Risk is part of every human endeavour. It means uncertainty of losses. Risk refers to a situation in which one can specify the relative probability distributions of the outcome of his decision. In other words, it is a situation where there are many states and the decision maker knows the probability of occurrence of each state. Uncertainty is the reverse of the probability in practice. The uncertainty of loss is the basic characteristic of risk.
According to Frank Knight, “Risk is a measurable uncertainty”. In the words of Irving Fisher, “Risk may be defined as a combination of hazards measured by probability.”
So risk is phenomena closely associated with uncertain events of perils such as fire, storms, collision to which the object is exposed.
Risk in insurance jargon means the uncertainty that is associated with any kind of financial loss. The loss can be from any damage to property, interruption in business, inability to earn due to a disability, an auto accident and the like. According to Knight risk arises due to uncertainty of losses. Without uncertainty there is no risk. Whether the occurrence of any peril and uncertain event would result into loss or not, is called risk in insurance. To be able to balance the situation, the risk needs to be reduced as far as possible. The best way to do this is to follow a well-designed risk management strategy.
Features of insurance risks
There are various types of risks related with insurance. Risk is the degree of variation in the possible outcomes from an uncertain event or as the variation in actual from expected outcomes. We know that all risks are not insurable. There is no hard and fast rule to determine whether as risk is insurable or not. The following features are present in any risk which is insurable.
- Insurable interest: Risk can be insured if it has insurable interest in its object or person’s life
- The likelihood of loss should be predictable. Insurance companies know approximately how many fires will occur each year, how many people of a certain age will die, how many burglaries will occur, and how many traffic accidents and job-related injuries will take place. Knowledge of the numbers of such losses and of their average size allows the insurance company to determine the amount of premiums necessary to repay those companies and individuals who suffer losses.
- The loss should be financially measurable. In order to determine the amount of premium income necessary to cover the costs of losses, the dollar amount of losses must be known. For this reason, life insurance policies are purchased in specific rupee amounts, which eliminate the problem of determining the value of a person’s life. Many health insurance policies list the rupee value for specific medical procedures. Some policies have no schedule of benefits for such procedures but pay, say, 80 or 100 percent of the cost.
- The loss should be fortuitous or accidental. Losses must happen by chance and must not be intended by the insured. The insurance company is not required to pay for damages caused by a fire if the insured is found guilty of arson. Similarly, life insurance policies typically exclude the payment of proceeds if the insured commits suicide in the first year of the policy’s coverage.
- The risk should be spread over a wide geographic area. An insurance company that concentrates its coverage in one geographic area risks the possibility of a major catastrophe affecting most of its policyholders. A major hurricane, earthquake, or tornado might bankrupt the company.
- The insurance company has the right to set standards for accepting risks. The company may refuse insurance coverage to individuals with heart disease or to those in dangerous occupations, such as fire fighters, test pilots, and crop dusters. Or the company may choose to insure these people at considerably higher rates due to the greater risks involved. In the same manner, fire insurance rates may be different for residences and commercial buildings.
- Pure and major risks: Risk is said to be pure when it is casual, uncertain and non-speculative. Uncertain events which causes are insurable risks. The risk must be large amount of loss which cannot be borne by a single person.
- Monetary risks: Only monetary risks are insured. That means such risks are insurable which are capable of being compensated in monetary terms only.
- Objects of risks not to be illegal: Risks to be insurable must possess a valid or legal object. Loss on smugglers, thieves etc. are not insurable.
- Catastrophic: Some risks are catastrophic which affect large number of persons adversely. For example flood, earthquakes etc.
- Real risks: The insured risk must be real and not imaginary. Self-created or self-invited perils cannot be called as real risks. So these risks are not insurable.
Sources of risk
There are many sources of risk that an organization must take into account before a decision is made. Risk may be specific at corporate level such as political, legal and financial risk. At the strategic business level economic, natural and market risks may be assessed. Project risks may be a specific to a project such as technical, health and safety operational and quality risks.
- Political risk: Political risk is a type of risk faced by investors, corporations, and governments. Political risk faced by firms can be defined as “the risk of a strategic, financial, or personnel loss for a firm because of such non market factors as macroeconomic and social policies (fiscal, monetary, trade, investment, industrial, income, labour, and developmental), or events related to political instability (terrorism, riots, coups, civil war, and insurrection). This risk is due to change in government policy, public opinion, change in ideology, legislation etc.
- Environmental risks: Management of environmental risk is a part of corporates Life. Identifying environmental hazards and controlling associated risks is important, not only protect the environment but also prevent the corporates from incurring large fines, remediation costs, loss of reputation etc. Environmental risks can be caused by the release of pollutants to the air, land or water. Here the uncertainty is due to contaminated land, or pollution liability, noise, public opinion, internal or external corporate policy, environmental regulations etc.
- Planning risk: It arises when permission is required, socio economic impact etc.
- Market risk: Market risk is the risk that the value of a portfolio, either an investment portfolio or a trading portfolio, will decrease due to the change in value of the market risk factors. This risk arises due to competition, demand, obsolesce, customer satisfaction etc.
