Chapter 1 Notes

Chapter 1: The Problem of Risk The Concept of Risk - Basic Problem with which insurance deals - Insurance theorists have not been able to agree on a definition Common Elements in Definitions of Risk - Indeterminacy - at least two possible outcomes are possible - Adversity - at least one of the outcomes is undesirable and results in a loss. With risk: Something can happen and something can't happen. Outcome: Something will and something won't The Text's Definition of Risk - " Risk is a condition in which there is a possibility of an adverse deviation from a desired outcome that is expected or hoped for." o Risk not subjective - a state of the real world where the probability of an adverse event is between 0 and 1. o Risk can exist whether or not it is perceived o The probability of an adverse event may not be measurable, but still exist. Uncertainty and its Relationship to Risk The most widely held meaning of uncertainty refers to a state of mind characterized by a lack of knowledge or doubt about the future. It is contrasted with certainty , as in - I am certain I will get an A in this course." - "I am uncertain what grade I will get." The Degree of Risk What is more risk or less risk? Varies with the probability of deviation o from what is expected in case of aggregate data o from what is hoped for (no loss) in case of individual Risk Distinguished From Peril and Hazard ***(NEED TO KNOW) *** - Peril: The cause of loss - Hazard: a condition that creates or increases the chance of loss. - Ex: Car Accident o Peril: driving to fast (Cause) o Condition: the snow (Condition that caused it) - Ex: House burns down o Peril: fire o Condition: fireplace, heated blanket
Classifications of Hazards 1. Physical: Bad space heater 2. Moral: I have insurance so I'm not going to clean my fireplace 3. Morale: Set fire to the house on purpose 4. A fourth type of hazard--legal hazard should also be recognized. Classifications of Risk: Pure and speculative Speculative risks involve the possibility of loss or gain. They are voluntarily accepted because of the possibility of gain. Pure risks involve the possibility of loss or no loss only. In general, insurance deals with pure risks only. You will win or loss Pure risk: had a possibility of getting into a car crash or not . Insurable Speculative: gambling is NOT insurable Classifications of Pure Risk: 1. Personal risks o Personal risks consist of the possibility of loss of income or assets as a result of the loss of the ability to earn income. In general, earning power is subject to four perils: a. premature death, b. dependent old age, c. sickness or disability, and d. unemployment. 2. Property risks o Property risks embrace two types of loss: direct loss and indirect or "consequential" loss. i. Direct loss is the loss of the property itself, and is measured by the value of the property or the cost of repairing the property. ii. Indirect loss results from the loss of use of the asset that is damaged or destroyed, for the period required to repair or replace the property. Example of Indirect loss: the loss of the use of your car after a car accident. 3. Liability risks: Hit someone else when driving (Not too important to know.) o Liability risks therefore involve the possibility of loss of present assets or future income as a result of damages assessed or legal liability arising out of either intentional or unintentional torts, or invasion of the rights of others 4. Risks arising out of failure of others: Hiring someone to put in new flooring and they damage your walls.
- When a person who has agreed to meet an obligation might fail to do so and such failure would produce financial loss, risk exists. - Examples of risks in this category include failure of a contractor to complete a construction project as scheduled, or failure of debtors to make payments as expected. The Burden of Risk: a. Some losses will occur b. The cost of accumulated reserves c. Deterrent effect on capital accumulation d. Higher cost of capital e. Feeling of frustration and mental unrest Increasing Variety of Risks: - The earliest risks were exposure to the ravages of nature and predators. Advances in technology produced new risks: industrialization power sources legal system Risks of the Modern Environment: - Many risks facing individuals and organizations today were unknown a generation ago. Liability for environmental damage, discrimination in employment, sexual harassment, and violence in the workplace. Hazards of the nuclear age Terrorism — bombings Risks related to information technology - Cyber Increasing Severity of Losses: - Although earthquakes, floods, and storms occur at about the same rate as in the past, each new catastrophe seems to exceed previous losses. There is simply more wealth, more assets and more investment exposed to loss. As business has become more capital intensive, capital investment increases and with it, the risk of financial loss. Important: Know the difference between Frequency and Severity o Frequency refers to the number of claims that an insurer expects to see. High frequency means that a large number of claims is expected to come in. o Severity refers to the cost of a claim, with high severity claims being more expensive than average estimates and low severity claims being less expensive than the average. Managing Risk:
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