CHAPTER ONE

RISK AND RELATED TOPICS

1.1 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.  Economists,  behavioural  scientists,  risk  theorists,  statisticians,  and actuaries each have their own concept of risk. Some of the definitions of different scholars are shown below:

• Risk is the variation in outcomes that could accumulate over a specified period in a given condition (Brian A. Burt).
• Risk is a chance of a loss, and this depends on three elements, hazard, vulnerability and  exposure (William’s and Heins).
• Risk is the actual exposure of something of human value to a hazard and is often regarded as the combination of probability and loss (Smith, 1996)
• Risk  is  the  objectified  uncertainty  as  to  occurrence  of  an  undesired  event (Stanchion, 1997).
• Risk is expected losses due to a particular hazard for a given area and reference period (Blong, 1996)
• Risk is the possibility that actual results may differ from predicted average results.

Based on the  above stated definition of  risk, we can  conclude that risk is defined as the uncertainty concerning the occurrence of a loss. This means that the loss may or may not happen. If a loss is certain to occur, it may be planned in advance and treated as a definite. However, if there is uncertainty about the occurrence of a loss, then the risk becomes an important problem.

 

1.2 Risk Vs Uncertainty

If  we  observe  from  many  text  books  and  researchs,  there  has  been  a  major  debate  on  the differences  and  common  features  of  risk  and  uncertainty.  In  many  textbooks  both  notions  are related but they do not coincide. However, the difference between the two must be distinguished. The “risk versus uncertainty” debate is long-running and far from resolved at present. Although the two are closely related, quite many authors make a distinction between the two terms. Uncertainty refers to the doubt as to the occurrence of a certain desired outcome. It is more of subjective belief. Subjective in a sense that it  is  based  on  the  knowledge  and  attitudes  of  the  person  viewing  the  situation.   As  a  result, different  subjective  uncertainties  are  possible  for different  individuals  under  identical circumstances of the external world. Prefer has distinguished the difference between risk and uncertainty as “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.

Knight defined “risk” as a measurable uncertainty that can be determined by objective analysis based on prior experience. In contrast, “uncertainty” referred to events when randomness could not be expressed in terms of mathematical probability that is of a more subjective nature because it  is  without  precedent.  Risk  is  dealt  with  every  day  by  weighing  probabilities  and  surveying options  but  uncertainty  can  be  debilitating,  even  paralyzing,  because  so  much  is  new  and unknown. The practical difference between the two categories, risk and uncertainty is that risk is determinant  and  thus  presents  foreseeble consequences.  Therefore,  it  is  objective  and  not dependent  on  any  one  individual,  while,  uncertainty is  indeterminate  and  characterized  by unforeseeable.  Thus,  it  is  subjective  that  cannot  be  measured  objectively.  It  is  the  state  of mankind of predicting the future.

In general, it can be concluded that many writers specified so as to risk is objective phenomenon that can be measured mathematically or statistically. It is independent of the individuals’ belief. Whereas,  uncertainty  is  subjective  that  cannot  be  measured  objectively.  Of  course,  risk  and uncertainty may have some relationship. Uncertainty results from the imperfection of knowledge of  mankind  of  predicting  the  future.  The  higher  the lack  of  knowledge  about  the  future,  the higher the uncertainty. But, it is debatable to say that higher uncertainty leads to higher risk. The presence and absence of uncertain does not necessarily mean the presence and absence of risk respectively.

 

1.3 Risk and Probability

It  is  important  to  identify  carefully  the  difference  between  risk  and  probability.  Risk  is differentiated from probability by concept in relative variation. The  probability  associated  with  a  certain  outcome  is  the  relative  likelihood  that  outcome  will occur.  And  probability  varies  between  0  and  1.  If  the  probability  is  0,  that  outcome  will  not occur, if the probability is 1, that outcome will occur. Probabilities  are  generally  assigned  to  events  that are  expected  to  happen  in  the  future.  There may be a number of possible events that will take place under given set of conditions; and these events may occur in equal or different chance of occurrence. The weights given to each possible event may depend on prior knowledge, past experience, statistical or mathematical estimation of relevant data or psychological belief. Thus, to each possible event is assigned a corresponding probability  of  occurrence  that  leads  to  probability distribution.  This  means  that  probability relates to a single possible event. Risk  on  the  other  hand  refers  to  the  variation  in  the  possible  outcomes.  This  means  that  risk depends on the  entire probability distribution.  It  specifies the concept of  variability.  Thus, the concepts of risk and probability are two different things.

The  following  example  shows  the  difference  between  risk  and  probability.  Assume  the occurrence of a particular event is to be considered. One extreme is that this event is certainly to take place. Thus, the probability that this event will take place is 1. There is certainty as to the occurrence of this event with prefect foresight in  this regard. Accordingly, there is no risk. The other extreme is that the event will not take place at all. Hence, the probability of occurrence is zero. Here, there is certainty and therefore,  there is no risk. In between these two extremes there  could  be  several  occurrences  of  the  events  with  the  corresponding  probabilities  of occurrence. It is therefore; risk and probability are different but related concepts.

