2. introduction to risk and uncertainty

KOLEJ UINIVERSITI ISLAM KOLEJ UINIVERSITI ISLAM ANTARABANGSA SELANGOR (KUIS)ANTARABANGSA SELANGOR (KUIS)

ExerciseExercise• What is Risk Management?What is Risk Management?

• What are the objectives of Risk What are the objectives of Risk Management, pre loss and post loss?Management, pre loss and post loss?

• List down 5 activities of Risk List down 5 activities of Risk ManagerManager


RISK MANAGEMENTRISK MANAGEMENT

2. AN INTRODUCTION TO RISK 2. AN INTRODUCTION TO RISK AND UNCERTAINTY AND UNCERTAINTY


OutlineOutline– Foundation ConceptsFoundation Concepts

CertaintyCertaintyUncertaintyUncertaintyRiskRisk

– Some Further Concept Related to RiskSome Further Concept Related to RiskPure and Speculative RiskPure and Speculative RiskDiversifiable and Nondiversifiable RiskDiversifiable and Nondiversifiable Risk

– Some Further Issues Related to UncertaintySome Further Issues Related to UncertaintyLevel of UncertaintyLevel of UncertaintyUncertainty, Information and CommunicationUncertainty, Information and Communication

– Two Specific Concept Related to UncertaintyTwo Specific Concept Related to UncertaintyAdverse SelectionAdverse SelectionMoral HazardsMoral Hazards

– Managing Risk and UncertaintyManaging Risk and Uncertainty

DEFINITION AND DEFINITION AND CLASSIFICATION OF RISKCLASSIFICATION OF RISK

Definition of RiskDefinition of Risk Risk is defined as Risk is defined as uncertaintyuncertainty concerningconcerning lossloss..

E.g. owning a house expose to the risk of the E.g. owning a house expose to the risk of the house damage due to fire.house damage due to fire.

Definition of UncertaintyDefinition of UncertaintyUncertainty is a state of doubt about our ability to predict Uncertainty is a state of doubt about our ability to predict the future outcome of current actionsthe future outcome of current actions

E.g., if a house-owner is E.g., if a house-owner is uncertainuncertain whether his house will whether his house will catch fire, this reflects his lack of knowledge about the catch fire, this reflects his lack of knowledge about the possibility of his house catching fire in the future.possibility of his house catching fire in the future.

Ahmad Yani Ismail Ahmad Yani Ismail

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UncertaintyUncertainty occurs if at least two occurs if at least two possible outcomes can arise out of possible outcomes can arise out of an event.an event.If one possible outcome, then the If one possible outcome, then the outcome is known for certain, so outcome is known for certain, so there is no risk.there is no risk.


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House - two possibilities (in relation to House - two possibilities (in relation to fire):fire):1.1. Catch fire or Catch fire or uncertainty existsuncertainty exists2.2. May not catch fireMay not catch fire

If the house-owner certain that his house If the house-owner certain that his house will not catch fire because it was entirely will not catch fire because it was entirely built using fire-resistant materials, then built using fire-resistant materials, then there is no risk associated with fire.there is no risk associated with fire.


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Risk vs UncertaintyRisk vs UncertaintyWhen risk is present, outcomes When risk is present, outcomes cannot be forecasted with certainty.cannot be forecasted with certainty.As a result risk gives rise to As a result risk gives rise to uncertainty.uncertainty.


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LossLoss in insurance refers to in insurance refers to insurable lossinsurable loss..Insurable lossesInsurable losses are those losses that can are those losses that can be inssured.be inssured.To be insurable, a loss must meet the To be insurable, a loss must meet the following criteria:following criteria:1.1. Unintentional occurrence and based on Unintentional occurrence and based on

chancechance2.2. UndesirableUndesirable3.3. Results in a reduction of economic value or Results in a reduction of economic value or

financial loss.financial loss.


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Risk exists if there is uncertainty Risk exists if there is uncertainty about the outcome of an event or an about the outcome of an event or an activitiy.activitiy.The greater the number of outcomes The greater the number of outcomes from an event, the greater would be from an event, the greater would be the uncertainty and thus the risk.the uncertainty and thus the risk.E.g. fixed-return investment vs stock E.g. fixed-return investment vs stock investmentinvestment


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Risk is also associated with a Risk is also associated with a possible unfavourable outcome of an possible unfavourable outcome of an event, or possibility of loss.event, or possibility of loss.Unfavourable outcome can be Unfavourable outcome can be described as a deviation from a described as a deviation from a desired outcome.desired outcome.E.g. hoping for car would not be E.g. hoping for car would not be stolen, however the outcome is stolen, however the outcome is undesirable, so risk exists.undesirable, so risk exists.


