Unit 1: Concept of risk & risk management
Risk Management and Insurance notes · PTU syllabus (BCOP 622-18)
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Unit summary
Risk is part of every personal and business decision. This unit covers the concepts of risk and uncertainty, types and sources of risk, methods of handling risk, the degree of risk, corporate and personal risk management processes, objectives and techniques of risk management, and the cost of risk.
After this unit you can
- Distinguish risk and uncertainty and classify risks
- Explain methods of handling risk and the degree of risk
- Explain the corporate and personal risk management process and its objectives
- Explain the components of the cost of risk
PTU syllabus topics
- Risk and uncertainty
- types and sources of risk
- methods of handling risk
- degree of risk
- corporate and personal risk management process
- objectives and techniques of risk management
- understanding the cost of risk
Avoid
Do not take the activity
Reduce
Safety measures lower the chance or impact
Retain
Bear small risks yourself
Transfer
Insure or contract it out
Topic 1
Risk and uncertainty
- Risk: the possibility of an adverse deviation from a desired or expected outcome; can be measured with probabilities.
- Uncertainty: a state of doubt about the future where probabilities cannot be estimated (Frank Knight, 1921).
Probability
Known or estimable
Unknown
Measurement
Objective, statistical
Subjective
Insurable
Yes (if conditions met)
No
Example
Probability of a house fire in a city
Impact of a future technology
- Peril: cause of loss (fire, flood, theft). Hazard: condition that increases the chance or severity of loss — physical (faulty wiring), moral (dishonesty), morale (carelessness because insured), legal (court tendencies).
Topic 2
Types and sources of risk
Pure vs speculative
Loss or no loss (insurable) vs loss or gain (investment)
Fundamental vs particular
Group-wide (earthquake, inflation) vs individual (car accident)
Static vs dynamic
Not due to change (fire) vs due to change (new technology)
Personal risks
Premature death, old age, illness, unemployment
Property risks
Direct and indirect (consequential) loss
Liability risks
Legal liability for injury or damage to others
Enterprise risks
Strategic, operational, financial, compliance, reputational
- Sources: physical environment, social environment, political, legal, economic, operational, cognitive (perception errors), technological (cyber).
Topic 3
Methods of handling risk and degree of risk
Avoidance
Do not undertake the activity
Loss control
Prevention (reduce frequency) and reduction (reduce severity)
Retention
Bear the loss — active (planned, deductibles, self-insurance) or passive
Non-insurance transfer
Contracts, hold-harmless clauses, hedging, outsourcing
Insurance
Transfer to an insurer for a premium
Separation and diversification
Spreading exposures
- Degree of risk: the relative variation of actual losses from expected losses — measured by the objective risk formula and standard deviation.
Objective risk
(Actual loss − Expected loss) ÷ Expected loss
Expected loss
Probability of loss × Size of loss
Law of large numbers
As exposures increase, actual loss experience approaches expected loss
Example
An insurer expects 1% of 10,000 houses (100) to burn. If 110 burn, objective risk = 10 ÷ 100 = 10%. With 1,00,000 houses, the relative variation falls — the basis of insurance pooling.
Topic 4
Corporate and personal risk management process
- 1Identify loss exposures
Property, liability, personnel, income
- 2Measure and analyse
Frequency, severity, maximum possible loss
- 3Select techniques
Avoid, control, retain, transfer
- 4Implement the programme
Policies, insurance purchase, safety measures
- 5Monitor and review
Changes in exposures and costs
- Corporate risk management: risk manager, risk policy statement, Enterprise Risk Management (ERM) integrating all risks (COSO, ISO 31000); board-level risk management committee (mandatory for top 1,000 listed companies under SEBI LODR).
- Personal risk management: identify risks to life, health, income, property and liability; use emergency funds, term and health insurance, motor and home insurance, wills.
Objectives
- Pre-loss objectives: economy (lowest cost), reduce anxiety, meet legal obligations (third-party motor insurance, public liability).
- Post-loss objectives: survival, continuity of operations, earnings stability, continued growth, social responsibility.
Topic 5
Understanding the cost of risk
Retained losses
Uninsured and deductible losses
Insurance premiums
Net of commissions/rebates
Loss control costs
Safety equipment, training, sprinklers
Administrative costs
Risk management department, consultants
Indirect costs
Business interruption, lost customers, reputational damage, higher cost of capital
- Cost of risk ratio = Total cost of risk ÷ Revenue — used to benchmark risk management performance.
- Risk management aims to minimise the total cost of risk, not to eliminate risk entirely.
Exam tip
Use the frequency–severity matrix — retain (low/low), reduce (high/low), transfer (low/high), avoid (high/high) — to conclude any risk-handling answer.
Key terms
- Risk
- Possibility of an adverse deviation from the expected outcome
- Hazard
- Condition increasing the likelihood or severity of loss
- Pure risk
- Risk with only loss or no loss outcomes
- Retention
- Bearing a loss oneself
- Cost of risk
- Total of retained losses, premiums, loss control and administrative costs
Quick revision
- Risk measurable; uncertainty not.
- Peril vs hazard (physical, moral, morale).
- Types: pure/speculative, fundamental/particular, static/dynamic.
- Handling: avoid, control, retain, transfer, insure.
- Process: identify → measure → select → implement → monitor; minimise cost of risk.
Important exam questions
Practice questions written to the PTU exam pattern for this unit's syllabus: short answers (Section A style) and long answers (Sections B and C style).
Short-answer questions
- Q1.Distinguish risk and uncertainty.
- Q2.What is moral hazard?
- Q3.What is a pure risk?
- Q4.State the methods of handling risk.
- Q5.What is the law of large numbers?
- Q6.What is the cost of risk?
Long-answer questions
- Q1.Explain the concept and classification of risk.
- Q2.Explain the methods of handling risk with the frequency–severity matrix.
- Q3.Explain the corporate and personal risk management process and its objectives.
- Q4.Explain the components of the cost of risk.
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