 

1.4 ​Risk, Peril and Hazard

Many persons commonly employ the terms "risky,"  "hazardous," and "perilous" synonymously.  Although, the  three  concepts  have  one  common  characteristic  in  transmitting  bad  experience  or  feeling, they are differentiated as follows:

Peril: Peril is defined as the cause of loss. If a house burns because of fire, the peril (the cause of loss) is the fire. Likewise, some common perils that cause damage or loss to the property include lightening, windstorm, tornadoes, earthquakes, theft and burglary.

Hazard: refers to the condition that may create or increase the chance of a loss arising from a given  peril.   These  hazards  are  not  themselves  the  cause  of  the  loss,  but  they  can increase  or decrease the effect loss. Thus,  they affect the magnitude and frequency of a loss. The more hazardous conditions are, the higher the chance of loss.

There are three major types of hazards: Moral hazard, Physical hazards, Morale hazard.

Physical hazards: This is related with the physical properties of  the thing exposed to risk, such as the nature of construction of a building, the nature of the road. Examples are:

-  Type of construction material such as wood, bricks,

-  Location of property such as near to fuel station,  near to flood area, near to earthquake area, etc.

Moral  hazard:  Moral hazard is dishonesty or character defects in an individual that increase the frequency or severity of loss. For example, the dishonest persons may fake an accident to collect the insurance or they intentionally burn unsold merchandise that is insured. Moral hazard is present in all forms of insurance and it is difficult to control. Dishonest individuals often rationalize their actions on the ground that “the insurers has plenty of money”. However, this view is incorrect because the insurer can pay claims only by collecting premiums from other insured. Because of moral hazard, premiums are higher for everyone.

Morale  hazard: it  initiated  from  act  of  carelessness  which  leading  to  the  occurrence  of  a loss.  Thus,  it  occurs  due  to  lack  of  concern  for  events.  Examples  of  Morale  hazard  include the leaving car keys in an unlocked car, poor house keeping in stores, leaving a door unlocked that allows a burglar to enter, etc.

 

1.5 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. Objective and Subjective Risk

Some authors make a careful distinction between objective and subjective risk. These two  types of risk are also mentioned as measurable and Non-measurable risk.

Objective  risk:  is  defined  as  the  relative  variation  of  the  actual  loss  from  expected  loss. 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.

Objective risk can be statistically measured by some measure of dispersion, such as the standard deviation or the coefficient of variation. Since objective risk can be measured, it is an extremely useful concept for an insurer or a corporate risk manager. As the number of exposures increases, an insurer can predict its future loss experience more accurately because it can rely on the law of large numbers.The law of large numbers states that as the number of exposure units increases, the  more  closely  will  the  actual  loss  experience  approach  the  probable  loss  experience.  For example  as  the  number  of  homes  under  observation  increases,  the  greater  is  the  degree  of accuracy in predicting the proportion of homes that will burn.

Subjective risk- is defined as uncertainty based on a person’s mental condition or state of mind. For example, an individual is drinking heavily in a bar and attempts to derive home. The driver may be uncertain whether he or she will arrive home safely without being arrested by the police for  drunk  driving.  This  mental  uncertainty  is  called  subjective  risk.  Often  subjective  risk  is expressed in terms of the degree of belief.

The  impact  of  subjective  risk  varies  depending  on  the  individual.  Two  persons  in  the  same situation may have a different perception of risk,  and their conduct may be altered accordingly. If  an individual experiences great mental uncertainty  concerning the occurrence of a loss, that person’s conduct may be affected. High subjective risk often results in less conservative conduct, while  low  subjective  risk  may  result  in  less  conservative  conduct.  A  driver  may  have  been previously arrested for drunk driving and is aware that he or she has consumed too much alcohol. The driver may then compensate for mental uncertainty by getting someone else to drive him or her  home  or  by  taking  a  cab.  Another  driver  in  the  same  situation  may  perceive  the  risk  of arrested  as  slight.  The  second  driver  may  drive  in  more  careless  and  reckless  manner;  a  low subjective risk results in less conservative driving behavior.

   2. Financial and Non-Financial Risk

We have already said that risk implies a situation where there is uncertainty about the outcome. A financial risk is one where the outcome can be measured in monetary terms. This is easy to see in the case of material damage to property, theft of property or lost business profit following a fire. In cases of personal injury, it can also be possible to measure financial loss in terms of a court award of damages, or as a result of negotiation between lawyers and insurers.  In any of these  cases,  the  outcome  of  the  risky  situation  can be  measured  financially.  On  another  hand, non-financial  risk  does  not  have  financial  implication.  This  means  in  this  case  the  outcome measured  in  monetary  terms  is  not  possible.  Take  the  case  of  the  choice  of  a  new  car,  or  the selection of an item from a restaurant menu. These could be taken as risky situations, not because the  outcome  will  cause  financial  loss,  but  because  the  outcome  could  be  uncomfortable  or disliked  in  some  other  way.   For  example,  network  connection  failure,  death/injury  of  an employee.

