The
Burden of Risk
The
presence of risks saddles on the individual and society some measure of social
and economic pains. Every risk holds the
prospect of actually resulting in some economic losses and in addition some
social pains.
When a
house is destroyed by fire, or a vehicle is ruined in a crash, or a breadwinner
dies or money is stolen or you negligently injure a person or damage his
property, financial losses would be involved.
In addition to the financial cost of losses brought about by risk, there
is the pain of fears and worries resulting from the uncertainty as to whether
or not loss would occur. All these
underwrite the need why a prudent individual and society should prepare for a
possible occurrence of loss. The greatest burden of risk, therefore is
loss.
Risk put
three major burden on the society:
(i)
The creation of adequate contingency
(ii)
Deprivation of society of needed goods and services
(iii)
The creation of perpetual state of fear and mental worry.
i.
Adequate Contingency Fund
Prudent
individual and business organizations would have to set up adequate contingency funds to meet emergency
situations. For example, in the absence
of an insurance cover if your house presently worth $500,000 and you desire to
set up a contingency fund that can enable you quickly rebuild the house in the
event of is destruction by fire or earthquake,
you will need to set aside $500,000 or more in liquid cash or very easily
realizable securities.
This would
entail building up at least $170,000 savings annually for three years. For an average salary earner in Nigeria, this
would be difficult to achieve, if not impossible. Even , given that it is possible to build up
this fund within the first three years period, if the house is destroyed at the
end of the first year, for example, the amount of money in the fund would
certainly not be enough to rebuild the house.
And in fact, setting aside annually, this amount of money would reduce
your consumption spending and lower your standard of living.
In
addition, accumulation of such large savings has its own opportunity cost. Since the money would be locked up in cash
savings or in very highly liquid assets, it would not be able to earn its full
economic incomes it cannot be most gainfully invested.
ii.
Deprivation of Society of Needed Goods and Services
Risks
may deprive society of certain goods and services. For example, in 1976 a swine Flu broke out in America, and the then American Administration passed a bill of $135 million for national
vaccination programme to fight the risk of flu epidemic. Strangely enough major drug manufacturers
were not enthusiastic about the production of the vaccine. Initial responses of the manufacturer were
poor, they simply refused to be interested in the programme. The reason why manufacturers were not
enterprising but was because of the risk of producing defective vaccine, and
the consequential product liability risk.
Similarly,
insurers were unwilling to provide products liability insurance cover because
of the anticipated heavy liability claims against drug manufacturers by those
who would have suffered adverse reaction to the vaccine. In addition there was the risk of heavy legal
defense cost to be paid. Because of
these potential risks, insurers were requesting government to give her
guarantee and ultimate acceptance of the associated risks.
Finally,
the government gave in, gave the required guarantee and accepted the ultimate
associated risks. This encouraged the
drug manufacturers to manufacture the vaccine.
Eventually, the flu vaccine was produced and it was a big success. The vaccine would not have been produced if
the government had not stepped in. An in
that case, the society would have been deprived of the flu vaccine because of
the great risk involved.
The
society always pays more for needed goods and services than it ought ordinarily
to pay. The extra payment is to take
care of the risk associated with the provision of such
goods
and services. For example, because of
the fear of the risk of catastrophic
lawsuit the premiums charged for product liability for manufacturers are
high. These costs are passed on to the
consumers who would eventually have to pay for the high risk associated with
manufacturing.
iii.
Mental Worries Aid Fears
Risk
always imposes on the individuals, corporate bodies, and the society the heavy
burden of mental worries and fears. The
uncertainty associated with risk always produces a feeling of frustration and
mental worries. For example, a
graduating students, whose father has taken a loan to pay his school fees, may
be gripped with a feeling of apprehension and fear, if he is having difficulty
in securing employment and set his father free of the shackles of
creditors. Passengers in a lorry may
become nervous and fearful if the lorry driver drives dangerously and moves at
extremely high speed.
Between
August and November 1996, the fear of buying poisoned beans gripped people living
in Lagos so much that the demand for
beans fell off and beans traders suffered heavy losses. Every individual is exposed to different
kinds of risk. Some of these risks are
recognized, by those who are exposed to them, while others are not recognized,
by those who are exposed to them, while others are not recognized. When we
perceives a risk, we would develop a feeling of uncertainty. People generally hope that no misfortune
would befall them and that the present state of health and economic well being
would continue. While they nourish this
hope, people are nevertheless worried about possible misfortune befalling
them. This worry which is a burden of
risk, induces a feeling of insecurity and less well being.
