RISK AND INSURANCE

The Nature of Risks

CONCEPT OF RISK
Risk is a situation in which some kind of loss is possible. Risk is a part of life. Insurance protects against risk, in the sense that people who buy insurance are financially compensated in case of loss. Purchasing insurance does not remove risk. It merely provides compensation for the loss and spreads the cost of sharing the risk.

CONCEPT OF RISK
Because insurance is intangible, you do not actually see what you are getting which some people cannot bring themselves to spend money on something they cannot see and might not need. Risk is intangible too, until you experience a loss, or survive a close call.

CONCEPT OF RISK
Dealing with risk
There are several ways to handle risk.
Avoid risk for example, decided not to smoke Reduce risk, by limiting the number of cigarettes you smoke if you are a smoker Ignore risk Transfer risk

PROBABILITY THEORY
A Priori Probability
Determined when the total number of possible events are known. Example: the probability of getting a six on a roll of dice is 1/6. This concept has a limited practical application in the study of risk because situations where a number of possible outcome are known are very rare.

PROBABILITY THEORY
Empirical Probability
Determined on the basis of historical data Example: road accidents. The underlying concept that makes it possible for empirical probability to be measured accurately is that as the number of observations increases, the predicted loss tends to approach the actual loss (the law of large numbers)

PROBABILITY THEORY Empirical Probability

Law of large numbers is a concept with the following requirements:
Large number of similar loss exposures Loss exposures must be independent Random occurrence of losses.

PROBABILITY THEORY
Judgemental Probability
Determined based on the judgement of the person predicting the outcome. It is used when there is lack of historical data or credible statistics. Example: Astronaut program by Malaysia. The insurance company in Malaysia uses judgemental probability due to lack of credible statistics.

RELATED CONCEPT
Loss
A reduction or disappearance of economic value Hazard
A condition that increases the chance of loss Physical Hazard
Physical condition that increases the condition of loss

Peril
Is a cause of loss

Moral Hazard
A character defect in an individual that increases the chance of loss

Morale Hazard
A character defect in an individual that increases the chance of loss with the knowledge that insurance exists

BASIC CATEGORIES OF RISKS

Fundamental and Particular Risks
Fundamental risk
Affects the entire economy or large number of persons/groups within the economy Affects the society in general and cannot be controlled Example: flood or inflation

Particular risk
Those future outcomes that we can partially control Arises from individual decisions Example: to further study or to drive a car

BASIC CATEGORIES OF RISKS

Pure and Speculative Risks
Pure Risk
There are possibility of loss or no loss Example: to pass or to fail the exam

Speculative Risk
Possibility of loss, no loss or profit Example: investment

TYPES OF PURE RISKS

PERSONAL RISKS PROPERTY RISKS LIABILITY RISKS

TYPES OF PURE RISKS

Personal Risks
Risk of premature death
Significant losses: loss of human value and additional expenses

Risk of old age

Significant loss: insufficient income during retirement

Risk of poor health

Significant losses: Expensive medical charges and loss of earned income

Risk of unemployment
Significant losses: loss of earned income and depletion of accumulation financial assets.

TYPES OF PURE RISKS

Direct Loss
Damage to property by a peril. Example: house destroyed by fire

Indirect loss
Loss in consequence of a direct loss Example: loss of profit

Extra expenses
Extra costs incurred as a result of the loss Example: owner have to rent another building to continue operation/ living.

TYPES OF PURE RISKS

Liability risks
Anybody is exposed to liability risk as you can be held legally liable if you do something that results in bodily injury or property damage to someone else. A court of lay may order you to pay substantial damage to the person whom you have injured.