risk management 2010 subjective

8/3/2019 Risk Management 2010 Subjective

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Risk is defined asRisk is defined as

uncertainty concerning theuncertainty concerning theoccurrence of a lossoccurrence of a loss


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Objective riskObjective risk

Also called degree of risk is defined asAlso called degree of risk is defined asthe relative variation of actual loss fromthe relative variation of actual loss from

expected loss.expected loss.


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Subjective riskSubjective risk

This is defined as uncertainty based on aThis is defined as uncertainty based on apersons mental condition or state ofpersons mental condition or state of

mind. For example, a customer who wasmind. For example, a customer who wasdrinking heavily, may attempt to drive.drinking heavily, may attempt to drive.


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pure riskpure risk

DefinitionDefinition

S

ituation where there is aS

ituation where there is a chancechance of eitherof eitherlossloss or no loss, but noor no loss, but nochance ofchance ofgaingain; for example either a; for example either a buildingbuilding will burn down or itwill burn down or itwon't. Only purewon't. Only pure risksrisks are insurable because otherwise (where theare insurable because otherwise (where thechance of the occurrence of a loss is determinable)chance of the occurrence of a loss is determinable) insuranceinsurance isisakin to betting and theakin to betting and the insuredinsured may stand to gain from it a situationmay stand to gain from it a situationcontrary to the mostcontrary to the most fundamentalfundamental conceptconcept of insurance. Alsoof insurance. Alsocalledcalled absolute riskabsolute risk..


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speculative riskspeculative risk

DefinitionDefinition InsuranceInsurance industryindustry term for a situation whereterm for a situation where

the possibility of either athe possibility of either a financialfinancial lossloss or aor afinancialfinancial gaingain exists, such as inexists, such as in purchasepurchase ofofsharesshares or betting on horses. Unlikeor betting on horses. Unlike pure riskspure risks,,

speculativespeculative risksrisks are usually not insurable.are usually not insurable.


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Chance of lossChance of loss

This is defined as the probability that anThis is defined as the probability that anevent will occur. Like risk, probability hasevent will occur. Like risk, probability has

both objective and subjective aspects.both objective and subjective aspects.


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Objective probability refers to the longObjective probability refers to the longrun relative frequency of an event basedrun relative frequency of an event based

on the assumptions of an infinite numberon the assumptions of an infinite numberof observations and of no change in theof observations and of no change in theunderlying conditionsunderlying conditions


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Objective probabilities can be determinedObjective probabilities can be determinedin two ways. First, they can bein two ways. First, they can be

determined by deductive reasoning.determined by deductive reasoning.These probabilities are called prioriThese probabilities are called prioriprobabilities. Eg. The probability ofprobabilities. Eg. The probability of

getting a head from the toss of agetting a head from the toss of aperfectly balanced coin is 1perfectly balanced coin is 1--2 since there2 since thereare two sides and only one is a head.are two sides and only one is a head.


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Inductive reasoningInductive reasoning

The probability that a person aged 21 willThe probability that a person aged 21 willdie before age 26 cannot be logicallydie before age 26 cannot be logically

deduced. However, by a careful analysisdeduced. However, by a careful analysisof past mortality experience, life insurersof past mortality experience, life insurerscan estimate the probability of death.can estimate the probability of death.


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Subjective ProbabilitySubjective Probability

This is the individuals personal estimateThis is the individuals personal estimateof the chance of loss.Eg. People who buyof the chance of loss.Eg. People who buy

a lottery ticket on their birthday maya lottery ticket on their birthday maybelieve it is their lucky day andbelieve it is their lucky day andoverestimate the small chance ofoverestimate the small chance of

winning.winning.


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A wide variety of factors can influenceA wide variety of factors can influencesubjective probability, including asubjective probability, including a

persons age, gender, intelligence,persons age, gender, intelligence,education, and the use of alcohol.education, and the use of alcohol.


