Download VTU (Visvesvaraya Technological University) MBA 4th Semester (Fourth Semester) 16MBAFM402-Risk Management and Insurance RMI Module 1 Important Lecture Notes (MBA Study Material Notes)
management
MODULE 1
FirstRanker.com - FirstRanker's Choice
Risk and its
management
MODULE 1
What is risk ?
Risk is uncertainty about the outcome? in a general
sense
Possible variability in outcomes around some
expected values?.Specific meaning used for
events.
Expected value is outcome that would occur on an
average when a person or business is exposed
repeatedly to the same type of risk.
Ex: Sachin?s batting average is 67 based on past
data. So the expected score he is likely to hit is 67.
However, there is a degree variability around this
value. He might duck out or hit a century.
FirstRanker.com - FirstRanker's Choice
Risk and its
management
MODULE 1
What is risk ?
Risk is uncertainty about the outcome? in a general
sense
Possible variability in outcomes around some
expected values?.Specific meaning used for
events.
Expected value is outcome that would occur on an
average when a person or business is exposed
repeatedly to the same type of risk.
Ex: Sachin?s batting average is 67 based on past
data. So the expected score he is likely to hit is 67.
However, there is a degree variability around this
value. He might duck out or hit a century.
Risk
Expected loss Variability/Uncertainty
FirstRanker.com - FirstRanker's Choice
Risk and its
management
MODULE 1
What is risk ?
Risk is uncertainty about the outcome? in a general
sense
Possible variability in outcomes around some
expected values?.Specific meaning used for
events.
Expected value is outcome that would occur on an
average when a person or business is exposed
repeatedly to the same type of risk.
Ex: Sachin?s batting average is 67 based on past
data. So the expected score he is likely to hit is 67.
However, there is a degree variability around this
value. He might duck out or hit a century.
Risk
Expected loss Variability/Uncertainty
Risk v/s uncertainty
Risk Uncertainty
Probability of the
possible outcomes of
the event is known
probability of the
possible outcomes is
not known
Dispersion of the
probability
distribution is risk
Lack of confidence
that the estimated
probability
distribution is correct
FirstRanker.com - FirstRanker's Choice
Risk and its
management
MODULE 1
What is risk ?
Risk is uncertainty about the outcome? in a general
sense
Possible variability in outcomes around some
expected values?.Specific meaning used for
events.
Expected value is outcome that would occur on an
average when a person or business is exposed
repeatedly to the same type of risk.
Ex: Sachin?s batting average is 67 based on past
data. So the expected score he is likely to hit is 67.
However, there is a degree variability around this
value. He might duck out or hit a century.
Risk
Expected loss Variability/Uncertainty
Risk v/s uncertainty
Risk Uncertainty
Probability of the
possible outcomes of
the event is known
probability of the
possible outcomes is
not known
Dispersion of the
probability
distribution is risk
Lack of confidence
that the estimated
probability
distribution is correct
Types of risks
? BUSINESS RISK
Business risk is possible reductions in value of business from any
source. Business value depends upon size, timing and risk variability
in cash flows. Unexpected changes in future cash flows can lead to
business risk.
There are three main risks involved in business:
Price risk, Credit risk and Pure risk
1. Price risk:
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)
FirstRanker.com - FirstRanker's Choice
Risk and its
management
MODULE 1
What is risk ?
Risk is uncertainty about the outcome? in a general
sense
Possible variability in outcomes around some
expected values?.Specific meaning used for
events.
Expected value is outcome that would occur on an
average when a person or business is exposed
repeatedly to the same type of risk.
Ex: Sachin?s batting average is 67 based on past
data. So the expected score he is likely to hit is 67.
However, there is a degree variability around this
value. He might duck out or hit a century.
Risk
Expected loss Variability/Uncertainty
Risk v/s uncertainty
Risk Uncertainty
Probability of the
possible outcomes of
the event is known
probability of the
possible outcomes is
not known
Dispersion of the
probability
distribution is risk
Lack of confidence
that the estimated
probability
distribution is correct
Types of risks
? BUSINESS RISK
Business risk is possible reductions in value of business from any
source. Business value depends upon size, timing and risk variability
in cash flows. Unexpected changes in future cash flows can lead to
business risk.
There are three main risks involved in business:
Price risk, Credit risk and Pure risk
1. Price risk:
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)
Types of risk
2. Credit risk:
Risk that a firm?s customers and the parties to which it has lent money will
delay or fail to make promised payments is called credit risk. Most firms
face credit risk from accounts receivables. Financial institutions carry 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:
Risk management function traditionally concentrates on management of
pure risk. Pure risk relates to losses associated with assets. It comprises of:
Damage to assets: (reduction of value of business assets due to physical
damage, theft, and expropriation (seizure by foreign govt)
Legal liability: of harm to customers, suppliers, share holders, other parties
Worker injury: risk of paying compensation and damages to employees
Employee benefits: risk of death, illness and disability to
employees/families as per contracts/Acts.
FirstRanker.com - FirstRanker's Choice
Risk and its
management
MODULE 1
What is risk ?
Risk is uncertainty about the outcome? in a general
sense
Possible variability in outcomes around some
expected values?.Specific meaning used for
events.
Expected value is outcome that would occur on an
average when a person or business is exposed
repeatedly to the same type of risk.
Ex: Sachin?s batting average is 67 based on past
data. So the expected score he is likely to hit is 67.
However, there is a degree variability around this
value. He might duck out or hit a century.
Risk
Expected loss Variability/Uncertainty
Risk v/s uncertainty
Risk Uncertainty
Probability of the
possible outcomes of
the event is known
probability of the
possible outcomes is
not known
Dispersion of the
probability
distribution is risk
Lack of confidence
that the estimated
probability
distribution is correct
Types of risks
? BUSINESS RISK
Business risk is possible reductions in value of business from any
source. Business value depends upon size, timing and risk variability
in cash flows. Unexpected changes in future cash flows can lead to
business risk.
There are three main risks involved in business:
Price risk, Credit risk and Pure risk
1. Price risk:
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)
Types of risk
2. Credit risk:
Risk that a firm?s customers and the parties to which it has lent money will
delay or fail to make promised payments is called credit risk. Most firms
face credit risk from accounts receivables. Financial institutions carry 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:
Risk management function traditionally concentrates on management of
pure risk. Pure risk relates to losses associated with assets. It comprises of:
Damage to assets: (reduction of value of business assets due to physical
damage, theft, and expropriation (seizure by foreign govt)
Legal liability: of harm to customers, suppliers, share holders, other parties
Worker injury: risk of paying compensation and damages to employees
Employee benefits: risk of death, illness and disability to
employees/families as per contracts/Acts.
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 income
earner?s productivity due to death, disability, aging, or a change in
technology.
Medical expense risk:
Liability risk on auto and home
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.
FirstRanker.com - FirstRanker's Choice
Risk and its
management
MODULE 1
What is risk ?
Risk is uncertainty about the outcome? in a general
sense
Possible variability in outcomes around some
expected values?.Specific meaning used for
events.
Expected value is outcome that would occur on an
average when a person or business is exposed
repeatedly to the same type of risk.
Ex: Sachin?s batting average is 67 based on past
data. So the expected score he is likely to hit is 67.
However, there is a degree variability around this
value. He might duck out or hit a century.
Risk
Expected loss Variability/Uncertainty
Risk v/s uncertainty
Risk Uncertainty
Probability of the
possible outcomes of
the event is known
probability of the
possible outcomes is
not known
Dispersion of the
probability
distribution is risk
Lack of confidence
that the estimated
probability
distribution is correct
Types of risks
? BUSINESS RISK
Business risk is possible reductions in value of business from any
source. Business value depends upon size, timing and risk variability
in cash flows. Unexpected changes in future cash flows can lead to
business risk.
There are three main risks involved in business:
Price risk, Credit risk and Pure risk
1. Price risk:
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)
Types of risk
2. Credit risk:
Risk that a firm?s customers and the parties to which it has lent money will
delay or fail to make promised payments is called credit risk. Most firms
face credit risk from accounts receivables. Financial institutions carry 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:
Risk management function traditionally concentrates on management of
pure risk. Pure risk relates to losses associated with assets. It comprises of:
Damage to assets: (reduction of value of business assets due to physical
damage, theft, and expropriation (seizure by foreign govt)
Legal liability: of harm to customers, suppliers, share holders, other parties
Worker injury: risk of paying compensation and damages to employees
Employee benefits: risk of death, illness and disability to
employees/families as per contracts/Acts.
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 income
earner?s productivity due to death, disability, aging, or a change in
technology.
Medical expense risk:
Liability risk on auto and home
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?
?Much of this course talks about
pure risk and its management.
?However, the principles and
techniques discussed will apply to
all types of risks.
FirstRanker.com - FirstRanker's Choice
Risk and its
management
MODULE 1
What is risk ?
Risk is uncertainty about the outcome? in a general
sense
Possible variability in outcomes around some
expected values?.Specific meaning used for
events.
Expected value is outcome that would occur on an
average when a person or business is exposed
repeatedly to the same type of risk.
Ex: Sachin?s batting average is 67 based on past
data. So the expected score he is likely to hit is 67.
However, there is a degree variability around this
value. He might duck out or hit a century.
Risk
Expected loss Variability/Uncertainty
Risk v/s uncertainty
Risk Uncertainty
Probability of the
possible outcomes of
the event is known
probability of the
possible outcomes is
not known
Dispersion of the
probability
distribution is risk
Lack of confidence
that the estimated
probability
distribution is correct
Types of risks
? BUSINESS RISK
Business risk is possible reductions in value of business from any
source. Business value depends upon size, timing and risk variability
in cash flows. Unexpected changes in future cash flows can lead to
business risk.
There are three main risks involved in business:
Price risk, Credit risk and Pure risk
1. Price risk:
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)
Types of risk
2. Credit risk:
Risk that a firm?s customers and the parties to which it has lent money will
delay or fail to make promised payments is called credit risk. Most firms
face credit risk from accounts receivables. Financial institutions carry 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:
Risk management function traditionally concentrates on management of
pure risk. Pure risk relates to losses associated with assets. It comprises of:
Damage to assets: (reduction of value of business assets due to physical
damage, theft, and expropriation (seizure by foreign govt)
Legal liability: of harm to customers, suppliers, share holders, other parties
Worker injury: risk of paying compensation and damages to employees
Employee benefits: risk of death, illness and disability to
employees/families as per contracts/Acts.
