Chapter 1 - Risk in Our Society

C H A P T E R 1 RISK IN OUR SOCIETY

“When we take a risk, we are betting on an outcome that will result from a decision we have made, though we do not know

for certain what the outcome will be.”

Peter L. BernsteinAgainst the Gods, The Remarkable Story of Risk

LEARNING OBJECTIVES

After studying this chapter,you should be able to

� Explain the meaning of risk.

� Distinguish between purerisk and speculative risk.

� Identify the major pure risksthat are associated withfinancial insecurity.

� Understand how risk is aburden to society.

� Explain the major methods of handling risk.

� Access an Internet site toobtain and analyze infor-mation dealing with risk.

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I N T E R N E T R E S O U R C E S� ARIAWeb is the Web site of the American Risk and Insurance Association (ARIA)—the premier

professional association of risk management and insurance scholars and professionals. ARIA is thepublisher of The Journal of Risk and Insurance and Risk Management and Insurance Review. Links areprovided to research, teaching, and other risk and insurance sites. Visit the site at

http://www.aria.org

� The Risk Theory Society is an organization within the American Risk and Insurance Association thatpromotes research in risk theory and risk management. Papers are distributed in advance to themembers and are discussed critically at its annual meeting. Visit the site at

http://www.aria.org/rts

� The Federal Emergency Management Agency (FEMA) is a federal agency that deals with naturaldisasters. Its mission is to reduce the loss of life and property and protect the nation’s infrastructurethrough a comprehensive, risk-based, emergency management program of mitigation, preparedness,response, and recovery. Visit the site at

http://www.fema.gov

� The Insurance Information Institute is a trade association that provides consumers with informationon catastrophic losses and the filing of claims from terrorist attacks, hurricanes, floods, earthquakes,and other natural disasters. Visit the site at

http://www.iii.org

� RISKMail allows persons around the world to participate in a “no holds barred” discussion of risk andinsurance issues. RISKMail Archive contains previous comments on risk and insurance topics. Links areprovided to other academic and professional sites. Visit the site at

http://www.riskmail.org/account.htm

� Society for Risk Analysis (SRA) provides an open forum for all persons interested in risk analysis,including risk assessment, risk management, and policies related to risk. SRA considers threats fromphysical, chemical, and biological agents and from a variety of human activities and natural events.SRA is multidisciplinary and international. Visit the site at

http://www.sra.org

MEANING OF RISKThere is no single definition of risk. Economists,behavioral scientists, risk theorists, statisticians, andactuaries each have their own concept of risk.However, risk traditionally has been defined in termsof uncertainty. Based on this concept, risk is definedhere as uncertainty concerning the occurrence of aloss.1 For example, the risk of being killed in an autoaccident is present because uncertainty is present.The risk of lung cancer for smokers is present becauseuncertainty is present. And the risk of flunking a col-lege course is present because uncertainty is present.

Although risk is defined as uncertainty in thistext, employees in the insurance industry often usethe term risk to identify the property or life beinginsured. Thus, in the insurance industry, it is commonto hear statements such as “that driver is a poor risk”or “that building is an unacceptable risk.”

Finally, when risk is defined as uncertainty, someauthors make a careful distinction between objectiverisk and subjective risk.

Objective RiskObjective risk is defined as the relative variation ofactual loss from expected loss. For example, assumethat a property insurer has 10,000 houses insuredover a long period and, on average, 1 percent, or100 houses, burn each year. However, it would be

rare for exactly 100 houses to burn each year. Insome years, as few as 90 houses may burn; in otheryears, as many as 110 houses may burn. Thus, thereis a variation of 10 houses from the expectednumber of 100, or a variation of 10 percent. Thisrelative variation of actual loss from expected loss isknown as objective risk.

Objective risk declines as the number of expo-sures increases. More specifically, objective riskvaries inversely with the square root of the numberof cases under observation. In our previous example,10,000 houses were insured, and objective risk was10/100, or 10 percent. Now assume that 1 millionhouses are insured. The expected number of housesthat will burn is now 10,000, but the variation ofactual loss from expected loss is only 100. Objectiverisk is now 100/10,000, or 1 percent. Thus, as thesquare root of the number of houses increased from100 in the first example to 1000 in the secondexample (10 times), objective risk declined to one-tenth of its former level.

Objective risk can be statistically calculated bysome measure of dispersion, such as the standarddeviation or the coefficient of variation. Becauseobjective risk can be measured, it is an extremelyuseful concept for an insurer or a corporate risk man-ager. As the number of exposures increases, aninsurer can predict its future loss experience moreaccurately because it can rely on the law of largenumbers. The law of large numbers states that as

3

On September 11, 2001, foreign terrorists hijacked four commercial jets. Two

jets crashed into the World Trade Center towers; the third jet crashed into the

Pentagon in Arlington, Virginia, while the fourth plane crashed in a field in south-

western Pennsylvania. Thousands of people died or are missing as a result of the attack.

The shocking terrorist attack shows clearly that we live in a risky world. Other tragic

events occur daily. Motorists die or are severely injured in auto accidents. Homeowners

lose their homes and personal property because of fires, floods, hurricanes, earthquakes,

and other natural disasters. Others incur catastrophic medical bills and the loss of earn-

ings because of heart disease, cancer, AIDS, or other diseases. Still others face financial

ruin because they negligently injure someone and cannot pay a liability judgment.

This chapter discusses the nature and treatment of risk in our society. Topics dis-

cussed include the meaning of risk, the major types of risk that threaten our financial

security, and the basic methods for handling risk.

the number of exposure units increases, the moreclosely the actual loss experience will approach theexpected loss experience. For example, as the numberof homes under observation increases, the greater isthe degree of accuracy in predicting the proportion ofhomes that will burn. The law of large numbers isdiscussed in greater detail in Chapter 2.

