CHAPTER

R ISK

IN

O UR S OCIETY

LEARNING OBJECTIVES
After studying this chapter, you should be able to
N N

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. Bernstein Against the Gods, The Remarkable Story of Risk

Explain the meaning of risk. Distinguish between pure risk and speculative risk. Identify the major pure risks that are associated with nancial insecurity. Understand how risk is a burden to society. Explain the major methods of handling risk. Access an Internet site to obtain and analyze information dealing with risk.

INTERNET

RESOURCES

I 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 the publisher of The Journal of Risk and Insurance and Risk Management and Insurance Review. Links are provided to research, teaching, and other risk and insurance sites. Visit the site at http://www.aria.org I The Risk Theory Society is an organization within the American Risk and Insurance Association that promotes research in risk theory and risk management. Papers are distributed in advance to the members and are discussed critically at its annual meeting. Visit the site at http://www.aria.org/rts I The Federal Emergency Management Agency (FEMA) is a federal agency that deals with natural disasters. Its mission is to reduce the loss of life and property and protect the nations infrastructure through a comprehensive, risk-based, emergency management program of mitigation, preparedness, response, and recovery. Visit the site at http://www.fema.gov I The Insurance Information Institute is a trade association that provides consumers with information on catastrophic losses and the ling of claims from terrorist attacks, hurricanes, oods, earthquakes, and other natural disasters. Visit the site at http://www.iii.org I RISKMail allows persons around the world to participate in a no holds barred discussion of risk and insurance issues. RISKMail Archive contains previous comments on risk and insurance topics. Links are provided to other academic and professional sites. Visit the site at http://www.riskmail.org/account.htm I 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 from physical, 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

n 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 eld in southwestern 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 res, oods, hurricanes, earthquakes, and other natural disasters. Others incur catastrophic medical bills and the loss of earnings because of heart disease, cancer, AIDS, or other diseases. Still others face nancial 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 discussed include the meaning of risk, the major types of risk that threaten our nancial security, and the basic methods for handling risk.

MEANING OF RISK
There is no single denition of risk. Economists, behavioral scientists, risk theorists, statisticians, and actuaries each have their own concept of risk. However, risk traditionally has been dened in terms of uncertainty. Based on this concept, risk is dened here as uncertainty concerning the occurrence of a loss.1 For example, the risk of being killed in an auto accident is present because uncertainty is present. The risk of lung cancer for smokers is present because uncertainty is present. And the risk of unking a college course is present because uncertainty is present. Although risk is dened as uncertainty in this text, employees in the insurance industry often use the term risk to identify the property or life being insured. Thus, in the insurance industry, it is common to hear statements such as that driver is a poor risk or that building is an unacceptable risk. Finally, when risk is dened as uncertainty, some authors make a careful distinction between objective risk and subjective risk.

Objective Risk
Objective risk is dened as the relative variation of actual loss from expected loss. For example, assume that a property insurer has 10,000 houses insured over a long period and, on average, 1 percent, or 100 houses, burn each year. However, it would be

rare for exactly 100 houses to burn each year. In some years, as few as 90 houses may burn; in other years, as many as 110 houses may burn. Thus, there is a variation of 10 houses from the expected number of 100, or a variation of 10 percent. This relative variation of actual loss from expected loss is known as objective risk. Objective risk declines as the number of exposures increases. More specically, objective risk varies inversely with the square root of the number of cases under observation. In our previous example, 10,000 houses were insured, and objective risk was 10/100, or 10 percent. Now assume that 1 million houses are insured. The expected number of houses that will burn is now 10,000, but the variation of actual loss from expected loss is only 100. Objective risk is now 100/10,000, or 1 percent. Thus, as the square root of the number of houses increased from 100 in the rst example to 1000 in the second example (10 times), objective risk declined to onetenth of its former level. Objective risk can be statistically calculated by some measure of dispersion, such as the standard deviation or the coefcient of variation. Because objective risk can be measured, it is an extremely useful concept for an insurer or a corporate risk manager. As the number of exposures increases, an insurer can predict its future loss experience more accurately because it can rely on the law of large numbers. The law of large numbers states that as
3

CHAPTER 1 / RISK IN OUR SOCIETY

the number of exposure units increases, the more closely the actual loss experience will approach the expected loss experience. For example, as the number of homes under observation increases, the greater is the degree of accuracy in predicting the proportion of homes that will burn. The law of large numbers is discussed in greater detail in Chapter 2.

