Risk

1. RISK MANAGEMENT
AND
INSURANCE
TOPIC 1
FUNDAMENTALS
AND TERMINOLOGY

2. RISK
• Risk: is the possibility of bearing
unwanted events.
• Risk is defined as uncertainty of loss.
• Uncertainty: The perception that several
different outcomes are possible.
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3. Definition of Risk
• There is no single definition of Risk; however,
two distinctive definitions are used commonly.
• The variations in possible outcomes of an event
based on chance. (greater the number of
different outcomes that may occur, the greater
the risk).
• “Risk is an uncertainty concerning a possible
loss”.
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4. Who Are Under Risk?
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• Individuals,
• Companies,
• Organizations
• Governments, etc.
face with loss from natural disasters.

5. Risk Taking Behavior
• Risk-Averse
• Risk-Neutral
• Risk-Taker (Risk-Seeker, Risk-Lover)
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6. Risk and Relative Return
Risk-
Adjusted
Return
Zone 1
Insufficient
Risk Taking
Zone 2
Optimal
Risk Taking
Zone 3
Excessive
Risk Taking
Risk

7. What are the Sources of Risk?
• Physical Environment
• Social Environment
• Political Environment
• Legal Environment
• Operational Environment
• Economic Environment
• Cognitive Environment
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8. Categorizing Risk
• Pure Risk : is the situation that can result in
only loss or no change.
Example: premature death, damage to a property from fire,
lightening, flood, etc.
• Speculative Risk: refers to those exposures
that can result in loss, gain or no change.
Example : If you purchase 100 shares of common stock if the
price goes up you make a benefit but the price goes
down you make a loss.
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9. The Degree of Risk
• The Degree of Risk:
is a measure of the accuracy with which the
outcome of an event based on chance can
be predicted.(Health certificate, occupations)
 Insurers use risk to identify the property or life that is
being insured.
 “Loss exposure” is used instead of risk in the
insurance industry
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10. Examples of Risks
• Risk of being killed in the auto accident.
• Risk of lung cancer for smokers.
• Risk of failing in examination or college course.
Examples of presence of risks in our society:
• A gunman kills 10 customers in a local department store
• A small town is wiped out by tornado.
• A drunk driver kills 5 people in a van on a expressway.
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11. RISK MANAGEMENT
• Risk Management:
The art and science of anticipating these
potential losses and developing a plan to survive
them.
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Hurricane Katrina: Landfall August 29, 2005

12. Why Manage Risk?
- Individuals
• Reduce anxiety
• Planning
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13. 13
Corporation
owners
employees
suppliers
customers
government
creditors
Why Manage Risks
- Corporation
(Nexus of Contracts)

14. INSURANCE
• Insurance protects you against potential
financial losses or liability as a result of
unexpected events.
• Its primary function is to maintain your existing
level of wealth.
• Insurance is beneficial even when no payments
are received from the insurance company.
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15. The Two Definitions of Insurance
• Financial Definition of Insurance:
Insurance is a financial arrangement that
redistributes the costs of unexpected losses.
• Legal Definition of Insurance
Insurance is a contractual arrangement whereby
one party agrees to compensate another party
for losses.
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16. Some Insurance Terms
(Actors of the Game)
• Insurer : Party agreeing to pay for the losses.
• Insured: Party who loss causes the insurer to
make a claims payment.
• Premium: is the payment insurer receives.
• Policy: is the insurance contract
• Exposure to Loss: the insured’s possibility of
loss. (The exposure is transferred to the
insurer by purchasing an insurance policy)
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17. Some More Insurance Terms
• Sum Insured: a maximum amount that an insurance company will
pay to someone who makes a claim.
• Claim/Loss: formal request to an insurance company asking for a
payment based on the terms of the insurance policy.
• Reinsurance: Practice where an insurance company (the insurer)
transfers a portion of its risks to another (the reinsurer). Known as
insurance for insurers.
• Solvency Ratio: Available capital / Required capital.
• Laws and Regulations: Governs and regulates the insurance
industry and those engaged in the business of insurance.
• The Superintendent (Regulator): is the competent authority of the
insurance sector. Exercise all the powers granted by law for the
purpose of protecting the policyholders and the insurance
beneficiaries. 17

