CHAPTER OBJECTIVES

When you have finished this chapter, you should be able to do the following:

• Define and explain the meaning of the term risk
• Distinguish among the terms risk, peril, and hazard
• Identify and explain the classes of hazards
• Differentiate between pure risk and speculative risk
• Differentiate between fundamental and particular risk
• Describe the categories into which pure risk may be subdivided
• Identify and explain the principal methods of handling risk

You see the mangled metal of two cars that have collided on an interstate highway. A fire engine with its siren screaming roars down the street. A building in your neighborhood burns, or you see an ambulance racing to the hospital. Such tragic events arouse your interest and emotions. After the noise and excitement have died down, you are grateful that the loss did not happen to you and you may feel sorry for whoever suffered the loss. But you're glad that it wasn't you. Losses like these happen to some people, whereas others go along happily, free from misfortune. The fact that these losses or similar events could happen to you, and the fact that you can't tell for sure whether or not they will, is a condition we call risk. Risk is a pervasive condition of human existence. Although our instinctive understanding of the concept of risk is clear enough, terms that have a simple meaning in everyday usage sometimes have a specialized connotation when used in a particular field of study. In this chapter, we will examine the concept of risk as the fundamental problem with which insurance deals. In addition, we will examine several related concepts.

THE CONCEPT OF RISK

It would seem that the term risk is a simple enough notion. When someone states there is risk in a particular situation, the listener understands what is meant: In the given situation, there is uncertainty about the outcome, and the possibility exists that the outcome will be unfavorable. This loose, intuitive notion of risk, which implies a lack of knowledge about the future and the possibility of some adverse consequence, is satisfactory for conversational usage, but for our purpose, a somewhat more rigid definition is desirable.

Economists, statisticians, decision theorists, and insurance theorists have long discussed the concepts of risk and uncertainty in an attempt to construct a definition of risk that is useful for analysis in each field of investigation. So far, they have not been able to agree on a single definition that can be used in each field. A definition of risk that is suitable for the economist or statistician may be worthless as an analytic tool for the insurance theorist. Because each group treats a different body of subject matter, each requires a different concept of risk. Although the statistician, the decision theorist, and the insurance theorist use the term risk, each may mean something different.

Insurance is in its infancy as a body of theory. As a result, we find contradictory definitions of risk throughout the literature dealing with this phenomenon from an insurance point of view. One reason for these contradictions is that insurance theorists have attempted to borrow the definitions of risk used in other fields. Surprising as it may seem, insurance text writers have not been able to agree on a definition of this basic concept.

To compound the problem, the term risk is used by people in the insurance business to mean either a peril insured against (e.g., fire is a risk to which most property is exposed) or a person or property protected by insurance (e.g., many insurance companies believe young drivers are not good risks). In this text, however, we will use the term in its general meaning to indicate a situation in which an exposure to loss exists.

Current Definitions of Risk

If we were to survey the best-known insurance textbooks used in colleges and universities today, we would find a general lack of agreement concerning the definition of risk.¹ Although the insurance theorists have not agreed on a universal definition, there are common elements in all the definitions: indeterminacy and loss.

• The notion of an indeterminate outcome is implicit in all definitions of risk: The outcome must be in question. For risk to exist, there must be at least two possible outcomes. If we know for certain that a loss will occur, there is no risk. Investment in a capital asset, for example, usually involves a realization that the asset is subject to physical depreciation and its value will decline. Here, the outcome is certain, so there is no risk.
• At least one of the possible outcomes is undesirable. This may be a loss in the generally accepted sense in which something the individual possesses is lost, or it may be a gain smaller than the gain that was possible. For example, the investor who fails to take advantage of an opportunity “loses” the gain that might have been made. The investor faced with the choice between two stocks may be said to lose if he or she chooses the one that increases in value less than the alternative.

Our Definition of Risk

We define risk as a condition of the real world in which there is an exposure to adversity. More specifically,

First, in this definition, risk is a condition of the real world; it is a combination of circumstances in the external environment. Second, in this combination of circumstances, there is a possibility of loss. When we say that an event is possible, we mean that it has a probability between zero and one; it is neither impossible nor definite. Third, there is no requirement that the possibility be measurable but only that it must exist. We may or may not be able to measure the degree of risk, but the probability of the adverse outcome must be between zero and one.²

The undesirable event is described as “an adverse deviation from a desired outcome that is expected or hoped for.” The reference to a desired outcome that is either expected or hoped for contemplates individual and aggregate loss exposures. The individual hopes that adversity will not occur, and it is the possibility that this hope will not be met that constitutes risk. If you own a house, you hope that it will not catch fire. When you make a wager, you hope that the outcome will be favorable. That the outcome in either event may be something other than what you hope for constitutes the possibility of loss or risk.

