The law of conservation of risk

Note: 
Click http://ifexplorer.blogspot.ca/2015/09/hukum-kekekalan-resiko.html for Bahasa Indonesia version of this article.

To understand insurance one must begin with discussing the concept of risk.  Risk is defined as uncertainty of loss.  Loss is any bad, unwanted or unfavoured events that can generally be measured financially.

Indeed, throughout our lifetime, from one moment to another, we are facing risks or uncertainties of impending loss.  Let us take the example of an employee who works in Jakarta but lives in Bogor.  He has several options to come to work. He may drive his car and faces risk of being involved in road accidents that lead to impairment of the car or even fatality.  He may avoid the risk of road accidents by commuting by train, but at the same time exposes himself to other types of uncertainties such as a train collision, injury when jostling to enter or exit the train, or being pick-pocketed.

Many may recall in school we were introduced to the law of conservation of energy, that energy can not be created nor destroyed, only transformed from one form to another.  The same principle applies to risk. We should have so-called the law of conservation of risk.  Like energy, risk can not be completely eliminated, it just changes form depending on the choices we make.

When the employee reaches his office, he may think that he is in a comfortable and very secure place. In fact, he continues to be exposed to a number of risks or uncertainties that may bring harm, from possible cut by sharp edge of paper, slipped on freshly mopped tile floor, splashed by freshly brewed morning coffee, electric shocked by photocopier open wire, wedged the doors to being caught in a fire on the high floor then decided to plunge through window or decided not to but roasted by the flame or die from inhaling thick smoke.

So, there are many bad things might happen to everyone, even though in the place that looks very safe.  Their possibilities remains an uncertainty because we do not have the knowledge of when it happens in the future and how bad its consequence is.

Now, what should we do? Should we live our life anxiously all the time worrying about possibilities something bad to happen? Or, why not just leave to God the Almighty, at the end of the day, He decides our destiny?  Or, is there anything we can do?

Frequency and Severity
To answer above questions, we need to sort out the risks that we are exposed to everyday into several categories.  The easiest and most common way is to classify risks based on frequency and severity. This two dimensional classification leads us to four groups of risk, namely:

1. Rare and not severe (low frequency, low severity)
2. Often, but not severe (high frequency, low severity)
3. Rare, but severe (low frequency, high severity)
4. Frequent and severe (high frequency, high severity)

Actually not all of them need to be worried about.  Risk category 1 should be ignored, we do not need to waste our time thinking about it, then plan and take specific steps to deal with it.  Possible fingers cut by sharp paper edge is an example. It rarely occurs and when it does, it would not be severe enough to bring life-threatening consequence.  A wash of antibiotics liquid and a band aid to cover the cut are sufficient.  So, the first option in dealing with risk is to ignore it.

As for the risk group 2, as it often happen, someone may have to do something.  Let’s take the employee again as the example, he may be a careless fellow who too often lose his pen.  He always leave his pen in places like meeting room, boss office, colleague desk, canteen, guard post, parking area etc.  Whenever and wherever he pulls his pen out, it would highly likely be the last time he uses it.  High frequency rate (as it often happen) allow him to predict the level of losses he may suffer for a certain period of time.  This guy can predict fairly accurately how many pens that will disappear in a month.  Say, on average he loses 10 pens in a month and the pen value is Rp 5,000 each.  Thus, he has to set aside a fund of Rp 50,000 per month to buy pens.  For the forgetful and careless like him, there is no need to buy an expensive pen, those wrapped in gold or silver, if three days later it had gone anyway.  The decision of setting aside some funds to deal with risk is called retaining the risk. The amount of Rp 50,000 in this case is called retention level.  If the employee is lucky enough, all kind of stationeries are fully provided by the company.  Whenever he lose his pen, all he need to do is walking a few steps to stationery cabinet and pull a new pen out.  In this situation, from the perspective of the employee, he has transferred risk of losing pens to his employer.  In other words, company who now retain loss of Rp 50,000 per month.

As a check-point, so far we have acquainted with three possible actions that one can take in dealing with risk, i.e to ignore, to retain and to transfer.

Source: nickogusthiarakbar.blogspot.com

Let’s discuss now the risk of category 3 and 4.  Risks category 3 have a low frequency (rare to very rare), but if it happens, the consequences could be fatal and/or financial losses caused could be very high.  The risk of employee’s house is destroyed by a fire or his car involves in serious road accident are example of this riks.  Because it is rare, he can not make a reliable prediction of total losses in a given period of time. On the other hand, if it does happen, the consequences could be very severe, physically and/or financially.  Thus, to ignore or to retain are not wise choices.  In fact, transferring the risk to other party sounds much more sensible.

