Chapter
25
Introduction to
Risk Management
25.1 Understanding Risk
25.2 Managing Risk
© 2010 South-Western, Cengage Learning
Lesson 25.1
Understanding Risk
GOALS
■ Explain risk and the different types of risk.
■ Explain the concept of insurance and how
risks are spread.
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Types of Risk
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Pure risk
Speculative risk
Economic risk
Insurable risk
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Pure Risk
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Pure risk is a chance of
loss with no chance for
gain.
Pure risks are random (can
happen to anyone) and
result in loss (not gain).
Examples of pure risk
include the following:
Accidents resulting in physical
injury and damage to property
Illnesses that people get
throughout life, as a part of
aging
Acts of nature, resulting in
damage to persons and
property
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Speculative Risk
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A speculative risk may result in
either gain or loss.
Because speculative risks are not
“accidental” or random, and may
result in either gain or loss, you
cannot protect yourself from
losses in a traditional manner.
While hedging (making an
investment to help offset against
loss) is a technique used to help
reduce losses from such risky
acts, it does not reduce the risk
itself.
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Economic Risk
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Economic risk may result in gain or
loss because of changing
economic conditions.
For example, when the business
cycle is in a period of recovery or
growth, most people and
businesses are realizing gains in
their financial position.
However, the economy can slow
down.
During this time, people lose jobs
and are unable to buy goods and
services.
As a result, many businesses find
themselves unable to meet their
debts.
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Insurable Risk
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You can reduce negative
consequences of a pure risk
by purchasing insurance.
Insurance is a method for
spreading individual risk
among a large group of
people to make losses more
affordable for all.
An insurable risk is a pure risk
that is faced by a large
number of people and for
which the amount of the loss
can be predicted.
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(continued)
Insurable Risk
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Insurance companies can make
these predictions by examining
the amount of loss incurred from
past events, such as flooding.
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To purchase insurance, you must
have an insurable interest to protect.
An insurable interest is any financial
interest in life or property such that, if
the life or property were lost or
harmed, the insured would suffer
financially.
There are three major insurable
risks: personal, property, and
liability.
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Personal Risk
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A personal risk is the chance of loss involving
your income and standard of living.
You can protect yourself from personal risks by
buying life, health, and disability insurance.
In addition, insurance against personal risks
protects others who are depending on your
income to provide food, clothing, shelter, and the
comforts of life.
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Property Risk
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The chance of loss or harm to
personal or real property is
called property risk.
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For example, your home, car, or
other possessions could be
damaged or destroyed by fire,
theft, wind, rain, accident, and
other hazards.
To protect against such risks,
you can buy property insurance.
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Liability Risk
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A liability risk is the chance of loss
that may occur when your errors or
actions result in injuries to others or
damages to their property.
For example, you could accidentally
cause injury or damage to others or their
property by your conduct while driving a
car.
Or a person could fall because of your
home’s crumbling front steps and break
an arm.
Liability insurance will protect you
when others sue you for injuring
them or damaging their property.
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Spreading the Risk
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An insurance company, or insurer, is a
business that agrees to pay the cost of
potential future losses in exchange for
regular fee payments.
When people buy insurance, they join a
risk-sharing group by purchasing a
written insurance contract (a policy).
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(continued)
Spreading the Risk
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Under the policy, the insurer
agrees to assume an
identified risk for a fee, called
the premium, usually paid at
regular intervals by the owner
of the policy (the
policyholder).
The insurer collects insurance
premiums from policyholders
under the assumption that
only a few policyholders will
have financial losses at any
given time.
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Indemnification
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Insurance is not meant to enrich—only to
compensate for actual losses incurred.
This principle is called indemnification.
Indemnification means putting the
policyholder back in the same financial
condition he or she was in before the loss
occurred.
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Insurance Terminology
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Actuarial table
Actuary
Beneficiary
Benefits
Cash value
Claim
Coverage
Deductible
Exclusions
Face amount
Grace period
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Hazard
Insurance agent
Insured
Insurer
Loss
Peril
Probability
Proof of loss
Standard policy
Unearned premium
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Lesson 25.2
Managing Risk
GOALS
■ Discuss the risk-management process.
■ Explain how to create a riskmanagement plan.
■ Discuss ways to reduce the costs of
insurance.
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Risk Management Is a Process
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While you cannot
eliminate risk, you can
manage it so that a loss
does not become
financially devastating.
Risk management is an
organized strategy for
controlling financial loss
from pure risks and
insurable risks.
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Risk Assessment
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Risk management begins with a systematic study of the risks
that you face.
It begins with risk assessment, or understanding the types of
risk you will face and their potential consequences.
Risk assessment is a three-step process:
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Step 1: Identify risks of loss
Step 2: Assess seriousness of risks
Step 3: Handle risks
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Techniques for Handling Risks
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Risk shifting
Risk avoidance
Risk reduction
Risk assumption
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Risk Shifting
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Risk shifting, also called risk transfer,
occurs when you buy insurance to cover
financial losses caused by damaging
events, such as fire, theft, injury, or death.
By making premium payments, you shift
the risk of major financial loss to the
insurance company.
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Risk Avoidance
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Risk avoidance lowers
the chance for loss by
not doing the activity
that could result in the
loss.
Examples:
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Instead of having a party
at your house and risking
damage, you could
reserve a section of a
restaurant.
Instead of participating in
a dangerous sport, you
could go camping.
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Risk Reduction
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Risk reduction lowers the chance of loss
by taking measures to lessen the
frequency or severity of losses that may
occur.
For example, you may put studded snow
tires on your car, install fire alarms or
sprinklers in your home, or use seat belts.
All these steps would lessen the financial
risk of potential losses.
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Risk Assumption
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Risk assumption is the
process of accepting the
consequences of risk.
To help cushion your
financial burden, you
could establish a
monetary fund to cover
the cost of a loss.
People who self-insure
plan to absorb the costs
of some risks
themselves.
This strategy can reduce
the cost of insurance.
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The Risk-Management Plan
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List identified risks.
List assessment of risks’ financial
impact.
List techniques to manage each risk.
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Reducing Insurance Costs
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Increase deductibles.
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A deductible is the specified
amount of a loss that you
must pay.
Generally, the higher the
deductible, the lower the
insurance premium.
Purchase group insurance.
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The premiums for group
plans are usually
considerably lower than for
an individual plan.
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(continued)
Reducing Insurance Costs
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Consider payment options.
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Monthly payments usually contain an extra
charge, while semiannual payments do not.
Having premiums automatically deducted
from your checking account or paying
electronically may reduce your costs.
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(continued)
Reducing Insurance Costs
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Look for discount
opportunities.
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Many insurance companies
offer discounts for special
conditions.
Comparison shop.
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Get quotes from several
insurers.
Be sure to give each one the
same information so you can
compare exact coverage and
costs.
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