CHAPTER ONE

RISK AND RELATED TOPICS

 MEANING OF RISK
 There is no single definition of risk.
 Risk is the possibility of an unfortunate occurrence.
 Risk is a combination of hazards.
 Risk is unpredictability
 Risk is uncertainty of loss.
 Risk is possibility of loss.
CONT’D
 When risk is said to exist, there must always be at
least two possible outcomes.
 At least one of the possible outcomes is

undesirable.
 May be a loss or profit less than the expected.
 Risk is a condition in which there is a possibility

of an unfavorable deviation from a desired

outcome that is expected or hoped for.
CONT’D
 Risk is uncertainty concerning the occurrence of
loss.
 Risk is potential variation in outcomes.
 If a loss is certain to occur, the outcome is one and

known in advance, therefore, there is no risk.

 It is when many outcomes are possible and when

there is uncertainty about the occurrence of a loss

that the notion of risk is to exist.
 The degree of risk is inversely related to the ability

to predict which outcome will actually occur.

 The greater the variation, the greater the risk.
 RISK VERSUS UNCERTAINTY
 The term “certainty” is “a state of being free from
doubt,” a definition will suit to the study of risk
management.
 The antonym of certainty is “uncertainty” which is

“doubt about our ability to predict the future

outcome of current actions.”
 Uncertainty refers to a feelings characterized by

doubt, based on the lack of knowledge about what

will or will not happen in the future.
CONT’D
 Uncertainty is doubt about our ability to predict
the future.
 Uncertainty is a subjective concept, so it cannot be

measured directly - cannot be measured by any

acceptable yardstick.
 Since it is a state of mind, uncertainty varies across

individuals.
LEVELS OF UNCERTAINTY
RISK, PERIL AND HAZARD
 The terms peril and hazard should not be confused with the
concept of risk discussed earlier.
Peril
 Peril is defined as the cause of loss that occurred.

 If a house burns because of a fire, the peril, or cause of

loss, is the fire.

 If a car is damaged in a collision with another car,

collision is the peril, or cause of loss.

 Common perils that cause property damage included fire,

lightning, windstorm, tornadoes, earth quakes, theft

and robbery.
HAZARD
 A hazard is a condition that creates or increases the chance
of loss from a given peril.
 For example, one of the perils that can cause loss to a house is

fire.
 The fire can be caused while we go out of home leaving the

cylinder switched on in the kitchen.

 Using the cylinder properly will not cause a loss, rather poor

handling does.
 There are 4 major types of hazards;

 Physicalhazard
 Moral hazard

 Morale hazard

 Legal hazard
PHYSICAL HAZARD
 A physical hazard is a physical condition that increases
the chance of loss.
 It is a condition stemming from the physical

characteristics of an object that increases the probability

and severity of loss from given perils.
 Examples; Ice covered roads that increase the chance of a

car accident, a defective lock on door that increases the

chance of theft.
 Such hazards may or may not be with in human control.

 Hazards for fire can be controlled by placing restrictions

on buildings or taking care while operating.

MORAL HAZARDS
 It is deceitfulness or character defects in an individual
that increase the frequency or severity of loss.
 Examples; include forged or calculated car accident,

submitting a fraudulent claim, intentionally burning

unsold insured merchandise and etc.
 It exists where there is corrupt intention to claim

excessive amount of insurance for properties that are no

longer profitable.
 Moral hazard may happen in all forms of insurance, and it

is difficult to control.
MORALE HAZARD
 Moral hazard refers to dishonest by an insured
that increases the frequency or severity of loss.
 Morale hazard is carelessness or indifference to a

loss because of existence of insurance.

 Some insured persons are careless or indifferent

to a loss because they have insurance.

