RMI 2101 Quiz 1

Topic 1

Why do we take risks?

For the possibility of being rewarded

What does risk entail?

• uncertainty on the outcome

• risk management manages how/what risks we take

• risks can be losses for a firm or an individual

• most risks are about money

Pure Risk

• there’s either a 100% chance of losing, or a 100% of not losing

• 0% chance of loss means impossible loss

• risk =/= loss

Probability of the Loss

how likely the event is to occur

• ranges from 0-1 or 0%-100%

• risk =/= probability of the loss

Types/Classifications of Risk

1. Pure vs. Speculative

2. Static vs. Dynamic

3. Diversifiable vs. Non-Diversifiable

4. Objective vs. Subjective

Pure vs. Speculative

• both involve uncertainty

pure: loss or no loss

• losses associated with pure risks are typically insurable

• pure risk has 0 gain

speculative: loss, no loss, or gain

• most common speculative risk is buying a house, gambling, stocks, paying for university

• speculative risks is the basis for Enterprise Risk Management

• most orgs face speculative over pure

• many speculative risks aren’t insurable, ones that are are difficult and expensive, like if your alcohol business ends up having a major marijuana competitor, or if your junk food business lowers because of GLP-1s

Static vs. Dynamic

static: hasn’t changed much over time, fairly consistent

• always present for orgs, societies, individuals, etc.

• ex: risks of the Earth, human risk

dynamic: arises out of changing circumstance

• ex: law change, tech change, AI change

Diversifiable vs. Non-Diversifiable

Diversifiable: when there’s true randomness and no correlation

• ex: within 20mi of where I’m standing, there will be 10 car crashes

• impacts only some individuals/groups

• random, not dependent on one another

• one event, a couple losses

• ex: car accident involving 2 people/vehicles; rear-end chain reaction

Non-Diversifiable: one event, many losses

• highly correlated

• ex: natural disasters, stock crash, inflation, unemployed

• hard to manage, but not impossible

Objective vs. Subjective

objective: measurable variation in uncertain outcomes based on facts and data

• variation of actual data from expected outcomes

• variation is key - more variation means more risk

• let the numbers speak

• flaw: numbers don’t tell us the future, the story can change

subjective: an individual’s view of uncertainty of the situation involving risk

• airplanes are incredibly safe, but people will subjectively avoid them because they’re afraid

• cars are very dangerous, yet people will drive them anyway

• depends on the individual’s attitude toward the risk

• how you feel about it doesn’t have to make sense

• not easily measured

• risk takers and risk averrers don’t easily get along

• influences how a firm handles risks

• ex: don’t bring up AI to someone who doesn’t trust technology

• AI is great with objective risk, terrible with subjective risk

Factors Affecting Risk

1. Peril

2. Frequency of the Loss

3. Severity

4. Hazard

Peril

• the “what”

• immediate cost of the loss

• phone stolen, you broke your leg, you died, you lost your job

Frequency of the Loss

• how often does the risk occur

• tendency to overestimate little risks & underestimate big risks

• ex: avoiding ocean due to sharks but getting in cars

• number of losses in a given time period (cannot be negative)

• low frequency = low probability, high frequency = high probability

Severity

• how bad is the loss ($$)

• conditional upon frequency being positive

• not an issue of the frequency is 0

Different Types of Hazards

1. Physical Hazard

2. Moral Hazard

3. Morale Hazard

Hazard

• underlying condition behind a loss occurrence

• either increases frequency of the loss, increases severity of the loss, or increases both

• explains the peril

• ex: texting while driving

Physical Hazard

• location

  • House at Jersey shore. Peril is flood, shore is physical hazard (frequency)

• construction

  • fire peril, wood structure physical hazard (freq. & severity)

• use

  • peril fire, use of building as factory physical hazard (severity)

Moral Hazard

• act/behave differently because of the existence of insurance

• freq. & severity increases

• insurance fraud, husband kills wife to get her life insurance

• not all moral hazards are illegal

  • cash bar = you pay. open bar = free. drink more at open

  • 2 ppl w/same health conditions. 1 w/insurance sees doctor more

• behavior change =/= bad

• costly, pay more for car insurance or more taxes bc of this

Morale Hazard

• carelessness concerning losses

• has nothing to do with insurance

• texting while driving even if they know it’s dangerous because of addiction

Decision Making Process

• Manage Pure Risk (TRM) and Speculative Risk (ERM)

• goal in TRM is minimizing financial impact on the organization

• goal in ERM is maximizing shareholder value

Risk Management Function in an Organization

• RM originally was a specialized area of finance

• continuously evolving, isn’t only insurance-buying now

• finance dept. → risk manager → chief risk officer

Evolution of Risk Management

• 1950s: firms didn’t manage risks, only bought insurance

  • narrow and non-strategic

• Mid-60s: professor Wayne Snider coins the term RM, beginning evolution into strategy

• Present: important function in a firm, very broad scope

Steps In The Risk Management Process

1. Identify exposure to losses

2. Evaluate exposure to losses

3. Identify possible alternatives

4. Select among the alternatives

5. Implement chosen option

6. Periodically evaluate chosen strategy