Risk Management and Insurance
Risk Management and Insurance

Risk Management and Insurance

Lead Author(s): Rob Hoyt, David Sommer

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The text covers the foundations of risk management and insurance. The broad view of risk reflected in the concept of enterprise risk management is incorporated throughout the text, while still maintaining features that are important for introductory courses in risk management and insurance. The text considers property, liability, life, health, and income risks for both individuals and organizations. For all risks discussed, both insurance and non-insurance solutions are analyzed.

Chapter 1

Introduction to Risk


[1]

Eastman Enterprises specializes in home renovation, landscape design, and the historic preservation of buildings. It began operations in Pennsylvania and expanded rapidly, and now has branches throughout the midwestern and southeastern regions of the United States.

Because of the firm’s phenomenal rate of growth, Eastman’s managers have had virtually no time to think about anything other than trying to meet customers’ demands. No thought has been given to the potential consequences of events such as employee injuries or actions that might damage customers’ property. Even the very basic potential problem of loss due to fire has received only cursory attention from management. The attitude is best characterized by owner Carol Eastman’s statement: “Maybe we’ll have time to think about those things tomorrow. Nothing really terrible has happened yet, and we’ve got a business to run!”

As Eastman may soon discover, the time for a business to think about terrible things is before they happen—afterward may be too late. For example, the likelihood that a tornado will hit Eastman’s headquarters building may seem remote, but if it does happen, the potential consequences could be disastrous. Eastman could lose not only its main building but also the equipment and inventory stored inside. Vital computer records might be destroyed, key personnel could be injured, and operations could be curtailed for weeks or months. Such damage could also impact business at Eastman’s other locations, resulting in a much greater total loss than management ever imagined.

The many uncertainties that may cause losses for businesses and individuals, as well as ways to manage those uncertainties, form the basis of this book. This first chapter explores the nature of uncertainty, also known as risk.

After studying this chapter, you should be able to

  • Explain three ways to categorize risk.
  • List the components of an entity’s cost of risk.
  • Give several examples of risks involving property, liability, life, health, loss of income, and financial losses.
  • Distinguish between chance of loss and degree of risk.
  • Give examples of three types of hazards.
  • Identify the difference between hazards and perils.
  • Explain the evolving concept of integrated risk management.
  • Explain the four steps in the risk management process.

INTRODUCTION

Risk, which is often used to mean uncertainty, creates both problems and opportunities for businesses and individuals in nearly every walk of life. Executives, employees, investors, students, householders, travelers, and farmers all confront risk and deal with it in various ways. Sometimes a particular risk is consciously analyzed and managed; other times risk is simply ignored, perhaps out of lack of knowledge of its consequences.

Risk regarding the possibility of loss can be especially problematic. If a loss is certain to occur, it may be planned for in advance and treated as a definite, known expense. It is when there is uncertainty about the occurrence of a loss that risk becomes an important problem. Thus, if a store owner knows for sure that a certain amount of shoplifting will occur, this loss may be recovered by marking up all goods by the necessary percentage. There is little or no risk involved unless actual shoplifting is greater than normal. The store is more concerned about the risk of abnormal shoplifting losses than about those viewed as normal or expected.

THE BURDEN OF RISK

The idea of risk bearing can be tantalizing. After all, it is a well-known investment principle that the largest potential returns are associated with the riskiest ventures. There are some risks, however, that involve only the possibility of loss. For example, businesses located near the Mississippi River confront the possibility of periodic flooding. When a flood occurs, loss caused by property damage and lost revenues is likely. On the other hand, no gain is expected merely because in some years a flood does not occur.

The risk surrounding potential losses creates significant economic burdens for businesses, government, and individuals. Billions of dollars are spent each year on strategies for financing potential losses. But when losses are not planned for in advance, they may cost even more. For example, a multimillion dollar adverse liability judgment may reduce a business’s profitability, lower its credit ratings, cause a loss of customers, and perhaps result in bankruptcy if the firm has not made adequate plans to pay for the loss.

