Objective and Subjective Risk

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Risk can be classify as objective or subjective.

Objective Risks 
Assume that an insurer has 100000 cars insured for a long period of time, and on the average 10000 cars meet with at least one accident and claim for damages each year. However, for a particular year, it is unlikely that there will be exactly 10000 claims. Under certain assumptions, it can be proven that over a long period of time, the deviation of the number of claim in a year from 10000 will, on the average be 100. Thus there is a variation of 100 claims from the expected number of 10000 or a variation of 1%. This relative variation of actual loss from expected loss is known as objective risk.

Objective risk will reduce as the number of exposure increases. In the example above, 100000 cars were insured and the objective risk was 1%. Instead, if 1000000 cars were insured, the expected number of claims will increase from 10000 to 100000 (10% of 1000000 cars) by 10 times, but the variation will only increase from 100 to 316 ( approximately square root of 100000) by slightly more than 3 times. As a result, the relative variation or the objective risk actually reduces from 1% ( 100/10000) to 0.316%(316/100000).

Since objective risk can be statistically measured, it is a very powerful method for managing risk. As the number of exposure increases, the insurer is able to predict its future loss experience more precisely. This phenomenon is based on the law of large numbers. The law states that as the number of exposeur increases, the variation reduces, therefore the actual loss experience will approach the expected loss experience.

Subjective Risk
As the term suggests, subjective risk can be defined as the degree of uncertainty perceived by an individual. It can therefore vary from one person to another. For example, a person who has consumed a large amount of alcohol at a party and intends to drive home will be uncertain if he wil be booked by the police. This mental uncertainty is an instance of subjective risk.

Two persons it the same situation may have different perceptions of the risks and show markedly different attitudes and responses towards the risks. Further, perceptions of risk can be affected by prior experience. If, in the example above, the drinker had been booked previously for driving under the influence of alcohol, he will probably judge that the risk of being booked again is high and may not attempt to drive home.