Risk Exam 1

loss

to individuals, firms, or society; can be quantified financially as a reduction in value

probability

change or likelihood, ranges from 0-1, quantifies risk

static risk

always present, has been present, doesn’t change significantly over time,

ex: Illness, theft, and pandemic.

dynamic risks

arise from changing condition; risks that arise from changing conditions; new and emerging risks that did not exist before

ex: Cyber, AI replacing humans, genetically modified humans, terrorism, and privacy

diversifiable

Affect only some individuals, businesses, and society. 

1. Uncorrelated risks.

2. Ex: Fire in a single building, school shooting, and local cafe closes.

non-diversifiable

Affect large segments of society. 

1. Correlated risks– simultaneous occurrences of many from a single event.

2. Ex: AWS shutdown, 2008 financial crisis, unemployment, and pandemic.

objective

Measurable variation in uncertain outcomes based on facts and data

1. Ex: Probability of a plane crash from PHL to LAX is approximately 0.001%.

subjective

1.  Perceived amount of risk based on opinion or attitude, individual perception, hard to measure and different person to person

   1. Ex: Some people think they are in more/less danger, even though everyone has the same probable outcome. 

correlated risks

refers to simultaneous occurrence of many losses from a single random event

ex; single building fire, earthquake, hurricane (causes destruction to things around it)

peril

immediate cause of a loss, a random event that causes loss/losses to occur

hazard

a condition that lies behind a loss that can increase frequency, increase severity, or increase frequency and severity

frequency

Number of losses

severity

the size/magnitude of a loss, given a loss occurred how much will it cost

types of hazard

physical

moral

morale

legal

physical hazard

a tangible characteristic of property, persons, or operations that increase loss frequency or severity, or both

2 types of physical hazard

1. location-house, property loss

2. construction-wood home vs stone home (wood has higher severity if fire occurs)

moral hazard

a change in behavior in the presence of insurance, that increases frequency, severity, or both. This behavior is intentional.

Ex: setting fire to your own building to collect insurance money

morale hazard

carelessness or indifference with respect to a loss. 

Ex: leaving a door unlocked increases the frequency of a robbery;

legal hazard

condition of the legal environment, that increases frequency or severity or both

Ex: courts in some geographic locations (increase in frequency) are more likely to fine the plaintiff

Risk

is a variability concept, variation of actual from expected outcome, objective measure, measured in frequency and severity

When is risk present

when there is a variation of actual from expected (outcomes or losses)

Good variation

AL < EL

Bad variation

AL > EL

Neutral variation

AL = EL

types of costs of risk

1. Financial losses

2. Possible loss of goodwill/reputation

3. Cost of risk management

4. Possible loss of goods and services judged to be “too risky”

5. Cost of residual uncertainty

Financial losses

ex Ex:  hospital medical malpractice

 legal fees, paying damages

Possible loss of goodwill/reputation

ex Ex:  hospital medical malpractice

 less people come to the hospital.

Cost of risk management

ex Ex:  hospital medical malpractice

1. Cost of mitigation: medication errors → mitigate using training programs

2. Financial tools to pay for losses: medical malpractice insurance

Possible loss of goods and services judged to be “too risky”

ex Ex:  hospital medical malpractice

1. Ex: all hospitals have an emergency department, but not all emergency departments have a trauma center since it’s too risky. Trauma centers get sued often because their patients are very sick and likely to die. 

2. Ex: some hospitals also stopped delivering babies since there’s not enough insurance to offload risk.

Cost of residual uncertainty

ex Ex:  hospital medical malpractice

known as the cost of worry

It is the level of risk that remains, even after implementing risk management plans.

Loss exposure

used in traditional risk management

 (1) possibility of a financial loss a (2) particular entity faces as a result of (3) a particular peril, (4) striking a particular thing of value.

Steps Risk Management Process

1. Identify the loss exposure.

2. Measurement and evaluation of loss exposures

3. Determine the risk management options available to use two broad categories

4. Choose your risk management options

5. Implement risk management options

6. Evaluate chosen strategy option

identify loss exposure

most important step in the process– if you don’t identify the loss exposure, you can’t manage the risk. 

1. If you fail– insolvency (shutdown).

Measurement and evaluation of loss exposures

E(f) * E(s) = expected loss (EL)

to measure involves looking @ past information data and making forecast of prediction about the future

measured in frequency and severity

Determine the risk management options available to use two broad categories

Risk Control and Risk Financing

Risk Control

decrease in frequency, severity, and variation.

Risk Financing

preparing to pay for losses, insurance, and captives

A captive is

an insurance company owned by the business itself. 

Evaluate chosen strategy option

did # of patient falls increase

how many times did alarm go off

TRM loss exposures

1. property

2. liability

3. personel

4. net income

property loss exposure

damage or loss of physical things, a type is Legal interest in property

Legal interest in property

if you have a financial stake in the property, you would lose money if it were damaged or destroyed

Sources of Legal Interest in Property

1. Ownership interests

2. Lease agreements

3. Secured creditors

4. Buyers and sellers

ownership interests

most common, present or future.

