Concept and Categories of Risk (A Risk Management Concept)

Risk is potential of losing something of value. Values (such as physical health, social status, emotional well being or financial wealth) can be gained or lost when taking risk resulting from a given action, activity and/or inaction, foreseen or unforeseen. Risk can also be defined as the intentional interaction with uncertainty. Uncertainty is a potential, unpredictable, un-measurable and uncontrollable outcome, risk is a consequence of action taken in spite of uncertainty. Risk perception is the subjective judgment people make about the severity and/or probability of a risk, and may vary person to person. Any human endeavor carries some risk, but some are much riskier than others.

International Organization for Standardization

The ISO 31000 (2009) / ISO Guide 73:2002 definition of risk is the 'effect of uncertainty on objectives'. In this definition, uncertainties include events (which may or may not happen) and uncertainties caused by ambiguity or a lack of information. It also includes both negative and positive impacts on objectives. Many definitions of risk exist in common usage, however this definition was developed by an international committee representing over 30 countries and is based on the input of several thousand subject matter experts.

There is no single definition of risk, Economist, behavioral scientist, risk theorist, stratification and actuaries each have their own concept of risk. However risk traditionally has been defined in terms of uncertainty. Based on this concept, risk is defined as uncertainty concerning the occurrence of a loss. For example, the risk of being killed in an auto accident is present because uncertainty is present. The risk of lung cancer for smokers is present because uncertainty is present. The risk of flunking a college course is present because uncertainty is present. Although risk is define as uncertainty in this text, employees in the insurance industry often use the term risk to identify the property or life being insured. Thus, in the insurance industry, it is common to hear statement such as “that driver is a poor risk” or that building is an unacceptable risk.

Definition:

• A probability or threat of damage, injury, liability, loss, or any other negative occurrence that is caused by external or internal vulnerabilities, and that may be avoided through preemptive action.
• A situation where the probability of a variable(such as burning down of a building) is known but when a mode of occurrence or the actual value of the occurrence (whether the fire will occur at a particular property) is not. A risk is not an uncertainty (where neither the probability nor the mode of occurrence is known), a peril (cause of loss), or a hazard (something that makes the occurrence of a peril more likely or more severe).

Peril and Hazard

The term peril and hazard should not be confused with the concept of risk discussed earlier:

Peril

Peril is define as the cause of loss. If your house burns because of a fire, the peril, or cause of loss is fire. If your car is damaged in a collision with another car, collision is the peril, or cause of loss. Common perils that cause property damage include fire, lighting, windstorm, hail, tornadoes, earthquakes, theft and burglary.

Hazard

A hazard is a condition that creates or increase the chance of loss. There are four major types of hazards

• Physical Hazard

A physical hazard is a physical condition that increases the chance of loss. Examples of physical hazards include icy roads that increase the chance of an auto accident, defective wiring in a building that increases the chance of fire and a defective lock on a door that increases the chance of theft.

• Moral Hazard

Moral hazard is dishonesty or char-actor defects in an individual that increase the frequency or severity of loss. Examples of moral hazard include faking an accident to collect from an insured submitting a fraudulent claim, inflating the "amount of a claim, and intentionally burning unsold merchandise that is insured. Murdering the insured to collect the life insurance proceeds is another important example of moral hazard. Moral hazard is present in all forms of insurance, and it is difficult.to control. Dishonest individuals often rationalize their actions on the grounds that "the insurer has plenty of money." This view is incorrect because the insurer can pay claims 'only by collecting premiums from other insureds. Because of moral hazard, premiums are higher for everyone. Insurers attempt to control moral hazard by careful underwriting of applicants for insurance and, by various policy provisions, such as deductibles, waiting periods, exclusions, and hiders.

• Morale Hazard

Some insurance authors draw a subtle distinction between moral hazard and morale hazard. Moral hazard refers to dishonesty by an insured that increase the frequency or severity of a loss because of the existence of 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 burglar to enter and changing lanes suddenly on a congested interstate highway without signaling. Careless act like these increase the chance of 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 verdicts or large damage awards in liability lawsuits, statutes 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.

Basic Categories of Risk:

• Pure Risk and Speculative risk

Pure risk is defined as a situation in which, there are only the possibilities of loss or no loss. The only possible outcomes are adverse (loss) and neutral (no loss). Examples of pure risks include premature death, job-related accidents, catastrophic medical expenses, and damage' to property from fire, lightning, flood, or earthquake. Speculative risks 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 the stock increases but would lose if the price declines. Other examples of speculative risks include betting on a horse race, investing in real estate, and going into business for yourself. In these situations, both profit and loss are possible. It is important to distinguish between pure and speculative risks for three reasons. First, private insurers typically insure only pure risks. With certain exceptions, private insurers generally do not insure speculative risks, and other techniques for dealing with speculative risk must be used. One exception is that some insurers will insure institutional portfolio investments and municipal bonds against loss. Second, the law of large numbers can be applied more easily to pure risks than to speculative risks. The law of large numbers is important because it enables insurers to predict future loss experience. In contrast, it is generally more difficult to apply the lays; 0 large numbers to speculative risks to predict future toss experience. An exception is the speculative risk of gambling, where casino operators can apply the law of large numbers in a most efficient manner. F, society may benefit from a speculative risk even though a loss occurs, but it is harmed if a pure risk is present and a loss occurs. For example, a firm may develop new technology for producing inexpensive computers. As a result, some competitors max be forced into, bankruptcy. Despite the bankruptcy, society benefits because the computers are produced at a lower cost. However, society normally does not benefit when a loss from a pure risk occurs, such as a flood or earthquake that devastates an area.