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Foundation ConceptsFoundation ConceptsDefinition of CertaintyDefinition of Certainty– Certainty Certainty is lack of doubtis lack of doubt– A state of being free from doubtA state of being free from doubt

Definition of UncertaintyDefinition of Uncertainty– Doubt about our ability to predict the future outcome of Doubt about our ability to predict the future outcome of

current actionscurrent actions– UncertaintyUncertainty arises when an individual perceives that arises when an individual perceives that

outcomes cannot be known with certaintyoutcomes cannot be known with certainty– Uncertainty is a state of doubt about our ability to Uncertainty is a state of doubt about our ability to

predict the future outcome of current actionspredict the future outcome of current actions


Definition of RiskDefinition of Risk

–Risk is defined as uncertainty Risk is defined as uncertainty concerning loss.concerning loss.


Risk vs UncertaintyRisk vs Uncertainty

– When risk is present, outcomes cannot When risk is present, outcomes cannot be forecasted with certainty.be forecasted with certainty.

– As a result risk gives rise to uncertainty.As a result risk gives rise to uncertainty.

Classification of RiskClassification of Risk

Risks can be categorized into TWO types Risks can be categorized into TWO types of classifications:of classifications:

1. Pure Risk versus Speculative Risk

2. Diversifiable Risk versus Non-diversifiable Risk.


Pure Risk vs Speculative RiskPure Risk vs Speculative RiskPure Risk Speculative Risk

Pure risk exists when there is uncertainty as to whether loss will occur. A category of risk in which loss is the only possible outcome; there is no beneficial result.

Speculative risk exists when there is uncertainty about an event that could produce either a profit or a loss. A category of risk that, when undertaken, results in an uncertain degree of gain or loss.

• No possibility of gain is presented by pure risk – only the potential for loss.

• Gains as well as losses may occur, changing the nature of the uncertainty that is present.

• Examples :o Home insurance can be used to protect

homeowners from the risk that their homes will be destroyed.

o The uncertainty of damage to property by fire or flood

o The prospect of premature death caused by accident or illness

• Examples:o Business ventureso Investment decisions


Diversifiable vs Non DiversifiableDiversifiable vs Non DiversifiableDiversifiable Risk Non-diversifiable Risk

Risk that is, in the limit, eliminated by combining a large number of assets in a portfolio.

Risk that can be eliminated through diversification.

Also called Unsystematic Risk or controllable risk.

The risk inherent to the entire market or entire market segment.

Also known as "systematic risk" or "market risk."

It results from the occurrence of random events such as labor strikes, lawsuits, or loss of key accounts. Business, liquidity, and default risks fall into this category. It is assumed that any investor can create a portfolio in which this type of risk is completely eliminated through diversification.

For example, a sudden strike by the employees of a company you have shares in, is considered to be an unsystematic risk.

Interest rates, recession and wars all represent sources of systematic risk because they will affect the entire market and cannot be avoided through diversification. Whereas this type of risk affects a broad range of securities, unsystematic risk affects a very specific group of securities or an individual security. Systematic risk can be mitigated only by being hedged.


http://www.answers.com/topic/unsystematic-risk

Some Further Issues Related to UncertaintySome Further Issues Related to Uncertainty

Levels of UncertaintyLevels of UncertaintyUncertainty is doubt about our ability to predict the future.Uncertainty is doubt about our ability to predict the future.Uncertainty arises when an individual perceives riskUncertainty arises when an individual perceives riskParticipating in a business venture, some are very cautious, Participating in a business venture, some are very cautious, others are more aggressive.others are more aggressive.Although risk aversions explains some of the reluctance to Although risk aversions explains some of the reluctance to participate, the level of risk perceived by individual also participate, the level of risk perceived by individual also plays a key role.plays a key role.The perceived level of risk depends on information that an The perceived level of risk depends on information that an individual can use to evaluate the likelihood of outcomes individual can use to evaluate the likelihood of outcomes and, perhaps, on the individual’s ability to evaluate and, perhaps, on the individual’s ability to evaluate informationinformation


The level and type of information on the nature of The level and type of information on the nature of a risky activity have an important effect on a risky activity have an important effect on uncertainty.uncertainty.Our ability to predict the future outcome of an Our ability to predict the future outcome of an action is strongly affected by the amount and action is strongly affected by the amount and type of information available to forecast the type of information available to forecast the consequences of our actions.consequences of our actions.In other words, uncertainties are present in levels In other words, uncertainties are present in levels or degrees as illustrated in table below.or degrees as illustrated in table below.


