ELEVENTH EDITION - ELEVENTH EDITION Fundamentals of Risk and Insur...

Instructor’s Resource Guide to Accompany

ELEVENTH EDITION

Fundamentals of Risk and Insurance

Emmett J. Vaughan

Therese M. Vaughan 1 / 4

CHAPTER 1

THE PROBLEM OF RISK

General Comments on the Chapter A discussion of risk—the basic problem with which insurance deals—logically precedes the discussion of insurance itself. This chapter introduces the concept of risk, defines it, and discusses the distinctions that can be drawn among the different classifications of risk.The definition of risk used in the text evolved over a period of many years, and grew out of a personal dissatisfaction with the definitions used in other books. It has always seemed to us that the definition of risk in an insurance course should immediately suggest to the reader the basic problem insurance is designed to solve, and that risk should not be a concept treated in the first chapter and then forgotten for the remainder of the book.Most people immediately recognize a situation in which a loss may occur as the basic reason for buying insurance. In simplest terms, risk is defined as a condition in which a possibility of loss exists. More specifically, risk is "...a condition in which there is a possibility of an adverse deviation from a desired outcome that is expected or hoped for." Defining risk as "a condition" seems to us to be both semantically and intuitively appropriate. It delineates the essence of the thing being defined and helps to emphasize the notion that risk is a state of the world created by a combination of circumstances. In addition, it more or less coincides with the intuitive notion of risk. Risk can exist (as a condition of the real world) even when the danger is not perceived and when there is no uncertainty. Uncertainty can exist in situations where there is no risk (that is, where the possibility of loss does not exist).In addition to establishing a formal definition of risk, the chapter stresses the distinctions among the various subclassifications into which risk may be divided. We believe that the most important of these are the "fundamental-particular" and the "pure-speculative" distinctions. The discussion of fundamental and particular risk is a convenient time to consider terrorism risk and the merits of the federal terrorism reinsurance program that was created following the terrorist attack on the World Trade Center. Some time should also be spent in distinguishing among the terms "risk," "peril," and "hazard," and in differentiating among the classes of hazard.This edition includes a discussion of “systemic risk,” reflecting the increased attention given to the concept in the aftermath of the recent financial crisis. The focus of this course is not on systemic risk, its cause, and the regulatory response, but it seems reasonable for students to have some exposure to the concept. In our experience, students are interested in learning about the financial crisis and its onset. Thus, the instructor may choose to take a brief detour to discuss AIG and its role in the crisis. A simple explanation in video form is provided at http://www.youtube.com/watch?v=DdEI6PkGZK8. Alternatively, the instructor may prefer to defer the discussion to chapter 6, when the regulatory response is also presented. Because the video refers to credit default swaps as insurance, this is also an opportunity to discuss the the differences between insurance and credit default swaps, and the fact that AIG’s difficulty was not its traditional insurance business. This discussion is likely to be more clear to students after they have completed chapter 3, The Insurance Device.

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The evolving nature of risk can often be illustrated with current events. Cyber risk is one area that is often in the news (As this is being written, Target is in the news for a cyber security loss, in which the credit and debit card information of up to 40 million customers was stolen in late November and early December 2013. The case is an excellent example of both cyber risk and reputational risk.)

The section entitled The Burden of Risk explains why risk is a problem and briefly notes some of the detrimental aspects of risk. In discussing the burden or risk, we stress the dual-faceted nature of the burden; first, the costs associated with the losses that will actually occur, and second, the costs associated with the uncertainty regarding who and what will suffer loss. The uncertainty associated with risk creates the need to accumulate a reserve for contingencies (which involves an opportunity cost), deters capital accumulation, increases the cost of capital, and results in anxiety and worry.Important Concepts to be Stressed The most important concepts in the chapter, and the principles that we believe should be

stressed in the lecture are:

• The definition of risk as a state of the real world • The degree of risk • Risk distinguished from peril and hazard • Classification of hazards as physical, moral, and morale • The distinction between static and dynamic risks • The distinction between fundamental and particular risk • The distinction between pure and speculative risk • The concept of systemic risk • Classifications of pure risk • The burden of risk • The increasing frequency and severity of losses Answers to Questions for Review