In the case of an insurer, actuaries predict some specified number and amount of losses and charge a premium based on this expectation. The amount of predicted losses is the desired outcome that is expected by the insurer. For the insurer, risk is the possibility that losses will deviate adversely from what is expected.

Uncertainty and Its Relationship to Risk

Because the term uncertainty is often used in connection with the term risk (sometimes even interchangeably), it seems appropriate to explain the relationship between the two terms.

The most widely held meaning of uncertainty refers to a state of mind characterized by doubt, based on a lack of knowledge about what will or will not happen in the future. It is the opposite of certainty, which is a conviction or certitude about a particular situation. A student says “I am certain I will get an A in this course,” which means the same as “I am positive I will get an A in this course.” Both statements reflect a conviction about the outcome. Uncertainty, on the other hand, is the opposite mental state. If one says “I am uncertain what grade I am going to get in this course,” the statement reflects a lack of knowledge about the outcome. Uncertainty, then, is simply a psychological reaction to the absence of knowledge about the future.³ The existence of risk—a condition or combination of circumstances in which there is a possibility of loss—creates uncertainty on the part of individuals when that risk is recognized.

The individual's conviction or lack thereof (certainty or uncertainty) about a specific fact or situation may or may not coincide with the conditions of the real world. The student who says “I am certain I will get an A in this course” may actually get a B, a C, a D, or even an F. Uncertainty varies with the knowledge and attitudes of the person. Different attitudes are possible for different individuals under identical conditions of the real world. It is possible, for example, for a person to experience uncertainty in a situation in which he or she imagines there is a chance of loss but where no chance of loss exists. Similarly, an individual may feel no uncertainty regarding a particular risk when the exposure to loss is not recognized. Whether or not a risk is recognized, however, does not alter its existence. When there is a possibility of loss, risk exists whether or not the person exposed to loss is aware of the risk.⁴

The Degree of Risk

It is intuitively obvious that there are some situations in which the risk is greater than in other situations. Just as we should agree on what we mean when we use the term risk, we should agree on the way(s) in which risk can be measured. Precisely what is meant when we say that one alternative involves “more risk” or “less risk” than another?

It would seem that the most commonly accepted meaning of degree of risk is related to the likelihood of occurrence. We intuitively consider those events with a high probability of loss to be riskier than those with a low probability. This intuitive notion of the degree of risk is consistent with our definition of risk. When risk is defined as the possibility of an adverse deviation from a desired outcome that is expected or hoped for, the degree of risk is measured by the probability of the adverse deviation. In the case of the individual, the hope is that no loss will occur, so the probability of a deviation from what is hoped for (which is the measure of risk) varies directly with the probability that a loss will occur. In the case of the individual, we measure risk in terms of the probability of an adverse deviation from what is hoped for. Actuarial tables tell us, for example, that the probability of death at age 60 is approximately 1 percent, and at age 83 it is about 10 percent. At age 96, the probability of death increases to nearly 30 percent. Using the probability of an adverse deviation from the outcome that is hoped for, we view the risk of death at age 83 as greater than that at age 60 but less than that at age 96. The higher the probability that an event will occur, the greater the likelihood of a deviation from the outcome that is hoped for and the greater the risk, as long as the probability of loss is less than one.

If the probability of loss is 1.0, there is no chance of an outcome other than that which is expected and, therefore, no hope of a favorable result. Similarly, when the probability of loss is zero, there is no possibility of loss and, therefore, no risk.

In the case of a large number of exposure units, estimates can be made about the likelihood that a given number of losses will occur, and predictions can be made on the basis of these estimates. Here the expectation is that the predicted number of losses will occur. In the case of aggregate exposures, the degree of risk is not the probability of a single occurrence or loss; it is the probability of some outcome different from that predicted or expected. Insurance companies make predictions about losses that are expected to occur and charge a premium based on this prediction. For the insurance company, the risk is that its prediction will be inaccurate. Suppose that based on past experience, an insurer estimates that 1 out of 1,000 houses will burn. If the company insures 100,000 houses, it might predict that 100 houses will burn out of the 100,000 insured, but it is highly unlikely that 100, and only 100, houses will burn. The actual experience will undoubtedly deviate from the expectation, and insofar as this deviation is unfavorable, the insurance company faces risk. Therefore, the insurance company predicts the number of houses that will burn, and it estimates the range of error. The prediction might be that 100 losses will occur and that the range of possible deviation will be plus or minus 10. Some number of houses between 90 and 110 are expected to burn, and the possibility that the number will be more than 100 is the insurer's risk. Students who have studied statistics will note that when one of the standard measures of dispersion (such as the standard deviation) is used, risk is measurable, and we can say that more risk or less risk exists in a given situation, depending on the standard deviation.