Aside from actual losses after events occur, the mere existence of the risk of potential losses puts burdens on society.  Risk can increase the cost of borrowing, since lenders will demand higher interest on loans to account for the risk of not getting repaid.  When risk is not transferred to another party, it requires individuals and business to hold large amounts of liquid assets in order to be prepared to pay for unexpected events.  Risk of loss may also deprive society of services judged to be too risky. A member of the American Medical Association once commented that without malpractice insurance many physicians would refuse to practice medicine. Similarly, businesses of all types may be reluctant to engage in projects that are deemed too risky, potentially depriving society of valuable innovations.

Businesses, as well as individuals, may try to quantify the impact that risk has on them.  One common measure of the impact of risk on a business is called the cost of risk , which is the sum of: (1) expenses of strategies to finance potential losses, (2) the cost of unreimbursed losses, (3) outlays to reduce risks, and (4) the opportunity cost of activities forgone due to risk considerations. For a particular firm, the first two components of the cost of risk are often the easiest to measure. When insurance costs are rising, firms tend to place more emphasis on retaining losses and on efforts to keep losses from happening in order to reduce their cost of risk.  They may increase deductibles, move to self-insurance, or spend more on loss control activities.  When insurance prices are falling, they may do the opposite.  To minimize the cost of risk efficiently, one must study the subject of risk, learn more about the different types of risk, and find ways to deal with risk more effectively.

CATEGORIES OF RISK

Thus far, the terms risk and uncertainty have been used interchangeably. However, many forms of uncertainty exist and, in a comprehensive study of risk, it is helpful to define the concept more precisely. This book deals primarily with the type of uncertainty in which the possible outcomes are either “loss” or “no loss,” rather than with uncertainties that also present the opportunity for profit. It must be noted, however, that organizations increasingly are considering the broader set of risks that they face, regardless of type. This new view reflects the realization that risks from different sources interact to define the overall risk profile of the firm and recognizes the importance of all forms of risk that affect a firm’s ability to realize its strategic objectives. Therefore, although much of this book focuses on risk regarding the possibility of loss, the discussion throughout also addresses the most significant elements of the new emerging viewpoint. Three common ways to classify risk are described in this section. These groupings are not mutually exclusive. Rather, risks can be categorized simultaneously according to all three types of classifications.

Pure versus Speculative Risk

An important classification of risk involves the concepts of pure risk and speculative risk. Pure risk exists when there is uncertainty as to whether loss will occur. No possibility of gain is presented by pure risk—only the potential for loss. Examples of pure risk include the uncertainty of damage to property by fire or flood, the prospect of premature death caused by accident or illness, or the chance of a products liability lawsuit against a company. In contrast to pure risk, speculative risk exists when there is uncertainty about an event that could produce either a profit or a loss (or no change at all). Business ventures and investment decisions are examples of situations involving speculative risk. Gains as well as losses may occur, changing the nature of the uncertainty that is present.

Both pure and speculative risks may be present in some situations. It is important to recognize that many profit-motivated, speculative-risk decisions made by individuals and firms can have an impact on pure risk exposures. For example, a firm purchasing land for development is making a decision that entails speculative risk. However, if after the purchase it discovers that the land contains a latent pollution problem, the firm would then face a new pure risk. Another example is the decision that a firm makes to introduce a new product. This decision may represent primarily a speculative risk. But as has been seen for products like asbestos and silicone breast implants, this decision also is accompanied by the pure risk associated with potential product liability. Failure to consider the overlapping effects of these two types of risk can lead to an analysis that misrepresents the true situation, possibly resulting in bad decisions.

Concept Check 1.1

Which of the following would be an example of a pure risk?

A

The risk from opening a small business

B

The risk of fire damage to a restaurant

C

The risk of a change in tax rates

D

All of the above


Fundamental versus Particular Risk

Another way of classifying risk is based on how widesrpead the impact of the risk is.  A particular risk is one which, when it occurs, only impacts an individual person or business or a small group of people or businesses.  Examples include auto accidents, building fires, and worker injuries.  By contrast, a fundamental risk impacts a large number of people or companies, or even the economy as a whole.  Examples include disasters such as hurricanes, earthquakes, and major terrorist attacks, as well as economic phenomena such as inflation, recession, and changes in interest rates.