Subjective RiskSubjective risk is defined as uncertainty based on aperson’s mental condition or state of mind. Forexample, a customer who was drinking heavily in abar may foolishly attempt to drive home. The drivermay be uncertain whether he will arrive home safelywithout being arrested by the police for drunk driv-ing. This mental uncertainty is called subjective risk.

The impact of subjective risk varies dependingon the individual. Two persons in the same situationcan have a different perception of risk, and theirbehavior may be altered accordingly. If an individualexperiences great mental uncertainty concerning theoccurrence of a loss, that person’s behavior may beaffected. High subjective risk often results in conser-vative and prudent behavior, while low subjectiverisk may result in less conservative behavior. Forexample, a motorist previously arrested for drunkdriving is aware that she has consumed too muchalcohol. The driver may then compensate for themental uncertainty by getting someone else to drivethe car home or by taking a cab. Another driver inthe same situation may perceive the risk of beingarrested as slight. This second driver may drive in amore careless and reckless manner; a low subjectiverisk results in less conservative driving behavior.

CHANCE OF LOSSChance of loss is closely related to the concept ofrisk. Chance of loss is defined as the probability thatan event will occur. Like risk, “probability” has bothobjective and subjective aspects.

Objective ProbabilityObjective probability refers to the long-run relativefrequency of an event based on the assumptions ofan infinite number of observations and of no change

in the underlying conditions. Objective probabilitiescan be determined in two ways. First, they can bedetermined by deductive reasoning. These probabili-ties are called a priori probabilities. For example,the probability of getting a head from the toss of a perfectly balanced coin is 1/2 because there aretwo sides, and only one is a head. Likewise, theprobability of rolling a 6 with a single die is 1/6,since there are six sides and only one side has sixdots on it.

Second, objective probabilities can be deter-mined by inductive reasoning, rather than by deduc-tion. For example, the probability that a person age21 will die before age 26 cannot be logicallydeduced. However, by a careful analysis of pastmortality experience, life insurers can estimate theprobability of death and sell a five-year term lifeinsurance policy issued at age 21.

Subjective ProbabilitySubjective probability is the individual’s personalestimate of the chance of loss. Subjective probabilityneed not coincide with objective probability. Forexample, people who buy a lottery ticket on theirbirthday may believe it is their lucky day and over-estimate the small chance of winning. A wide varietyof factors can influence subjective probability,including a person’s age, gender, intelligence, educa-tion, and the use of alcohol.

In addition, a person’s estimate of a loss maydiffer from objective probability because there maybe ambiguity in the way in which the probability isperceived. For example, assume that a slot machinein a gambling casino requires three lemons to win.The person playing the machine may perceive theprobability of winning to be quite high. But if thereare 10 symbols on each reel and only one is a lemon,the objective probability of hitting the jackpot withthree lemons is quite small. Assuming that each reelspins independently of the others, the probabilitythat all three will simultaneously show a lemon isthe product of their individual probabilities (1/10 �1/10 � 1/10 � 1/1000). This knowledge is advanta-geous to casino owners, who know that most gam-blers are not trained statisticians and are thereforelikely to overestimate the objective probabilities ofwinning.

4 C H A P T E R 1 / R I S K I N O U R S O C I E T Y

Chance of Loss Distinguished from RiskChance of loss can be distinguished from objectiverisk. Chance of loss is the probability that an eventthat causes a loss will occur. Objective risk is the rel-ative variation of actual loss from expected loss. Thechance of loss may be identical for two differentgroups, but objective risk may be quite different. Forexample, assume that a property insurer has 10,000homes insured in Los Angeles and 10,000 homesinsured in Philadelphia and that the chance of loss ineach city is 1 percent. Thus, on average, 100 homesshould burn annually in each city. However, if theannual variation in losses ranges from 75 to 125 in Philadelphia, but only from 90 to 110 in LosAngeles, objective risk is greater in Philadelphia eventhough the chance of loss in both cities is the same.

PERIL AND HAZARDThe terms peril and hazard should not be confusedwith the concept of risk discussed earlier.

PerilPeril is defined as the cause of loss. If your houseburns because of a fire, the peril, or cause of loss, isthe fire. If your car is damaged in a collision withanother car, collision is the peril, or cause of loss.Common perils that cause property damage includefire, lightning, windstorm, hail, tornadoes, earth-quakes, theft, and burglary.

HazardA hazard is a condition that creates or increases thechance of loss. There are four major types of hazards:

� Physical hazard� Moral hazard� Morale hazard� Legal hazard

Physical Hazard A physical hazard is a physicalcondition that increases the chance of loss. Exam-ples of physical hazards include icy roads thatincrease the chance of an auto accident, defectivewiring in a building that increases the chance of fire,

and a defective lock on a door that increases thechance of theft.

Moral Hazard Moral hazard is dishonesty or char-acter defects in an individual that increase the fre-quency or severity of loss. Examples of moralhazard include faking an accident to collect from aninsurer, submitting a fraudulent claim, inflating theamount of a claim, and intentionally burning unsoldmerchandise that is insured.

Moral hazard is present in all forms of insur-ance, and it is difficult to control. Dishonest individ-uals often rationalize their actions on the groundsthat “the insurer has plenty of money.” This view isincorrect because the insurer can pay claims only bycollecting premiums from other insureds. Because ofmoral hazard, premiums are higher for everyone.

Insurers attempt to control moral hazard bycareful underwriting of applicants for insurance andby various policy provisions, such as deductibles,waiting periods, exclusions, and riders. These provi-sions are examined in Chapter 6.

