RISK MANAGEMENT

L1 The Concept of Risk

 The Origin of
the word
“Risk”
Risk from an
Islamic What is Risk?
Perspective

The
Classification Risk and
of Risks Concept Uncertainty
of Risk

Types of Pure Loss, Peril

Risk and Hazard

Enterprise
Risk
 THE ORIGIN OF THE WORD “RISK”
Latin word risqum (Kedar,
Arabic word risq or 1970), referred to the
challenge that a barrier reef
presents to a sailor.

Risq means “anything that has been

endowed to humans (by Allah SWT)
and from which they attain goodness”
and has connotations of a fortuitous
and favourable outcome.
 THE ORIGIN OF THE WORD “RISK”
Risq has connotations of a fortuitous
(happening by chance) and favourable
outcome

Risqum refers to the challenge that a

barrier reef presents to a sailor.
 THE ORIGIN OF THE WORD “RISK”
The word risq was used in the 12th century
related to chance of outcomes and had
neither positive nor negative implications.

Risque (French word) has mainly

negative but occasionally positive
connotations.
 THE ORIGIN OF THE WORD “RISK”

The word “risk” used since the 18th century

and has very negative associations.

The study of risk that exists at present is

based on this understanding of risk in 18th
century.

It is the understanding of risk based on

the Western worldview i.e. eurocentric.
 Application of risk
Information
Technology and
information
Health, Safety security
and Insurance
Environment

Health Banking

Economics
Risk Finance
 Literal meaning of risk
• A situation involving exposure to danger.
 Risk in business
• Business risk is the possibility a company will
have lower than anticipated profits or
experience a loss rather than taking a profit.
• Business risk is influenced by numerous
factors, including sales volume, per-unit price,
input costs, competition, the overall economic
climate and government regulations
 Risk in Finance
• The uncertainty associated with any
investment.
• That is, risk is the possibility that the act
ual return on investment
will be different from its expected
return.
• In finance, higher risk investment, has
the potential of a higher return.
 Risk in Insurance
• A probability or threat of damage, injury,
liability, loss, or any other negative
occurrence.
 WHAT IS RISK?

No one single definition

“A condition in which there

is a possibility of adverse
deviation from a desired
outcome that is expected or
hoped for” Vaughan and
Vaughan (2003)
 WHAT IS RISK?.. Cont’d
Risk is defined as uncertainty
concerning loss.
Trieschmann, Hoyt and Sommer (2005)
Risk is defined as a situation where
there is uncertainty about the outcome.
Risk is defined as an event that will
prevent us from achieving our desired
objectives.
 WHAT IS RISK?.. Cont’d

Risk is defined as “uncertainty

concerning the occurrence of
a loss or uncertainty
regarding loss”
 EXAMPLES OF RISK
A smoker may face the
risk of being diagnosed
with lung cancer,
however, not all smokers
will have lung cancer,
thus uncertainty is
present when the
probability of a future
event occurring is not
known.
EXAMPLES OF RISK
A passenger on an
aeroplane may risk
being killed in a plane
crash even though
such an event rarely
occurs. Despite the
low probability of
such a catastrophe
happening, it could
happen.
Other catastrophe
 Uncertainty
Definition of Uncertainty
Uncertainty is a state of doubt about our ability to predict the
future outcome of current actions

• E.g., if a house-owner is uncertain whether his house will

catch fire, this reflects his lack of knowledge about the
possibility of his house catching fire in the future.

• Uncertainty occurs if at least two possible outcomes can arise

out of an event.
• If one possible outcome, then the outcome is known for
certain, so there is no risk.
 Uncertainty..cont’d
• House - two possibilities (in relation to fire):
1. Catch fire or uncertainty exists
2. May not catch fire

• If the house-owner certain that his house will not catch fire
because it was entirely built using fire-resistant materials,
then there is no risk associated with fire.

Risk vs Uncertainty
• When risk is present, outcomes cannot be forecasted with
certainty.
• As a result risk gives rise to uncertainty.
19
 Uncertainty..cont’d
• Risk exists if there is uncertainty about the
outcome of an event or an activity.
• The greater the number of outcomes from an
event, the greater would be the uncertainty
and thus the risk.
• E.g. fixed-return investment vs stock
investment

20
 Uncertainty..cont’d
• Risk is also associated with a possible
unfavourable outcome of an event, or
possibility of loss.
• Unfavourable outcome can be described as a
deviation from a desired outcome.
• E.g. hoping for car would not be stolen,
however the outcome is undesirable, so risk
exists.
 LOSS, PERIL AND HAZARD

In discussing the concept of risk, other

commonly used terms associated such
as loss, peril and hazard.

