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Risk Management Exam 1

Risk Management
-uncertainty about future outcomes
-outcomes may be good/desirable/positive or they may be bad/undesirable/negative
4 Part to RM
1.Identify- where is the risk
2.Measure- how much risk? Quantify the risk
3.Control- try to keep risk at appropriate level
4.Finance- preparing money to pay for the risk loss
2 Basic Elements of Risk
1. Uncertain outcomes: inability to predict the future. Such as what? How? Will events happen?
2. Possibility of negative outcome
(chance/likelihood)-a number i.e. between 0-1
not quantifiable, risk is simply identified but no likelihood or chance is indicated
Does risk=loss?
Does loss=risk?
1 —loss will certainly occur
3 Basic Measurements of Risk
-total loss
possible outcomes in the future are limited to a loss or no loss
3 possible outcomes:
Loss, No Loss, or Gain
Objective Risk
a measurable variation in uncertain outcomes based on facts and past data
Subjective Risk
the perceived amount of risk based on personal opinion, feelings, preferences
Objective and Subjective Risk vary for what 3 reasons?
1. Familiarity and control “the more familiar you are with a particular risk, the lower subjective risk you have regarding that risk”
2. If you underestimate risk subjective risk is lower. If you overestimate risk subjective risk is higher.
3. Taste of risk. Risk lovers vs Risk averse.
Diversifiable Risk
only affects a portion of the population, but not everyone if a loss occurs
-aka non-systematic risk
-not correlated…car accident vs defective car
-“risk pool”
-insurable risk
risk affects the whole population once a loss occurs
-aka systematic risk
-not insurable traditionally
(non-diversifiable) risks are correlated
Systemic Risk
the risk that an event will trigger a loss of economic value of confidence in a substantial segment of the financial system that may have significant adverse effect of Real Economy
Static Risk
always present over time i.e. ocean marine–death/health
Dynamic Risk
emerging from changing economic environment –cyber risk, terrorism risk, financial crisis
immediate cause of a loss
a condition that increases (f) frequency, severity (s), or both f and s
4 Types of Hazards
Physical Hazard
the condition of property, persons, operations (actions) that increase f or s or both
Moral Hazard
change in behavior in the presence of insurance
Morale Hazard
the condition of carlessnes or indifference
-morale hazard is never intentional
Legal Hazard
the condition in legal environment that ^f,s, or both
-i.e. medical malpractice
3 Components of Cost of Risk
1. Expected costs of losses
2. Expenditure on Risk Management
3. Cost of Residual Uncertainty
fractions, sample/pop. 0-1
Degree of Risk
variability concept, measures the variation of actual outcome from the expected outcome


silo approach–no evaluation of the correlations among risks
-each department manages its own risk
-focuses on pure risk
-non-silo approach
-emphasizes the correlation among risks
-analyzes the risks in an organization as a whole
-focus’ on both pure and speculative risks
Types of TRM Risk?
CEO>> reputation risk
Finance>> financial risk, such as credit risk, interest rate risk
HR>> employee benefits, workers compensation
Marketing>> Sales, competition, advertising
60’s-70’s safety management, insurance management
Pre-loss goals
to be met even if a loss does not occur
1. Efficiency/economy of operation (MC=MR–profic maximization)
2. Maintain the managements uncertainty at a tolerable level
3. Legally or regulatory requirements
4 Ethical conduct/social responsibility (they need to do the right thing)
Post Loss Goals
1. Survival: loss will put firm out of business
2. Continuity of Operation: loss will not interrupt operations for an appreciable period of time
3. Profitability/earning stability
4. Growth
5. Ethical Conduct/social responsibility (the only post loss goal that always need to be met)
Loss Exposure
Crisis a condition or a situation that presents a possibility of loss, regardless of whether a loss actually
3 Elements of Loss Exposure
1. Asset exposed to loss
2. Peril
3. Financial consequence of the loss
6 Step Risk Management Process
1. Identify Loss Exposure
2. Analyze (measure) Loss Exposure
3. Identify Possible RM Options
4. Select the Appropriate RM Options
5. Implement the RM Option
6. Evaluation, revisit of the RM
Step 1: Loss Exposure
-On site inspections
-talk to employees
-use external expertise (e.g. risk management associations)
-Document analysis
-Survey, questionnaire
-Financial Statements
-Review Insurance Policy
-Flow Chart & Organization chart
4 Types of TRM-loss exposure
Property, Liability, Personal/Personnel, Net Income
Property Loss Exposure
asset: property >> real property and personal property
-Real Property-land and anything permanently attached to the land, anything growing on the lan
Personal Loss Exposure
any property that is not a real property
-tangible-physical property
-in-tangible- non-physical form
Who faces property loss exposure?
whoever has legal interest on the property will face a property loss exposure
Legal Interest
financial stake, so that if the property has a loss, that party will suffer a financial loss
-Sources:ownership, franchise, secure creditor (bank mortgage), lease agreements
Lease Agreement
1. tenants have a use interest in the property
2. landlord or tenants may have a Lease-hold interest
Freight on Board
(FOB) point at which financial responsibility for goods in transit shifts from seller to buyer
Bailee Interest
bailee receives property from bailer for a specific purpose, then returns the property to the bailer later e.g. pawn shop, dry cleaning, valet parking, auto repair
Liability Loss Exposure
condition that presents a possibility of loss due to alleged liability claims (mostly with lawsuits)
*theoretically unlimited
Personnel/Personal Loss Exposure
person and the value that person added to the family(personal) or to the firm
Key Person Insurance
manages personnel loss
Net-income Loss Exposure
aka indirect loss exposure
Net income= revenue-expenses
If R decreases, or E increases, or both, Net Income decreases
-“business interruption loss”-NI loss where the primary loss is your own
-“contingent business interruption loss”-NI loss where the primary loss is other peoples loss
4 Quadrants of ERM Loss Exposure
1. Hazard Risk (TRM)
2. Financial Risk
3. Operational Risk
4. Strategic Risk
Hazard Risks
(pure risks) unforeseen events arise outside the normal operating environment. hazard risks often managed by TRM and insurance policies.