18. Insurance System
• It redistrubutes the cost of losses by collecting a
premium payment from every participant (insured) in the
system
• Insurer promises to pay the insured’s claims in the event
of covered loss.
• Only a small percentage of insured suffers losses.
• Insurance reduce risk through pooling and operation of
law of large numbers.
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19. Basic Characteristics of Insurance
• Pooling of Losses
 Spreading losses incurred by the few over the entire group.
 Risk reduction based on the ‘law of large numbers’
• Payment of fortuitous losses
 Insurance pays for the losses that are unforeseen, unexpected
and occur as a result of chance.
• Risk transfer
 A pure risk is transferred from the insured to the insurer, who
typically is in a stronger finanicial position.
• Indemnification
 The insured is restored to his or her approximate financial
position prior to the occurence of the loss
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20. The Costs and Benefits Insurance System
• Operating Expense
• Distribution cost
• Underwriting cost
• Policy administration cost
• Reserve cost
• Moral hazard resulting in extra
cost
• Exaggerated Losses
• Benefit-cost tradeoff
• Reinsurance cost
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Cost Of Insurance

21. Benefits of Insurance
Benefits of Insurance to Individuals
• Peace of mind
• Aversion of risk
• Protects mortgaged properties
• Provides self dependacy
• Tool of savings
• Tool of Investment
• Satisfies various needs
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22. Benefits of Insurance contn’d..
• Reduced reserve requirements
• Capital freed for invesment
• Indemnification
• Reduction of uncertainity
• Reduced cost of capital
• Reduced credit risk
• Risk assesment / Risk management
• Loss contro activities
• Business and social stability
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Benefits of Insurance to Business

23. Benefits of Insurance contn’d..
• Protects and contributes wealth of the country
(loss prevention, medical research)
• Helps in economic growth
(insurances collect savings and re-invest into the economy)
• Controls inflation
• Social peace
• Stability in families
• Anti-monopoly device.
(Only large corporations would be able to stay in business as small
would not be able to sustain losses and remain in operation)
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Benefits of Insurance to Society

24. LOSS
Loss: being without something previously owned.
Insurable Loss: an undesired, unplanned
reduction of economic value arising from
chance.
(Depreciation and other expenses are exluded)
Direct Losses:
• Immediate, first result of an insured peril
• Property Insurance, Car Insurance
Indirect Losses:
• Consequential losses
• Secondary result of an insured peril
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25. Chance of Loss
• It refers to a fraction;
 Chance of Loss: Actual or expected number of losses
Number of exposures to loss
 A priori chance of loss: expected no. of loss
exposure units
 An ex-post (actual) chance: actual no. of losses
total no. of exposure units
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26. Terms Related to Loss
• Peril : is the cause of loss.
• Hazards : are the conditions that increase either the
frequency or the severity of losses.
• Moral Hazard : If a person does a harm on a property to
have the money for the loss, the loss is said to result
from the moral hazard (dishonesty).
• Morale Hazard : refers to an attitude of indifference or
carelessness to loss created by the purchase of an
insurance contract.
“Why should I care?, I am insured”
• Proximate Cause: The first peril in a chain of events leading
to a loss. The cause without which the loss would not
have occurred. It is the most important concept in
insurance (Hurricane Katrina,2005).
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27. THE MATHEMATICAL BASIS FOR
INSURANCE
• Losses needs to be predicted accurately.
• Law of Large Numbers: The greater the
number of observations of an event based
on chance, the more likely the actual results
will approximate the expected results.
• This system allows an insurance to reduce risk.
• Based on law of large numbers, if there are
large number of similar but not necessarily
identical exposure units, the insurer may be able
to predict future losses with greater accuracy.
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28. Practical Example of the Law of Large
Number
You flip a balanced coin into the air, the
probability of getting head(actual probability) is
0.5. If you flip the coin 10 times, you may get a
head eight times and then the observed
probability of getting a head is 0.8.
If you flipped 1 million times, however, the
actual number of heads would be approximately
500,000. Thus, if the number of random tosses
increases, the actual results approach the
expected results.
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29. UNDERWRITING
• Underwriting :
The process of pricing the insurance and
selecting the insured is called underwriting.
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30. Cash Flow Underwriting
• Cash Flow Underwriting: describes the practice of trying to
attract new business by pricing insurance “at a loss”.
• Loss ratio: Percentage of the earned premium represented by
losses.
incurred losses/ earned premiums
• Expense ratio:
Total Expenses/ written premiums
Unearned premiums: written premiums-earned premiums
• Combined Ratio: sum of the losses and the expense ratio.
• At some cases even with combined ratios above 100 %, the
insurance industries may be making profit because investment
earnings exceeded underwritting losses. Insurance industry making
loss in insurance underwritting but offsetting them by investment
income.
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31. Arson: Who Really Pays for Insured
Losses?
• Arson: Deliberate, malicious burning of a
building or other property t collect
insurance proceeds.
(eg: unprofitable businesses such as restaurants and hotels)
• Selling and reselling the same property between
conspirators, each sale at higher price with the final
highly inflated ‘market’ value being insured.
• Overall, it is the honest premium-paying insured, not the
insurer, who pays for the losses.
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