Risk Management

Introduction to risk management

Human beings are trying to manage risk in their day to day life
Ex: keeping inflammable material away from fire, saving for possible future needs and creation of a legal will etc.

Risk is the possibility of the actual outcome being different from the expected outcome. Elements of uncertainty and risk Risk and Uncertainty are not synonymous Certainty : Know what will happen Risk : Number of specific and probable outcomes, but it is certain as to
which one of

them will actually happen. Uncertainty: the probable outcomes are not known.

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Introduction to risk management

Risk is not an abstract concept. It is a variable which can be measured and compared. The degree of risk attached to an event depends on occurrence of that event. Higher the probability of the actual outcome being different from the expected outcome, the higher is the risk attached to the event. Risk is a function of probable outcomes and its potential intensity, if it occurs. Risk is generally measured using the concept of Standard deviation. Risk is differ from Peril and Hazard Risk : Possibility of loss Peril : Cause of loss Ex: fire Hazard : Factor that may create or increase the possibility of a loss. Ex: inappropriate wiring in the factory
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Introduction to risk management

Risk is the possibility of loss due to peril and hazard. Degree of the risk present in a particular situation is not an absolute and independent. It is dependent on the level of information available with the entity facing it.

The degree of information available determines the entitys perception of the expected value, which in turn determines the degree of risk.
Even when complete information is available, risk is dependent on the interpretation by the entity and its perception as to the future outlook.

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Risk - definition
Risk is the possibility of some thing unpleasant happening or the chance of encountering loss or harm. Risk in the context of organization is uncertainty of the future cash flows Company objective is wealth maximization

The job of a risk manager is

- identification of the risk and factors effecting the risk - identification of the remedial measures available to manage the risk - the cost of managing the risk

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Different interpretations of risk

Depending on the capacity and attitude towards the risk, it can be divided into the following Pure risks and speculative risks Acceptable risks and Non - Acceptable risks Static risks and Dynamic risks

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Pure Risks and Speculative Risks

Pure risks are those in which the outcome tends to be a loss with no possibility of gain. These risks can be insured. Ex: risk of fire in a godown

Speculative risks are those in which there is a possibility of profit or loss. These risks are not insured. Ex : secondary market operations.

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Acceptable risks and Non Acceptable risks

While risks of unavoidable in any business, the potential loss may be so minimal that some risks are acceptable without any prevention being taken.

Certain risks are major and those are known as non acceptable risks. For unacceptable risks, the management must find out ways to reduce, avoid or transfer the risk.

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Static risks and Dynamic risks

Various risks depend on changes in the economical, political, social and other scenarios. Such risks are known as Dynamic risks.

Risks that do not depend on various scenarios are known as static risks.

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Sources of Risk
Risks can be pure risks or speculative risks. The list of pure risks is vast and it suffices to say that doing anything in life involves risk. The main pure risks may be arising from Property Exposure Liability Exposure Life and Health Exposure Financial Exposure

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Property Exposure
Any business or individual that uses any kind of property whether owned, leased, rented or otherwise is exposed to the risk of loss, theft, and damage due to man made reasons or natural causes. Depending on the extent of exposure and damage, the business may be effected.

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Liability Exposure
Around the world, liability to any business due to litigation, damages, claims, etc., has become a major issue of concern. Millions of dollars are lost by companies over legal suits and settlements. Such risks exist for an individual also.

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Life and Health Exposure

Human beings are certain to die, although the extent of life and its quality cannot be determined. An individual may die while still young or may be bedridden for most of his life. Some people are healthy while others have to spend a major portion of their earnings on health related matters. This exposure leads to loss of earnings for an individual as well as loss of man hours to the business he is associated with.

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Financial Exposure
The three exposures like property, liability and life and health exposures are pure risks. Financial exposure may arise out of speculative nature of risks also and should not always be considered as a pure risk, but it still has the same problems associated with pure risks. Although the techniques to manage these risks may be different from those used to manage the other risks mentioned above, it remains critical that these risks be identified and assessed so that the firm could achieve its business goals.

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Types of Risk
Interest rate Risk : interest rate risk is the risk of an adverse effect of interest rate movements on a firms profits or balance sheet. Interest rates affect a firm in two ways- by affecting the profits - by affecting the value of its assets and liabilities For Example: A firm has borrowed money on a floating rate basis faces the risk of lower profits in an increasing interest rate scenario. Similarly, a firm having fixed rate assets faces the risk of lower value of investments in an increasing interest rate scenario.

