Classification of Risk

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 Risk can be classified as under

• 1. Personal, property and liability risk

• i. Personal: Potential loss to the persons.

• ii. Property: Potential loss to the property.

• iii. Liability Risk: Potential liability for any individual or institution.

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 2. ) Physical, social or market risk
• i. Physical: Storm, Tempest, Flood, Hurricane and such other
natural calamities.

• ii. Social: Riot, Strike, Civil Commotion, Burglary, Theft etc.

• iii. Market: The price reduction or the purchase and sale constraints
are involved.

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 3. Static Risk and Dynamic Risk
Static Risk
• Definition: Static risks are those that are constant over time and do not
change. They are predictable and can often be measured and mitigated
effectively.
• Characteristics:
• Predictability: Static risks remain relatively stable and can be forecasted based on
historical data.
• Examples: Natural disasters like earthquakes, hurricanes, or floods; health risks like
genetic disorders.
• Mitigation: These risks are often managed through insurance, engineering controls,
safety protocols, and contingency planning.

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 Dynamic Risk
• Definition: Dynamic risks are those that change over time and are influenced
by various factors such as economic conditions, technological
advancements, regulatory changes, and societal trends.
• Characteristics:
• Variability: Dynamic risks can fluctuate and evolve, making them harder
to predict and manage.
• Examples: Market risks due to economic fluctuations, political risks due
to changes in government policies, cybersecurity threats due to
technological changes.
• Mitigation: These risks require ongoing monitoring, flexible strategies,
adaptive risk management plans, and continuous improvement
processes.
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 Key Differences
• Nature: Static risks are more predictable and stable,
while dynamic risks are unpredictable and variable.
• Management: Static risks often rely on established
methods and historical data for management, whereas
dynamic risks require adaptive and proactive strategies.
• Examples: Static risks include natural disasters and
health risks, while dynamic risks include market
fluctuations and technological threats
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 4. Fundamental risks and Particular risks
• Fundamental risks. These risks affect a large number of people or the entire
economy and are often caused by
1. Social Factors = Crime rate, Workplace health and safety, Pandemics, Physical
security, Cyber security, Demographic shifts, Labor issues, Human rights violations,
Corruption, Public health issues
2. Economic = Liquidity risk, Interest rate risk, Credit risk, Currency risk etc.
3. Natural factors.= Earthquakes, hurricanes, floods
These risks are generally beyond the control of individuals or businesses and require
collective action to manage.
Widespread Impact: Fundamental risks affect large groups or entire communities.
Management: These risks are typically managed through public policy, government
intervention, social insurance programs, and large-scale disaster preparedness plans.

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 Particular risks: Are risks that affect specific individuals or
businesses. These risks are often unique to the particular
circumstances of the individual or entity and are usually not caused by
broader social or economic factors.
Characteristics:
• Localized Impact: Particular risks affect specific individuals or
entities rather than a large group.
• Examples: Car accidents, house fires, business failures, theft, and
personal liability risks.
• Management: These risks are managed through private insurance,
personal risk management strategies, business contingency plans,
and other individual protective measures.
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 Key Differences
• Scope: Fundamental risks have a broad impact affecting many
people or the entire economy, while particular risks are more
localized and affect specific individuals or businesses.
• Causes: Fundamental risks arise from large-scale social, economic,
or natural factors, whereas particular risks are often due to specific
circumstances or actions.
• Management: Fundamental risks require collective solutions and
often involve government intervention, while particular risks are
typically managed through private means such as insurance and
individual risk management strategies.

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 (5) Pure Risk and Speculative Risk
• Pure Risk :Pure risk involves situations where there is only a possibility of loss
or no change but there is no potential for gain. These risks are typically
insurable because they are predictable and measurable.
Characteristics:
• Outcome: The outcomes of pure risk are either a loss or no change.
• Examples: Natural disasters (earthquakes, floods), illnesses,
accidents(Automobile drivers always face the risk of accidents), theft, and
fires.
• Management: Pure risks are often managed through insurance, safety
measures, and loss prevention strategies.
•
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 Classes of Pure Risks
A) Personal Risks - These are the basic pure risks which an individual
has to face. They are: Premature death, Dependent, old age, Sickness
or disability ,Unemployment.
B) Property Risks – These risks are not individual in nature but involve
property losses direct or consequential .These are:
▪ The loss of the property,
▪ Loss of use of the property and
▪ Additional expenses occasioned by the loss of the property

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• C) Liability risks- The basic cause of the liability risk is the
unintentional injury to other persons or damage to their
property through negligence or carelessness. e.g. Product
Liability, Directors and officers liability, Doctors Indemnity
policy,Cyber Crimes liability, Pollution Liability.

