prelims for risk management

• Risk is defined as uncertainty concerning the occurrence of a loss
• Many authors and corporate risk managers use the term “loss exposure” to identify potential losses
• A loss exposure is any situation or circumstance in which a loss is possible, regardless of whether a loss occurs
• Objective risk (degree of risk) is the relative variation of actual loss from expected loss
• Subjective risk is uncertainty based on a person’s mental condition or state of mind
• Chance of loss is the probability that an event will occur
• Objective probability refers to the long-run relative frequency of an event based on the assumptions of an infinite number of observations and of no change in the underlying conditions
• Subjective probability is the individual’s personal estimate of the chance of loss
• Peril is the cause of loss
• For example, if your house burns because of a fire, the peril or cause of loss is the fire
• A hazard is a condition that creates or increases the frequency or severity of loss
• There are four major types of hazards: Physical hazard, Moral hazard, Attitudinal hazard (morale hazard), Legal hazard
• Risk can be classified into several distinct classes
• Pure risk is a situation with only the possibilities of loss or no loss
• Speculative risk is a situation where either profit or loss is possible
• Diversifiable risk affects only individuals or small groups and can be reduced by diversification
• Nondiversifiable risk affects the entire economy or large numbers of persons or groups and cannot be eliminated by diversification
• Enterprise risk encompasses all major risks faced by a business firm
• Includes strategic risk, operational risk, financial risk
• Strategic risk refers to uncertainty regarding the firm’s financial goals and objectives
• Operational risk results from the firm’s business operations
• Financial risk refers to the uncertainty of loss due to adverse changes in commodity prices, interest rates, foreign exchange rates, and the value of money
• Personal risks directly affect an individual or family
• Property risks involve the risk of property being damaged or lost from numerous causes
• Direct loss is a financial loss resulting from physical damage, destruction, or theft of the property
• Indirect is a financial loss resulting indirectly from the occurrence of a direct physical damage or theft loss
• Liability risks are an important type of pure risk that most persons face
• Commercial risks are faced by business firms and can financially cripple or bankrupt the firm if a loss occurs
• Other risks faced by business firms include: Crime exposures, Human resources exposures, Foreign loss exposures, Intangible property exposures, Government exposures
• • Chance of loss is defined as the probability that an event will occur . Like risk, “probability” has both objective and subjective aspects.
• deductive reasoning are called a priori probabilities
• Diversifiable risk is a risk that affects only individuals or small groups and not the entire economy. It is a risk that can be reduced or eliminated by diversification.

  Nondiversifiable risk is a risk that affects the entire economy or large numbers of persons or groups within the economy. It is a risk that cannot be eliminated or reduced by diversification.
• • Strategic risk refers to uncertainty regarding the firm’s financial goals and objectives; for example, if a firm enters a new line of business, the line may be unprofitable.
  • Operational risk results from the firm’s business operations. For example, a bank that offers online banking services may incur losses if “hackers” break into the bank’s computer.
  • Financial risk refers to the uncertainty of loss because of adverse changes in commodity prices, interest rates, foreign exchange rates, and the value of money.
• Personal risks are risks that directly affect an individual or family .
• Other Risks Business firms must cope with a wide variety of additional risks, summarized as follows:

  ■ Crime exposures

  ■ Human resources exposures   

  ■ Foreign loss exposures

  ■ Intangible property exposures  

  ■ Government exposures  
• Inductive reasoning For example, the probability that a person age 21 will die before age 26cannot be logically deduced. However, by a careful analysis of past mortality experience, can estimate the probability of death
• Deductive reasoning also known as priori probabilities.For Example, the probability of getting a headfrom the toss of a perfectly balanced coin is 1/2because there are two sides, and only one is ahead.
• Physical hazards are physical conditions thatincrease the chance of loss (icy roads, defective wiring)
• Moral hazard is dishonesty or character defects in anindividual, that increase the chance of loss (fakingaccidents, inflating claim amounts)
• Attitudinal Hazard (Morale Hazard) is carelessnessor indifference to a loss, which increases the frequencyor severity of a loss (leaving keys in an unlocked car)