Static versus Dynamic Risk

Yet another way of classifying risk involves the extent to which uncertainty changes over time. Static risks, which can be either pure or speculative, stem from an unchanging environment that is in stable equilibrium. Examples of pure static risks include the uncertainties due to such random events as lightning, windstorms, and death. Business undertakings in a stable economy illustrate the concept of speculative static risk. In contrast, dynamic risks are produced because of changes in society. Dynamic risks also can be either pure or speculative. Examples of sources of dynamic risk include urban unrest, increasingly complex technology, and changing attitudes of legislatures and courts about a variety of issues.

Static and dynamic risks are not independent; greater dynamic risks may increase some types of static risks. An example involves uncertainty due to weather-related losses. This risk is usually considered to be static. However, evidence suggests that environmental pollution may be affecting global weather patterns and thereby increasing this source of static risk.


Concept Check 1.2

Cyber attack risk would be best classified as a

A

pure static risk

B

pure dynamic risk

C

speculative static risk

D

speculative dynamic risk


Subjective versus Objective Risk

A third way to classify risk is by whether it is objective or subjective. Subjective risk refers to the mental state of an individual who experiences doubt or worry as to the outcome of a given event. In addition to being subjective, a particular risk may also be either pure or speculative and either static or dynamic. Subjective risk is essentially the psychological uncertainty that arises from an individual’s mental attitude or state of mind. Objective risk differs from subjective risk primarily in the sense that it is more precisely observable and therefore measurable. In general, objective risk is the probable variation of actual from average outcomes. This term is most often used in connection with pure static risks, although it can also be applied to the other types of uncertainties. Details regarding measurement of objective risk are included later in this chapter.

The concept of subjective risk is especially important because it provides a way to interpret the behavior of individuals faced with seemingly identical situations yet arriving at different conclusions.  For example, one person may look at a situation and conclude that it is low risk, while another may look at an identical situation and conclude that it is high risk.  Objective risk is the same in both cases, but neither person may be able to determine the true, objective risk.  Therefore, they base their decisions on their subjective analysis of the risk.  Ideally, we would always make all important decisions based on objective risk, but in many cases we simply do not know the objective risk.

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ATTITUDES TOWARD RISK

Even when two people agree on the risk of a situation, they may react differently.  For example, consider a pure risk which both Barbara and Sam know has a 50 percent chance of no loss and a 50 percent chance of a $10,000 loss.  The average outcome of the situation, which we will define later in the chapter as the expected loss, is $5,000 (0.5 x $0 + 0.5 x $10,000).  Barbara may be willing to pay someone (such as an insurance company) $5,500 to take that risk away from her, while Sam may only be willing to pay $5,100 to get rid of the same risk.  This implies that Barbara dislikes risk more than Sam, making her willing to pay more to get rid of it.  The technical term for "disliking risk" is risk aversion.  A person who is risk averse prefers certainty to uncertainty.  Using the example above, a risk averse person would prefer to lose $5,000 for certain rather than to take the 50 percent chance of losing $10,000.  The reason Barbara and Sam were willing to pay more than the expected loss to get rid of the risk is that they are both risk averse.  Barbara is more risk averse than Sam, so she is willing to pay more than he is to get rid of the risk.

Economists generally assume that when people make financial decisions, they behave in a risk averse manner.  In fact, if people were not risk averse, they would never buy insurance, because an insurance company always has to charge more than expected losses on the policies it sells in order to remain in business.  Even people who make risky financial decisions are risk averse.  For example, the only reason people invest in high-risk stocks is because they are "compensated" for taking that risk through higher expected returns.  No smart investor would choose a high-risk stock over a low-risk stock if both offered the same expected return.  

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TYPES OF RISK

The emphasis of this book is on pure risks. The array of pure risks encountered is vast. Some of these risks are static, while many others are extremely dynamic. This section briefly describes the common sources of pure risks, which include property risks; liability risks; and life, health, and loss of income risks, with some consideration also given to financial risks of a speculative nature. A more extensive discussion of these topics is provided in subsequent chapters.

