Introduction to Risk and Insurance

Chapter 1
Introduction to Risk and Insurance

Topics (hyperlinked)


Risk



Basic Categories of Risk



Uncertainty



Pure, Speculative, Fundamental, Particular Risk



Law of Large Number



Types of Pure Risk



Objective Risk



Personal, Property, Liability Risk



Subjective Risk



Burden of Risk in our Society



Chance of Loss



Insurance



Objective Probability



Pooling



Subjective Probability



Basic Characteristics of Insurance



Frequency vs. Severity



Requirements of an Insurable Risk



Henrich Triangle



Large Loss Principle



Domino Theory



Subsidization



Severity Reduction



Adverse Selection



Peril



Reinsurance



Hazard

Risk


Risk is defined as uncertainty concerning the occurrence of a loss. It is a persuasive condition of human existence.

Uncertainty
Uncertainty about about the the outcome outcome Possibility
Possibility of of that that outcome outcome being being unfavorable unfavorable Uncertainty


Uncertainty is the state of mind which is characterized by doubt. It can also be defined as the psychological reaction which arise due to lack of knowledge about the future. In corporate finance risk is different from uncertainty. But elsewhere these two concepts are related.

Law of Large Number


The law of large number states that as the number of exposure units increases, the more closely the actual loss experience will approach the expected loss experience.

Chart Title

Expected Loss

4.5
4
3.5
3
2.5
2
1.5
1
0.5
0
100

200
Dwelling fire

300
Theft

Accident

400

Objective Risk


Objective risk is defined as the relative variation of actual loss from expected loss. It is also called “degree of risk”. Objective risk can be stated as numerical uncertainty. It follows the law of large numbers. As the number of exposure increases, an insurer can predict it’s future loss experience more accurately.

Actual Loss
Expected Loss

Subjective Risk


Subjective risk refers to the uncertainty based on a person’s mental condition or state of mind. It is the mental uncertainty based on difference in mental state.

Chance of Loss


Chance of loss is closely related to the concept of risk. It is defined as the probability that as event will occur. Like risk, probability has both subjective and objective aspects. Objective
Objective Probability
Probability

Subjective
Subjective Probability
Probability

Objective Probability


Objective probability refers to the long-run relative frequency of an event based on the assumption of an infinite number of observation. And of no change in the underlying condition. It can be determined in two ways.

Deductive
Deductive Reasoning
Reasoning

Inductive
Inductive Reasoning
Reasoning

Subjective Probability


Subjective probability is the individual’s personal estimate of the chance of loss. It need not coincide with objective probability. A wide variety of factors can influence subjective probability. Such as,

Frequency VS Severity
High
Frequency
Low Severity

High
Low
Frequency
Frequency
High Severity Low Severity

Low
Frequency
High Severity

Uncertainty

low

removed

high

high

Risk

low

high

low

high

Decision of
Insurance
Company

Not the perfect Will not come solution forward

Offer insurance Insurance is perfect solution

Henrich Triangle


H.W. Henrich, an industrial engineer, did a survey on accident which is known as Henrich Triangle.



In clear call, there will be no significant loss and less flaws. In near miss, there will be minor loss like burning your hand. In minor injury, there will be recoverable injury like 2days leave due to an operation. In major injury, disability may occur such as loosing hand. In fatal stage, the severity is the highest, such as death. From the model we can see with the rise in severity, frequency is decreasing.

Clear
Clear Call
Call

Near
Near Miss
Miss

Minor
Minor Injury
Injury
Major
Major Injury
Injury

Fatal
Fatal

Henrich Triangle (graphical)

Domino Theory


Domino Effect: An event that causes a series of similar events to occur one after another. Domino Theory (graphical)

Heredity and
Environment

Personal Fault

Unsafe Act

Accident

Injury

Severity Reduction


The severity of an accident can be reduced in two ways.

1. Separation: Separation is used to reduce maximum possible losses with some kind of work. Work operation dispersion helps reduce the possibility of accident by separating the factors for which the accident will occur.
2. Duplication: It is a similar technique in which spare parts and equipment are maintained to replace immediately damaged equipment or parts.

Peril


Peril is defined as the cause of loss. Common perils that cause property damage includes fire, lightning, hail storm, wind storm, tornadoes, earthquake, theft and burglary.

Hazard


Hazard is a condition that creates or increases the chance of loss.



There are four major types of hazard.

Physical
Physical Hazard
Hazard

Moral
Moral Hazard
Hazard

Morale
Morale Hazard
Hazard

Legal
Legal Hazard
Hazard

Types of Hazard


Physical Hazard: A physical condition that increases the chance of loss.
Example of physical hazard include icy roads, that increase the chance of auto accidents.



Moral Hazard: Dishonesty or character defects in an individual that increase the frequency or severity of loss. Example of moral hazard include faking an accident to collect claim from an insurer.



Morale Hazard: Carelessness or indifference to a loss because of the existence of an insurance. For example, leaving car keys in an unlocked car increases the chance of theft.



Legal Hazard: The characteristics of the legal system or regulatory environment that increase the frequency of severity of losses.

Basic Categories of Risk


Risk can be classified into several distinct categories. The most important ones are as follows.