Morale Hazard Some insurance authors draw asubtle distinction between moral hazard and moralehazard. Moral hazard refers to dishonesty by aninsured that increases the frequency or severity ofloss. Morale hazard is carelessness or indifference toa loss because of the existence of insurance. Someinsureds are careless or indifferent to a loss becausethey have insurance. Examples of morale hazardinclude leaving car keys in an unlocked car, whichincreases the chance of theft; leaving a door unlockedthat allows a burglar to enter; and changing lanessuddenly on a congested interstate highway withoutsignaling. Careless acts like these increase the chanceof loss.

Legal Hazard Legal hazard refers to characteristicsof the legal system or regulatory environment thatincrease the frequency or severity of losses. Examplesinclude adverse jury verdicts or large damage awardsin liability lawsuits, statutes that require insurers toinclude coverage for certain benefits in health insur-ance plans, such as coverage for alcoholism; and reg-ulatory action by state insurance departments thatrestrict the ability of insurers to withdraw from thestate because of poor underwriting results.

P E R I L A N D H A Z A R D 5

BASIC CATEGORIES OF RISKRisk can be classified into several distinct categories.The two major categories are as follows:

� Pure and speculative risks� Fundamental and particular risks

Pure and Speculative RisksPure risk is defined as a situation in which there areonly the possibilities of loss or no loss. The only pos-sible outcomes are adverse (loss) and neutral (noloss). Examples of pure risks include prematuredeath, job-related accidents, catastrophic medicalexpenses, and damage to property from fire, light-ning, flood, or earthquake.

Speculative risk is defined as a situation inwhich either profit or loss is possible. For example,if you purchase 100 shares of common stock, youwould profit if the price of the stock increases butwould lose if the price declines. Other examples ofspeculative risks include betting on a horse race,investing in real estate, and going into business foryourself. In these situations, both profit and loss arepossible.

It is important to distinguish between pure andspeculative risks for three reasons. First, privateinsurers generally insure only pure risks. With cer-tain exceptions, speculative risks generally are notconsidered insurable, and other techniques forcoping with speculative risk must be used. (Oneexception is that some insurers will insure institu-tional portfolio investments and municipal bondsagainst loss.)

Second, the law of large numbers can be appliedmore easily to pure risks than to speculative risks.The law of large numbers is important because itenables insurers to predict future loss experience. Incontrast, it is generally more difficult to apply the lawof large numbers to speculative risks to predict futureloss experience. An exception is the speculative riskof gambling, where casino operators can apply thelaw of large numbers in a most efficient manner.

Finally, society may benefit from a speculativerisk even though a loss occurs, but it is harmed if apure risk is present and a loss occurs. For example, afirm may develop new technology for producinginexpensive computers. As a result, some competi-

tors may be forced into bankruptcy. Despite thebankruptcy, society benefits because the computersare produced at a lower cost. However, society nor-mally does not benefit when a loss from a pure riskoccurs, such as a flood or earthquake that devastatesan area.

Fundamental and Particular RisksA fundamental risk is a risk that affects the entireeconomy or large numbers of persons or groupswithin the economy. Examples include rapid infla-tion, cyclical unemployment, and war because largenumbers of individuals are affected.

The risk of a natural disaster is another impor-tant risk. Hurricanes, tornadoes, earthquakes, floods,and forest and grass fires can result in billions of dol-lars of property damage and numerous deaths. In1999, Hurricane Floyd caused $2 billion of insuredlosses. In 1994, a major earthquake in Northridge,California, caused $13 billion of insured losses andthe loss of numerous lives. In 1992, HurricaneAndrew caused insured losses of about $16 billionand the failure of a number of property insurers.

More recently, the risk of a terrorist attack israpidly emerging as a fundamental risk. Many coun-tries have experienced a substantial increase in ter-rorism in recent years, resulting in substantial prop-erty damage and the loss of human lives. Theterrorist attack in the United States on September 11,200l, resulted in the loss of four commercial jets,destruction of the World Trade Center towers inNew York City, substantial damage to the Pentagon,and thousands of dead or missing persons. At thetime of this writing, estimated losses are about$40 billion. The terrorist attack is the largest singlecatastrophic loss in the United States to date (seeExhibit 1.1).

In contrast to a fundamental risk, a particularrisk is a risk that affects only individuals and not theentire community. Examples include car thefts, bankrobberies, and dwelling fires. Only individuals expe-riencing such losses are affected, not the entireeconomy.

The distinction between a fundamental and aparticular risk is important because governmentassistance may be necessary to insure a fundamentalrisk. Social insurance and government insuranceprograms, as well as government guarantees and


subsidies, may be necessary to insure certain funda-mental risks in the United States. For example, therisk of unemployment generally is not insurable byprivate insurers but can be insured publicly by stateunemployment compensation programs. In addition,flood insurance subsidized by the federal governmentis available to business firms and individuals inflood-prone areas.

TYPES OF PURE RISKThe major types of pure risk that can create greatfinancial insecurity include personal risks, propertyrisks, and liability risks.

Personal RisksPersonal risks are risks that directly affect an indi-vidual. They involve the possibility of the completeloss or reduction of earned income, extra expenses,

and the depletion of financial assets. There are fourmajor personal risks:2

� Risk of premature death� Risk of insufficient income during retirement � Risk of poor health� Risk of unemployment

Risk of Premature Death Premature death is de-fined as the death of a household head with unful-filled financial obligations. These obligations caninclude dependents to support, a mortgage to be paidoff, or children to educate. If the surviving familymembers receive an insufficient amount of replace-ment income from other sources or have insufficientfinancial assets to replace the lost income, they maybe financially insecure.

Premature death can cause financial problemsonly if the deceased has dependents to support ordies with unsatisfied financial obligations. Thus, thedeath of a child age seven is not “premature” in theeconomic sense.

