Determining an Optimal Level of

Risk Management - How much

should you spend on it?

Barbara A. Price
Professor of Quantitative Analysis, Georgia Southern University and
Fulbright Lecturer, University of Debrecen

Kevin Eastman
Professor of Finance, Georgia Southern University
May 2011
risk management is a
systematic process of
identifying and assessing
company risks and taking
actions to protect a company
against them

Encyclopedia of Business, 2/e, Risk Management,

http://www.referenceforbusiness.com/management/Pr-Sa/Risk-Ma
nagement.html
The Best Decisions are most often a
function of an organization’s

 Resources
 Environment
 Risk Aversion Stance
Risk management can be applied to
specific aspects of an organization’s
operations, such as …
 workplace safety
 owned buildings, equipment, and land
 inventory
 loss of key personnel
 Liability
 interest rate changes
 currency fluctuations
 etc.
Addressing a specific aspect may be
complex in itself; however, it is
important to realize that an
organization should take a systems
approach in an attempt to consider all
possible risks and develop an approach
that results in an optimal plan for the
organization as a whole and not just for
each specific aspect.
Be aware that risk management
is a dynamic process
Steps in a Risk Management Process

 The identification and measurement of

potential risks or loss exposures.

 Analysis of alternatives and selection of the

“best” or “optimal” method of addressing the
potential risks.

 Periodic review and monitoring of the plan for

potential improvement or need for revision.
Identification – Traditional Risk
Management Viewpoint
 Direct property losses

 Indirect losses of income and extra expenses

following a property loss

 Liability losses

 Losses caused by death, disability, or

unplanned retirement of key people
Introduction to Risk Management and Insurance,
9/e, Dorfman, Mark S., Prentice Hall, 2008
Measurement: Evaluation of Risk
involves …

 estimation of the frequency (or probability) of

loss from a particular exposure
 estimation of the severity (or dollar amount)

of losses that occur

the total loss per exposure is the

product of these two measures
Analysis of Alternatives and Development of Risk Management Plan

The goal of risk management is to

minimize the cost of risk, not the level
of risk. While it might be nice to
reduce the level of risk to zero, at
some point it usually is not cost-
effective (i.e., it costs more than it is
worth to reduce the risk beyond a
certain point).
The total cost of risk includes three
things:

1. the cost of paying any expected losses that

remain your responsibility

2. the cost of the so-called "residual

uncertainty

3. the cost of the risk management method(s)

you have adopted.
We must stress that several factors
influence an organization’s risk
management plan including

 available financial resources

 attitudes toward risk

 the inability to protect against a risk.

An effective and efficient risk
management program minimizes
the impact of losses on the
bottom line.
Activities to Control Loss
 risk avoidance

 loss prevention

 loss reduction

These activities are designed to reduce the

frequency and severity of losses.
Risk Financing provides for
paying for those losses that do
occur

The Basic Decision is whether to

 Retain the Loss
 Transfer the Loss
Now, how does an organization determine
the balance between the cost of its risk
management plan and expected losses?

.. finally into my area!

Methods to Determine the Optimal
Amount of Loss Control

 Known Costs and Benefits

 Incorporating Time and the Time Value of

Money

 Decision Making Under Uncertainty

A Simple Example of Safety
Expenditures
A firm is deciding how much to spend to make
its workplace safer. The table on the next
slide provides a simple example of the effects
of varying levels of safety expenditures on the
frequency of accidents per employee per year.
For simplicity, insurance is ignored and it is
assumed that safety expenditures must be
made in incremental amounts of $500,000.
Note the diminishing returns for safety
expenditures.
Risk Management & Insurance, 2/e,
Harrington, Scott and Gregory Niehaus,
The McGraw-Hill Companies, 2004
 Average Loss Severity = $20,000 and Total Employees = 5,000

