CHAPTER ONE

CONCEPTS OF RISK AND INSURANCE

1.1.Introduction

In your earlier courses, you have discussed some important concepts in business. Business,
which refers to all those activities there are connected with production or purchase of goods and
services with the object of selling them at profit, has some essential characteristics and one of
these is the fact that it involves an element of risk and uncertainty. Because the adverse effects of
risk have affected mankind since the beginning of time, individuals’ groups and societies have
developed various methods for managing risk. Since no one knows the future exactly, everyone
is a risk manager not by choice, but by sheer necessity. The purpose of this course is then to
examine how businesses and families might effectively manage a major class of exposures to
loss through a process called risk management, which is the identification, measurement, and
treatment of exposures to potential accidental losses.

1.2.Meaning of Risk

There is no single definition of risk. Many writers have produced a number of definitions of risk.
These are usually accompanied by lengthy arguments to support the particular view they put
forward. Economists, behavioral scientists, risk theorists, and statisticians each have their own
concept of risk. Some of these definitions are forwarded for your consideration.
A. Risk is potential variation in outcomes. When risk is present, outcomes cannot be forecasted
with certainty. William, Smith and Young
B. Risk is the variation in outcomes that could accrue over a specified period in a given
situation. William’s and Heins
C. Risk is the condition in which there is a possibility of adverse deviant from desired outcome
that is expected or hoped for. Vaughen

Based on the above stated definition of risk, we can conclude that risk is the possibility of loss.

1.3.Risk and Uncertainty

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 ⮚ The dictionary meaning of risk is “the possibility of meeting danger or suffering harm/

loss”.

⮚ The dictionary meaning of uncertainty is “the state of being uncertain” here, uncertain

means “feeling of doubt about something”

⮚ Generally, uncertainty is a state of mind characterized by doubt, based on lack of

knowledge about what will or will not happen in the future.

⮚ The existence of uncertainty creates risk. Therefore, uncertainty is a pre-condition for

risk.

⮚ Risk is dealt with every day by weighing probabilities and surveying options but

uncertainty can be debilitating, even paralyzing, because so much is new and unknown.

⮚ Risk is the combination of hazard and is measured by probability while uncertainty is

measured by the degree of belief.

⮚ On the other hand, risk is a state of the world and uncertainty is the state of mind.

⮚ Uncertainty results from the imperfection of knowledge of mankind of predicting the

future and the higher the lack of knowledge about the future, the higher the uncertainty.

⮚ Risk” as a measurable uncertainty that can be determined by objective analysis based on

prior experience. In contrast, “uncertainty” referred to events when randomness could not
be expressed in terms of mathematical probability that is of a more subjective nature
because it is without precedent.

1.4.Risk and probability

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Probability: is the long-run chance of occurrence, or relative frequency of some events.
Risk: is relative variation/deviation of items. Therefore, probability is expectation of outcomes
but risk is deviation (variation) of outcomes from expectation.
Risk is differentiated from probability by concept in relative variation. It is the variation in
outcomes, while Probability shows to the long-run chance of occurrence, or relative frequency of
some event. The probability associated with a certain outcome is the relative likelihood that
outcome will occur. And probability varies between 0 and 1. If the probability is 0, that outcome
will not occur, if the probability is 1, that outcome will occur.
1.5.Risk, Peril and Hazard
Peril: - is the prime cause; that will give rise to the loss. Often it is beyond the control of anyone
who may be involved. In this way we can say that storm, fire, theft, motor accident and
explosion are all perils.
Hazard: - refers to the condition that may create or increase the chance of a loss arising from a
given peril. These hazards are not themselves the cause of the loss, but they can increase or
decrease the effect should a peril operate. Thus, they affect the magnitude and frequency of a
loss. The more hazardous conditions are, the higher the chance of loss.
There are four major types of hazards:
1. Moral hazard: - is a dishonesty, fraudulence or character fault in an individual that increases
the frequency or severity of loss. It is associated with the human feature which may influence the
result. This usually refers to the attitude of the insured person. Examples of moral hazard include
dishonesty, fraudulent intention, exaggeration of claims,
2. Physical hazards: - This is related with the physical properties of the thing exposed to risk,
such as the nature of construction of a building, the nature of the road. Examples are:
o Icy, rough roads that increase the likelihood of an auto accident
o Type of construction material such as wood, bricks,
o Location of property such as near to fuel station, near to flood area, near to earthquake
area, etc.
3. Morale hazard: it initiated from act of carelessness which leading to the occurrence of a loss.
Thus, it occurs due to lack of concern for events. Examples of Morale hazard include the leaving
car keys in an unlocked car, poor housekeeping in stores, leaving a door unlocked that allows a
burglar to enter, etc.

