Some terminology (Chapter 1)

Risk The definition of risk varies between finance and insurance Finance: Risk = dispersion of returns (Standard deviation of returns) Insurance: Condition of possible adverse outcomes Adverse deviation from a desired or expected outcome

Degree of risk More risk and less risk Higher/lower probability of loss Higher/lower level of loss Frequency and severity Contrast with finance (Is near certain death high risk or low risk?)

Perils and Hazards A peril is a cause of loss Examples: Fire, collision Excluded perils, multiple perils Hazard: Condition that aggravates the chance of loss or its severity Example: Fog

Types of hazards Physical Moral Morale Legal

Moral and morale hazards There could be outright dishonesty in making claims (feigned back problems) Or it could be a case of change in attitude or behavior after the insurance is purchased (morale hazard) Legal: Liability laws could change adversely after the policy has been sold (asbestos, cigarettes)

Classifications of risk Fundamental and particular() Pure() and speculative Financial () and non-financial Static () and dynamic indicates the type risk suited for insurance contracts

Types of pure risks Personal (life and health) mortality, longevity, disability, sickness, unemployment Property (loss of property, loss of use) Liability Performance failure of others (debtors, contractors, employees

The burden of risk Need to have reserve funds Reduced incentive to engage in certain productive activities Reduced incentive for capital investment Difficulty in making long term plans

Dealing with risk Insurance is not the only way Contracts Loss reduction/prevention efforts Reserve funds