Risk Management

Chapter 1 Introduction to Risk Management

Risk is a possibility of damage, injury, loss or any other negative occurrences that
is caused by external or internal vulnerabilities (inability or weakness).

Definition

According to mansson and sevenone “Risk is the potential (possibility) of losing

something of value against the potential to gain something of value, value such as
physical health, social status, emotional well being or financial wealth can be
gained or lost”.

Uncertainty, Peril, Hazards

Uncertainty: this is a situation where a possible outcomes or probability of

outcomes is unknown. In other words it is a situation where the future events are
not known.

Peril: peril is a cause of loss. Peril is the possibility of cause that exposes a person
or property to the risk of injury or damage or loss.

Types of perils

a. Natural perils: natural perils are those perils on which people have little
control.
b. Human perils: human perils includes causes of loss that lie within peoples
control like terrorism, war, theft, environmental pollution etc…
c. Economic perils: economic peril causes loss due to changes in economy like
changes in customer taste and preferences, technological advances, currency
fluctuations…

Ms. MADHUSHREE.P Assistant Professor, SDUIM Page 1

Risk Management

Natural perils Human perils Economic perils

Insurable Difficulty to Insurable Difficulty to Difficulty to insure
insure insure
Wind storm Flood Theft War Changes in
customer taste &
preferences
Lighting Earth quake Human Terrorism Technological
accidents changes
Heart attack Volcanic negligence Civil unrest Currency
eruption fluctuations

Hazards: hazards is a condition that increases the possibility of loss.

Types of Hazards:

a. Physical Hazards:
It refers to Physical condition or tangible condition that increases the
possibility of loss.
Example: smoking is a physical hazard that increases the possibility of house
fire & illness. Slippery roads which often increases the number of auto
accidents.
b. Moral / Legal Hazards:
Moral hazards are losses that results from dishonesty and fraudulent activities
of a individuals.
Example: insurance company suffers losses because of fraudulent claims.
c. Morale hazards:
Morale hazards are losses that do not involve dishonesty but arises attitude
of carelessness and lack of concern.
Example : careless cigarette smoking

Difference between Risk and Uncertainty

Risk Uncertainty
Possibility of losing or winning It is a situation where future events are
something is known not known
Chances of outcomes are known Chances of outcomes are not known
It can be controllable Uncontrollable

Ms. MADHUSHREE.P Assistant Professor, SDUIM Page 2

Risk Management

Types of Risks ( 6 marks or 14 marks)

1. Financial risk
2. Static and dynamic risk
3. Speculative and pure risk
4. Fundamental and particular risk
5. Market risk
6. Interest rate risk
7. Exchange rate risk
8. Liquidity risk
9. Country risk
10.Operational risk
11.Credit risk
12.Business risk

1. Financial risk
Financial risk is a possibility of loss when bond issuer will default by failing
to repay principle amount and interest in a timely manner.

2. Static and Dynamic risk:

Dynamic risks are those risks resulting from changes in the economy such as
changes in customer taste and preferences, changes in price level, income
and technological changes.

Static risks are those risks that would occur even there is no changes in
economy. If we hold customer taste, income level and technology some
individuals still suffered financial loss.

3. Speculative and pure risk

Speculative risk refers to a situation where there is possibility of loss and
also a possibility of Gain (profit).
Gambling is a good example of speculative risk.

Ms. MADHUSHREE.P Assistant Professor, SDUIM Page 3

Risk Management

Pure risk is a situation that involves only the possibility of loss OR no loss.
Example: possibility of loss surrounding the ownership of vehicles. The
person who buys a vehicle immediately faces the possibility that something
may happened and damage or destroy the vehicle. At last the final result will
be loss or no loss.
4. Fundamental and particular risk:
The fundamental risk is one that affects the entire economy or large number
of persons or group within community. It involves losses that are impersonal
in origin.
Example : cyclical unemployment, war, earth quake, terrorism…

Particular risk involves losses that arises out of individual events and it affects
only a particular individual and not the entire economy.
Example: burning of House

5. Market risk:
Market risk is a risk of loss resulting from fluctuations in the market prices
of shares or securities or commodities.

6. Interest rate risk:

Interest rate risk arises due to variability in the interest rates from time to time.
The fluctuation in the interest rate is caused by the changes in government
monitory policy.

7. Exchange rate risk:

Exchange rate risk is a risk that arises due to changes in Exchange rates.
In other words it is form of risk that arises from changes in the price of one
country currency against another country currency.

