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Chapter One
General Concepts of Risk Management

1.1 General

The word risk is certainly used frequently in everyday conversation and seems to be
well understood by those using it.

What is your understanding of the word risk? What impression does it give you
when somebody mentions the word to you?

Before you go to the next paragraph, ask yourself this question and try to answer it.
And later on, you will compare your answer with the definitions I am going to give
you.

To most people risk implies some form of uncertainty about an outcome in a given
situation. An event might occur and, if it does, the outcome is not favorable. The
word risk then implies both doubt about the future and the fact that the outcome
could leave us in a worse situation than we are in at the moment.

If you want to go out during the evening, a family member could say to you, “Take
care, it is risky.” What is the message being sent? You are being warned that a bad
event (such as robbery, assault, etc.) could occur to you. You can easily see from this
that the word risk has some bad test.

It is interesting to contrast risk with the use of the word chance. Like risk chance
also implies some doubt. But unlike risk, in the case of chance, the expected outcome
is favorable. We talk about the risk of an accident, the risking of losing our job, but
we talk about the chance of winning a lottery, the chance of getting a scholarship,
etc.

Risk refers to the possible occurrence of an unfavorable event.

Chance refers to the possible occurrence of a favorable event.

This is how people understand risk. But as students of risk management and
insurance, you do not need to stop with this simple analysis of risk. Rather, you need
to explore more the concepts incorporated in it.

The understanding of the word risk is made more difficult by the variety of ways in
which it is used in the world of risk management and insurance.

In this course, in other materials, and in everyday business conversations, you will
come across the word risk to mean different things. Below are some possible ways
of using the word.
Risk as a cause

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This is when the word risk is used to refer to the cause of an outcome. For example,
when we say” There is a possible risk of theft”, we are referring to the possible loss
of our property by theft, but we use the word risk to imply that the cause of this loss
of property is theft.

Risk as a cause is used to refer to the cause of an outcome.

Risk as a likelihood
We often talk about the risk of something happening, meaning the probability or
likelihood of it occurring. This is sometimes modified by referring to the high or low
risk of some event: for example, when do you think is the risk of getting robbed
high? When you sleep leaving your door open or when you sleep after properly
closing your door?

During the former surely: This example reveals that there are levels of risk or
degrees of likelihood of its happening.

Risk as a likelihood refers to the probability or likelihood of something

happening.

Risk as an object
The word risk can also be used to refer to the object or person at risk. If a group of
engineers go to visit a building, which is on the verge of cracking, they can say, ‘let’s
go and see the risk. In this case, the word ‘risk’ is used to refer to the object at risk,
i.e. the building.

Risk as a loss
Suppose someone you do not really trust asks you to lend him money. You decide to
give him but you feel that you are taking a risk. In this case, you are using the word
risk as a loss.
Risk as a loss refers to cases when we put ourselves in a situation where there is
some doubt about the future outcome.

Risk as a verb
Finally, the word risk is used not only as a noun but also as a verb. A girl could risk
walking alone during the night, someone could risk swimming in a river where there
is crocodile, etc. In this instance the word risk is used as a verb implying an act of
placing oneself in a situation where a loss could occur.

When the word risk is used as a verb it refers to the act of positively or willingly
placing oneself in a situation where a loss could occur

1.2 The Meaning of Risk

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Different text books, writers, authors, and practitioners have tried to define risk in
various ways and it is difficult to pick one of these definitions and make it a
universally accepted one. That is way I said in the above overview, we need to know
a relatively proper definition of risk.

Definition 1. Risk is a condition in which there is a possibility of an adverse

deviation from a desired outcome that is expected or hoped for.

Definition 2. Risk is the objectified uncertainty as to the occurrence of an undesired

event.
Definition 3. Risk simply is uncertainty about loss.

Have you read the above definitions properly? Have you noticed that in spite of the
differences in wording, the essence in most of the definitions is similar?

That is why I gave you only three definitions. That does not mean, however, that we
would stick rigidly to one or two definition. As a single definition would not
sufficiently capture the comprehensive flavor of risk, we would analyze its meaning
by considering the concepts embodied in various definitions: you can note from the
above definitions that risk refers to the possibility of an undesired event. Risk
materializes when something you do not want to happen occurs or when something
you want to happen fails to happen. It is simply a negative deviation from your
expectation.

