UNIT-2

RISK
Meaning-:
Risk is the possibility of something bad happening. Risk involves uncertainty
about the effects/implications of an activity with respect to something that
humans value (such as health, well-being, wealth, property or the environment),
often focusing on negative, undesirable consequences.
Risk is defined in financial terms as the chance that an outcome or investment's
actual gains will differ from an expected outcome or return. Risk includes the
possibility of losing some or all of an original investment.

All investments involve some degree of risk. In finance, risk refers to the degree
of uncertainty and/or potential financial loss inherent in an investment decision.
In general, as investment risks rise, investors seek higher returns to compensate
themselves for taking such risks.

Every saving and investment product has different risks and returns. 
Differences include: how readily investors can get their money when they need
it, how fast their money will grow, and how safe their money will be.

Risk has been defined as the possibility of occurrence of an unfavourable

deviation expected that is what you want to happen does not happen or vice-
versa, i.e., what you don’t want to happen actually happen.

TYPES OF RISK
1) Financial and Non-Financial Risks

Financial risks are the risks where the outcome of an event (i.e. event giving
birth to a loss) can be measured in monetary terms.

The losses can be assessed and a proper money value can be given to those
losses. The common examples are:

 Material damage to property arising out of an event.

 Theft of a property which may be a motorcycle, motor car, machinery,
items of household use or even cash.
 Loss of profit of a business due to fire damage the material property.
 Personal injuries due to the industrial, road or other accidents
  Death of a breadwinner in a family leading to corresponding financial
hardship.

All such losses, i.e. the outcome of unforeseen untoward events can be
measured in monetary terms. The losses can be replaced, reinstated or repaired
or even a corresponding reasonable financial support (in case of death) can be
thought about.

We would call all such financial risks as insurable risks and these are indeed the
main subjects of insurance.

Non-Financial risks are the risks the outcome of which cannot be measured in
monetary terms. There may be a wrong choice or a wrong decision giving rise
to possible discomfort or disliking or embarrassment but not being capable of
valuation in money terms.

Examples-:

 Choice of a car, its brand, colour, etc.

 Selection of a restaurant menu,
 Career selection, whether to be a doctor or engineer etc.
 Choice of bride/bridegroom,
 Choice of publicity etc.

Since the outcome cannot be valued in terms of money, we shall call these non-
financial risks as uninsurable.

2) Pure Risk and Speculative Risks

Pure risks are those risks where the outcome shall result in loss only or at best
a break-even situation. We cannot think about a gain-gain situation. The result
is always unfavourable, or maybe the same situation (as existed before the
event) has remained without giving birth to a profit (or loss).

As opposed to this, speculative risks are those risks where there is the
possibility of gain or profit. At least the intent is to make a profit and no loss
(although loss might ensue).

Investing in shares may be a good example. Pricing, marketing, forecasting,

credit sale, etc. are yet examples falling within the domain of speculation.

Consider another example where we can have the existence of both pure risks
and speculative risks. A garment factory may be in our minds. Here we have:
  Cyclone damage possibility to the factory building,
 Fire damage possibility to stock,
 Machinery breakdown possibility to Machinery,
 Theft possibility to removable items,
 Personal accident possibility of factory workers etc.

Also, we have:

 the question of pricing of the product to remain in the competitive

market,
 the question of fashion changes leading to a drastic fall in the demand of
the product,
 the question of withdrawal of quota system,
 the question of credit sale

In the first set of examples we are indeed talking about the possibility of certain
losses emanating from certain untoward events or unforeseen contingencies
(like a cyclone, fire, theft, accident, etc.) and for convenience we shall call them
the risks of trade.

These are identified as pure risks and as such insurable. Notice that these losses
can also be measured in monetary terms.

As opposed to this, if we refer to the second set of examples we notice that the
outcome of the trade or business is not the result of pure risks but indeed the
result of economic factors, supply & demand, change of fashion, trade
restriction or liberalization, etc. and for convenience we call them trade risks.

These may be identified as speculative risks and usually not insurable.