Subjective Risk
Subjective risk is dened as uncertainty based on a persons mental condition or state of mind. For example, a customer who was drinking heavily in a bar may foolishly attempt to drive home. The driver may be uncertain whether he will arrive home safely without being arrested by the police for drunk driving. This mental uncertainty is called subjective risk. The impact of subjective risk varies depending on the individual. Two persons in the same situation can have a different perception of risk, and their behavior may be altered accordingly. If an individual experiences great mental uncertainty concerning the occurrence of a loss, that persons behavior may be affected. High subjective risk often results in conservative and prudent behavior, while low subjective risk may result in less conservative behavior. For example, a motorist previously arrested for drunk driving is aware that she has consumed too much alcohol. The driver may then compensate for the mental uncertainty by getting someone else to drive the car home or by taking a cab. Another driver in the same situation may perceive the risk of being arrested as slight. This second driver may drive in a more careless and reckless manner; a low subjective risk results in less conservative driving behavior.

in the underlying conditions. Objective probabilities can be determined in two ways. First, they can be determined by deductive reasoning. These probabilities 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 are two sides, and only one is a head. Likewise, the probability of rolling a 6 with a single die is 1/6, since there are six sides and only one side has six dots on it. Second, objective probabilities can be determined by inductive reasoning, rather than by deduction. For example, the probability that a person age 21 will die before age 26 cannot be logically deduced. However, by a careful analysis of past mortality experience, life insurers can estimate the probability of death and sell a ve-year term life insurance policy issued at age 21.

Subjective Probability
Subjective probability is the individuals personal estimate of the chance of loss. Subjective probability need not coincide with objective probability. For example, people who buy a lottery ticket on their birthday may believe it is their lucky day and overestimate the small chance of winning. A wide variety of factors can inuence subjective probability, including a persons age, gender, intelligence, education, and the use of alcohol. In addition, a persons estimate of a loss may differ from objective probability because there may be ambiguity in the way in which the probability is perceived. For example, assume that a slot machine in a gambling casino requires three lemons to win. The person playing the machine may perceive the probability of winning to be quite high. But if there are 10 symbols on each reel and only one is a lemon, the objective probability of hitting the jackpot with three lemons is quite small. Assuming that each reel spins independently of the others, the probability that all three will simultaneously show a lemon is the product of their individual probabilities (1/10 1/10 1/10 1/1000). This knowledge is advantageous to casino owners, who know that most gamblers are not trained statisticians and are therefore likely to overestimate the objective probabilities of winning.

CHANCE OF LOSS
Chance of loss is closely related to the concept of risk. Chance of loss is dened as the probability that an event will occur. Like risk, probability has both objective and subjective aspects.

Objective Probability
Objective probability refers to the long-run relative frequency of an event based on the assumptions of an innite number of observations and of no change

PERIL AND HAZARD

Chance of Loss Distinguished from Risk

Chance of loss can be distinguished from objective risk. Chance of loss is the probability that an event that causes a loss will occur. Objective risk is the relative variation of actual loss from expected loss. The chance of loss may be identical for two different groups, but objective risk may be quite different. For example, assume that a property insurer has 10,000 homes insured in Los Angeles and 10,000 homes insured in Philadelphia and that the chance of loss in each city is 1 percent. Thus, on average, 100 homes should burn annually in each city. However, if the annual variation in losses ranges from 75 to 125 in Philadelphia, but only from 90 to 110 in Los Angeles, objective risk is greater in Philadelphia even though the chance of loss in both cities is the same.

and a defective lock on a door that increases the chance of theft.

PERIL AND HAZARD

The terms peril and hazard should not be confused with the concept of risk discussed earlier.

Moral Hazard Moral hazard is dishonesty or character defects in an individual that increase the frequency or severity of loss. Examples of moral hazard include faking an accident to collect from an insurer, submitting a fraudulent claim, inating the amount of a claim, and intentionally burning unsold merchandise that is insured. Moral hazard is present in all forms of insurance, and it is difcult to control. Dishonest individuals often rationalize their actions on the grounds that the insurer has plenty of money. This view is incorrect because the insurer can pay claims only by collecting premiums from other insureds. Because of moral hazard, premiums are higher for everyone. Insurers attempt to control moral hazard by careful underwriting of applicants for insurance and by various policy provisions, such as deductibles, waiting periods, exclusions, and riders. These provisions are examined in Chapter 6. Morale Hazard Some insurance authors draw a subtle distinction between moral hazard and morale hazard. Moral hazard refers to dishonesty by an insured that increases the frequency or severity of loss. Morale hazard is carelessness or indifference to a loss because of the existence of insurance. Some insureds are careless or indifferent to a loss because they have insurance. Examples of morale hazard include leaving car keys in an unlocked car, which increases the chance of theft; leaving a door unlocked that allows a burglar to enter; and changing lanes suddenly on a congested interstate highway without signaling. Careless acts like these increase the chance of loss. Legal Hazard Legal hazard refers to characteristics of the legal system or regulatory environment that increase the frequency or severity of losses. Examples include adverse jury verdicts or large damage awards in liability lawsuits, statutes that require insurers to include coverage for certain benets in health insurance plans, such as coverage for alcoholism; and regulatory action by state insurance departments that restrict the ability of insurers to withdraw from the state because of poor underwriting results.

Peril
Peril is dened as the cause of loss. If your house burns because of a re, the peril, or cause of loss, is the re. If your car is damaged in a collision with another car, collision is the peril, or cause of loss. Common perils that cause property damage include re, lightning, windstorm, hail, tornadoes, earthquakes, theft, and burglary.

