Understanding Risk, Peril, and Hazards

• Risk is traditionally defined as uncertainty concerning the occurrence of a loss.
• In the insurance industry, risk identifies what is being considered for insurance.
• In economics and finance, risk is used when probabilities of outcomes are known.
• Uncertainty is used when probabilities of outcomes are not estimated.
• Loss Exposure: Any situation or event in which a loss is possible.
• Objective risk is the relative variation of actual loss from expected loss, calculated statistically.
• Subjective (perceived) risk is uncertainty based on a person's mental condition.
• Chance of loss: The probability that an event that causes a loss will occur.
• Objective probability is the long-run relative frequency of an event based on assumptions.
• Subjective probability is an individual's personal estimate of the chance of loss.
• A peril is defined as the cause of the loss.
• A hazard is a condition that creates or increases the frequency or severity of loss.

Hazards

• Physical hazard: A physical condition that increases the frequency or severity of loss.
• Moral hazard: Dishonesty or character defects that increase loss frequency or severity.
• Attitudinal Hazard (Morale Hazard): Carelessness that increases loss frequency or severity.
• Legal Hazard: Characteristics of the legal/regulatory environment that increase loss frequency or severity.

Classifications of Risk

• Pure risk: Situations with only loss or no loss possibilities. (e.g., earthquake)
• Speculative risk: Situations where profit or loss is possible. (e.g., gambling)
• Diversifiable risk: Affects individuals or small groups, can be reduced by diversification. (e.g., car theft)
• Nondiversifiable risk: Affects the entire economy, also called fundamental risk; government aid may be needed. (e.g., hurricane)
• Enterprise risk: Encompasses all major risks faced by a business firm.
• Strategic Risk refers to uncertainty regarding the firm's financial goals and objectives.
• Operational risk results from the firm's business operations.
• Financial Risk refers to the uncertainty of loss because of adverse changes in commodity prices, interest rates, foreign exchange rates, and the value of money.
• Enterprise Risk Management: Combines all major risks into a single program.
• By packaging major risks into a single program, the firm can offset one risk against another.
• As long as all risks are not perfectly correlated, the firm can offset one risk against another, thus reducing the firm's overall risk.
• Financial risks require complex hedging techniques and financial instruments for treatment.
• Systemic risk: Risk of collapse of an entire system due to failure of a single entity.

Personal and Commercial Risks

• Personal risks: Directly affect individuals or families, involving loss/reduction of income, extra expenses, or depletion of assets.
• Premature death, retirement risks, poor health, unemployment, and addiction are examples of personal risks.
• Property risks: Involve losses associated with destruction/theft of property.
• Direct loss: Financial loss from physical damage/theft of property (e.g., fire damage to home).
• Indirect loss: Financial loss indirectly resulting from direct physical damage/theft (e.g., extra living expenses after a fire).
• Liability risks: Being held legally liable for bodily injury/property damage to someone else.
• There is no maximum upper limit with respect to the amount of the loss for liability risks.
• A lien can be placed on your income and financial assets for liability risks.
• Legal defense costs can be enormous for liability risks.
• Firms face pure risks with serious financial consequences if a loss occurs.
• Examples of property risks for firms are damage to buildings, furniture, and office equipment.
• Examples of liability risks for firms are suits for defective products, pollution, and sexual harassment.
• Firms may experience a loss of business income if they must shut down after a physical damage loss.
• Firms face cybersecurity and identity theft risks from thieves breaking into computer systems.
• Firms face human resources exposures with job-related injuries.
• Firms face foreign loss exposures with acts of terrorism.
• Firms face intangible property exposures, such as damage to the market reputation and public image of the company.
• Firms face government exposures, such as violation of safety standards.

Burden of Risk on Society

• There are three major burdens when risk is present on society:
• Large emergency funds must be maintained in absence of insurance
• Innovation can be discouraged by the risk of liability lawsuits
• Risk causes worry and fear

Techniques for Managing Risk

• Risk Control: Techniques that reduce the frequency/severity of losses.
• Risk control includes avoidance, loss prevention, and loss reduction.
• Loss prevention: Activities that reduce the frequency of losses.
• Loss reduction: Activities that reduce the severity of losses.
• Loss reduction includes duplication, separation, and diversification.
• Risk Financing: Techniques providing funding for losses.
• Retention means business or individual will retain part or all of the losses that result.
• Active retention: Individual is aware of risk and deliberately plans to retain all or part of it.
• Passive retention: Risks unknowingly retained due to ignorance, indifference, or laziness.
• Self-Insurance: Planned retention where part/all of loss exposure is retained by the firm.
• Noninsurance transfer: Transferring risk to another party.
• A hold-harmless clause in a contract is a risk transfer by contract.
• Hedging is transferring the risk of price fluctuations to a speculator.
• Incorporation transfers creditors the risk of insufficient assets.
• Insurance: Practical approach for handling major risks due to risk transfer to the insurer. The pooling technique is used to spread the losses of the few over the entire group Risk may be reduced by application of the law of large numbers