RISK
1.1 Concept of Risk
The word risk is certainly used frequently in everyday conversation and seems
to be well understood. Risk implies some form of uncertainty about an
outcome in a given situation. An event might occur and if it does, the outcome
is not favourable to us. Risk can be contrasted with the word chance which
implies some doubt about the outcome in a given situation; the difference is
that the outcome may also be favourable e.g. risk of an accident, chance of
winning a bet etc
However in common business conversations the word risk is used to mean
different things:
i) Risk as cause e.g. fire as a risk, Personal injury as a risk etc.
ii) Risk as likelihood e.g. the risk of something happening, leaving keys in
a car results in high risk etc.
iii) Risk as the object – e.g. factory, plane, machine or ship might be
referred to as the risk.
vi) Risk as verb – It is not only used as a noun but also as a verb e.g. risk
of crossing the road.
All the above illustrate how the use of the word goes far beyond its technical
meaning.
1.2 Meaning of risk
Various scholars have advanced different definitions of risk as follows:-
i) Risk is the possibility of an unfortunate occurrence.
ii) Risk is a combination of hazards.
iii) Risk is unpredictability – the tendency that actual results may differ from
predicted results.
iv) Risk is uncertainty of loss.
v) Risk is the possibility of loss.
,Rather than try to ascertain the best definition of risk, the underlying commonality in
all the definitions should be of interest. From the above definitions some common
thread runs through each of them namely:
i) Uncertainty – If suffices because we have imperfect knowledge which leads
to doubt and hence the uncertainty which we express e.g. a child playing in the
middle of a busy road. Uncertainty implies doubt about the future based on a
lack of knowledge or imperfection in knowledge. If we always knew what was
going to happen, there would be no risk. Risk exists outside the individual, it
might be recognized as existing but this is not a pre-requisite. Risk is thus
objective and not dependent on any one individual.
ii) Levels of Risk – there are different levels of risk; some will be more or less
risky than others. This can be illustrated by looking at a house constructed by
the river side (river Nzoia in Budalangi, Busia), the river being known for its
potential to overflow its banks. The word risky may describe this situation.
There is uncertainty as to whether the river will flood or not. The fact that the
river is known for flooding has heightened the prospect that damage will
occur, that is, the frequency of damage is high. The term risky may be used to
denote this heightened possibility. If another house is constructed further from
the river bank and on a slight hill, it is in a less risky situation, not because the
prospect of the river flooding has changed but because the possibility of
damage being caused to the house is much lower. However, judgment may
change if the value at risk is considered. If the first house is valued at Ksh
50,000 and the second at Ksh 5,000,000, the higher risk in view of higher
potential of severity of loss may be the second house. Risk is thus a
combination of the likelihood of an event and the severity of damage should
the event occur. If an event occurs a great deal, then our knowledge about the
future begins to increase and an element of certainty begins to creep in e.g.
shoplifting. Combining frequency and severity we find two relationships
a) High frequency and low severity e.g. industrial injuries.
b) Low frequency and high severity e.g. 1998 Nairobi bomb blast.
,iii) Peril and Hazard (Cause(s))
We often use risk to mean both the event which will give rise to some loss and
the factors which may influence the outcome of a loss. In our house example,
flood is the cause of the loss and the fact that one of the houses is near the
river bank influences the outcome. Flood is the peril and the proximity of the
house to the river is the hazard. Peril is the prime cause, it is what will give
rise to the loss e.g. storm, fire etc. Factors which may influence the outcome
are referred to as hazards. Hazards are not themselves the cause of the loss but
they can increase or decrease the effect should a peril operate. Hazard can be
physical or moral. Physical hazard relates to the physical characteristics of risk
e.g. grass thatched house while moral hazard concerns human aspects which
may influence the outcome. It usually relates to the attitude of the person e.g.
conman.
1.3 Classification of Risk
Risks could be classified as follows:
(i) Financial and non-financial risks- a financial risk is one where the
outcome can be measured in monetary terms and where it is possible to
place some value on the outcome. Measurement in personal injury may be
done by a court when damages are awarded or negotiation among lawyers
and insurers. There are cases where measurement is not possible e.g.
choice of a new car, selection from a restaurant menu, selection of a
career, choice of a marriage partner etc all these are non-financial risks.
Generally in business we are concerned with financial risks.
