Explain the effect of risk.

The effect of risk is measured and to a certain extent it can be insured. Two concepts which are used to measure risks are chance of loss and degree of risk.

1. Chance of loss
Loss is the injury or damage borne by the insured in consequence of the happening of one or more of the accidents or misfortunes against which the insurer, in consideration of the premium, has undertaken to assure the insured. Chance of loss is defined as the probability that an event that causes a loss will occur. The chance of loss is a result of two factors, namely peril and hazard. Hazards are further classified into the following four types: 

Physical hazard - This is a danger likely to happen due to the physical characteristics of an object, which increases the chance of loss. For example defective wiring in a building which enhances the chance of fire. 

Moral hazard - It is an increase in the probability of loss due to dishonesty or character defects of an insured person. For example, Burning of unsold goods that are insured in order to increase the amount of claim is a moral hazard. 

Morale hazard - It is an attitude of carelessness or indifference to losses, because the losses were insured. For example, careless acts like leaving a door unlocked which makes it easy for a burglar to enter, or leaving car keys in an unlocked car increase the chance of loss. 

Legal hazard - It is the severity of loss which is increased because of the regulatory framework or the legal system. For example actions by government departments restricting the ability of insurers to withdraw due to poor underwriting results or a new environment law that alters the risk liability of an organization.

2. Degree of risk
Degree of risk refers to the intensity of objective risk, which is the amount of uncertainty in a given situation. It can be assessed by finding the difference between expected loss and actual loss. The formula used is

Degree of risk = Difference between the expected and actual loss
                                                 Expected loss

Degree of risk is measured by the probability of adverse deviation. If the probability of the occurrence of an event is high, then greater is the likelihood of deviation from the outcome that is hoped for and greater the risk, as long as the probability of loss is less than one. In the case of exposures in large numbers, estimates are made based on the likelihood of the number of losses that will occur. With regard to aggregate exposures the degree of risk is not the probability of a single occurrence but it is the probability of an outcome which is different from that expected or predicted. Therefore insurance companies make predictions about the losses that are expected to occur and formulate a premium based on that.