1st UNIT

Risk Management and its

Objectives
 1. Meaning of risk
2. Types of risk facing business and
individuals
3. Risk management process and methods
Outline

4. Risk management in organization structure

5. Need for risk management objective
6. Understanding cost of risk
7. Firm value maximization and cost of risk
8. Individual Risk management and cost of
risk
9. Risk management and Societal Welfare
 INTRODUCTION

✓ Risk exists everywhere in the society. It is being

part of a daily life of individual and business.
✓ In recent years, many passengers died in road
and aircraft accident.
✓ Every year we hear news that millions of people
suffered from tsunami,earthquake,explosion of
atomic station,landslides,flood and drought.
✓ Due to natural calamities and disaster people are
losing their lives health as well as their property.
 INTRODUCTION

✓ Not only personal life and property, business is

also suffering from various risks and compels to
face financial and non financial losses.
✓ There are various accidents like theft of cash and
goods, caught by fire on warehouse, employees
in job-related accidents, changing consumer
tastes that transform their profits into losses,
production of faulty products and complaint by
the customers and loss of business and of
employee dishonesty.
 INTRODUCTION

✓ A real estate business may suffer loss from the

downfall the price of land and buildings,
investment company might face serious loss due
to declining of market place.
✓ The severity and frequency of the risk may be
different from person to person, business to
business time to time and place to place. It is
almost impossible to have the state of riskless
situations.
✓ Risk is considered as an universal phenomenon.
 CONCEPT OF RISK

✓ From above example we may perceive that risk is

related to financial loss.
✓ But, all types of loss are not measured in terms of
money.
✓ So, loss impacts on two aspects: financial aspects
and non-financial aspect.
 MEANING OF RISK

Writers have produced a number of definitions of

risk.
Some definitions are as follows;
- risk is the possibility of an unfortunate event.
- risk is the combination of hazard
- risk is unpredictability – the tendency that actual
results may differ from predicted results
- risk is uncertainty of loss
- risk is the possibility of loss .
 Nature/Characteristics of Risk
✓ Chance of loss-Risk means chances of loss which may
occur at any time.
✓ Transferrable, not avoidable-Risk can be transferrable but
not avoidable like personal, property & liability risk are under
the pure risk which can be transferred to the insurer.
✓ Unfavorable and Undesirable- No ones desires any type of
risk but unexpected events may occur suddenly in human
life.So,risk is unfavorable and undesirable.
✓ Peril and Hazard-Peril results in damage of property and
hazard are any condition that creates or increases the
chances of loss.
✓ Pure and speculative-Pure is loss or no loss and
speculative is either profit or loss is possible.
 Chances of Loss

1 2 4
3 5

Risks upon Unwanted

3D Loss Measured in money
situation

6
•Death
Life
•Damage Property Insurance indemnifies
Life
Third party
•Destroy
Property& Third
party
 Chances of Loss

✓ Chances of loss is related to concept of risk.

✓ It is the profitability that a loss will occur, which
can either be an expected loss or an actual
loss, divided by the number of exposures to
loss, or the sample population.

✓ Chances of loss= Expected loss or Actual loss

Number of Possible Loss
 Chances of Loss

✓ For Example:
✓ In a city,1 lakh car owners purchased insurance
policy against car accident, car theft and injury.
✓ The historical data shows that average accident
loss of car among the policyholders per year is 50
cars.
✓ Here, number of possible loss is 1 Lakh and actual
or expected loss is 50.
✓ In this case, chances of loss is 0.05%
 Perils

✓ It is the main cause of accident.

✓ It can be defined as the cause of loss or the
contingency that may cause loss.
✓ Perils refer to the immediate causes of loss.
✓ If a house burns because of fire, the peril is fire.
✓ If a car is damaged in a collision with another car,
collision is the peril.
✓ Perils that cause damage to the properties include
fire,earthquakes,theft,earthquakes,theft,windstorm.
 Hazards

✓ Hazards are the conditions that increase the

chances of loss.
✓ Economic slow down is a peril that may cause a
loss to the business, but it is also a hazard that
may cause a heart attack or mental shock to the
proprietor of the business.
✓ Types of hazard are
1. Physical Hazard
2. Moral Hazard
3. Morale Hazard
4. Legal Hazard
 Hazards