For insurance purposes, risk refers to uncertainty about financial loss. A person
driving a car might face a car accident, a factory building may be burnt and
production in the factory could be stopped. But loss is not always associated with
accident. If a firm could not get enough market for its products, it would suffer loss
(we will discuss the different types of risks in the following unit.)

The first important point you note from the above examples and the proceeding
definitions is that risk is associated with bad and harmful incidents. You can see this
clearly from the first definition given above. In that definition, risk is defined as an
adverse deviation from expectations. Risk is understood as occurrence of a bad
situation. The second definition, too, conveys this message as risk is defined as
undesired event.

Risk has a bad taste.

You get the second important point from the second definition.

Risk is an objective concept.

Risk is something measurable. There is every possibility to quantitatively measure
the bad occurrence we are talking about. Hence, risk is something objective (we will
discuss this at length in the following section.)

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In the third definition the fact that this negative deviation or loss is underscored.
This loss could either be financial or non-financial. A death of a close relative could
be an example of a non-financial loss while loss of a car by theft could be an example
of financial loss.

Risk refers to a possibility that a loss might occur.

Form the discussion made so far it is possible to conclude that risk refers to the
uncertainty human beings face in life that a bad incident entailing loss could
possibility occur.

Risk and Uncertainty

But you are not yet very clear as to what uncertainty actually means and how it
differs from the word risk. Getting clear idea here, therefore, would help you much
to have a proper understanding of the concept of risk.
What do we mean by uncertainty? Are risk and uncertainty similar?
Even though risk and uncertainty are closely related and most of the time used
interchangeably, they are not one and the same.

Think of times when you felt certain about something. When you feel certain, it
seems you are free from doubt. Certainty refers to the state of being doubtless about
something. Its antonym uncertainty is doubt about our ability to predict the future
outcome of current actions. Clearly the term uncertainty describes a state of mind. It
has something to do with subjective beliefs. It arises when someone has doubt or
cannot be certain about the outcome of events.

Risk is a combination of hazards and is measured by probability; uncertainty

is measured by the degree of belief. Risk is a state of the world. Uncertainty is
a state of the mind.

You can see from the above definition that risk is an objective concept that can be
measured. We can measure risk by using statistical techniques

When we say uncertainty is subjective, does it mean that the intensity of uncertainty
differs among people?
Of course! Since uncertainty depends on the knowledge and attitude of a person,
individuals facing the same situation can show differing levels of uncertainties. Two
people working on the same business could feel uncertain about future loss of their
job with varying degrees.

Individuals facing the same situation could experience differing levels of

uncertainties.
In discussing the concept of uncertainty, we can take the rather philosophical view
and say that uncertainty is, like beauty, in the eyes of the beholder.

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We quite often say there is a risk of rain, the risk of being in an accident, the risk of
getting HIV/AIDS, etc.; we use these phrases almost suggesting that the event may
or may not happen. The fact is that the event will or will not happen, there is no
doubt about that. What we want to express when using these phrases is that there is
some doubt as to whether the event will occur or not. The information we have
about the future is imperfect and this leads us to the doubt, and hence uncertainty
which we express.

The analysis in the above paragraph supports the view that uncertainty is in the
eyes of the beholder. But be careful in that you should not go too far down that road
and make the same conclusions about risk, too.

To say that risk only exists when it is recognized by an individual would discount
certain situations where we would all agree risks are present, even if not recognized
by anyone.

Writers in risk management and insurance have predicted different answers for this
question. Some argue that uncertainty, like risk, exists whether or not the person is
aware of it. Others argue that uncertainty being a subjective feeling exists only with
awareness.

Uncertainty exists only with awareness; it is a state of mind. Risk, however,

exists whether or not a person is aware of it. It is a state of world.

In general, uncertainty results in a feeling of insecurity, which makes one worry,

about the uncertain situation. And worry leads a person to take the necessary action
so that the possible loss is avoided. For example, the moment you started taking
courses, you face a risk of failing the exam if you do not study properly. This is
something objective. When someone takes courses, he/she will either pass or fail.
And this creates uncertainty and starts worrying the student. But this is totally
absent with non students.

