Chapter 2 Managing Risk

What is Risk? Risk exists whenever there is an uncertainly about an outcome If you knew for certain you would become a millionaire by purchasing the stock of a particular company, there would be no risk involved since you would know in advance what was to occur. Same would occur if you knew you would never be in an car accident. You would likely not purchase insurance since the uncertainty would be removed from the situation. Of course, none of us can perfectly predict the future, so we must take steps to reduce risk in our lives.

Managing Risk In order to suffer a loss, three things are essential: An item can suffer a loss (such as a building, personal wealth, or a person’s health) A cause of the loss (fire, a lawsuit, or a disease) Financial impact of the loss (decline in the building’s value, cost of hiring attorneys, or medical expenses

Risk and Loss Three possible outcomes: Gain Loss Neutral Whenever you are faced with a risk, there are three possible things that can happen. First, the outcome can be positive. When you risk your money buying a lottery ticket you could win (gain). Second, the outcome could be negative and produce a loss. When you face the risks associated with driving a car, you could have an accident. The accident is a loss, because you have to pay to have your car repaired or be responsible for the damage you cause to someone else’s car. Third, the outcome could be neutral – neither positive or negative. There’s no loss, but there’s no gain either.

Pure Risk vs. Speculative Risk Pure Risk – when there are only two possible outcomes to risk, loss or no loss Speculative Risk – when there is a third possible outcome, gain. Insurance is designated to treat pure risk exposures. The purpose of insurance is to protect against loss. If no loss occurs or there is potential for gain, insurance usually cannot be purchased.

Identifying Loss Exposures Property Loss Exposures – Real property (houses, buildings, etc. and anything that is attached to the property, like a carport, built-in pool, etc.) Personal Property – Automobile, clothing, furniture, appliances, televisions, etc. Whenever someone faces the possibility of loss, they are said to be exposed to loss. In other words, while we don’t know for sure that a loss will take place, it is a possibility.

Identifying Loss Exposures Liability Loss Exposures examples Hitting another persons car with your car A fire in your home causing damage to a neighbors home

Property Loss vs. Liability Loss The main difference between liability and property loss exposures, is that the amount of a potential loss to property can rather easily be estimated prior to the loss, the amount of a claim for liability is not determined until after something has happened.

Identifying Loss Exposures Human Loss Exposures – loss of income/earnings because of: Ill health Disability Death One of the most significant forms of loss is losing health and being unable to earn income. One of the biggest assets any person has is their potential earning capacity. If that potential is interrupted by ill healthy, disability or death, there is a significant loss not only to that person, but to others who are dependent upon them. In addition to lost income, serious illness can also result in large medical bills for treatment.

Causes of Loss Just having an item of property that is exposed to loss does not mean you will actually suffer a loss. There must also be a cause of the loss, or peril: Natural Human Economic You might notice that fire appears on both the natural causes and human causes list. That’s because some fires, such as wildfires, can be caused by lightning strikes in dry, forested areas during warm summer months – cause of nature. Other fires are caused by humans, either through carelessness or intention to cause damage, such as when someone burns down a building in an attempt to hide some other crime. The list of perils is nearly endless and is being expanded constantly as the world changes.

Activity! What are some natural causes of loss caused by nature? What are some human causes of loss caused by people? What are some economic causes of loss caused by changes in the economy? Natural: Wind, rain, earthquake, flood, fire, lightning, drought, erosion Human: Theft, vandalism, negligence, fraud, murder, discrimination, fire, malpractice Economic: Inflation, depreciation, recession, obsolescence, stock market declines, technological changes, currency fluctuations, changes in tastes and preferences.

Cost of Loss In addition to the direct loss, there also may be other costs that are not as obvious, like costs to stay at a hotel while your house is repaired. Indirect Loss Cost Hotel Stay $550 Meals out for the family (cannot cook at home) $906 Starbucks (no coffee maker) $57 Extra mileage/gas to drop kids at school (not on bus route) $67 Laundry mat $23 Total $1,603 If a family were to stay in a hotel for five days while their house is repaired after a fire, these are just some examples of indirect loss costs the family would incur.

How Can you Manage Risk? Avoidance –eliminate the loss exposure or never acquire it in the first place Loss Control – reduce the number of losses or the cost of losses that occur (ie. burglar alarms, seat belts, airbags) Transfer to Others – someone else's responsibility via a contract or agreement (ie. rental car contract) Retention – paying some or all of the losses that occur out of your own personal income. (ie paying for a crack in your windshield rather than claiming it on insurance) Insurance- transfer of loss to an insurance company This slide has animations.

Questions?