Ch 1 Risk Saturday August 31 2013 9 58 PM Risk and Uncertainty A Risk uncertainty concerning the occurrence of a loss i i i i a b Used in situations where the probability of possible outcomes can be estimated with some accuracy Objective aka degree of risk the relative variation of actual loss from expected loss Ex How many houses burn down each year c Subjective uncertainty based on a person s mental condition or state of mind Ex Drunk driving B C D Uncertainty used in situations where such probabilities can not be estimated Loss exposure any situation or circumstance in which a loss is possible regardless of whether a loss occurs Chance of Loss the probability that an event will occur Objective probability refers to the long run relative frequency of an event based on the assumptions of an infinite number of observations and of no change in the underlying condition Subjective probability the individual s personal estimate of the chance of loss E Chance of loss vs Objective risk 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 a b a b Peril and Hazard A Peril the cause of loss a Ex If your house burns because a fire the peril is the fire B Hazard a condition that creates or increases the frequency or severity of loss a Four major areas i Physical a physical condition that increases the frequency or severity of loss 1 Ex Icy roads defective lock on a door ii Moral dishonesty or character defects in an individual that increase the frequency or severity of loss 1 Ex Fraudulent claim faking an accident fire to collect insurance iii Attitudinal Morale carelessness or indifference to a loss which increases the frequency or severity of a loss 1 Ex Leaving keys in an unlocked car increases chance of theft changing lanes suddenly without signaling iv Legal characteristics of the legal system or regulatory environment that increases the frequency or severity of losses Classification of Risk A Pure and Speculative Risk a Pure risk situations where there is only loss adverse or no loss neutral Ex Premature death flood earthquake b Speculative risk either profit or loss is possible Ex Stock market investing going into business for yourself B Diversifiable and Nondiversifiable Risk a b Diversifiable risk that affects only individuals or small groups and not the entire economy Nondiversifiable a risk that affects the entire economy or large numbers of persons or groups within the economy i A risk that cannot be eliminated or reduced by diversification C Enterprise Risk encompasses all major risks faced by a business firm Such risks include pure risk speculative risk strategic risk operational risk and financial risk RMI Page 1 speculative risk strategic risk operational risk and financial risk Major Personal and Commercial Risks A Personal Risks risks that directly affect and individual or family a Premature death the death of a family head with unfulfilled financial obligations i Ex Mortgage credit card loans Insufficient income during retirement Poor health can lead to payment of medical bills and the loss of earned income Unemployment B Property Risks risks of having property damaged or lost from numerous causes Direct loss a financial loss that results from the physical damage destruction or theft of the property i Ex Physical damage to the home caused by a fire is a direct loss Indirect consequential loss a financial loss that results indirectly from the occurrence of a direct physical damage or theft loss i Ex If your house burns down in a fire you may incur additional living expenses to maintain your normal standard of living b c d a b Burden of Risk on Society A B C The size of an emergency fund must be increased Society is deprived of certain goods and services Worry and fear are present Techniques for Managing Risk A Risk control techniques that reduce the frequency or severity of losses Includes the following a b Avoidance not always practical Loss prevention aims at reducing the probability of loss so that the frequency of losses is reduced i Ex Auto accidents can be reduced by driving defensively c Loss reduction aims to reduce the severity of the loss Ex Installing a sprinkler in case of fire Risk financing techniques that provide for the funding of losses i B a Retention means that an individual or business firm retains part of all of the losses that can result from a given risk i Self insurance a special form of planned retention by which part or all of a given loss exposure is retained by the firm b Noninsurance transfers the risk is transferred to a party other than an insurance company i ii iii Transfer of risk by contracts Hedging price risks Incorporation of a business firm c Insurance RMI Page 2 Ch 2 Insurance Insurance A B Insurance the pooling of fortuitous losses by transfer of such risks to insures who agree to indemnify insured for such losses to provide other pecuniary benefits on their occurrence or to render services connected with the risk Basic Characteristics of Insurance a Pooling of losses spreading of losses incurred by the few over the entire group so that in the process average loss is substituted for actual loss Reduces variation in possible outcomes thus reducing risk b Payment of Fortuitous Losses Fortuitous losses one that is unforeseen and unexpected by the insured and occurs as a result of chance Aka must be accidental Ex A person may slip on an icy sidewalk and break a leg c d Risk Transfer a pure risk is transferred from the insured to the insurer who typically is in a stronger financial position to pay the loss than the insured Indemnification means that the insured is restored to his or her approximate financial position prior to the occurrence of the loss Ex If you are sued because of negligent operations of your car your car insurance will pay those sums that you are legally obligated to pay C Characteristics of Ideally Insurable Risks a There must be a large number of exposure units Purpose to enable the insurer to predict loss based on the law of large numbers b The lost must be accidental and unintentional A deliberately caused loss is not a random event because the insured knows when the loss will occur i i ii i i i c The loss must be determinable and measurable i Cause time place and amount should all be known d The loss should not be catastrophic i ii iii A large portion of exposure units should not incur losses at the same time Can
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