Unit 1: Risk Management – Basic Concepts of risks: hazards, perils,

assets - Different Types of Risks: Financial and non- financial:

static risks, dynamic risks, speculative risks- Management of
Risks.

Meaning of Risk:

People seek security. A sense of security may be the next basic goal after food,
clothing, and shelter. An individual with economic security is fairly certain that
he can satisfy his needs (food, shelter, medical care, and so on) in the present
and in the future.
Economic risk (which we will refer to simply as risk) is the possibility of losing
economic security. Most economic risk derives from variation from the
expected outcome. One measure of risk, used in this study note, is the standard
deviation of the possible outcomes.

Modern society provides many examples of risk. A homeowner faces a large

potential for variation associated with the possibility of economic loss caused by
a house fire. A driver faces a potential economic loss if his car is damaged. A
larger possible economic risk exists with respect to potential damages a driver
might have to pay if he injures a third party in a car accident for which he is
responsible.

Historically, economic risk was managed through informal agreements within a

defined community. If someone’s barn burned down and a herd of milking cows
was destroyed, the community would pitch in to rebuild the barn and to provide
the farmer with enough cows to replenish the milking stock. This cooperative
(pooling) concept became formalized in the insurance industry.

Under a formal insurance arrangement, each insurance policy purchaser

(policyholder) still implicitly pools his risk with all other policyholders.
However, it is no longer necessary for any individual policyholder to know or
have any direct connection with any other policyholder.

HOW INSURANCE WORKS

Insurance is an agreement where, for a stipulated payment called the premium,
one party (the insurer) agrees to pay to the other (the policyholder or his
designated beneficiary) a defined amount (the claim payment or benefit) upon
the occurrence of a specific loss.

This defined claim payment amount can be a fixed amount or can reimburse all
or a part of the loss that occurred. The insurer considers the losses expected for
the insurance pool and the potential for variation in order to charge premiums
that, in total, will be sufficient to cover all of the projected claim payments for
the insurance pool. The premium charged to each of the pool participants is that
participant’s share of the total premium for the pool. Thus, the entire pool
compensates the unfortunate few.

Each policyholder exchanges an unknown loss for the payment of a known

premium. Under the formal arrangement, the party agreeing to make the claim
payments is the insurance company or the insurer. The pool participant is the
policyholder. The payments that the policyholder makes to the insurer are
premiums. The insurance contract is the policy. The risk of any unanticipated
losses is transferred from the policyholder to the insurer who has the right to
specify the rules and conditions for participating in the insurance pool.
The insurer may restrict the particular kinds of losses covered. For example, a
peril is a potential cause of a loss. Perils may include fires, hurricanes, theft, and
heart attack. The insurance policy may define specific perils that are covered, or
it may cover all perils with certain named exclusions (for example, loss as a
result of war or loss of life due to suicide).

Hazards are conditions that increase the probability or expected magnitude of a

loss. Examples include smoking when considering potential healthcare losses,
poor wiring in a house when considering losses due to fires. In summary, an
insurance contract covers a policyholder for economic loss caused by a peril
named in the policy.
The policyholder pays a known premium to have the insurer guarantee payment
for the unknown loss. In this manner, the policyholder transfers the economic
risk to the insurance company. Risk is the variation in potential economic
outcomes. It is measured by the variation between possible outcomes and the
expected outcome: the greater the standard deviation, the greater the risk.
Types of Risk in Insurance

1, Financial and Non-Financial Risks.

Financial risks are the risks where the outcome of an event (i.e. event giving
birth to a loss) can be measured in monetary terms. The losses can be assessed
and a proper money value can be given to those losses. The common examples
are:

● Material damage to property arising out of an event. We may consider the

damage to a ship due to a cyclone or even sinking of a ship due to the
cyclone.
● Damage to the motor car due to a road accident which may be of partial
or total nature.
● Theft of a property which may be a motorcycle, motor car, machinery,
items of household use or even cash.

All such losses, i.e. the outcome of unforeseen untoward events can be
measured in monetary terms. The losses can be replaced, reinstated or repaired
or even a corresponding reasonable financial support (in case of death) can be
thought about.

Non-Financial risks are the risks the outcome of which cannot be measured in
monetary terms.

● Career selection, whether to be a doctor or engineer etc.

● Choice of bride/bridegroom,
● Choice of publicity etc.

Since the outcome cannot be valued in terms of money, we shall call these
non-financial risks as uninsurable.

Pure Risk and Speculative Risks

Pure risks are those risks where the outcome shall result in loss only or at best a
break-even situation. We cannot think about a gain-gain situation. The result is
always unfavorable, or maybe the same situation (as existed before the event)
has remained without giving birth to a profit (or loss). There are no
opportunities for gain or profit when pure risk is involved.

As opposed to this, speculative risks are those risks where there is the
possibility of gain or profit. At least the intent is to make a profit and no loss
(although loss might ensue). Investing in shares may be a good example.
Pricing, marketing, forecasting, credit sale, etc. are yet examples falling within
the domain of speculation.

