Types of Risks

Financial and Non-financial Risks

Financial risk involves the simultaneous existence of three important elements in a risky
situation – (a) that someone is adversely affected by the happening of an event, (b) the assets or
income is likely to be exposed to a financial loss from the occurrence of the event and (c) the
peril can cause the loss. For example, loss occurred in case of damage of property or theft of
property or loss of business. This is financial risk since risk resultant can be measured in
financial terms. When the possibility of a financial loss does not exist, the situation can be
referred to as non-financial in nature. Financial risks are more particular in nature. For example,
risk in the selection of career, risk in the choice of course of study, etc. They may or may not
have any financial implications. These types of risk are difficult to measure. As far as insurance
is concerned, risk is involved with an element of financial loss.

Individual and Group Risks

A risk is said to be a group risk or fundamental risk if it affects the economy or its participants
on a macro basis. These are impersonal in origin and consequence. They affect most of the social
segments or the entire population. These risk factors may be socio-economic or political or
natural calamities, e.g., earthquakes, floods, wars, unemployment or situations like 11th
September attack on US, etc. Individual or particular risks are confined to individual identities or
small groups. Thefts, robbery, fire, etc. are risks that are particular in nature. Some of these are
insurable. The methods of handling fundamental and particular risks differ by their very nature,
e.g., social insurance programmes may be undertaken by the government to handle fundamental
risks. Similarly, fire insurance policy may be bought by an individual to prevent against the
adverse consequences of fire.

Pure and Speculative Risks

Pure risk situations are those where there is a possibility of loss or no loss. There is no gain to
the individual or the organization. For example, a car can meet with an accident or it may not
meet with an accident. If an insurance policy is bought for the purpose, then if accident does not
occur, there is no gain to the insured. Contrarily, if the accident occurs, the insurance company
will indemnify the loss. Speculative risks are those where there is possibility of gain as well as
loss. The element of gain is inherent or structured in such a situation. For example — if you
invest in a stock market, you may either gain or lose on stocks. The distinguishing characteristics
of the pure and speculative risks are: (a) Pure risks are generally insurable while the speculative
ones are not. (b) The conceptual framework of the risk pooling can be applied to pure risks,
while in most of the cases of speculative risks it is not possible. However, there may be some
situation where the law of mathematical expectation might be useful. (c) Speculative risk carry
some inherent advantages to the economy or the society at large while pure risks like uninsured
catastrophes may be highly damaging.

Static and Dynamic Risks

Dynamic risks are those resulting from the changes in the economy or the environment. For
example economic variables like inflation, income level, price level, technology changes etc. are
dynamic risks. Since the dynamic risk emanates from the economic environment, these are very
difficult to anticipate and quantify. Dynamic risk involves losses mainly concerned with
financial losses. These risks affect the public and society. These risks are the best indicators of
progress of the society, because they are the results of adjustment in misallocation of resources.
On the other hand, static risks are more or less predictable and are not affected by the economic
conditions. Static risk involves losses resulting from the destruction of an asset or changes in its
possession as a result of dishonesty or human failure. Such financial losses arise, even if there
are no changes in the economic environment. These losses are not useful for the society. These
arise with a degree of regularity over time and as a result, are generally predictable. Example for
static risk includes possibility of loss in a business: unemployment after undergoing a
professional qualification, loss due to act of others, etc.

Dynamic vs. Static Risks

Dynamic Risks Static Risks

Losses are not easily predictable Losses can be predicted
These risk result from the changes in There occur even if there is no change in
economic environment economic environment
These risks are not covered by insurance These risk can be covered by insurance
These risks benefit the society These risks don’t benefit the society

Quantifiable and Non-quantifiable Risks

The risk which can be measured like financial risks are known to be quantifiable while the
situations which may result in repercussions like tension or loss of peace are called as non-
quantifiable.

Risk for Financial Institutions

In line with the BASEL accord, the risks for banks, financial institutions, etc. can classified as
follows:10
Credit Risk: The risk that a customer, counterparty, or supplier will fail to meet its obligations.
It includes everything from a borrower default to supplier missing deadlines because of credit
problems. Credit risk is the change in value of a debt due to changes in the perceived ability of
counterparties to meet their contractual obligations (or credit rating). Also known as default risk
or counterparty risk, credit risk is faced by lending institutions like banks, investors in debt
instruments of corporate houses, and by parties involved in contractual agreements like forward
contracts. There are independent agencies that assess the credit risk in the form of credit ratings.
Credit rating is an opinion (of the credit rating agency) on the ability of the organization to
perform its contractual obligations (pay the principle and/or interest of the loan) on a timely
basis. Each level of rating indicates a probability of default. International credit rating agencies
(like Moody’s, Fitch, and S&P) use quantitative models along with their experience to predict
the credit ratings. Credit scoring models of banks and lending institutions use stock prices (if
available), financial performance and sector-specific data, and macroeconomic forecasts to
predict the credit rating.

