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The Burden of Risk


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 catastrophiclawsuit 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.

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