 Examples of morale hazard include leaving car

keys in an unlocked car, which increase the

chance of theft; leaving a door unlocked that
allows a robber to enter; and etc.
CONT’D
 Morale hazard is also reflected in the attitude of
persons who are not insured.
 This includes the tendency of physician to

provide expensive examinations or tests when

costs are to be covered by insurance.
 Insurers try to control or reduce both moral and

morale hazard by carefully selecting their insured

and/or by providing contractual provisions that
oblige the insurer to pay some percentage of the
loss.
LEGAL HAZARD
 Legal hazard refers to characteristics of the legal

system or regulatory environment that increase the

frequency or severity of losses.
 Examples include adverse jury decisions or large

damage awards in liability lawsuits, orders that

require insurers to include coverage for certain
benefits in health insurance plans, such as
coverage for alcoholism; and regulatory action by
state insurance departments that restrict the ability
of insurers to withdraw from the state because of
poor underwriting results.
CLASSES OF RISK
 The major categories are as follows:
 Objective and Subjective risks;
 Pure and Speculative risks;
 Fundamental and Particular risks;
 Financial and Non- Financial risks and
 Static and Dynamic risks
OBJECTIVE RISK AND SUBJECTIVE RISK
 Objective risk, also called statistical risk, is
defined as the relative variation of actual loss from
expected loss.
 It is applicable to groups of objects exposed to

loss.
 Thus, there is a variation of 10 houses from the

expected number of 100, or a variation of 10%.

 This relative variation of actual loss from expected

loss is known as Objective Risk.

CONT’D
 It’sdeclines as the number of exposures increases.
 Objective risk can be statistically calculated by

some measure of dispersion, such as the

standard deviation or the coefficient of
variation.
 Because objective risk can be measured, it is an

extremely useful concept for an insurer or a

corporate risk manager.
SUBJECTIVE RISK
 Subjective risk is defined as uncertainty based on
a person’s mental condition or state of mind.
 It is a psychological uncertainty that stems from

the individual’s mental attitude or state of mind.

 For example, a customer who was drinking heavily

in a bar may 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.
 This mental uncertainty is called subjective risk.
CONT’D
 Impact of subjective risk varies depending on the
individual.
 Two persons in the same situation can have a

different perception of risk, and their behavior

may be altered accordingly.
 If an individual experiences great mental

uncertainty concerning the occurrence of a loss,

that person’s behavior may be affected.
 High subjective risk often results in conservative

and prudent behavior, while low subjective risk

may result in less conservative behavior.
CONT’D
The driver may then compensate for the
mental uncertainty by getting someone else
to drive the car home or by taking a taxi.
Another driver in the same situation may

perceive the risk of being arrested as slight.

This second driver may drive in a more

careless and reckless manner; a low

subjective risk results in less conservative
driving behavior.
CONT’D
 Subjective risk can be measured by means of
different psychological tests, but no widely
accepted or uniform tests of proven reliability have
been developed.
 Thus though there are different degrees of risk

taking willingness in persons, it is difficult to

measure these attitudes scientifically and to predict
risk taking behavior.
 Subjective risk may affect a decision when the

decision maker is interpreting objective risk.

 A risk manager may determine some given level

of risk as high, while another may interpret small .

PURE AND SPECULATIVE RISKS
 Pure risk is defined as a situation in which there are
only the possibilities of loss or not loss.
 The only possible outcomes are adverse (loss) and

neutral (no loss).

 A pure risk occurs when there is a chance of loss but

no chance of gain.
 For example a shop owner will suffer financial loss if

the shop is burnt in fire, but no gain if there is no fire.

