Chapter one

The Nature of risk

Introduction:

The risk is concerned with physical and financial well-being. The people are living with some
threatening like fire, flood, earthquake, accident, terrorist attack, etc. That shows certain risks are
present in our society. We can say, we are living in a risky world. In the present day context,
individuals have a strong desire for financial security and protection against those events that
threaten their financial security. Financial security can be threatened by numerous factors such
as;

- If the family head is killed in an accident

- Destruction of property by fire, floods, earth quakes and other natural factors.

- Infected by serious diseases such as Cancer, Heart disease, HIV etc.

Thus, it is apparent that certain factors can threaten the financial security of individuals and their
families.

1.1 Meaning of Risk:

There is no single definition of risk. But for our understanding we can define risk as follow:

Uncertain event or condition, which occur undefined or unknown impact on achievement of

objectives

1. Risk is defined as uncertainty concerning the occurrence of a loss.

2. The chance of loss.
3. The dispersion of actual from expected results
4. The probability of any outcome different from the one expected

From the above definitions of risk there are common elements in all definitions i.e.
indeterminacy (the outcome must be in question) and loss( at least one of the possible outcomes
is undesirable
For example, the risk of being killed in an auto accident for a truck driver is present because
uncertainty is present. Likewise, the risk of lung cancer for smokers is present because
uncertainty is present.

Thus, risk is uncertainty regarding loss. This means that the loss may or may not happen. In
short, risk is the same thing as uncertainty.

1.2 RISKS vs. UNCERTAINTY:

Uncertainty is a state where the current conditions are unknown.

The dictionary meaning of risk is the possibility of meeting danger or suffering harm or loss”.
The dictionary meaning of uncertainty is “the state of being uncertain”. Here, uncertain means
“feeling doubt about”.

Thus, uncertainty of meeting with a loss or damage is known as risk.

Uncertainty refers to a state of mind characterized by doubt, based on a lack of knowledge about
what will or will not happen in the future. Uncertainty is simply psychological reaction to the
absence of knowledge about the future.

Similarity

Both are concepts of involving the unknown.

Both concepts cause fear and anxiety.

Difference

Risk involves an unknown future while uncertainty involves an unknown present, when you are
uncertain; you don’t know the entire variable. You cannot diversify away uncertainty.

Uncertainty is not broken down into sub-types.

1.3 Risk vs. Probability (chance of loss)

Chance of loss is closely related to the concept of risk. “Chance of loss” is the long- run chance
of occurrence or relative frequency of some event where as risk is a concept in relative variation.
Probability has both objective and subjective aspects.
Objective probability: is the long-run relative frequency of an event based on the assumption of
an infinite number of observations and of no change in the underlying conditions.

Subjective probability is the individual’s personal estimate of the chance loss

Chance of loss is the probability that an event will occur. Objective risk is the relative variation
of actual loss from expected loss. “The chance of loss may be same for two different groups, but
objective risk may be different.

For example, Africa Insurance Company (AIC) has 10000 homes insured in Addis Ababa and
10000 homes insured in Nazareth and that the chance of loss in each city is 1%. Thus, on an
average 100 homes should burn annually in each city. However, if the annual variation in losses
ranges from 70 to 120 in Addis, but only from 90 to 110 in Nazareth, objective risk is greater in
Addis even though the chance of loss in both cities is the same.

1.4 Distinction of Risk from Peril & Hazard:

Peril is defined as the cause of loss. If a house burns because of fire, the peril (the cause
of loss) is the fire. Likewise, some common perils that cause damage or loss to the property
include fire, theft, burglary, storm, earthquake, etc.

A hazard is a condition that creates or increases the chance of loss. There are three types of
hazards;

i) Physical hazard

ii) Moral hazard

iii) Morale hazard

i) Physical Hazard:

A physical hazard is a physical condition that increases the chance of loss. Examples of
physical hazards are icy roads that increase the chance of an auto accident, defective lock on a
door that increases the chance of theft, etc. If a house with defective wiring burns in a fire, the
defective wiring is the physical hazard.
ii) Moral Hazard:

Moral hazard is dishonesty or character defects in an individual that increase the

frequency or severity of loss. For example, the dishonest persons may fake an accident to collect
the insurance or they intentionally burn unsold merchandise that is insured.

A business firm may be overstocked with inventories and insured. The man may deliberately
burn unsold merchandise that is insured to collect claims from the insurance company. Here, the
unsold merchandise burns in a fire due to the dishonesty of that man. This is known as moral
hazard.

iii) Morale Hazard: Morale hazard is defined as carelessness to a loss because of the
existence of insurance. Examples of morale hazard include leaving a door unlocked that allows
a burglar to enter, rash driving without proper signaling. Careless acts like these increase the
chances of loss.

1.5 CLASSES OF RISK

The risks may be classified basically into the following major types. They are as follows;

1) Objective and subjective risks.

