Module 1

Concept of Risk
People express risk in different ways. To some it the chance or possibility of loss, to
others it may be uncertain situations or deviations or statisticians call dispersion from the
expectations. However in most terminology the tern risk includes exposure to adverse
situations.
According to dictionary meaning “it is the possibility that something unpleasant or
dangerous might happen”
Risk is a condition in which there is a possibility of an adverse deviation from a desired
outcome that is expected or hoped for
Risk may be objective or subjective. Objective risk is defined as the relative variation of
actual loss from the expected loss. Eg. Assume that a property insure has 10000 houses
insured and expected that 100 house burn every year, but only actual occurrence differ in
each year
Subjective risk is uncertainty based on person’s menatal condition or state of mind. Eg .
The possibility of arrest by police when the driver has taken alcohol.
Thus there is no single definition of risk, economists, risk theorist, statisticians and
actuaries have their own definition of risk
But in most of the risky situation two elements are common
1. The outcome is uncertain. ie there is a possibility that one or other may occur
2. Out of the possible outcome, one is unfavorable or not liked by individuals
Risk and Uncertainty
 Introduction
In our day to day life, there are many circumstances,
where we have to take risks, which involves exposure to
lose or danger.
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.
So, in short, risk describes a situation, in which there is a
chance of loss or danger. Conversely, uncertainty refers to
a condition where you are not sure about the future
outcomes.
We use the terms risk and uncertainty in a single breath,
but there is a difference between them
 Definition of Risk
In the ordinary sense, the risk is the outcome of an action taken or not
taken, in a particular situation which may result in loss or gain. It is
termed as a chance or loss or exposure to danger, arising out of
internal or external factors, that can be minimized through preventive
measures.

In the financial glossary, the meaning of risk is not much different. It

implies the uncertainty regarding the expected returns on the
investments made i.e. the probability of actual returns may not be
equal to the expected returns. Such a risk may include the probability
of losing the part or whole investment. Although the higher the risk,
the higher is the expectation of returns, because investors are paid off
for the additional risk they take on their investments. The major
elements of risk are defined as below:

 Systematic Risk: Interest Risk, Inflation Risk, Market Risk, etc.

 Unsystematic Risk: Business Risk and Financial Risk.
 Uncertainty
 Uncertainty is always confused with risk. Uncertain refers to a situation where the
outcome is not certain or unknown. It is characterized by doubt, based on the lack of
knowledge about what will or will not happen in future.
 Uncertainty is opposite of certainty where are assure of outcome of what will happen
 Decision under uncertain situations is very difficulty for the decision maker . It all
depends upon the skill, the judgement and luck.
 Uncertainty being a perceptual phenomenon implies different degrees to different
person. Eg. A student who studied well and wrote the examination, the unceratinity
of the result is different to that of a student who did study well
 By the term uncertainty, we mean the absence of certainty or something which is not
known. It refers to a situation where there are multiple alternatives resulting in a
specific outcome, but the probability of the outcome is not certain. This is because of
insufficient information or knowledge about the present condition. Hence, it is hard to
define or predict the future outcome or events.

 Uncertainty cannot be measured in quantitative terms through past models.

Therefore, probabilities cannot be applied to the potential outcomes, because the
probabilities are unknown
Comparison Chart

Comparison
Basis for Comparison Risk Uncertainty

The probability of Uncertainty implies a

winning or losing situation where the
Meaning
something worthy is future events are not
known as risk. known.

Ascertainment It can be measured It cannot be measured.

Chances of outcomes are The outcome is

Outcome
known. unknown.

Control Controllable Uncontrollable

Minimization Yes No

Probabilities Assigned Not assigned

 Key Differences Between Risk and Uncertainty
 The difference between risk and uncertainty can be drawn clearly on the
following grounds:

 The risk is defined as the situation of winning or losing something worthy.

Uncertainty is a condition where there is no knowledge about the future
events.
 Risk can be measured and quantified, through theoretical models.
Conversely, it is not possible to measure uncertainty in quantitative terms,
as the future events are unpredictable.
 The potential outcomes are known in risk, whereas in the case of
uncertainty, the outcomes are unknown.
 Risk can be controlled if proper measures are taken to control it. On the
other hand, uncertainty is beyond the control of the person or enterprise,
as the future is uncertain.
 Minimization of risk can be done, by taking necessary precautions. As
opposed to the uncertainty that cannot be minimised.
 In risk, probabilities are assigned to a set of circumstances which is not
possible in case of uncertainty.
 Loss and Peril
 A risk refers to a situation where there is
possibility of loss
 In accounting loss means that portion of the
expired cost for which no compensating value
has been received
 From insurance perspective, it is the probability
of loss that essentiates the need for insurance
 Peril refers to the cause of loss or the
contingency that may cause a loss. It means the
serious and immediate danger.Peril refers to the
immediate cause of loss . Eg Fire may affect the
assets like building , automobile, machinery ect
 Hazards
 Hazards are conditions that affect the severity of loss or conditions
affecting peril. Economic slow down is a peril that may cause a loss
the business, but it is also hazard that may cause a heart attack or
mental shock to the proprietor of the business. Hazards can be
classified as
 Physical Hazard: Property conditions –consists of those physical
propertis that increase the chance of loss from the various perils.Eg.
Stocking crackers in a packed commercial complex increases the
peril of fire
 Intangible Hazard :Attitues and Culture- More of less
psychological in nature and can be classified as
– Moral Hazard: Fraud- Increase in the possibility of loss emanating from the
intention to deceive or cheat. Eg Putting fire to a factory running in loss
– Morale Hazard: Indifference- Attitude of indifference to take care of the
property on the premises that the loss will be indemnified by insurance company.
Eg smoking in an oil refinery, careless driving
– Societal Hazard: Legal and Cultural-refers to the increase in the frequency
and severity of the loss arising from legal doctrines or societal customs and
culture. Eg Construction of the possibility of demotion of building in unauthorized
colonies