RISK MANAGEMENT FOR ENTERPRISES

AND INDIVIDUALS

Chapter 1
The Nature of Risk: Losses
and Opportunities
 Learning Objectives

 Build the definition of risk as a consequence of

uncertainty and within a continuum of decision-
making roles.
 Learn about the three major types of “risk
attitudes.”
 Learn what a risk professional means by exposure.
 Learn several different ways to split risk
exposures according to the risk types involved.

©
©2010
2010Flat World
Flat Knowledge,
World Inc. Inc.
Knowledge, 11 -- 22
 Learning Objectives

 Learn how enterprise-wide risk approaches

combine risk categories.
 Learn the terminology used by risk professionals
to note different risk concepts.
 Learn about causes of losses—perils and the
hazards, which are the items increasing the chance
of loss.

©
©2010
2010Flat World
Flat Knowledge,
World Inc. Inc.
Knowledge, 11 -- 33
 The Notion and Definition of Risk

 The notion of risk is inextricably linked to the

notion of uncertainty.
 Uncertainty is having two potential outcomes for
an event or situation.
 Uncertainty about which of several possible
outcomes will occur circumscribes the meaning of
risk.

©
©2010
2010Flat World
Flat Knowledge,
World Inc. Inc.
Knowledge, 11 -- 44
 The Notion and Definition of Risk

 Risk is the uncertainty about a future outcome,

particularly the consequences of a negative
outcome.
 Our perception of risk arises from our perception
of and quantification of uncertainty.

©
©2010
2010Flat World
Flat Knowledge,
World Inc. Inc.
Knowledge, 11 -- 55
 Table 1.1 - Examples of Consequences
That Represent Risks

©
©2010
2010Flat World
Flat Knowledge,
World Inc. Inc.
Knowledge, 11 -- 66
 The Role of Risk in Decision Making

 Risk encompasses the potential provision of both

an opportunity for gains as well as the negative
prospect for losses.
 Risk permeates the spectrum of decision making
from goals of value maximization to goals of
insolvency minimization.

©
©2010
2010Flat World
Flat Knowledge,
World Inc. Inc.
Knowledge, 11 -- 77
 Attitudes Toward Risks

 Risk averse refers to shying away from risks and

preferring to have as much security and certainty
as is reasonably affordable.
 Risk seeker is someone who will enter into an
endeavor as long as a positive long run return on
the money is possible, however unlikely.
 Risk neutral attitude is seen when one’s risk
preference lies between the extremes of risk
averse and risk seeking.

©
©2010
2010Flat World
Flat Knowledge,
World Inc. Inc.
Knowledge, 11 -- 88
 Types of Risks—Risk Exposures

 Pure versus speculative risk exposures

Pure risk: Risk that features some chance of loss and
no chance of gain.
Speculative risk: Risk that features a chance to either
gain or lose.
Some risks can be transferred to a third party, while
some require risk transfers that use capital markets,
known as hedging or securitizations.

©
©2010
2010Flat World
Flat Knowledge,
World Inc. Inc.
Knowledge, 11 -- 99
 Types of Risks—Risk Exposures

 Personal loss exposures (personal pure risk)

 Property loss exposures (property pure risk)
 Liability loss exposures (liability pure risk)
Liability loss is loss caused by a third party who is
considered at fault.

©
©2010
2010Flat World
Flat Knowledge,
World Inc. Inc.
Knowledge, 11 -- 10
10
 Types of Risks—Risk Exposures

 Catastrophic loss exposure and fundamental or

systemic pure risk
Fundamental risk or systemic risk are risks that are
pervasive to and affect the whole economy, as opposed
to accidental risk for an individual.

©
©2010
2010Flat World
Flat Knowledge,
World Inc. Inc.
Knowledge, 11 -- 11
11
 Table 1.3 - Examples of Risk Exposures by the
Diversifiable and Nondiversifiable Categories

©
©2010
2010Flat World
Flat Knowledge,
World Inc. Inc.
Knowledge, 11 -- 12
12
 Enterprise Risks

 The opportunities in the risks and the fear of

losses encompass the holistic risk or the enterprise
risk of an entity.
 Enterprise risk management (ERM) is one of
today’s key risk management approaches.

©
©2010
2010Flat World
Flat Knowledge,
World Inc. Inc.
Knowledge, 11 -- 13
13
 Perils and Hazards

 Perils: The causes of loss.

Natural perils: Causes of losses over which people
have little control.
Human perils: Causes of losses that lie within
individuals’ control.
Economic perils: Causes of losses resulting from the
state of the economy.

©
©2010
2010Flat World
Flat Knowledge,
World Inc. Inc.
Knowledge, 11 -- 14
14
 Table 1.4 - Types of Perils by Ability to
Insure

©
©2010
2010Flat World
Flat Knowledge,
World Inc. Inc.
Knowledge, 11 -- 15
15
 Perils and Hazards
 Hazards: Conditions that increase the cause of
loss; they may increase the probability of losses,
their frequency, their severity, or both.
Physical hazards: Tangible environmental conditions
that affect the frequency and/or severity of loss.
Intangible hazards: Attitudes and nonphysical
cultural conditions can affect loss probabilities and
severities of loss.
 Hazards are critical as our ability to reduce their
effects will reduce both overall costs and
variability.
©
©2010
2010Flat World
Flat Knowledge,
World Inc. Inc.
Knowledge, 11 -- 16
16
 Summary

 Risk is a consequence of uncertainty, and can be

emotional, financial, or reputational.
 The three risk attitudes include being risk averse,
risk neutral, and a risk seeker.
 The main categories of risks include pure versus
speculative, diversifiable versus nondiversifiable,
and idiosyncratic versus systemic risk.
 Perils are the causes of loss while hazards are
conditions that increase the cause of loss.

©
©2010
2010Flat World
Flat Knowledge,
World Inc. Inc.
Knowledge, 11 -- 17
17
 The five C’s of Credit

 Capital
Capital
 Capacity Capacity

 Collateral Collateral
 Character Character
 Conditions
Conditions

©
©2010
2010Flat World
Flat Knowledge,
World Inc. Inc.
Knowledge, 11 -- 18
18
 Capital

 “Capital is any form of wealth employed to

produce more wealth for the firm”

 Does the business already have a stable capital

base?
 Is there an equity base of investment made by the
owner?

©
©2010
2010Flat World
Flat Knowledge,
World Inc. Inc.
Knowledge, 11 -- 19
19
 Capacity

Cash! Cash! Cash!

 Capacity to meet financial obligations
 Ability to pass the liquidity tests:
Current Ratio
Quick Ratio

©
©2010
2010Flat World
Flat Knowledge,
World Inc. Inc.
Knowledge, 11 -- 20
20
 Collateral

 Does the business have any assets that can be used

to secure a loan?
 Personal or business assets can be used.
 If a business owner is willing to use his own
property as collateral then he is making a
commitment to do all he can to help the business
succeed.

©
©2010
2010Flat World
Flat Knowledge,
World Inc. Inc.
Knowledge, 11 -- 21
21
 Character

 The owner’s character says  Positive Character

a lot about his ability to Qualities:
successfully run a business.  Honesty
 Incompetent management  Competence
is a major reason why  Polish
businesses fail.  Determination
 Intelligence
 Ability

©
©2010
2010Flat World
Flat Knowledge,
World Inc. Inc.
Knowledge, 11 -- 22
22
 Conditions

 Outside factors that affect the loan decision:

Potential growth in the market
Competition
Location
Form of ownership
Loan purpose
Condition of the economy

©
©2010
2010Flat World
Flat Knowledge,
World Inc. Inc.
Knowledge, 11 -- 23
23