BSTL COLLEGE HAWASSA

DEPARTMENT OF ACCOUNTING AND

MANAGEMENT
COURSE:
RISK MANAGEMENT AND INSURANCE
CREDIT HOUR:3
COURSE INSTRUCTOR:
TIBEBU YACOB (Msc & MA)

ACADEMIC YEAR:2023/2015
SEMISTER:TWO
 CHAPTER ONE
1) RISK AND RELATED TOPICS
At the end of this unit you as a student be able to:
 Know the concept of risk and list some of its
basic definitions,
 Identify the association between risk ( Danger),
uncertainty ( Improbability) and
probability( Possibility),
 Describe and explain the causes and effect
relationship between risk, peril, and hazards, and
 Know the major classification of risk.
 1.1. Definition of Risk
Why Risk exists ?
 Risk exists because there is no perfect foresight
about the future.
 Because risk is undesirable and its consequences
are, at times, damaging to individual, businesses
and the society as a whole, mankind is constantly
developing its predictive ability through the
constant upgrading and refinement
/Improvement/ of its knowledge.
 Risk is the possibility of something bad
happening.
 Definition of Risk…
 In general, risk refers to exposure to adverse consequences.
 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 uncertainty and undesirable outcomes.
 "Risk is the combination of the risk of exposure and the impact =
combination of (likelihood of the threat being able to expose an
element(s) of the system) and impact“
 "[Risk is] a situation involving exposure to danger:
'flouting/Breaking/ the law was too much of a risk'
 "[Risk is] A probability or threat of damage, injury, loss, or any
other negative occurrence that is caused by external or internal
vulnerabilities/exposures/, and that may be avoided through
preemptive/defensive/ action."
 Definition of Risk…
What all definitions [of risk] have in common is
agreement that risk has two characteristics:
1. Uncertainty: An event may or may not happen.
2. Loss: An event has unwanted consequences or
losses
[Risk is the] Combination of the probability or
frequency of occurrence of a defined threat or
opportunity and the magnitude of the consequences
of the occurrence.
[Risk is] The likelihood/ possibility / of variation in the
occurrence of an event, which may have either
positive or negative consequences.
 Definitions given by different scholars
 The term risk used in different ways; the following are some
definitions given by different scholars and practitioners in
the different fields:
 Risk is the chance of loss.
 Risk is the possibility of loss.
 Risk is uncertainty of loss.
 Risk is the exposure to adverse consequence
 Risk is the probability of any outcome different from the
one expected.
 Doubt
 Worry
 Undesirable events
 Risk is a combination of hazards
 Important concepts we should note from the definition of Risk

In general, the following are some important concepts you should note
from the above definitions and discussions.
Risk is the reality of the real world, but not belief i.e. risk is an
objective concept.
Risk refers to uncertainty as to the loss.
Risk becomes important if there is uncertainty as to the occurrence of
the loss
If we are certain there is no risk
Under risky condition, the outcome is undesirable / Unattractable/
The degree of risk is inversely related to the ability to predict the
future.
The more the future is unpredictable and unmanageable, the greater
will be the risk
If the probability of the occurrence is 1 or 0, the degree of risk is zero
If many outcomes are possible, the risk is not zero. The greater the
variation, the greater the risk.
 1.2. Risk, Peril & Hazard
Peril: A Peril is a contingency, which may cause a loss.
 It refers to the specific cause of a loss.
 Peril is also called loss producing agent.
 It is the source of a specific loss.
 Peril refers to prime source of specific loss.
Most of time, it is beyond the control of anyone involved in the
situation.
 If your house burns because of a fire, the peril, or cause of
loss, is the fire.
 If your car is damaged in a collision/Crash/ with another car,
collision is the peril, or cause of loss.
 Common perils that cause property damage included fire,
lightning, windstorm (አውሎ ንፋስ) , hail (በረዶ), tornadoes
(ንጉድጓድ,), earth quakes, theft and robbery.
 Examples of perils

