Chapter 1

Textbook

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Get motivated
if you had a bad time last year
https://www.youtube.com/watch?
v=MRQizPcZWBI
http://www.youtube.com/watch?
v=0yetHqWODp0

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Source:Internet

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Then

http://www.youtube.com/watch?v=obq5gJrO3z0

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FIERY BALLOON ACCIDENT KILLS 19 TOURISTS IN EGYPT

By MAGGIE MICHAEL
Feb. 26, 2013 9:11 PM EST
LUXOR, Egypt (AP) The terror lasted less than two minutes:
Smoke poured from a hot air balloon carrying sightseers on a
sunrise flight over the ancient city of Luxor, it burst in a flash of
flame and then plummeted about 1,000 feet to earth. A farmer
watched helplessly as tourists trying to escape the blazing
gondola leaped to their deaths.
Nineteen people were killed Tuesday in what appeared to be the
deadliest hot air ballooning accident on record. A British tourist
and the Egyptian pilot, who was badly burned, were the sole
survivors.
http://bigstory.ap.org/article/official-least-19-foreign-touristsdie-egypt-hot-air-balloon-crashes-near-luxor

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How do you see the activity now?

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Risk and Its Treatment

Different Definitions of Risk

Chance of Loss
Peril and Hazard
Classification of Risk
Major Personal Risks and Commercial Risks
Burden of Risk on Society
Techniques for Managing Risk

Outcome

Understand the terms above and how they are

related to our daily lives and learn the
technique for risk management)
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How do you see Risk?

Ahotairballoonburstintoflamesandcrashedtothegroundin
NewZealandonSaturday,killingall11peopleonboard,after
hittingapowerline.(January7,2012)
Similaraccidentscontinuetohappeneveryyear.

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Definition of RISK
webster.com
1: possibility of loss or injury : peril
2: someone or something that creates or suggests a hazard
3a : the chance of loss or the perils to the subject matter of an
insurance contract; also : the degree of probability of such loss
b : a person or thing that is a specified hazard to an insurer c :
an insurance hazard from a specified cause or source <war
risk>
4: the chance that an investment (as a stock or commodity)
will lose value

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Different Definitions of Risk

Risk: Uncertainty concerning the occurrence of a loss
Expected loss
Riskier => greater frequency or severity of loss (any
examples?)
Riskier => The expected loss will be higher
E.g. higher risk of Earthquake: Japan, higher risk of car
accident: drunk driving
Variability of loss (around expected value)
Riskier => more difficult to predict
E.g. Price change of stock vs price change of bonds
Loss Exposure: Any situation or circumstance in which a loss
is possible, regardless of whether a loss occurs.

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Different Definitions of Risk

Objective Risk vs. Subjective Risk
Objective risk is defined as the relative variation of actual
loss from expected loss
It can be statistically calculated using a measure of
dispersion, such as the standard deviation
Remember any graphs of normal distribution & standard
deviation?
How does the risk change with a larger units of exposure?
Objective risk declines as the number of exposure increases
claims: on average 10 out of 10,000 cases insured (from
experience)
Actual claims can be say, 8 or 12 => 2/10 or 20%
variation
How can we reduce the variation?
If 100 x 10,000 cases insured => objective risk =20%
/sqrt(100) =2%

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Subjectiveriskisdefinedasuncertaintybasedona
personsmentalconditionorstateofmind(hotair
balloon=>moreriskynow!Howabouttravellingby
planeafterthedisappearanceoftheMalaysiaAirlines
Flight17)
Twopersonsinthesamesituationmayhave
differentperceptionsofrisk(youmayhavenofearif
youarebeinggunpointedif.)
Highsubjectiveriskoftenresultsinconservative
behavior
Thinkaboutbuyingstocks
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Chance of Loss
Chance of loss: The probability that an event will occur
Objective Probability vs. Subjective Probability
Objective probability refers to the long-run relative frequency of
an event assuming an infinite number of observations and no
change in the underlying conditions
It can be determined by deductive or inductive reasoning
E.g. probability of getting a head from coin tossing vs probability
of a person having car accident in a year.

