Unit 1

Insurance and Risk:

Meaning of Risk and Uncertainty,

Risk can be understood as the potential of loss. It is not exactly same as uncertainty, which
implies the absence of certainty of the outcome in a particular situation. There are instances,
wherein uncertainty is inherent, with respect to the forthcoming events, i.e. there is no idea, of
what can happen next.

BASIS FOR
RISK UNCERTAINTY
COMPARISON

Meaning The probability of winning or Uncertainty implies a situation

losing something worthy is where the future events are not
known as risk. known.

Ascertainment It can be measured It cannot be measured.

Outcome Chances of outcomes are known. The outcome is unknown.

Control Controllable Uncontrollable

Minimization Yes No

Probabilities Assigned Not assigned

Loss, perils, hazards

A risk is simply the possibility of a loss, but a peril is a cause of loss. A hazard is a condition that
increases the possibility of loss. For instance, fire is a peril because it causes losses, while a
fireplace is a hazard because it increases the probability of loss from fire.

Risk is the chance of loss, and peril is the direct cause of the loss. If a house burns down, then
fire is the peril. A hazard is anything that either causes or increases the likelihood of a loss. For
instance, gas furnaces are a hazard for carbon monoxide poisoning.

Loss

Loss is the detriment resulting from a decline in or disappearance of values arising from a
contingency.

The major types of losses insured against through a life insurance contract are those produced by
expenses and interruption of income associated with death. For the typical family, loss of
incomes resulting from the death of its breadwinner is the more serious of the two; however, the
final expenses of any family member can be a problem in those families operating on a close
budget. For the wealthy family, death taxes and the cost of probating the estate could be the more
serious loss. Loss of income, although large, might be of only secondary importance, especially
in view of the high tax rates applicable to that income.

Accident and sickness also involve both expenses and income losses. Medical, surgical, and
hospital expenses can amount to large sums. A disability resulting from accident or sickness can
cause loss of income for lengthy periods, sometimes permanently. For the typical family, both
types of losses can be serious, and they require efficient before-the-loss arrangements fro and
effective after-the-loss balance between resources needed and resources available. What is an
efficient before-the-loss arrangement and what is an effective after-the-loss balance between
available and needed resources will vary from family to family because decisions in these
matters are personal and are governed by one’s own set of values. However, some procedures for
use in analyzing the problem and in reaching decisions on these matters have been developed
and they are discussed later in the text.

Peril

A peril may be defined as the cause of a loss. Examples of perils, which can cause loss of life
values, are economic aberrations, bodily injuries, physical and mental illnesses, premature death,
and superannuation. Causes of loss (bodily injuries, sickness, premature death, old age) often are
loosely called risks. Correctly, risk is the uncertainty about the happening of an event that can
create a loss, whereas peril is the cause of the loss.

Students of insurance need to understand the concept of a peril because insurance policies nearly
always limit the perils from which loss is covered. Life insurance usually is written to cover
death from any cause except a suicide that occurs within one or two years after the policy is
issued. Health insurance policies sometimes restrict coverage to losses caused by particular
named accidents or illnesses. More frequently, they cover losses caused by any accident or
illness except those specifically excluded. Annuities have no peril restrictions. As long as the
insured is alive, for whatever reason, his annuity income continues.

Hazard

Hazard is a condition that increases the chances of a loss arising from a peril. For example, an
accident may be the cause of a permanent and total disability. The cause of the accident may
have been faulty driving attributable to carelessness, poor eyesight, liquor; it may have been a
faulty vehicle, with bad brakes, poor lights, defective tires; or it may be bad driving conditions
such as icy roads, glaring sun, poorly marked highways. These conditions are hazards and must
not be confused with perils. Illness, for example, is a peril creating a loss of income and medical
expense, but it is also a hazard increasing the chance of loss by death.

For insurance purposes, two types of hazard may be distinguished: physical and moral.

Physical

A physical hazard is an objective characteristic increasing the chance of loss from a given peril.
For a simple example: coal mining and metal grinding are hazardous occupations because they
increase the chance of illness by exposing workers to inhalation of mineral dust. Race car driving
and window washing in a tall building are two examples of hazardous occupations that increase
the chance of death by accidents. Poor health is a physical hazard that increases the chance of
death by natural causes.

Moral

Moral hazard is a subjective characteristic of the insured, which increased the chance of loss by
reason of intention or lack of responsibility of the insured. It is found in the insured’s habits,
financial practices, or lack of integrity. In life and health insurance, moral hazards are present
in criminals, people who associate with criminals, those who skirt the edges of the law, people
with unsavory moral reputations generally, alcoholics, dope addicts, and philanders. A problem
relating to moral hazard in health insurance, not found in life insurance, is claim exaggeration
either through outright false statements or through malingering (that is, extending their hospital
stays beyond the time needed for recovery, or by staying away from their jobs longer than is
necessary).

