Lec 01 for risk management
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DESCRIPTIONrisk management lecture 1. this contains info on ch 1 for risk management. meaning of risk, hazards, types of risk, ways to indemnify risk, insurance types, etc.
Chapter 1Risk in Our Society
11-2AgendaMeaning of RiskChance of LossPeril and HazardBasic Categories of RiskTypes of Pure RiskBurden of Risk on SocietyMethods of Handling Risk2Risk Management An Overview http://www.project-portfolio-management-blog.com/2007/08/11/introduction-to-risk-management/ 1-31-4Meaning of RiskRisk: Uncertainty concerning the occurrence of a loss
Objective Risk vs. Subjective RiskObjective risk is defined as the relative variation of actual loss from expected lossIt can be statistically calculated using a measure of dispersion, such as the standard deviationSubjective risk is defined as uncertainty based on a persons mental condition or state of mindTwo persons in the same situation may have different perceptions of riskHigh subjective risk often results in conservative behavior4Transparency Master 1.21-5Chance of LossChance of loss: The probability that an event will occur
Objective Probability vs. Subjective ProbabilityObjective probability refers to the long-run relative frequency of an event assuming an infinite number of observations and no change in the underlying conditionsIt can be determined by deductive or inductive reasoningSubjective probability is the individuals personal estimate of the chance of loss A persons perception of the chance of loss may differ from the objective probability5Transparency Master 1.21-6Peril and HazardA peril is defined as the cause of the lossIn an auto accident, the collision is the perilA hazard is a condition that increases the chance of loss Physical hazards are physical conditions that increase the chance of loss (icy roads, defective wiring)Moral hazard is dishonesty or character defects in an individual, that increase the chance of loss (faking accidents, inflating claim amounts) Morale Hazard is carelessness or indifference to a loss because of the existence of insurance (leaving keys in an unlocked car)Legal Hazard refers to characteristics of the legal system or regulatory environment that increase the chance of loss (large damage awards in liability lawsuits)6Transparency Master 1.21-7Basic Categories of RiskPure and Speculative RiskA pure risk is one in which there are only the possibilities of loss or no loss (earthquake)A speculative risk is one in which both profit or loss are possible (gambling)Fundamental and Particular RiskA fundamental risk affects the entire economy or large numbers of persons or groups (hurricane)A particular risk affects only the individual (car theft)Enterprise RiskEnterprise risk encompasses all major risks faced by a business firm, which include: pure risk, speculative risk, strategic risk, operational risk, and financial risk7Transparency Master 1.2Risk, Risk, RiskTypes of Risk?
Distinction Between Moral Hazard and Morale Hazardhttp://thismatter.com/money/insurance/risks-perils-hazards.htm
1-81-9Types of Pure RisksPersonal risks involve the possibility of a loss or reduction in income, extra expenses or depletion of financial assets:Premature death of family headInsufficient income during retirementMost workers are not saving enough for a comfortable retirementPoor health (catastrophic medical bills and loss of earned income)Involuntary unemployment9Transparency Master 1.2Exhibit 1.1 Reported Total Savings and Investments among Those Responding, by Age(not including value of primary residence or defined benefit plans)
101-11Types of Pure RisksProperty risks involve the possibility of losses associated with the destruction or theft of property:Physical damage to home and personal property from fire, tornado, vandalism, or other causesDirect loss vs. indirect lossA direct loss is a financial loss that results from the physical damage, destruction, or theft of the property, such as fire damage to a restaurantAn indirect loss results indirectly from the occurrence of a direct physical damage or theft loss, such as lost profits due to inability to operate after a fire111-12Exhibit The 10 Most Costly Hurricanes in the United States ($ millions)
121-13Types of Pure RisksLiability risks involve the possibility of being held liable for bodily injury or property damage to someone elseThere is no maximum upper limit with respect to the amount of the lossA lien can be placed on your income and financial assetsDefense costs can be enormous131-14Burden of Risk on SocietyThe presence of risk results in three major burdens on society:In the absence of insurance, individuals would have to maintain large emergency funds The risk of a liability lawsuit may discourage innovation, depriving society of certain goods and servicesRisk causes worry and fear141-15Methods of Handling RiskAvoidanceLoss controlLoss prevention refers to activities to reduce the frequency of lossesLoss reduction refers to activities to reduce the severity of lossesRetentionAn individual or firm retains all or part of a lossLoss retention may be active or passiveNoninsurance transfersA risk may be transferred to another party through contracts, hedging, or incorporationInsurance15Transparency Master 1.2Should We Manage Risk?Why InsuranceWhy HedgeWhy Do Nothing1-1617The Japanese eat very little fat and suffer fewer heart attacks than the British or Americans.On the other hand, the French eat a lot of fat and also suffer fewer heart attacks than the British or Americans.
The Chinese drink very little red wine and suffer fewer heart attacks than the British or Americans.The Italians drink excessive amounts of red wine and also suffer fewer heart attacks than the British or Americans.
Conclusion: Eat & drink what you like. It's English that kills you .18I N S U R A N C E
19Insurance in broad terms may be described as a method of sharing financial losses of few from a common fund who are equally exposed to the same loss.20ExampleSay 1000 motor cars valued @ 300000/- are observed over a period of five years. On an average say per year two are total loss by accident. Then the total annual loss would be Rs.600000. If the loss is to shared by all the thousand owners then they have to contribute Rs.600/-The loss experience will be established by taking the past experience, geographical area in which the vehicles are used and density of traffic.21Rate of contribution or premium The degree of hazard it is exposed to.Classification of various types of properties.PRINCIPLES OF INSURANCE22IMPORTANT ELEMENTS INVOLVED IN THE CONCEPT OF INSURANCE Subject matter of insurance.The PERIL (risk)The financial loss.Can You Shed All Risk?http://blogs.reuters.com/felix-salmon/2011/07/01/why-you-cant-hedge-tail-risk/ 1-23Simple HedgingBuy a StockEliminate downside riskFuturesOptionFutures OptionOthersSwapsMisc. 1-24Quick Explain Peril and Hazard http://missourifamilies.org/quick/financeqa/finqa140.htm 1-25