Subjective probability is the individuals personal estimate of the

chance of loss
A persons perception of the chance of loss may differ from the
objective probability
E.g. before and after global financial crisis
2012 Mayan Calendar Doomsday, End-of-the-World

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Peril and Hazard

A peril is defined as the cause of the loss
In an auto accident, the collision is the peril

A hazard is a condition that increases the chance of loss

Physical hazards are physical conditions that increase the chance
of loss
icy roads, defective wiring
Moral hazard is dishonesty or character defects in an individual,
that increase the chance of loss
faking accidents, inflating claim amounts
Attitudinal Hazard (Morale Hazard) is carelessness or indifference
to a loss, which increases the frequency or severity of a loss
leaving keys in an unlocked car
Legal Hazard refers to characteristics of the legal system or
regulatory environment that increase the chance of loss
large damage awards in liability lawsuits

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Questions (take out a paper)

Given the following scenario, state which is the
hazard, the peril, and the exposure, respectively?
You recently moved from Beijing to Taiwan and
bought a home. A typhoon destroys your home.
True or False? Twin towers burn to the ground
resulting in a complete loss. The fact that the
construction material is steel is the peril involved in
this loss.

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Classification of Risk
Pure and Speculative Risk
A pure risk is one in which there are only the possibilities of
loss or no loss
earthquake
A speculative risk is one in which both profit or loss are
possible
gambling
Diversifiable Risk and Nondiversifiable Risk
A diversifiable risk affects only individuals or small groups (car
theft). It is also called nonsystematic or particular risk.
A nondiversifiable risk affects the entire economy or large
numbers of persons or groups within the economy (hurricane).
It is also called systematic risk or fundamental risk.
Government assistance may be necessary to insure
nondiversifiable risks.

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Classification of Risk
Enterprise risk encompasses all major risks faced by a
business firm, which include: pure risk, speculative risk,
strategic risk, operational risk, and 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.

Enterprise Risk Management combines into a single unified

treatment program all major risks faced by the firm:

Pure risk
Speculative risk
Strategic risk
Operational risk
Financial risk

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Major Personal Risks and Commercial Risks

Personal risks involve the possibility of a loss or reduction
in income, extra expenses or depletion of financial assets:
Premature death of family head
Insufficient income during retirement
Most workers are not saving enough for a
comfortable retirement
More Americans Say 80 Is The New Retirement
Age Forbes
http://www.youtube.com/watch?v=8t1cBn7Vnns
Poor health (catastrophic medical bills and loss of
earned income)
Involuntary unemployment

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Insight
About half of all personal bankruptcy cases are (at
least in part) due to medical reasons
2000-2007 June: 5 million families filed for
bankruptcy due to medical reasons
20% of people who reported having medical bill
problems considered filing for bankruptcy (bills too
expensive)
More than half of adults with inadequate insurance:
didnt fill in prescription, skipped recommended
tests, treatment or didnt go to doctor for medical
advices. $$ problem
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Exhibit 1.1 Reported Total Savings and

Investments among Those Responding, by Age

Whatcanyoutellfromthefiguresabove?
(not including value of primary residence or defined benefit plans)

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Major Personal Risks and

Commercial Risks
Property risks involve the possibility of losses
associated with the destruction or theft of property:
Physical damage to home and personal property from fire,
tornado, vandalism, or other causes

Direct loss vs. indirect loss

A direct loss is a financial loss that results from the physical
damage, destruction, or theft of the property, such as fire
damage to a home
An indirect loss results indirectly from the occurrence of a direct
physical damage or theft loss, such as the additional living
expenses after a fire to a home. These additional expenses would
be a consequential loss.

e.g. FireatFaYuenStreetkilled9andinjured34(Nov.2011 )
Rallyover'photoban'shutsretailerDolce&GabbanainTsimShaTsui,Jan10,2012

