MODULE 1 BASICS OF RISK What is Risk o Many Definitions Individual Organization Society Our definition Uncertainty Regarding Loss o Using the term risk Which is riskier Jumping off of a 1 story building Jumping off of a 25 story building What is a high risk driver Danger Risk Frequency Likelihood o Risk Measurement Terminology Measure of probability Usually referring to financial loss Severity Impact Expected Value Loss Risk Profile o Risk Measurement Degree of Risk Relative variation of actual from expected loss variation or standard deviation Variation a way of measuring degree of risk How far is it from what we expected to happen to what actually happened o Start Thinking about Risk Uncertainty doubt about our ability to predict future outcomes Uncertainty can differ across individuals even when risk is the same subjective Information does not alter risk objective but can alter uncertainty Reduction in uncertainty can be a good thing o Categories of Risk PURE RISK SPECULATIVE RISK 2 potential outcomes loss or no loss no potential for gain insurance can handle pure risk potential of loss no loss or gain ex buying stock to mitigate risk of buying stock in Facebook diversify portfolio FUNDAMENTAL RISK affects large s of individuals PARTICULAR RISK only affects individual ex flood diversification doesn t work ex heart attack diversification works STATIC RISK risk doesn t change ex probability of earthquake DYNAMIC RISK risk changes ex risk of having identity stolen is stronger today b c of technology avoid CORE RISK can t ex pharmaceutical companies face the risk that their product could kill someone SECONDARY RISK usually can avoid those companies can control the healthcare prices for their patients o Sources of Risk Personal Risks Property Risks play Liability Risks Financial Risks Almost always just you ex health divorce Risk of losing the things you own this is where insurance comes into You are held responsible for what you did or didn t do Making or losing money o Some More Risk Terminology Exposure Peril person or property facing risk of loss ex if your car was stolen theft would be the peril fire is peril if house the immediate cause of loss burns down condition affecting the frequency or severity of loss fire in your home increases ex if you store gas cans next to your fireplace the probability of a Hazard o Types of Hazards Physical hazards property conditions Intangible hazards attitudes or culture Hazards conditions affecting perils frequency or severity of loss Moral hazard behavioral changes Morale hazard indifference Societal hazards legal or cultural ex smoking is much more of a hazard today abortion o Attitude Toward Risk Risk Neutral indifferent toward risk Risk Averse Prefer to avoid risk Value of risky situation is expected loss Willing to pay more than expected loss to avoid risk Risk Seeker prefer risk Would pay more than expected return to engage in risky situation o Burden of Risk on Society Need for Larger Emergency Funds However there is an opportunity cost risk of accumulating emergency funds instead of using emergency funds for hurricanes we could use it to feed the poor Fear and Worry o How Do We Handle Risk Individuals Organizations Entire Industry Risk Management Society o Definition of Risk Management Scientific approach to dealing with risk o 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 The Risk Management Process 1 Determination of objectives 2 Identification of risks If you don t identify risk you implicitly decide to retain that risk There are a variety of tools available to assist in risk identification including questionnaires checklists and procedure guides Inspections typically used for manufacturing companies 1 Just as one picture is worth a thousand words one inspection tour may be worth a thousand checklists 2 An examination of the various operation sites of the firm and discussions with managers and workers will often bring attention to risks that might otherwise have been undetected Analysis of Documents 1 Analysis of Financial Statements Interviews Dun and Bradstreet SEC 10 K Report Annual Report Balance Sheet Income Statement 2 Flow Charts shows flow of materials 3 Organization Charts 4 Existing Policies 5 Loss Reports 6 Contracts and Leases 1 Operations Managers 2 Chief Financial Officer 3 Legal Counsel 4 Plant Engineer 5 Purchasing Agent 6 Personnel Manager 7 Plant Nurse 8 Safety Manager 9 Employees and Supervisors 10 External Parties The preferred approach to risk identification is a combination approach in which all of the tools available are brought to bear on the problem Evaluation of risks Loss Frequency probability distributions Loss Severity how bad the loss is Maximum Possible Loss how far away from median is deviation Probable Maximum Loss 3 A B Use of Statistics Central Tendency Measures of Variation Law of Large Numbers Importance of Severity in Ranking Exposures 2 reasons that potential severity must be measured 1 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 2 Severity must also be measured to determine the amount of insurance that should be purchased when the decision is made to transfer the risk 4 Consideration of alternatives selection of the tool Risk Control Risk Prevention and Reduction Avoiding losses has always been one of humanity s greatest concerns and risk control was undoubtedly the first risk management technique Broadly defined risk control encompasses all techniques aimed at reducing the number of risks facing the organization or the amount of loss that can arise from these exposures Risk control includes risk prevention and risk reduction Broadly speaking loss prevention efforts are aimed at preventing the In addition loss reduction efforts can be directed toward reducing In other words some risk control efforts aim at reducing frequency occurrence of loss the severity of those losses that do occur prevention others seek to reduce the severity of the losses that do occur reduction DON T FORGET COST BENEFIT ANALYSIS Risk Financing C Retention Planned vs Unplanned Funded vs Unfunded Types of Funded Retention Self Insurance Reserves Captive Insurance Companies Credit D Transfer 1 Noninsurance Transfers a Contracts b Hedging 2 Insurance buying insurance is method of transferring risk 5 6 Implementing the
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