The Tools of Risk Management

RISK CONTROL

Focuses on minimizing the risk of loss to which

the firm is exposed.

Includes the techniques of

• Avoidance
• Reduction.

3-1
 The Tools of Risk Management

RISK FINANCING

Concentrates on arranging the availability of

funds to meet losses arising from the risks that
remain after the application of risk control.

Includes the tools of

• Retention
• Transfer.

3-2
 Risk Management Decisions

Once risks have been identified and measured, a

decision must be made regarding what, if
anything, should be done about each risk.

This is the basic risk management problem.

There are several approaches that are used, or

that have been suggested as the approach to risk
management decisions.

3-3
 Traditional “Decision” Processes

Instinctive reactions

Learned behavior

Institutional Reactions

3-4
 “Good” and “Bad”
Risk Management Decisions

• One complexity in risk management decisions

is in distinguishing good decisions from bad
ones.

• Because risk management involves decision-

making under conditions of uncertainty, the
decisions are sometimes judged as good or
bad in ways that are inappropriate.

3-5
 “Good” and “Bad”
Risk Management Decisions

• A risk manager elects not to purchase the

umbrella liability policy suggested by his broker.
No losses occur and the firm saves $13,000.
• Another risk manager selects a $100,000
deductible in the fire insurance policies covering
her firm's plant. The saving is $18,000. A
$200,000 loss occurs.
• Another person against the advice of his agent,
carries collision coverage on an old truck worth
$1,000. The premium is $150. A loss occurs and
he collects $1000.
3-6
 “Good” and “Bad”
Risk Management Decisions

• There is something terribly wrong with labeling

each of these decisions as "good" or "bad"
based on the outcome.

• One cannot evaluate a decision made under

conditions of uncertainty in the light of what
happens after the decision is made.

• The evaluation must be made on the basis of

the information available at the time that the
decision is made.
3-7
 Heads or Tails?

• You and I wager $1 on the flip of a coin.

• I call “heads” but the outcome is “tails”

• Was my choice of heads a bad decision?

• Knowing what I knew about the probabilities —

that heads is as likely as tails— the decision is
as good a decision as I can make.
3-8
 Heads or Tails

• Now let us change the scenario.

• I offer to wager $50,000 on the flip of the same

coin ($50,000 which, by the way, I don’t have).

• You accept and flip the coin.

• The outcome is a head.

• Was my decision a good one?

3-9
 “Good” and “Bad”
Risk Management Decisions

• Decisions under conditions of uncertainty must

be judged in light of the information available at
the time the decision is made—that is, before
the outcome is known.

• On what basis should the decisions be judged

as good or bad?

• One criterion: how bad it will hurt if the

decision is wrong.

3-10
 Cost-Benefit Analysis

• Attempts to measure the suitability of a risk

management technique by measuring whether,
and by how much, the benefits the technique
produces exceed the cost of the technique.
• The greater the benefits for a given cost, or the
lower the cost for a given level of benefits, the
more cost effective the technique is judged to be.

• Cost-benefit analysis can be used to judge any

business decision where benefits and costs can
be determined.
3-11
 Cost Benefit Analysis

• When benefits will be realized over time (or

when costs will be incurred over time), they are
expressed as discounted cash flows.

• Major Impediments or problem with cost-

benefit analysis:

• Although costs are generally measurable,

benefits may not be.

3-12
 Utility Theory and Risk Management
Decisions

• Some writers have proposed that utility theory

be used as an approach to risk management
decisions.

• Utility theory was devised by economists to

explain why people make the choices they do.

3-13
 Utility Theory and Risk Management
Decisions

• Utility theory is based on the principle of

diminishing marginal utility: that utility or
satisfaction does not increase proportionately
with marginal increments of a good.

• Economists hypothesize that for most people,

money has a diminishing marginal utility

3-14
 Hypothetical Utility Function
Utility

Wealth in Dollars
3-15
 Hypothetical Utility Function
Utility

Wealth in Dollars
3-16
 Hypothetical Utility Function
Utility

600

$40,000 in wealth
produces 600 utils

$40,000

Wealth in Dollars
3-17
 Hypothetical Utility Function
Utility
900

600
$80,000 in wealth
produces 900 utils

$40,000 in wealth
produces 600 utils

$40,000 $80,000

Wealth in Dollars
3-18
 Utility Theory and Insurance Decisions

• Increasing wealth from $40,000 to $80,000, a

100% increase, produces only a 50% increase
in utility (from 600 to 900 “utils”).

• Can this information be useful in insurance

decisions?

• Some people have suggested it can.

3-19
 Utility Theory and Decision Theory

• To illustrate, assume the $80,000 in wealth

consists of $60,000 in the bank and a $20,000
automobile.

