Cpcu 500 Ch.1

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Risk

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A key to risk management is understanding and quantifying various risk.

Risk is possibility of gain or loss.

Uncertainty is not knowing what/when something will happen. The uncertainty associated with risk is best described as the uncertainty as to the timing and type of an outcome.

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Elements of risk

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Two elements of risk:

Uncertainty regarding the type or timing of outcomes.

Possibility of loss, possibility means outcome or event may or may not occur. Does not quantify likelihood of outcome or event occurring.

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Loss

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Undesirable end result.

Probability of loss quantifies risk. If event is not possible, value is 0. If event is certain, value is 1 (100%). All other probabilities fall between 0 and 1 (100%).

Probabilities are not used to determine if insurance is actually available but they may be used to determine if insurance is necessary and which risk management technique to use. However, possibility does determine if insurance is available while probability is whether or not you should purchase the insurance.

When "likelihood" is mentioned that has to do with assigning a value, which is probability. Probability, not possibility, represents the likelihood that an event will occur.

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Understanding the probability of outcomes helps

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Focus risk management attention on those risks that can be managed. Need to assign probabilities to events.

Decide which risk management technique to use. E.g. if probability of being injured driving is 3%, while probability of taking a bus is 1%, individual may choose to take a bus.

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Definitions

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Loss exposure - loss that might occur.

Peril - cause of a loss, such as a theft or fire.

Hazard - condition that increases the likelihood of the occurrence of a loss.

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Risk classifications

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Pure and speculative risk. Subjective and objective risk. Diversifiable and nondiversifiable risk.

The classifications are not mutually exclusive. Insurable risks (risks for which insurance products are generally available) are generally categorized as pure, objective and diversifiable.

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Pure and speculative risk

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Pure risk is the possibility of loss. No chance of gain (either loss or no loss). Insurance is primarily designed for pure risk.

Speculative risk is possibility of gain or loss. Market risk is fluctuations is securities prices. Financial risk is the risk of company carrying too much debt. Can be managed through hedging.

House is e.x. of both pure and speculative risk. Pure risk of house is that it could be destroyed by fire or water. However based on the economy, it can be sold at a loss or gain. Insurance will only cover the "pure" risks.

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Subjective and objective risk

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Objective risk is based on fact (sometimes past data). Objective risks are generally insurable.

Subjective risk is based on opinion. Can exist even when objective risk does not. Based on the organization, not the risk.

E.g. Flying on an airplane is objectively less risky than driving if you look at the data. However flying may be perceived as more risky by some people which is subjective.

Risk assessment relies on objective facts combined with subjective opinions of the future. But insurance itself is really only based on objective risk.

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Diversifiable and nondiversifiable risk

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Diversifiable risks only affect one, or a small number, of people or businesses. Risks tend to not be correlated. Focus of private insurance. E.g. homeowners insurance. If a house burns down, chances are it will be the only one to burn down out of several others that are covered by the insurer so the insurer can use the premiums paid by the nonburned houses to pay for the loss of the burned house.

Nondiversifiable risks are correlated, and therefore diversification will not lower the risk. Inflation, natural disasters and unemployment. Focus of government insurance (unemployment benefits). E.g. flood in an area that typically floods.

The distinction between these two risks is not always clear, and some risks can fall under both classifications.

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Types of risk management

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Traditional risk management - when an organization or individual focuses on pure risk.

Enterprise-wide risk management - focuses on pure and speculative risk. One approach is to take pure and speculative risk and divide them into 4 groups called risk quadrants.

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Risk quadrants

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One enterprise-wide risk management (ERM) approach involves dividing risks into quadrants. Quadrants include 2 quadrants of pure and 2 quadrants of speculative risk.

Pure risk quadrants (generally diversifiable and insurable): hazard risks which include property damage (like fire) and third-party liability (risk often transferred through insurance) (typically managed by risk management professionals). Operational risk which is product recall, embezzlement and provider interruption (occur in business operations, cannot gain from these so they are "pure").

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Risk quadrants pt.2

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Speculative risk quadrants: financial risks which include liquidity, debt rating, interest rates and commodity prices (may be diversifiable or nondiversifiable) (typically handled by the treasury function or chief executive officer). Strategic risks which include intellectual property, competitors, ethics and media (generally diversifiable risks)

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Risk consequences

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Components of financial consequences of risk:

Expected cost of losses or gains.

Risk management expenditures (insurance premiums that you pay).

Cost of residual uncertainty (worry).

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Expected costs of losses or gains

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The expected cost of gains or losses includes direct and indirect losses associated with a risk. Direct and indirect costs should be considered.