Property Risks

All businesses and individuals that own, rent, or use property are exposed to the risk that the property may be damaged, destroyed, or stolen. For example, lightning may strike a building, causing a fire that destroys the structure and the inventory, supplies, and equipment inside. Property owned or used outside of the building may also be susceptible to loss. Typical examples include trucks, automobiles, and mobile equipment. To fully analyze property risk exposures, businesses must consider both the types of property susceptible to loss and the potential sources of such risk. Sources include not only fire and lightning but also theft, tornadoes, hurricanes, explosions, riots, collisions, falling objects, floods, earthquakes, and freezing, to name only a few.

If property damage is extensive, a business may be forced to shut down temporarily, thereby incurring a loss of income in addition to the expense of replacing the damaged property. But in some instances involving severe property damage, management may decide that temporarily closing the business is not a viable option. For example, Rocky Mountain Bank likely would never regain its customers if it were to close for several months following a fire and not allow its customers to transact necessary banking business. In this situation, the bank would probably incur the extra expenses necessary to continue operations from a different location while repairs were made to its own premises.

In addition to risks arising out of property they own and/or use, businesses also are exposed to risks associated with property owned or used by other firms. For example, an explosion at ABC Company’s clothing factory may interrupt the supply of suits and dresses that QED Department Store usually purchases from ABC. Thus, QED may incur income losses as a result of ABC’s property damage. Similarly, if QED Department Store is the primary buyer of clothes manufactured by ABC, then a fire loss that requires QED to close temporarily likely will also have an adverse impact on ABC. Another illustration of losses to one business affecting another business involves companies selling primarily over the Internet. Such firms typically utilize others to make deliveries to their customers and could suffer significant losses if the delivery firms were unable to perform.

Liability Risks

A second major category of risks is liability exposure. Society has become increasingly litigious in recent years, with businesses and individuals often held financially liable for damages resulting from a vast and expanding array of situations. Liability judgments may result in payments made to compensate injured parties as well as to punish those responsible for the injuries, with multimillion dollar awards no longer rare. Even when an individual is eventually absolved of liability, the expenses involved in defending a case often prove to be substantial. Consequently, both individuals and businesses must be careful to identify all sources of liability risk that may affect them and then make suitable arrangements for dealing with such exposures to loss.

As an illustration of some specific sources of liability risk, all entities that own or use real property are susceptible to liability losses if others are injured on their premises. For example, the owner of Bill’s Fix-It Shop may be responsible for injuries suffered by a customer who trips and falls over trash stored near the entrance to the building. Another common liability risk arises from automobile use. Drivers involved in accidents may be liable if their actions are judged to be the cause of harm to someone else or to another person’s property. Businesses also face other situations that may result in damages payable to others. For example, if customers are injured by a firm’s products or through the actions of a company’s employees, the business may be held responsible for several million dollars worth of losses. Similarly, actions that pollute the environment or violate the personal rights of employees may also prove to be expensive from a liability perspective. These examples only begin to illustrate some of the situations that may result in severe losses for an individual or a business. Additional details about liability risks are discussed in later chapters.

Life, Health, and Loss of Income Risks

Potential losses associated with the health and well-being of individuals make up the third and final category of sources of risk. The possibility of the untimely death of star salesperson Ann Costello exposes her employer to potential loss if a replacement with the same skills and experience is not readily available. Even if Ann could be easily replaced, in many cases employee deaths are disruptive for other workers and may result in temporarily reduced productivity. This phenomenon is especially true if the death is due to job-related conditions.

Ann’s employer may also face risks associated with Ann’s potential death through the employee benefits provided to workers. Death benefits typically include a lump sum payment to survivors. Of course, employees also may face additional risks related to their premature death. For instance, the potential death of a parent exposes young children to the risk that their primary source of income may disappear. In addition, death usually results in certain expenses that must be paid before assets can be used for the support of survivors. Examples include funeral and burial costs, existing debts, and possibly estate and inheritance taxes.

Businesses and individuals also face risks associated with health problems. Persons who become ill or who are injured in accidents will incur expenses for medical treatment, and the cost of such treatment is becoming increasingly expensive. Sometimes businesses arrange to pay some or all of such expenses for their employees, regardless of whether a sickness or injury is job related. As medical costs increase, however, more and more individuals (whether employed or not) must pay substantial sums each year for medical care for themselves and their families. In addition to these expenses, there is another potential loss associated with sickness and accidents. If a previously employed individual is severely injured or gravely ill, that person may be unable to work for several months or even years. The resultant loss of income can have serious repercussions on the financial stability of the person and family involved.