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 income
earner?s productivity due to death, disability, aging, or a change in
technology.
Medical expense risk:
Liability risk on auto and home
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?
?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:
? 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 of risk
companies have discontinued manufacturing
certain goods and services. Eg: certain vaccines,
asbestos products, breast inplants, 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 flight,
writing exams, skiing etc
FirstRanker.com - FirstRanker's Choice
Risk and its
management
MODULE 1
What is risk ?
Risk is uncertainty about the outcome? in a general
sense
Possible variability in outcomes around some
expected values?.Specific meaning used for
events.
Expected value is outcome that would occur on an
average when a person or business is exposed
repeatedly to the same type of risk.
Ex: Sachin?s batting average is 67 based on past
data. So the expected score he is likely to hit is 67.
However, there is a degree variability around this
value. He might duck out or hit a century.
Risk
Expected loss Variability/Uncertainty
Risk v/s uncertainty
Risk Uncertainty
Probability of the
possible outcomes of
the event is known
probability of the
possible outcomes is
not known
Dispersion of the
probability
distribution is risk
Lack of confidence
that the estimated
probability
distribution is correct
Types of risks
? BUSINESS RISK
Business risk is possible reductions in value of business from any
source. Business value depends upon size, timing and risk variability
in cash flows. Unexpected changes in future cash flows can lead to
business risk.
There are three main risks involved in business:
Price risk, Credit risk and Pure risk
1. Price risk:
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)
Types of risk
2. Credit risk:
Risk that a firm?s customers and the parties to which it has lent money will
delay or fail to make promised payments is called credit risk. Most firms
face credit risk from accounts receivables. Financial institutions carry 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:
Risk management function traditionally concentrates on management of
pure risk. Pure risk relates to losses associated with assets. It comprises of:
Damage to assets: (reduction of value of business assets due to physical
damage, theft, and expropriation (seizure by foreign govt)
Legal liability: of harm to customers, suppliers, share holders, other parties
Worker injury: risk of paying compensation and damages to employees
Employee benefits: risk of death, illness and disability to
employees/families as per contracts/Acts.
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 income
earner?s productivity due to death, disability, aging, or a change in
technology.
Medical expense risk:
Liability risk on auto and home
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?
?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:
? 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 of risk
companies have discontinued manufacturing
certain goods and services. Eg: certain vaccines,
asbestos products, breast inplants, 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 flight,
writing exams, skiing etc
Sources of risk
External sources:
? Business factors
? Natural factors ? earthquake, famine, cyclone,
lightning,
? Political factors ? change of govt, civil war, riots, policy
changes
Internal sources:
? Operational -
? Technological
? Human factors
? Technological
? physical
FirstRanker.com - FirstRanker's Choice
Risk and its
management
MODULE 1
What is risk ?
Risk is uncertainty about the outcome? in a general
sense
Possible variability in outcomes around some
expected values?.Specific meaning used for
events.
Expected value is outcome that would occur on an
average when a person or business is exposed
repeatedly to the same type of risk.
Ex: Sachin?s batting average is 67 based on past
data. So the expected score he is likely to hit is 67.
However, there is a degree variability around this
value. He might duck out or hit a century.
Risk
Expected loss Variability/Uncertainty
Risk v/s uncertainty
Risk Uncertainty
Probability of the
possible outcomes of
the event is known
probability of the
possible outcomes is
not known
Dispersion of the
probability
distribution is risk
Lack of confidence
that the estimated
probability
distribution is correct
Types of risks
? BUSINESS RISK
Business risk is possible reductions in value of business from any
source. Business value depends upon size, timing and risk variability
in cash flows. Unexpected changes in future cash flows can lead to
business risk.
There are three main risks involved in business:
Price risk, Credit risk and Pure risk
1. Price risk:
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)
Types of risk
2. Credit risk:
Risk that a firm?s customers and the parties to which it has lent money will
delay or fail to make promised payments is called credit risk. Most firms
face credit risk from accounts receivables. Financial institutions carry 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:
Risk management function traditionally concentrates on management of
pure risk. Pure risk relates to losses associated with assets. It comprises of:
Damage to assets: (reduction of value of business assets due to physical
damage, theft, and expropriation (seizure by foreign govt)
Legal liability: of harm to customers, suppliers, share holders, other parties
Worker injury: risk of paying compensation and damages to employees
Employee benefits: risk of death, illness and disability to
employees/families as per contracts/Acts.
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 income
earner?s productivity due to death, disability, aging, or a change in
technology.
Medical expense risk:
Liability risk on auto and home
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?
?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:
? 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 of risk
companies have discontinued manufacturing
certain goods and services. Eg: certain vaccines,
asbestos products, breast inplants, 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 flight,
writing exams, skiing etc
Sources of risk
External sources:
? Business factors
? Natural factors ? earthquake, famine, cyclone,
lightning,
? Political factors ? change of govt, civil war, riots, policy
changes
Internal sources:
? Operational -
? Technological
? Human factors
? Technological
? physical
Degree of risk/objective risk
? Degree of risk is defined as relative variation of actual loss from
actual loss.
? Assume that out of 10000 houses, 1% ie 100 houses bun every 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.
? Assume that 1 million houses are insured. Expected houses to 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% from
original level.
? Objective risk can be statistically measured by measure of
dispersion like standard deviation. As the number of exposure
increases prediction will be more accurate as variation is lesser.
FirstRanker.com - FirstRanker's Choice
Risk and its
management
MODULE 1
What is risk ?
Risk is uncertainty about the outcome? in a general
sense
Possible variability in outcomes around some
expected values?.Specific meaning used for
events.
Expected value is outcome that would occur on an
average when a person or business is exposed
repeatedly to the same type of risk.
Ex: Sachin?s batting average is 67 based on past
data. So the expected score he is likely to hit is 67.
However, there is a degree variability around this
value. He might duck out or hit a century.
Risk
Expected loss Variability/Uncertainty
Risk v/s uncertainty
Risk Uncertainty
Probability of the
possible outcomes of
the event is known
probability of the
possible outcomes is
not known
Dispersion of the
probability
distribution is risk
Lack of confidence
that the estimated
probability
distribution is correct
Types of risks
? BUSINESS RISK
Business risk is possible reductions in value of business from any
source. Business value depends upon size, timing and risk variability
in cash flows. Unexpected changes in future cash flows can lead to
business risk.
There are three main risks involved in business:
Price risk, Credit risk and Pure risk
1. Price risk:
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)
Types of risk
2. Credit risk:
Risk that a firm?s customers and the parties to which it has lent money will
delay or fail to make promised payments is called credit risk. Most firms
face credit risk from accounts receivables. Financial institutions carry 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:
Risk management function traditionally concentrates on management of
pure risk. Pure risk relates to losses associated with assets. It comprises of:
Damage to assets: (reduction of value of business assets due to physical
damage, theft, and expropriation (seizure by foreign govt)
Legal liability: of harm to customers, suppliers, share holders, other parties
Worker injury: risk of paying compensation and damages to employees
Employee benefits: risk of death, illness and disability to
employees/families as per contracts/Acts.
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 income
earner?s productivity due to death, disability, aging, or a change in
technology.
Medical expense risk:
Liability risk on auto and home
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?
?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:
? 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 of risk
companies have discontinued manufacturing
certain goods and services. Eg: certain vaccines,
asbestos products, breast inplants, 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 flight,
writing exams, skiing etc
Sources of risk
External sources:
? Business factors
? Natural factors ? earthquake, famine, cyclone,
lightning,
? Political factors ? change of govt, civil war, riots, policy
changes
Internal sources:
? Operational -
? Technological
? Human factors
? Technological
? physical
Degree of risk/objective risk
? Degree of risk is defined as relative variation of actual loss from
actual loss.
? Assume that out of 10000 houses, 1% ie 100 houses bun every 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.
? Assume that 1 million houses are insured. Expected houses to 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% from
original level.
? Objective risk can be statistically measured by measure of
dispersion like standard deviation. As the number of exposure
increases prediction will be more accurate as variation is lesser.
Risk management
? 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, approach and
processes to the tasks of identifying and assessing
risks and then planning and implementing risk
responses.
FirstRanker.com - FirstRanker's Choice
Risk and its
management
MODULE 1
What is risk ?
Risk is uncertainty about the outcome? in a general
sense
Possible variability in outcomes around some
expected values?.Specific meaning used for
events.
Expected value is outcome that would occur on an
average when a person or business is exposed
repeatedly to the same type of risk.
Ex: Sachin?s batting average is 67 based on past
data. So the expected score he is likely to hit is 67.
However, there is a degree variability around this
value. He might duck out or hit a century.
Risk
Expected loss Variability/Uncertainty
Risk v/s uncertainty
Risk Uncertainty
Probability of the
possible outcomes of
the event is known
probability of the
possible outcomes is
not known
Dispersion of the
probability
distribution is risk
Lack of confidence
that the estimated
probability
distribution is correct
Types of risks
? BUSINESS RISK
Business risk is possible reductions in value of business from any
source. Business value depends upon size, timing and risk variability
in cash flows. Unexpected changes in future cash flows can lead to
business risk.
There are three main risks involved in business:
Price risk, Credit risk and Pure risk
1. Price risk:
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)
Types of risk
2. Credit risk:
Risk that a firm?s customers and the parties to which it has lent money will
delay or fail to make promised payments is called credit risk. Most firms
face credit risk from accounts receivables. Financial institutions carry 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:
Risk management function traditionally concentrates on management of
pure risk. Pure risk relates to losses associated with assets. It comprises of:
Damage to assets: (reduction of value of business assets due to physical
damage, theft, and expropriation (seizure by foreign govt)
Legal liability: of harm to customers, suppliers, share holders, other parties
Worker injury: risk of paying compensation and damages to employees
Employee benefits: risk of death, illness and disability to
employees/families as per contracts/Acts.
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 income
earner?s productivity due to death, disability, aging, or a change in
technology.
Medical expense risk:
Liability risk on auto and home
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?
?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:
? 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 of risk
companies have discontinued manufacturing
certain goods and services. Eg: certain vaccines,
asbestos products, breast inplants, 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 flight,
writing exams, skiing etc
Sources of risk
External sources:
? Business factors
? Natural factors ? earthquake, famine, cyclone,
lightning,
? Political factors ? change of govt, civil war, riots, policy
changes
Internal sources:
? Operational -
? Technological
? Human factors
? Technological
? physical
Degree of risk/objective risk
? Degree of risk is defined as relative variation of actual loss from
actual loss.
