fin360 chapter 1- risk and its treatment

PERIL

THE CAUSE OF A LOSS/EVENT THAT TRIGGERED A LOSS

ex: EARTHQUAKE/ FLOOD/ HURRICANE

HAZARD

CONDITION THAT INCREASES THE SEVERITY OF A LOSS

Ex: ICY ROAD/ WET FLOORS/ EXPOSED WIRES

PHYSICAL HAZARD

PHYSICAL CONDITION THAT INCREASES THE SEVERITY OF A LOSS

Ex: POTHOLE/SNOW

MORAL HAZARD

DISHONESTY OR CHARACTER DEFECTS IN AN INDIVIDUAL THAT INCREASES THE SEVERITY OF A LOSS (intentional)

ex: DRUNK DRIVING

ATTITUDINAL (MORALE) HAZARD

CARELESSNESS OR INDIFFERENCE TO A LOSS WHICH INCREASES THE FREQUENCY OF A LOSS (unintentional)

ex: DRIVING TOO FAST B/C YOU HAVE INSURANCE TO PROTECT YOU

LEGAL HAZARD

REFERS TO CHARACTERISTICS OF THE LEGAL SYSTEM OR REGULATORY ENVIRONMENT THAT INCREASES THE SEVERITY OF A LOSS

EX: OPERATING A BUSINESS WITHOUT CHECKING LOCAL ZONING LAWS, RISKING A SHUTDOWN FINE

Basic probability

• of independent events – P(A and B) = P(A)*P(B)

• of compliment of an event - P(compliment of A) = 1-P(A)

• of mutually exclusive events – P(A or B) = P(A)+P(B)

PURE RISK

A SITUATION WHERE THERE ARE ONLY TWO OUTCOMES - LOSS OR NO LOSS/CHANGE (NO FINANCIAL GAIN)

EX: A HURRICANE DAMAGES HOME. BEST OUTCOME IS STORM MISSED THE HOUSE AND NOTHING HAPPENED. BAD OUTCOME IS PHYSICAL DESTRUCTION

SPECULATIVE RISK

A CHANCE THAT A DECISION COULD RESULT IN PROFIT, LOSS, OR BREAK EVEN

EX: PLACING A WAGER AT A CASINO WHERE YOU CAN WIN MONEY, LOSE EVERYTHING, OR WALK AWAY EVEN

ENTERPRISE RISK

A TERM THAT ENCOMPASSES ALL MAJOR RISKS FACED BY A BUSINESS FIRM WHICH INCLUDE,

• STRATEGIC RISK

• OPERATIONAL RISK

• FINANCIAL RISK

STRATEGIC RISK

UNCERTAINTY REGARDING THE FIRMS FINANCIAL GOALS AND OBJECTIVES OR THREATS TO YOUR ORGANIZATION ACHIEVING ITS BUSINESS OBJECTIVES

• EX: FAILING TO ADOPT NEW TECHNOLOGIES OR SHIFTING MARKET TRENDS IN TIME

OPERATIONAL RISK

THE DANGER OF LOSS/DISRUPTION CAUSED BY FAILED INTERNAL PROCESSES, HUMAN ERRORS, SYSTEM BREAKDOWNS, OR EXTERNAL EVENTS

EX: SOFTWARE GLITCHES, HARDWARE BREAKDOWN, VANDALISM

FINANCIAL RISK

THE POSSIBILITY OF LOSING MONEY OR EXPERIENCING A FINANCIAL LOSS DUE TO

EX: ADVERSE CHANGES IN COMMODITY, FOREIGN EXCHANGE RATES, AND VALUE OF MONEY

ENTERPRISE RISK MANAGEMENT

A PLAN TO SPOT, MEASURE, AND HANDLE ANY RISKS OR SURPRISE THAT COULD STOP A BUSINESS FROM REACHING ITS GOALS

• COMBINES INTO A SINGLE UNIFIED TREATMENT PRORAM ALL MAJOR RISK FACED BY FIRM

DIVERSIFIABLE RISK (UNSYSTEMATIC)

