UNIT 1

RISK AND RELATED CONCEPTS

1.1 Introduction

Due to imperfect knowledge about the future, our activities are likely to result in outcomes,
which are different from our expectations. These deviations are not desirable. Risk is undesirable
outcome that exists due to imperfect foresight about the future. The future is always uncertain
and no one can be perfect about the future.

The more knowledgeable the person is, the more certain it will be concerning the future events.
However, the disappointing phenomenon is that perfect foresight about the future is something
impossible. Thus, risk becomes facts that always remain side by side with human being
activities.
1.2 Definition of Risk

There is no one universal and comprehensive definition of risk that exists so far. It is
defined in different forms by several authors with some differences in the wordings used.
The essence, however, is very similar. Some of the definitions are shown below:
- Risk is a condition in which there is a possibility of an adverse deviation from a
desired from a desired outcome that is expected or hoped for.
- Risk is the objectified uncertainty as to the occurrence of an undesired event.
- Risk is the possibility of an unfavorable deviation from expectations; it is the
possibility that something we do not want to happen will happen or something that
we want to happen will fail to do so.
- Risk is the variation in the outcomes that could occur over a specified period in a
given situation.
- Risk is the dispersion of actual from expected results.

From the above mentioned and other definitions of risk, we can infer that risk is undesired
outcome or it is the possibility of loss. The important point is there should be more than one
outcome for the risk to happen, i.e. there will be no risk if there is only one outcome. This is
because it is certain that only one outcome will take place. The absence of risk in this case

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implies that the future is perfectly predictable. Variations in the possible outcomes, then, lead to
the existence of risk; and the greater the variability, the greater the risk will be. .

1.3 DISTINCTION OF RISK, PERIL AND HAZARD

The concept of risk has already been defined above. Two concepts, peril and hazard must
be distinguished from risk. Although, the three concepts have one common feature in
transmitting bad taste or feeling, they are differentiated as follows:

Peril: - refers to the specific cause of a loss. For example, fire, windstorm, theft, explosion,
flood etc. therefore, the source or cause of a loss is called a peril.

Hazard: - refers to the condition that may create or increase the chance of a loss arising
from a given peril. Hazard affects the magnitude and frequency of a loss. The more
hazardous conditions are, the higher the chance of loss. There are three categories of
hazards:

1. Physical Hazard: - This is associated with the physical properties of the item exposed to
risk. Examples of physical hazard include the following:
- type of construction material such as wood, bricks, etc
- Location of property such as near to fuel station, near to flood area, near to
earthquake area, etc.
- Occupancy of building such as dry cleaning, chemicals, supermarket etc.
- Working condition such as machines for personal accidents.
- etc.
2. Moral Hazard: - This originates from evil tendencies in the character of the insured
person. It is associated with human nature, qualities, reputation, attitude, etc. examples
include the following:
- dishonesty, fraudulent intention, exaggeration of claims, etc …

3. Morale Hazard: - This originates from acts of carelessness leading to the occurrence of a
loss. It occurs due to lack of concern for events. Examples are:
- poor housekeeping in stores
- Cigarette smoking around petrol sations.

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 - etc.

In some situations, however, it is difficult to distinguish between a peril and a hazard. Fore
example, a fire in general may be regarded as a peril concerning the loss of physical
property. It may also be regarded as a hazard concerning auto collisions created by the
confusion in the vicinity of the fire (around the fire).
1.4 CLASSIFICATION OF RISK
Risk can be classified in several ways according to the cause, their economic effect, or some
other dimensions. The following summarizes the different ways of classifying risks.

1. Financial Vs Non-financial risks

This way of classification is self explanatory. Financial risks result in losses that can be
expressed in financial terms. Non-financial risk does not have financial implication. For
example, loss of cars (property) is a financial risk, and deate of relatives is a non-financial
risk.

2. Static Vs Dynamic risks

Dynamic risks originate from changes in the over all economy which are associated with
such as human wants, improvements in technology and organization (price changes,
consumer taste changes, income distribution, political changes, etc.). They are less
predictable and hence beyond the control of risk managers some times.

Static risks, on the other hand, refer to those losses that can take place even though there
were no changes in the over all economy. They are losses arising from causes other than
changes in the overall economy. Unlike dynamic risks, they are predictable and could be
controlled to some extent by taking loss prevention measures.

3. Fundamental Vs Particular risks

Fundamental risks are essentially group risks; the conditions, which cause them, have no
relation to any particular individual. Most fundamental risks are economic, political or
social.

Particular risks are those due to particular and specific conditions, which obtain in
particular cases. They affect each individual separately. They are usually personal in cause,

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almost always personal in their application. Because they are so largely personal in their
nature, the individual has certain degree of control over their causes.

