Introduction To Risk1

Agenda
• What Businesses do
• Different Definitions of Risk
• Chance of Loss
• Peril and Hazard
• Classification of Risk
• Major Personal Risks and Commercial Risks
• Burden of Risk on Society
• Techniques for Managing Risk
Copyright © 2011 Pearson Prentice Hall. All rights reserved.

1-1
WHAT BUSINESSES DO
• The Value Chain - It’s a perspective which sees as a chain
of activities that transforms inputs into outputs that
consumer’s value.

1-2
PRIMARY ACTIVITIES
• Inbound logistics – costs of obtaining RM, parts and
components, merchandise from suppliers, receiving, storing
inspection and inventory management.
• Operations – converting inputs to outputs i.e. Production
assembly, packaging, equipment maintenance, facilities,
quality assurance and environmental protection.
• Outbound logistics – activities in distributing the product to
buyers i.e. warehousing, order processing, packing shipping
and delivery.
• Sales and Marketing – activities, costs and assets related to
the sales force i.e. advertising, promotion, market research,
planning and distributor support. For insurance companies
Sales and Marketing involves direct and intermediary sales,
websites advertising and public relations
• Service – activities that are involved in providing buyer
assistance e.g. installation, spare part delivery, maintenance
and repair, technical assistance, buyer inquiries and
complaints.
1-3
SECONDARY/ SUPPORT ACTIVITIES
• Procurement – purchasing RM, supplies, services,
outsourcing necessary to support the firm in its activities
• Research, Technological and systems development –
product and process R& D, process design improvement,
equipment design, computer software, telecommunications
and so on.
• Human resource management – activities, costs and
assets related with recruitment, hiring, training,
development and compensation of all types of personnel,
labor relations and development based skills.
• General Administration – activities and costs associated
with general management accounting and finance, legal and
regulation, safety and security, MIS and overheads.

1-4
1-5
Illustration – Transport Industry

1-6
1-7
Illustration 1 – Transport Industry
Risks

1-8
ENTERPRISE VALUE MAP
• It is easy to say shareholder value is important. Not so easy
to make it influence the decisions that are made every
day: where to spend time and resources, how best to
get things done, and, ultimately, how to win in the
competitive marketplace.
• This map is designed to accelerate the connection
between actions you can take and shareholder value.
It is not rocket science and it is not complete, but it can
jump-start the process of focusing on the things that matter
most and then choosing practical ways to get them done.

1-9
Defining Risk
• According to the dictionary, risk is “the possibility of loss or injury.”
1. Risk is the chance of a loss
This definition implies that one is exposed to some loss at any time in his or her
life. The loss may take place or never take place, but there is always a
chance that the loss may take place.
2. Risk is a possibility of a loss

When we talk about the possibility of something happening, we are not very
certain that the event will take place, but from experience we know that the
event could take place. If we have experienced a loss in the past, then there
is a possibility that a similar loss could take place again.
3. Risk is the dispersion of actual from expected results

In business especially, we undertake certain business decisions and expect
certain results. When we do not realize the expected results, there is a
dispersion from the actual that is the result is different from what was
expected. This dispersion is the risk and can be measured in absolute terms
or using percentages.
5-10 1-10
Defining Risk
• According to the dictionary, risk is “the possibility of loss or injury.”
1. Risk is the chance of a loss
This definition implies that one is exposed to some loss at any time in his or her
life. The loss may take place or never take place, but there is always a
chance that the loss may take place.
2. Risk is a possibility of a loss

When we talk about the possibility of something happening, we are not very
certain that the event will take place, but from experience we know that the
event could take place. If we have experienced a loss in the past, then there
is a possibility that a similar loss could take place again.
3. Risk is the dispersion of actual from expected results

In business especially, we undertake certain business decisions and expect
certain results. When we do not realize the expected results, there is a
dispersion from the actual that is the result is different from what was
expected. This dispersion is the risk and can be measured in absolute terms
or using percentages.
5-11 1-11
Defining Risk
4. Risk is the Probability of any outcome different from the one
Expected
Probabilities are measured from 0 to 1(or. 0% to 100%). We can therefore
assign a probability of a certain event happening based on past occurrences or
experiences. The higher the probability the higher the chance of that event
occurring. Therefore the risk is measured by the probability assigned to it.