Ex: inheritance – a person named in a will to inherit property has a legal interest, damage to the property would reduce the value of their future inheritance

lease agreements

even without ownership, you have financial responsibilities, a lease grants “use interest” use the property period of time specific purpose and price, Tennant is obligated to return property w/out damage

Ex: signing a lease for an apartment.

Secured creditors

a lender that has a legal interest in property used as collateral for a loan and can take possession of that property if the borrower defaults.

Ex: a bank holds a mortgage on property, and can repossess it if the borrower defaults, and would suffer a financial loss if the property were damaged or destroyed.

Buyers and sellers

who is responsible for losses to goods in transit?, determined by Freight on Board (FOB)

Freight on Board (FOB)

is the physical point along the shipping route where financial responsibility shirts from seller to the buyer

Ex: shipping from Houston to Philly (FOB is Houston ← responsibility shifts to Philly)

liability loss exposure

conditions or situation that presents the possibility of situations that presents the possibility of claim aligning legal responsibility of a person or business for injury or damage suffered by another party

ex; civil liability, torts, contract, statues, you can be sued for liability

personnel loss exposure

 risks that an organization will suffer losses due to a key employee (injury, illness, death)

btw:Personal loss can lead to personnel loss.

ex; nutrition scientist for McDonalds suddenly resigns

net income loss exposure

also known as business interruption loss exposure

NI=Revenue (P*Q)-Expenses

NI is Secondary Loss

events that trigger NI loss

1. loss to property you own

2. loss to property owned by others

3. legal liability loss (Tylenol case held J+J liable)..this reduced revenue and increased expense

4. retraced for safety

5. crisis management (post loss)

Enterprise Resource Management (ERM)

is a unified management strategy to look at, evaluate, and manage all risks faced by the firm– both pure and speculative.

Looks at risks across the enterprise, not in silos.

Manages risk and maximizes long-run viability of the firm.

• Uses holistic or interconnected view of risk (how are risks related)

• ERM does not need or have net income loss because it evaluates correlations across loss exposures. 

Traditional Risk Management (TRM)

focuses on managing safety, purchasing insurance, and controlling financial recovery from losses generated by hazard risk. Concerned mainly about pure risks and are mostly insurable. Practiced in silos

ONLY MANAGES PURE RISK

Example of correlated/interdependent risks

Directors and officers make a bad decision or poor implementation → reputation begins to decrease → stock prices drop → shareholders want to sue

4 Quadrants of Risk

hazard, operational, financial, and strategic. Risks are listed in each quadrant. The quadrant itself is not the risk

Hazard risks

property, liability, safety, natural disaster (perils), pandemic.

(Typically pure risk and insurable)

Operational risks

arise from day-to-day business operations.

(Includes issues related to manufacturing products, customer service, employment practices, and supply chain risk)

Financial risks

arise from changing conditions in financial/economic markets that impact firms financial position, external to the firm.

(Ex: inflation, recession, depression, tariffs, interest rate, commodity prices, exchange rate changes)

1. Mostly speculative and depends on perspective (you might gain). 

1. Not every risk is a financial risk, just because you lose money. (Losses as a result of a risk is a cost of risk.)

Strategic risks

board level risks, SWOT analyses… arise from bad business decisions

{ improper implementation of a decision, ethics (human trafficking, bad for environment), media coverage (reputation), competition, industry changes, and technological changes (AI).}

ERM=

-pure and speculative risk

-breaks down silos

-uses risk map to do this

best place in org for risk identification

employees

risk map

label with what’s actually the risk don’t classify the point like stock price or product liability

3 functions of risk map

1. breaks down silos

2. efficient all risks in one place

3. easy to interpret/understand

Methods of Risk Identification

1. Onsight inspections

2. Contract analysis

3. Analysis of past losses

4. Flow chart method

5. Expertise outside of firm

6. Financial statements approach

Contract analysis

What risks/losses are you responsible for? 

Ex: reading contracts.

Analysis of past losses

use loss histories and/or data. Characteristics of past losses may help identify future losses.

Factors they might look at: speed, how long you drive (rest, sleep), driving in areas with higher frequency of accidents, infrastructure, weather, time of day, driver history, obstacles in road (ex: deer)

Assumption: past is a good indicator of future. BUT

may have a loss that never occurred before

Flow chart method

example with Crayola supply chain.

1. (1) Supplier → (2) warehouse → (3) production → (4) warehouse → (5) distributors → (6) market

   1. Issues can happen along the flow chart:

      1. (3) Machine breaks – property loss. 

      2. (3) Worker injured – personnel loss. 

      3. (1) Drastic increase in input costs.

      4. (1) Late delivery or supplier drops your backorder.

      5. (1) Supplier has a loss and you cannot get your materials. 

Financial statements approach

review balance sheet (assets and liabilities) and net income statement (revenues and expenses; gains and losses)

a priori

probability of events that if you understand nature of event you can use deductive reasoning probabilities

ex; fair coin toss

statistical probabilities

to estimate look at past data to estimate

law of large numbers

in order to obtain “accurate” estimates of probability of future events based on past information- a large number of past information must be used

random variable

variable whose outcome is dependent on some chance event

ex; fate shipment A is RV

mean is…

average or expected value

dispersion

the degree to which the volume in a distribution differ from the average (mean)

measure of dispersion are: standard deviation, variance, coefficient of variation