- Economic risk: It arises due to taxation; cost inflation changes in interest rates, exchange rates etc. Economic risk is a nebulous term with a variety of definitions. In a nutshell, economic risk is the risk that an endeavor will be economically unsustainable, for a variety of reasons ranging from a change in economic trends to fraudulent activities which ruin the outcome of the project. Before starting projects, economic risk has to be considered to determine whether or not the potential risks are outweighed by the benefits.
- Natural risk: Uncertainty due to unforeseen ground conditions, weather, earth quake etc.
- Project risk: This risk is occurring due to uncertainty in performance requirement, standard, leader ship, organization, planning and quality control, labour and resources, communication and culture.
- Technical risk: Technical Risk is simply the risk associated directly with the knowledge base being employed and its technical aspects including such things as understanding, reproducibility and the like. Exposure to loss arising from activities such as design and engineering, manufacturing, technological processes and test procedures. It arises due to uncertainty due to design adequacy, operation ability and reliability.
Types of risk
Risk can be categorized into,
- Pure Risk
- Speculative Risk
Pure risk: Pure risk is a physical loss that the insured faces due to occurrence of a danger that has been insured against. Such a physical loss may be caused because of a halt in factory production, damage to a property arising from tire, accident and the like. Pure risks or risks of trade are such that they can seldom be avoided but can be insured against. Pure (static) risk is a situation in which there are only the possibilities of loss or no loss, as oppose to loss or profit with speculative risk. In other words these are the risks which may cause loss only and profits can never be expected out of such risks. The only outcome of pure risks are adverse (in a loss) or neutral (with no loss), never beneficial. Examples of pure risks include premature death, occupational disability, catastrophic medical expenses, and damage to property due to fire, lightning, or flood. Under such risks loss of property or person is probable and even in certain cases it may create liability on the property or person also. Pure risks can be further classified as:
- Property risk: This is the uncertainty associated with loss of wealth resulting from damage or destruction of property. For example, destruction of house property, factory, godown etc. destroyed by fire.
- Liability risk: This is the uncertainty related to financial instability that can arise from bodily injury including health) or loss of wealth that an individual or an organization causes to others. It is the risks which create financial liability on any person on the Occurrence of an uncertain event.
- Personnel risk: These consist of the possibility of loss of income or assets as a result of the loss of ability to earn income. This type of risk is associated with the loss to a firm as a result of death, incapacity, loss of health, prospect of harm to or unexpected departure of key staff. It is related with persons. Risk associated with human life due to illness, disease, unemployment, death, old age injury etc.
Speculative risks: Speculative risks are such that is faced by business or trade. This risk describes a situation in which there is a possibility of loss, but also a possibility of gain. The risk may include loss because of stagnancy of goods, goods being unsold due to war being declared or even if the product goes out of fashion. Risks is said to be speculative when there is possibility of profit or loss. Generally introducing a new product in the market is speculative.
Pure risks are risks that can be insured whereas speculative risks cannot be insured. Insurance can be the answer to many a risk management process. There are known risks as well as unknown risks. If you know the risks involved with a certain business or a certain situation, you may take a step to insure yourself against the said risk factors. Unknown perils cannot be insured against and you have no option but to face the situation.
The other classifications are,
Financial Risk: Financial risk arises from an individual’s or organization’s ownership or use of financial instruments. Financial risk is the chance amount involved when making investments. To ensure a great return on investments, risks should be limited and maintained at a low level. Investors who are planning to invest on stocks should explore the latest and past performance of the option before making an investment. Corporations that plan to purchase properties will also examine the business risk in terms of equity buildup. To ensure the stability of the business, adequate cash flow is also important because the property might not appreciate quickly. There are a number of economic factors that can give rise to financial risks including changes in interest rates, extensions of credit, issuance of stock, 1oreign currency transactions and the use of derivatives. Therefore, the extension of credit to customers by businesses such as credit card companies gives rise to the risk, financial risk, that some will default. Investment activities of individuals and the borrowing they undertake when making purchases of capital items such as cars, houses etc. also give rise to financial risk.
Non-financial (operational) risk: Non-financial risk, including operational risk, arises from the existence and activities of an individual or from the operations of an organization. For organizations, operational risk may arise directly or indirectly through inadequate internal processes, accounting, human error, systems or business continuity failures, fraud or inadequate legal and other documentation. An operational risk is a risk arising from execution of a company’s business functions. It is a very broad concept which focuses on the risks arising from the people, systems and processes through which a company operates. It also includes other categories such as fraud risks, legal risks, physical or environmental risks.
Static and dynamic risk: Static risk can be described as risk arising from damage or destruction of property and/or property that is illegally transferred as the result of misconduct of individuals. t involves those losses that would occur even if there were no changes in the economy. The risk is insurable. Dynamic risks are those resulting from changes in the economy. Dynamic risk results from exposure to loss from changes in the environment, such as changes in price levels, output, fashions, people’s tastes, and regulatory requirements. Dynamic risks are not insurable.