✓ Physical Hazard- A physical situation that increases

the chances of loss is called physical hazard.eg
defective construction of bridge increase the chances
of breakdown.
✓ Moral Hazard- It is the dishonesty/attempt to fraud or
character defects in an individual that increases the
chances of accident e.g.. Intentionally burning unsold
goods that are insured.
✓ Morale Hazard- It is the carelessness or indifference
to a loss because of the existence of insurance.
Normally some insured are careless to a loss because
they have insurance.
 Hazards

✓ Legal Hazard: It refers to characteristics of the legal

system or regulatory environment that increase the
frequency or severity of losses. Legal hazard can also
result from the regulations that force insurance
companies to cover risks. If legal system is more
liberal to insured and more rigid to insurer, if consumer
protection law is more powerful, if movement of
consumer rights is more aggressive at that situation
insurer need to pay more compensation.
✓ For example: alcohol is excluded in health insurance
but if court order to pay the compensation to insured
who used alcohol and died.
 Types /Classification of Risk

1. Pure Risk

2. Speculative Risk

3. Fundamental & Particular Risk

4. Dynamic & Static Risk

5. Financial Risk
 Types /Classification of Risk

6. Demand Risk

7. Environmental Risk

8. Personal Risk

9. Input Risk

10.Transferrable Risk
 Pure Risk

✓ It is a situation in which there are only the

possibilities of loss or /no loss.
✓ The outcome can only be unfavorable to us or leave
us in the same position as we enjoyed before the
event occurred .
✓ The risk of a motor accident, fire at a factory, theft
of goods from a store, injury at work are all pure
risks, with no element of gain.
✓ Personal risk, property risk and liability risk are
under pure risk.
 Speculative Risk

✓ It is a situation in which either profit or loss is

possible.
✓ Investing money in shares is a good example.
You will earn profit if the price of shares
increases, but will lose if the price of share
declines,
✓ The other examples may be like in real estate
business, betting in horse race
 Fundamental Risk

✓ Fundamental risks are those risks which affects the

economy as a whole, such as risk of floods,
earthquake, economic crisis etc.
✓ It is a risk that affects large number of people within
the economy.
✓ Nepal is suffering big loss of property and human lives
from floods, landslides every year.
✓ Terrorist attack in US affect the US economy.
✓ Such risk are not insured by private insurers but
supported or insured by the government .
 Particular Risk

✓ Risk affecting only individuals is known as

particular risk.

✓ Particular risk do not affect the entire society.

✓ It is personal risk rather than social risk.

✓ For example: car accident, theft, store fire etc.

✓ Such risk is insured by the private insurers

 Dynamic and Static Risks

✓ Dynamic risks are from the changes that take

place in every society that is economic, social,
technological, environmental and political
changes.

✓ Static risks are those risks which exists in

absence of such changes.
 Financial and Demand Risk

✓ Financial Risk-For establishment and operation of

business there is need of financial resources but
there is risk associated with this financial
transaction due to changes in economic factors like
market interest rate, fluctuation of exchange rate.

✓ Demand Risk-Success of a company largely

depends on the demand of its product they produce
or sell ,but as the demand for the product
decreases with time there is a risk associated with it
for the business which is the demand risk.
 Environmental Risk

With the production activities in the factories there is

affect in the environment and the health of people
due to environment pollution which leads to shift of
the company from the present place or the
investment in that location to control or prevent
pollution. So, the cost involved in this process leads
to environmental risk.

✓ Shift of Himal Cement Factory due to environment

pollution.
✓ Shift of whole cotton industry in Balotra,India.
 Personnel , Input and Transferable risk
Personnel risk-The risk associated due to involvement
of employees in fraud and dishonesty behavior in
organization can create greater loss to organization
which is called personnel risk.

Input risk-With the increase in cost of raw material or

the labor cost it becomes difficult for companies to
operate their business so risk associated with it is input
risk.

Transferable/nontransferable risk – Those risk like

personal ,property,liablity risk which can be transferable is
called transferable risk. but risk like risk of civil war is not
covered by insurance which is nontransferable risk.
 Types of Risk Facing Business and Individuals
✓ Major types of business risk are:
1. Price risk: Price risk is divided into output price risk
and Input price risk, Three specific types of price risk
are: commodity price risk, exchange rate risk and
interest rate risk.

2. Credit risk

3. Pure risk
 Types of Risk Facing Business and Individuals

1. Price risk: Price risk refers to uncertainty over the

magnitude of cash flows due to possible changes in
output and input prices.

Output prices risk refers to the risk of changes in the

prices that a firm can demand for its goods and services.