• Fundamental Risk and Particular Risk

A fundamental risk is a risk that affects the entire economy or large numbers of persons or groups within the economy. Examples include, rapid inflation, cyclical unemployment, and war because large numbers of individuals are affected. The risk of a natural disaster is another important fundamental risk. Hurricanes, tornadoes, earth-quakes, floods, and forest and grass fires can result in billions of dollars of property damage losses and numerous deaths. In 2005, Hurricane Katrina destroyed a large part of New Orleans, Louisiana, and caused billions of property damage in Louisiana, Florida, Mississippi, and Texas. Hurricane Katrina - was the largest single catastrophe in the history-of the United States. Insured property damage losses exceeded the property damage to the World-Trade Center caused by terrorists on September 11, 2001. Hurricanes Rita and Wilma caused additional property damage as well. More recently, the risk of a terrorist attack is rapidly emerging as a fundamental risk. Many countries have experienced' a substantial increase in terrorism in recent years, resulting in substantial property damage and the loss of human lives. The terrorist attack in the United States on September 11, 2001, resulted in the loss of four commercial jets, destruction of the World Trade Center in New York City, substantial damage to the Pentagon, and thousands of dead or injured persons. . In contrast to a fundamental risk; a particular risk is a risk that affects only individuals and not the entire community. Examples include car thefts, bank robberies, and dwelling fires. Only individuals experiencing such losses are affected, not the entire economy or large groups of people. The distinction between a fundamental and a particular risk is important because government assistance may be necessary to insure a fundamental risk. Social insurance and government insurance programs, as well as government guarantees and subsidies, may be necessary to insure certain fundamental risks in the United States. For example, the risk of unemployment generally is not insurable by private insurers but can be; inured publicly by state unemployment compensation programs. In addition, flood insurance subsidized by the federal governs meat is available to business firms and individuals in flood-prone areas.

• Enterprise Risk

Enterprise risk is a term that encompasses all major risks faced by a business firm. Such risks include pure risk, speculative risk, strategic risk, operational risk, and financial risk. We have already explained the meaning of pure and speculative risk. Strategic risk refers to uncertainty regarding the firm's financial goals and objectives; for example, if a firm enters a new line of business, the line may be unprofitable. Operation 4 risk results from the firm's business operations; for example, a bank that offers online banking services may incur losses if hackers" break into the bank's computed Enterprise risk also *includes financial risk, t. which .is becoming more important in commercial risk management program. Financial risk refers to the uncertainty of loss because to adverse changes in commodity prices, interest rates, -foreign exchange • rates, and the value of money. For example, a food company that agrees to &fryer cereal at a fixed price to a supermarket in six months may lose money 4 'gain -prices rise. A bank with a large portfolio of Treasury bonds may incur losses if interest rates rise. Likewise, an American corporation doing, business in Japan may lose money when Japanese yen is exchanged for American dollars. Enterprise risk is becoming more important in commercial risk management, which is a process that organizations use to identify and treat major and minor risks. In the evolution of commercial risk management, some risk managers are now considering all types of risk in one program. Enterprise risk management combines into a single unified treatment program all major risks faced by the firm. As explained earlier, these risks include pure risk, speculative risk, strategic risk; operational risk, and financial risk. By packaging major risks into a single program, the firm can offset one risk against another. As a result, over-all risk can be reduced. As long as all risks are not perfectly correlated, the combination of risks can reduce the firm's overall risk. In particular, if some risks are negatively correlated, overall risk can be significantly reduced. Chapter A discusses enterprise risk management in greater detail. Treatment of financial risks typically requires the use of complex hedging techniques, financial derivatives, futures contracts, options, and other financial instruments. Some firms appoint a chief risk officer (CRO), such as the treasurer, t4 manage the firm's financial risks. Chapter 4 discusses financial risk management in greater detail.

Conclusion

A probability or threat of damage, injury, liability, loss, or any other negative occurrence that is caused by external or internal vulnerabilities, and that may be avoided through preemptive action. All business involves a degree of risk. It is important to consider and express the potential risks for your business in order to prove you understand them and also, to an extent, that you have taken measures in preparation. Explain how you plan to limit or overcome the risks inherent in your business.