Thus, fundamental risks affect the entire society or a large group of the population. They
are usually beyond the control of individuals. Therefore, the responsibility for controlling
these risks is left for the society it self. Examples include: unemployment, famine, flood,
inflation, war, etc. Particular risks are the responsibility of individuals. They can be
controlled by purchasing insurance policies and other risk handling tools. Examples
include: property losses, death, disability, etc.

4. Objective Vs Subjective risks

Some authors classify risk in to objective and subjective. These two types of risk are also
mentioned as measurable and Non-measurable risk.

Objective risk has been defined as “the variation that exists in nature and is the same for
all persons facing the same situation”. it is the state of nature (world). However, each
individual’s estimate of the objective risk varies due to a number of factors. Thus, the
estimate of the objective risk which depends on the person’s psychological belief is the
subjective risk. The problem, however, is that it is difficult to obtain the true objective risk
in most business situation.

The characteristics of objective risk is that it is measurable. In other words, it can be

quantified using statistical or mathematical techniques.

5. Pure Vs Speculative risks

The distinction between pure and speculative risks rest primarily on profit/loss structure of
the underlying situation in which the event occurs. Pure risks refer to the situation in
which only a loss or no loss would occur. There are only two distinct outcomes: loss or no
loss. They are always undesirable and hence people take steps to avoid such risks. Most
pure risks are insurable. Pure risks are further classified in to three categories: personal
risk, property risk, and liability risk.

i. Property risk

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This refers to losses associated with ownership of property such as destruction of property
by fire. Ownership of property puts a person or a firm to property exposure, i.e. the
property will be exposed to a wide range of perils.

ii. Personal risk

This refers to the possibility of loss to a person such as death, disability, loss of earning
power, etc. There are losses to a firm regarding its employees and their families. Personal
risks may arise due to accidents while off duty, industrial accident, occupational disease,
retirement, sickness, etc. Generally, financial losses caused by the death, poor health,
retirement, or unemployment of people are considered as personal losses. Either the
workers and their families or their employers may suffer such losses.

iii. Liability risk

The term liability is used in various ways in our present language. In general usage, the
term has become synonymous with “responsibility” and involves the concept of penalty
when a responsibility may not have been met. A person may be generally obligated to
another, because of moral or other reasons, to do or not to do something; the law, however,
does not recognize moral responsibility alone as legally enforceable. One would be legally
obliged to pay for the damage he/she inficted upon other persons or their property.

Speculative risks, on the other hand, provide favorable or unfavorable consequences. The
situation is characterized by a possibility of either a loss or a gain. People are more adverse
to pure risks as compared to speculative risks. In speculative risk situation, people may
deliberately create the risk when they realize that the favorable outcome is so promising.
Speculative risks are generally uninsurable. For example, expansion of plant, introduction
of new product to the market, lottery, and gambling.

Both pure and speculative risks commonly exist at the same time. For instance, accidental
damage to a building (pure risk) and rise or fall in property values caused by general
economic conditions (speculative risk). Risk managers are concerned with most but not all
pure risks. For the detail refer unit 2.

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1.5 RISKS RELATED TO BUSINESS ACTIVITIES

Most risks in business environment are speculative in nature. The finance literature considers
[five types of risks that business organizations face in the course of their normal operation:
business risk, financial risk, interest rate risk, purchasing power risk, and market risk.

1. Business Risk: - This the risk associated with the physical operation of the firm. Variations in
the level of sales, costs, profits, are likely to occur due to a number of factors inherent in the
economic environment. Business risk is independent of the company’s financial structure.

2. Financial Risk: - This is associated with debt financing. Borrowing results in the payment of
periodic interest charge and the payment of the principal upon maturity. There is a risk of default
by the company if operations are not profitable. Other financial risks include: bankruptcy, stock
price decline, insolvency, etc. Bond holders are less exposed to financial risk than common stock
holders because they have a priority claim against the assets of an insolvent firm.

3. Interest Rate Risk: - This is a risk resulting from changes in interest rates. Changes in interest
rates affect the price of financial securities such as the price of bonds, stock, etc---

4. Purchasing power Risk: - This 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. It 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 like presidential election, trade balances,
wars, new inventories, 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.

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1.8 Summary

Risk is an adverse deviation from the desired or expected outcome while results due to imperfect
knowledge of the future.

Risk and uncertainty are two different but related concepts. Risk is objective and the state of the
world while uncertainty is subjective, the state of the mind.

Risk can be classified in various ways by considering the different aspects of it. Financial Vs non
financial risks, static Vs dynamic risks, fundamental Vs particular risk, objective Vs subjective
risks, and pure Vs speculative risks. However, in risk management pure Vs speculative way of
classifying risks is common.

Pure risks are those, which occur in situation where only two (loss or no loss) distinct outcomes
exists. And they are further classified as personal property, and liability risk.

Business cannot be undertaken in a vacuum. Hence, there are various risks associated with it
such as: market risk, interest rate risk, purchasing power risk, and others.