Risk and its management
MODULE 1
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What is risk?
Risk is uncertainty about the outcome... in a general sense
Possible variability in outcomes around expected values....Specific meaning US events.
Expected value is outcome that would occur on average when a person or business is exposed repeatedly to the same type of risk.
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Ex: Sachin's batting average is 67 based on data. So the expected score he is likely to hit.
However, there is a degree variability around the value. He might duck out or hit a century.
Risk
Expected loss
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Variability/Uncertainty
Risk v/s uncertainty
| Risk | Uncertainty |
|---|---|
| Probability of the possible outcomes of the event is known | probability of the possible outcome is not known |
| Dispersion of the probability distribution is risk | Lack of confidence that the estimated probability distribution is correct |
Types of risks
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BUSINESS RISK
Business risk is possible reductions in value of business from a source. Business value depends upon size, timing and risk variability in cash flows. Unexpected changes in future cash flows can cause business risk.
There are three main risks involved in business:
Price risk, Credit risk and Pure risk
1. Price risk:
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Refers to uncertainty over magnitude of cash flows due to possible changes in output and input prices. Analysis of price risk associated with sale and production of existing and future products gains strategic management. Three specific types of price risks are
Commodity price risk
Exchange rate risk
Interest rate risk (affects terms of credit, speed of repayment and cost of borrowings)
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Types of risk
2. Credit risk:
Risk that a firm's customers and the parties to which it has lent delay or fail to make promised payments is called credit risk. Firms face credit risk from accounts receivables. Financial institutions face risk of default by borrowers. Firms carry risk of non-payment and bankruptcy.
Firms have to pay more to borrow money as risk increases.
3. Pure risk:
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Risk management function traditionally concentrates on managing pure risk. Pure risk relates to losses associated with assets. It covers:
Damage to assets: (reduction of value of business assets due to damage, theft, and expropriation (seizure by foreign govt)
Legal liability: of harm to customers, suppliers, share holders, others
Worker injury: risk of paying compensation and damages to employees
Employee benefits: risk of death, illness and disease of employees/families as per contracts/Acts.
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Types of risk
4. Personal risk:
Earnings risk: refers to potential fluctuations in a family's earnings which can occur as a result of decline in in the value of an earner's productivity due to death, disability, aging, or a change in technology.
Medical expense risk:
Liability risk on auto and home
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Risk of loss of value of physical assets like auto, home, boats, watercrafts, electronics. They can be lost stolen or damaged.
Risk of loss of value of financial assets like stocks and bonds
Longevity risk refers to retired people outliving their financial resources.
This course...
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Much of this course talks about pure risk and its management.
However, the principles and techniques discussed will apply to all types of risks.
Burden of risk
Risk results in certain social and economic effects
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Larger emergency fund: one needs huge funds to take care of emergency requirements of repair and loss of property. This affects business
Loss of certain goods and services: because companies have discontinued manufacturing certain goods and services. Eg: certain vaccines, asbestos products, breast implants, birth control devices due to fear of law suits
Worry and fear: induced in the mind of people when they encounter risk involved in jet flights, writing exams, skiing etc
Sources of risk
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External sources:
Business factors
Natural factors – earthquake, famine, cyclone, lightning,
Political factors – change of govt, civil war, riot changes
Internal sources:
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Operational -
Technological
Human factors
Technological
physical
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Degree of risk/objective risk
Degree of risk is defined as relative variation of actual loss to actual loss.
Assume that out of 10000 houses, 1% ie 100 houses burn each year. In reality 110 houses or 90 houses may burn. Relative variation is 10%. This is objective risk or degree of risk
Objective risk declines with increase in number of exposures. More specifically, objective risk varies inversely with the square root of number of cases under observation.
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Assume that 1 million houses are insured. Expected houses that burn is 1% ie 10000. 10% relative variation is 100 houses. Objective risk therefore is 100/10000 = 1%
Therefore square root of the number of house goes up 10 times from 100 to 1000, the objective risk comes down to 10% of the original level.
Objective risk can be statistically measured by measures of dispersion like standard deviation. As the number of exposures increases prediction will be more accurate as variation is less.
Risk management
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Risk management is the identification, assessment, and prioritization of risks followed by coordinated and economical application of resources to minimize monitor and control the probability and/or impact of unfortunate events.
Jorin defined risk management as the process by which various risk exposures are identified, measured and controlled.
Risk management refers to the systematic application of principles, approaches and processes to the tasks of identifying and assessing risks and then planning and implementing responses.
Methods of risk management
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Broadly 3 methods:
Loss control
Loss financing
Internal risk reduction
1 and 3 involves decisions to invest/not invest to reduce losses while 2nd one refers to how to pay for losses if they do occur
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1. Loss control
Actions that reduce the expected cost of losses by reducing the frequency of losses and/or the severity (size) of losses that occur are known as loss control. It is also sometimes known as risk control.
Actions that reduce the frequency of losses are commonly called loss prevention methods. Eg: routine inspection of aircrafts. Actions that reduce the severity of losses are called loss reduction methods. Eg: smoke detectors. Some combine both eg: airbags in vehicles.
There are 2 general approaches to loss control.
