Chapter 1 – The Nature of Risk: Losses and Opportunities
Review and Practice
1. What are underlying objectives for the definition of risk?
The underlying objectives for the definition of risk are maximization of value and the
minimization of bankruptcy.
2. How does risk fit on the spectrum of certainty and uncertainty?
Risk is a consequence of uncertainty. Uncertainty is having two potential outcomes for an
event or situation. These outcomes can be positive or negative. Risk exists only in a
situation of uncertainty. In a situation with certainty, risk is absent.
3. Provide the formal definition of risk.
Actual outcomes may differ from expectations. We can, therefore measure risk as the
perceived variability of future outcomes. Such variability of future outcomes corresponds to
the economist’s notion of risk.
4. What are three major categories of risk attitudes?
The three major categories of risk attitudes are risk averse, risk neutral, and risk seeking.
5. Explain the categories and risk and provide examples for each category.
,Risk averse: People are risk averse when they shy away from risks and prefer to have as
much security and certainty as is reasonably affordable.
An individual who invests in Treasury bills, which is the least risky investment available,
can be categorized as a risk averse individual.
Risk seeker: People are risk seeker if they enter into an endeavor as long as a positive long
run return on the money is possible, however unlikely.
Gamblers can be categorized as risk seekers.
Risk neutral: An individual is risk neutral when an individual’s preference lies between the
extremes of risk averse and risk seekers.
An individual who does not pay for insurance and who does not gamble can be categorized
as a risk neutral individual.
6. What are exposures? Give examples of exposures.
Exposure is a term used to describe the enterprise, property, person, or activity facing a
potential loss.
A house built on the coast near Galveston, Texas is called an “exposure unit” for the
potentiality of loss due to a hurricane.
7. What are perils? Give examples of perils.
Risk management professionals use the term peril to refer to “the causes of loss.”
The environment is filled with perils such as floods, theft, death, sickness, accidents, fires,
tornadoes, and lightning.
8. What are hazards? Give examples of hazards.
Risk professionals refer to hazards as conditions that increase “the cause of losses.”
Examples of hazards include the lax security measures in airports before the 9/11 terrorist
attacks; the decline of humidity and the rise in temperature and winds during the summer
which can result in fires.
,9. In a particular situation, it may be difficult to distinguish between moral hazard and
morale hazard. Why? Define both terms.
Moral hazards are hazards that involve behavior that can be construed as negligence or that
borders on criminality.
Morale hazards are hazards that involve attitudes of carelessness and lack of concern.
In certain situations, it is difficult to distinguish between moral and morale hazards. These
situations arise when an incident occurs and it is difficult to prove whether the act was
intentional or an act of carelessness. For example, a house is completely destroyed by fire.
The house is insured and the owner receives the entire amount. Investigation shows that
the fire started because the micro oven was not switched off. In this case, it is difficult to
prove whether the act of the owner was intentional or an act of negligence.
10. Some people with complete health insurance coverage visit doctors more often than
required. Is this tendency a moral hazard, a morale hazard, or simple common sense?
Explain.
This is an act of simple common sense because there is no harm in going to the doctor more
often. Especially, if one does not have to pay for it.
It is not a moral hazard because visiting a doctor more often than required does not involve
dishonesty.
It is not a morale hazard because hazard because visiting a doctor more often than required
is not an act of carelessness or negligence but rather the opposite.
11. Give examples of perils, exposures, and hazards for a university or college. Define each
term.
The term peril can be used to refer to “the causes of loss.” There are many examples of
perils, exposures, and hazards for a university or college and student examples would differ.
Perils for a university or college include fire in the premises, theft of property etc.
, Exposures are used to describe the enterprise, property, person or activity facing a potential
loss. Exposures for a university or college include the college building, the library, the
students etc.
Hazards can be defined as the conditions that increase the cause of loss.
Hazards for a university or college include the lax security department of the university, the
lack of fire extinguishers in the premises, and the location of the university.
12. Give examples of exposure for speculative risks in a company such as Google.
Speculative risks feature a chance to either gain or lose.
A company like Google faces numerous exposures for speculative risks and student
examples would differ. Its forays into mobile phones, its decision to use Chrome as an
operating platform, the reputational risk, and brand risk can be included as examples of
speculative risks.
13. Inflation causes both pure and speculative risks in our society. Can you give some
examples of each?
Inflation can cause pure risks. Some examples include:
The rise in production costs due to inflation and the resulting rise in prices of raw materials;
The rise in prices of necessities due to inflation.
Inflation can also cause speculative risks. Example includes:
Interest rates are affected by inflation. Nominal interest rates include inflation rates. Real
interest rates are nominal interest rates minus the inflation rates. Since the inflation rate
over the course of a loan is not known initially, volatility in inflation represents a risk to
both the lender and the borrower.
