Chapter 1 The Nature of Risk: Losses and Opportunities
Uncertainty and Risk Uncertainty means having two or more potential outcomes for an event or a situation Uncertainty is a precursor to risk Risk is a consequence of uncertainty (but risk is not the same thing as uncertainty) If we have perfect certainty, we have no risk
Understanding risk Risk can be emotional, financial, or reputational Risk is anchored on a continuum of maximizing value and minimizing losses Actual outcomes for an event or situation often differ from expected outcomes: this creates risk
Attitudes Toward Risk (which impact decisions) Different people have different attitudes towards the risk-return tradeoff A risk-adverse person leans away from risk, seeking as much security as possible A risk-neutral person remains equidistant from the extremes of avoiding risk and accepting risk A risk-seeking person embraces risk as long as a gain is possible, although unlikely
Types of Risks—Risk Exposures Risk exposure: the enterprise, property, person or activity facing a potential loss Pure risk: facing loss with no chance of a gain (purview of traditional risk management or TRM) Speculative risk: a chance of either gain or loss (purview of enterprise risk management or ERM)
Examples of Pure vs. Speculative Risk Exposures Pure Risk: potential loss but no possible gain Physical damage to property from fire, flood or other natural disasters Liability risk: getting sued over products; employment practices Individual risk of mortality or morbidity Manmade risks: war; unemployment Global pandemics; social program failure Speculative risk: potential gain or loss Market risk: interest rate fluctuation, foreign exchange volatility, stock price Reputational risk Brand risk Individual credit risk Regulatory changes Accounting risk
Main Sources of Loss Personal loss exposures: sickness, disability, individual deaths; also impacts organizations and society Property loss exposures Liability loss exposures: individuals and organizations can get sued Catastrophic loss exposures Accidental loss exposures
Diversifiable vs. Non-diversifiable Risks Diversifiable risks: risks whose adverse consequences can be mitigated simply by having a diversified portfolio of risk exposures Non-diversifiable risks: risks, shared by all persons or organizations, that cannot be mitigated by adding exposures to the portfolio
Examples of Diversifiable and Non- Diversifiable risks Diversifiable Risks Reputational risk Brand risk Credit risk Product risk Legal risk Physical damage risk Operational risk Strategic risk Non-diversifiable Risks Market risk Regulatory risk Environmental risk Political risk Inflation and recession risk Accounting risk Pandemics, social security program risks
Frequency and Severity Frequency is the number of times losses have happened in a given time period, often 12 months Severity denotes how bad the loss has been in both human and dollar terms Total cost of loss for a particular loss exposure = (average severity) x (the frequency of loss)
Perils and Hazards In risk management, a peril is the direct or immediate cause of a loss (such as a fire or automobile crash) A hazard is a condition that increases the possible frequency or severity of a loss, or both – Moral hazard: deceit, often involves insurance – Morale hazard: carelessness – Physical hazard: tangible conditions (snow, ice)
Enterprise Risk Management Enterprise risk management (ERM) is a newer concept in risk management that takes a holistic view of all of the possible risks an organization faces. ERM considers speculative risks as well as pure risks. ERM does not replace traditional risk management (TRM), it expands upon TRM’s practices and techniques to consider more risks and offer additional solutions to finance or manage them.
End of Chapter 1