Risk Management:

Management is the art of getting things done through others.

Risk:

• It is a general uncertainty about outcome.

• It can be defined as the chance that actual outcome will differ from the
Expected Outcome.

• It has a variety of meaning in business and everyday life.

• Generally or a general level, Risk is used to describe any situation where

there is uncertainty about what outcome will arise.

• It denotes the deviation of actual return from estimated return.

In Fm & Investment Mgmt, risk is often used in more specific sense to indicate
possible variability in outcome around Expected Value. Thus, risk refers to the
variability of its expected value & other times to describe the Expected loss.

[Expected Value is an outcome that would occur on an average, if a person or

business were repeatedly exposed to the same type of risk, i.e. uncertainty
which may or may not occur.]

Eg: insurance market-high risk-policy holder

Here risk-expected value of loss to be paid by the insurer.

One situation is riskier than the other if it has greater in terms of: Expected loss
& variability around the expected loss.

Difference between Risk & Uncertainty:

• Interest Rate such as loan on bond, Variability of interest, Price if Fixed

Rates decreases and vice versa.

• Risk can be quantified of the like hood of future outcome, whereas

uncertainty cannot be quantified by the like hood of future outcome.

Types of Risk

Systematic Risk
Unsystematic Risk

Market Risk Business

Risk Financial Risk

Interest Rate Risk Internal Risk

External Risk
 Inflation Risk

Mkt Risk: It is related to mkt, decline of price because of general falling of mkt,
change in mkt price. Also depends on the psychology of investors, or risk which
is common to the entire class of assets or liabilities. Risk is borne by interest
borne assets.

Systematic Risk: It is the risk that arises out of mkt risk, interest rate risk,
inflation risk, etc. This risk cannot be avoided, it affects the entire business. This
is because of the economic, social, political changes. This particular risk is non
diversifiable.

Inflation: Value of income , as the inflation shrinks, with the purchasing power
having an impact. Loss arises from income due to the raising costs of Goods &
Services.

Unsystematic Risk: Risk refers to that portion of risk which is caused due to the
factor unique or related to the firm or industry. This risk arises out of external,
internal, & financial risk, which is unique to a particular company and that which
is diversifiable.

Financial Risk: Risk associated to the company not having adequate cash flow to
meet financial objectives. Economic value to the firm is added by using Financial
Instrument.

Business Risk – Types

Price Risk Credit Risk

Pure Risk

Da
mage to Assets

Output Price Input Price Legal

Liability

Risk Risk
Worker Injury

Empl
oyee Benefits

Commodity Price Risk

Exchange Rate Risk

Interest Rate Risk

Diversifiable Risk factors:

 • Company Strike.

• Bankruptcy of a major supplier.

• Death of a key officer.

• Unexpected entry of new competitors into the mkt.

Non Diversifiable Risk factors:

• Major changes in the tax rate.

• Increase or decrease in the inflation rate.

• Changes in the economic policy.

• Natural & other calamities.

• Industrial Recession and so on.

Price risk: Uncertainty over the magnitude of cash flows due to the possible
changes in the output & input prices.

Output price: Firm can demand for its goods & services.

Input price: Risk of changes in the price that a firm must pay for labour, material
& other inputs to its production process.

There are 3 types of price risk:

• Commodity Price Risk- Arises out of the fluctuation in the price of the
commodities like oil, electricity, gas etc. It acts as input price for one &
output price for the other. Business is going towards Globalisation, where
the output & input prices are being affected by the exchange rates that
are the foreign exchange rates and the interest rates.

• Exchange Rate Risk-

• Interest Rate Risk-

Changes in the interest rate may affect the firm’s revenue. By the credit allowed,
the speed in which the customer pays for the product purchased on credit. The
changes in the interest rate, can affect the cost of the firm’s borrowing costs.

Credit Risk: Firm’s customers & parties to which it has lent money will delay or
fail to make promised payment; this kind of risk can be called as credit risk.

Eg: Firm faces credit risk in the accounts receivable

Firm borrows money from the bank

Firm The bank gives loan.

In turn lends money to the customers, & these customers might fail to give back
the borrowed money.

So firm has to pay more money as credit risk increases.

Pure Risk: Here Risk Mgmt, has traditionally focussed on the Mgmt of what is
known as pure risk, which includes managing functions from medium to large
corporations. This risk affects the businesses.

• This risk might lead to reduction of value of assets due to the physical
damage and theft.

• Risk of legal liabilities to customers, suppliers, shareholders, and the other

parties.

• Paying benefits to injured workers as per the worker’s compensation law.

• Employee benefits, in case of death, disability and illness. The company

has to agree to pay the worker under the employee benefits plans
including obligations to the employee under pension, retirement, etc.

PERSONAL RISK :

Faced by individual and families.

Earnings : Death, disability, aging, underemployment(technology).

Medical expenses :

Liability: auto, home.

Physical asset : auto, computer.

Financial asset : stocks, bonds.[fluctuates]

Longevity : retired people will outlive then financial resources.

ATTITUDE TO RISK :

1. Aversion to risk.

2. Desire to take risk.

3. Neutral.
INSURANCE – financial definition

 It is the financial arrangement that redistributes the cost of unexpected

losses.

 Involves- transfer of potential losses to an insurance pool.

 Insurance system redistributes the cost of losses by collecting a premium

payment from every participant(insured)in the system.

INSURANCE- legal definition

 It is the contractual arrangement whereby one party agrees to

compensate another party for loses.

 Party agreeing to pay for the losses –insurer.

 Party whose loss cause the insurer to make a claim payment – insured.

 Payment insurer received premium.

 Insurance contract is called as policy.

 Insured the possibility of loss the insured “exposure to loss”.

Insurance is a branch of “contract law”.

Insurance policy like all contracts is arrangement creating rights & duties for
those who are parties to it. Insurance is easy to understand if we apply exact
meaning to words used in discipline.

LOSS :

Undesired , unplanned reduction of economic value.

Direct losses immediate or first result of insured peril

Insurance loss

Indirect losses consequential losses

Loss of use or secondary result of insured

peril

eg: fire--- destroy--- home direct losses.

Expenses of living in a hotel--- while house is rebuilt indirect losses.

There must be direct loss before there can be indirect loss.

PERIL : it is defined as the cause of loss. Eg. Fire, heart attack, criminals act.
Insurance policies provides financial protection against losses caused by perils.

HAZARDS : are conditions that increases frequency or the severity of losses. Eg.
Poor lighting in a crime prone area.

Moral hazards individual cause loss to collect insurance.

Hazards

Morale hazards attitude of carelessness or indifference to loss

created by the purchase of insurance contract
.eg. person stays unnecessarily in hospital to
collect insurance amt.

CHARACTERISTICS OF INSURABLE LOSS EXPOSURES :

 Risk identification

 Risk measurement

 Physical – automobile

 Financial – mutual

 Life and legal

Characteristics:

 Large group of similar items[house burnt-brick or wood]exposed to

loss.

 Accident losses.

 Losses must be definite and should be measurable.

Physical- can b measured

Health insurance

Mental- difficult in determining