e.g. Valuable property (pure, D), Product Liability (pure, D), D&O liability (pure, D), natural disaster (pure, d/nd), terrorism (d,nd)

Financial Risks
risk of a change of firm value arising from changes in market conditions

e.g. Inflation Risk (spec, nd), Credit Risk (spec, d), Interest Rate Risk (spec, nd), Exchange Rate Risk (spec, nd), Commodity Price Risk (spec, nd)
*asset valuation (spec, D)–stock price, franchise value

Operational Risk
related to ongoing day-to-day business

e.g. Product Recal (pure, D), Workplace Violence (pure, D), Supplier Interrpution (pure d/nd) Power Outage (pure, d/nd)

Strategic Risk
associated with management decision

e.g. Intellectual Property (spec, d), Product Design (sepc, d), Business ethics (spec, d), Reputation (spec, d), M&A–merger and acquisition (spec, d)

ERM vs TRM Characteristics
-There is no net income loss in ERM >> focuses on correlation of risks
-only ERM uses a risk map (Y-axis= severity, X-axis=frequency)
-Under TRM each risk is managed under different departments
Probability Distribution
A table or graph that indicates for each possible outcome of the RV, the corresponding probability of that outcome occuring
Expected Loss
E(x)= sum of RV(p)
Gross Premium
Pure Premium
the amount or portion of the gross premium that is estimated as being sufficient to pay for the EL (only)
Administrative Cost
payroll, fixed costs, taxes, marketing costs, commission, claim adjustment
Risk Charge
the monetary cushion for estimation errors
-size based on the accuracy of the estimate of EL
ex. going on vacation expending to spend 100 a day but bring 200 a day just in case
Sum of (outcomes-mean)^2*p
Standard Deviation
square root of variance
Coefficient of Variation
Standard Deviation/Mean
-we always use CV in this class to measure risk
-higher CV >> higher risk
-CV is unit less
Expected Loss
EL=E(f) x E(s)
aka Pure Premium
Theoretical Probability
derived from the nature of the event
Empirical Probability
based on past data, empirical estimation
Not to do it. Goal to reduce f and s to ZERO!
-proactive avoidance: firm or individual never has/ will engage in activities that may cause losses
-reactive avoidance (abandonment): firm or individual ceases the activities that may cause losses (eliminating an existing loss exposure)
Problem: it will avoid losses only from future activities but it does not eliminate losses from past activities
Disadvantage of Avoidance
-avoidance may be associated with losing profit/ opportunities (do a cost benefit analysis)
-some loss exposure are not able to avoided
-avoiding one loss exposure may create another loss exposure
-in general avoidance is most suitable for a high severity loss exposure
Loss Prevention
-primary goal is to decrease f to a lower level, but NOT zero
-to make the loss less likely to happen and to break the chain of events leading to a loss
-always implemented before a loss occurs
ex. fire alarms, speed bump, safety training
Loss Reduction
-primary goal is to decrease s should a loss occur
-pre-loss reduction: assume a loss will happen, what could have been done to decrease damage/injuries
-post loss reduction: mainly focuses on loss recovery, and crisis management
ex. medical team on hand, seatbelt
Separation of Exposure Units
separate the exposure units used in daily business activities, so that ONE peril will not affect all units
Duplication of Exposure Units
copy key assets/activities/responsibilities but the duplicates are held in reserve and not used until a loss actually occurs
*duplicaiton without separation will not work well
-similar to separation and duplication but more community applied to speculative risk
-3 Common Types of Diversification:
1. Investment diversification (stock portfolios)
2. Product diversification (multiple product, brand names, etc)
3. Geographic diversification
3 Risk Financing Options
1. Risk Transfer
2. Risk Retention
3. Alternate Risk Financing
Risk Financing Goals
1. Pay for losses
2. Maintain appropriate liquidity level
-avoid poor cash flow
-maintain appropriate level of risk for the organization
3. Manage Cost of Risk
4. Compliance
-legal or regulatory requirements (auto ins, workers comp, health ins, medical malpractice ins)
Risk Transfer
a third party assumes financial responsibility for the loss
-only the financial responsibility is transferred, the assets or activity is NOT transferred
INSURANCE: for a fee, an insurance company will agree to accept financial responsibility for your losses FEE=Gross Premium
Non-insurance Risk Transfers
-Hold Harmless Agreement
*Contractor is made financially responsible for certain losses
Risk Retention
firm or individual assumes financial responsibility for losses and “generates” funds to pay for losses
-Active retention: deliberate decision to engage in retention
-Passive retention: retain the loss exposures but you are unaware of doing so (usually a result of failure to properly identify the loss exposure)
-Complete retention: assume the full cost of losses
-Partial retention: assume part of the losses and transfer the rest (deductibles, limit)

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