• Risk is defined as a condition in which there is the possibility of an adverse deviation from a

desired outcome that is expected or hoped for. In simpler terms, it is the possibility of loss. Risk is a state of the real world in which a possibility of loss exists, while uncertainty is a state of mind characterized by doubt or a lack of knowledge about the outcome of an event. Risk can exist (as a state of the real world) even when the danger is not perceived and where there is therefore no uncertainty. Uncertainty can exist where there is no risk. See pages 2-3.

• Risk may be subclassified as dynamic or static, fundamental or particular, pure or

speculative, and systemic or nonsystemic. The distinguishing characteristics of each class are discussed in pages 6 and 7 of the text. Dynamic risks are those that arise from changes in the economy; static risks would exist even in the absence of economic change. Fundamental risks are those that are impersonal in origin and consequences—they are generally beyond the control of the individual. Particular risks are personal in origin and consequence, and are generally considered to be the individual's own responsibility. Pure risks are those in which there is a chance of loss or no loss only. Speculative risks involve the chance of loss or gain. Systemic risks affect an entire system and could cause cascading effects that disrupt other institutions.

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• The distinction between fundamental and particular risk is important because whether a risk

is fundamental or particular may determine how society will choose to deal with it. Fundamental risks cannot usually be prevented, especially by the individual, and to the extent that they are beyond the control of the individual and affect large segments of the population, there may be a feeling that such risks are appropriate to the realm of social insurance or some other government program. However, it is also true that some fundamental risks may be dealt with through private insurance. Particular risks are usually more suited to treatment through private insurance, and are generally thought to be the individual's own responsibility.

• The existence of risk may be a deterrent to economic activity and capital accumulation.

Investors will undertake new risks only if the return on the investment is sufficiently high to compensate for both the dynamic and static risks. The cost of capital is higher in situations in which the risk is greater, and the consumer must pay the higher cost of the goods and services or they will not be forthcoming. See page 8 of the text.

• The four types of risks facing the individual or organization and an example of each include

Personal risks (death, sickness, or disability); Property risks (damage to or destruction of property and the loss of use of property that has been damaged); Liability risks (liability suits arising out of the use of automobiles or otherwise); Risks resulting from human failure (default of a debtor or failure of a contractor to complete a project contracted for). See pages 7-8 of the text.

• As the text points out on page 8, whether we define risk as the possibility of loss,

uncertainty, or the probability that results will differ from what is expected, the greatest burden in connection with risk is that some losses will actually occur. Losses constitute a detrimental aspect of risk from the perspective of both the individual and society, since we lose want-satisfying goods. In addition, for the individual, there is the cost of preparing for the possible losses and the worry that generally accompanies risk. For society, risk may have a deterrent effect on economic growth by retarding capital accumulation. Risk increases the cost of capital, and the consumer must pay the higher cost of the goods and services or they will not be forthcoming.

• Perils are causes of loss, and examples would include fire, wind, earthquake, flood, sickness,

and death. A hazard is a condition that increases the probability of loss from a peril. Examples would include faulty wiring, careless driving, sickness, improper storage of flammables, and so on.

• Hazards have traditionally been classified as physical, moral, and morale. Physical hazards

include conditions such as faulty housekeeping, defective wiring, storage of flammables, obesity, and road conditions. Moral hazard is a dishonest tendency, and examples of moral hazard include businesses that are losing money, obsolete inventory that is overinsured, and similar temptations to defraud an insurer. Morale hazard is reflected in a careless attitude that may accompany the existence of insurance, or the inflated losses that occur simply because the loss is insured. For example, the tendency on the part of those with health insurance to spend more time in the hospital per illness than those without health insurance.The classification of hazards "is "physical, moral, and morale," is not exhaustive. For example, it has been suggested that we should add a fourth type of hazard, the "legal hazard." Clearly, statutes, court decisions, and the legal environment are additional factors that can influence the probability of loss.

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