DETERRENT EFFECT OF
RISK ON ECONOMIC GROWTH
Risk may have deterrent effect on economic growth and accumulation of
capital. Economic growth and development
can be made possible by availability of sufficient investible capital. However, investment of capital involves risk
of failure. As a result of this, no
investment would voluntarily be undertaken unless there is sufficient
expectation that the return on the investment would be more than compensate for
both the dynamic and static risks as to leave a margin of profit. The cost of capital is directly related to
the risk, the greater would be the cost of capital and the higher the price the
consumer must be prepared to pay for goods and service he wants.
This is
especially true of pure risk, which holds out the prospect of loss only. The uncertainty associated with speculative risk provides a
measure of tune to the gambler. The
gambler for example enjoys the uncertainty associated with wagering which to
him is some kind of tune and without which he may probably not gamble. The possibility of gain that exists in
speculative risk provides the basis of attraction for speculative risk
taken. This can be contrasted with pure
risk in which only the possibility of loss exists, an outcome that makes pure
risk distasteful and unwanted.
METHOD OF HANDLING RISK
We are
living in a world of risk. Risk is all
pervading. Risk is very
distasteful. But no matter how
distasteful risk is, and how much we try to run away from it, we can never
succeed in our desire to avoid exposing ourselves to risks. What we may succeed in doing is to
haphazardly arrange the various risks to which we desire to expose ourselves.
For
example, if you are afraid to travel in plane because of the fear of plane
crash, you may decide to travel in a car.
By doing so, you have merely decided not to expose yourself to the risk
of plane crash and instead choose to expose yourself to the risk of car
crash. This means that, if you must
travel at all, you cannot avoid exposing yourself to one type of risk or the
other, but you may have the opportunity to choose the type of risks to which
you wish to expose yourself.
The best
way of handling risks therefore is to find out the ways of dealing with
them.
Firstly,
those sets of risks referred to as fundamental risks whose effects are non-discriminatory
but universal and whose incidences fall on everybody alike, are better handled
by the society and state collectively.
This is so, because, the extent of loss which fundamental risks could
bring about is enormous and maybe far beyond the means of an individual. An example of such collectivity is the relief
efforts of both the society and government for victims of draught and famine or
war. Notable among these efforts are the
UNO relief efforts in Ethiopia, Burundi and other crisis stricken parts of the
world. The American government and
organizations relief efforts for floodvictims in America.
Secondly,
pure and speculative risks are largely handled by individuals as their effects
and incidences are localized and fall on an individual or few individuals.
The
existence of risk is a source of pain, anguish and misery to people and the
accompanying uncertainty causes great anxiety and mental worry.
Because
risk is unpleasant distasteful and therefore undesired, the rational nature of
man has led him to attempt to finding effective ways of dealing with
risks. There are many techniques of
dealing with, the problem of risk.
The most
important methods of dealing with risk includes:
·
Risk avoidance
·
Risk retention
·
Risk transfer
·
Loss control
·
Insurance
Risk Avoidance
We can
avoid risk when we refuse to accept it.
For example if you do not want undertake the risk of divorce, you would
have to refrain from marrying, if a company wants to avoid the risk of being
sued for producing a defective product, then it would not engage in producing
or manufacturing any product. If you
want to avoid the risk associated with owing and running a business
enterprises, you would simply refuse to establish one.
The
alternatives to engaging in our door activities is boring and unappealing. If you want to avoid the risk associated with
owing a vehicle, do not purchase or own a vehicle. Risk avoidance is a negative method of
dealing with risk because it inhibits progress.
Individuals and societal’s advancement requires a measure of risk
taking, but if risk avoidance as a method of dealing with risk is extensively
applied individuals and societal progress would be greatly retailed.
As a
result of this, risk avoidance is an unsatisfactory method of dealing with many
risks. It must however be noted that it
is not possible or reasonable to avoid all risks. For example, you can avoid the risk of out
door activities by staying inside your house.
But in reality is this practicable, desirable or feasible?
Risk
Retention or Risk Assumption
Risk
retention or risk assumption is the same.
To assume implies that the object is taken on while retention implies
that something is kept. Any distinction
is a matter of semantic. Risk is
retained and the loss that occurs in assumed.
