Introduction to Risk Management - Finance - Lecture Slides, Slides of Finance

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Introduction to Risk

Management

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Lecture Agenda

• Risk versus Uncertainty
• Risk Management
• Basic Types of Risk
• Management of Risk
• Evaluation of Risk
• Risk Management Strategies
  • Pure Risks & Insurance
  • Speculative Risk

Risk vs. Uncertainty

• Risk involves the possibility of loss
• Uncertainty involves the range of all

possible outcomes both good and bad.

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expected outcome

_ x =

Probability

Risk Uncertainty

Risk Management

• A growing area of finance.
• Involves:
  • Identifying risk
  • Measuring risk
  • Managing / Mitigating / Eliminating /

Controlling risk

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Management of Pure Risk

• Approaches to managing pure risks

include:

• Ignoring the risk
• Avoiding the activity / reducing the

likelihood of the event occurring (wearing a

seat belt – avoiding being a pilot in

command.)

• Purchasing insurance (transferring risk

from yourself to other parties better able,

and willing to bear the risk)

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Insurance

• Transfer of risk – usually based on the

pooling of resources and the law of large

numbers.

• Used to protect against catastrophic loss

from a pure risk

• Examples include:
  • Life insurance
  • Disability insurance
  • Home insurance
  • Automobile insurance
  • Third party liability insurance

Not All Pure Risk is Insurable

Increasing Probability of Loss

Increasing Magnitude of Loss

Insurable Risk

(Large Magnitude, Low Probability of Occurrence)

Increasing Probability of Loss

Increasing Magnitude of Loss

Losses to property (flood, fire, theft) – Losses to human capital

- high magnitude but low probability.

Insurance is used to deal with the losses from pure risks that are

faced by a group – and are statistically predictable for the group.

Insurable Risk

(Small Magnitude, High Probability of Occurrence)

Increasing Probability of Loss

Increasing Magnitude of Loss

Not worth insuring. Simply replace loss and treat as an expense.

Rock chips on the front of your car (live with it and touch up yourself)…regular wear and tear of household furniture (tolerate it until you replace)…cuts and bruises treated with bandaids you buy from the store!

Counterintuitive

• An increasing probability of loss does not necessarily mean that you

require insurance against the risk.

• When the probability of loss is very high, buying insurance is of no

value, since it would simply be a prepayment plan.

• Can you give me examples of this?
  • Lava flow damage next to a volcano
  • Earthquake damage on structures built on the San Andres fault
  • Water damage on homes built outside Winnipeg’s flood way.
• It is often difficult and sometimes impossible to find an insurer to

insure against highly probable risks

• Flood insurance is not available from commercial carriers for Manitoba

property owners outside of the floodway.

Insurance Not Available

Increasing Probability of Loss

Increasing Magnitude of Loss

Earthquake insurance in an earthquake zone.

Probability and Magnitude of loss help to select an appropriate risk

management strategy.

Why Are there Deductibles?

Increasing Probability of Loss

Increasing Magnitude of Loss

Deductibles are used by the insurance industry to limit claims to

only those that cause catastrophic losses. Frequent, trivial claims

cost more to process and would cause the cost of all insurance to

skyrocket.

Insurance for dents in automobile doors at Lakehead University.

Management of Speculative

Risk

• Approaches to management include:
  • Choose to avoid ‘taking the position’
  • Ignoring the risk
  • Take an offsetting position (using derivative

securities)

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Use of Derivatives

• There are two very different ways derivatives can be used:

1. To Hedge

2. To Speculate