• D) Risks arising from failure of others – There are certain

risks which exist due to failure of another person to meet an
obligation e.g W.C. Policy, Motor T.P liability.

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 Speculative Risk
In subjective risk 'the uncertainty of an event as seen or perceived by
an individual‘ when its accuracy cannot be measured.
These risks are typically not insurable because individual has a
possibility of loss, no change, or gain.
There are following two common impediments:
▪ Insufficiently large samples (that is, the available details of past
experience are based on only a small number of exposure units).
▪ Changes in risk factors that cast doubts on the usefulness of past
experience as a guide to the future.
• There is no alternative but to draw on one's experience and
judgment to interpret data available and to analyze loss trends to
arrive at subjective probability estimates.
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• Characteristics:
• Outcome: The outcomes of speculative risk uncertain ,i.e.
there can be a loss, no change, or a gain.
• Voluntary: People or businesses typically take on
speculative risks by choice, often in pursuit of profit or
growth
• Associated with investment and business activities:
Common in financial and entrepreneurial decision
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•Stock Market Investment:
•Buying shares of a company involves speculative risk because
the stock price may rise (profit), fall (loss), or stay the same (no
change).
•Real Estate Investment:
•Purchasing property to rent out or sell later involves speculative
risk. The property value may appreciate (profit), depreciate
(loss), or remain stable.
•Starting a New Business:
•Launching a new company is speculative since the business
might succeed (gain profits), fail (result in losses), or break
even.
•Foreign Exchange Trading:
•Engaging in currency trading carries speculative risk due to
fluctuating exchange rates, which can result in gains or losses.
•Cryptocurrency Investments:
•Buying cryptocurrencies is a speculative risk because their values are
highly volatile, offering potential for significant gains or losses.
•Venture Capital:
•Investing in startups involves speculative risk as the business could
grow exponentially (gain) or fail entirely (loss).

•Management: Speculative risks are managed through careful planning,

diversification, market analysis, and risk-reward assessments
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 Key Differences
• Nature of Outcomes: Pure risk only involves the potential
for loss or no change, while speculative risk involves the
potential for loss, no change, or gain.
• Insurability: Pure risks are typically insurable because they
are more predictable and measurable, whereas speculative
risks are generally not insurable due to their inherent
uncertainty and potential for profit.
• Examples: Pure risks include natural disasters, health issues,
and accidents. Speculative risks include financial
investments, business ventures, and gambling.
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• Thus the risks faced by the business enterprise fall into three
main categories:
• a) Those which are at least partially manageable by
management such as physical damage, liability etc
• b) Those directly controllable by management including
risks normally associated with commercial management
such as staff selection and control
• c) Those which are not under the direct control of
management but which may be manageable to some degree
or other such as the social, political and physical
environment.
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 Classification of Risk by size of loss
• Risks can be classified according to potential loss severity as
follows;
• Class I (Low)-Those losses which do not disturb a firm's
basic finance.
• Class II (Moderate)-Those losses which would necessitate
borrowing for additional finance.
• Class III (Severe) - Large losses which might bankrupt the
firm.
• Class I and Class II risks can be handled by the firm
internally and Class III risks are usually transferred to an
insurer.
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 Attitudes towards the Risk
• “Attitude” is defined as “chosen state of mind, mental view
with regard to a fact or state”, then combining the two words
risk and attitude gives a working definition of “risk attitude”
as “chosen state of mind with regard to risk.” i.e. how
individual perceives the risk is termed as attitudes to Risk .

• When risk cannot be measured objectively with a high

degree of accuracy, individual judgment and attitudes enter
into the process.
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• One person may be very cautious and averse to taking chances,
whereas another may be highly optimistic regarding uncertain
outcomes: the former is likely to arrive at higher loss probability
estimates than the latter.

• Attitude to risk influences not only subjective estimates of

probability but also risk handling decisions.