Other risks that confront an employed individual are those associated with unemployment and retirement. Both events result in the loss of an income source that previously existed. A significant difference, however, relates to timing. Retirement usually is not a surprise and therefore presents many options for advance planning. In contrast, abrupt layoffs often are not expected and are therefore harder to plan for ahead of time. Through pension and other retirement benefits, as well as unemployment insurance provided in each state, businesses are also affected by these risks that their employees face.

Financial Risks

Although the major emphasis of this book is on pure risks, it is increasingly important that risks from other sources be considered as well. A variety of financial risks, which often are speculative in nature, can impact on a firm’s earnings. Examples of these financial risks include credit risk, foreign exchange risk, commodity risk, and interest rate risk. Although most of these financial risks tend to have the characteristics of speculative risks, they still present the firm with some of the same problems associated with pure risks. Although the techniques used to manage these risks may be very different from those used to manage pure risks, it remains critical that these risks be identified and assessed in order for the firm to achieve its business goals.


Concept Check 1.5

Match the type of risk with the example illustrating that risk.

Premise
Response
1

Liability risk

A

A rise in borrowing costs

2

Property risk

B

A company getting sued for discrimination

3

Financial risk

C

A person becoming unemployed

4

Loss of income risk

D

A warehouse being destroyed by a tornado


What Do YOU Think? 1.1

At this point in your life, which category of pure risks are of greatest concern to you personally: (1) property risks; (2) liability risks; (3) life, health, and loss of income risks; or (4) financial risks? Why?


MEASUREMENT OF RISK

Once risk sources have been identified, it is often helpful to measure the extent of the risk that exists. As noted above, risks that are classified as subjective cannot be precisely measured. In contrast, the amount of objective risk is often more readily observable. Several important concepts related to the measurement of objective risk are discussed in this section.

Chance of Loss

The long-term chance of occurrence, or relative frequency of loss, is defined to be the chance of loss. This is equivalent to the more general term of probability.  The concept has little meaning if applied to the chance of occurrence of a single event. Rather, it is meaningful primarily when applied to the chance of a loss occurring among a large number of possible events. Thus, chance of loss is expressed as the ratio of the number of losses that are likely to occur compared to the larger number of possible losses in a given group. For example, suppose 1,000 buildings in a particular city are considered to be susceptible to the risk of loss due to a tornado. If past experience indicates that 20 of these buildings are likely to be damaged by a tornado during a given time period, then the chance of loss due to a tornado is 2 percent. This number is determined by dividing the probable number of losses (20) by the number of buildings exposed to loss (1,000).



Concept Check 1.6

In decimal terms, what is the probability of getting a number greater than 3 when rolling a die?


Expected Loss

The expected loss of a situation is the average loss over a large number of exposures or over a long period of time.  Consider the example introduced earlier in the chapter of the risk with a 50 percent chance of no loss and a 50 percent chance of a $10,000 loss.  If you observed the outcome of this risk 5,000 times, then added up the losses and divided by 5,000, the result would be very close to $5,000.  Therefore, $5,000 would be the expected loss for this risk.  The chapter on Risk Identification and Evaluation will provide a more complete discussion of how to calculate expected loss.

Degree of Risk

When faced with a risk, you would certainly care about the expected loss.  However, because you are risk averse, you care not just about the expected loss, but also the amount of risk.  The amount of objective risk present in a situation, sometimes referred to as the degree of risk, is the relative variation of actual from expected losses. More precisely, the degree of risk is the range of variability around the expected losses, which are calculated using the chance of loss concept by means of the following formula:

 Objective Risk = (Probable variation of actual from expected losses)/(Expected Losses)

Consider the possibility of fire losses to buildings in Acworth and Branson. There are 100,000 buildings in each city and, on average, each city has 100 fire losses per year. By looking at historical data, statisticians are able to estimate that the actual number of fire losses in Acworth during the next year will very likely range from 95 to 105. In Branson, however, the range probably will be greater, with at least 80 fire losses expected and possibly as many as 120. The degree of risk for each city is computed as follows:

          RiskAcworth = (105 – 95) / 100 = 10 percent

          RiskBranson = (120 – 80) / 100 = 40 percent

As shown, the degree of risk for Branson is four times that for Acworth, even though the chances of loss are the same.  The example above is very simple.  The chapter on Risk Identification and Evaluation will discuss more sophisticated measures of the degree of risk.


