Risk, Regulation, and Capital Adequacy PDF - The Chartered Insurance Institute

 Risk, regulation and capital adequacy New edition: April 2007 510TB April 2007 Study course 510  © The Chartered Insurance Institute 2007 All rights reserved. Material publishe...

 Risk, regulation and capital adequacy New edition: April 2007 510TB April 2007 Study course 510  © The Chartered Insurance Institute 2007 All rights reserved. Material published in this coursebook is copyright and may not be reproduced in whole or in part including photocopying or recording, for any purpose without the written permission of the copyright holder. Such written permission must also be obtained before any part of this publication is stored in a retrieval system of any nature. This coursebook is supplied for study by the original purchaser of the book only and must not be sold, lent, hired or given to anyone else. Every attempt has been made to ensure the accuracy of this coursebook, however no liability can be accepted for any loss incurred in any way whatsoever by any person relying solely on the information contained within it. The coursebook has been produced solely for the purpose of exam preparation and should not be taken as definitive of the legal position. Specific advice should always be obtained before undertaking any investments. ISBN: 978 1 85369 7104 This revised and updated edition printed April 2007 Previous edition: October 2004 (ISBN 1 85369 419 3) The authors Dr Derek Atkins BSc, PhD, MIM, CEng, FCII, FCMI, Chartered Insurer. Derek has over 30 years' experience working for a large UK composite insurer, initially in Loss Control/Surveying and latterly as Director of Corporate Strategy and Planning. His special interests are: the theory and practice of strategy development and implementation, underwriting and risk control practice, the identification and response to emerging issues, and the development and implementation of business-wide control processes. Ian Bates BSc, FCA. Ian has over 25 years' experience in personal and commercial insurance, initially as an external auditor, and then subsequently as Head of Internal Audit, major change programme director, and most recently strategy director. His special interests are: risk identification, assessment and management, internal control processes, corporate governance, and the identification and response to new strategic challenges. Reviewer for April 2007 edition, chapters 13 and 14 Tony Wiltshire FCII, AdS, Chartered Insurer. The reviewers for October 2004 edition Martin Alderman Bsc, FCCA, ACII, MBA. At the time of going to press, Martin had just been appointed to the role of Internal Audit Manager, Commercial & Underwriting at RSA. Prior to this he worked for UK Commercial in a variety of roles, most recently as Manager, Finance & Operations for Professional & Financial Risks and Business Transformation & Strategic Planning Manager for London Specialist Businesses. Martin has also worked in portfolio underwriting management and spent ten years' working in a number of regional and Head Office finance roles. He completed his ACII in 1998 and is also a qualified accountant. Martin is a member of the RSA UK Community Investment Steering Committee, Secretary to the RSA UK Management Association and a Prince's Trust Business Mentor. Rob Curtis B.Bus, G.Dlp. Ins., MM, MBA, M.Bus FS, FANZII. Rob Curtis is head of ICA Implementation at Aviva plc. Before joining Aviva, Rob was the Director of Economic Capital Management at Royal & SunAlliance where he was responsible for the Capital and Risk Management Transformation team which designed and built a new Capital and Risk Management Framework (CRMF). Prior to RSA, Rob had the lead role as policy developer and drafter for reforms to the non-life insurance sector at the FSA, in particular, designing the new minimum capital requirements and regulatory reporting resulting in CPI9O and DPI2. Rob was also the UK representative on the solvency and actuarial subcommittee of IAIS and drafted the IAIS Stress Testing Paper. Before joining the FSA, Rob was a manager with the Australian Prudential Regulation Authority responsible for conducting risk-based supervision of banks, insurance firms and pension funds and was heavily involved in the reforms to the general insurance industry in Australia. Kerrie Smith Bsc, ACA. As UK Head of Risk, Kerrie heads up the technical risk & compliance team in Royal & SunAlliance's UK Region. The team is comprised of around 20 people, with responsibilities for supporting the business in operating within a regulatory and risk compliant framework. Prior to joining RSA Kerrie spent ten years working with leading financial services organisations to develop and implement risk management tools and techniques. Kerrie is a qualified Chartered Accountant, with a first class honours degree in Mathematics. Dr Bill Stein BA, PhD, FCII. Bill is a senior lecturer at Glasgow Caledonian University, teaching insurance and risk management. Before entering the world of education he gained extensive experience in the insurance industry. He is a Chartered Insurance Practitioner, a Fellow of the Chartered Insurance Institute, a Fellow of the Institute of Risk Management and a Member of the Institute of Learning and Teaching. His research interests include insurance, risk financing, risk management in healthcare, audit and internal control, and risk management in public authorities. Acknowledgements Books are rarely written without a great deal of help having been sought from the author. This text has been no exception. The assistance of a large number of insurance organisations is acknowledged, in their willingness to provide documentation and information on current practice. Special thanks are due to Royal and SunAlliance, The Association of British Insurers, McLarens Loss adjusters, Standard & Poor's Insurance Ratings, and Barlow, Lyde & Gilbert. The CII is grateful to those who have contributed to previous editions of the 510 coursebook: Professor Gordon Dickson Dr Bill Stein Typesetting, page make-up and editorial services CII Learning Solutions Printed and collated in Great Britain.  Examination syllabus 510 Risk, Regulation and capital adequacy Objective: To develop in the candidate: a knowledge and appreciation of the nature of risk and risk management; a knowledge and appreciation of the capital adequacy requirements for insurers and reinsurers; a knowledge and appreciation of the regulatory requirements on the insurance industry; a knowledge and understanding of basic statistical concepts relating to the insurance environment and the estimation of risk; the ability to apply knowledge and skills to practical situations; the ability to synthesise different aspects of the syllabus and apply them to given scenarios. Assumed knowledge and application skills: - analyse the financial implications of risk; - discuss the requirements for companies in order to meet statutory Assumed knowledge may not appear in detail within the regulations in the analysis, reporting and monitoring of risk. learning outcomes but forms part of the syllabus and thus may be examined. It is assumed that the candidate already has 2. Risk management knowledge of the fundamentals of insurance gained from a study of P01 Insurance practice and regulation or an equivalent 2.1 Risk management qualification. Candidates should be able to - give a clear definition of risk management; Method of assessment: See the 2007 Advanced - describe the effectiveness of the risk management process; Diploma in Insurance 'Information for candidates' brochure. - describe the importance to and impact of risk management on businesses. Notes: - The syllabus will be based on UK law and practice. 2.2 Risk identification - The April session will test the legal position as of 31st Candidates should be able to August of the preceding year. - describe the main features of risk identification - The October session will test the legal position as of 28th techniques, including: February of the same year. physical inspections; flow charts; 1. Risk check lists; - recognise the limitations of risk identification techniques and evaluate their effectiveness in different situations. 1.1 Perception of risk and the difference between perceived and actual risk 2.3 Risk analysis Candidates should be able to Candidates should be able to - explain the reasons for the difference between perceived - describe the main features of risk analysis; and actual risk. - recognise the limitations of risk analysis techniques and evaluate their effectiveness in different situations. 1.2 Responses to risk Candidates should be able to 2.4 Risk control - discuss the different responses to risk of individuals and Candidates should be able to corporations. - describe the main features of risk control; 1.3 Utility theory - recognise the limitations of risk control techniques and evaluate Candidates should be able to their effectiveness in different situations; - discuss the need for and measures used in the control of property, - describe the main features of utility theory; liability and pecuniary risks. - apply utility theory to insurance. 1.4 Ways in which risk affects the business environment and the cost of risk Candidates should be able to - describe and analyse the implications of risk for the business environment; © The Chartered Insurance Institute 2007 510/.April 2007 5 Risk, regulation and capital adequacy 2.5 Risk transfer relative frequency; Candidates should be able to subjective probability; - describe and evaluate risk transfer options as part of the - combine probabilities for alternative or joint events. risk management process. 4.8 Normal Distribution 2.6 Characteristics of risk data Candidates should be able to Candidates should be able to - describe and apply the main features of the Normal - describe the characteristics of risk data both qualitative Distribution. and quantitative. 