ABAARSO UNIVERSITY

COURSE : FINANCIAL INSTITUIONS &

Capital MARKETS

Instructor: Abdihakim Tiyari ( BA, MBA)

Credit Hour: 3 hrs

CHAPTER FIVE: NATURE OF RISK
PART ONE
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 Chapter Five

The Nature of Risk

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 Meaning of Risk
• There is no single definition of risk.
• Although the insurance theorists have not agreed on
a universal definition there are common elements in
all the definitions:
Indeterminacy
 When risk is said to exist, there must always be at
least two possible outcomes.
Loss
 At least one of the possible outcomes is undesirable.
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 Continued..........
• From this point we can define risk as follows:
 Risk is a condition in which there is a
possibility of an adverse deviation from a
desired outcome that is expected or hoped
for.
 Risk is uncertainty regarding loss.
 Risk is potential variation in outcomes.
 The greater the variation is the greater the
risk.
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 Continued.....

 Risks versus Uncertainty

Uncertainty
 it is simply a psychological reaction to the
absence of knowledge about the future.
 The most widely held meaning of 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. It is the opposite of
certainty

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• A student says “I am certain I will get an A
in this course,” which means the same as “I
am positive I will get an A in this course.”
Both statements reflect a conviction about
the outcome.
• Uncertainty, on the other hand, is the
opposite mental state. If one says “I am
uncertain what grade I am going to get in
this course,” the statement reflects a lack of
knowledge about the outcome.
• Uncertainty, then, is simply a psychological
reaction to the absence of knowledge about 6
 The Degree of Risk
• It is intuitively obvious that there are some
situations in which the risk is greater than in
other situations.
• Just as we should agree on what we mean
when we use the term risk, we should agree
on the way(s) in which risk can be
measured. Precisely what is meant when we
say that one alternative involves “more risk”
or “less risk” than another?
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• It would seem that the most commonly accepted
meaning of degree of risk is related to the likelihood
of occurrence.
• The degree of risk is measured by the probability of
the adverse deviation.
• In the case of the individual, the hope is that no loss
will occur, so that the probability of a deviation from
what is hoped for (which is the measure of risk) varies
directly with the probability that a loss will occur.
• In the case of the individual, we measure risk in terms
of the probability of an adverse deviation from what is
hoped for.
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 Continued......
Risk distinguish from peril and hazard
Peril
 is defined as the cause of loss.
 It is a contingency that may cause a loss.
 Examples include: peril of fire, windstorm,
collision, theft, etc...
Hazard
 a condition that may create or increase the
chance of a loss arising from a given peril.
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 Continued.....

Some of the examples of hazard are:

Ice street for collision
Storing gasoline in kitchen for fire
Poor lighting for theft
Types of hazards
There are three basic types of hazards:
a. Physical Hazard
 a condition stemming from the physical
characteristics of an object that increases the
probability and severity of loss from given perils. 10
 Continued......

 Examples of physical hazard includes: are the

type of construction, the location of the
property, and the occupancy of the building.,
etc…
b. Moral Hazard
 is dishonesty or character defects in an individual
that increase the frequency or severity of loss.
 Example of moral hazard includes: submitting
fraudulent claim, inflating the amount of claim,
burning unsold merchandise, etc…
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 Continued……..

c. Morale Hazard
 Morale Hazard is also reflected in the attitude of
persons who are not insured’s.
 Examples of morale hazard includes: The
tendency of physicians to provide more
expensive levels of care when costs are covered
by insurance is a part of the morale hazard., etc…
 . for example, the inclination of courts to make
larger award when the loss is covered by
insurance
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 Classification of Risk
• There are different ways of classifying risk. The major
categories of risk are:
Financial and non-financial risks
Financial Risks
 These are risks that the out come can be measured in
monetary terms.
 Example includes, damage to property, theft of property.
Non-financial Risks
 It is a condition which measuring the risk in monetary
terms is difficult.
 Example includes, choice of a marriage partner
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 Continued…….
Static and Dynamic Risks
Dynamic risks
 are those resulting from changes in the economy.
 Changes in the price level, consumer tastes, income and
output, and technology may cause financial loss to
members of the economy.
Static risks
 involve those losses that would occur even if there were
no changes in the economy.
 These losses arise from causes other than the changes in
the economy, such as the perils of nature and the
dishonesty of other individuals. 14
 Continued…….

Fundamental and Particular Risks

fundamental risk
 is a risk that affects the entire economy or large
numbers of personas or groups within the
economy.
 Fundamental risks involve losses that are
impersonal in origin and consequence.
 Examples of fundamental risks include high
inflation, war, drought, earthquakes, floods and
other natural disasters
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 Continued……

Particular risk
 is a risk that affects only individuals and not
the entire community.
 Examples of particular risks are the burning of
a house, the robbery of a back, and the
damage of a car.

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