At times we use the terms more risk and less risk to indicate a measure of the possible size of the loss. Many people would say that there is more risk involved in a possible loss of $1000 than in that of $1 even though the probability of loss is the same in both cases. The probability that a loss may occur and the potential severity of the loss if it does occur contribute to the intensity of one's reaction to risk. It seems, therefore, that a measurement of risk should recognize the magnitude of the potential loss. Given two situations, one involving a $1,000 exposure and the other a $1 exposure and assuming the same probability in each case, it seems appropriate to state that there is a greater risk in the case of the possible loss of 1,000 dollars. This is consistent with our definition of risk since the loss of $1,000 is a greater deviation from what is hoped for (i.e., no loss) than is the loss of 1 dollar. On the other hand, given two situations in which the amount exposed is the same (e.g., $1,000), there is more risk in the situation with the greater probability of loss.

While it may be difficult to relate the size of the potential loss and the probability of that loss in the measurement of risk, the concept of expected value may be used to relate these two facets of a given risk situation. The expected value of a loss in a given situation is the probability of that loss multiplied by the amount of the potential loss. If the amount at risk is $10 and the probability of loss is 0.10, the expected value of the loss is $1. If the amount at risk is $100 and the probability is 0.01, the expected value is also $1. This is a very useful concept, as we will see later.

Risk Distinguished from Peril and Hazard

The terms peril and hazard are commonly used interchangeably with each other and with risk. However, to be precise, it is important to distinguish these terms. A peril is a cause of a loss. We speak of the peril of fire, windstorm, hail, or theft. Each of these is the cause of the loss that occurs. A hazard, on the other hand, is a condition that may create or increase the chance of a loss arising from a given peril. It is possible for something to be both a peril and a hazard. For instance, sickness is a peril causing economic loss, but it is also a hazard that increases the chance of loss from the peril of premature death. Hazards are normally classified into three categories:

1. Physical hazard consists of those physical properties that increase the chance of loss from the various perils. Examples of physical hazards that increase the possibility of loss from the peril of fire are the type of construction, the location of the property, and the occupancy of the building.
2. Moral hazard refers to the increase in the probability of loss that results from dishonest tendencies in the character of the insured person. More simply, it is the dishonest tendencies on the part of an insured that may induce that person to attempt to defraud the insurance company. A dishonest person, in the hope of collecting from the insurance company, may intentionally cause a loss or may exaggerate the amount of a loss in an attempt to collect more than the amount to which he or she is entitled. Fraud is a significant problem for insurance companies and increases the cost of insurance.
3. Morale hazard, not to be confused with moral hazard, acts to increase losses where insurance exists, not necessarily because of dishonesty but because of a different attitude toward losses that will be paid by insurance. When people have purchased insurance, they may have a more careless attitude toward preventing losses or may have a different attitude toward the cost of restoring damage. Morale hazard is also reflected in the attitude of persons who are not insureds. The tendency of physicians to provide more expensive levels of care when costs are covered by insurance is a part of the morale hazard. Similarly, the inclination of juries to make larger awards when the loss is covered by insurance, the so-called deep-pocket syndrome, is another example of morale hazard. In short, morale hazard acts to increase the frequency and severity of losses when such losses are covered by insurance.

In addition to these three traditional types of hazard, a fourth hazard—the legal hazard—should be recognized. Legal hazard refers to the increase in the frequency and severity of loss that arises from legal doctrines enacted by legislatures and created by the courts. Jurisdictions in which legal doctrines favor a plaintiff represent a hazard to persons or organizations who are sued at tort. Although legal hazard is greatest in the field of legal liability, it also exists in the case of property exposures. In jurisdictions where building codes require that new buildings conform to statutory requirements, the destruction of a building that does not meet the requirements may force an owner to incur additional costs in reconstruction, thereby increasing the exposure to loss.

Classifications of Risk

In its broadest context, the term risk includes all situations in which there is an exposure to adversity. Risks may be classified in many ways; however, certain distinctions are particularly important for our purposes. These include the following.