Possession of insurance may itself create a moral hazard. For instance, possession of hospital
insurance increases the incidence of hospitalization arising out of indifference to loss. There is
no evidence that an individual becomes careless of life simply because he is insured.
A study of hazards is important to the understanding of insurance. Insurance companies must
review the hazards involved when an applicant for insurance is submitted. If the hazards are
unusually significant, the company must charge a higher premium, restrict the coverage, or deny
the insurance. Insurance buyers must review their policies to be aware of the hazardous
exposures not covered by their insurance so that they know what hazards to handle through some
other before the loss arrangement.
Types of Risks

Having dealt with the meaning of risk we shall now attempt to divert our attention to another
aspect of the nature of risk which we shall call as Classification of risk. It is required to know the
complex classification and sub-classification of risk and also an insight into risks that can be
insured and which cannot be.

Financial and Non-Financial Risks

Financial risks are the risks where the outcome of an event (i.e. event giving birth to a loss) can
be measured in monetary terms.

The losses can be assessed and a proper money value can be given to those losses. The common
examples are:

 Material damage to property arising out of an event. We may consider the damage to a
ship due to a cyclone or even sinking of a ship due to the cyclone. Damage to the motor
car due to a road accident which may be of partial or total nature. Damage to stock or
machinery etc.

 Theft of a property which may be a motorcycle, motor car, machinery, items of

household use or even cash.

 Loss of profit of a business due to fire damage the material property.

 Personal injuries due to the industrial, road or other accidents resulting in medical costs,
Court awards, etc.

 Death of a breadwinner in a family leading to corresponding financial hardship.

All such losses, i.e. the outcome of unforeseen untoward events can be measured in monetary
terms.

The losses can be replaced, reinstated or repaired or even a corresponding reasonable financial
support (in case of death) can be thought about.

We would call all such financial risks as insurable risks and these are indeed the main subjects of
insurance.

Non-Financial risks are the risks the outcome of which cannot be measured in monetary terms.

There may be a wrong choice or a wrong decision giving rise to possible discomfort or disliking
or embarrassment but not being capable of valuation in money terms.

Examples can be:

  Choice of a car, its brand, color, etc.

 Selection of a restaurant menu,

 Career selection, whether to be a doctor or engineer etc.

 Choice of bride/bridegroom,

 Choice of publicity etc.

Since the outcome cannot be valued in terms of money, we shall call these non-financial risks as
uninsurable.

Individual and Group Risks

An insurance risk class is a group of individuals or companies that have similar characteristics,
which are used to determine the risk associated with underwriting a new policy and the premium
that should be charged for coverage. Determining the insurance risk class is a primary
component of an insurance company’s.
 An insurance risk class is a way for insurers to underwrite policies based on one's
belonging to a particular risk group.
 People in each risk group will generally share similar characteristics that help insurers
better estimate the chances that the policyholder will file a claim.
 Riskier risk groups will pay higher premiums—for example, people who are sick, older,
or have a poor driving record.

Group risk benefits are a useful tool for managing and mitigating some of the risks associated
with employing people. They can also help recruit, retain and engage talent and can support the
values and culture of an organisation. Group risk benefits allow employers to reinforce their
position as a caring employer, throwing a financial lifeline to people when they need it most.

Group risk policies are commercial contracts which support employers in meeting their
contractual promises and legal obligations to their employees.

The employer is generally the policyholder, pays the premiums and claims are made by the
employer in respect of their employees. Generally any claim is paid to the employer (or often the
trustees of the pension scheme in the case of group life assurance).

Group risk policies are generally taken out through an adviser who is responsible for helping the
employer to decide on the design of the benefit structure, who will be covered by the policy, the
suitability of the policy and the selection of a provider.

Expert advice should always be taken when setting up or reviewing a group risk insurance
scheme to ensure that optimum cover is provided, any extra support services offered alongside
the policy are used and all tax efficiencies are maximised.
Pure and Speculative Risk

Insurance provides protection from the exposure to hazards and the probability of loss. Risk is
defined as the possibility of loss or injury, and insurance is concerned with the degree of
probability of loss or injury. We're now going to unravel the complexity of speculative risks and
pure risks.

Risk = Possibility of loss

Insurance = Probability of loss

Only pure risks are insurable because they involve only the chance of loss. They are pure in the
sense that they do not mix both profits and losses. Insurance is concerned with the economic
problems created by pure risks. Speculative risks are not insurable.

Both speculative risk and pure risk involve the possibility of loss. However, speculative risk also
involves the possibility of gain as well - even if there is no loss. In order to understand why, you
will need to understand the difference between the two.

Investing in the stock market is an example of a speculative risk. One can only speculate on
whether the investment will produce a profit or a loss. Insuring an automobile is an example of
pure risk. If the insured auto is involved in an auto accident, there is most definitely going to be
some sort of damage (loss). On the other hand if no accident occurs, there is no possibility of
gain. And that's the difference.

Speculative risks involve the possibility of loss and gain.

Pure risks involve the possibility of loss only.

Static and Dynamic Risk

Static risks are risks that involve losses brought about by irregular action of nature or by
dishonest misdeeds and mistakes of man. Static losses are present in an economy that is not
changing (static economy) and as such, static risks are associated with losses that would occur in
an unchanging economy. For example, if all economic variables remain constant, some people
with fraudulent tendencies would still go out steal, embezzle funds and abuse their positions. So
some people would still suffer financial losses. These losses are brought about by causes other
than changes in the economy. Such as perils of nature, and the dishonesty of other people.

