What is risk?

The term risk may be defined as the possibility of adverse results flowing from any
occurrence.
- It arises thereof out of uncertainty
- It also represent the possibility of an outcome being different from expected.
Risk is a condition where
- there is a possibility of an adverse deviation from a desired outcome that is
expected or hoped for;
- there is no requirement that the possibility be un-measurable,
- Only that it must exist.
Risk distinguish from peril and hazard?

Risk is the chance of loss, and peril is the direct cause of the loss. A peril is the
immediate specific event causing loss and giving rise to risk. For example, if a house
burns down, then fire is the peril.
A hazard is the source of danger. It is a condition that may create or increase the
chance of loss arising from a given peril or under a given condition.
Hazards are normally classified into three categories:

- A physical hazard consists of those physical conditions that increase the chance
of a loss from any peril. Smoking is considered a physical hazard because it
increases the chance of a fire occurring.
- A moral hazard refers to the increase in probability of loss that results from
dishonesty in the character of the insured person. Health insurance companies
suffer losses because of fraudulent or inflated claims.
- A Morale hazard consists of the acts which increase losses where insurance
exists, not necessarily because of dishonesty, but because of different attitude
toward losses that will be paid by insurance than attitude toward losses that
would be borne by the individual. For example: Having insurance tend to make
people less careful about avoiding injuries or illness, because they know they
have insurance to cover medical costs.
Risk Opportunity or threat?

Threat: A risk that may hinder the achievement of objectives.

Opportunities: A risk that may help in the achievement of objectives

Interest rates
Foreign exchange rate
Supply of service product/resources
Demand for service/ product/ resources
The economy
The weather
The stock market
Classification of Risk

Static Risk Dynamic Risk

1. Static risks involve those losses that occur
even if there are no changes in economy.
2. The society derives no benefit or gain
from static risk. Static risks are always
harmful.
3. Static risks affect only individuals or very
few individuals.
4. They are easily predictable.
5. Static risks are insurable.
6. Example: Perils of nature, and the
1. Dynamic risks involve those risks
resulting from changes in the economy.
2. The society derives some benefits from
dynamic risk.
3. Dynamic risk affect large number of
Individuals.
4. They are not easily predictable.
5. Dynamic risks are not insurable.
6. Example: if one sells for-profit insurance,
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 dishonesty of other people. one takes the dynamic risk that the
government will ban this type of
insurance.

Fundamental Risk Particular Risk

Fundamental risks involve losses that are Particular risks involve losses that arise out of
impersonal in origin and consequences. They are individual events and are felt by individual rather
group risks, and affect a larger segments or even than by entire group.
all the population.

Examples of fundamental risks are high inflation,

unemployment, war, and natural disasters such as
earthquakes, hurricanes, tornadoes, and floods.
Examples of particular risks are burglary, theft,
auto accident, dwelling fires.

Pure risk Speculative risk

1. Pure risk is a risk where there is only
the possibility of a loss or no loss.
There is no possibility of gain.
2. Only pure risk are insurable.
3. For example, if one buy a new car,
he face the prospect of the car being
stolen or not being stolen.
1. Speculative risk is a risk where both profit and
loss are possible.
2. Speculative risks are not normally insurable.
3. For example, if you establish a new business, you
would make a profit if the business is successful
and sustain loss if the business fails.

4. Pure risk is not voluntarily accepted.

5. Society will not benefit from a pure
risk if a loss occurs. For example, if
a flood or earthquake devastates a
region, society will not benefit from
such devastation.
6. Pure risk are generally easily
predictable.
Types of Peril
4. Speculative risks are more voluntarily accepted
because of its two-dimensional nature of gain or
loss.
5. Society may benefit from a speculative risk if a
loss occurs. For example, a firm may develop a
new invention for producing a commodity more
cheaply. As a result of this, a competitor may be
forced out of the market into bankruptcy. In this
situation, the society will benefit in both case.
6. Speculative risk are not easily predictable

There are 3 types of relevant perils, which are as follows:

Insured Perils: Insured perils are those which are stated in the policy as insured, such
as fire and lightning

Excepted or Excluded Perils: Expected or excluded perils are those which are stated
in the policy as excluded either as causes of insured perils, such as earthquake or as
a result of insured perils.

