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Topic 2

InsuranceRisk and Uncertainty in Human

Life

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UCSB Bren School of EnvironmentalManagement 2

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Risk and Uncertainty in Human

Life

Human activities involve a greatcircumstances full of hazard and

uncertainty

Risk can define as the probability of an

unfavorable events and its consequences.

Risk and uncertainty are accompanied by

the fear of financial loss or hope of gain or

both thus heightening our awareness of

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Uncertainty vs. Risk

Risk we sort of understand the

probabilities (eg, hurricanes in the

Gulf)

Uncertaintywe dont really even

understand how likely or unlikely

things are (eg, shut down of Gulf

Stream). Most climate

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Consider some of these

definitions: Risk is the possibility of an unfortunate

occurrence.

Risk is a combination of hazards

Risk is unpredictably the tendencythat actual results may differ from

predicted results

Risk is uncertainty of loss

Risk is the possibility of loss

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Cont:

Risk is referring to a

HIGH RISK? LOW RISK?

E.G. leaving the keys in a car

locking the car in a garage

Which signifies higher risk?

POTENTIAL CAUSE

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Concept of Risk

Risk is the chance of loss.

Loss - reduction or disappearance of

economic value

Peril - a direct cause of loss

Hazard condition that increases the

chance of loss.

Imperfect information and knowledge willleads to the doubt and hence to the

UNCERTAINTY

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Concept of Risk (ctd)

3 Types of Hazards

1. Physical hazard

Physical condition that increases the

possibility of a loss.

Smoking is a physical hazard that

increases the likelihood of a house

fire and illness.

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Cont:

2. Moral/Legal Behavior / Characterdefect

Losses that results from dishonesty.

Insurance companies suffer lossesbecause of fraudulent or inflated

claims.

Laws or regulations that force

insurance companies to cover risks

that they would otherwise not cover,

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Cont:

American legal system is a moralhazard in that it motivates many

people to sue simply for financial profit

because of the enormous amount ofmoney that can sometimes be won,

and because there is little cost to the

plaintiff even if he loses.

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3. Morale - Feelings

Insurance can be regarded as a morale

hazard because it increases the

possibility of a loss that results from theinsured worrying less about losses.

Insured take fewer precautions and mayengage in riskier activitiesbecause

they have insurance.

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Concept of Risk (ctd)

Peril great danger / risk e.g. property: destroyed or loss

e.g. lives : injured or killed

How to manage/anticipate with the risk??

3 Types of Probability :1. A Priority Probability possible events are

known

2. Empirical Probability based on historical data

3. Judgmental Probability based on judgment

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Business Risk and Uncertainty

The types of risk that company may faces:

I. Strategic risks competitor / not meetingorganizations agenda.

II. Compliance risks responding to rules and

regulations

III. Financial risks Non payment or increases ininterest rates

IV. Operational risks non-functioning of equipment,

theft

Every businesses will possess risks that could

become a threat to a business success.

Risk can be categorized as to why the risk exists,

and to whom it affects

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Every risk is not insured?

PURE

Insurable

How to be?

SPECULATIVE

Not insurable

Occur bychance

Must bedefinite

Rate of lossmust be

predictable

Must not becatastrophic

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Pure Risk Situation where there is ONLY a chance of either loss

or no loss, but no chance of gain. Also called as an Absolute risks

Example:

The owner of an automobile faces the risk

associated with a potential collision loss. If acollision occurs, the owner will suffer a financial

loss. If no collision occurs, the owner does not

gain.

Other example, the possibility that a person's

house will be destroyed due to a natural disaster is

pure risk. In this example, it is unlikely that there

would be any potential benefit to this risk.

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Cont:

Pure risk can be categorized aspersonal, property, or legal risk.

Personal risks are risks that affect

someone directly, such as illness,disability, or death.

Property risk affects either personal orreal property.

Thus, a house fire or car theft are

examples of property risk.

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Cont:

A property loss often involves both a direct

loss and consequential losses.

A direct loss is the loss or damage to the

property itself.

A consequential loss (aka indirect loss)

is a loss created by the direct loss. Thus, if

your car is stolen, that is a direct loss; if you

have to rent a car because of the theft, then

you have some financial lossa

consequential lossfrom renting a car.

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Cont:

Legal risk (aka liability risk) is a particulartype of personal risk that you will be sued

because of neglect, malpractice, or causing

willful injury either to another person or to

someone else's property.

