Ch. 1 Definitions of Risk

Attitudinal Hazard

AKA Morale Hazard Carelessness or indifference to a loss which increases the frequency or severity of a loss

Loss Exposure

Any situation or circumstance in which a loss is possible, regardless of whether loss occurs

How may a firm reduce overall risk?

As long as risks are not perfectly correlated, firm can offset one risk against another, thus reducing overall risk of the firm.

Diff. B/W chance of loss and objective risk

Chance of Loss = Probability that an event that causes loss will occur Objective Risk = Relative Variation of Actual loss from ecpected loss

Legal Hazard

Characteristics of legal system or regulatory environment that increase the frequency or severity of losses

Enterprise Risk Management

Combines into a single unified treatment program all major risks faced by firm: 1. Pure Risk 2. Speculative 3. Strategic Risk 4. Operational Risk 5. Financial Risk

Hazard

Condition that increases the chance of loss (4 types of hazard are physical, moral, attitudinal, and legal)

Peril

Defined as the immediate cause of a loss. Ex. property damage from fire, windstorm or lightening. Or damage to your car from collision with another vehicle

Objective Risk

Defined as the relative variation of actual loss from expected loss. Can be statistically calculated by some measure of dispersion, such as the standard deviation

Moral Hazard

Dishonesty or character defects in an individual that increase frequency or severity loss

Diversifiable vs. Non-diversifiable Risk

Diversifiable= Risk that affecets only individuals or small groups (Car Theft). It can be reduced or eliminated by diversification. Non-Diversifiable = Risk which affects entire economy or large numbers of people or groups within the economy (hurricane). Also called Fundamental Risk

Enterprise Risk

Encompasses all major risks faced by a firm which include: 1. Pure Risk 2. Speculative Risk 3. Strategic Risk 4. Operational Risk 5. Financial Risk

Direct Loss

Financial Loss that results from the damage, destruction, or theft of the property such as fire damage to a home

Indirect/Consequential Loss

Financial Loss that results indirectly from the occurrence of a direct physical damage or theft loss (additional living expenses after a fire)

More Commercial Risks

Human Resources Exposures (Job related Injuries) Foreign Loss exposures (acts of terrorism) Intangible Property Exposures (Damage to market reputation and public image) Gov't Exposures ( violation of safety standards)

Burdens of Risk's Presence on Society

In absence of insurance, individuals and business firms would have to maintain large emergency funds to pay for unexpected losses Risk of a liability lawsuit may discourage innovation, depriving society of certain goods and services Risk causes worry and fear

Subjective Probability

Individual's personal estimate of the chance of loss

Most Practical method of handling major risks

Insurance. Risk transfer is used because a pure risk is transferred to the insurer. Pooling Technique used to spread losses of the few over the entire group. Risk may also be reduced by application of Law of Large Numbers

Objective Probability

Long-Run relative frequency of an event based on the assumptions of an infinite number of observations and of no change in underlying conditions

Active Retention

Means and Individual is aware of the risk and deliberately plans to retain part or all of it.

Retention

Means that an individual or business firm retains part or all of the losses that can result from a given risk.

Subjective Risk

Perceived Risk. Uncertainty based on a person's mental condition or state of mind

Physical Hazard

Physical Condition that increases frequency or severity of loss

Liability Risk

Possibility of being held legally liable for bodily injury or property damage to someone else. No maximum upper limit w/ respect to the amount of loss. A lien can be placed on your income and financial assets. Legal defense costs can be enormous

Chance of Loss

Probability that an event will occur

Major Commercial Risks

Property Risks (damage to buildings or office equipment), Liability Risks (suits for defective products, pollution and sexual harrassment), Loss of business income (firm must shut down for some time after a physical damage loss), Cybersecurity and identity theft (by thieves breaking into a firms computer system).

Pure Risk vs. Speculative Risk

Pure Risk = Situation in which the only possibilities are loss or no loss (earthquake) Speculative Risk = Situation in which either profit or loss is possible (gambling)

Loss Reduction

Refers to activities to reduce the severity of losses. This includes duplication, separation, and diversification

Risk Control

Refers to techniques that reduce the frequency or severity of losses. Avoidance and Loss Prevention (Loss prevention refers to activities to reduce the frequency of losses)

Financial Risk

Refers to the uncertainty of loss b/c of adverse changes in commodity prices, interest rates, foreign exchange rates and value of money

Treatment of Financial Risk

Requires use of complex hedging techniques, financial derivatives, futures contracts, and other fin. instruments.

Operational Risk

Results from the firm's business operations

Techniques for Managing Risk

Risk Control Loss Reduction Risk Financing Self-Insurance Non-Insurance Transfer

Systemic Risk

Risk of the collapse of entire system or market due to the failure of a single entity or group of entities that can result in the breakdown of the entire financial system. Especially important to large "too big to fail" US financial institutions

Passive Retention

Risks may be unknowingly retained because of indifference, or laziness

Personal Risks

Risks that directly affect an individual or family. Involve the possibility of a loss or reduction in income, extra expenses or depletion of financial assets due to: 1. Premature death of family head 2. Insufficient Income during retirement 3. Poor Health 4. Involuntary Unemployment

Self-Insurance

Special Form of planned retention by which part or all of a given loss is retained by the firm

Risk Financing

Techniques that provide for payment of losses after they occur. Includes Retnetion, Active Retention and Passive Retention.

Whose Assistance may be necessary to insure non-diversifiable risk?

The government

"Risk" in Econ and Finance

The term "risk" is used in situations where probabilities of possible outcomes are known

"Uncertainty" in Econ and Finance

The term "uncertainty" is used in situations where such probabilities cannot be estimated

Non-Insurance Transfer

Transfers a risk to another party. Transfer of risk by contract, such as hold-harmless clause in a contract. Hedging (technique for transferring risk of unfavorable price fluctuations to a speculator) Incorporation of a business firm transfers the creditors the risk of having insufficient assets

Traditional Definition of Risk

Uncertainty concerning the occurrence of loss

Strategic Risk

Uncertainty regarding the firm's financial goals and objectives.

How is Risk used in the Ins. Industry?

Used to identify the property or life being considered for insurance

Property Risks

involve possibility of losses associated with the destruction or theft of property