Risk and Insurance 2024-2025

LO 1 – Examine the concepts of risks within the insurance industry

LO 1 – a Concept of Risk
LO 1 – a – I Risk Perception
LO 1 – a – II Definition of Risk

LO 1 – a – I Concept of Risk

The concept of Risk

Risk is a word that has more than one meaning. It is a term that can mean different things
depending on the circumstances and the context in which it is used. Here are some of the
meanings it can assume.
(i) Uncertainty
The primary meaning of risk as applied to risk management and insurance is that
of the uncertainty of an outcome in a given. The key word here is “uncertainty”.

It is the doubt whether a given event will take place or not. The greater the
doubt or uncertainty, the greater is the risk. You can only be at risk if you face an
event which may or may not occur, if there is at least two or more possible
outcomes from the event, and you cannot determine in advance which one of
the two or more possible outcomes you will actually experience.

There is no risk, no uncertainty or doubt in a situation where there is only one

possible outcome. Or where we can tell in advance which outcome shall be
experienced because in such cases there will be no uncertainty or doubt about
the expected outcome.

Uncertainty or risk is only relevant if one of the expected possible outcomes is a

loss. A risk is not significant if it cannot cause us a loss of any kind. Risk
therefore has two main things to it, uncertainty of occurrence of an event and a
possible loss of some kind from the event. Risk management and insurance is
therefore more concerned with those risks capable of causing losses.

A loss is the unintentional or involuntary parting with something of value. A loss

may be either financial or non-financial and could involve both tangible and
intangible assets.

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Some situations of uncertainty that could give rise to risk and loss include :
(a) The negligence of participants in a certain activity or the negligence of others.
(b) Events that may be foreseeable or not foreseeable for now.
(c) Hazards or conditions arising out of ownership or operating in premises.
(d) Performing certain activities or participating in certain activities.
(e) Failure to perform certain activities such as proper maintenance, inspection,
supervision, controls, etc
(f) Failure to provided warnings on existing dangerous conditions
(g) Poor administrative structures
(h) Environmental factors such as political instability, socio-cultural practices,
natural calamities, etc.

(ii) Chance of loss or the probability of occurrence of a loss

As already defined, risk is the uncertainty of occurrence of an event. But the
term risk can also mean something else. It can also be defined as the chance or
probability of occurrence of a loss. This is the long run relative frequency of a
loss. The probability or chance of occurrence of a loss varies between 0 and 1.
The 0 position says there is no chance of a loss occurring. At the other end 1, the
chance of loss is 100% because the loss is certain to occur.

Situations with a high probability of loss are said to be riskier than those with a
low probability of loss. The risk is greater if the probability of loss is higher.

Normally when we say that something is very risk, we are in essence saying that
the probability that it will cause a loss is very high. Greater loss and greater
event likelihood result in a greater overall risk.

Take note that if risk means uncertainty according to our first definition then risk
does not exist where the chance of loss is either 0 or 1. This is because there is
no doubt or uncertainty about the expected outcome in the two positions. The
outcomes in the two positions are already definite or certain.

(iii) The subject matter insured in a contract of insurance

The term risk can refer to the object covered or insured in a contract of
insurance. It could be a house, a car, a life, etc for every contract of insurance
there must be something being insured against a loss. This becomes the subject
matter of the contract and can be referred to by the insurers as the risk.

(iv) Peril (or risk)

Risk can also mean a peril. This is the immediate cause of a loss such as a fire or
earthquake. Each loss that occurs must have a cause. These causes such as
accident, illness, theft, etc. is knows as peril or risk. So when we talk of the risk
of fire, or theft, etc in insurance policies it is common to find a section dealing

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with ‘insured perils’ and the n listing the risks or perils. These would simply be
some possible causes of loss which the insurer is accepting to cover. Note that
the insurer is only liable to compensate for a loss if the loss is caused by a peril
or risk covered in the policy.

(v) The dispersion of actual from expected results

This is the statistical definition of risk as measured by the standard deviation,
which is the most widely accepted measure of risk. It is a figure that more or less
measures the degree or the level of in a given situation. It is a measure of risk
that is objective.

In conclusion, we have seen that the term risk can mean five different things
depending on the circumstances and the context in which it is applied.

LO 1 – a – II Definition of Risk

Risk is the possibility that a loss or injury will occur. It is impossible to escape all types of risk
in today’s world. For individuals, driving a car, investing in stocks or bonds, and even jogging
are situations that involve some risk. For businesses, risk is a part of every decision. In fact,
the essence of business decision making is weighing the potential risks and gains involved in
various courses of action.

LO 1 – b Categories of Risk

LO 1 – b – 1 Insurable and Non-Insurable risks

What are the three types of insurable risk? Insurable risks

Most pure risks can be divided into three categories: personal risks that affect the
income-earning power of the insured person, property risks, and liability risks that
cover losses resulting from social interactions.
What are the types of risk that Cannot be insured? Non-insurable risks
Some of the most common non-insurable risks include natural disasters, pandemics,
and acts of terrorism. While business Insurance can help protect businesses from
many types of risks, it is important to be aware of the risks that are not covered.

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There is obviously a difference between the risk of losing money that one has invested and
the risk of being hit by a car while jogging. This difference leads to the classification of risks
as either speculative or pure risks.

