Exercise

• What is Risk Management?

• What are the objectives of Risk

Management, pre loss and post loss?

• List down 5 activities of Risk

Manager

KOLEJ UINIVERSITI ISLAM

ANTARABANGSA SELANGOR (KUIS)
RISK MANAGEMENT
2. AN INTRODUCTION TO RISK
AND UNCERTAINTY

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ANTARABANGSA SELANGOR (KUIS)
 Outline
– Foundation Concepts
Certainty
Uncertainty
Risk
– Some Further Concept Related to Risk
Pure and Speculative Risk
Diversifiable and Nondiversifiable Risk
– Some Further Issues Related to Uncertainty
Level of Uncertainty
Uncertainty, Information and Communication
– Two Specific Concept Related to Uncertainty
Adverse Selection
Moral Hazards
– Managing Risk and Uncertainty

KOLEJ UINIVERSITI ISLAM

ANTARABANGSA SELANGOR (KUIS)
 DEFINITION AND
CLASSIFICATION OF RISK
Definition of Risk
Risk is defined as uncertainty concerning loss.

E.g. owning a house expose to the risk of the

house damage due to fire.

Definition of Uncertainty
Uncertainty is a state of doubt about our ability to predict
the future outcome of current actions

E.g., if a house-owner is uncertain whether his house will

catch fire, this reflects his lack of knowledge about the
possibility of his house catching fire in the future.
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Ahmad Yani Ismail
Lecture 1
Uncertainty occurs if at least two
possible outcomes can arise out of
an event.
If one possible outcome, then the
outcome is known for certain, so
there is no risk.

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Ahmad Yani Ismail
Lecture 1
House - two possibilities (in relation to
fire):
1. Catch fire or uncertainty exists
2. May not catch fire

If the house-owner certain that his house

will not catch fire because it was entirely
built using fire-resistant materials, then
there is no risk associated with fire.

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Ahmad Yani Ismail
Lecture 1
Risk vs Uncertainty
When risk is present, outcomes
cannot be forecasted with certainty.
As a result risk gives rise to
uncertainty.

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Ahmad Yani Ismail
Lecture 1
Loss in insurance refers to insurable loss.
Insurable losses are those losses that can
be inssured.
To be insurable, a loss must meet the
following criteria:
1. Unintentional occurrence and based on
chance
2. Undesirable
3. Results in a reduction of economic value or
financial loss.
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Ahmad Yani Ismail
Lecture 1
Risk exists if there is uncertainty
about the outcome of an event or an
activitiy.
The greater the number of outcomes
from an event, the greater would be
the uncertainty and thus the risk.
E.g. fixed-return investment vs stock
investment
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Ahmad Yani Ismail
Lecture 1
Risk is also associated with a
possible unfavourable outcome of an
event, or possibility of loss.
Unfavourable outcome can be
described as a deviation from a
desired outcome.
E.g. hoping for car would not be
stolen, however the outcome is
undesirable, so risk exists.
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Ahmad Yani Ismail
Lecture 1
 Foundation Concepts
Definition of Certainty
– Certainty is lack of doubt
– A state of being free from doubt

Definition of Uncertainty
– Doubt about our ability to predict the future outcome of
current actions
– Uncertainty arises when an individual perceives that
outcomes cannot be known with certainty
– Uncertainty is a state of doubt about our ability to
predict the future outcome of current actions

KOLEJ UINIVERSITI ISLAM

ANTARABANGSA SELANGOR (KUIS)
Definition of Risk

– Risk is defined as uncertainty

concerning loss.

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ANTARABANGSA SELANGOR (KUIS)
Risk vs Uncertainty

– When risk is present, outcomes cannot

be forecasted with certainty.
– As a result risk gives rise to uncertainty.

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ANTARABANGSA SELANGOR (KUIS)
Classification of Risk

Risks can be categorized into TWO types

of classifications:

1. Pure Risk versus Speculative Risk

2. Diversifiable Risk versus Non-diversifiable

Risk.