The point, anyway, is that uncertainty refers to the doubt a person expresses as to
which of the many possible future outcomes will take place.

The concept of uncertainty implies doubt about the future based on a lack of
knowledge or imperfection in knowledge.

So far, we’ve discussed at length the concept of uncertainty. We did this because
uncertainty forms one of the components of the concept of risk. Now, using our
understanding of uncertainty and going back to the broader idea of risk, we can say
that the basis of risk is lack of knowledge regardless of whether the state of lack of
knowledge is recognized.

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The only difference between risk and uncertainty lies on measurability. As

we’ve discussed earlier, risk is objective and can be measured using statistical
techniques while uncertainty, which is a subjective concept does not.

Let me finish this section by mentioning the four situations. Crowe and Horn
described in their book “The meaning of risk” in an article to show the difference
between risk and uncertainty.

A) The first situation is when both risk and uncertainty are present. Suppose
someone cuts his hand with a blade that an HIV positive person has used.
This person would experience uncertainty and indeed there is a risk of
getting infected.
B) The second situation is when both risk and uncertainty are absent. We all
know that the earth is not flat but egg shaped. But there is no possibility of
falling off the edge of the earth. As a result we neither experience risk nor
uncertainty.
C) The third situation is when risk is present while uncertainty is absent. A
good example for this could be a person driving a car whose brake has a
problem. The person does not experience uncertainty as he is totally
unaware of the problem. The risk of accident, however, is clearly present.
D) Finally there are situations when risk is absent but uncertainty is present.
For illustration consider the following example.
While listening to the news, a woman finds out that one of the five buses that go to
Dessie has overturned. She knew her husband was in one of these buses though she
does not know which one he specifically took.

In this case, there is no risk as risk refers to future outcomes. In the above example,
since the incident has already occurred, there is no adverse deviation from
expectation that will happen in the future. Whether the man is in the bus or not, the
incident has already happened. But there is uncertainty as it relates to past, present
and future situations. The women would be worried sick until she finds out that her
husband is safe.

Uncertainty relates to past present and future situations where as risk refers only to
future outcomes.

1.3 Risk and Probability

Probability Defined

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What is probability? Have you ever purchased a lottery?

What is the probability that you win the lottery?

I am not asking you the chance of winning the lottery. As far as the chance is
concerned, there are two outcomes. You will either win or lose. Probability is a bit
different from this. The probability of winning a lottery depends on the number of
people buying the lottery. If you are one of the 100,000 people who have bought the
lottery the probability that you win is 1/100,000.

Thus probability refers to the chance of occurrence of one particular event.

We use the word probability to refer to the likelihood of occurrence of a given event
specifically it is a mathematical rate expressing the chance that a certain event will
occur.

Risk and probability distinguished

When you read materials on risk management and insurance, you might come
across some definitions which more or less threat risk and probability similarly.
Look at the following definition of risk, which simply defines risk as a chance of loss.

Nobody blames you if this definition confuses you with what we’ve said about
probability in the previous sub-section. The distinction gets more blurred as one
explores their relationship.

Risk and probability are two concepts which are different but related. The
probability of a certain outcome is the number of times that outcome would occur,
assuming finite number of observations and no change in underling conditions. Risk,
however, refers to deviations from expectations. This statement deserves a little bit
more elaboration.

When do we assign probability to events?

Generally, probabilities are assigned to events that are expected to happen in the
future. In the case of probability there might be a number of possible events that
will take place under a given set of conditions; and that events may occur in equal or
different chances of occurrence.
Consider these extreme situations. Sometimes you will be very certain that a certain
event is going to take place, i.e. there is perfect foresight as to the occurrence of the
events probability in this case is 1.

For example, if you have 10 fifty Birr notes in your wallet, what is the probability
that a randomly selected note will be a fifty Birr note?

The probability is 1. You are very certain that whichever note you pick, it is going to
be a fifty Birr note. In this situation there is no risk involved. Even if you pay your
bill without looking, there is no risk of paying a 100 Birr note by mistake.

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The other extreme situation is when probability is zero. This happens when event is
certainly not going to take place. Consider the above situation again.

What is the probability that a randomly selected note will be a 100 Birr note?