Uninsured or Other Perils: Uninsured perils are those which are not mentioned in the
policy at all. Storm, smoke and water are not excluded nor mentioned as insured in
a fire policy. It is possible for a water damage claim to be covered under a fire policy,
if for example, a fire occurs and the fire brigade extinguishes it with water.

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 Nature of Pure Risk

Personal Risks:

Risk of premature death:

It is generally believed that the average life span of a human being is 70 years. So, anybody
who dies before the age 70 years, regarded as having died prematurely. Premature deaths
usually bring great financial and economic insecurity to dependents. In most cases, a family
breadwinner who dies prematurely has children to educate, dependents to support, mortgage
loan to pay.

Risk of old age:

Old age is a risk of insufficient income during retirement. When older workers retire, they lose
their normal amount of earnings.

Risk of sickness or disability

In case of sickness or disability, there is a substantial loss of earned income, medical bills are
incurred, employee benefits may be lost, and savings depleted.

Risk of unemployment
Unemployment is a situation where a person who is willing to work and is looking for work to
do but cannot find work to do. Unemployment can be the result of an industry cycle
downswing, economic changes, seasonal factors and frictions in the labor market. It always
brings financial insecurity to people such as the unemployment person would lose his earned
income, employment benefits and deplete his savings.

Predicting unemployment is difficult because of the different types of unemployment and

labour. There are professional, highly skilled, semiskilled, unskilled workers. Moreover,
unemployment rates vary significantly by occupation, age, gender, education, marital status,
city, state, and by a host of other factors, including government programs and economic
policies that frequently change. So the risk of unemployment generally is not privately
insurable, but it can be insured by social insurance programs.

Property risk:

- The loss of property: Property loss can occur as a result of fire, lightning,
windstorms, hail, and a number of other causes.
- Loss of use of property because of damage by various causes.
- Additional expenses of maintaining the property or losses due to natural
disasters, stolen, damaged or destroyed by various causes.
Liability risks

- Unintentional injury of other person or

- damage to their property through negligence or carelessness
Risk arising from failure of others: Risks exists due to failure of another person to meet an
obligation.

Risk management
- Risk management is a process of indetification, analysis, and economic control of
those risks which can be threaten the assets or earning capacity of an enterprise.
- It refers to the practice of identifying potential risjs in advamce, analyzing them
and taking precautionary steps to reduce the risks.
- It is a scientific approach of dealing with pure risks faced by individuals and
business.

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 Risk Management Basic

Why do we need risk Management?

- The only alternative to risk management is crisis management --- and crisis
management is much more expensive, time consuming and embarrassing.
JAMES LAM, Enterprise Risk Management, Wiley Finance 2003

- Without good risk management practices, government cannot manage its

resources effectively. Risk management means more than preparing for the
worst; it also means taking advantage of opportunities to improve services or
lower costs.
Sheila Fraser, Auditor General of Canada

Why bother with RM?

1. Increase risk awareness about

- What could affect the achievement of objectives?

- What could change?

- What could go wrong?

- What could go right?

2. Increase understanding of risk-sensitivities.

What makes my risks increase/decrease/disappear?

3. Promote a healthy risk culture to talk safely about risk-Open and transparent

4. Develop a common and consistent approach to risk across the organization- Not
intuition-based.

5. Allows intelligent informed risk-taking.

6. Focuses efforts helps prioritize. Top 10 list. Or top 3. Or

7. Is proactive. not reactive

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 - Prepare for risks before they happen.

- Identify risks and develop appropriate risk mitigating strategies.