Perils can range from weather events to other events like theft or vandalism.
Here are a few examples of common perils:
1) Fire or lightning: Includes damage caused by lightning or an event
caused by a lightning strike, such as a fire.
2) Weight of ice, snow, and sleet: Refers to snow accumulation or an
ice dam that causes damage to your home, such as a roof leak.
3) Windstorm & hail: Includes damage caused by a wind or hailstorm.
4) Theft & vandalism: Refers to stolen belongings and willful damage
to your property.
5) Accidental water/steam overflow or discharge: Refers to water
damage from a sudden break or blockage in your plumbing or HVAC
system.
6) Falling objects: Includes damage from a
tree that falls on your house.
7) Power surges: Refers to sudden and accidental damage from an
artificially generated electrical current or power surge.
 A peril
A peril is any event that can cause a financial loss.
Examples include a car crash, death, disability,
fires, floods, illness, theft, and tornadoes (wind).
 An insurance agent can help you calculate the
potential loss that you might experience from
various types of perils as part of the process of
determining how much coverage you need.
 Hazard (ሓደጋ ሊያስነሱ የሚችሉ ነገሮች)
Hazard: A hazard, on the other hand is that the
condition which creates or increases the
probability of a loss arising from a given peril.
 increases the likelihood of a peril happening
 Examples include slick roads during a snowstorm,
leaving car doors unlocked, and driving while
under the influence of alcohol.
 People often mistakenly interchange perils and
hazards when discussing property insurance, but they.
aren't synonyms
 Relationship between Hazard ,Peril,& Risk

For example, one of the perils that can cause loss to

automobile is collusion. A condition that makes the
occurrence of collusions more likely is an icy street. The
icy street is the hazard and the collusion is the peril. It is
possible to establish the following relationship.

Note: this relationship is not always true: because

sometimes it is possible for something to be both a peril
and hazard.
For instance, sickness is a peril causing economic loss, but
it also a hazard that increases the chance of loss from the
peril of premature death.
 Types of hazards:
There are four major types of hazards:
1) Physical hazard
2) Moral hazard
3) Morale hazard
4) Legal hazard
A) Physical hazard
A physical hazard is a physical condition that increases the chance of loss.
A physical hazard is a condition stemming from the physical characteristics
of the exposure (object) and that increases the probability and severity of
loss from given perils.
Examples of physical hazards include icy roads that increase the chance of
a car accident, defective wiring in a building that increases the chance of
fire, and location of property, (near burglar/Thief/ area, flood area,
earthquake area).
Such hazards may or may not be within human control.
 2) Moral Hazards:
 Moral hazard is dishonesty (ሐቀኝነት የጎደለው) or character
defects in an individual that increase the frequency or severity
of loss.
 Moral hazard refers to dishonest by an insured that increases
the frequency or severity of loss.
 It origins from the evil character of that insured person.
 Arise due to dishonest and fraudulent acts of individual. A
dishonest person, in the hope of collecting from the insurance
company, may intentionally cause a loss, or may exaggerate the
amount of a loss.
Examples of moral hazard include faking an accident to collect
from an insurer, submitting a fraudulent claim, inflating the
amount of a claim, and intentionally burning unsold
merchandise that is insured.
 3) Morale Hazard:

