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Chapter 1

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Heather Graham

BU353 Chapter 1 – Why Manage Risk? Week 1 Risk -A fundamental distinction between today and our past is the active management of risk The Meaning of Risk -Risk is any situation where there is uncertainty about what outcome will occur -In other situations, the term risk may refer to the expected value of the outcome -Risk is sometimes used in a specific sense to describe variability around the expected value and other times to reflect greater expected losses, due to either a higher probability of loss or a higher value of loss Risks Faced by Individuals and Businesses Personal Risks -Personal risk is classified by six categories: -Earnings risk -Medical expense risk -Liability risk -Physical asset risk -Financial asset risk -Longevity risk -Earnings risk refers to the potential fluctuation in a family’s earnings -Longevity risk refers to the possibility that retired people will outlive their financial resources Business Risks -Business risk management is concerned with possible reductions in business value from any source -Unexpected changes in expected future net cash flows are a major source of fluctuations in business value Hazard Risk -Hazard risk – those that pose a threat to life, health, property, or the environment -Ex. Product liability claims, slip and falls -The risk manager’s job typically has focused on managing hazard risks such as the reduction in value of business assets due to physical damage, theft, and expropriation; the risk of legal liability for damages for harm to customers, suppliers, shareholders, and other parties; and the risk associated with employee injuries Financial Risk -Financial risk – uncertainty over the magnitude of cash flows due to possible changes in prices, asset values, exchange rates, liquidity and credit risk -Price risk – possible changes in output and input prices -Output price risk refers to the risk of changes in the prices that a firm can demand for its goods and services -Input price risk refers to the risk of changes in the prices that a firm must pay for labour, materials, and other inputs to its production process -Three specific types of price risk are commodity price risk, exchange rate risk, and interest rate risk -Commodity price risk arises from fluctuations in the prices of commodities, such as coal, copper, oil, gas and electricity -Output and input prices can also fluctuate due to change in interest rates -Credit risk – the risk that a firm’s customers and the parties to which it has lent money will delay or fail to make promised payments -The exposure to credit risk is particularly large for financial institutions, such as commercial banks, that routinely make loans that are subject to risk of default by the borrower Operational Risk -Operational risk – the risk of direct or indirect loss resulting from inadequate or failed internal BU353 Chapter 1 – Why Manage Risk? Week 1 processes, people or systems -These are risks that have traditionally been managed informally by line managers as part of their everyday work Strategic Risk -Strategic risk – risks associated with an organization’s ability to achieve their business strategy -Ex. Social, regulatory and political trends as well as changes in customer taste -Strategic risks are managed by the directors and officers of an organization Comparison of Hazard Risk Management and Other Types of Risk -The underlying causes of losses associated with hazard risk are often largely specific to a particular firm and depend on the firm’s actions -The underlying causes of these losses are often subject to a significant degree of control by businesses; that is, firms can reduce the frequency and severity of losses through actions that alter the underlying causes -Businesses commonly reduce uncertainty and finance losses associated with hazard risk by purchasing contracts from insurance companies that specialize in evaluating and bearing such risks -Price risks that can simultaneously produce gains for many firms and losses for many others are commonly reduced with financial derivatives, such as forwards and futures contracts, options contracts, and swaps -Losses from hazard risk usually are not associated with offsetting gains for other parties -Enterprise Risk Management (ERM) – a strategic business discipline that supports the achievement of an organization’s objectives by addressing the full spectrum of its risks and managing the combined impact of those risks as an interrelated risk portfolio -Effective risk management requires organizations to have a consistent, comprehensive, and disciplined approach to managing risk The Cost of Risk Risk is Costly -Risk management seeks to mitigate this reduction in value and thus increase welfare -In addition to the component needed to pay losses, auto and health insurance premiums must include a consideration for the insurer’s administrative costs and provide a reasonable expected return on the insurer’s capital -Even with insurance, you face some uncertainty about the cost of losses that are less than your deductible -The guiding principle or fundamental objective of risk management is to minimize the cost of risk -When we consider individual risk management, the objective is to minimize the individual’s cost of risk -Minimizing a firm’s cost of risk is the same as maximizing the firm’s value Components of the Cost of Risk -Most risk management decisions must be made before losses are known -Before losses occur, the cost of losses reflects the predicted or expected value of losses during an upcoming time period -The cost of losses can be estimated ex ante (before the fact) and determined ex post (after the fact) -The cost of risk has five main components: -Expected losses -The cost of loss control -The cost of loss financing -The cost of internal risk reduction -The cost of any residual uncertainty that remains after loss control, loss financing, and BU353 Chapter 1 – Why Manage Risk? Week 1 internal risk reduction methods have been implemented Expected Cost of Losses: Direct and Indirect -Includes the expected cost of both direct and indirect losses -Direct losses: cost of repairing or replacing damaged assets, cost of paying worker’s comp -Indirect losses: reductions in net profits that occur as a consequence of direct losses -In the case of large losses, indirect losses can include loss of profits from forgone investment -Ex. When a pers
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