? Assume that out of 10000 houses, 1% ie 100 houses bun every 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.
? Assume that 1 million houses are insured. Expected houses to 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% from
original level.
? Objective risk can be statistically measured by measure of
dispersion like standard deviation. As the number of exposure
increases prediction will be more accurate as variation is lesser.
Risk management
? 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, approach and
processes to the tasks of identifying and assessing
risks and then planning and implementing risk
responses.
Methods of risk management
? Broadly 3 methods:
? Loss control
? Loss financing
? Internal risk reduction
? 1 and 3 involves decisions to invest/not invest to reduce losses
while 2
nd
one refers to how to pay for losses if they do occur
FirstRanker.com - FirstRanker's Choice
Risk and its
management
MODULE 1
What is risk ?
Risk is uncertainty about the outcome? in a general
sense
Possible variability in outcomes around some
expected values?.Specific meaning used for
events.
Expected value is outcome that would occur on an
average when a person or business is exposed
repeatedly to the same type of risk.
Ex: Sachin?s batting average is 67 based on past
data. So the expected score he is likely to hit is 67.
However, there is a degree variability around this
value. He might duck out or hit a century.
Risk
Expected loss Variability/Uncertainty
Risk v/s uncertainty
Risk Uncertainty
Probability of the
possible outcomes of
the event is known
probability of the
possible outcomes is
not known
Dispersion of the
probability
distribution is risk
Lack of confidence
that the estimated
probability
distribution is correct
Types of risks
? BUSINESS RISK
Business risk is possible reductions in value of business from any
source. Business value depends upon size, timing and risk variability
in cash flows. Unexpected changes in future cash flows can lead to
business risk.
There are three main risks involved in business:
Price risk, Credit risk and Pure risk
1. Price risk:
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)
Types of risk
2. Credit risk:
Risk that a firm?s customers and the parties to which it has lent money will
delay or fail to make promised payments is called credit risk. Most firms
face credit risk from accounts receivables. Financial institutions carry 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:
Risk management function traditionally concentrates on management of
pure risk. Pure risk relates to losses associated with assets. It comprises of:
Damage to assets: (reduction of value of business assets due to physical
damage, theft, and expropriation (seizure by foreign govt)
Legal liability: of harm to customers, suppliers, share holders, other parties
Worker injury: risk of paying compensation and damages to employees
Employee benefits: risk of death, illness and disability to
employees/families as per contracts/Acts.
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 income
earner?s productivity due to death, disability, aging, or a change in
technology.
Medical expense risk:
Liability risk on auto and home
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?
?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:
? 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 of risk
companies have discontinued manufacturing
certain goods and services. Eg: certain vaccines,
asbestos products, breast inplants, 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 flight,
writing exams, skiing etc
Sources of risk
External sources:
? Business factors
? Natural factors ? earthquake, famine, cyclone,
lightning,
? Political factors ? change of govt, civil war, riots, policy
changes
Internal sources:
? Operational -
? Technological
? Human factors
? Technological
? physical
Degree of risk/objective risk
? Degree of risk is defined as relative variation of actual loss from
actual loss.
? Assume that out of 10000 houses, 1% ie 100 houses bun every 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.
? Assume that 1 million houses are insured. Expected houses to 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% from
original level.
? Objective risk can be statistically measured by measure of
dispersion like standard deviation. As the number of exposure
increases prediction will be more accurate as variation is lesser.
Risk management
? 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, approach and
processes to the tasks of identifying and assessing
risks and then planning and implementing risk
responses.
Methods of risk management
? Broadly 3 methods:
? Loss control
? Loss financing
? Internal risk reduction
? 1 and 3 involves decisions to invest/not invest to reduce losses
while 2
nd
one refers to how to pay for losses if they do occur
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 are both
eg: airbags in vehicles.
? There are 2 general approaches to loss control.
- Reducing the level of risk activity (truck with toxic
chemicals shifting over to other products)
- increasing precautions against loss of activity
FirstRanker.com - FirstRanker's Choice
Risk and its
management
MODULE 1
What is risk ?
Risk is uncertainty about the outcome? in a general
sense
Possible variability in outcomes around some
expected values?.Specific meaning used for
events.
Expected value is outcome that would occur on an
average when a person or business is exposed
repeatedly to the same type of risk.
Ex: Sachin?s batting average is 67 based on past
data. So the expected score he is likely to hit is 67.
However, there is a degree variability around this
value. He might duck out or hit a century.
Risk
Expected loss Variability/Uncertainty
Risk v/s uncertainty
Risk Uncertainty
Probability of the
possible outcomes of
the event is known
probability of the
possible outcomes is
not known
Dispersion of the
probability
distribution is risk
Lack of confidence
that the estimated
probability
distribution is correct
Types of risks
? BUSINESS RISK
Business risk is possible reductions in value of business from any
source. Business value depends upon size, timing and risk variability
in cash flows. Unexpected changes in future cash flows can lead to
business risk.
There are three main risks involved in business:
Price risk, Credit risk and Pure risk
1. Price risk:
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)
Types of risk
2. Credit risk:
Risk that a firm?s customers and the parties to which it has lent money will
delay or fail to make promised payments is called credit risk. Most firms
face credit risk from accounts receivables. Financial institutions carry 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:
Risk management function traditionally concentrates on management of
pure risk. Pure risk relates to losses associated with assets. It comprises of:
Damage to assets: (reduction of value of business assets due to physical
damage, theft, and expropriation (seizure by foreign govt)
Legal liability: of harm to customers, suppliers, share holders, other parties
Worker injury: risk of paying compensation and damages to employees
Employee benefits: risk of death, illness and disability to
employees/families as per contracts/Acts.
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 income
earner?s productivity due to death, disability, aging, or a change in
technology.
Medical expense risk:
Liability risk on auto and home
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?
?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:
? 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 of risk
companies have discontinued manufacturing
certain goods and services. Eg: certain vaccines,
asbestos products, breast inplants, 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 flight,
writing exams, skiing etc
Sources of risk
External sources:
? Business factors
? Natural factors ? earthquake, famine, cyclone,
lightning,
? Political factors ? change of govt, civil war, riots, policy
changes
Internal sources:
? Operational -
? Technological
? Human factors
? Technological
? physical
Degree of risk/objective risk
? Degree of risk is defined as relative variation of actual loss from
actual loss.
? Assume that out of 10000 houses, 1% ie 100 houses bun every 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.
? Assume that 1 million houses are insured. Expected houses to 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% from
original level.
? Objective risk can be statistically measured by measure of
dispersion like standard deviation. As the number of exposure
increases prediction will be more accurate as variation is lesser.
Risk management
? 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, approach and
processes to the tasks of identifying and assessing
risks and then planning and implementing risk
responses.
Methods of risk management
? Broadly 3 methods:
? Loss control
? Loss financing
? Internal risk reduction
? 1 and 3 involves decisions to invest/not invest to reduce losses
while 2
nd
one refers to how to pay for losses if they do occur
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 are both
eg: airbags in vehicles.
? There are 2 general approaches to loss control.
- 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
? Broad methods
- retention: business retains the right to pay up losses.
Also called self-insurance
- Insurance: pay premium and receive funds to make
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.
FirstRanker.com - FirstRanker's Choice
Risk and its
management
MODULE 1
What is risk ?
Risk is uncertainty about the outcome? in a general
sense
Possible variability in outcomes around some
expected values?.Specific meaning used for
events.
Expected value is outcome that would occur on an
average when a person or business is exposed
repeatedly to the same type of risk.
Ex: Sachin?s batting average is 67 based on past
data. So the expected score he is likely to hit is 67.
However, there is a degree variability around this
value. He might duck out or hit a century.
Risk
Expected loss Variability/Uncertainty
Risk v/s uncertainty
Risk Uncertainty
Probability of the
possible outcomes of
the event is known
probability of the
possible outcomes is
not known
Dispersion of the
probability
distribution is risk
Lack of confidence
that the estimated
probability
distribution is correct
Types of risks
? BUSINESS RISK
Business risk is possible reductions in value of business from any
source. Business value depends upon size, timing and risk variability
in cash flows. Unexpected changes in future cash flows can lead to
business risk.
There are three main risks involved in business:
Price risk, Credit risk and Pure risk
1. Price risk:
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)
Types of risk
2. Credit risk:
Risk that a firm?s customers and the parties to which it has lent money will
delay or fail to make promised payments is called credit risk. Most firms
face credit risk from accounts receivables. Financial institutions carry 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:
Risk management function traditionally concentrates on management of
pure risk. Pure risk relates to losses associated with assets. It comprises of:
Damage to assets: (reduction of value of business assets due to physical
damage, theft, and expropriation (seizure by foreign govt)
Legal liability: of harm to customers, suppliers, share holders, other parties
Worker injury: risk of paying compensation and damages to employees
Employee benefits: risk of death, illness and disability to
employees/families as per contracts/Acts.
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 income
earner?s productivity due to death, disability, aging, or a change in
technology.
Medical expense risk:
Liability risk on auto and home
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?
?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:
? 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 of risk
companies have discontinued manufacturing
certain goods and services. Eg: certain vaccines,
asbestos products, breast inplants, 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 flight,
writing exams, skiing etc
Sources of risk
External sources:
? Business factors
? Natural factors ? earthquake, famine, cyclone,
lightning,
? Political factors ? change of govt, civil war, riots, policy
changes
Internal sources:
? Operational -
? Technological
? Human factors
? Technological
? physical
Degree of risk/objective risk
? Degree of risk is defined as relative variation of actual loss from
actual loss.
? Assume that out of 10000 houses, 1% ie 100 houses bun every 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.
? Assume that 1 million houses are insured. Expected houses to 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% from
original level.
? Objective risk can be statistically measured by measure of
dispersion like standard deviation. As the number of exposure
increases prediction will be more accurate as variation is lesser.
Risk management
? 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, approach and
processes to the tasks of identifying and assessing
risks and then planning and implementing risk
responses.
Methods of risk management
? Broadly 3 methods:
? Loss control
? Loss financing
? Internal risk reduction
? 1 and 3 involves decisions to invest/not invest to reduce losses
while 2
nd
one refers to how to pay for losses if they do occur
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 are both
eg: airbags in vehicles.