T Y P E S O F P U R E R I S K 7

EXHIBIT 1.1United States: Top 10 Biggest Catastrophes (by insured loss)

30

35

20

10

25

15

5

0

Terro

rist

Attack

s (’01)*

40

Hurr. A

ndrew

(’92)

15.5

Northr

idge E

q. (’9

4)

12.5

Hurr. H

ugo (

’89)

4.2

Hurr. G

eorg

es (’9

8)

2.9

TS A

llison

(’01)

2.5

Hurr. O

pal (’

95)

2.1

Hurr. F

loyd (

’99)

2.0

20-Stat

e Stor

m (’93)

1.8

Oaklan

d Fire

(’91)

1.7

Iniki

(’92)/F

ran (’9

6)

1.6

$40

Billions

*III estimate; includes life, liability, and workers compensation losses.

SOURCE: Insurance Services Office, Insurance Information Institute.

There are at least four costs that result from thepremature death of a household head. First, thehuman life value of the family head is lost forever.The human life value is defined as the present valueof the family’s share of the deceased breadwinner’sfuture earnings. This loss can be substantial; theactual or potential human life value of most collegegraduates can easily exceed $500,000. Second, addi-tional expenses may be incurred because of funeralexpenses, uninsured medical bills, probate andestate settlement costs, and estate and inheritancetaxes for larger estates. Third, because of insufficientincome, some families may have trouble makingends meet or covering expenses (see Insight 1.1).Finally, certain noneconomic costs are also incurred,including emotional grief, loss of a role model, andcounseling and guidance for the children.

Risk of Insufficient Income During Retirement Themajor risk associated with old age is insufficientincome during retirement. The vast majority ofworkers in the United States retire before age 65.When they retire, they lose their earned income.Unless they have sufficient financial assets on whichto draw, or have access to other sources of retire-ment income, such as Social Security or a privatepension, they will be exposed to financial insecurityduring retirement.

The majority of workers experience a substan-tial reduction in their money incomes when they

retire, which can result in a reduced standard ofliving. For example, the median income for allhouseholds in the United States in 2000 was$42,148. In contrast, the median income for house-holds with an aged householder age 65 and over wasonly $23,048 in 2000, or 45 percent less.3 Thisamount is generally insufficient for retired workerswho have substantial additional expenses, such ashigh uninsured medical bills, or high property taxes,or are paying for the cost of long-term care in anursing home.

Most workers are not saving enough for a com-fortable retirement. The 2001 Retirement Confer-ence Survey by the Employee Benefit ResearchInstitute shows that the amounts saved for retirementby workers as a whole are generally small. Abouttwo in ten workers reported saving nothing forretirement; half reported saving less than $50,000,while only 15 percent reported saving $100,000 ormore. These amounts are relatively small for a com-fortable retirement. However, workers who have cal-culated the amount of money needed for retirementby a needs analysis generally tend to save more (seeExhibit 1.2).

Risk of Poor Health Poor health is another impor-tant personal risk. The risk of poor health includesboth the payment of catastrophic medical bills andthe loss of earned income. The costs of major sur-gery have increased substantially in recent years. For


I n s i g h t 1 . 1Making Ends Meet Can Be Tough for Widows

Most people think they have enough life insurance so thattheir survivors can get along just fine. But they may be foolingthemselves—at least according to a study sponsored by LIMRAInternational, the research arm of the insurance industry.

The study looked at the finances of men and women wholost a spouse “prematurely” (between ages 25 and 54).“Widows—not widowers—were having trouble making endsmeet or covering expenses,” says Cheryl Retzloff, the projectdirector. Although the women received more than double theaverage death benefit that was paid to the men—$162,600versus $73,100—widows reported more financial problems.On average, the death benefit for widows was approximately

three times the total household income; widowers averagedonly one year’s household income. Interestingly, survivors gen-erally spent the insurance benefit on short-term needs, suchas paying off debts or paying down a mortgage.

LIMRA says that insurance agents need to do a morethorough needs analysis, especially for wives. If a wife’searning potential is more limited, the agent should recom-mend higher levels of coverage and make sure it covers thecosts associated with death (funeral, medical expenses, plusaccess to health benefits).

SOURCE: Adapted from “More Bad News for Widows,” On Investing (Fall 1999), p. 14.

example, an open heart operation can cost morethan $200,000, a kidney or heart transplant can costmore than $400,000, and the costs of a cripplingaccident requiring several major operations, plasticsurgery, and rehabilitation can exceed $500,000. Inaddition, long-term care in a nursing home can cost$50,000 or more each year. Unless these personshave adequate health insurance, private savings andfinancial assets, or other sources of income to meetthese expenditures, they will be financially insecure.In particular, the inability of some persons to paycatastrophic medical bills is an important cause ofpersonal bankruptcy.

The loss of earned income is another majorcause of financial insecurity if the disability is severe.In cases of long-term disability, there is a substantialloss of earned income, medical bills are incurred,employee benefits may be lost or reduced, savingsare often depleted, and someone must take care ofthe disabled person.

Most workers seldom think about the financialconsequences of long-term disability. The probabilityof becoming disabled before age 65 is much higherthan is commonly believed, especially at the youngerages. For individuals age 25, the 1985 Commis-sioners Disability Table shows that the probability ofbeing totally disabled for 90 or more days prior toage 65 is 54 percent.4 The loss of earned income

during an extended disability can be financially verypainful.

Risk of Unemployment The risk of unemploymentis another major threat to financial security. Unem-ployment can result from business cycle down-swings, technological and structural changes in theeconomy, seasonal factors, and imperfections in thelabor market.

Several important trends have aggravated theproblem of unemployment. To hold down labor costs,large corporations have downsized, and their work-force has been permanently reduced; employers areincreasingly hiring temporary or part-time workersto reduce labor costs; and millions of jobs have beenlost to foreign nations because of global competition.