Hazard
A hazard is a condition that creates or increases the chance of loss. There are four major types of hazards:
I I I I

Physical hazard Moral hazard Morale hazard Legal hazard

Physical Hazard A physical hazard is a physical condition that increases the chance of loss. Examples of physical hazards include icy roads that increase the chance of an auto accident, defective wiring in a building that increases the chance of re,

CHAPTER 1 / RISK IN OUR SOCIETY

BASIC CATEGORIES OF RISK

Risk can be classied into several distinct categories. The two major categories are as follows:
I I

Pure and speculative risks Fundamental and particular risks

tors may be forced into bankruptcy. Despite the bankruptcy, society benets because the computers are produced at a lower cost. However, society normally does not benet when a loss from a pure risk occurs, such as a ood or earthquake that devastates an area.

Fundamental and Particular Risks Pure and Speculative Risks

Pure risk is dened as a situation in which there are only the possibilities of loss or no loss. The only possible outcomes are adverse (loss) and neutral (no loss). Examples of pure risks include premature death, job-related accidents, catastrophic medical expenses, and damage to property from re, lightning, ood, or earthquake. Speculative risk is dened as a situation in which either prot or loss is possible. For example, if you purchase 100 shares of common stock, you would prot if the price of the stock increases but would lose if the price declines. Other examples of speculative risks include betting on a horse race, investing in real estate, and going into business for yourself. In these situations, both prot and loss are possible. It is important to distinguish between pure and speculative risks for three reasons. First, private insurers generally insure only pure risks. With certain exceptions, speculative risks generally are not considered insurable, and other techniques for coping with speculative risk must be used. (One exception is that some insurers will insure institutional portfolio investments and municipal bonds against loss.) Second, the law of large numbers can be applied more easily to pure risks than to speculative risks. The law of large numbers is important because it enables insurers to predict future loss experience. In contrast, it is generally more difcult to apply the law of large numbers to speculative risks to predict future loss experience. An exception is the speculative risk of gambling, where casino operators can apply the law of large numbers in a most efcient manner. Finally, society may benet from a speculative risk even though a loss occurs, but it is harmed if a pure risk is present and a loss occurs. For example, a rm may develop new technology for producing inexpensive computers. As a result, some competiA fundamental risk is a risk that affects the entire economy or large numbers of persons or groups within the economy. Examples include rapid ination, cyclical unemployment, and war because large numbers of individuals are affected. The risk of a natural disaster is another important risk. Hurricanes, tornadoes, earthquakes, oods, and forest and grass res can result in billions of dollars of property damage and numerous deaths. In 1999, Hurricane Floyd caused $2 billion of insured losses. In 1994, a major earthquake in Northridge, California, caused $13 billion of insured losses and the loss of numerous lives. In 1992, Hurricane Andrew caused insured losses of about $16 billion and the failure of a number of property insurers. More recently, the risk of a terrorist attack is rapidly emerging as a fundamental risk. Many countries have experienced a substantial increase in terrorism in recent years, resulting in substantial property damage and the loss of human lives. The terrorist attack in the United States on September 11, 200l, resulted in the loss of four commercial jets, destruction of the World Trade Center towers in New York City, substantial damage to the Pentagon, and thousands of dead or missing persons. At the time of this writing, estimated losses are about $40 billion. The terrorist attack is the largest single catastrophic loss in the United States to date (see Exhibit 1.1). In contrast to a fundamental risk, a particular risk is a risk that affects only individuals and not the entire community. Examples include car thefts, bank robberies, and dwelling res. Only individuals experiencing such losses are affected, not the entire economy. The distinction between a fundamental and a particular risk is important because government assistance may be necessary to insure a fundamental risk. Social insurance and government insurance programs, as well as government guarantees and

TYPES OF PURE RISK

EXHIBIT 1.1 United States: Top 10 Biggest Catastrophes (by insured loss)
Billions $40 35 30 25 20 15.5 15 10 5 0
Te At rro ta ris H ck t ur s r. (0 An 1) dr * ew N or (9 th 2) rid ge Eq .( 9 H 4) ur r. H ug o H ur (8 r. 9) G eo rg es (9 TS 8) Al lis on (0 H 1) ur r. O pa l( 9 H 5) ur r. Fl oy 20 d -S (9 ta 9) te St or m O (9 ak 3) la nd Fi re In iki (9 (9 1) 2) /F ra n (9 6)
*III estimate; includes life, liability, and workers compensation losses. SOURCE: Insurance Services Ofce, Insurance Information Institute.

40

12.5

4.2

2.9

2.5

2.1

2.0

1.8

1.7

1.6

subsidies, may be necessary to insure certain fundamental risks in the United States. For example, the risk of unemployment generally is not insurable by private insurers but can be insured publicly by state unemployment compensation programs. In addition, ood insurance subsidized by the federal government is available to business rms and individuals in ood-prone areas.

and the depletion of nancial assets. There are four major personal risks:2
I I I I

Risk of premature death Risk of insufcient income during retirement Risk of poor health Risk of unemployment

TYPES OF PURE RISK

The major types of pure risk that can create great nancial insecurity include personal risks, property risks, and liability risks.