Static losses involve destruction of assets or change in their possession as a result of dishonesty.
Static losses seem to appear periodically and as a result of these they are generally predictable.
Because of their relative predictability, static risks are more easily taken care of, by insurance
cover then are dynamic risks. Example of static risk include theft, arson assassination and bad
weather. Static risks are pure risks.
Dynamic risk is risks brought about by changes in the economy. Changes in price level, income,
tastes of consumers, technology etc (which is examples of dynamic risk) can bring about
financial losses to members of the economy. Generally dynamic risks are the result of
adjustments to misallocation of resources. In the long run, dynamic risks are beneficial to the
society. For example, technological change, which brings about a more efficient way of mass
producing a higher quality of article at a cheaper price to consumers than was previously the
case, has obviously benefited the society.
Dynamic risk normally affects a large number of individuals, but because they do not occur
regularly, they are more difficult to predict than static risk.

Quantifiable and non-quantifiable risk

Quantifiable risks are those that can be measured, while non-quantifiable risks are those that are
not tangible. Non quantifiable risks cannot be measured for example – risks which leads to
tension or loss of peace, etc.
Risks for Financial Institutions
One of the major objectives of a financial institution’s (FI’s) managers is to increase the FI’s
returns for its owners
Increased returns often come at the cost of increased risk, which comes in many forms:
– credit risk – foreign exchange risk
– liquidity risk – country or sovereign risk
– interest rate risk – technology risk
– market risk – operational risk
– off-balance-sheet risk – insolvency risk
Credit risk is the risk that the promised cash flows from loans and securities held by FIs may not
be paid in full
– FIs that make loans or buy bonds with long maturities are relatively more exposed to credit risk
• thus, banks, thrifts, and insurance companies are more exposed than MMMFs and property-
casualty insurance companies
– many financial claims issued by individuals or corporations have:
• limited upside return with a high probability
• large downside risk with a low probability
– a key role of FIs involves screening and monitoring loan applicants to ensure only the
creditworthy receive loans
• FIs also charge interest rates commensurate with the riskiness of the borrower

Credit risk is the risk that the promised cash flows from loans and securities held by FIs may
not be paid in full
– FIs that make loans or buy bonds with long maturities are relatively more exposed to credit risk
• thus, banks, thrifts, and insurance companies are more exposed than MMMFs and property-
casualty insurance companies
– many financial claims issued by individuals or corporations have:
• limited upside return with a high probability
• large downside risk with a low probability
– a key role of FIs involves screening and monitoring loan applicants to ensure only the
creditworthy receive loans
• FIs also charge interest rates commensurate with the riskiness of the borrower

FIs can diversify away some individual firm-specific credit risk, but not systematic credit risk
• firm-specific credit risk is the risk of default for the borrowing firm associated with the
specific types of project risk taken by that firm
• systematic credit risk is the risk of default associated with general economy-wide or
macroeconomic conditions affecting all borrowers

Liquidity risk is the risk that a sudden and unexpected increase in liability withdrawals may
require an FI to liquidate assets in a very short period of time and at low prices
– day-to-day withdrawals by liability holders are generally predictable
– unusually large withdrawals by liability holders can create liquidity problems
• the cost of purchased and/or borrowed funds rises for FIs
• the supply of purchased or borrowed funds declines
• FIs may be forced to sell less liquid assets at ―fire-sale‖ prices
Interest rate risk is the risk incurred by an FI when the maturities of its assets and liabilities are
mismatched and interest rates are volatile
– asset transformation involves an FI issuing secondary securities or liabilities to fund the
purchase of primary securities or assets
– if an FI’s assets are longer-term than its liabilities, it faces refinancing risk
• the risk that the cost of rolling over or re-borrowing funds will rise above the returns being
earned on asset investments
– if an FI’s assets are shorter-term than its liabilities, it faces reinvestment risk
• the risk that the returns on funds to be reinvested will fall below the cost of funds
– all FIs face price risk (or market value risk)
• the risk that the price of the security changes when interest rates change
– FIs can hedge or protect themselves against interest rate risk by matching the maturity of their
assets and liabilities
• this approach is inconsistent with their asset transformation function

Market risk is the risk incurred in trading assets and liabilities due to changes in interest rates,
exchange rates, and other asset prices
– closely related to interest rate and foreign exchange risk – adds trading activity—i.e., market
risk is the incremental risk incurred by an FI (in addition to interest rate or foreign exchange
risk) caused by an active trading strategy
– FIs’ trading portfolios are differentiated from their investment portfolios on the basis of time
horizon and liquidity
• trading assets, liabilities, and derivatives are highly liquid
• investment portfolios are relatively illiquid and are usually held for longer periods of time
– declines in traditional banking activity and income at large commercial banks have been offset
by increases in trading activities and income
– declines in underwriting and brokerage income at large investment banks have been offset by
increases in trading activity and income
– actively managed MFs are also exposed to market risk
– FIs are concerned with fluctuations in trading account assets and liabilities
• value at risk (VAR) and daily earnings at risk (DEAR) are measures used to assess market
risk exposure
– market risk exposure has caused some highly publicized losses
• the failure of the 200-year old British merchant bank Barings in 1995
• $7.2 billion in market risk related loss at Societe Generale in 2008

