Uncertainty
Ambiguous, cannot learn about it, completely random, cannot estimate probability
Risk
The chance you will lose something of value to you; we continually make choices about risk, sometimes consciously, most times not
- managing risks involves making good choices involving trade-offs
- managing risk well is critical to individuals, household
Objective Risk
Relative variation of actual from expected loss; quantitative
Objective risk = Standard Deviation (Loss) / Expected (Loss)
Subjective Risk
Uncertainty based on mental condition or state of mind; matter of perspective and can vary among people which can be difficult to measure
Law of Large Numbers (LLN)
Objective risk declines with the number of exposures
Example: the more times you toss a coin, the closer the frequency of heads and tails approaches 1/2
Which involves greater objective risk?
a. Investing in one stock
b. Investing in a mutual fund of similar stocks
A. ; because the risk can be spread in option B which makes it less of a bigger risk.
Which involves greater objective risk?
a. covering the losses of one home
b. covering the losses of 100,000 homes
A.
Chance of Loss
Probability that a loss will occur
Objective Probability
Long- Run relative Frequency of event
Deductive reasoning
A logical process in which a conclusion is based on the concordance of multiple premises that are generally assumed to be true.
A game of chance; top-down logic; General --> Particular
Inductive reasoning
Bottom-top logic; Particular --> General
It gathers together particular observations in the form of premises, then it reasons from these particular premises to a general conclusion.
Peril
Causes of losses
Example: auto accidents, fires, storms, recessions, etc.
Hazards
Conditions that create or increase the frequency or severity of losses
Example: bad brakes, icy roads, old wiring, etc.
Physical hazards
Icy streets, old wiring
Moral hazards
Dishonesty or character defect in an individual that increases the frequency or severity of loss, e.g., setting your house on fire to collect on insurance
Legal Hazard
Characteristics of the legal system/regulatory environment that increase the frequency or severity of losses.
Attitudinal (moral) hazard
Indifference to loss because of insurance, e.g., you drive less safely because you have insurance
Moral Hazard (re-defined)
Increased incentives to cause a loss or diminished incentives to prevent a loss because of insurance or other means to externalized loses to others (e.g. through bankruptcy)
Pure Risk
Possibilities of loss or no loss, no change of gain, e.g., Fire
Diversifiable Risk:
Affects only individuals or small groups and not the entire economy
Nondiversifiable risk
Affects the entire economy or large numbers of persons or groups within the economy
Enterprise Risk
All major risks faced by a firm
Systemic risk
The risk of collapse of an entire system or market due to the failure of one or group of firms
Example: 2008-2009 Housing market crisis
Personal Risks
Premature death, insufficient income during retirement, poor health, unemployment
Potential Losses
Loss of income, extra expenses, depletion of financial assets
Liability Risks/ Losses
Legal liability for bodily injury or physical damage losses to another
Negligence, breach of warranty, absolute liability
Property RIsks/ Liability
- Direct physical damage losses
- Theft losses
- Indirect or consequential losses
- Extra expenses
Risk to Firms
- Property risks
- Liability risks
- Losses of income
- Cyber risks
- Financial risks
- Strategic risks
- Operational risks
- Other risks: Human resources
Foreign loss exposure, intangible property exposures, Government exposures
Commercial Risks Elaboration
- property
- liability
- loss of business income
- cyber risk
- other risk
Burden of Risk on Society
- Need for larger emergency fund
- Loss of certain goods and services
- Worry and fear
- Other costs
Techniques for Managing Risk
Risk Control: Avoidance, loss prevention, loss reduction
Risk Financing: retention, non-insurance transfer, insurance
Loss prevention
Reduces frequency
Loss reduction
Reduces severity; includes duplication separations & diversification
Risk Financing: Retention
Active, passive, self-insurance
Risk Financing: Non-insurance transfer
Contractual transfer, hedging, incorporation