4.9 Calculation of the standard deviation 3. Risk financing Candidates should be able to - understand, calculate and evaluate standard deviation. 3.1 Methods of risk financing 4.10 Application of risk estimation techniques Candidates should be able to Candidates should be able to - explain the main methods of risk financing; - apply risk estimation techniques, including: - explain the use of these methods; linear regression; - assess the implications of using each method. correlation. 4. Risk data 5. Risk pricing 5.1 Basis of premium calculations for reinsurance contracts 4.1 Data collection Candidates should be able to Candidates should be able to - describe the basis of premium calculations for reinsurance - describe typical methods of data collection; contracts; - discuss the nature of internal data and the advantages and disadvantages compared to published data. - assess the factors that need to be considered in this process. 5.2 Pricing of the direct risk and the factors which influence 4.2 Representation of risk data the calculation of the premium Candidates should be able to Candidates should be able to - identify, and describe typical techniques for representing - describe the pricing methods for direct risks; risk data; - construct and interpret methods of data representation - analyse the factors which influence the calculation of the including: premium. graphs; charts; 6. Capital adequacy histograms; 6.1 Capital adequacy and solvency - recommend the most appropriate techniques for Candidates should be able to different situations. - explain the solvency margin and reasons for its calculation; - outline the calculation of solvency requirements; 4.3 Databases - describe the requirements for insurers to submit annual Candidates should be able to financial returns. - outline the uses and features of databases; - describe the process involved in creating databases. 6.2 Monitoring Candidates should be able to 4.4 Sources of data - explain who monitors capital adequacy; Candidates should be able to - outline the consequences for insurers of failing to maintain - list and describe sources of published data. capital adequacy. 4.5 Frequency distributions 6.3 Capital constraints Candidates should be able to Candidates should be able to - construct and use frequency distributions to represent - explain the requirement for capital adequacy and the data. impact of capital constraints in the insurance industry; - outline the treatment of capital under the Financial Services 4.6 Statistical risk measurement Authority Prudential regime; Candidates should be able to - outline the provisions of the Basel Il Capital Accord and - calculate and evaluate the effectiveness of statistical risk assess its implications for the insurance industry. measurement techniques such as: measurement of location; 6.4 Risk-Based Capital measurement of dispersion; Candidates should be able to measurement of skew. - outline the link between risk and capital management; - explain the application of RBC techniques, including 4.7 Probability enhanced capital requirements. Candidates should be able to - describe the concept and main elements of probability; - apply the main methods of deriving probability such as: a priori; 6 510/April 2007 © The Chartered Insurance Institute 2007  Examination syllabus 6.5 Rating agencies Candidates should be able to Additional reading Risk analysis. Gordon C A Dickson. 3rd ed. London: - describe the role of rating agencies and their impact on Witherby, 2003. insurers. Insurance in the single market. Paul Clarke. London: CII Knowledge 7. Regulation and supervision Services. Updated as necessary. Available online at www.cii.co.uk knowledge/factfiles (CIl/Personal Finance Society 7.1 The European Union Candidates should be able to members only). - outline the rights of establishment and freedom of services under the Treaty of Rome and EC directives; The prudential regulation of insurance companies. Tony - analyse their impact on and implications for the Wiltshire. London: CII Knowledge Services. Updated as insurance and reinsurance markets; necessary. Available online at www.cii.co.uk/knowledge/factfiles - explain the principles of the Freedom of Establishment (CIl/Personal Finance Society members only). and the impact for insurers; - outline the principles relating to Home Country and Host The regulation of general insurance business. Tony Wiltshire. Country control; - London: CII Knowledge Services. Updated as necessary. Available online - outline the role of the International Association of at www.cii.co.uk/knowledge/factfiles (CII/Personal Finance Society Insurance Supervisors. members only). 7.2 Financial Services Authority The regulation of insurance, investment and mortgage intermediaries. Candidates should be able to Tony Wiltshire. London: CII Knowledge Services. Updated as necessary. - explain the role, aims and objectives of the FSA; Available online at www.cii.co.uk/knowledge/factfiles (CIl/Personal - discuss the FSA risk based approach to regulation, Finance Society members only). monitoring and supervision; - explain the main FSA provisions for supervision of the UK The regulation of Long-term insurance and investment business. insurance and reinsurance markets, including: Tony Wiltshire. London: CII Knowledge Services. Updated as the role and responsibilities of the Approved necessary. Available online at www.cii.co.uk/knowledge/factfiles Person regime; (ClI/Personal Finance Society members only). Senior Management Arrangements, Systems and Control (SYSC). Reference works 7.3 Training and Competence Dictionary of insurance. C Bennett. London: Pearson Education, Candidates should be able to 2004. Also available online at www.cii.co.uk/knowledge/doi (CIl/Personal Finance Society members only). - outline the training and competence requirements for an insurer and an intermediary; Tolley's insurance handbook. Barlow Lyde & Gilbert. 3rd ed. Croydon: - explain the consequences of non-compliance. LexisNexis UK, 2004. Reading list Tolley's life and allied insurance handbook. Mike Mead... [et al]. The following list provides details of various publications Croydon: Tolley, 2001. which may assist with your studies. The primary text for this syllabus is shown in bold type. Periodicals and publications Kluwer's handbook of insurance. Kingston upon Thames, listed as additional reading will be of value in ensuring Surrey: Croner.CCH. Looseleaf, updated. candidates keep up to date with developments and in providing a wider coverage of syllabus topics. Any reference Regulation of insurance in the United Kingdom and Ireland. materials cited are authoritative, detailed works which should T Henry Ellis, lames A Wiltshire. London: Sweet & Maxwell. be used selectively as and when required. Looseleaf, updated. Note: The examination will test the syllabus alone. The reading list is provided for guidance only and is not in itself Periodicals The Journal. London: The CII. Six issues a year. Also available online the subject of the examination. (CIl/Personal Finance Society members only) at www.cii.co.uk/knowledge/journal CII/Personal Finance Society members can borrow most of these additional study materials from CII Post Magazine. London: Incisive Financial Publishing. Weekly. Knowledge Services and may be able to purchase some at a special discount. For further information on lending and discounts go to www.cii.co.uk/knowledge Websites CII Knowledge Services www.cii.co.uk/knowledge Primary text Risk, regulation and capitaL adequacy. London: The CII. Examination guides Coursebook 510. You are strongly advised to study these before the examination. Please visit www.cii.co.uk to buy online or contact CII Customer Service for further information on +44 (0)20 8989 8464. Exam technique/study skills There are many modestly priced guides available in bookshops. You should choose one which suits your requirements. You will also find advice at www.cii.co.uk/knowledge/careersupport (CIl/Personal Finance Society members only). For a more interactive approach, you should consider: Winning the brain game. London: The CII, 2006. CD.ROM. © The Chartered Insurance Institute 2007 510/.April 2007 7 Risk, regulation and capital adequacy 8 510/April 2007 © The Chartered Insurance Institute 2007  Foreword The 510 syllabus, which can be seen in full at the front of this book has, as its objective, to develop in students: a knowledge and appreciation of the nature of risk, risk management and risk assessment; a knowledge and understanding of capital adequacy requirements for insurers and reinsurers; a knowledge and understanding of the impact of regulation on the insurance industry; a knowledge and understanding of basic statistical concepts relating to the insurance environment and the measurement of risk; and the ability to apply knowledge to given scenarios. This edition of Risk, regulation and capital adequacy is set in five parts to provide a logical sequence for study. It begins with the concept of risk, considers its management, moves on to explain the basic statistical methodology used in the industry, and describes how underwriters use this knowledge to price the individual risks of customers. The final part deals with the increasingly important topic of risk-based regulation and capital adequacy. This involves a significant change of focus from the earlier parts, as we look at risk and risk management from the corporate, 'top down' perspective, i.e. in its totality for the insurer as an entity, rather than as discrete/individual risks. N.B. website references provided in this edition are up to date as at March 2007. © The Chartered Insurance Institute 2007 510/.April 2007 13  Contents 1: The property insurance market A The policyholder 1/2 B Intermediaries 1/3 C Insurers 1/4 D Third party claims administrators 1/5 E Trade and market associations 1/6 2: The policy A Policy interpretation 2/2 B Operative clause 2/3 