Lecture Two ： Risk and Insurance. Learning Objectives Explain the meaning of the risk Distinguish between pure risk and speculative risk Understand how.

Lecture Two ：

Risk and Insurance

Learning Objectives

Explain the meaning of the risk Distinguish between pure risk and speculative risk Understand how risk is a burden to society Explain the objectives of risk management process Describe the steps in the risk management Explain the major methods of handling risk

Main ContentsRisk in our society Types of riskBurdens of riskThe objectives of risk managementThe steps in the risk management process Methods of handling risk

Risk in our society

• Definition of risk

• Characteristics of risk

• Peril, Hazard and risk

What’s a risk ? What kinds of risks do

we meet in our society?

“ 天有不测风云，人有旦夕祸福。人事变迁无常，则危险亦必随之而起。沧海桑田，华屋山丘，寿命之修短，事业之兴替，举凡一切危险发生，动有出入意表者，如不绸缪未雨，熟筹先事预防之术，则一旦横逆之来，猝逢意外，未有不噬脐莫及，而叹应付之无方者。”

• Definition of risk

There is no single definition of risk. Traditionally, risk is defined in terms of uncertainty.

Based on this concept, risk is defined here as uncertainty concerning the occurrence of a loss.

Two concepts objective risksubjective risk

objective risk the relative variation of actual loss

from expect loss. (on average in a long period VS a specific year; (examples;)

Objective risk declines as the number of exposures increases. （ inversely with the spare root of the number of cases under observation)

can be statistically calculated

subjective risk being defined as uncertainty based on

a person’s metal condition or state of mind.

High subjective risk often result in conservative and prudent behavior. While low subjective risk may result in less conservative behavior.

• Characteristics of risk

objective in occurrence potential loss uncertain predictable changeable

•Peril,Hazard and loss

PerilPeril is defined as the cause of loss.

Common perils that cause property damage include fire, lightning, windstorm, hail, earthquake, theft, burglary, etc.

Peril, Hazard and loss

HazardA hazard is a condition that creates or increases the chance of loss. There are four major types of hazards:

• physical hazard• moral hazard• morale hazard• legal hazard

Peril, Hazard and loss

•physical hazard: is a physical condition that increase the chance of loss. (examples)

• moral hazard: is dishonesty or character defects in an individual that increase the frequency or severity of loss. (examples). Moral hazard is present in all forms of insurance, and it is difficulty to control. Moral hazard leads to higher premiums for everyone.Insurers try to control moral hazard by various policy provisions.

Peril, Hazard and loss

•morale hazard: is carelessness or indifference to a loss because of the existence of insurance. (Examples) Morale hazard increases the chance of loss.

•Legal hazard: refers to characteristics of the legal system or regulatory environment that increase the frequency and severity of losses. (Examples)

Peril, Hazard and loss

LossLoss is the probability of losing. The chance go loss is closely related to the concept of risk. From perspective of insurers, loss is defined as unintentional, unplanned and unexpected economic loss of value. (examples)There are two major types of loss associated with the risks.

Direct loss: is defined as a financial loss that results from the physical damage, destruction , etc. (examples) Indirect loss: is defined as a financial loss that results indirectly from the occurrence of direct physical damage loss. (examples)

hazard

peril

loss

risk management

insurance

Types of risk

•Risk can be classified into several categories•Two major categories are as follows: pure risk speculative risks

fundamental risk particular risk

Pure and speculative risks

Pure riskDefined as a situation in which there are only the possibilities of loss or no loss. (examples)

Speculative risk Defined as a situation in which either profit or loss is possible (examples)

Pure and speculative risks

Why it is important to distinguish pure risk and speculative risk?

Reason 1: private insurers generally insure only pure risk.

(insurable VS not insurable risks)Reason 2: Reason3:

Fundamental and particular risks

Fundamental risk Being a risk that affects the entire economy or large numbers of persons or groups within the economy. (most natural disasters and some social risks ) (examples) Particular risk Being a risk that affects only individuals and not the entire community. (examples)

Sept. 11 Industry Loss Estimates($ Billions)

Life$1.0 (3.1%)

AviationLiability

$3.5 (10.8%)

OtherLiability

$4.0 (12.3%)

BizInterruption

$11.0 (33.8%)

Property -WTC 1 & 2

$3.6 (11.1%) Property -Other

$6.0 (19.5%)

Aviation Hull$0.5 (1.5%)

EventCancellation$1.0 (3.1%)

WorkersComp

$1.8 (5.8%)