Regardless of the reason, unemployment cancause financial insecurity in at least three ways. First,workers lose their earned income and employee ben-efits. Unless there is adequate replacement income orpast savings on which to draw, the unemployedworker will be financially insecure. Second, becauseof economic conditions, the worker may be able towork only part-time. The reduced income may beinsufficient in terms of the worker’s needs. Finally, ifthe duration of unemployment is extended over along period, past savings and unemployment bene-fits may be exhausted.

T Y P E S O F P U R E R I S K 9

EXHIBIT 1.2Amounts Saved for Retirement2001 Retirement Confidence Survey

All Done Needs Not Done NeedsWorkers Calculation Calculation

Nothing 19% 6% 28%Less than $5,000 8 8 9$5,000–$9,999 6 4 7$10,000–$24,999 10 10 10$25,000–$49,999 7 8 8$50,000–$99,999 8 10 7$100,000 or more 15 25 8Don’t know/refused 27 30 24

SOURCE: Excerpted from The 2001 Retirement Confidence Survey Summary of Findings (Washington, DC: Employee Benefit ResearchInstitute, 2001).


Property RisksPersons owning property are exposed to propertyrisks—the risk of having property damaged or lostfrom numerous causes. Real estate and personalproperty can be damaged or destroyed because offire, lightning, tornadoes, windstorms, and numerousother causes. There are two major types of loss asso-ciated with the destruction or theft of property: directloss and indirect or consequential loss.

Direct Loss A direct loss is defined as a financialloss that results from the physical damage, destruc-tion, or theft of the property. For example, if youown a restaurant that is damaged by a fire, the phys-ical damage to the restaurant is known as a directloss.

Indirect or Consequential Loss An indirect loss is afinancial loss that results indirectly from the occur-rence of a direct physical damage or theft loss. Thus,in addition to the physical damage loss, the restau-rant would lose profits for several months while therestaurant is being rebuilt. The loss of profits wouldbe a consequential loss. Other examples of a con-sequential loss would be the loss of rents, the loss of the use of the building, and the loss of a localmarket.

Extra expenses are another type of indirect, orconsequential, loss. For example, suppose you own anewspaper, bank, or dairy. If a loss occurs, you mustcontinue to operate regardless of cost; otherwise,you will lose customers to your competitors. It maybe necessary to set up a temporary operation at somealternative location, and substantial extra expenseswould then be incurred.

Liability RisksLiability risks are another important type of purerisk that most persons face. Under our legal system,you can be held legally liable if you do somethingthat results in bodily injury or property damage tosomeone else. A court of law may order you to paysubstantial damages to the person you have injured.

The United States is a litigious society, and law-suits are common. Motorists can be held legallyliable for the negligent operation of their vehicles.The liability exposure can be especially high forteenage drivers (see Insight 1.2). Operators of boatsand lake owners can also be held legally liablebecause of bodily injury to boat occupants, swim-mers, and water skiers. Business firms can be heldlegally liable for defective products that harm orinjure customers; physicians, attorneys, accountants,engineers, and other professionals can be sued bypatients and clients because of alleged acts of mal-practice. In addition, new types of lawsuits are con-stantly emerging. For example, some ministers havefaced lawsuits brought by church members becauseof improper counseling.

Liability risks are of great importance for sev-eral reasons. First, there is no maximum upper limitwith respect to the amount of the loss. You can besued for any amount. In contrast, if you own prop-erty, there is a maximum limit on the loss. Forexample, if your car has an actual cash value of$10,000, the maximum physical damage loss is$10,000. But if you are negligent and cause an acci-dent that results in serious bodily injury to the otherdriver, you can be sued for any amount—$50,000,$500,000, or $1 million or more—by the personyou have injured.

I n s i g h t 1 . 2Runaway Car Hits Toddler, Kills Her Father

A man was killed and his 2-year-old daughter seriouslyinjured when an out-of-control car mowed them down on asidewalk Friday night.

Daniel Callahan, 35, was pushing the girl in a strollerabout 6:30 p.m. when a car carrying three teen-age boyscame careening around a curve, jumped the curb and struckthe man and toddler, police said.

Callahan died later at an Omaha hospital from massivehead injuries. The girl was thrown from her stroller, whichwas crushed by the car. She was in serious condition Saturdaywith a broken leg, cuts and bruises. Charges against theteenage driver are pending, investigators said.

SOURCE: From “Runaway Car Hits Toddler, Kills Her Father,” Lincoln Journal StarSunday, June 3, 2001, p. 2B.

Second, a lien can be placed on your income andfinancial assets to satisfy a legal judgment. Forexample, assume that you injure someone, and acourt of law orders you to pay damages to theinjured party. If you cannot pay the judgment, a lienmay be placed on your income and financial assetsto satisfy the judgment. If you declare bankruptcy toavoid payment of the judgment, your credit ratingwill be impaired.

Finally, legal defense costs can be enormous. Ifyou have no liability insurance, the cost of hiring anattorney to defend you can be staggering. If the suitgoes to trial, attorney fees and other legal expensescan be substantial.

BURDEN OF RISK ON SOCIETYThe presence of risk results in certain undesirablesocial and economic effects. Risk entails three majorburdens on society:

� The size of an emergency fund must be increased.� Society is deprived of certain goods and services.� Worry and fear are present.

Larger Emergency FundIt is prudent to set aside funds for an emergency.However, in the absence of insurance, individualsand business firms would have to increase the size oftheir emergency fund to pay for unexpected losses.For example, assume you have purchased a $150,000home and want to accumulate a fund for repairs ifthe home is damaged by fire, hail, windstorm, orsome other peril. Without insurance, you wouldhave to save at least $25,000 annually to build upan adequate fund within a relatively short period oftime. Even then, an early loss could occur, and youremergency fund may be insufficient to pay the loss.If you are a middle-income wage earner, you wouldfind such saving difficult. In any event, the higher theamount that must be saved, the more current con-sumption spending must be reduced, which resultsin a lower standard of living.

