CHAPTER

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Fundamentals of Risk
 Learning Outcomes

Fundamentals of Risk

Pure risks faced

Classifications Attitudes
Basic Concepts by individuals
of Risk towards risk
and businesses
 INTRODUCTION

• we encounter many risky situations in our daily lives. From the

moment we get up from bed, take a shower in the bathroom, prepare
our meal in the kitchen and take a bus or drive to campus or work,
we are exposed to a number of risks.
• Even though we usually take the effort to be careful, misfortunes do
happen, causing grief and loss that may severely affect us.
• However, as you will learn in later chapters of this book, there are
various measures that can be undertaken to manage risk, thereby
reducing the probability of its adverse consequences.
 BASIC CONCEPTS
CERTAINTY, UNCERTAINTY AND LOSS

• A certainty is a situation where an outcome is sure to

happen. An example of a certainty is that all of us are
bound to die. This is a fact and the outcome is certain.
• Uncertainty, on the other hand, is a situation where the
outcome cannot be determined with accuracy.
• Loss refers to a reduction in value that can be measured in
monetary terms.
 BASIC CONCEPTS
RISK

• we define risk as a situation of uncertain possible

outcomes of loss.
• In finance, risk of an investment is measured using standard
deviation-which in essence, measures the variability of outcomes
from expected returns. The higher the variability, the higher the
standard deviation or risk involved in the investment.
• Since risk relates to a probable loss, there is a cost associated with
risk. The higher the risk, the higher the cost will be.
 BASIC CONCEPTS
LOSS EXPOSURE

• A loss exposure is a condition where a potential loss may or

may not occur.
Direct and Indirect Loss
• Direct loss refers to loss that occurs resulting from a
catastrophe .
• The indirect loss is the additional loss that results from
the direct loss.
• Peril is defined as the cause of a loss.
BASIC CONCEPTS
 BASIC CONCEPTS
LOSS EXPOSURE

Hazard: Hazard is a situation that increases the chances of a loss,

either through the severity or frequency of a loss. Hazards may be
grouped under three groups as described below:
• A physical hazard relates to a physical condition that
increases the probability of the loss.
• Moral hazard refers to deliberate acts of dishonesty that
increase the severity or frequency of a loss.
• Attitudinal hazard refers to an individual's careless or
indifferent attitude that increases severity or frequency of a
loss due to the presence of insurance.
 CLASSIFICATIONS OF RISK
> Pure vs Speculative Risks
• Pure risk is a condition in which there are two possible outcomes: a chance of loss
or no loss. Hence, there is no possibility of a gain.
• Speculative risk refers to a situation in which there are three possible outcomes: a
chance of loss, no loss, or a gain.
> Diversifiable vs Non-Diversifiable Risks
• Diversifiable risks are risks that involve only a small proportion of people from a
relatively large group, and can be reduced by diversification.
• Non-diversifiable risks are risks that involve a large number of people or the whole
economy (aka fundamental or systematic risk).
> Insurable vs Non-Insurable Risks
• Risks that are insurable are pure risks, that is, risks that involve a chance of loss or
no loss. Non-insurable risks are those that involve speculative risk.
PURE RISKS FACED BY INDIVIDUALS AND BUSINESSES

Death of a child is Risk of

NOT premature Premature death

Risk of poor
health
Personal Risks
Risk of
unemployment
Pure risks faced
Property Risks
by Individuals
Risk of
longevity
Liability Risks
PURE RISKS FACED BY INDIVIDUALS AND BUSINESSES

Risk to human
resources

Crime risk
Other risks
Intangible risk
Property Risks
Pure risks faced
Regulatory risk
by Businesses
Loss of Business
Income

Liability Risks
 ATTITUDES TOWARDS RISK
Risk tolerance: Risk tolerance measures how much risk a person is
willing to endure. The level of risk tolerance an individual is willing to
take varies by age, gender, occupation, income, marital status and
expectations. There are three types of risk tolerance:
• A risk averse person is one who, given the same amount of risk,
prefers a lower but guaranteed returns, as opposed to an option that
gives higher but uncertain returns.
• A risk neutral person is one who is indifferent about risk. Thus, in
making decisions, risk will not influence his decisions.
• A risk seeker is one who loves taking risks.
 END OF
CHAPTER
ONE