Assignment On

Principles of Insurance

Different types of Risk, Peril and Hazard

Risk = the possibility of something unexpected happening

People seek security. A sense of security may be the next basic goal after food, clothing, and shelter. An individual with economic security is fairly certain that he can satisfy his needs (food, shelter, medical care, and so on) in the present and in the future. Economic risk (which we will refer to simply as risk) is the possibility of losing economic security. Most economic risk derives from variation from the expected outcome. One measure of risk, used in this study note, is the standard deviation of the possible outcomes. As an example, consider the cost of a car accident for two different cars, a Porsche and a Toyota. In the event of an accident the expected value of repairs for both cars is 2500. However, the standard deviation for the Porsche is 1000 and the standard deviation for the Toyota is 400. If the cost of repairs is normally distributed, then the probability that the repairs will cost more than 3000 is 31% for the Porsche but only 11% for the Toyota. Modern society provides many examples of risk. A homeowner faces a large potential for Variation associated with the possibility of economic loss caused by a house fire. A driver faces a potential economic loss if his car is damaged. A larger possible economic risk exists with respect to potential damages a driver might have to pay if he injures a third party in a car accident for which he is responsible. Historically, economic risk was managed through informal agreements within a defined Community. If someones barn burned down and a herd of milking cows was destroyed, the community would pitch in to rebuild the barn and to provide the farmer with enough cows to replenish the milking stock. This cooperative (pooling) concept became formalized in the insurance industry. Under a formal insurance arrangement, each insurance policy purchaser (policyholder) still implicitly pools his risk with all other policyholders. However, it is no longer necessary for any individual policyholder to know or have any direct connection with any other policyholder. -1-

Types of Risk
Unfortunately, the concept of risk is not a simple concept in finance. There are many different types of risk identified and some types are relatively more or relatively less important in different situations and applications. In some theoretical models of economic or financial processes, for example, some types of risks or even all risk may be entirely eliminated. For the practitioner operating in the real world, however, risk can never be entirely eliminated. It is ever-present and must be identified and dealt with. In the study of finance, there are a number of different types of risk the been identified. It is important to remember, however, that all types of risks exhibit the same positive risk-return relationship. Some of the most important types of risk are defined below. Default Risk The uncertainty associated with the payment of financial obligations when they come due. Put simply, the risk of non-payment. Interest Rate Risk The uncertainty associated with the effects of changes in market interest rates. There are two types of interest rate risk identified; price risk and reinvestment rate risk. The price risk is sometimes referred to as maturity risk since the greater the maturity of an investment, the greater the change in price for a given change in interest rates. Both types of interest rate risks are important in banking and are addressed extensively in Bank Management classes. Price Risk The uncertainty associated with potential changes in the price of an asset caused by changes in interest rate levels and rates of return in the economy. This risk occurs because changes in interest rates affect changes in discount rates which, in turn, affect the present value of future cash flows. The relationship is an inverse relationship. If interest rates (and discount rates) rise, prices fall. The reverse is also true.

Since interest rates directly affect discount rates and present values of future cash flows represent underlying economic value, we have the following relationships.

Reinvestment Rate Risk The uncertainty associated with the impact that changing interest rates have on available rates of return when reinvesting cash flows received from an earlier investment. It is a direct or positive relationship. This type of interest rate risk is also covered extensively in the Bank Management courses.

