DISCUSS THE COST AND BURDEN OF RISKS TO A SOCIETY

(30 marks)

MEANING OF RISK
Risk traditionally has been defined in terms of uncertainty. Based on this concept, risk is defined here as uncertainty
concerning the occurrence of a loss.
Although risk is defined as uncertainty, employees in the insurance industry often use the term risk to identify the
property or life being insured. When risk is defined as uncertainty, some authors make a careful distinction between
objective risk and subjective risk.
Objective risk: is defined as the relative variation of actual loss from expected loss. It declines as the number of
exposures increases. More specifically, objective risk varies inversely with the square root of the number of cases
under observation. 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 the number of
exposure units increases, the more closely the actual loss experience will approach the expected loss experience.
Subjective risk is defined as uncertainty based on a person’s mental condition or state of mind. 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. High subjective risk often results in conservative and prudent
behavior, while low subjective risk may result in less conservative behavior.

Risk can be classified into several distinct categories. The two major categories are as follows
 Pure and speculative risks
 Fundamental and particular risks
Pure risk is defined 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)
Speculative risk is defined as a situation in which either profit 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
A particular risk is a risk that affects only individuals and not the entire community
TYPES OF PURE RISK
The major types of pure risk that can create great financial insecurity include personal risks, property risks, and
liability risks and the depletion of financial assets. There are four major personal risks:
Personal Risks
 Risk of premature death: is defined as the death of a household head with unfulfilled financial 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 insufficient amount of replacement income from other sources or
have insufficient financial assets to replace the lost income, they may be financially insecure. Premature
death can cause financial problems only if the deceased has dependents to support or dies with unsatisfied
financial obligations. Thus, the death of a child age seven is not “premature” in the economic sense.
 Risk of Insufficient Income during Retirement: The major risk associated with old age is insufficient income
during retirement. Unless they have sufficient financial 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 financial
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. Most workers are not saving
enough for a comfortable retirement
 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. Unless these persons have adequate health insurance, private
savings and financial assets, or other sources of income to meet these expenditures, they will be financially
insecure. The loss of earned income is another major cause of financial 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 benefits may be lost or reduced, savings are often depleted, and someone must take care of the
disabled person. Most workers seldom think about the financial consequences of long-term disability.
 Risk of unemployment: risk of unemployment is another major threat to financial 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. Unemployment
can cause financial insecurity in at least three ways. First, workers lose their earned income and employee
benefits. Unless there is adequate replacement income or past savings on which to draw, the unemployed
worker will be financially insecure. Second, because of economic conditions, the worker may be able to
work only part-time. The reduced income may be insufficient in terms of the worker’s needs. Finally, if the
duration of unemployment is extended over a long period, past savings and unemployment benefits may be
exhausted.

Property Risks
The risk of having property damaged or lost from numerous causes. Real estate and personal property can be
damaged or destroyed because of fire, lightning, tornadoes, windstorms, and numerous other causes. There are two
major types of loss associated with the destruction or theft of property;
 Direct loss is defined as a financial loss that results from the physical damage, destruction, or theft of the
property.
 Indirect loss is a financial 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 profits for several
months while the restaurant is being rebuilt. The loss of profits would be a consequential loss.

Liability Risks
Liability risks are 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 .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. Second, a lien can be placed on
your income and financial assets to satisfy a legal judgment
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.

BURDEN OF RISK ON SOCIETY

The presence of risk results in certain undesirable social and economic effects. Risk entails three major burdens 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 Fund

It is prudent to set aside funds for an emergency .However, in the absence of insurance, individuals and business
firms would have to increase the size of their emergency fund to pay for unexpected losses. 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.
Loss of Certain Goods and Services
Another burden of risk is that society is deprived of certain goods and services. Because of the risk of a liability
lawsuit, many corporations have discontinued manufacturing certain products. Other firms 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 final burden of risk is that worry and fear are present. Numerous examples can illustrate the mental unrest and fear
caused by risk for example Some passengers in a commercial jet may become extremely nervous and fearful if the
jet encounters severe turbulence during the flight.

METHODS OF HANDLING RISK

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 five major methods of handling risk
 Avoidance
 Loss control
 Retention
 Non-insurance 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. Not all risks should be avoided, however. For example, you can avoid the risk of
death or disability in a plane crash by refusing to fly. But is this choice practical or desirable?
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: it aims at reducing the probability of loss so that the frequency of losses is reduced. Also
important for business firms. The goal of loss prevention is to prevent the loss from occurring
 Loss reduction: 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.
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. 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 worker’s family loses its share of the worker’s earnings and may experience considerable grief and financial
insecurity. And the worker may personally experience great pain and suffering before dying. In short, these social
costs can be reduced through an effective loss control program.
Retention
Retention is a third method of handling risk. An individual or a business firm 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. is used for two major reasons it can save money. Insurance may not be 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 financially. However, the adverse financial consequences of total and permanent disability generally
are more severe than the financial 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.
Risk retention is an important technique for handling risk, especially in a modern corporate risk management
program.
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.
Non-insurance 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:
 Transfer of risk by contracts: Unwanted risks can be transferred by contracts .The risk of a price increase in
construction costs can be transferred to the builder by having a fixed price in the contract
 Hedging price risks: Hedging price risks is another example of risk transfer. Hedging is a technique for
transferring the risk of unfavorable price fluctuations to a speculator by purchasing and selling futures
contracts on an organized exchange. 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 profit 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: is another example of risk transfer. If a firm is a sole proprietorship, the
owner’s personal assets can be attached by creditors for satisfaction of debts. If a firm incorporates,
personal assets cannot be attached by creditors for payment of the firm’s debts. In essence, by
incorporation, the liability of the stockholders is limited, and the risk of the firm having insufficient assets
to pay business debts is shifted to the creditors.
REFERENCES
1. This section is based on George E. Rejda, Social Insurance and
Economic Security, 6th ed. Upper Saddle River, NJ: Prentice Hall,
1999,
2. Rejda, George E. “Causes of Economic Insecurity.” In Social
Insurance and Economic Security, 6th ed. Upper Saddle River, NJ:
Prentice-Hall, 1999,
3. Wiening, Eric A. Foundations of Risk Management and Insurance.
Malvern, PA: American Institute for CPCU,2002, ch. 1.