Loss of Certain Goods and ServicesA second burden of risk is that society is deprived ofcertain goods and services. For example, because ofthe risk of a liability lawsuit, many corporations

have discontinued manufacturing certain products.Numerous examples can be given. Some 250 com-panies in the world once manufactured childhoodvaccines; today, only a small number of firms manu-facture vaccines, due in part to the threat of liabilitysuits. Other firms have discontinued the manufac-ture of certain products, including asbestos prod-ucts, football helmets, silicone-gel breast implants,and certain birth-control devices because of fear oflegal liability.

Worry and FearA final burden of risk is that worry and fear arepresent. Numerous examples can illustrate the men-tal unrest and fear caused by risk. Parents may befearful if a teenage son or daughter departs on askiing trip during a blinding snowstorm because therisk of being killed on an icy road is present. Somepassengers in a commercial jet may become extremelynervous and fearful if the jet encounters severe tur-bulence during the flight. A college student whoneeds a grade of C in a course to graduate may enterthe final examination room with a feeling of appre-hension and fear.

METHODS OF HANDLING RISKAs we stressed earlier, risk is a burden not only tothe individual but to society as well. Thus, it isimportant to examine some techniques for meetingthe problem of risk. There are five major methods ofhandling risk:

� Avoidance� Loss control� Retention� Noninsurance transfers� Insurance

AvoidanceAvoidance is one method of handling risk. Forexample, you can avoid the risk of being mugged ina high-crime rate area by staying out of the area; youcan avoid the risk of divorce by not marrying; and abusiness firm can avoid the risk of being sued for adefective product by not producing the product.

Not all risks should be avoided, however. Forexample, you can avoid the risk of death or disability

M E T H O D S O F H A N D L I N G R I S K 11


in a plane crash by refusing to fly. But is this choicepractical or desirable? The alternatives—driving ortaking a bus or train—often are not appealing.Although the risk of a plane crash is present, thesafety record of commercial airlines is excellent, andflying is a reasonable risk to assume.

Loss ControlLoss control is another important method for han-dling risk. Loss control consists of certain activitiesthat reduce both the frequency and severity of losses.Thus, loss control has two major objectives: loss pre-vention and loss reduction.

Loss Prevention Loss prevention aims at reducingthe probability of loss so that the frequency of lossesis reduced. Several examples of personal loss preven-tion can be given. Auto accidents can be reduced ifmotorists take a safe-driving course and drive defen-sively. The number of heart attacks can be reduced ifindividuals control their weight, give up smoking,and eat healthy diets.

Loss prevention is also important for businessfirms. For example, strict security measures at air-ports and aboard commercial flights can reducehijacking by terrorists. Boiler explosions can be pre-vented by periodic inspections by safety engineers;occupational accidents can be reduced by the elimi-nation of unsafe working conditions and by strongenforcement of safety rules; and fires can be pre-vented by forbidding workers to smoke in a buildingwhere highly flammable materials are used. In short,the goal of loss prevention is to prevent the lossfrom occurring.

Loss Reduction Strict loss-prevention efforts canreduce the frequency of losses, yet some losses willinevitably occur. Thus, the second objective of losscontrol is to reduce the severity of a loss after itoccurs. For example, a department store can installa sprinkler system so that a fire will be promptlyextinguished, thereby reducing the loss; a plant canbe constructed with fire-resistant materials to mini-mize fire damage; fire doors and fire walls can beused to prevent a fire from spreading; and a commu-nity warning system can reduce the number ofinjuries and deaths from an approaching tornado.

From the viewpoint of society, loss control ishighly desirable for two reasons. First, the indirectcosts of losses may be large, and in some instancescan easily exceed the direct costs. For example, aworker may be injured on the job. In addition tobeing responsible for the worker’s medical expensesand a certain percentage of earnings (direct costs),the firm may incur sizable indirect costs: a machinemay be damaged and must be repaired; the assemblyline may have to be shut down; costs are incurred intraining a new worker to replace the injured worker;and a contract may be canceled because goods arenot shipped on time. By preventing the loss fromoccurring, both indirect costs and direct costs arereduced.

Second, the social costs of losses are reduced.For example, assume that the worker in the pre-ceding example dies from the accident. Society isdeprived forever of the goods and services thedeceased worker could have produced. The worker’sfamily loses its share of the worker’s earnings andmay experience considerable grief and financial inse-curity. And the worker may personally experiencegreat pain and suffering before dying. In short, thesesocial costs can be reduced through an effective loss-control program.

RetentionRetention is a third method of handling risk. An indi-vidual or a business firm retains all or part of a givenrisk. Risk retention can be either active or passive.

Active Retention Active risk retention means thatan individual is consciously aware of the risk anddeliberately plans to retain all or part of it. Forexample, a motorist may wish to retain the risk of asmall collision loss by purchasing an auto insurancepolicy with a $250 or higher deductible. A home-owner may retain a small part of the risk of damageto the home by purchasing a homeowners policywith a substantial deductible. A business firm maydeliberately retain the risk of petty thefts byemployees, shoplifting, or the spoilage of perishablegoods. In these cases, a conscious decision is madeto retain part or all of a given risk.

Active risk retention is used for two major rea-sons. First, it can save money. Insurance may not be

purchased at all, or it may be purchased with adeductible; either way, there is often a substantialsaving in the cost of insurance. Second, the risk maybe deliberately retained because commercial insur-ance is either unavailable or unaffordable.

Passive Retention Risk can also be retained pas-sively. Certain risks may be unknowingly retainedbecause of ignorance, indifference, or laziness. Pas-sive retention is very dangerous if the risk retainedhas the potential for destroying you financially. Forexample, many workers with earned incomes arenot insured against the risk of total and permanentdisability under either an individual or group dis-ability income plan. However, the adverse financialconsequences of total and permanent disability gen-erally are more severe than the financial conse-quences of premature death. Therefore, people whoare not insured against this risk are using the tech-nique of risk retention in a most dangerous and in-appropriate manner.