Personal Risks
Personal risks are risks that directly affect an individual. They involve the possibility of the complete loss or reduction of earned income, extra expenses,

Risk of Premature Death Premature death is dened as the death of a household head with unfullled nancial obligations. These obligations can include dependents to support, a mortgage to be paid off, or children to educate. If the surviving family members receive an insufcient amount of replacement income from other sources or have insufcient nancial assets to replace the lost income, they may be nancially insecure. Premature death can cause nancial problems only if the deceased has dependents to support or dies with unsatised nancial obligations. Thus, the death of a child age seven is not premature in the economic sense.

CHAPTER 1 / RISK IN OUR SOCIETY

Insight 1.1
Making Ends Meet Can Be Tough for Widows
Most people think they have enough life insurance so that their survivors can get along just ne. But they may be fooling themselvesat least according to a study sponsored by LIMRA International, the research arm of the insurance industry. The study looked at the nances of men and women who lost a spouse prematurely (between ages 25 and 54). Widowsnot widowerswere having trouble making ends meet or covering expenses, says Cheryl Retzloff, the project director. Although the women received more than double the average death benet that was paid to the men$162,600 versus $73,100widows reported more nancial problems. On average, the death benet for widows was approximately three times the total household income; widowers averaged only one years household income. Interestingly, survivors generally spent the insurance benet on short-term needs, such as paying off debts or paying down a mortgage. LIMRA says that insurance agents need to do a more thorough needs analysis, especially for wives. If a wifes earning potential is more limited, the agent should recommend higher levels of coverage and make sure it covers the costs associated with death (funeral, medical expenses, plus access to health benets).
SOURCE: Adapted from More Bad News for Widows, On Investing (Fall 1999), p. 14.

There are at least four costs that result from the premature death of a household head. First, the human life value of the family head is lost forever. The human life value is dened as the present value of the familys share of the deceased breadwinners future earnings. This loss can be substantial; the actual or potential human life value of most college graduates can easily exceed $500,000. Second, additional expenses may be incurred because of funeral expenses, uninsured medical bills, probate and estate settlement costs, and estate and inheritance taxes for larger estates. Third, because of insufcient income, some families may have trouble making ends meet or covering expenses (see Insight 1.1). Finally, certain noneconomic costs are also incurred, including emotional grief, loss of a role model, and counseling and guidance for the children.

Risk of Insufcient Income During Retirement The major risk associated with old age is insufcient income during retirement. The vast majority of workers in the United States retire before age 65. When they retire, they lose their earned income. Unless they have sufcient nancial assets on which to draw, or have access to other sources of retirement income, such as Social Security or a private pension, they will be exposed to nancial insecurity during retirement. The majority of workers experience a substantial reduction in their money incomes when they

retire, which can result in a reduced standard of living. For example, the median income for all households in the United States in 2000 was $42,148. In contrast, the median income for households with an aged householder age 65 and over was only $23,048 in 2000, or 45 percent less.3 This amount is generally insufcient for retired workers who have substantial additional expenses, such as high uninsured medical bills, or high property taxes, or are paying for the cost of long-term care in a nursing home. Most workers are not saving enough for a comfortable retirement. The 2001 Retirement Conference Survey by the Employee Benet Research Institute shows that the amounts saved for retirement by workers as a whole are generally small. About two in ten workers reported saving nothing for retirement; half reported saving less than $50,000, while only 15 percent reported saving $100,000 or more. These amounts are relatively small for a comfortable retirement. However, workers who have calculated the amount of money needed for retirement by a needs analysis generally tend to save more (see Exhibit 1.2).

Risk of Poor Health Poor health is another important personal risk. The risk of poor health includes both the payment of catastrophic medical bills and the loss of earned income. The costs of major surgery have increased substantially in recent years. For

TYPES OF PURE RISK

EXHIBIT 1.2 Amounts Saved for Retirement 2001 Retirement Condence Survey
All Workers Done Needs Calculation Not Done Needs Calculation

Nothing Less than $5,000 $5,000$9,999 $10,000$24,999 $25,000$49,999 $50,000$99,999 $100,000 or more Dont know/refused

19% 8 6 10 7 8 15 27

6% 8 4 10 8 10 25 30

28% 9 7 10 8 7 8 24

SOURCE: Excerpted from The 2001 Retirement Condence Survey Summary of Findings (Washington, DC: Employee Benet Research Institute, 2001).

example, an open heart operation can cost more than $200,000, a kidney or heart transplant can cost more than $400,000, and the costs of a crippling accident requiring several major operations, plastic surgery, and rehabilitation can exceed $500,000. In addition, long-term care in a nursing home can cost $50,000 or more each year. Unless these persons have adequate health insurance, private savings and nancial assets, or other sources of income to meet these expenditures, they will be nancially insecure. In particular, the inability of some persons to pay catastrophic medical bills is an important cause of personal bankruptcy. The loss of earned income is another major cause of nancial insecurity if the disability is severe. In cases of long-term disability, there is a substantial loss of earned income, medical bills are incurred, employee benets may be lost or reduced, savings are often depleted, and someone must take care of the disabled person. Most workers seldom think about the nancial consequences of long-term disability. The probability of becoming disabled before age 65 is much higher than is commonly believed, especially at the younger ages. For individuals age 25, the 1985 Commissioners Disability Table shows that the probability of being totally disabled for 90 or more days prior to age 65 is 54 percent.4 The loss of earned income

during an extended disability can be nancially very painful.