The probability is zero. Since you do not have any one hundred birr note there is no
chance that a randomly selected note will be a 100 Birr note. In this case, too, risk is
absent. A risk of giving someone a 100 Birr note by mistake (when you actually
wanted to give 50 Birr) is absent as you do not have a 100 Birr note in your wallet in
the first place.

In between these two extreme possibilities, there could be several occurrences of

the events with the corresponding probabilities of occurrence. In these situations,
since we cannot exactly tell which of the many possible events will take place, we
will be in an uncertain situation, and this creates risk.

When probability of occurrence of a given event is either zero or one, there is no

risk involved.

1.4. Risk, Peril and Hazard

Overview

So far we’ve looked at the notion of risk by comparing it with concepts of

uncertainty and probability. One final thing we should do before completing this
unit is to look into the relationship of risk, peril and hazard. As it is the case with
uncertainty and probability, these words are also used confusedly with risk. In this
brief section, I will make clear to you the distinction between risk, peril & hazard.

What do we mean by the words peril and hazard?

Are they used interchangeably with risk?

The word risk is often used to mean both the event which will give rise to some loss
and the factors which might influence the outcome of a loss.

What sense does it make to you when somebody mentions to you a risk of a plane
explosion?

What you understand from this statement is the risk of human and property damage
due to explosion of the plane otherwise the risk of explosion by itself does not really
make much sense. A plane explosion could cause human and property damage.

Thus when we mention the phrase” the risk of plane explosion” we are highlighting
the explosion as a cause for possible human and property damage. This explosion,
say, could possibly be created due to engine failure.

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When you think of a cause of risk, you should consider two aspects of it. The
explosion is the cause of the human and property damage and the fact that the plane
has an engine problem increased the possibility that the plane might explode.

Are you able to separately see these two aspects of risk?

If you do then you are beginning to see the difference between peril and hazard.
Peril is the prime or specific cause of a loss while hazard refers to those factures
which might influence the outcome specifically, hazard refers to those conditions
that may create or increase the chance of loss arising from a given peril. In our
example the peril is the plane explosion, which is the cause of human and material
loss suffered, while the engine problem is the hazard.

Can you think of some examples of peril?

You might have thought of fire, storm, theft, collision, explosion, flood, and others as
possible examples of peril. Thus, peril refers to the prime source of a specific loss.
Most of the time it is beyond the control of anyone involved in the situation.

Hazards unlike perils do not cause risk by themselves. But, considering a given peril,
hazards can increase or decrease the effect. In other words a hazard affects the
magnitude and frequency of a loss caused by a given peril. The more hazardous
conditions are the higher the chances of losses are.
Peril is a specific cause of loss while hazard is a condition that creates or
increases the chance of a loss
There are various types of hazards but risk and insurance writers focus mostly on
four major types of hazards discussed below.

Physical hazard
Physical hazard refers to a physical condition that increases the chance of a loss I
prelates to the physical properties of the item exposed to risk.

Surely, a house located near a river bank is more exposed to risk of flood than
another house located far away from the river. Note that in this case we are
referring specifically to the physical property of the house. The house that is
physically proximate to the river happens to be more prone to risk of flood due to its
physical characteristics.

Can you give some examples of physical hazards?

 The nature of construction of a building;

A building made up of bricks is stronger than the one made up of wood
 Security protection of a shop or factory
A supermarket that has a well-designed security system is less susceptible to
theft-than the one with no security protection system.

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 Occupancy of building
What the building occupies also matters in consideration of hazard. For
instance, a building that occupies chemicals is more exposed to fire risk than the
one occupying furniture.
 Working condition
A person who works in mining fields is more exposed to risk than a person
working in an office.

Physical hazard refers to a physical condition that increases the chance of a loss

Moral hazard
Moral hazard is associated with human nature, qualities, reputation, attitudes, etc.
More specifically, it is dishonesty or character defects in an individual that increase
the frequency or severity of a loss. It originates from deliberate evil tendencies in
the character of individuals.

What examples of moral hazard can you think of?

You may have thought of the following as possible answers:
 Faking an accident to collect money from an insurance company;
 Dishonest act of an individual;
 Fraudulence, etc.

Moral hazard is very important for insurance consideration. It is present in all forms
of insurance and is difficult to control. Insurance companies make attempts to
control moral hazard by carefully examining the person to be insured through a
process called under writing.

