FIN 3305 Exam 1 Flashcards
Definition of Risk
Uncertainty about economic loss
What are the consequences of risk?
Risk creates additional costs for businesses, government, and individuals
- Losses (when they occur)
- Higher borrowing costs
- Greater liquidity needs
- Opportunity costs
Cost of Risk
Cost to finance potential losses + cost of unreimbursed losses + outlays to reduce risk + opportunity cost of forgone activities
What are the 4 Categories of Risk?
- Pure vs. Speculative Risk
- Fundamental vs. Particular Risk
- Static vs. Dynamic Risk
- Subjective vs. Objective Risk
Pure Risk
2 Possible outcomes: loss or nothing
(ex. fire, theft, flood)
Speculative Risk
3 Possible Outcomes: Loss, nothing, or GAIN
(ex. investing, gambling, entrepreneurship)
Fundamental Risk
Impacts a large number of people or companies
(ex. Hurricanes, inflation, pandemics)
**Losses are correlated
Particular Risk
Impacts only one or a few people or companies
(ex. auto accidents, burglaries, lightning strikes)
**Losses are uncorrelated
What is one important thing to note about fundamental vs. particular risk? (category 2)
Unlike pure vs speculative, this is a continuum … some risks impact a medium number of people and could be categorized as either
Static Risk
Risk in an unchanging environment
(ex. lightning, windstorms, death)
**These risks look similar from each year to the next
Dynamic Risk
Risk created by changes in society
(cyber attacks, regulatory/tax compliance, oil prices)
**These risks look quite different each year
Subjective Risk
Risk based on the mental state of an individual; Stems from doubt or worry about outcomes; Psychological uncertainty (ex. fear of airplane travel)
Objective Risk
The probable variation of actual from expected experience; Precisely observable and thus measurable
(ex. outcome of a dice roll)
Property Risk
- The risk that property may be damaged, destroyed, or stolen
- Property includes real property (land, buildings, and the things attached to them) and personal property (items that can be moved, such as inventory and vehicles)
- Property losses that happen to others can have domino effects - a fire at a supplier can cause interruptions and shortages for others in the supply chain.
Liability Risk
- The risk of being held financially liable for “damages” to another party (ex. bodily injury, property damage, breach of contract, regulatory noncompliance)
- Stems from judicial and regulatory systems
- Damages include judgements, settlements, legal fees, and fines
Life, Health, and Loss of Income Risk
- The risk that a person loses their ability to generate income
- Can be caused by death, injury/illness, retirement, unemployment, etc.
- In addition to loss of income, there may be: funeral costs, medical expenses, additional education/training/travel
Financial Risk
The risk created by fluctuations in financial markets and economies (ex. credit risk, commodity prices, foreign exchange rates, investment returns, interest rates)
Peril
A cause of a loss
Hazard
Conditions that increase the cause of loss
Loss
Injury or damage sustained by an insured
Identify the Peril, Hazard, and Loss in this scenario
“Rashid wrecked his car in the rain yesterday, resulting in a dented fender and crumpled hood”
Peril - wrecked his car
Hazard - in the rain
Loss - dented fender and crumpled hood
Moral Hazard
- An intentional change in behaviors or attitudes caused by the presence of insurance
- People act differently when they have insurance than when they don’t
- Ex. Committing arson to collect insurance money on a building
- Can be, but is not necessarily, immoral behavior … How likely are you to go to the doctor for a cold if you don’t have insurance?
Morale Hazard
- Carelessness or indifference to loss, usually caused by the presence of insurance or other protection from loss
- Ex. Forgetting to lock your front door, distracted driving, building in a flood zone
Moral Hazard vs. Morale Hazard
How does this relate to “Adverse Selection”?
- Insurance traditionally distinguishes between these two, economics does not
- Closely related to “adverse selection” - the tendency of a higher-than-average risk to seek insurance coverage at the rate for an average risk
- Both are issues of asymmetric information - the insured knows more of their own behavior and motives than the insurer
Risk Management
- The process used to systematically manage risk exposures
- Traditionally referred to management of PURE RISKS only
Risk Manager
A person responsible for minimizing the adverse impact of losses on the achievement of a company’s goals
Enterprise Risk Management (ERM)
(also known as “integrated risk management”)
- A modern and expanded risk management approach which targets all forms of risk
- Management of BOTH pure and speculative risks
*Also known as integrated risk management
Chief Risk Officer (CRO)
A risk manager responsible for coordinating and executing a company’s ERM strategy
Risk Management Process
- Identify risks
- Quantify risks (frequency and severity)
- Evaluate
- Model - risk map
- Manage
How is financial statement analysis important in the risk management process?