3) Fundamental Risk and Particular Risks

Fundamental risks are the risks mostly emanating from nature. These are the
risks that arise from causes that are beyond the control of an individual or group
of individuals.
The losses arising out of such causes may be catastrophic in dimension and felt
by a huge number of populations, the society or by the state although an
individual may be a part of that catastrophe. The common examples are:
 Flood & Cyclone, Subsidence & landslip,
 Earthquake & volcanic eruption, Tsunami,
 The convulsion of nature and other natural disasters,
 Famine, Draught
We may also add in the list perils like war, terrorism, riots & other political
activities which are neither created by nature nor by an individual but resulting
in colossal losses.
But one thing is certain which are this that all such perils are impersonal not
being caused or contributed by an individual or even a group of individuals.
Normally fundamental risks were not supposed to be insurable because of the
magnitude and these were considered to be the responsibility of State. Now
because of demand and insurers’ strength, these risks are easily insurable.
Particular risks are; as opposed to what has been narrated hereinbefore, there
are risks which usually arise from actions of individuals or even group of
individuals.
These may be identified as causes arising from personal (or group) behavior and
effects (losses) not being of that magnitude. These are mostly men created
because of their negligence, error in judgment, carelessness, and disregard for
law or respect.
We may even go onto suggesting that these are indeed the cases (both cause and
effect) where there has been an omission to do something which should have
been done or there has been done something which should not have been done.
We may call these as risks of personal nature. The common examples are:
 Fire, Explosion,
 Burglary, housebreaking, larceny, and theft,
 Stranding, Sinking, Capsizing, Collision in case of a ship, including cargo
loss,
 Machinery breakdown and deterioration of stock due to machinery
breakdown,
 Motor accidents including death and bodily injuries, Industrial accidents,
 The collapse of bridges, Derailments.
Particular risks are insurable risks and most of the insurances relate to these
risks.

METHODS OF HANDLING RISK

1. Risk Control/ Transferring Risk
Risk control is the best method of managing risk and usually the least
expensive. Risk control involves avoiding the risk entirely or mitigating the risk
by lowering the probability and magnitude of losses. Many risks cannot be
avoided, but almost all risks can be mitigated through the use of loss control.
Nonetheless, even losses from mitigated risks can be expensive, so both people
and businesses usually transfer some of that risk to 3r d  parties.
2. Avoiding Risk
The surest way to prevent the potential loss arising from a certain activity is to
completely avoid it. For example, if I want to avoid the possibility of having to
pay for a stranger’s medical expenses due to an auto accident, I could stop
driving a car. So why not just avoid all risks? The problem is that whenever we
avoid a risk we also miss out on the benefits we could have received for
participating in the associated activity. In addition, not all risks can be
completely avoided, such as the risks of illness or natural disaster.

Risk avoidance is the elimination of risk. You can avoid the risk of a loss in the
stock market by not buying or shorting stocks; the risk of a venereal disease can
be avoided by not having sex, or the risk of divorce, by not marrying; the risk of
having car trouble, by not having a car. Many manufacturers avoid legal risk by
not manufacturing particular products.
3. Risk Reduction
Loss control (a.k.a. risk reduction) can either be effected through loss
prevention, by reducing the probability of risk, or loss reduction, by minimizing
the loss. Loss prevention requires identifying the factors that increase the
likelihood of a loss, then either eliminating the factors or minimizing their
effect. For instance, speeding and driving drunk greatly increase auto accidents.
Not driving after drinking alcohol is a method of loss prevention that reduces
the probability of an accident. Driving slower is an example of both loss
prevention and loss reduction, since it both reduces the probability of an
accident and, if an accident does occur, it reduces the magnitude of the losses,
since accidents at slower speeds generally cause less damage. Salvage
operations may also reduce the cost of the loss.
Most businesses actively control losses because it is a cost-effective way to
prevent losses from accidents and damage to property, and generally becomes
more effective the longer the business has been operating, since it can learn
from its mistakes. Businesses can control losses through either an engineering
approach or behavioural approach. The engineering approach sets up both the
business environment and procedures to lower the probability of losses. For
instance, using robots to perform hazardous procedures eliminates the risk of
having people perform those procedures. The behavioural approach recognizes
that many losses are incurred because of human error or lack of training, so
workers are trained to follow procedures that will lower the probability of losses
or the magnitude of those losses. Monitoring the workers to ensure that they are
practicing safety is another effective means of loss control.
4. Risk Retention
Risk retention, (aka active retention, risk assumption), is handling the
unavoidable or unvoiced risk internally, either because insurance cannot be
purchased or it is too expensive for the risk, or because it is much more cost-
effective to handle the risk internally. Usually, retained risks occur with greater
frequency, but have a lower severity. An insurance deductible is a common
example of risk retention to save money, since a deductible is a limited risk that
can save money on insurance premiums for larger risks. Businesses actively
retain many risks — what is commonly called self-insurance — because of the
cost or unavailability of commercial insurance.
Retention is the most suitable approach when the potential severity of a loss is
low, regardless of how frequently it is expected to occur, or if the cost of
insuring the risk would be higher over time than the actual potential loss
incurred.

