risk topic 1

uncertainty

• regards events that may produce a loss

• risk managers do not take risk

• can be a loss for both firm and individuals

• reduction in value (in financial terms, money!)

pure risk

• losses can be known with certainty

• a loss which is certain has a 100% chance

• impossible loss has 0% chance of happening

• losses can be known with certainty- if there is no risk there is no uncertainty

• loss is still present; no uncertainty about the loss

• risk does not equal loss

probability of the loss

• probability is the number that indicates how likely the event is to occur

• ranges from 0 to 1 (or 0% to 100%)

• risk does does not equal the probability of the loss

types of classifications in risk

• pure vs speculative

• static vs dynamic

• diversifiable vs non-diversifiable

• objective vs subjective

pure vs speculative risk

• both involve uncertainty (“alive or dead tomorrow”

• difference is in future states of the world or the outcomes

pure risk

• 2 future states of the world or the outcomes

• there’s either loss or no loss (ex: fire, flood, death, sickness)

• loss associated with pure risk events are typically insurable

speculative risk

• 3 future states of the world: gain, loss, or no gain/loss

• ex: gambling, buying a stock, buying a home

• basis for enterprise risk management (ERM)

• most businesses/organizations face more speculative risk than pure risk

• many speculative risks are not able to be insured- ones that are insurable are difficult and expensive

static risk

• does not change significantly over time

• risk always present for organizations, society, individuals, etc.

dynamic risk

• arises out of changing circumstances (ex: AI, covid, social media, etc.)

• there isn’t just always one risk, there are multiple side impacts that come

diversifiable risk

• not highly correlated

• random- not dependent on one another

• impacts only some individuals, businesses, or group (ex: car accident involving two vehicles)

non-diversifiable

• highly correlated

• simultaneous occurrence of many losses from a single event

• impacts large segments of society at once/one event

• ex: natural disasters, inflation, unemployment

measurement of risk - objective risk

• measurable variation in uncertain outcomes based on facts and data

• variation of actual from expected outcomes

• variation is key- more variation means more risk

• let the numbers speak- view the risk strictly through the data

measurement of risk - objective vs subjective - subjective risk

• an individuals view of uncertainty or the situation involving risk (ex: travel on airplanes)

• depends on the individual - measures attitude toward risk

• not easily measured

• not easy to compare among individuals

• risk lovers/takers, risk averse (do not take risk), risk-neutral

• influences how a firm or key decision makes will handle risky situations

factors affecting risk

• peril

• frequency of the loss

• severity of the loss

• hazard

peril (1st factor)

• peril is the WHAT not why

• immediate cause of the loss (ex: fire, flood, theft, injury, sickness, death, unemployment, etc.)

frequency of loss (2nd factor)

• how often do losses occur?

• # of losses in a given time period (how often? 1, 2, 3, 4…100)

• what is likelihood of loss?

• low frequency losses, low probability loss

• high frequency losses, high probability loss

severity of the loss (3rd factor)

• given that a loss has occurred, how bad is it in $ terms

• severity is conditional upon frequency being positive

• if frequency is 0, severity is not an issue

hazard (4th factor)

• underlying condition lying behind a loss occurrence which either: increases the frequency of the loss, increases the severity of the loss, increases both severity and frequency

three types of hazards

• physical hazard

• moral hazard

• morale hazard

physical hazard #1 Location

• if peril is flood, living at the shore is physical hazard (frequency)

• if peril is fire, distance to a fire hydrant is a physical hazard (severity)

physical hazard #2 construction

• fire peril, wood structure is physical hazard (frequency and severity)

• Frequency: Wood catches fire more easily than brick or steel (e.g., a stray spark or faulty wiring is more likely to ignite a wood-frame house), so fires start more often.

• Severity: Once a fire starts, wood burns and spreads faster, so the same fire does more damage to a wood structure than it would to a concrete one — making the loss bigger when it does occur.

physical hazard #3 use

• university classroom building vs a church

• if peril is fire, the use of a university building a church poses a physical hazard (fire hazard due to candles)

moral hazard

• more human and more behavioral

• act (behavior) different because of the existence of insurance

• frequency/severity increases because of the existence of insurance

classic examples of fraud/dishonesty

• telling a lie to an insurance company so you get some financial benefit

• insurance fraud: have your car “stolen” and collect insurance

• arson: burn your own building for insurance

• husband kills wife or vice versa: life insurance collected

common thread between all fraud/dishonesty

• presence in insurance

• change in behavior

fraud/dishonesty

• significant parallels in risk management, insurance, and gambling because they involve prices and outcomes

• not all moral hazard is illegal

• cash bar vs open bar: you may not drink as much at a cash bar because you personally have to pay for each drink

• two individuals have the same health (age, demographic, etc.) one has health insurance, the other does not; the one with health insurance will access healthcare more than the one without (change in behavior, not illegal)

• healthcare is a product- the one who has insurance will consume more of the product - why? - the price is fixed

• price is fixed for someone with insurance

• lower cost = higher demand

• nothing to do with bad behavior- but behavior changes occur because of insurance

• costly activity - you pay more for auto insurance or more taxes

morale hazard

• carelessness concerning losses

• has nothing to do with the existence of insurance

decision making process

TRM = traditional risk management

ERM - enterprise risk management

• manage pure risk (TRM) and speculative risk (ERM)

• goal in TRM is minimizing financial impact on an organization

• goal in ERM is maximizing shareholder value

difference example: TRM: “the building can catch on fire, let’s handle that” ERM: “these building MAY catch on fire, but the odds are low and we are making a lot of money”

risk management function in an organization

risk management - originally specialized area of finance

• finance department (small)

• risk manager (medium)

• chief risk officer (CRO) (large)

• RM is continuously evolving

• RM is not only insurance buying

evolution of risk management

• 1950’s firms did not manage risk

• just bought insurance - narrow and not strategic

• mid 60’s professor wayne snider (temple) coins the term risk management

• begins evolution into strategy

• present - important function in a firm - very broad scope

steps in the risk management process

1. identification of exposures to loss

2. evaluate the exposure

3. identify possible alternatives

4. select among the alternatives

5. implementation of chosen options

6. re-evaluate periodically the chosen strategies