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In addition, a persons estimate of a lossIn addition, a persons estimate of a lossmay differ from objective probabilitymay differ from objective probability

because there may be ambiguity in thebecause there may be ambiguity in theway in which the probability is perceivedway in which the probability is perceived


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PerilPeril

Peril is defined as the cause of loss. IfPeril is defined as the cause of loss. Ifyour house burns because of a fire, theyour house burns because of a fire, the

peril.or cause of loss, is the fire. Commonperil.or cause of loss, is the fire. Commonperils that cause property damageperils that cause property damageinclude fire, lightening hurricanes theftinclude fire, lightening hurricanes theft

burglary.burglary.


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HazardHazard

A hazard is a condition that creates orA hazard is a condition that creates orincreases the chance of loss. There areincreases the chance of loss. There are

three major types of hazards.three major types of hazards. Physical hazardPhysical hazard

Moral hazardMoral hazard

Morale hazardMorale hazard


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Physical HazardPhysical Hazard

A physical hazard is a physical conditionA physical hazard is a physical conditionthat increases the chance of loss. Eg. Athat increases the chance of loss. Eg. A

physical hazard include icy roads thatphysical hazard include icy roads thatincrease the chance of an auto accident,increase the chance of an auto accident,defective wiring in a building thatdefective wiring in a building that

increases the chance of fireincreases the chance of fire


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Moral HazardMoral Hazard

Moral hazard is dishonesty or characterMoral hazard is dishonesty or characterdefects in an individual that increases thedefects in an individual that increases the

frequency or severity of a loss. Eg.frequency or severity of a loss. Eg.Faking an accident to collect from anFaking an accident to collect from aninsurer. Murdering the insured to collectinsurer. Murdering the insured to collect

life insurancelife insurance


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Moral hazard is present in all forms ofMoral hazard is present in all forms ofinsurance and it is difficult toinsurance and it is difficult to

contron.Dishonest individuals oftencontron.Dishonest individuals oftenrationalize their actions on the groundsrationalize their actions on the groundsthat the insurer has plenty of money.that the insurer has plenty of money.


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Insurers attempt to control moral hazrdInsurers attempt to control moral hazrdby careful underwriting of applicants forby careful underwriting of applicants for

insurance and by various policyinsurance and by various policyprovisions and riders.provisions and riders.


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Morale HazardMorale Hazard

Morale hazard refers to carelessness orMorale hazard refers to carelessness orindifference to a loss because of theindifference to a loss because of the

existence of insurance. Eg. Leaving carexistence of insurance. Eg. Leaving carkeys in an unlocked car. Careless acts ofkeys in an unlocked car. Careless acts ofsuch a nature increases the chance ofsuch a nature increases the chance of

loss.loss.


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The changing Scope ofThe changing Scope of

R.M.R.M. Traditionally risk management wasTraditionally risk management was

limited in scope to pure loss exposures,limited in scope to pure loss exposures,

including property risks liability risks andincluding property risks liability risks andpersonnel risks. In the 1990s howeverpersonnel risks. In the 1990s howevermany businesses began to expand theirmany businesses began to expand their

scope of risk management to includescope of risk management to includespeculative financial risk.speculative financial risk.


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Financial RiskFinancial Risk

ManagementManagement Business firms face a number ofBusiness firms face a number of

speculative financial risks. Financial riskspeculative financial risks. Financial risk

management refers to the identification,management refers to the identification,analysis and treatment of speculativeanalysis and treatment of speculativefinancial risks. These risks includefinancial risks. These risks include

Commodity price riskCommodity price risk

Interest rate riskInterest rate risk

Currency exchange riskCurrency exchange risk


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Commodity Price RiskCommodity Price Risk

Commodity price risk is the risk of losingCommodity price risk is the risk of losingmoney if the price of a commoditymoney if the price of a commodity

changes. Eg. Consider an agriculturalchanges. Eg. Consider an agriculturaloperation that will have thousands ofoperation that will have thousands ofmelons at harvest time. The price maymelons at harvest time. The price mayincrease or decrease at harvest timeincrease or decrease at harvest time

depending on the demand and supply.depending on the demand and supply.But because it is perishable it has to beBut because it is perishable it has to besold at current price.sold at current price.


