PBBF 303: RISK MANAGEMENT AND INSURANCE

LECTURE TWO

VARIOUS CATEGORIES OF RISK

1

Major types of pure risk that can create great financial insecurity include

Personal risks

Property risks

Liability risks

2

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

3

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.

4

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.

5

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 as a result of severe disability can be another major cause of financial insecurity.

6

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.

7

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.

8

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.

9

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.

10

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.

11

RISK AFFECTING FINANCIAL

INSTITUTIONS

12

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)

13

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.

14

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.

15