Off-balance-sheet (OBS) risk is the risk incurred by an FI as the result of activities related to
contingent assets and liabilities
– OBS activity can increase FIs’ interest rate risk, credit risk, and foreign exchange risk
– OBS activity can also be used to hedge (i.e., reduce) FIs’ interest rate risk, credit risk, and
foreign exchange risk
– large commercial banks (CBs) in particular engage in OBS activity
• on-balance-sheet assets of all U.S. CBs totaled $10.8 trillion in 2007
• the notional value of OBS items totaled $180.6 trillion in 2007
– OBS activities can affect the future shape of FIs’ balance sheets
• OBS items become on-balance-sheet items only if some future event occurs
• a letter of credit (LOC) is a credit guarantee issued by an FI for a fee on which payment is
contingent on some future event occurring,
most notably default of the agent that purchases the LOC
• other examples include:
– loan commitments by banks
– mortgage servicing contracts by savings institutions
– positions in forwards, futures, swaps, and other derivatives held by almost all large FIs
Foreign exchange (FX) risk is the risk that exchange rate changes can affect the value of an
FI’s assets and liabilities denominated in foreign currencies
– FIs can reduce risk through domestic-foreign activity/investment diversification
– FIs expand globally through
• acquiring foreign firms or opening new branches in foreign countries
• investing in foreign financial assets
– returns on domestic and foreign direct and portfolio investment are not perfectly correlated
• underlying technologies of various economies differ
• exchange rate changes are not perfectly correlated across countries
– a net long position in a foreign currency involves holding more foreign assets than foreign
liabilities
• FI loses when foreign currency falls relative to the U.S. dollar
• FI gains when foreign currency appreciates relative to the U.S. dollar
– a net short position in a foreign currency involves holding fewer foreign assets than foreign
liabilities
• FI gains when foreign currency falls relative to the U.S. dollar
• FI loses when foreign currency appreciates relative to the U.S. dollar
– an FI is fully hedged if it holds an equal amount of foreign currency denominated assets and
liabilities (that have the same maturities)

Country or sovereign risk is the risk that repayments from foreign borrowers may be
interrupted because of interference from foreign governments
– differs from credit risk of FIs’ domestic assets
• with domestic assets, FIs usually have some recourse through bankruptcy courts—i.e., FIs can
recoup some of their losses when defaulted firms are liquidated or restructured
– foreign corporations may be unable to pay principal and interest even if they would desire to
do so
• foreign governments may limit or prohibit debt repayment due to foreign currency shortages or
adverse political events
– thus, an FI claimholder may have little or no recourse to local bankruptcy courts or to an
international claims court
– measuring sovereign risk includes analyzing:
• the trade policy of the foreign government
• the fiscal stance of the foreign government
• potential government intervention in the economy
• the foreign government’s monetary policy
• capital flows and foreign investment
• the foreign country’s current and expected inflation rates
• the structure of the foreign country’s financial system
Technology risk and operational risk are closely related – technology risk is the risk incurred
by an FI when its technological investments do not produce anticipated cost savings
• the major objectives of technological expansion are to allow the FI to exploit potential
economies of scale and scope by:
– lowering operating costs
– increasing profits
– capturing new markets
– operational risk is the risk that existing technology or support systems may malfunction or
break down
• the BIS defines operational risk as ―the risk of loss resulting from inadequate or failed internal
processes, people, and systems or from external events‖
Insolvency risk is the risk that an FI may not have enough capital to offset a sudden decline in
the value of its assets relative to its liabilities
– insolvency risk is a consequence or an outcome of one or more of the risks previously
described:
• interest rate, market, credit, OBS, technological, foreign exchange, sovereign, and/or liquidity
risk
– generally, the more equity capital to borrowed funds an FI has the less insolvency risk it is
exposed to
– both regulators and managers focus on capital adequacy as a measure of a FI’s ability to
remain solvent

Other risks and interactions among risks

– in reality, all of the previously defined risks are interdependent
• e.g., liquidity risk can be a function of interest rate and credit risk
– when managers take actions to mitigate one type of risk, they must consider such actions on
other risks
– changes in regulatory policy constitute another type of discrete or event-specific risk
– other discrete or event specific risks include
• war, revolutions, sudden market collapses, theft, malfeasance, and breach of fiduciary trust
– macroeconomic risks include increased inflation, inflation volatility and unemployment
Classifying Pure risks.
Pure risks are types of risk where no profit is possible and only full loss, partial loss or break-
even situation are probable outcomes. Types of pure risks are; (1) personal risks, (2) property
risks, and (3) liability risks
Pure risks are types of risk where no profit or gain is possible and only full loss, partial loss or
break-even situation are probable outcomes. There are three types of pure risk.
The result is always unfavorable, or maybe the same situation (as existed before the event) has
remained without giving birth to a profit (or loss). Pure risk is a situation that holds out only the
possibility of loss or no loss or no loss.
For example, if you buy a new Samsung Note 7, you face the prospect of the book being stolen
or not being stolen and no profit from this situation.
There is only the prospect of loss or no loss, and no prospect of gain or profit under pure risk.
So, Pure risks are those risks where the outcome shall result in loss only or at best a break-even
situation. We cannot think about a gain-gain situation.

