Chapter 01 Risk

Insurance
Chapter 1 and
Risk Management
Risk:
An Overview
1
©2023 Md. Anum Shahriar Rabbi, Assistant Professor, IBA, R.U. All rights reserved!
Learning Outcomes:
After studying this chapter you will be able to
■ Define the concept of risk,
■ Relate risk with chance of loss,
■ Identify the degree of risk,
■ Relate risk with uncertainty, peril and hazard,
■ Identify factors creating and increasing risks
■ Measure the burden of risk on society
■ Classify the risk
Major personal and commercial risk
Business enterprise, industry and factory Risk
■Apply Techniques for managing risk
©2023 Md. Anum Shahriar Rabbi, Assistant Professor, IBA, R.U. All rights reserved! 2
Historical Concept of Risk
• Risk:
Uncertainty concerning the occurrence of a
loss;
Loss exposure-the situation in which a loss is
possible;
Chance of loss or probability of loss;
The dispersion of actual from expected
results
The probability of adverse outcome.
Objective Risk vs. Subjective Risk
– Objective risk is defined as the relative

variation of actual loss from expected loss. It
can be statistically calculated using a measure of
dispersion, such as the standard deviation. So,
objective risk can be measured.
– Subjective risk is defined as uncertainty
based on a person’s mental condition or state
of mind.
• Two persons in the same situation may have
different perceptions of risk
• High subjective risk often results in conservative
behavior
Chance of Loss
• Chance of loss: The probability that an event will occur.
Probability has both objective and subjective aspects.
• Objective Probability vs. Subjective Probability
– Objective probability refers to the long-run relative
frequency of an event assuming an infinite number
of observations and no change in the underlying
conditions
• It can be determined by deductive /inductive reasoning.
– Subjective probability is the individual’s personal
estimate of the chance of loss.
• A person’s perception of the chance of loss may differ
from the objective probability.
Degree Of Risk
• The degree of risk is related to the likelihood of
occurrence in which risk can be measured.
• Objective risk is the ground of the degree of risk.
– Insurance company uses the degree of risk to make
predictions about losses and charge a premium based
on this predictions.
– High probability (1=high risk) and low probability
(0= no risk) of occurrences
– Greater risk and smaller risk
– “more risk” or “less risk”
Risk and Uncertainty
Risk is used in situations where Uncertainty is used in
the probabilities of possible situations where such
outcomes are known or can be probabilities cannot be
estimated with some degree of estimated. Doubt based on
accuracy. lack of knowledge about
future or outcome.
Risks can be measured and Uncertainty cannot due to lack
quantified which results either of sufficient information or
gain or loss. inability to predict.
Risk can be managed. Uncertainty is uncontrollable.
Ex: The probability of dying at each Ex: Destruction of your home by a
attained age can be estimated with meteorite from outer space.
considerable accuracy.
Peril And Hazard (Sources of Risk)
• 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. In an auto accident, vehicle/driver/road could be Hazard
– Physical hazards are physical conditions that increase the
chance of loss.
– Moral hazard is dishonesty or character defects in an
individual.
– Morale Hazard ((Attitudinal Hazard) is carelessness or
indifference to a loss because of the existence of insurance.
– Legal Hazard refers to characteristics of the legal system or
regulatory environment.
Peril And Hazard (Sources of Risk) Continued…
Factors creating and increasing risks
1. Life and Health :
Age, Gender, Body structures, Physical conditions
(heart, kidneys, Personal History (Past habits, health
records, occupation, Family History (Diabetics), Race
and Nationality etc.
2. Society:
Residence (climate, atmosphere, geography,
humidity), Defense Services, Economic status etc.
3. Property: Morals, economic system, natural calamities etc.
Burden Of Risk On Society
• The presence of risk results in major burdens
on society:
– Individuals would have to maintain large emergency
funds
– Discourage innovation, depriving society of certain
goods and services
– Risk causes worry and fear
– Effect on economic growth and capital accumulation
– Producing a feeling of frustration and mental unrest
– Costly preparation for possible occurrence
(opportunity cost, high liquid state)
Classification Of Risk
• Pure and Speculative Risk
– A pure risk is one in which there are only the
possibilities of loss (adverse) or neutral (no loss).
(death, earthquake)
– A speculative risk is one in which both profit or
loss are possible. (gambling)
• Fundamental and Particular Risk