C Definitions 2/4 D Exclusions 2/5 E Conditions 2/6 F Warranties 2/12 G The schedule 2/13 3: Utmost good faith A Utmost good faith 3/2 B FSA Insurance Conduct of Business rules (ICOB) 3/4 C Rehabilitation of Offenders Act 1974 3/5 D Proposal forms 3/5 E Non-disclosure 3/6 4: Insurable interest A Legal position 4/2 B Types of insurable interest 4/3 C Extent of insurable interest 4/4 D Fixtures and fittings 4/4 5: Proximate cause A Principles 5/2 B Perils policies 5/3 C All risks policies 5/8 6: Indemnity A Principle 6/2 B Replacement 6/2 C Reinstatement Memorandum 6/4 D Public authorities' clause 6/7 E Day One 6/8 F Salvage 6/10 G Debris removal 6/12 H Average 6/12 © The Chartered Insurance Institute 2005 P18/October 2005 7 Property claims handling 7: Contribution A Principle 7/2 B The policy 7/4 C Methods of apportionment 7/4 D Inter-company agreements 7/8 E Other matters 7/10 8: Subrogation A Principle 8/2 B The policy 8/2 C Statute 8/3 D Tort 8/4 E Contract 8/4 F Investigation 8/5 G Other matters 8/5 H Limitations 8/7 9: Claims handling A Reserving 9/2 B Repudiation 9/3 C Regulation 9/4 D Delegated authority 9/4 E Dispute resolution 9/5 F Data Protection Act 1998 9/7 G Money laundering 9/7 10: Fraud A The policy 10/2 B Definition 10/2 C Detection 10/3 11: Basic security devices A Doors 11/3 B Windows 11/4 C Other security devices 11/5 D Miscellaneous 11/6 12: Basic building construction and common defects A Roofs 12/3 B Gutters 12/3 C Walls 12/4 D Drains 12/4 E Chimneys 12/5 F Windows 12/5 G Wetanddryrot 12/5 H Frost 12/6 I Ceilings 12/6 Answers A1-A12 Cases cited i Statutes iii Index vvi 8 P18/October 2005 © The Chartered Insurance Institute 2005  Part 1 Concept of risk In the first part of this coursebook we examine the concept of risk. Chapter 1 considers the meaning of risk, how it is classified, and its costs and benefits. Particular attention is drawn to the importance of recognising both frequency and severity to understand risk. In chapter 2 we look at the different ways that individuals and corporations may react to risk, and explain utility theory.  1 Nature of risk A Meaning of risk B Classification of risk C Cost of risk D Benefits of risk Learning objectives After studying this chapter, you should be able to: outline the ideas incorporated in the meaning of risk; classify risk according to various criteria; describe the extent of risk in various areas (for example: at work, crime, road accidents, fire); and distinguish between the upside and downside of risk. © The Chartered Insurance Institute 2007 510/.April 2007 1/1 Risk, regulation and capital adequacy Introduction The logical starting point for a textbook on this subject must be: exactly what is meant by risk? The word is certainly used frequently in everyday conversation, and seems to be well understood by those using it. To most people, risk implies some form of uncertainty about an outcome in a given situation. An event might occur and, if it does, the outcome is not favourable to us; it is not an outcome we look forward to. The word risk implies both doubt about the future, and that the outcome could leave us in a worse position than we are in at the moment. It is interesting to contrast this with the use of the word chance. Chance also implies some doubt about the outcome in a given situation; the difference is that the possible outcome is usually favourable. We talk about the risk of an accident, the risk of losing our job, but we talk about the chance of winning a bet, the chance of passing an examination. For many people the analysis of what we mean by risk stops there. In fact we have probably gone beyond the level of thought which most people give to the word. However, as students and practitioners in the insurance marketplace, we cannot be content with this relatively brief analysis of the concept. Our understanding of the word is made more difficult by the variety of ways in which it is used in the world of risk management and insurance. Throughout this text, and in common business conversations, we will come across the word risk used to mean different things. For example: Risk as the cause. We use the word risk to refer to the cause of an outcome. In this way we speak about fire as a risk, theft as a risk, personal injury as a risk. If we are looking around a factory and we see a storeroom piled high with empty cardboard packaging, we might say: 'That is a major fire risk!', meaning the risk of fire damage. But we are still using the word risk to mean a potential cause. In those circumstances most risk management professionals prefer to use the expression hazard. Risk as the likelihood. We often talk about the risk of something happening, meaning the probability or likelihood ofit occurring. We sometimes modify this by referring to a high or low risk of some event: leaving the keys in a car results in a high risk of theft; locking the car in a garage results in a lower risk of theft. The implication is that there are levels of risk, degrees of likelihood. Risk as the object. When we talk about going to see a risk, we do not mean that we are going to look at a storm. In this context we mean the object or person at risk. The factory, plane, machine or ship is often referred to as the risk to be covered by an insurance policy, and we might send someone to look at it. Taking a risk. We might say that we are taking a risk by insuring a building against fire. We might decide to risk crossing the road when the traffic is very busy, or we might risk investing money in a new venture. What we mean in these cases is the act of positively placing ourselves in a situation where a loss could occur. So you can see that the word risk is used in lots of different ways. This is all part of the jargon of the world of risk and insurance, and shows how the use of the word goes far beyond that of its use in everyday language. 1/4 510/April 2007 © The Chartered Insurance Institute 2007  1: Nature of risk A Meaning of risk By now you may be asking: 'What is the point of discussing lots of different ways to define risk?' There are two main reasons. Firstly, it is a fact that many writers have published ideas, theories, and philosophies about risk. As students of insurance you will need to be open to all new ideas. Secondly, the most practical of reasons insurance offers protection against risk. It may help you to contribute to the design of the most relevant covers if you understand what risk really means. Writers, particularly in the USA, have produced a number of definitions of risk. These are usually accompanied by lengthy arguments to support the particular view they put forward. Given the brief discussion we have had on the nature and use of the word risk, you can imagine that academics and others have found considerable scope for intellectual discussion. However, despite the variety of definitions, three common threads seem to emerge. Firstly, there is the underlying idea of uncertainty, what we have referred to as doubt about the future. Secondly, there is the implication that there are differing levels or degrees of risk. The use of words such as possibility and unpredictability, do seem to indicate some measure of variability in the effect of this doubt. Thirdly, there is the idea of a result having been brought about by a cause or causes. This does seem to tie in nicely with the working definition we used earlier of uncertainty about the outcome in a given situation. The value of settling on a single definition is questionable, because it is likely to be limited in its ability to capture the comprehensive flavour of risk. It is more valuable for us at this stage to dissect the idea of risk and consider its component parts. Unfortunately, the issue of definition will not go away, particularly when words like risk and risk management are beginning to be used in government regulations. We will therefore be returning to it in chapter 3 when we consider the efforts of risk management professionals to standardise their terminology. Meanwhile, we will look at the three common threads that we have identified. In doing this we may be able to move towards a more comprehensive and practical understanding of the meaning and nature of risk than would be the case if we stuck rigidly to one or two definitions. A1 Uncertainty We have used the word uncertainty several times already. In our first attempt at a working definition of risk, we said that it was uncertainty about the outcome in a given situation. Uncertainty is at the very core of the concept of risk itself, but are we clear what we mean by it when we use the word? We could take the rather philosophical view and say that uncertainty is, like beauty, in the eye of the beholder. We could go a step further than this and say that there is no real uncertainty in the natural order of things in our world. This point is worth exploring a little further as part of our consideration of the nature of risk. An argument can be put which says that uncertainty does not exist in the natural order of things. You may well respond to this by saying that there are a number of outcomes which are uncertain. For example: the weather for the test match; the possibility of being made redundant; the risk of having an accident. There is surely uncertainty surrounding all of these events or is there? We may say that there is a risk of rain, a risk of being made redundant or a risk of being in an accident. We use the phrase almost suggesting that the event may or may not happen. The fact is that the event will or will not occur, there is no doubt about that. What we are really expressing is the fact that we have some doubt as to whether the event will occur or not. We have imperfect information about the future, and this imperfection in our knowledge is what leads to the doubt and hence to the uncertainty which we express. © The Chartered Insurance Institute 2007 510/April 2007 1/3 Risk, regulation and capital