A TYPE OF INVESTMENT RISK THAT AFFECTS INDIVIDUALS/SMALL GROUPS BUT CAN BE REDUCED OR REMOVED BY SPREADING YOUR MONEY ACROSS MANY DIFFERENT COMPANIES AND INDUSTRIES (DIVERSIFICATION)

EX: IF YOU OWN STOCK IN ONE COMPANY AND IT GOES BANKRUPT, YOU LOSE EVERYTHING. IF YOU OWN SHARES IN 50 DIFFERENT COMPANIES ACROSS INDUSTRIES A FAILURE AT ONE COMPANY ONLY HURTS YOU A LITTLE

NON-DIVERSIFIABLE (SYSTEMATIC)

 RISK THAT IMPACTS THE ENTIRE ECONOMY OR MARKET ALL AT ONCE AND CANNOT BE REMOVED BY SPREADING INVESTMENTS ACROSS DIFFERENT COMPANIES

ex: GLOBAL HEALTH CRISES OR WARS DISRUPT GLOBAL TRADE

PERSONAL RISKS

POTENTIAL LOSSES THAT DIRECTLY IMPACT AN INDIVIDUAL OR FAMILY

• INVOLVE THE POSSIBILITY OF A LOSS OR REDUCTION IN INCOME, EXTRA EXPENSES OR DEPLETION OF FINANCIAL ASSETS DUE TO

• ex:  PREMATURE DEATH, RETIREMENT RISKS, POOR HEALTH

PROPERTY RISK

INVOLVES THE POSSIBILITY OF LOSSES ASSOCIATED WITH THE DESTRUCTION OR THEFT OF PROPERTY

DIRECT LOSS (PROPERTY RISK)

A FINANCIAL LOSS THAT RESULTS FROM THE PHYSICAL DAMAGE, DESTRUCTION, OR THEFT OF THE PROPERTY

Ex: FIRE DAMAGE TO HOME/HOUSE BURNS DOWN

INDIRECT OR CONSEQUENTIAL LOSS (PROPERTY RISK)

A FINANCIAL LOSS THAT RESULTS INDIRECTLY FROM THE OCCURRENCE OF A DIRECT PHYSICAL DAMAGE OR THEFT

ex: ADDITIONAL LIVING EXPENSES AFTER A FIRE THAT IS NOT THE REBUILDING OF THE HOUSE LIKE PAYING TO TEMPORARILY LIVE IN AN APARTMENT

LIABILITY RISK

INVOLVE THE POSSIBILITY OF BEING HELD LEGALLY RESPONSIBLE FOR BODILY INJURY OR PROPERTY DAMAGE TO SOMEONE ELSE

ex: CUSTOMER SLIPS ON A WET RETAIL FLOOR

LIABILITY RISK includes

• NO MAXIMUM UPPER LIMIT WITH RESPECT TO THE AMOUNT OF LOSS (IF YOU CAUSE ACCIDENT, AMOUNT YOU CAN BE SUED FOR IS POTENTIALLY ENORMOUS)

• A LIEN (LEGAL CLAIM AGAINT YOUR PROPERTY) CAN BE PLACED ON YOUR INCOME AND FINANCIAL ASSETS BY CREDITORS IF YOU DON'T PAY

• LEGAL DEFENSE COSTS CAN BE ENORMOUS

FIRMS FACE A VARIETY OF PURE RISKS THAT CAN GAVE SERIOUS FINANCIAL CONSEQUENCES

• PROPERTY RISK

• LIABILITY RISK

• LOSS OF BUSINESS INCOME

• CYBERSECURITY AND IDENTITY THEFT

PROPERTY RISKS (PURE RISKS)

SUCH AS DAMAGE TO BUILDINGS, FURNITURE, AND OFFICE EQUIPMENT

LIABILITY RISKS (PURE RISKS)