Generally, perils are causes of loss while

hazards refer to conditions that increase
the chance of loss.
 LOSS

Unexpected reduction or disappearance

of economic value.

Losses are confined to the economic

value of an asset.
 LOSS
Loss in insurance refers to insurable loss.
Insurable losses are those losses that
can be insured.
To be insurable, a loss must meet the following
criteria:
1. Unintentional occurrence and based on chance
2. Undesirable
3. Results in a reduction of economic value or
financial loss.
 Four types of losses :
• Cost of repairing thins like jewellery,
Loss of Property clothing or cars that have been stolen or
have been damaged by fire, collision or
vandalism.

• Result from sickness, accidental injury or death.

Loss of income • Business may lose income if equipment or
buildings are damaged seriously enough to force
a temporary business closure

Loss associated with • Based on laws of negligence

legal liability claims

• Crippling medical costs that can come from an

Loss due to unexpected injury or illness.
unexpected expenses • Each year, many families are faced with large medical
bills from doctors, hospitals and nursing homes
 PERIL
Peril is the cause of a loss.
Commonly insured perils include fire,
theft, explosion, impact damage, etc.
A single peril can cause more than one
type of loss.
E.g. a natural gas pipeline explosion could result in
damage to a building, loss of rental income, lawsuits and
unexpected medical expenses for the injured.
 HAZARD
A hazard is a condition that increases
the likelihood of a loss due to a
particular peril.
Four types of hazard:

Legal Physical

Morale Moral
 Physical hazard

Physical hazards are tangible characteristics of

whatever that increases the chance of a loss
Examples
Defective electrical wiring in a building increases
the chance of fire
Slippery or uneven floors increase the risk of falls
A river close to an insured property increases the
probability of floods.
 Moral hazard
Moral hazard refers to dishonesty or character
defects in an individual that increase the chance
of a loss.

Moral hazard is present in all forms of insurance,

and insurers try to avoid insuring situations for
which there is evidence of moral hazard.
Example :

Intentional burning of unsold goods that is

insured to claim from an insurer.
 Morale hazard
Morale hazard refers to carelessness or
indifference to a loss because of the existence of
insurance.
This indifference can result in the insured failing
to take reasonable care to protect his or her
property because “it’s insured, so why should I
worry?”
Example :
Homeowners leaving a door unlocked that allows a
burglar to enter the house because all the major
household items are covered under insurance.
 Legal hazard

Legal hazard is the increased likelihood of loss

due to legal actions.

Example :

New laws are constantly enacted to address a

wide range of issues and this could create a host
of legal hazards for individuals and organisations.
 CONCLUSION

Risk is every where

Every one of us is facing with risk of

one kind or another

Every organization is facing with risk

of one kind or another

Therefore the need to manage the risk

 Risk from an Islamic Perspective

Humans are continuously exposed to the

possibility of meeting catastrophes and disasters
giving rise to misfortunes and suffering such as
the premature death of a family’s bread winner,
disabilities, accidents, destruction of business or
wealth etc.

“We will surely test you through some fear,

hunger, and loss of money, lives and crops. Give
good news to the steadfast” Al Baqarah 2:104
 Risk from an Islamic Perspective
In our everyday lives, we are facing many
challenges .
Success will only be achieved by those able to
handle such trials and tribulations.
“Al-ghurm bil ghunm”
“No reward without risk”
One cannot expect to achieve success or make
profit without enduring some risks in his
undertakings.
 Risk from an Islamic Perspective
The assumption of risk by a person and the
transfer of risk from one person to another is
allowed in Islam.
In kafalah contract, the guarantor(bank) assumes
the risk of the creditor, whether partly or wholly.
If debtor(customer) fails to pay off his debts, the
guarantor runs the risk of paying that debt.
Shipping Guarantee-i is a facility granted by the Bank to
importers for clearance of goods at the port without
producing original Bill of Lading. It should only be issued
for documents drawn under the Bank's LC or customers
with approved SG-i facilities for collections documents.
 Risk from an Islamic Perspective

“When the Prophet (p.b.u.h.) asked a Bedouin Arab,

who entered the mosque with his camel left outside
untied, if his camel woul run astray, he said,
“InshaAllah”. The prophet (p.b.u.h) then said: “Tie your
camel first, then say InsyaAllah”

The hadith indicates that the Prophet’s instruction is to

manage the risk at hand before leaving to the will of
Allah.
 Risk from an Islamic Perspective

3 types of risk (Hassan, 2009):

Essential risk

Prohibited risk

Permissible risk
 Essential risk

Essential risk is prevalent in all business

undertakings.