8. Improve outcomes achievement of objectives (corporate, school-based, etc.)

9. Really comes to down to simple good management

10. Enables accountability, transparency and responsibility

11. And maybe even mean survival

Risk Management process

Step 1 Communication and consult

Communication and consultation takes place during all stages of the risk management
process.
- It is essential to identify who should be involved in assessment of risk (including
identification, analysis and evaluation).
- It should engage those who will be involved in treatment, monitoring, and review of
risk.
- Communication and consult aims to get risk information and manage stakeholder
perception for management of risk.
Step 2- Establish the context
Before risk can be clearly understood and dealt with, it is important to understand the context
in which it exists. Establishing the context for a risk management assessment confirms the
subject of the risk assessment. Establish the content by considering:
The internal context objective, culture, staff, resistance etc.
The external context external environment, clients perceptions, legal issues,
political context.
The risk management context- limits, objectives, scope of risk management.
Develop risk criteria- define acceptable/ unacceptable level of risk
Define the structure for risk- isolate category of risk that need to be managed.
Step 3 Identify the risks
The aim of risk identification is to identify
- Possible risks that may affect, either positively or negatively, the objective of the
business, the activity under analysis
Answering the following questions identifies the risk,
- What can happen?
- How it can happen?
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 - Why could it happen?
There are two main ways to identify risk:
a) Identifying retrospective risks:
Retrospective risks are those that have previously occurred, such as incidents or accidents.
Retrospective risk identification is often the most common way to identify risk, and the
easiest. Because its easier
To believe something if it has happened before
To quantify its impact
To see the damage it has caused.
There are many sources of information about retrospective risk. These include:
Hazard or incident logs or registers
Audit reports
Customer complaints
Authorized documents and reports
Past staff or client surveys
Newspapers or professional media, such as journals or websites.

b) Identifying prospective risks

Prospective risks are often harder to identify. These are things that have not yet happened,
but might happen sometime in the future.
Identification should include all risks, whether they are currently being managed or not.
The rationale here is to record all significant risks and monitor or review the effectiveness of
their control.
Methods for identifying prospective risks include:
Brainstorming (communicating) with staff or external stakeholders.
Researching the economic, political, legislative and operating environment.
Conducting interviews with relevant people and organizations
Undertaking surveys of staff or clients to identify anticipated issues or problems
Flow charting a process
Reviewing system design or preparing system analysis techniques.
Categorizing Risk- Comprehensive
Political or Reputational Risk ---Financial Risk-----Service Delivery or Operational Risk
People / HR Risk----Information/Knowledge Risk-----Strategic / Policy Risk
Stakeholder Satisfaction -----Public Perception Risk---Legal / Compliance Risk----
Technology Risk----Governance / Organizational Risk----Privacy Risk----Security Risk---Equity
Risk----Environmental Risk
Step 4 Analyse the risks (& evaluate)
The risk analysis step helps in determining which risks have a greater consequence or impact
than others.
Risk analysis involves combining the possible consequences or impact of an event with the
probability of that event occurring.
The result is a level of risk. That is: Risk = consequence x probability
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 Risk Prioritization: Probability and impact
Probability (likelihood) of a risk event occurring Risk impact: level of damage that can occur when a
risk event occurs:
Very High: Is almost certain to occur.
Threatens the success of the project.
High: Is likely to occur.
Much impact on time, cost or quality.
Notable impact on time, cost or quality.
Medium: Is as likely as not to occur
Minor impact on time, cost or quality
Low: May occur occasionally
Negligible impact
Very low: Unlikely to occur.
Third dimension for rating risks: Proximity
- Immediate- now
- Less than 6 months
- Between 6-12 months
- Between 12-24 months
- Between 24-36 months
- More than 36 months
Elements of risk analysis
The elements of risk analysis are as follows:
Identify existing strategies and controls that act to minimize negative risk and enhance
opportunities.
Determine the consequences of a negative
impact or an opportunity (these may be positive or negative).
Determine the probability of a negative consequence or an opportunity.
Estimate the level of risk by combining consequence and probability
Consider and identify any uncertainties in the estimates.
Types of analysis
Three categories or types of analysis can be used to determine level of risk:
Qualitative: In qualitative analysis, the importance and probability of potential
consequences are presented and described in detail.
Semi-quantitative: Semi-quantitative methods are used to describe the relative risk scale.
For example, risk can be classified into categories like "low", "medium", "high" or "very high".
Quantitative: In quantitative analysis numerical values are assigned to both impact and
probability.
Step 5 Evaluate the Risk
Risk evaluation involves

- Comparing the level of risk found during the analysis process with previously
established risk criteria, and

- Deciding whether these risks require treatment.

The result of a risk evaluation is a prioritized list of risks that require further action.

This step is about deciding whether risks are acceptable or need treatment.

Risk acceptance
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A risk may be accepted for the following reasons:

If cost of treatment far exceeds the benefit, then acceptance is the only option
(applies particularly to lower ranked risks)

When the level of the risk is so low that specific treatment is not appropriate with
available resources

The opportunities presented outweigh the threats to such a degree that the risks
justified

The risk is such that there is no treatment available, for example the risk that the
business may suffer storm damage.