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Interest rate riskInterest rate risk

Financial institutions are especiallyFinancial institutions are especiallysusceptible to interest rate risk. Interestsusceptible to interest rate risk. Interest

rate risk is the risk of loss caused byrate risk is the risk of loss caused byadverse interest rate movement.adverse interest rate movement.


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Currency Exchange rateCurrency Exchange rate

RiskRisk The currency exchange rate is the valueThe currency exchange rate is the value

for which one nations currency may befor which one nations currency may be

converted to another nations currency.converted to another nations currency.Eg. One U.S. dollar is worth $90 JA. AnyEg. One U.S. dollar is worth $90 JA. Anymovement in the U.S. dollar can havemovement in the U.S. dollar can have

adverse effect on Jamaican businesses.adverse effect on Jamaican businesses.


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Managing Financial risksManaging Financial risks

The traditional separation of pure andThe traditional separation of pure andspeculative risks meant that differentspeculative risks meant that different

business departments addressed thesebusiness departments addressed theserisks.risks.


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Pure risks were handled by the riskPure risks were handled by the riskmanager throughmanager through

Risk retentionRisk retention

Risk transferRisk transfer

Loss controlLoss control


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Speculative risks were handled by theSpeculative risks were handled by thefinance division through contractualfinance division through contractual

provisions and capital marketprovisions and capital marketinstruments.instruments.


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Contractual provisions that addressContractual provisions that addressfinancial risks include call features onfinancial risks include call features on

bonds that permit bonds with highbonds that permit bonds with highcoupon rates to be retired early andcoupon rates to be retired early andadjustable interest rate provisions onadjustable interest rate provisions on

mortages through which the interest ratemortages through which the interest ratevaries with interest rates in the generalvaries with interest rates in the generaleconomy.economy.


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A variety of capital market approachesA variety of capital market approachesare also employed, includingare also employed, including

Options contractsOptions contracts

Forward contractsForward contracts

Futures contractsFutures contracts

Interest rate swapsInterest rate swaps


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Risk retentionRisk retention

risk retentionrisk retention

The assumption of certain risks as opposed toThe assumption of certain risks as opposed to

paying another party to assume the risks. Forpaying another party to assume the risks. Forexample, a corporation may decide to pay theexample, a corporation may decide to pay thehealth expenses of its employees rather thanhealth expenses of its employees rather thanpurchase a health insurance plan. Similarly, anpurchase a health insurance plan. Similarly, an

individual with an older vehicle may decide toindividual with an older vehicle may decide toretain the risk of damage to the vehicle andretain the risk of damage to the vehicle andforgo collision and comprehensive insurance.forgo collision and comprehensive insurance.


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Risk transferRisk transfer

ShiftingShifting riskrisk from onefrom one partyparty to another;to another;examples includeexamples include purchasingpurchasing insuranceinsurance

coveragecoverage or issuingor issuing debtdebt..


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Loss ControlLoss Control

Reducing & eliminating the occurrence ofReducing & eliminating the occurrence ofundesired events through engineering controls,undesired events through engineering controls,enforcement of established procedures, frequentenforcement of established procedures, frequent

training and continuous evaluation.training and continuous evaluation.