Level of Uncertainty Characteristics Examples

None (certainty) Outcomes can be

predicted with precision

Physical laws, natural

sciences

Level 1 (objective

uncertainty

Outcomes are identified

and probabilities are

known

Games of chance : cards,

dice, risk of loss of life

Level 2 (subjective

uncertainty)

Outcomes are identified

but probabilities are

unknown

Fire, motor vehicle

accident, many

investments

Level 3 Outcomes are not fully

identified and

probabilities are unknown

Space exploration,

genetic research


Level 1Level 1The lowest level of uncertaintiesThe lowest level of uncertaintiesPossible outcomes have been identified and we Possible outcomes have been identified and we know the likelihood of occurrence.know the likelihood of occurrence.Can be described as Can be described as objective uncertaintyobjective uncertainty..E.g. games of chance, such as cards, dice and the E.g. games of chance, such as cards, dice and the toss of coin are examples of the first level of toss of coin are examples of the first level of uncertaintyuncertaintyIn these games, the outcomes are fixed by the In these games, the outcomes are fixed by the bets of the participants and probabilities are bets of the participants and probabilities are known or can be calculatedknown or can be calculated


Level 2Level 2Also called Also called subjective uncertaintysubjective uncertaintyCharacterises many business ventures, investment projects and Characterises many business ventures, investment projects and insured risksinsured risksE.g. the owner of a vehicle that might be damaged in an accident E.g. the owner of a vehicle that might be damaged in an accident can identify possible outcomes : The vehicle may or may not be can identify possible outcomes : The vehicle may or may not be involved in an accidentinvolved in an accident

Level 3Level 3We are uncertain about the nature of the outcomes themselves, We are uncertain about the nature of the outcomes themselves, which have not been fully identified.which have not been fully identified.E.g. early exploration of space E.g. early exploration of space The nature of all possible outcomes may not be completely The nature of all possible outcomes may not be completely identified prior to undertaking the projectidentified prior to undertaking the project


The response to uncertainty will be partially The response to uncertainty will be partially influenced by the level of uncertainty.influenced by the level of uncertainty.The management of risks falling at Level 1 is The management of risks falling at Level 1 is close to being a science.close to being a science.Most important risks encountered by Most important risks encountered by organizations involve uncertainty levels 2 organizations involve uncertainty levels 2 and 3and 3The organizations must rely on less-than- The organizations must rely on less-than- scientific methods to evaluate and control scientific methods to evaluate and control risks at these levelsrisks at these levels


Uncertainty, Information and Uncertainty, Information and CommunicationCommunication

The reduction of uncertainty has economic value, and the information can The reduction of uncertainty has economic value, and the information can reduce uncertainty.reduce uncertainty.

The level of uncertainty depends on :The level of uncertainty depends on :

– the amount andthe amount and

– the type of information availablethe type of information available

to identify possibles outcomes and estimates their likelihood.to identify possibles outcomes and estimates their likelihood.

Communication can reduce levels of uncertainty in an organization’s Communication can reduce levels of uncertainty in an organization’s stakeholders.stakeholders.Communication between the organization and these stakeholder groups is Communication between the organization and these stakeholder groups is an important part of the manager’s responsibility.an important part of the manager’s responsibility.


By communicating the organization’s policies for managing By communicating the organization’s policies for managing risk, the organization may reduce levels of uncertainty in risk, the organization may reduce levels of uncertainty in these stakeholders, which increases their willingness to these stakeholders, which increases their willingness to deal with the organization on favourable terms.deal with the organization on favourable terms.In the absence of this information, these stakeholders may In the absence of this information, these stakeholders may be uncertain about the nature of the organization’s actions be uncertain about the nature of the organization’s actions with respect to matters affecting their interest.with respect to matters affecting their interest.Their uncertainty leads them to charge a higher price for Their uncertainty leads them to charge a higher price for their goods and services or place restrictions on their their goods and services or place restrictions on their activities that can be detrimental to other stakeholder activities that can be detrimental to other stakeholder groups, especially stockholdersgroups, especially stockholdersIn other words, the organization can provide stakeholders In other words, the organization can provide stakeholders with the assurance that it has not and will not take actions with the assurance that it has not and will not take actions that are detrimental to their interests.that are detrimental to their interests.


