Chapter One

The Nature of Risk

1.1. Meaning of Risk

There is no single definition of risk. 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.
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.

1.2. Risk and related terminologies

1.2.1. Risk versus uncertainty

In his seminal work Risk, Uncertainty, and Profit, Frank Knight (1921) established the
distinction between risk and uncertainty.

“ ... Uncertainty must be taken in a sense radically distinct from the familiar notion of Risk, from which it has
never been properly separated.” Thus, Knightian uncertainty is immeasurable, not possible to calculate,
while in the Knightian sense risk is measurable. Another distinction between risk and uncertainty is
proposed by Doug Hubbard:

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 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.
 Four further situations that illustrate the distinction between the two concepts:
 Both risk & uncertainty are present:
 An individual may be exposed to risk of disability and may experience
uncertainty.
 Both risk & uncertainty are absent:
 Modern sailors know that the world is not flat; there is no possibility of falling
off the edge of the world, therefore, they would experience no uncertainty
about such a contingency.
 Risk is present & uncertainty is absent:
 A businessman may be exposed to the possibility loss of due to interruption of
operations by fire.
 Risk is absent but uncertainty is present:
 When Columbus sailed there was no possibility that he would fall off the edge
of the world. Never the less, presumably he was uncertain about his
possibility.

1.2.2. Risk Vs probability

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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.

1.2.3. 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.

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.

Hazards are:
 Factors which may influence the outcome.
 Conditions that tend to increase the probability & severity of loss.
Classification of hazard
i. Physical Hazard:
A physical hazard is a physical condition that increases the possibility of a loss. Thus,
smoking is a physical hazard that increases the likelihood of a house fire and illness.
 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

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 ii. 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.

iii. 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.
1.3. 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:

1.3.1. Financial Versus Non-Financial Risk

This classification is based on the nature of the outcome. In its broadest context, the term risk
includes all situations in which there is an exposure to adversity. In some cases this adversity
involves financial loss, while in others it does not. There is some element of risk in every
aspect of human endeavor, and many of these risks have no or only incidental financial
consequences.

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1.3.1.1. Financial Risk
 The outcome is measurable in monetary terms.
 e.g., material damage to property, theft of property
1.3.1.2. 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.
1.3.2. Pure Versus Speculative Risks

One of the most useful distinctions is that between pure risk and speculative risk.
Speculative risk describes a situation where there is a possibility of loss, but also a
possibility of gain. Gambling is a good example of a speculative risk. In a gambling
situation, risk is deliberately created in the hope of gain. The person wagering $10 on the
outcome of a game faces the possibility of loss, but this is accompanied by the possibility
of gain. The entrepreneur or capitalist faces speculative risk in the quest for profit. The
investment made may be lost if the product is not accepted by the market at a price
sufficient to cover costs, but this risk is borne in return for the possibility of profit.

The term pure risk, in contrast, is used to designate those situations that involve only the
chance of loss or no loss. One of the best examples of pure risks is the possibility of loss
surrounding the ownership of property. The person who buys an automobile, for example,
immediately faces the possibility that something may happen to damage or destroy the
automobile.

The distinction between pure and speculative risks is an important one, because normally
only pure risks are insurable. Insurance is not concerned with the protection of individuals
against those losses arising out of speculative risks. Speculative risk is voluntary accepted
because of its two-dimensional nature, which includes the possibility of gain. Not all pure
risks are insurable, and a further distinction between insurable and uninsurable pure risks
may also be made.

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1.3.2.1. Pure Risks
 Pure risks involve only two possible outcomes: a loss or, at best, no loss.
Examples may include:
 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.

1. Personal Risk
 are risks that directly affect an individual.
 involve the possibility of the complete loss or reduction of earned income, extra
expenses, and the depletion of financial assets.
i. Risk of premature death – this refers to the death of a household head with
unfulfilled financial obligations.
 Premature death can cause financial problems only if the deceased has
dependents to support or dies with unsatisfied financial obligations.
 Costs related to the premature death of a household head.
 the human life value of the family head is lost forever.
 the additional expenses may be incurred.
 the family’s income from all sources may be inadequate just in terms of
its basic needs.
 non-economic costs
ii. Risk of old age – the major risk associated with old age is insufficient income
during retirement.
iii. Risk of poor health –includes both catastrophic medical bills and the loss of
earned income.
iv. Risk of unemployment –Unemployment can result from a business cycle
downsizing, from technological and structural changes in the economy, from
seasonal factors, and from fluctuations in the labour market.

