Understanding the Concept of Risk in Insurance

Human beings are considered the most intelligent creatures on this earth. The thinking power available to human being is enormous and this has led human beings to define their style of living and distinguish between good and bad situations.

The criteria for deciding whether the situation is good or bad depend upon individual’s perception.

However, one thing is sure;

That human beings always prefer and strive for happy situations and wants to avoid the adverse ones. Actually, the zeal to be happy always has given birth to the jargon risk.

Risk is a concept which relates to human expectations. It denotes a potential negative impact to an asset or some characteristic of value that may arise from some present process or from some future event.

In everyday usage, “risk” is often used synonymously with “probability” of a loss or threat.

In professional risk assessments, risk combines the probability of an event occurring with the impact that event would be and with its different circumstances.

However,

Where assets are priced by markets, all probabilities and impacts are reflected in the market price, and risk therefore comes only from the variance of the outcomes.

According to the Dictionary;

  • ‘Risk refers to the probability that something unpleasant or dangerous might happen.’
  • ‘Risk is a condition in which there is a possibility of an adverse deviation from a desired outcome that is expected or hoped for’

For understanding the risk we should know these terms which are related with the concept of risk;

What is the Definition of Chance

This is a term which refers to the probable advantageous, desirable or profitable outcome of a fortuitous event.

For example, we usually say. Chance of passing an examination and not Chance of failing an examination.

What is the Definition of Risk

This is a term which refers to the probable disadvantageous, undesirable or unprofitable outcome of a fortuitous event, an event which is not desired, but nevertheless taking place.

For example,

We usually say risk of death and not risk of survival as death is something which is never desired.

What is the Definition of Probability

This is a term which refers to a neutral mathematical quantitative expression of an unforeseen or fortuitous event.

What is the Definition of Uncertainty

Uncertainty refers to a situation where the outcome is not certain or unknown. Uncertainty refers to a state of rind characterized by doubt, based on the lack of knowledge about what will or what will not happen in the future.

Very often the meaning of Risk and uncertainty gets mixed but there are fundamental differences between them;

RISK vs. UNCERTAINTY

  • Uncertainty is often confused with risk. Uncertainty refers to a situation where the outcome is not certain or unknown.

    Uncertainty refers to a state of rind characterized by doubt, based on the lack of knowledge about what will or what will not happen in the future.

  • Uncertainty can be perceived as opposite of certainty where you are assure of outcome or what will happen.

    Accordingly, some weight or probabilities can be assigned into risky situations but uncertainty, the psychological reaction 10 the absence of knowledge lacks this privilege.

  • Decision under uncertain situations is very difficult for the decision-maker. It all depends upon the skill, the judgment and of course luck.
  • Uncertainty being a perceptual phenomenon implies different degrees to different person.

    For example: Assume a situation where an individual has to appear for the first in the newly introduced insurance examination.

  • An individual student had undergone training in insurance.
  • An individual with training or experience in insurance A’s perception towards uncertainty (of performance in examination) is different from that of B. Nonetheless, in both situations, the outcomes that are the questions which will be asked in the examination are different.

These terminologies are referring to the result of an unforeseen or fortuitous event irrespective of whether it is advantageous or disadvantageous, desired or undesired, qualitative or quantitative.

The business of risk management necessarily deals with the Control and management of risk, i. e„ the effects of fortuitous events which are never expected or desired, but nevertheless taking place to our detriment.

One thing is clear that there is no single definition of risk. Economists, behavioral scientists, risk theorists, statisticians, and actuaries each have their own concept of risk.

However,

Risk traditionally has been defined in terms of uncertainty. Based on this concept, risk is denied here as uncertainty concerning the occurrence of a loss.

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. The risk of flunking a college course is present because uncertainty is present.

From more clear definition about risk the authors and experts looked at the risk objectively and subjectively.

OBJECTIVE RISK

Objective risk (also called degree of risk) is defined 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 specifically, 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, 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 the expected loss is 100.

Objective risk is now 100/1000 or 1 percent. Thus, as the square root of houses increased from 100 in the first example to 1000 in the second example (10 times), objective risk declined to one-tenth of its former level.

Objective risk can be statistically calculated by some measure of dispersion, such as the standard deviation or the coefficient of variation. Because objective risk can be measured, it is an extremely useful concept for an insurer or a corporate risk manner.

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.

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.

SUBJECTIVE RISK

Subjective risk is defined as uncertainty- based on a person’s 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 person’s 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 he 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 walks of lives, human beings are constantly running various types of risk every day, every moment.

The followings are just a few examples to emphasize how all types of human activities are getting threatened by the application or risks and undesired and unforeseen contingencies:

  • A man crossing the road is running the risk of being knocked down by a moving car.
  • A house owner is running the risk of loss or damage to his house or property therein by fire or burglary.
  • A businessman or an industrialist, or a shopkeeper is running the risk of similar types of various unforeseen contingencies.
  • A merchant is running the risk of various maritime perils.
  • An organization handling money matters is running the risk of possible defalcation by employees as well as loss by outside miscreants.
  • People are running the risk of incurring liabilities for their wrong deeds.
  • A dependent family is running the risk of financial insolvency arising out of premature death of the breadwinner.

Risk is therefore, incidental to life. Some people live dangerously others exercise extreme caution.

Nevertheless,

The happening of a fortuitous event or element cannot be avoided, although its effects may be either good or bad.

Some fortuitous events are of course advantageous, but some are not. The study of risk management primarily deals with these fortuitous events and their impacts.

In this study certain terminologies are required to be properly understood because of their differences with each other and at the same time because of their necessary application.