Topic 1: INTRODUCTION TO RISK

Introduction
This first topic examines the background to insurance and risk management. Risk management
has become paramount in today’s business society owing to the many risks that enterprises are
exposed to. Insurance is a risk transfer mechanism and helps businesses, individuals, commerce
and industry to transfer the financial consequences of an occurrence to the insurer and pays
premiums in return.

Objectives
By the end of this topic you should be able to:
1. Define risk
2. Explain the components of risk, hazards and perils
3. Classification of risks
4. Discuss methods of handling risks
5. Examine the burden of risk to the society

Learning activities
Learning Activity 1.1: Reading
Read the provided topic notes on Introduction To Risk.

Learning Activity 1.2: Discussion

Giving appropriate examples, discuss the various types of risks that a business organization may
be exposed to

Learning Activity 1.3: Topic Assignment

Explain FIVE techniques of handling risks in an organization
Topic Resources
1. Kenya College of Insurance. (2000). Principles of Insurance, KCI, Nairobi
2. Rejda G.E (2008). Principles of Risk Management and Insurance, Pearson Education
Asia, New Delhi
3. Vaughan E and T. Vaughan (2008). Risk Management and Insurance, 9th edition, John
Wiley and Sons, New York.

URL Links
https://en.wikipedia.org/wiki/Risk

Topic 1 Notes

1. INTRODUCTION TO RISK

1.0 INTRODUCTION
Risk is the basic issue with which Risk management and insurance deals. There is no universal
definition of risk. The understanding of “risks” in risk management and insurance has been made
difficult by the variety of ways in which the term is used in daily conversations, in academic
discipline, and even in business of insurance itself.
Because the term risk is ambiguous and has different meanings, many authors and corporate risk
managers use the term loss exposure to identify potential losses. A loss exposure is any situation
or circumstance in which a loss is possible regardless of whether a loss occurs.

1.1 DEFINITIONS OF RISK

In insurance and risk management, risk can be defined as;
(i) The chance of loss, where chance implies some doubt about an outcome in a given situation
which is unfavorable
(ii) The possibility of loss
(iii) The uncertainty of loss
(iv) The dispersion of actual from expected results
(v) The probability of any outcome being different from the one expected
(vi) A combination of hazards or
(vii) A condition in which loss or losses are possible

1.2 COMPONENTS OF RISK

Risk has three vital components;

1.2.1 Uncertainty
The concept of risk revolves around uncertainty. This implies some doubts about the future based
on either lack of knowledge or imperfection of knowledge. Uncertainty exists even when the
person exposed to risk does not know of its existence. If a baby is crossing the road, even if he or
she may not know of the risk he or she is facing, uncertainty still exists.

1.2.2 Levels of Risk

Risks are of different levels. Some risks such as minor injuries while at work place and shoplifting
occur frequently but with very minimal impact. Certain risks such as plane crashes, train accidents
and marine accidents, occur rarely but their impact is severe. We therefore have high frequency
low severity risks and low frequency high severity risks.

1.2.3 Risk as the causes of loss

The tern peril and hazards are sometimes used interchangeably with each other and with risk. The
three terms are very different in risk management and insurance, however, risk is often used to
mean both peril and hazard.
A peril is the prime cause of loss e.g. fire, theft, hail, earthquake and so on
A hazard is a condition that may increase or decrease the effect of a peril. For example, the nature
of construction in fire insurance, the state of health in life insurance or the nature of goods sold in
theft policy.
1.3 Classification of hazards
Hazards can be Physical, Moral or legal hazards

1.3.1 Physical hazards

Physical hazards relate to the tangible characteristics of the subject matter of insurance that may
increase or decrease the likelihood of an event. Examples of physical hazards in fire insurance are;
(i) The type of construction
(ii) Location of the building and
(iii) The occupancy of the building
(iv) In motor insurance, the age and the value of a vehicle are hazards

1.3.2 Moral hazards / Attitudinal hazards

Moral hazards are risks arising from the nature and behavior of human beings towards the subject
matter of the insurance. From the view point of the insured, this may relate to tendencies such as
lodging fraudulent claims, exaggerating losses, withholding material facts and carelessness such
as leaving car keys in unlocked car which increases the chance of theft.

1.3.3 Legal hazards

Legal hazards refer the characteristics of the legal system or regulatory environment that increases
or decreases the frequency or severity of losses. Examples includes adverse jury verdict or large
damage awards in liability law suits.

1.4 CLASSIFICATION OF RISK

Risk may be classified into a number of ways, but the most commonly used classifications are;
(i) Financial versus non-financial risks
(ii) Pure versus speculative risks and
(iii) Fundamental versus particular risks

1.4.1 Financial versus Non-financial risks

(a) Financial risks: risks whose outcome can be measured in monetary terms, such as material
damage to property after fire or theft of goods.
(b) Non-financial risks: risks whose outcome may not be quantified in monetary terms, such as
choices of wrong careers or loss of items with sentimental attachment, such as locket given by a
loved one or choice of marriage.

1.4.2 Pure versus Speculative Risks

(i) Pure risks involve loss or break even situations. They might not only be unfavorable but also
may leave a person in the same position, he or she enjoyed before the occurrence of the event, such
as fire or burglary risk
(ii) Speculative risks involve loss, break even and the possibility of gain. An example is buying
shares or inventing new products.

1.4.3 Fundamental versus Particular Risks

(i) Fundamental risks: are risks whose cause is beyond the control of human beings and are
indiscriminate in their effects. They are impersonal in origin and consequences e.g. earthquake,
floods, landslide, typhoon, windstorm, war, unemployment etc. They are also known as non-
diversifiable risks as they cannot be eliminated or reduced through diversification or systematic
risks since they affect a large number without any discrimination.
(ii) Particular risks on the other hand are risks, which are personal in origin and consequences e.g.
fire, burglary, motor accidents etc. They are also known as diversifiable risks since they can be
eliminated or reduced by diversification, an example being having a portfolio of bonds and stocks
instead of investing in only one of them.

