You are on page 1of 5

Overview of the risk

Meaning of the risk: There is no single definition of risk. Economists behavioral scientist, risk theorists, statisticians, and actuaries each have their own concept of risk. However, risk traditionally has been defined in terms of uncertainty. Based on this concept, risk of defined here as Uncertainty concerning the occurrence of a loss. Risk is a condition in which there is possibility of an adverse deviation from a desired outcome that is expected or hoped for. At its most general level risk is used to describe any situation where there is uncertainty about what outcome will occur. Life is obviously risky and investing in the securities. In most of the risky situation, two elements are commonly found: 1. The outcome is uncertain i.e. there is a possibility that one or other (s) may occur .Therefore, logically, there are at least two possible outcomes for a given situation. 2. Out of the possible outcomes, one is unfavorable or not liked by the individual or the analyst.
Risk vs. Uncertainty: Uncertainty is often confused with the risk. Uncertainty refers to a situation where the outcome is not certain or unknown. Uncertainty refers to a state of mind characterized by doubt, based on the lack of knowledge about what will or what will not happen in the future. Example: Risk of lung cancer for smokers is present because uncertainty is present. Uncertainty can be perceived as opposite of uncertainty where you are assure of outcome or what will happen .decision under uncertain situation is very difficult for the decision maker .it all depend upon the skill, the judgment and of course of luck. Finally when risk is defined as uncertainty, some authors make a careful distinction between objective risks a subjective risk

Objective risk: It is defined as the relative variation of actual loss from expected loss. For example, assume that a property insurer has 10,000 houses insured over a period and, on average 1 percent or 100 houses, burn each year. However, it would be rare for exactly 100 houses to burn each year .In some year; as few as 90 hous3es may burn: in other years as many as 110 houses from the expected number of 100, or a variation of 10 percent .this relative variation of actual loss from expected loss is known as objective risk. Subjective risk:

It is defined as uncertainty based on a persons mental condition or state of mind .The impact of subjective risk varies depending on the individual .two persons in the same situation in have a different perception of risk, and their behavior may be altered accordingly. For example a customer who was drinking heavily in a car foolishly attempt to drive home. The driver may be uncertain whether he will arrive home safely without being arrested by the police for drunk driving. The mental uncertainty is called subjective risk

Measurement of risk
Peril and hazard: Peril is defined as the cause of loss. If your house burns because of a fire, the peril, or cause of loss is the fire. Common perils that cause property damage include fire, lighting windstorm, hail, tornadoes, earthquakes, theft and burglary. Hazard: A hazard is a condition that creates or increases the chance of loss. There are four major types of hazard. Physical hazard: It is a physical condition that increases the chance of loss. Example icy roads that increase the chance of an auto accident, defective wiring in a building that increases the chance of fire. And a defective lock on a door that increases the chance of theft. Moral hazard: It is a dishonesty or character defects in an individual that increases the frequency or severity of loss. Morale hazard: Some insurance authors draw a subtle distinction between moral hazard and morale hazard. It is a carelessness or indifference to a loss because of the existence of insurance. For example leaving car keys in an unlocked car, which increases the chance of theft. Legal hazard: It refers to characteristics of the legal system or regulatory environment that increases the frequency or severity of loss.

Basic categories of risk 1. Pure and speculative risk:


It is defined as the situation in which there are only the possibilities of loss or no loss. The only possible outcomes are adverse (loss) and neutral (no loss).example of this includes premature death, job related accidents, catastrophic medical expenses and damages to property from fire lightning, flood, or earthquakes.
Types of pure risk:

a) Personal risk It is a risk that directly affects an individual. They involve the possibility of the complete loss or reduction of earned income, extra expenses and depletion of financial asset. There are four major personal risks; Risk of premature risk- family head with unfulfilled financial obligation Risk of insufficient income during retirement- old age Risk of poor health- loss of earned income, catastrophic medical bills Risk of unemployment- business cycle down swings, technological and structural changes in the economy ,seasonal factors and imperfection in the labor market b) Property risk: Person owing property are exposed to property risks-the risk of having property damaged or lost from numerous causes. There are two major types of loss associated with the theft of property: direct loss- physical damage Indirect or consequential -indirect from the occurrence of indirect physical damage or theft of loss c) Liability risk: It is another type of pure risk that most persons face .under our legal system you can be held legally liable if you do something that results in bodily injury or property damage to someone else. A court of law may order you to pay substantial damages to the person you have injured.
Speculative risk:

It is defined as a situation in which either profits or losses possible. Example if you purchase 100 shares of a common stock, you would profit if the price of the stock increases but would lose if the price declines. Other example betting on horse race, investing in real estate.