Legal risk is the possibility of financial loss if

you are found liable, or the financial loss

incurred just defending yourself, even if you

are not found liable. Most personal, property,

and legal risks are insurable.

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Speculative Risk

Speculative risk are normally taken in the

hope of some gain and the provision of

insurance may act as a distinct disincentive

to effort.

This characterizes most financialinvestments.

Possibilities of gain, loss or no loss

Most speculative risks are uninsurable,

because they are undertaken willingly for

the hope of profit.

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Cont:

Example:

A person hoped to gain from an enterprise

Investment in stocks market Betting in a horse race

Speculative risk will generally involvea greater frequency of loss than a

pure risk.

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Cont:

Why the speculative risk cannot be

insurable?

i.e Market risks such as price changes

and/or changes in the exchange rate ofcurrency are not insurable.

These risks are not subject to advance

calculation, hence the insurer would have norealistic basis for computing his premium.

The speculative risks are handled

businessmen by way of hedging, whereby a

speculator assumes the price risk.

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Cont:

Pure risk is insurable, because the lawof large numbers can be applied to

forecast future losses, and, thus,

insurance companies can calculate what

premium to charge based on expected

losses.

Speculative risks have more varied

conditions that make estimating future

losses difficult or impossible.

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Taking one example of new lineclothing business enterprise, identify

the pure risk and speculative risk that

may exists in this business activity?

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Level of Risk

We cannot make the assumptions that all risks

are equally likely to occur.

Some will be more or less risky than others.

Example: Consider there is a house by the side of river

which is known for the tendency to overflow

its banks compares for the house on the hill.

thus, we may say that the prospect that damage

will occur to the house by the side of river is

high.

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Cont: Frequency and Severity

Shoplifting high-frequency risk, number of occurrenceis high but low severity.

Airplanes crash and ships accident low-frequency risk

but high severity

A person may be willing to fund losses which are

frequent and not too severe rather than doing the

same for rare events which have the potential for very

high costs

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Cont: The Utility Theory

This relates more to the measure of risk to which anindividual is exposed.

The Utility Theory attempts to represent the probability

of loss and the COST of loss in one measurement.

The value which a person attaches to a risky situation isa function of the probability of the loss occurring and the

severity should it occur.

Example:

A person who only possesses RM10 would view the

risk of losing RM8 as extremely serious, while

millionaire would not even think twice about a

potential loss of such a small amount.

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Risk-Averse

Risk-Seeking

Risk-Neutral

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Cont:

Hence, we can look at the cost of risk the perspectivesof:-

Frequency of risk

Monetary cost of financial severity

Human cost in terms of pain and

suffering

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Law of Large Numbers

The operation of the common pool is very much based

on the successful application of the Law of largenumbers.

Definition:

The law states that the larger the group of similar risks,the closer the actual losses experienced by the group

will approach the expected losses.

Measure of probability of the incidence of a particular

result during one experiment.

Also known as a law of averages.

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Gambling

Uncertainties which are not a necessary part ofeveryday living and working.

Also called a game of chance which is a result

of voluntarily choice.

Such risks entail both loss and gain and the

hope of gain motivating the taking of risk.

For instances, betting in casino.

E i I t f Ri k

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1. To smooth flow of business activity and

production process.

2. Large-scale supply of capital

3. Cost estimation and cost reduction

Economic Importance of Risk

Reduction

E i I t f Ri k

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1. To smooth flow of business activity and

production process.

o Capacity to minimize the financial losses andrelieve the burden of losses.

o It will facilitate the conduct of business and more

people are willing to engage in business activity.

Economic Importance of Risk

Reduction (ctd)

E i I t f Ri k

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2. Large-scale supply of capitalo Organization of industrial and commercial requires

a vast scale availability of huge capital.

o Capital is thus raised by numbers of investors not

depending on single individual.

o Insurance then will encourage the investor toventure into a business because they have a

protection mechanism.

Economic Importance of Risk

Reduction (ctd)

E i I t f Ri k

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3. Cost estimation and cost reductiono Under the circumstances of uncertainty, it is

impossible for producer to have an accurate idea

of total cost.

o By taking an insurance, the producer can minimize

the risk against uncertainties such as in the event

of loss incurred from accidents.

o In the context of cost reduction, the amount of

premium that producer has to pay to insurer is

lower compare when producer has to bear much

Economic Importance of Risk

Reduction (ctd)

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Thank You