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Undesired EventsUndesired Events

Not an Accident, but aNot an Accident, but a Loss IncidentLoss Incident

3 Causes3 Causes 1. Lack of Control1. Lack of Control 2. Basic Causes2. Basic Causes

3. Immediate Causes3. Immediate Causes

Causing an Undesired EventCausing an Undesired Event Resulting in LossResulting in Loss


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Lack ofControlLack ofControl

Inadequate SystemsInadequate Systems

Program in place hire, train and evaluateProgram in place hire, train and evaluate

desirable associates.desirable associates. Inadequate StandardsInadequate Standards

Procedures in place to perform critical tasksProcedures in place to perform critical tasks

Inadequate Compliance with StandardsInadequate Compliance with Standards Established standards are not enforcedEstablished standards are not enforced


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Basic CauseBasic Cause

Basic Causes have 2 major categoriesBasic Causes have 2 major categories

1.1. Personal FactorsPersonal Factors Inadequate CapabilityInadequate Capability

lack of Knowledgelack of Knowledge

Lack ofShillLack ofShill

2.2. EnvironmentalEnvironmental Inadequate LeadershipInadequate Leadership

Inadequate EquipmentInadequate Equipment

Inadequate EngineeringInadequate Engineering


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Immediate CausesImmediate Causes

The unsafe act or condition that caused theThe unsafe act or condition that caused theevent to occur.event to occur.

2 Categories2 Categories 1.1.Substandard Acts (Behavior)Substandard Acts (Behavior)

Improper LiftingImproper Lifting

Failure to Lock Out equipmentFailure to Lock Out equipment

Using Equipment improperlyUsing Equipment improperly

2.2.Substandard ConditionsSubstandard Conditions Inadequate GuardsInadequate Guards

Defective ToolsDefective Tools

Inadequate IlluminationInadequate Illumination

-- e con ac even ae con ac even a


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-- e con ac even ae con ac even acauses harm or damage.causes harm or damage.

Struck AgainstStruck Against

Struck ByStruck By

FallFall Caught InCaught In

Caught OnCaught On

Caught BetweenCaught Between Contact WithContact With

Release of EnergyRelease of Energy


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LossLoss

Damaged PropertyDamaged Property

Damaged ProductDamaged Product

Environmental PollutionEnvironmental Pollution

InjuryInjury

DeathDeath


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Non monetary costNon monetary cost

Bad PressBad Press

Loss of EfficacyLoss of Efficacy

Employee MoralEmployee Moral

Organization of a UnionOrganization of a Union

Additional FrustrationAdditional Frustration


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Options contrctOptions contrct

A financial derivativeA financial derivative that representsthat represents aa contract sold bycontract sold byone party (option writer)one party (option writer) to another party (optionto another party (optionholder). The contract offers the buyer the right, but notholder). The contract offers the buyer the right, but notthe obligation, to buy (call) or sell (put) a security orthe obligation, to buy (call) or sell (put) a security orother financial assetother financial asset at an agreedat an agreed--upon price (the strikeupon price (the strikeprice)price) during a certain period of time or on a specificduring a certain period of time or on a specificdate (exercise date).date (exercise date).

Call options give the option toCall options give the option to buy at certain price, sobuy at certain price, sothe buyer would want the stock to go up.the buyer would want the stock to go up.

Put options give the option to sell at a certain price, soPut options give the option to sell at a certain price, sothe buyer would want the stock to go down.the buyer would want the stock to go down.


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An option is a contractAn option is a contract that givesthat gives thethebuyer the right, but not the obligation, tobuyer the right, but not the obligation, to

buy or sell anbuy or sell an underlyingunderlying asset at aasset at aspecific price on or before a certain date.specific price on or before a certain date.An option, just like a stock or bond, is aAn option, just like a stock or bond, is a

securitysecurity.I

t is also a binding contract with.I

t is also a binding contract withstrictly defined terms and properties.strictly defined terms and properties.


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The idea behind an option is present in manyThe idea behind an option is present in manyeveryday situations. Say, for example, thateveryday situations. Say, for example, that youyoudiscover a house that you'd love to purchase.discover a house that you'd love to purchase.Unfortunately, you won't have the cash to buy itUnfortunately, you won't have the cash to buy itfor another three months. You talk to the ownerfor another three months. You talk to the ownerand negotiate a deal that gives you an optionand negotiate a deal that gives you an optionto buy the house in three months for a price ofto buy the house in three months for a price of

$200,000. The owner agrees, but for this$200,000. The owner agrees, but for thisoption, you pay a price of $3,000.option, you pay a price of $3,000.