Static and Dynamic Risks An important distinction exists between static and dynamic risks.⁵

Dynamic risks are those resulting from changes in the economy. Changes in the price level, consumer tastes, income and output, and technology may cause financial loss to members of the economy. These dynamic risks normally benefit society over the long run since they are the result of adjustments to misallocation of resources. Although these dynamic risks may affect a large number of individuals, they are generally considered less predictable than static risks since the former do not occur with any precise degree of regularity.

Static risks involve those losses that would occur even if there were no changes in the economy. If we could hold consumer tastes, output and income, and the level of technology constant, some individuals would still suffer financial loss. These losses arise from causes other than the changes in the economy, such as the perils of nature and the dishonesty of other individuals. Unlike dynamic risks, static risks are not a source of gain to society. Static losses involve the destruction of the asset or a change in its possession as a result of dishonesty or human failure. Static losses tend to occur with a degree of regularity over time, and as a result, are generally predictable. Because they are predictable, static risks are more suited to treatment by insurance than are dynamic risks.

Fundamental and Particular Risks The distinction between fundamental and particular risks is based on the difference in the origin and consequences of the losses.⁶ Fundamental risks involve losses that are impersonal in origin and consequence. They are group risks caused, for the most part, by economic, social, and political phenomena although they may result from physical occurrences. They affect large segments or even all of the population. Particular risks involve losses that arise out of individual events and are felt by individuals rather than by the entire group. They may be static or dynamic. Unemployment, war, inflation, earthquakes, and floods are all fundamental risks. The burning of a house and the robbery of a bank are particular risks.

Since fundamental risks are caused by conditions more or less beyond the control of the individuals who suffer the losses and since they are not the fault of anyone in particular, it is held that society rather than the individual has a responsibility to deal with them. Although some fundamental risks are dealt with through private insurance,⁷ usually some form of social insurance or government transfer program is used to deal with fundamental risks. Unemployment and occupational disabilities are fundamental risks treated through social insurance. Flood damage or earthquakes make a district a disaster area eligible for federal funds.

In the final analysis, whether a risk is considered fundamental or particular depends on current public opinion concerning the responsibility for the causes and consequences of the risk. In the aftermath of the terrorist attack on the World Trade Center on September 11, 2001, Congress and the insurance industry debated the question of whether terrorist attacks are a fundamental or particular risk. Reinsurers, the insurers that provide insurance to insurance companies, announced their intent to exclude acts of terrorism from the coverage they provide to other insurers. Faced with the loss of backup coverage, the insurers that deal with the public developed an endorsement for their policies excluding loss from terrorist acts. In response to these developments, Congress established a federal terrorism reinsurance program in November 2002.

Particular risks are considered to be the individual's own responsibility, inappropriate subjects for action by society as a whole. They are dealt with by the individual through the use of insurance, loss prevention, or some other technique.

Pure and Speculative Risks One of the most useful distinctions is that between pure risk and speculative risk.⁸ Speculative risk describes a situation in which there is a possibility of loss but also a possibility of gain. Gambling is a good example of a speculative risk. In a gambling situation, risk is deliberately created in the hope of gain. The student wagering $10 on the outcome of Saturday's game faces the possibility of loss, but this is accompanied by the possibility of gain. The entrepreneur or capitalist faces speculative risk in the quest for profit. The investment made may be lost if the product is not accepted by the market at a price sufficient to cover costs, but this risk is borne in return for the possibility of profit. The term pure risk, in contrast, is used to designate those situations that involve only the chance of loss or no loss. One of the best examples of pure risk is the possibility of loss surrounding the ownership of property. The person who buys an automobile, for example, immediately faces the possibility that something may happen to damage or destroy the automobile. The possible outcomes are loss or no loss.

The distinction between pure and speculative risks is an important one because normally only pure risks are insurable. Insurance is not concerned with the protection of individuals against those losses arising out of speculative risks. Speculative risk is voluntarily accepted because of its two-dimensional nature, which includes the possibility of gain. Not all pure risks are insurable, and a further distinction between insurable and uninsurable pure risks may be made. A discussion of this difference will be delayed until Chapter 2.

Systemic Risk The global financial crisis of 2008 to 2009 has increased attention on another category of risk known as systemic risk. Generally, systemic risk refers to a risk that can affect an entire system, rather than just one entity. In economics, the term is often used where a shock, such as the failure of a single entity, could cause cascading effects and severely disrupt the financial system. For example, in March 2008, Bear Stearns, the fifth largest U.S. investment bank, was threatened with failure. Concerned about the potential for contagion and disruption in the financial markets, the Federal Reserve and U.S. Treasury arranged for JP Morgan Chase to acquire Bear Stearns with financial assistance from the Federal Reserve Bank of New York (NY Fed). In September 2008, the NY Fed agreed to lend up to $85 billion to prevent the bankruptcy of American International Group (AIG). Over the next several years, the U.S. Treasury and the Federal Reserve provided additional support to financial institutions, primarily banks. Public outrage has led to a number of changes in regulation to address systemic risk, particularly the problem of institutions that are “too big to fail” or TBTF.

