THE CONCEPT OF RISK

THE CONCEPT OF RISK

It would seem that the term risk is a simple enough

notion. When someone states that there is risk in a

particular situation, the listener understands what is

meant: that in the given situation there is uncertainty

about the outcome, and the possibility exists that

the outcome will be unfavorable. This loose, intui-

tive notion of risk, which implies a lack of knowl-

edge about the future and the possibility of some

adverse consequence, is satisfactory for conversa-

tional usage, but for our purpose a somewhat more

rigid definition is desirable.

Economists, statisticians, decision theorists, and

insurance theorists have long discussed the con-

cepts of risk and uncertainty in an attempt to con-

struct a definition of risk that is useful for analy-

sis in each field of investigation. So far, they have

not been able to agree on a single definition that

can be used in each field. A definition of risk that

is suitable for the economist or statistician may be

worthless as an analytic tool for the insurance the-

orist. Because each group treats a different body

of subject matter, each requires a different con-

cept of risk. Although the statistician, the deci-

sion theorist, and the insurance theorist all use the

term risk, each may mean something entirely dif-

ferent.

Insurance is still in its infancy as a body of

theory. As a result, we find contradictory defini-

tions of risk throughout the literature dealing with

this phenomenon from an insurance point of view.

One reason for these contradictions is that insur-

ance theorists have attempted to borrow the def-

initions of risk used in other fields. Surprising as

it may seem, insurance text writers have not been

able to agree on a definition of this basic con-

cept.

To compound the problem, the term risk is used

by people in the insurance business to mean either

a peril insured against (e.g., fire is a risk to which

most property is exposed) or a person or property

protected by insurance (e.g., many insurance com-

panies feel that young drivers are not good risks).

In this text, however, we will use the term in its gen-

eral meaning, to indicate a situation in which an

exposure to loss exists.

THE PROBLEM OF RISK

OBJECTIVES

When you have finished this chapter, you should be able to

• Define and explain the meaning of the term risk

• Distinguish among the terms risk, peril, and hazard

• Identify and explain the classes of hazards

• Differentiate between pure risk and speculative risk

• Differentiate between fundamental and particular risk

• Describe the categories into which pure risk may be subdivided

• Identify and explain the principal methods of handling risk

You can see the entangled metal of the two cars that crashed into the interstate freeway. The siren screams and the fire engine makes the street run. You can see the building in your neighborhood burns and an ambulance running in the hospital. Such tragic events evoke your interests and emotions. After the noise and excitement disappears you appreciate what loss did not happen to you and you may feel sorry for those who suffered loss. But I'm glad that it is not you. Such loss will happen to some people, but others live happily liberated from misfortune. The fact that these losses and similar events can happen to you, and the fact that you can not reliably tell if you really want to do is what we call risk. Risk is an extensive state of existence of human beings. Instinctive understanding of the concept of risk is well-defined, but when used in a particular field, terms with simple meanings in everyday use may include technical terms. In this chapter we will consider the concept of risk as a fundamental problem of insurance contracts. In addition, we will also consider some related concepts.

ACKNOWLEDGMENTS

Many people have provided support and encouragement as I have worked on this revision. First, of course, are the members of my family, including my husband, children, mother, and siblings. I am particularly grateful for their patience. Thanks also to Emily Rosenberger, who maintained our household, took messages, and handled administrative details while I was preoccupied.

As a book progresses through successive editions, the number of persons to whom an author is indebted increases geometrically, since the efforts of so many people become a part of the work. Over the years, my father recognized many people for their efforts, and I continue that appreciation. Our teachers, reviewers, and users have helped shape our thoughts and the book. Although much has changed over the years, colleagues and students who provided comments on earlier editions continue to influence it. As a result, there are many to whom special thanks are due. They include our former colleague and my teacher, Professor Michael Murray, who shared his insights with us over the years and whose influence has been significant. They also include my colleague, Professor Robert Cooper, who has generously provided his support and guidance over the years. The reviewers of the first nine editions, whose contributions to those editions helped to shape this one as well, were Tom Auippa, Richard C. Allgood, Garth H. Allen, Albert L. Auxier, W. Oscar Cooper, Robert W. Cooper, Richard Corbett, Darlene Dicco, Bill Feldhaus, Roger A. Formisano, John W. Hanye, Kenneth J. Krepas, E. J. Leverett, Aaron Lieberman, Jim Milanese, Joseph R. Morrin, Robert J. Myers, John J. O’Connell, Mike Thorne, S. Travis Pritchett, Dede Paul, Gary K. Stone, and Robert Witt.

As in previous editions, I want to give special thanks to Mandell S. Winter, Jr. and to Michael Snowdon of the College for Financial Planning, for their assistance in reviewing several editions. Their suggestions and insights helped to clarify many concepts and to avoid errors that would otherwise have marred the book. Mr. Winter’s contributions to the seventh and eighth editions and Mr. Snowden’s assistance in the ninth editions went far beyond those of a reviewer.

I also offer special thanks to a number of my father’s former graduate teachings assistants, who taught the basic insurance course at the University of Iowa and offered many suggestions over the years. They are Lois Anderson, Phillip Brooks, Robb Fick, Tim Hamann, Terry Leap, Lacy McNeill, Joseph Panici, Mark Power, Lori Rider, Roger Stech, Ellen Steele, Mike Steele, Patrick Steele, Art Cox, Robert Carney, and Changsu Ouh. Their suggestions contributed significantlytothe earlier editions, andtheir influence carries through to this edition.

Thank you also to the folks at John Wiley and Sons, who were so helpful in completing this revision. Barbara Ligouri did an outstanding and thorough job of copyediting, reading the text with a critical eye and making several suggestions that improved the end result. Shelley Creager and Sarah Vernon provided invaluable assistance, responding quickly to numerous requests for information and other help. Finally, thank you to all of the students we have had over the years. Their many comments and intelligent questions contributed to the design of the book and to the examples and illustrations used. Thank you also to all of the users of the first nine editions who took time to write with their suggestions and comments.

I would be grateful to receive advice from the teachers who will use this book, particularly concerning any errors that should be corrected and any materials should be added or omitted when it is again revised. To the students who will be compelled to read it, I extend the hope that the material will seem as exciting and interesting as it has seemed to both of its authors.

Therese M. Vaughan 

Des Moines, Iowa 

September 2007