1.6: Perils and Hazards (2023)

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    Learning Objectives
    • In this section you will learn the terminology used by riskprofessionals to note different risk concepts.
    • You will learn about causes of losses—perils and the hazards,which are the items increasing the chance of loss.

    As we mentioned earlier, in English, people often use the word“risk” to describe a loss. Examples include hurricane risk or fraudrisk. To differentiate between loss and risk, risk managementprofessionals prefer to use the term perils torefer to “the causes of loss.” If we wish to understand risk, wemust first understand the terms “loss” and “perils.” We will useboth terms throughout this text. Both terms represent immediatecauses of loss. The environment is filled with perils such asfloods, theft, death, sickness, accidents, fires, tornadoes, andlightning—or even contaminated milk served to Chinese babies. Weinclude a list of some perils below. Many important risk transfercontracts (such as insurance contracts) use the word “peril” quiteextensively to define inclusions and exclusions within contracts.We will also explain these definitions in a legal sense later inthe textbook to help us determine terms such as “residual riskretained.”

    Table 1.4 Types of Perils by Ability to Insure
    Natural PerilsHuman Perils
    GenerallyInsurableGenerally Difficult toInsureGenerallyInsurableGenerally Difficult toInsure
    LightningEarthquakeVandalismRadioactive contamination
    Natural combustionEpidemicHunting accidentCivil unrest
    Heart attacksVolcanic eruptionNegligenceTerrorism
    FrostFire and smoke

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

    We can also divide perils into insurable and noninsurableperils. Typically, noninsurable perils include those that may beconsidered catastrophic to an insurer. Such noninsurable perils mayalso encourage policyholders to cause loss. Insurers’ problems restwith the security of its financial standing. For example, aninsurer may decline to write a policy for perils that mightthreaten its own solvency (e.g., nuclear power plant liability) orthose perils that might motivate insureds to cause a loss.

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    Risk professionals refer to hazards asconditions that increase the cause of losses. Hazards may increasethe probability of losses, their frequency, their severity, orboth. That is, frequency refers to the number oflosses during a specified period. Severity refersto the average dollar value of a loss per occurrence, respectively.Professionals refer to certain conditions as being “hazardous.” Forexample, when summer humidity declines and temperature and windvelocity rise in heavily forested areas, the likelihood of fireincreases. Conditions are such that a forest fire could start veryeasily and be difficult to contain. In this example, low humidityincreases both loss probability and loss severity. The morehazardous the conditions, the greater the probability and/orseverity of loss. Two kinds of hazards—physical andintangible—affect the probability and severity of losses.

    Physical Hazards

    We refer to physical hazards as tangibleenvironmental conditions that affect the frequency and/or severityof loss. Examples include slippery roads, which often increase thenumber of auto accidents; poorly lit stairwells, which add to thelikelihood of slips and falls; and old wiring, which may increasethe likelihood of a fire.

    Physical hazards that affect property include location,construction, and use. Building locations affect theirsusceptibility to loss by fire, flood, earthquake, and otherperils. A building located near a fire station and a good watersupply has a lower chance that it will suffer a serious loss byfire than if it is in an isolated area with neither water norfirefighting service. Similarly, a company that has built a backupgenerator will have lower likelihood of a serious financial loss inthe event of a power loss hazard.

    Construction affects both the probability and severity of loss.While no building is fireproof, some construction types are lesssusceptible to loss from fire than others. But a building that issusceptible to one peril is not necessarily susceptible to all. Forexample, a frame building is more apt to burn than a brickbuilding, but frame buildings may suffer less damage from anearthquake.

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

    Intangible Hazards

    Here we distinguish between physical hazards andintangible hazards—attitudes and nonphysicalcultural conditions can affect loss probabilities and severities ofloss. Their existence may lead to physical hazards. Traditionally,authors of insurance texts categorize these conditions as moral andmorale hazards, which are important concepts but do not cover thefull range of nonphysical hazards. Even the distinction betweenmoral and morale hazards is fuzzy.

    Moral hazards are hazards that involve behaviorthat can be construed as negligence or that borders on criminality.They involve dishonesty on the part of people who take outinsurance (called “insureds”). Risk transfer through insuranceinvites moral hazard by potentially encouraging those who transferrisks to cause losses intentionally for monetary gain. Generally,moral hazards exist when a person can gain from the occurrence of aloss. For example, an insured that will be reimbursed for the costof a new stereo system following the loss of an old one has anincentive to cause loss. An insured business that is losing moneymay have arson as a moral hazard. Such incentives increase lossprobabilities; as the name “moral” implies, moral hazard is abreach of morality (honesty).

    Morale hazards, in contrast, do not involvedishonesty. Rather, morale hazards involve attitudes ofcarelessness and lack of concern. As such, morale hazards increasethe chance a loss will occur or increase the size of losses that dooccur. Poor housekeeping (e.g., allowing trash to accumulate inattics or basements) or careless cigarette smoking are examples ofmorale hazards that increase the probability fire losses. Often,such lack of concern occurs because a third party (such as aninsurer) is available to pay for losses. A person or company thatknows they are insured for a particular loss exposure may take lessprecaution to protect this exposure than otherwise. Nothingdishonest lurks in not locking your car or in not taking adequatecare to reduce losses, so these don’t represent morality breaches.Both practices, however, increase the probability of lossseverity.

