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.
 That is, it is the possibility of adverse consequences. y
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 (emotional) 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 conse­quences.
 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

 Lien: a right to keep possession of property belonging to

another person until a debt owed by that person is
discharged.
 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.
End of the chapter