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FIN512 NOTES CHAPTER 1: RISK, RISK MANAGEMENT, AND INSURANCETwo fundamental principles that explain how insurance can work:1. The law of large numbers= explains how insurance companies can charge a relatively small premium for large loss exposures. 2. An insurance policy is a contract. Risk:oUndesirable event or an expected or possible loss oHazard, danger; exposure to mischance or periloStatistical probability of something happening oA variance from expectations based on the possibility of a number of outcomes Risk/return tradeof= the more risk one is willing to accept, the higher the possible return – is intended to be used to make investment decisions that are in line with one’s own risk tolerance. oBernstein: “risk management should concentrate either on limiting the size of the bet or on finding ways to hedge the bet so you are not wiped out if youtake the wrong side”There are many ways of categorizing risks in order to predict the probability of a loss occurring. oRisk takesoRisk averseoRisk seekers Exogenous risks= risks over which we have no control and which are not affected by our actions. Ex: earthquakes or hurricanesEndogenous risks = risks that are dependent on our actions. Ex: smoking, jay-walking, studying for an exam, etc. Objective risk= a risk that is determined by analyzing past experiences and calculating the mean(average) of the losses and the standard deviation(the average difference of each loss from this average) of the actual losses from the expected losses for a particular risk exposure. Insurers can calculate the objective probabilityof a loss by tracking various classes of drivers over several years. Subjective risk= means the uncertainty is based on a person’s mental condition or state of mind and the resulting subjective probabilityis based on an individual’s personal estimate of a chance of loss. Ex: driving accidents often occur because people fall asleep at the wheel. Insurance companies use inductive reasoningto come to conclusions about objective risks – they analyze past data to predict future losses. Deductive reasoning = can be used with probabilities of drawing a red card form a deck of cards Pure risk = refers to risks where there is a chance of a loss or no loss, but no chance of a gain – they are usually insurable. Speculative risk = describes situations where there is the possibility of a loss butalso the possibility of a gain.Property risk = the risk of damage to or loss of one’s auto, home, and personal belongings as a result of a fire, an accident, an earthquake, theft. oDirect loss = damage to or loss of the property
oIndirect losses = need to rent another space while their house is being rebuilt or repaired.