SUCH AS SUITS FOR DEFECTIVE PRODUCTS, POLLUTION, OR SE*XUAL HARASSMENT

LOSS OF BUSINESS INCOME (PURE RISKS)

WHEN FIRM MUST SHUT DOWN FOR SOME TIME AFTER A PHYSICAL DAMAGE LOSS

CYBERSECURITY AND IDENTITY THEFT (PURE RISKS)

BY HACKERS BREAKING INTO A FIRMS COMPUTER SYSTEM

RISK CONTROL

TECHNIQUES THAT REDUCE THE FREQUENCY OR SEVERITY OF LOSSES:

• AVOIDANCE

• LOSS PREVENTION

• LOSS REDUCTION

AVOIDANCE

AVOID ACTIVITY THAT CREATES RISK

LOSS PREVENTION

 ACTIVITIES TO REDUCE THE FREQUENCY (# OF TIMES) LOSSES OCCUR

EX: LOCKING YOUR APARTMENT TO PREVENT THEFT

LOSS REDUCTION

ACTIVITIES TO REDUCE THE SEVERITY (SIZE OR IMPACT) OF A LOSS AFTER IT OCCURS

EX: WEARING A SEATBELT TO REDUCE INJURY IN ACCIDENT

TO REDUCE LOSS (LOSS REDUCTION)

• DUPLICATION: HAVING BACK UPS

• SEPARATION: KEEPING ASSETS IN DIFFERENT LOCATIONS SO ONE EVENT DOESN'T DESTROY EVERYTHING

• DIVERSIFICATION:SPREADING RISK ACROSS MULTIPLE ASSETS OR ACTIVITIES

RISK FINANCING

TECHNIQUES THAT PROVIDE FOR THE FUNDING OF THE LOSSES

• RETENTION

• ACTIVE RETENTION

• PASSIVE RETENTION

RETENTION (RSK FINANCING)

AN INDIVIDUAL OR BUSINESS FIRM RETAINS PART OR ALL OF THE LOSSES THAT CAN RESULT FROM A GIVEN RISK

• keeping a specifc portion of finanical risk yourself instead of tranferring 100% of it to an insurance

ACTIVE RETENTION (RISK FINANCING)

• AN INDIVIDUAL IS AWARE OF THE RISK AND DELIBERATELY PLANS TO RETAIN (KEEP) ALL OR PART OF IT

PASSIVE RETENTION (RISK FINANCING)

RISKS MAY BE UNKNOWINGLY RETAINED B/C OF IGNORANCE, INDIFFERENCE, OR LAZINESS

• dont know about the risk or forgot to plan for it

SELF-INSURANCE

A SPECIAL FORM OF PLANNED (ACTIVE) RETENTION BY WHICH PART OR ALL OF A GIVEN LOSS EXPOSURE IS RETAINED BY THE FIRM (company chooses to pay for losses itself instead of buying insurance)

NON-INSURANCE TRANSFER

TRANSFERS A RISK TO ANOTHER PARTY (NO INSURANCE PURCHASE)

HOLD-HARMLESS CLAUSE

CONTRACT PROVISION WHERE ONE PARTY AGREES TO BE RESPONSIBLE FOR CERTAIN LOSSES OR LAWSUITS (TRANSFER OF RISK LIKE THIS)

HEDGING ???

 USED TO PROTECT AGAINST PRICE CHANGES (TRANSFER OF RISK LIKE THIS)

INCORPORATION OF A BUSINESS ????

FIRM TRANSFERS TO THE CREDITORS THE RISK OF HAVING INSUFFICIENT ASSET

• LIMITED LIABILITY MEANS THE OWNER'S PERSONAL ASSETS ARE GENERALLY PROTECTED, AND CREDITORS BEAR THE RISK IF THE CORPORATION DOESN'T HAVE ENOUGH ASSETS TO PAY ITS DEBTS