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http://www.youtube.com/watch?
v=00ZmGa8Q42E
http://www.youtube.com/watch?v
=O4rSiUPGt3A
http://www.youtube.com/watch?
feature=player_embedded&v=Vde
yQaQNckA
Amazontestingdronesfordeliveries
Writedownthetypesofriskinvolved

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Major Personal Risks and

Commercial Risks
Liability risks involve the possibility of being held liable
for bodily injury or property damage to someone else
There is no maximum upper limit with respect to the amount
of the loss
A lien can be placed on your income and financial assets
Defense costs can be enormous

Haveyoueverplayedgolf,remotecontrol(rc)toys,etc?
WomenkilledbyrcaeroplaneinMainland.
Mangothitbyagolfball.
ManparalyzedbyrchelicopteraccidentinH.K.
TheownerofthehelithathithimwasonlyfinedHK$5000(US$642).

AcivilsuitthenfollowedandthevictimwasawardedHK$8.8M(U$1.13M).

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Brainsurgeryformanhitbywaywardtoycopter
PatsyMoyandCarolChung
Monday,January14,2008,,http://www.thestandard.com.hk
A44yearoldmanunderwentemergencybrainsurgeryafterhewashitbyaremote
controlledtoyhelicopteryesterday.LawKwokwahwasrushedbyambulancetoQueen
ElizabethHospitalwitha20centimeterlongwoundtothebackofhishead.Law,who
worksinatravelcompany,wassaidtohaveover10yearsofexperienceflyingtoy
helicoptersandhadwoninlocalcompetitions.Policesaidtheaccidenthappenedat
1.48pmwhenLawandhisfriend,surnamedWongandover40yearsold,wereflyinga
remotecontrolhelicopteratanopenspaceonChunWangStreetinTseungKwanO.
Policesaidthemanwasafriendofthetoyowner.Lawaskedtotrythetoyand
accidentallyhitabuttonon
theremotecontrol,causingthehelicoptertocrashintohishead.
Thebladesofthe1.5meterlonghelicopterbrokeoffintheaccident.Thehelicopter,
weighingsixkilograms,canflyupto90kilometersanhour.Policearestillinvestigating.
TheCivilAviationDepartmentsaiditwillfollowupthecase,addingthatlicensingisnot
requiredforhelicoptersweighinglessthansevenkilograms.Theaccidenthappenedata
governmentsitewithawarningsignprohibitingflyingremotecontroltoys.Butsome
aficionadossaidtheysimplyignoredthewarningduetolackofotherplacesinurban
districtsfortheiractivities.AMrTong,whohasbeenflyingremotecontrolhelicopters
forthepastthreeyears,estimatedtherewere50,000to80,000playersinHongKong.24
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 5000
( )2 6 05:05

5000
45

http://www.daddyhobby.com06022009
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9/11/2004

TheHighCourtorderedtheIncorporatedOwnersAssociationofAlbertHouse
inAberdeentowindup,tenyearsafterafatalcanopycollapsethere,inwhich
awomanwaskilledand13othersinjured.Itcouldnotrepay morethan
25milliondollarsincompensationandlegalfeeswithinareasonable
period.

Beawareoftheabovecasewhenyoubecomeapropertyowner

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encumbrance

2500

6 22 10

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 94 8 1
1
13

6
3000
136
2001 15%

http://www.gaforum.org/archive/index.php/t101471.html

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Indirect loses
2008 08 18
http://hk.apple.nextmedia.com
14
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..