But, who is on earth willing to voluntarily accept disaster potential?  Here is the insurance industry play a role.  An insurance company is a party who volunteered itself to receive uncertainty and bear financial loss incurred should the risk turn to disaster.  But, its willingness to take over that certainly is not for free.  The insurance company will ask for a fee, called a premium.  The premium rate must be much smaller than the possible financial loss that may result from a risk, otherwise insurance will lose its relevance.  There is no point to remove the risk or uncertainty when certain cost spent upfront is almost or as large as the loss we may suffer.

Next question is why is then insurance company willing to take over risk or uncertainty of other party, even for a fee?  The key answer lies on the ability of insurance companies to predict the amount of losses over a certain period of time.  Where do insurance companies gain the ability to predict the amount of losses in the future, whereas the risk of that type rarely happen? Do they hire a wizard or fortune-teller or something? 

Actually, low frequency is in fact the main issue solved by the insurance company.  What they are doing is increasing number of the same or similar risks by pooling them.  The more the better, because the accuracy of their prediction will increase as number increases.  This is called the law of large numbers that say if we estimate an unknown population parameter through sampling, the larger the sample size, statistic (estimated value) generated will be closer to the actual value (parameter). Thus, we can conclude that by collecting premiums (pooling of risks) and take advantage of the law of large numbers, the insurance company is able to predict how much loss that may arise from all risks they carry (aggregate amount of loss) over certain period of time. Adding costs other than losses/claims and dividing it by number of risks, company get the amount of premium to be charged to each individual risk owner (insured).

Ok, what if the insurance company get the calculation wrong, whereby actual aggregate loss over certain period of time turn to be greater than estimate amount?  This is a very interesting topic indeed, but let’s skip it for now and reserve it for next discussion on reinsurance.

Let us now talk about the last category of risk , category 4, i.e the risk of frequent occurrence and severe consequence.  Compared to the other three, the risk of this type is clearly the most fatal and dangerous.  This is an extreme category and not easy to find an example, perhaps because people generally try to avoid being exposed to this risk.  The risk of flooding for the residents who live on the banks of the Ciliwung River in Jakarta, could be used as an example. Flood comes almost certainly during rainy season and damage all properties on its way, houses and its contents.  Since flood comes so often, people learn from experience how to minimize loss.  For example, water usually went up to three meter only, rarely reach second floor, so people would keep all electronic equipments, important documents and most valuable items on second floor. Those who have single storey house may move their valuable stuff to room between ceiling and roof.

Some hazardous occupations or hobbies, to some extent, may also categorized the risk of this type.  Stuntman job, circus performers, motorcycle riders, free fall, cliff hanger, to name a few.  Although, you may argue that with the increase of individual skill, those works or hobbies could be categorize as third type of risk instead, due to the decreasing frequency of accidents.  Would insurance company like to assume risk category 4?  Generally speaking, no.  Although the amount of loss can be predicted fairly accurately because the frequency is high, high amount of loss makes the risk of this type not economically viable to be managed through insurance schemes. Premiums to be paid in advance by the owner of the risk will be way too high, relative to the potential loss itself.  That is why insurance exclude the risks associated with hazardous work or hobbies.

When risks can not be transferred to another party, then the best solution is to avoid it.  Moving away from Jakarta’s Ciliwung riverbank, quit the job of stuntman, switch to safer hobby, from rock climbing to dancing, for example.

Second check-point, there are four possible actions one can take to deal with risk i.e to ignore, to retain, to transfer and to avoid.

Hazard
It is incomplete to talk about risk without mentioning hazard.  We are not talking about Belgian footballer who plays for FC Chelsea, Eden Hazard.  Risk is a situation where a person faces the uncertainty of the losses.  In other words, the risk is not a problem if it remains as a risk.  Problems arise when the risk unfortunately turns into a loss.  Chance or probability of a risk turns into a loss is determined by certain factors or characteristics, called hazard.  Hazard could also be characteristic that affect the severity of the loss, if it does occur.  Based on which direction it affects frequency or severity of loss, hazard can be divided into good hazard and poor hazard. Good hazard is a characteristic that lower the chances of a risk to be a loss or decrease the severity if the loss occurred. Poor hazard is exactly the opposite, raising the chance or severity. Building constructed in accordance with a strict regulation, always wear a seatbelt when driving, wearing a helmet when riding motorcycles are examples of good hazard. Wooden or bamboo housing, storing flammable materials or explosive in premise, reckless driving are examples of poor hazard.
(Seoul – 26 July 2016)

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