Concept Check 1.7

The formula used to calculate the degree of objective risk is

A

probable variation of actual from expected losses divided by the expected loss

B

expected loss multiplied by the quantity 1 minus variance divided by expected loss

C

range of reasonable loss expectation divided by actual loss experience

D

expected losses minus probable losses divided by the range of actual losses experienced.


A few other observations are important regarding degree of risk and chance of loss. If a loss has already occurred, the probable variation of actual from expected losses in that particular situation is zero and, therefore, the degree of risk is zero. At the opposite extreme, if it is impossible for a loss to occur, the probable variation also is zero and the degree of risk is zero as well. Finally, in measuring the degree of risk, results are meaningful only in terms of a group large enough to analyze statistically. If the numbers involved are very small, then the range of probable variation may be so large as to seem virtually infinite when viewed in a relative sense.

To illustrate this latter point, consider the Online Action Corporation, which is concerned about the possible death of Barbara Thomas, a valuable, highly paid 24-year-old worker in its product development department. Online Action has been informed that Barbara’s probability of dying during the next year is 0.3 percent. Or, using the terminology introduced in this chapter, the chance of loss due to the peril of death is 0.003. The degree of risk is not particularly meaningful, however, when applied only to Barbara’s life. Either Barbara will die or she will not, making the relative variation of actual from expected losses extremely large:

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PERILS AND HAZARDS ASSOCIATED WITH RISK

In measuring risk, it is common practice to perform separate computations for different causes of loss. The term peril is used to describe a specific contingency that may cause a loss. For example, one of the perils that can cause loss to an automobile is collision. Other perils are illustrated by considering ways in which a building can be damaged; examples include fires, tornadoes, and explosions. Sometimes conditions exist that either increase the chance of loss from particular perils or tend to make the loss more severe once the peril has occurred. Such conditions are known as hazards and can be classified in the following three ways.

Physical Hazard

A physical hazard is a condition stemming from the material characteristics of an object. Consider the peril of collision, which may cause loss to an automobile. A physical condition that makes the occurrence of collision more likely is an icy street. The icy street is the hazard, and the collision is the peril. The chance of loss due to collision may be higher in winter than at other times of the year because of the greater incidence of the physical hazard of icy streets.

Physical hazards include such phenomena as the existence of dry forests (a hazard affecting the peril of fire), earth faults (a hazard for earthquakes), and the existence of oily rags in a firm’s storage closet (a hazard for fire). Such hazards may or may not be within human control. For example, the oily rag hazard can easily be eliminated. Other physical hazards, such as weather conditions, usually cannot be controlled, although their existence often may be observed.

Moral Hazard

The condition known as moral hazard stems from a change in an individual’s mental attitude because the person has insurance. It is associated with intentional actions designed either to cause a loss or to increase its severity because of the existence of insurance.  For example, managers who purchase fire insurance on a factory full of unprofitable, out-of-date equipment may feel an incentive to “sell the building to the insurance company” by arranging for a fire to destroy the property. Moral hazard also describes changes in attitude that can occur even when an honest person has insurance available to pay for loss.  An example of this would be the tendency for individuals to consume more health care if the costs are covered by insurance.

Other examples of moral hazards involve accidents and sicknesses, especially where an employer provides generous income replacement during the time an employee is unable to work. In these situations, workers who are not pleased with their jobs or who fear being laid off in the future may be inclined to suffer an “accident” or contract an “illness.” Closely related to this are cases where the original accident or illness is indeed legitimate but the recovery period is intentionally extended by the injured or sick person. 