Credit risk can be further segregated as:

(a) Direct Credit Risk – due to counterparty default on a direct, unilateral extension of credit
(b) Trading credit risk – counterparty default on a bilateral obligation (repos)
(c) Contingent credit risk – counterparty default on a possible future extension of credit
(d) Correlated credit risk – magnified effect
(e) Settlement risk – failure of the settlement conditions
(f) Sovereign risk – due to government policies (exchange controls)

Market Risk: The risk that process will move in a way that has negative consequences for a
company. Market Risk is the change in value of assets due to changes in the underlying
economic factors such as interest rates, foreign exchange rates, macroeconomic variables, stock
prices, and commodity prices. All economic entities that own assets face market risk. For
example, bills receivable of software exporters that are denominated in foreign currencies are
exposed to exchange rate fluctuations; while value of bonds/government securities owned by
investors depend on prevailing interest rates. Organizations with huge exposures, either have a
dedicated treasury department, or outsource market risk management to banks. Modeling market
risk requires forecasting the changes in the economic factors, and assesses their impact on the
asset value. Almost popular measure for expressing market risk is Value-at-Risk, which is ‘the
maximum loss’ from an unfavourable event, within a given level of confidence, for a given
holding period. Various financial instruments like options, futures, forwards, swaps, etc. can be
used effectively to hedge the market risk. Availability of huge data on various markets has
facilitated the development of many sophisticated models.

These risks can be broken into following components:

(a) Directional Risk – deviations due to adverse movement in the direction of the underlying
reference asset.
(b) Curve Risk – deviation due to adverse change in the maturity structure of a reference asset.
(c) Volatility risk – unexpected volatility of financial variable.
(d) Time decay risk – risk due to passage of time.
(e) Spread risk – adverse change in two reference assets that are unrelated.
(f) Basis risk – adverse change in two reference assets that are related
(g) Correlation risk – risk due to adverse correlations.

Operational: The risk that people, processes, or systems will fail or that an external event will
negatively affect the company. Practically speaking, all organizations face operational risk. For a
financial institution/bank, operational risk can be defined as the possibility of loss due to
mistakes made in carrying out transactions such as settlement failures, failures to meet regulatory
requirements, and untimely collections. No concrete model of managing credit risk is available
till today. Still lot of research is being done in this direction.

Other: Extensions of the above categories, viz., business risk is that future operating results may
not meet expectations; organizational risk arises from a badly designed organizational structure
or lack of sufficient human resources.

1.8 Classifying Pure Risks

Since pure risks are generally insurable, the discussion on risk in further chapters of the book is
skewed towards pure risks only. On the presumption that insurable pure risks being static can be
classified as follows:

Pure Risk

Personal Property Liability

Personal Risks

Personal risks are risks that directly affect an individual. They involve the possibility of the
complete loss or reduction of earned income. There are four major personal risks.

Risk of Premature Death: Premature death is defined as the death of the household head with
unfulfilled financial obligations. If the surviving family members receive an insufficient amount
of replacement income from other sources or have insufficient financial assets to replace the lost
income, they may be financially insecure. Premature death can cause financial problems only if
the deceased has dependents to support or does with unsatisfied financial obligations. Thus, the
death of a child aged 5 is not premature in the economic sense.

Risk of Insufficient Income during Retirement: It refers to the risk of not having sufficient
income at the age of retirement or the age becoming so that there is a possibility that individual
may not be able to earn the livelihood. When one retires, he loses his earned income. Unless he
has sufficient financial assets from which to draw or has access to other sources of retirement
income such as social security or a private pension, he will be exposed to financial insecurity
during retirement.

Risk of Poor Health: It refers to the risk of poor health or disability of a person to earn the
means of survival. For example, losing the legs due to accident, heart surgery that is costly.
Unless the person has adequate health insurance, private savings or other sources of income to
meet these losses, he will be financially insecure. The loss of insecurity is significant if the
disability is severe. In case of long-term disability, things will become worst and someone must
take care of the disabled person. The loss of earned income can be financially painful.

