Risk identification
Critical aspect of risk management.
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Failure to identify risk exposures will lead to huge losses. There is no scientific method to identify risks and sometimes they may even be unknown. It is usually done on the basis of what is insurable and on the basis of past experience.
“Risk identification is the process by which a business systematically and continuously identifies property, liability and personal exposures as soon as and before they emerge" .... Williams and Heins
Risk identification
Risk identification
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Business risk exposures
Individual risk exposures
Identifying business risk exposures
- Physical assets/property
- Financial assets
- Legal liability
- Human assets/personnel
- External economic forces
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Types of property loss exposures:
- Direct loss: direct loss happening to the property either wholly or on coming in contact with the incident. Eg P&M
- Indirect loss: indirect loss occurring while the direct damage is on some other property. Eg: factory being torn down to facilitate rebuilding
- Net income loss: refers to reduction in net income(revenue less expenses)
- Decrease in revenue may be because of loss of rent, interruption of operation, contingent business interruption (losses occurring because a loss eg loss of records)
- Increase in expenses: owing to spending extra money in the wake of a damage. Eg: spending extra money to hire a house/hotel room, spending extra money to continue the operation.
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Value of exposures of physical assets
- Property insurance policies indemnifies insured on the basis of either... or...
- Actual Cash Value (ACV) : cost to replace or repair damaged property less value of physical depreciation and obsolescence.
- Replacement Cost : cost to replace or repair damaged property with same or like-kind property WITHOUT any value of physical depreciation and obsolescence. Also called re-instatement cost.
- Value by second method is always higher.
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Types of exposure to financial assets
- Risk of loss of financial assets like
- 1. credit exposure: debtors or accounts receivable fail to pay or delay payments. Bad-debts can lead to huge losses. Delayed payments lead to loss of money due to interest cost .
- 2. currency exposure: involves losses in adverse movement of exchange rates. It affects companies which are in international trade. Indirectly it also affects companies which have competitions from abroad.
- 3. country exposure: arising out of problems in the country of operation. Comprises of political risk, regulatory risk and economic risk.
- 4. Liquidity exposure: this refers to the risk of a financial asset like bond, debentures going illiquid.
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Features of financial asset exposure
- Financial asset exposure depends upon its financial structure
- If the capital structure makes earnings unstable company may fail
- When company raises funds to finance its growth have impact on future earnings and stability
- Debt financing offers a low cost source of funds - company and financial leverage to stock holders
- Large amounts of debt increases variability of returns to the stock holders thereby increasing their risk
- Variability in returns is for shareholders is more in leveraged firms than in unleveraged firms.
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Types of legal liability exposures
- Arising out of ownership/use/possession: puts onus to keep it risk free. And safe
- Arising from manufacture/distribution/sale owing to breach of warranty, defective product. May lead to penal provisions
- Arising from fiduciary relations: failure to discharge duty towards shareholders by directors
- Employers' liability: for job related injuries and compensation to workmen. Usually discharged by workmen compensation policies.
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Legal wrong
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- A legal wrong is a violation of a person's legal rights or a failure to perform legal duty towards another person or society.
- There are 3 broad categories of legal wrongs:
- a crime is a legal wrong against society and punishable by fines, imprisonment, death.
- a breach of contract is another legal wrong
- a tort is a legal wrong for which the remedy is in the form of money damages. It is a personal injury law. Torts are of 3 types: intentional torts, absolute/strict liability and negligence.
- A person who is harmed (plaintiff, claimant) can sue for damages from the defendant or tortfeasor.
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Categories of legal liability
- Criminal liability: comes under IPC generally directed at wrongs against the society. Police begins the legal procedure and the court will impose penalty and/or imprisonment.
- Civil liability: directed at wrongs against individuals/organisations where one party files a liability suit against another. Penalty in the form of indemnity for loss or punitive damages may be levied by the court.
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Exposure of human assets/personnel
- Exposure when employees/people get injured, reach old age, fall ill or leave jobs. Companies manage these exposures either due to legal strictures or as part of compensation/motivation to employees.
- Employers resort to provisioning through pension, gratuity, life and health insurance cover and disability benefits.
- A special kind of risk is a key person's death or disability . Keyman insurance is available for this purpose.
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Exposure from external economic forces
Losses arise from factors outside the firm like,
- Changes in input/output prices, changes in exchange rate, credit or financial distress experienced by important suppliers/buyers.
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Identifying personal risk exposures
- Personal loss/injury exposures
- Property loss exposures
- Legal liability loss exposures
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Personal loss/injury exposures
- Loss of income to the family because of death of the family head
- Huge medical bills and loss of earnings during disability
- Insufficient income/assets during retirement
- Loss of income from unemployment
- Identity theft
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Property loss exposures
- Direct physical damage to home/personal property because of fire, lightning, flood, earthquake, etc
- Indirect expenses arising out of above damage or physical loss like expenses for hotel, travel during period of reconstruction, loss of rent of use of the building etc
- Theft of valuable personal property including money, securities, jewellery, electronics
- Direct physical damage to cars, bikes, etc from collision and non-collision reasons
- Theft of cars, bikes, and other vehicles
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Legal liability loss exposure
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Legal liability arising out of:
- Personal acts that cause bodily injury to others
- Libel, slander, defamation of character and similar exposure
- Negligent operation of vehicles
- Business or professional activities
- Payment of attorney fees and other legal defense costs
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Probability and Statistics - concepts
- Random Variable – A variable whose outcome is uncertain. Eg: head or tail in a coin flip is uncertain.
