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Risk Management for Individuals and Enterprises

v2.0 Etti Baranoff, Patrick Lee Brockett, Yehuda Kahane, and Dalit Baranoff

1.5 Perils and Hazards

Learning Objectives

In this section we review the following:

  1. The terminology used by risk professionals to denote the risk concepts “peril,” “loss,” and “hazard.” 

  2. The different types of perils and hazards.

In English, people often use the word “risk” to describe a loss. Examples include hurricane risk or fraud risk. To differentiate between loss and risk, risk management professionals prefer to use the term to refer to “the causes of loss.” Similarly, they  use the term  to refer to “conditions that increase the cause of losses.” You will see all three terms used throughout this text. Distinguishing between “loss”, “perils”, and “hazards” is critical for our understanding of risk. In insurance contracts, a refers to the injury or damage sustained by the insured.

Our environment is filled with perils such as floods, theft, death, sickness, accidents, fires, tornadoes, and lightning. We include a list of some perils below. Many important risk-transfer contracts (such as insurance contracts) use the word “peril” quite extensively to define inclusions and exclusions within contracts. We will also explain these definitions in a legal sense later in the textbook to help us determine terms such as “residual risk retained.”

Table 1.3 Types of Perils by Ability to Insure


Natural Perils

Human Perils

Generally Insurable

Generally Difficult to Insure

Generally Insurable

Generally Difficult to Insure

Windstorm

Flood

Theft

War

Lightning

Earthquake

Vandalism

Radioactive contamination

Natural combustion

Epidemic

Hunting accident

Civil unrest

Heart attacks

Volcanic eruption

Negligence

Terrorism

Frost

Fire and smoke

Global

Cyber

Mold

Although professionals attempt to categorize perils, doing so is difficult. We could talk about natural versus human perils. are those over which people have little control, such as hurricanes, volcanoes, and lightning. , then, would include causes of loss that lie within individuals’ control, including suicide, terrorism, war, theft, defective products, environmental contamination, terrorism, destruction of complex infrastructure, and electronic security breaches. Though some would include losses caused by the state of the economy as human perils, many professionals separate these into a third category labeled . Professionals also consider employee strikes, arson for profit, and similar situations to be economic perils.

We can also divide perils into insurable and non-insurable. Typically, non-insurable perils include those that may be considered catastrophic to an insurer.  An insurer could also  decline to write a policy for perils that might threaten its own solvency (e.g., nuclear power plant liability) or those perils that might encourage insureds to cause a loss.

Hazards

Risk professionals refer to hazards as conditions that increase the cause of losses. Hazards can increase the probability of losses, their frequency, their severity, or both.  is the number of losses during a specified period, while  is the average dollar value of a loss per occurrence). Professionals refer to certain conditions as being “hazardous.” For example, in heavily forested areas, when summer humidity declines and temperature and wind velocity rises, the likelihood of fire increases. Conditions are such that a forest fire could start very easily and be difficult to contain. In this example, low humidity increases both loss probability and loss severity. The more hazardous the conditions, the greater the probability and/or severity of loss. The conditions increasing the likelihood of a forest fire are considered “physical” hazards. Hazards may also be classified as “intangible.” Both types of hazards—physical and intangible—affect the probability and severity of losses.

Physical Hazards

are tangible environmental conditions affecting the frequency and/or severity of loss. Examples include slippery roads, which often increase the number of auto accidents; poorly lit stairwells, which add to the likelihood of slips and falls; and old wiring, which may increase the chances of a fire.

Physical hazards involving property include location, construction, and use. A building’s locations affects its  susceptibility to loss by fire, flood, earthquake, and other perils. A building located near a fire station and a good water supply has a lower chance of suffering a serious loss by fire than a building in an isolated area with neither water nor firefighting service. Similarly, a business with a backup generator has a lower likelihood of a serious financial loss in the event of a power loss hazard.

Construction influences both the probability and severity of loss. While no building is fireproof, some construction types are less susceptible to loss from fire than others. A building’s susceptibility to one peril, however, does not necessarily determine its susceptibility to all perils. For example, a frame building is more apt to burn than a brick building, but frame buildings may suffer less damage from an earthquake.

Use or occupancy may also create physical hazards. For example, a building used to manufacture or store fireworks has a greater probability of loss by fire than does an office building. Likewise, buildings used for dry cleaning (which uses volatile chemicals) constitute a greater physical hazard than do elementary schools. Cars used for business purposes may be exposed to a greater chance of loss than a typical family car, since businesses use vehicles more extensively and in more dangerous settings. Similarly, people have physical characteristics that affect loss. Some of us have brittle bones, weak immune systems, or vitamin deficiencies. Any of these characteristics could increase the probability or severity of health expenses.

Intangible Hazards

are attitudes and nonphysical cultural conditions that can affect loss probabilities and the severity of loss. Their existence may lead to physical hazards. Traditionally, authors of insurance texts categorize these conditions as moral and morale hazards, which are important concepts but do not cover the full range of nonphysical hazards. Even the distinction between moral and morale hazards is fuzzy.

are hazards involving behavior that can be construed as negligence or that borders on criminality. They involve dishonesty on the part of individuals who take out insurance (called “insureds”). Risk transfer through insurance invites moral hazard by potentially encouraging those who transfer risks to cause losses intentionally for monetary gain. Generally, moral hazards exist when a person can gain from the occurrence of a loss. For example, an insured who expects reimbursement for the cost of a new stereo system following the loss of an old one has an incentive to cause loss. Likewise, an insured business owner who is losing money may be motivated to commit arson. Such incentives increase loss probabilities; as the name “moral” implies, moral hazard is a breach of morality (honesty).