Risk of Unemployment: The risk of unemployment is another major threat to financial security.
Unemployment can result from business cycle downswings, technological and structural changes
in the economy, seasonal factors, etc. Employers are increasingly hiring temporary or part-time
workers to reduce labor costs. Being temporary employees, workers lose their employee benefits.
Unless there is adequate replacement income or past savings on which to draw, the workers
(unemployed, part time and temporary) will be financially insecure. By passage of time, past
savings and unemployment benefits may be exhausted.

Property Risks

It refers to the risk of having property damaged or lost because of fire, windstorm, earthquake
and numerous other causes. There are two major types of loss associated with the destruction or
theft of property.

Direct Loss: A direct loss is defined as a financial loss that results from the physical damage
destruction, or theft of the property. For example, physical damage to a factory due to fire is
known as direct loss.

Indirect or Consequential Loss: An indirect loss is a financial loss that results indirectly from
the occurrence of a direct physical damage or theft loss. For example, in factory, there may be
apparent financial losses resulting from not working for several months while the factory was
rebuilt and also extra expenses termed as indirect loss. Regardless of the cost, business may lose
its customers. In this case, it is necessary to setup a temporary operation at some alternative
location and extra expenses would occur. These are the indirect expenses resulting from the
damage of the factory.

Liability Risks

These are the risks arising out of the intentional or unintentional injury to the persons or damages
to their properties through negligence or carelessness. Liability risks generally arise from the
law. For example, the liability of an employer under the workmen’s compensation law or other
labor laws in India. In addition to the above categories, risks may also arise due to the failure of
others. For example, the financial loss arising from the non-performance or standard
performance in an engineering or construction contract.

Risk Management Process

Risk Management Process is the process of making and implementing decisions that will
minimize the adverse effects of accidental business losses on an organization. Making these decisions
involves a sequence of five steps: identifying and analyzing exposures to loss, examining feasible
alternative risk management techniques to handle exposures, selecting the most appropriate risk
management techniques to handle exposures, implementing the chosen techniques, and monitoring the
results. Implementing these decisions requires performing the four functions of the management process:
planning, organizing, leading, and controlling resources.

Steps in the Risk Management Process

Steps in the Risk Management Process include

1. Identify loss exposures

2. Analyse the loss exposures
3. Select appropriate techniques for treating the loss exposures
4. Implement and monitor the risk management program

I. Identify loss exposures.

The first step in the risk management process is the identification of loss exposures. Important loss
exposures relate to the following.

1. Property loss exposures

a. Building, plants, other structure
b. Furniture, equipment
c. Computers, computer software and data
d. Valuable papers and records
e. Company vehicles, planes, boats, mobile equipment
2. Liability loss exposures
a. Defective products
b. Environmental pollution
c. Sexual harassment of employees, discrimination against employees
d. Liability arising from company vehicles
 e. Misuse of internet
f. Directors’ and officers’ liability suits
3. Business income loss exposures
a. Loss of income
b. Continuing expenses after a loss
c. Extra expenses
d. Contingent business income loss
4. Human resource loss exposure
a. Death or disability of key employees
b. Retirement or unemployment
c. Job-related injuries or disease experienced by workers
5. Crime loss exposures
a. Holdups, robberies, burglaries
b. Employee theft and dishonesty
c. Fraud and embezzlement
d. Internet and comport crime exposures
e. Theft of intellectual property
6. Employee benefit loss exposures
a. Failure to comply with government regulations
b. Violation of fiduciary responsibilities
c. Failure to pay promised benefits.
7. Market reputation and public image of the company.

A risk manager has several sources of information that he or she can use to identify the loss
exposures. They include:

 Risk analysis questionnaires: Questionnaires require the risk manager to answer numerous
questions and identify major and minor loss exposures.
 Physical inspection: A physical inspection of company plants and operations can identify
major loss exposures.
 Flowcharts: Flowcharts that show the flow of production and delivery can reveal production
bottlenecks where a loss can have severe financial consequences for the firm.
 Financial statements: Analysis of Financial Statements can identify the major assets that must
be protected, loss of income exposures, and key customers and suppliers.

II. Analyze the loss exposures.

This step involves the estimation of the frequency and severity of loss. Loss frequency refers to the
probable number of losses that may occur during some given time period. Loss severity refers to the
probable size of the losses that may occur.