adequacy A1A When does uncertainty exist? This rather places the idea of uncertainty, and consequently risk, with the individual and supports the view that uncertainty is in the eye of the beholder. However, we must be careful not to go too far down that road. Are we to say that uncertainty only exists when an individual recognises that they have some doubt about the future? To say that risk and uncertainty only exist when they are recognised by an individual would discount certain situations where we would all agree uncertainty was present, even if not recognised by anyone. Consider a child playing in the middle of a busy road; a workman using a machine while being unaware that it is faulty and dangerous; pedestrians unaware that a wall running alongside a pavement is in a dangerous condition and about to collapse. In each of these situations there is an element of risk and uncertainty. The child may escape injury, the machine may hold out until the workman has finished using it, and the wall may not collapse and injure passers-by. Alternatively, there could be serious injury in each case. The people involved in each of these examples are unaware of the uncertainty, but does this mean that there is no uncertainty? Most people would agree that uncertainty is present, even if it is not recognised by the people who could be affected. We conclude therefore that uncertainty can exist in the abstract: it is not dependent on being recognised as existing by those who may be most directly involved. Uncertainty is linked more to the event itself, rather than to any personal perception of the existence of uncertainty. Now, can we go as far as to say that uncertainty exists even when there is no possibility of personal involvement? If the wall we mentioned earlier is on an uninhabited desert island, is there still uncertainty, is it a risky situation? The difference, of course, is that nobody can be injured. There is no potential for an unfortunate outcome, and this is probably the important point. Under such circumstances it is hard to argue that uncertainty exists. To bring this philosophical discussion to some kind of conclusion, we could say that the concept of uncertainty implies doubt about the future based on a lack of knowledge, or imperfection in knowledge. Uncertainty exists regardless of whether this doubt has been recognised by those who may be most directly involved. A1B Risk as a lack of knowledge The reason for looking at uncertainty is that it forms one of the components of the concept of risk. Going back to the broader idea of risk, and using our understanding of uncertainty, we could say that the basis of risk is lack of knowledge, regard less of whether the state of lack of knowledge is recognised. If we always knew what was going to happen there would be no risk. We would know for certain if our house was going to burn down this year, ifwe were going to have an accident, if burglars were going to select our house, if our car was going to be stolen, and so on. We do not have this knowledge, and hence operate in an uncertain or risky environment. We can therefore say that, risk exists outside the individual. It may be recognised as existing, but this is not a prerequisite. In this sense, it is objective and not dependent on any one individual. Indeed, in chapter 2 we will see that people, very often, do place their own subjective assessments on the existence and level of risk in given situations. By careful study we may seek to 'perfect' our knowledge of the future as much as we possibly can. There may be little that individuals can do to 'perfect' their knowledge, but insurers do have ways of looking into the future. For them it is, to some extent, possible to predict the turn of future events so far as the world at large is concerned. They do this partly by looking at the past to see how loss experience has changed up to the present day (the trends). And partly they look at changes in the world and society in general and form judgements about how this will change loss experience in the future. For example, we can predict reasonably well the number of road accidents next year we begin by looking at the past and adjusting for an upwards, downwards, or even static, trend. Then we adjust for other factors that we feel sure will influence the number of losses in the future for example, predicted number of new cars, new roads, improved braking systems, and factory fitted security devices. Even more sophisticated processing of past information is possible with the use of highly complex mathematical models, such as the computer models now regularly used in weather forecasting. 1/4 510/April 2007 © The Chartered Insurance Institute 2007  1: Nature of risk A2 Level of risk The second component of risk is the idea that there are different levels of risk. We cannot make the assumption that all risks are equally likely to occur, some will be more or less risky than others. What exactly do we mean when we use the word risky; what do levels of risk mean? Example I There is a house by the side of a river which is known for a tendency to overflow its banks. We might use the word risky to describe this situation. There is doubt about the future outcome, there is uncertainty about whether or not the river will flood and cause damage to the house. The fact that the river is known for flooding has heightened the prospect that damage will occur, in fact we may say that the frequency of damage will be high. We use the term 'risky' to denote this heightened possibility. We can see this clearly if we imagine a second house, which is further from the river bank and on a slight hill. This second house would be described as being in a less risky situation. The prospect of the river flooding its banks has not altered in any way, but the possibility of damage being caused to the house as a result is much lower. However, our judgement may be altered by considering the value which is at risk. Let us say that the first house, on the river bank, is a holiday home, rarely used and in a poor state of repair, with a value of no more than £50,000. The second house, on the other hand, is a luxury house valued at more than £500,000. We might want to modify our view about which house represents the higher risk, in view of the higher potential severity. This example highlights two important concepts in the consideration of the level of risk, and we will look at each in turn. A2A Frequency and severity We must recognise that risk is a combination of the likelihood of an event and the severity should the event occur. In the example of the two houses, we can see that the frequency of damage by flooding will be higher for the house on the bank of the river than for the house on the hill. However, the severity of damage, should a flood occur, is likely to be higher for the second house in view of its higher value. When we turn to the assessment of risk in later chapters, we will see that the distinction between frequency and severity of risk is important from an insurance point of view. The reason for this can be illustrated by thinking back to the idea of uncertainty and lack of knowledge about the future. If an event occurs often, then our knowledge about the future begins to increase and an element of certainty begins to creep in. Shoplifting is an example of this kind of high. frequency risk. In many shops there will be a high incidence of shoplifting. The risk is predictable in the sense that the owners of the shop know that, on average, a certain volume of goods will be stolen each year, and hence the uncertainty has been reduced by the frequency of the event. An insurance company can predict events more accurately if the frequency of occurrence is high. This means that the premium they charge is more likely to be accurate than if the event being insured against is very rare. The individual running a high frequency risk must decide whether insurance is the best mechanism for financing the potential losses. They may be better advised to meet the cost of the risk themselves, by reflecting the cost in the product price, rather than insure. This may seem strange but the insurance company will have to charge a premium that is sufficient to cover the expected losses and make provision for profit and expenses. The individual, therefore, could do better to put aside money to meet these almost inevitable losses when they occur, and in this way avoid paying the expenses and profit of the insurance company. These decisions about insurance could almost be taken in isolation of the severity of individual events, but when we combine frequency and severity we find two relationships which predominate. The first relates to a large number of different risk situations where there is a high frequency and low severity profile. Figure 1.1 shows how a summary of household claims might look, first in table form and then as a chart. (We will look at the preparation and use of such charts in chapter 7.) © The Chartered Insurance Institute 2007 510/April 2007 1/5 Risk, regulation and capital adequacy The vertical axis measures the frequency with which events occur and the horizontal axis measures the severity or the cost of the event, should it in fact occur. Many risk situations match this shape. There are a large number of small fires and relatively few large ones. This could translate into a large number of small fires, causing damage to just one room or a few items of furniture, and a few houses being totally destroyed by fire. A person may be willing to fund losses which are frequent and not too severe, but they would be unwilling to consider doing the same for rare events which have the potential for very high costs. This form of relationship between frequency and severity is not limited to fire damage, or even to property loss or damage. Industrial injury incidents follow a very similar pattern. In figure 1.2 we have shown a well-known diagram, which is referred to as the Heinrich triangle. 