determining an optimal level of risk management - iii jornadas de gestão isvouga

8/6/2019 Determining an Optimal Level of Risk Management - III Jornadas de Gestão ISVOUGA

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Barbara A. PriceProfessor of Quantitative Analysis, Georgia Southern University andFulbright Lecturer, University of Debrecen

Kevin EastmanProfessor of Finance, Georgia Southern University

May 2011



Encyclopedia of Business, 2/e, Risk Management,http://www.referenceforbusiness.com/management/Pr-Sa/Risk-

Management.html

risk management is asystematic process of identifyingand assessing company risksand taking actions to protect acompany against them



`Resources

`

Environment`Risk Aversion Stance



` workplace safety

` owned buildings, equipment, and land

` inventory` loss of key personnel

` Liability

` interest rate changes

` currency fluctuations

` etc.



Addressing a specific aspect may becomplex in itself; however, it is importantto realize that an organization should takea systems approach in an attempt toconsider all possible risks and develop anapproach that results in an optimal planfor the organization as a whole and not

just for each specific aspect.



` The identification and measurement of potentialrisks or loss exposures.

` Analysis of alternatives and selection of the

³best´ or ³optimal´ method of addressing the

potential risks.

` Periodic review and monitoring of the plan for potential improvement or need for revision.



` Direct property losses

` Indirect losses of income and extra expenses

following a property loss

` Liability losses

` Losses caused by death, disability, or unplannedretirement of key people

Introduction to Risk Management and Insurance, 9/e,

Dorfman, Mark S., Prentice Hall, 2008



` estimation of the frequency (or probability) of lossfrom a particular exposure

` estimation of the severity (or dollar amount) of losses that occur

the total loss per exposure is theproduct of these two measures



The goal of risk management is tominimize the cost of risk, not the level of

risk. While it might be nice to reduce thelevel of risk to zero, at some point itusually is not cost-effective (i.e., it costsmore than it is worth to reduce the riskbeyond a certain point).



1. the cost of paying any expected losses thatremain your responsibility

2. the cost of the so-called "residual uncertainty

3. the cost of the risk management method(s) you

have adopted.



` available financial resources

` attitudes toward risk

` the inability to protect against a risk.



An effective and efficient risk

management program minimizes theimpact of losses on the bottom line.



` risk avoidance

` loss prevention

` loss reduction

These activities are designed to reduce thefrequency and severity of losses.



The Basic Decision is whether to`Retain the Loss

` Transfer the Loss



.. finally into my area!



` Known Costs and Benefits

` Incorporating Time and the Time Value of Money

` Decision Making Under Uncertainty



0

500000

1000000

1500000

2000000

2500000

$0 500,000 1,000,000 1,500,000 2,000,000

Safety Expenditure Level

Marginal Costs for Loss Control Marginal Benefits from Loss Control



A firm is looking at the option of investing $15 millionnow to improve the safety of its manufacturing facilities. Assume

`the firm will maintain a constant workforce of 5,000.

`The benefits will accrue over a ten-year period.

`Today, the firm estimates that the yearly frequency of accidents per employee is 5%.

`With the investment in safety, the annual frequency will

drop to 4% and the average severity of an accident willfall from $20,000 to $15,000.

Risk Management &

Insurance, 2/e, Harrington, Scott and

Gregory Niehaus,T

he McGraw-HillCompanies, 2004



That is it is estimated that the benefits to the firmwill be $2 million (5,000*.05*20,000 ±5,000*0.04*15,000) annually for the next 10 years.

On the surface, the decision appears to be aneasy one. Invest $15 million and obtain $2 million

* 10 year = $20 million in benefits



Cost of Capital 4.0%

Year

Expected

Cash Flow

Present Value

Factor

Present Valueof Expected

Cash Flow

0 -$15 1.0000 ($15.0000)

1 $2 0.9615 $1.9231

2 $2 0.9246 $1.8491

3 $2 0.8890 $1.7780

4 $2 0.8548 $1.7096

5 $2 0.8219 $1.6439

6 $2 0.7903 $1.5806

7 $2 0.7599 $1.51988 $2 0.7307 $1.4614

9 $2 0.7026 $1.4052

10 $2 0.6756 $1.3511

All numbers in $millions

Net Present Value $1.2218



Cost of Capital 5.6%

Year

Expected

Cash Flow

Present

Value Factor

Present Valueof Expected

Cash Flow

0 -$15 1.0000 ($15.0000)

1 $2 0.9469 $1.8939

2 $2 0.8967 $1.7934

3 $2 0.8491 $1.6982

4 $2 0.8040 $1.6081

5 $2 0.7614 $1.5227

6 $2 0.7210 $1.4419

7 $2 0.6827 $1.36548 $2 0.6465 $1.2929

9 $2 0.6122 $1.2243

10 $2 0.5797 $1.1593

All numbers in $millions

Net Present Value ($0.0000)



` To this point we have assumed that costs andbenefits are known values and the optimaldecisions have been based upon knowing those

values with certainty.