Risk
retention or assumption is a very common method of dealing with risk. Risk retention exists when an individuals
does not take any positive action to deal with risk. Man faces avalanche of risk and in most
cases, he does not do anything about them in which case, he retains them. This retention may be voluntary or
involuntary.
Voluntary (Active) Risk Retention
A
voluntary (Active) risk retention exists in a situation in which an individual
knowingly retains risk to himself and assume the loss involved. This may be due to the fact that the
individual has no alternative way of dealing with the risk. For example if you insure your car, the
insurer may impose an excess for small losses.
In this case, you will be responsible and keep to yourself such small
losses. Excess is the amount of loss
under a policy which the insured retains with himself. A company may insure its stocks with a
deductible imposed.
In these
examples, you and the company make deliberate decisions to retain part of the
risk. We use voluntary (active) risk
retention technique for the purpose of saving money. This could be accompanied by refusing to
purchase insurance or by agreeing to the inclusion of excess or deductible
clauses in the policies purchased. Also,
if the premiums charged by insurers are inordinately high an individual may
deliberately decide not to purchase a policy and instead retain risk to
himself. For example, a manufacturer may
find insurance premium unreasonably high and refuse to purchase product
liability insurance.
An individual
may also decide to retain risk if the insurance market offers no cover for the
particular risk.
Involuntary
(Passive) Risk Retention
Risk can
be retained involuntarily (passively).
This occurs when the individual exposed to the risk is not aware of the
existence of the risk and unknowingly retains the risk in ignorance. Through his ignorance, laziness or sheer
indifference, the individual retains the financial consequence of the possible
loss. This could be very dangerous, if
the risk that is retained is sufficiently high as to involve the individual in
great financial loss that could possibly ruin him/her. For example, most of people in Africa are not
aware of most of the risks to which they are exposed. As a result of this, they do nothing to take
insurance cover and simply retain all risks to themselves. In the event of any misfortune, they suffer
very heavily.
Risk
retention as a technique for handling risk is suitable only to handling high
frequency low severity risks where possible losses are retentively simply and
very unsuitable for handling low frequency high severity risks, where potential
losses are relatively high such as in product liability risks.
Risk
Transfer
This is
another technique for handling risk.
Risk can be transferred from one person who is not willing to bear a
risk to another person who is more willing and more able to bear the risk.
Risk can
be transferred by different methods which include:
(i)
Transfer of risk by contracts
(ii)
Transfer of risk through the process of hedging
(iii)
Transfer of risk through incorporation of a
business firm.
Transfer
of Risk by Contracts
You can
transfer some unwanted risks by contract.
For example you may agree with your landlord to be responsible for the
cost of any repairs to the rented house or to be liable for any judgment debt
against the landlord arising from the use of the house. In these cases, the landlord transfer his
risks to you. If you reasonably believe
that rent is likely to rise substantially in future you can transfer the risk
of increase in rent to the landlord by a long term lease.
A risk
can be transferred by a hold-harmless agreement. A hold harmless agreement is an agreement in
which one individual assumes, the loss which another individual may possibly
suffer. For example the manufacturer of
ladies head drier may insert a hold-harmless clause in the contract of sale to
the retailer in which case the retailer agrees to hold the manufacturer
harmless in case the head drier malfunctions and injure another person. In this case, the retailer accepts liability
for injury to a third party arising from deficiency inherent in the drier.
Transfer
of Risk Through The Process of Hedging
Risk can
be transferred through the process of hedging.
Hedging is the method of transferring risk of unfavourable price
fluctuations to a speculator by purchasing and selling future contracts on an
organized commodity market. You could
buy a hedge or sell a hedge. Buying
hedge is the forward purchase in order to avoid a possible future increase in
the price of the commodity, while selling hedge is the forward sales of a
commodity in order to avoid a possible future fall in the price of the
commodity. For example, A. a cocoa
exporter receives an export order to export #100,000 worth of cocoa to an
importer in harmony by delivered 90 days after receipt of the order. In this case, A runs the risk of rise in
price of cocoa at the time it is to be delivered. If A perceives that the risk is higher than
what he is prepared to bear he can take step to protect himself against such
future rise in price. This, he can do by
buying the cocoa now at a low price for delivery in 90 days time. Under this arrangement
A would be able to avoid future rise in price of cocoa and still make his
margin of profit by the difference between his current selling and purchase
prices. As a result of this, potential
losses would be avoided.