In summary, risk retention is an important tech-nique for handling risk, especially in a modern cor-porate risk management program, which will bediscussed in Chapters 3 and 4. Risk retention, how-ever, is appropriate primarily for high-frequency,low-severity risks where potential losses are rela-tively small. Except under unusual circumstances,risk retention should not be used to retain low-frequency, high-severity risks, such as the risk of cat-astrophic medical expenses, long-term disability, orlegal liability.

Noninsurance TransfersNoninsurance transfers are another technique forhandling risk. The risk is transferred to a party otherthan an insurance company. A risk can be transferredby several methods, among which are the following:

� Transfer of risk by contracts� Hedging price risks� Incorporation of a business firm

Transfer of Risk by Contracts Unwanted risks canbe transferred by contracts. For example, the risk ofa defective television or stereo set can be transferredto the retailer by purchasing a service contract,

which makes the retailer responsible for all repairsafter the warranty expires. The risk of a rent increasecan be transferred to the landlord by a long-termlease. The risk of a price increase in constructioncosts can be transferred to the builder by having afixed price in the contract.

Finally, a risk can be transferred by a hold-harmless clause. For example, if a manufacturer ofscaffolds inserts a hold-harmless clause in a contractwith a retailer, the retailer agrees to hold the manu-facturer harmless in case a scaffold collapses andsomeone is injured.

Hedging Price Risks Hedging price risks is anotherexample of risk transfer. Hedging is a technique fortransferring the risk of unfavorable price fluctua-tions to a speculator by purchasing and sellingfutures contracts on an organized exchange, such as the Chicago Board of Trade or New York StockExchange.

For example, the portfolio manager of a pensionfund may hold a substantial position in long-termU.S. Treasury bonds. If interest rates rise, the valueof the Treasury bonds will decline. To hedge thatrisk, the portfolio manager can sell U.S. Treasurybond futures. Assume that interest rates rise asexpected, and bond prices decline. The value of thefutures contract will also decline, which will enablethe portfolio manager to make an offsetting pur-chase at a lower price. The profit obtained fromclosing out the futures position will partly or com-pletely offset the decline in the market value of theTreasury bonds. Of course, markets do not alwaysmove as expected, so the hedge may not be perfect.Transaction costs also are incurred. However, byhedging, the portfolio manager has reduced thepotential loss in bond prices if interest rates rise.

Incorporation of a Business Firm Incorporation isanother example of risk transfer. If a firm is a soleproprietorship, the owner’s personal assets can beattached by creditors for satisfaction of debts. If afirm incorporates, personal assets cannot be attachedby creditors for payment of the firm’s debts. Inessence, by incorporation, the liability of the stock-holders is limited, and the risk of the firm havinginsufficient assets to pay business debts is shifted tothe creditors.

M E T H O D S O F H A N D L I N G R I S K 13


InsuranceFor most people, insurance is the most practicalmethod for handling a major risk. Although privateinsurance has several characteristics, three majorcharacteristics should be emphasized. First, risktransfer is used because a pure risk is transferred tothe insurer. Second, the pooling technique is used tospread the losses of the few over the entire group sothat average loss is substituted for actual loss.Finally, the risk may be reduced by application ofthe law of large numbers by which an insurer canpredict future loss experience with greater accuracy.Each of these characteristics is treated in greaterdetail in Chapter 2.

SUMMARY� There is no single definition of risk. Risk traditionally

has been defined as uncertainty concerning the occur-rence of a loss.

� Objective risk is the relative variation of actual lossfrom expected loss. Subjective risk is uncertainty basedon an individual’s mental condition or state of mind.Chance of loss is defined as the probability that anevent will occur; it is not the same thing as risk.

� Peril is defined as the cause of loss. Hazard is any con-dition that creates or increases the chance of loss.There are four major types of hazards. Physical hazardis a physical condition present that increases the chanceof loss. Moral hazard is dishonesty or character defectsin an individual that increase the chance of loss.Morale hazard is carelessness or indifference to a lossbecause of the existence of insurance. Legal hazardrefers to characteristics of the legal system or regu-latory environment that increase the frequency orseverity of losses.

� The basic categories of risk include the following:

Pure and speculative risks

Fundamental and particular risks

A pure risk is a risk where there are only thepossibilities of loss or no loss. A speculative riskis a risk where either profit or loss is possible.

A fundamental risk is a risk that affects theentire economy or large numbers of persons orgroups within the economy, such as inflation,

war, or recession. A particular risk is a risk thataffects only the individual and not the entirecommunity or country.

� The following types of pure risk can threaten an indi-vidual’s financial security:

Personal risks

Property risks

Liability risks

� Personal risks are those risks that directly affect anindividual. Major personal risks include the following:

Risk of premature death

Risk of insufficient income during retirement

Risk of poor health

Risk of unemployment

� Property risks affect persons who own property. Ifproperty is damaged or lost, two principal types oflosses may result:

Direct loss to property

Indirect, or consequential, loss

A direct loss is a financial loss that results fromthe physical damage, destruction, or theft ofthe property.

An indirect, or consequential, loss is a financialloss that results indirectly from the occurrenceof a direct physical damage or theft loss. Exam-ples of indirect losses are the loss of use of theproperty, loss of profits, loss of rents, and extraexpenses.

� Liability risks are extremely important because there isno maximum upper limit on the amount of the loss,and if a person must pay damages, a lien can be placedon income and assets to satisfy a legal judgment; sub-stantial legal defense costs and attorney fees may alsobe incurred.

� Risk entails three major burdens on society:

The size of an emergency fund must be increased.

Society is deprived of needed goods and services.

Worry and fear are present.