` Most often, that is not the case and manydecisions must be made under conditions of

uncertainty.



Ìf she fires the VP and he is the informer, she estimatesthat the firm will gain $500,000.

Ìf she fires him and he is not the informer, the firm will

lose his expertise and still have the informer. The CEOestimates this outcome will cost her firm $2.5 million.

Ìf the CEO does not fire the VP, she estimates the firmwill lose $1.5 million regardless of whether or not the VPis the informer since the informer will still be employed bythe firm.

Data Analysis and Decision Making with

Microsoft Excel, 3/e Revised, Albright, S.

Christian, Wayne L. Winston, and Christopher J. Zappe, South-Western, 2009.



State of Nature

Decision VP is Informer VP is Not Informer

Fire the VP -$0.5 $2.5

Do Not Fire the VP $1.5 $1.5

All costs in $millions with a negative cost being a gain



State of Nature

Decision VP is Informer

VP is Not

Informer Min Cost Max Cost

Fire the VP -$0.5 $2.5 -$0.5 $2.5

Do Not Fire the VP $1.5 $1.5 $1.5 $1.5

MIN MIN

All costs in $millions with a negative cost

being a gain -$0.5 $1.5

Fire the VPDo Not Fire the VP



This example could be extended to include the

possibility provided in the text:

Before deciding whether to fire the VP, the CEO

could order lie detector tests to avoid possible

lawsuits. The tests would need to beadministered to all employees at a cost of

$150,000. An extension of this option is that the

lie detector tests are not perfectly reliable and she would need to incorporate the reliability

factors into the decision making process.



CEO decision on whether to fire vice president

Input DataC E 's ti t Fire t e -Fi ce

If VP-Finance is the informer $500,000

If VP-Finance is not the informer -$2,500,000

CEO's Option Not to Fire the VP-Finance

If VP-Finance is the informer -$ ,500,000If VP-Finance is not the informer -$ ,500,000

CEO's Estimate that the VP-Finance is informant (lying) 0.80

Cost of Performing Lie etector Tests $ 0,000

Probability that test indicates person is lying when actually lying 0. 5

Probability that test indicates person is not lying when actually

not lying 0.85



` an understanding of potential losses

` the ability to measure those potential losses

` an understanding of alternatives available to manage the risks

` an understanding of the uncertainties surrounding the decision

` the ability to judge the risk stance of the decision makers

` knowledge of methods that can be applied to determine the best

path to address each risk.



` Data Analysis and Decision Making with Microsoft Excel, 3/eRevised, Albright, S. Christian, Wayne L. Winston, andChristopher J. Zappe, South-Western, 2009.

` Introduction to Management Science, 10/3, Taylor, Bernard W.III, Prentice Hall, 2010.

` Introduction to Risk Management andInsurance, 9/e, Dorfman, Mark S., Prentice Hall, 2008, Chapter 3 ± Risk Management, pp. 43-62, and Chapter 17 ± AdvancedTopics in Risk Management, pp. 324-343.

` Risk Management & Insurance, 2/e, Harrington, Scott andGregory Niehaus, The McGraw-Hill Companies, 2004, Chapter 11 ± Loss Control, pp. 201- 213.



` Spreadsheet Modeling & Decision Analysis: A PracticalIntroduction to Management Science, 6/e, Ragsdale, Cliff T., South-Western, 2011.

` C ontrolling C osts with Risk Management , 2011 Insurance Bureau of Canada, http://www.ibc.ca/en/Business_Insurance/Risk_Management/.

` Making risk management a value-adding function in the boardroom,Brodeur, Andre and Gunnar Pritsch, McKinsey Working Papers on

Risk, Number 2, September 2008.

` Encyclopedia of Business, 2/e, Risk Management,http://www.referenceforbusiness.com/management/Pr-Sa/Risk-Management.html

` The Sabanci Group on Risk Management,http://www.sabanci.com/sabanci_i.asp?M=7&K=49&I=57



Barbara A. Price

[email protected]

determining an optimal level of risk management - iii jornadas de gestão isvouga

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