Moral hazard concerns the human aspect which may influence the outcome. It
relates to evil tendencies in the character of individual.

Morale hazard
It is helpful to make distinction between moral and morale hazards. Unlike moral
hazard which refers to dishonesty of individuals, morale hazard originates from an
act of carelessness leading to the occurrence of a loss. It occurs due to lack of
concern, carelessness, or indifference to a loss.

Have you come across people who smoke cigarettes in a gas station disregarding the
no smoking sign?
This is an example of morale hazard. Other examples include leaving car keys in an
unlocked car, which increase the chance of theft; leaving a house door unlocked that
allows a burglar to enter, etc.
Morale hazard refers to carelessness or lack of concern to occurrences of losses.

Legal hazard
Legal hazard refers to characteristics of the legal system or regulatory environment
that increases the frequency or severity of government laws that may change quite

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often based on new developments. And this could possibly influence the outcome of
a loss.

Consider this example for illustration purposes. At present, there is no insurance

coverage for HIV/AIDS related deaths under their health insurance policies this law
would increase the frequency of severity of loss to insurance companies.

In the above paragraphs you’ve studied about risk peril and hazard and by now, you
are clear as to what risk, peril, and hazard actually mean.

But is it possible to establish a specific cause effect relationship between these

concepts?

Yes, though it does not always work that way, we can conclude that peril which is a
prime cause of risk, is by itself caused or influenced by hazard. Accordingly, it is
possible to establish the following relationship

Hazard peril risk

But be careful! As I said earlier, this relationship is not always true. Sometimes a
given hazard by itself can cause risk. And sometimes you might face difficulty
distinguishing between a peril and a hazard. Consider a situation where a fire is in
progress in a given locality and due to the confusion created in the area, two cars
collided.

How do you regard the fire? As a peril or as a hazard?

May be both. Concerning the loss of a building which caught fire, the peril the cause
of the risk, is surely the fire. But when it comes to the collision of the cars the fire is
rather a hazard than a peril. The risk of losing those cars by the accident is caused
by collision (which is the peril. But this peril is affected by the hazard situation
created i.e. the fact that there was fire in the vicinity.)

You might sometimes, encounter these types of overleaping but in most cases, ‘the
hazard leads to peril and peril leads to risk’ step works.

1.5. General Classifications of Risk

Even though many classes of risk have been identified in insurance related
literature, it seems there is some agreement as to which of these classifications are
the major ones. This Section presents three of these major classifications of risk.
This will enable you to differentiate between financial and non-financial, pure and
speculative, and static and dynamic risks.

Pure and speculative risks

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In various risk management and insurance, text book authors have tried to
distinguish between pure and speculative risks. But what actually is the difference
between pure and speculative risks?

The distinction between pure and speculative risks rests on whether or not gain is
involved. Pure risk exists when there is a chance of loss but not of chance of gain.
Hence there are two possible outcomes in the case of pure risks: when pure risk
happens the person facing the risk will either be left in the same position he has
been before the incident occurred or the outcome will be unfavorable to him. In any
case there is no possibility of gain in the case of pure risk.

Owner of an automobile can be an example of pure risk. When this person drives his
car, he faces the risk associated with a potential collision loss. If his car collides with
another car, the owner will suffer financial loss If no collision occurs the owner
would neither suffer loss nor gain anything. Since there is no possibility of gain, the
owner’s financial position remains unchanged.

 Pure risk refers to a situation in which only a loss or no loss would occur.
What about speculative risks?
In the case of speculative risks, there exists both a chance of gain as well as a chance
of loss. For example when someone makes an investment there is an expectation of
profit out of the investment. The investor speculates that the investment venture
entered into could bring gain to him/her.
In fact there is a possibility that a person may just get back his money (break even)
or experience loss. That is what makes the venture risky after all. The point, any
way, is that in the case of speculative risk there is a possibility of gain or loss.

 Speculation risk refers to a situation where there is a chance of loss or gain.

However distinct pure and speculative risks may look theoretical in real business
world, both of them could exist. The distinction made between them to a large
extent is semantic. In actual facts a given risk has both pure and speculative
elements.

An owner of a residential building, for instance, faces the risk that the value of the
building at the end of a year might be grater or smaller than its current value. This
risk can be caused, among other things, due to partial damage of the building by fire
or due to possible general decline in prices of buildings.