Risk of Unemployment The risk of unemployment is another major threat to nancial security. Unemployment can result from business cycle downswings, technological and structural changes in the economy, seasonal factors, and imperfections in the labor market. Several important trends have aggravated the problem of unemployment. To hold down labor costs, large corporations have downsized, and their workforce has been permanently reduced; employers are increasingly hiring temporary or part-time workers to reduce labor costs; and millions of jobs have been lost to foreign nations because of global competition. Regardless of the reason, unemployment can cause nancial insecurity in at least three ways. First, workers lose their earned income and employee benets. Unless there is adequate replacement income or past savings on which to draw, the unemployed worker will be nancially insecure. Second, because of economic conditions, the worker may be able to work only part-time. The reduced income may be insufcient in terms of the workers needs. Finally, if the duration of unemployment is extended over a long period, past savings and unemployment benets may be exhausted.

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Insight 1.2
Runaway Car Hits Toddler, Kills Her Father
A man was killed and his 2-year-old daughter seriously injured when an out-of-control car mowed them down on a sidewalk Friday night. Daniel Callahan, 35, was pushing the girl in a stroller about 6:30 p.m. when a car carrying three teen-age boys came careening around a curve, jumped the curb and struck the man and toddler, police said. Callahan died later at an Omaha hospital from massive head injuries. The girl was thrown from her stroller, which was crushed by the car. She was in serious condition Saturday with a broken leg, cuts and bruises. Charges against the teenage driver are pending, investigators said.
SOURCE: From Runaway Car Hits Toddler, Kills Her Father, Lincoln Journal Star Sunday, June 3, 2001, p. 2B.

Property Risks
Persons owning property are exposed to property risksthe risk of having property damaged or lost from numerous causes. Real estate and personal property can be damaged or destroyed because of re, lightning, tornadoes, windstorms, and numerous other causes. There are two major types of loss associated with the destruction or theft of property: direct loss and indirect or consequential loss.

Liability Risks
Liability risks are another important type of pure risk that most persons face. Under our legal system, you can be held legally liable if you do something that results in bodily injury or property damage to someone else. A court of law may order you to pay substantial damages to the person you have injured. The United States is a litigious society, and lawsuits are common. Motorists can be held legally liable for the negligent operation of their vehicles. The liability exposure can be especially high for teenage drivers (see Insight 1.2). Operators of boats and lake owners can also be held legally liable because of bodily injury to boat occupants, swimmers, and water skiers. Business rms can be held legally liable for defective products that harm or injure customers; physicians, attorneys, accountants, engineers, and other professionals can be sued by patients and clients because of alleged acts of malpractice. In addition, new types of lawsuits are constantly emerging. For example, some ministers have faced lawsuits brought by church members because of improper counseling. Liability risks are of great importance for several reasons. First, there is no maximum upper limit with respect to the amount of the loss. You can be sued for any amount. In contrast, if you own property, there is a maximum limit on the loss. For example, 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 accident that results in serious bodily injury to the other driver, you can be sued for any amount$50,000, $500,000, or $1 million or moreby the person you have injured.

Direct Loss A direct loss is dened as a nancial loss that results from the physical damage, destruction, or theft of the property. For example, if you own a restaurant that is damaged by a re, the physical damage to the restaurant is known as a direct loss. Indirect or Consequential Loss An indirect loss is a nancial loss that results indirectly from the occurrence of a direct physical damage or theft loss. Thus, in addition to the physical damage loss, the restaurant would lose prots for several months while the restaurant is being rebuilt. The loss of prots would be a consequential loss. Other examples of a consequential loss would be the loss of rents, the loss of the use of the building, and the loss of a local market. Extra expenses are another type of indirect, or consequential, loss. For example, suppose you own a newspaper, bank, or dairy. If a loss occurs, you must continue to operate regardless of cost; otherwise, you will lose customers to your competitors. It may be necessary to set up a temporary operation at some alternative location, and substantial extra expenses would then be incurred.

METHODS OF HANDLING RISK

11

Second, a lien can be placed on your income and nancial assets to satisfy a legal judgment. For example, assume that you injure someone, and a court of law orders you to pay damages to the injured party. If you cannot pay the judgment, a lien may be placed on your income and nancial assets to satisfy the judgment. If you declare bankruptcy to avoid payment of the judgment, your credit rating will be impaired. Finally, legal defense costs can be enormous. If you have no liability insurance, the cost of hiring an attorney to defend you can be staggering. If the suit goes to trial, attorney fees and other legal expenses can be substantial.

have discontinued manufacturing certain products. Numerous examples can be given. Some 250 companies in the world once manufactured childhood vaccines; today, only a small number of rms manufacture vaccines, due in part to the threat of liability suits. Other rms have discontinued the manufacture of certain products, including asbestos products, football helmets, silicone-gel breast implants, and certain birth-control devices because of fear of legal liability.