Recommended Definition
As you can see, all the above definitions reflect an aspect of uncertainty. Risk is
therefore defined as:
1.“Risk is a condition in which there is a possibility of an adverse

deviation from a desired outcome that is expected or hoped for”
2. “Risk is a measure of uncertainty about the future payoff to an

investment, measured over some time horizon and relative to a
benchmark.”

1-12
Different Definitions of Risk
• Risk: Uncertainty concerning the occurrence of a loss
• Loss Exposure: Any situation or circumstance in which a loss
is possible, regardless of whether a loss occurs.
• Objective Risk vs. Subjective Risk

– Objective risk is defined as the relative variation of actual loss
from expected loss
• It can be statistically calculated using a measure of dispersion, such
as the standard deviation
– Subjective risk is defined as uncertainty based on a person’s
mental condition or state of mind
• Two persons in the same situation may have different perceptions of
risk
• High subjective risk often results in conservative behavior

1-13
Chance of Loss
• Chance of loss: The probability that an event will occur
• Objective Probability vs. Subjective Probability

– Objective probability refers to the long-run relative frequency of
an event assuming an infinite number of observations and no
change in the underlying conditions
• It can be determined by deductive or inductive reasoning
– Subjective probability is the individual’s personal estimate of the
chance of loss
• A person’s perception of the chance of loss may differ from the
objective probability

1-14
Understanding Risk - Characteristics
1. Risk is a measure that can be quantified.
– The riskier the investment, the less desirable and the lower the price.
2. Risk arises from uncertainty about the future.

– We do not know which of many possible outcomes will follow in the
future.
3. Risk has to do with the future payoff of an investment.

– We must imagine all the possible payoffs and the likelihood of each.
4. Definition of risk refers to an investment or group of investments.

– Investment described very broadly.
5. Risk must be measured over some time horizon.

– In general, risk over shorter periods is lower.
6. Risk must be measured relative to some benchmark - not in isolation.

1. A good benchmark is the performance of a group of experienced
investment advisors or money managers.
5-15 1-15
Understanding risk
7. Risk can be emotional, financial, or reputational

8. Risk is anchored on a continuum of maximizing value and minimizing
losses
9. Actual outcomes for an event or situation often differ from expected
outcomes: this creates risk

1-16
Sources & Classification Of Risk

1-17
Sources & Classification Of Risk

1-18
Attitudes Toward Risk
(which impact decisions)
Different people have different attitudes towards the
risk-return tradeoff
1.A risk-adverse person leans away from risk, seeking as
much security as possible
2.A risk-neutral person remains equidistant from the
extremes of avoiding risk and accepting risk
3.A risk-seeking person embraces risk as long as a gain is
possible, although unlikely

1-19
LOSSES
noun: loss; plural noun: losses
•the fact or process of losing something or someone.
•"avoiding loss of time"
– an amount of money lost by a business or
organization.
•"insurance can protect you against financial loss"
– the state or feeling of grief when deprived of
someone or something of value.
•"I feel a terrible sense of loss"
– a person or thing that is badly missed when lost.
•"he will be a great loss to many people"
– Physics
•a net reduction of resources eg power within or among
circuits, measured as a ratio of power input to power output.

1-20
Main Sources of Loss
1. Personal loss exposures: sickness, disability,
individual deaths; also impacts organizations and
society
2. Property loss exposures
3. Liability loss exposures: individuals and
organizations can get sued
4. Catastrophic loss exposures
5. Accidental loss exposures

1-21
Frequency and Severity
1. Frequency is the number of times losses have

happened in a given time period, often 12
months
2. Severity denotes how bad the loss has been in
both human and dollar terms
3. Total cost of loss for a particular loss exposure
= (average severity) x (the frequency of loss)

1-22
Peril and Hazard
• A peril is defined as the cause of the loss

– In an auto accident, the collision is the peril
• A hazard is a condition that increases the chance of loss
– Physical hazards are physical conditions that increase the chance
of loss (icy roads, defective wiring)
– Moral hazard is dishonesty or character defects in an individual,
that increase the chance of loss (faking accidents, inflating claim
amounts)
– Attitudinal Hazard (Morale Hazard) is carelessness or indifference
to a loss, which increases the frequency or severity of a loss
(leaving keys in an unlocked car)
– Legal Hazard refers to characteristics of the legal system or
regulatory environment that increase the chance of loss (large
damage awards in liability lawsuits)

1-23
Classification of Risk
• Pure and Speculative Risk

– A pure risk is one in which there are only the possibilities of loss
or no loss (earthquake)
– A speculative risk is one in which both profit or loss are possible
(gambling)
• Diversifiable Risk and Nondiversifiable Risk
– A diversifiable risk affects only individuals or small groups (car
theft). It is also called nonsystematic or particular risk.
– A nondiversifiable risk affects the entire economy or large
numbers of persons or groups within the economy (hurricane). It
is also called systematic risk or fundamental risk.
– Government assistance may be necessary to insure
nondiversifiable risks.