8. Liquidity risk:
Liquidity risk is the risk that arises when a company or bank unable to meet
its short term financial obligations. Liquidity risk is arises due to inability to
convert a security or asset into cash.

Ms. MADHUSHREE.P Assistant Professor, SDUIM Page 4

Risk Management

9. Country risk:
Country risk arises from an adverse change in the financial condition of a
country or political condition of a country in which a business operates.

10. Operational risk:

Operational risk is define has the risk of loss resulting from inadequate or
failure of internal process, people and system or from external events.

11. Credit risk:

Credit risk is the risk of loss due to debtors non payment of loan or other line
of credits either principal amount or interest amount or both.

12. Business risk:

The term business risk refers to the possibility of inadequate profits or lower
profits or experience a loss rather than making profit due to uncertainties.
Example: changes in customer taste & preference, strikes, lockout, increased
competition, changes in govt policy etc…

Various means of Managing or Handling Risks (6 marks)

1. Risk avoidance ( elimination of risk)

2. Risk reduction ( mitigating risk )
3. Risk transfer (insuring against risk)
4. Risk retention ( accepting risk )
5. Non insurance transfer

1. Risk avoidance
Risk avoidance is completely avoiding the activity that posses a potential risk.
By avoiding risk we are also avoiding a possibility of gain. Because gain or
profit will arises after taking a risk.
Example: 1. investors can avoid the risk of loss in stock market by not buying
stocks. 2. Divorce can be avoided by not marrying.

2. Risk reduction:

Ms. MADHUSHREE.P Assistant Professor, SDUIM Page 5

Risk Management

Risk reduction is reducing the possibility of loss, by taking the precautionary

measures we can reduce the possibility of loss.
Example: installing a security alarms we can reduce the possibility of theft,
wearing seat belts or helmets we can reduce the possibility of accidents.

3. Risk transfer:
Insurance policies are another methods to manage risks. By taking insurance
policy the risk of loss can be transferred from insured person to insurance
company.
Example: by taking a fire insurance policy the house owner can transfer the
risk of loss by fire to insurance company.

4. Risk retention:
Risk retention involves accepting the risk when risk is not avoided or
reduced or transferred then it is retained.
Risk retention is accepting the risk because risk is unknown
Example: smoking cigarette is considered a form of risk retention, since
many people smoke without knowing the many risk of diseases.

5. Non insurance transfers:

a. Contract: A common way of transfer risk by contract, by purchasing the
warranty extensions the risk of manufacturing defects transferred from
customers to manufacturers.
b. Hedging: reducing the risk
c. Diversification of investments: Instead of investing all funds in one
security, invest in different securities.

Risk management (2 mark compulsory question)

Risk management refers to the practice of identifying potential risks in advance,

analyzing them and taking precautionary steps to reduce the risk.

Risk management is the identifying, analysis, assessment, control and avoidance,

minimization or elimination of unacceptable risks. An organization may use risk
avoidance, risk reduction, risk transfer, risk retention or any other strategies to
manage the risks

Ms. MADHUSHREE.P Assistant Professor, SDUIM Page 6

Risk Management

Process of Risk management or steps in risk management OR Corporate Risk

Management Process (14 mark compulsory question)

1. Establishing the context

2. Risk identification
3. Risk analysis
4. Risk evaluation
5. Risk treatment
6. Monitor and review
7. Communication and consult

Ms. MADHUSHREE.P Assistant Professor, SDUIM Page 7

Risk Management

1. Establishing the context:

The purpose of this stage is to understand the risk environment in the
organization that means to understand the internal and external environment
of the organization.
Establishing the context means all possible risk are identified and the possible
solutions are analysis thoroughly. Various strategies are discussed and
decisions will be made for dealing with the risks.
The methods of analysis the organization environment are SWOT analysis
(strength, weakness, opportunities and threats) and PEST analysis (political,
economic, societal and technological)
Standard Australia and standard newzeland provides a 5 step process to assist
with establishing the context:
a. The external context
b. The internal context
c. Risk management context
d. Develop risk evaluation criteria
e. Define the structure of risk analysis\

2. Risk identification:
Once the context has been established successfully, the next step is
identification of potential threats or risks, this step reveals and determines
the possibility of risks which are highly occurring and other risks which are
occur very frequently.

3. Risk analysis:
Once the risks are identified we should determine level of risk, likelihood
(possibility) of risk and consequence (effect) of risk.
In this step we should understand the nature of risk to know the effects of
risks on organizational goals and objectives.
The impact of risk should be considered on the basis of time, equality,
benefit and recourses.