1/8 510/April 2007 © The Chartered Insurance Institute 2007  1: Nature of risk The second relationship between frequency and severity that we need to consider is low frequency and high severity. Figure 1.3 shows how a summary of aviation claims might look, again, first in table form and then as a chart. The total number of such events will not be as high as the events we illustrated in figure 1.1. However, when they occur they will result in very large costs. Accidents involving ships and planes are an example. When a loss does occur, it is usually very substantial indeed. A2B Utility When we introduced the idea of levels of risk, we said that there were two aspects which merited consideration. We have dealt with the first when we looked at frequency and severity, and now turn to the second issue. This relates more to the measure of risk to which an individual is exposed. We have looked at the number of times an event may occur and the cost should it occur, but we dealt with them as independent components of risk. Utility theory attempts to represent the probability of loss and the cost of loss in one measurement. In chapter 2 we will spend some time looking at utility theory in detail; at the moment it will be sufficient to suggest what is meant by utility and look at how it fits in to our understanding of levels of risk. The value that a person attaches to a risky situation is a function of the probability of the loss occurring and the severity should it occur. The point which utility theory stresses is that this cannot be viewed in isolation from the aggregate wealth of the person. Think back to the problem of the two houses for a moment. We used this example to illustrate the idea that there is both a frequency and severity dimension when we use the word risk. Consider now that the £50,000 house is owned by a man with total assets of £60,000; the loss of the house would represent financial ruin. Even if it were sited up the hill, further from the river, the owner might still consider the risk of flood damage to be high. On the other hand, imagine that the £500,000 house is owned by a multi-millionaire with 10 houses and several million pounds in the bank. The loss of £500,000 would be serious, but in relative terms it would be much less important to him than the loss of £50,000 would be to the first person. This leads us into the whole area of how an individual judges the level of risk, and we will spend some time on this in chapter 2. © The Chartered Insurance Institute 2007 510/April 2007 1/7 Risk, regulation and capital adequacy A3 Periland hazard We have looked at the notion of uncertainty, the fact that there are different levels of risk, and the final component of risk that we will look at is the cause of the eventual loss. We often use the word risk to mean both the event which will give rise to some loss, and the factors which may influence the outcome of a loss. When we think about cause, we must be clear that there are at least these two aspects to it. We can see this if we think back to the two houses on the river bank and the risk of flood. The risk of flood does not really make sense, what we mean is the risk of flood damage. Flood is the cause of the loss and the fact that one of the houses was right on the bank of the river influences the outcome. Flood is the peril and the proximity of the house to the river is the hazard. The peril is the prime cause; it is what will give rise to the loss. Often it is beyond the control of anyone who may be involved. In this way we can say that storm, fire, theft, motor accident and explosion are all perils. Factors which may influence the outcome are referred to as hazards. These hazards are not themselves the cause of the loss, but they can increase or decrease the effect should a peril operate. The consideration of hazard is important when an insurance company is deciding whether or not it should insure some risk and what premium to charge. We will look further at the assessment of hazard in chapter 10. Hazard can be physical or moral. Physical hazard relates to the physical characteristics of the risk, such as the nature of construction of a building, security protection at a shop or factory, or the proximity of houses to a river bank. Moral hazard concerns the human aspects which may influence the outcome. This usually refers to the attitude of the insured person. When used in conjunction with peril and hazard we find that risk means the likelihood that the hazard will indeed cause the peril to operate and cause the loss. For example, if the hazard is old electrical wiring prone to shorting and causing sparks, and the peril is fire, then the risk is the likelihood that the wiring will indeed be a cause of fire. We will conclude the study of the concept of risk itself at this point, and move on to examine some of the various classes of risk. 1/8 510/April 2007 © The Chartered Insurance Institute 2007  1: Nature of risk B Classification of risk We now turn our attention to the classes into which risk can be placed. We are still dealing with abstract ideas and concepts, but on a rather more practical level. If we look at the world of risks and note what is able to be insured, and what is not able to be insured, will we see any patterns emerge? The answer to that question is yes and we can note that risks can be quite easily grouped into several different classifications. Of the many classes we will look at three. Again, you might also ask if there is any useful point in trying to classify risk. The answer to that is: whenever we look at a complex activity, breaking it down into separate classifications is one way to help understand why things are done the way they are, and it may also be useful when considering future plans. It is not just an intellectual exercise for its own sake. B1 Financial and non-financial risk We have already said that risk implies a situation where there is uncertainty about the outcome. A financial risk is one where the outcome can be measured in monetary terms. This is easy to see in the case of material damage to property, theft of property or lost business profit following a fire. In cases of personal injury, it can also be possible to measure financial loss in terms of a court award of damages, or as a result of negotiations between lawyers and insurers. In any of these cases, the outcome of the risky situation can be measured financially. There are other situations where this kind of measurement is not possible. Take the case of the choice of a new car, or the selection of an item from a restaurant menu. These could be construed as risky situations, not because the outcome will cause financial loss, but because the outcome could be uncomfortable or disliked in some other way. We could even go as far as to say that the great social decisions of life are examples of non-financial risks: the selection of a career, the choice of a marriage partner, having children. There may or may not be financial implications, but in the main the outcome is not measurable financially but by other, more human, criteria. Insurance is primarily concerned with risks that have a financially measurable outcome. But not all risks are capable of measurement in financial terms. One example of a risk that is difficult to measure financially is the effect of bad publicity on a company consequently this risk is very difficult to insure. However, this is a good point to stress how innovative some insurers are in that they are always looking for ways to provide new covers which the customers want. The hard part is to be innovative and still make a profit! © The Chartered Insurance Institute 2007 510/April 2007 1/7 Risk, regulation and capital adequacy B2 Pure and speculative risks The second risk classil:ication also concerns the outcome. It distinguishes between those situations where there is only the possibility of loss, and those where there is also the possibility of a gain arising. Pure risks involve a loss or, at best, a break-even situation. The outcome can only be unfavourable to us, or leave us in the same position as we enjoyed before the event occurred. The risk of a motor accident, fire at a factory, theft of goods from a store, or injury at work are all pure risks, with no element of gain attached. The alternative to this is speculative risk, where there is the chance of gain. Investing money in shares is a good example. The investment may result in a loss, or possibly a break-even position, but the reason it was made was the prospect of gain. Example 2 In the world of business there are both pure and speculative risks. Take the case of a food manufacturer. They have a large factory with sophisticated machinery and production lines. They produce a range of foodstuffs for both the home and export markets. Examples of the pure and speculative risks they might experience, are the following: Pure risks Damage to the factory, machinery and stock this could be by lire, storm, explosion, malicious damage, or any other peril. Following damage by a peril, there is the potential for interruption of the business, and the consequential loss of profit. Machinery upon which they depend may break down and take some time to repair or replace. This will involve the cost of repair and may involve a loss of production. They are also exposed to the risk of theft. This includes theft of the finished stock, the raw materials and even the machinery in the factory. A person does not have to work long in the risk and insurance industry to discover that there is no limit to the ingenuity of the determined criminal. Liability also poses a potential threat. They may find themselves liable to employees at work, or visitors to the plant, who may be injured or have property damaged. As a food manufacturer, they may also be liable to any consumer who is injured or otherwise suffers as a result of