– A fundamental risk affects the entire economy or
large numbers of persons or groups. (hurricane)
– A particular risk affects only the individual. (Car
theft)
Classification Of Risk Continued…
• Diversifiable and Non-diversifiable Risk
Diversifiable risk is a risk that affects only
individuals or small groups and not the entire economy.
Non-diversifiable risk is a risk that affects the entire
economy or large numbers of persons or groups within
the economy.
• Enterprise Risk
– encompasses all major risks faced by a business firm,
which include: pure risk, speculative risk, strategic
risk, operational risk, and financial risk
• Systemic Risk is the risk of collapse of an entire system or
entire market due to the failure of a single or group of entities
that can result in the breakdown of the entire financial system.
Types of Pure Risks
Personal Risks involve the possibility of a loss or
reduction in income, extra expenses or depletion of
financial assets:
– Premature death of family head
– Insufficient income during retirement
– Poor health (catastrophic medical bills and loss of
earned income)
– Involuntary unemployment
– Dependent Old-age
Types of Pure Risks- Continue…
• Property Risks involve the possibility of losses

associated with the destruction or theft of property:
– Physical damage to home and personal property from fire,
tornado, vandalism, or other causes
• 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 restaurant
– An indirect loss results indirectly from the occurrence of a
direct physical damage or theft loss, such as lost profits due
to inability to operate after a fire
Types of Pure Risks- Continue…
• Commercial Risk: Business firms also face a wide variety
of pure risks that can financially cripple or bankrupt the firm if a
loss occurs. These risks include
 Liability risks involve the possibility of being held liable for
bodily injury or property damage to someone else
• A lien can be placed on your income and financial assets
• Defense costs can be enormous
 Loss of business income,
 Cyber-security and identity theft, and
 Other risks.
Human resources exposures.
Foreign loss exposures.
Government exposures.
Risks involved in business enterprise,
industry and factory
• Pure risk,
• Speculative risk,
• Strategic risk refers to uncertainty regarding the firm’s
financial goals and objectives; for example, if a firm enters a
new line of business, the line may be unprofitable.
• Operational risk results from the firm’s business operations.
For example, a bank that offers online banking services may
incur losses if “hackers” break into the computer.
• 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.
• Commercial risks (Pure Risk)
Methods of Handling Risk
1. Risk Control:
–Avoidance
–Loss prevention refers to activities to
reduce the frequency of losses
–Loss reduction refers to activities to reduce
the severity of losses
»Duplication
»Separation
»Diversification
Methods of Handling Risk (Continued..
2. Risk Financing
Retention
–An individual or firm retains all or part of a loss
–Loss retention may be active or passive
Noninsurance transfers
–A risk may be transferred to another party
through contracts, hedging, or incorporation
Insurance
Case Application 1
Assume that the chance of loss is 3 percent

for two different fleets of trucks. Explain how
it is possible that objective risk for both fleets
can be different even though the chance of
loss is identical.
Case Application 2
Several types of risk are present in the economy of Bangladesh. For
each of the following, identify the type of risk that is present. Explain
your answer.
a. The security department NSI alerts the nation of a possible attack
by terrorists.
b. A house may be severely damaged in a fire.
c. A family head may be totally disabled in a plant explosion.
d. An investor purchases 100 shares of Beximco Pharma stock.
e. The Jamuna river that periodically overflows may cause substantial
property damage to thousands of homes in the floodplain.
f. Home buyers may be faced with higher mortgage payments if the
Bangladesh Bank Reserve raises interest rates at its next meeting.
g. A worker on vacation plays the slot machines in a casino.
Case Application 3
Mr. Khan owns a gun shop in a high crime area.

The store does not have a camera surveillance
system. The high cost of burglary and theft
insurance has substantially reduced his profits. A
risk management consultant points out that
several methods other than insurance can be
used to handle the burglary and theft exposure.
Identify and explain two noninsurance methods
that could be used to deal with the burglary and
theft exposure.

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Chapter 01 Risk

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Insurance

– Objective risk is defined as the relative

3. Property: Morals, economic system, natural calamities etc.

• Fundamental and Particular Risk

• Property Risks involve the possibility of losses

Assume that the chance of loss is 3 percent

Mr. Khan owns a gun shop in a high crime area.

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