Chapter- One
Risk and Its Management
Prepared by-
Fatema Afreen
Faculty Member
Premier University
Meaning of Risk:
In simple terms, risk is the possibility of something bad
happening. Risk involves uncertainty about the
effects/implications of an activity with respect to something
that humans value (such as health, well-being, wealth,
property or the environment), often focusing on negative,
undesirable consequences.
Risk is defined in financial terms as the chance that an
outcome or investment's actual gains will differ from an
expected outcome or return. Risk includes the possibility of
losing some or all of an original investment.
Risk
The cost is Costly:
of risk is the cost of incurring losses because of
risk and managing risks. The total of this cost is the sum of
every aspect of a company’s functions relating to risk,
consisting of retained (uninsured) losses, related loss
adjustment expenses, administrative costs, risk control
costs, and transfer costs.
Direct vs. Indirect Expected Losses:
Direct Loss — loss incurred due to direct damage to
property, as opposed to time element or other indirect
losses.
Indirect losses, often referred to in business insurance
policies as "consequential losses," are not inflicted by the
peril itself but describe losses suffered as a result or
consequence of the direct loss.
Types of Risk Facing Business and
Individuals:
Mainly two types—
A. Business Risk
B. Personal Risk
A. Business Risk:
Business risk refers to the chance that a firm / business cash
flows are not enough to cover its operating costs like-
cost of goods sold
rent & wages
salaries / Remunerations
commissions
bills & taxes, etc.
Classification of Business Risk:
Business Risk
Price Risk Credit Risk Pure Risk
Input Price Output Price Damage to Assets
Risk Risk
Legal Liability
Commodity Price Risk
Worker Injury
Exchange Rate Risk
Employee Benefits
Interest Rate Risk
A.1 Price Risk:
Price risk refers to the uncertainty over the magnitude of
cash flows due to possible changes in input and output
prices.
There are specific types of price risk-
a) Commodity price risk
b) Exchange rate risk
c) Interest rate risk
a. Commodity Price Risk:
Commodity price risk is the threat that a change in the price of
a production input or output prices will adversely impact a
producer / seller who uses that input/sales output.
Factors that can affect commodity prices include –
political & regulatory changes
seasonal variations
weather
technology
market conditions
b. Exchange Rate Risk/ Currency Risk/ Foreign Exchange
Risk:
Exposure or uncertainty that is inherent in dealing with two
or more currencies that do not have fixed parity values.
c. Interest Rate Risk:
Interest rate risk arises due to variability in the interest rates
from time to time.
A.2. Credit Risk:
The risk that a firm’s customers and the other parties to
which it has lent money will delay or fail to make promised
payments. Most firms face some credit risk for accounts
receivables.
A.3. Pure Risk:
Pure risk is a category of risk in which loss is the only
possible outcome and it is a category of threat that is beyond
human control.
The main types of pure risk that affect business include:
a) Damage to assets
b) Legal liability
c) Worker injury
d) Employee benefits
B. Personal Risk:
These are the risks that directly affect the individual's
capability to earn income.
Personal risks can be classified into the following types:
a) Death
b) Aging
c) Disability
d) Unemployment
The Risk Management Process:
1. Identify all significant risks
2. Evaluate the potential frequency and severity of losses
3. Develop and select methods for managing risk
4. Implement the risk management methods chosen
5. Monitoring the performance and suitability of the risk
management methods and strategies on an ongoing
basis.
Risk Management Methods:
Internal risk
Loss control Loss financing
reduction
Retention and self-
insurance
Reduced level of Diversification
risky activity
Insurance
Investments in
Increased Hedging information
precautions
Other contractual
risk transfers
The end