Difference between pure risk and speculative risk:

Private insurance typically insure only pure risk. With certain exceptions, private insurers generally do not insure speculative risks, and other techniques for dealing with speculative risk must be used. The law of large numbers can be applied more easily to pure risks than to speculative risks. Society may benefit from a speculative risk even though a loss occurs, but it is harmed if a pure risk is present and loss occurs .for example a firm may develop a new technology for producing inexpensive computers. As a result some competitors may be forced in to bankruptcy. Despite the bankruptcy, society benefits because the computers because the computers are produced at a lower cost. However ,society

normally does not benefit when a loss from a pure risk occurs, such as a flood or earthquake that devastates an area
2. Fundamental Risk and particular Risk:

It is a risk that affects the entire economy or large number of persons or groups within the economy. Examples include rapid inflation, cyclical unemployment, and war because large numbers of individuals are affected. Particular risk: It is a risk that affects the only individuals and not the entire community. Example includes car theft, bank robberies and dwelling fires. Only individuals experiencing such losses are affected, not the entire economy. 3) Enterprise Risk: It is a relatively new term that encompasses all major risks faced by a business firm. Such risks include pure risk, and fundamental risk, speculative risk, strategic risk, operational risk, and financial risk. Strategic risk refers to uncertainty regarding the firms financial goals and objectives; for example if a firm enters in to a new line of a business the line may be unprofitable .operational risk result from the firms business operations. Financial risk refers to uncertainty of loss because of adverse changes in commodity prices, interest rates, foreign exchange rates and the value of money. 4) Quantifiable and non- quantifiable Risk: The risk which can be measured like financial risks are known to be quantifiable while the situation which may result in repercussion like tension or loss of peace are called as nonquantifiable. 5) Financial risk and non financial risk: Financial risk involves the simultaneous of three important elements in a risky situation -that someone is adversely affected by the happening of an event, -the assets or income is likely to be exposed to a financial loss from the occurrence of the event -the peril can cause the loss. When the possibility of financial loss does not exist, the situation can be referred to as nonfinancial in nature .financial risk are more important in nature.

Methods of handling risk: How the risk can be handled Avoidance: Avoid the risk or the circumstances which may lead to losses .for example-not to visit border areas at the time of war tension. Avoid manufacturing and marketing a product of which patent/copyright is doubtful. Loss control: Loss prevention-reduce loss frequency-for example not to smoke in a factory producing inflammable products, getting training before driving etc. Loss reduction-lower loss severity-deployment of firefighting equipment, first and boxes etc. Retention-to retain in full of part of the risk. A risk is said to be actively retained if the individual is fully aware of the risk and its implication and prefers to retain it. On the contrary, it is said to be passive, if the individual is ignorant of the risk or there is carelessness on part of the exposed. Transfer: Contractual agreement-insurance, derivatives, diversification strategies etc. Corporatizing- converting the sole proprietor/partnership business in to a company from an organization. It is well known that it is case of a proprietor firm, the proprietor is individually liable in an unlimited sense and in case of partnership firm, the partners are jointly and severally liable which is also in the nature of unlimited liability. However ,in case of companies the liability of the shareholders is generally limited to the extent of capital contributed by the them

Bibliography: Dr P.K Guptha/Himalaya publishing house/Insurance and Risk management Page no-3-9 Trieschnann Hayt sommer/12th edition risk management and insurance Page no3-11 George E Rejda/ninth edition Principle of risk management and insurance page no 23-32

You might also like