 Examples of pure risk include premature death,

industrial accidents, terrible medical expenses, and

damage to property from fire, lightning, flood, or
earthquake.
TYPES OF PURE RISK
The major types of pure risk that can create
great financial insecurity include;
 Personal Risks
 Property Risks
 Liability Risks
PERSONAL RISKS
 Personal risks are risks that directly affect an
individual.
 They involve the possibility of the complete loss

or reduction of earned income, extra expenses, and

the depletion of financial assets.
 There are four major personal risks.
 Risk of premature death,
 Risk of insufficient income during retirement,
 Risk of poor health and
 Risk of unemployment.
PROPERTY RISKS
 Persons owning property are exposed to property
risks – the risk of having property damaged or
lost from numerous causes.
 Real estate and personal property can be damaged

or destroy because of fire, lightning, tornadoes,

windstorms, and numerous other causes.
 There are two major types of loss associated with

the destruction or theft of property: direct loss and

indirect loss or consequential loss.
 LIABILITY RISK
 Liability risks are another important type of pure
risk that most persons face.
 One can be held legally liable if he/she does

something that result in bodily injury or property

damage to someone else.
 A court of law may order him/her to pay

substantial damages to the person he/she has

injured.
 SPECULATIVE RISK
 It is defined as a situation in which either profit or

loss is possible.
 For example, if you purchase 100 shares of

common stock, you would profit if the price of

stock increases but would loss if the price declines.
 Other examples, of speculative risk include betting

on horse race, card games, investing in real estate,

and going into business for oneself.
 In these situations, both profit and loss are possible.
FUNDAMENTAL AND PARTICULAR RISKS
 A fundamental risk is a risk that affects the entire
economy or large numbers of persons or groups within
the economy.
 Fundamental risks involve losses that are impersonal in

origin and consequence.

 They are group risks for the most part by economic,

social and political phenomena, although they may also

result from physical occurrences.
 They affect large segments or even all of the population.

 Examples include; rapid inflation, cyclical

unemployment, and war because large numbers of

individuals are affected.
CONT’D
 The risk of a natural disaster is another important
risk.
 Hurricanes, tornadoes, earthquakes, floods, and

forest and grass fires can result in billions of

dollars of property damage and numerous deaths.
 More recently, the risk of a terrorist attack is

rapidly emerging as fundamental risk.

PARTICULAR RISK
 A particular risk is a risk that affects only
individuals and not the entire community.
 Particular risk involves losses that arise out of

individual events and are felt by individuals rather

than by the entire group.
 Examples include car thefts, gold thefts, bank

robberies, and dwelling fires.

 Only individuals experiencing such losses are

affected, not the entire economy.

 FINANCIAL AND NON- FINANCIAL RISK
 In its broadest context, the term risk includes all
situations in which there is an exposure to
adversity.
 In some cases this adversity involves financial

loss, while in the others it does not.

 There is some element of risk in every aspect of

human endeavor, and many of these risks have no

financial consequences.
EXAMPLES FINANCIAL AND NON-FINANCIAL RISKS
 Financial risks: Credit Risk • Market Risk •
Interest rate Risk in the Banking Book • Liquidity
Risk
 Non- Financial risks: Operational Risk •

Compliance Risk • Conduct Risk • IT Risk • Cyber

Risk • Model Risk • Third-party Risk
STATIC AND DYNAMIC RISKS
 Static risks involve those losses that would occur

even if there were no changes in the economy.

 If we could hold consumer tastes, output and

income, and the level of technology constant, some

individuals would still suffer financial loss.
 These losses arise from causes other than the

change in the economy.

 These risks are not source of gain to society.
CONT’D
 Examples include uncertainty due to random
events such as fire; windstorm, or death, etc. static
losses do involve either the destruction of the asset
or a change in its possession as a result of
dishonesty or human failure.
 These types of losses tend to occur with a degree

of regularity overtime and are generally

predictable – which make static risks more suitable
for treatment by insurances.
DYNAMIC RISKS
 Dynamic risks are those resulting from changes in the
economy.
 Change in the price level, consumer tastes, income and

outputs and technology may cause financial losses to

members of the society.
 Dynamic risks normally benefit the society over a long

run, since they are the results of adjustments to

misallocation of resources.
 Although they may affect a large number of individuals,

dynamic risks are generally considered less predictable

than static risks, as they do not occur with any precise
degree of regularity.
E ND