Chapter 1: Risk and Insurance PDF

# Chapter 1: Risk and Insurance ## Introduction - This chapter focuses on the *concept of risk* and how it is *perceived*. - It discusses how insurance acts as a *risk transfer mechanism*. - It introduces the *main classes of insurance*. ### Key Terms | Term | Description | |---|---| | Attitude...

# Chapter 1: Risk and Insurance ## Introduction - This chapter focuses on the *concept of risk* and how it is *perceived*. - It discusses how insurance acts as a *risk transfer mechanism*. - It introduces the *main classes of insurance*. ### Key Terms | Term | Description | |---|---| | Attitude to risk | | | Co-insurance | | | Dual insurance | | | Financial risks | | | Fortuitous events | | | Homogeneous exposures | | | Moral hazard | | | Particular risks | | | Peril | | | Equitable premiums | | | Insurable interest | | | Law of large numbers | | | Physical hazard | | | Pure risks | | | Risk management | | | Self-insurance | | ## The Role of Risk in Insurance - *Risk* can refer to the event being insured against, like *fire* or *theft*. - It can refer to the *object* being insured (*a car, a house*). - Underwriters may talk about being *'on risk'*, which means the item is insured by their company. - *Risk* can also refer to a *potential hazard*. - We are *responsible* for the risks we choose to take, yet *some risks are outside our control*. - *Insurance* can help protect us from some of the risks we face. - We can *transfer some risk* by taking out an insurance policy. ## Principal Definitions of Risk - Different ways of defining risk: - *Doubt concerning the outcome of a situation*. - *Unpredictability*. - *The possibility of loss*. - *The chance of gain*. - **Example: Owning a Car** - *Risk of theft*. - *Risk of a car accident*. - *Risk of injury to driver*. - *Risk of injuring others*. - *Risk of damage to the car*. - *Risk of car depreciation*. - **Insurance** protects against these risks. - It replaces the *unknown financial loss* (the risk) with a *known cost* (the premium). - It *transfers the risk* from the policyholder to *the insurer*. ## Other Common Uses of Risk in the Insurance Industry - *The peril that is insured* (the fire risk, the theft risk, etc.). - The *thing or subject-matter actually being insured* (e.g., a manufacturer's liability to the public). - **Understanding the Term in Different Contexts** - An underwriter might ask, *'I've just seen crime statistics for this postcode, what is the risk of this house being burgled?'*. - A commercial underwriter might say, *'we have received a large risk of three offices to insure'*. ## Risk Perception - People perceive risk differently. - A *business owner* might be concerned about a *recession*. - A *parent* might be worried about *their children's safety*. - We all make *risk assessments* informally. - *Deciding whether to take an umbrella based on a weather forecast.* - *Looking out the window to make a judgment about the possibility of rain.* - **Importance of Risk Measurement** - The approach described above for casual events may be suitable in *low-risk scenarios*. - However, we need *better measurement tools* in situations where *the potential for loss is significant*. ## Example 1.1 - *Risk perception* can vary significantly between individuals. - Many are more concerned about *airplane crashes* than *car accidents*, even though the risk of a car accident is higher. - This perception can be influenced by *perceived control*. - Someone recently involved in a motor accident might overestimate *the risk of it happening again*. ## Attitude to Risk - People have different *attitudes toward risk*. - Some are *risk-seeking*, willing to take risks. - Others are *risk-averse*, seeking to *minimize risk*. ## Categories of Risk - Financial and Non-Financial Risks - **Financial risks:** The outcome can be measured in *monetary terms*. - **Non-financial risks:** The outcome cannot be measured in *monetary terms*. - Pure and Speculative Risks - **Pure risks:** Only involve the possibility of *loss* (or *breaking even*). There is no chance of *gain*. - **Speculative risks:** Involve the possibilities of *loss, break-even, or gain*. Insurers do not typically insure these risks, as they are voluntarily undertaken. - Particular and Fundamental Risks - **Particular risks:** Affect *individuals or local communities*. - **Fundamental risks:** Affect *large groups of people* (e.g., war, economic recession, natural disasters). ## Financial and Non-Financial Risks - *Financial risks* are *insurable* because they have a *measurable value* attached to them. - *Non-financial risks* are *not insurable* because the outcome is not measurable in monetary terms. ### Examples | Loss | What Is Insurable? | |---|---| | Accidental damage to a motor car | The Cost of Repairing or Replacing the Vehicle | | Theft of property | The item's current market value (sentimental is not measurable). | | Loss of business profits following a fire | Measurable since comparisons to similar periods can be made to determine a fair estimate of the loss to be paid as compensation. | - *Insurance* should be considered for risks where *the outcome can be measured in financial terms*. ## Pure and Speculative Risks - **Pure Risk:** The best outcome is to break even, the worst is a loss. | Pure Risk | Information | |---|---| | Risk of fire | Could cause damage or destroy property or cause an interruption to the running of a business, both of which are measurable financially. | | Risk of machinery breakdown | Could lead to actual damage or business interruption, which is measurable in financial terms. | | Risk of injury to employees at work | If such injury is caused by the negligence of the company, a court may award damages and costs. | - **Speculative Risk:** There is the possibility of loss, breakeven, or gain. *Examples*: Gambling, Investing in the stock market, and starting up a new business. ## Particular and Fundamental Risks - **Particular Risk:** Affects a limited number of people or a small geographical area. | Particular Risk | Information | |---|---| | Factory fire | Cause localized damage to the factory and potentially to its surroundings, but would not affect the whole community. | | Car collision | Damage to vehicles and any third-party liability