Industrial accidents are very appropriate for demonstrating direct and indirect costs. If someone is hurt on the job this includes cost of compensation paid to injured worker and many other hidden costs (indirect e.g. all the employees watching while the injured person is tended to so they aren't working).

More difficult to calculate expected cost of speculative risk than pure risk b/c speculative has some element of gain so it's more difficult to estimate.

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Risk management expenditures

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Expenditures on insurance are component of the financial consequences of risk. Risk financing (insurance) is most widely used risk management technique for individuals. Organizations tend to use a wider variety of risk management techniques than individuals.

Risk management makes those who own or run an organization more willing to undertake risky activities.

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Residual uncertainty

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The cost of residual uncertainty is the cost of worry and concern. Very subjective measure. Difficult to measure and is often ignored in cost of risk studies. Can be minimized, but doing so is costly.

Residual uncertainty is a factor in the case of both pure and speculative risk.

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Residual uncertainty pt.2

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Cost of residual uncertainty includes the effect uncertainty has on investors, suppliers and customers. E.g. if you make a product but have a history of poor safety records, your customers may not be willing to pay as much for your product. Society benefits from the great differences in residual uncertainty that individuals and organizations are willing to accept b/c if you're willing to take on risk due to lower residual uncertainty you may be able to pursue some profitable ventures.

Residual uncertainty is the level of risk that remains after implementing risk management plans.

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Individual risk management

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Individuals use risk management to help meet goals and protect their assets e.g. home insurance. May be considered as part of the financial planning process e.g. life insurance to pay for college education of children if parent dies early.

Individuals and families typically don't implement a formal risk management process. Risk management for individuals is typically a very informal series of efforts e.g. buying auto, home owner or life insurance.

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Organization risk management

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Risk management is usually not a designated function in smaller organizations. May be carried out by business owner.

In larger organizations, a formal risk management program may be implemented. Often structured around risk management process.

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Enterprise-wide risk management

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Enterprise-wide risk management is focused on managing an organization's pure and speculative risk. Goal is to maximize organization's value.

Enterprise-wide risk management process occurs at the enterprise level, not at the department level.

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Elements of loss exposure

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Elements of loss exposure: asset exposed to loss which includes tangible and intangible property (for an organization, human resources is considered an asset exposed to losses). Cause of loss a.k.a. peril which is influenced by hazards. Financial consequences which include value of damages property and loss of business (depends on type of loss exposure, cause of loss and frequency and severity).

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Hazards

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Increases frequency or severity of a loss.

Moral hazard - intentionally causing a loss (they have no morals, embezzlement or arson).

Morale hazard - carelessness or indifference.

Physical hazard - tangible characteristics of property e.g. where is it located? does it have a high likelihood of being hit by a tornado?

Legal hazard - condition of legal environment (some courts tend to favor plaintiff).

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Property loss exposure

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Represents damage of or deconstruction to property. Asset exposed (tangible, real (land and attachments to building, could include another building or crops on land) and personal property (other than real property like a laptop or anything not attached to the building or land) and intangible property).

Cause of loss (peril) - fire, theft, weather, water, ice.

Financial consequences - financial damage to the property, limited by the value of the property.

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Liability loss exposure

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Represents possibility of a legal claim against the company.

Asset exposed - money.

Cause (peril) - claim or suit against organization.

Financial consequences - theoretically unlimited.

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Personnel loss exposure

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Represents loss to an organization of a key person.

Asset exposed - value of key person.

Cause (peril) - death, disability, retirement, layoff.

Financial consequences - varies depending on key person's value. Can be partial or total loss. Can be temporary or permanent.

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Net income loss exposure

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Represents reduction of net income e.g. if building holding materials for company burns down, the building is the property loss exposure and net income loss exposure is a loss b/c company may need to shut down.

Asset exposed - future stream of income to itganization or individual.

Cause (peril) - property loss (most common), liability loss, personnel loss, poor planning.

Financial consequences - worst case scenario is a decrease in revenue to zero, with increase in expenses.

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Risk management benefits

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Risk management benefits individuals, organizations and society.

Organization with effective risk management program should experience: smaller expected losses (preserves financial resources). Less residual uncertainty (reduces anxiety and improves allocation of resources).

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Benefits to individuals

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Risk management helps preserve resources which lowers expected losses.

Risk management reduces anxiety. Most individuals are somewhat risk averse. Risk management allows individual to invest time and money into managing risks to reduce uncertainty.

E.g. if person has an umbrella policy to protect against liability losses, liability exposures are covered, lowering expected losses, and they'll have reduced worry.

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Benefits to organizations

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Risk management helps preserve resources. Makes organization more attractive to investors.

