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Chapter 1

RISK AND UNCERTAINTY

Introduction
Life is full of risk Risk brings changes to our life Risk brings surprises and makes life interesting Risk brings losses, danger and unwanted consequences

Taking risk means undertaking risk as part of our decision in any business or personal activity The outcome of the decision made may vary. It may be favourable or unfavourable

What is Risk?
There are no precise definition of what risk is However there are two common elements in most definitions: 1. Notion of indeterminacy 2. Notion of loss

Notion of indeterminacy
The outcome is not known with certainty at the time the decision is made For risk to exist, there must be at least 2 possible outcome It the outcome is known with certainty, there is no risk

Notion of loss
At least one of the expected outcome is undesirable. Even if the expected outcomes could all be favourable, some will be less favourable than others. These are considered undesirable

Definition of Risk

A possible definition of risk is: Risk is a condition in which there is a possibility of an adverse deviation from a desired outcome that is expected for

Definition by E. Vaughan

Uncertainty and Risk


Uncertainty is not risk Uncertainty refers to the state of mind characterized by doubt due to lack of knowledge about the condition or the future Uncertainty is a reaction to the absence of knowledge

Uncertainty do not suggest the existence of risk It is possible to experience uncertainty in an unfamiliar condition when in fact there is no risk It is also possible for risk to exist even if we are unaware of the possibility of loss

Degree of Risk
Degree of risk refers to our perception of more or less risky. Our perception are determined by measures of: 1. probability 2. dispersion (range) 3. size

Law of Large Numbers


The law of large numbers imply that as the sample size increases, the actual result would be much closer to the expected result. Insurance companies uses the law of large numbers to make prediction about the expected losses.

The larger the sample size, the more reliable these predictions would be. These predictions about expected losses would then be the basis for determining the appropriate insurance premiums

Perils and Hazards


Perils is the cause of loss. Examples of perils are fire, floods, theft, accidents, earthquake

Hazards are characteristics or conditions that increases the chance of loss A wooden house is more hazardous to loss by fire as compared to a brick house

Types or Categories of Hazards


1. Physical hazard 2. Moral hazard 3. Morale hazard 4. Legal hazard

Physical hazard
Refers to physical properties (characteristics) that increases the chance of loss. Type of construction material and the location of the asset.

Moral hazard
Refers to the characteristics of the individual (insured) that can increase the size of loss. A person of low moral values is more inclined to deceive (thereby increasing the amount of loss) by submitting nonexistent claims, inflated claims or even causing the loss (eg: arson)

Morale Hazard

Refers to the indifferent attitude of the individual (insured) that can increase the chance of loss. Morale hazards relates to the careless attitude of property owners in properly safeguarding their assets on the assumption that because they had purchased insurance, whatever losses would be compensated by the insurance company

Legal hazard
Refers to the increase in the chance of loss due to enactments of new laws that may create a situation that may lead to a loss to the individual. New legal doctrines may also be created based on new precedents that may increase the severity of the loss

Classification of Risk

Risk can be classified in the following manner: 1. Financial or Non-financial Risk 2. Dynamic or Static Risk 3. Pure or Speculative Risk 4. Particular or Fundamental Risk

Financial or Non-Financial Risk

A financial risk results in a financial loss whereas a non-financial result risk has no financial consequences This classification is useful in order for the individual or organization to address risk issues Risk that results in financial losses are addressed based on the severity of loss while those with no financial impact can be ignored

Dynamic or Static Risk


Dynamic risk are those resulting from changes in the economy They arises from the external environment, such as competition, consumer preferences, industrial growth, or from speculative choices that management undertakes such as what to produce and how to produce them

Dynamic risk is deemed to be useful as any losses suffered is usually a result of misalignment or misallocation of resources. Organization will usually respond to these changes or choices in ways that will be beneficial

Static risk involves losses that are expected even if there are no changes in the economy. Individuals and organizations still incur losses as a result of human failure or dishonest behaviour

Static risk is not beneficial to society However, because they are more predictable, they are more suited to treatment by insurance compared to dynamic risk

Pure and Speculative Risk


Pure risk involves only the possibility of loss or no loss An example is the possibility of loss for a property owner. Speculative risk involves the possibility of a gain or a loss An example is the risk involved in a business endeavour

Most pure risk are insurable (Note: Some are not insurable due to high degree of loss) Speculative risk are usually voluntarily accepted because of the choice between gain and loss Speculative risk are generally not insurable

Particular or Fundamental Risk


Particular risk affects an individual or a particular segment of society Fire, death, theft affect certain individuals or organization who are misfortuned by these losses The particular individual or organization should address these risk individually if these risks affects them

Fundamental risk results in large and catastrophic losses that may affect large segments of society Inflation, war, famine and floods are not selective and affects the general population These risks cannot be tackled individually but they must be addressed by societal interventions

Risks affecting Individuals and Businesses

The risks listed below are generally pure risk that affects most individuals and businesses: 1. Personal Risk 2. Property Risk 3. Liability Risk 4. Financial Risk 5. Risk arising from failure of other parties

Financial risk can be classified as a speculative risk since there is a possibility of a gain or loss

Personal Risk

Personal risk are those risks that affects the individuals/families They arises from the possibility of the loss of the ability to earn income The sources of loss (perils) are: 1. untimely death 2. old age 3. sickness or disability 4. unemployment or retrenchment

Property Risk
Property risk are faced by property owners Various perils include fire, theft, landslide, floods Losses may be direct (destruction of the asset) or indirect/consequential loss which comes from the loss of income or the incurrence of additional expenses

Liability Risk
Liability risk arise from our actions that may cause bodily harm or physical damages to others The law imposes a duty of care on everyone The law will compel the wrongdoer to pay damages to the person who suffers the loss

Financial Risk
Financial risk in this context, refers to a spectrum of financial changes that may affect the individual or organization Examples are changes in prices, interest rates and exchange rates Fluctuations in these factors may cause the individual or organization to suffer losses

Risks arising from failure of other parties

An individual or organization may from time to time enters into agreement with other parties. The other party may intentionally or unintentionally fails to fulfill their obligation which will then result in a loss to us Example is the failure of the contractor to complete the construction as scheduled or the failure of debtors to make payments as expected

Burden of Risk to Individuals and Society

The following are some of the detrimental effects of risk on individuals and society: 1. Actual burden of financial losses 2. Emotional distress and anxiety 3. Deprive society of certain goods and services 4. Deterrent effect on economic growth

5. Increases the cost of capital 6. Negative accumulation of reserves that are held back to replace losses if they were to take place

Managing Risk
Risk management should not be a one time event It requires careful analysis of risk, its severity, frequency and priority Individuals and corporations should apply a systematic approach in identifying, evaluating and dealing with risk .

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