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Unformatted text preview: bnmbnmbn mbn,bm,b Dr Mariusz Dybał Institute of Economic Sciences [email protected] Insurance market Risk in our society 1 Mariusz Dybał – Risk in our society Scheme of the Lecture 1. 2. 3. 4. 5. 6. 7. 8. Meaning of risk Chance of loss Peril and hazard Basic categories of risk Types of pure risk Burden of risk on society Methods of handling risk Case application no. 1 2 Mariusz Dybał – Risk in our society 1. Meaning of risk   There is no single definition of risk; Risk traditionally has been defined as uncertainty concerning the occurence of a loss. loss. 3 1 bnmbnmbn mbn,bm,b Mariusz Dybał – Risk in our society 1. Meaning of risk  Employees in the insurance industry often use the term risk to identify the property or life being insured:   „That driver is poor risk”; „That building is an unacceptable risk”. 4 Mariusz Dybał – Risk in our society 1. Meaning of risk  When risk is defined as uncertainty, we can make distinction between:   Objective risk; Subjective risk. 5 Mariusz Dybał – Risk in our society 1. Meaning of risk  Objective risk (also called degree of risk):   Is defined as the relative variation of actual loss from expected loss; For example:     Property insurer has 10,000 houses insured and, on average 1%, or 100 houses, burn each year; However, it wolud be rare for exactly 100 houses to burn each year; In some year 90 may burn; in others 110; Thus, there is a variation of 10 houses from the expected number of 100, or a variation of 10%. 6 2 bnmbnmbn mbn,bm,b Mariusz Dybał – Risk in our society 1. Meaning of risk   Objective risk declines as the number of exposures increases; More specifically, objective risk varies inversely with the square root of the number of cases under observation; observation;   For example, 10,000 houses were insured, and objective risk was 10/100, or 10%; Now assume that 1 million houses are insured;   That expected number of houses that will burn is now 10,000, but the variation of actual loss from expected loss is only 100; Objective risk is now 100/10,000, or 1%. 7 Mariusz Dybał – Risk in our society 1. Meaning of risk    Objective risk can be statistically calculated; Because objective risk can be measured, it is an extremely useful concept for an insurer; As the number of exposures increases, an insurer can predict its future loss experience more accurately because it can rely on the law of large numbers. 8 Mariusz Dybał – Risk in our society 1. Meaning of risk  The law of large numbers states that as number of exposure units increases, the more closely the actual loss experience will aproach the expected loss experience:  For example, as number of homes under observation increases, the greater is the degree of accuracy in predicting the proportion of homes that will burn. 9 3 bnmbnmbn mbn,bm,b Mariusz Dybał – Risk in our society 1. Meaning of risk  Subjective risk:  Is defined as uncertainty based on a person’s mental condition or state of mind; mind;  For example:   A customer who was drinking heavily in the bar may foolishly attempt to drive home; The driver may be uncertain whether he will arive home safely without being arrested by the police for drunk driving. 10 Mariusz Dybał – Risk in our society 1. Meaning of risk    The impact of subjective risk varies depending on the individual; Two persons in the same situation can have a diffrent perception of risk, and their behavior may be altered accordingly; High subjective risk often results in conservative and prudent bahavior, while low subjective risk may result in less conservative behavior. 11 Mariusz Dybał – Risk in our society 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; occur; Like risk, „probability” has both:   Objective aspects; Subjective aspects. 12 4 bnmbnmbn mbn,bm,b Mariusz Dybał – Risk in our society 2. Chance of loss  Objective probability:   Refers to the longlong-run relative frequency of an event based on the assumptions of an infinite number of observations and of no change in the underlaying conditions;; conditions Objective probabilities can be determined in two ways:   By deductive reasoning; By inductive reasoning. 13 Mariusz Dybał – Risk in our society 2. Chance of loss  Objective probabilities determined by deductive reasoning are called a priori probabilities;; probabilities  For example, the probability of getting a head from the toss of a perfectly balanced coin is ½ because there are two sides, and only one is a head. 14 Mariusz Dybał – Risk in our society 2. Chance of loss  Objective probabilities can be determined also by inductive reasoning;  For example:   The probability that a person age 21 will die before age 26 cannot be logically deduced; However, by a careful analysis of past mortality experience, life insurers can estimate the probability of death and sell a fivefive-year term life insurance policy issued at age 21. 