Step 6 Treat the risks

Risk treatment involves identifying options for treating or controlling risk, in order to
- Either reduce or eliminate negative consequences, or
- Reduce the probability of an adverse occurrence.
Risk treatment should also aim to enhance positive outcomes.
The following methods may be usually considered:
Risk Avoidance
This involves selection of those business activities only which involve the minimum amount of
risks.
Examples: Avoid manufacturing and marketing a product of which patent/copyright is
doubtful.
Risk Prevention: involves
- Eliminating the cause of loss and protecting loss of things or persons exposed to
damage or injury.
- Minimizing the loss when it occurs.
Risk Assumption
This refers to the individual or firm assuming the risk itself and bearing the ensuing
uncertainty. This is also known as Self-insurance.
Risk Distribution
This involves spreading of risk by means of group sharing such as, partnership or company
form of business organization.
Hedging and Neutralization
This involves offsetting loss from the occurrence of a risk by a compensating gain from
another activity or purchasing future contract.
Minimization of Risk
It is illogical to spread risks that can be minimized. Much efforts can made by the business
community to improve their equipment and methods of working so that any unnecessary
element of risk is minimized.
However, improvement in the system requires extra expenditure, but this will be justified
because this cost is less than the potential loss.
Risk Transfer
This refers to one person guaranteeing another against the risk of loss. Insurance is the form
of risk transfer as such. In insurance, insurer promises to pay a fixed sum at given
contingency and premium is the consideration from the insured. By paying premium the
insured transfers the risk to the insurer.
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 Step 7 Monitor and review
- Monitor and review is an essential and integral step in the risk management process.

- A business owner must monitor risks and review the effectiveness of the treatment
plan, strategies and management system that have been set up to effectively manage
risk.

Characteristics of an insurable risk

1. The risk must be of an accidental in nature. If the event is certain and is bound to
occur, then it cannot be insured against. Thus insurance is not available for wear and
tear, depreciation etc.
2. The risk must be pure risk. Pure risk is a risk where there is only the possibility of a
loss or no loss. There is no possibility of gain. Trade risk cannot be insured against.
For example- market fluctuations or increased taxation cannot be insured.
3. The loss caused by the risk must be capable of being measured in monetary terms.
4. The risk must not be of an illegal in nature. The object of the contract must be lawful.
5. Insurance must not be against public policy. The term public policy may be broadly
described as a set of moral and social principles or rules of conduct which have to be
observed in a society.
6. The risk must not be of a catastrophic nature. However, insurance cover is available
for flood, cyclone, earthquake which may also cause catastrophic loss but these are
capable of being borne by insurers.
Mathematical Valuation of Risks

- Under mathematical valuation of risk we actually find out the behaviour of risk,
expressed in quantitative mathematical term.
- Here the theory of probability and the law of large numbers are very important.
The theory of probability: The theory of probability actually indicates a mathematical
quantitative expression of an unforeseen happing or contingency.

For example, if we toss a coin it may be either head or tail. So the probability is 0.5. In
practice, the more and more we tossing the coin, the more our theoretical result would agree
with practice.

The law of large number: The law of large numbers states that as the number of policyholder
increases, the insurance company is more confident about its prediction that it will be true.
If this be so then the insurance companies can certainly find out the death behaviour in a
group of people and forecast the rate of morality of a man which is important in life insurance.
Mathematical value is calculated by considering and tabulating a large number of similar
case.
So, insurance companies try to acquire a large number of similar policyholders who all
contribute to a fund which will pay the losses.
Self-Insurance

Self-insurance refers to the plan by which individuals or organization sets up a private

fund out of which to pay losses.
It is an alternative to purchasing insurance in the market.
Here risk is retained and the organizations accumulate funds to meet insurable
losses.
Advantages:

1. Outgo is lower as there are no cost in respect of agent/brokers commission, insurers

administrative cost and profit margins.
2. Interest on the investment of the fund belongs to the insured.
3. There is no direct stimulus to reduce and control the risk of loss.
4. No disagreement will arise with insurer over claims.
5. The profit from the fund belongs to the insured.
6. Large organization can afford to hire qualified insurance personnel to guide the fund.

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