Chapter 1

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Introduction to Risk Management

Learning Objectives
1:1 Meaning of Risk.
1:2 Perils & Hazards.
1:3 Basic Categories of Risk.
1:4 Types of Pure Risk.
1:5 Evolutionary Process of Risk

1:1 Meaning of Risk

“There is nothing certain in the world except death and tax: yet death and tax are uncertain as no
body knows when he will die or when the tax will change” – Benjamin Franklin
We live in a risky world. Forces that threaten our Financial well being constantly surround us and are
largely outside our direct control. Some people experience the pre-mature death of their near and dear
ones, loss and destruction of their property from both manmade and natural disasters.
Majority of Insurance authors have defined Risk in terms of uncertainty. Based on this theory, risk is
defined as “Uncertainty concerning the occurrence of a loss”. Risk therefore arises out of uncertainty.
It is measured in terms of the likelihood of it happening and, the consequences that will arise if it does
happen. Chance of loss is the likelihood of the occurrence of an event causing a loss. It is the relative
frequency of occurrence of an event resulting in loss. It is calculated as the ratio of the number of expected
losses to a total number of actual losses that actually occur.
Chances of loss = Number of likely losses / Total number of possible losses
For example: There are 1000 houses in a community. Out of past experience and records, there is a
possibility that 10 of these houses will be damaged by fire during a given period of time. Then, the chance
of loss due to fire is 1% (10/1000).
All of us encounter risks in everything we do – driving a car to work or even shopping in the supermarket.
Most of us try to reduce the likelihood of risk that can affect our daily activities.
A few examples will illustrate the extent of the uncertainties to which all sections of society are exposed.
Individuals and families are exposed to the chances of loss due to disease, accidental injuries, death,
unemployment, loss of possessions due to perils which may befall liability for injury caused to others, and
many other events which may diminish their welfare. On the brighter side there can be unexpected gains
too, such as a large win on a game-show, or a chance encounter that may lead to a better job.
From the above discussion, we can conclude that Risk has the following characteristics:-

Risk is unpredictable.

Risk is uncertainty about the future.

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Risk is the possibility of an adverse deviation from expected outcomes.

Risk is an outcome that is not favorable.

All the above characteristics of risk highlight one element, namely, the presence of uncertainty with regard
to the outcome. Uncertainty is subjective as it depends on the individual’s perception of risks. It is obvious
that no two persons exposed to the same risk will perceive it in the same manner. The level of uncertainty
will also depend on the information available on the risk.
Is there a difference between Risk and Uncertainty?
We often find the terms “risk” and “uncertainty” used interchangeably. However, a distinction needs to be
drawn between the two. Risk is often thought of in terms of chance (or probability) of loss. Uncertainty falls
into two broad categories. There are those for which the probability of occurrence is calculable either on a
priori grounds or through the statistical analysis of a series of similar events that have occurred in the past.
The remainder do not lend themselves to such measurement, either because their occurrence follows no
discernable pattern, or, because they are unique events. The importance of uncertainty arises from its
influence on the process of decision making of individuals, businesses as also society.
While risk is a state of nature, uncertainty is a state of human mind. It is therefore possible to consider a
situation risky if a number of outcomes is possible and the actual outcome that materializes is not known
in advance. Thus, risk is defined as the relative variation of the actual outcome from the anticipated or
expected outcome.

Definition
Risk is the possibility of harm, injury, loss, danger, or destruction.

1:2 Perils & Hazards

The term Peril and Hazard are often used interchangeably in connection with Risk. It is important to
distinguish them for the sake of clarity. A Peril is one cause of a loss. We refer to the peril of Fire, Burglary
etc. A Hazard, on the other hand is a condition that may create or increase the chance of loss – arising out
of the given peril.
Sometimes it is possible that one particular item can be identified as both a peril and a hazard. For eg.
Burglary is a peril involving an economic loss, but it is also a hazard that increases the chance of loss from
the peril of accident / premature death.
Three major types of hazards are usually distinguished as-:

1:2:1 Physical Hazard

Physical hazards are the conditions in which the physical characteristics of an object or an individual tend
to increase the frequency of loss.
For example, bad weather conditions increase the chances of airplane accidents, defective materials used
in construction of buildings result in collapse of buildings and unsafe conditions in the workplace increase
the chance of accidents to the workers.