Types of Pure Risks are;

1. Personal risks.
2. Property risks.
3. Liability risks
Since pure risks are generally insurable, the discussion on risk is skewed towards pure risks
only.
1. Personal Risks
These are the risks that directly affect the individual’s capability to earn income. Personal risks
can be classified into the following types:
 Premature Death: Death of the bread earner with unfulfilled or unprovided financial
obligations.
 Old Age: It refers to the risk of not having sufficient income at the age of retirement or
the age becoming so that mere is a possibility that the individual may not be able to earn
the livelihood.
 Sickness or Disability: The risk of poor health or disability of a person to earn the means
of survival. E.g. the possibility of damage to limbs of a driver due to an accident.
 Unemployment: The risk of unemployment due to socio-economic factors resulting in
financial insecurity.

2. Property Risks
These are the risks to the persons in possession of the property being damaged or lost.
The immovable like land and building being damaged due to flood, earthquake or fire, the
movables like appliances and personal assets being destroyed due to the fire or stolen.
The losses may be direct or indirect/consequential.

A direct loss implies the visible financial loss to the property due to mishappenings.
Whereas, the indirect ones are the losses arising from the occurrence of an incident resulting in
direct/physical damages or loss.
The loss to crops due to flood is a direct loss – the destruction of the growing power is a
consequential one.
3. Liability Risks
These are the risks arising out of the intentional or unintentional injury to the persons or damages
to their properties through negligence or carelessness.
Liability risks generally arise from the law. e.g. liability of the employer under the workmen’s
compensation law or other labor laws in India.
In addition to the above categories, risks may also arise due to the failure of others.
For example, the financial loss arising from the non-performance or standard performance in a
contract, in engineering or construction contracts.
Risk Management:
Risk Management Process,
All risk management processes follow the same basic steps, although sometimes different jargon
is used to describe these steps. Together these 5 risk management process steps combine to
deliver a simple and effective risk management process.
Step 1: Identify the Risk. You and your team uncover, recognize and describe risks that might
affect your project or its outcomes. There are a number of techniques you can use to find project
risks. During this step you start to prepare your Project Risk Register.
Step 2: Analyze the risk. Once risks are identified you determine the likelihood and
consequence of each risk. You develop an understanding of the nature of the risk and its
potential to affect project goals and objectives. This information is also input to your Project
Risk Register.
Step 3: Evaluate or Rank the Risk. You evaluate or rank the risk by determining the risk
magnitude, which is the combination of likelihood and consequence. You make decisions about
whether the risk is acceptable or whether it is serious enough to warrant treatment. These risk
rankings are also added to your Project Risk Register.
Step 4: Treat the Risk. This is also referred to as Risk Response Planning. During this step you
assess your highest ranked risks and set out a plan to treat or modify these risks to achieve
acceptable risk levels. How can you minimize the probability of the negative risks as well as
enhancing the opportunities? You create risk mitigation strategies, preventive plans and
contingency plans in this step. And you add the risk treatment measures for the highest ranking
or most serious risks to your Project Risk Register.
Step 5: Monitor and Review the risk. This is the step where you take your Project Risk
Register and use it to monitor, track and review risks.
Risk management objectives
The objectives of risk management can be broadly classified into two:
1. Pre-loss Objectives
2. Post-loss Objectives
Pre-loss Objectives:
An organization has many risk management objectives prior to the occurrence of a loss. The
most important of such objectives are as follows;
a. The first objective is that the firm should prepare for potential losses in the most
economical way possible. This involves as analysis of safety program, insurance
premiums and the costs associated with the different techniques of handling losses.
b. The second objective is the reduction of anxiety. In a firm, certain loss exposures can
cause greater worry and fear for the risk manager, key executives and unexpected
stockholders of that firm. For example, a threat of a lawsuit from a defective product can
cause greater anxiety than a possible small loss from a minor fire. However, the risk
manager wants to minimize the anxiety and fear associated with such loss
exposures.
c. The third pre-loss objective is to meet any externally imposed obligations. This
means that the firm must meet certain obligations imposed on it by the outsiders. For
example, government regulations may require a firm to install safety devices to
protect workers from harm. Similarly, a firm’s creditors may require that property
pledged as collateral for a loan must be insured. Thus, the risk manager is expected to see
that these externally imposed obligations are met properly.
Post-loss Objectives:
Post-loss objectives are those which operate after the occurrence of a loss. They are as follows:
a. The first post-loss objective is survival of the firm. It means that after a loss occurs, the
firm can at least resume partial operation within some reasonable time period.
b. The second post loss objective is to continue operating. For some firms, the ability
to operate after a severe loss is an extremely important objective. Especially, for
public utility firms such as banks, dairies, etc, they must continue to provide service.
Otherwise, they may lose their customers to competitors.
c. Stability of earnings is the third post-loss objective. The firm wants to maintain its
earnings per share after a loss occurs. This objective is closely related to the objective of
continued operations. Because, earnings per share can be maintained only if the
firm continues to operate. However, there may be substantial costs involved in achieving
this goal, and perfect stability of earnings may not be attained.
d. Another important post-loss objective is continued growth of the firm. A firm may grow
by developing new products and markets or by acquiring or merging with other
companies. Here, the risk manager must consider the impact that a loss will have on the
firm’s ability to grow.
e. The fifth and the final post-loss objective is the social responsibility to minimize
the impact that a loss has on other persons and on society. A severe loss can adversely
affect the employees, customers, suppliers, creditors and the community in general.
Thus, the risk manager’s role is to minimize the impact of loss on other persons.
Thus, there are the pre-loss and post-loss objectives of risk management. A prudent risk manager
must keep these objectives in mind while handling and managing the risk.
Risk retention and risk transfer