Accident Expected Total

Frequency Accident Expected Marginal Marginal
Safety per Cost per Accident Costs for Benefits
Expenditure Employee Employee Costs Loss from Loss
(a) (b) (c = a*b) (c*5,000) Control Control
$0 0.100 $2,000 $10,000,000    
500,000 0.080 1,600 8,000,000 $500,000 $2,000,000

1,000,000 0.070 1,400 7,000,000 500,000 1,000,000

1,500,000 0.066 1,320 6,600,000 500,000 400,000
2,000,000 0.063 1,260 6,300,000 500,000 300,000
 Marginal Costs for Loss Control
Marginal Benefits from Loss Control
2500000

2000000

1500000

1000000

500000

0
0 500,000 1,000,000 1,500,000 2,000,000

Safety Expenditure Level

Incorporating Time and the Time Value of Money

A firm is looking at the option of investing $15 million now

to improve the safety of its manufacturing facilities.
Assume
the firm will maintain a constant workforce of 5,000.
The benefits will accrue over a ten-year period.
Today, the firm estimates that the yearly frequency of
accidents per employee is 5%.
With the investment in safety, the annual frequency will
drop to 4% and the average severity of an accident will fall
from $20,000 to $15,000. Risk Management & Insurance, 2/e,
Harrington, Scott and Gregory Niehaus,
The McGraw-Hill Companies, 2004
That is it is estimated that the benefits to the
firm will be $2 million (5,000*.05*20,000 –
5,000*0.04*15,000) annually for the next 10
years.

On the surface, the decision appears to be an

easy one. Invest $15 million and obtain $2
million * 10 year = $20 million in benefits
 Cost of Capital 4.0%

Present Value
Expected Present Value of Expected
Year Cash Flow Factor Cash Flow

0 -$15 1.0000 ($15.0000)

1 $2 0.9615 $1.9231
2 $2 0.9246 $1.8491
3 $2 0.8890 $1.7780
4 $2 0.8548 $1.7096
5 $2 0.8219 $1.6439
6 $2 0.7903 $1.5806
7 $2 0.7599 $1.5198
8 $2 0.7307 $1.4614
9 $2 0.7026 $1.4052
10 $2 0.6756 $1.3511
All numbers in $millions
Net Present Value $1.2218
 Cost of Capital 5.6%

Present Value
Expected Present of Expected
Year Cash Flow Value Factor Cash Flow

0 -$15 1.0000 ($15.0000)

1 $2 0.9469 $1.8939
2 $2 0.8967 $1.7934
3 $2 0.8491 $1.6982
4 $2 0.8040 $1.6081
5 $2 0.7614 $1.5227
6 $2 0.7210 $1.4419
7 $2 0.6827 $1.3654
8 $2 0.6465 $1.2929
9 $2 0.6122 $1.2243
10 $2 0.5797 $1.1593
All numbers in $millions

Net Present Value ($0.0000)

Decision Making Under Uncertainty

 To this point we have assumed that costs and

benefits are known values and the optimal
decisions have been based upon knowing
those values with certainty.

 Most often, that is not the case and many

decisions must be made under conditions of
uncertainty.
The CEO of a firm believes that her VP for Finance is
providing confidential information to the competition .

If she fires the VP and he is the informer, she

estimates that the firm will gain $500,000.
If she fires him and he is not the informer, the firm

will lose his expertise and still have the informer.

The CEO estimates this outcome will cost her firm
$2.5 million.
If the CEO does not fire the VP, she estimates the

firm will lose $1.5 million regardless of whether or

not the VP is the informer since the informer will still
be employed by the firm.
Data Analysis and Decision Making with
Microsoft Excel, 3/e Revised, Albright, S.
Christian, Wayne L. Winston, and
Christopher J. Zappe, South-Western, 2009.
  State of Nature

Decision VP is Informer VP is Not Informer

Fire the VP -$0.5 $2.5

Do Not Fire the VP $1.5 $1.5

All costs in $millions with a negative cost being a gain

  State of Nature
VP is Not
Decision VP is Informer Informer Min Cost Max Cost

Fire the VP -$0.5 $2.5 -$0.5 $2.5

Do Not Fire the
VP $1.5 $1.5 $1.5 $1.5

MIN MIN
All costs in $millions with a negative cost
being a gain -$0.5 $1.5
Do Not Fire
Fire the VP the VP
When the probabilities of the states of nature are not known, there are other
options besides minimin cost (maximax profit) and minimax cost (maximin profit).
Those most widely presented include minimax regret, Hurwicz, and LaPlace.