One can say that the fire risk is pure risk while decline in price of the building is not.
What you can clearly see from the example is that both of them are examples of the
total risk the owner of the building faces.

But do not take me wrong! I am not in any way implying that there is no need to
distinguish between the two concepts. Though the distinguishing line between pure
and speculative risks may be fuzzy, we will keep on treating them separately as this
is the case in the whole business world.

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There is considerable amount of evidence that people react differently to each type
of risk. And more importantly, in the world of business, organizations often plan
differently for managing pure and speculative risks or another possible explanation
is that unlike speculative risks, in the case of pure risks, people do not have perfect
information about the risk to which they are exposed.

Any way it is important that you make distinction between the two types of risks. To
help you differentiate pure and speculative risks, consider the case of Dire Dawa
Food Complex, which is a large factory with sophisticated machinery and
production lines. This factory produces a range of foodstuffs for both domestic and
foreign markets.

 What possible pure and speculative risks do you think would the owners of the
factory face?
I hope you have identified some of the following.
Pure risks
 A material damage can possibly occur to the factory machinery or stock due to
fire, storm, explosion malicious damage or any other peril;
 There is exposure to the risk of theft. The finished stock, the raw materials and
even the machinery in the factory might probably be stolen;
 The sophisticated machinery the firm owns may break down and take some time
to repair or replace; involving the cost of repair and a loss of production;
 There is a risk that the factory products could possibly be tampered in some
criminal way.
You can think of others more:

Speculative risk
 A mistake in pricing could possibly entail a loss to the factory. A price might be
made too high resulting in sharp decline in demand or it may be made too low to
yield sufficiently high return to the company;
 You have studied about marketing in your earlier courses. All marketing
decisions carry a speculative risk. An incorrect interpretation of market needs may
cause a loss while a correct decision could prove very profitable;
 Credit sales may also be very risky. A merchant from market could buy a large
amount of stock on credit basis and may become unable to pay the debt. Thus credit
sales though made in the hope of gain could result in a loss.

The list goes on!

When you start studying insurance as this course progresses you will see the
importance of stressing the distinction between pure and speculative risks. This is
because though there are some changes lately, from the insurance company’s point
of view, speculative risks are of the no interest as they cannot be insured.

 Pure risks are normally insurable while speculative risks are not.
Why do you think is insurance unavailable for speculative risks?

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The reason is easy to see. Speculative risks are entered into voluntarily, in the hope
that there will be gain. If it is known that an insurance company would cover the
risk of loss, regardless of the effort made by the individual facing the risk, the person
would exert very little effort, if any, to avoid the risk of loss. If a business man knows
that any loss he might experience is insurable, he will not bother match to be
profitable.

As I have mentioned above, however, these days it is difficult to be dogmatic about

the non-insurable nature of speculative risks. Practice tells us that insurance is
becoming available to those risks which are normally considered speculative risks.
Credit insurance is a good example in this case. Credit insurance is an arrangement
that creditors make with insurance companies so that the latter would cover the
resultant loss should the debtor default.

Further Classification of Pure Risks:

Pure risks are further classified into three categories.
Personal risks
As the name itself indicates personal risk refers to the possibility of loss to a person.
It is chiefly concerned with death, and the time of it occurrence. And apart from
death incapacity through accident, injury, illness or old age loss of earning power is
considered to personal a risk.

 Personal loss refers to possibility of loss to a person.

Property Risk
Property risk refers to a possible loss of physical property due to various causes.
Look at the possible pure risks we’ve mentioned earlier in connection with dire
Dawa Food Complex. Loss of physical property by fire, theft, explosion, windstorm,
flood and any other peril is categorized under property risk.

In addition to direct losses, property risk can also result in individual losses
commonly known as consequential losses. For example, as a consequence of
interruption of operation due to various reasons a firm could lose income; hence the
name consequential loss.
 By property loss we mean a physical property loss suffered due to various
causes.

Liability Risk
Liability risk is occasioned by the operation of the law of liability and may be termed
third party risk. It materializes when someone internationally or unintentionally
inflicts damage to other persons or their property. In this case the person would
legally be obliged to pay for the damage he/she has inflicted.