Once the frequency and severity of loss for each type of loss exposure are estimated, the various
loss exposures are ranked according to their relative importance. This also helps the risk manager in
selecting the most appropriate technique for handling each loss exposure.

Although the risk manager must consider both loss frequency and loss severity, severity is more
important because a single catastrophic loss could wipe out the firm. Therefore the risk manager must
also consider all losses that can result from a single event. Both the maximum possible loss and maximum
probable loss must be estimated. The maximum possible loss is the worst loss that could happen to the
firm during its lifetime. The maximum probable loss is the worst loss that is likely to happen.

III. Select the appropriate technique for treating the loss exposures.

The techniques for treating loss exposures can be classified broadly into Risk Control and Risk
Financing.

Risk Control:

It refers to techniques that reduce the frequency and severity of losses. Major risk control
techniques include:

a. Avoidance:
Avoidance means a certain loss exposure is never acquired, or an existing loss exposure
is abandoned. For example, a pharmaceutical firm that markets a drug with dangerous
side effects can withdraw the drug from the market to avoid possible legal liability. The
major advantage of avoidance is that the chance of loss is reduced to zero if the loss
exposure is never acquired. However it is not free from disadvantages. Firstly, the firm
may not be able to avoid all losses. Secondly, it may not be feasible or practical to avoid
the exposure.
b. Loss Prevention:
Loss prevention refers to measures that reduce the frequency of a particular loss. For
example, measures that reduce truck accidents include driver examinations, zero
tolerance for alcohol or drug abuse and strict enforcement of safety rules.
c. Loss Reduction:
Loss reduction refers to measures that reduce the severity of a loss after it occurs. Eg:
Installation of automatic sprinkler system that promptly extinguishes fire.

Risk Financing:

Risk Financing refers to techniques that provide for the funding of losses after they occur. It
includes the following:

a. Retention:
Retention means that the firm retains part or all of the losses that can result from a given
loss. Retention can be either active or passive. Active retention means that the firm is
aware of the loss exposure and plans to retain part or all of it. Passive retention, on the
other hand, is the failure to identify a loss exposure, failure to act or forgetting to act. Eg:
A risk manager may fail to identify all company assets that could be damaged in an
earthquake. Retention can be effectively used in risk management program in the
following conditions.
 No other method of treatment is available.
  The worst possible loss is not serious.
 Losses are highly predictable.
Advantages of retention.

 Saves money
 Lower expenses
 Encourage loss prevention
 Increase cash flow
Disadvantages of retention.

 Possible higher losses

 Possible higher expenses
 Higher taxes

b. Noninsurance Transfers:
Noninsurance transfers are methods other than insurance by which a pure risk and its
potential financial consequences are transferred to another party. For example, a
company’s contract with a construction firm to build a new plant can specify that the
construction firm is responsible for any damage to the plant while it is being built.
Advantages:

 The risk manager can transfer some potential losses that are not commercially insurable.
 Costs less than insurance.
 The potential loss may be shifted to someone who is in a better position to exercise loss
control.
Disadvantages:

 The transfer of potential loss may fail because the contract language is ambiguous.
 If the party to whom the potential loss is transferred is unable to pay the loss, the firm is
still responsible for the claim.

c. Insurance
Insurance is another major method that most people, businesses, and other organizations
can use to transfer pure risks, by paying a premium to an insurance company in exchange
for a payment of a possible large loss. By using the law of large numbers, an insurance
company can estimate fairly reliably the amount of loss for a given number of customers
within a specific time. An insurance company can pay for losses because it pools and
invests the premiums of many subscribers to pay the few who will have significant
losses. Not every pure risk is insurable by private insurance companies. Events which are
unpredictable and that could cause extensive damage, such as earthquakes, are not
insured by private insurers, although reinsurers may cover these types of risks by relying
on statistical models to estimate the probabilities of disaster. Speculative risks — risks
taken in the hope of making a profit — are also not insurable, since these risks are taken
voluntarily, and, hence, are not pure risks.
 If the risk manager uses insurance to treat certain loss exposures, five key areas must be
emphasized.

1. Selection of insurance coverage.

2. Selection of an insurer.
3. Negotiation of terms.
4. Dissemination of information concerning insurance coverage.
5. Periodic review of the program.
Advantages:

 The firm will be indemnified after a loss.

