Chapter 1

Nature of Risk
 SCOPE of this Chapter

 Meaning of Risk
 Risk and related terminologies
 Classification of Risks
 Major types of personal risk and commercial risk
 Risks Related to International Business
 The burden/ effects of risk on society
 Risk Definition

 There is no single definition of Risk; however, Economists, statisticians

and actuaries each have their own concept of risk. The many inconsistent
and ambiguous meanings attached to "risk" lead to widespread confusion
and also mean that very different approaches to risk management are
taken in different fields. For example:
– In information security, risk is defined as "the potential that a given
threat will exploit vulnerabilities of an asset or group of assets and
thereby cause harm to the organization.
– In finance risk is often defined as the unexpected variability or
volatility of returns and thus includes both potential worse-than-
expected as well as better-than-expected returns.
– In risk and insurance text books risk is defined as a condition in which
there is a possibility of an adverse deviation from a desired outcome
that is expected or hoped for.
Cont’d

• However, even if there is no single definition, there are common

elements in all the definitions: indeterminacy and loss.
• Risk can be both negative and positive, but it tends to be the negative
side that people focus on.
• As risk carries so many different meanings there are
many formal methods used to assess or to
"measure" risk. Some of the quantitative definitions
of risk are well-grounded in statistics theory and
lead naturally to statistical estimates, but some are
more subjective. Thus in many cases a critical factor
is human decision making
 Risk and related terminologies
1. Risk versus uncertainty
• Uncertainty:
– The lack of complete certainty, that is, the existence of more than one
possibility. The "true" outcome/state/result/value is not known.
– The doubt as to the occurrence of a certain desired outcome.
– A state of mind whereby a sentient entity experience doubt.
– A subjective phenomenon - one of the possible reactions of an entity to its
interpretation of reality.
• Risk:
– A state of uncertainty where some of the possibilities involve a loss,
catastrophe, or other undesirable outcome.
– an objective phenomenon that can be measured mathematically or
statistically
– independent of the individual's beliefs
– exists whether or not person is aware of it.
– it is the state of the world.
 2. Risk Vs probability
 It is necessary to distinguish carefully between risk and probability.
– Probability refers to the long run chance of occurrence or relative
frequency of some events.
– Risk, as differentiated from probability, is a relative variation of
actual loss from expected loss.
3. Risk, Peril, & Hazard
 Peril
– The prime cause: it is what will give rise to the loss.
– e.g., Storm, Flood, Fire, Thefts, collusion, etc
 Risk is the chance of loss, and peril is the direct cause of the loss. If
a house burns down, then fire is the peril.
Cont’d
 Hazards
– A hazard is anything that either causes or increases the likelihood of a loss.
For instance, gas furnaces are a hazard for carbon monoxide poisoning.
– Factors which may influence the outcome.
– Conditions that tend to increase the probability & severity of loss.
– Classification of hazard
• Physical Hazard:
– A physical hazard is a physical condition that increases the possibility
of a loss.
– Conditions stemming from the physical characteristics of an object.
– Physical condition that increases the probability and severity of loss
form a given peril.
– Examples may include:
» Existence of dry forest - for fire
» Earth faults - for earth quakes
» Icebergs - ocean shipping
» Icy roads - for auto accident
Cont’d
• Moral Hazard:
– Moral hazards stems from dishonesty or character defects of an
individual (mental attitude of the individual) that increases the
probability as well as the severity of loss.
– Examples may include:
» Faking an accident to collect insurance money
» Submitting a fraudulent claim
» Inflating the size of a claim.
» Intentionally burning unsold merchandise that is insured.
• Morale Hazard
– Carelessness or indifference to a loss because of the existence of
insurance.
– Insurance can be regarded as a morale hazard because it increases
the possibility of a loss that results from the insured worrying less
about losses. Therefore, they take fewer precautions and may engage
in riskier activities—because they have insurance.
– Examples may include:
• leaving key in an unlocked car, leaving a door unlocked.
Classification of Risks