On the
other hand, B, a rice merchant anticipates that price would fall in future and
sells his stock of rice now at a high price and immediately enters into a
purchase contract to buy rice in future at a lower price. If his judgment is correct, and price falls
sufficiently well, he would have succeeded in avoiding making a loss. His profit per measure of rice would be his
selling price now and his buying price in future and by this succeeds in
handling the risk of potential loss by hedging.
Incorporation
of a Business Firm
Establishment
of a firm is a method of transferring risk from an individual or a sale
proprietorship on to a corporate body.
If a firm is a sole proprietor, the personal assets of the owners in
addition to the assets of the firm can be attached by creditors in satisfaction
of their debts. In this case the
liability of the owners in unlimited.
However, if the firm is incorporated, then it acquires a status of its
legal personality which is distinct and separate from that of its legal
personality which is distinct and separate from that of its owners. By this it can own properties, enters into
contracts, sued and be sued. It becomes
a separate legal entity.
In
essence, when a firm is incorporated, the liability of the owners of the
incorporated firm becomes limited to the amount of the value of shares that may
be outstanding against them, and the risk of insufficient assets of the firm to
pay business debts is transferred to the creditors.
Loss
Control
Loss
control consists of those activities undertaken by individuals or firms to
reduce both the frequency and severity of losses. The objectives of loss control are to prevent
likely occurrence of losses and to reduce the extent of losses. Loss control is an important method of
handling risk.
Loss Reduction
The
objective of loss reduction is to prevent loss from occurring. Loss reduction entails reducing the
probability of loss in order to reducer the frequency of losses. If the likelihood of loss occurring is
reduced then the frequency of its occurrence would equally be reduced.
If our
medical personnel are well trained, the likelihood and frequency of death
arising from incompetence would be
reduced, if students study sufficiently hard the rate of failure in examination would be reduced, if drivers are well trained
and drive with great caution and considerations for the lives and safety of
other road users the nation would record fewer road accidents and
casualties. If vehicles are inspected
regularly and necessary repairs effected, fewer accidents would occur, also, a
boiler explosion can be prevented by periodics inspections by qualified
engineers, fires can be prevented by forbidding workers to smoke in the
vicinity of highly inflammable materials.
Loss
Prevention
Effective
loss prevention effort would reduce the frequency of losses. However, no matter how effective the loss
prevention effort is, some losses would inevitably occur. The objective of loss reduction therefore, is
to reduce the severity of loss after its occurrence. For example, fire doors and walls can be
constructed and used to confine fire to a particular area and prevent it from
spreading, a sprinkler can be installed in a building to put out any fire
promptly. Fire proof cabinet can be
purchased to ensure safety of documents night security guards could be employed
to deter thieves, burglary alarm installed.
The examples are endless. Loss
prevention is an appropriate method of handling risk for two main reasons.
Firstly,
the indirect cost of losses can be very large and even large than the direct
cost in some cases. For example, if an
employee is injured at work, the employer would be responsible for the medical
expenses and certain proportion of his earnings. These are direct costs of the loss. In addition, as a result of the accident, a
machine may be damaged and needs repairs, production may be halted for some
time, a new employee may have to be trained at a high cost to take the place of
the disabled employee, contracts for purchases of raw materials or for sales of
finished goods may be cancelled because production is halted. These are indirect costs of the loss. If the loss is prevented from occurring both
these direct and indirect costs would be dominated. Loss prevention is the most appropriate
method of dealing with risk.
Secondly,
there is the social cost of losses.
These social costs are important and must be considered. For example, if an employee dies of injuries
sustained at work, the society is forever deprived of the goods and services
which the employee could have produced.
The family of the workers would lose their share of deceased earnings
forever and the family may as a result of the death, the employee suffers some
financial insecurity. Even, the employee
himself may suffer great pain before he finally dies.
These
social costs can be reduced by the use of effective loss control system. Another method of reducing losses is through
the application of the law of large number, if wer have sufficiently large
number homogenous exposure units.
Through this, a reasonable estimate of the cause of the losses can be
made. On the basis of estimate, an
organization such as insurance company can assume the possibility of loss of
each exposure, without necessarily facing the same possibility of loss itself.
Insurance
Insurance
is another technique of handling risk.
It is a practical method of handling risk. Commercial insurance has three main
characteristics:
(i)
It makes use of the device of risk transfer
(ii)
It makes use of the pooling technique to spread
the losses of few over the whole group so that average loss is substituted for
actual loss.
(iii)
It makes use of the application of the law of
large numbers or reduce risk by predicting future loss experience more
accurately.