 Morale hazard is carelessness (ግድየለሽነት) or

indifference to a loss because of existence of insurance.
 Some insured's are careless or indifferent to a loss because
they have insurance.
Examples of morale hazard include
 leaving car keys in an unlocked car, which increase the
chance of theft;
 leaving a door unlocked that allows a robber to enter; and
 changing lanes/ traffic line/ suddenly on a
congested/crowded/ interstate highway without signaling.
 Careless acts like these increase the chance of loss.
 The critical difference between moral hazard and morale
hazard is the intent.
 A morale hazard
A morale hazard, according to the International
Risk Management Institute (IRMI), is defined as a
subjective hazard that tends to increase the
probable frequency or severity of loss due to an
insured peril. It can be described as one’s
indifference to loss or increased carelessness due
to the presence of insurance. The main difference
between morale and moral hazard is the presence
of intent (ዓላማ) or malice(ክፋት) or ተንኮል , morale
hazard is void of this element.
 A moral hazard
A moral hazard, according to IRMI, is defined as a
subjective hazard that tends to increase the probable
frequency or severity of loss due to an insured peril.
 Moral hazard is measured by the character of the
insured and the circumstances surrounding the
subject of the insurance, especially the extent of
potential loss or gain to the insured in case of loss.
Insurance policies are designed to lower the risk of
moral hazards.
 Deductibles are one way insurance companies lower
moral hazard by having the policyholder share in the
loss.
 Moral hazard & Morale hazard
Moral hazard described the intentional seeking of
risk for personal gain because we do not bear the
cost of failure. Morale hazard describes
indifference to unintentional risk.
Moral hazard =የሥነ ምግባርአደጋ
Morale hazard =ግብረ ገብነትአደጋ, ጠንቅ
 Moral hazard & Morale hazard …
Moral Hazard: A condition that increases the
probability that a person will intentionally cause,
create or inflate a loss.
A moral hazard is generally an act created out of
intent and can be calculated, even premeditated.
Morale Hazard: A condition of inattention or disregard
that increases the frequency or size of a loss.
A morale hazard is attitudinal, involving a perspective
that demonstrates apathetic disregard for safety and a
duty of care.
For definitions provided by the Insurance and Risk
Management Institute, see:
 4) Legal Hazard:
Legal hazard refers to characteristics of the legal
system or regulatory environment that increase the
frequency or severity of losses.
Examples include adverse jury/ judges/ verdicts
/outcomes/or large damage awards in liability
lawsuits, statutes that require insurers to include
coverage for certain benefits in health insurance
plans, such as coverage for alcoholism; and
regulatory action by state insurance departments
that restrict the ability of insurers to withdraw from
the state because of poor underwriting results.
 1.5. Classification of Risk
 Risk can be classified into several distinct categories
according to their cause, their economic effect, or some
other dimension.
1) Financial Vs Non Financial Risks
a. Financial risks are one where the loss occurred has some
financial implication; or where loss occurred can be
measured in monetary terms. Examples of financial risks
include:
 Credit risk
 Foreign exchange risk
 Commodity risk
 Interest risk
 Financial risks
 Financial risks are reflected in the financial
positions on banks' balance sheets and result from
their risk-taking activity.
 Nonfinancial risks arise from the bank's
operations (processes and systems) and are
similar to risks faced by companies outside the
financial sector (“corporates”).
Financial Risk…
Financial Vs Non Financial Risks
Non-Financial Risk
 Non-Financial risks …
b. Non-financial risks: those risks which do not have or expressed in
financial terms.
Example: Agony one feels following the death of a person, personal injury
and etc.
2) Static and Dynamic Risks
This is classification of risk based on its degree of intensity and its
predictability.
a. Dynamic Risks
Are caused by perils which have national economic consequence, like
inflation, calamities, technology, political upheavals, etc.
 Originates/ resulting from changes in the overall economy such as price
level changes, changes in the consumer taste, income distribution,
technological changes, political changes and the like. They are less
predictable and hence are not usually covered by insurance policies.
 Risk type which its effect is felt widely, and its effect is more serious
compared to static risk.
 Dynamic Risk…
 An obvious example of a dynamic risk is the COVID-19
pandemic. The multi-faceted nature of this has caused drastic
effects on many lines of insurance coverage. Some of the
affected lines include business interruption, trade credit
insurance, travel, cyber liability and event cancellation. Some
businesses made claims due to a disruption to supply chains
and the inability to operate as normal due to government
lockdown measures. Others needed to claim coverage for
income lost when customers who owe money for products or
services delay payment or could not pay at all.
 Dynamic risks are those that are difficult to predict and can
result from organizational and environmental changes,
e.g., slip hazards caused by bad weather or physical danger
from visiting someone's home, severe weather, supply chain
disruptions, inflation, etc.
Difference between dynamic risk and Static Risk
 static risks