Worry and Fear

A nal burden of risk is that worry and fear are present. Numerous examples can illustrate the mental unrest and fear caused by risk. Parents may be fearful if a teenage son or daughter departs on a skiing trip during a blinding snowstorm because the risk of being killed on an icy road is present. Some passengers in a commercial jet may become extremely nervous and fearful if the jet encounters severe turbulence during the ight. A college student who needs a grade of C in a course to graduate may enter the nal examination room with a feeling of apprehension and fear.

BURDEN OF RISK ON SOCIETY

The presence of risk results in certain undesirable social and economic effects. Risk entails three major burdens on society:
I I I

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

Larger Emergency Fund

It is prudent to set aside funds for an emergency. However, in the absence of insurance, individuals and business rms would have to increase the size of their emergency fund to pay for unexpected losses. For example, assume you have purchased a $150,000 home and want to accumulate a fund for repairs if the home is damaged by re, hail, windstorm, or some other peril. Without insurance, you would have to save at least $25,000 annually to build up an adequate fund within a relatively short period of time. Even then, an early loss could occur, and your emergency fund may be insufcient to pay the loss. If you are a middle-income wage earner, you would nd such saving difcult. In any event, the higher the amount that must be saved, the more current consumption spending must be reduced, which results in a lower standard of living.

METHODS OF HANDLING RISK

As we stressed earlier, risk is a burden not only to the individual but to society as well. Thus, it is important to examine some techniques for meeting the problem of risk. There are ve major methods of handling risk:
I I I I I

Avoidance Loss control Retention Noninsurance transfers Insurance

Avoidance
Avoidance is one method of handling risk. For example, you can avoid the risk of being mugged in a high-crime rate area by staying out of the area; you can avoid the risk of divorce by not marrying; and a business rm can avoid the risk of being sued for a defective product by not producing the product. Not all risks should be avoided, however. For example, you can avoid the risk of death or disability

Loss of Certain Goods and Services

A second burden of risk is that society is deprived of certain goods and services. For example, because of the risk of a liability lawsuit, many corporations

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CHAPTER 1 / RISK IN OUR SOCIETY

in a plane crash by refusing to y. But is this choice practical or desirable? The alternativesdriving or taking a bus or trainoften are not appealing. Although the risk of a plane crash is present, the safety record of commercial airlines is excellent, and ying is a reasonable risk to assume.

Loss Control
Loss control is another important method for handling risk. Loss control consists of certain activities that reduce both the frequency and severity of losses. Thus, loss control has two major objectives: loss prevention and loss reduction.

Loss Prevention Loss prevention aims at reducing the probability of loss so that the frequency of losses is reduced. Several examples of personal loss prevention can be given. Auto accidents can be reduced if motorists take a safe-driving course and drive defensively. The number of heart attacks can be reduced if individuals control their weight, give up smoking, and eat healthy diets. Loss prevention is also important for business rms. For example, strict security measures at airports and aboard commercial ights can reduce hijacking by terrorists. Boiler explosions can be prevented by periodic inspections by safety engineers; occupational accidents can be reduced by the elimination of unsafe working conditions and by strong enforcement of safety rules; and res can be prevented by forbidding workers to smoke in a building where highly ammable materials are used. In short, the goal of loss prevention is to prevent the loss from occurring. Loss Reduction Strict loss-prevention efforts can reduce the frequency of losses, yet some losses will inevitably occur. Thus, the second objective of loss control is to reduce the severity of a loss after it occurs. For example, a department store can install a sprinkler system so that a re will be promptly extinguished, thereby reducing the loss; a plant can be constructed with re-resistant materials to minimize re damage; re doors and re walls can be used to prevent a re from spreading; and a community warning system can reduce the number of injuries and deaths from an approaching tornado.

From the viewpoint of society, loss control is highly desirable for two reasons. First, the indirect costs of losses may be large, and in some instances can easily exceed the direct costs. For example, a worker may be injured on the job. In addition to being responsible for the workers medical expenses and a certain percentage of earnings (direct costs), the rm may incur sizable indirect costs: a machine may be damaged and must be repaired; the assembly line may have to be shut down; costs are incurred in training a new worker to replace the injured worker; and a contract may be canceled because goods are not shipped on time. By preventing the loss from occurring, both indirect costs and direct costs are reduced. Second, the social costs of losses are reduced. For example, assume that the worker in the preceding example dies from the accident. Society is deprived forever of the goods and services the deceased worker could have produced. The workers family loses its share of the workers earnings and may experience considerable grief and nancial insecurity. And the worker may personally experience great pain and suffering before dying. In short, these social costs can be reduced through an effective losscontrol program.

Retention
Retention is a third method of handling risk. An individual or a business rm retains all or part of a given risk. Risk retention can be either active or passive.

Active Retention Active risk retention means that an individual is consciously aware of the risk and deliberately plans to retain all or part of it. For example, a motorist may wish to retain the risk of a small collision loss by purchasing an auto insurance policy with a $250 or higher deductible. A homeowner may retain a small part of the risk of damage to the home by purchasing a homeowners policy with a substantial deductible. A business rm may deliberately retain the risk of petty thefts by employees, shoplifting, or the spoilage of perishable goods. In these cases, a conscious decision is made to retain part or all of a given risk. Active risk retention is used for two major reasons. First, it can save money. Insurance may not be

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purchased at all, or it may be purchased with a deductible; either way, there is often a substantial saving in the cost of insurance. Second, the risk may be deliberately retained because commercial insurance is either unavailable or unaffordable.