Input price risk refers to the risk of changes in the prices

that a firm must pay for labor, materials and other inputs
to its production process.
 Types of Risk Facing Business and Individuals

1. Price risk:
✓ Three types of price risk are commodity price risk,
exchange rate risk and interest rate risk.
✓ Commodity price risk arises from fluctuations in the
price of commodities such as copper,oil,gas,electricity.
✓ Due to globalization of economic activitiy,output and
input prices for many firms also are affected by
fluctuations in foreign exchange rates.
✓ Output and input prices also can fluctuate due to
changes in interest rates.
 Types of Risk Facing Business and Individuals

2.Pure risk
Pure risk creates great financial insecurity for
individual and society. The major types of pure
risk are.

1. Personal Risks
2. Property Risks
3. Liability Risks
 Types of Risk Facing Business and Individuals

1. Personal Risks:
✓ The risks that directly affect an individual are known
as personal risks.
✓ They involve the possibility of the complete loss are
reduction of earned income, extra, expense and the
depletion of financial assets.
✓ There are four major personal risks.
a) Risk of premature death
b) Risk of insufficient Income after Retirement
c) Risk of Poor Health:
d) Risks of Unemployment:
 Types of Risk Facing Business and Individuals

2. Property Risk:
✓ All non living things owned by persons are
property. Real state land and building, vehicles
machines and equipments goods raw materials
furniture etc are the common examples of
property damaged or lost from numerous causes.
✓ Real estate and personal property can be
damaged by fire lightening tornadoes,
windstorms, earthquakes floods etc. There are
two major types of loss associated with the
destruction or theft or property.
 Types of Risk Facing Business and Individuals

3. Liability Risk

✓ Risk to a company arising from the possibility

of liability for damages resulting from
the purchase, ownership, or use of a good
or service offered by that company.
✓ Liability risk can be identified and reduce
through careful product design and testing, but
may also be natural in the nature of
the product to some extent, as in the case
of automobiles or pharmaceutical supplies.
 Types of Risk Facing Business and Individuals

3. Credit Risk
✓ The risk that a firm’s customers and the parties to which
it has lent money will delay of fail to make promised
payments is known as credit risk. Most firms face some
risk for account receivable.
✓ The exposure to credit risk is particularly large for
financial institutions such as banks that routinely make
loans that are subject to risk of default by the borrower.
As a result ,borrowing exposes the firm’s owner to the
risk that the firm will be unable to pay its debt and thus
be forced into bankruptcy, and the firm generally will
have to pay more to borrow money as credit risk
increases.
 Burden of risk on Society
1. Emergency fund

2. Loss of certain goods and services

3. Worry and fear

 Burden of Risk on Society

1.Emergency Fund
✓ People have been facing various risk.
✓ Your house might be damaged by earth quake, car
may be stolen and health may be deteriorated
suddenly.
✓ If you have not purchased insurance policy to
protect from these risk, you need to spend large
amount of fund to recover such a loss.
 Burden of Risk on Society

1.Emergency Fund
✓ If you are average income people, to manage big
amount of money you need to reduce your present
consumption results in a lower standard of living.
✓ Reduction in purchasing capacity affects the
economic cycle. It reduces the employment
opportunity, production volume, amount of
consumption and growth rate of economy.
 Burdens of Risk on Society

2. Loss of certain goods and services

✓ Another burden of risk is that we are missing certain
goods and services. Some companies already have
been stopped their manufacturing unit like child
vaccine, child food and medicines due to fear of
liability suits. If the product found damaged or
unhealthy or poor quality, producers have to pay
maximum compensation to the consumers or
victims.Company has to pay heavy compensation
which increases the amount of financial loss. Due to
fear of possible compensation, such products are
not more available in market.
 Burdens of Risk on Society

3. Worry and Fear

✓ Worry and fear are states of mind and relates to
psychological conditions. Unfavorable situations
creates worry and fear to people.
✓ Some people are always living in horrible situations
like parent worry children might face accident due to
different causes, students have fear of examination,
everyone is afraid due to health problems or
because of business or investment.
✓ All situation above may brings small or large
amount of loss is source of wear and fear.
 Risk Management

✓ Risk management is a process to identify loss

exposure faced by an organization or individual
and to select the most appropriate techniques to
overcome such exposures.
✓ Risk management is the management of various
risks that might affect a business firm.
✓ Its purpose is to identify potential loss situations
and control or reduce them through insurance,
elimination of risk or improve or additional safety
practices.
 Risk Management

✓ Risk management is a strategic process that

will protect the assets and ensure the financial
stability of an organization from the result of
competitive business decisions.
✓ Risk management will reduce uncertainty and
the potential for accidental or unanticipated
loss and will provide the basis for maximum
opportunity.
Process of Risk Management

Review the
Identify and Develop and
plan
measure execute a plan
continuously
potential to manage the
after it puts in
losses loss potential
operation.
Risk Management Process

1. Identify the loss exposures

2. Analyze the loss exposure

3. Select appropriate techniques for treating loss

exposures.

