BBM 207:

Introduction to Risk Management and Insurance Notes

TOPIC ONE: INTRODUCTION TO RISK MANAGEMENT AND INSURANCE

We start our lesson by defining and explaining three basic concepts critical to understanding
both insurance and risk management.
1. THE CONCEPT OF RISK
What does risk mean to you? Risk is a word that has more than one meaning. It is a term that can mean
different things depending on the circumstances and the context in which it is used. Here are some of
the meanings it can assume.

(i) Uncertainty
The primary meaning of risk as applied in risk management and insurance is that of the uncertainty of
an outcome in a given situation. The key word here is “uncertainty” It is the doubt whether a given
event will take place or not. The greater the doubt or uncertainty, the greater is the risk. When are you
uncertain? When are you in doubt? And so when are you at risk? In this context, you can only be at risk
if you face an event which may or may not occur, if there are at least two or more possible outcomes
from the event, and you cannot determine in advance which one of the two or more possible outcomes
you will actually experience.
There is no risk, no uncertainty or doubt in a situation where there is only one possible outcome. Or
where we can tell in advance which outcome shall be experienced because in such cases there will be
no uncertainty or doubt about the expected outcome. Uncertainty or risk is only relevant if one of the
expected possible outcomes is a loss. A risk is not significant if it cannot cause us a loss of any kind.
Risk therefore has two main things to it, uncertainty of occurrence of an event and a possible loss of
some kind from the event. Risk management and insurance is therefore more concerned with those
risks capable of causing losses.

So what is a loss? A loss is the unintentional or involuntary parting with something of value. A loss
may be either financial or non-financial and could involve both tangible and intangible assets.

Some situations of uncertainty that could give rise to risk and loss include:
(a) The negligence of participants in a certain activity or the negligence of others.
(b) Events that may be foreseeable or not foreseeable for now.
(c) Hazards or conditions arising out of ownership or operating in premises.
(d) Performing certain activities or participating in certain activities.
(e) Failure to perform certain activities such as proper maintenance, inspection, supervision,
(f) Failure to provide warnings on existing dangerous conditions.
(g) Poor administrative structures.
(h) Environmental factors such as political instability, socio-cultural practices, natural calamities, etc.

Can you now list some specific loss causing events which could occur in the situations (a) to (h) above?

(ii) Chance of loss or the probability of occurrence of a loss.

We have already in the previous section defined risk as uncertainty of occurrence of an event. But the
term risk can also mean something else. It can also be defined as the chance or probability of occurrence
of a loss. This is the long run relative frequency of a loss. The probability or chance of occurrence of a
loss varies between 0 and 1. The 0 position says there is no chance of a loss occurring. At the other end
1, the chance of loss is 100 percent because the loss is certain to occur.
The chance or probability of loss may be conveniently expressed as a fraction, and it indicates the
probable number of losses out of a given number of exposures and expresses it as a percentage.
Expressed as a fraction, the numerator represents the probable number of losses, and the denominator
represents the number of times that the event could possibly occur.

In this context, situations with a high probability of loss are said to be riskier than those with a low
probability of loss. The risk is greater if the probability of loss is higher. Normally when we say that
something is very risky, we are in essence saying that the probability that it will cause a loss is very
high. Qualitatively, risk is proportional to both the expected losses which may be caused by an event
and to the probability of this event. Greater loss and greater event likelihood result in a greater overall
risk.

Take note that if risk means uncertainty according to our first definition then risk does not exist where
the chance of loss is either 0 or 1. This is because there is no doubt or uncertainty about the expected
outcome in the two positions. The outcomes in the two positions are already definite and certain.

(iii) The subject matter insured in a contract of insurance.

The term risk can also refer to the object covered or insured in a contract of insurance. It could be a
house, a car, a life, etc. for every contract of insurance there must be something being insured against
loss. This becomes the subject matter of the contract and can be referred to by the insurers as the risk.

(iv) A peril
Risk can also mean a peril. This is the immediate cause of a loss such as a fire or earthquake. Each loss
that occurs must have a cause. These causes such as accident, illness, theft, fire. Etc. is known as peril
or risk. So when we talk of the risk of fire, or theft, etc. In insurance policies it is common to find a
section dealing with “insured risks” or “insured perils” and then listing the risks or perils. These would
simply be some possible causes of loss which the insurer is accepting to cover. Note that the insurer is
only liable to
compensate for a loss if the loss is caused by a peril or risk covered in the policy.