consuming one of their products. As a food manufacturer, they are also exposed to the risk of their products being tampered with in some criminal way. There have been a number of cases of this over recent years. Speculative risks The pricing of the products. The risk being that a wrong price may either render the products uncompetitive or, not yield a sufficiently high enough return to the company. The price is intended to result in a gain for the company. Marketing decisions all carry a speculative risk. An incorrect interpretation of market needs may cause a loss, but a correct decision could be very profitable. Any decision on diversification, expansion or acquisition could result in substantial gains for the company. They may, however, cause losses. Providing credit to customers can be a risky venture. The goods have been sold in the hope of gain, but the customer may not be in a position to pay and the end result is a loss. These are often referred to as the risks of business or trading risks. Looking at these two lists, it is a wonder that anyone should want to be in business in the first place. It may seem that placing their money in a bank would be far less stressful for the factory owner. However, the world of business is a world of risk and uncertainty, and this is the reason why profit can be made, If the result of all business ventures or decisions was certain, then there would be little scope for one competitor having an edge over another, and taking risks would be impossible. The existence of risk separates the sound from the unsound and, in the end, is for the benefit of the consumer. 1/10 510/April 2007 © The Chartered Insurance Institute 2007  1: Nature of risk The reason for stressing the difference between pure and speculative risks is to highlight the fact that pure risks are usually insurable, while speculative risks are not usually insurable. It is difficult to be dogmatic about this, as practice is changing and the division between pure and speculative is becoming more blurred as time passes. Take the case of the credit risk that we listed under the heading of speculative risks. The goods have been sold on credit in the hope that a gain will result, but a form of credit insurance is available that will meet some of the consequences should the debtor default. However, insurance is not usually available for those risks where the outcome can be a gain and it is easy to see why this should be the case. Speculative risks are entered into voluntarily, in the hope that there will be gain. There would be very little incentive to work towards achieving that gain if it was known that an insurance company would pay up, regardless of the effort expended by the individual. Using the terminology of hazard, we could say that there would be a very high risk of moral hazard. However, we should be clear that the pure risk consequences of speculative risks can be insured against and that more and more people involved in risk and insurance are being asked to handle speculative risks. The stock markets of the world, the home of speculative risks, are increasingly turned to as a means of transferring risk through the purchase of options and futures. These so-called 'Alternative Risk Transfer products' are discussed in chapter 5. Major insurance brokers, and some international insurance and reinsurance groups, are increasingly seeking to develop products in this area. This is another good example of how the division between classifications is becoming less and less clear. B3 Fundamental and particular risks The final classification relates to both the cause and the effect of risk. Fundamental risks are those which arise from causes outside the control olany one individual, or even a group of individuals. In addition, the effect of fundamental risks is felt by large numbers of people. This classification would include earthquakes, floods, famine, volcanoes and other natural disasters. However, it would not be accurate to limit fundamental risk to naturally occurring perils. Social change, political intervention, terrorism and war are all capable of being interpreted as fundamental risks. In contrast to this form of risk, which is impersonal in origin and widespread in effect, we have particular risks. Particular risks are much more personal in both their cause and effect. This would include many of the risks we have already mentioned, such as fire, theft, work related injury and motor accidents. All of these risks arise from individual causes and affect individuals in their consequences. What is interesting is the way in which risks can change classification. This supports the view that risk is a dynamic concept, and that our view of it can be modified as time passes. Much of this movement in classification has been from particular to fundamental. Unemployment was regarded as a particular risk for much of the twentieth century. There was almost the implication that being unemployed was the fault of the individual. However, the technological unemployment of recent decades has changed that view, and we now talk about people 'suffering unemployment'. As a consequence of changes in our industrial and commercial world, the emphasis has moved away from the individual to society as a whole. The evidence of this is seen in the financial provision made for those who are unemployed, in almost all industrialised countries. A similar move has taken place concerning injury in motor accidents, injury at work, and injury caused by faulty products. In each of these cases society has decided that those who are injured should be able to receive compensation, or that those who are injured need not have the burden of proving fault. It does this by passing legislation, which ensures that either, suitable insurance is in force or, those who are injured need not have the burden of proving fault. In the main, particular risks are insurable while fundamental risks are not, but it is difficult to generalise as views in the insurance marketplace change from time to time. We could say that fundamental risks are usually so uncontrollable, widespread and indiscriminate that it is felt they should be the responsibility of society as a whole. The geographical factor is often important, particularly for natural hazards such as flood and earthquake. In many parts of the world these risks would be regarded as fundamental and not insurable, but in the UK they are insurable. © The Chartered Insurance Institute 2007 510/April 2007 1/11 Risk, regulation and capital adequacy 84 Risk and change We must always bear in mind that the world is constantly changing. In the most developed countries this has had considerable impact on what we have come to regard as risk. We tend to live longer and be healthier. We expect to find high levels of health and safety in our workplaces. We are increasingly prepared to pay for safety and environmental protection. In short, we are aiming for the lowest possible risk. On the other hand, we can observe trends of increased risk in many aspects of our lives. In terms of social risk, for example, we can witness more aggressive behaviour, resulting in increased personal injury, physical damage, vandalism and arson. We see more emphasis on public and consumer rights, with ever higher values ascribed to human life and increasing levels of awards in compensation for death and injury. In terms of technological change we see more reliance on complex electronic systems, much greater scope for consequential losses and new risks of obsolescence as the pace of technological development gets even faster. The discussion up to this point has been intended to give a rounded view of the nature of the concept of risk itself. It may have seemed rather philosophical at times, but it has been useful to explore ideas rather than simply accept definitions. We now move on to the much more practical and objective question of the cost of risk. C Cost of risk We can Look at the cost of risk from a number of different perspectives. There is at least the: frequency of risk; monetary cost, or financial severity; and human cost in terms of pain and suffering. There is no doubt at all that, regardless of how we measure risk, it has had a significant impact on the personal and national life of very many countries. We can see this by looking back over the recent past. During the last two decades we have had a number of major incidents, the names of which are recognised across the world. Names such as: 9/11, South Asian Tsunami, Hurricane Katrina, Pakistan, Bali, Bhopal, Mexico City, Exxon Valdez, Madrid, Lockerbie, Piper Alpha, Kobe. These were major events which grabbed the headlines when they occurred. However, they are very much the tip of the risk iceberg. As with the Heinrich triangle, there will be many less serious events for each major incident. It is this main core of risk with which most people in the risk and insurance business will spend their time, the fires, thefts, accidents, liabilities etc., not the major events listed above. To put this in context a little, the number of people who died in the Piper Alpha oil rig disaster was 167. This is roughly the same as the number of people who are killed in road accidents in the UK every two weeks. The Swiss Re publication Sigma produces regular reports on large losses. These make it clear that, since 1970 the number and the extent of natural catastrophes and man-made disasters recorded had been on the increase. This reflects the rising damage potential of: higher population densities; more insured values in endangered areas; higher concentration of values in industrialised countries; and climate change. Visit the website www.swissre.com and browse the Sigma archive. You will be able to download these and a wide range of other useful reports on risk related subjects. 