(ii) Pure and speculative risks- pure risks involve a loss or at best a break even
situation. The outcome can only be unfavourable to us or leave us in the
same position as we enjoyed before the event occurred e.g. motor accident,
fire, theft etc. Speculative risk on the other hand is where there is a chance
of gain e.g. investing money in stocks (the investment may result in a loss
or possibly a break even but the reason it was made was the prospect of
gain), pricing of products, marketing decisions, decisions on
diversification, expansion or acquisition, providing credit to customers
among others. Generally pure risks are normally insurable while
, speculative risks are generally not insurable though the trend is changing
and hence dynamic.
(iii) Fundamental and particular risks- fundamental risks are those which arise
from causes outside the control of any one individual or even a group of
individuals. In addition the effect of fundamental risks is felt by large
numbers of people e.g. earthquakes, floods, famine, volcanoes, war etc.
Particular risks are much more personal both in their cause and effect e.g.
fire, theft etc. All these risks arise from individual causes and affect
individuals in their consequences. Risks however change classification,
mostly from particular to fundamental e.g. unemployment. In the main,
particular risks are insurable while fundamental risks are not.
1.4 INDIVIDUAL ATTITUDES TO RISK
The attitude to risk differs from one individual to another. The stance to risk is a
function of individual position in the corporate and investment world. It means that
such differing attitudes influence decision making in investment and commitment of
corporate funds into projects by investors, financial analysts and managers. Attitude
to risk influences not only the subjective estimates of probability of occurrence of loss
but it also affects such individual‟s decisions in handling risk.
Risk Averters
The risk averters are those individuals who have the attitude of taking appropriate
measure to avoid incurring risk or the outcomes of risky events. Therefore, to be risk
averse implies that an individual is not willing to stake in excess of the expected
return in exchange for some certainty about the future. For instance, taking an
insurance policy and paying the periodic insurance premium involves taking steps to
forgo some prosperity in exchange for the insurance company‟s promise that the
covered risk or expected losses will be paid to compensate the insured. In insurance
parlance, some people refer to this approach as an exchange of a certain loss of funds,
which involves payment of premium for an uncertain future loss. The critical
consideration in the process of the exchange is that the total quantum of premium
being paid by the insured is larger than the average or expected loss. This is in view of
1.1 Concept of Risk
The word risk is certainly used frequently in everyday conversation and seems
to be well understood. Risk implies some form of uncertainty about an
outcome in a given situation. An event might occur and if it does, the outcome
is not favourable to us. Risk can be contrasted with the word chance which
implies some doubt about the outcome in a given situation; the difference is
that the outcome may also be favourable e.g. risk of an accident, chance of
winning a bet etc
However in common business conversations the word risk is used to mean
different things:
i) Risk as cause e.g. fire as a risk, Personal injury as a risk etc.
ii) Risk as likelihood e.g. the risk of something happening, leaving keys in
a car results in high risk etc.
iii) Risk as the object – e.g. factory, plane, machine or ship might be
referred to as the risk.
vi) Risk as verb – It is not only used as a noun but also as a verb e.g. risk
of crossing the road.
All the above illustrate how the use of the word goes far beyond its technical
meaning.
1.2 Meaning of risk
Various scholars have advanced different definitions of risk as follows:-
i) Risk is the possibility of an unfortunate occurrence.
ii) Risk is a combination of hazards.
iii) Risk is unpredictability – the tendency that actual results may differ from
predicted results.
iv) Risk is uncertainty of loss.
v) Risk is the possibility of loss.
,Rather than try to ascertain the best definition of risk, the underlying commonality in
all the definitions should be of interest. From the above definitions some common
thread runs through each of them namely:
i) Uncertainty – If suffices because we have imperfect knowledge which leads
to doubt and hence the uncertainty which we express e.g. a child playing in the
middle of a busy road. Uncertainty implies doubt about the future based on a
lack of knowledge or imperfection in knowledge. If we always knew what was
going to happen, there would be no risk. Risk exists outside the individual, it
might be recognized as existing but this is not a pre-requisite. Risk is thus
objective and not dependent on any one individual.
ii) Levels of Risk – there are different levels of risk; some will be more or less
risky than others. This can be illustrated by looking at a house constructed by
the river side (river Nzoia in Budalangi, Busia), the river being known for its
potential to overflow its banks. The word risky may describe this situation.