(v) The dispersion of actual from expected results.

This is the statistical definition of risk as measured by the standard deviation, which is the most widely
accepted measure of risk. It is a figure that more or less measures the degree or the level of in a given
situation. It is a measure of risk that is objective.

In conclusion we have seen that the term risk can mean five different things depending on the
circumstances and the context in which it is applied. You should now be able to explain the five different
meanings.

CLASSIFICATIONS OF RISK
We started our discussions in this lecture by giving meanings to the term risk. We saw that the word
risk can mean five different things. Let us now look at the different classes of risk. We have thousands
if not millions of risks that could cause losses. All these risks can broadly be classified into two main
categories. These are pure risks and speculative risks.

Pure risks
A pure risk exists when there is uncertainty as to whether a given event will cause a loss or not. The
occurrence of the risk may cause a loss only. There is no possibility that the event may cause a gain or
profit. There are only two possible outcomes in a pure risk situation. The risk can cause either a loss or
no loss. There are only two possibilities that could result from the risk and that it is that either causes a
loss or things stay as they were. Can you think of any risk of this nature can only either cause a loss or
no loss?

Fire in a given building is a pure risk. Within any given period of time either fire incident occurs in the
building or it does not occur. There is no third possibility. Death is a pure risk, by the end of the year,
there can only be two possible outcomes. Either death has occurred or the person is still alive. There
are many others such as accidents, earthquakes, theft, etc.

Can you list some other pure risks?

The other main characteristic of a pure risk is that in fact differentiates it from other risks is that it has
no element of a profit. There is no chance that the risk could cause a profit as one of its possible
outcomes. Pure risks occur naturally and are not created by those exposed to them. They can generally
be handled through the practice of insurance.

Speculative risks:
Speculative risks involve events which may produce either a gain or a loss. The main characteristic of
a speculative risk is that there is an element of profit. There is a chance that the risk could result in a
profit as an outcome. Speculative risks are generally associated with business investments where people
invest in the hope of making profits. Who is a speculator? This is one who buys today in the hope of
selling tomorrow at a profit. Speculative risks may also be associated with betting or gambling where
there is a chance of ending up with profits. Speculative risks are not naturally occurring. They are self-
created and voluntarily taken by those who want to make profits.
We had earlier said that all risks can be classified into two categories. Any risk will be either a pure risk
or a speculative risk. However these two primary classifications, risks can be further be sub-classified
into other sub classes. It is possible for a risk to be a pure risk or a speculative risk and at the same time
also fall into other sub classes such as;

(a) Fundamental risks

These are risks that arise from causes outside the control of any one individual or even a group of
individuals. The effect of fundamental risks is felt by large numbers of people. They are impersonal in
origin and widespread in effect. Examples include earthquakes, floods, volcanic eruptions, and other
natural disasters. They are not however limited to naturally occurring perils. Social change, political
intervention, and war are all capable of being interpreted as fundamental risks.

(b) Particular risks

They can also be referred to as personal risks. These are personal in both cause and effect. All of them
arise from individual causes and affect individuals in their consequences. They are risks faced by
individuals and their families. They are in areas such as loss of earnings, death, disability, liability suits,
medical expenses, loss of physical assets, etc.

(c) Objective risks

This is the measure of the degree of variation in the proportion of actual from expected events. The
probable variation of actual from expected experience. It is observable and measurable. This proportion
declines as the number of observed events increases. It follows from the law of large numbers.

(d) Subjective risks

Subjective risk refers to the mental state of an individual who experiences doubt or worry as to the
outcome of a given event. It is the psychological uncertainty that arises from an individuals or state of
mind. It is the uncertainty of an event as seen or perceived by an individual. This perception depends
on the individual’s attitudes towards risk. Objectively the risk may be small but the person sees it as a
big risk. Alternatively it may be true that the risk is a big one but the person sees it as a small risk. An
objective risk may be the same but different people may see it differently depending on whether they
are risk averse or not.

(e) Static risks

This refers to a risk that does not change much overtime. It stems from an unchanging society that is at
equilibrium. Pure static risks include the uncertainties of due to such random events as lightning,
windstorms and death. Speculative static risks may be experienced in undertaking a business venture
in a stable economy.

(f) Dynamic risks.