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Types of Risk
Interest rate risk becomes prominent when the assets and liabilities of a firm do not match their exposure to interest rate movements. For example : A firm that has fixed rate borrowings and floating rate investments has a higher exposure than a firm with fixed rate borrowings and fixed rate investments for the same. It can also be defined as the risk arising due to sensitivity of the interest income/expenditure or values of assets/ liabilities to the interest rate fluctuations.

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Types of Risk
Exchange Risk : The volatility in the exchange rates will have a bearing on
the values of the assets and liabilities which are denominated in the foreign currencies. Appreciation of home/domestic currency decreases the value of an asset and liability in terms of home currency, depreciation of the home currency will increase the value of assets and liabilities. Increase in the value of asset and decrease in the value of liability have a positive impact on the corporate, increase in the value of liabilities and decrease in the value of assets have a negative impact.

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Types of Risk
Liquidity Risk : Liquidity risk refers to the risk of a possible bankruptcy
arising due to the inability of the firm to meet its financial obligations. There is a misconception that a profitable firm will have little or no liquidity risk. It is possible that a firm may be very profitable but may face a severe liquidity crunch because it has blocked its money in illiquid assets.

Liquidity Risk also refers to the possibility of having excess funds i.e., the risk of having more funds that it can profitably deploy.
Liquidity which is represented by the quality and marketability of the assets and liabilities, exposes the firm to liquidity risk.

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Types of Risk
Though the management of liquidity risk and interest rate risk go hand in hand, there is a phenomenal difference in the approach to tackle both these risks. A bank generally aims to eliminate the liquidity risk while it only tries to manage the interest rate risk. This differential approach is primarily based on the fact that elimination of interest rate risk is not profitable, while elimination of liquidity risk does result in long term sustenance.

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Types of Risk
Default Risk : Default risk is the risk of non recovery of sums due from
outsiders which may arise either due to their inability to pay or unwillingness to do so. This risk has to be considered when credit is extended to any party.

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Types of Risk
Internal Business Risk : The internal business risk refers to the degree of
operational efficiency of the management towards the unanticipated future. The system adopted , the decision making abilities, the ability of the management to visualize the future will all contribute to the internal business risk. To a great extent it is a controllable factor. The risk of losses that may arise due to personnel can also be classified here. A loss may occur due to the registration/death of a key individual. It may also arise due to the frauds perpetuated by the staff.

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Types of Risk
External Business Risk : The external business risk is the result of
external environment in which the business exists. It emanates from the factors which are not within the control of the company. Delayed monsoon or fiscal policy or stability of the Government or any similar factors may have a bearing on the income earning capacity of the company.

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Cost of Risk
There are various costs involved in risk.

Risk Identification costs : Risk identification costs are those costs which an enterprise incurs to identify and analyze the risk like fees for consultants. Risk handling costs: After the risks are identified, certain expenses of handling them are to be incurred like insurance premiums, alarm installation and loss prevention devices etc., in addition to the man hours spent on risk handling.

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Cost of Risk
Actual Losses : Actual Losses imply direct as well as indirect losses. Damages caused by fire, death of personnel, injuries, loss of production and finished stocks are direct losses while indirect losses imply productivity reduction, stoppage etc., which will happen if the fire takes place. Social Costs : These are the costs that the company may have to undertake to compensate the society for whatever damages may be caused by its actions or by pure risks. For Ex: Union Carbide had to pay millions of dollars as compensation to the society because of the poisonous gas leak at Bhopal in 1984.

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Cost of Risk

Loss financing costs : These costs also include insurance policies, hedging arrangements and other contractual risk transfers.

Loss control costs : Loss control costs are the increased precautions and limits on the risk activities in order to reduce the chances of recurrence of risks. Ex: Proper timely maintenance of machinery can reduce the break downs and chances of accidents.

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Risk Management
Once the different types of risk identified, the next step is to identify the alternate tools available to manage them. The tools may be as follows

Avoidance Loss control Separation Combination Transfer

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Limitations of risk management

Risk can be minimized but never completely erased. No risk manager can guarantee a full proof system against risks, mainly because many risks are unexpected.

Remedial measures to manage risks are mostly based on general experience from the past.
Risk management tools may be costly and not justify the returns.

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Limitations of risk management

None of the risk management method is perfect and may not even work the same in similar situations. Selection of suitable methods for risk management depends on firms expectations regarding the future as well as the degree of risks acceptable to management.

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