- Discrete variable v/s continuous variable.
- All the possible outcome in a random variable and their probabilities is identified in a probability distribution. This can be represented tabular or graphical. (probability of head and probability of tail occurring)
- In a graphical representation, you put outcome on the X axis and probability on the Y axis.
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| Possible outcome for X | probability |
|---|---|
| $1 | 0.5 or 50% |
| -$1 | 0.5 or 50% |
Another example
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Probability distribution for damages to your car.
| Damages | Probability |
|---|---|
| 0 | 0.5 |
| 500 | 0.3 |
| 1000 | 0.1 |
| 5000 | 0.06 |
| 10000 | 0.04 |
Characteristics of a probability distribution
- In order to compare and analyse different probability distributions following characteristics may be used:
- Expected value
- Variance and standard deviation
- Skewness
- Correlation
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Expected value
- Expected value of an outcome tells where the outcome tends to average
- Expected value
- = average
- = add up all (outcome*probability)
- = x1p1+x2p2+x3p3+...........
- = Summation xipi (Sigma xipi)
- Graphically expected value = Mean can be easily identified visually if the graph is symmetric.
- If not, it is a bit difficult.
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What is the expected value of damages?
| Possible outcomes for damage (Rs) | probability |
|---|---|
| 0 | 0.5 |
| 500 | 0.3 |
| 1000 | 0.1 |
| 5000 | 0.06 |
| 10000 | 0.04 |
What is the expected value of damages?
| Possible outcomes for damage (Rs) | probability | xipi |
|---|---|---|
| 0 | 0.5 | 0 |
| 500 | 0.3 | 150 |
| 1000 | 0.1 | 100 |
| 5000 | 0.06 | 300 |
| 10000 | 0.04 | 400 |
What is the expected liability
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- 5000000 with probability of 0.004
- 1500000 0.025
- Loss of 500000 0.030
- 0 0.941
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What is the expected liability
- 5000000 * 0.004 = 20000
- 1500000 * 0.025 = 37500
- 500000 * 0.030 = 15000
- 0 * 0.941 = 0
- EXPECTED LIABILITY = 72500
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Variance & standard deviation
- Variance of a probability distribution provides information about the likelihood and magnitude by which a particular outcome will differ from the expected value (or average)
- A low variance means that an actual outcome is very close to the expected value and a high variance means that the actual outcome differs from the expected value.
- Variance = Sigma pi (xi-mu)2
- It is mathematically more convenient to work with the square root of variance which is called standard deviation.
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Solve...
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- What is the expected value of the outcome if you win Rs 1 for heads and lose Rs 1 for tails; in a coin toss game?
- Calculate the sample mean and sample standard deviation if the game is played 5 times with the following results: T,T,H,T,H
- EXPECTED VALUE = 1*0.5+(-1*0.5) = 0
- Sample mean = 1*2/5 + (-1*3/5) = -0.2
- Sample standard deviation = square root Summation pi(xi-mu)2
- = ROOT OF 2/5(1-(-0.2))2 + 3/5(-1-(-0.2))2
- Root 0.96 = 0.98
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Skewness
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- Skewness measures the symmetry of a distribution. A normal distribution has zero skewness and is symmetric. Most of the risk management distributions are skewed.
- If one assumes a symmetric distribution then one would underestimate the likelihood of large losses which can be very harmful.
Maximum probable loss
- Maximum possible Loss is the maximum amount a firm may lose given an incident. It is may be the total value of the assets
- Maximum probable loss is the expected loss given the most likely probability of an event happening. eg: MPL at 5% is 20 million, MPL at 1% is 30 million
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Value-at-risk
- Value at risk is the value of the property at risk for a givendescribes probability distribution for the value of a firm/portfolio that is subject to loss.
- Fig 3.9; 5 million is the value at risk for our portfolio at 5% risk, the probability that the firm will lose more than 5 million is 5%(curve to the left of 5 million is 0.05) similarly if 7.5 million is the value at risk at 1% level, the probability that the firm will lose > 7.5 million is 1%
- Firms use value at risk concept to measure risk and rebalance portfolio by
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Normal distribution and VAR
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- Probability of VAR (mu+/-1.645 sigma) = 0.05
- Probability of VAR (mu+/- 2.33 sigma) = 0.01
Correlation
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- Correlation measures the relationship between random variables.
- If the correlation between two random variables is zero then they are not correlated. I means that knowing value of one will not reveal the value of the other. Eg: liability claims for an auto company and steel prices. They are independent or uncorrelated.
- on the other hand, demand for new cars and steel prices are correlated.
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This download link is referred from the post: VTU MBA Lecture Notes - 1st Sem, 2nd Sem, 3rd Sem and 4th Sem || Visvesvaraya Technological University