These are risks arising out of changes in society. They are risks resulting from changes in the economy.
Urbanization, social crimes, changing attitudes, etc. are some of the factors that could cause dynamic
risks.

We have noted that there are two basic classes of risk. There are pure risks and speculative risks. We
have also seen that both classes of risk can also at the same time be classified into other classes. It is
possible for example for a risk to be a pure risk and at the same time be a particular or personal risk. it
is not therefore a must that a risk belongs to only one class.

(g) Political risks

This refers to decisions of the government that may impact negatively on the business as well as the
stability of the political systems in place in a particular country. Examples include; cancellation or non-
renewal of licenses, expropriation or confiscation of the business, imposition of duties and even
banning of products, imposition of exchange controls, political instability, etc.

(h)Operational risks.
These are risks resulting from inadequate or failed internal processes, from failed systems, from failures
of people, and external events. Examples include; technology failure, business premises becoming
unavailable, inadequate record keeping, poor management, and lack of supervision, accountability, and
control, as well as third party fraud, etc.

(i) Credit risks

This is the risk of loss due to a debtor’s nonpayment of a loan or line of credit. This involves either the
principal or interest or both.

THE IMPACT OF RISK

In the previous sections, we looked at the different meanings that the terms risk and hazards can assume.
We now need to examine the effect of risks and hazards on enterprises. Businesses always face the
uncertainty of losses that may never occur. Each day, risks and hazards threaten business enterprises
affecting them both positively and negatively in the some ways. Risks can also create opportunities for
a business enterprise. But now we examine the negative impacts of risks on a business enterprise. The
following are some of the negative consequences of risk on a business.

(1) Cost to business

(i) Causing losses. Risks cause actual losses. The actual losses may serious and crippling to a business
or cause great financial hardship. The losses caused by risk may direct losses resulting from the
occurrence of the risk or indirect losses such as loss of profits, loss of life, and disability.
(ii) Interrupting business operations
(iii) Reducing profits
(iv.) Limiting ability to compete and slowing growth.
(v) Uncertainty. Most businesses face threats of losses that may never occur. This causes uncertainties
in regard to the possibility of a loss.
(vi.) Fear and worry. Even if no loss ever occurs as anticipated, at least two factors add to the cost of
uncertainty. These are fear and worry. The time spent thinking about real or imagined chances of loss
is
expensive considering the many other things that could be done if there were no fear of loss. The cost
of loss of peace of mind is great indeed. Fear and worry may stop a business from engaging in certain
profitable activities and otherwise alter how it conducts its operations.
(vii) Less than optimal use of resources. Investments are frequently influenced by the risks to which
they are exposed. Some activities or investments are completely avoided because the exposure to loss
is very high. The amount of money “put away for a rainy day” is not readily available for investment
and cannot be invested in a much more productive capacity. Investments may be diverted to more liquid
or safer types of assets than are really necessary. This results in reduced earnings which is an additional
cost of risk.
(vii) short- term planning. Risk causes the tendency to concentrate planning in the near future, rather
than on the significant benefits of long range planning.

METHODS OF HANDLING RISKS

The following five basic methods or techniques can be used in the management of risks.
i) Avoidance
A person who is exposed to risk can handle the situation by avoiding any activity with which the risk
is associated. It involves not performing an activity that could carry the risk. This tends to eliminate the
chance that the person will suffer loss. It may also mean avoiding any property with which the risk is
associated. But it must be noted that some risks like death are unavoidable. It is also necessary to take
some risks in life to develop and prosper. A person who avoids all risks in life will never achieve
anything. Avoiding risks also means losing out on the potential gain that accepting (retaining) the risk
may have allowed. Not entering a business to avoid the risk of loss also avoids the possibility of earning
profits.

ii) Prevention and risk reduction

This technique involves taking deliberate measures to prevent the risk from physically causing a loss.
It also includes measures intentionally to reduce the severity of the loss or the extent of loss. Examples
include putting money in a safe to prevent thieves from accessing it. Having in place a sprinkler
designed to put out a fire to reduce the risk of loss by fire.

iii) Risk retention/assumption/acceptance

This method involves accepting the loss when it occurs. It can also be referred to as acceptance of risk
or assumption of risk. Risk retention can be in the form of simple assumption which means the risk is
ignored and the person goes about his/her business as if the risk does not exist. You probably simply
assumed death today and went about your duties as if the risk does not exist. It can also be in the form
of self- insurance. In this case there is a financial plan to deal with the loss if it occurs. Risk retention
is a viable strategy for small risks where the cost of insuring against the risk would be greater over time
than the total losses sustained. All risks that are not avoided or transferred are retained by default. This
includes risks that are so large or catastrophic that they either cannot be insured against or the premiums
would be infeasible like war.