? There are 2 general approaches to loss control.
- 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
? Broad methods
- retention: business retains the right to pay up losses.
Also called self-insurance
- Insurance: pay premium and receive funds to make
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.
3. Internal risk reduction
?Businesses can reduce risk internally by:
?1. Diversification: Businesses spread
across different areas can help reduce
risk. Do not keep all eggs in the same
basket.
?2. Invest on information: in order to get
superior forecasts of future cash flow
thereby reducing variability.
FirstRanker.com - FirstRanker's Choice
Risk and its
management
MODULE 1
What is risk ?
Risk is uncertainty about the outcome? in a general
sense
Possible variability in outcomes around some
expected values?.Specific meaning used for
events.
Expected value is outcome that would occur on an
average when a person or business is exposed
repeatedly to the same type of risk.
Ex: Sachin?s batting average is 67 based on past
data. So the expected score he is likely to hit is 67.
However, there is a degree variability around this
value. He might duck out or hit a century.
Risk
Expected loss Variability/Uncertainty
Risk v/s uncertainty
Risk Uncertainty
Probability of the
possible outcomes of
the event is known
probability of the
possible outcomes is
not known
Dispersion of the
probability
distribution is risk
Lack of confidence
that the estimated
probability
distribution is correct
Types of risks
? BUSINESS RISK
Business risk is possible reductions in value of business from any
source. Business value depends upon size, timing and risk variability
in cash flows. Unexpected changes in future cash flows can lead to
business risk.
There are three main risks involved in business:
Price risk, Credit risk and Pure risk
1. Price risk:
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)
Types of risk
2. Credit risk:
Risk that a firm?s customers and the parties to which it has lent money will
delay or fail to make promised payments is called credit risk. Most firms
face credit risk from accounts receivables. Financial institutions carry 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:
Risk management function traditionally concentrates on management of
pure risk. Pure risk relates to losses associated with assets. It comprises of:
Damage to assets: (reduction of value of business assets due to physical
damage, theft, and expropriation (seizure by foreign govt)
Legal liability: of harm to customers, suppliers, share holders, other parties
Worker injury: risk of paying compensation and damages to employees
Employee benefits: risk of death, illness and disability to
employees/families as per contracts/Acts.
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 income
earner?s productivity due to death, disability, aging, or a change in
technology.
Medical expense risk:
Liability risk on auto and home
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?
?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:
? 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 of risk
companies have discontinued manufacturing
certain goods and services. Eg: certain vaccines,
asbestos products, breast inplants, 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 flight,
writing exams, skiing etc
Sources of risk
External sources:
? Business factors
? Natural factors ? earthquake, famine, cyclone,
lightning,
? Political factors ? change of govt, civil war, riots, policy
changes
Internal sources:
? Operational -
? Technological
? Human factors
? Technological
? physical
Degree of risk/objective risk
? Degree of risk is defined as relative variation of actual loss from
actual loss.
? Assume that out of 10000 houses, 1% ie 100 houses bun every 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.
? Assume that 1 million houses are insured. Expected houses to 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% from
original level.
? Objective risk can be statistically measured by measure of
dispersion like standard deviation. As the number of exposure
increases prediction will be more accurate as variation is lesser.
Risk management
? 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, approach and
processes to the tasks of identifying and assessing
risks and then planning and implementing risk
responses.
Methods of risk management
? Broadly 3 methods:
? Loss control
? Loss financing
? Internal risk reduction
? 1 and 3 involves decisions to invest/not invest to reduce losses
while 2
nd
one refers to how to pay for losses if they do occur
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 are both
eg: airbags in vehicles.
? There are 2 general approaches to loss control.
- 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
? Broad methods
- retention: business retains the right to pay up losses.
Also called self-insurance
- Insurance: pay premium and receive funds to make
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.
3. Internal risk reduction
?Businesses can reduce risk internally by:
?1. Diversification: Businesses spread
across different areas can help reduce
risk. Do not keep all eggs in the same
basket.
?2. Invest on information: in order to get
superior forecasts of future cash flow
thereby reducing variability.
Risk management process
? Identify all significant process
? Evaluate the potential frequency and severity
of losses
? Develop and select methods for managing risk
? 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)
FirstRanker.com - FirstRanker's Choice
Risk and its
management
MODULE 1
What is risk ?
Risk is uncertainty about the outcome? in a general
sense
Possible variability in outcomes around some
expected values?.Specific meaning used for
events.
Expected value is outcome that would occur on an
average when a person or business is exposed
repeatedly to the same type of risk.
Ex: Sachin?s batting average is 67 based on past
data. So the expected score he is likely to hit is 67.
However, there is a degree variability around this
value. He might duck out or hit a century.
Risk
Expected loss Variability/Uncertainty
Risk v/s uncertainty
Risk Uncertainty
Probability of the
possible outcomes of
the event is known
probability of the
possible outcomes is
not known
Dispersion of the
probability
distribution is risk
Lack of confidence
that the estimated
probability
distribution is correct
Types of risks
? BUSINESS RISK
Business risk is possible reductions in value of business from any
source. Business value depends upon size, timing and risk variability
in cash flows. Unexpected changes in future cash flows can lead to
business risk.
There are three main risks involved in business:
Price risk, Credit risk and Pure risk
1. Price risk:
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)
Types of risk
2. Credit risk:
Risk that a firm?s customers and the parties to which it has lent money will
delay or fail to make promised payments is called credit risk. Most firms
face credit risk from accounts receivables. Financial institutions carry 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:
Risk management function traditionally concentrates on management of
pure risk. Pure risk relates to losses associated with assets. It comprises of:
Damage to assets: (reduction of value of business assets due to physical
damage, theft, and expropriation (seizure by foreign govt)
Legal liability: of harm to customers, suppliers, share holders, other parties
Worker injury: risk of paying compensation and damages to employees
Employee benefits: risk of death, illness and disability to
employees/families as per contracts/Acts.
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 income
earner?s productivity due to death, disability, aging, or a change in
technology.
Medical expense risk:
Liability risk on auto and home
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?
?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:
? 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 of risk
companies have discontinued manufacturing
certain goods and services. Eg: certain vaccines,
asbestos products, breast inplants, 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 flight,
writing exams, skiing etc
Sources of risk
External sources:
? Business factors
? Natural factors ? earthquake, famine, cyclone,
lightning,
? Political factors ? change of govt, civil war, riots, policy
changes
Internal sources:
? Operational -
? Technological
? Human factors
? Technological
? physical
Degree of risk/objective risk
? Degree of risk is defined as relative variation of actual loss from
actual loss.
? Assume that out of 10000 houses, 1% ie 100 houses bun every 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.
? Assume that 1 million houses are insured. Expected houses to 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% from
original level.
? Objective risk can be statistically measured by measure of
dispersion like standard deviation. As the number of exposure
increases prediction will be more accurate as variation is lesser.
Risk management
? 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, approach and
processes to the tasks of identifying and assessing
risks and then planning and implementing risk
responses.
Methods of risk management
? Broadly 3 methods:
? Loss control
? Loss financing
? Internal risk reduction
? 1 and 3 involves decisions to invest/not invest to reduce losses
while 2
nd
one refers to how to pay for losses if they do occur
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 are both
eg: airbags in vehicles.
? There are 2 general approaches to loss control.
- 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
? Broad methods
- retention: business retains the right to pay up losses.
Also called self-insurance
- Insurance: pay premium and receive funds to make
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.
3. Internal risk reduction
?Businesses can reduce risk internally by:
?1. Diversification: Businesses spread
across different areas can help reduce
risk. Do not keep all eggs in the same
basket.
?2. Invest on information: in order to get
superior forecasts of future cash flow
thereby reducing variability.
Risk management process
? Identify all significant process
? Evaluate the potential frequency and severity
of losses
? Develop and select methods for managing risk
? 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
? ASSIGNEMENTQUESTION
FirstRanker.com - FirstRanker's Choice
Risk and its
management
MODULE 1
What is risk ?
Risk is uncertainty about the outcome? in a general
sense
Possible variability in outcomes around some
expected values?.Specific meaning used for
events.
Expected value is outcome that would occur on an
average when a person or business is exposed
repeatedly to the same type of risk.
Ex: Sachin?s batting average is 67 based on past
data. So the expected score he is likely to hit is 67.
However, there is a degree variability around this
value. He might duck out or hit a century.
Risk
Expected loss Variability/Uncertainty
Risk v/s uncertainty
Risk Uncertainty
Probability of the
possible outcomes of
the event is known
probability of the
possible outcomes is
not known
Dispersion of the
probability
distribution is risk
Lack of confidence
that the estimated
probability
distribution is correct
Types of risks
? BUSINESS RISK
Business risk is possible reductions in value of business from any
source. Business value depends upon size, timing and risk variability
in cash flows. Unexpected changes in future cash flows can lead to
business risk.
There are three main risks involved in business:
Price risk, Credit risk and Pure risk
1. Price risk:
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)
Types of risk
2. Credit risk:
Risk that a firm?s customers and the parties to which it has lent money will
delay or fail to make promised payments is called credit risk. Most firms
face credit risk from accounts receivables. Financial institutions carry 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:
Risk management function traditionally concentrates on management of
pure risk. Pure risk relates to losses associated with assets. It comprises of:
Damage to assets: (reduction of value of business assets due to physical
damage, theft, and expropriation (seizure by foreign govt)
Legal liability: of harm to customers, suppliers, share holders, other parties
Worker injury: risk of paying compensation and damages to employees
Employee benefits: risk of death, illness and disability to
employees/families as per contracts/Acts.
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 income
earner?s productivity due to death, disability, aging, or a change in
technology.
Medical expense risk:
Liability risk on auto and home
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?
?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:
? 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 of risk
companies have discontinued manufacturing
certain goods and services. Eg: certain vaccines,
asbestos products, breast inplants, 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 flight,
writing exams, skiing etc
Sources of risk
External sources:
? Business factors
? Natural factors ? earthquake, famine, cyclone,
lightning,
? Political factors ? change of govt, civil war, riots, policy
changes
Internal sources:
? Operational -
? Technological
? Human factors
? Technological
? physical
Degree of risk/objective risk
? Degree of risk is defined as relative variation of actual loss from
actual loss.
? Assume that out of 10000 houses, 1% ie 100 houses bun every 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.
? Assume that 1 million houses are insured. Expected houses to 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% from
original level.
