INSURANCE AND RISK MANAGEMENT

INTRODUCTION

 

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 favorable 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 favorable 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:

  • Risk as cause e.g. fire as a risk, Personal injury as a risk etc.
  • Risk as likelihood e.g. the risk of something happening, leaving keys in a car results in high risk etc.
  • Risk as the object – e.g. factory, plane, machine or ship might be referred to as the risk.
  • 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:-

  • Risk is the possibility of an unfortunate occurrence.
  • Risk is a combination of hazards.
  • Risk is unpredictability – the tendency that actual results may differ from predicted results.
  • Risk is uncertainty of loss.
  • 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:

 

  1. 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.
  2. Levels of Risk – there are different levels of risk, some will be more or less risky than others. This can be illustrated looking at a house constructed 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

– High frequency and low severity e.g. industrial injuries.

– 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 out come.  It usually relates to the attitude of the person e.g. conman.

 

1.3 Classification of Risk

 

Risks could be classified as follows:

  • 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 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.
  • Pure and speculative risks- pure risks involve a loss or at best a break even situation. The outcome can only be unfavorable to us of leave us in the same position as we enjoyed before the event occurred e.g. motor accident, fire, theft etc. speculative risk is where there is a chance of gain e.g. investing money in shares (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.
  • 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 large numbers of people e.g. earthquakes, floods, famine, volcanos, war etc. Particular risks are much more personal both in their cause and effect e.g. fire, theft etc. Al 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.

 

1.5 Response to Risk

Conventionally insurance was always assumed to be the answer to risk. In a soft market, where the premium levels are generally low, all that is considered is the cost of premium and not alternatives. But in a hardening market, where premium levels are generally high, alternatives to insurance are considered. For a long time, general management suffered from ‘it won’t happen to me syndrome’ and many would go through the school system without sensitization on risk. The trend has been changing however with more positive attitude to risk developing and today we have individuals designated as risk managers. At personal level individuals could be risk takers-jumping on any bandwagon, risk neutral- fence seaters and risk averse-those avoiding it at all costs. In measuring attitudes towards risk, we could use the standard gamble:-

 

Standard gamble is concerned with measuring attitude to risk in a financial setting. If one was offered a gamble to win Ksh 4,000 on the toss of a coin. If it is a head one wins ksh 4,000 and if a tail nothing. This is a 50/50 bet. If one is offered a sum of money instead of the gamble, what is the least amount one would expect for sure than gamble?. The amount Ksh Z is equivalent, in certain money, to the gamble. It is referred to as the certainty equivalent. A person may decide to be indifferent between accepting ksh 1,000 for sure and the gamble of ksh 4,000. With a large number of people answering we could rank them according to how much or how little their certainty equivalents are. We can measure the extent to which a person deviated from the mathematically rational answer. The mathematical or objectively rational answer is based on the fact that the expected value of the gamble is ksh 2,000. If a person accepts less than the expected value then he has preference for certainty while more than expected value would be classified as a risk taker.

 

1.6 The cost and Burden of Risk

The risk surrounding potential losses creates significant economic burdens for businesses, governments and individuals. Millions of shillings are spent every year on strategies for financing potential losses, especially when losses are not planned for in advance, items may cost even more.

Businesses may be reluctant to engage in projects that are otherwise strategically attractive if the potential losses appear to be unmanageable, theredepriving the society of services judged to be too important.

 

The following are the cost and burden of risk to a society;

  1. The greatest burden of risk is that some losses will actually occur e.g. floods will destroy houses hence loss to the house owner. That is why individuals attempt to avoid risk or minimize its impact.
  2. Risk also has additional detriment apart from causing loss. The uncertainty as to whether loss will occur makes individuals establish risk minimization measures such as taking insurance cover or accumulating funds to meet such losses should they occur.  The accumulated funds are reserved in highly liquid investments so that they are readily available to set off the losses.  Such investments yield very low returns and hence investment waste due to low return investments.
  3. Without insurance as a risk minimization measure, each property will be required to accumulate their own individual funds so that the aggregate of individual funds will exceed the insurance funds hence another wasteful investments.
  4. Existence of risk may also have different effects on economic growth and capital accumulation which determines economic progress.  Investors incur risks of a new venture only if the returns from the venture are high enough to compensate both static and dynamic risks.  Such investors therefore make the cost of borrowing capital expensive to new venture owners.  The venture owners must in turn charge higher prices to consumers; the economy will therefore have the cost of living increased in order to bear the burden of risk.
  5. The uncertainty caused risks produces feelings of frustrations and unrest, particularly in the case of pure risk more than others.  Speculative risks are attractive to many individuals because it offers a chance to make gains or profits.
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