Welcome to Principles of Risk Management and Insurance! As you start the course, you may want to

Principles of Risk Management and Insurance, 14e George Rejda, Michael McNamara

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Copyright © 2020 Pearson Education, Inc.Chapter 1 Risk and Its Treatment  Teaching Note Welcome to Principles of Risk Management and Insurance! As you start the course, you may want to emphasize to your students the practical nature of the material that will be covered. Individuals and families face real-world risks—premature death, poor health, property damage, liability claims, and other loss exposures.In presenting the material in this chapter, keep in mind that students must master a certain amount of new insurance terminology. Studying insurance is similar to becoming fluent in a foreign language. The student starts by building upon a basic vocabulary when learning a new language. The same is true for insurance.Insurance is a technical subject that requires a basic vocabulary.It is also worthwhile to point out that there is no single definition of risk. However, risk has been traditionally defined as uncertainty concerning the occurrence of a loss. Because the term “risk” is ambiguous, many risk managers use the term “loss exposure.” Take some time to discuss the major types of pure risks that can result in great financial insecurity. Pure risks can result in loss or no loss. Speculative risks may produce a loss or a gain. This chapter summarizes the important points concerning the different types of risk and methods of handling risk.In discussing the major methods of handling risk, several points should also be stressed. First, explain that these concepts are discussed in greater detail in Chapter 3. Second, stress the idea that insurance is only one of several methods for handling risk. Finally, explain that in many cases other methods for handling risk may be more effective and that several risk treatment measures may be used together. Outline

• Definitions of Risk
• Different definitions of risk; risk historically has been defined as uncertainty.
• Objective Risk
• Defined as the relative variation of actual loss from expected loss
• Declines as the number of exposure units increases
• Can be measured by using the standard deviation or coefficient of variation
• Subjective (Perceived) Risk
• Defined as uncertainty based on one’s mental condition or state of mind
• Difficult to measure

II. Chance of Loss 2 / 4

• Rejda/McNamara • Principles of Risk Management and Insurance, Fourteenth Edition

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• Objective Probability
• A priori—by logical deduction such as in games of chance
• Empirically—by induction, through analysis of data
• Subjective Probability—a personal estimate of the chance of loss. It need not coincide with

objective probability and is influenced by a variety of factors including age, sex, intelligence, education, and personality.

• Chance of Loss Versus Objective Risk—although chance of loss may be the same for two

groups, the relative variation of actual loss from expected loss may be quite different. The expected prices of two stocks might each be $60 one year from today, and the distribution of expected prices might symmetric, meaning a fifty percent chance the price will be greater than $60 and a fifty percent change the price will be less than $60.III. Peril and Hazard

• Peril—defined as the cause of loss
• Hazard
• Physical hazard—physical condition that increases the chance of loss. Examples are icy

streets, poorly designed intersections, and dimly lit stairways.

• Moral hazard—dishonesty or characteristics of an individual that increase the chance of loss
• Attitudinal (Morale) hazard—carelessness or indifference to a loss, which increases the

frequency or severity of loss

• Legal hazard—characteristics of the legal system or regulatory environment that increase the

frequency or severity of losses IV. Classifications of Risk

• Pure and Speculative Risk
• Pure risk—a situation where there are only the possibilities of loss or no loss
• Speculative risk—a situation where either profit or loss is possible
• Diversifiable Risk and Nondiversifiable Risk. Diversifiable risk affects only individuals or small

groups and not the entire economy; it can be reduced or eliminated by diversification.Nondiversifiable risk affects large numbers of persons or groups in the economy and cannot be eliminated or reduced by diversification.

• Enterprise Risk. This is a term that encompasses all major risks faced by a business firm,

including pure risk, speculative risk, strategic risk, operational risk, and financial risk.

• Systemic Risk. This is the risk of collapse of an entire system or entire market due to the failure

of a single entity or group of entities that can result in the breakdown of the entire financial system.

• Major Personal Risks and Commercial Risks
• Personal Risks
• Risk of premature death
• Risk of insufficient income during retirement
• Risk of poor health
• Risk of unemployment
• Alcohol and drug addiction
• Property Risks 3 / 4

Chapter 1 Risk and Its Treatment 3 Copyright © 2020 Pearson Education, Inc.

• Direct loss
• Indirect or consequential loss
• Liability Risks
• Commercial Risks
• Property risks
• Liability risks
• Loss of business income
• Cybersecurity and identity theft
• Other risks—crime exposures, human resources exposures, foreign loss exposures, intangible

property exposures, government exposures VI. Burden of Risk on Society

• Need for a Larger Emergency Fund
• Loss of Needed Goods and Services
• Worry and Fear

VII. Techniques for Managing Risk

• Risk Control
• Avoidance
• Loss prevention
• Loss reduction
• Duplication
• Separation
• Diversification
• Risk Financing
• Retention
• Noninsurance transfers
• Insurance

 Answers to Case Application

• Retention. Because the car is old and has a limited market value, collision insurance should not be

purchased. Retention can be used to deal with the exposure.

• Liability insurance. Because the exposure has the potential for causing a catastrophic loss, auto

liability insurance should be purchased.

• Insurance. Property insurance could be purchased to deal with the property exposure of $10,000. The

policy should contain a deductible.

• Retention. The dollar value of the loss of a disposable contact lens is small.
• Loss control. The waterbed should be carefully checked for possible leaks to reduce the possibility of

damage to the apartment. As an alternative, an endorsement can be added to a homeowners policy to cover the liability exposure.

• Avoidance. Michael should pick a new running route.
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