Classifications of Pure Risk Although it would be impossible in this book to list all the risks confronting an individual or business, we can briefly outline the nature of the various pure risks that we face. For the most part, these are static risks. Pure risks that exist for individuals and business firms can be classified under one of the following:

1. Personal risks. These consist of the possibility of loss of income or assets as a result of the loss of the ability to earn income. In general, earning power is subject to four perils: (a) premature death, (b) dependent old age, (c) sickness or disability, and (d) unemployment.
2. Property risks. Anyone who owns property faces property risks because such possessions can be destroyed or stolen. Property risks embrace two distinct types of loss: direct loss and indirect or “consequential” loss. Direct loss is the simplest to understand: If a house is destroyed by fire, the owner loses the value of the house. This is a direct loss. However, in addition to losing the value of the building, the property owner no longer has a place to live. During the time required to rebuild the house, it is likely that the owner will incur additional expenses living somewhere else. This loss of use of the destroyed asset is an indirect, or consequential, loss. An even better example is the case of a business firm. When a firm's facilities are destroyed, it loses the value of those facilities and the income that would have been earned through their use. Property risks, then, can involve two types of losses: (a) the loss of the property and (b) loss of use of the property resulting in lost income or additional expenses.
3. Liability risks. The basic peril in the liability risk is the unintentional injury of other persons or damage to their property through negligence or carelessness; however, liability may result from intentional injuries or damage. Under our legal system, the laws provide that one who has injured another, or damaged another's property through negligence or otherwise, can be held responsible for the harm caused. Liability risks, therefore, involve the possibility of loss of present assets or future income as a result of damages assessed or legal liability arising out of either intentional or unintentional torts, or invasion of the rights of others.
4. Risks arising from failure of others. When another person agrees to perform a service for you, he or she undertakes an obligation that you hope will be met. When the person's failure to meet this obligation would result in your financial loss, risk exists. Examples of risks in this category would include failure of a contractor to complete a construction project as scheduled, or failure of debtors to make payments as expected. With the development of the Internet, the rapid evolution of e-commerce, and the increased trend toward outsourcing by big businesses, a variety of new risks relating to the failure of others have emerged.

THE BURDEN OF RISK

Regardless of the manner in which risk is defined, the greatest burden in connection with risk is that some losses will occur. When a house is destroyed by fire, money is stolen, or a wage earner dies, there is a financial loss. When someone is negligent and that negligence results in injury to a person or damage to property, there is a financial loss. These losses are the primary burden of risk and the primary reason that individuals attempt to avoid risk or alleviate its impact.

In addition to the losses, there are other detrimental aspects of risk. The uncertainty as to whether the loss will occur requires the prudent individual to prepare for its possible occurrence. In the absence of insurance, one way this can be done is to accumulate a reserve fund to meet the losses if they do occur.⁹ Accumulation of such a reserve fund carries an opportunity cost, for funds must be available at the time of the loss and must, therefore, be held in a highly liquid state. The return on such funds will presumably be less than if they were put to alternative uses. If each property owner accumulates his or her own fund, the amount of funds held in such reserves will be greater than if the funds are amassed collectively.

Furthermore, the existence of risk may have a deterrent effect on economic growth and capital accumulation. Progress in the economy is determined to a large extent by the rate of capital accumulation, but the investment of capital involves risk that is distasteful. Investors as a class will incur the risks of a new undertaking only if the return on the investment is sufficiently high to compensate for the dynamic and static risks. The cost of capital is higher in those situations in which the risk is greater, and the consumer must pay the resulting higher cost of the goods and services or they will not be forthcoming.

Finally, the uncertainty connected with risk usually produces a feeling of frustration and mental unrest. This is particularly true in the case of pure risk. Speculative risk is attractive to many individuals. The gambler obviously enjoys the uncertainty connected with wagering more than the certainty of not gambling otherwise he or she would not gamble. But the possibility of gain or profit, which exists only in the speculative risk category, is attractive. In the case of pure risk, where there is no compensating chance of gain, risk is distasteful. Most people hope that misfortunes will not befall them and that their present state of well-being will continue. While they hope that no misfortune will occur, people are nevertheless likely to worry about possible mishaps. This worry, which induces a feeling of diminished well-being, is an additional burden of risk.