are localized events affecting relatively few individuals. | | Theft of personal possessions from a home | An event affecting only an individual or family. | - **Fundamental Risk:** Affects large groups of people or a wide geographical area, often catastrophic. Examples include *economic recession, war, earthquake, and famine*. - Some fundamental risks can be insured *individually,* like loss of income after a recession due to job loss. ## Features of Insurable Risks - For a risk to be insurable, it must: - Be *fortuitous* (accidental or unexpected). - Have *insurable interest* (the insured must suffer a financial loss). - *Not be against public policy* (e.g., insurance for a criminal activity). - *Homogeneous exposures* (enough similar risks to make accurate predictions about losses). ## Fortuitous Event - An *insurable event* must be *unforeseen* and *accidental*. - It cannot be something within the control of the insured. ### Example: Burglaries - Two apartments are burglarized. - The first was *properly secured* but the burglar forced entry through a window. - The second apartment had *keys left in the door* and *open windows*. - The first burglary is *fortuitous* and *likely to be covered by insurance*. - The second burglary is *not fortuitous* and *likely to be denied coverage*. ## Insurable Interest - **Insurable interest** is a *legally recognized financial relationship* between the insurer and the *object* being insured. - To insure against *theft of a car*, you must *own the car* and would *suffer a financial loss* if it were stolen. ## Public Policy - Insurers *cannot* cover risks that: - Are *against public policy* (e.g., insurance for a crime like speeding). - *Encourage breaking the law*. - Lack *homogeneous exposures* (enough similar risks for accurate predictions). ## Homogeneous Exposures - *Insurers* need *a large number of similar risks* to predict the *frequency and extent* of losses. - This is based on the *law of large numbers*. - The *more similar risks* there are, *the more accurate* the predictions become. ## Components of Risk - Risk involves: - *Uncertainty* (we don’t know what will happen in the future). - *Level of risk* (how likely an event is to occur and what the cost would be). - *Peril* (the cause of the loss). - *Hazard* (something that influences the peril). ## Uncertainty - We are *always uncertain* about the future. - If we knew exactly what would happen, there would be no *risk*. ## Level of Risk - Insurers assess risk in terms of: - *Frequency* (how often the event might happen). - *Severity* (how costly the event would be). ### Example: Flooding - A house *near a river* that floods frequently has a *higher risk* of flooding. - A house *further from the river* on a hill has a *lower risk* of flooding. - The *severity* of the loss is higher for a *larger house*. - There is a correlation between *frequency and severity*. - *High frequency, low severity events*: Dented bumpers, cracked windshields (common but inexpensive). - *Low frequency, high severity events*: Aircraft accidents, oil spills (rare but very costly). ## Peril and Hazard - The *peril* is that which gives rise to the *loss*. - The *hazard* is that which *influences the operation of the peril*. ### Example: House Fire - **Peril:** Fire - **Hazard:** Smoking a cigarette (increases the likelihood of fire). ## Physical Hazard - *Physical hazard* relates to the physical characteristics of the risk. - *Examples*: The type of construction of a building, the condition of a motor vehicle, and the age of an insured. ## Moral Hazard - *Moral hazard* relates to the insured's *attitudes and behaviors*. - *Examples*: *Carelessness*, *intentional recklessness*, and *fraud*. - Moral hazard can also arise from the behavior of *employees or the general public.* - *Moral hazard* is often difficult to separate from *physical hazard*. - A *dangerous workplace* could result from *lack of proper safety protocols* (physical hazard) or *negligence by employees* (moral hazard). ## Insurance as a Risk Transfer Mechanism - The primary function of insurance is to *transfer risk*. - Individuals exchange a *large unknown financial risk* for a *smaller, more certain cost* (the premium). - This provides *peace of mind* and *financial security* for the insured. ## Risk Management - Risk management involves: - *Identifying risks*. - *Analyzing risks* (looking at frequency and severity). - *Controlling risks* (reducing or eliminating them). ## Benefits of Insurance - Insurance benefits *businesses and society at large*. - **Benefits for Businesses:** - *Improved cash flow* because money does not need to be held in reserve for potential losses. - *Expansion of business* is encouraged as insurance makes it easier to invest, innovate, and grow. - *Loss control* efforts to reduce both the frequency and severity of losses, benefiting both the insurer and policyholder. - Premiums can be *invested to earn interest*, creating a *premium reserve*. - **Benefits for Society:** - *Social benefits* such as promoting business activity, keeping people employed, and providing insurance coverage for business interruption losses. ## Key Points - *Risk*: An element of *uncertainty, unpredictability, and sometimes danger*. - *Insurance*: Acts as a *risk transfer mechanism*; individuals exchange an unknown financial risk for a known cost. - *Types of risk*: - *Financial risks*: Measurable in monetary terms. - *Non-financial risks*: Not measurable in monetary terms. - *Pure risks*: Only involve the possibility of loss. - *Speculative risks*: Involve the possibility of loss, break-even, or gain. - *Particular risks*: Affect individuals or local communities. - *Fundamental risks*: Affect large groups of people or wide geographic areas. - *Features of insurable risks*: They must be fortuitous, have insurable interest, not be against public policy, and be based on homogeneous exposures. - *Components of risk*: Frequency, severity, peril, and hazard. ## Conclusion - Insurance plays a vital role in *managing risk* for individuals and businesses. - It *transfers risk* from the insured to the insurer, providing peace of mind and financial security. - Risk management is an essential part of conducting business; it aims to *identify, analyze, and control risks*.