2) Pure risks and Speculative risks

3) Static risks and Dynamic risks

4) Fundamental risks and Particular risks

5) Financial and Non-financial risk

6) Diversifiable and non- diversifiable risks

7) Risk Related with Business Activities

1) Objective and subjective risks

Objective Risk:

Objective risk is defined as the relative variation of actual loss from the expected loss.
For example, assume that a man has 1000 houses insured over a long period of time, and on
average10 houses burn each year. However, we cannot expect 10 houses to burn each year
exactly. In some years, 8 houses may burn, while other years 12 houses may burn. Thus, there is
a variation of 2 houses from the expected number of 10. This relative variation of an actual loss
from expected loss is known as OBJECTIVE RISK.

Subjective Risk:

Subjective risk is defined as uncertainty based on a person’s mental condition or state

of mind.

For example, a person who has drunk more in the bar may attempt to drive home on his own.
Here, he may uncertain whether he will arrive home safely without any accident due to drunken
driving. This mental uncertainty is called SUBJECTIVE RISK.

The impact of subjective risk varies depending on the individual. Two persons in the
same situation may have a different perception of risk, and their behavior may be altered
accordingly. If an individual experiences great mental uncertainty (high subjective risk)
concerning the occurrence of a loss, that person’s behavior may be affected. Thus, high
subjective risk often results in conservative and prudent behavior, while low subjective risk
results in less conservative behavior. A motor cyclist who has met with an accident in a
particular road will be more cautious and he will drive slowly while riding through that road.
However, another motor cyclist who has not met with an accident may have a rash driving on the
dame road. Thus, the risk of meeting with an accident is perceived in different manner by the
two motor cyclists. The first motor cyclist has high subjective risk and thus prudent, but the
second motorcyclist has less subjective risk and thus less conservative

The Degree of Risk

Degree of risk is the range of variability around the expected losses, which are calculated using
the chance of loss concept by means of the following formula:

Objective risk= probable variation of actual from expected loss⁄ expected loss
 Consider the possibility of fire loss to buildings in two towns i.e Adama and Addis Ababa.
There are 200,000 houses in each town and, on average , each town has 100 fire losses per year.
By looking at historical data from the towns, statisticians are able to estimate that in Adama town
the actual number of fire losses during the nest year will very likely range from 95to 105. In
addis ababa, however, the range probably will be greater , with at least 80 fire losses expected
and possibly as many as 120.The degree of risk for each town is computed as follows:

Degree of risk for Adama= 105-95⁄100=10 percent

Degree of risk for addis= 120-80⁄100= 40 percent

As shown ,the degree of risk for addis is four times that for Adama, even though the chance of
loss are the same

2) 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 loss and no loss. Examples of pure risks include premature
death, medical expenses, damages of properties from fire, flood, earthquake, etc.

Types of Pure Risk:

The following are the important types of pure risks;

i) Personal risks

ii) Property risks

iii) Liability risks

iv) Risks arising from the failure of others

i) Personal Risks:

Personal risks are risks that directly affect an individual. Examples of personal risks are
possibility of the complete loss or reduction of earned income, extra expenses, etc. There are four
major personal risks.

a) Risk of premature death

 b) Risk of insufficient income during retirement

c) Risk of poor/unfortunate health

d) Risk of unemployment

(a) Risk of premature death is defined as the possibility of death of a person to die before
attaining the average age of living. If the family head dies, then surviving family members
receive an insufficient amount. They may be financially insecure.

(b) Risk of old age is the possibility of insufficient income during the retirement. The
majority of workers in Ethiopia retire before age 65. When they retire, they lose their earned
income. Unless they have sufficient financial assets, or have access to other sources of
retirement, they will be exposed to financial insecurity during retirement.

(c) Risk of poor health is another important personal risk. The risk of poor health includes
both the payment of medical bills and the loss of earned income. For example, an open heart
surgery may cost more than 50,000 Birr, a kidney transplant can cost more than 30,000 Birr.
Unless these persons have adequate health insurance, private savings, and financial assets, or
other sources of income to meet these expenditures, they will be financially insecure.

(d) Risk of unemployment is another major threat to financial security. Unemployment can
cause financial insecurity in three ways;

- First, the worker loses his or her earned income

- Second, because of economic conditions, the worker may be able to work only part time

- Finally, if the duration of the unemployment is extended a long period, past savings may
be exhausted

(ii) Property Risks:

Persons owning property can be damaged because of fire, lightning, windstorms and
numerous other causes.

There are two major types of loss in the damage of property;

a) Direct loss
 b) Indirect loss

A direct loss is defined as a financial loss that results from the physical damage, destruction, or
theft of the property. For example, if a house is destroyed by a fire, the physical damage to the
house is known as direct loss.

An indirect (consequential) loss is a financial loss that results indirectly from the occurrence of a
direct physical damage or theft loss. Thus, in addition to the physical damage loss, the property
owner no longer has a place to live, and during the time required to rebuild the house, it is likely
the owner will incur additional expense living somewhere else. This loss of use of the destroyed
asset is an indirect loss.