THE GROWING NUMBER AND VARIETY OF PURE RISKS

From the dawn of civilization, humans have faced the possibility of loss. Our ancestors confronted an environment characterized by incredible perils and hazards. The earliest perils giving rise to risk were those of nature and predators (including savage beasts and human predators). Humans learned to anticipate and prepare for adversity, collectively and individually. They built shelter and they saved for the future. This provided protection from the elements and savage beasts, but it created new risks. Structures constructed for protection were vulnerable to damage, and saving meant accumulation of wealth, which inevitably created new risks. Those who saved were exposed to the predatory inclinations of those who did not (an exposure that continues to the present day). Despite progress in learning how to deal with risks, the challenge of dealing with risk continued to grow. As new ways of addressing risk are found, new risks appear, often as a result of progress.

Harnessing energy has made life easier, but it has created new risks. Until about 200 years ago, the major sources of energy were muscle (from humans and animals), wind, and water, and the risks associated with energy sources were modest. Since the early 1800s, advances in technology have increased the sources of energy available to humankind, and with each new source have come new risks. For example, the Industrial Revolution witnessed the application of steam to the production process, and with steam came new risks. The early steam engines were hazardous mechanisms and explosions were common. Steam power produced the risk of explosion, and it created other risks as well. Steam engines were far less likely to stop in an accident; they continued to grind away, oblivious to the hands and arms that got entangled in gears. As with the application of steam, the introduction of electric power, the internal combustion engine, and nuclear power have created new risks.

One can argue that the invention of the legal system was an effort to address risk. By defining individual rights and responsibilities, the legal system created a framework whose basic function was to protect those rights. At the same time, the legal system became a source of risk by creating a system in which those who are injured or damaged by others may seek compensation. As the concept of rights and responsibilities has developed, new causes of action have emerged. Many of the current legal risks were unknown a generation ago. These include potential liability for a profusion of new transgressions: environmental damage, discrimination in employment, sexual harassment, and violence in the workplace.

The most recent expansion of risks we face, like many previous expansions, is traceable to advances in technology. The information age in which we are immersed embodies a variety of new exposures. Information has value, and as such, its exposure to loss represents risk. Information has, of course, always had value. What has changed is the way information is collected, sorted, and communicated electronically. In an earlier era, when information was recorded on hard media, it was easier to protect. Equally important, it was easy to detect when the information security system had been breached. The interconnectivity of the Internet and electronic communication generally exposes valuable information to loss in ways not previously imagined, and businesses and individuals are increasingly worried about this cyber risk.

One example of cyber risk is cyber crime. Pirates and thieves have been a constant source of potential loss throughout history. Hackers who commit vandalism and electronic larceny have replaced the bandits and pirates who threatened early traders.¹⁰ Modern thieves steal not only assets but sometimes one's identity. According to the Federal Bureau of Investigation (FBI), identity theft is the fastest growing white-collar crime in the nation.¹¹

With each advance in technology, new risks arise. Because many of the old risks remain, the inventory of risks that must be addressed increases geometrically. Daily newspapers indicate the simultaneous threat of new-age hazards and age-old perils of nature. The hazards posed by the nuclear age were demonstrated by the incident at the Three Mile Island nuclear facility in Pennsylvania in 1979 and the accident at the Soviet Union's Chernobyl plant in April 1987. The destruction that can be wreaked by nature are evidenced by Hurricane Katrina and, more recently, Hurricane Sandy, with estimated losses of $80 billion and $65 billion, respectively, by the 2013 floods in Central Europe, and by the 2011 Tohoku earthquake and tsunami in Japan. The bombings of the World Trade Center and the Oklahoma City Federal Building in 1993 and 1995, respectively, and the terrorist attack on the World Trade Center and the Pentagon on September 11, 2001, are stark reminders that nature and people can cause death and destruction. Although other losses are less momentous, it is only because they affect a single individual or firm. For the party suffering the loss, they are no less devastating.

INCREASING SEVERITY OF LOSSES

As might be expected, with the increasing array of risks, the dollar amount of losses arising from accidents has increased. Interestingly, however, the increasing dollar amount of losses is not solely a function of the increasing number of risks. Even those losses that arise from the perils of nature, such as windstorms, earthquakes and floods, have exhibited an increasing severity. Nor is the increasing severity merely a reflection of inflation; the dollar total from these losses continues to increase even when adjusted for inflation. Although earthquakes, floods, and windstorms occur at essentially the same rate as in the past, each new catastrophe seems to exceed previous losses. The reason, of course, is that there is simply more wealth, investment, and assets exposed to loss. As businesses become more capital intensive, and the technology of production equipment becomes more costly, capital investment increases. With the growth in capital investment, the risk of financial loss also increases.¹²

MANAGING RISK

There is no escape from the presence of risk, and humanity must seek ways of dealing with it. Some risks, generally of a fundamental nature, are met through the collective efforts of society and government. Municipal police and fire departments are good examples of the collectively financed approaches to dealing with risk, but countless others might be suggested. Although society and government can help alleviate the burden of risks in many areas, some risks are considered the responsibility of the individual.

