CHAPTER ONE

THE CONCEPT OF RISK

1.1 Definition of Risk
There is no one universal and comprehensive definition of risk that exists so far. It is defined in different
from by several authors with some differences in the wording used. The essence, however, is very similar.
Some of the definitions are:
1. Risk is a condition in which there is a possibility of an adverse deviation from a desired outcome that
is expected or hoped for.
2. Risk is the objectified uncertainly as to the occurrence of an undesired event.
3. 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
4. Risk is the variation in the outcomes that could occur over a specified period in a given situation.
5. Risk is the dispersion of actual from expected results.
 Definition no 1-3 focuses on the negative felling of risk. But the remaining definitions are not
focus only on the negative side as variation could be both positive and negative. The emphasis is
then on both negative and positive.
The general conclusion from the definition
 Risk is undesired outcome or it is the possibility of loss.
 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.
 Variations in the possible outcomes, then, lead to the existence of risk; and the greater the variability,
the greater the risk will be.
1.2 Risk Vs. Uncertainty
Many textbooks use the terms risk and uncertainty interchangeably. Although the two are closely related,
quite many authors make a distinction between the two terms. The only difference between risk and
uncertainty lies on measurability.

Uncertainty  Uncertainty is a measured by the degree of

 Uncertainty refers to doubt as to the belief.
occurrence of a certain desired outcome.  Uncertainty is a state of the mind
 It is more of subjective belief. Subjective in  Uncertainty is subjective that cannot be
a sense that it is based on the knowledge and measured objectively.
attitudes of the person viewing the situation  Uncertainty relates to past, present and
and as the result different subjective future situations.
uncertainties are possible for different  Uncertainty results from the imperfection of
individuals under identical circumstances of knowledge of mankind of predicting the
the external world. future.
 We don’t know what is going to happen
next, and we do not know what the possible Risk
distribution looks like. Ex. Processor  Risk is a potential variation in outcomes.
capacity of second hand computer. There When risk is present, outcomes cannot be
is uncertainty that the new processor will be forecasted with certainty.
fast enough to handle the load because there  We don’t know what is going to happen
is no way to test its capacity before we put it next, but we do know what the distribution
to work. looks like. Ex. dice or a multiple choice
 It as UN measureable uncertainly that is of a exam — we have risk, but we do NOT
more subjective nature because it is without have uncertainty. We never know what the
precedent. roll of the dice will be, but we do know its’
 Uncertainty can be debilitating, even one of six choices.
paralyzing, because so much is new and  Risk is measurable uncertainly that can be
known. determined by objective analysis based on
 In general that it is impossible to form a prior experience.
group of instances, because the situation  Risk is dealt with every day by weighing
dealt with is in a high degree unique. probabilities and surveying options.

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  In the risk the distribution of the outcome
in a group of instances is known either
through calculation a priori or from
statistics of past experience.
 Risk is a combination of hazards and is
measured by probability.
 Risk is a state of the world.
 Risk is objective phenomenon that can be
measured mathematically or statistically. It
is independent of the individual’s belief.
 Risk refers only to future outcomes.

 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 following four situations underscore the difference between risk and uncertainly:

1. Both risk and uncertainty are present

e.g. a person may be exposed to risk of disability and may experience uncertainty
2. Both risk and uncertainty are absent
e.g. sailors at present known that the earth is not flat. There is no possibility of falling off the edge of
the earth
3. Risk is present and uncertainty absent
e.g. An possibility of loss due to interruption of operation by fire. There may be no uncertainty
because of failure to recognize the existence of such risk, understatement of the situation or because
of preoccupation with other problems.
4. Risk absent but uncertainty present
e.g. an hour ago, a man heard that a plane departing from the airport crashed. The man knows that his
wife was scheduled to fly from the airport earlier today, but he does not know whether she was on the
plane crashed. Here there is no risk as risk refers to future outcomes. However, there is uncertainty
since it relates to past, present and future situations.

1.3 Risk and probability

 It is necessary to distinguish carefully between risk and probability

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Probability

 The probability refers to the long-run chance of occurrence or relative frequency of some event.
 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.

Risk
 Risk, as differentiated from probability, is a concept in relative variation.
 Risk on the other hand refers to the variation in the possible outcomes.
 This means that risk depends on the entire probability distribution. It indicates the concept of
variability.
 It is therefore; risk and probability are different but related concepts.
1.4 Risk, peril and hazard
Although, the three concepts have one common feature in transmitting bad taste or feeling, they are
differentiated as follows:

Risk: - We often use the word risk to mean both the event, which will give rise to some loss and the
factors which may influence the outcome of a loss

Peril: - refers to the specific cause f a loss.