• Someone who is strongly averse to accepting even the smallest

degree of risk may choose to insure, whereas a less risk averse
individual may be prepared to carry the risk himself.
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 Factors affecting risk attitude
• Many researchers have investigated the demographic
characteristics, personality traits, and environmental
conditions determines person's reaction to risk.
• These investigations have contributed substantially to the
understanding of how persons behave in a situations
involving risk.
• They suggested that such behavior is extremely complex,
depending upon number of factors and varying over time.
• They also indicate that a person may react differently to
financial risks than to physical and social risks.
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• Studies have also indicates that risk taking ability varies with
gender, age, intellectual level, education, etc.
• One extremely interesting and important finding is that
individuals tend to be more willing to accept risk after they
participate in a group facing the same risk than they would
have previously as individuals.
• Consequently group (for example, committee) decisions tend
to be riskier than the average decision made by the members
of the group prior to their group experience.

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 Categories of Risk Attitude
Risk Neutral
• The risk neutral person reacts to risk in line with its
statistical probability i.e. with the likelihood of its
occurrence.
• He tries to neutralize or balance the chance of a loss
against the chance of gain e.g. if he has to bet on the
result of a match between two teams, he will bet
equal amounts on both the teams.
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• The risk preferer actually welcomes the
existence of risk and uncertainty. He is willing to
take chance of gain against the odds posed by
risks.
• The risk averter is the one normally frightened
by risk and does not like to live with uncertainty.
• He would rather pay for certainty and will even
pay for changing uncertainty into certainty, e.g.
payment of premium to insurer for the
assurance of loss compensation.
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 Acceptable Versus Unacceptable Risks
There are two elements of uncertainty which are:
• (a) The likelihood of the event occurring.
• (b) The size of the ensuing loss.

• These two elements make a risk either acceptable or unacceptable to a risk

manager.
For a firm, beyond a certain size of loss, the risk becomes unacceptable and
ways will be sought to avoid, reduce or transfer that risk.
In this concept of defining acceptable and unacceptable risks on the basis of size
of loss two factors are to be considered.

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• i) Time factor - The size of loss that could be absorbed by,
say, one year's profits would normally be far larger than
could be accommodated within one month's operating
budget

• ii) Cost of handling risk - If loss reduction measures

would greatly exceed the expected reduction in losses, or
if the premium required by insurers is deemed high
relative to the risk that would be transferred, then no
attempt may be made to reduce the risk or insure it.
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 Risk/Loss Costs
• The costs incurred by the existence of risk can be identified in three separate
areas:
1. Cost of the loss: (Insured bears)
• This includes both direct and indirect costs.
▪ Direct Costs-In industrial accidents the compensation payable to
employees, repair or replacement of to machinery, equipment, loss of
production directly attributable to the accident,third party
compensation and accident investigation expenses etc.

▪ An explosion in a factory may cause extensive damage to surrounding

properties and injuries to members of the public. Even if there is no
legal compulsion to compensate injured third parties, the company
may feel it as its moral obligation to do so in keeping better public
relations.
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▪ Indirect Costs –
• In the industrial accidents, it may happen that employees may either
stop work for a short time or their work rate may slow down.
• A poor accident record is likely to have its effect on the morale of
workers with a consequent drop in productivity and increase in inferior
production.
• Wear and tear on other vehicles and time lost by other drivers attending
the scene of the accident.
• A serious fire may close down a factory with a consequent loss of
employment not only for those who worked there, but also amongst its
suppliers and local trade man.
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• 2. Risk Handling Costs(For Insurer)
• Expenses associated with managing and mitigating the risks
that insurers take on when providing insurance coverage.
1.Underwriting Costs: Expenses related to evaluating and
selecting which risks to insure. This includes the cost of
gathering information, assessing risk levels, and setting
appropriate premiums.
2. Claims Handling Costs: Costs incurred in the process of
managing and paying out claims. This includes the
administrative expenses of processing claims, investigating
claims for validity, surveyors fee and legal fees if disputes arise.
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3. Loss Prevention and Control: Expenses related to programs and
initiatives aimed at reducing the likelihood or severity of losses. This
might involve safety inspections, risk assessments, and client
education programs.
4. Opportunity costs- Management and staff time spent of dealing
with risks. These resources cannot be devoted to other activities, and
the cost of avoiding a risk may be a loss of revenue derived from the
particular activity involved.
5. Reinsurance Costs: Premiums paid to other insurers to share the
risk. This helps insurance companies manage their exposure to large
losses.
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6. Regulatory Compliance: Costs associated with adhering to
laws and regulations governing the insurance industry. This
includes the expenses of licensing, reporting, and audits.
7. Operational Costs: General administrative expenses, such
as salaries, office space, technology, and other overheads
necessary for the day-to-day operations of an insurance
company.
8. Capital Costs: Costs related to maintaining the necessary
financial reserves to ensure that the insurer can pay claims.
This includes the cost of capital and any financing expenses.