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 2. Property Risk
 Refers to losses associated with ownership of property.
 Persons owning property are exposed to the risk of having their property damaged or lost
from numerous causes.
 Property risk stems from diverse perils accompanied by different hazards: physical, moral
or morale.
 Originates from changes in the overall economy such as price level changes, changes in
consumer tastes, income distribution, technological changes, political changes and the
like.
 Are less predictable and hence beyond the control of risk managers.
3. Liability Risk
Liability risk is the possibility of loss arising from intentional or unintentional
damage made to others persons or to their property.

1.3.2.2. Speculative Risks

 There are three possible outcomes – loss, breakeven, and gain situation.
 Examples may include: Investing in a venture; gambling transactions.
 People may deliberately create speculative risks.

1.3.3. Static and dynamic risks

1.3.3.1. Dynamic Risks

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,
since they are the result of adjustments to misallocation of resources. Although these
dynamic risks may be affected a large number of individuals, they are generally considered
less predictable than static risks, since they do not occur with any precise degree of
regularity.

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1.3.3.2. Static Risks

Static risks involve those losses that would occur even if there were no changes in the
economy, if we could hold consumer tastes, output and income, and the level of technology
constant, some individuals would still suffer financial loss. 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. Static
losses involve either the destruction of the asset or a change in its possession as a result of
dishonesty or human failure. Static losses tend to occur with a degree of regularity over time
and, as a result, are generally predictable. Because they are predictable, static risks are more
suited to treatment by insurance than are dynamic risks.

 Losses that can take place even though there were no changes in the overall economy.
 Are losses arising from causes other than changes in the economy.
 Are predictable and could be controlled to some extent by taking loss prevention
measures. Many of the perils fall under this category.

1.3.4. Fundamental Vs Particular Risks

The distinction between fundamental and particular risks is based on the difference in the
origin and consequences of the losses. This classification relates to both the cause and effect of
risk.

1.3.4.1. Fundamental Risk

 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

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1.3.4.2. Particular Risks

 are much more personal both in their cause and effect.

 Examples would include fire, theft, work related injury and motor accidents.
 arise from individual causes and affect individuals in their consequences.

Fundamental risks involve losses that are impersonal in origin and consequence. They affect
large segments or even all of the population. Particular risks involve losses that arise out of
individual events and are felt by individuals rather than by entire group. Unemployment, war,
inflation, and floods are all fundamental risks. The burning of a house and the robbery of a
bank are particular risks.

Since fundamental risks are caused by conditions more or less beyond the control of the
individuals who suffer the losses and since they are not the fault of anyone in particular, it is
held that society rather than the individual has a responsibility to deal with them. Although
some fundamental risks are dealt with through private insurance, it is an inappropriate tool for
dealing with most fundamental risks. Usually, some form of social insurance or other
government transfer program is used to deal with fundamental risks. Unemployment and
occupational disabilities are fundamental risks treated through social insurance. Flood damage
or earthquakes make a district a disaster area eligible for federal funds.

Particular risks are considered to be the individual's own responsibility. They are dealt with by
the individual through the use of insurance, loss prevention, or some other technique.

1.3.5. Objective versus Subjective Risk

1.3.5.1. Objective Risk
 The relative variation of actual loss form probable or expected loss.
 Is concerned with the range of variability of economic losses about some long-run
average (most probable) loss in a group large enough to analyse significantly in a
statistical sense.

Objective Risk = Probable Variation of Actual Loss

Probable Losses

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Example 1:

Consider the possibility of fire losses to buildings in towns A and B. There are 100,000 buildings
in each town and, on average each town has 100 fire losses per year. By looking at historical data
from the towns, statisticians are able to estimate that in town A, the actual number of fire losses
during the next year will very likely range from 95 to 105. In town B, however, the range
probably will be greater, with at least 80 fire losses expected and possibly as many as 120.

Objective Risk town A = (105 – 95)/100 = 10%

Objective Risk town B = (120 – 80)/100 = 40%

 Effects of Numbers Exposed on Objective Risk

 The Law of Large Numbers
States that as the number of exposure units increases, the more certain it becomes that
actual loss experience will equal probable loss experience. Hence, the risk diminishes
as the number of exposure units increases.

Example 2:

Suppose that Company A and Company B own 100 and 900 automobiles, respectively. These
cars are used by the sales personnel of each firm and are driven in the same geographical
territory. The chance of loss in a given year due to accident is 20%.

The expected number of losses is:

For Company A = 0.20 * 100 = 20

For Company B = 0.20 * 900 = 180

Suppose further those statisticians have computed that the likely range in the number of losses in
one year is 8 for Company A and 24 for Company B. thus, the objective risk is:

Objective Risk Company A = 8/20 = 40%

Objective Risk Company B = 24/180 = 13.3%

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  By increasing the number of exposed units by nine times, the risk was reduced
to a third.
 Objective risk varies inversely with the square root of the
number of exposed units.
 Effects of Probability on Objective Risk
 The higher the probability of loss, the lesser the objective risk would be.