(iii) Liability Risks:

Liability risks are another type of pure risk that most persons face. One can be made
legally liable, if he or she do something that results in bodily injury or property damage to
someone else. The court of law may order that person to pay substantial damages to the person
who is injured.

Motorists are being held legally liable for the negligent operation of their vehicles. Business
firms are also being sued because of defective products that harm or injure customers.

(IV) Risks arising from failure of others. When another person agrees to perform a service for
you, Him or her undertakes an obligation that you hope will be met. When the person’s failure
to meet this obligation would result in your financial loss. Example of risk min this category is
the failure of a contractor to finish the construction according to the agreed schedule.

Speculative Risk:

Speculative risk is defined as a situation in which either profit or loss is possible. For
example, if you purchase 100 shares of a company, you may gain if the price of that share
increases but may lose if the price declines. Thus, here there are possibilities of both profit and
loss.

Pure risk Vs Speculative risk:

Speculative risk can be differentiated from the pure risk in three ways;
Pure risk Speculative risk

1. Private insurers generally insure only 1. Speculative risks are not considered
pure risks. insurable.

2. Insurers can predict loss in advance in 2. Insurers cannot predict loss/gain in

pure risks. advance in speculative risks.

3. It is harmful to the society. 3. Society may benefit from a speculative

risk even though a loss occurs.
E.g. Earthquake, fire, flood, etc.
E.g. Increase in share price.

3) Static Risks and Dynamic Risks:

Static risks are risks connected with losses caused by the irregular action of nature or by
the mistakes and misdeeds of human beings. These losses arise from causes other than the
changes in the economy, such as the perils of nature and the dishonesty of other individuals.
static risks are not a source of gain to the society. Examples of static risks include earthquake,
flood, premature death, etc. Static risks are same as pure risks and present in an unchanging
economy.

Dynamic risks are associated with a changing economy. Dynamic risks are always
speculative risks where both profit and loss are possible. Examples are the changes in the price
level, tastes of consumers, income, technological changes, new methods of production, etc.
These dynamic risks normally benefit society over the long run, since they are the result of
adjustment to misallocation of resources

Static Vs Dynamic Risk:

Static Risks Dynamic Risks

1. More static risks are pure risks. 1. Dynamic risks are always speculative
risks.

2. Dynamic risks are associated with a

2. Static risks are present in an unchanging
economy. changing economy.

3. It is harmful to the society. 3. It may be beneficial to the society.

4. It affects people as a whole. 4. It affects more individuals.

Static and dynamic risks are not independent. Greater dynamic risks may increase some
types of static risks. An example involves uncertainty due to weather related losses. This risk is
usually considered to be static. However, recent evidence suggests that environmental pollution
caused by increased industrialization may be affecting global weather patterns and there by
increasing the source of static risk. Here, the increased industrialization is a dynamic risk.

4) Fundamental Risks and Particular Risks:

fundamental risks involve losses that are impersonal in origin and consequence.
Fundamental risk is a risk that affects the entire economy or large number of persons or groups
within the economy. Examples include high inflation, cyclical unemployment and war.

The risk of a natural disaster is another important fundamental risk. Tornadoes,

earthquakes, floods and forest fires can result in property damage as well as the loss of numerous
lives.

Particular risks involve losses that arise out of individual events and are felt by
individuals. A particular risk is a risk that affects only individuals and not the entire
community. Examples are car thefts, house thefts, etc. Here, only individuals experiencing such
losses are affected, not the entire economy.

5. Financial and non- financial Risk

Financial risk is the one where the outcome can be measured in monetary terms. Example: loss
of car through accident or collision

Non- Financial risk refers to risky situation where outcomes cannot be measured in terms of
money. Example: one’s feeling following death of a close relative.

6. Diversifiable and non-diversifiable risks

A risk is non-diversifiable if pooling agreements are ineffective to reduce risks for the
participants in the pool. They are uninsurable. Example: Economic depression of 1929-1933

A Risk is diversifiable if it is possible to reduce risks through pooling or risk sharing agreements.
They are insurable. Example: automobile owners , persons injured by car accident

1.6 Risk Related with Business Activities

1. Business Risks- are inherent in the economic environment and related with the physical
operation of the firm. Example: variation in the level of sales , cost

2.Financial Risk- Related with debt financing . Example: unable to pay interest rate and the
principal on maturity, stock prices, bankruptcy, insolvency, etc

3. Interest rate risk- related with change in interest rate

4. Purchasing power risk- due to inflationary situations

5. Market risk- due to stock price variability caused by investors reaction to real or psychological
expectations and working of the economy. It is systematic and no diversifiable risk on investors

Risk related with International Business Activities:

 exposure:-due to gain and loss of foreign currency

 Translation exposure:-through consolidation of financial statements

 Economic exposures:- exchange rate risk which affect future cash flows