Risk Retention
This risk management approach is an extreme opposite on the Risk Transfer approach in that it
upholds the principle of taking responsibility for one’s action. Risk Retention technique is the
intentional decision of organizations to handle opposing risk of a firm internally rather than
transferring them to insurance or any other third party. By so doing, the risk of the organization
is self-financed and managed. In accounting perspective, this is done by setting an amount/
account aside called Provisioning. The provisioning account is used to service bad debts
(defaulting loans). The provision account is a loss financing (reserve funds) account that pays for
the potential losses arising from client’s loan defaults.
Organizations make decisions to retain risk when a cost analysis review shows that it is cost
effective to handle the risk internally as opposed to the cost of fully or partially insuring against
it. Companies choose to retain risk when the premium of transferring them is substantially high.
You could rename the risk retention approach as self-insurance.
What Financial Institutions actually do- The Risk Management Committee strikes a balance in
determining the appropriate level of risk transfer or risk retention for their organization. It is
unwise to completely transfer your risk and foolhardier to totally retain them. Experience has it
that organizations choose to transfer high risk options and retain lower risk. By so doing, they
partially retain the risk of their business. There is however no best brilliant way to handle risk.
Organizations should work with their risk advisor to determine which risk-financing option is
most appropriate for them. The role of risk advisors in this balancing act is crucial. Experienced
risk advisors can help organizations determine the best risk-financing program or strategy by
conducting a detailed analysis of their risk management profile, risk-taking philosophy and
appetite.

Risk Transfer
Risk transfer can be defined as a mechanism of risk management that involves the transfer of
future risks from one person to another and one of the most common examples of risk
management is purchasing insurance where the risk of an individual or a company is transferred
to a third party (insurance company).
Risk transfer in its true essence is the transfer of the implications of risks from one party
(individual or an organization) to another (third party or an insurance company). Such risks may
or may not necessarily take place in the future. Transfer of risks can be executed through buying
an insurance policy, contractual agreements, etc.