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4. Legal hazard: -refers to characteristics of the legal system or regulatory environment that
increase the frequency or severity of losses. Examples of legal hazards include adverse jury
verdicts or large damage awards in liability lawsuits, statutes that require insurers to include
coverage for certain benefits in health insurance plans, such as coverage for alcoholism, and
regulatory action by state insurance departments that restrict the ability of insurers to withdraw
from the state because of poor underwriting results.
1.6. Classification of Risk
1. Objective and Subjective Risk

⮚ Objective risk- is defined as the relative variation of the actual loss from expected loss.

Objective risk can be statistically measured by some measure of dispersion, such as the
standard deviation or the coefficient of variation. Since objective risk can be measured, it
is an extremely useful concept for an insurer or a corporate risk manager

⮚ Subjective risk- is defined as uncertainty based on a person’s mental condition or state of

mind. For example, an individual is drinking heavily in a bar and attempts to derive
home. The driver may be uncertain whether he or she will arrive home safely without
being arrested by the police for drunk driving. This mental uncertainty is called subjective
risk. Often subjective risk is expressed in terms of the degree of belief.
2. Financial and Non-Financial Risk

⮚ A financial risk is one where the outcome can be measured in monetary terms. For

example, this is easy to see in the case of material damage to property, theft of property
or lost business profit following a fire. In cases of personal injury, it can also be possible
to measure financial loss in terms of a court award of damages, or as a result of
negotiation between lawyers and insurers

⮚ Non-financial risk if the risk does not have financial implication (if the outcomes is not

related with money). For example, For example, network connection failure, death/injury
of an employee.
3. Pure and Speculative Risks

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The distinction between pure and speculative risks based on situations where there is only the
possibility of loss and those where a gain may also result.
Pure risks refer to the situation in which only a loss or no loss would occur. The outcome can
only be unfavorable to us, or leave us in the same position as we enjoyed before the event
occurred. Examples of pure risks include premature death, risks of a motor accident, catastrophic
medical expenses, lightning, flood, fire at a factory, theft of goods from a store, or injury at work
are all pure risks with no element of gain.

Classification of pure risks

1. Personal risk: are risk that consist of possibility of loss income as a result of loss of
ability to participate in some activity.
A. Risk of premature-death: - it is the death of bread winner (header of family) without
satisfied financial obligation such as dependent to support, Child to educate, liability to
be paid. Example, cost that resulting from premature death, human life value is lost,
Extra cost may incur (e.g., funeral expense) and Reduction of living standard

B. Risk of insufficient income during retirement: is cause of financial insecurity because of

old age.
C. Risk of poor health: medical expenses and loss of earned income. Both of them expenses
are causes financial insecurity (shortage of money)
D. Risk of unemployment: - unemployment you lose your income. This is risk for you.

2. Property risk: are risks associated with defect (change or destroy) in possession of property.

⮚ The loss from property can be categorized into two: A) Direct loss and B) Indirect loss

A) Direct loss: is financial loss that result from the physical damage of property.
B) Indirect loss: is financial loss that result from due to the occurrence of Direct damage of
property .example, when the rent house is damaged, we loss the rent house, in addition to
this we also loss income from the rent house.
3. Liability risk: are risk result from injury of other person or damage to their property.
(intentionally or unintentionally)

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4. Risk arising from failure of other: it is a risk arise when person’s fail to meet an obligation
that you hope will be meet. E.g., Failure of a contractor to complete a contraction project as
scheduled program, which result failure of income to make payment as expected.

Speculative risk is defined as a situation in which either profit or loss is possible. Expansion of
plant, introduction of new product to the market, lottery, football, investors and gambling.
4. Static and Dynamic Risks
Dynamic risk originates from changes in the overall economy such as price level changes,
changes in consumer taster, income distribution, technological changes, political changes and the
like. They are less predictable and hence beyond the control of risk managers some times.
In contrast to a dynamic risk, static risk refers to those losses that can take place even though
there were no changes in the overall economy. They are losses arising from causes other than
changes in the economy. Unlike dynamic risks, they are predictable and could be controlled to
some extent by taking loss prevention measures. Many of the perils fall under this category.
5. Fundamental and Particular Risks
Fundamental risk is a risk that affects the entire economy or large numbers of persons or
groups within the economy. Examples include rapid inflation, natural disaster, cyclical
unemployment, and war because large numbers of individuals are affected.
Thus, fundamental risks affect the entire society or a large group of the population. They are
usually beyond the control of individuals. Therefore, the responsibility for controlling these risks
is left for the society itself.
Particular risk is a risk that affects only individuals and not the entire community. Examples
include car thefts, bank robberies, property losses, death, disability and dwelling fires. Only
individuals experiencing such losses are affected, not the entire economy or large groups of
people. Therefore, particular risks affect each individual separately.

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