Passive Retention Risk can also be retained passively. Certain risks may be unknowingly retained because of ignorance, indifference, or laziness. Passive retention is very dangerous if the risk retained has the potential for destroying you nancially. For example, many workers with earned incomes are not insured against the risk of total and permanent disability under either an individual or group disability income plan. However, the adverse nancial consequences of total and permanent disability generally are more severe than the nancial consequences of premature death. Therefore, people who are not insured against this risk are using the technique of risk retention in a most dangerous and inappropriate manner. In summary, risk retention is an important technique for handling risk, especially in a modern corporate risk management program, which will be discussed in Chapters 3 and 4. Risk retention, however, is appropriate primarily for high-frequency, low-severity risks where potential losses are relatively small. Except under unusual circumstances, risk retention should not be used to retain lowfrequency, high-severity risks, such as the risk of catastrophic medical expenses, long-term disability, or legal liability.

which makes the retailer responsible for all repairs after the warranty expires. The risk of a rent increase can be transferred to the landlord by a long-term lease. The risk of a price increase in construction costs can be transferred to the builder by having a xed price in the contract. Finally, a risk can be transferred by a holdharmless clause. For example, if a manufacturer of scaffolds inserts a hold-harmless clause in a contract with a retailer, the retailer agrees to hold the manufacturer harmless in case a scaffold collapses and someone is injured.

Noninsurance Transfers
Noninsurance transfers are another technique for handling risk. The risk is transferred to a party other than an insurance company. A risk can be transferred by several methods, among which are the following:
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Hedging Price Risks Hedging price risks is another example of risk transfer. Hedging is a technique for transferring the risk of unfavorable price uctuations to a speculator by purchasing and selling futures contracts on an organized exchange, such as the Chicago Board of Trade or New York Stock Exchange. For example, the portfolio manager of a pension fund may hold a substantial position in long-term U.S. Treasury bonds. If interest rates rise, the value of the Treasury bonds will decline. To hedge that risk, the portfolio manager can sell U.S. Treasury bond futures. Assume that interest rates rise as expected, and bond prices decline. The value of the futures contract will also decline, which will enable the portfolio manager to make an offsetting purchase at a lower price. The prot obtained from closing out the futures position will partly or completely offset the decline in the market value of the Treasury bonds. Of course, markets do not always move as expected, so the hedge may not be perfect. Transaction costs also are incurred. However, by hedging, the portfolio manager has reduced the potential loss in bond prices if interest rates rise. Incorporation of a Business Firm Incorporation is another example of risk transfer. If a rm is a sole proprietorship, the owners personal assets can be attached by creditors for satisfaction of debts. If a rm incorporates, personal assets cannot be attached by creditors for payment of the rms debts. In essence, by incorporation, the liability of the stockholders is limited, and the risk of the rm having insufcient assets to pay business debts is shifted to the creditors.

Transfer of risk by contracts Hedging price risks Incorporation of a business rm

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

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Insurance
For most people, insurance is the most practical method for handling a major risk. Although private insurance has several characteristics, three major characteristics should be emphasized. First, risk transfer is used because a pure risk is transferred to the insurer. Second, the pooling technique is used to spread the losses of the few over the entire group so that average loss is substituted for actual loss. Finally, the risk may be reduced by application of the law of large numbers by which an insurer can predict future loss experience with greater accuracy. Each of these characteristics is treated in greater detail in Chapter 2.
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war, or recession. A particular risk is a risk that affects only the individual and not the entire community or country. The following types of pure risk can threaten an individuals nancial security: Personal risks Property risks Liability risks
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Personal risks are those risks that directly affect an individual. Major personal risks include the following: Risk of premature death Risk of insufcient income during retirement Risk of poor health Risk of unemployment

SUMMARY
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Property risks affect persons who own property. If property is damaged or lost, two principal types of losses may result: Direct loss to property Indirect, or consequential, loss A direct loss is a nancial loss that results from the physical damage, destruction, or theft of the property. An indirect, or consequential, loss is a nancial loss that results indirectly from the occurrence of a direct physical damage or theft loss. Examples of indirect losses are the loss of use of the property, loss of prots, loss of rents, and extra expenses.

There is no single denition of risk. Risk traditionally has been dened as uncertainty concerning the occurrence of a loss. Objective risk is the relative variation of actual loss from expected loss. Subjective risk is uncertainty based on an individuals mental condition or state of mind. Chance of loss is dened as the probability that an event will occur; it is not the same thing as risk. Peril is dened as the cause of loss. Hazard is any condition that creates or increases the chance of loss. There are four major types of hazards. Physical hazard is a physical condition present that increases the chance of loss. Moral hazard is dishonesty or character defects in an individual that increase the chance of loss. Morale hazard is carelessness or indifference to a loss because of the existence of insurance. Legal hazard refers to characteristics of the legal system or regulatory environment that increase the frequency or severity 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 the possibilities of loss or no loss. A speculative risk is a risk where either prot or loss is possible. A fundamental risk is a risk that affects the entire economy or large numbers of persons or groups within the economy, such as ination,
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Liability risks are extremely important because there is no maximum upper limit on the amount of the loss, and if a person must pay damages, a lien can be placed on income and assets to satisfy a legal judgment; substantial legal defense costs and attorney fees may also be 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 ve major methods of handling risk: Avoidance Loss control Retention Noninsurance transfers Insurance

