risk management and insurance

Trieschmann,Hoyt&SommerIntroductiontoRiskChapter1©2005,Thomson/South-Western2ChapterObjectives•Explainthreewaystocategorizerisk•Listthecomponentsofanentity’scostofrisk•Giveseveralexamplesofrisksinvolvingproperty,liability,life,health,lossofincome,andfinanciallosses•Distinguishbetweenchanceoflossanddegreeofrisk•Giveexamplesofthreetypesofhazards•Identifythedifferencebetweenhazardsandperils•Explaintheevolvingconceptofintegratedriskmanagement•Explainthefourstepsintheriskmanagementprocess3Introduction•Riskregardingthepossibilityoflosscanbeespeciallyproblematic•Ifalossiscertaintooccur–Itmaybeplannedforinadvanceandtreatedasadefinite,knownexpense•Whenthereisuncertaintyabouttheoccurrenceofaloss–Riskbecomesanimportantproblem4TheBurdenofRisk•Somerisksinvolveonlythepossibilityofloss•Riskssurroundingpotentiallossescreatesignificanteconomicburdensforbusinesses,government,andindividuals–Billionsofdollarsarespenteachyeartofinancepotentiallosses•Butwhenlossesarenotplannedforinadvancetheymaycostevenmore•Riskoflossmaydeprivesocietyofservicesjudgedtobetoorisky–Forinstance,withoutmalpracticeinsurancemanyphysicianswouldrefusetopracticemedicine5TheBurdenofRisk•Businessesmaytrytoeitheravoidriskoflossortoreduceitsnegativeconsequences•Anentity’scostofriskisthesumof–Expensesofstrategiestofinancepotentiallosses–Thecostofunreimbursedlosses–Outlaystoreducerisks–Opportunitycostofactivitiesforgoneduetoriskconsiderations6FIGURE1-1TypesofRisk7PurevsSpeculativeRisk•Pureriskexistswhenthereisuncertaintyastowhetherlosswilloccur•Nopossibilityofgainispresentedonlythepotentialforloss•Speculativeriskexistswhenthereisuncertaintyaboutaneventthatcanproduceeitheraprofitoraloss•Bothpureandspeculativerisksmaybepresentinsomesituations8SubjectivevsObjectiveRisk•Subjectiveriskreferstothementalstateofanindividualwhoexperiencesdoubtorworryastotheoutcomeofagivenevent–Itisessentiallythepsychologicaluncertaintythatarisesfromanindividual’smentalattitudeorstateofmind•Objectiveriskdiffersfromsubjectiveriskinthesensethatitismorepreciselyobservableandthereforemeasurable–Itistheprobablevariationofactualfromexpectedexperience9SourcesofRisk•Propertyrisks–Riskthatpropertymaybedamaged,destroyedorstolen•Forexample,lightning,tornadoes,hurricanes,explosions,riots,collisions,fallingobjects,floods,earthquakes,freezing,etc.•Liabilityrisks–Legaljudgmentsmayresultinpaymentsmadetocompensateinjuredpartiesaswellastopunishthoseresponsiblefortheinjuries•Eveniftheindividualisabsolvedofliabilitytheexpensesinvolvedinthedefensemaybesubstantial–Allindividualswhoownoruserealpropertyaresusceptibletoliabilitylossesifothersareinjuredontheirpremises10SourcesofRisk•Lifeandhealthandlossofincomerisks–Thepossibilityoftheuntimelydeathofastarsalesperson–Thepotentialdeathofaparentwithyoungchildren–Employeeswhobecomeillorinjuredinaccidents•Financialrisk–Includecreditrisk,foreignexchangerisk,commodityrisk,andinterestraterisk–Theserisksmustbeidentifiedandassessedinorderforthefirmtoachieveitsbusinessgoals11MeasurementofRisk•Chanceofloss–Thelongtermchanceofoccurrence,orrelativefrequencyofloss–Meaningfulonlywhenappliedtothechanceoflossoccurringamongalargenumberofpossibleofevents•Expressedastheratioofthenumberoflossesthatarelikelytooccurcomparedtothelargernumberofpossiblelossesinagivengroup•Peril–Specificcontingencythatmaycausealoss•Hazards–Conditionsthatexistwhicheitherincreasethechanceofalossforaparticularperilortendtomakethelossmoresevereoncetheperilhasoccurred12Hazards•Physicalhazard–Aconditionstemmingfromthematerialcharacteristicsofanobject•Anicystreetmakestheoccurrenceofcollisionmorelikelytooccur–Theicystreetisthehazardandthecollisionistheperil•Moralhazard–Stemsfromanindividual’smentalattitude–Associatedwithintentionalactionsdesignedeithertocausealossortoincreaseitsseverity–Alsodescribesthechangeinattitudethatcanoccurwheninsuranceisavailabletopayforloss•Suchasthetendencyforindividualstoconsumemorehealthcareifthecostsarecoveredbyinsurance•Moralehazard–Thementalattitudeofacarelessoraccident-proneperson13DegreeofRisk•Amountofobjectiveriskpresentinasituation•Relativevariationofactualfromexpectedlosses•Rangeofvariabilityaroundtheexpectedlosses–Objectiverisk=probablevariationofactualfromexpectedlosses÷expectedlosses14DegreeofRisk•Ifalosshasalreadyoccurredtheprobablevariationofactualfromexpectedlossesiszero–Thereforethedegreeofriskiszero•Ifitisimpossibleforlosstooccurtheprobablevariationisalsozero•Inmeasuringthedegreeofrisk,resultsaremeaningfulonlyintermsofagrouplargeenoughtoanalyzestatistically15Managementofrisk•Riskmanagement–Processusedtosystematicallymanageriskexposures•Integratedriskmanagementandenterpriseriskmanagement–Intenttomanageallformsofrisk,regardlessoftype•Manybusinesseshavespecialdepartmentschargedwithoverseeingthefirm’sriskmanagementactivities–Theheadofsuchadepartmentofteniscalledariskmanager•Somefirmshaveformedriskmanagementcommittees•Somefirmshavecreatedthepositionofchiefriskofficertocoordinatethefirm’sriskmanagementactivities16RiskManagementProcess•Identifyrisks•Evaluaterisks•Selectriskman