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Major Personal Risks and

Commercial Risks
Commercial Risks
Firms face a variety of pure risks that can have serious
financial consequences if a loss occurs:
Property risks, such as damage to buildings, furniture and office
equipment (flooding in Thailand)
Liability risks, such as suits for defective products, pollution of the
environment, and sexual harassment
Loss of business income, when the firm must shut down for some
time after a physical damage loss
Other risks to firms include crime exposures, human resource
exposures (Steve Jobs), foreign loss exposure (Citic Pacifics $2bn
in forex losses, FX, heads kidnapped, overseas construction of
water dam), intangible property exposures, and government
exposures (e.g. new environmental protection laws, labor laws in
mainland, laws related to raising product prices affecting inflation)

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HaveyouheardabouttheBPoilspill2010?Notyetsettledin2014
Whatisthedirectloss?
Indirectlosses?
AUSjudgehasgivenfinalapprovalto
BPs$7.8bn(4.8bn)partsettlementwith
businessesandindividualswhosuffered
lossesfollowingitsdisastrousGulfof
Mexicooilspill.
Thesettlementresolvesmostprivate
individualsclaimsforeconomiclossand
propertydamage,butitdoesntcover
lawsuitsbroughtbytheUSgovernmentor
thosebroughtbythestatesofAlabama
andLouisiana.
http://www.telegraph.co.uk22Nov2012

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Burden of Risk on Society

The presence of risk results in three major
burdens on society:
In the absence of insurance, individuals would
have to maintain large emergency funds
The risk of a liability lawsuit may discourage
innovation, depriving society of certain goods
and services
Risk causes worry and fear

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Techniques for Managing Risk

There are five major methods for managing risk
1. Avoidance
2. Loss control
Loss prevention refers to activities to reduce the frequency of
losses
Loss reduction refers to activities to reduce the severity of losses
3. Retention
An individual or firm retains all or part of a given risk
Active retention means that an individual is consciously aware of
the risk and deliberately plans to retain all or part of it
Passive retention means risks may be unknowingly retained
because of ignorance, indifference, or laziness
Self Insurance is a special form of planned retention by which
part or all of a given loss exposure is retained by the firm

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Techniques for Managing Risk

4. Noninsurance transfers
A risk may be transferred to another party by several methods:
A transfer of risk by contract, such as through a service contract or
a hold-harmless clause in a contract
Hedging is a technique for transferring the risk of unfavorable
price fluctuations to a speculator by purchasing and selling
futures contracts on an organized exchange
Incorporation of a business firm transfers to the creditors the risk
of having insufficient assets to pay business debts

5. Insurance

For most people, insurance is the most practical method for

handling a major risk

WhattechniquesdoyouthinkBPemployed?
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Concept check
Fog that increases the chance of an
automobile accident is an example of a

A) speculative risk.
B) peril.
C) physical hazard.
D) moral hazard.

Why not peril?

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Concept check
the cause of a loss is called________

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Chapter 1 CASE APPLICATION

Mike is a college senior who is majoring in BBA.
He owns a high-mileage 2000 Ford with current
market value of $2,500.
The current replacement value of his personal
property in a rented apartment totals $10,000.
He wears disposable contact lenses, which cost $300
for a six-month supply.
He also has a waterbed in his rented apartment that
has leaked water in the past.
As avid runner, Mike run five miles daily in a nearby
public park that has reputation of being extremely
dangerous due to drug dealers.
Mikes parents both work to help him pay for his
tuition.

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Mikes Methods of Handling

Risks
For each of the following risks and loss
exposures, identify an appropriate RM
technique that could have been used to
deal with the exposure. (use the same
paper to answer the questions)
Physical damage to the 2000 Ford due to
a collision with another motorist.

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Mikes Methods of Handling

Risks

Liability lawsuit against Mike arising out of

the negligent operation of his car.

Total loss of personal property due to a

fire in the kitchen of his rented
apartment.
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Mikes Methods of Handling

Risks

Disappearance of one contact lens.

Waterbed leak that cause property damage to

the apartment.

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Mikes Methods of Handling Risks

Physical assault on Mike by gang members who are

dealing drugs in the park where he runs.

Loss of tuition assistance from Mikes father who is

killed by a drunk driver in an auto accident.

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In class exercise, take out a paper

10000 car insurance

Chance of car accident in a year 1%
Kowloon: 80 to 120
Hong Kong: 75 to 125

Are the chances of loss different in Kln and HK?

What type of risk should be considered?
Ans: Objective
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