Speculative risk  is a risk that accompanies the possibility of earning a profit. (eg: if the
investment in the market succeeds, there are profits; if it fails, there are losses).
Pure risk  is a risk that involves only the possibility of loss, with no potential for gain.
(eg : hurricane).

Pure risks
A pure risk exists when there is uncertainty as to whether a given event will cause a loss or
not. The occurrence of the risk may cause a loss only. There is no possibility that h event
may cause a gain or profit. There are only two possible outcomes in a pure risk situation.
The risk can cause either a loss or not loss. There are only two possibilities that could result
from the risk and that it is that either causes a loss or things stay as they were.
Fire in a given building is a pure risk. Within any given period of time either fire incident
occurs in the building or it does not occur. There is no third possibility. Death is a pure risk,
by the end of the year, there can only be two possible outcomes. Either death has occurred
or the person is still alive. There are many others such as accidents, earthquakes, thefts,
etc.

The other main characteristic of a pure risk is that in fact differentiates it from other risks is
that it has no element of a profit. There is no chance that the risk could cause a profit as
one of its possible outcomes. Pure risks occur naturally and are not created by those
exposed to them. They can generally be handled through the practice of insurance.

Speculative risks
Speculative risks involve events which may produce either a gain or a loss. The main
characteristic of a speculative risk is that there is an element of profit. There is a chance
that the risk could result in a profit as an outcome. Speculative risks are generally
associated with business investments where people invest in the hope of making profits.
Who is a speculator? This is one who buys today in the hope of selling tomorrow at a profit.
Speculative risks may also be associated with betting or gambling where there is a chance of
ending up with profits. Speculative risks are not naturally occurring. They are self-created
and voluntarily taken by those who want to make profits.

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We had earlier said that all risks can be classified into two categories. Any risk will be either
a pure risk or a speculative risk. However these two primary classifications, risks can be
further be sub classified into other sub classes. It is possible for a risk to be a pure risk or a
speculative risk and at the same time also fall into other sub classes such as

(i) Fundamental risks

These are risks that arise from causes outside the control of any one individual or even a
group of individuals. The effect of fundamental risks is felt by large numbers of people.
They are impersonal in origin and widespread in effect. Examples include earthquakes,
floods, volcanic eruptions, and other natural disasters. They are not however limited to
naturally occurring perils. Social change, political intervention, and war are all capable of
being interpreted as fundamental risks.
(ii) Particular risks
They can also be referred to as personal risks. These are personal in both cause and effect.
All of them arise from individual causes and affect individuals in their consequences. They
are risks faced by individuals and their families. They are in areas such as loss of earnings,
death, disability, liability suits, medical expenses, loss of physical assets, etc.

(iii) Objective risks

This is the measure of the degree of variation in the proportion of actual from expected
events. The probable variation of actual from expected experience. It is observable and
measurable. This proportion declines as the number of observed events increases. It
follows from the law of large numbers.

(iv) Subjective risks

Subjective risk refers to the mental state of an individual who experiences doubt or worry as
to the outcome of a given event. It is psychological uncertainty that arises from an
individual’s or state of mind. It is the uncertainty of an event as seen or perceived by an
individual. This perception depends on the individual’s attitudes towards risk. Objectively
the risk may be small but the person sees it as a big risk. Alternatively it may be true that
the risk is a big one but the person sees it as a big risk. Alternatively it may be true that the
risk is a big one but the person sees it as a small risk. An objective risk may be the same but
different people may see it differently depending on whether they are risk averse or not.

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LO 1 – c Components of Risk
LO 1 – c – I Uncertainty
LO 1 – c – II Level of Risk
LO 1 – c – III Perils and Hazards

The components of risk include :

 Uncertainty
 Levels of risk
 Perils and hazards

Uncertainty
Risk is all about uncertainty. The risk of something is the fact that we don’t know when and
if something will happen. Nobody knows from before if they will have an accident or not.
Similarly, everyone knows that one day they have to die but no one knows when. Therefore
it is uncertainty that makes insurance a need.

Level of risk
Not all risks are the same. When you compare two things, for example two houses, one can
identify many differences which will make one risk worse than another. This is mainly based
on two aspects which are frequency and severity.
Frequency – the amount / number of happenings to a particular risk.
Severity – impact or resultant following a particular accident
Frequency and severity are inversely proportional, for example, if severity is high, frequency
is low. Example : air crash, if severity is low. Severity is high for motor accident.

Perils and hazards

Peril is that which gives rise to a loss eg: fire, theft, explosion, therefore we insure against
perils (risks).
Hazards are those which influence the operation of a peril. Eg: they will increase or
decrease the risk.
Perils are all the same (eg: fire is fire but hazards will influence he effect of that fire.
Perils may be also know n as risks which are insured.

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For example, sprinklers will decrease the chance of fire whilst stock of thinner will increase
the effect of fire since it is highly flammable.
Hazards are categorised as physical or moral hazards, and hey can also e further classed as
good or bad hazards.
Physical hazards are hazards which relate to the physical aspect of risk (eg: the age of a
driver).
Moral hazard is related to the attitude and conduct of a person (Eg: a careful driver is a good
moral hazard while a fraudster is a bad moral hazard).
We insure ourselves (illness, accidents) or our car (accident) our house (fire, theft) against
the perils.

LO 1 – d – Pooling of risks
LO 1 – d – I Law of large numbers
LO 1 – d – II Equitable premiums