1 Risk in Business and in Society Fall 2014 Notes What is risk o Many definitions Uncertainty regarding loss Individual Organization Society Using the term risk o Danger does not equal risk Risk measurement Terminology o Frequency Likelihood o Severity Impact o Expected value loss o Risk profile Risk measurement Degree of Risk o Relatable variation of actual from expected loss variation and o How far is it from what we expect to happen to what actually standard deviation happened Start thinking about risk o Uncertainty o Uncertainty can differ across individuals even when risk is the same is doubt about our ability to predict future outcomes subjective o Information does not alter risk objective but can alter uncertainty o Reduction in uncertainty can be a good thing Categories of risk o Pure vs Speculative Loss No Loss o Static vs dynamic does it change through time Static Earthquake risk won t change in time Dynamic Changes with time o Fundamental vs Particular Fundamental Large percentage of population at the same time Ex Earthquake the economy Particular Specific person or group o Core vs Secondary Sources of risk o Personal risk o Property risk o Liability risk o Financial risk More terminology o Exposure Person or property facing risk of loss 2 o Peril The immediate cause of loss o Hazard Condition affecting the frequency or severity of loss Ex not locking the car Types of hazards o Hazards Conditions affecting risks frequency or severity of loss o Physical hazards Property conditions leaving oil rag near a furnace o Intangible hazards Attitudes or culture Moral hazard behavioral changes Morale hazard Indifference Societal hazard legal or cultural changing laws Attitude toward risk o Risk neutral Indifferent toward risk Value of risky situation is expected loss Risk adverse prefer to avoid risk Willing to pay more than expected loss to avoid risk Risk seeker prefer risk Would pay more than expected return to engage in Burden of risk on society risky situation o Need for larger emergency funds set aside money for things that may occur o Loss of needed goods and service o Fear and worry Definition of Risk Management o Scientific approach to dealing with risk Rules of Risk Management o Don t risk more than you can afford to lose o Don t risk a lot for a little o Consider the odds The Risk Management Process Test Question 1 Determination of objectives Post Loss Objectives Survival Continuity of operations Earnings stability Continued growth Social responsibility Pre Loss Objectives Economy Reduction in Anxiety Meeting Externally imposed obligations Social responsibility 2 Identification of risk 3 Tools to identify include questions checklists and procedure guides The preferred approach is combination approach Inspections Can bring attention to risks that may have been undetected Analysis of Documents Analysis of financial statements o Dun and Bradstreet o SEC 10 K Report o Annual Report o Balance Sheet o Income Statement Flow charts Organization charts Existing Policies Contracts and Leases Loss reports 3 Evaluation of risks Loss Frequency probability distributions Loss Severity Maximum possible loss worst case scenario Probable maximum loss most likely loss o Severity must be measured for two reasons Some notion of severity is necessary for classifying risks Whether an exposure will be classed as critical important or unimportant depends on the potential severity of loss Severity must also be measured to determine the amount of insurance that should be purchased when the decision is made to transfer the risk Use of statistics Central tendency Measures of variation Law of large numbers 4 Consideration of alternatives selection of the tool 4 5 Implementing the decision 6 Evaluation and review In theory the evaluation and review are the final step in the risk management process Except in the rare case where an organization is newly created every organization will have a risk management program already in existence Variance calculation Variance Coefficient of variation SD E Loss Standard Deviation Square root of variance Risk Prevention Reduction Some risk control efforts aim at reducing frequency prevention and others Risk Financing C Transfer Planned vs Unplanned Funded vs Unfunded Types of Funded retention 5 Self Insurance Reserves Captive insurance companies Credit D Transfer Non insurance Transfers Contracts Hedging Incorporation Insurance MODULE TWO Risk and the Entrepreneurial Spirit Innovation Risk Innovations can make us feel safe True Inventors can perfectly predict how their innovations will be used False Inventions can change risk reward trade off True 1 2 3 4 Which is more likely Child to be president Child die in a plane crash Riskiness of innovation depends on choices people make More informed choices the lower the risk Innovations to make us feel safer often lead to us changing our habits because we feel safer May lead to additional risk 2 rules of thumb to minimalize risk o Recognize that you need a model o Acknowledge your model s limitation o Expect the unexpected o Understand use and user o Check the infrastructure Decision about risk and return when you adopt a new product technology is informed by a mental model o A mental model may be an oversimplification Additional variables and their relationship make model more complicated o Mathematical model allows more precision than human cognition Humans set math models to execute things based on guidelines No model is correct because it is always missing info but it can make it better Incorrect Model whose internal logic or underlying assumptions are manifestly wrong o The only correct thing to do is stop using it Incomplete characteristic shared by all models basic model doesn t need to be unlearned but added to 6 o Until a fundamental violation or error in assumptions is found within a model the logical course if to refine rather than reject Some factors overlooked o Happens when an innovation interacts with other changes in environment that is unrelated thus not recognized as risk factors o Financial crisis was caused when these 3 factors occurred simultaneously Efficient mortgage refinancing market Low interest rates Rising house prices What happens when we all use the same model o April 23rd 2013 Associated Press twitter account is hacked Immediate financial market reaction Two fake posts Explosions at the White House DJIA drops 140 points Automated trading programs that look at twitter accounts and other
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