Risk Management and Insurance Handout

CHAPTER ONE: RISK AND RELATED TOPICS

1.1. RISK DEFINED

No comprehensive definition exists so far. It is defined in different forms by several authors with
some differences in the wordings used. The essence, however, is very similar. In general, risk
refers to exposure to adverse consequences. Some definitions are as follows:

 “Risk is a condition in which there is a possibility of an adverse deviation from a

desired outcome that is expected or hoped for” (1)

In this definition risk exists when there is an adverse (unfavorable) deviation from expectation.
In fact, deviations from expectations could be either favorable or unfavorable. Favorable
deviations are, in most cases, welcome since they have desirable effects. Risk generally is
associated with bad and harmful incidents. Accordingly, some explain risk as a situation where
there is unfavorable (harmful) deviation from what has been expected.

Look at the following definition of risk given by Crowe & Horn:

 “Risk is the possibility that an entity will incur loss” (2)

The underlying theme of this definition is the explanation given to “loss” by the authors. The
loss under their definition is explained as an “Involuntary reduction in the capacity of an entity to
satisfy its wants”. Thus, loss” is presented as similar to the economic concept of utility.

Willet defined risk in the following manner:

 “Risk is the objectified uncertainty as to the occurrence of an undesired even. It varies

with uncertainly and not with the degree of Probability” (3)

The central theme is still prevalent – the possibility of undesired event. More than explaining the
essence, the definition implies the existence of two types of uncertainties: objective and
subjective uncertainty. Moreover, the definition indicates the positive relationship of risk and
uncertainty. It also implies that risk and probability are two different concepts although they may
have functional relationship.

Greene and Serbian defined risk as:

 “… The uncertainty of occurrence of economic loss” (4)

In this definition, the loss is considered as generally economic in nature; meaning the loss is
economically measurable.

The following definition of risk is given by Athearn:

\
1
 Risk Management and Insurance Handout

 “The possibility of an unfavorable deviation from expectations; it is the possibility that

something we do not want to happen will happen or that something we want to happen
will fail to do so” (5)

Athearn called the unfavorable deviation a loss; and this loss, although in most cases has
economic implications, may at times be difficult to describe in economic terms. For
example, the unexpected death of a pet could be a great loss to a family. But, the loss cannot
be measured in economic terms. The loss whether or not measurable in economic terms is an
incident to be avoided. It is an unfavorable occurrence.

Another important point mentioned by Athearn is that expectations may or may not be
thought consciously or described verbally. In many business endeavors expectations are
consciously described in the form of plans or project undertakings. In other situations, for
example, one normally expects to find his car safe in a parking lot. If the car is stolen, there
is a loss to the individual. But, his expectation to get his car safe was not in any way
consciously formulated or verbally stated.

Williams and Heins defined risk as:

 “…the variations in the outcomes, that could occur over a specified period in a given
situation” (6). According to their definitions there will be no risk if there is only one
outcome.

1.2 Risks vs. Uncertainty

It is the condition that exists when decision making must rely on incomplete yet reliable
information. In risk we can discuss with certainty and uncertainty.

Certainty: It is the condition that exists when decision makers are fully informed about the
problem, its alternative solutions and their respective outcomes.

Uncertainty: It is the condition that exists when little or no actual information is available about
a problem, its alternative solutions and their respective outcomes.

Generally if the information is available there is a certainty and there will be low risk.

Even though risk and uncertainty are closely related and most of the time used interchangeably,
they are not the one and the same. Uncertainty describes the state of mind and it is subjective
belief where as risk is state of world.

Risk is combination of hazards and it is measured by probability concept

1.3 RISK AND PROBABILITY OVERVIEW

Where one defines risk as a chance of loss, it would be very difficult to make significant
difference between risk and probability. The other difficulty is whether or not probability
measures risk. For example, what we have seen in the above definition of risk stated that risk is
measured by probability

\
2
 Risk Management and Insurance Handout

Probabilities are generally assigned to events that are expected to happen in the future. There
may be a number of possible events that will take place under given set of conditions; and these
events may occur in equal or different chance of occurrence. The weights given to each possible
event may depend on prior knowledge, (toss of a coin), past experience, statistical or
mathematical estimation of relevant data or possible event is assigned a corresponding
probability of occurrence that leads to probability distribution. This means that probability
relates to a single possible event.

Risk, on the other hand, refers to the variation in the possible outcomes. This means that risk
depends on the entire probability distribution. It indicates the concept of variability. The
concepts of risk and probability are, therefore, two different things.

