RMI Topic 1: Intro and Overview

Risk

-Uncertainty

-Events which may produce a loss/reduction in value

Pure Risk

Type of risk that involves only the possibility of loss or no loss (Traditional Risk Management)

-Associated with insurance
ex. fire, floods, death

Speculative Risk

Type of risk that involves gain, loss, or no loss (Enterprise Risk Management)

-The basis for Enterprise Risk Management (ERM)

-ex. gambling, stocks, home value

Probability

Number that indicates how likely the event is to occur

• Risk ≠ Probability of a Loss

Pure vs. Speculative Risk

Pure: Has no upside, managed by insurance and preventative controls

Speculative: Has upside, managed through strategy and analysis

• Businesses face more Speculative Risk > Pure Risk

Static Risk

Risks that are constant overtime and arise from unchanging or predictable sources, risk that is always present and can be insured

-ex. natural disasters, theft, fire

Dynamic Risk

Risks that arise out of unchanging circumstances and are unpredictable

-ex. social media, AI

Static vs. Dynamic Risk

Static: Risk that is unchanging and predictable

Dynamic: Risk that evolves due to social, economic, or technological changes

Diversifiable Risk

Risks that only affects one company or a small group and not the entire market

-ex. car accident involving two vehicles (doesn’t affect the whole society)

Non-Diversifiable Risk

Risks that affects the entire market and economy

-ex. natural disasters, inflation, unemployment, COVID-19

Diversifiable vs. Non-Diversifiable Risk

Diversifiable: Only affects a small group and not the entire market

Non-Diversifiable: Affects the entire market and economy

Objective Risk

The measurable and quantifiable difference between actual loss and the expected loss based on historical data and statistical analysis

Expected Losses (EL)

Based on experience, data, or other means-what we expect to happen

Actual Losses (AL)

Losses that actually occur

Variation of Loss Formula

(AL - EL) / EL

Subjective Risk

The personal feeling or perception of how risky something is

-ex. Opinions on drafting players in fantasy football

-not easily measured and not easy to compare among individuals

Objective vs. Subjective Risk

Objective: Risk measured based on facts and data

Subjective: Risk measured based on feelings and perceptions

Factors That Affect Risk

• Peril (1st Factor)

The immediate cause of the loss

ex. fire, flood, theft, injury, sickness, etc.

Factors That Affect Risk

• Frequency of the Loss (2nd Factor)

How often does it occur? Number of losses in a given period

-Cannot be negative

-Low frequency loss = Low probability loss

Factors That Affect Risk

• Severity of the Loss (3rd Factor)

Given that a loss has occurred, how bad is it in money terms?

Frequency = 0 → Severity is not an issue

Factors That Affect Risk

• Hazard (4th Factor)

A condition that causes losses to happen more often, become more serious, or both:

• Increases frequency of the loss

• Increases severity of the loss

• Increases both

Three Types of Hazards

Physical, Moral, Morale

Physical Hazard

Location

• Peril = Flood, living at the shore is a physical hazard (frequency)

• Peril = Fire, distance to a fire hydrant is a physical hazard (severity)

Construction

• Peril = Fire, wood is a physical hazard (frequency and severity)

Usage

• University classroom vs Church fire

Moral Hazards

Behavior difference because of the existence of insurance

Morale Hazards

Carelessness concerning losses

• Has nothing to do with the existence of insurance

-ex. why do people text and drive?

Goal of TRM

Minimizing financial impact on organization (playing defense)

Goal of ERM

Maximizing shareholder value

Risk Management in an Organization

-Originally was a specialized area of finance

-Constantly evolving

-It is not just insurance buying

Evolution of Risk Management

Risk Management began evolving in the mid 1960’s from Temple professor Wayne Snider

Steps in the Risk Management Process

1. Identify the exposures to loss

2. Evaluate the exposures to loss

3. Identify possible alternatives

4. Select among alternatives

5. Implement the chosen option

6. Re-evaluate the chosen strategy