Understanding Risk and Probability

Definitions of Risk

• Risk refers to the uncertain possibility of a loss occurring

Loss Exposure

• Loss exposure is any situation with the possibility of a loss, regardless of whether it occurs

Objective Risk vs. Subjective Risk

• Objective risk is the relative variation of actual loss from expected loss and can be statistically calculated
• Subjective risk is the uncertainty based on a person's mental condition or state of mind
• Different people may have different perceptions of risk in the same situation
• High subjective risk often leads to conservative behavior

Chance of Loss

• Chance of loss is the probability of an event occurring

Objective Probability vs. Subjective Probability

• Objective probability refers to the long-run relative frequency of an event, assuming infinite observations without underlying condition changes, and can be determined deductively or inductively
• Subjective probability is an individual's personal estimate of the chance of loss, which may differ from objective probability

Peril and Hazard

• Peril is the cause of a loss, like a collision in a car accident
• Hazard is a condition increasing the chance of loss
  • Physical hazards are physical conditions increasing the chance of loss like icy roads
  • Moral hazard is dishonesty that increases the chance of loss like faking accidents
  • Attitudinal hazard is carelessness that increases the frequency or severity of a loss
  • Legal hazard refers to legal system characteristics increasing the chance of loss

Classification of Risk: Pure and Speculative Risk

• Pure risk involves only loss or no loss possibilities
• Speculative risk involves possibilities of profit or loss

Diversifiable Risk and Nondiversifiable Risk

• Diversifiable risk affects only individuals or small groups; also called nonsystematic or particular risk
• Nondiversifiable risk affects the entire economy or large groups; also called systematic or fundamental risk
• Government assistance may be necessary to insure nondiversifiable risks

Classification of Risk: Enterprise Risk

• Enterprise risk includes all major risks faced by a business: pure, speculative, strategic, operational, financial

Financial Risk

• Financial risk refers to uncertainty of loss due to adverse changes in commodity prices, interest rates, exchange rates, and the value of money

Enterprise Risk Management

• Enterprise risk management combines all major risks faced by a firm which include: pure. speculative, strategic, operational, and financial risks into a single unified treatment program

Major Personal Risks

• Involve the possibility of lost income, extra expenses, or depleted assets
  • Premature death of family head
  • Insufficient income during retirement
  • Poor health
  • Involuntary unemployment

Property Risks

• Involve the possibility of losses from destruction or theft
  • Direct loss is financial loss from physical damage, destruction, or theft
  • Indirect loss results indirectly from a physical damage or theft, these additional expenses are described as a consequential loss

Liability Risks

• Involve being held liable for injury or property damage to someone else like lawsuits
  • There is no upper limit to the amount of the loss
  • A lien can be placed on income and assets
  • Defense costs can be enormous

Commercial Risks

• Commercial risks can have serious financial consequences including pure risks such as:
  • Property risks like damage to buildings
  • Liability risks like suits for defective products
  • Loss of business income
  • Other risks, including crime, intangible property, human resource, foreign and governmental risks

Burden of Risk on Society

• The presence of risk results in major burdens including:
  • Requires emergency funds to be maintained
  • Discourages innovation
  • Causes worry and fear

Techniques for Managing Risk

• There are five major methods for managing risk
  • Avoidance is avoiding risk
  • Loss control involves activities to reduce the frequency of losses
  • Prevention refers to activities that lower the intensity of losses

Risk Retention

• An individual or firm retains all or part of all risks
  • Active retention is when an individual is consciously aware of the risk and deliberately plans to retain all or part of it
  • Passive retention means risks may be unknowingly retained due to ignorance
  • Self-insurance is a form of planned retention where the firm retains part or all of a given loss exposure

Noninsurance Transfers

• Risk may be transferred to another party by several methods including
  • Contract such as through a service contract or hold-harmless clause
  • Hedging is a technique for transferring the risk of unfavorable price fluctuations to a speculator
  • Incorporation of a business firm transfers to the creditors the risk of not being able to pay debts

Insurance

• For most people, insurance is the most practical method for handling a major risk