� There are five major methods of handling risk:

Avoidance

Loss control

Retention

Noninsurance transfers

Insurance

KEY CONCEPTS AND TERMS insurance underwriter is concerned with risk, hazard,and chance of loss.a. Describe several risks to which the frame dwelling

is exposed.b. Compare and contrast moral hazard and morale

hazard with respect to property insurance on theframe dwelling. Give an example of each.

2. Assume that chance of loss is 3 percent for two dif-ferent fleets of trucks. Explain how it is possible thatobjective risk for both fleets can be different eventhough the chance of loss is identical.

3. Identify the types of financial losses likely to beincurred by each of the following parties.a. A person who negligently injures another motorist

in an auto accidentb. A restaurant that is shut down for six months

because of a tornadoc. A family whose family head dies prematurelyd. An attorney who fails to file a legal brief on time

for a cliente. A tenant whose apartment burns in a fire

4. Several methods are available for handling risk. How-ever, certain techniques are more appropriate thanothers in a given situation.a. (1) Should retention be used in those situations

where both loss frequency and loss severityare high? Explain your answer.

(2) Explain why loss control is a highly desirablemethod for handling risk.

b. Explain why chance of loss and risk are not thesame thing.

5. Sarah operates a pawn shop in a large city. Her shopis in a high-crime area, and the high cost of burglaryinsurance is threatening the existence of her business.A trade association points out that several methodsother than insurance can be used to handle the bur-glary exposure. Identify and illustrate three differentnoninsurance methods that might be used to dealwith this exposure.

SELECTED REFERENCESBernstein, Peter L. Against the Gods, The Remarkable

Story of Risk. New York: Wiley, 1996.Rejda, George E. “Causes of Economic Insecurity.” In

Social Insurance and Economic Security, 6th ed.Upper Saddle River, NJ: Prentice-Hall, 1999, pp. 4–9.

S E L E C T E D R E F E R E N C E S 15

AvoidanceChance of lossDirect lossFundamental riskHazardHedgingHold-harmless clauseHuman life valueIncorporationIndirect, or consequential

lossLaw of large numbersLegal hazardLiability risksLoss controlMoral hazard

Morale hazardNoninsurance transfersObjective probabilityObjective riskParticular riskPerilPersonal risksPhysical hazardPremature deathProperty risksPure riskRetentionRiskSpeculative riskSubjective probabilitySubjective risk

REVIEW QUESTIONS1. Explain briefly the meaning of risk.

2. How does objective risk differ from subjective risk?

3. Define chance of loss.

4. Distinguish between an objective probability and asubjective probability.

5. Define peril, hazard, physical hazard, moral hazard,morale hazard, and legal hazard.

6. Explain the difference between pure and speculativerisk and between fundamental and particular risk.

7. Identify the major types of pure risk that are associ-ated with great financial insecurity.

8. Why is pure risk harmful to society?

9. What is the difference between a direct loss and anindirect, or consequential, loss?

10. Describe briefly the five major methods of handlingrisk. Give an example of each method.

APPLICATION QUESTIONS1. Union Insurance received an application to provide

property insurance on a frame dwelling located nearan oil refinery in an industrial section of the city. Inconsidering this property for insurance, the property


The 2001 Retirement Confidence Survey, Summary ofFindings. Washington: Employee Benefit ResearchInstitute, 2001.

U.S. Census Bureau, Money Income in the United States,2000, Current Population Reports, P60-213. Wash-ington, DC: Government Printing Office, 2001.

Wiening, Eric A. Foundations of Risk Management andInsurance. Malvern, PA: American Institute for CPCU,2002, ch. 1.

NOTES1. Risk has also been defined as (1) variability in future

outcomes, (2) chance of loss, (3) possibility of anadverse deviation from a desired outcome that isexpected or hoped for, (4) variation in possible out-comes that exist in a given situation, and (5) possi-bility that a sentient entity can incur a loss.

2. This section is based on George E. Rejda, SocialInsurance and Economic Security, 6th ed. UpperSaddle River, NJ: Prentice-Hall, 1999, pp. 4–9.

3. U.S. Census Bureau, Current Population Reports,P60-213, Money Income in the United States, 2000(Washington, DC: Government Printing Office, 2001),table A.

4. Data based on the 1985 Commissioners DisabilityTable as cited in Edward E. Graves, ed., McGill’s LifeInsurance, 3rd ed. (Bryn Mawr, PA: The AmericanCollege, 2000), table 7.2, p. 168.

C a s e A p p l i c a t i o nTyrone is a college senior who is majoring in jour-nalism. He owns a high-mileage 1990 Ford that has acurrent market value of $1500. The current replace-ment value of his clothes, television set, stereo set, andother personal property in a rented apartment total$5000. He wears disposable contact lenses, which cost$200 for a six-month supply. He also has a waterbed inhis rented apartment that has leaked water in the past.An avid runner, Tyrone runs five miles daily in a nearbypublic park that has the reputation of being extremelydangerous because of drug dealers, numerous assaultsand muggings, and drive-by shootings. Tyrone’s parentsboth work to help him pay his tuition.

For each of the following risks or loss exposures,identify an appropriate risk management technique thatcould be used to deal with the exposure. Explain youranswer.

a. Physical damage to the 1990 Ford because of a col-lision with another motorist

b. Liability lawsuit against Tyrone arising out of thenegligent operation of his car

c. Total loss of clothes, television, stereo, and personalproperty because of a grease fire in the kitchen ofhis rented apartment

d. Disappearance of one contact lense. Waterbed leak that causes property damage to the

apartmentf. Physical assault on Tyrone by gang members who

are dealing drugs in the park where he runsg. Loss of tuition from Tyrone’s father who is killed

by a drunk driver in an auto accident

Students may take a self-administered test on this chapter at www.aw.com/rejda

Documents

Chapter 1 - Risk in Our Society