1/12 510/April 2007 © The Chartered Insurance Institute 2007  1: Nature of risk The Sigma Report Nol/2005 Natural Catastrophes and Man-made Disasters in 2004 identified around 330 such events worldwide, in which more than 300,000 people lost their lives. By far the largest number of victims was the 280,000 claimed by the South Asian tsunami.The study puts the total losses attributable to these natural and man-made disasters at $123bn. Of this $49bn was covered by property insurance. For property insurers 2004 was a record year in terms of claims, mainly due to windstorms; hurricanes in the US and neighbouring countries cost insurers around $32bn while typhoons in the Japan region cost another $6bn. These record figures were the result of both the unusually high number of storms (13 hurricanes in US and 10 typhoons in Japan) and the increasing concentration of insured assets in highly exposed coastal areas. Climatologists attribute the high windstorm frequency to above average sea surface temperatures There are many such statistics published on the cost of risk. However, the student should be aware that the true cost of risk is a notoriously difficult concept to measure. In particular: Studies by the Health & Safety Executive and by the Audit Commission have shown that easily identified losses, such as replacement property or court awards, are likely to be exceeded many times by less visible costs such as loss of experience, quality, reputation and cost of retraining. The monetary measures conceal the human dimension of the cost of risk. The pain, suffering, trauma and psychological impact of risk cannot be measured in cold statistics. D Benefits of risk We have looked at the nature of risk, the various classifications into which it can be put, and the cost of risk. The concept which develops is one of risk as an all pervasive force in the world; a negative feature that only has, to use the language of risk management, a downside. The various classifications that we have used all tend to support the view that risk is to be avoided at all costs. It would be valuable to stop here for a moment and take stock of what this means. Are we to conclude that risk brings no benefits, has no upside to it? Is it solely a negative concept, implying toss and not gain? Has the world gained nothing from the existence of risk? Looking back over the history of mankind, we can certainly see the effect of risk. It has had its negative impact, but it is also true to say that there have been many positive outcomes from the ways in which people have been prompted to respond to risk. Think of the great explorers of the Middle Ages; they were certainly risk takers because they ventured off into unknown parts of the globe. In fact, many of them believed the world to be flat and, while we now know that this is not true, they did nott The same could be said of space exploration in the latter part of the twentieth century. People have taken great risks, but mankind has seen the material benefits in so many ways. Medical research is in the same category. Many of the great steps forward in medicine have been achieved at the personal risk of those researchers and patients who were prepared to test new drugs and treatments. There are many other examples in the social history of our world, where people have taken a stand at great personal risk. Suffragettes, prison reformers, emancipation of slavery campaigners, trade unionists and others have all had an impact on our world and our understanding of civilisation. We could argue whether these various achievements are due to risk or to risk taking, but ultimately it is the existence of uncertainty, and the desire to overcome it, which is important. © The Chartered Insurance Institute 2007 510/April 2007 1/13 Risk, regulation and capital adequacy How can this be translated to the world of business? We have already seen the extent of risk in the business world. It enters into all aspects of business life, but does it have any beneficial function at all? One view which could be taken is that risk is at the very heart of any free market economy. Risk enables wealth to be created; it does this in a number of ways: It creates the hope for profit. Entrepreneurs are encouraged to take risks of all kinds, in the hope that the reward will be higher than they could achieve by choosing a safer option. Often, this risk taking will create wealth in the form of employment, goods, services, investment. Risk is a bar to entry into the marketplace for ventures which are unsound, or likely to be short-lived. The cost of risk will be viewed as too high and potential players in the risk marketplace will look elsewhere for a return. The result should be a more competitive marketplace, which is to the benefit of the consumer and the economy. Risk encourages a safety culture. This means safety in its widest sense and includes employees, consumers, the public and the environment. Those who operate in the marketplace cannot afford to run too high a risk. All these points suggest a slightly more positive side to risk taking, but we should modify this by including a form of, 'Health Warning: Risks can have an upside or a downside!' That is, businesses exist in part because there is risk, but this risk can also be their downfall. The answer must be to manage the risks to which the business is exposed, a subject which we will discuss in chapter 3. Summary In this chapter we have introduced the concept of risk and considered what we mean by it. We have considered how it can be classified and its cost and benefits. In the next chapter we will look at how individual perceptions of risk may differ, and how this might affect the approach to the way a risk is dealt with. 1/14 510/April 2007 © The Chartered Insurance Institute 2007  1: Nature of risk Questions 1. List the three components of risk that have been considered. 2. What is the difference between risk and chance? 3. Define peril and hazard, making clear the difference between the two. 4. Draw the Heinrich Triangle and explain briefly what it represents. 5. The construction industry has a very narrow Heinrich Triangle what do we mean by this? © The Chartered Insurance Institute 2007 510/April 2007 1/15 Risk, regulation and capital adequacy 6. Define fundamental and particular risks, making clear the difference between the two. 7. What is the difference between pure and speculative risk, and which (in general) is insurable? 8. List three general requirements for risks to be insurable. You will find the answers at the back of the book 1/16 510/April 2007 © The Chartered Insurance Institute 2007  2 Human perception of risk A Human perception of risk B Utility theory Learning objectives After studying this chapter, you should be able to: outline the different responses to risk of different individuals and corporations; understand that the level of risk is often perceived by individuals as different from the actual risk, and know some of the reasons why this is the case; and state the basics of utility theory, and how they apply to insurance consumption. © The Chartered Insurance Institute 2007 510/April 2007 2/1 Risk, regulation and capital adequacy Introduction In chapter 1 we introduced you to the concept of risk and demonstrated its importance in personal, corporate and national life. We talked about how the word may be used in different contexts, but still retains the underlying ideas of an event having been brought about by a cause, and there being uncertainty about its likelihood of occurrence and the severity of its impact. Some of the ways in which risk can be classified were then mentioned, together with their relevance to the most common of all risk transfer options - insurance. Finally, we noted that, although we tend to think only of the negative aspects of risk, there are also substantial positive aspects that must be recognised. Indeed, the so called 'upside risks' are the very opportunities that drive businesses forward. In this chapter we continue our study of the theoretical background of risk by examining how individual perceptions of similar risks may vary and lead to totally different approaches in the way the risks are dealt with. A Human perception of risk Human beings are complex creatures. You do not really need this book to tell you that some people get pleasure out of risk taking, and that others prefer to avoid risk if they are able to choose. Sometimes we can make choices but sometimes they are made for us. We have already emphasised the pervasive nature of risk, It enters into all aspects of life: Personal Individuals are faced with many different forms of risk: the choice of a career; selecting a course of study to follow; deciding on a suitable investment for savings; even the choice of a marriage partner, could be said to carry a risk with it. Medical Doctors and surgeons are often faced with difficult choices in the face of uncertainty: the decision to operate or not; to prescribe one drug as opposed to another; to diagnose accurately in the light of uncertain and possibly incomplete information. In recent years we have seen the impact of risk on the decisions taken by social workers and others in positions of similar responsibility: should a child be taken into care or left with parents; should a possibly rehabilitated mental patient be released into the community? Political In the world of politics, particularly international politics, the scale of risk is increased significantly. In some parts of the world we have seen the very great risks which many individuals take in demonstrating for democracy. We have also seen the parallel risks which certain politicians take, in allowing freedom to spread. Business The business world is based on risk. Potential investors could simply put their money in a building society or bank, rather than run the risk of a business venture failing. However, they prefer to invest in speculative risk, and hope for a gain by doing so. These are only a few examples of the areas in life which are invaded by risk. What we observe is a wide variation in the response of individuals to the risks; we call this risk appetite: There are individuals who voluntarily take risks or expose themselves to it. For example, there are people who hang-glide for enjoyment, climb mountains, pot hole, play dangerous sports, gamble, never insure. On the other hand, there are people who would never participate in dangerous sports, rarely gamble and who would always insure. Certain businesses take far higher risks than others in the ventures with which they become involved. We have seen examples of this in the past, usually when things go wrong and questions are asked as to why certain risks were ever taken. We see evidence of financial risk in the very existence of the stock market itself. If there were no risk, and hence no possibility of gain or loss, the need for a marketplace where shares are traded would almost disappear. Even in the 'conservative' world of banking and insurance, we see different responses to risk. We can have one bank that will not lend money to a certain country, while the bank next door may trade extensively with that same country. Two insurers may also exhibit quite different attitudes to the same risk. Even where the influence of competition, expense levels and investment income are taken into account, there are still cases where one insurer will want to charge a higher level of 'pure' premium than another. 