RISK MANAGEMENT

2. AN INTRODUCTION TO RISK
AND UNCERTAINTY

JOUHARA G. SAN JUAN DR. V.V. SALENTES

DBA Student Professor Lecturer

1
Foundation Concept:
Certainty, Risk and Uncertainty
Concept Certainty Risk (Known risk) Uncertainty (Unknown Risk)
Definition -certainty is lack -defined as uncertainty -Uncertainty is a state of
of doubt. concerning loss. doubt about our ability to
-a state of being -risk gives rise to uncertainty. predict the future outcome
free from -intentional interaction with of current actions
doubt. uncertainty. -is a potential unpredictable
-action taken in spite of and uncontrollable outcome
uncertainty

Description -All possible -you can predict the possibility
information is of a future outcome
known; -can be managed
outcome are -can be
certain measured and quantified
-Potential outcomes and
probability are quantifiable /
measurable using statistics and
modelling (e.g. the lottery ,
game of chance.)
-you cannot predict the
possibility of a future
outcome.
-is uncontrollable.
-unquantifiable
- the outcome of the event is
unknown and it cannot be
measured or guessed for you
don’t have any background
information on the event.
(e.g. earthquake , shocks
health , romance.)
2
 Certainty, Risk and Uncertainty
Concept Certainty Risk (known risk) Uncertainty (unknown Risk
Example -Celebration of -E.g. buying/ -E.g., a house-owner is
Christmas on owning a house uncertain/not concern or has
December 25th expose to the totally no idea whether his house
of this year . risk of the will catch fire, this reflects his lack
house damage of knowledge about the possibility
due to fire. of his house catching fire in the
-E.g. hoping that future.
your car would
not be stolen,
however the
outcome is
undesirable, so
risk exists.

Approach -Ability to understand -Ability to recognise when

Required predictions means; something cannot be known
1. Logic 1. Intuition
2. Statistical Analysis 2. Heuristics (practical method)
3
 Classification of Risk
• Risks can be categorized into TWO types of
classifications:

1. Pure Risk versus Speculative Risk

2. Diversifiable Risk versus Non-diversifiable Risk.

4
 Pure Risk VS Speculative Risk
Pure Risk
Pure risk exists when there is uncertainty
as to whether loss will occur.
A category of risk in which loss is the only
possible outcome; there is no beneficial
result.
 No possibility of gain is presented by pure risk 
– only the potential for loss.
 Examples :
o Home insurance can be used to protect
homeowners from the risk that their
homes will be destroyed.
oThe uncertainty of damage to property by
fire or flood
oThe prospect of premature death caused by
accident or illness
Speculative Risk
Speculative risk exists when there is
uncertainty about an event that could
produce either a profit or a loss.
A category of risk that, when undertaken,
results in an uncertain degree of gain or
loss.
Gains as well as losses may occur, changing
the nature of the uncertainty that is present.
 Examples:
o Business ventures
o Investment decisions
5
 Diversifiable VS Non Diversifiable
Diversifiable Risk Non-diversifiable Risk
-Risk that is, in the limit, eliminated by combining -The risk inherent to the entire market or entire
a large number of assets in a portfolio. market segment.

-Risk that can be eliminated -Also known as "systematic risk" or "market

through diversification. risk."

-Also called Unsystematic Risk or controllable

risk.

-It results from the occurrence of random events -Interest rates, recession and wars all represent
such as labor strikes, lawsuits, or loss of key sources of systematic risk because they will
accounts. affect the entire market and cannot be avoided
-Business, liquidity, and default risks fall into this
through diversification.
category. -Whereas this type of risk affects a broad range of
-It is assumed that any investor can create a securities, unsystematic risk affects a very
portfolio in which this type of risk is completelyspecific group of securities or an individual
eliminated through diversification. security.
-Systematic risk can be mitigated only by being
-For example, a sudden strike by the employees of
hedged.
a company you have shares in, is considered to be
an unsystematic risk.-

6
 Levels of Uncertainty
Level of Uncertainty Characteristics Examples
None (certainty) Outcomes can be Physical laws, natural
predicted with precision sciences

Level 1 (objective Outcomes are identified Games of chance : cards,

uncertainty and probabilities are dice, risk of loss of life
known

Level 2 (subjective Outcomes are identified Fire, motor vehicle

uncertainty) but probabilities are accident, many
unknown investments

Level 3 Outcomes are not fully Space exploration,

identified and genetic research
probabilities are unknown

7
 How can we reduce Uncertainty?
• The reduction of uncertainty has economic value, and
information and communication can reduce
uncertainty.

• The level of uncertainty depends on :

– the amount and

– the type of information available

• to identify possible outcomes and estimates their likelihood.

• Communication can reduce levels of uncertainty in an

organization’s stakeholders.
• Communication between the organization and these
stakeholder groups is an important part of the manager’s
responsibility.
8
• By communicating the organization’s policies for
managing risk, the organization may reduce levels of
uncertainty in these stakeholders, which increases
their willingness to deal with the organization on
favourable terms.
• In the absence of this information, these
stakeholders may be uncertain about the nature of the
organization’s actions with respect to matters affecting
their interest.
• Their uncertainty leads them to charge a higher
price for their goods and services or place
restrictions on their activities that can be detrimental
to other stakeholder groups, especially stockholders
• In other words, the organization can provide
stakeholders with the assurance that it has not and
will not take actions that are detrimental to their
interests. 9
 Example of Reducing Uncertainty
• -Insurance will be identified as an
arrangement for reducing
uncertainty.
• -Insurance companies encounter
aspects of risk or uncertainty that are
largely unique to the insurance
arrangement.

10
 (2) Two Specific Concept Important to Risk
Management
Adverse Selection
-is the result of insurance
having the greatest appeal
to the individuals who are
likely to have a loss.
E.g. the demand for health
insurance is likely to be
high for an individual who
feels in poor health
Hazard
-Condition that increases the
likelihood of loss or loss amount
a. Physical hazard -refers to a
physical condition or characteristic
such as flammable liquids stored
near open flame
b. Moral hazard describes an effect
on an individual’s behaviour
E.g. Arson would be an extreme
example of a moral hazard, here,
the individual deliberately sets fire
to collect insurance proceeds
11
 Impact of Managing Risk and Uncertainty:
-Risk and uncertainty result in a cost referred to as
the cost of risk.

Cost of Risk

Cost of Uncertainty Cost of Losses

-no losses occurs , the
presence of uncertainty
may impose a cost.
Example :
b. Organizational Level -Property
Destroyed
-the cost of
a. Basic Level: uncertainty may -Human is
appear in the form of injured.
-Uncertainty can worry or anxiety or the
misallocation of
Lead to worry. resources.

12
Why Study Risk Management ?
• Risk and Uncertainty give rise to benefits.
Speculative risks can result in positive
outcomes in which the organization is
rewarded for facing the risk.
• Undoubtedly, organizations have motives
to address risk and uncertainty and this
motivation gives rise to risk management
• At most basic level, risk management is
practiced because the negative and positive
possibilities of risk – as well as moral
considerations – provide incentives for an
organization to take steps to minimize the
costs of risk while striving to maximize
benefits

***Thank You And God Bless***

13