4. Implement, regular review and monitor the risk

management program.
1. Identify the Loss Exposures

✓ Before managing the risk, firm should have

enough knowledge on scope of loss
exposure.First,of all firm need to identify major
and minor loss exposures. Some important loss
exposures are:
1. Property loss exposure: Land and Building,
Plant and equipments, data and inventory,
valuable documents,receiveables etc.
2. Liability loss exposure: defective products,
environmental pollution, sexual harassment in
workplace, discrimination against employers,
lawsuit against the Director’s and officer’s.
1. Identify the Loss Exposures

3. Business income loss exposure: loss of

income by covered loss, continuing expenses
after loss, contingent business income loss.
4. Human resources loss exposure: death
and disability of key employees, job related
injuries or diseases experienced by workers.
5. Crime loss exposure: robberies, employee
theft and dishonesty, fraud and internet and
computer crime exposure, theft of intellectual
property.
1. Identify the Loss Exposures

6. Employee benefit loss exposure: Failure to

obey with government regulations, failure to pay
promised benefits.
7. Foreign loss exposure: acts of terrorism,
foreign currency risk, kidnapping of key
personnel, political risk.
8. Reputation and public image of the
company: misinformation from media about
the company, clients complains on public
hearing.
2. Analyze the Loss Exposure

✓ This step involves an estimation of the frequency

and harshness of loss.
✓ It analyzes how many times loss occurs within
certain period and how large the size of loss occurs
within the same period.
✓ After analyzing and estimating the loss frequency
and severity, the risk manager selects the most
suitable techniques of handling risk.
✓ Loss severity is more important than loss frequency
because a single severity(earthquake and
tornado)which can finish large number of
exposures.
 3.Select appropriate techniques for
treating loss exposures
✓ The third step of risk management is to select
appropriate techniques to handle the loss
exposures.

1. Risk Control

2. Risk Financing
Risk Control
✓ Avoidance: It means not acquiring new loss
exposures or abandon loss exposure. It reduces
the chance of loss to zero. For example: a car
accidental loss can be avoided by not using car
to travel somewhere.
✓ Loss Prevention: It refers to reduce the frequency
of a particular loss. For example: road accident can
be controlled by strict examination of driving
license, orientation to drive before providing
license, restriction on the use of alcohol and drug
while driving and enforcement of highway safety
rules.
Risk Control

✓ Loss Reduction: It refers to minimize the

severity of loss using risk reduction techniques.
✓ For example: installation of automated sprinkler
system promptly controls the fire, assigning the
security personnel in gate reduces the
possibility of theft, installation of CC camera and
TV reduces the loss of goods.
Risk Financing

✓ It is another technique that provides funding of loss.

✓ Major risk financing techniques are: risk retention,
noninsurance risk transfers and commercial
insurance.
✓ The ability of assuming risk is function of a firm’s
financial capacity. Risk retention means retaining
the risk by exposure unit itself. on Insurance risk
transfer means transferring the risk by hold
harmless agreement, futures contract and hedging
.Commercial insurance means purchasing
insurance policy to cover the certain loss.
Risk Financing

1. Retention: Retention of firm means firm itself

hold a part or all of the losses that can result
from a given loss. There are two types of risk
retention techniques: active or passive.
a) Active retention: it means firm need to aware
of the loss exposure and plan to retain a part or
all of it.
b) Passive retention: it means failure to identify
the risk or loss exposures, failure to act or
forgetting to act.
Risk Financing
2. Non Insurance risk transfer: The potential risk is
transferred to another party with mutual agreement.
For example: a new plant may damage during the
transportation from manufacturer to factory site. The
possible risk of damage during the transportation can
be transferred to transportation company by written
agreement.
3. Commercial Insurance: it is the best way of risk
management.But,all risk are not insurable. Some risk
may not affordable by insurer and others may not be
practicable to implement. Insurer can get various
benefit from insurance, insurance reduces the
uncertainity,indemnify the loss, reduce the worry and
fear, increase the efficiency saves taxes in certain
limit.
4. Implement, regular review and monitor the risk
management program.

