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Lecture 1 Risk Mgmt Overview Process

7 Pages

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FIN 3440

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Finance 3440 DateSpring 2013RISK MANAGEMENT OVERVIEW AND PROCESSWe can define risk in our course as the possibility of an unfavorable variation from a desired resultAn individual for example hopes that his house will not burn down or that he will not die prematurelyThe insurer hires professionals actuaries to predict losses and to develop insurance pricing premiums so that the company is profitable the insurer hopes that actual losses will not vary unfavorably from forecasted lossesThe concept of expected value that you learned in statistics is also useful in assessing risk for our purposes because it captures the probability and severity of a loss in the calculationFor example if the potential severity of a loss 1000000 but its probability of occurrence is 1 the expected value of the loss is only 10000 Conversely if the potential severity were quite low say 1 and the probability of loss were high at 95 the expected value of the loss would be quite low at 95 centsWe will discover later in the lecture that probability and severity of loss are useful concepts to develop a risk management framework and to determine when the use of insurance for risk management is most appropriate BURDEN OF RISKSome risks involve possibility of gainloss investment in stocks bonds and other securitiesOthers risks involve possibility of loss only loss of home life healthThis course deals primarily with lossno loss type of uncertainties not gainlossServices judged too risky can be withdrawn from society malpractice big business exposureBusinessesindividuals may try to reduce the negative consequences of risk by transfer or retention of the risk or in extreme cases avoidance of the risk entirelyCost of riskoutlay to reduceopportunity cost of activities foregone due to riskexpenses of strategies to finance potential lossescost of losses not reimbursedDEFINITIONS OF RISKPure vs SpeculativePure risk is uncertainty of loss only fire or flood to property premature death by accident or illnessNormally only pure risks are insurable but not all pure risks are insurableSpeculative risk is uncertainty of loss or gain business ventures gambling where a voluntary choice of risk is assumed because of the possibility of gainStatic vs DynamicStatic derives from perils in nature or dishonesty of people random events such as lightning windstorms and death do not benefit society and tend to occur with predictable regularity such that they are more appropriate to the use of insurance than dynamic risksDynamic risks are produced by changes in the economy price levels increasing technology and changing legal systems usually benefit society over time and are generally less predictable than static risksSubjective vs ObjectiveSubjective risk is psychological assessment of outcome
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