# Introduction to Risk and Insurance

Topics: Insurance, Risk, Moral hazard Pages: 42 (1963 words) Published: March 16, 2015
Chapter 1
Introduction to Risk and Insurance

Risk

Basic Categories of Risk

Uncertainty

Pure, Speculative, Fundamental, Particular Risk

Law of Large Number

Types of Pure Risk

Objective Risk

Personal, Property, Liability Risk

Subjective Risk

Burden of Risk in our Society

Chance of Loss

Insurance

Objective Probability

Pooling

Subjective Probability

Basic Characteristics of Insurance

Frequency vs. Severity

Requirements of an Insurable Risk

Henrich Triangle

Large Loss Principle

Domino Theory

Subsidization

Severity Reduction

Peril

Reinsurance

Hazard

Risk

Risk is defined as uncertainty concerning the occurrence of a loss. It is a persuasive condition of human existence.

Uncertainty
the outcome
outcome

Possibility
Possibility of
of that
that outcome
outcome being
being unfavorable
unfavorable

Uncertainty

Uncertainty is the state of mind which is characterized by doubt. It can also be defined as the psychological reaction which arise due to lack of knowledge about the future. In corporate finance risk is different from uncertainty. But elsewhere these two concepts are related.

Law of Large Number

The law of large number states that as the number of exposure units increases, the more closely the actual loss experience will approach the expected loss experience.

Chart Title

Expected Loss

4.5
4
3.5
3
2.5
2
1.5
1
0.5
0
100

200
Dwelling fire

300
Theft

Accident

400

Objective Risk

Objective risk is defined as the relative variation of actual loss from expected loss. It is also called “degree of risk”. Objective risk can be stated as numerical uncertainty. It follows the law of large numbers. As the number of exposure increases, an insurer can predict it’s future loss experience more accurately.

Actual Loss
Expected Loss

Subjective Risk

Subjective risk refers to the uncertainty based on a person’s mental condition or state of mind. It is the mental uncertainty based on difference in mental state.

Chance of Loss

Chance of loss is closely related to the concept of risk. It is defined as the probability that as event will occur. Like risk, probability has both subjective and objective aspects.

Objective
Objective Probability
Probability

Subjective
Subjective Probability
Probability

Objective Probability

Objective probability refers to the long-run relative frequency of an event based on the assumption of an infinite number of observation. And of no change in the underlying condition. It can be determined in two ways.

Deductive
Deductive Reasoning
Reasoning

Inductive
Inductive Reasoning
Reasoning

Subjective Probability

Subjective probability is the individual’s personal estimate of the chance of loss. It need not coincide with objective probability. A wide variety of factors can influence subjective probability. Such as,

Frequency VS Severity
High
Frequency
Low Severity

High
Low
Frequency
Frequency
High Severity Low Severity

Low
Frequency
High Severity

Uncertainty

low

removed

high

high

Risk

low

high

low

high

Decision of
Insurance
Company

Not the perfect Will not come
solution
forward

Offer insurance Insurance is
perfect
solution

Henrich Triangle

H.W. Henrich, an industrial engineer, did a survey on accident which is known as Henrich Triangle.

In clear call, there will be no significant loss and less flaws. In near miss, there will be minor loss like burning your hand. In minor injury, there will be recoverable injury like 2days leave due to an operation. In major injury, disability may occur such as loosing hand. In fatal stage, the...