15 5 bnmbnmbn mbn,bm,b Mariusz Dybał – Risk in our society 2. Chance of loss  Subjective probability:   Is the individual’s personal estimate of the chance of loss; Subjective probability need not coincide with objective probability;  For example:   People who buy a lottery ticket on their birthday may belive it is their lucky day and overestimate the small chance of winning; A wide variety of factors can influance subjective probability, including a person’s age, gender, intelligence, education, use of alcohol. 16 Mariusz Dybał – Risk in our society 2. Chance of loss  Chance of loss can be distinguished from objective risk;  The chance of loss may be identical for two different groups, but objective risk may be quite different;    For example, assume that a property insurer has 10,000 homes in New York and 10,000 in London and that the chance of a fire in both cities is 1%; Thus, on average, 100 homes should burn annualy in each city; However if the annual variation in losses ranges from 75 to 125 in New York, but only from 90 to 110 in London, objective risk is greater in New York even though the chance of loss in both cities is the same. 17 Mariusz Dybał – Risk in our society 3. Peril and hazard  Peril:  is defined as the cause of loss; loss;    If your house burns because of 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 property damage include fire, lightening, windstorm, hail, tornadoes, earthearthquakes, theft, and burglary. 18 6 bnmbnmbn mbn,bm,b Mariusz Dybał – Risk in our society 3. Peril and hazard  Hazard:   is a condition that creates or increases the chance of loss; loss; There are four major types of hazards:     Physical hazard, Moral hazard, Morale hazard, Legal hazard. 19 Mariusz Dybał – Risk in our society 3. Peril and hazard  Physical hazard:  Is a physical condition that increases the chance of loss; loss;  Examples of physical hazards include icy roads that increase the chance of an auto accident, defective wiring in a building that increases the chance of fire, and a defective lock on a door that increases the chance of theft. 20 Mariusz Dybał – Risk in our society 3. Peril and hazard  Moral hazard:  Is dishonesty or character defects in an individual that increase the frequency or severity of loss; loss;  Examples of moral hazard include faking an accident to collect from an insurer, submitting a fraudulent claim, inflating the amount of a claim, intentionally burning unsold merchandise that is insured, and murdering the insured to collect the life insurance, etc. 21 7 bnmbnmbn mbn,bm,b Mariusz Dybał – Risk in our society 3. Peril and hazard  Morale hazard:  Is carelessness or indifference to a loss because of the existence of insurance; insurance;  Examples of morale hazard include leaving car keys in an unlocked car, which increases the chance of theft; leaving door unlocked that allows a burglar to enter. 22 Mariusz Dybał – Risk in our society 3. Peril and hazard  Legal hazard:  Refers to characteristics of legal system or regulatory environment that increase the frequency or severity of losses; losses;  Examples include adverse jury verdicts or large damage awards in liability lawsuits and regulatory action by state insurance departments that restrict the ability of insurers to withdraw from the state because of poor underwriting results. 23 Mariusz Dybał – Risk in our society 4. Basic categories of risk  Risk can be classified into several distinct categories:    Pure and speculative risk; Fundamental risk and particular risk; Enterprise risk. 24 8 bnmbnmbn mbn,bm,b Mariusz Dybał – Risk in our society 4. Basic categories of risk  Pure risk:    Is defined as situation in wich there are only the possibilities of loss or no loss; loss; The only possible outcomes are adverse (loss) and neutral (no loss); Examples of pure risk include premature death, jobjob-related accidents, catastrophic medical expenses, and damage to the property from fire, lightning, flood, or earthquake. 25 Mariusz Dybał – Risk in our society 4. Basic categories of risk  Speculative risk:   Is defined as situation in wich either profit or loss is possible;; possible For example, if you purchase 100 shares of common stock, you would profit if the price of the stock increases but would lose if the price declines. 26 Mariusz Dybał – Risk in our society 4. Basic categories of risk  It is important to distinguish between pure and speculative risks for three reasons:    First, private insurers typically insure only pure risks; Second, law of large numbers can be applied more easily to pure risks than to speculative risks (except gambling); Finally, society may benefit from speculative risk even though a loss ocurs, but it is harmed if a pure risk is present and a loss ocurs. 