Morale Hazard

The mental attitude of carelessness or indifference due to insurance or other protection from loss is known as morale hazard. Sometimes a subconscious desire for a loss may exist, even though the individual is not fully aware of this desire. In other cases, circumstances may cause someone to be indifferent to the possibility of a loss, thus causing that person to behave in a careless manner. For example, suppose the managers of ABC Company believe the federal government will provide disaster assistance that will fully compensate ABC for all earthquake losses it may incur. In making plans for a new building near a major fault line, ABC’s management may be tempted to ignore more expensive construction designs and procedures that can lessen damage from earthquakes. In essence, ABC’s assumption regarding the potential for federal disaster aid makes its management indifferent to the prospect of loss and, therefore, more prone to make unmindful decisions.  The more common reason for morale hazard is insurance or similar protection.  Do you have insurance or a "protection plan" on your phone?  If so, do you think you are as careful with your phone as you would be without that protection?  If not, that's an example of morale hazard.

Concept Check 1.8

Match the terms with the corresponding examples.

Premise
Response
1

Peril

A

Not using a phone case because you know that you have insurance to cover your phone if it breaks

2

Physical hazard

B

Burning down your own building to collect insurance money

3

Moral hazard

C

Collision

4

Morale hazard

D

Malfunctioning traffic light


MANAGEMENT OF RISK

In the previous sections, several types of risk that affect individuals and businesses were introduced, together with ways to measure the amount of objective risk present. After sources of risk are identified and measured, a decision can be made as to how the risk should be handled. A pure risk that is not identified does not disappear; the business or individual merely loses the opportunity to consciously decide on the best technique for dealing with that risk. The process used to systematically manage risk exposures is known as risk management.

Some persons use the term risk management only in connection with businesses, and often the term refers only to the management of pure risks. In this sense, the traditional risk management goal has been to minimize the cost of pure risk to the company. But as firms broaden the ways that they view and manage many different types of risk, the need for new terminology has become apparent. The terms integrated risk management and enterprise risk management reflect the intent to manage all forms of risk, regardless of type.

Many businesses have a special department charged with overseeing the firm’s risk management activities; the head of such a department often has the title of risk manager. The traditional type of risk manager may be charged with minimizing the adverse impact of losses on the achievement of the company’s goals. In implementing the more integrated approach to risk management, however, some firms have formed risk management committees. Some firms also have created a new position of chief risk officer (CRO) to coordinate the firm’s risk management activities, regardless of the source of the risk. As part of his or her duties, the risk manager and/or CRO is likely to be involved in many aspects of a firm’s activities. Examples may include developing employee safety programs, examining planned mergers and acquisitions, analyzing investment opportunities, purchasing insurance to protect against some types of risk, and setting up pension and health plans for employees. The evolution of integrated risk management reflects a realization of the importance of coordinating the many risk management activities of the firm in order to meet its strategic goals.

Whether the concern is with a business or an individual situation, the same general steps can be used to systematically analyze and deal with risk. Known as the risk management process, these steps form the basis for many of the upcoming chapters of this text. At this point they can be summarized as follows:

            1.         Identify risks. There are many potential risks that confront individuals and businesses. Therefore, the first step in the risk management process is to identify relevant exposures to risks. This step is important not only for traditional risk management, which focuses on pure risks, but also for enterprise risk management, where much of the focus is on identifying the firm’s exposures from a variety of sources, including operational, financial, and strategic activities.

            2.         Evaluate risks. For each source of risk that is identified, an evaluation should be performed. At this stage, pure risks can be categorized as to how often associated losses are likely to occur. In addition to this evaluation of loss frequency, an analysis of the size, or severity, of the loss is necessary. Consideration should be given both to the most probable size of any losses that may occur and to the maximum possible losses that might happen. As part of the overall risk evaluation, in some situations it may be possible to measure the degree of risk in a meaningful way. In other cases, especially those involving individuals, computation of the degree of risk may not yield helpful information.

            3.         Select risk management techniques. The results of the analyses in step 2 are used as the basis for decisions regarding ways to handle existing risks. In some situations, the best plan may be to do nothing. In other cases, sophisticated ways to finance potential losses may be arranged. The available techniques for managing risks are discussed in the next several chapters, together with consideration of when each technique is appropriate.

            4.         Implement and review decisions. Following a decision about the optimal methods for handling identified risks, the business or individual must implement the techniques selected. However, risk management should be an ongoing process in which prior decisions are reviewed regularly. Sometimes new risk exposures arise or significant changes in expected loss frequency or severity occur. As noted in this chapter, even pure risks are not necessarily static; the dynamic nature of many risks requires a continual scrutiny of past analyses and decisions.


