RMI 3011 UNIT ONE OUTLINE KEY purple highlighted words things to know from review guide Yellow highlighted words definitions CHAPTER ONE Risk in Our Society 1 Different Definitions a Risk uncertainty concerning the occurrence of a loss historical definition i Insurance industry defines it differently to identify the property or life that is being considered for insurance ii A situation involving exposure to danger iii Possibility of loss on the person or entity that is insured iv Probability or threat of damage injury liability loss or other negative occurrence that is caused by external of internal vulnerabilities and that may be avoided through preemptive action v Example risk of being killed in an auto accident is present because uncertainty is present historical that building is an unacceptable risk b Loss exposure any situation or circumstance in which a loss is possible regardless of whether a loss occurs i Example defective products that may result in lawsuits against the manufacturer potential injury to employees because of unsafe working conditions c Objective Risk also degree of risk the relative variation of actual loss from expected loss i Declines as the of exposures increases ii Because objective risk can be measured it is an extremely useful concept for an insurer or a corporate risk manager iii Example property insurer has 10 000 houses insured over a long period and on average 1 or 100 houses burn each year However it would be rare for exactly 100 houses to burn each year in some years as few as 90 houses may burn in other years it may be 110 Thus variation of 10 houses from the expected of 100 or variation of 10 d Law of Large Numbers as the number of exposure units increases the more closely the actual loss experience will approach the expected loss experience i Example as the of homes under observation increases the greater is the degree of accuracy in predicting the proportion of homes that will burn e Subjective Risk uncertainty based on a person s mental condition or state of mind i High subjective risk results in conservative and prudent behavior while low subjective risk may result in less conservative behavior ii Example a customer who was drinking heavily in a bar may foolishly attempt to drive home The driver may be uncertain whether he will arrive home safely without being arrested by the police for drunk driving 2 Chance of Loss a Chance of Loss the probability that an event that causes a loss will occur b Objective Probability 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 conditions i Can be determined in two ways 1 Deductive reasoning priori probabilities a Example the probability of getting a head from the toss of a perfectly balanced coin is because there are two sides and only one head 2 Inductive reasoning objective probabilities a Example the probability that a person age 21 will die before age 26 cannot be logically deduced However life insurers can estimate the probability of death and sell a five year term life insurance policy issued at age 21 c Subjective Probability the individual s personal estimate of the chance of loss i Variety of factors can influence subjective probability person s age gender intelligence education and the use of alcohol ii Example people who buy lottery ticket on their birthday may believe it is their lucky day and overestimate the small chance of winning d The chance of loss may be identical for two different groups but objective risk may be quite different 3 Peril and Hazard a Peril the cause of loss i Example in an auto accident the collision is the peril b Hazard a condition that creates or increases the frequency or severity of loss i Four major types of hazards 1 Physical a physical condition that increases the frequent or severity of loss accident a Example icy roads that increase the chance of an auto 2 Morale dishonesty or character defects in an individual that increase the frequency or severity of loss a Example faking an accident to collect from an insurer b Morale hazard difficult to control 4 Classification of Risk a Most important classes of risk i Pure Risk and Speculative Risk c Because of morale hazard premiums are higher for everyone 3 Attitudinal carelessness or indifference to a loss which increases the frequency or severity of a loss Who cares mentality a Example leaving car keys in unlocked car increasing the chance of theft b Morale and accidental hazard are used interchangeably but attitudinal is used more today less confusing and more descriptive 4 Legal characteristics of the legal system or regulatory environment that increases the frequency or severity of losses a Example adverse jury verdicts or large damage awards in liability lawsuits statutes that require insurers to include coverage for certain benefits in health insurance plans such as coverage for alcoholism 1 Pure Risk a situation in which there are only the possibilities of loss adverse or no loss neutral a Sources of pure risk personal property liability b Example premature death job related accidents c Private insurers typically insure only pure risks d Law of Large Numbers can be applied more easily to pure risks because it is important in enabling insurers to predict future loss experience 2 Speculative Risk a situation in which either profit or loss is possible a Example if you purchase 100 shares of common stock you would profit if the price of the stock increase but would lose if the price declines betting on horse races investing in real estate going into business for yourself b Society may benefit from a speculative risk even though a loss occurs but it is harmed if a pure risk is present and a loss occurs ii Diversifiable Risk and Non diversifiable Risk 1 Diversifiable risk also nonsystematic risk or particular risk risk that affects only individuals or small groups and not the entire economy a Can be reduced or eliminated by diversification b Example a diversified portfolio of stocks bonds and CDs is less risky than a portfolio that is 100 invested in stocks robberies dwelling fires 2 Non diversifiable Risk also systematic risk or fundamental risk a risk that affects the entire economy or large numbers of persons or groups within the economy a Cannot be eliminated or reduced by diversification b Example rapid inflation war hurricanes c Social insurance and gov t insurance programs may be necessary to insure certain non
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