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ANTARABANGSA SELANGOR (KUIS)
Pure Risk vs Speculative Risk
Pure Risk
Pure risk exists when there is uncertainty
as to whether loss will occur.
A category of risk in which loss is the only
possible outcome; there is no beneficial
result.
Speculative Risk
Speculative risk exists when there is
uncertainty about an event that could
produce either a profit or a loss.
A category of risk that, when undertaken,
results in an uncertain degree of gain or
loss.

• No possibility of gain is presented by pure • Gains as well as losses may occur, changing
risk – only the potential for loss. the nature of the uncertainty that is present.
• Examples : • Examples:
o Home insurance can be used to protect o Business ventures
homeowners from the risk that their o Investment decisions
homes will be destroyed.
o The uncertainty of damage to property
by fire or flood
o The prospect of premature death caused
by accident or illness

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ANTARABANGSA SELANGOR (KUIS)
 Diversifiable vs Non Diversifiable
Diversifiable Risk Non-diversifiable Risk
Risk that is, in the limit, eliminated by combining a The risk inherent to the entire market or entire
large number of assets in a portfolio. market segment.

Risk that can be eliminated through Also known as "systematic risk" or "market risk."
diversification.

Also called Unsystematic Risk or controllable risk.

It results from the occurrence of random events
such as labor strikes, lawsuits, or loss of key
accounts.
Business, liquidity, and default risks fall into this
category.
It is assumed that any investor can create a
portfolio in which this type of risk is completely
eliminated through diversification.
For example, a sudden strike by the employees of
a company you have shares in, is considered to
be an unsystematic risk.
Interest rates, recession and wars all represent
sources of systematic risk because they will
affect the entire market and cannot be avoided
through diversification.
Whereas this type of risk affects a broad range of
securities, unsystematic risk affects a very
specific group of securities or an individual
security.
Systematic risk can be mitigated only by being
hedged.

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ANTARABANGSA SELANGOR (KUIS)
 Some Further Issues Related to Uncertainty
Levels of Uncertainty
Uncertainty is doubt about our ability to predict the future.
Uncertainty arises when an individual perceives risk
Participating in a business venture, some are very cautious,
others are more aggressive.
Although risk aversions explains some of the reluctance to
participate, the level of risk perceived by individual also
plays a key role.
The perceived level of risk depends on information that an
individual can use to evaluate the likelihood of outcomes
and, perhaps, on the individual’s ability to evaluate
information

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ANTARABANGSA SELANGOR (KUIS)
The level and type of information on the nature of
a risky activity have an important effect on
uncertainty.
Our ability to predict the future outcome of an
action is strongly affected by the amount and
type of information available to forecast the
consequences of our actions.
In other words, uncertainties are present in levels
or degrees as illustrated in table below.

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ANTARABANGSA SELANGOR (KUIS)
 Level of Uncertainty Characteristics
None (certainty) Outcomes can be
predicted with precision
Level 1 (objective Outcomes are identified
uncertainty and probabilities are
known
Level 2 (subjective Outcomes are identified
uncertainty) but probabilities are
unknown
Level 3 Outcomes are not fully
identified and
probabilities are unknown
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ANTARABANGSA SELANGOR (KUIS)
Examples
Physical laws, natural
sciences
Games of chance : cards,
dice, risk of loss of life
Fire, motor vehicle
accident, many
investments
Space exploration,
genetic research
Level 1
The lowest level of uncertainties
Possible outcomes have been identified and we
know the likelihood of occurrence.
Can be described as objective uncertainty.
E.g. games of chance, such as cards, dice and the
toss of coin are examples of the first level of
uncertainty
In these games, the outcomes are fixed by the
bets of the participants and probabilities are
known or can be calculated
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ANTARABANGSA SELANGOR (KUIS)
Level 2
Also called subjective uncertainty
Characterises many business ventures, investment projects and
insured risks
E.g. the owner of a vehicle that might be damaged in an accident
can identify possible outcomes : The vehicle may or may not be
involved in an accident

Level 3
We are uncertain about the nature of the outcomes themselves,
which have not been fully identified.
E.g. early exploration of space
The nature of all possible outcomes may not be completely
identified prior to undertaking the project

KOLEJ UINIVERSITI ISLAM

ANTARABANGSA SELANGOR (KUIS)
The response to uncertainty will be partially
influenced by the level of uncertainty.
The management of risks falling at Level 1 is
close to being a science.
Most important risks encountered by
organizations involve uncertainty levels 2
and 3
The organizations must rely on less-than-
scientific methods to evaluate and control
risks at these levels

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ANTARABANGSA SELANGOR (KUIS)
 Uncertainty, Information and
Communication
The reduction of uncertainty has economic value, and the information can
reduce uncertainty.

