1. PBBF 303: RISK MANAGEMENT AND INSURANCE
LECTURE TWO
VARIOUS CATEGORIES OF RISK

2. Types of Pure Risk
Major types of pure risk that can create great financial insecurity include
Personal risks
Property risks
Liability risks

3. Personal Risks
Personal risks are risks that directly affect an individual. They involve the possibility of the loss or reduction of earned income, extra expenses and the depletion of financial assets. There are four major personal risks.
Risk of premature death
Risk of insufficient income during retirement
Risk of poor health
Risk of unemployment

4. Risk of Premature Death
Risk of premature death: Premature death is defined as the death of a family head with unfulfilled financial obligations.
These obligations can include dependents to support, a mortgage to be paid off, or children to educate.
If the surviving family members receive an insufficient amount of replacement income from other sources or have insufficient financial assets to replace the lost income, they may be financially insecure.

5. Risk of Insufficient Income During Retirement
The major risk associated with old age is insufficient income during retirement. The vast majority of workers in Ghana retire at the age of 60. (exceptions are doctors and judges)
When they retire, they lose their earned income. Unless they have sufficient financial assets on which to draw, or have access to social security or private pension, they will be exposed to financial insecurity during retirements.
Majority of workers experience a substantial reduction in their money incomes when they retire. In addition, most workers are not saving enough for a comfortable retirement.

6. Risk of Poor Health
Poor health is another important personal risk. The risk of poor health includes both the payment of catastrophic medical bills and the loss of earned income. The costs of major surgery have increased substantially in recent years. Example, an open heart operation can cost more than $300,000.
Unless one has adequate health insurance (not the Ghanaian health insurance, because it does not cater for certain ailment), private savings and financial assets, or other sources of income to meet these expenditures, you may be financially insecure.
The loss of earned income is another major cause of financial insecurity if the disability is severe.

7. Risk of Unemployment
The risk of unemployment is another major threat to financial security. Unemployment can result from business cycle downswings, technological and structural changes in the economy, seasonal factors, and imperfection in the labour market.
Several important trends have aggravated the problems of unemployment. To hold down labour costs, larger corporations have downsized, and their workforce has been permanently reduced; employers are increasingly hiring temporary or part- time workers to reduce labour costs; and millions of jobs have been lost to foreign nations because of outsourcing.
Regardless of the reason, unemployment can cause financial insecurity in at least three ways.

8. Cont.
1. Workers lose their earned income and employees benefits. Unless there is adequate replacement income or past savings on which to draw, the unemployed worker will be financially insecure.
2. Because of economic conditions the workers may be able to work only part-time. The reduced income may be insufficient in terms of the worker’s needs.
3. If the duration of unemployment is extended over a long period, past savings and unemployment benefits may be exhausted.

9. PROPERTY RISKS
Persons owning property are exposed to property risks- the risk of having property damaged or lost from numerous causes.
Real estate and personal property can be damaged or lost from numerous causes. These can be damaged or destroyed because of fire, lightening, windstorms, and numerous other causes.
There are two major types of loss associated with the destruction or theft of property; direct loss and indirect or consequential loss.

10. LIABILITY RISKS
Liability risks are another important type of pure risk that most persons face. Under our legal system, you can be held legally liable if you do something that results in bodily injury or property damage to someone else.
Business firms can be held legally liable for defective products that harm or injure customers; physicians, attorneys, accountants, engineers and other professionals can be sued by patients and clients because of alleged acts of malpractice.
Liability risks are of great importance for several reasons.

11. Cont.
First, there is no maximum upper limit with respect to the amount of loss
A lien can be placed on your income and financial assets to satisfy a legal judgement. E.g if you injure someone, and a court of law orders you to pay damages to the injured party. If you declare bankruptcy to avoid payment of judgment, your credit rating will be impaired.
Finally, legal defence costs can be enormous. If you have no liability insurance, the cost of hiring an attorney to defend you can be staggering. If the suit goes to trial, attorney fees and other legal expenses can be substantial.

12. RISK AFFECTING FINANCIAL INSTITUTIONS

13. Credit Risk
Also known as default risk. According to Sinkey (2002), credit risk is the uncertainty associated with borrowers’ repaying their loans. Credit risk is the first of all risks in terms of importance (Bessis, 2002) for banks and financial institutions.
Default risk, a major source of loss, is the risk that customers default, meaning they fail to comply with their obligation to service debt. Default triggers a total or partial loss of any amount lent to the counterparty.
If the principal on all financial claims held by FIs was paid in full on maturity and interest payments were made on the promised dates, FIs would always receive back the original principal lent plus an interest returns. That is, they would face no credit risk (Saunders &Cornett, 2011)

14. Country or Sovereign Risk
Bessis (2002) defines country risk loosely speaking as, the risk of a ‘crisis’ in a country. There are many risk related to local crises, including:
Sovereign risk, which is the risk of default of sovereign issuers, such as central banks or government sponsored banks. The risk of default often refers to that of debt restructuring for countries.
Saunders &Cornett (2011), country or sovereign risk is a different type of credit risk that is faced by FI that purchases assets such as the bonds and loans of foreign corporations.

15. Cont.
The impossibility of transferring funds from the country, either because there are legal restrictions imposed locally or because the currency is not convertible any more.
Convertibility or transfer risks are common and restrictive definitions of country risk.
Country risk also called political risk, is the uncertainty of returns caused by the possibility of a major change in the political or economic environment of a country.

16. Liquidity Risk
Bessis (2002) posit that liquidity risk refers to three (3) multiple dimensions: inability to raise funds at normal cost; market liquidity risk and asset liquidity risk.
a) Funding risk depends on how risky the market perceives the issuer and its funding policy to be. An institution coming to the market with unexpected and frequent needs for funds sends negative signals, which might restrict the willingness to lend to this institution.