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 Liability risk arises when a damage is inflicted on a third party or on her/his

property.

Can you give an example of liability risk?

Cakes a given pastry makes available for sale may create health problems on
consumers due to sanitation problems and people may die because of this. If the
consumers go to a court of law demanding compensation, the pastry would face
liability risk which is specifically referred to as product liability.

In this sub-section, you’ve studied one class of risk, namely speculative and pure
risk. In the remainder of this section, though briefly, you will study the other classes
of risk.

Financial and Non – financial Risk

The second classification of risk groups risk into financial and non-financial
category. This classification is self explanatory by itself. Financial risks result in
losses that can be expressed in financial terms whereas non- financial risks do not
have financial implications.

Can you think of some risks which are measured financially?

Financial risk can easily be seen in the case of material damage to property, theft of
property or loss of business profit following a fire accident. In each of these cases
the effect of the risk can be expressed in terms of money.

Is personal injury a financial risk?

Personal injuries are also financial risks as it is possible to measure the loss
associated with personal injuries in terms of a court award of damages or based on
negotiations made between the injured person and the person who inflicted the
damage. The point is if a given risk can be measured in financial terms, it would
automatically be categorized as financial risk. But there are situations where this
kind of measurement is not possible.

Can you measure the agony one fells following the death of a close relative in terms
of money? What is the financial loss of losing a father? Is it measurable financially?

The above two cases are examples of non- financial risks. If a car you bought for
60,000 Birr overturns and is totally damaged, you can say that your loss is 60,000
Birr. But you cannot assign price to people’s lives. Some writers argue that it has
been possible to assign money to people’s lives after the introduction of life
insurance. But the money insurance companies’ pay for relatives of the deceased
person is by no means the value of the dead person and cannot measure the value of
a person’s life. It is rather a mere compensation made to the relatives so that they
can overcome financial hardships.

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Can you think of other examples of non-financial risk?

Take the case of the choice of a new car or the selection of an item from a restaurant
menu. Surely, risk is involved in making this choice. But these situations are
considered risk not because the outcome could cause financial loss but because the
outcome could be uncomfortable or disliked in some other way. After buying a pair
of shoes, your friend may make bad comments about it and you may not feel free
whenever you wear it. Or the food item you selected from the menu could taste bad
and make you uncomfortable the whole day.

We can even go on as far as mentioning the big choices people make in life as
examples of non- financial risks. The choice of marriage partner, the decision to
have children, the selection of a career, etc. are instances of this situation. These
decisions may or may not have financial implications but to measure them other
more human criteria than money is used.

 Financial risk is one where the outcome can be measured in monetary terns.
 Non-financial risk refers to risky situation where outcome cannot be measured
in terms of money.
In this course and in real business world, the focus is more on financial risks than on
non financial risks.

Static and Dynamic Risks

It is also possible to classify a risk based on its degree of intensity and its
predictability.

Which one do you think is a more severe risk? A risk associated with changes in
coffee price international or a risk of a farmer losing his/her coffee plant due to fire
accident?

Undoubtedly the former one is more severe as its effect is more serious than the
latter one. This is what we refer to as dynamic risk. Dynamic risk originates from
changes in the overall economy such as price level changes, changes in consumer
tastes, changes on government policies, technological change, political changes and
the like. It is very much difficult to predict these kinds of risk.

Two years before the 1974 Ethiopian Revolution, say, who thought the reign of
Emperor Haileselassie I, the king so much respected and almost worshiped, would
come to an end in that spectacular fashion?

Due to the difficulty involved in prediction, dynamic risks, are beyond the control of
risk mangers and hence are not usually covered by insurance policies.

 Dynamic risk originates from changes in the oversell economy and its effect is
felt widely.

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What about static risks?

Static risks refer to those losses that can take place even though there were no
changes in the overall economy. Consider the example I have mentioned above. A
farmer’s loss of his coffee plant could be very painful to the individual, but it won’
have a wider effect like the case of a major decline in the price of coffee in the
international market. Unlike dynamic risks, for static risks to happen there should
not necessarily be change in the overall economy.

Can you think of some examples of static risks?

You may have thought of many of the perils that make life uncertain. Property might
get stolen, a car may collide with another car, a person could fall and break his leg,
etc.