GE31103 Risk Management & Insurance Sem 1 2022/2023 Chapter 2 PDF

GE31103 RISK MANAGEMENT AND INSURANCE SEM 1 (2022/2023) CHAPTER 2 RISK AND ITS TREATMENT Labuan Faculty of International Finance Universiti Malaysia Sabah Labuan International Campus Dr. Hjh Haneffa Muchlis Gazali Senior Lecturer in Isla...

GE31103 RISK MANAGEMENT AND INSURANCE SEM 1 (2022/2023) CHAPTER 2 RISK AND ITS TREATMENT Labuan Faculty of International Finance Universiti Malaysia Sabah Labuan International Campus Dr. Hjh Haneffa Muchlis Gazali Senior Lecturer in Islamic Finance, FKAL, UMS 23/10/2023 1 2 1. Historical Definition of Risk Risk: risk is defined as uncertainty concerning the occurrence of a loss. Example: i. The risk of lung cancer for smokers is present because uncertainty is present. ii. The risk of flunking a required college course is present because uncertainty is present 3 1. Historical Definition of Risk Risk Term risk is used in situations where the probabilities of possible outcomes are known or distinguished can be estimated with some degree of accuracy, whereas uncertainty is used in situations where such probabilities cannot be estimated. from uncertainty Example: The probability of dying at each attained age can be estimated with considerable accuracy. In contrast, the probability of the destruction of your home by a meteorite from outer space is only a guess and generally cannot be accurately estimated. A loss exposure is any situation or circumstance in which a loss is possible, regardless of Loss exposure whether a loss actually occurs. Example: Manufacturing plants that may be damaged by an earthquake or flood, defective products that may result in lawsuits against the manufacturer, possible theft of company property because of inadequate security, and potential injury to employees because of unsafe working conditions. 4 1. Historical Definition of Risk Defined as the relative variation of actual loss from expected loss. Objective risk Example: Assume that a property insurer has 10,000 houses insured over a long period and, on average, 1 percent, or 100 houses, burn each year. However, it would be rare for exactly 100 houses to burn each year. The law of large numbers states that as the number of exposure units increases, the more closely the actual loss experience will approach the expected loss experience. Defined as uncertainty based on a person’s mental condition or state of mind. Subjective risk (perceived risk) Example: Assume that a driver with several convictions for drunk driving is drinking heavily in a neighborhood bar and foolishly attempts to drive home. The driver may be uncertain whether he will arrive home safely without being arrested by the police for drunk driving. This mental uncertainty or perception is called subjective risk. High subjective risk often results in conservative and prudent behavior, whereas low subjective risk may result in less conservative behavior 5 2. Chance of Loss Chance of loss is closely related to the concept of risk. Chance of loss is defined as the probability that an event will occur. Like risk, probability has both objective and subjective aspects. Objective Refers to the long-run relative frequency of an event based on the assumptions of an infinite number of observations and of no probability change in the underlying conditions. i. Deductive reasoning For example, the probability of getting a head from the toss of a perfectly balanced coin is 1/2 because there are two sides only one is a head. ii. Inductive reasoning People who buy a lottery ticket on their birthday may believe it is their lucky day and overestimate the small chance of winning Subjective Subjective probability is the individual’s personal estimate of the chance of loss Subjective probability need not coincide with objective probability probability Example: People who buy a lottery ticket on their birthday may believe it is their lucky day and overestimate the small chance of winning. A wide variety of factors can influence subjective probability, including a person’s age, gender, intelligence, education, and the use of alcohol or drugs. 6 2. Chance of Loss Chance of loss is closely related to the concept of risk. Chance of loss is defined as the probability that an event will occur. Like risk, probability has both objective and subjective aspects. Chance of loss can be distinguished from objective risk. Chance of Loss Chance of loss is the probability that an event that causes a loss will occur. Objective risk is the relative variation of actual loss from expected loss. vs The chance of loss may be identical for two different groups, but the objective risk may be quite different. Objective Risk Example: Assume that a property insurer has 10,000 homes insured in Los Angeles and 10,000 homes insured in Philadelphia and that the chance of a fire in each city is 1 percent. Thus, on average, 100 homes should burn annually in each city. However, if the annual variation in losses ranges from 75 to 125 in Philadelphia, but only from 90 to 110 in Los Angeles, objective risk is greater in Philadelphia even though the chance of loss in both cities is the same. 7 3. Peril and Hazard Peril Peril is defined as the cause of loss. Example: If your house burns because of a fire, the peril, or cause of loss, is the fire. If your car is damaged in a collision with another car, collision is the peril or cause of loss. Common perils that cause loss of property include fire, lightning, windstorm, hail, tornado, earthquake, flood, burglary, and theft. 8 3. Peril and Hazard Hazard Physical Hazard Moral Hazard Dishonesty or character defects in an A physical condition that increases the individual increase the frequency or severity of frequency or severity of a loss. a loss. Example: Example: Icy roads increase the chance of an auto Moral hazards in insurance include faking an accident, defective wiring in a building accident to collect benefits from an insurer, increases the chance of fire, and a defective submitting a fraudulent claim, inflating the lock on a door increases the chance of theft. amount of a claim, and intentionally burning unsold merchandise that is insured. Murdering the insured to collect the life insurance proceeds is another important example of moral hazard. 