RISK MANAGEMENT

Lecture 1

Introduction to Risk
& Risk Management-1
Learning Objectives
 What is Risk?
 Types of Risk
 Chance of loss
 Peril & Hazard
 Categories of Risk
 How to handle risks?
 What is Risk Management?
 Objectives of Risk Management
Learning Objectives
 Steps in Risk Management Process
 Benefits of Risk Management
What is Risk?
 No single definition.
 Risk is defined as uncertainty concerning the
occurrence of a loss.
 In finance, risk is defined as variability of
returns.
 Measure of financial risk:
 Standard Deviation
Is risk bad?
 No, risk is not bad.
 Risk-return framework.
 No gain without pain.
 One cannot expect higher return unless one
exposes oneself to higher level of risks.
 Investors differ in their risk bearing capacity.
 Risk averse
 Risk neutral
 Risk seeker
Types of Risk
 Objective Risk (Degree of Risk)
 Relative variation of actual loss from expected
loss.
 It varies inversely with square root of number of
cases under observation.
 Law of large numbers: As number of exposures
increases the actual loss will approach the
expected loss.
 Measures: Standard deviation, coefficient of
variation
Types of Risk
 Subjective Risk
 Uncertainty based on a person’s mental condition
or state of mind.
 High subjective risk leads to more conservative
behavior.
 Low subjective risk leads to less conservative
behavior.
Chance of loss
 Defined as probability that an event that
causes a loss will occur.
 Objective Probability:
 Long run relative frequency of an event.
 Can be determined by deductive or inductive
reasoning.
 Subjective Probability:
 Individuals personal estimate of chance of loss.
 Depends on age, gender, education, etc.
Chance of loss vs. Objective
Risk
 Chance of loss is defined as probability that
an event that causes a loss will occur.
 Objective Risk is the relative variation of
actual loss from expected loss.
Peril & Hazard
 Peril is defined as the cause of loss.
Examples: Fire, earthquake, flood, etc.
 Hazard is a condition that creates or
increases the chance of loss.
 Physical hazard
 Moral hazard
 Morale hazard
 Legal hazard
Categories of Risk
 Pure Risk: situation in which possibilities are
loss and no loss.
 Speculative Risk: either profit or loss is
possible.
 Differences:
 Law of large numbers can be easily applied to
pure risks.
 Insurers typically insure pure risks.
 Society may benefit from speculative risks.
Categories of Risk
 Fundamental Risk: affects entire economy or
large sections of it. Examples: War, inflation,
etc.
 Particular Risk: affects individuals.
 Enterprise Risk: encompasses all major risks
faced by a firm.
 Pure, speculative, strategic, operational &
financial risks.
Categories of Risk
 Systematic Risk: Risk that cannot be
diversified. Also called market risk.
 Non-systematic Risk: Risk that can be
eliminated by diversification. Also called
Unique/Specific risk.
Types of Pure Risk
 Personal Risk:
 Premature death.
 Insufficient income after retirement.
 Poor health or disability.
 Unemployment.
 Property Risk: Direct or Indirect.
 Liability Risk
Burden of risk on society
 Larger emergency fund
 Loss of certain goods or services.
 Worry and fear
Methods of handling risk
 Avoidance
 Loss Control
 Loss prevention
 Loss reduction
 Retention
 Active retention: Individual is aware of risk and deliberately plans
to retain it.
 Passive retention: Ignorance, indifference.
 Non-insurance Transfers
 Transfer of risks by contracts.
 Hedging price risks.
 Limited liability company.
 Insurance
What is Risk Management?
 Does it mean ‘reduction of risk’?
 Risk Management (RM) is a process that
identifies loss exposure faced by a firm and
selects the most appropriate techniques for
treating such exposures.
 Points to note:
 It is a dynamic process.
 Does not talk about risk reduction.
Objectives of Risk Management
 Pre-loss objectives:
 Economy: Firm should prepare for potential losses in most
economical manner.
 Reduction of anxiety.
 Meeting legal obligations.
 Post loss objectives:
 Survival
 Continued operations
 Stability of earnings
 Growth
 Social responsibility
Application
 Why doesn’t Government of India insure its
assets?
 Large number & value of assets. Itself becomes
an insurer.
 Worst case scenario does not threaten its
survival.
Steps in RM process
 Identify loss exposures.
 Analyze the loss exposures.
 Select appropriate technique for treating the
loss exposures.
 Implement and monitor the risk management
program.
Steps in RM process-1
 Identify loss exposures.
 Property loss: buildings, plants, inventory, etc.
 Liability loss: defective products, pollution, law
suits, etc.
 Business income loss.
 Human resources loss: death of key employees,
injuries, etc.
 Crime loss: theft, fraud, cyber crimes, etc.
Steps in RM process-1
 Identify loss exposures.
 Employee benefit loss: failure to comply with govt.
regulations, etc.
 Foreign loss: currency risks, kidnapping,
nationalization, etc.
 Reputation.
 Sources: inspections, financial statements,
historical loss data, analysis of operations,
etc.
Steps in RM process-2
 Analyze the loss exposures.
 Estimation of frequency and severity.
 Loss frequency: probable number of losses in a given
time frame.
 Loss severity: probable size of loss.
 Maximum possible loss: worst loss that could
happen.
 Maximum probable loss: worst loss that is likely to
happen.
Steps in RM process-3
 Selecting the appropriate technique.
 Risk Control: techniques that reduce frequency
and severity of losses.
 Avoidance: means a loss exposure is not acquired or
existing loss exposure is abandoned.
 Loss prevention: measures that reduce frequency of a
particular loss.
 Loss reduction: measures that reduce severity of a
loss after it occurs.
Steps in RM process-3
 Selecting the appropriate technique.
 Risk Financing: techniques that provide for
funding of losses:
 Retention: active or passive.
 Can be used if no other method is available, losses are
highly predictable, worst possible loss is not serious.
 Advantages: save money, lower expenses, encourage
loss prevention, increase cash flow.
 Disadvantages: possible higher losses, higher
expenses, higher taxes.
Steps in RM process-3
 Selecting the appropriate technique.
 Non-insurance transfers: pure risk & its potential
financial consequences are transferred to another
party. Examples: leases, hold-harmless agreements.
 Insurance: appropriate for loss exposures that have a
low probability but high severity.
 Advantages: indemnification, reduction of uncertainty, tax
deductible, risk management services provided by insurers.
 Disadvantages: cost of premiums, time & effort in
negotiating insurance, less incentive to follow loss-control
program.
Steps in RM process-4
 Implement and monitor the RM program.
 Policy statement.
 Cooperation with other departments.
 Periodic review and Evaluation.
Benefits of RM
 Pre-loss and post-loss objectives are more
easily attainable.
 Cost of risk is reduced.
 Benefits to society.