1:2:2 Moral Hazard

It is a situation wherein the frequency and severity of loss increases due to an individual’s dishonesty. A

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moral hazard also occurs due to a defective attitude of employees and individuals. Moral hazards can be
controlled or reduced by taking appropriate steps and precautions. Dishonest individuals contribute to the
increase in moral hazards.
Examples of moral hazards are, the providing of false information in order to collect claims, intentionally
inflating the amount of the claim, faking an accident etc.

1:2:3 Morale Hazard

While moral hazards occur due to defects in an individual’s character, morale hazards are due to an
individual’s indifference or negligence. An individual’s indifference to the risk because of the existence of an
insurance cover constitutes a morale hazard.
Examples of morale hazards are rash driving, leaving the car unlocked and not checking whether the house
doors are locked properly before leaving on a holiday thus inviting burglary etc.

1:3 Basic Categories of Risk

There are different classifications of risk:

1:3:1 Financial and Non-financial Risk

In its broadest context, the term risk includes all situations in which there is an exposure to adversity. In some
cases, the adversity involves financial loss, while in others it does not. There is some element of risk in every
aspect of human endeavour, and many of these risks have no (or only incidental) financial consequences.
Here, in this book, we will concentrate only on those risks, which may give rise to a financial loss.

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1:3:2 Subjective and Objective Risks

Subjective risk arises out of an individual’s mental state. It is the result of an individual’s uncertainty about
the outcome of an event. Subjective risks occur due to psychological fear about the outcome of an event
whether it will be favorable or not to an individual.
Objective risks as the term suggests, can be observed and, for that reason, capable of measurement
unlike subjective risks which are not. Here, the probability of an event occurring can be determined in two
ways: either by deductive reasoning (as in the case of a balanced coin being tossed) or, by inductive
reasoning (as in the case of an actuary determining the probability of death of a person at a certain age).
1:3:3 Fundamental and Particular risks
Fundamental risks are group risks, which occur due to social, economic and political changes in the
country. Large numbers of people are affected by these fundamental risks. Fundamental risks also arise
due to natural calamities.
Examples: Crisis in the economy, widespread unemployment, sudden wars, poverty, dramatic changes in
government policies, inflation, floods, earthquakes, famine, volcanic eruptions and other natural calamities
are also described as fundamental risks.
Particular risks, on the contrary, are personal in nature. These arise from individual causes and the
consequences and affect only the individuals.
Examples: Injury due to accidents, poor health condition, robbery, damage due to fire etc.
Generally governments formulate certain programmes to deal with fundamental risks whereas an affected
individual’s deals with particular risks by using suitable risk management techniques.

1:3:4 Static and Dynamic risk

Static risks can be pure or speculative. Natural events such as storms, snowfalls and death are described
as pure static risks. Industries in a stable economy are a good example of static speculative risks.
Dynamic risks can also be pure or speculative risks. Dynamic risks will affect the whole economy. These
risks are beyond the control of an individual. Dynamic risks arise out of socio- economic changes such as
globalization of the economy, the impact of IT, the information explosion and other major changes affecting
society. Society often benefits due to dynamic risks, though only in the long term.

1:3:5 Pure and Speculative Risks

Pure risk is used to designate those situations that involve only the chance of loss or no loss. Pure risks
do not have favorable outcomes; at best, we are left in the same situation in which we were before the event
causing loss occurred. Fires in a godown or a factory, an injury at the work place or on the road or a theft
or burglary in the home are all instances of pure risks.
Speculative risk describes situations in which there are three possible outcomes namely-:

a possibility of loss,

a possibility of gain or

a ‘break-even’ of a no profit–no loss situation.