 The peril is the prime cause it is that will give rise to the loss
 Often it is beyond the control of anyone who may be involved. In this way we can say that
windstorm, fire, flood, theft, motor accident and explosion are all perils.

Hazard: - refers to the condition that may create or increase the chance of a loss arising from a given
peril.
 Factors, which may influence the outcome are refers to as hazards.
 Hazard affects the magnitude and frequency of a loss. The more hazardous conditions are, the
higher the chance of loss.
 These hazards are not themselves the cause of the loss, but they can increase or decrease the
effect should a peril operate. In fact, hazards would facilitate the occurrence of perils. The
consideration of hazard is important when an insurance company is deciding whether or not it
should insure some risk and what premium to charge.
There are four categories of hazards:
1. Physical Hazard
 It relates to the physical characteristics of the item or the property expose to the risk that increases
the likelihood of loss, such as the nature of construction of a building, the nature of the road (e.g.
Icy, rough roads that increase the likelihood of an auto accident, etc), loose security protection at
a shop or factory, or the proximity of houses to a riverbank, earthquake area and fuel station.
2. Moral Hazard
 This originates from evil tendencies in the character of the insured person.
 It is dishonesty or character defects in an individual that increase the frequency or severity of
loss.
 It is related with human aspects which may influence the outcome. This usually refers to the
attitude of the insured person.
 Examples of moral hazard include taking an accident to collect from an insurer, submitting a
fraudulent claim, inflating the amount of the claim, and intentionally burning unsold merchandise
that is insured.
3. Morale Hazard
 This originates from acts of insured’s carelessness or indifference leading to the occurrence of a
loss because of the existence of insurance.

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  It occurs due to lack of concern for events.
 Examples of moral hazard include leaving car keys in an unlocked car., which increases the
chance of theft; leaving a door unlocked that allows a burglar to enter, poor housekeeping in
stores, cigarette smoking around petrol stations, etc.
4. Legal Hazard
 Refers to characteristics of the legal system or regulatory environment that increase the frequency
or severity of losses.
 Examples include adverse jury verdicts or large damage awards in liability lawsuits, statutes that
require insurers to include coverage for certain benefits in health insurance plants, such as
coverage for alcoholism; and restrict the ability of insurers to withdraw from the state because of
poor underwriting results.
 In some situations, however, it is difficult to distinguish between a peril and a hazard. For
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).
1.5. 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. Financial Vs Non-financial Risks
This way of classification is self explanatory.
 Financial risks result in losses that can be expressed in financial terms. 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 insures. In any of these cases, the outcome of the risky situation can
be measured financially.
 Non-financial risk does not have financial implication. In this condition measuring the outcome in
monetary term is not possible. Take the case of the choice of a new car, or the selection of an item
from a restaurant menu and death of relatives are non-financial risk. 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. We could even go as far as to say that the great social
decisions of life are examples of non-financial risks: the selection of a career, the choice of a marriage
partner, having children. There may or may not be financial implications, but the main the outcome is
not measurable financially but by other, more human, criteria.
In the world of business we are primarily concerned with risks which have a financially measurable
outcome.
2. Dynamic Risks Vs Static Risk
 Dynamic risks originate from changes in the overall economy which are associated with such as
human wants, improvements in technology and organization (price changes, consumer taste changed,
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 overall 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. Many of the perils fall under this category.
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. 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 society itself. Examples
include: unemployment, famine, flood, earthquake, inflation, social change, political intervention and
war are all capable of being interpreted as fundamental risks.

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 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, 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. This would include many of the risks we have already mentioned
such as fire, theft, work related injury and motor accidents. All of these risks arise from individual
causes of affect individuals their consequences. Particular risks are the responsibility of individuals.
Hence 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
 Objective risk (measurable risk) has been defined as “the variation that exists in nature and is the
same for all persons facing the situation.” It is the state of nature (world). The characteristic of
objective risk is that it is measurable. In other words, it can be quantified using statistical or
mathematical techniques.
 Subjective risk (non-measurable risk) defined as uncertainty based on a person’s mental condition
or state of mind. The problem, however, is that it is difficult to obtain the true objective risk in most
business situation.
5. Pure Vs Speculative Risks
The decision between pure and speculative risks is 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. The risks of a motor accident, fire at a factory, theft of goods form 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.
Most pure risks are insurable. Pure risks are further classified in to three categories: personal risk,
property risk, and liability risk.
i. Property risk: 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, illness,
old age 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 infected 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 manager are concerned with most but not all pure risk.

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