Essential risk is inevitable and

entrepreneurs must take this type of risk
in order to harvest associated benefits
and rewards.
 Essential risk..cont’d
Two legal maxims relate essential risk to
corresponding returns :

Al-ghurm bil ghunm

“No risk, no reward”
A man cannot expect to achieve
success or make profit without
enduring some risks in his
undertakings.
 Essential risk..cont’d

Al-kharaj bil daman

“The benefit of a thing is a return for

the liability for loss from that thing”

To reap the rewards of an asset, one

should endure the risks of ownership
 Prohibited risk

This risk appears in the form of excessive

gharar namely gharar fahish.
Two types of gharar:
Gharar fahish Excessive risk that can
affect and nullify a
contract.

Gharar yasir Minor uncertainty and

can be tolerated
 Gharar

Surah Al An’am 6:151 – 152 has explicitly

forbidden all business transactions which result
in injustice in any form to any parties, whether
in the form of deceit or fraud or undue
advantage or peril, thus leading to uncertainty
or ambiguity and lack of clarity surrounding the
subject matter, will be considered void.
 Permissible risk

This form of risk is neither essential nor

prohibited and it could either be accepted or
avoided.

Can be present in the form of market risk,

operational risks, etc.
 Classification of Risk

Risk can be classified into several categories:

Fundamental and particular risks

Pure and speculative risks

Objective and subjective risks
Static and dynamic risks
Financial and non-financial risks
 Fundamental and particular risks
Fundamental risks are those that affect large segments of
population, or even the entire community.

The occurrence of these types of risk is usually beyond

the control of individuals.

It is the responsibility of society to deal with them

through government intervention, social insurance and
other similar programmes.

Tsunami and earthquake that struck Sendai, Japan in

March 2011.

Subprime mortgage crisis in The US in 2008.

Political upheavals in Tunisia, Egypt, Yemen and Libya.

 Fundamental and particular risks..cont’d
Particular risks are much more personal in their cause and effect.

This form of risk arises out of individual events such as

fire to dwellings, robberies, car collisions, etc.

Can be dealt with through the mechanism of takaful,

insurance, risk retention and risk prevention
programmes.
 Pure and speculative risks
Pure Risk Speculative Risk

Pure risk exists when there is uncertainty as
to whether loss will occur.
A category of risk in which loss is the only
possible outcome; there is no beneficial
result.
Speculative risk exists when there is
uncertainty about an event that could
produce either a profit or a loss.
A category of risk that, when undertaken,
results in an uncertain degree of gain or loss.

 No possibility of gain is presented by pure  Gains as well as losses may occur,

risk – only the potential for loss. changing the nature of the uncertainty that
is present.

 Examples :  Examples:
o Home insurance can be used to o Business ventures
protect homeowners from the risk that o Investment decisions
their homes will be destroyed.
o The uncertainty of damage to property
by fire or flood
o The prospect of premature death
caused by accident or illness
 Pure and speculative risks

This classification between pure and speculative risk is important

because insurers normally insure only pure risks.

Furthermore, the law of large numbers, which forms the statistical

basis for the operation of takaful and insurance, can be applied
more easily to pure risk than to speculative risk.
 Objective and subjective risks

Objective risk or statistical risk refers to the relative

variation of actual loss from expected losses.

It can be measured statistically by some measures of

dispersion such as standard deviation or variance.

Subjective risk refers to the mental condition or state of

mind of individuals who experience doubt or worry as to
the outcome of a given event.

E.g. Two risk managers with different attitudes towards

a similar situations will reach different interpretations
with regard to the level of risk perceived.
 Static and dynamic risks
Dynamic risks can be defined as those risks that can
cause financial loss as a result of changes in the
environment.

These exposures to loss could be in the form of changes

in the economy, technology, consumer tastes and
regulatory requirements.