? Objective risk can be statistically measured by measure of
dispersion like standard deviation. As the number of exposure
increases prediction will be more accurate as variation is lesser.
Risk management
? 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, approach and
processes to the tasks of identifying and assessing
risks and then planning and implementing risk
responses.
Methods of risk management
? Broadly 3 methods:
? Loss control
? Loss financing
? Internal risk reduction
? 1 and 3 involves decisions to invest/not invest to reduce losses
while 2
nd
one refers to how to pay for losses if they do occur
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 are both
eg: airbags in vehicles.
? There are 2 general approaches to loss control.
- 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
? Broad methods
- retention: business retains the right to pay up losses.
Also called self-insurance
- Insurance: pay premium and receive funds to make
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.
3. Internal risk reduction
?Businesses can reduce risk internally by:
?1. Diversification: Businesses spread
across different areas can help reduce
risk. Do not keep all eggs in the same
basket.
?2. Invest on information: in order to get
superior forecasts of future cash flow
thereby reducing variability.
Risk management process
? Identify all significant process
? Evaluate the potential frequency and severity
of losses
? Develop and select methods for managing risk
? 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
? ASSIGNEMENTQUESTION
Objectives of risk management
? To be consistent with corporate objectives of returns
and safety
? To provide good service to customers
? 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.
? To be able to make informed decisions and make
choices on possible outcomes.
FirstRanker.com - FirstRanker's Choice
Risk and its
management
MODULE 1
What is risk ?
Risk is uncertainty about the outcome? in a general
sense
Possible variability in outcomes around some
expected values?.Specific meaning used for
events.
Expected value is outcome that would occur on an
average when a person or business is exposed
repeatedly to the same type of risk.
Ex: Sachin?s batting average is 67 based on past
data. So the expected score he is likely to hit is 67.
However, there is a degree variability around this
value. He might duck out or hit a century.
Risk
Expected loss Variability/Uncertainty
Risk v/s uncertainty
Risk Uncertainty
Probability of the
possible outcomes of
the event is known
probability of the
possible outcomes is
not known
Dispersion of the
probability
distribution is risk
Lack of confidence
that the estimated
probability
distribution is correct
Types of risks
? BUSINESS RISK
Business risk is possible reductions in value of business from any
source. Business value depends upon size, timing and risk variability
in cash flows. Unexpected changes in future cash flows can lead to
business risk.
There are three main risks involved in business:
Price risk, Credit risk and Pure risk
1. Price risk:
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)
Types of risk
2. Credit risk:
Risk that a firm?s customers and the parties to which it has lent money will
delay or fail to make promised payments is called credit risk. Most firms
face credit risk from accounts receivables. Financial institutions carry 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:
Risk management function traditionally concentrates on management of
pure risk. Pure risk relates to losses associated with assets. It comprises of:
Damage to assets: (reduction of value of business assets due to physical
damage, theft, and expropriation (seizure by foreign govt)
Legal liability: of harm to customers, suppliers, share holders, other parties
Worker injury: risk of paying compensation and damages to employees
Employee benefits: risk of death, illness and disability to
employees/families as per contracts/Acts.
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 income
earner?s productivity due to death, disability, aging, or a change in
technology.
Medical expense risk:
Liability risk on auto and home
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?
?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:
? 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 of risk
companies have discontinued manufacturing
certain goods and services. Eg: certain vaccines,
asbestos products, breast inplants, 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 flight,
writing exams, skiing etc
Sources of risk
External sources:
? Business factors
? Natural factors ? earthquake, famine, cyclone,
lightning,
? Political factors ? change of govt, civil war, riots, policy
changes
Internal sources:
? Operational -
? Technological
? Human factors
? Technological
? physical
Degree of risk/objective risk
? Degree of risk is defined as relative variation of actual loss from
actual loss.
? Assume that out of 10000 houses, 1% ie 100 houses bun every 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.
? Assume that 1 million houses are insured. Expected houses to 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% from
original level.
? Objective risk can be statistically measured by measure of
dispersion like standard deviation. As the number of exposure
increases prediction will be more accurate as variation is lesser.
Risk management
? 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, approach and
processes to the tasks of identifying and assessing
risks and then planning and implementing risk
responses.
Methods of risk management
? Broadly 3 methods:
? Loss control
? Loss financing
? Internal risk reduction
? 1 and 3 involves decisions to invest/not invest to reduce losses
while 2
nd
one refers to how to pay for losses if they do occur
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 are both
eg: airbags in vehicles.
? There are 2 general approaches to loss control.
- 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
? Broad methods
- retention: business retains the right to pay up losses.
Also called self-insurance
- Insurance: pay premium and receive funds to make
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.
3. Internal risk reduction
?Businesses can reduce risk internally by:
?1. Diversification: Businesses spread
across different areas can help reduce
risk. Do not keep all eggs in the same
basket.
?2. Invest on information: in order to get
superior forecasts of future cash flow
thereby reducing variability.
Risk management process
? Identify all significant process
? Evaluate the potential frequency and severity
of losses
? Develop and select methods for managing risk
? 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
? ASSIGNEMENTQUESTION
Objectives of risk management
? To be consistent with corporate objectives of returns
and safety
? To provide good service to customers
? 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.
? To be able to make informed decisions and make
choices on possible outcomes.
Need for a rationale for
risk management in org
? ASSIGNMENT QUESTION
FirstRanker.com - FirstRanker's Choice
Risk and its
management
MODULE 1
What is risk ?
Risk is uncertainty about the outcome? in a general
sense
Possible variability in outcomes around some
expected values?.Specific meaning used for
events.
Expected value is outcome that would occur on an
average when a person or business is exposed
repeatedly to the same type of risk.
Ex: Sachin?s batting average is 67 based on past
data. So the expected score he is likely to hit is 67.
However, there is a degree variability around this
value. He might duck out or hit a century.
Risk
Expected loss Variability/Uncertainty
Risk v/s uncertainty
Risk Uncertainty
Probability of the
possible outcomes of
the event is known
probability of the
possible outcomes is
not known
Dispersion of the
probability
distribution is risk
Lack of confidence
that the estimated
probability
distribution is correct
Types of risks
? BUSINESS RISK
Business risk is possible reductions in value of business from any
source. Business value depends upon size, timing and risk variability
in cash flows. Unexpected changes in future cash flows can lead to
business risk.
There are three main risks involved in business:
Price risk, Credit risk and Pure risk
1. Price risk:
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)
Types of risk
2. Credit risk:
Risk that a firm?s customers and the parties to which it has lent money will
delay or fail to make promised payments is called credit risk. Most firms
face credit risk from accounts receivables. Financial institutions carry 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:
Risk management function traditionally concentrates on management of
pure risk. Pure risk relates to losses associated with assets. It comprises of:
Damage to assets: (reduction of value of business assets due to physical
damage, theft, and expropriation (seizure by foreign govt)
Legal liability: of harm to customers, suppliers, share holders, other parties
Worker injury: risk of paying compensation and damages to employees
Employee benefits: risk of death, illness and disability to
employees/families as per contracts/Acts.
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 income
earner?s productivity due to death, disability, aging, or a change in
technology.
Medical expense risk:
Liability risk on auto and home
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?
?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:
? 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 of risk
companies have discontinued manufacturing
certain goods and services. Eg: certain vaccines,
asbestos products, breast inplants, 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 flight,
writing exams, skiing etc
Sources of risk
External sources:
? Business factors
? Natural factors ? earthquake, famine, cyclone,
lightning,
? Political factors ? change of govt, civil war, riots, policy
changes
Internal sources:
? Operational -
? Technological
? Human factors
? Technological
? physical
Degree of risk/objective risk
? Degree of risk is defined as relative variation of actual loss from
actual loss.
? Assume that out of 10000 houses, 1% ie 100 houses bun every 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.
? Assume that 1 million houses are insured. Expected houses to 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% from
original level.
? Objective risk can be statistically measured by measure of
dispersion like standard deviation. As the number of exposure
increases prediction will be more accurate as variation is lesser.
Risk management
? 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, approach and
processes to the tasks of identifying and assessing
risks and then planning and implementing risk
responses.
Methods of risk management
? Broadly 3 methods:
? Loss control
? Loss financing
? Internal risk reduction
? 1 and 3 involves decisions to invest/not invest to reduce losses
while 2
nd
one refers to how to pay for losses if they do occur
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 are both
eg: airbags in vehicles.
? There are 2 general approaches to loss control.
- 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
? Broad methods
- retention: business retains the right to pay up losses.
Also called self-insurance
- Insurance: pay premium and receive funds to make
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.
3. Internal risk reduction
?Businesses can reduce risk internally by:
?1. Diversification: Businesses spread
across different areas can help reduce
risk. Do not keep all eggs in the same
basket.
?2. Invest on information: in order to get
superior forecasts of future cash flow
thereby reducing variability.
Risk management process
? Identify all significant process
? Evaluate the potential frequency and severity
of losses
? Develop and select methods for managing risk
? 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
? ASSIGNEMENTQUESTION
Objectives of risk management
? To be consistent with corporate objectives of returns
and safety
? To provide good service to customers
? 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.
? To be able to make informed decisions and make
choices on possible outcomes.
Need for a rationale for
risk management in org
? ASSIGNMENT QUESTION
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
? 4. cost of internal risk reduction
? 5. cost of any residual uncertainty that remains
after 2,3,4 are implemented
FirstRanker.com - FirstRanker's Choice
Risk and its
management
MODULE 1
What is risk ?
Risk is uncertainty about the outcome? in a general
sense
Possible variability in outcomes around some
expected values?.Specific meaning used for
events.
Expected value is outcome that would occur on an
average when a person or business is exposed
repeatedly to the same type of risk.
Ex: Sachin?s batting average is 67 based on past
data. So the expected score he is likely to hit is 67.
However, there is a degree variability around this
value. He might duck out or hit a century.
Risk
Expected loss Variability/Uncertainty
Risk v/s uncertainty
Risk Uncertainty
Probability of the
possible outcomes of
the event is known
probability of the
possible outcomes is
not known
Dispersion of the
probability
distribution is risk
Lack of confidence
that the estimated
probability
distribution is correct
Types of risks
? BUSINESS RISK
Business risk is possible reductions in value of business from any
source. Business value depends upon size, timing and risk variability
in cash flows. Unexpected changes in future cash flows can lead to
business risk.