17. Cont.
The cost of funds also depends on the bank’s credit standing. If the perception of the credit standing deteriorates, funding becomes more costly.
b) The second dimension which is the liquidity of the market relates to liquidity crunches because of lack of volume.
Prices become highly volatile, sometimes embedding high discounts from par, when counterparties are unwilling to trade.

18. Cont.
Funding risk materializes as a much higher cost of funds, although the cause lies more with the market than the specific financial institution. Market liquidity materializes as an impaired ability to raise money at a reasonable cost.
C) Asset liquidity risk results from lack of liquid related to the nature of assets (etc. mortgage) rather than to the market liquidity.

19. Cont.
Holding a pool of liquid assets acts as a cushion against fluctuating market liquidity, this is because liquid assets, allows the meeting of short-term obligations without recourse to external funding, thus, the rationale for banks to hold a sufficient fraction of their balance sheet as liquid assets (a regulatory rule).
The ‘liquidity ratio’ of banks makes it mandatory to hold more short-term assets than short-term liabilities, in order to meet short-run obligations.

20. Cont.
Liquidity risk might become a major risk for the banking portfolio.
Extreme lack of liquidity results in bankruptcy, making liquidity risks a fatal risk. However, extreme conditions are often the outcome of other risks. Important unexpected losses raise doubts with respect to the future of the organization and liquidity issues.
When a commercial bank gets into trouble, depositors “run” to get their money back. Lenders refrain from further lending to the troubled institution. Massive withdrawals of funds or the closing of credit lines by other institutions are direct outcomes of such situations. A brutal liquidity crisis follows, which might end up in bankruptcy (Bessis, 2002).

21. Interest Rate Risk
The interest rate risk is the risk of a decline in earnings due to the movements of interest rates.
Most of the items of banks balance sheets generate revenues and costs that are interest rate driven. Since interest rates are unstable, so are earnings.
Anyone (especially banks) who lends or borrows is subject to interest rate risk. The lender earning a variable rate has the risk of seeing revenue reduced by a decline in interest rates. The borrower paying a variable rate bears higher costs when interest rates increase.

22. Cont.
Both positions are risky since they generate revenues or costs indexed to market rates. The other side of the coin is that interest rate exposure generates chances of gains as well (Bessis, 2002).

23. Market Risk
Market risk is the change in net asset value (the value of an entity asset less the value of its liabilities) due to changes in underlying economic factors such as interest rates, exchange rates and equity and commodity prices (Pyle, 1997).
Market risk arises when FIs actively trade assets and liabilities (and derivatives) rather than hold them for longer-term investment, funding or hedging purposes.
The risk incurred in the trading of assets and liabilities due to changes in interest rates, exchange rates, and other asset prices.

24. Off-Balance Sheet Risk
Large banks invest heavily in off-balance sheet assets and liabilities, particularly derivatives securities and letters of credit
The risk incurred by a FI due to activities related to contingent (dependent/ conditional) assets and liabilities.
A letter of credit is a credit guarantee issued by an FI for a fee on which payment is contingent on some future event occurring.

25. Foreign Exchange Risk
Currency risk is the risk of incurring losses due to changes in the exchange rates.
Variations in earnings result from the indexation of revenues and changes to exchange rates or of changes of the values of assets and liabilities denominated in foreign currencies.
Foreign exchange risk is a classical field of international finance.

26. Cont. Exposure of exchange rate fluctuations comes in three forms:
1. Transaction exposure
2. Economic exposure
3. Translation exposure

27. Transaction Exposure
Transaction exposure is the degree to which the value of future cash transactions can be affected by exchange rate fluctuations.
The value of a firm’s cash inflows received in various currencies will be affected by the respective exchange rates of these currencies when they are converted into the currency desired.

28. Economic Exposure
The degree to which a firm’s present value of future cash flows can be influenced by exchange rate fluctuations is referred to as economic exposure to exchange rates.
All types of transactions that cause transaction exposure also cause economic exposure because these transactions represent cash flows that can be influenced by exchange rate fluctuations.

29. Translation Exposure
The exposure of the MNC’s consolidated financial statements to exchange rate fluctuations is known as translation exposure.
An MNC creates its financial statements by consolidating all of its individual subsidiaries financial statements. A subsidiary’s financial statement is normally measured in its local currency.
To be consolidated, each subsidiary’s financial statement must be translated into the currency of the MNC parent. Since exchange rates change over time, the translation of the subsidiary’s financial statement into different currency is affected by exchange rate movements.

30. Solvency Risk
Solvency risk is the risk of being unable to absorb losses, generated by all types of risks, with the available capital. Solvency is a joint outcome of available capital and of all risks.
The basic principle of ‘capital adequacy promoted by regulators is to define what level of capital allows a bank to sustain the potential losses arising from all current risks and complying with an acceptable solvency level.
The capital adequacy principle follows the major orientations of risk management.

31. Operating Risk
The Basel Committee on Banking Supervision (2001) defines operational risk as, the risk of direct or indirect loss resulting from inadequate or failed internal processes, people and systems or from external events”.
This class of risks has unlimited downside and can expose a financial institution to serious financial and reputational losses.

32. Underwriting Risk Underwriting Risk/ Insurance Technical Risk
These are the risks undertaken by insurance companies through the contracts they underwrite.
The risks within this category are associated with the perils covered and with the specific processes associated with the conduct of insurance business.

33. Cont.
They include underwriting process risk (financial loss related to selection and approval of risk to be insured),
Pricing risk (financial loss due to insufficient premium charged for a risk undertaken),
Product design risk (exposure to events not anticipated in the design and pricing of the insurance contracts), and
Claims risk (more than expected number of claims arising) amongst many others.