The level of uncertainty depends on :

– the amount and

– the type of information available

to identify possibles outcomes and estimates their likelihood.

Communication can reduce levels of uncertainty in an organization’s

stakeholders.
Communication between the organization and these stakeholder groups is
an important part of the manager’s responsibility.

KOLEJ UINIVERSITI ISLAM

ANTARABANGSA SELANGOR (KUIS)
By communicating the organization’s policies for managing
risk, the organization may reduce levels of uncertainty in
these stakeholders, which increases their willingness to
deal with the organization on favourable terms.
In the absence of this information, these stakeholders may
be uncertain about the nature of the organization’s actions
with respect to matters affecting their interest.
Their uncertainty leads them to charge a higher price for
their goods and services or place restrictions on their
activities that can be detrimental to other stakeholder
groups, especially stockholders
In other words, the organization can provide stakeholders
with the assurance that it has not and will not take actions
that are detrimental to their interests.
KOLEJ UINIVERSITI ISLAM
ANTARABANGSA SELANGOR (KUIS)
 Two Specific Concept Related to
Uncertainty
Insurance will be identified as an
arrangement for reducing uncertainty.
Insurance companies encounter aspects of
risk or uncertainty that are largely unique
to the insurance arrangement.
Two specific concepts are generally
important to risk management:
1. Adverse Selection
2. Moral Hazards

KOLEJ UINIVERSITI ISLAM

ANTARABANGSA SELANGOR (KUIS)
Adverse Selection (Antiselection)
Adverse selection is the result of insurance
having the greatest appeal to the individuals who
are likely to have a loss.
As a result, the demand for insurance is largest
for individuals who are most likely to have a loss
or, more generally, who expect their loss to be
larger than average
E.g. the demand for health insurance is likely to
be high for an individual who feels in poor health

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ANTARABANGSA SELANGOR (KUIS)
Hazard
Condition that increases the likelihood of loss or
loss amount
Physical hazard refers to a physical condition or
characteristic such as flammable liquids stored
near open flame
Moral hazard describes an effect on an
individual’s behaviour
Arson would be an extreme example of a moral
hazard, here, the individual deliberately sets fire
to collect insurance proceeds
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ANTARABANGSA SELANGOR (KUIS)
Managing Risk and Uncertainty
Risk and uncertainty have an important impact
on organizations.
Risk and uncertainty result in a cost referred to
as the cost of risk.
Risk imposes costs on an organization that would
not be incurred in a world of certainty
The most obvious cost is the cost of losses, that
is property is destroyed, a human is injured.
Second cost of risk is the cost of uncertainty itself
Even if no losses occur, the presence of risk and
uncertainty may impose a cost.
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ANTARABANGSA SELANGOR (KUIS)
At a basic level, risk and uncertainty can lead to worry.
Even if the individual never has an motorcar accident, the
risk of an accident lead to fear, sleepless nights
On the organization level, the cost of uncertainty may
appear in the form of worry or anxiety, but is probably
most clearly seen in the misallocation of resources.
This means organizations do not deploy their resources
optimally because uncertainty clouds their judgment, or
because the fear of loss discourages investment in certain
activities.

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ANTARABANGSA SELANGOR (KUIS)
Illustration of cost of risk – the reluctance of some
pharmaceutical companies to invest in new product
development (for fear of product liability suits).
Risk and Uncertainty also give rise to benefits. Speculative
risks can result in positive outcomes in which the
organization is rewarded for facing the risk.
Undoubtedly, organizations have motives to address risk
and uncertainty and this motivation gives rise to risk
management
At most basic level, risk management is practiced because
the negative and positive possibilities of risk – as well as
moral considerations – provide incentives for an
organization to take steps to minimize the costs of risk
while striving to maximize benefits
KOLEJ UINIVERSITI ISLAM
ANTARABANGSA SELANGOR (KUIS)