PBBF 303: FINANCIAL RISK MANAGEMENT AND INSURANCE LECTURE ONE FUNDAMENTALS AND TERMINOLOGY 1Lecturer: Diamond Addo

PBBF 303: FINANCIAL RISK MANAGEMENT AND INSURANCE

LECTURE ONE

FUNDAMENTALS AND TERMINOLOGY

1Lecturer: Diamond Addo

Different meaning of risk Definition of Perils, Hazard, Insurance The Cost of Risk Burden of risk on society Direct and indirect losses Basic categories of risk


The term risk has a variety of meanings in business and everyday life. At its most general level, risk is used to describe any situation where there is uncertainty about what outcomes will occur.

In probability and statistics, financial management, and investment management, risk is often used in a more specific sense to indicate possible variability in outcomes around some expected value.


In other situations, the term risk may refer to the expected losses associated with a situation. In insurance markets e.g. it is common to refer to high-risk policy holders. (meaning of risk in this context is that the expected value of losses to be paid by the insurer is high)

Risk is also defined as uncertainty concerning the occurrence of a loss. Some authors make a careful distinction between objective risk and subjective risk.


Also called degree of risk is defined as the relative variation of actual loss from expected loss.

E.g. A property insurer has 10,000 houses insured over a long period and, on average, 1% or 100 houses, burn each year.

In some years, as few as 90 houses may burn; in other years, as many as 110 houses may burn. Thus, there is a variation of 10 houses from expected number of 100, or variation of 10%.

This relative variation of actual loss from expected loss is known as objective risk.


Is defined as uncertainty based on a person’s mental condition or state of mind.

E.g. A driver who drinks heavily in a bar may foolishly attempt to drive home. The driver may be uncertain whether he will arrive home safely without being arrested by the police for drink driving. This mental uncertainty is called subjective risk.

In summary risk is sometimes used in a specific sense to describe variability around the expected value and other times to describe the expected losses.


Risk averse: The assumption that people find the possibility of suffering a large loss unpleasant, so they take minimum risk or avoid the risk.

Insurance is a financial arrangement that redistributes the costs of unexpected losses. Insurance involves the transfer of potential losses to an insurance pool. The pool combines all the potential losses and then transfers the cost of predicted losses back to those exposed.


Peril is defined as the cause of the loss. Examples are fire, heart attacks and criminal acts.

If your house burns because of fire, the peril or cause of loss is the fire.


A hazard is a condition that creates or increases the chance of loss. They are conditions that increase the frequency or the severity of losses.

There are four major types of hazards. Physical hazard Moral hazard Morale hazard Legal hazard


A physical hazard is a physical condition that increases the chances of loss.

E.g. of physical hazards include, defective wiring in a building that increases the chance of fire, a defective lock on a door that increases the chance of theft.


Moral hazard is dishonesty or character defect in an individual that increases the frequency or severity of loss.

E.g. include faking an accident to collect from an insurer, submitting a fraudulent claim, inflating the amount of a claim and intentionally burning unsold merchandise that is insured.

Moral hazard is present in all forms of insurance, and its difficult to control. Dishonest individuals often rationalize their actions on the grounds that the insurer has plenty of money.


Morale hazard is carelessness or indifference to a loss because of the existence of insurance.

Some insureds are careless or indifferent to a loss because they have insurance.

E.g. leaving car keys in an unlocked car, which increases the chance of theft; leaving a door unlocked that allows a burglar to enter. Careless acts like these increase the chance of loss.


Legal hazard refers to characteristics of the legal system or regulatory environment that increase the frequency or severity of losses.

E.g. large damage awards in liability lawsuit

The duration of settling court cases (in terms of defaulters owing a bank)


Greater risk usually implies greater cost. E.g. suppose two identical homes are in different but equally attractive locations. The structures have the same value (GHc100,000), and initially there is no risk damage to either houses.

Then Accra Meteorologist announce that there is going to be severe storms which will flood one house which is in the potential impact area within the next week. (one house now has greater risk than the other)

Assume the probability of ones house being flooded is 0.1 (10%)

and that the probability of the other house being flooded is zero (0%)


Assume the house would be completely destroyed if the storm is to come (all GHc100,000 would be lost). Then the expected property loss at one house is greater by an amount equal to 0.1 times GHc100,000 or GHc10,000.

If the owner were to sell the house immediately following the release of news about the storm, potential buyers would naturally pay less than GHc100,000 for the house. Rational people would pay at least GHc10,000 less, because that is the expected loss from the storm.

Thus, greater risk – in the sense of higher expected losses- is costly to the original homeowner. The value of the house would drop by at least the expected loss.


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PBBF 303: FINANCIAL RISK MANAGEMENT AND INSURANCE LECTURE ONE FUNDAMENTALS AND TERMINOLOGY 1Lecturer: Diamond Addo