There are three main risks involved in business:
Price risk, Credit risk and Pure risk
1. Price risk:
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)
Types of risk
2. Credit risk:
Risk that a firm?s customers and the parties to which it has lent money will
delay or fail to make promised payments is called credit risk. Most firms
face credit risk from accounts receivables. Financial institutions carry 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:
Risk management function traditionally concentrates on management of
pure risk. Pure risk relates to losses associated with assets. It comprises of:
Damage to assets: (reduction of value of business assets due to physical
damage, theft, and expropriation (seizure by foreign govt)
Legal liability: of harm to customers, suppliers, share holders, other parties
Worker injury: risk of paying compensation and damages to employees
Employee benefits: risk of death, illness and disability to
employees/families as per contracts/Acts.
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 income
earner?s productivity due to death, disability, aging, or a change in
technology.
Medical expense risk:
Liability risk on auto and home
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?
?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:
? 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 of risk
companies have discontinued manufacturing
certain goods and services. Eg: certain vaccines,
asbestos products, breast inplants, 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 flight,
writing exams, skiing etc
Sources of risk
External sources:
? Business factors
? Natural factors ? earthquake, famine, cyclone,
lightning,
? Political factors ? change of govt, civil war, riots, policy
changes
Internal sources:
? Operational -
? Technological
? Human factors
? Technological
? physical
Degree of risk/objective risk
? Degree of risk is defined as relative variation of actual loss from
actual loss.
? Assume that out of 10000 houses, 1% ie 100 houses bun every 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.
? Assume that 1 million houses are insured. Expected houses to 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% from
original level.
? Objective risk can be statistically measured by measure of
dispersion like standard deviation. As the number of exposure
increases prediction will be more accurate as variation is lesser.
Risk management
? 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, approach and
processes to the tasks of identifying and assessing
risks and then planning and implementing risk
responses.
Methods of risk management
? Broadly 3 methods:
? Loss control
? Loss financing
? Internal risk reduction
? 1 and 3 involves decisions to invest/not invest to reduce losses
while 2
nd
one refers to how to pay for losses if they do occur
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 are both
eg: airbags in vehicles.
? There are 2 general approaches to loss control.
- 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
? Broad methods
- retention: business retains the right to pay up losses.
Also called self-insurance
- Insurance: pay premium and receive funds to make
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.
3. Internal risk reduction
?Businesses can reduce risk internally by:
?1. Diversification: Businesses spread
across different areas can help reduce
risk. Do not keep all eggs in the same
basket.
?2. Invest on information: in order to get
superior forecasts of future cash flow
thereby reducing variability.
Risk management process
? Identify all significant process
? Evaluate the potential frequency and severity
of losses
? Develop and select methods for managing risk
? 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
? ASSIGNEMENTQUESTION
Objectives of risk management
? To be consistent with corporate objectives of returns
and safety
? To provide good service to customers
? 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.
? To be able to make informed decisions and make
choices on possible outcomes.
Need for a rationale for
risk management in org
? ASSIGNMENT QUESTION
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
? 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 cost
of house.
If a factory is destroyed, then,
? direct loss is the value of the factory, cost of repair, cost of paying
compensation,/claims, cost of defending liability claims.
? Indirect losses are:
- Loss of normal profit,
- Extra operating expenses
- Higher costs of funds
- Legal expenses and Bankruptcy costs
- Foregone investments
- Reorganisation and liquidating costs.
FirstRanker.com - FirstRanker's Choice
Risk and its
management
MODULE 1
What is risk ?
Risk is uncertainty about the outcome? in a general
sense
Possible variability in outcomes around some
expected values?.Specific meaning used for
events.
Expected value is outcome that would occur on an
average when a person or business is exposed
repeatedly to the same type of risk.
Ex: Sachin?s batting average is 67 based on past
data. So the expected score he is likely to hit is 67.
However, there is a degree variability around this
value. He might duck out or hit a century.
Risk
Expected loss Variability/Uncertainty
Risk v/s uncertainty
Risk Uncertainty
Probability of the
possible outcomes of
the event is known
probability of the
possible outcomes is
not known
Dispersion of the
probability
distribution is risk
Lack of confidence
that the estimated
probability
distribution is correct
Types of risks
? BUSINESS RISK
Business risk is possible reductions in value of business from any
source. Business value depends upon size, timing and risk variability
in cash flows. Unexpected changes in future cash flows can lead to
business risk.
There are three main risks involved in business:
Price risk, Credit risk and Pure risk
1. Price risk:
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)
Types of risk
2. Credit risk:
Risk that a firm?s customers and the parties to which it has lent money will
delay or fail to make promised payments is called credit risk. Most firms
face credit risk from accounts receivables. Financial institutions carry 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:
Risk management function traditionally concentrates on management of
pure risk. Pure risk relates to losses associated with assets. It comprises of:
Damage to assets: (reduction of value of business assets due to physical
damage, theft, and expropriation (seizure by foreign govt)
Legal liability: of harm to customers, suppliers, share holders, other parties
Worker injury: risk of paying compensation and damages to employees
Employee benefits: risk of death, illness and disability to
employees/families as per contracts/Acts.
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 income
earner?s productivity due to death, disability, aging, or a change in
technology.
Medical expense risk:
Liability risk on auto and home
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?
?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:
? 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 of risk
companies have discontinued manufacturing
certain goods and services. Eg: certain vaccines,
asbestos products, breast inplants, 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 flight,
writing exams, skiing etc
Sources of risk
External sources:
? Business factors
? Natural factors ? earthquake, famine, cyclone,
lightning,
? Political factors ? change of govt, civil war, riots, policy
changes
Internal sources:
? Operational -
? Technological
? Human factors
? Technological
? physical
Degree of risk/objective risk
? Degree of risk is defined as relative variation of actual loss from
actual loss.
? Assume that out of 10000 houses, 1% ie 100 houses bun every 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.
? Assume that 1 million houses are insured. Expected houses to 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% from
original level.
? Objective risk can be statistically measured by measure of
dispersion like standard deviation. As the number of exposure
increases prediction will be more accurate as variation is lesser.
Risk management
? 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, approach and
processes to the tasks of identifying and assessing
risks and then planning and implementing risk
responses.
Methods of risk management
? Broadly 3 methods:
? Loss control
? Loss financing
? Internal risk reduction
? 1 and 3 involves decisions to invest/not invest to reduce losses
while 2
nd
one refers to how to pay for losses if they do occur
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 are both
eg: airbags in vehicles.
? There are 2 general approaches to loss control.
- 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
? Broad methods
- retention: business retains the right to pay up losses.
Also called self-insurance
- Insurance: pay premium and receive funds to make
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.
3. Internal risk reduction
?Businesses can reduce risk internally by:
?1. Diversification: Businesses spread
across different areas can help reduce
risk. Do not keep all eggs in the same
basket.
?2. Invest on information: in order to get
superior forecasts of future cash flow
thereby reducing variability.
Risk management process
? Identify all significant process
? Evaluate the potential frequency and severity
of losses
? Develop and select methods for managing risk
? 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
? ASSIGNEMENTQUESTION
Objectives of risk management
? To be consistent with corporate objectives of returns
and safety
? To provide good service to customers
? 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.
? To be able to make informed decisions and make
choices on possible outcomes.
Need for a rationale for
risk management in org
? ASSIGNMENT QUESTION
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
? 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 cost
of house.
If a factory is destroyed, then,
? direct loss is the value of the factory, cost of repair, cost of paying
compensation,/claims, cost of defending liability claims.
? Indirect losses are:
- Loss of normal profit,
- Extra operating expenses
- Higher costs of funds
- Legal expenses and Bankruptcy costs
- Foregone investments
- Reorganisation and liquidating costs.
Cost of risk
? 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 (size) 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
FirstRanker.com - FirstRanker's Choice
Risk and its
management
MODULE 1
What is risk ?
Risk is uncertainty about the outcome? in a general
sense
Possible variability in outcomes around some
expected values?.Specific meaning used for
events.
Expected value is outcome that would occur on an
average when a person or business is exposed
repeatedly to the same type of risk.
Ex: Sachin?s batting average is 67 based on past
data. So the expected score he is likely to hit is 67.
However, there is a degree variability around this
value. He might duck out or hit a century.
Risk
Expected loss Variability/Uncertainty
Risk v/s uncertainty
Risk Uncertainty
Probability of the
possible outcomes of
the event is known
probability of the
possible outcomes is
not known
Dispersion of the
probability
distribution is risk
Lack of confidence
that the estimated
probability
distribution is correct
Types of risks
? BUSINESS RISK
Business risk is possible reductions in value of business from any
source. Business value depends upon size, timing and risk variability
in cash flows. Unexpected changes in future cash flows can lead to
business risk.
There are three main risks involved in business:
Price risk, Credit risk and Pure risk
1. Price risk:
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)
Types of risk
2. Credit risk:
Risk that a firm?s customers and the parties to which it has lent money will
delay or fail to make promised payments is called credit risk. Most firms
face credit risk from accounts receivables. Financial institutions carry 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:
Risk management function traditionally concentrates on management of
pure risk. Pure risk relates to losses associated with assets. It comprises of:
Damage to assets: (reduction of value of business assets due to physical
damage, theft, and expropriation (seizure by foreign govt)
Legal liability: of harm to customers, suppliers, share holders, other parties
Worker injury: risk of paying compensation and damages to employees
Employee benefits: risk of death, illness and disability to
employees/families as per contracts/Acts.
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 income
earner?s productivity due to death, disability, aging, or a change in
technology.
Medical expense risk:
Liability risk on auto and home
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?
?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:
? 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 of risk
companies have discontinued manufacturing
certain goods and services. Eg: certain vaccines,
asbestos products, breast inplants, 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 flight,
writing exams, skiing etc
Sources of risk
External sources:
? Business factors
? Natural factors ? earthquake, famine, cyclone,
lightning,
? Political factors ? change of govt, civil war, riots, policy
changes
Internal sources:
? Operational -
? Technological
? Human factors
? Technological
? physical
Degree of risk/objective risk
? Degree of risk is defined as relative variation of actual loss from
actual loss.
? Assume that out of 10000 houses, 1% ie 100 houses bun every 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.
? Assume that 1 million houses are insured. Expected houses to 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% from
original level.
? Objective risk can be statistically measured by measure of
dispersion like standard deviation. As the number of exposure
increases prediction will be more accurate as variation is lesser.