- Review of a firm’s balance sheet and income statement
- Helpful to identify risks associated with: asset values, market risks, and business interruption
- Also useful to review strategic plans, budgets, forecasts, etc.
Loss Exposure Checklists
(way of identifying risk)
- Lists of potential sources of loss
- Audits
- Customer complaints
- Industry trends
- Current Events
- New or pending legislation or regulation
- “Is this a potential source of loss to me or my firm?”
- Focuses primarily on property and liability exposure
- Some lists are designed for specific industries (ex. education)
- Some lists focus on specific risk categories (ex. property)
Loss Exposure
A potential loss that may be associated with a specific type of risk
Analysis of Past Losses
(way of identifying risk)
- Review loss history (lawsuits, regulatory fines, significant financial losses)
- Conduct statistical analysis
Risk Management Information System (RMIS)
- Software to track past losses and their characteristics
- Increasingly sophisticated and user-friendly
- Trend toward web-based access
Flowcharts
(way of identifying risk)
- Graphical representation of a firm’s inputs, processes, and outputs
- “What events could disrupt the even and uninterrupted flow of parts to the final assembly floor, on which the whole production process depends?”
- Helpful to identify risks associated with: supply chains, interdependencies between two processes, Potential bottlenecks and domino effects
*Pay special attention to new products, procedures, personnel
Contract Analysis
(way of identifying risk)
- Review of the firm’s contracts with other parties
- Helps to identify
1. New risks from other parties
2. Whether the firm is effectively transferring risk to
other parties
Contractual Liability
Liability arising from contractual agreements, which state that some losses (if they occur) are to be borne by specific parties
On-site inspections
(way of identifying risk)
- Physical inspection of property
- May include interviews/discussions with on-site employees
- Helps to identify both property and liability risk (and hazards)
- Can be done by internal parties (risk manager) or external parties (consultant)
Risk Maps
(way of evaluating risk)
- A matrix of all major risks the firm faces
- Plots frequency against severity
- May also denote risk type, risk management activities, etc.
- Helps to prioritize risks and allocate risk management resources
Frequency
(way of evaluating risk)
- The long-term probability of an event’s occurrence (aka chance/likelihood)
- ranges from 0 (impossible) to 1 (certain)
Probability Distribution
Mutually exclusive and exhaustive list of possible events and their probabilities
Law of Large Numbers (LLN)
- As the number of exposure units increases, the more likely that actual loss experience will equal probable loss experience
- In other words … if you have more data, your predictions will be more accurate
How many exposure units are needed? (LLN formula)
S = number of standard deviations in the distribution
p = probability of loss
E = degree of accuracy required
Chance of Loss
- The probability that a specific loss occurs in a particular period of time
Expected Loss
The average loss amount, adjusting for loss probability
Degree of Risk
- The amount of objective risk present in a situation
- The difference between actual losses and expected losses
- Actual losses involve a range of outcomes
- Captures variation around expected loss
(only meaningful for uncertain events … definite or impossible events do not involve risk)
Measuring Degree of Risk (calculation)
Risk Evaluation
Estimate frequency and severity of potential losses
Inherent Risk
Risk before any risk management implemented
Residual Risk
Risk remaining after risk management has been implemented
Common Measures of Risk
Frequency and Severity
Frequency
The number of losses during a specified period
Severity
The average magnitude of loss (usually $ value) per claim
Mean
Sum of measurements divided by number of measurements (average)
Median
The midpoint in a range of measurements
Mode
The value that occurs most often in a frequency distribution
Is severity a continuum?
Yes, severity is a continuum - assets may not be completely destroyed
Maximum Probable Loss
The likely amount of loss that might result
Maximum Possible Loss
The worst amount of loss that could result
Historical Method of Valuing Risk
Measuring actual gains or losses over a period of time
Probability
The long-term frequency of an event’s occurrence (aka likelihood); Ranges from 0 to 1
The Binomial Distribution
- Measures number of outcomes in a fixed number of trials
- Probability of an event is p
- Probability of an event NOT happening is q = p-1
- There are n possible times the event could happen
- The probability that the event happens r times
The Poisson Distribution
- Models the number of events occurring in a fixed interval of time or space
- Event occurs with probability p
- Mean loss frequency is m
- The probability that the event happens r times
(e is the constant 2.72)