Risk can also be managed by noninsurance transfers of risk. The 3 major

forms of noninsurance risk transfer are by contract, hedging, and, for business
risks, by incorporating. A common way to transfer risk by contract is by
purchasing the warranty extension that many retailers sell for the items that they
sell. The warranty itself transfers the risk of manufacturing defects from the
buyer to the manufacturer. Transfers of risk through contract is often
accomplished or prevented by a hold-harmless clause, which may limit liability
for the party to which the clause applies.
Hedging is a method of reducing portfolio risk or some business risks involving
future transactions. Thus, the possible decline of a stock price can be hedged by
buying a put for the stock. A business can hedge a foreign exchange transaction
by purchasing a forward contract that guarantees the exchange rate for a future
date.
Insurance is another major method that most people, businesses, and other
organizations can use to transfer pure risks, by paying a premium to an
insurance company in exchange for a payment of a possible large loss. By using
the law of large numbers, an insurance company can estimate fairly reliably the
amount of loss for a given number of customers within a specific time. An
insurance company can pay for losses because it pools and invests the premiums
of many subscribers to pay the few who will have significant losses.

PEIRL
A peril is an event, like a fire or break-in, that may damage your home or
belongings. The perils covered by your homeowner’s insurance are listed in
your policy.
A peril is any event, situation, or incident that causes property damage or loss.
Fire, theft, wind, and vandalism are common perils that homeowner’s insurance
can cover. It’s important to understand which perils your policy covers and
which perils it doesn’t so you know when you can count on your insurance to
pick up the repair bill if necessary.
16 named perils:
 • Fire or lightning
 • Windstorm or hail
 • Explosion
 • Riots
 • Aircraft
 • Vehicles
 • Smoke
 • Vandalism
 • Theft
 • Falling objects
 • Weight of ice, snow, or sleet
 • Accidental discharge or overflow of water or steam
 • Sudden and accidental tearing, cracking, burning, or bulging
 • Freezing
 • Sudden and accidental damage due to short circuiting
 • Volcanic Eruption
HAZARD
Hazard insurance is coverage that protects a property owner against damage
caused by fires, severe storms, hail/sleet, or other natural events. As long as the
specific weather event is covered within the policy, the property owner will
receive compensation to cover the cost of any damage incurred.
Hazard describes anything that increases the potential for a loss. (An
unintended, unforeseen event that causes injury to an insured or damage to
property.
For insurance purposes, hazards are classified as one of four types:
 • Physical hazards.
 • Legal hazards.
 • Moral hazards.
 • Morale hazards.

Physical Hazards
A physical hazard increases the likelihood of a loss occurring due to
inadequacies in the condition, structure, or operation of an insured or insured
property. For example, a roof covered with heavy snow might be considered a
physical hazard when it comes to homeowner’s insurance, including High-
Value home insurance. At the same time, a health insurance policy might
consider an insured’s heart condition to be a physical hazard.

Legal Hazards
A legal hazard meanwhile, increases the likelihood and severity of a loss due to
a condition imposed by the legal process that forces an insurer to cover a risk
that it would otherwise deem uninsurable. For example, the American legal
system motivates many people to bring litigation suits in order to realize the
potentially lucrative profits in doing so. Anything that might prompt a lawsuit
involving an insurer can be considered a legal hazard.

Morale Hazards
A morale hazard, as the name might suggest, results from fraudulent acts
committed by an insured. Examples of morale hazards include filing false
insurance claims or misrepresenting oneself on a life insurance application in
order to obtain coverage or more favorable coverage terms.