1-24
Examples of Pure vs.
Speculative Risk Exposures
Speculative risk:
Pure Risk: potential loss potential gain or loss
but no possible gain
• Physical damage to • Market risk: interest rate
property from fire, flood fluctuation, foreign
or other natural disasters exchange volatility, stock
• Liability risk: getting sued price
over products;
employment practices • Reputational risk
• Individual risk of mortality • Brand risk
or morbidity • Individual credit risk
• Manmade risks: war;
unemployment • Regulatory changes
• Global pandemics; social • Accounting risk
program failure

1-25
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

1-26
Examples of Diversifiable
and Non-Diversifiable
risks
Non-diversifiable
Diversifiable Risks Risks
• Reputational risk • Market risk
• Brand risk • Regulatory risk
• Credit risk • Environmental risk
• Product risk • Political risk
• Legal risk • Inflation and recession
• Physical damage risk risk
• Operational risk • Accounting risk
• Strategic risk • Pandemics, social security
program risks

1-27
Classification of Risk
• Enterprise risk encompasses all major risks faced by a

business firm, which include: pure risk, speculative risk,
strategic risk, operational risk, and financial risk
– Financial Risk refers to the uncertainty of loss because of
adverse changes in commodity prices, interest rates, foreign
exchange rates, and the value of money.
• Enterprise Risk Management combines into a single unified
treatment program all major risks faced by the firm:
– Pure risk
– Speculative risk
– Strategic risk
– Operational risk
– Financial risk

1-28
The Burden of Risk
• Some risks involve only the possibility of loss
• Risks surrounding potential losses create significant economic burdens for

businesses, government, and individuals
– Billions of dollars are spent each year to finance potential losses
• But when losses are not planned for in advance they may cost even
more
• Risk of loss may deprive society of services judged to be too risky

– For instance, without malpractice insurance many physicians would
refuse to practice medicine
• The Burden of Risk occurs at

– Personal,
– Business and
– Social (Society) levels
1-29
29
The Burden of Risk
• Businesses may try to either avoid risk of loss or to reduce its negative
consequences
• An entity’s cost of risk is the sum of
– Expenses of strategies to finance potential losses
– The cost of unreimbursed losses
– Outlays to reduce risks
– Opportunity cost of activities forgone due to risk considerations
1-30
30
Major Personal Risks
• Personal risks involve the possibility of a loss or reduction in income, extra
expenses or depletion of financial assets:
– Premature death of family head
– Insufficient income during retirement
• Most workers are not saving enough for a comfortable retirement
– Poor health (catastrophic medical bills and loss of earned income)
– Involuntary unemployment
• Property risks involve the possibility of losses associated with the destruction
or theft of property:
– Physical damage to home and personal property from fire, tornado,
vandalism, or other causes
• Direct loss vs. indirect loss
– A direct loss is a financial loss that results from the physical damage,
destruction, or theft of the property, such as fire damage to a home
– An indirect loss results indirectly from the occurrence of a direct physical
damage or theft loss, such as the additional living expenses after a fire to
a home. These additional expenses would be a consequential loss.

1-31
Major Personal Risks
• Liability risks involve the possibility of being held liable for bodily injury or
property damage to someone else
– There is no maximum upper limit with respect to the amount of the loss
– A lien can be placed on your income and financial assets
– Defense costs can be enormous

1-32
Major Commercial Risks
• Commercial Risks
– Firms face a variety of pure risks that can have serious
financial consequences if a loss occurs:
• Property risks, such as damage to buildings, furniture and
office equipment
• Liability risks, such as suits for defective products, pollution of
the environment, and sexual harassment
• Loss of business income, when the firm must shut down for
some time after a physical damage loss
• Other risks to firms include crime exposures, human resource
exposures, foreign loss exposures, intangible property
exposures, and government exposures

1-33
Burden of Risk on Society
• The presence of risk results in three major

burdens on society:
– In the absence of insurance, individuals would
have to maintain large emergency funds
– The risk of a liability lawsuit may discourage
innovation, depriving society of certain goods
and services
– Risk causes worry and fear

