Module 6 Results of Decision Making Risk Reward Relationship Any individual organization or government willing to take on additional risk should be compensated with some type of additional reward Level of risk should have a commensurate level of reward Risk reward trade off will differ among individuals depending on level of risk aversion Will vary among organizations as well but not as much Because organizations make decisions based on expected value rather than expected utility there is less variation in decision making Some organizations are much more willing to take risks because the expectations are high risk high reward Are measured by using expected utility How much reward is necessary to induce you to take a risk How much are you willing to pay to avoid risk Purpose of insurance people willing to pay Individuals to avoid risk Organizations Are measured by expected value There is no natural risk aversion Opportunity cost or cost of capital Cost of capital the rate of return that could have been earned by putting the same money into a different investment with equal risk Most organizations project future cash flows from investments opportunities They utilize opportunity cost through discounting When you compare the value of investing a dollar today to the value of a dollar in the future you must discount or bring that future dollar back to a value today The higher the opportunity cost or cost of capital the larger the future value needs to be to get them to invest present value They estimate the future cash flows of an investment and then discount them back to The discount rate is the reward necessary for the organization to take on risk The cost of capital corresponds with the riskiness of the firm CAPM Capital Asset Pricing Model Describes relationship of risk expected return Only reward systemic risk risk to an overall market not just a specific industry not diversifiable risk industry or company specific hazard Government Society Not as easy to determine what reward is needed for governments to take on additional risk Many times governments are the only option for some risk regardless of reward National Difficult to measure the social benefit of some things which would be the reward Ex What Food Insurance Program is the social benefit of national parks Problems with Decision Making Biases Bias an inclination of temperaments or outlook to present or hold a partial perspective at the expense of possibly equally valid alternatives in references to objects people or groups Subjective view that is one sided Our models will be off in some way we will either be overestimating or underestimating Ex Donald Rumsfeld the Secretary of Defense under G W Bush quote about the unknown unknowns Biases we are unaware of but still have problems modeling Age biases certain age groups tend to interpret information about risk differently Cultural biases certain culture view of risk differ Gender biases Experience biases people who experienced a low probability high consequence event tend to overestimate its likelihood people who have not experienced one tend to underestimate Media biases risks that garner a lot of media attention murder terrorism kidnapping are typically overestimated while other risks car accidents health risks tend to be underestimated Incentives Incentives are things that motivate individuals to perform an action Can be at the individual level organizational level or societal level Types of incentives Financial most incentives Moral do the right thing Natural curiosity fear anger pain joy pursuit of happiness Coercive negative reinforcement Personal vs Social Beware The law of Unintended consequences People offering incentives are often unable to predict the way that people will respond to them Imperfect knowledge and unintended consequences can make incentives more complex than the people offering them originally expected Can lead to unexpected disasters Political incentives Short term vs long term planning Political incentives increase the discount rate Module 7 Overview of Risk Individuals Lots of categories of risk at the individual level Property Liability Life Health Financial Some risks may appear in multiple categories Risk Management for Individuals Loss Exposures any condition or situation that presents possibility of loss regardless of whether that loss actually occurs Three elements to a loss exposure 1 Asset exposed to loss 2 Cause of loss 3 Financial consequences of the loss Property Risk Asset exposed to loss Real property land buildings Personal property furniture jewelry art Cause of loss Fire theft accidents Financial consequences of the loss Reduction in property value Increased expenses Lost income Liability Risk Asset exposed to loss Money other financial assets General special punitive damages Cause of loss Claim lawsuit Civil law vs criminal law Contract statutory Negligence Financial consequences of the loss Defense costs monetary damages Types property owners automobiles employer employee parents and children animals Life Risk Premature Death Premature death is defined as death with financial obligations remaining Asset exposed to loss life Cause of loss premature death illness accident Financial consequences of the loss Wage earning adult married single with dependents single with no dependents Non wage earning adult married single with dependents single with no dependents Child Life Risk Long Life Asset exposed to loss savings retirement wealth Cause of loss outliving assets expenses income for too long Financial consequences of the loss Income Expenses which increase decrease Health Disability Risk Asset exposed to loss health livelihood Cause of loss poor care poor genes bad luck injury illness Financial consequences of the loss Ability to earn income may decrease or cease as in premature death Living expenses may continue or increase Evaluate same exposure categories as premature death Financial Risk Asset exposed to loss wealth Cause of loss health disability unemployment poor planning Financial consequences of the loss Inadequate savings back to work can t retire Risk Management Process Determine objectives Review and evaluate Identity risk Evaluate risk Choose your alternatives Implement How do you apply the Risk Management Process Objectives change throughout life Ex Premature death 20 s not many people relying on you your income 30 s family life changing significant risk 40 s your grown up highest this risk will ever be 50 s risk
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