Risk management
? 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, approach and
processes to the tasks of identifying and assessing
risks and then planning and implementing risk
responses.
Methods of risk management
? Broadly 3 methods:
? Loss control
? Loss financing
? Internal risk reduction
? 1 and 3 involves decisions to invest/not invest to reduce losses
while 2
nd
one refers to how to pay for losses if they do occur
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 are both
eg: airbags in vehicles.
? There are 2 general approaches to loss control.
- 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
? Broad methods
- retention: business retains the right to pay up losses.
Also called self-insurance
- Insurance: pay premium and receive funds to make
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.
3. Internal risk reduction
?Businesses can reduce risk internally by:
?1. Diversification: Businesses spread
across different areas can help reduce
risk. Do not keep all eggs in the same
basket.
?2. Invest on information: in order to get
superior forecasts of future cash flow
thereby reducing variability.
Risk management process
? Identify all significant process
? Evaluate the potential frequency and severity
of losses
? Develop and select methods for managing risk
? 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
? ASSIGNEMENTQUESTION
Objectives of risk management
? To be consistent with corporate objectives of returns
and safety
? To provide good service to customers
? 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.
? To be able to make informed decisions and make
choices on possible outcomes.
Need for a rationale for
risk management in org
? ASSIGNMENT QUESTION
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
? 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 cost
of house.
If a factory is destroyed, then,
? direct loss is the value of the factory, cost of repair, cost of paying
compensation,/claims, cost of defending liability claims.
? Indirect losses are:
- Loss of normal profit,
- Extra operating expenses
- Higher costs of funds
- Legal expenses and Bankruptcy costs
- Foregone investments
- Reorganisation and liquidating costs.
Cost of risk
? 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 (size) 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
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:
? 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.
FirstRanker.com - FirstRanker's Choice
Risk and its
management
MODULE 1
What is risk ?
Risk is uncertainty about the outcome? in a general
sense
Possible variability in outcomes around some
expected values?.Specific meaning used for
events.
Expected value is outcome that would occur on an
average when a person or business is exposed
repeatedly to the same type of risk.
Ex: Sachin?s batting average is 67 based on past
data. So the expected score he is likely to hit is 67.
However, there is a degree variability around this
value. He might duck out or hit a century.
Risk
Expected loss Variability/Uncertainty
Risk v/s uncertainty
Risk Uncertainty
Probability of the
possible outcomes of
the event is known
probability of the
possible outcomes is
not known
Dispersion of the
probability
distribution is risk
Lack of confidence
that the estimated
probability
distribution is correct
Types of risks
? BUSINESS RISK
Business risk is possible reductions in value of business from any
source. Business value depends upon size, timing and risk variability
in cash flows. Unexpected changes in future cash flows can lead to
business risk.
There are three main risks involved in business:
Price risk, Credit risk and Pure risk
1. Price risk:
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)
Types of risk
2. Credit risk:
Risk that a firm?s customers and the parties to which it has lent money will
delay or fail to make promised payments is called credit risk. Most firms
face credit risk from accounts receivables. Financial institutions carry 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:
Risk management function traditionally concentrates on management of
pure risk. Pure risk relates to losses associated with assets. It comprises of:
Damage to assets: (reduction of value of business assets due to physical
damage, theft, and expropriation (seizure by foreign govt)
Legal liability: of harm to customers, suppliers, share holders, other parties
Worker injury: risk of paying compensation and damages to employees
Employee benefits: risk of death, illness and disability to
employees/families as per contracts/Acts.
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 income
earner?s productivity due to death, disability, aging, or a change in
technology.
Medical expense risk:
Liability risk on auto and home
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?
?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:
? 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 of risk
companies have discontinued manufacturing
certain goods and services. Eg: certain vaccines,
asbestos products, breast inplants, 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 flight,
writing exams, skiing etc
Sources of risk
External sources:
? Business factors
? Natural factors ? earthquake, famine, cyclone,
lightning,
? Political factors ? change of govt, civil war, riots, policy
changes
Internal sources:
? Operational -
? Technological
? Human factors
? Technological
? physical
Degree of risk/objective risk
? Degree of risk is defined as relative variation of actual loss from
actual loss.
? Assume that out of 10000 houses, 1% ie 100 houses bun every 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.
? Assume that 1 million houses are insured. Expected houses to 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% from
original level.
? Objective risk can be statistically measured by measure of
dispersion like standard deviation. As the number of exposure
increases prediction will be more accurate as variation is lesser.
Risk management
? 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, approach and
processes to the tasks of identifying and assessing
risks and then planning and implementing risk
responses.
Methods of risk management
? Broadly 3 methods:
? Loss control
? Loss financing
? Internal risk reduction
? 1 and 3 involves decisions to invest/not invest to reduce losses
while 2
nd
one refers to how to pay for losses if they do occur
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 are both
eg: airbags in vehicles.
? There are 2 general approaches to loss control.
- 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
? Broad methods
- retention: business retains the right to pay up losses.
Also called self-insurance
- Insurance: pay premium and receive funds to make
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.
3. Internal risk reduction
?Businesses can reduce risk internally by:
?1. Diversification: Businesses spread
across different areas can help reduce
risk. Do not keep all eggs in the same
basket.
?2. Invest on information: in order to get
superior forecasts of future cash flow
thereby reducing variability.
Risk management process
? Identify all significant process
? Evaluate the potential frequency and severity
of losses
? Develop and select methods for managing risk
? 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
? ASSIGNEMENTQUESTION
Objectives of risk management
? To be consistent with corporate objectives of returns
and safety
? To provide good service to customers
? 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.
? To be able to make informed decisions and make
choices on possible outcomes.
Need for a rationale for
risk management in org
? ASSIGNMENT QUESTION
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
? 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 cost
of house.
If a factory is destroyed, then,
? direct loss is the value of the factory, cost of repair, cost of paying
compensation,/claims, cost of defending liability claims.
? Indirect losses are:
- Loss of normal profit,
- Extra operating expenses
- Higher costs of funds
- Legal expenses and Bankruptcy costs
- Foregone investments
- Reorganisation and liquidating costs.
Cost of risk
? 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 (size) 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
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:
? 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
? 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.
FirstRanker.com - FirstRanker's Choice
Risk and its
management
MODULE 1
What is risk ?
Risk is uncertainty about the outcome? in a general
sense
Possible variability in outcomes around some
expected values?.Specific meaning used for
events.
Expected value is outcome that would occur on an
average when a person or business is exposed
repeatedly to the same type of risk.
Ex: Sachin?s batting average is 67 based on past
data. So the expected score he is likely to hit is 67.
However, there is a degree variability around this
value. He might duck out or hit a century.
Risk
Expected loss Variability/Uncertainty
Risk v/s uncertainty
Risk Uncertainty
Probability of the
possible outcomes of
the event is known
probability of the
possible outcomes is
not known
Dispersion of the
probability
distribution is risk
Lack of confidence
that the estimated
probability
distribution is correct
Types of risks
? BUSINESS RISK
Business risk is possible reductions in value of business from any
source. Business value depends upon size, timing and risk variability
in cash flows. Unexpected changes in future cash flows can lead to
business risk.
There are three main risks involved in business:
Price risk, Credit risk and Pure risk
1. Price risk:
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)
Types of risk
2. Credit risk:
Risk that a firm?s customers and the parties to which it has lent money will
delay or fail to make promised payments is called credit risk. Most firms
face credit risk from accounts receivables. Financial institutions carry 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:
Risk management function traditionally concentrates on management of
pure risk. Pure risk relates to losses associated with assets. It comprises of:
Damage to assets: (reduction of value of business assets due to physical
damage, theft, and expropriation (seizure by foreign govt)
Legal liability: of harm to customers, suppliers, share holders, other parties
Worker injury: risk of paying compensation and damages to employees
Employee benefits: risk of death, illness and disability to
employees/families as per contracts/Acts.
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 income
earner?s productivity due to death, disability, aging, or a change in
technology.
Medical expense risk:
Liability risk on auto and home
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?
?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:
? 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 of risk
companies have discontinued manufacturing
certain goods and services. Eg: certain vaccines,
asbestos products, breast inplants, 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 flight,
writing exams, skiing etc
Sources of risk
External sources:
? Business factors
? Natural factors ? earthquake, famine, cyclone,
lightning,
? Political factors ? change of govt, civil war, riots, policy
changes
Internal sources:
? Operational -
? Technological
? Human factors
? Technological
? physical
Degree of risk/objective risk
? Degree of risk is defined as relative variation of actual loss from
actual loss.
? Assume that out of 10000 houses, 1% ie 100 houses bun every 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.
? Assume that 1 million houses are insured. Expected houses to 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% from
original level.
? Objective risk can be statistically measured by measure of
dispersion like standard deviation. As the number of exposure
increases prediction will be more accurate as variation is lesser.
Risk management
? 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, approach and
processes to the tasks of identifying and assessing
risks and then planning and implementing risk
responses.
Methods of risk management
? Broadly 3 methods:
? Loss control
? Loss financing
? Internal risk reduction
? 1 and 3 involves decisions to invest/not invest to reduce losses
while 2
nd
one refers to how to pay for losses if they do occur
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 are both
eg: airbags in vehicles.
? There are 2 general approaches to loss control.
- 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
? Broad methods
- retention: business retains the right to pay up losses.
Also called self-insurance
- Insurance: pay premium and receive funds to make
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.
3. Internal risk reduction
?Businesses can reduce risk internally by:
?1. Diversification: Businesses spread
across different areas can help reduce
risk. Do not keep all eggs in the same
basket.
?2. Invest on information: in order to get
superior forecasts of future cash flow
thereby reducing variability.
Risk management process
? Identify all significant process
? Evaluate the potential frequency and severity
of losses
? Develop and select methods for managing risk
? 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
? ASSIGNEMENTQUESTION
Objectives of risk management
? To be consistent with corporate objectives of returns
and safety
? To provide good service to customers
? 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.
? To be able to make informed decisions and make
choices on possible outcomes.
Need for a rationale for
risk management in org
? ASSIGNMENT QUESTION
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
? 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 cost
of house.
If a factory is destroyed, then,
? direct loss is the value of the factory, cost of repair, cost of paying
compensation,/claims, cost of defending liability claims.
? Indirect losses are:
- Loss of normal profit,
- Extra operating expenses
- Higher costs of funds
- Legal expenses and Bankruptcy costs
- Foregone investments
- Reorganisation and liquidating costs.