   3. Pure and Speculative Risks

The distinction between pure and speculative risks  based on situations where there is only the possibility of loss and those where a gain may also result. Pure risks refer to the situation in which only a loss or no  loss would occur. The outcome can only  be  unfavorable  to  us,  or  leave  us  in  the  same  position  as  we  enjoyed  before  the  event occurred. Examples of pure risks include premature death, risks of a motor accident, catastrophic medical expenses, lightning, flood, fire at a factory, theft of goods from a store, or injury at work are all pure risks with no element of gain. It is a loss or no loss that can result from such risks.

Pure risks are further classified in to three categories: property risk, personal risk, and liability risk.

       a) Property risk

It 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.  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,  assume  that  you  own  a restaurant,  and  the  building  is  insured  by  a  property  insurance  policy.  If  the  building  is damaged by a fire, the physical damage to the property is known as a direct loss. In other words,  property  suffers  a  direct  loss  when  the  property  itself  is  directly  damaged  or destroyed or disappears because of contact with a physical or social peril.

Indirect or consequential loss: an indirect loss is a financial loss that results indirectly from the occurrence of a direct physical damage, destruction, or theft. Thus, in addition to the physical damage loss, the restaurant would lose profits for several months while it is being  rebuilt.  The  loss  of  profits  would  be  a  consequential  loss.  Other  examples  of consequential loss would be the loss of the use of  the building, the loss of rents, and the loss of a market.

Extra expenses are another type of indirect or consequential loss. For example, suppose you  own  a  newspaper,  bank,  or  dairy.  If  a  loss  occurs,  you  must  continue  to  operate regardless  of  cost;  otherwise,  you  will  lose  customers  to  your  competitors.  It  may  be necessary  to  set  up  a  temporary  operation  at  some  alternative  location,  and  substantial extra expenses would then be incurred.

       b) 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. There are four major personal risks:

Risk of premature death: is defined as the death of a family head with unfulfilled financial obligations. These obligations can include dependents to support, mortgage to be paid off, or children  to  educate.  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. Therefore, premature death can cause financial problems only if the deceased has dependents to support or dies with unsatisfied financial obligations. Thus, the death of a child age seven is not premature in the economic sense.

Risk of insufficient income during retirement: this risk is a major risk that associated with old age. The most majority of workers retire befor eage of 65. When they retire, they loss their earned income. Unless they have sufficient financial assets on which to draw, or access to other  sources  of  retirement  income,  they  will  be  exposed  to  financial  insecurity  during retirement.

Risk of poor health: includes both the payment of catastrophic medical bills and the loss of earned  income.  The  payment  of  catastrophic  medical  bills  is  a  major  cause  of  financial insecurity if the costs of major surgery are increased. As well as the loss of earned income is another major cause of financial insecurity if the disability is severe.

Risk of unemployment: this is another major threat to financial security. Unemployment can cause  financial  insecurity  in  three  ways.  First,  workers  loss  their  earned  income  and employee benefits. Unless there is adequate replacement income or past savings on which to draw,  the  unemployed  worker  will  be  financially  insecure.  Second,  because  of  economic conditions,  the  worker  may  be  able  to  work  only  part-time.  The  reduced  income  may  be insufficient  in  terms  of  the  worker’s  needs.  Finally,  if  the  duration  of  unemployment  is extended over a long period, past savings and unemployment benefits may be exhausted.

        c) Liability risk

Liability risk is the possibility of loss arising from intentional or unintentional damage made to other persons or to their property. A person may begenerally 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 his/her infected upon other persons or their property.

Speculative risk is defined as a situation in which either profit or loss is possible. Expansion of plant, introduction of new product to the market, lottery, and gambling are good example. 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 favourable outcome is, indeed, so promising. Generally  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.

   4. Static and Dynamic Risks

Dynamic  risk  originates  from  changes  in  the  overall economy  such  as  price  level  changes, changes in consumer taster, income distribution, technological changes, political changes and the like. They are less predictable and hence beyond the control of risk managers some times. In contrast to a dynamic risk, static risk refers to those losses that can take place even though there were no changes in the overall economy. They  are losses arising from causes other than changes in the economy. Unlike dynamic risks, they  are predictable and could be controlled to some extent by taking loss prevention measures. Many of the perils fall under this category.

   5. Fundamental and Particular Risks

Fundamental  risk  is  a  risk  that  affects  the  entire  economy  or  large  numbers  of  persons  or groups  within  the  economy.  Examples  include  rapid  inflation,  natural  disaster,  cyclical unemployment, and war because large numbers of individuals are affected. 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 itself.

Particular riskis a risk that affects only individuals and not the entire community. Examples include  car  thefts,  bank  robberies,  property  losses,  death,  disability  and  dwelling  fires.  Only individuals  experiencing  such  losses  are  affected,  not  the  entire  economy  or  large  groups  of people. Therefore, particular risks affect each individual  separately. They are usually personal in cause, 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,  particular  risks  are  the responsibility of individuals. They can be controlled by purchasing insurance policies and other risk handling tools.