Eg: Consider another example where we can have the existence of both pure
risks and speculative risks. A garment factory may be in our minds. Here we
have:

● Cyclone damage possibility to the factory building,

● Fire damage possibility to stock,
● Machinery breakdown possibility to Machinery,
● Theft possibility to removable items,
● Personal accident possibility of factory workers etc.
Also, we have:

● the question of pricing of the product to remain in the competitive

market,
● the question of fashion changes leading to a drastic fall in the demand of
the product,
● the question of withdrawal of quota system,
● the question of credit sale

The students should appreciate that in the first set of examples we are indeed
talking about the possibility of certain losses emanating from certain untoward
events or unforeseen contingencies (like a cyclone, fire, theft, accident, etc.) and
for convenience we shall call them the risks of trade.

These are identified as pure risks and as such insurable. Notice that these losses
can also be measured in monetary terms. As opposed to this, if we refer to the
second set of examples we notice that the outcome of the trade or business is not
the result of pure risks but indeed the result of economic factors, supply &
demand, change of fashion, trade restriction or liberalization, etc. and for
convenience we call them trade risks. These may be identified as speculative
risks and usually not insurable.
Fundamental Risk and Particular Risks
Fundamental risks are the risks mostly emanating from nature. These are the
risks that arise from causes that are beyond the control of an individual or group
of individuals. The losses arising out of such causes may be catastrophic in
dimension and felt by a huge number of populations, the society or by the state
although an individual may be a part of that catastrophe.

The common examples are:

 Flood & Cyclone, Subsidence & landslip,
 Earthquake & volcanic eruption, Tsunami,
 The convulsion of nature and other natural disasters,
 Famine, Draught

We may also add in the list perils like war, terrorism, riots & other political
activities which are neither created by nature nor by an individual but resulting
in colossal losses.

But one thing is certain which are this that all such perils are impersonal not
being caused or contributed by an individual or even a group of individuals.
Normally fundamental risks were not supposed to be insurable because of the
magnitude and these were considered to be the responsibility of State. Now
because of demand and insurers’ strength, these risks are easily insurable.
Particular risks are risks which usually arise from actions of individuals or
even group of individuals. These may be identified as causes arising from
personal (or group) behavior and effects(losses) not being of that magnitude.

These are mostly men created because of their negligence, error in judgment,
carelessness, and disregard for law or respect. We may even go onto suggesting
that these are indeed the cases (both cause and effect) where there has been an
omission to do something which should have been done or there has been done
something which should not have been done. We may call these as risks of
personal nature.

The common examples are:

 Fire, Explosion,
 Burglary, housebreaking, larceny, and theft,
 Stranding, Sinking, Collision in case of a ship, including cargo loss,
 Motor accidents including death and bodily injuries, Industrial accidents,
 The collapse of bridges, Derailments.
Particular risks are insurable risks and most of the insurances relate to these
risks.
Risk Management Process :

1. Establish the Context :

The purpose of this stage of planning enables to understand the environment
in which the respective organization operates, that means the thoroughly
understand the external environment and the internal culture of the organization.
You cannot resolve a risk if you do not know that it is. At the initial stage it is
necessary to establish the context of risk. To establish the context there is a need
to collect relevant data. There is a need to map the scope of the risks and
objectives of the organization.

2. Identification :
After establishing the context, the next step in the process of managing risk is to
identify potential risks. Risks are about events that, when triggered, will cause
problems. Hence, risk identification can start with the source of problems, or
with the problem itself.

Risk identification requires knowledge of the organization, the market in which

it operates, the legal, social, economic, political, and climatic environment in
which it does its business, its financial strengths and weaknesses, its
helplessness to unplanned losses, the manufacturing processes, and the
management systems and business mechanism by which it operates.
3. Assessment :
Once risks have been identified, they must then be assessed as to their potential
severity of loss and to the probability of occurrence. These quantities can be
either simple to measure, in the case of the value of a lost building, or
impossible to know for sure in the case of the probability of an unlikely event
occurring. Therefore, in the assessment process it is critical to make the best
educated guesses possible in order to properly prioritize the implementation of
the risk management plan.
4. Potential Risk Treatments :(Risk Response Strategies)
Once risks have been identified and assessed, all techniques to manage the risk
fall into one or more of these four major categories.

a) Risk Transfer : Risk transfer means that the expected party transfers
whole or part of the losses consequential to risk exposure to another party
for a cost. The insurance contracts fundamentally involve risk transfers.
Apart from the insurance device, there are certain other techniques by
which the risk may be transferred.
b) Risk Avoidance : Avoid the risk or the circumstances which may lead to
losses in another way, includes not performing an activity that could carry risk.
Avoidance may seem the answer to all risks but avoiding risks also means
losing out on the potential gain that accepting (retaining) the risk may have
allowed.

c) Risk Retention : Risk retention implies that the losses arising due to a risk
exposure shall be retained or assumed by the party or the organization. Risk
retention is generally a deliberate decision for business organizations inherited
with the following characteristics.
d) Risk Control : Risk can be controlled whether by avoidance or by
controlling losses. Avoidance implies that either a certain loss exposure is not
acquired or an existing one is neglected.

5. Review and evaluation of the plan :

Initial risk management plans will never be perfect. Practice, experience and
actual loss results, will necessitate changes in the plan and contribute
information to allow possible different decisions to be made in dealing with the
risk being faced. Risk analysis results and management plans should be updated
periodically.