RISK IN INSURANCE

The concept of Risk

  • Introduction

 Welcome to the first lecture on the definition of risk and related terms. We shall begin the lecture highlighting meaning of risk. We will further explain the other related terms; perils and hazard, and classification of risk.

 

  • Lecture Outline

 

1.2.1 Introduction

1.2.2 Meaning of risk

1.2.3 Perils and Hazards

1.2.4 Classification of risk.

 

Introduction

The word risk is certainly used frequently in everyday conversation and seems to be well understood. Risk implies some form of uncertainty about an outcome in a given situation. An event might occur and if it does, the outcome is not favorable to us. Risk can be contrasted with the word chance which implies some doubt about the outcome in a given situation; the difference is that the outcome may also be favorable e.g. risk of an accident, chance of winning a bet etc

 

However in common business conversations the word risk is used to mean different things:

  • Risk as cause e.g. fire as a risk, Personal injury as a risk etc.
  • Risk as likelihood e.g. the risk of something happening, leaving keys in a car results in high risk etc.
  • Risk as the object – e.g. factory, plane, machine or ship might be referred to as the risk.
  • Risk as verb – It is not only used as a noun but also as a verb e.g. risk of crossing the road.

 

All the above illustrate how the use of the word goes far beyond its technical meaning.

 

Meaning of risk

Various scholars have advanced different definitions of risk as follows:-

  • Risk is the possibility of an unfortunate occurrence.
  • Risk is a combination of hazards.
  • Risk is unpredictability – the tendency that actual results may differ from predicted results.
  • Risk is uncertainty of loss.
  • Risk is the possibility of loss.

 

Rather than try to ascertain the best definition of risk, the underlying commonality in all the definitions should be of interest and they include;

 

i) Uncertainty

Uncertainty implies doubt about the future based on a lack of knowledge or imperfection in knowledge. If we always knew what was going to happen, there would be no risk.

 

ii) Levels of Risk

Risk is thus a combination of the likelihood of an event and the severity of damage should the event occur. If an event occurs a great deal, then our knowledge about the future begins to increase and an element of certainty begins to creep in e.g. shoplifting, combining frequency and severity we find two relationships

iii) Peril and Hazard (Cause(s))

Peril is the prime cause, it is what will give rise to the loss e.g. storm, fire etc. Factors which may influence the outcome are referred to as hazards.  Hazards are not themselves the cause of the loss but they can increase or decrease the effect should a peril operate. Hazard can be physical or moral. Physical hazard relates to the physical characteristics of risk e.g. grass thatched house while moral hazard concerns human aspects which may influence the outcome.  It usually relates to the attitude of the person e.g. conman.

 

Classification of Risk

Risks could be classified as follows:

  1. Financial and non-financial risks- a financial risk is one where the outcome can be measured in monetary terms and where it is possible to place some value on the outcome. Measurement in personal injury may be done a court when damages are awarded or negotiation among lawyers and insurers. There are cases where measurement is not possible e.g. choice of a new car, selection from a restaurant menu, selection of a career, choice of a marriage partner etc all these are non-financial risks. Generally in business we are concerned with financial risks.
  2. Pure and speculative risks- pure risks involve a loss or at best a break even situation. The outcome can only be unfavorable to us or leave us in the same position as we enjoyed before the event occurred e.g. motor accident, fire, theft etc. speculative risk is where there is a chance of gain e.g. investing money in shares (the investment may result in a loss or possibly a break even but the reason it was made was the prospect of gain), pricing of products, marketing decisions, decisions on diversification, expansion or acquisition, providing credit to customers among others. Generally pure risks are normally insurable while speculative risks are generally not insurable though the trend is changing and hence dynamic.
  3. Fundamental and particular risks- fundamental risks are those which arise from causes outside the control of any one individual or even a group of individuals. In addition the effect of fundamental risks is felt large numbers of people e.g. earthquakes, floods, famine, volcanos, war etc. Particular risks are much more personal both in their cause and effect e.g. fire, theft etc. Al these risks arise from individual causes and affect individuals in their consequences. Risks however change classification, mostly from particular to fundamental e.g. unemployment. In the main, particular risks are insurable while fundamental risks are not.
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