, in contrast, do not involve dishonesty. Rather, morale hazards involve attitudes of carelessness and lack of concern. As such, morale hazards increase the chance a loss will occur or increase the size of losses that do occur. Poor housekeeping (e.g., allowing trash to accumulate in attics or basements) or careless cigarette smoking are examples of morale hazards that increase the probability of fire losses. Often, such lack of concern occurs because a third party (such as an insurer) is available to pay for losses. A person or company that knows they are insured for a particular loss exposure may take fewer precautions to protect against this exposure than otherwise. Nothing dishonest lurks in not locking your car or in not taking adequate care to reduce losses, so these don’t represent morality breaches. Both practices, however, increase the probability of loss severity.

Many people unnecessarily, and often unconsciously, create morale hazards that can affect their health and life expectancy. Such hazards include excessive use of tobacco, drugs, and other harmful substances; poor eating, sleeping, and exercise habits; unnecessary exposure to falls, poisoning, electrocution, radiation, venomous stings and bites, and air pollution; and so forth.

Hazards are critical because our ability to reduce their effects will reduce both overall costs and variability. Hazard management, therefore, can be a highly effective risk management tool. At this point, many corporations around the world emphasize disaster control management to reduce the effect of biological or terrorist attacks. Security screening at airports is one example of disaster control management that intensified after September 11. See “Is Airport Security Worth It to You?” for a discussion of safety in airports.

Is Airport Security Worth It to You?

Following the September 11, 2001, terrorist attacks, the Federal Aviation Administration (now the Transportation Security Administration [TSA] under the U.S. Department of Homeland Security [DHS]) wrestled with a large question—how could a dozen or more hijackers armed with knives slip through security checkpoints at two major airports? Sadly, it wasn’t hard. Lawmakers and security experts had long complained about lax safety measures at airports, citing several studies over the years that had documented serious security lapses. “I think a major terrorist incident was bound to happen,” Paul Bracken, a Yale University professor who teaches national security issues and international business, told Wired magazine a day after the attacks. “I think this incident exposed airport security for what any frequent traveler knows it is—a complete joke. It’s effective in stopping people who may have a cigarette lighter or a metal belt buckle, but against people who want to hijack four planes simultaneously, it is a failure.”

Two days after the attacks, air space was reopened under extremely tight security measures, including placing armed security guards on flights; ending curbside check-in; banning sharp objects (at first, even tweezers, nail clippers, and eyelash curlers were confiscated); restricting boarding areas to ticket-holding passengers; and conducting extensive searches of carry-on bags.

In the years since the 2001 terrorist attacks, U.S. airport security procedures have undergone many changes, often in response to current events and national terrorism threat levels. For example, the “shoe bomber” incident in December 2001 (in which a terrorist failed to detonate plastic explosives hidden in his shoe) led to the requirement that all passengers remove their shoes at TSA security checkpoints. (Today children 12 and under, seniors 75 and older, and pre-screened passengers no longer have to remove their shoes).

Beginning in December 2005, the Transportation Security Administration (TSA) refocused its efforts to detect suspicious persons, items, and activities. The new measures called for increased random passenger screenings. They lifted restrictions on certain carry-on items. Overall, the changes were viewed as a relaxation of the extremely strict protocols that had been in place subsequent to the events of 9/11.

The TSA had to revise its airline security policy yet again shortly after the December 2005 adjustments. On August 10, 2006, British police apprehended over twenty suspects implicated in a plot to detonate liquid-based explosives on flights originating from the United Kingdom bound for several major U.S. cities. Following news of this aborted plot, the U.S. Terror Alert Level soared to red (denoting a severe threat level). As a result, the TSA quickly barred passengers from carrying on most liquids and other potentially explosives-concealing compounds to flights in U.S. airports. Beverages, gels, lotions, toothpastes, and semisolid cosmetics (such as lipstick) were thus expressly forbidden. (The quantity of liquid allowed in carry-on bags is currently restricted to that which can fit into 3.4-oz or smaller containers).

Not long after publication of the initial requirements, less-burdensome modifications were made to the list of TSA-prohibited items. Nevertheless, compliance remains a controversial issue among elected officials and the public, who contend that the many changes are difficult to keep up with. Many asserted that the changes represented too great a tradeoff of comfort or convenience for the illusion of safety. To many citizens, though, the 2001 terrorist plot served as a wake-up call, reminding a nation quietly settling into a state of complacency of the need for continued vigilance. Regardless of the merits of these viewpoints, air travel security will no doubt remain a hot topic in the years ahead as the economic, financial, regulatory, and sociological issues become increasingly complex.

Questions for Discussion

  1. Discuss whether the government has the right to impose great cost to many in terms of lost time in using air travel, inconvenience, and affronts to some people’s privacy, in order to protect a few individuals.

  2. Do you see any morale or moral hazards associated with the TSA/DHS monitoring, actively searching people, and doing preflight background checks on individuals prior to boarding?

  3. Discuss the issue of personal freedom versus national security as it relates to this case.

Key Takeaways

  1. The terms “peril” and “hazard” are used to distinguish between the cause of a loss and the conditions contributing to the loss.

  2. Perils can be categorized as natural, human, or economic.

  3. Hazards can be physical or intangible. Intangible hazards include moral hazard and morale hazard.

Discussion Questions

  1. What are perils? Provide an example of a peril.

  2. What are hazards? Provide an example of a hazard.

  3. Why can’t we just call perils and hazards “risks” as is often done in common English conversations?

  4. Identify and discuss the perils and hazards in “Is Airport Security Worth It to You?”.