Ms. MADHUSHREE.P Assistant Professor, SDUIM Page 8

Risk Management

Impact of risk table:

5 CATASTROPHIC : most of the objectives severely affected
4 MAJOR: most of the objectives threatened
3 MODERATE : some objectives affected
2 MINOR: with some effort objectives can be achieved
1 NEGLIGIBLE: very small impact

Likelihood of the risk table:

5 ALMOST CERTAIN –occur several times
4 LIKELY – arise once in a year
3 POSSIBLE – arise over a 5 years
2 UNLIKELY – arise over a 5 to 10 years
1 RARE – unlikely but not impossible, over a 10 year period

4. Risk evaluation:
This step is deciding whether risks are acceptable or unacceptable or need
treatment.
The acceptable or unacceptable risk is based on “risk appetite” (the amount
of risk they are willing to take).

5. Risk treatment:
After analyzing the risk we should determine whether the risk needs
treatment or not. Usually an unacceptable risk requires treatment.
The treatment of risks includes:
a. Risk avoidance
b. Risk reduction
c. Risk transfer
d. Risk retention

6. Monitor and review:

Monitor and review is an essential and integral steps in the risk management
process. Risks needs to be monitored to ensure the changing environment does
not alter risk priorities.

Ms. MADHUSHREE.P Assistant Professor, SDUIM Page 9

Risk Management

7. Communication and consult:

Communication and consult aim to identify who should be involved in the
assessment of risk ( identification of risk, analysis of risks, evaluation of risks)
and who will be involved in the treatment, monitor and review ofrisks.

Importance or benefits of risk management:

1. Effective utilization of resources

2. Enables decision making: regarding accepting or non accepting risk and
treatment of risks
3. Helps to avoid reduce and prevent risks
4. Increases the possibility of risks
5. Performance monitoring
6. Helps to identification of possible risks or threats
7. Helps to reduce the effects of risks
8. Reducing the risk creating greater confidence in your activities.

Objectives of risk management

1. Pre loss objectives

2. Post loss objectives

(a) Pre loss objectives:

1. Economy :
Which means the firm should prepare for possible losses in the most
economical way. This involves an analysis of the cost of insurance
premiums and the cost associated with different techniques for handling
losses.
2. Reduction of anxiety:
Some losses make greater worries for the risk manager and key
executives. Risk management enables the organization to reduce the
possibilities of risks and worries.

Ms. MADHUSHREE.P Assistant Professor, SDUIM Page 10

Risk Management

3. Meet any legal obligation:

The next objective is to meet legal obligations. For example: the
government regulation may require a firm to install safety devices to
protect workers from harm & industrial accidents.

(b) Post loss objectives:

1. Survival of the firm:
Some losses are so extreme that destroys the existence of the
organization. Survival means after a loss occurs the ability of a firm to
rebuild their operations.
2. Continuation in operation:
After the loss it is important for the companies to continue their
operations for its survival.
3. Stability of earnings:
Some losses directly affect the earnings of the company. A risk
management technique helps the organization to earn stable incomes
even after the loss.
4. Continue growth of the company
Risk management helps the organization to grow by developing new
product, market and business strategies.

Limitations of risk management

1. Complex calculations:
Without any automatic tool each and every calculation regarding risk
becomes difficult,
2. Unmanaged losses:
Losses can be control to the some extent; beyond that level losses cannot be
controlled and managed.
3. Depends on external entities:
For managing the risk we require information. For getting the information
about the external environment of the organization we depend on external
entities.

Ms. MADHUSHREE.P Assistant Professor, SDUIM Page 11

 Risk Management
4. Difficulty in implementing:
Risk management implementation requires long time to gather the
information regarding the risk plan and strategies.
5. Potential threats:
Potential threats means possible threats which may or may not be occur.
6. Performance:
Risk management tools and techniques is understand by only qualified
professionals. It is very difficult to understand by common man.
7. Wastage of time:
If identification of risks is not done then it will be wastage of time and money.

Important questions from I chapter (22 marks)2

marks:
1. What is risk management?

6 marks :

1. Various means of managing or handling risks

2. Limitation of risk management
3. Objectives of risk management any one
4. Benefits of risk management
5. Types of risks

14 marks

1. Risk management process or steps in Risk management.

2. Types of risks any one

Section A (2mark) Section B (6 marks) Section C (14 marks)

1 1 1

Ms. MADHUSHREE.P Assistant Professor, SDUIM Page 12