The Concept Of Risk
Risk is pervasive in nature. It is everywhere human activities portend consequences that are not completely detectable. Only a person who risks is free.
Meaning Of Risk
Risk is present whenever human beings are unable to control or perfectly to foresee the future. The term risk is used where:
(i) although the precise future outcome is unknown, the possible alternatives can be listed (such as ‘heads or ‘tails’). And
(ii) the chances associated with those possible alternatives are also known such as a 50 percent chance of either ‘heads’ or ‘tails’).
The term uncertainty is used where future alternatives and chances are not known, such as in speculative ventures like the outcomes of business venture or of possible new invention.
Major Types Of Risks
Types of Risks: Risk may be categorized as follows:
1. According to their effects
2. According to their outcomes
1. Risks Categorized According To Their Effects
a. Fundamental Risk
Fundamental risk affects either society in general or groups of people, and cannot be controlled even partially by any one person.
Such risk is present in the forces of nature and the economy, since the outcomes of, say, the weather or inflation or mass unemployment are beyond individual influences, e.g. the world economic meltdown that signified by the crashing of stock prices and closing down of companies.
Fundamental risks are generally regarded as the responsibility of society and government, and the state now undertakes to deal with the consequences of events such as unemployment, earthquake or riots.
b. Particular Risk
Particular risk refers to those future outcomes that we can partially (though not predictably) control. It arise from individual decisions to drive a motor vehicle, for instance, to own property or even to cross the road. Since particular risks are the responsibility of individuals, each person must live with their consequences.
2. Categorization Of Risks By Their Outcomes
Another way of categorizing risks arises when we look at their outcomes:
a. Speculative Risk
Speculative risk is present if either beneficial or adverse outcomes could arise from a specific event. For example, the outcomes of a business venture may be either profit or loss. It comes under the heading of speculative risk.
b. Pure Risk
Pure risk is present if possible harm is the only consequence of the occurrence of a specific event.
Generally the distinction between speculative and pure risk depend on whether the unknown future holds out prospects of both good and bad or merely the possibility of damage or hurt.
Risks That Are Insurable
Not all risks can be insured. In order for a risk to be covered by insurance, it must meet certain conditions, which includes:
1. Measurable in monetary terms
2. Pure risks only
3. A large number of independent exposures/occurences
1. Measurable In Monetary
You cannot buy insurance to cover losses that are not measurable in terms of money. The objectives of insurance is to preserve the insured’s financial position, and this is obviously inaffected by losses that have no monetary values, such as loss of sentimental value or good character. It may be difficult to determine the monetary value of some items e.g. Rare works of art whose market value is unknown. Similarly, the ‘value’ of a person’s life can never really be measured. In such case the usual procedure is to agree to a nominal monetary value in advance.
2. Pure Risk Only
Insurers do not usually allow speculative risks to be insured. In general, only pure risks are insurable. Such risks must meet the other criteria i.e. measurable in monetary terms and a large number of independent exposures.
3. A Large Number Of Independent Exposures
The insurer must be able to collect together a sufficiently large group of separate and independent exposure units which are subject to broadly similar risks. This is so that the law of large number can operate effectively.
Methods Of Dealing With Risks
Insurance is not the only way of handling risk, and not necessarily the cheapest way either. The office manager must be able to weigh up the costs and benefits of insurance and compare them with other methods of transferring or reducing risk, and then decide what types of insurance cover needs to be bought and how much. The analysis of the various methods of handling risk and purchasing insurance are aspects of risk management.
The Roles Of Risk Management
Risk management is defined as the “planning, arranging and controlling of activities and resources in order to minimize the imact of uncertain events”. The process of risk management has three main elements, which are identification, measurement and control of risks.
1. Risk Identification: This is concerned with identifying the possible causes of loss. It has 3 stages: (i) an analysis of the major types of loss affecting the individual or firm (ii) a systematci search for all immediate cause of such loss (iii) a systematic assessment of the underlying causes and their consequences.
2. Risk Management: This is concerned with measuring the impact of possible loss on the enterprise by an assessment of the frequent of losses and their possible size in relation to the values at risk. It involves the examination of: (i) the number of possible losses each year (the frequent loss); (ii) the possible size of each of these losses; (iii) the value of the assets at risk (the maximum possible loss).
3. Risk Control: This is concerned with minimizing the adverse effects of loss. Controls may be either financial or physical, and firms generally use both methods: Insurance is th best-known method of financial control. Physical risk control may involve (a) avoidance or loss prevention, (b) risk reduction. While financial control may involve (a) risk retention, (b) or risk transfer.