(iv)Risk transfer
Means causing another party to accept the risk, typically by contract or by hedging. Insurance is one
type of risk transfer that uses contracts. Other times it may involve contract language that transfers a
risk to another party without the payment of an insurance premium. Liability among construction or
other contractors is very often transferred this way. On the other hand, taking offsetting positions in
derivatives is typically how firms use hedging to manage risk. Outsourcing is another example of Risk
transfer where companies outsource.

THE CONCEPT OF HAZARDS

Meaning of hazard.
The term hazard refers to any condition that has an impact on risk in the following two ways. First, it
is a condition that increases probability that a particular risk will physically cause a loss. It is a condition
that increases the frequency or incidence of loss or makes it more likely that a risk will physically cause
a loss. Secondly, a hazard is a condition that increases the extent of loss. It is therefore a condition that
ensures that any loss that the risk causes will be more severe or serious than normal. This means that it
increases the size of the loss resulting from the occurrence of risk. A hazard therefore increases both
the chance of loss and the severity of loss. A risk on its own may not cause a loss or the loss it causes
may be small but combined with a hazard there is a much greater chance that the loss will occur or that
the loss that occurs will be much more severe than normal under the circumstances. It is important
therefore to give as much attention to hazards as is given to risks.
Three different types of hazards can be identified. These are:

Physical hazards
A physical hazard is a condition stemming from the material or physical characteristic of an object that
increases its chances of suffering a loss through a particular risk or which makes the loss resulting from
the risk to be more severe than normal in the circumstances. Consider the risk or peril of collision of
motor vehicles. Some physical conditions that make a loss from a particular risk more likely.

Examples are; collisions involving motor vehicles more likely to occur if the physical condition of the
road is wet and slippery; if the physical condition of the motor vehicle is that it has faulty brakes or if
there is a fog, etc. The chances of suffering a heart attack or stroke are higher if the physical condition
of the person is that he has high blood pressure. A building could be made of wood concrete blocks. the
physical characteristics of wood makes it more likely that a fire breaking out will have more severe
consequences than that breaking out ii a concrete block building. The same would apply where a
building is roofed with either makuti or grass. So the physical qualities of an object will increase its
chances of suffering a loss through a particular loss or may make a loss that occurs to be more severe
than normal.

Moral Hazards
This refers to certain personality characteristics that increase both the incidence and the extent of loss.
This is a hazard that is only unique to human beings, who have a sense of judgment and is able to tell
what is right to do and what is wrong to do. It is a question of whether person has moral or immoral
tendencies. A moral hazard exists where a person has immoral tendencies. Such a person has certain
personality traits that lead to dishonesty and lack of moral integrity. This increases the chances that a
loss will occur because the person is motivated to dishonestly cause his own loss intentionally in order
to obtain financial benefit. The loss may also be more severe either because the person does not mitigate
it and so ends up with a bigger loss or because the person exaggerates the actual loss in order to obtain
a bigger compensation than the loss actually suffered.

Morale Hazards
This refers to certain mental characteristics that increase both the probability of occurrence of loss and
the severity of loss. It is essentially a mental state. A person who is motivated may have a very high
morale. Such a person becomes mentally very active and reaches a very aggressive mental state. This
could lead to recklessness in the way the person does certain things. There is a greater chance of loss
where a person is in an aggressive and reckless mental state. The person fails to exercise due care in
performing activities which lead to the occurrence of loss. In Kenya many accidents have occurred on
our roads simply because the driver was very reckless and aggressive in the way he or she was driving.
Many industrial accidents have occurred simply because an employee was reckless in the way he was
handling a particular machine, thereby causing injury to himself or to other fellow employees. A person
may not be motivated and in a state of low morale. Such a person is not in an active mental state. He is
in a mentally lazy state. He does not exercise keenness in doing certain things. Such a person becomes
careless in the way he is handling things. This will lead to more losses occurring. An overaggressive
mental state or a mentally lazy state therefore leads to more losses due to either recklessness or
carelessness.