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3. Costs imposed by risk:
In uncertain world, individuals pay amounts in excess of the
sums which they stand to lose in the long term i.e. over their
lifetime. This is known as the expected value of loss.

The cost of risk is, thus, dependent on three variables, viz.

a) Risk control measures.
b) Uninsured losses.
c) Insurance.

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 Private and Social cost
1. Private costs are those costs necessarily incurred by the individual firm
engaging in a particular activity. A manufacturing company bears direct cost
raw materials, labour and other utility services.
2. Social costs, as referred by economists, are those which fall on
community at large arising out of that activity.

• If during manufacturing process, it discharges untreated effluents into nearby

area or discharge smoke into the air, the ensuing loss of amenities, additional
clearing costs etc will fall upon the surrounding community.
• Prevailing law as applicable at the location of the activity whether the
company has to pay for these if they form part of the Private costs.

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 Ways of Handling Risk
• They include avoidance, risk reduction, risk retention, combination,
transfer, hedging, and research.

1. Avoidance
▪ Avoidance involves ceasing to undertake the activity which creates
the risk or performing it in another way or at some other place.
▪ E.g. the potential consequences of an escape of a highly toxic gas
may be so catastrophic that a chemical company may decide to
avoid the risks by ceasing to produce or use it.
▪ A risk of damage by flooding may be avoided by moving to another
site well above recorded flood levels.
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 2. Risk Reduction and loss prevention
• Methods employed to reduce either the probability of loss-
producing events occurring, or the potential size of losses that do
occur.
Contingency planning, that is, planning to minimise the extent of losses
caused by the occurrence of a loss producing event.
▪ Using safety devices
▪ Training people to deal promptly with emergencies and to carry out
salvaging operations.
▪ Panning to ensure that any interruption to the business is kept to a
minimum; for example, arrangements may be made for alternative
power
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 3.Risk Retention
Retention Means to pay for small losses from own resources or possibly to
set aside a contingency fund to meet large losses.
Retention of risks may be either a deliberate decision or inadvertent
omission. The risk may be retained when
▪ The established risk levels of identified risks are in the ‘Low’ category, or it
is decided that the risk is otherwise acceptable; no risk treatment may be
required.
▪ e.g. the risk that a project might be terminated following a change of
government is not within the control of the organisation.
▪ The cost treatment, including insurance costs may be so excessive
compared to the benefit that acceptance is the only option.
▪ This applies particularly to lower ranked risks

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 4.Combination
▪This works on the principle of law of large numbers.
▪By combining a large number of independent exposure units in one portfolio,
large diversified organisations can reduce the variations of its aggregate actual
losses from the expected losses for any one year.
▪Insurance companies do precisely the same thing.
5. Risk Transfer
•This is accomplished by contractually transferring the risk to another entity.
a)Buying insurance
b)Contractually transferring the risk. A firm may seek to transfer the activity
which creates the risk e.g.a civil engineering contractor may sub-contract
particular hazardous jobs.
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 6.Hedging
▪ Hedging is normally done through forward contracts as illustrated in the
following examples.
▪ A firm may agree to sell at a fixed price the product at a future date and
reduce the risk of increase in price of raw materials in future by entering into a
forward contract with raw material suppliers.
▪ An importer may hedge against exchange rate fluctuations by entering into
forward contracts.
7.Research : Research designed to improve the information on which decision are
taken can help to reduce risk.
▪ A firm thinking of marketing a new product may seek to reduce the
uncertainty by conducting marketing research.
▪ However under the limitations of such research there can be no guarantee
that actual outcomes will match the expected.
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 Conclusion

▪ Generally, in practice, two or more methods may be employed in

handling any risk. For example, loss prevention and insurance are
usually complements.
▪ Although a firm may spend large sums on trying to reduce the
incidence and severity of industrial accidents it is still likely to insure
the employers' liability risk.
• In India public liability insurance is compulsory for those who deals
in hazardous goods, and certain loss prevention measure must be
taken to comply with the provisions of the Factories Act.

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 THANKS

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