Cost of risk
? 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 (size) 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
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:
? 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
? 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 and
cost of risk
? Apart from pure risk under business risks, concepts 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 like
insurance , cost of gathering weather information. He
would also consider cost of residual uncertainty which
depends upon the person?s attitude towards risk.
? 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 outcome
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 to be
compensated more for taking risk.
FirstRanker.com - FirstRanker's Choice
Risk and its
management
MODULE 1
What is risk ?
Risk is uncertainty about the outcome? in a general
sense
Possible variability in outcomes around some
expected values?.Specific meaning used for
events.
Expected value is outcome that would occur on an
average when a person or business is exposed
repeatedly to the same type of risk.
Ex: Sachin?s batting average is 67 based on past
data. So the expected score he is likely to hit is 67.
However, there is a degree variability around this
value. He might duck out or hit a century.
Risk
Expected loss Variability/Uncertainty
Risk v/s uncertainty
Risk Uncertainty
Probability of the
possible outcomes of
the event is known
probability of the
possible outcomes is
not known
Dispersion of the
probability
distribution is risk
Lack of confidence
that the estimated
probability
distribution is correct
Types of risks
? BUSINESS RISK
Business risk is possible reductions in value of business from any
source. Business value depends upon size, timing and risk variability
in cash flows. Unexpected changes in future cash flows can lead to
business risk.
There are three main risks involved in business:
Price risk, Credit risk and Pure risk
1. Price risk:
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)
Types of risk
2. Credit risk:
Risk that a firm?s customers and the parties to which it has lent money will
delay or fail to make promised payments is called credit risk. Most firms
face credit risk from accounts receivables. Financial institutions carry 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:
Risk management function traditionally concentrates on management of
pure risk. Pure risk relates to losses associated with assets. It comprises of:
Damage to assets: (reduction of value of business assets due to physical
damage, theft, and expropriation (seizure by foreign govt)
Legal liability: of harm to customers, suppliers, share holders, other parties
Worker injury: risk of paying compensation and damages to employees
Employee benefits: risk of death, illness and disability to
employees/families as per contracts/Acts.
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 income
earner?s productivity due to death, disability, aging, or a change in
technology.
Medical expense risk:
Liability risk on auto and home
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?
?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:
? 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 of risk
companies have discontinued manufacturing
certain goods and services. Eg: certain vaccines,
asbestos products, breast inplants, 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 flight,
writing exams, skiing etc
Sources of risk
External sources:
? Business factors
? Natural factors ? earthquake, famine, cyclone,
lightning,
? Political factors ? change of govt, civil war, riots, policy
changes
Internal sources:
? Operational -
? Technological
? Human factors
? Technological
? physical
Degree of risk/objective risk
? Degree of risk is defined as relative variation of actual loss from
actual loss.
? Assume that out of 10000 houses, 1% ie 100 houses bun every 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.
? Assume that 1 million houses are insured. Expected houses to 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% from
original level.
? Objective risk can be statistically measured by measure of
dispersion like standard deviation. As the number of exposure
increases prediction will be more accurate as variation is lesser.
Risk management
? 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, approach and
processes to the tasks of identifying and assessing
risks and then planning and implementing risk
responses.
Methods of risk management
? Broadly 3 methods:
? Loss control
? Loss financing
? Internal risk reduction
? 1 and 3 involves decisions to invest/not invest to reduce losses
while 2
nd
one refers to how to pay for losses if they do occur
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 are both
eg: airbags in vehicles.
? There are 2 general approaches to loss control.
- 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
? Broad methods
- retention: business retains the right to pay up losses.
Also called self-insurance
- Insurance: pay premium and receive funds to make
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.
3. Internal risk reduction
?Businesses can reduce risk internally by:
?1. Diversification: Businesses spread
across different areas can help reduce
risk. Do not keep all eggs in the same
basket.
?2. Invest on information: in order to get
superior forecasts of future cash flow
thereby reducing variability.
Risk management process
? Identify all significant process
? Evaluate the potential frequency and severity
of losses
? Develop and select methods for managing risk
? 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
? ASSIGNEMENTQUESTION
Objectives of risk management
? To be consistent with corporate objectives of returns
and safety
? To provide good service to customers
? 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.
? To be able to make informed decisions and make
choices on possible outcomes.
Need for a rationale for
risk management in org
? ASSIGNMENT QUESTION
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
? 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 cost
of house.
If a factory is destroyed, then,
? direct loss is the value of the factory, cost of repair, cost of paying
compensation,/claims, cost of defending liability claims.
? Indirect losses are:
- Loss of normal profit,
- Extra operating expenses
- Higher costs of funds
- Legal expenses and Bankruptcy costs
- Foregone investments
- Reorganisation and liquidating costs.
Cost of risk
? 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 (size) 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
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:
? 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
? 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 and
cost of risk
? Apart from pure risk under business risks, concepts 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 like
insurance , cost of gathering weather information. He
would also consider cost of residual uncertainty which
depends upon the person?s attitude towards risk.
? 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 outcome
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 to be
compensated more for taking risk.
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 produces
an efficient level of risk. Efficient level is where
the marginal benefit of risk reduction equals
marginal cost of these methods.
? Maximising the value of resources with minimum
cost of risk makes the economy more efficient
? Differential insurance premia in the society (like
differential taxes) works against maximisation of
wealth to some extent.
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Risk and its
management
MODULE 1
What is risk ?
Risk is uncertainty about the outcome? in a general
sense
Possible variability in outcomes around some
expected values?.Specific meaning used for
events.
Expected value is outcome that would occur on an
average when a person or business is exposed
repeatedly to the same type of risk.
Ex: Sachin?s batting average is 67 based on past
data. So the expected score he is likely to hit is 67.
However, there is a degree variability around this
value. He might duck out or hit a century.
Risk
Expected loss Variability/Uncertainty
Risk v/s uncertainty
Risk Uncertainty
Probability of the
possible outcomes of
the event is known
probability of the
possible outcomes is
not known
Dispersion of the
probability
distribution is risk
Lack of confidence
that the estimated
probability
distribution is correct
Types of risks
? BUSINESS RISK
Business risk is possible reductions in value of business from any
source. Business value depends upon size, timing and risk variability
in cash flows. Unexpected changes in future cash flows can lead to
business risk.
There are three main risks involved in business:
Price risk, Credit risk and Pure risk
1. Price risk:
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)
Types of risk
2. Credit risk:
Risk that a firm?s customers and the parties to which it has lent money will
delay or fail to make promised payments is called credit risk. Most firms
face credit risk from accounts receivables. Financial institutions carry 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:
Risk management function traditionally concentrates on management of
pure risk. Pure risk relates to losses associated with assets. It comprises of:
Damage to assets: (reduction of value of business assets due to physical
damage, theft, and expropriation (seizure by foreign govt)
Legal liability: of harm to customers, suppliers, share holders, other parties
Worker injury: risk of paying compensation and damages to employees
Employee benefits: risk of death, illness and disability to
employees/families as per contracts/Acts.
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 income
earner?s productivity due to death, disability, aging, or a change in
technology.
Medical expense risk:
Liability risk on auto and home
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?
?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:
? 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 of risk
companies have discontinued manufacturing
certain goods and services. Eg: certain vaccines,
asbestos products, breast inplants, 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 flight,
writing exams, skiing etc
Sources of risk
External sources:
? Business factors
? Natural factors ? earthquake, famine, cyclone,
lightning,
? Political factors ? change of govt, civil war, riots, policy
changes
Internal sources:
? Operational -
? Technological
? Human factors
? Technological
? physical
Degree of risk/objective risk
? Degree of risk is defined as relative variation of actual loss from
actual loss.
? Assume that out of 10000 houses, 1% ie 100 houses bun every 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.
? Assume that 1 million houses are insured. Expected houses to 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% from
original level.
? Objective risk can be statistically measured by measure of
dispersion like standard deviation. As the number of exposure
increases prediction will be more accurate as variation is lesser.
Risk management
? 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, approach and
processes to the tasks of identifying and assessing
risks and then planning and implementing risk
responses.
Methods of risk management
? Broadly 3 methods:
? Loss control
? Loss financing
? Internal risk reduction
? 1 and 3 involves decisions to invest/not invest to reduce losses
while 2
nd
one refers to how to pay for losses if they do occur
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 are both
eg: airbags in vehicles.
? There are 2 general approaches to loss control.
- 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
? Broad methods
- retention: business retains the right to pay up losses.
Also called self-insurance
- Insurance: pay premium and receive funds to make
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.
3. Internal risk reduction
?Businesses can reduce risk internally by:
?1. Diversification: Businesses spread
across different areas can help reduce
risk. Do not keep all eggs in the same
basket.
?2. Invest on information: in order to get
superior forecasts of future cash flow
thereby reducing variability.
Risk management process
? Identify all significant process
? Evaluate the potential frequency and severity
of losses
? Develop and select methods for managing risk
? 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
? ASSIGNEMENTQUESTION
Objectives of risk management
? To be consistent with corporate objectives of returns
and safety
? To provide good service to customers
? 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.
? To be able to make informed decisions and make
choices on possible outcomes.
Need for a rationale for
risk management in org
? ASSIGNMENT QUESTION
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
? 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 cost
of house.
If a factory is destroyed, then,
? direct loss is the value of the factory, cost of repair, cost of paying
compensation,/claims, cost of defending liability claims.
? Indirect losses are:
- Loss of normal profit,
- Extra operating expenses
- Higher costs of funds
- Legal expenses and Bankruptcy costs
- Foregone investments
- Reorganisation and liquidating costs.
Cost of risk
? 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 (size) 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
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:
? 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
? 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 and
cost of risk
? Apart from pure risk under business risks, concepts 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 like
insurance , cost of gathering weather information. He
would also consider cost of residual uncertainty which
depends upon the person?s attitude towards risk.
? 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 outcome
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 to be
compensated more for taking risk.
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 produces
an efficient level of risk. Efficient level is where
the marginal benefit of risk reduction equals
marginal cost of these methods.
? Maximising the value of resources with minimum
cost of risk makes the economy more efficient
? Differential insurance premia in the society (like
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.
? Regulation from the governement legally takes
care of the fact that businesses do not
concentrate on reducing private cost to
maximise profits which results in a higher risk to
the society.
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This post was last modified on 18 February 2020