Other types of risks

1.4.4 Diversifiable versus non-diversifiable risks
(i) Diversifiable (nonsystematic or particular) risks affect only individuals or small groups and
not the entire economy and can be reduced or eliminated or reduced by diversification e.g. portfolio
technique- where losses of one type of one line are offset by profits of other lines.
(i) Non-diversifiable (systematic or fundamental) risks affect the entire economy or large
number of persons or groups within the economy and cannot be eliminated by diversification.
Mostly dealt with by governments assistance-social insurance, guarantees or subsidies
(i) Enterprise risk: refers to all major risks faced by a business firm and include; pure, speculative,
strategic, operational and financial risks.

1.4.5 Strategic versus operational risks

(i) Strategic risks refer to uncertainty regarding a firm’s financial goals and objectives e.g.
entering a new line of business.
(ii) Operational risks results from the firm’s business operations e.g. hacking in online banking.

1.4.6 Financial / Market Risks

Financial/Market risks:- uncertainty of loss because of adverse changes in commodity prices,
interest rates, foreign exchange rates and the value of money

Note: Enterprise risk management combines in a single unified treatment program all major risks
faced by the firm

1.5 MAJOR PERSONAL AND COMMERCIAL RISKS

1.5.1 Personal risks: - are risks that directly affect an individual and involve the possibility of the
loss or reduction of earned income, extra expenses and depletion of financial assets e.g.
(i) Risk of premature death
(i) Risk of insufficient retirement income
(ii) Risk of poor health
(iii) Risk of unemployment

1.5.2 Property risks: - these are risk of having property damaged or lost from various causes e.g.
fire, theft, earthquakes, flood etc. these can be divided into two;
(i) Direct loss: - financial loss that results from the physical damage, destruction or theft of the
property e.g. home damaged by fire.
(ii) Indirect or consequential loss: - financial loss that results indirectly from the occurrence of
physical damage, destruction or theft of the property e.g. additional living expenses after home
damage.
1.5.3 Liability risks: - risks resulting to bodily injury or loss of property of third parties

1.5.4 Commercial risks: - risks faced by business firms which may cripple or bankrupt them.
These include property, liability, loss of income and other risks such as crime, intangible property
exposures etc.

1.6 METHODS OF HANDLING RISKS

Risk is pervasive, and therefore, people must find proper ways of dealing with it. In developed
countries, governments handle some fundamental risks, but in under-developed countries
governments role in handling fundamental risks is passive or absent. Given their nature, however,
particular risks are handled by individuals, who may use some or all of the following methods to
handle risks: avoidance, retention, reduction or risk transfer.

1.6.1 Avoidance
Risk may be avoided if one does not engage in a venture which one considers risky. No measures
are taken to reduce the risk. Risk avoidance, however, is a negative approach to handling the risk
and may affect the society negatively. Secondly, not all risks are avoidable.

1.6.2 Retention:-This means that an individual or a business firm retains part or all of the financial
consequences of a given risk. Risk may be retained intentionally (actively) or unintentionally
(passively).
(i) Intentional / active or voluntary retention occurs when an individual or an organization is
consciously aware of the existence of risk but decides to retain part or all the risk. A fund is then
created from where losses would be paid (i.e. self-insurance/funding). This decision may be taken
to save money or because there are no attractive alternatives, an example being when premiums
are very high.
In deciding on whether or not to retain risks voluntarily, the guiding factor should be the frequency
and severity of risk. Large unpredictable risks require insurance and vice versa.
(ii) Unintentional/Involuntary/ passive retention occurs when risks retained simply because an
individual or organization does not recognize the existence of the risk. This may be due to
ignorance, indifference, or laziness.
Note. Risk retention is appropriate primarily for high frequency-low severity risks where potential
losses are relatively low.

1.6.3 Reduction (Loss control) - consist of certain activities that reduce the frequency or severity
of loss.
(i) The essence of pre-loss minimization is that the effect of the loss is anticipated and steps taken
to ensure that the frequency and/or the severity of the loss are reduced to the minimum. Pre-loss
control measures are preventive, for example, police escort in money insurance, employment of a
watchman and burglar proofing in theft insurance. Strict loss prevention efforts can reduce the
frequency of losses, yet some losses will inevitably occur hence,
(ii) Post-loss control which are loss minimization measures taken once a loss has taken place, for
example, fixing sprinklers in fire insurance, installation of intruder alarm in burglary insurance
and economic disposal of salvage in motor insurance. These measures are desirable to reduce both
direct/indirect and social costs.

1.6.4 Risk Transfer

This is a mechanism by which financial consequences of an event are shifted from one party to
another. For example, a landlord may shift the risk of the house catching fire to the tenant and the
owner of transported goods to the transporter. Risk transfer is normally done through suitably
worded contracts and the most commonly used method of transferring risk is through the insurance
device.
Insurance involves transferring risks to some other party more competent to handle the risk. It
means spreading an individual’s risk across a number of people so to make it bearable for
individuals exposed to the risk. Through insuring, a person transfers the risk to the insurer that in
turn, spreads the risk.

1.7 BURDEN OF RISK TO THE SOCIETY

The presence of risk results in certain undesirable social and economic effects such as;
(i) The size of emergency fund must be increased to pay for the unexpected losses
(ii) Society is deprived of certain goods and services
(iii) Worry and fear are present (mental unrest)