There is uncertainty as to whether the river will flood or not. The fact that the
river is known for flooding has heightened the prospect that damage will
occur, that is, the frequency of damage is high. The term risky may be used to
denote this heightened possibility. If another house is constructed further from
the river bank and on a slight hill, it is in a less risky situation, not because the
prospect of the river flooding has changed but because the possibility of
damage being caused to the house is much lower. However, judgment may
change if the value at risk is considered. If the first house is valued at Ksh
50,000 and the second at Ksh 5,000,000, the higher risk in view of higher
potential of severity of loss may be the second house. Risk is thus a
combination of the likelihood of an event and the severity of damage should
the event occur. If an event occurs a great deal, then our knowledge about the
future begins to increase and an element of certainty begins to creep in e.g.
shoplifting. Combining frequency and severity we find two relationships
a) High frequency and low severity e.g. industrial injuries.
b) Low frequency and high severity e.g. 1998 Nairobi bomb blast.
,iii) Peril and Hazard (Cause(s))
We often use risk to mean both the event which will give rise to some loss and
the factors which may influence the outcome of a loss. In our house example,
flood is the cause of the loss and the fact that one of the houses is near the
river bank influences the outcome. Flood is the peril and the proximity of the
house to the river is the hazard. Peril is the prime cause, it is what will give
rise to the loss e.g. storm, fire etc. Factors which may influence the outcome
are referred to as hazards. Hazards are not themselves the cause of the loss but
they can increase or decrease the effect should a peril operate. Hazard can be
physical or moral. Physical hazard relates to the physical characteristics of risk
e.g. grass thatched house while moral hazard concerns human aspects which
may influence the outcome. It usually relates to the attitude of the person e.g.
conman.
1.3 Classification of Risk
Risks could be classified as follows:
(i) Financial and non-financial risks- a financial risk is one where the
outcome can be measured in monetary terms and where it is possible to
place some value on the outcome. Measurement in personal injury may be
done by a court when damages are awarded or negotiation among lawyers
and insurers. There are cases where measurement is not possible e.g.
choice of a new car, selection from a restaurant menu, selection of a
career, choice of a marriage partner etc all these are non-financial risks.
Generally in business we are concerned with financial risks.
(ii) Pure and speculative risks- pure risks involve a loss or at best a break even
situation. The outcome can only be unfavourable to us or leave us in the
same position as we enjoyed before the event occurred e.g. motor accident,
fire, theft etc. Speculative risk on the other hand is where there is a chance
of gain e.g. investing money in stocks (the investment may result in a loss
or possibly a break even but the reason it was made was the prospect of
gain), pricing of products, marketing decisions, decisions on
diversification, expansion or acquisition, providing credit to customers
among others. Generally pure risks are normally insurable while
, speculative risks are generally not insurable though the trend is changing
and hence dynamic.
(iii) Fundamental and particular risks- fundamental risks are those which arise
from causes outside the control of any one individual or even a group of
individuals. In addition the effect of fundamental risks is felt by large
numbers of people e.g. earthquakes, floods, famine, volcanoes, war etc.
Particular risks are much more personal both in their cause and effect e.g.
fire, theft etc. All these risks arise from individual causes and affect
individuals in their consequences. Risks however change classification,
mostly from particular to fundamental e.g. unemployment. In the main,
particular risks are insurable while fundamental risks are not.
1.4 INDIVIDUAL ATTITUDES TO RISK
The attitude to risk differs from one individual to another. The stance to risk is a
function of individual position in the corporate and investment world. It means that
such differing attitudes influence decision making in investment and commitment of
corporate funds into projects by investors, financial analysts and managers. Attitude
to risk influences not only the subjective estimates of probability of occurrence of loss
but it also affects such individual‟s decisions in handling risk.
Risk Averters
The risk averters are those individuals who have the attitude of taking appropriate
measure to avoid incurring risk or the outcomes of risky events. Therefore, to be risk
averse implies that an individual is not willing to stake in excess of the expected
return in exchange for some certainty about the future. For instance, taking an
insurance policy and paying the periodic insurance premium involves taking steps to
forgo some prosperity in exchange for the insurance company‟s promise that the
covered risk or expected losses will be paid to compensate the insured. In insurance
parlance, some people refer to this approach as an exchange of a certain loss of funds,
which involves payment of premium for an uncertain future loss. The critical
consideration in the process of the exchange is that the total quantum of premium
being paid by the insured is larger than the average or expected loss. This is in view of