27 9 bnmbnmbn mbn,bm,b Mariusz Dybał – Risk in our society 4. Basic categories of risk  A fundamental risk:   Is a risk that affects the entire economy or large numbers of persons or groups within the economy; economy; Examples include rapid inflation, cyclical unemployment, war, natural disaster, terrorist attack. 28 Mariusz Dybał – Risk in our society 4. Basic categories of risk  A particular risk:   Is a risk that affects only individuals and not the entire community;; community Examples include car thefts, bank robberies, and dwelling fires. 29 Mariusz Dybał – Risk in our society 4. Basic categories of risk  The distinction between a fundamental and a particular risk is important because government assistance may be necessary to insure a fundamental risk. 30 10 bnmbnmbn mbn,bm,b Mariusz Dybał – Risk in our society 4. Basic categories of risk  Enterprise risk:  Is a term that encompasses all major risks faced by a busines firm;  Such risks include pure risk, speculative risk, strategic risk, operational risk, and financial risk. 31 Mariusz Dybał – Risk in our society 4. Basic categories of risk  Enterprise risk/Strategic risk/Strategic risk:  Refers to uncertainty regarding the firm’s financial goals and objectives;  For example, if a firm enters a new line of business, the line may be unprofitable. 32 Mariusz Dybał – Risk in our society 4. Basic categories of risk  Enterprise risk/Operational risk/Operational risk:  Results from the firm’s business operations;  For example, a bank that offers online banking services may incur losses if „hackers” break into the bank’s computer. 33 11 bnmbnmbn mbn,bm,b Mariusz Dybał – Risk in our society 4. Basic categories of risk  Enterprise risk/Financial risk/Financial risk:  Refers to the uncertainty of loss because of adverse changes in commodity prices, interest rates, foreign exchange rates, and the value of money;  For example, a bank with large portfolio of Treasury bonds may incur losses if interest rate rise. 34 Mariusz Dybał – Risk in our society 5. Types of pure risk  Major types of pure risk that can create great financial insecurity include:    Personal risks, Property risks, Liability risks. 35 Mariusz Dybał – Risk in our society 5. Types of pure risk  Personal risks:   Are risks that directly affect an individual. individual. There are four major personal risks:     Risk of premature death, Risk of insufficient income during retirement, Risk of poor health, Risk of unemployment. 36 12 bnmbnmbn mbn,bm,b Mariusz Dybał – Risk in our society 5. Types of pure risk  Personal risks/Risk risks/Risk of premature death:  Premature death is defined as the death of a family head with unfulfilled financial obligations; obligations;   These obligations can include dependents to suport, a mortgage to be paid off, or children to educate; Thus, the death of a child age seven is not „premature” in the economic sense. 37 Mariusz Dybał – Risk in our society 5. Types of pure risk  Personal risks/Risk risks/Risk of insufficient income during retirement:  The majority of workers experience a substantial reduction in their money incomes when they retire, which can result in a reduced standard of living. 38 Mariusz Dybał – Risk in our society 5. Types of pure risk  Personal risks/Risk risks/Risk of poor health:  Includes both the payment of catastrophic medical bills and the loss of earned income;  Unless you have adequate health insurance, private savings and finanncial assets, or other sources of income to meet these expendituries, you may be financially insecure. 39 13 bnmbnmbn mbn,bm,b Mariusz Dybał – Risk in our society 5. Types of pure risk  Personal risks/Risk risks/Risk of unemployment:  Unemployment can cause financial insecurity in at least three ways:    First, workers lose their earned income and employee benefits; Second, because of economic conditions, the worker may be able to work only partpart-time; Finally, if the duration of unemployment is extended over a long period, past savings and unepmloyment benefits may be exhausted. 40 Mariusz Dybał – Risk in our society 5. Types of pure risk  Property risks:  are defined as risk of having property damaged or lost from numerous causes; causes;   Examples include fire, lightening, tornadoes, windstorms, etc.; There are two major types of loss associated with the destruction or theft of property:   Direct loss; Indirect or consequential loss. 41 Mariusz Dybał – Risk in our society 5. Types of pure risk  Property risks/Direct risks/Direct loss:   Is defined as a financial loss that results from the physical damage, destruction, or theft of the property; property; For example, if you own a restaurant that is damaged by a fire, the physical damage to the restaurant is known as a direct loss. 42 14 bnmbnmbn mbn,bm,b Mariusz Dybał – Risk in our society 5. Types of pure risk  Property risks/Indirect risks/Indirect or consequential loss:   Is defined as a financial loss that results indirectly from the occurence of a direct physical damage, destruction, or theft of the property; property; For example, in addition to the physical damage loss, the restaurant would lose profits for several months while the restaurant is being rebuilt. 