Liquidity risk

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The uncertainty associated with the ability to sell an asset on short notice without loss of value. A highly liquid asset can be sold for fair value on short notice. This is because there are many interested buyers and sellers in the market. An illiquid asset is hard to sell because there there few interested buyers. This type of risk is important in some project investment decisions but is discussed extensively in Investment courses. Inflation Risk (Purchasing Power Risk) The loss of purchasing power due to the effects of inflation. When inflation is present, the currency loses it's value due to the rising price level in the economy. The higher the inflation rate, the faster the money loses its value. Market risk Within the context of the Capital Asset Pricing Model (CAPM), the economy wide uncertainty that all assets are exposed to and cannot be diversified away. Often referred to as systematic risk, beta risk, non-diversifiable risk, or the risk of the market portfolio. This type of risk is discussed extensively in Investment courses. Firm specific risk The uncertainty associated with the returns generated from investing in an individual firms common stock. Within the context of the Capital Asset Pricing Model (CAPM), this is the investment risk that is eliminated through the holding of a well diversified portfolio. Often referred to as un-systematic risk or diversifiable risk. This type of risk is discussed extensively in Investment courses. Project risk In the advanced capital budgeting topics, the total risk associated with an investment project. Sometimes referred to as stand-alone project risk. In advanced capital budgeting, project risk is partitioned into systematic and unsystematic project risk. Financial risk The uncertainty brought about by the choice of a firms financing methods and reflected in the variability of earnings before taxes (EBT), a measure of earnings that has been adjusted for and is influenced by the cost of debt financing. This risk is often discussed within the context of the Capital Structure topics. Business risk The uncertainty associated with a business firm's operating environment and reflected in the variability of earnings before interest and taxes (EBIT). Since this earnings measure has not had financing expenses removed, it reflect the risk associated with business operations rather than methods of debt financing. This risk is often discussed in General Business Management courses. Foreign Exchange Risks Uncertainty that is associated with potential changes in the foreign exchange value of a currency. There are two major types: translation risk and transaction risks. Translation Risks Uncertainty associated with the translation of foreign currency denominated accounting statements into the home currency. This risk is extensively discussed in Multinational Financial Management courses. Transactions Risks Uncertainty associated with the home currency values of transactions that may be affected by changes in foreign currency values. This risk is extensively discussed in the Multinational Financial Management courses. Total Risk While there are many different types of specific risk, we said earlier that in the most general sense, risk is the possibility of experiencing an outcome that is different from what is expected. If we focus on this definition of risk, we can define what is referred to as total risk. In financial terms, this total risk reflects the variability of returns from some type of financial investment. Measures of Total Risk The standard deviation is often referred to as a "measure of total risk" because it captures the variation of possible outcomes about the expected value (or mean). In financial asset pricing theory there is a pricing model (Capital Asset Pricing Model or CAPM) that separates this "total risk" into two different types of risk (systematic risk and unsystematic risk). Another related measure of total risk is the "coefficient of variation" which is calculated as the standard deviation divided by the expected value. The following notes will discuss these concepts in more detail.

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Severity of losses. Risk professionals refer to hazards as conditions that increase the cause of losses. Hazards may increase the probability of losses, their frequency, their severity, or both. That is, frequency refers to the number of losses during a specified period. Severity refers to the average dollar value of a loss per occurrence, respectively. Professionals refer to certain conditions as being hazardous. For example, when summer humidity declines and temperature and wind velocity rise in heavily forested areas, the likelihood of fire increases. Conditions are such that a forest fire could start very easily and be difficult to contain. In this example, low humidity increases both loss probability and loss severity. The more hazardous the conditions, the greater the probability and/or severity of loss.

Physical hazards are the most common and will be present in most workplaces at one time or another. They include unsafe conditions that can cause injury, illness and death. They are typically easiest to spot but, sadly, too often overlooked because of familiarity (there are always cords running across the aisles), lack of knowledge (they aren't seen as hazards), resistance to spending time or money to make necessary improvements or simply delays in making changes to remove the hazards (waiting until tomorrow or a time when "we're not so busy"). None of these are acceptable reasons for workers to be exposed to physical hazards. Examples of physical hazards include:

electrical hazards: frayed cords, missing ground pins, improper wiring unguarded machinery and moving machinery parts: guards removed or moving parts that a worker can accidentally touch constant loud noise high exposure to sunlight/ultraviolet rays, heat or cold working from heights, including ladders, scaffolds, roofs, or any raised work area working with mobile equipment such as fork lifts (operation of fork lifts and similar mobile equipment in the workplace requires significant additional training and experience) spills on floors or tripping hazards, such as blocked aisle or cords running across the floor.