Two Specific Concept Related to Two Specific Concept Related to UncertaintyUncertainty

Insurance will be identified as an Insurance will be identified as an arrangement for reducing uncertainty.arrangement for reducing uncertainty.Insurance companies encounter aspects of Insurance companies encounter aspects of risk or uncertainty that are largely unique risk or uncertainty that are largely unique to the insurance arrangement.to the insurance arrangement.Two specific concepts are generally Two specific concepts are generally important to risk management:important to risk management:1.1. Adverse SelectionAdverse Selection2.2. Moral HazardsMoral Hazards


Adverse Selection (Antiselection)Adverse Selection (Antiselection)Adverse selection Adverse selection is the result of insurance is the result of insurance having the greatest appeal to the individuals who having the greatest appeal to the individuals who are likely to have a loss.are likely to have a loss.As a result, the demand for insurance is largest As a result, the demand for insurance is largest for individuals who are most likely to have a loss for individuals who are most likely to have a loss or, more generally, who expect their loss to be or, more generally, who expect their loss to be larger than averagelarger than averageE.g. the demand for health insurance is likely to E.g. the demand for health insurance is likely to be high for an individual who feels in poor healthbe high for an individual who feels in poor health


HazardHazardCondition that increases the likelihood of loss or Condition that increases the likelihood of loss or loss amountloss amountPhysical hazard Physical hazard refers to a physical condition or refers to a physical condition or characteristic such as flammable liquids stored characteristic such as flammable liquids stored near open flamenear open flameMoral hazardMoral hazard describes an effect on an describes an effect on an individual’s behaviourindividual’s behaviourArson would be an extreme example of a moral Arson would be an extreme example of a moral hazard, here, the individual deliberately sets fire hazard, here, the individual deliberately sets fire to collect insurance proceedsto collect insurance proceeds


Managing Risk and UncertaintyManaging Risk and UncertaintyRisk and uncertainty have an important impact Risk and uncertainty have an important impact on organizations.on organizations.Risk and uncertainty result in a cost referred to Risk and uncertainty result in a cost referred to as the as the cost of riskcost of risk..Risk imposes costs on an organization that would Risk imposes costs on an organization that would not be incurred in a world of certaintynot be incurred in a world of certaintyThe most obvious cost is the The most obvious cost is the cost of lossescost of losses, that , that is property is destroyed, a human is injured.is property is destroyed, a human is injured.Second cost of risk is the Second cost of risk is the cost of uncertainty itselfcost of uncertainty itselfEven if no losses occur, the presence of risk and Even if no losses occur, the presence of risk and uncertainty may impose a cost.uncertainty may impose a cost.


At a basic level, risk and uncertainty can lead to worry.At a basic level, risk and uncertainty can lead to worry.Even if the individual never has an motorcar accident, the Even if the individual never has an motorcar accident, the risk of an accident lead to fear, sleepless nightsrisk of an accident lead to fear, sleepless nightsOn the organization level, the cost of uncertainty may On the organization level, the cost of uncertainty may appear in the form of worry or anxiety, but is probably appear in the form of worry or anxiety, but is probably most clearly seen in the misallocation of resources.most clearly seen in the misallocation of resources.This means organizations do not deploy their resources This means organizations do not deploy their resources optimally because uncertainty clouds their judgment, or optimally because uncertainty clouds their judgment, or because the fear of loss discourages investment in certain because the fear of loss discourages investment in certain activities.activities.


Illustration of cost of risk – the reluctance of some Illustration of cost of risk – the reluctance of some pharmaceutical companies to invest in new product pharmaceutical companies to invest in new product development (for fear of product liability suits).development (for fear of product liability suits).Risk and Uncertainty also give rise to benefits. Speculative Risk and Uncertainty also give rise to benefits. Speculative risks can result in positive outcomes in which the risks can result in positive outcomes in which the organization is rewarded for facing the risk.organization is rewarded for facing the risk.Undoubtedly, organizations have motives to address risk Undoubtedly, organizations have motives to address risk and uncertainty and this motivation gives rise to and uncertainty and this motivation gives rise to risk risk managementmanagementAt most basic level, risk management is practiced because At most basic level, risk management is practiced because the negative and positive possibilities of risk – as well as the negative and positive possibilities of risk – as well as moral considerations – provide incentives for an moral considerations – provide incentives for an organization to take steps to minimize the costs of risk organization to take steps to minimize the costs of risk while striving to maximize benefitswhile striving to maximize benefits


Date post:	10-Jul-2015
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2. introduction to risk and uncertainty

Economy & Finance