The following example illustrates the distinction between risk and probability. Suppose the
occurrence of a particular event is to be considered. One extreme is that this event certainly to
take place is 1. There is certainty as to the occurrence of this event with perfect foresight in this
regard accordingly, there is no risk. The other extreme is that the event will not take place at all.
Hence, the probability of occurrence is zero. Here, too, there is certainty and therefore, there is
no risk. In between these two extreme there could be several occurrences of the events with the
corresponding probabilities of occurrence. This puts us in situation of uncertainty because it is
difficult to exactly tell which of the many possible events will take place.

1.4. RISK, PERIL AND HAZARD

Risk has already been defined above. Two concepts, peril and hazard must be distinguished from
risk. The three concepts have one common feature; however, All of them transmit bad taste or
feeling.

Peril: refers to the specific cause of a loss, such as fire, windstorm, theft, explosion, flood etc….
The source of a specific loss is, therefore, called a peril.

Hazard: refers to “the condition that may create or increase the chance of a loss arising from a
given peril. The more hazardous conditions are, the higher the chance of loss. Three categories of
hazard are identified:

1. Physical Hazard

This is associated with the physical properties of the item exposed to risk. Examples of physical
hazard include the following

Type of construction, (wood, bricks)

Location of property, (near burglar area, flood area, earthquake)

Occupancy of building, (dry cleaning, chemicals, super market)

Working condition, (personal accidents)

Use of automobiles, (private, business)

\
3
 Risk Management and Insurance Handout

2. Moral Hazard

This originates from evil tendencies or dishonesty in the character of the insured person. It is
associated with human nature; qualities, reputation, attitude etc… Examples include the
following:

Dishonesty, fraudulent intention, exaggeration of claims, etc…

3. Morale Hazard

This originates from acts of carelessness leading to the occurrence of a loss. It does not involve
dishonesty but it occurs due to lack of concern for events. For example, Poor housekeeping in
stores and Cigarette smoking around petrol stations.

In some situation, it is difficult to distinguish between a peril and a hazard. For example, a fire in
progress may be regarded as a peril concerning the loss of physical property. It may also be
regarded as a hazard concerning auto collisions created by the confusion.

4. Legal Hazard

It is characteristics of legal system/regulatory environment that increase the frequency of or

severity of government laws that may change quite often based on new development. For
example, the government may declare that HIV/AIDS related death has health insurance
coverage. At this time there will be high risk for insurance company.

1.5. CLASSIFICATION OF RISK

1. Financial Vs Non-financial Risks

This classification is self-explanatory. Financial risk results in losses that can be expressed in
financial terms. Non financial risk does not have financial implication.
2. Statistic Vs Dynamic Risks
This classification of risk is given by Willet; Dynamic risks originate from changes in the overall
economy such as: Price level changes, changes in consumer taste, income distribution,
technological changes, political changes and the like. They are less predictable and hence beyond
the control of risk managers. Static risks on the other hand, refer to those losses that can take
place even though there were no changes in the over –all economy. They are losses arising from
causes other than changes in the economy.

3. Fundamental Vs Particular Risks

The analysis of risk into Fundamental and particular is made by Kulp . Kulp distinguished the
two types of risks as follows:
Fundamental risks are essentially group risks: the conditions which cause them have no relation
to any particular individual. Most fundamental risks are economic, political or social …

\
4
 Risk Management and Insurance Handout

Particular risks are those due to particular conditions, which obtain in particular causes they
affect each individual separately… They are usually personal in cause, almost always personal in
their application. Because they are so largely personal in their nature, the individual has a certain
degree of control over their causes.

Thus, fundamental risks affect the entire society or a larger segment of the population, which are
usually, beyond the control of individuals. The responsibility for tackling these risks is,
therefore, left to the society itself. Examples include; unemployment. Famine, flood; inflation,
war, etc … they are generally uninsurable.

Particularly risks are the responsibility of individuals. They are dealt with by purchasing
insurance policies and other techniques. Examples include: property losses, death, disability,
etc….

4. Diversifiable vs. Non Diversifiable

A risk is said to be non diversifiable where the pooling agreements are ineffective in reducing
risks for participants in the pool.
e.g. 1930s worldwide economic depression
Diversifiable risks refer to situation where it is possible to reduce risks through pooling or risk
sharing agreement.
E,g purchasing insurance premium.

5. Objective Vs Subjective Risk

These two types of risk are also mentioned as Measurable and Non-measurable Risk. Objective
risk has been defined as “.the relative variation of actual from expected loss. However, the
amount of objective risk present in a situation some times, referred to as degree of risk. It is the
relative variation of actual from expected loss.
Objective risk = probable variation of actual from expected loss

The characteristic of objective risk is that it is measurable. In other words, it can be quantified
using statistical or mathematical techniques. For example, the variance or standard deviation is
used as a measure of risk in finance. In some situations, the coefficient of variation is used as a
measure of risk.
Subjective risk is defined as uncertainty based on a person’s mental condition or a state of mind.
A subjective risk is a psychological uncertainty that stems from the individual’s mental attitude
or a state of mind.