However, overtime, with appropriate alignments and

adjustments, dynamic risks could benefit society at
large.
 Static and dynamic risks
Static risks can be either pure or speculative in nature,
or arise from causes other than changes in business
environment such as the perils of nature.

Static risks are more predictable and can normally be

insured.

Both dynamic and static risks are related. For example, a

the increased rate of industrialisation has caused
widespread pollution and this, over time, has magnified
the phenomenon of global warming
 Financial and non-financial risks
Financial risks exist in situations where there is an
exposure to adversity involving financial losses.

This type of risk can be measured in monetary terms,

and at the same time values can be placed on its
outcome.

Generally, financial risk involves 3 elements:

Those objects exposed to the risk
The peril causing the risk
The assets affected by the risk
 Financial and non-financial risks
Financial risk can easily be identified in instances where
there are damages to properties.

For example, a fire at a factory, there will be

consequential loss of profit and maybe even employee
injuries.

Non-financial risks, however, involve adversities that

pose no financial loss.
 Types of Pure Risk
Pure risk that can cause financial security can be
categorised into 3 types:

Personal risks

Property risks

Liability risks
 The 3 Types of Pure Risk and their subcategories
Risk Description Example
Personal Refers to risks that directly affect individuals. They involve the possibility of loss or
reduction of income, extra expenses and depletion of financial assets. Personal risk
is further divided into four:

a) Risk of death Possibility of death of a bread winner with

unfulfilled financial obligations. This risk may
cause financial problems if the deceased has
dependents to support or dies with unsatisfied
financial obligations.

b) Risk of insufficient income Possibility of retirees not having sufficient

during retirement financial assets or other sources of retirement
income to cover the basic living expenses,
resulting in reduced standard of living.

c) Risk of poor health Possibility of having to pay for medical bills

and loss of earned income.

d) Risk of unemployment Major threat to personal financial security

resulting from business cycle downswings,
technological and economic changes, etc.
 The 3 Types of Pure Risk and their subcategories
Risk Description Example
Property Refers to the possibility of loss due to damage to properties caused by fire, flood,
earthquake and other natural disasters. There are two types of property loss:

a) Direct loss For example, when a factory is damaged by a

Financial loss that results fire, the physical damage to the factory is a
from the physical damage, direct loss.
destruction or theft of the
property.
b) Indirect Loss or In addition to the physical damage to the
consequential loss factory, the owner would lose his income from
Financial loss that results sales while factory is being rebuilt. Thus, the
indirectly from the loss of sales would a consequential loss.
occurrence of a direct
physical damage or theft loss
of the property.
Liability Liability risk Business firs can be held legally liable for
Refers to an act involving a risk of defective products that harm customers.
inflicting bodily injury on another
person or inflicting damage on
someone else’s property. The
court may order the wrongdoer
to pay substantial damages to the
person suffering from losses.
 Enterprise Risk
In the 1950s, discussions on risk had mainly revolved
around pure risk.

However, in the late 1980s, speculative risk began to be

addressed.

As a result, a new category of risk, known as enterprise

risk came into existence.

Enterprise risk refers to all major risks faced by a

business entity.

It includes pure risk, speculative risk, operational risk,

financial risk, legal risk and strategic risk.
 Types of Enterprise Risk
Risk Description
Strategic Refers to uncertainty of loss relating to
an organization’s financial goals and
objectives.
Operational Refers to the uncertainty of loss relating
to an organization’s business operation
that involves the people, processes and
technology.
Financial Refers to the uncertainty of loss
regarding adverse changes in commodity
prices, interest rates and foreign
exchange rates.
Legal Refers to the uncertainty of loss
regarding adverse changes in rules and
regulation of the industry.
Example
An investment bank ventures
into a new line of business (e.g.
real estate investment). The
new business line may not be
profitable to the bank.
A trading company that offers
online services to its customers
may suffer losses if hackers
break into the company’s
computer systems.
A confectionery manufacturer
that agrees to sell various
confectionery products at a
fixed price to a supermarket
chain for the next three months
may lose money if sugar prices
rise.
A court decision to allow
payment for disablement
benefits after normal retirement
age will increase insurance claim
and costs of liability insurance.
 GENERAL CONCEPT OF RISK…cont’d

Muslims must believe in Qadha and Qadr

But…. we must look for ways and means to

mitigate risk and to avoid misfortunes and
sufferings wherever possible.

“Allah will not change the condition of

community if they do not change their
state themselves” Ar-Ra’d 13:11