2/2 510/April 2007 © The Chartered Insurance Institute 2007  What these examples are intended to illustrate is that, individual people, and individual corporations, respond to risk in different ways. We cannot assume that the insuring public will all respond to risk in the same way. The best we can say is that everyone is on a continuum, as we have shown in figure 2.1. At one end we have people who are risk averse. These are the people who will always insure, rarely gamble and take the sate option at every stage. At the other end of the scale are the people who have a predilection for risk, the risk seekers. They gamble, are not as likely to insure and prefer the risky option in any uncertain situation. However, these are the extremes, and there will be very few, if any, people at each end. The vast bulk of people will lie somewhere between the extremes. It will be valuable for us to lay down some kind of behavioural foundation at this point for what will follow in later chapters. We are not suggesting that a full course in psychology is necessary, but there are certain features of attitude towards risk about which we should have some knowledge, particularly as they affect the transaction of insurance. Two particular reasons for taking time to look at the human response to risk are suggested: The first reason is that there is some value in recognising the fact that people are different and have different responses to risk. There is no correct response or behaviour, and it is as well that we understand this fundamental point. People may respond in a way or in a manner which we might find difficult to understand, but that does not necessarily make their response wrong. Insurance is an intangible service. When someone purchases insurance, they do not buy a physical product. What many people are purchasing is security, peace of mind, freedom from financial anxiety. They do not receive something which they can look at, try out, test and display to friends. The extent to which they perceive the need for security and peace of mind is a measure of how likely they are to buy insurance, and of how much they may be willing to pay. We will be in a better position to help them if we ourselves have a firm understanding of how risk is perceived. We are opening up a large area of study and, within the confines of this text, must be selective in what we include. We have selected two principal areas to examine. The first concerns the way people perceive the risks which exist in the world, and the second moves on to look at the response people make to risk, with specific reference to insurance purchasing. Even within these fairly narrow areas we have had to exercise further selection, but this is sufficient, it is hoped, to give a broad overview of relevant ideas. The ideas and theories you will read about in this section are just a few out of many attempts to explain how we behave in relation to risk. The ones we have used have gained some credibility, but there will be others. A1 Actual and perceived risk We start our brief examination of attitudes to risk by focusing on perception of risk and, in particular, on the differences which often emerge between the actual level of risk and the risk as it is perceived by individuals. We do not always act in what can be considered to be a rational manner. In other words, we often overstate or understate the actual level of risk. The problem in this discussion is the definition ofactual'. What does 'actual risk' mean? There are at least two views that we could take: It could mean the risk we can observe by counting, for example, the number of deaths per year in a particular population. We could call this the real, observable risk. Or it could mean the risk as measured in a mathematical way. We could call this the objective risk. © The Chartered Insurance Institute 2007 510/April 2007 2/3 Risk, regulation and capital adequacy A1A Real versus perceived risk One way to look upon the actual level of risk is to compare perception against the known or real risk. In this way, we are construing the actual level of risk as being the known or real level. Will people perceive different risks in line with their actual or real level? There has been a great deal of research dealing with this question. In recent years much of the work has been related to energy sources, such as nuclear power, where researchers have been trying to understand the way in which people perceive the level of risk associated with nuclear power stations, as opposed to more conventional forms of energy. There has also been work of a more general nature, and one of the best known of such pieces of research was by Slovic, Fischoff, Lichtenstein and others. These American researchers have been fairly prolific over many years and have produced some very interesting work. The particular piece of research that we are going to look at was quoted in a major study by the Royal Society in 1981: The Assessment and Perception of Risk The researchers asked a number of people to estimate how many people died, in one year, from 41 different causes of death. As a benchmark, the people involved in the experiment were given the real number of deaths in road accidents. Once all the people had responded, the estimates for each cause were averaged, and these 41 averages were compared with the real number of deaths for each cause. The real numbers were obtained from official government sources. An extract of one of their findings is shown in figure 2.2. The real numbers of deaths cover a very wide numerical range and so a logarithmic scale was used for the axes. Rather than have a scale which increased in steps of the same size, the axes have a scale which moves from one to ten, to one hundred, to one thousand, and so on. This allows smaller figures to be plotted with a reasonable degree of accuracy, while very large figures can still be fitted on the graph. Only a few of the 41 causes of death are plotted on the graph. In addition, a diagonal line which bisects the origin of the graph is shown. At every point along this line, the estimated number of deaths per year equals the real number of deaths per year. That is to say, if the estimate was exactly correct (equal to the real number of deaths), then the point plotted would be on this Line. An example of this is the point for deaths due to motor accidents; we would expect this because the real figure was given to the people taking part in the experiment, as a benchmark. 2/4 510/April 2007 © The Chartered Insurance Institute 2007  2: Human perception of risk Other points plotted do not lie on this line, some lie above and some below it. Let us first consider any point above the line: in this area the estimated number of deaths per year is higher than the real number of deaths (that is, deaths were overestimated). Similarly, in the area below the line the estimated number of deaths per year is lower than the real number (that is, deaths were underestimated). When we look at the graph, a number of interesting features emerge: The events which we could describe as dramatic or glamorous are overestimated. These would include tornado, flood and botulism. There are many reasons why such events should be overestimated by the public, but the easiest to see is probably the effect of the media. Certain causes of death do seem to receive much more media attention than others, and it is not unreasonable to suggest that these causes would be overstated. The medical, and less media related, events such as diabetes, heart disease and strokes are underestimated by the public. These are the common events, the causes of death with which we are all familiar, and yet they were understated. There was a tendency to overestimate low frequency events and to underestimate high frequency events. Events which are on the same horizontal line imply that the respondents estimated the same number of deaths, but the real number of deaths was quite different. An example of this is pregnancy and diabetes. These two causes had roughly the same estimate of number of deaths, but in fact diabetes accounted for about 80 times the number of deaths arising from pregnancy. Causes of death which are on the same vertical line imply that the respondents estimated quite different numbers dying from causes which in fact accounted for the same number of deaths. We can see how far away the estimate of those dying from diabetes is from the figure for road deaths, and yet about the same number die from these two causes. The above pie