The optimal decisions using each of these methods are displayed in this
Excel Table.
A key component of decision making under uncertainty when the probabilities for the states of nature are not known and cannot be estimated is the risk position of the decision maker.
  State of Nature

Weighted Cost
Decision VP is Informer VP is Not Informer

Fire the VP -$0.5 $2.5 $0.10

Do Not Fire the

VP $1.5 $1.5 $1.50

Probability 0.8 0.2 MIN

All costs in $millions with a negative cost being a gain $0.1

Fire the VP
This example could be extended to include the
possibility provided in the text:

Before deciding whether to fire the VP, the CEO

could order lie detector tests to avoid possible
lawsuits. The tests would need to be
administered to all employees at a cost of
$150,000. An extension of this option is that the
lie detector tests are not perfectly reliable and
she would need to incorporate the reliability
factors into the decision making process.
CEO decision on whether to fire vice president

Input Data
CEO's Option to Fire the VP-Finance
If VP-Finance is the informer $500,000
If VP-Finance is not the informer -$2,500,000

CEO's Option Not to Fire the VP-Finance

If VP-Finance is the informer -$1,500,000
If VP-Finance is not the informer -$1,500,000

CEO's Estimate that the VP-Finance is informant (lying) 0.80

Cost of Performing Lie Detector Tests $90,000

Probability that test indicates person is lying when actually lying 0.95
Probability that test indicates person is not lying when actually
not lying 0.85
Summary and Conclusions
From these examples, it should be clear that the development of a risk management plan is a very complex and difficult process that requires

 an understanding of potential losses

 the ability to measure those potential losses

 an understanding of alternatives available to manage the risks

 an understanding of the uncertainties surrounding the decision

 the ability to judge the risk stance of the decision makers

 knowledge of methods that can be applied to determine the

best path to address each risk.

References
 Data Analysis and Decision Making with Microsoft Excel, 3/e Revised,
Albright, S. Christian, Wayne L. Winston, and Christopher J. Zappe, South-
Western, 2009.

 Introduction to Management Science, 10/3, Taylor, Bernard W. III, Prentice

Hall, 2010.

 Introduction to Risk Management and Insurance, 9/e, Dorfman, Mark S.,

Prentice Hall, 2008, Chapter 3 – Risk Management, pp. 43-62, and Chapter
17 – Advanced Topics in Risk Management, pp. 324-343.

 Risk Management & Insurance, 2/e, Harrington, Scott and Gregory Niehaus,
The McGraw-Hill Companies, 2004, Chapter 11 – Loss Control, pp. 201- 213.
 Spreadsheet Modeling & Decision Analysis: A Practical Introduction to
Management Science, 6/e, Ragsdale, Cliff T., South-Western, 2011.

 Controlling Costs with Risk Management, 2011 Insurance Bureau of

Canada, http://www.ibc.ca/en/Business_Insurance/Risk_Management/.

 Making risk management a value-adding function in the boardroom ,

Brodeur, Andre and Gunnar Pritsch, McKinsey Working Papers on Risk,
Number 2, September 2008.

 Encyclopedia of Business, 2/e, Risk Management,

http://www.referenceforbusiness.com/management/Pr-Sa/Risk-Managem
ent.html

 The Sabanci Group on Risk Management,

http://www.sabanci.com/sabanci_i.asp?M=7&K=49&I=57
Questions?
 Thank You

Barbara A. Price
baprice@georgiasouthern.edu