FIN4243 / BEC4248

Risk Management and

Insurance

T. P. Rathnasuriya
;;

Department of Finance
Faculty of Management and Finance
University of Colombo
 Lesson 01

An Introduction to Risk and Uncertainty

2
 NO Is there a Risk ? YES
RISK ANALYSIS

Can it be Avoided or
NO Can it be Reduced ?
Eliminated ?

RISK EVALUATION YES

Avoid or Eliminate YES

Is the residual Risk

Disregard NO
Significant ?

Is it a YES
NO
Catastrophe ?
RISK FINANCING
Can it be Retained ?
YES Transfer

Retain Other Insurance 3

• Life is full of risks

• Personal risks

• Business risks

4
 Concepts
Certainty

• free from doubt, definite

• Theoretical condition in which decision making is

without risk, because the decision maker has all
the information about the exact outcome of the
decision, before he or she makes the decision.
• Know the objectives and have accurate,
measurable, reliable information about the
outcome of each available alternative.
 
5
Uncertainty
Situation where the current state of knowledge is such that
• the order or nature of things is unknown
• the consequences, extent, or magnitude of
circumstances, conditions, or events is unpredictable, and
• credible probabilities to possible outcomes cannot
be assigned

Lack of information or knowledge makes the outcome of each

alternative unpredictable such that no probabilities can be
determined.

6
 Uncertainty, Information and
Communication
• Reduction of uncertainty has economic value

• Information can reduce the levels of uncertainty but will

depend on the type of information to identify the possible
outcomes

• Communication can reduce the levels of uncertainty.

• Communicating and informing the stakeholders, would

reduce the levels of uncertainty in their minds

7
 Risk
• Risk is potential variation in outcomes or gives rise to possible
gain or loss that cannot be predicted.

Risk is an uncertainty; creates both problems and opportunities.

• Risk has an unknown outcome, and a known underlying outcome

distribution.

• Probabilities can be assigned to each outcome.

8
• Typical dictionary definition of risk is a chance or
possibility of danger, loss, injury or other adverse
consequences.

• Risk is the “effect of uncertainty on objectives”

and an effect is a positive or negative deviation from
what is expected.

• So, risk is the chance that there will be a positive or

negative deviation from the objective you expect to
achieve. (ISO 31000)

9
• Risk consists of two components
• Objective : measurable component of the risk
• Subjective: individual’s attitude towards the risk

• Information lessens the doubt a person has about

predictability

• Risks could be reduced by pooling/sharing

• Non-diversifiable risks are those which cannot be reduced by

pooling/sharing

10
• In financial management view, risk is the chance that
an investment's actual return will be different than
expected. Risk includes the possibility of losing some or
all of the original investment.

• Different versions of risk are usually measured by

calculating the standard deviation of the historical
returns or average returns of a specific investment. A
high standard deviations indicates a high degree of risk.
11
 Certainty
Possibility of failure

Managerial Control
Risk

Uncertainty

12
 The Certainty – Uncertainty Continuum

Level if Uncertainty Characteristics Examples

None (Certainty) Outcomes can be Physical laws, natural
predicted with precision sciences

Level 1 Outcomes are identified Throwing a dice

(Objective uncertainty) and probabilities are Flipping a coin
known
Level 2 Outcomes are identified Fire, Outcome of a
(Subjective uncertainty) but probabilities are match, investments
unknown

Level 3 (uncertainty) Outcomes are not fully Space exploration,

identified and genetic research, new
probabilities are markets
unknown
13
 Archimedes' principle (physical law
of buoyancy)
Any object, wholly or partially immersed in a fluid, is
buoyed up by a force equal to the weight of the fluid
displaced by the object.
Archimedes

14
Objective probability is the basis for risk, while
subjective probability underlies uncertainty. 15
 Risk averse, Risk neutral and Risk seeker

A psychological state of mind,

Risk averse
being worried of risk and would pay more to avoid it

Risk neutral
does not have a bearing and has no effect

Risk seeker
don’t care and would in fact seek risky situations

16
 Hazard
A hazard is a situation that poses a level of
threat to life, health, property, or environment.

Hazard and possibility interact together to

create risk.

Hazard
Physical
Moral

17
 Physical Hazard
• Refers to physical condition or characteristics of the
subject matter.

• Such hazards may or may not be within human control,

can be both natural and human made elements.

• Physical issues which are likely to influence the

frequency of the loss and/or severity.

E.g.: earthquake, fire, floods, poor storage, irregular

maintenance (poor housekeeping, excessive vibration,
improper wiring etc.)

18
 Moral Hazard
Stems from an individual’s mental attitude which has a
bearing on insurance/risk.

Intentional actions designed either to cause a loss or

increase its severity.

(Concealing information, dishonesty, bad attitude, difficult to

negotiate, fraud, profit from insurance)

19
Do we need to

manage risks ???