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Concept Check 1.10

Put the steps of the risk management process in the proper order

A

Select risk management techniques

B

Identify risks

C

Evaluate risks

D

Implement and review decisions


1.         Risk is defined as uncertainty concerning loss.

2.         Risk creates an economic burden for society by raising the cost of certain goods and services and eliminating the provision of others.

3.         The cost of risk includes outlays to reduce risks, the opportunity cost of activities forgone due to risk considerations, expenses of strategies to finance potential losses, and the cost of unreimbursed losses.

4.         Pure risk exists when there is uncertainty as to whether loss will occur. Speculative risk exists when there is uncertainty about an event that could produce either a profit or a loss.

5.         Static risks are present in an unchanging, stable society. Dynamic risks are produced by changes in society.

6.         Subjective risk refers to the mental state of an individual. Objective risk, which is measurable, is the probable variation of actual from expected experience.

7.         There are many sources of risk. One way of classifying them is in relation to property, liability, life, health, loss of income, and financial exposures.

8.         Chance of loss is the long-term relative frequency of a loss due to a particular peril, or cause of loss. The degree of risk is the relative variation of actual from expected losses.

9.         A hazard is a condition that increases the chance of loss due to a peril. Hazards can arise out of both physical conditions and the mental attitudes of individuals.

10.       Risk management is the process used to systematically manage exposures to pure risk. The four steps in the process are (1) identify risks, (2) evaluate risks, (3) select risk management techniques, and (4) implement and review decisions.

11.       Integrated or enterprise risk management is an emerging view that recognizes the importance of risk, regardless of its source, in affecting a firm’s ability to realize its strategic objectives.

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Risk
Uncertainty as to economic loss.
Cost of Risk
The sum of: (1) expenses of strategies to finance potential losses, (2) the cost of unreimbursed losses, (3) outlays to reduce risks, and (4) the opportunity cost of activities forgone due to risk considerations.
Pure risk
Uncertainty as to whether a loss will occur.
Speculative risk
The uncertainty of an event that could produce either a profit or a loss, such as a business venture or a gambling transaction.
A risk which only impacts an individual person or business or a small group of people or businesses
Risk that impacts a large number of people or companies, or the economy as a whole.
Static risks
Uncertainties, either pure or speculative, that stem from an unchanging environment that is in stable equilibrium.
Dynamic risks
Uncertainties, either pure or speculative, that are produced because of societal or environmental changes.
Subjective risk
The risk based on the mental state of the individual who experiences uncertainty or doubt as to the outcome of a given event.
Objective risk
the probable variation of actual from expected experience.
The average loss of a situation if observed over and over a large number of times.
Prefers certainly to uncertainty; is willing to pay more than expected loss to eliminate a risk.
Risk involving credit, foreign exchange, commodity trading, and interest rate; may involve chance for gain as well as loss.
The long-term chance of occurrence or relative frequency of loss. Expressed by the ratio of the number of losses likely to occur compared to the larger number of possible losses in a given group.
Relative variation of actual from expected losses.
A specific contingency that may cause a loss.
Conditions that increase the frequency or severity of loss stemming from the existence of a given peril.
A condition stemming from the material characteristics of an object, e.g., icy street (increasing chance of car collision) and earth faults (hazard for earthquakes).
Intentional acts by an individual that make a loss either more likely or more severe. Insurance fraud would be a special case of moral hazard.
The process used to systematically manage pure risk exposures.
Approach for managing all forms of risk faced by the firm, regardless of type; another name for enterprise risk management.
Approach for managing all forms of risk faced by the firm, regardless of type; another name for integrated risk management.
An individual charged with minimizing the adverse impact of losses on the achievement of a company’s goals.
New position within some organizations, denoting the responsibility for coordinating an enterprise risk management strategy.
(1) Identify risks; (2) evaluate risks as to frequency and severity; (3) select risk management techniques; and (4) implement and review decisions.
How often a loss occurs or is likely to occur.
The extent or magnitude of a loss; how serious it is.