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Reducing the level of risk activity (truck with toxic chemicals shifting over to other products)
- increasing precautions against loss of activity
2. Loss financing
Methods used to obtain funds to pay for or offset losses that occur is called loss financing
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Broad methods
retention: business retains the right to pay up losses. Also called self-insurance
Insurance: pay premium and receive funds to recover good losses. Risk transferred to insurers.
Hedging: Derivatives like futures, forwards, options, swaps manage mainly the price risk.
Other contractual risk transfers: indemnity taken from others (contractors) for damage/injury etc.
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3. Internal risk reduction
Businesses can reduce risk internally
1. Diversification: Businesses spreading across different areas can help reduce risk. Do not keep all eggs in the same basket.
2. Invest on information: in order to obtain superior forecasts of future cash flows thereby reducing variability.
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Risk management process
Identify all significant process
Evaluate the potential frequency and severity of losses
Develop and select methods for managing risk
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Implement the risk management methods chosen
Monitor the performance and suitability of the risk management methods and strategies on an ongoing basis.
(Detailed explanations given in guide
Risk management by individuals and corporations
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ASSIGNEMENTQUESTION
Objectives of risk management
To be consistent with corporate objectives of revenue and safety
To provide good service to customers
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Initiate action to reduce or prevent risk and its effects
Minimise human costs of risk
To meet statutory and legal obligations
Minimise financial losses and claims
Minimise the risks associated with new developments and activities.
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To be able to make informed decisions and more choices on possible outcomes.
Need for a rationale for risk management in org
ASSIGNMENT QUESTION
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Cost of risk
We know the actual cost only ex-post. Ex-ante estimate of loss is done on the basis of
1. expected loss
2. cost of loss control
3. cost of loss financing
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4. cost of internal risk reduction
5. cost of any residual uncertainty that remains after 2,3,4 are implemented
Cost of risk
1. Expected loss = direct loss of the value of the asset + indirect loss arising out of the event. If a house is destroyed additional indirect losses occur because of hotel expenses, additional food expenses, additional travel costs etc. This is in addition to the direct loss of house.
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If a factory is destroyed, then,
direct loss is the value of the factory, cost of repair, cost of product compensation,/claims, cost of defending liability claims.
Indirect losses are:
Loss of normal profit,
Extra operating expenses
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Higher costs of funds
Legal expenses and Bankruptcy costs
Foregone investments
Reorganisation and liquidating costs.
Cost of risk
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2. cost of Loss control
Cost of actions that reduce the expected cost of losses by reducing the frequency of losses and/or the severity of losses.
eg: cost of testing facilities, lost profit because of limited distribution of defective goods.
3. cost of loss financing:
Cost of methods used to obtain funds to pay for or offset losses that occur is called loss financing. This includes cost of maintaining reserve funds for self insurance- tax on interest and opportunity cost, insurance premiums, transaction cost of arranging, negotiating and enforcing hedging arrangements and other risk transfers
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Cost of risk
4. Cost of internal risk reduction methods:
Transaction costs associated with achieving and managing diversification and cost of obtaining and analysing data to obtain more accurate cost forecasts. This may include consultancy costs of procuring more accurate data.
5. Cost of residual uncertainty:
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Cost of uncertainty left over after selecting and implementing loss control, loss financing, internal risk reduction is called cost of residual uncertainty. This increases the risk of business and increases the cost of holding that stock. Employees require higher wages.
Cost tradeoffs
1. Trade off between expected cost of direct/indirect loss and loss control costs
2. Tradeoff between expected cost of indirect loss and cost of loss financing /internal risk reduction
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3. Tradeoff between cost of loss financing /internal risk reduction and cost of residual uncertainty.
An increase in the cost of one would reduce the cost of the other. Companies have to decide on the right mix of cost of each risk management tool.
Individual risk management or cost of risk
Apart from pure risk under business risks, concept of risk management applies to individual risk management as well. An individual would consider expected loss (both direct and indirect) from accidents, loss prevention activities (driving less at night), loss reduction activities (insurance, cost of gathering weather information). He would also consider cost of residual uncertainty which depends upon the person's attitude towards risk
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Amount of risk management undertaken by an individual depends upon degree of his risk aversion. Risk aversion is the tendency to choose alternative with lesser or lower variability. Eg: 100, -100 v/s 1000, -1000 .
Most people are risk averse. They are willing to pay more to reduce risk (more insurance). They also need funds
Risk management and societal welfare
How to reduce the total aggregate cost of risk (cost of losses, cost of risk control, loss financing, internal risk reduction, and residual uncertainty
Minimising the cost of risk for the society promotes an efficient level of risk. Efficient level is where the marginal benefit of risk reduction equals the marginal cost of these methods.
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Maximising the value of resources with minimum cost of risk makes the economy more efficient
Differential insurance premia in the society (differential taxes) works against maximisation of wealth to some extent.
Risk management and societal welfare
Minimising the cost of risk for a business does not lead to minimising cost of risk to the society. It works adversely as the employees/contractors/ suppliers etc get exposed to more risk. Therefore the business must build in the social cost of risk into its own private cost of risk. (Total cost to society). Business value maximisation does not result in minimising total social cost to society
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Regulation from the governement legally takes care of the fact that businesses do not concentrate on reducing private cost to maximise profits which resuits in a higher risk to the society.
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