Levels of risk management

At the PMI Hungary Chapter international Art of Projects conference in Budapest this month,
Rick Graham spoke about risk management in the globalised world. He talked about how Monte
Carlo analysis is used to establish risk and how companies gather sophisticated data to make
good decisions about the actions they need to take as a result of identifying risk.
Rick said that there are three levels of risk management that apply to projects.
1. Project risk
This is perhaps the most obvious. These risks do not recognise interdependencies and risks
outside the scope of the project. Rick recommended doing Monte Carlo analysis at this level to
identify project risk. He also talked about scenario building as a good tool for project risk
identification and management, giving the example of Shell.
Shell was the only company which modelled the risk of the OPEC countries putting up the price
of oil. Because of their analysis they were able to adapt their plants to deal with less refined oil
and gained a two-year head start on the competition when the prices did go up.
Rick recommended “building limited models around sensitive areas”: in other words, not
spending time on modelling when the risk is low or when it isn’t worth doing. Models and
analysis help explain the risk you are taking at the project level in comparative terms, which
helps set them in context for team members and stakeholders.
2. Project selection risk
At this level the question relates to how risk plays a part in making decisions about which
projects should be started. The challenge here is whether the business just says yes or no to a
project without looking at the overall position and the wider business requirements.
For example, a risky project may not be inherently bad for the business. If you always say no to
risky projects you end up with a portfolio full of low risk but also probably low benefit projects
that present reduced opportunities for the company.
This level links to the strategic objectives and how the deliverables will be achieved in the
organisational context.
It should also include the risk of not doing or deferring the project, as that decision presents a
different path forward for the business with its own challenges.
3. Project portfolio risk
This is where you start to look outside the projects as individual initiatives and start to gather
rich data about the organization’s approach to risk management as a whole.
Rick recommended doing Monte Carlo analysis at programme level to identify risks across
dependent streams of work. He then talked about using this output to identify the right
combination of projects to work on at portfolio level.
The problem I found with this model is that there isn’t any level that I can see where risks fit that
fall outside the project but that are managed in some shape or form by the project manager. For
example, dependencies on other projects – the risk that the other project may not deliver on time.
Or the risk that the company might go bust – this is out of scope of the project but something like
this could feasibly be on your risk register.
This model also assumes that you have a process to apply risk management to.
Rick said that you can only do portfolio level risk management if there is one single repository of
project data. This isn’t the case in many businesses where project managers are based in
functional silos and even if there is a PMO it serves one business unit and not the enterprise as a
whole.
A spreadsheet is good enough for this: no need to invest in anything more complicated, he said.
You can start to put some science behind your spreadsheet once you have everything
documented in one place.
Corporate risk management
In a corporate setting, the familiar division of risks into market, credit and operational risks
breaks down.
Of these, credit risk poses the least challenges. To the extent that corporations take credit risk
(some take a lot; others take little), new and traditional techniques of credit risk management are
well established and transferable from one context to another.
Operational risk has little applicability to most corporations. It includes such factors as model
risk or settlement errors. Some aspects do affect corporations—such as fraud or natural disasters
—but corporations have been addressing these with internal audit, facilities management and
legal departments for decades. Corporations may face risks that are akin to the operational risk of
financial institutions but are unique to their own business lines. An airline is exposed to risks due
to weather, equipment failure and terrorism. A power generator faces the risk that a generating
plant may go down for unscheduled maintenance. In corporate risk management, these risks—
those that overlap with the operational risks of financial firms and those that are akin to such
operational risks but are unique to non-financial firms—are called operations risks.
The biggest challenge of corporate risk management is those risks that are akin to market risk but
aren’t market risk. An oil company holds oil reserves. Their “value” fluctuates with the market
price of oil, but what does this mean? Oil reserves don’t have a market value. As another
example, suppose a chain of restaurants is thriving. Its restaurants are “valuable,” but it is
impossible to assign them market values. Something that doesn’t have a market value doesn’t
pose market risk. This is almost a tautology. Such risks are business risks as opposed to market
risks.
In the realm of corporate risk management, we abandon the division of risks into market, credit
and operational risks and replace it with a new categorization:
 market risk,
 business risk,
 credit risk,
 operations risk.
Corporations do face some market risks, such as commodity price risk or foreign exchange risk.
These are usually dwarfed by business risks. Techniques for addressing business risk take two
forms:
 those that treat business risks as market risks, so that techniques of financial risk
management can be directly applied or adapted, and
 those that address business risks from a book value standpoint, modifying or adapting
techniques of asset-liability management.
Both approaches are discussed below.
Economic Value
Techniques of the first form focus on a concept called economic value. If a market value exists
for an asset, then that market value is the asset’s economic value. If a market value doesn’t exist,
then economic value is the “intrinsic value” of the asset—what the market value of the asset
would be, if it had a market value. Economic values can be assigned in two ways. One is to start
with accounting metrics of value and make suitable adjustments, so they are more reflective of
some intrinsic value. This is the approach employed with economic value added (EVA) analyses.
The other approach is to construct some model to predict what value the asset might command, if
a liquid market existed for it. In this respect, an unflattering name for economic value is mark-to-
model value.
Once some means has been established for assigning economic values, these are treated like
market values. Standard techniques of financial risk management—such as value-at-risk (VaR)
or economic capital allocation—are then applied.
This economic approach to managing business risk is applicable if most of a firm’s balance sheet
can be marked to market. Economic values then only need to be assigned to a few items in order
for techniques of financial risk management to be applied firm wide. An example would be a
commodity wholesaler. Most of its balance sheet comprises physical and forward positions in
commodities, which can be mostly marked to market.
More controversial has been the use of economic valuations in power and natural gas markets.
The actual energies trade and, for the most part, can be marked to market. However, producers
also hold significant investments in plants and equipment—and these cannot be marked to
market. Suppose some energy trades spot and forward out three years. An asset that produces the
energy has an expected life of 50 years, which means that an economic value for the asset must
reflect a hypothetical 50-year forward curve. The forward curve doesn’t exist, so a model must
construct one. Consequently, assigned economic values are highly dependent on assumptions.
Often, they are arbitrary.
In this context, it isn’t enough to assign economic values. Value-at-risk analyses require standard
deviations and correlations as well. Assigning these to 50-year forward prices that are themselves
hypothetical is essentially meaningless—yet, those standard deviations and correlations
determine the reported value-at-risk.
Such practices got out of hand in the US energy markets during the late 1990s and early 2000s.
The most publicized case was Enron Corp., which went beyond using economic values for
internal reporting and incorporated them into its financial reporting to investors. The 2001
bankruptcy of Enron and subsequent revelations of fraud tainted mark-to-model techniques.
Book Value
The second approach to addressing business risk starts by defining risks that are meaningful in
the context of book value accounting. Most typical of these are:
 earnings risk, which is risk due to uncertainty in future reported earnings, and
 cash flow risk, which is risk due to uncertainty in future reported cash flows.
Of the two, earnings risk is more akin to market risk. Yet, it avoids the sometimes arbitrary
assumptions of economic valuations. A firm’s accounting earnings are a well defined notion. A
problem with looking at earnings risk is that earnings are, well, non-economic. Earnings may be
suggestive of economic value, but they can be misleading and are often easy to manipulate. A
firm can report high earnings while its long term franchise is eroded by lack of investment or the
emergence of competing technologies. Financial transactions can boost short-term earnings at the
expense of long-term earnings.
Cash flow risk is less akin to market risk. It relates more to liquidity than the value of a firm, but
this is only partly true. As anyone who has ever worked with distressed firms can attest, “cash is
king.” When a firm gets into difficulty, earnings and market values don’t pay the bills. Cash flow
is the life blood of a firm. However, as with earnings risk, cash flow risk offers only an imperfect
picture of a firm’s business risk. Cash flows can also be manipulated, and steady cash flows may
hide corporate decline.
Techniques for managing earnings risk and cash flow risk draw heavily on techniques of asset-
liability management—especially scenario analysis and simulation analysis. They also adapt
techniques of financial risk management. In this context, value-at-risk (VaR) becomes earnings-
at-risk (EaR) or cash-flow-at-risk (CFaR). For example, EaR might be reported as the
10% quantile of this quarter’s earnings.
The actual calculations of EaR or CFaR differ from those for VaR. These are long-term risk
metrics, with horizons of three months or a year. VaR is routinely calculated over a one-day
horizon. Also, EaR and CFaR are driven by rules of accounting while VaR is driven by financial
engineering principles. Typically, EaR or CFaR are calculated by first performing a simulation
analysis. That generates a probability distribution for the period’s earnings or cash flow, which is
then used to value the desired metric of EaR or CFaR.
One decision that needs to be made with EaR or CFaR is whether to use a constant or contracting
horizon. If management wants an EaR analysis for quarterly earnings, should the analysis
actually assess risk to the current quarter’s earnings? If that is the case, the horizon will start at
three months on the first day of the quarter and gradually shrink to zero by the end of the quarter.
The alternative is to use a constant three-month horizon. After the first day of the quarter, results
will no longer apply to that quarter’s actual earnings, but to some hypothetical earnings over a
shifting three-month horizon. Both approaches are used. The advantage of a contracting horizon
is that it addresses an actual concern of management—will we hit our earnings target this
quarter? A disadvantage is that the risk metric keeps changing—if reported EaR declines over a
week, does this mean that actual risk has declined, or does it simply reflect a shortened horizon?
Management of risk by individuals
Personal Risk Management (PRM) — the process of applying risk management principles to the
needs of individual consumers. It is the process of identifying, measuring, and treating personal
risk (including, but not limited, to insurance), followed by implementing the treatment plan and
monitoring changes over time.