Reduces residual uncertainty. Deterrence effect (fear of possible future losses that tends to make management reluctant to undertake activities). Risk management can reduce or even eliminates deterrence effect. Organization can plan for future with less uncertainty.

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Benefits to society

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Risk management helps preserve resources. Focuses on efficient use of resources consumed in running an economy's risk management program.

Reduces residual uncertainty. Improves allocation of productive resources.

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Pre-loss goals

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Represents goals to be achieves before a loss has occurred. Should ensure organization's legal obligations are met. Includes economy of operations, tolerable uncertainty, legality and social responsibility (both pre and post loss goal).

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Pre-loss goals pt.2

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Economy of operations: program should be efficient and economic. Organization should not incur large costs for small benefit. Uses bench marking to compare costs.

Tolerable uncertainty (how much risk can the organization tolerate): keeping managers' uncertainty regarding losses at acceptable levels. Program should assure managers that losses are within boundaries of what is anticipated.

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Pre-loss goals pt.3

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Legality: risk management program should ensure organization's legal obligations are satisfied. Risk management professional should be aware of organizations contractual obligations, and federal and state regulations.

Social responsibility: includes ethical behavior, as well as fulfilling obligations to the community. Pre-loss and post-loss goal.

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Post-loss goals

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Represent goals to be achieved after a signigicant loss has occured.

Includes survival, continuity of operations, profitability, earnings stability, social responsibility and growth

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Post-loss goals pt.2

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Survival: most basic goal after a severe loss. Individuals - staying alive. Organizations - resuming operations, even if not returning to previous activity level.

Continuity of operations: more demanding than survival goal. Essential goal for all public entities.

E.g. survival means loss isn't going to permanently shut down the business while continuity of operations means the operation wont be shut down for extended period of time.

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Post-loss goals pt.3

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Profitability: achieve a minimum profit or budget. Insurance is particularly important to ensure financial results fall within acceptable range b/c insurance will often cover the majority of the loss.

Earnings stability: organizations should strive for consistent earnings over time. Does not indicate organization should strive for the highest possible profit after a loss.

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Post-loss goals pt.4

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Social responsibility: organizational disruption affect relationships with customers, suppliers, etc. Both a pre-loss and post-loss goal.

Growth: includes the goal of increasing market share.

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Conflict between goals

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Goals may conflict with each other:

Post-loss may conflict with pre-loss goals. Post-loss goals involve expending resources, which may conflict with pre-loss goal of economy of operations.

Pre-loss goals my compete with each other. Economy of operations goal may conflict with tolerable uncertainty goal b/c managing uncertainty may involve spending resources. Legality and social responsibility goals may conflict with economy of operations.

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Risk management process

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Steps of the risk management process: identify loss exposures, analyze loss exposures (first two steps, when combined, constitute the process of assessing loss exposures), examine feasibility of techniques, select appropriate techniques, implement appropriate techniques and monitor the plan.

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Identifying loss exposures

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No single method exists for identifying loss exposures.

Methods that can be used: document analysis, compliance reviews, inspections and expertise with and outside of the organization.

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Analyzing loss exposure

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Loss exposures are analyzed based on frequency, severity, dollar amount, and timing. Loss frequency - number of losses within specified time period. Loss severity - dollar amount of the each individual loss. Total dollar loss - total losses for all occurrences during a specified time period. Timing - when loss payments are made.

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Examine feasibility of techniques

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Loss exposures can be addressed through risk control and risk financing techniques. Risk control (include risk avoidance and loss reductions that minimizes frequency or severity of losses). Risk financing (includes insurance and hedging techniques, generate funds to finance losses).

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Select appropriate techniques

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Selecting the appropriate techniques is based on qantitatice and qualitative considerations. Technique should be effective and economical. Organization should forecast potential losses and costs of applying techniques.

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Implementing techniques

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Implementation may involve: puchasing loss reduction devices, using loss prevention services, implementing loss control programs and purchasing insurance.

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Monitoring plan

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Involves determining acceptable levels of performance, comparing actual results to acceptable levels, correcting substandard results and evaluating results that exceeded acceptable levels.

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4 steps to monitor and revise the risk management program are:

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Establish standards for acceptable performance.

Compare established standards to actual results.

Correct substandard performance or revise goals.

Evaluate standards that have bee substantially exceeded.

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Examples

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If you receive a gift of money and use it to purchase a rental property, you could profit from it, based on rental income and the possibility that the property value will increase (speculative risk). The property is also subject to pure risk b/c you could face a loss from fire or other hazard.

If you purchase a car, the risk of damages to the car are diversifiable b/c you can purchase insurance.