Biological hazards come from working with animals, people or infectious plant materials. Work in day care, hospitals, hotel laundry and room cleaning, laboratories, veterinary offices and nursing homes may expose you to biological hazards. The types of things you may be exposed to include:

blood or other body fluids fungi bacteria and viruses plants insect bites animal and bird droppings.

Ergonomic hazards occur when the type of work, body position and working conditions put strain on your body. They are the hardest to spot since you don't always immediately notice the strain on your body or the harm these

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hazards pose. Short-term exposure may result in "sore muscles" the next day or in the days following exposure, but long term exposure can result in serious long-term injuries. Ergonomic hazards include:

poor lighting improperly adjusted workstations and chairs frequent lifting poor posture awkward movements, especially if they are repetitive repeating the same movements over and over having to use too much force, especially if you have to do it frequently.

Chemical hazards are present when a worker is exposed to any chemical preparation in the workplace in any form (solid, liquid or gas). Some are safer than others, but to some workers who are more sensitive to chemicals, even common solutions can cause illness, skin irritation or breathing problems. Beware of:

liquids like cleaning products, paints, acids, solvents especially chemicals in an unlabelled container (warning sign!) vapours and fumes, for instance those that come from welding or exposure to solvents gases like acetylene, propane, carbon monoxide and helium flammable materials like gasoline, solvents and explosive chemicals.

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Types of Perils
Risk is the chance of loss, and peril is the direct cause of the loss. A peril is an immediate, specific event, causing a loss and giving rise to risk. If a house burns down, then fire is the peril. If we wish to understand risk, we must first understand the terms loss and perils. We will use both terms throughout this text. Both terms represent immediate causes of loss. The environment is filled with perils such as floods, theft, death, sickness, accidents, fires, tornadoes, and lightningor even contaminated milk served to Chinese babies. A peril refers to the actual source (or cause) of a loss. Examples of perils that could be involved in car insurance are: fire, explosion, storm, hail, collision, theft.

Perils must be insurable and in a car insurance policy it will clearly state which perils you are insured against. Insurable perils will always be fortuitous and not planned. For example a fire can be started by lightning but arson is a deliberate act and therefore not insurable. Insurance policies will also state the perils that are not covered by the policy these are called excepted perils. Natural perils One of the three categories of perils commonly considered by insurance, the other two being human perils and economic perils. This category includes such perils as injury and damage caused by natural elements such as rain, ice, snow, typhoon, hurricane, volcano, wave action, wind, earthquake, or flood. Human perils one of three broad categories of perils commonly referred to in the insurance industry which includes not only human perils, but also natural perils and economic perils. Human perils are those caused directly by people and include crime, liability, fidelity, and some types of property damage such as vehicle damage or arson. Contrast those with natural perils which include wind, flood, or earthquake, or economic perils such as inflation or obsolescence.

Economic perils One of the three common categories of perils used in the insurance industry to classify causes of loss. Economic perils are those caused by loss of market, loss of income, local, national, or worldwide economic conditions, inflation, or obsolescence of an industry. The other two common categories of perils are human perils and natural perils. We could talk about natural versus human perils. Natural perils are those over which people have little control, such as hurricanes, volcanoes, and lightning. Human perils, then, would include causes of loss that lie within individuals control, including suicide, terrorism, war, theft, defective products, environmental contamination, terrorism, destruction of complex infrastructure, and electronic security breaches.

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References:
1. M.N. MISHRA, Insurance Principal and practice, 10th edition, RAN NAGAR, NEW DELHI 2. Azizul Haq, Principles of Insurance.
3. www.google .com 4. http://www.wikipedia.org/

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