✓ It is selection of better method among the

available alternatives. The final step is
implementing the selected method regularly and
review and monitor in a period basis. This step
includes following procedures while
implementing risk management, they are
1. Formulation of policy
2. Co operation with other departments
3. Periodic review and evaluation
4. Implement, regular review and monitor the risk
management program.

1. Formulation of policy: At first management should

formulate appropriate risk management policy and risk
management manual. The manual should be a detail
documents including all roles and responsibilities.
2. Co operation with other departments: To
implement the policy, all departments of the
organization also should be coordinated by the risk
management department. All staffs posses knowledge
on risk management; they need to be trained and
acquired enough skill on risk handling techniques. All
departments should be responsible to decrease the
4. Implement, regular review and monitor the risk
management program.

2. Co operation with other departments: (Contd.)

the corporate risk of respective field such as account
department controls the cash misuse fraud and
internal operation system. All other department carry
on their respective works.
3. Periodic review and evaluation: The risk
manager must ensure whether the program is
implemented effectively and objectives are being
attained. If policy is not appropriate in a changing
environment, it should be revised. There should
be continuous review of risk management plan.
Benefits of Risk Management

1. Reduce the loss: Preventive measure is always

better than curative one. A small amount of money
spending in advance may save large amount of
loss in future.Pre-loss control is essential because
it is extremely useful to the organization. Spending
on pre loss activities prevent the larger potential
loss which ultimately increases firm’s profit.
2. Benefit to enterprise: Risk management
strategy saves unnecessary loss and maximizes
their earnings.Pre loss activities prevents large
amount of possible loss. It saves life of business
for long period, and it reduces the burden of risk to
manager.
Benefits of Risk Management

3. Benefit for individual: Personal health and peace

of mind is very important. Proper risk management is
a effective tool to take away personal anxiety, worry
and fear. People can do their work smoothly. They
can enjoy even they are working. They can travel
without fear, can sleep without bothering.

4. Benefit for the society: Society also gets benefits

from the risk management activities. It saves direct
and indirect expenses; reduces burden and anxiety,
pain and suffering. Risk management activities saves
huge amount of public fund spending from
unnecessary sector. The fund can invest in productive
and social security sector such
as:road,hospital,energy and school.
Personal Risk Management
✓ Personal risk management refers to identification of
pure risk faced by an individual or family, and to the
selection of the most appropriate techniques for
treating such risks.
✓ Personal risk management program involves four
steps:
1. Identify loss exposures
2. Analyze the loss exposure
3. Select appropriate techniques for treating the
loss exposures
4. Implement and review the program
periodically.
Personal Risk Management

1. Identify the loss exposures: As a human being,

a person might face various losses. These are as
follows:
a) Personal loss exposures which includes life and
health related loss and income related loss.
b) Property related loss exposures which includes
damage of home and other property due to
various reasons like fire,lightning,windstrom,flood
etc.
c) Liability related loss exposures includes insult
of character, negligence and carelessness
specially arise from the professional activities.
Personal Risk Management
2. Analyze of loss exposures: It involves to
estimate the amount of probable loss and
frequency of loss events. Chance of car theft,
chances of house damage, chances of robbery
of the house property and documents, chances
of motorcycle loss in fire or in accidents.
3. Select appropriate techniques for treating
the loss: loss can be minimized adopting
various technique like avoidance, risk
control,retention,non insurance transfer and
insurance.
Personal Risk Management
4. Implement and monitor the program
Periodically:
✓ It is to implement the personal risk
management program and review the program
periodically.Political,legal,social and cultural
environment is changing rapidly, personal
event also change time by
time,climate,weather,state of nature also
dynamic.
✓ So, that existing risk management program
need to review and monitor periodically.
Risk Management Functions

✓ Business has to perform different activities to

attain its objectives. Organization hires different
experts like:
1. Insurance expert
2. Financial risk manager
3. Claim manager
4. Loss control manager
5. Employee benefits specialist
6. Financial analysis
Risk Management Functions
1. Insurance expert: He purchases and renews the
organization’s commercial insurance policies.
2. Financial risk manager: His duty is to prepare
forward contract, purchase and sell future
contracts, hedging contract to prevent interest rate
risk,exchange rate risk and commodity price risk.
3. Claim manager: He needs to track and process
claims from the time of loss until the claim is
settled by the insurer.
4. Loss control engineer: His responsibility is
managing losses arising from such a thing as
defective products, employee injuries and
environmental pollution.
 Methods of Handling Risk