20
 Managing Risks and Uncertainties

• Risk imposes cost to the organization – Cost of risk

E.g.: Loss by fire or robbery

• Cost of risk is the sum of

• The cost of strategies to reduce risks
(e.g.: fire alarms, internal control systems)
• Expenses of strategies to finance potential losses
• The cost of unreimbursed losses
• The opportunity cost of activities forgone due to risk
considerations (e.g.: expansion to hill country)
21
 Managing risks and Uncertainty

Uncertainty too has a cost on the organization - Cost of uncertainty

- Fear

- No peace of mind

- Insurance cost

22
 What can we do ???

 We could eliminate the risk

 We could reduce the risk
 We could transfer the risk
 We could avoid the risk
 We could accept the risk

23
 What is a Risk ?

 Risk as to the frequency or probability of

loss (likelihood of occurring)

 Risk as to the severity of the loss when it

occurs (degree of impact)

24
 Frequency Vs. Severity

Frequency

Common fever Bush Fires

Minor thefts/shop lifting Landslides
High Minor motor car
accidents

Minor medical surgery Major Floods

3rd party property Terrorism
Low damage Major fire
Physical illnesses Tsunami/Earthquake
Pollution
Severity
Low High
25
 Frequency Vs. Severity
Frequency

High

Low

Severity
Low High
26
27
 Classifications of Risk
Risk
There is a chance of loss
or breakeven but no gain
Ex. Fire, Accidents,
Sickness, Floods, Thefts,
premature death etc.
There is a chance of loss,
breakeven or a gain/profit
Ex. Investment in stock
market, Venturing into new
markets, launching new
products, Hedging,
Forward contracts
28
 Classifications of Risk cont.

Risk

Impersonal both in origin and Has its origin in individual events

consequence. Not normally caused and its impact is felt locally
by one individual and their impact
generally falls on a wide range of
people. Arise out of the nature of Ex. Theft of property, Fire,
the society we live in or some explosion, accidental damage to
physical occurrence beyond the personal effects, death etc.
control of man

Ex. War, Inflation, Terrorism,

Changing customs, Natural
Hazards, Recession, changing of
laws etc.
29
 Classifications of Risk cont.

Risk

Mental state or attitude of an More precisely observable,

individual who experiences doubt hence, measurable. Probable
or worry as to the outcome of a variation of actual from
given event. Essentially a expected experience.
psychological uncertainty.

30
31
 Classifications of Risk cont.

Risk

Pure Speculative

Static Dynamic Static Dynamic

Subjective Objective Subjective Objective Subjective Objective Subjective Objective

Source: Risk Management and Insurance 12 th Edition by Trieschmann, Hoyt, Sommer

32
 Sources of Risk

• Property risks

• Liability risks

• Life, Health and Loss of Income risks

• Financial risks

33
 Property Risks
All businesses and individuals that own, rent or use property are
exposed to the risk that the property may be damaged, destroyed
or stolen.
• Fire damage, lightning
• Explosions
• Theft

• Natural catastrophes- tornadoes, hurricanes, floods,

earthquakes
• Loss or destruction of supplier’s and/or customer’s premises 34
 Liability Risks
Businesses and individuals often held financially liable for
damages resulting from a vast and expanding array of situations.

Examples:
• Court awards for compensation to 3rd parties
• Legal expenses involved in defending a case
• Injury or damage in the premises (Public Liability)
or by the premises/business (Environmental Liability),
injury or damage due to use/consumption (Product Liability),
losses due to professional advise or service (Professional
Negligence)

35
 Life, Health and Loss of Income risks
Potential losses associated with the health and well-being
of individuals.

Example:
• Death of a key/important employee
• Death of a parent
• Health and safety risks
(Medical Insurance, contribution loss)
• Unemployment, Downsizing or Retirement
(Loss of Income, financial instability)

36
 Financial Risks
Considered as a speculative risk .
A variety of financial risks, which often are speculative
in nature can impact on a firm’s earnings.

Examples:
• Financial Loss following property loss or damage
(Business Interruption Insurance)
• Credit risk, Foreign exchange risk, Interest rate risk

37
 Types of Risk
Risks can be classified in number of ways.

– Business / operational risks

– Financial risks
– Environmental risks

– Reputation risks

38
 Business / Operational Risks
Type of risks relating to activities carried out within an
organization arising from structure, systems, people, products
or processes.
• Business interruption
• Errors or omissions by employees
• Product failure
• Health & safety
• Failure of IT systems
• Fraud
• Loss of key people
• Loss of suppliers
39
 Financial Risks

• Credit risk: The possibility that a debtor/ bond issuer will

default, by failing to repay principal and interest in a timely
manner.
• Liquidity risk: The risk that arises from the difficulty of
selling an asset. An investment may sometimes need to be
sold quickly. Unfortunately, an insufficient secondary
market may prevent the liquidation or limit the funds that
can be generated from the asset.
40
 Financial Risks contd.

• Currency risk: The risk that a business’s operations or an

investment's value will be affected by changes in exchange rates.

• Interest rate risk: The possibility of a reduction in the value of a

security, especially a bond, resulting from a rise in interest rates.

• Cash flow risk: Risk arises from the variability of future cash
flows.

41
 Environmental risks
Environmental risk relates to changes in political, economic,
social and financial environment over which an organization
has little influence.
– Legislative change
– Regulations
– Climate change
– Natural disasters
– Loss of business
– Competition
– Economic slowdown
– Stock market fluctuations 42
Reputation Risk

“It takes many good deeds to

build a good reputation, and
only one bad one to lose it.”

Benjamin Franklin

43
 Reputation Risk

• Reputation takes year to build but seconds to destroy’

• It is within the organization’s control but requires
organization to take a wider view of its role in society.
• Reputation risk is caused by failing to address some
other risk.
• Highly correlated to other types of risk

44
 Reputation Risk
Adverse events typically associated with reputation risk
include
• Ethics / Corporate Governance
• Safety
• Security
• Sustainability
• Product Quality
• employee relations
• customer service
• financial performance
• handling of environmental and social issues 45
 Global Risks classification by World
Economic Forum (WEF)

• Economic Risks

• Environmental Risks

• Geopolitical Risks

• Societal Risks

• Technological Risks
46
End of Lesson 1

Thank you!