43 Mariusz Dybał – Risk in our society 5. Types of pure risk  Liability risks:   Under legal system, you can be held legally liable if you do something that results in bodily injury or property damage to someone else; A court of law may order you to pay substantial damages to the person you have injured. 44 Mariusz Dybał – Risk in our society 6. Burden of risk on society   The presence of risk results in certain undesirable social and economic effects; Risk entails three major burdens on society:    The size of emergency fund must be increased; Society is deprived of certain goods and services; Worry and fear are present. 45 15 bnmbnmbn mbn,bm,b Mariusz Dybał – Risk in our society 6. Burden of risk on society  The size of emergency fund must be increased:   In the absence of insurance, individuals and business firms would have to increase the size of their emergency fund to pay for the unexpected losses; The higher the amount that must be saved, the more current consumption spending must be reduced, which results in a lower standard of living. 46 Mariusz Dybał – Risk in our society 6. Burden of risk on society  Society is deprived of certain goods and services:  Because of the risk of a liability lawsuit, many corporations have discontinued manufactoring certain products (childhood vaccines, asbestos products, football helmets, siliconesilicone-gel breast implants, etc.) 47 Mariusz Dybał – Risk in our society 6. Burden of risk on society  Worry and fear are present:  Numerous examples can illustrate the mental unrest and fear caused by risk:   Some passangers in a commercial jet may become extremely nervous and fearful if the jet encounters severe turbulence during the flight; A college student who needs a grade of C in a course to graduate may enter the final examination room with a feeling of apprehension and fear. 48 16 bnmbnmbn mbn,bm,b Mariusz Dybał – Risk in our society 7. Methods of handling risk  There are five major methods of handling risk:      Avoidance; Loss control; Retention; Noninsurance transfers; Insurance. 49 Mariusz Dybał – Risk in our society 7. Methods of handling risk  Avoidance:    You can avoid the risk of being mugged in a highhigh-crime rate area by staying out of the area; You can avoid the risk of divorce by not marrying; Business firm can avoid the risk of being sued for a defective product by not producting the product. 50 Mariusz Dybał – Risk in our society 7. Methods of handling risk  Loss control:   Loss control consists of certain activities that reduce both the frequency and severity of losses; Thus, loss control has two major objectives:   Loss prevention; Loss reduction. 51 17 bnmbnmbn mbn,bm,b Mariusz Dybał – Risk in our society 7. Methods of handling risk  Loss control/Loss control/Loss prevention:   Loss prevention aims at reducing the probability of loss so that the frequency of losses is reduced; For example:   Auto accidents can be reduced if motorists take a safesafe-driving course and drive defensively; Boiler explosions can be prevented by periodic inspections by safety engineers. 52 Mariusz Dybał – Risk in our society 7. Methods of handling risk  Loss control/Loss control/Loss reduction:   The second objective of loss control is to reduce the severity of a loss after it occurs; For example:   A plant can be constructed with firefire-resistant materials to minimize fire damage; A community warning system can reduce the number of injuries and deaths from an approaching tornado. 53 Mariusz Dybał – Risk in our society 7. Methods of handling risk  Retention:    Retention means that an individual or a business firm retains all or part of a given risk; Risk retention should not be used to retain lowlow-frequency, high high--severity risks, such as the risk of catastrophic medical expenses, longlongterm disability, or legal liability; Risk retention can be:   Active; Passive. 54 18 bnmbnmbn mbn,bm,b Mariusz Dybał – Risk in our society 7. Methods of handling risk  Retention/Active Retention /Active retention:   Active risk retention means that an individual is consciously aware of the risk and deliberately plans to retain all or part of it; For example:   A motorist may wish to retain the risk of a small collision loss by purchasing an auto insurance policy with a 500$ or higher deductible; Active risk retention is used for two major reasons:   First, it can save money; Second, the risk may be deliberately retained because commercial insurance is either unavaiable or unaffordable. 55 Mariusz Dybał – Risk in our society 7. Methods of handling risk  Retention/Passive Retention /Passive retention:   Certain risks may be unknowingly retained because of ignorance, indifference, or laziness; For example:  Many workers...
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