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Unformatted text preview: Risk Management & Insurance Notes Chapters 1-4, 9 & 10 Chapter One Meaning of Risk There is no single definition of risk; there are many different concepts, but traditionally, risk has been defined in terms of uncertainty o Risk: uncertainty concerning the occurrence of a loss • Ex. The risk of being killed in a car accident is present because uncertainty is present; the risk of failing a class is present because uncertainty is present o Objective Risk: also called degree of risk; the relative variation of actual loss from expected loss; it declines as the number of exposures increases • Ex. A property insurer has 10,000 houses insured over a long period and, on average, 1%, or 100 houses, burn each year; can vary from 90 to 110 houses, thus there is a variation of 10 houses, or 10%, from the expect number of 100 • Objective risk varies inversely with the square root of the number of cases under observation ♦ 10,000 houses insured; objective risk = 10/100, or 10%; if 1 million houses insured, 10,000 will burn, but the variation of actual loss from expected loss is only 100; objective risk = 100/10,000, or 1% ♦ As the sq. rt. of the # of houses increased from 100 in the 1 st example to 1000 in the 2 nd (10 times), objective risk declined to 1/10 its former level • Because obj. risk is measurable, it is useful for insurers and corporate risk mgrs; as # of exposures increases, insurers can predict future losses more accurately • Law of Large Numbers: as the # of exposure units increases, the more closely the actual loss experience will approach the expected loss experience ♦ Ex. as the # of homes under observation increases, the greater the degree of accuracy in predicting the proportion of homes that will burn o Subjective Risk: uncertainly based on a person’s mental condition or state of mind • Ex. a heavy drinker in a bar attempts to drive home; the driver’s mental uncertainty on whether he will arrive home safely or get a DUI is subjective risk • SR’s impact varies based on an individual’s perception of risk, altering behaviors ♦ High SR = conservative/prudent behavior; Low SR = less conservative Chance of Loss Closely related to the concept or risk; defined as the probability that an event will occur Objective Probability: the long-run relative frequency of an event based on the assumptions of an infinite # of observations and of no change in underlying conditions; determined in 2 ways: o (1) Deductive Reasoning: priori probability; probability of getting heads in a coin...
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- Spring '08