made on the basis of estimates that a given event will occur.