Example 3:

Assume that employers A and B, each with 10,000 employees, are concerned about occupational
injuries to workers. Employer A is in a “safe” industry with the chance of loss of a disabling
injury in its plate being equal to 0.01. Employer B is in a more dangerous industry, with the
chance of loss equal to 0.25. It has been determined that the probable variation in injuries in
employer A’s plant will be no more than 20, whereas in employer B’s plant that the probable
variation will not exceed 87. Thus, the objective risk is:

Objective Risk Employer A = 20/(0.01 * 10,000) = 20%

Objective Risk Employer B = 87/(0.25 * 10,000) = 3.5%

 Objective risk varies inversely with the probability for any

constant number of exposure units. However, in general, the rate of decrease in
objective risk is less than proportionate to the rate of increase in probability of loss.

1.3.5.2. Subjective Risk

 Psychological uncertainty that stems from the individual’s mental attitude or state
of mind.
 May be measured by means of different psychological tests but no widely
accepted or uniform tests of proven reliability have been developed.
 The impact of subjective risk varies depending on the individual.
 Subjective risk may affect a decision when the decision maker is interpreting
objective risk.

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1.3.6. Risks Related to Business Activities
1. Business Risk –
- is the risk associated with the physical operation of the firm.
e.g. variations in the level of sales, costs, profits, etc
-is independent of the company’s financial structure.
2. Financial Risk
 Is associated with debt financing.
 Examples may include: risk of default, bankruptcy, stock price decline, insolvency.
3. Interest Rate Risk
 is a risk resulting from changes in interest rates.
 changes in interest rates affect the prices of financial securities such as the prices of
bonds etc. for interest rate rise depresses bond prices and vice, versa.
4. Purchasing Power Risk
 Arises under inflationary situations (general price rise of goods and services) leading to a
decline in the purchasing power of the asset held.
 Financial assets lose purchasing power if increased inflationary tendencies prevail in the
economy.
5. Market Risk
 Market risk is related to stock market.
 Unexpected changes in market-determined asset prices, indices, reference rates, etc.
 Refers to stock price variability caused by market forces. It is the result of investors’
reactions to real or psychological expectations.
 The market, in many cases, is also affected by such events as: presidential elections, trade
balances, balance of payment figures, wars, new inventions, etc...
 Market risk is also called systematic or non-diversifiable risk.
 All investors are subject to this risk.
 It is the result of the workings of the economy; and cannot be eliminated through
portfolio diversification.
 Investors are paid for this risk.

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1.3.7. 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.
1.3.7.1. Transaction Exposure
 Refers to the potential gains/losses in cash flows resulting from business transactions
denominated in a foreign currency.
1.3.7.2. 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 at the time of preparation of the consolidated
financial statements using the current exchange rate prevailing on the balance sheet date.
1.3.7.3. Economic Exposure
 Tend to affect a business’s future cash flow.
 Concerned with the impact of exchange rates on the NPV of the global company’s future
cash flows.

1.4. Burden of Risk on Society

 The presence of risk results in certain undesirable social and economic effects:
 In the absence of insurance, the size of emergency funds must be
increased.
 Deterrent effect on capital accumulation.
 The risk of a liability lawsuit may discourage innovation, depriving the
society of certain goods and services.
 Higher Cost of Capital—higher expected rate of return
 Worry and fear are present.

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The law of large number

Assume that an insurer has 100000 cars insured for a long period of time, and on the average

10000 cars meet with at least one accident and claim for damages each year. However, for a

particular year, it is unlikely that there will be exactly 10000 claims. Under certain assumptions,

it can be proven that over a long period of time, the deviation of the number of claim in a year

from 10000 will, on the average be 100. Thus there is a variation of 100 claims from the

expected number of 10000 or a variation of 1%. This relative variation of actual loss from

expected loss is known as objective risk.

Objective risk will reduce as the number of exposure increases. In the example above, 100000

cars were insured and the objective risk was 1%. Instead, if 1000000 cars were insured, the

expected number of claims will increase from 10000 to 100000 (10% of 1000000 cars) by 10

times, but the variation will only increase from 100 to 316 (approximately square root of

100000) by slightly more than 3 times. As a result, the relative variation or the objective risk

actually reduces from 1% (100/10000) to 0.316 %( 316/100000).

Since objective risk can be statistically measured, it is a very powerful method for managing

risk. As the number of exposure increases, the insurer is able to predict its future loss experience

more precisely. This phenomenon is based on the law of large numbers. The law state that as the

number of exposure increases, the variation reduces; therefore the actual loss experience will

approach the expected loss experience.

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