SELECTED REFERENCES

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KEY CONCEPTS AND TERMS

Avoidance Chance of loss Direct loss Fundamental risk Hazard Hedging Hold-harmless clause Human life value Incorporation Indirect, or consequential loss Law of large numbers Legal hazard Liability risks Loss control Moral hazard Morale hazard Noninsurance transfers Objective probability Objective risk Particular risk Peril Personal risks Physical hazard Premature death Property risks Pure risk Retention Risk Speculative risk Subjective probability Subjective risk

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 the frame dwelling. Give an example of each. 2. Assume that chance of loss is 3 percent for two different eets of trucks. Explain how it is possible that objective risk for both eets can be different even though the chance of loss is identical. 3. Identify the types of nancial losses likely to be incurred by each of the following parties. a. A person who negligently injures another motorist in an auto accident b. A restaurant that is shut down for six months because of a tornado c. A family whose family head dies prematurely d. An attorney who fails to le a legal brief on time for a client e. A tenant whose apartment burns in a re 4. Several methods are available for handling risk. However, certain techniques are more appropriate than others in a given situation. a. (1) Should retention be used in those situations where both loss frequency and loss severity are high? Explain your answer. (2) Explain why loss control is a highly desirable method for handling risk. b. Explain why chance of loss and risk are not the same thing. 5. Sarah operates a pawn shop in a large city. Her shop is in a high-crime area, and the high cost of burglary insurance is threatening the existence of her business. A trade association points out that several methods other than insurance can be used to handle the burglary exposure. Identify and illustrate three different noninsurance methods that might be used to deal with this exposure.

REVIEW QUESTIONS
1. Explain briey the meaning of risk. 2. How does objective risk differ from subjective risk? 3. Dene chance of loss. 4. Distinguish between an objective probability and a subjective probability. 5. Dene peril, hazard, physical hazard, moral hazard, morale hazard, and legal hazard. 6. Explain the difference between pure and speculative risk and between fundamental and particular risk. 7. Identify the major types of pure risk that are associated with great nancial insecurity. 8. Why is pure risk harmful to society? 9. What is the difference between a direct loss and an indirect, or consequential, loss? 10. Describe briey the ve major methods of handling risk. Give an example of each method.

SELECTED REFERENCES APPLICATION QUESTIONS

1. Union Insurance received an application to provide property insurance on a frame dwelling located near an oil renery in an industrial section of the city. In considering this property for insurance, the property Bernstein, 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. 49.

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Case Application
Tyrone is a college senior who is majoring in journalism. He owns a high-mileage 1990 Ford that has a current market value of $1500. The current replacement value of his clothes, television set, stereo set, and other 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 in his rented apartment that has leaked water in the past. An avid runner, Tyrone runs ve miles daily in a nearby public park that has the reputation of being extremely dangerous because of drug dealers, numerous assaults and muggings, and drive-by shootings. Tyrones parents both work to help him pay his tuition. For each of the following risks or loss exposures, identify an appropriate risk management technique that could be used to deal with the exposure. Explain your answer. a. Physical damage to the 1990 Ford because of a collision with another motorist b. Liability lawsuit against Tyrone arising out of the negligent operation of his car c. Total loss of clothes, television, stereo, and personal property because of a grease re in the kitchen of his rented apartment d. Disappearance of one contact lens e. Waterbed leak that causes property damage to the apartment f. Physical assault on Tyrone by gang members who are dealing drugs in the park where he runs g. Loss of tuition from Tyrones father who is killed by a drunk driver in an auto accident

The 2001 Retirement Condence Survey, Summary of Findings. Washington: Employee Benet Research Institute, 2001. U.S. Census Bureau, Money Income in the United States, 2000, Current Population Reports, P60-213. Washington, DC: Government Printing Ofce, 2001. Wiening, Eric A. Foundations of Risk Management and Insurance. Malvern, PA: American Institute for CPCU, 2002, ch. 1.

2. This section is based on George E. Rejda, Social Insurance and Economic Security, 6th ed. Upper Saddle River, NJ: Prentice-Hall, 1999, pp. 49. 3. U.S. Census Bureau, Current Population Reports, P60-213, Money Income in the United States, 2000 (Washington, DC: Government Printing Ofce, 2001), table A. 4. Data based on the 1985 Commissioners Disability Table as cited in Edward E. Graves, ed., McGills Life Insurance, 3rd ed. (Bryn Mawr, PA: The American College, 2000), table 7.2, p. 168.

NOTES
1. Risk has also been dened as (1) variability in future outcomes, (2) chance of loss, (3) possibility of an adverse deviation from a desired outcome that is expected or hoped for, (4) variation in possible outcomes that exist in a given situation, and (5) possibility that a sentient entity can incur a loss.

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