1-34
Techniques for Managing Risk
• There are five major methods for managing risk

– Avoidance
– Loss control
• Loss prevention refers to activities to reduce the frequency of losses
• Loss reduction refers to activities to reduce the severity of losses
– Retention
• An individual or firm retains all or part of a given risk
• Active retention means that an individual is consciously aware of the
risk and deliberately plans to retain all or part of it
• Passive retention means risks may be unknowingly retained because
of ignorance, indifference, or laziness
• Self Insurance is a special form of planned retention by which part or
all of a given loss exposure is retained by the firm

1-35
Techniques for Managing Risk
• Noninsurance transfers
– A risk may be transferred to another party by several methods:
– A transfer of risk by contract, such as through a service
contract or a hold-harmless clause in a contract
– Hedging is a technique for transferring the risk of unfavorable
price fluctuations to a speculator by purchasing and selling
futures contracts on an organized exchange
– Incorporation of a business firm transfers to the creditors the
risk of having insufficient assets to pay business debts
• Insurance
– For most people, insurance is the most practical method for
handling a major risk

1-36

Introduction To Risk1

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Introduction To Risk1

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Agenda

Copyright © 2011 Pearson Prentice Hall. All rights reserved.

Copyright © 2011 Pearson Prentice Hall. All rights reserved.

Copyright © 2011 Pearson Prentice Hall. All rights reserved.

Copyright © 2011 Pearson Prentice Hall. All rights reserved.

Copyright © 2011 Pearson Prentice Hall. All rights reserved.

Copyright © 2011 Pearson Prentice Hall. All rights reserved.

2. Risk is a possibility of a loss

3. Risk is the dispersion of actual from expected results

2. Risk is a possibility of a loss

3. Risk is the dispersion of actual from expected results

1.“Risk is a condition in which there is a possibility of an adverse

2. “Risk is a measure of uncertainty about the future payoff to an

Copyright © 2011 Pearson Prentice Hall. All rights reserved.

• Objective Risk vs. Subjective Risk

Copyright © 2011 Pearson Prentice Hall. All rights reserved.

• Chance of loss: The probability that an event will occur

• Objective Probability vs. Subjective Probability

Copyright © 2011 Pearson Prentice Hall. All rights reserved.

2. Risk arises from uncertainty about the future.

3. Risk has to do with the future payoff of an investment.

4. Definition of risk refers to an investment or group of investments.

5. Risk must be measured over some time horizon.

6. Risk must be measured relative to some benchmark - not in isolation.

7. Risk can be emotional, financial, or reputational

Copyright © 2011 Pearson Prentice Hall. All rights reserved.

Copyright © 2011 Pearson Prentice Hall. All rights reserved.

Copyright © 2011 Pearson Prentice Hall. All rights reserved.

Copyright © 2011 Pearson Prentice Hall. All rights reserved.

Copyright © 2011 Pearson Prentice Hall. All rights reserved.

Copyright © 2011 Pearson Prentice Hall. All rights reserved.

1. Frequency is the number of times losses have

Copyright © 2011 Pearson Prentice Hall. All rights reserved.

• A peril is defined as the cause of the loss

Copyright © 2011 Pearson Prentice Hall. All rights reserved.

• Pure and Speculative Risk

Copyright © 2011 Pearson Prentice Hall. All rights reserved.

Copyright © 2011 Pearson Prentice Hall. All rights reserved.

Copyright © 2011 Pearson Prentice Hall. All rights reserved.

Copyright © 2011 Pearson Prentice Hall. All rights reserved.

• Enterprise risk encompasses all major risks faced by a

Copyright © 2011 Pearson Prentice Hall. All rights reserved.

• Risks surrounding potential losses create significant economic burdens for

• Risk of loss may deprive society of services judged to be too risky

• The Burden of Risk occurs at

Copyright © 2011 Pearson Prentice Hall. All rights reserved.

Copyright © 2011 Pearson Prentice Hall. All rights reserved.

Copyright © 2011 Pearson Prentice Hall. All rights reserved.

• The presence of risk results in three major

Copyright © 2011 Pearson Prentice Hall. All rights reserved.

• There are five major methods for managing risk

Copyright © 2011 Pearson Prentice Hall. All rights reserved.

Copyright © 2011 Pearson Prentice Hall. All rights reserved.

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