Current Insured Losses Estimate: $32.5BSource: Insurance Information Institute

Why Is it important to distinguishpure and speculative risk &Fundamental and particular

risks

Types of risk

Personal risks Property risksLiability risks

Types of risk

Personal risks ：• risks that directly affect an individual • Four major personal risks:

•Risk of premature death•Risk of insufficient income during retirement •Risk of poor health •Risk of unemployment Personal risks result in “financial insecurity”

Types of risk• Risk of premature death

Be defined as the death of household head with unfulfilled financial obligations (dependent to support, children to educate, mortgage to be paid off)

In economic sense, the death of a seven-year-old child is not “premature”

Four costs resulting from premature:

human life value, additional expenses, family financial problems, noneconomic costs

Types of risk

•Risk of insufficient income during retirement: insufficient income during retirement•Risk of poor health: catastrophic medical bills, and the loss of earned income•Risk of unemployment: lose earned income and employee benefits

Types of risk

Property risks• The risk of having property

damaged or lost from numerous causes. (examples)

• Two major types of loss resulted from property risk:• Direct loss: • Indirect loss (or consequential loss):

Types of risk

Liability risks Under the legal system, a person should be liable if he or she does something that result in bodily injury or property damage to someone else. (examples) no maximum upper limit

Burden of risk

Risk can create great financial insecurity and losses.

The presence of risk result in certain undesirable effects for both individual and society.

Burden of risk

Burden of risk on societythree major burdens on society: • The size of economic emergency fund must be increased (examples) •Society is deprived of certain goods and services.• Worry and fear are present.

Methods of handling risks

As stressed, risk is a burden not only to the individual but to society as well. Thus ， it is important to examine some techniques for meeting and solving risk. There are five major methods of handling risk ：

Avoidance Loss control Retention Non-insurance transfers Insurance

Methods of handling risks

Avoidance: avoiding risks • Advantage• Disadvantage

Loss control: reducing both frequency and severity of losses

• including loss prevention and loss reduction

• advantage• disadvantage

Methods of handling risks

Retention: retaining all or part of a given risk (examples)

• including active retention and passive retention • Advantage• Disadvantage

Methods of handling risks

Non-insurance transfers: transferring risks to non-insurance company

Including several methods as follows:

• transfer of risk by contracts ：contract-out, trust fund, guarantee contract, our-source, etc. )

• hedging price risks• incorporation of a business firm

Methods of handling risksInsurance

• First, risk is transferred to the insurer

• Second, the pooling techniques is used to spread the losses of the few over the entire group

• Third, the risk may be reduced by application of the law of large numbers

Risk management

Risk management is a process that identifies loss exposures faced by an organization and selects the most appropriate techniques for treating such exposures. •In the past, risk managers generally consider only pure loss exposures•Nowadays, newer forms of risk management are emerging that consider certain speculative risk as well.

steps in the risk management process

Identify potential losses

Evaluate potential losses

Implement and administer the program

Select the appropriate techniques for treating Loss exposures. 1. risk control: avoidance loss control 2. risk financing retention non-insurance transfers commercial insurance

Risk management matrix type of loss loss frequency loss severity

appropriate risk management

techniques

1 low low retention 2 high low loss control and retention 3 low high insurance 4 high high avoidance

风险管理矩阵图

损 失 高 程度

低

风 险 频 率 高 低

回避 减损、转移

预防、自留 自留

Summary There is no single definition of risk. Risk traditionally has

been defined as uncertainty concerning the occurrence of a loss.

Peril is defined as the cause of loss; hazard is any condition that creates or increase the chance of loss. There are three types of hazards.

The basic types of risk include the following: pure and speculative risks, fundamental and particular risks

Risk entails three major burdens on society There are five major methods of handling risks:

avoidance loss control retention noninsurance transfer insurance

Review questions

Ⅰ. Key concepts Riskpure risk & speculative risk,hazard, peril and lossphysical hazard, moral hazard, morale hazard, legal hazard

Review questions

Ⅱ. Review questions Explain briefly the meaning of risk. How does objective risk differ from

subjective risk Define peril, hazard, physical hazard,

moral hazard Explain the difference between pure and

speculative risk. Identify the major types of pure risk that

are associated with great financial insecurity

Describe briefly the five major methods of handling risk. Give an example of each method.

Application Questions

Search for Information

1. 中国汶川大地震的各类保险补偿

2. 美国 1993 年洛杉矶大地震的保险补偿

3. 2008 年 1 月我国雪灾损失及保险赔偿给付

两国巨灾补偿体系有什么差别？

Preview

Read and prepare the questions from “Insurance and Risk” ( P15-28 ） ,