 Refers to those losses, which would occur even if there

are no changes in the overall economy. They are losses
arising from causes other than changes in the economy.
Unlike dynamic risk, they are predictable and could be
controlled to some extent by taking loss prevention
measures. Many of perils fall under this category.
 These are risks connected with losses caused by the
irregular action of the forces of nature/flood,
earthquake or the mistakes and misdeeds of human
beings (moral and morale hazards).
 are caused by perils which have no consequence on the
national economy, like a fire or theft or
misappropriation.
 static risks …

 Static risks would be present in an unchanging economy. If we could

hold consumer taste, output and income and the level of technology
constant, some individuals would still suffer financial losses. These
losses arise as a result of the perils of nature and the dishonesty of
other individuals.
 Dynamic risks benefit the society over the long run since they are the
result of adjustments to misallocation of resources.
 Unlike dynamic risk, static risks are not a source of gain to society. i.e.
they usually result in a loss to society. Static risks affect directly few
individuals at most exhibit more regularly over a specific period of time
and are generally predictable.
 Static risk and dynamic risks are not independent; greater dynamic
risks may increase some type of static risks. E.g. Industrialization
(technology) affects global weather patterns.
 Dynamic risks are less likely to occur than static risks, but are also less
predictable. Static risks are more suited to management through
insurance.
 Pure Risks 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.
A.Pure Risk:
 Pure risk is defined as a situation in which there are only the
possibilities of loss or not loss but no chance of gain/profit.
 The only possible outcomes are adverse (loss) and neutral (no loss). For
instance, owner of automobile faces the risk of a collusion loss. If
collusion occurs, he will suffer financial loss. If there is no collusion, the
owner does not gain.
 Other examples of pure risk include premature death, industrial
accidents, terrible medical expenses, and damage to property from fire,
lightning, flood, or earthquake.
 Most pure risks are insurable. They are always undesirable and hence
people take steps to avoid such risks.
 Pure risks that exist for individuals and business firms can be classified
 Pure Risks Vs Speculative Risks
 Pure risk refers to risks that are beyond human
control and result in a loss or no loss with no
possibility of financial gain. Fires, floods and other
natural disasters are categorized as pure risk, as
are unforeseen incidents, such as acts of terrorism
or untimely deaths.
 Risk managers deal with risk in four basic ways: They
reduce it, avoid it, accept it or transfer it. Many types of
pure risk are dealt with by purchasing insurance coverage
for the potential loss, which transfers the risk to an
insurance company
 Speculative Risks
 Speculative risks are thus considered controllable
risks. Almost all financial investment activities, for
example, are considered speculative risk because they
are chosen risks and can result in loss or gain.
 Betting on sports is considered a speculative,
controllable risk. A person betting on a National
Football League game could see either a financial gain
or loss from the bet, depending on whether the team
that's chosen wins or loses. Unlike pure risk, which is
generally handled by insurance, speculative risk is
traditionally handled by the capital markets.
 Most financial investments, such as the purchase of
stock, involve speculative risk.
 Fundamental Risk vs. Particular Risk

Fundamental risk vs. particular risk

 Fundamental risk is risk that affects entire societies or a
large population within a society. Natural disasters,
such as earthquakes and hurricanes( Storms) , fall into
the category of fundamental risk, as do phenomena such
as inflation and war, which typically affect large
numbers of people. In distinction to static risk,
fundamental risk may or may not be insurable.
 Particular risk, in contrast to fundamental risk, refers
to risks that affect an individual, such as a fire that
destroys a family home, theft of a car or robbery.
Particular risk can be insured.
 Cont…
 Pure risks are insurable through commercial, personal or
liability insurance policies. In these policies, individuals or
organizations transfer part of the pure risk to the insurer. For
example, home insurance policies protect against natural
disasters by providing money for rebuilding. For life insurance
policies, the insured makes premium payments, and the
insurance company provides a lump sum payment to
beneficiaries upon the insured person's death.
 When a company provides insurance against a pure risk, it is
engaging in speculative risk because the entity is trying to
ensure that the customer will not experience a loss until the
after the company has profited from the risk transfer.
 Pure risks are insurable partly because the law of large numbers
makes insurers capable of predicting loss figures in advance.
END OF CHAPTER-ONE