14. Define holistic risk and enterprise risk and give examples of each.
Review and Practice
1. What are underlying objectives for the definition of risk?
The underlying objectives for the definition of risk are maximization of value and the
minimization of bankruptcy.
2. How does risk fit on the spectrum of certainty and uncertainty?
Risk is a consequence of uncertainty. Uncertainty is having two potential outcomes for an
event or situation. These outcomes can be positive or negative. Risk exists only in a
situation of uncertainty. In a situation with certainty, risk is absent.
3. Provide the formal definition of risk.
Actual outcomes may differ from expectations. We can, therefore measure risk as the
perceived variability of future outcomes. Such variability of future outcomes corresponds to
the economist’s notion of risk.
4. What are three major categories of risk attitudes?
The three major categories of risk attitudes are risk averse, risk neutral, and risk seeking.
5. Explain the categories and risk and provide examples for each category.
,Risk averse: People are risk averse when they shy away from risks and prefer to have as
much security and certainty as is reasonably affordable.
An individual who invests in Treasury bills, which is the least risky investment available,
can be categorized as a risk averse individual.
Risk seeker: People are risk seeker if they enter into an endeavor as long as a positive long
run return on the money is possible, however unlikely.
Gamblers can be categorized as risk seekers.
Risk neutral: An individual is risk neutral when an individual’s preference lies between the
extremes of risk averse and risk seekers.
An individual who does not pay for insurance and who does not gamble can be categorized
as a risk neutral individual.
6. What are exposures? Give examples of exposures.
Exposure is a term used to describe the enterprise, property, person, or activity facing a
potential loss.
A house built on the coast near Galveston, Texas is called an “exposure unit” for the
potentiality of loss due to a hurricane.
7. What are perils? Give examples of perils.
Risk management professionals use the term peril to refer to “the causes of loss.”
The environment is filled with perils such as floods, theft, death, sickness, accidents, fires,
tornadoes, and lightning.
8. What are hazards? Give examples of hazards.
Risk professionals refer to hazards as conditions that increase “the cause of losses.”
Examples of hazards include the lax security measures in airports before the 9/11 terrorist
attacks; the decline of humidity and the rise in temperature and winds during the summer
which can result in fires.
,9. In a particular situation, it may be difficult to distinguish between moral hazard and
morale hazard. Why? Define both terms.
Moral hazards are hazards that involve behavior that can be construed as negligence or that
borders on criminality.
Morale hazards are hazards that involve attitudes of carelessness and lack of concern.
In certain situations, it is difficult to distinguish between moral and morale hazards. These
situations arise when an incident occurs and it is difficult to prove whether the act was
intentional or an act of carelessness. For example, a house is completely destroyed by fire.
The house is insured and the owner receives the entire amount. Investigation shows that
the fire started because the micro oven was not switched off. In this case, it is difficult to
prove whether the act of the owner was intentional or an act of negligence.
10. Some people with complete health insurance coverage visit doctors more often than
required. Is this tendency a moral hazard, a morale hazard, or simple common sense?
Explain.
This is an act of simple common sense because there is no harm in going to the doctor more
often. Especially, if one does not have to pay for it.
It is not a moral hazard because visiting a doctor more often than required does not involve
dishonesty.
It is not a morale hazard because hazard because visiting a doctor more often than required
is not an act of carelessness or negligence but rather the opposite.
11. Give examples of perils, exposures, and hazards for a university or college. Define each
term.
The term peril can be used to refer to “the causes of loss.” There are many examples of
perils, exposures, and hazards for a university or college and student examples would differ.
Perils for a university or college include fire in the premises, theft of property etc.
, Exposures are used to describe the enterprise, property, person or activity facing a potential
loss. Exposures for a university or college include the college building, the library, the
students etc.
Hazards can be defined as the conditions that increase the cause of loss.
Hazards for a university or college include the lax security department of the university, the
lack of fire extinguishers in the premises, and the location of the university.
12. Give examples of exposure for speculative risks in a company such as Google.
Speculative risks feature a chance to either gain or lose.
A company like Google faces numerous exposures for speculative risks and student
examples would differ. Its forays into mobile phones, its decision to use Chrome as an
operating platform, the reputational risk, and brand risk can be included as examples of
speculative risks.
13. Inflation causes both pure and speculative risks in our society. Can you give some
examples of each?
Inflation can cause pure risks. Some examples include:
The rise in production costs due to inflation and the resulting rise in prices of raw materials;
The rise in prices of necessities due to inflation.
Inflation can also cause speculative risks. Example includes:
Interest rates are affected by inflation. Nominal interest rates include inflation rates. Real
interest rates are nominal interest rates minus the inflation rates. Since the inflation rate
over the course of a loan is not known initially, volatility in inflation represents a risk to
both the lender and the borrower.
14. Define holistic risk and enterprise risk and give examples of each.