1. Avoidance
✓ Avoidance means elusion of certain events. If
you want to escape from risk, it is elimination of
risk.
✓ You can avoid the risk of a loss in the market
price of the stock by avoiding to buy of stocks.
You can avoid possible risk of business loss with
not doing the business and avoid the possibility
of divorce by not marrying. Many manufacturers
avoid legal risk by not manufacturing particular
products.
 Methods of Handling Risk

1. Avoidance
✓ Not all risk can be avoided like death.
✓ By avoiding risk, you may miss many pleasures
of life. Virtually any activity involves some risk.
✓ Where avoidance is not possible or
desireable.loss control is next better way of
reducing risk.
 Methods of Handling Risk

2. Loss of control
✓ Loss control means reducing the risk either by
loss prevention or loss reduction.
✓ Organization should find out best way to prevent
the life from accident and to prevent property
from damage.
✓ Thus, loss control has two major objectives:
a) Loss prevention
b) Loss reduction
 Methods of Handling Risk

a) Loss Prevention:
✓ Loss prevention aims at reducing the probability
of loss so that the frequency of losses is reduced.
✓ Examples like auto accidents can be reduced if
motorists take a safe-driving course and drive
defensively. The number of heart attacks can be
reduced if individuals control their weight, stop
smoking and eat healthy diets.
✓ Loss prevention is also important for business
firms like strict security measures at airports and
abroad commercial flights van reduce acts of
terrorism.
 Methods of Handling Risk

b) Loss Reduction: Strict loss prevention efforts

can reduce the frequency of losses, yet some
losses will certainly occur. It aims to reduce the
severity of a loss after it occurs.
✓ For example: a department store can install a
sprinkler system so that a fire will be promptly
extinguished. Community warning system can
reduce the number of injuries and deaths from an
approaching tornado. a plant can be constructed
with fire-resistant materials to minimize fire
damage.
 Methods of Handling Risk

3) Retention: It means that an individual or a

business firm retains all or part of a given risk.
✓ Risk retention can be active or passive.
✓ Active retention: it means that an individual is
consciously aware of the risk and deliberately
plan to retain all or part of it. For example: a
motorist may wish to retain the risk of a small
collision loss by purchasing an auto insurance
policy with a $500 or deductible.
 Methods of Handling Risk

3) Retention:
✓ Passive retention: risk can also be retained
passively. Certain risk may be unknowingly retained
because of ignorance, indifference or laziness.
✓ It is very dangerous if the risk retained has the
potential for destroying you financially.
✓ For example: many workers with earned incomes
are not insured against the risk of total and
permanent disability.However,the adverse financial
consequences of total and permanent disability
generally are more severe than the financial result of
premature death.
 Methods of Handling Risk

4) Non Insurance Transfers: Risk can be

transferred without purchasing of insurance policy.
There are four ways of transferring risk:
a) Transfer by contract

b) Transfer by hedging

c) Transfer by forming a corporation.

 Methods of Handling Risk

a) Transfer by contract :
✓ Unwanted risk can be transferred by contract. In
an agreement one party can declare that the
whole risk should be shared by another party.
✓ For example: the risk of a defective television or
stereo can be transferred to the retailer by
purchasing a service contract, which makes the
retailer responsible for all repairs after the
warranty expires.
 Methods of Handling Risk
b) Transfer by hedging: Hedging is a technique for
transferring the risk of unfavorable price fluctuations to a
speculator by purchasing and selling future contracts on
an organized exchange.

c) Transfer by forming a corporation: If a firm is a sole-

proprietorship, the owner’s personal assets can be
attached by creditors for satisfaction of debts. If a firm
incorporates, personal assets cannot be attached by
creditors for payment of the firm’s debts. In essence, by
incorporation, the liability of the stockholder is limited and
the risk of firm having insufficient assets to pay business
debts is shifted to creditors.
 Methods of Handling Risk

5) Insurance :
✓ This method is widely popular among the people,
businesses and other organizations. we can use to
transfer pure risks by paying a premium to an
insurance company in exchange for a payment of a
possible large loss.
✓ By using the law of large numbers, an insurance
company can estimate the amount of loss for a
given number of customers within a specific time.
 Components of the Cost of risk

