​​​Understanding Risk and Risk Management Concepts

Risk

Uncertainty regarding loss

Risk Management

It is the scientific approach to dealing with risk

Individual

(Risk: Uncertainty regarding Loss). There is risk associated with playing sports, driving a car, investing money, and most aspects of living.

Organization

It is an uncertain future event which could adversely affect the achievement of an organization's objectives.

Society

Has additional constraints that the outcome must affect large portions of the population. (EX: economic risk, health risk, and others that impact large segments of society).

Frequency

(Likelihood) how often will something happen

Severity

(Impact) How bad is it when does it happen

Expected Value

Calculated as: Frequency * Severity.

Risk Profile

Graphical representation of risks

Pure

Involve only two potential outcomes, either loss or no loss

Speculative

Are those when you may have a loss or no loss but also have a gain.

Static

Are risks that are unchanging through time

Dynamic

Are risks changing through time

Fundamental

Risks affect a large portion of the population at a given time

Particular

Risks that only affect a single person, or small group of people at a given time.

Core

Risks that are inherent to the fundamental activities of an organization

Secondary

Risks that are not part of the core operations of an organization.

Property Risks

Risks that are directly related to an individual's life, health, or safety

Liability Risks

Risks that are directly related to an entity (individuals, organizations, governments) being held liable for its actions or interactions.

Financial Risks

Risks that are directly related to the financial standing of an individual or organization. EX: investment risk, new product launches.

Personal Risks

Risks that are directly related to an individual's life, health, or safety

Exposure

Person or property facing risk of loss

Peril

Immediate cause of loss

Hazard

Condition affecting frequency or severity of loss

Physical Hazards

Tangible conditions, EX: a wet floor makes it more likely someone will slip and fall.

Intangible Hazards

Attitudes or culture

Moral/Morale Hazard

Attitude/behavior that affects the frequency/severity of loss, EX: not being careful with your cell phone because you purchased insurance coverage on it

Risk Neutral

Indifferent towards risk; the value of any risky situation is the expected outcome

Risk Averse

Prefer to avoid risk; willing to pay to remove risk

Risk Seeker

Prefer risky situations; willing to gamble or take on risk at values below expected value.

Determination of Objectives

Organizations have specific risk management objectives aimed at protecting and sustaining their operations, with both pre-loss and post-loss strategies focused on minimizing negative outcomes and ensuring organizational survival.

Identification of Risks

Inspection of facilities, analysis of documents (financial, legal, insurance), interviews with stakeholders, a variety of check lists.

Evaluation of Risks

Is a combination of quantitative and qualitative analysis. (Both can be analyzed using a variety of statistics and probability distributions)

Consideration of Alternatives

Once all the risks have been identified and properly evaluated, the main question is "what do we do about it? How do we manage all the risks we faced? (Divided into risk control, risk financing, internal risk reduction)

Implementing Decisions

Put in place all the techniques you selected in step 4

Evaluation and Review

Back to the beginning and do it all over again

Key rules of risk management

Don't risk more than you can afford to lose. Don't risk a lot for a little. Consider the odds

Loss Control

Reduced level of risky activity, Increased precautions.

Loss Prevention

Try to prevent the occurrence of loss (reduce frequency)

Loss Reduction

Try to reduce the severity of losses that do occur (reduce severity)

Loss Financing

Retention, Self-Insurance, Insurance

Retention

You pay for the adverse outcomes that may occur

Planned

You can create a retention plan (I will pay for any losses out of my savings account).

Unplanned

You can just ignore it. (if a loss occurs, I will figure it out).

Funded

You can create an account and put money into to pay for future losses.

Unfunded

You can pay it out of cash flow or other sources not specifically earmarked for losses.

Transfer

You get someone else to pay for it. EX: Contracts, Hedging, Insurance.

Decision theory

A formal analytic framework for decision-making under uncertainty.

Public policy perspective

Government policies affecting the entire population.

Steps of Decision-Making Process

1. Determine all possible future outcomes (states of the world). 2. Identify all potential organizational choices. 3. Combine outcomes and choices into a matrix (payoff table). 4. Select the best choice using specific decision criteria.

Maximax Criterion

Optimistic approach. Select the option with the maximum potential payoff. Focuses on the best possible outcome.

Maximin Criterion

Pessimistic approach. Select the option with the highest minimum payoff. Minimizes potential losses.

LaPlace Criterion

Calculate the average of all possible outcomes. Choose the option with the highest average. Useful when probabilities are unknown.

Maximum Likelihood

Select the choice corresponding to the most probable outcome. Based on the highest probability event.

Utility Theory

People do not always make decisions based on maximizing expected monetary value.

Utility

Increasing in wealth (more is better). Increasing at a decreasing rate. Assumes people are generally risk-averse.

Risk-averse

Person is always willing to accept a smaller cash-certain amount than the expected value of gamble. Most people are risk averse.

Risk-neutral

Person who prefers the expected value of a gamble to the same cash-certain amount.

Risk-seeker

Person who is indifferent (neutral) between a cash certain amount and a gamble with an expected value equal to the cash certain amount. Equivalent to making decisions based on expected value.

Opportunity cost

The value of what was given up to pursue another choice.

Marginal cost/marginal benefits

The benefit value of a choice can decrease over time, and when the cost exceeds the value of the benefit, the activity should stop.

Sunk costs

Costs that do not change regardless of choice and should not be considered when calculating utility.

Reservation Price

The minimum amount that must be offered to undertake an activity.

Externalities

Final consideration in understanding that all the benefits or all the costs of your decisions may not be borne by you, the decision maker.

Normative

What should be done.

Positive

What are the likely consequences.

Age biases

People in certain age groups tend to interpret information about risk differently: frequently younger people take more risk than older people.

Cultural biases

Certain culture views of risk differ.

Experience biases

People who have experienced a low-probability/high-consequence event tend to overestimate its likelihood; people who have not experienced one tend to underestimate the likelihood of it happening again.

Media biases

Risk that garner a lot of media attention (murder, terrorism, kidnapping) are typically overestimated, while other risks (car accidents, health risks) tend to be underestimated.

Types of Incentives

Financial. Moral. Natural. Coercive. Personal vs. social.

Risk categories for individuals

Property, liability, life, health, financial.

Three Elements of Loss Exposure

Asset (something of value) exposed to loss. A potential cause of loss. Financial consequences of the loss (if it occurs).

Individual Risk Management Process

Determine Objectives. Identify Risks. Evaluate Risks. Choose Alternatives. Implement. Review & Evaluate.