 Uncertainty is reduced, which permits the firm to lengthen its planning horizon.
 Insurers can provide valuable risk management services.
 Insurance premiums are income-tax deductible as a business expense.
Disadvantages:

 The payment of premium is a major cost.

 Considerable time and effort is spent in negotiating the insurance coverage.

IV. Implement and Monitor the Risk Management Program

This step begins with a policy a statement.

Risk Management Policy Statement:

A Risk Management Policy Statement is necessary to have an effective risk management

program. This statement outlines the risk management objectives of the firm, as well as
company policy with respect to treatment of loss exposure. It also educates top level
executives in regard to the risk management process, gives the risk manager greater authority
in the firm, and provides standards for judging the risk manager’s performance.

In addition, a Risk Management Manual may be developed and used in the program. It
describes in detail the risk management program of the firm and can be a very useful tool for
training new employees who will be participating in the program.

The risk manager should perform his work in cooperation with other departments like
accounting, finance, marketing, production and human resources.

The risk management program must be periodically reviewed and evaluated to determine
whether the objectives are being attained. The risk management costs, safety programs and
loss prevention programs must be carefully monitored.
Reinsurance:

Reinsurance is a form of insurance purchased by insurance companies in order to

mitigate risk. Essentially, reinsurance can limit the amount of loss an insurer can potentially
suffer. In other words, it protects insurance companies from financial ruin, thereby protecting the
companies' customers from uncovered losses. The simple explanation is that reinsurance is
insurance for insurance companies. Reinsurance is the mechanism that insurance companies use
to lower their risk or reduce their exposure to a specific catastrophic event. The company that
transfers the risk is called the ceding company and the accepting company is called reinsurer.
The reinsurer agrees to indemnify the cedent against complete or a part of a loss which the
primary insurance company may bear under certain insurance policies that it has sold. In return,
the cedent pays a premium to the reinsurer. Also, the ceding company discloses all the
information needed by the reinsurer to assess, set price, and manage the risks covered under the
reinsurance contract.

Benefits of Reinsurance
Buying reinsurance is one of the most important management strategies for insurance companies
hoping to insulate themselves from volatility and protect their bottom line. What are the specific
benefits of reinsurance? How can it be used to your company’s advantage? Let’s explore some of
the ways that companies keep things running smoothly with the safety net that reinsurance
provides.

1. Reinsurance helps decrease risk.

When an insurance company singularly insures a large number of clients and their property, they
take on a huge amount of risk. Reinsurance is a great strategy to reduce that risk, placing some of
the burden on a reinsurance company instead of shouldering the burden completely alone.

2. Reinsurance companies offer valuable advice.

When consumers need insurance advice, they turn to their insurance company. Where can
insurance companies turn? Because reinsurance companies are experienced and skilled at
understanding patterns in the industry, as well as risks that their individual clients face, they’re in
the perfect position to offer guidance and expertise. This is particularly helpful to fledgling
insurance firms that are just getting started, as well as insurance companies seeking to enter new
areas of the market.

3. It protects against natural disasters and catastrophic events.

This is especially important in areas with large numbers of high-risk policies. Places that are
often plagued by wildfires or that are constant targets for hurricanes and flooding mean that
insurance companies covering these areas face the potential of paying out huge numbers of high-
dollar claims should a disaster strike. Since having a large number of policy holders make these
kinds of claims all at once can be financially devastating, reinsurance helps soften the blow.

4. Reinsurance can stabilize financial losses.

Perhaps an insurance company has the financial ability to pay out a large number of high-dollar
claims. Even so, reinsurance can smooth the way so that a company need not face huge financial
losses that may cause undue strain.

5. It allows a company to take on more policyholders.

Reinsurance helps protect against insolvency. It ensures that insurance companies are able to
make payment on all claims, even in the case of a natural disaster or unexpected high number of
expensive claims. Because of this, it puts companies on more solid ground, allowing them to
offer services to a greater number of clients.

6. Reinsurance helps with company expansion.

Each policy sold carries a certain amount of risk. It also carries a certain amount of cost, from
pay to sales agents to administrative costs. This is why company growth is so important.
Unearned payment reserve requirements can be a burden, and reinsurance can help lessen that
burden – allowing the company to focus its attention on growing the company and number of
clients nationwide.

7. It’s a worthwhile investment.

Insurance companies understand the value of taking out insurance – it’s their business to do so.
Because of this, it seems natural that every insurance company would see the importance of
investing in insuring themselves and their reputation.