1. Expected cost of losses: It includes the

expected cost of both direct and indirect losses.
As direct losses includes the cost of repairing or
replacing damaged assests,cost of paying
workers’ compensation claims to injured workers
and cost of settling liabilities.
Indirect losses includes reduction in net profit that
occur as a result of direct losses such as loss of
normal profit and continuing and extra expense when
product is stopped due to direct damage to physical
assets.
 Components of the Cost of risk

2. Cost of loss control:

✓ It reflects the cost of increased precautions and
limits on risky activity designed to reduce the
frequency and severity of accidents.
✓ eg: the cost of loss control for the pharmaceuticals
company would include the cost of testing the
product for safety prior to its introduction and any
lost profit from limiting distribution of the product in
order to reduce exposure to lawsuits.
 Components of the Cost of risk

3. Cost of loss financing:

✓ It includes the cost of self-insurance, the loading in
insurance premium and the transaction costs in
arranging, negotiating and enforcing hedging
arrangement and other contractual risk transfers. The
cost of self insurance includes the cost of maintaining
reserve funds to pay losses. This cost in turn includes
taxes on income from investing these funds as well as
the possible opportunity cost that can occur if
maintaining reserve funds reduces the ability of
business to undertake profitable investment
opportunities.
 Components of the Cost of risk

3. Cost of loss financing:

✓ Here when losses are insured, the cost of loss
financing through insurance only reflects the
loading in the policy’s premium for the insurer’s
administrative expenses and required expected
profit.
 Components of the Cost of risk

4. Cost of internal risk reduction methods:

✓ It includes transaction cost associated with achieving
diversification and the cost associated with managing a
diversified set of activities.
✓ It also includes the cost of obtaining and analyzing data
and other types of information to obtain more accurate
cost forecasts.
✓ For example: It involve paying another firm for this
information since a pharmaceuticals company may pay
a risk management consultant to estimate the firm’s
expected liability costs.
 Components of the Cost of risk

5. Cost of residual uncertainty:

✓ The cost of uncertainty that remains once the
firm has selected and implemented loss control
financing and internal risk reduction is called the
cost of residual uncertainty.
✓ Residual uncertainty also can reduce value
through its effects on expected net cash flow.
For example: residual uncertainty might reduce
the price that customers are willing to pay for
the firm’s product or cause managers or
employees to require higher wages.
Firms Value Maximization and Cost of Risk

Determinants of Value

✓ A business value to shareholders depends

fundamentally on the expected magnitude,
timing, and risk associated with future net
cash flows(cash inflow minus cash
outflows) that will be available to provide
shareholders with a return in investment.
17–80
 Firms Value Maximization and Cost of Risk

✓ Value depends on expected future net cash flows

and risk associated with these cash flows.
✓ Cash inflows primarily result from sales of goods
and services.
✓ Cash outflow primarily result from the production of
goods and services.
✓ Increase in the expected size of net cash flows
increase business value and decrease in expected
net cash flow reduce value.
✓ The timing of cash flows affects value because a
dollar received today is worth more than a
dollar received in future.
 Firms Value Maximization and Cost of Risk

✓ Since, most investors are risk averse, the risk of

cash flows reduces the price that they are willing to
pay for the firm’s stock and thus its value.

✓ A fundamental principle of business valuation is that

risk reduces values and increases the expected
return required by investors.

✓ The actual return on investors in any given period

will depend on realizations of net cash flows during
the period and new information about the expected
future net cash flows and risk.
 Firms Value Maximization and Cost of Risk

Maximizing Value by Minimizing the Cost of

Risk

✓ Unexpected increases in losses that are not

offset by cash inflows from insurance contracts,
hedging arrangements, or other contractual risk
transfers increase cash outflow and often reduce
cash inflows, thus reducing value of firm’s stock.
 Firms Value Maximization and Cost of Risk

Maximizing Value by Minimizing the Cost of Risk

✓ The effects of risk and risk management on firm

value before losses are known reflect their
influence on
1. The expected value of net cash flows
2. The compensation required by shareholders to
bear risk
 Firms Value Maximization and Cost of Risk

Maximizing Value by Minimizing the Cost of Risk

✓ To understand that making risk management

decisions to maximize business value requires
an understanding of how risk and risk
management methods affect
a) Expected net cash flows
b) Compensation for risk that is required by
shareholders
 Firms Value Maximization and Cost of Risk