Gambling is an example of a speculative risk in which all the three outcomes are possible. The difference

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between pure and speculative risks is highlighted to make the point that, while pure risks are generally
insurable speculative risks are not, as the law of large numbers is applicable to pure risks and not to
speculative risks.

1:4 Types of Pure Risks

Pure risks that can cause financial insecurity can be categorized as below:

Let us look at these in greater detail.

1:4:1 Personal Risks

Personal risks are those risks that directly affect an individual. They cause financial insecurity because
they usually result in a reduction or stoppage of income, an increase in expenses and a depletion of
financial resources.
Some of the major personal risks are:
1:4:1:1 Risk of premature death
1:4:1:2 Risk of poor health
1:4:1:3 Risk of temporary or permanent disability
1:4:1:4 Risk of insufficient income during retirement

1:4:1:1 Risk of Premature Death:

If a person who has obligations like dependents to support, loans to pay off or children to educate dies,
then the surviving family members face financial insecurity. They need sufficient replacement income to
take care of their obligations.

1:4:1:2 Risk of Poor Health:

The risk of poor health may result in depletion of financial resources due to increased medical expenses as
well as loss of income. Unless a person has adequate financial resources, the risk of poor health can
cause financial insecurity.

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1:4:1:3 Risk of Temporary or Permanent Disability:

As with the risk of poor health, the risk of temporary or permanent disability may also cause financial insecurity
due to depletion of financial resources as a result of increased medical expenses and loss of income.

1:4:1:4 Risk of Insufficient Income during Retirement

Most people experience a significant reduction in their income when they retire. Unless they have saved for
their retirement in a planned manner, they are likely to experience financial insecurity.

1:4:2 Property Risks

Persons owning property face the risk of having that property damaged, destroyed or lost due to different
causes. They cause financial insecurity because they affect the income streams being produced from the
usage of the property. They also increase expenses because the damaged/destroyed/lost assets need to
be repaired / replaced. Property risks can cause loss in two major ways:
1:4:2:1 Direct Loss
1:4:2:2 Loss of Income from properties used for business purposes.
1:4:2:3 Indirect or Consequential Loss

1:4:2:1 Direct Loss

A direct loss results from physical damage, destruction or theft of property. For example if your house is
damaged due to earthquake, the amount of loss is known as direct loss.

1:4:2:2 Loss of Income

This loss arises as a result of a disability, injury, or business disruption. For example if a shop is destroyed
by a fire, apart from the physical damage: the shop-owner will face a loss in income till he can start his
business again.

1:4:2:3 Indirect or Consequential Loss

An indirect loss results from the consequences of a direct loss. For example, if your house is destroyed in
an earthquake, you may have to live in a rented house till your house is repaired. The rent that you pay is
the indirect loss.

1:4:3 Liability Risks

Liability risks arise from the possibility of being held legally liable for the loss to another person. If a person
commits a mistake or, because of negligence, causes bodily harm or injury to another person, a court of
law can order that individual to pay damages to the injured party.
Liability risks can be categorized into:
1:4:3:1 Statutory Liability
1:4:3:2 Common Law
1:4:3:3 Contract

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1:4:3:1 Statutory Liability

These represent any liability arising out of specific statute. For example Third Party Liability in Motor
Vehicle’s Act, & Industrial Dispute Act

1:4:3:2 Common Law

These represent any liability arising out of common law. For example Libel or Slander

1:4:3:3 Contract

These represent any liability arising out of mutual agreement between two or more parties. For example:
liabilities arising out of contractual obligations.
All these liabilities may arise in a Personal or a Professional capacity.

1:4:3:1:1 Personal Liability

Personal liability arises when a person acts negligently or carelessly during the course of his personal life
and causes harm to another. For example, if you hit a pedestrian with your car while jumping traffic lights,
you may be asked to bear expenses for the treatment and also pay damages to the victim.

