Concept of Risk
Introduction to Risk
Everyone makes use of the word Risk almost on a daily basis. In other words, everyone may have come across the word Risk. However, what we intend to do in this Lesson is to define risk and explain what it is as it relates to Insurance.
What Is Risk In Insurance?
Risk in insurance may be defined in any of the following ways:
– an uncertainty of loss:
– a possibility of loss,
– a combination of the possibility of occurrence of an undesired outcome (loss and its consequences)
– used to describe liability undertaken by the insurer
– used to describe the subject matter of insurance:
– used to describe the perils insured
– the danger individuals are likely to face in their day to day activities.
However, some people (especially, non-insurance people) may define risk as a ‘chance of loss’ such as the chance of winning a contract or the chance of making a profit. But, it is important to know that in insurance, the word ‘Chance’ is mostly associated with a positive or desired outcome, which makes one happy when it occurs, while risk in Insurance is not a desired outcome.
The General Meanings of Risk in Insurance
Generally, in insurance, the term risk may be used interchangeably to mean any of the following:
(a) As the main cause of an undesired outcome
Examples are death risk in life assurance, fire risk in a household insurance, occurrence of accident in a motor insurance and disability risk in the personal accident insurance.
(b) As the subject matter of insurance
Here, we are looking basically at the risks to be covered under various insurance policies. Examples are the life assured in a life assurance policy, the building and contents in a fire insurance policy and the motor vehicle in a motor insurance policy.
(c) As the probability (i.e. likelihood) of an undesired event taking place
Events with a high probability of occurrence are referred to as ‘high risk’ and those with a low probability of occurrence are referred to as ‘low risk’.
(d) As an act of negligence
This is not putting in place what a reasonable man would have put in place or doing something that a reasonable man would not have done in the same circumstance – A typical example is not having one’s property insured in the face of a potential loss.
Another example is when someone takes only a third party motor insurance as against a comprehensive motor insurance cover on his or her car.
A third party motor insurance can only compensate the insured for his liabilities towards a third party, whereas a comprehensive motor insurance will compensate both the insured and a third party in the event of a loss if they both suffers damages.
The Three Main Features of a Risk
The three main features that must be present in the definition of a risk are:
This is a state of being uncertain about the future concerning the occurrence or non-occurrence of an event. ‘Therefore, uncertainty is said to exist where a person expresses doubt about the future concerning the subject matter under consideration. Thus, in any situation where there is uncertainty, there is a risk.
ii. Degrees of Risk:
Risks may vary both in terms of –
(a) Number of times of occurrence (i.e. frequency)
(b) Exposure level. (i.e. severity)
(iia) Number of time of occurrence
(i.e. frequency) and impact (i.e. amount of loss): Frequency means how often the risk occurs, while the impact or severity is the exact amount of loss when the risk occurs. Usually in insurance, a high frequency of an event is associated with a low severity and vice versa. A high frequency would generally enable us to build a good database from which a reliable knowledge about the future outcome may be improved upon, thus leading to more precision about the certainty of the outcome.
(iib) Exposure level:
An individual’s level of exposure to risk is a measure of the probability of the event resulting into a loss and the cost of meeting the loss if it occurs. The product of these two items gives an estimate of the value an individual may attach to every risky situation or event.
For instance, if you assign 0.2 as the probability of a loss to a mobile phone with an estimated cost of N80,000 at the time of the loss, then the value that is being attached to the mobile phone is: 0.2 X N80,OO0 (i.e. N16,000)
iii. The cause of the loss:
This is the third main feature of a risk. A risk at times may be looked at as the cause of the undesired event (loss). However, there is a need for us to distinguish between what actually caused the loss and those other intervening factors which may either reduce or increase the level of the loss if it does happens.
Peril is the cause of the loss, while those other intervening factors are called hazards. It is important to note that hazards may operate to cause a peril, and eventually causing the loss to occur.
Therefore, to the insurer, hazards are important underwriting factors in deciding whether a risk being proposed is to be accepted or not and if it is to be accepted, what premium rates and terms should be imposed by the insurer.
Classification Of Risk
Risks may be classified in many ways in insurance, but we shall make use of the following four main classifications:
i. Pure and Speculative Risks.
ii. Particular and Fundamental Risks.
iii. Financial and Non-Financial Risks.
iv. Dynamic and Static Risks.
i. Pure and Speculative Risks:
A pure risk is a risk which involves a possibility of a loss (in a worst scenario) or, no loss or profit (at best). Thus, for a pure risk, it is either a person suffers a loss or in the absence of the loss, he remains in his position (status-quo).
While, in a speculative risk there is a possibility of a loss, no loss (break-even) or a profit. Investment risks generally are speculative risks. However, unlike the pure risks which are insurable (meaning, pure risks can be insured), all speculative risks are not insurable (mainly because of the possibility or chance of a gain being involved in them).
ii. Particular and Fundamental Risks:
A particular risk is a risk which has its origin in the activities of an individual or group of individuals and their effects borne by these individuals. Thus, particular risks are said to be personal in both their origin and effects. Particular risks are therefore insurable.
Fundamental risks are risks whose causes are impersonal and effects are borne by the society as a whole. Examples of fundamental risks are floods, Tsunamis, earthquakes as well as other major disasters. Though, perceived to be beyond human control, some fundamental risks may occur from acts of terrorism, war, riot and civil commotion.
Fundamental risks are generally considered uninsurable, but few of them these days may he insurable at an additional premium.
iii. Financial and Non-Financial Risks:
Financial risks are risks whose effects can be expressed in monetary values. That is, one can place a value on the risk to be insured. For general insurance, risks may easily be expressed in monetary terms. But, for life assurance, placing value on the risk is not as easy as it is found in the general insurance business.
Financial risks are directly linked to the insurable interest. Therefore, financial risks are insurable, whereas, non-financial risks are not insurable solely because monetary values cannot he placed on them.
iv. Dynamic and Static Risks:
Dynamic risks are risks with national consequences when they occur and as such they relate more to economic issues. Examples of dynamic risks are the negative consequences of inflation and political instability.
Static risks are those with no national consequences when they occur. They tend to affect individuals rather than the economy. Examples are theft and fire incidences.
The Cost of a Risk
This refers to the monetary value in meeting a risk when the undesired event (i.e. loss) happens. It has to be predetermined, though we might not get an accurate value, but an estimate of the value of the loss is preferred.
In getting this estimate, the following are to be considered:
(a) The frequency of occurrence of the risk
(b) The financial amount of the loss in the event of the risk happening.
(c) In the extreme case, one may need to consider the human cost aspect of the loss in the form of emotional feelings, suffering and pains.
Relationship Between Risk And Peril
We have explained risk in detail earlier. Peril can be defined as the cause of a loss.
For example, if a community suffers severe famine (scarcity of food) caused by drought, we can say that the peril of the famine is the drought. Similarly, if a house is destroyed by fire, then the cause of the damage to the house is fire and thus, we say the peril is fire.
Basically, in differentiating between a risk and peril, we can say a risk is uncertainty of loss, while a peril is the cause of a loss.
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