• Risks may be classified in many ways; however, there

are certain distinctions that are particularly important
for our purposes. These include the following:
– Financial risk Vs Non Financial risk
– Pure risk Vs Speculative risk
– Static risk Vs Dynamic risk
– Fundamental risk Vs Particular risk
– Objective risk Vs Subjective risk
– Diversifiable risk Vs non diversifiable risk
 Financial risk Vs Non Financial risk
• This classification is based on the nature of the outcome.
– Financial Risk
• The outcome is measurable in monetary terms.
• e.g., material damage to property, theft of
property
•
– Non-Financial Risk
• The outcome is not possible to measure in monetary terms.
• e.g., selection of an item from a restaurant menu,
great many decisions of life, such as marriage partner.
Pure risk Vs Speculative risk
– A pure risk is a situation in which there are only
the possibilities of loss or no loss (earthquake)
• The risk of a motor accident, fire at a factory, theft of
goods from a store, or injury at work is all pure risks
with no element of gain.
• The major types of Pure risks that are associated with
great financial and economic insecurity include personal
risks, property risks, and liability risks.
– A speculative risk is a situation in which either
profit or loss is possible (gambling)
• Investing in a venture; gambling transactions.
• People may deliberately create speculative risks.
• Society may benefit from a speculative risk even though a loss
occurs but it is harmed if a pure risk is present.
 Static risk Vs Dynamic risk
• Dynamic risks are those resulting from changes in the overall
economy.
• Changes in the price level, consumer tastes, income and output,
and technology may cause financial loss to members of the
economy.
• These dynamic risks normally benefit society over the long run
• they are generally considered less predictable than static risks
• Static risks involve those losses that would occur even if there
were no changes in the economy
• These losses arise from causes other than the changes in the
economy, such as the perils of nature and the dishonesty of other
individuals.
• Unlike dynamic risks, static risks are not a source of gain to
society.
 Fundamental risk Vs Particular risk
• Fundamental risks are those which arise from causes outside the
control of any one individual or even a group of individuals.
• impersonal in origin and widespread in effect.
• the effect of such risks is felt by large numbers of people.
– Examples would include earthquakes, floods, famine, volcanoes and other
natural ‘disasters’, social change, political intervention, war, etc
• Particular risks are much more per­sonal both in their cause and
effect.
• arise from individual causes and affect individuals in their conse­
quences.
– Examples would include fire, theft, work related injury and motor
accidents.
 Objective Risk vs Subjective Risk
• Objective risk is relative variation of actual loss from
expected loss.

Example: A property insurer has 10,000 houses to insure for

a long period and on average it expects 1 percent or 100
houses burn each year; however, it would be rare for exactly
100 houses to burn each year. The actual loss is between 90
to 110 over a period with variation of 10 houses from the
expected number of 100, or a variation of 10 percent.
10 percent is known as objective risk.
• Objective risk declines as the number of exposure
increases.

Assume 1 million houses are insured and expected

number of houses will burn is now 10,000, but the
variation of actual loss from expected loss is only
100.

Objective risk is now 100/10,000 or 1 percent.

“ Objective loss is inversely related to squared root
of number of exposure units”.
 Law of Large Number
 Objective risk is measurable and it is used by insurer and
corporate risk managers.
If the number of exposure units increases, an insurer can predict
its future loss experience more accurately due to
“law of large number”.
What dose law of large number explain ?
If number of exposure units increases, the actual loss experience
will approach more closely to expected loss experience.
If number of homes insured by property insurer increases, the
proportion of homes will burn is more accurately predictable.
 Subjective Risk
• Subjective risk is defined as uncertainty based on a
person’s mental condition or state of mind.
Example : A drunk driver may be uncertain whether he
will arrive home without being caught by the police.
The mental uncertainty is called subjective risk.
• The higher subjective risk the more conservative and
prudent behavior while low subjective risk may result
in less conservative behavior.
Example : A motorist previously arrested for drunk
driving is aware that he has consumed too much
alcohol (high subjective risk) versus another driver in
the same situation but not being arrested(low
subjective risk).
Diversifiable risk and non diversifiable risk
Diversifiable Risk(Nonsystematic Risk)
• Affects only the individuals or firms and not the entire economy
and can be reduced or eliminated by diversification.
Example: A diversified portfolio of stocks, bonds, and Treasury
bills is less risky than a portfolio of 100 percent stocks.
Non diversifiable Risk(Systematic Risk)
Affects the entire economy or large number of persons or groups
within the economy and can not be reduced or eliminated by
diversification.
Example : Cyclical unemployment, rapid Inflation, war, floods,
earthquakes.
Major Personal risks and Commercial risks

