The Economic Costs of Risks

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The Economic Costs of Risks
Regardless of the manner in which risk is defined, its existence affects the


economic performance of agents and therefore imposes constraints on the
optimum allocation of resources and on the economic development of all
nations. Individual as well as business decisions are not made under conditions
of certainty. Although the idea of risk may be difficult to conceptualize, all
economic agents are taking decisions they consider beneficial to them.
In 190 1, A.H. Willet refers to the costs of uncertainty arising out of (1) the
unexpected losses that do occur and (2) the uncertainty itself even if no losses
occur. He also refers to uncertainty as a disutility. The prudent individual
response to uncertainty (as to whether a loss will occur ) is to engage in safe
actions rather than risky ones. At the society level this behavior may cause
distortions in the optimal allocation of productive resources.
These economic costs are the primary reason why economic agents attempt
to avoid risk or alleviate its impact. "The existence of risk in an approximate
static state causes an economic loss. The assumption of risk, on the other hand,
is a source of gain to the society as a whole. " 19
Risk and Return
Risk is the common denominator of all decisions made by human being. The
objective in taking these decisions is not to avoid risk but to recognize its
existence and ensure that compensation is adequate for the risks being borne.
The presence of uncertainty about future income or future return from an
investment means that there is a risk to be evaluated by the economic agent
which is bearing the risk. Investors, for example, must be compensated (receive
a reward) for giving up present consumption and bearing the risk of the
7
investment. Almost all fInancial decisions including insurance involve some
sort of risk-return tradeoff.
Each individual economic agent regards each action he takes as being in
some way or another, beneficial to him, and he regards all actions when
combined, as yielding some maximum present and future level of satisfaction.
As a general rule it can still be said that most individuals prefer higher returns to
lower returns. Similarly they prefer lower risk to higher risk.
About a century ago, Marshall in "The Principles of Economics" recognized
the existence of a net premium for risk-taking. The most important development
in the fIeld of Finance in the past 30 years has been the ability to quantify the
meaning of risk for business decisions. This has led in turn to new theoretical
and empirical work relating to the relation between risk and expected return.
Other Definitions
Along with many other fIelds of activities, insurance has its own language.
While the definition of "risk" as inspired many authors, some other words are
often confused in the insurance jargon.
Accident: An unexpected, undesired event arising from a peril and
resulting in a loss of resources.
Peril: A peril is a situation that may cause a personal or property loss. Perils
are natural, human-made or economic.
Hazard: A hazard is something that increases the chance that a loss
will happen because of a specific peril (see appendix 2).
Exposure: An exposure is a defIned asset (human or physical) subject to
a defIned peril.
Loss Exposure: The potential financial loss or the monetary amount that is
involved in the exposure.

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