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Now, consider two theoretical situations thatNow, consider two theoretical situations thatmight arise:might arise:

1. It's discovered that the house is actually the1. It's discovered that the house is actually thetrue birthplace of Elvis! As a result, the markettrue birthplace of Elvis! As a result, the marketvalue of the house skyrockets to $1 million.value of the house skyrockets to $1 million.Because the owner sold you the option, he isBecause the owner sold you the option, he isobligated to sell you the house for $200,000. Inobligated to sell you the house for $200,000. In

the end,the end, you stand to make a profit ofyou stand to make a profit of $797,000$797,000($1 million($1 million -- $200,000$200,000 -- $3,000).$3,000).


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While touring the house, you discover not only that theWhile touring the house, you discover not only that thewalls are chockwalls are chock--full of asbestos, but also that the ghostfull of asbestos, but also that the ghostof Henry VII haunts the master bedroom; furthermore,of Henry VII haunts the master bedroom; furthermore,

a family of supera family of super--intelligent rats have built a fortress inintelligent rats have built a fortress inthe basement. Though you originally thought you hadthe basement. Though you originally thought you hadfound the house of your dreams, you now consider itfound the house of your dreams, you now consider itworthless. On the upside, because you bought anworthless. On the upside, because you bought anoption, you are under no obligation to go through withoption, you are under no obligation to go through with

the sale. Of course, you still lose the $3,000 price ofthe sale. Of course, you still lose the $3,000 price ofthe option.the option.


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This example demonstrates two very important points.This example demonstrates two very important points.First, when you buy an option, you have a right butFirst, when you buy an option, you have a right butnotnot an obligation to do something. You can always letan obligation to do something. You can always letthe expiration date go by, at which point thethe expiration date go by, at which point theoptionoption becomes worthless. If this happens, you losebecomes worthless. If this happens, you lose100% of your investment, which is the money you used100% of your investment, which is the money you usedto pay for the option. Second, an option is merely ato pay for the option. Second, an option is merely acontract that deals with an underlying asset. For thiscontract that deals with an underlying asset. For thisreason, options are called derivatives, which means anreason, options are called derivatives, which means an

optionoptionderivesderives

its value from something else.I

n ourits value from something else.I

n ourexample, the house is the underlying asset. Most of theexample, the house is the underlying asset. Most of thetime, the underlying asset is atime, the underlying asset is a stockstock or anor an indexindex..


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Options are extremely versatile securitiesOptions are extremely versatile securitiesthat can be used in many different ways.that can be used in many different ways.

Traders use options to speculate, whichTraders use options to speculate, whichis a relatively risky practice, whileis a relatively risky practice, whilehedgers use options to reduce the risk ofhedgers use options to reduce the risk of

holding an asset.holding an asset.


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In terms of speculation, option buyers and writers haveIn terms of speculation, option buyers and writers haveconflicting views regarding the outlook on theconflicting views regarding the outlook on theperformance of an underlying security.performance of an underlying security.

For example,For example, because the option writer will need tobecause the option writer will need toprovide the underlying shares in the event that theprovide the underlying shares in the event that thestock's market price will exceed the strike, an optionstock's market price will exceed the strike, an optionwriter that sells a call option believes that thewriter that sells a call option believes that the

underlying stock's priceunderlying stock's price will drop relative to the option'swill drop relative to the option'sstrike price during the life of the option, as that is howstrike price during the life of the option, as that is howhe or shehe or she will reap maximum profit.will reap maximum profit.


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This is exactly the opposite outlookThis is exactly the opposite outlook of theof theoption buyer.option buyer. The buyer believes that theThe buyer believes that the

underlying stock will rise, because if thisunderlying stock will rise, because if thishappens,happens, the buyerthe buyer will be able towill be able toacquireacquire thethe stockstock for a lower price andfor a lower price andthen sell it for a profit.then sell it for a profit.


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risk management 2010 subjective

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