9 3. Peril and Hazard Hazard Attitudinal Hazard Attitudinal hazard is carelessness or Legal Hazard Legal hazard refers to characteristics of the indifference to a loss, which increases the (Morale Hazard) legal system or regulatory environment that frequency or severity of a loss. increase the frequency or severity of losses. Examples: Example: Include adverse jury verdicts or Leaving car keys in an unlocked car, which large damage awards in liability lawsuits; increases the chance of theft; leaving a door statutes that require insurers to include unlocked, which allows a burglar to enter; and coverage for certain benefits in health changing lanes suddenly on a congested insurance plans, such as coverage for expressway without signaling, which increases alcoholism; and regulatory action by state the chance of an accident. insurance departments that prevents insurers Attitudinal hazard is more widely used today from withdrawing from a state because of and is less confusing to students and more poor underwriting results. descriptive of the concept being discussed. 10 4. Types of Risks Diversifiable risk and Pure and speculative risk Enterprise risk Systematic risk nondiversifiable risk Systematic risk is the risk of the Enterprise risk is a term that encompasses all major risks faced by a business firm. collapse of an entire system or entire A diversifiable risk is a risk that Such risks include pure risk, speculative market due to the failure of a single Pure risk A situation in which there affects only individuals or small entity or group of entities that can risk, strategic risk, operational risk, and are only the possibilities of loss or no groups and not the entire economy. financial risk. result in the breakdown of the entire loss. Example: a diversified portfolio of Strategic risk refers to uncertainty financial system. Example: of pure risks include stocks, bonds, and certificates of regarding the firm’s financial goals and Example: the severe 2008–2009 premature death, job-related deposit (CDs) is less risky than a objectives; for example, if a firm enters a business recession in the United accidents, catastrophic medical new line of business, the line may be portfolio that is 100 percent invested unprofitable. States was the second-worst expenses, and damage to property in common stocks. Operational risk results from the firm’s economic downswing in U.S. history from fire, lightning, flood, or business operations. For example, a bank that was caused largely by systemic earthquake that offers online banking services may risk. The economy experienced a Nondiversifiable risk (Fundamental incur losses if “hackers” break into the risk) is a risk that affects the entire massive financial meltdown and a Speculative risk is defined as a bank’s computer. brutal stock market crash; the situation in which either profit or economy or large numbers of Financial risk refers to the uncertainty of persons or groups within the loss because of adverse changes in national unemployment rate soared loss is possible. to historically high levels; the economy. Commodity prices, interest rates, foreign Example: betting on a horse race, exchange rates, and the value of money. housing market collapsed; more investing in real estate, and going Example: rapid inflation, cyclical For example, a food company that agrees than 100 commercial banks and into business for yourself. unemployment, war, hurricanes, to deliver cereal at a fixed price to a floods, and earthquakes. financial institutions failed or merged supermarket chain in six months may lose with other entities money if grain prices rise. 11 6. Burden of Risk in Society Burden of Risk in Society Loss of Certain Goods and Larger Emergency Fund Worry and Fear Services It is prudent to set aside funds for an emergency. In the absence of insurance, individuals The second burden of risk is that society is and business firms would have to increase deprived of important goods and services. Numerous examples illustrate the mental substantially the size of their emergency unrest and fear caused by risk. fund to pay for unexpected losses. Example: Because of the risk of a liability lawsuit, many Example: Example: corporations have discontinued manufacturing A college student who needs a grade of C assume you have purchased a $300,000 certain products. Some 250 companies in the in a course to graduate may enter the final home and want to accumulate a fund for world once manufactured childhood vaccines; examination room with a feeling of repairs if the home is damaged by fire, hail, today, only a small number of firms apprehension and fear. windstorm, or some other peril. Without manufacture vaccines, due in part to the threat insurance, you would have to save at least of liability suits. $50,000 annually to build up an adequate fund within a relatively short period of time. 12 7. Techniques for Managing Risk Techniques for Managing Risk Risk Control Risk Financing Self-insurance Avoidance Loss Prevention Loss Reduction Retention Insurance Noninsurance transfer Duplication Separation Diversification Incorporation of Business Firm 13 7. Techniques for Managing Risk Risk Control Avoidance Loss Prevention Loss Reduction Avoidance is one technique for managing risk. Duplication Separation Diversification Loss Prevention Loss prevention is a For example, you can avoid the risk of being technique that reduces the probability of loss mugged in a high-crime area by staying away so that the frequency of losses is reduced. The from high-crime rate areas; you can avoid the number of heart attacks can be reduced if risk of divorce by not marrying; and business individuals control their weight, stop smoking, firms can avoid the risk of being sued for a eat healthy diets, and follow an exercise defective product by not program. producing the product. 14 7. Techniques for Managing Risk Strict loss prevention efforts can reduce the frequency of losses; however, some losses will inevitably occur. Thus, another objective of loss control is to reduce the severity of a loss after it Loss Reduction occurs. For example, a department store can install a sprinkler system so that a fire will be promptly extinguished, Duplication Separation Diversification Reduce the chance of loss by spreading the loss exposure across different parties. Risk is The assets exposed to loss are separated reduced if a manufacturer has a number Duplication Losses can also be reduced by of customers and suppliers. For example, if or divided to minimize the financial loss from duplication. This technique refers to having the entire customer base consists of only four a single event. For example, a manufacturer back-ups or copies of important documents domestic purchasers, sales will be impacted may store finished goods in two warehouses or property available in case a loss occurs adversely by a domestic recession. However, in different cities. if there are foreign customers and additional domestic customers as well, this risk is reduced. 15 7. Techniques for Managing Risk Risk Financing Incorporation of Self-insurance business firm Retention Noninsurance transfer Insurance Transfer of risk by Transfer of risk by contracts contracts Hedging price risks Hedging price risks Incorporation business firm 16 Q & A Session 17