1:4:3:1:2 Professional Liability

Professional liability arises when a person harms another while performing as a professional. For example,
a doctor who causes harm due to a wrong diagnosis can be held professionally liable to pay damages to
the patient.
Liability risks cause financial insecurity because they result in depletion of existing financial resources.

1:4:3:1:3 Risks arising out of Failure of Others

When a third person agrees to perform a service for another individual, the third person undertakes an
obligation that one presumes will be met. When the failure of the third person to meet the obligation results
in a financial loss, risk exists.
Ex: Failure of a contractor to complete a construction project as scheduled, or failure of debtors to make
payments as expected. With the development of the Internet and the rapid evolution of e-commerce, a
variety of new risks relating to the failure of others have emerged.
Liability risks cause financial insecurity because they result in depletion of existing financial resources.

1:5 An evolutionary process of Pure Risk

From the beginning of civilization, human have faced possibility of loss. The ancestors faced enormous
amount of risk from their own habitat. The earliest perils giving rise to risk were the nature and the predators
(both beasts as well as human predators). The human slowly adapted to the system, and created the
machinery called society. The society created shelter and collectively blocked the ancient risks but in
effect brought in new and more complex set of risks. Thus as new ways of risk control are discovered, new
risks appear, often as a result of progress.
The era of industrialization saw steam energy replacing muscle power. Large machines were developed to

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boost the production process. However, the early machines were highly hazardous and explosions were
common destroying human life. Like steam (mechanical energy), the introduction of electrical energy and
more sophisticated nuclear energy brought with it new sources of risk.
Society created the legal system to safeguard human rights and promote human responsibility. The obvious
idea was to create a structure where an aggrieved could seek a compensation from his tormentor. But as
we are creating a safety net for the society, we have devised a mechanism where newer causes of action
emerge. These include professional liability risk, environmental damage risk, discrimination in employment
risk or corporate social responsibility risks.
The Information Technology (IT) revolution has brought its own share of risk inventory. Terms which were
unheard of to our older generation are floating around. A hacker can sweep an entire bank / or steal secret
information worth hundreds of crores of rupees, without firing a single gunshot. These information pirates are
more dangerous than our physical dacoits: as their cryptic method of operations cannot be understood with
traditional policing methods. These thieves not only steal assets but sometimes the whole identity of an
individual and then leverage the information to gain access to his accounts at bank, credit – cards or brokerages.
The net effect of the above discussion is the multiplication of risks faced by today’s society. The ancient
perils from natural disaster (Tsunami) co-habits with the nuclear age peril like erstwhile, Soviet Union’s
Chernobyl plant accident. It is of no help to know that society is also regularly attacked by terrorist activity.
What we have discussed so far are only collective risks. However, there are other risks, which affect an
individual or firm at a micro level. For a person or firm, who suffers from such peril: the consequences are
no less destructive.

Key Concepts

Risk
Uncertainty

Peril Hazard
Moral Hazard

Morale Hazard
Static Risk

Dynamic Risk
Fundamental Risk

Particular Risk
Pure Risk

Speculative Risk
Personal Risk

Property Risk
Liability Risk

Review Questions

1. Define Risk. In your definition, state the difference between Risk and Uncertainty?
2. Distinguish between peril and hazard with example?
3. What are the 3 categories of hazard? Explain your answer with suitable illustrations.
4. Risk may be classified in several ways. List the 3 principal ways in which risk may be
categorized, and explain the distinguishing character of each class?
5. List the 4 types of pure risk facing an individual or an organization with example?

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6. Two 10 year old boys Ram and Shyam are watching the India vs. West Indies, 1983 cricket world
cup finals. None of them know about the actual scores and they bet on the outcome. Ram bets for
India, while Shyam bets for West Indies. Discuss the risk in this situation for Ram or Shyam?
7. Record the risks faced by you as an individual. How did you treat these risks?
8. You have been given 2 options to invest.
Outcome of option I — 50% chance of loosing Rs. 100/-
Outcome of option II — 5% chance of loosing Rs. 1000/-
If you are given the option to choose only 1 investment, which of these options would you choose
and why?

Chapter Review

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