Moral Hazards
Not to be confused with morale hazards, a moral hazard results from a lack of
reasonable care put forth by an insured. For example, consider an insured whose
wallet is stolen from his car because the doors were left unlocked. This would
be a morale hazard, as the insured did not take the necessary care to prevent his
valuables from being stolen.

Moral Vs. Morale Hazards

 • The difference between a moral hazard and a morale hazard is the intent.
 • A moral hazard arises out of an individual’s deliberate intent to deceive.
 • A morale hazard, on the other hand, results from unintentional carelessness or
laziness.

RISK MANAGEMENT
Risk management is the process of identifying, assessing and controlling threats
to an organization's capital and earnings. These risks stem from a variety of
sources including financial uncertainties, legal liabilities, technology issues,
strategic management errors, accidents and natural disasters.
‘Risk Management’ refers to the systematic application of principles, approach,
and processes to the tasks of identifying and assessing risks, and then planning
and implementing risk responses. This provides a disciplined environment for
proactive decision-making.

PROCESS-:

Step 1: Identify the Risk

The initial step in the risk management process is to identify the risks that the
business is exposed to in its operating environment.
There are many different types of risks:
 • Legal risks
 • Environmental risks
 • Market risks
 • Regulatory risks etc.
It is important to identify as many of these risk factors as possible. In a manual
environment, these risks are noted down manually. If the organization has a risk
management solution employed all this information is inserted directly into the
system.
The advantage of this approach is that these risks are now visible to every
stakeholder in the organization with access to the system.

Step 2: Analyze the Risk

Once a risk has been identified it needs to be analyzed. The scope of the risk
must be determined. It is also important to understand the link between the risk
and different factors within the organization. To determine the severity and
seriousness of the risk it is necessary to see how many business functions the
risk affects. There are risks that can bring the whole business to a standstill if
actualized, while there are risks that will only be minor inconveniences in the
analysis.

Step 3: Evaluate the Risk or Risk Assessment

Risks need to be ranked and prioritized. Most risk management solutions have
different categories of risks, depending on the severity of the risk. A risk that
may cause some inconvenience is rated lowly, risks that can result in
catastrophic loss are rated the highest. It is important to rank risks because it
allows the organization to gain a holistic view of the risk exposure of the whole
organization. The business may be vulnerable to several low-level risks, but it
may not require upper management intervention. On the other hand, just one of
the highest-rated risks is enough to require immediate intervention.
Step 4: Treat the Risk
Every risk needs to be eliminated or contained as much as possible. This is done
by connecting with the experts of the field to which the risk belongs. In a
manual environment, this entails contacting each and every stakeholder and
then setting up meetings so everyone can talk and discuss the issues. The
problem is that the discussion is broken into many different email threads,
across different documents and spreadsheets, and many different phone calls.

Step 5: Monitor and Review the Risk

Not all risks can be eliminated – some risks are always present. Market risks
and environmental risks are just two examples of risks that always need to be
monitored. Under manual systems monitoring happens through diligent
employees. These professionals must make sure that they keep a close watch on
all risk factors. Under a digital environment, the risk management system
monitors the entire risk framework of the organization. If any factor or risk
changes, it is immediately visible to everyone. Computers are also much better
at continuously monitoring risks than people. Monitoring risks also allows your
business to ensure continuity.

Importance of Risk Management

Risk management is an important process because it empowers a business with
the necessary tools so that it can adequately identify and deal with potential
risks. Once a risk has been identified, it is then easy to mitigate it. In addition,
risk management provides a business with a basis upon which it can undertake
sound decision-making.
To reduce risk, an organization needs to apply resources to minimize, monitor
and control the impact of negative events while maximizing positive events. A
consistent, systemic and integrated approach to risk management can help
determine how best to identify, manage and mitigate significant risks.

Objectives of Risk Management

1. Ensure the management of risk is consistent with and supports the
achievement of the strategic and corporate objectives.
2. Provide a high-quality service to customers.

3. Initiate action to prevent or reduce the adverse effects of risk.

4. Minimize the human costs of risks, Where reasonably practicable.

5. Meet statutory and legal obligations.

6. Minimize the financial and other negative consequences of losses and claims.

7. Minimize the risks associated with new developments and activities.

8. Be able to inform decisions and make choices on possible outcomes.