Certain pure risks are associated with great

financial insecurity for both individuals and families,
as well as for commercial business firms.

1- Personal risks Types of pure risks that

2- Property risks can threaten an individual’s
3- Liability risks financial security

4- Commercial risks Types of pure risks

that can financially threaten

or bankrupt the firm
Major Personal Risks

• Personal risks are risks that directly affect

an individual or family. They involve the
possibility of a loss or reduction in income,
extra expenses or depletion of financial
assets, due to:
– Premature death of family head
– Insufficient income during retirement
– Poor health (catastrophic medical bills and loss of
earned income)
– Involuntary unemployment
 Major Property Risks
• Property risks involve the possibility of
losses associated with the destruction or
theft of property
• Direct loss vs. indirect loss
– A direct loss is a financial loss that results from
the physical damage, destruction, or theft of the
property, such as fire damage to a home
– An indirect or consequential loss is a financial
loss that results indirectly from the occurrence of
a direct physical damage or theft loss, e.g., the
additional living expenses after a fire
Major Liability Risks

• Liability risks involve the possibility of being

held legally liable for bodily injury or
property damage to someone else
– There is no maximum upper limit with respect to
the amount of the loss
– A lien can be placed on your income and financial
assets
– Legal defense costs can be enormous
Major Commercial Risks

• Firms face a variety of pure risks that can

have serious financial consequences if a loss
occurs:
– Property risks, such as damage to buildings, furniture and
office equipment
– Liability risks, such as suits for defective products,
pollution, and sexual harassment
– Loss of business income, when the firm must shut down
for some time after a physical damage loss
– Other risks to firms include crime exposures, human
resource exposures, foreign loss exposures, intangible
property exposures, and government exposures
 Risks Related to International Business
• IB is an organization that buys and/or sells goods and services across two or
more countries, even if management is located in a single country.
• IB operates in a highly uncertain turbulent environment.
• IB operates in a multi-currency environment.
– Transaction Exposure
• Refers to the potential gains/losses in cash flows resulting from
business transactions denominated in a foreign currency.
– Translation Exposure
• Is related to a balance sheet, it is sometimes called Balance Sheet
Exposure.
• The accounting convention requires that the assets and liabilities of
foreign affiliates should be translated into home currency
– Economic Exposure
• Concerned with the impact of exchange rates on the NPV of the global
company’s future cash flows.
 Burden/Effect of Risk on Society

The presence of risk results in three major

burdens on society:
1-In the absence of insurance, size of emergency
funds must be increased.
Example: you purchase a $300,000 home and want to
accumulate a fund for repairs if it is damaged by fire, hail,
wind-storm . Without the insurance you need at least $50,000
annually to build up an adequate fund. What if an early loss
occur?
Cont’d
2-Loss of Certain Goods and Services
• Society is deprived of certain goods and services.
• Example: Many manufacturing firms have discontinued
• the manufacture of childhood products, football
• helmets, and certain birth-control devices due to the
• threat of liability suit.
• - Consequence of September 11, 2001 on companies
• that manufactured anti-terrorism technologies.
3-Worry and Fear
• As a result of risk presence, fear and worry is present.
• Example: Parents may be fearful if son or daughter
• teenage departs on a skiing trip during a blinding snowstorm
• because of the threat of being killed on an icy road.