    Many people unnecessarily and often unconsciously create moralehazards that can affect their health and life expectancy. Suchhazards include excessive use of tobacco, drugs, and other harmfulsubstances; poor eating, sleeping, and exercise habits; unnecessaryexposure to falls, poisoning, electrocution, radiation, venomousstings and bites, and air pollution; and so forth.

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    Hazards are critical because our ability to reduce their effectswill reduce both overall costs and variability. Hazard management,therefore, can be a highly effective risk management tool. At thispoint, many corporations around the world emphasize disastercontrol management to reduce the impact of biological or terroristattacks. Safety inspections in airports are one example of disastercontrol management that intensified after September 11. See "IsAirport Security Worth It to You?" for a discussion of safety inairports.

    Is Airport Security Worth It to You?

    Following the September 11, 2001, terrorist attacks, the FederalAviation Administration (now the Transportation SecurityAdministration [TSA] under the U.S. Department of Homeland Security[DHS]) wrestled with a large question: how could a dozen or morehijackers armed with knives slip through security checkpoints attwo major airports? Sadly, it wasn’t hard. Lawmakers and securityexperts had long complained about lax safety measures at airports,citing several studies over the years that had documented serioussecurity lapses. “I think a major terrorist incident was bound tohappen,” Paul Bracken, a Yale University professor who teachesnational security issues and international business, toldWired magazine a day after the attacks. “I think thisincident exposed airport security for what any frequent travelerknows it is—a complete joke. It’s effective in stopping people whomay have a cigarette lighter or a metal belt buckle, but againstpeople who want to hijack four planes simultaneously, it is afailure.”

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

    In the years since the 2001 terrorist attacks, U.S. airportsecurity procedures have undergone many changes, often in responseto current events and national terrorism threat levels. Beginningin December 2005, the Transportation Security Administration (TSA)refocused its efforts to detect suspicious persons, items, andactivities. The new measures called for increased random passengerscreenings. They lifted restrictions on certain carry-on items.Overall, the changes were viewed as a relaxation of the extremelystrict protocols that had been in place subsequent to the events of9/11.

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    The TSA had to revise its airline security policy yet againshortly after the December 2005 adjustments. On August 10, 2006,British police apprehended over twenty suspects implicated in aplot to detonate liquid-based explosives on flights originatingfrom the United Kingdom bound for several major U.S. cities.Following news of this aborted plot, the U.S. Terror Alert Levelsoared to red (denoting a severe threat level). As a result, theTSA quickly barred passengers from carrying on most liquids andother potentially explosives-concealing compounds to flights inU.S. airports. Beverages, gels, lotions, toothpastes, and semisolidcosmetics (such as lipstick) were thus expressly forbidden.

    Less-burdensome modifications were made to the list ofTSA-prohibited items not long after publication of the initialrequirements. Nevertheless, compliance remains a controversialissue among elected officials and the public, who contend that themany changes are difficult to keep up with. Many contended that thechanges represented too great a tradeoff of comfort or conveniencefor the illusion of safety. To many citizens, though, the 2001terrorist plot served as a wake-up call, reminding a nation quietlysettling into a state of complacency of the need for continuedvigilance. Regardless of the merits of these viewpoints, air travelsecurity will no doubt remain a hot topic in the years ahead as theeconomic, financial, regulatory, and sociological issues becomeincreasingly complex.

    Questions for Discussion

    1. Discuss whether the government has the right to impose greatcost to many in terms of lost time in using air travel,inconvenience, and affronts to some people’s privacy to protect afew individuals.
    2. Do you see any morale or moral hazards associated with thehomeland security monitoring and actively searching people anddoing preflight background checks on individuals prior toboarding?
    3. Discuss the issue of personal freedom versus national securityas it relates to this case.

    Sources: Tsar’s Press release atwww.tsa.gov/public/display?theme=44&content=090005198018c27e.For more information regarding TSA, visit our Web site athttp://www.TSA.gov; DaveLinkups, “Airports Vulnerable Despite Higher Level of Security,”Business Insurance, 6 May 2002; “U.S. Flyers Still atRisk,” National Underwriter Property & Casualty/Risk& Benefits Management Edition, 1 April 2002; Stephen Power,“Background Checks Await Fliers,” The Wall Street Journal,7 June 2002. For media sources related to 2006 terrorist plot, seehttp://en.Wikipedia.org/wiki/2006_transatlantic_aircraft_plot#References.

    Key Takeaways

    • You should be able to differentiate between different types ofhazards.
    • You should be able to differentiate between different types ofperils.
    • Can you differentiate between a hazard and a peril?

    Discussion Questions

    1. What are perils?
    2. What are hazards?
    3. Why do we not just call perils and hazards by the name “risk,”as is often done in common English conversations?
    4. Discuss the perils and hazards in box, "Is Airport SecurityWorth It to You?".
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