Given the vast array of risks faced by individuals and businesses and the variety of possible ways to deal with them, a systematic approach is needed in dealing with risks. What can we do about the various risks we face? Which risks require attention first and how should they be addressed? In Chapter 2, we will begin our discussion of risk management and consider a systematic approach for dealing with pure risks faced by individuals and firms.

IMPORTANT CONCEPTS TO REMEMBER

risk

uncertainty

subjective risk

degree of risk

peril

hazard

physical hazard

moral hazard

morale hazard

deep-pocket syndrome

static risk

dynamic risk

fundamental risk

particular risk

pure risk

speculative risk

systemic risk

personal risk

property risk

direct loss

indirect loss

liability risk

probability of loss

expected value

QUESTIONS FOR REVIEW

1. Define risk. In your definition, state the relationship between risk and uncertainty.

2. Risk may be classified in several ways. List the principal ways in which risk may be categorized, and explain the distinguishing characteristics of each class.

3. The distinction between “pure risk” and “speculative risk” is important because only pure risks are normally insurable. Why is the distinction between “fundamental risk” and “particular risk” important?

4. Explain how pure risk has an adverse effect on economic activity.

5. List the four types of pure risk facing an individual or an organization and give an example of each.

6. The text discusses the “burden of risk.” What are the two principal ways in which the impact of risk may be felt by an individual or an organization?

7. Distinguish between “perils” and “hazards” and give two specific examples of each.

8. Briefly distinguish among the three categories into which hazards may be divided and give an example of each.

9. Explain why the number of risks and the severity of losses increase over time.

10. With respect to each of the following, indicate whether you would classify the event or condition as a peril or a hazard: an earthquake, sickness, worry, a careless act, and an economic depression.

QUESTIONS FOR DISCUSSION

1. Two 9-year-old boys are watching a television replay of a boxing match between Muhammad Ali and Joe Frazier on a program called “Great Fights of the Century.” Since the fight took place before they were old enough to remember the outcome, neither knows who won and they bet on the outcome. Tom bets on Ali and Tim bets on Frazier. Does risk exist in this situation? For Tim? For Tom?

2. Mike says, “The possibility that my house may burn is a pure risk for me, but if I buy insurance, it is a speculative risk for the insurance company.” Do you agree? Why or why not?

3. If risk is distasteful, how do you account for the existence of gambling, a pastime in which the participants indicate they prefer the risk involved to the security of not gambling?

4. What risks do you face as an individual? Which of these risks have you elected to retain and which have you transferred?

5. The probability of loss and its potential severity affect the intensity with which risk is felt by an individual. Would you find a 50 percent chance of losing $100 or a 5 percent chance of losing $1000 more distasteful? Why?

SUGGESTIONS FOR ADDITIONAL READING

Berenstein, Peter L. Against the Gods—The Remarkable Story of Risk. New York: John Wiley & Sons, Inc., 1996.

Denenberg, Herbert S., et al. Risk and Insurance, 2d ed. Englewood Cliffs, N.J.: Prentice-Hall, 1974. Chapter 1.

Hammond, J. D., ed. Essays in the Theory of Risk and Insurance. Glenview, Ill.: Scott, Foresman, 1968.

Head, G. L. “An Alternative to Defining Risk as Uncertainty.” Journal of Risk and Insurance, vol. 34, no. 2 (June 1967).

Houston, D. B. “Risk, Insurance, and Sampling.” Journal of Risk and Insurance, vol. 31, no. 4 (Dec. 1964).

Knight, F. H. Risk. Uncertainty and Profit. Boston: Houghton Mifflin, 1921.

Kulp, C. A., and John W. Hall. Casualty Insurance, 4th ed. New York: Ronald Press, 1968. Chapter 1.

Mowbray, A. H., R. H. Blanchard, and C. Arthur Williams. Insurance, 6th ed. New York: McGraw-Hill, 1969. Chapter 1.

Pfeffer, I. Insurance and Economic Theory. Homewood, Ill.: Richard D. Irwin, 1956.