To be updated with proper content later on

Measures of Risk – Mathematical, Subjective (Only theory)

The top three methods for measurement of risk in a business enterprise. The methods are:
1. Probability Distribution 2. Standard Deviation as a Measure of Risk 3. Coefficient of
Variation as a Relative Measure of Risk.

Measurement of Risk: Method # 1.

Probability Distribution:
As stated above, a risky proposition in a business enterprise is presumed to be with a wide range
of possible outcomes for each flow in year I is arranged in the form of a frequency distribution. It
is known as probability distribution.
The probability that a particular event will occur is a measure of its likelihood of occurrence.
Probabilities normally are stated as decimal fractions normalized to 1.0 but they can also be
expressed in percentage terms as in Table 20.1.
In capital budgeting, we are not faced with the problem of measuring relative frequency of
known events. Rather we forecast the likelihood of future events that will affect different
proposals. To do this, we make use of subjective probabilities. In contrast, objective probability
is based on prior experience and the laws of chance and on which there is a general agreement.
Examples are probabilities associated with the flip of a coin or the roll of a dice.
In capital budgeting, usually the forecast of annual cash flow in one single figure is made. This is
the most likely or most probable outcome perceived by the forecaster for the proposal. The
question that arises in this connection is how much the forecaster is confident about this
outcome. Is he very certain, very uncertain or somewhere in between? This degree of uncertainty
can be defined and measured in terms of the forecaster’s probability distribution.
Thus, a probability distribution consists of just a few potential outcomes, viz., an optimistic
estimate, a pessimistic estimate and a most likely estimate or alternately one could make high,
low and best guess estimates. An analysis is not limited to these three alternatives. Any number
may be used to express the future conditions applicable to the project.
Normally, the most likely estimate represents the expected value of the variable. This is in the
middle of other possibilities and has the highest probability of occurrence. Weighted arithmetic
mean provides expected value. This value is constructed by multiplying each possible outcome
by its associated probability and summing the products.

Measurement of Risk: Method # 2.

Standard Deviation as a Measure of Risk:

Probability distribution provides the basis for measuring the risk of a project. The rule set down
in this connection is “the higher the probability distribution of expected future return, the
smaller the risk of a given project and the vice versa.” To measure the rightness or dispersion
of the probability distribution the most widely used statistical technique of standard deviation is
employed.
The following steps are involved in computing standard deviation:
(i) Calculate the mean of expected value of the distribution.
(ii) Calculate the deviation from each possible outcome.
(iii) Square each deviation.
(iv) Multiply the squared deviations by the probability of occurrence for its related outcome.
(v) Sum all the products. This is called variance.
The smaller the standard deviation, the higher the probability distribution and accordingly the
lower the riskiness of the project.
Measurement of Risk: Method # 3.
Coefficient of Variation as a Relative Measure of Risk:
The size difficulty can be eliminated by developing a third measure, the coefficient of variation.
It measures the relative variability of returns.
It calls for nothing more difficult than dividing the standard deviation from an investment
by the expected value:
Generally, the larger the coefficient of variation, the greater the risk.