6. Pure Vs Speculative risks

The distinction between pure and speculative risks, rest primarily on profit/ loss structure of the
underlying situation, in which the event occurs. Pure risks refer to the situation in which only a
loss or no loss would occur. There are only two distinct outcomes; loss or no loss. Most pure
risks are insurable. They are always undesirable and hence people take steps to avoid such risks.
Speculative risks, on the other hand, provide favorable or unfavorable consequences. The
situation is characterized by a possibility of either a loss or a gain.

\
5
 Risk Management and Insurance Handout

Pure risks are further classified into three categories.

Personal Risk

This refers to the possibility of loss to a person such as: death, disability, loss of earning power
etc…

Property Risk

This refers to losses associated with ownership of property, such as destruction of property by
fire. The risk, in addition, to direct losses, may result in an indirect loss which is commonly
called consequential loss: loss of income due to interruption of operation. Property risk stems
from diverse perils accompanied by different hazards: physical, moral or morale.

Liability Risk

Intentional or unintentional damage made to other persons or to their property. One would be
legally obliged to pay for the damages he inflicted upon other persons or their property. And also
this type of pure risk is known as third person risk.

RISK RELATED TO BUSINESS ACTIVITIES

Most risks in business environment are speculative in nature: The finance literature considers
four types of risk that business organizations face in the course of their normal operation.

Financial Risk

This is associated with debt financing. Borrowing results in the payment of periodic interest
charge and the payment of the principal upon maturity. There is a risk of default by the company
if operations are not profitable.
Other financial risks include; bankruptcy, stock price decline, insolvency, bond holders because
they have a priority claim against the assets of an insolvent firm. Government securities,
however, bear very low risk.

Interest Rate Risk

Interest rate is the price paid by capital structure .This is a risk resulting from changes in interest
rates. Changes in interest rates affect the prices of financial securities such as the prices of bonds
etc… For example interest rate rise depresses bond prices and vice versa.
Purchasing Power Risk

This risk arises under inflationary situations (general price rise of goods and services) leading to
a decline in the purchasing power of the asset held. Financial assets lose purchasing power if
increased inflationary tendencies prevail in the economy.

\
6
 Risk Management and Insurance Handout

Market Risk

Market risk is related to stock market. It refers to stock price variability caused by market forces.
It is the result of investor’s reactions to real or psychological expectations. For example, some
forecasts may convince investors that the economy is heading, towards a recession. The market
index would decline accordingly. In other situation investors erroneously overreact to events and
affect the market by making abnormal transactions. The market, in many cases, is also affected
by such events as: presidential elections, trade balances, balance of payment figures, wars, new
inventions, etc…. market risk is also called systematic or non-diversifiable risk. All investors are
subject to this risk. It is the result of the working of the economy; and cannot be eliminated
through portfolio diversification…. However, investors are paid for this risk.

1.6. Sources of Risk

Source of risk are the sources of factors or hazards that may contribute to positive or negative
outcomes. Sources of risks can be classified in several ways these are:

Physical Environment
The physical environment can be source of risk. Earth quake, drought, or excessive rain fall can
all lead to loss. The ability to fully understand our environment and the effect we have on it –as
well as those it has on us – is the central aspects of this source of risk. The physical environment
may be the source of opportunity as well; for example Agro business and weather as contributing
factor to tourism.

Social Environment
Changing traditions and values, human behaviors, social structure and institution can be source
for risk.

Legal Environment
The expected laws and directives maybe issued by the government, which may render risk
environment to the business operating in the country. In the international domain, complexity
increases b/se legal standards can be vary dramatically from country to country. The legal
environment can also produce positive outcomes in the sense that rights are protected and the
legal system provide stabilizing influence on society.

Operational Environment
Process and procedures of an organization generate risk and uncertainty. A formal procedure of
promoting, hiring, or firing employees may generate a legal liability. The manufacturing process
may put employees at risk of physical harm. Activities of an organization may result in harm to
the environment. International business may suffer from risk or uncertainty due to unreliable
transportation systems. The operational environment also provides gains, as it is the ultimate
source of the goods and services by which an organization succeeds or fails.

Economic Environment
Although the economic environment often flows directly from the political realm, the dramatic
expansion of the global market place has created an environment that is greater than any single

\
7
 Risk Management and Insurance Handout

environment. Although a particular government s action may affect international capital markets,
control of capital market beyond the reach of a single nation. Inflation recession and depression
are now elements of independent economic systems. On a local level, interest rates and credit
policies can impose significant risk on an organization.

\
8