Maximizing Value by Minimizing the Cost of Risk

✓ If the firm’s cost of risk is defined to include all

risk related costs from perspective of
shareholders, a business can maximize its value
to shareholders by minimizing the cost of risk:

Cost of Risk :Value without Risk-Value with risk

Value with Risk: Value without Risk-Cost of Risk
 Firms Value Maximization and Cost of Risk

Measuring the Cost of Risk

✓ In order to maximize business value by

minimizing the cost of risk, businesses ideally will
estimate the size of various components of cost
of risk and consider how these costs will be
affected by firm’s operating and risks
management decisions.
 Firms Value Maximization and Cost of Risk

Subsidiary Goals
✓ While the overall objective of risk management is
to maximize the business value to shareholders
by minimizing the cost of risk, a variety of
subsidiary goals is used to guide day to day
decision making.

Examples: Making insurance decisions to keep the realized

cost of uninsured losses below a specified percent of revenues,
purchasing insurance against any loss that could be large
enough to seriously disturb operations.
 Individual Risk Management and Cost of Risk

✓ The cost of risk also applies to individual risk

management decisions.
✓ For managing individual risk like say eg. Automobile
accident, an individual can consider
1. Expected losses(both direct & indirect)from accidents,
2. Possible loss control activities(such as driving less at
night)and cost of these activities,
3. Loss financing alternatives(amount of insurance
coverage)and cost of these alternatives.
4. Cost and benefits of gathering information (weather and
road conditions).
5. Cost of residual uncertainty which depends on the person’s
attitude toward risk.
 Individual Risk Management and Cost of Risk

✓ The amount of risk management undertaken by

individuals depends in part on their degree of
risk aversion.

✓ A person is risk averse if when having to

decide between two risky alternatives that have
the same expected outcome, the person choose
the alternative whose outcomes have less
variability.
 Individual Risk Management and Cost of Risk

For example:
✓ Suppose that you must choose between the
following alternatives.
✓ With alternative A you have a 50% chance of
winning $100 and 50% chance of losing $100.
✓ With alternative B you have a 50% chance of
winning $10000 and 50% chance of losing
$10000.
 Individual Risk Management and Cost of Risk

✓ Both gambles have an expected value equal to zero, but

alternative A’s outcomes have less variability. Alternative
B is risker than A.So,if you choose alternative A ,you are
risk averse and if choose B you are risk loving, and if
you are indifferent in between the two, you are risk
neutral.

✓ Rise averse people are willing to pay to reduce risk, or

must be compensated for taking on risk. For example:
risk averse people buy insurance to reduce risk and also
risk averse people require higher expected returns to
invest in riskier securities and the degree of risk aversion
can vary across people.
 Risk Management and Societal Welfare

✓ From a societal perspective, the key question is

how risky activities and risk management by
individuals and businesses can best be
arranged to minimize the total risk for society.
✓ This cost is the aggregate- for all members of
society- of the cost of losses, loss control, loss
financing, internal risk reduction and residual
uncertainty.
✓ Minimizing total cost of risk in society would
maximize the value of societal resources.
 Risk Management and Societal Welfare

✓ Minimizing the total cost of risk for society

produces an efficient level of risk.
✓ Efficiency requires individuals and businesses
to pursue activities until the marginal benefit
equals the marginal cost, including risk related
costs.
 RISK MANAGEMENT MATRIX
✓ The risk management matrix is used to assess
the risk and suggest the appropriate risk
management techniques.
✓ It suggests to anyone to follow the risk
management technique as per the frequency and
severity of risk.
✓ The formula of selecting the technique is
quite easy.
✓ If both severity and frequency of risk is very high
avoid the subject. There is no benefits of any
type of risk management tool to adopt.
 RISK MANAGEMENT MATRIX
✓ Similarly, if both frequency and severity of risk is
very low, there is no need to transfer the risk.

✓ Retaining the risk by oneself is cheaper than

buying insurance. Incase of high frequency but
low severity, need to minimize the loss using risk
control mechanism.

✓ The cost of risk control device should be cheaper

than total expected loss. If the severity of risk is
high and frequency of risk is low insurance is
best tool of risk management .
 RISK MANAGEMENT MATRIX

SEVERITY OF RISK

HIGH LOW
FREQUENCY OF RISK

PREVENTION &
HIGH RISK AVOIDANCE CONTROL

LOW INSURANCE RETENTION