A Definition of Risk Risk is a condition in which there is a possibility of an adverse deviation from a desired outcome that is expected or hoped for. 1. Risk not subjective - a state of the real world 2. Risk can exist whether or not it is perceived 3. Risk can be imagined where possibility of loss does not exist (subjective)

The Degree of Risk 1. What is more risk or less risk? 2. Varies with the probability of deviation from what is expected in case of aggregate data from what is hoped for (no loss) in case of individual

Risk Distinguished From Peril and Hazard Peril: the cause of loss Hazard: a condition that creates or increases the chance of loss

Classifications of Hazards Physical Moral Morale

Classifications of Risk Financial and non-financial Static and dynamic Fundamental and particular 4. Pure and speculative

Static and Dynamic Risks 1. Dynamic risks result from changes in the economy (e.g., changes in price levels, consumer taste, income, and output). benefit society in the long run, by adjusting misallocations of resources 2. Static risks would exist even in the absence of economic change (from perils of nature or human dishonesty). not a source of gain to society

Fundamental and Particular Risks 1. Fundamental risks are impersonal in origin and consequences. They are societal risks. It is held that society (rather than the individual) should deal with them. 2. Particular risks involve losses that arise out of individual events and are felt by individuals rather than the entire group. Particular risks are considered the individual’s own responsibility that are properly addressed by the individual.

Pure and Speculative Risks 1. Speculative risks involve the possibility of loss or gain. They are voluntarily accepted because of the possibility of gain. 2. Pure risks involve the possibility of loss or no loss only. 3. In general, insurance deals with pure risks only.

Classifications of Pure Risk 1. Personal risks(premature death, retirement income, poor health,unemployment) 2. Property risks 3. Liability risks 4. Risks arising out of failure of others

The Burden of Risk 1. Some losses will occur 2. The cost of accumulated reserves 3. Deterrent effect on capital accumulation 4. Higher cost of capital 5. Feeling of frustration and mental unrest

Methods of Dealing With Risk 1. Avoidance 2. Reduction(loss control) 3. Retention (active or passive) 4. Transfer Sharing

Nature & Functions of Insurance In its simplest aspect, insurance has two fundamental characteristics: 1. Transfer of risk from the individual to the group. Sharing of losses on some equitable basis. (unstated but important third characteristic is that of INDEMNIFICATION)

Insurance Defined: Individual Perspective Insurance is an economic device whereby the individual substitutes a small certain cost (the premium) for a large uncertain financial loss (the contingency insured against) which would exist if it were not for the insurance.

Risk Reduction Through Pooling 1. The risk an insurer faces is not merely a summation of risks transferred to it by individuals. 2. Insurer can predict within narrow limits the amount of losses that will occur. 3. If insurer could predict future losses with absolute precision, it would have no risk. 4. Accuracy of insurer’s prediction is based on the law of large numbers.

Probability Theory and Law of Large Numbers Probability theory is the body of knowledge concerned with measuring the likelihood that something will happen and making predictions based on this likelihood.

Insurance Defined Social Perspective Insurance is an economic device for reducing and eliminating risk through the process of combining a sufficient number of homogeneous exposures to make the losses predictable for the group as a whole.

Insurance: Transfer or Pooling? 1. The view that the essence of insurance is risk transfer emphasizes the individual’s substitution of a small small certain cost for large uncertain loss. 2. Emphasis on pooling or risk sharing emphasizes the role of reducing risk in the aggregate. 3. Insurance can exist without pooling, but not without transfer.

Insurance and Gambling 1. In gambling, there is no chance of loss (and therefore no risk) prior to the wager. 2. In the case of insurance, the chance of loss exists whether or not insurance is purchased. 3. Gambling creates risk, while insurance provides for the transfer of existing risk.

Economic Contribution of Insurance 1. Creates certainty about burden of loss 2. Spreading losses that do occur 3. Provides for an optimal utilization of capital

Elements of an Insurable Risk 1. Large numbers of exposure units 2. Definite and measurable loss 3. The loss must be fortuitous 4. The loss must not be catastrophic

The Fields of Insurance 1. Private insurance voluntary programs designed to protect individual against financial loss 2. Social Insurance compulsory insurance programs generally operated by government 3. Public Benefit Guarantee Programs quasi-social coverages usually associated with regulation

Private (Voluntary) Insurance 1. Usually (but not always) voluntary. 2. Usually (but not always) offered by private insurers.

Private (Voluntary) Insurance 1. Life insurance 2. Accident and health insurance 3. Property and liability fire marine casualty fidelity and surety bonds

Casualty Insurance accident and health insurance automobile liability workers compensation boiler and machinery plate glass burglary, robbery, theft credit insurance title insurance

Social Insurance Based on the notion that there are some people in society who face fundamental risks that they cannot deal with themselves. Social insurance programs rest on the premise that if an individual cannot provide for a reasonable standard of living through personal efforts, society should assist.

Social Insurance Definition 1. Coverage is compulsory 2. Eligibility derived from contributions: no requirement to demonstrate need 3. Method of determining benefits prescribed by law 4. Benefits not directly related to contributions

Social Insurance Definition 5. Definite long-range plan for financing 6. Cost borne primarily by contributions 7. Plan administered or supervised by government 8. Plan not established solely for government employees

Social Insurance Programs in the U.S. 1. Old-Age, Survivors and Disability Insurance 2. Railroad Retirement, Disability and Unemployment Insurance 3. Unemployment Insurance 4. Medicare 5. State Compulsory Temporary Disability

Public Guarantee Insurance Programs 1. Quasi social insurance programs, mainly in connection with financial institutions 2. Public Guarantee Insurance Programs are usually allied with the function of regulation 3. Insurance principle is used to protect lenders, depositors, or investors against loss resulting from failure of a financial institution

Federal Public Guarantee Programs 1. Federal Deposit Insurance Corporation 2. National Credit Union Administration 3. Securities Investor Protection Corporation 4. Pension Benefit Guarantee Corporation