Pure Risk


The possibility of the occurrence of loss or not. Pure risk is different as a situation as there is loss or not. For example, if an accident occurs to someone’s car, it will cause some loss. Or if no accident occurs, no loss will be there.

Accident = Loss
No Accident = No Loss

Speculative Risk


Speculative risk refers to a situation in which either profit or loss is possible. For example, if someone purchases 100 shares of common stock, he could profit if the price of the stock increases. But could loss if the price declines.

Fundamental Risk


A risk that affects the entire economy or large number of person or groups within the economy. For example, rapid inflation, cyclical unemployment, war, natural disaster etc. Fundamental risk are covered mainly by government budget.

Natural Disasters

Particular Risk


The risk that affects only individuals and not the entire community. For example, car thefts, ban robberies, dwelling fires etc. Only individuals experiencing such losses are affected, not the entire economy.

Types of Pure Risk

Personal Risk


Personal risk is the risk that directly affects an individual. They involves the possibility of the loss or reduction of earned income, extra expenses and the depletion of financial assets. There are four major personal risk.

Personal Risks


Risk of Pre-mature Death: It is defined as the death of a family head with unfulfilled financial obligations.



Risk of Insufficient Income: The majority of workers experience a substantial reduction in their money incomes when they retire which can result in a reduced standard of living. 

Risk of Poor Health: Poor health is another important personal risk that includes both the payment of catastrophic medical bills and the loss of earned income.



Risk of Unemployment: It is another major threat to financial security. Unemployment can result from business cycle down-swings.

Property Risk


Persons owning property are exposed to property risk. Property risk refers to the risk of having property damaged or loss from numerous causes. Real-estate and personal property can be damaged or destroyed because of fire, lightning, tornadoes, thunder storms and numerous other causes.

Property Risk


Direct Loss: A direct loss is described as a financial loss that results from the physical damage, destruction or theft of the property.



Indirect Loss: Indirect loss is a financial loss that results indirectly from the occurrence of a direct physical damage or theft loss.

Liability Risk


Liability risk is another important type of pure risk that most persons. under our legal system, we can be held legally liable if we do something that results in bodily injury or property damage to someone else.

Burden of Risk in our Society


The presence of risk results in certain undesirable social and economic effects. Risk entails three major burdens in our society.

1. The size of an emergency fund must be increased.
2. Society is deprived of certain goods and services.
3. Worry and fear are present.

Insurance


Insurance is the pooling of fortuitous losses by transfer of such risk to insurers, who agree to indemnify insured for such losses, provide other monetary benefits on the occurrence, or to render services connected with the risk.

Testing various products determining degree of risk

Pooling


Pooling is the system or process of forming a group or team consist of several individuals or interested subjects.

G
U
O R
P

GROUP

Basic Characteristics of Insurance


Based on the definition of insurance, an insurance plan or arrangement typically includes the following characteristics.

1. Pooling of losses
2. Payment of fortuitous losses
3. Risk transfer
4. Indemnification

Basic Characteristics of Insurance


Pooling of losses: Pooling of losses is the spreading of losses incurred by the few over the entire group.



Payment of fortuitous losses: A fortuitous loss is one that is unexpected and unforeseen and occurs as a results of chance.



Risk transfer: It is another essential element of insurance which means that a pure risk is transferred from the insured to the insurer who typically is in a stronger financial position to pay the loss than the insured.



Indemnification: It is the final character of an insurance which means the insured is restored to his or her approximate financial position prior to the occurrence of the loss.

Requirements of an Insurable Risk


Insurers normally insure only pure risk. Certain requirements must be fulfilled before a pure risk can be privately insured. From the view point of the insurer, there are ideally six requirements of an insurable risk.

Requirements of an Insurable Risk


Large number of exposure units: There should be a large group of roughly similar, but not necessarily identical, exposure units that are subject to the same peril or group of perils. The purpose of the large number of exposure units is to enable the insurer to predict loss based on the law of large number.



Accidental and unintentional loss: The loss should be accidental, ideally the loss should be fortuitous and outside the insured's control.



Determinable and measurable loss: This means the loss should be definite as to cause time, place and amount.



Not catastrophic loss: The loss should not be catastrophic. This means that a large proportion of exposure units should not incur losses at the same time.



Calculable chance of loss: The insurer must be able to calculate both average frequency and the average severity of future losses with some accuracy.



Economically feasible premium: The insured must be able to pay the premium.

Large Loss Principle


Large loss principle states that the business or individual should insure potential serious losses before minor losses. Large loss means the loss which has low frequency and high severity. Insure Large Loss First

Subsidization
It occurs if each insured does not pay mathematically fair price for insurance. If the insurance purchaser is paying more than fair price, then he will provide subsidy if he pays less than the fair price, he will receive subsidy.

Getting
Getting
Subsidy
Subsidy

20
20 years years old old TK
TK 150
150

Subsidy
Subsidy

Fair
Fair price price TK
TK 212
212

Providing
Providing
subsidy subsidy 

50
50 years years old old TK
TK 275
275

Adverse Selection


Adverse selection is the action taken by one party using risk characteristics or other information known to suspected by that party that causes a financial disadvantage to the financial or personal security system.

Reinsurance


Reinsurance is an arrangement by which the primary insurer that initially writes the insurance transfers to another insurer (called the re-insurer) part or all of the potential losses associated with such insurance.

Thank You