Willet, A. The Economic Theory of Risk and Insurance. Philadelphia: University of Pennsylvania Press, 1951.

Wood, Oliver G., Jr. “Evolution of the Concept of Risk.” Journal of Risk and Insurance, vol. 31, no. 1 (March 1964).

¹The term risk is variously defined as (1) the chance of loss, (2) the possibility of loss, (3) uncertainty, (4) the dispersion of actual from expected results, or (5) the probability of any outcome different from the one expected.

²We measure probability on an imaginary ruler, marked at one end with a zero and unity at the other. The high end of the scale, marked unity, represents absolute certainty. Any proposition about which there is no doubt whatsoever finds its place at this point on the scale. For example, the probability that the reader will eventually die is equal to 1 because we will all die. Using the letter p to stand for probability, we would write p = 1. The bottom end of the scale, marked zero, represents absolute impossibility. The probability that the reader could run a mile in 30 seconds is zero because failure would be absolutely certain. The statistician here would write p = 0. Events that are neither certain nor impossible lie between the two ends of our imaginary ruler and are assigned values that vary with the likelihood of their occurrence. Thus, the probability of drawing the ace of spades from a deck of cards is 1/52, or .019. The probability of drawing any ace is 1/13; the probability of drawing a black card is 1/2, or .5.

³In addition to its meaning as a psychological phenomenon, a second possible meaning of the term uncertainty relates to probability and is contrasted with a second meaning of certainty: a situation in which the probability of an event is 100 percent. An event may be said to be impossible (probability = 0), certain (probability = 1), or uncertain. Used in reference to the likelihood of an event, uncertain means that the probability is judged to be between 0 and 1.

⁴Some authors equate our notion of uncertainty with subjective risk, which is a person's perception of risk. An individual may perceive risk where it does not exist. (Navigators in Columbus's day perceived a risk of falling off the edge of the world.) They may fail to perceive risk when it does exist. The distinction between objective risk and subjective risk (i.e., between risk and uncertainty) is important because subjective risk affects the decisions people make. Ideally, they should make decisions based on actual risk (i.e., objective risk). Better information reduces uncertainty (improves subjective risk estimates) and leads to better decisions.

⁵The dynamic–static distinction was made by Willett. See Alan H. Willett, The Economic Theory of Risk and Insurance, (Philadelphia: University of Pennsylvania Press, 1951) pp. 14–19.

⁶The distinction between fundamental and particular risks is based on C. A. Kulp's discussion of risk, which he referred to as “hazard”. See C. A. Kulp, Casualty Insurance, 3rd ed. (New York: Ronald Press, 1956), pp. 3, 4.

⁷For example, earthquake insurance is available from private insurers in most parts of the country, and flood insurance is frequently included in contracts covering movable personal property. Flood insurance on real property is available through private insurers only on a limited basis.

⁸Although the distinction between pure and speculative risk had been introduced earlier, Albert H. Mowbray formalized the distinction. See Albert H. Mowbray and Ralph H. Blanchard, Insurance, Its Theory and Practice in the United States, 5th ed. (New York: McGraw-Hill, 1961), pp. 6, 7.

⁹One great danger of this approach is the possibility that a loss may occur before a sufficient fund has been accumulated.

¹⁰In May 2013, the U.S. Department of Justice accused a global cyber crime ring of stealing $45 million by hacking into credit card processing firms and withdrawing funds from ATMs in 27 countries. Astonishingly, $40 million was stolen in a 10-hour period, making it one of the largest bank heists ever.

¹¹In 2003, Congress enacted amendments to the Fair Credit Reporting Act to provide consumers with some protection against indentity theft. Nonetheless, identity theft continues to be a problem, and it is estimated that millions of Americans are victims each year. In early 2005, a number of firms reported their data had been stolen or misplaced, heightening concerns about possible identity theft. In February 2005, ChoicePoint disclosed that it had sold sensitive information on at least 166,000 people to a Nigerian con artist posing as a debt collector. The Federal Trade Commission (FTC) fined ChoicePoint $10 million and ordered it to set aside $5 million to aid the victims of its error.

¹²The San Francisco earthquake of 1906 caused an estimated $400 million in damage from earthquake and fire. The cost in 2012 dollars would have been about $10 billion. Damage from an earthquake of the same intensity as the 1906 earthquake would likely exceed $100 billion; San Francisco today is a dramatically different place from the San Francisco of 1906. Buildings are taller and more expensive to build and there are more of them. There are more people, cars, and “stuff” today than in 1906. As population and wealth increase, the exposure to loss is magnified. The richer we become as a society, the more wealth that is exposed to loss.