• Suppose there is a 10% chance the auto will be

destroyed in a collision.

3-20
 Hypothetical Utility Function

900
Wealth if auto
does not suffer
loss= $80,000

$80,000

Wealth in Dollars
3-21
 Hypothetical Utility Function

900
800
Wealth if auto
does not suffer
loss= $80,000

Wealth if auto
does suffers a
loss = $60,000

$60,000 $80,000

Wealth in Dollars
3-22
 Utility Theory

• Without insurance, the individual’s expected

level of satisfaction is

(.9 X 900 utils) + (.1 X 800 utils) = 890 utils

• Now assume that the cost of insurance is

$3000.

3-23
 Utility Theory

• If the individual purchases insurance, he is

guaranteed a net wealth position of $77,000
($80,000 minus $3,000).
• If utility of the guaranteed $77,000 is greater than
890 utils, the individual will purchase insurance.
• To make the choice, one must derive a utility
function that tells whether the person prefers the
guaranteed position of $77,000 or the uncertain
position of $60,000 or $80,000.
• How? We ask and he tells us.
3-24
 Problems With Utility Theory

• There is a serious question whether a person’s

utility function can be derived by asking
hypothetical questions.

• An individual’s utility function is constantly

changing with the environment.

• We can determine utility preferences more

directly by observing the individual’s decision.

3-25
 Problems With Utility Theory

• Utility function for two individuals will differ for

different risk situations.

• Utility approach to risk management decisions

suggests that there are a variety of correct
answers.

• The scientific approach view of risk

management suggests that there is a right
solution to every risk management problem.

3-26
 Problems With Utility Theory

Another problem is whose utility function to use?

• the risk manager’s ?

• stockholders’ ?

3-27
 Problems With Utility Theory

• Utility theory is useful in explaining why people

make the decisions they do.

• It is not intended to be normative--to define

what decisions people should make.

• The study of risk management has as one of its

goals changing the utility function of risk
management decision makers.

3-28
 Decision Theory and
Risk Management Decisions

Types of Decision-Making Situations

• Decision making under certainty

• Decision making under risk

• Decision making under uncertainty

3-29
 Criteria for Decision Making Under Risk

V(d3, S1) = $100,000

Payoff (value) of decision 3, given state 1 = $100,000

3-30
 Expected Value

State 1 State 2 Expected

No Loss Loss Occurs Value

Insure - $1,500 X .99-$1,500 X .01$1,500

Retain $0 X .99 - $100,000 X .01

$1,000

Expected value is an appropriate

strategy when the results will be 3-31
repeated over a large number of trials.
 Minimax Regret

State 1 State 2 Expected

No Loss Loss Occurs Value

Insure - $1,500 - $1,500 $1,500

Retain $0 - $100,000-
$100,000

3-32
 Minimax Regret

Minimax Regret is an appropriate strategy when

the maximum cost associated with one of the
outcomes is unacceptable to management.

3-33
 Decision Theory and
Risk Management Decisions

• Note that the expected value strategy will

always suggest retention over insurance.

• Note also that the minimax regret strategy will

always suggest transfer (insurance) over
retention.

• The question then, is when is which strategy

appropriate?

3-34
 The Rules of Risk Management

Don't Risk More Than You Can Afford to Lose

Consider the Odds

Don't Risk a Lot for a Little

3-35
Risk Characteristics as Determinants of Tool

High Low
Frequency Frequency

High
Severity

Low
Severity

3-36
Risk Characteristics as Determinants of Tool

High Low
Frequency Frequency

High Avoid
Severity Reduce

Low
Severity

3-37
Risk Characteristics as Determinants of Tool

High Low
Frequency Frequency

High Avoid
Severity Reduce Transfer

Low
Severity

3-38
Risk Characteristics as Determinants of Tool

High Low
Frequency Frequency

High Avoid
Severity Reduce Transfer

Low Retain
Severity Reduce

3-39
Risk Characteristics as Determinants of Tool

High Low
Frequency Frequency

High Avoid
Severity Reduce Transfer

Low Retain
Severity Retain
Reduce

3-40
 The Special Case of Risk Reduction

1. A technique should be used when it is the

lowest cost approach for the particular risk.
2. Humanitarian considerations and legal
requirements sometimes dictate that loss
prevention and control be used when they
are not the lowest cost approach.
3. OSHA requires employers to incur expenses that
might not be justified based on a marginal-
revenue/marginal cost analysis.
4. Building codes impose similar mandates.
3-41
 Common Errors in Buying Insurance

1. Buying too much

2. Buying too little

3. Buying too much and too little at the same

time

3-42
 Priority Ranking for Insurance Coverages

Essential insures against losses that could

cause bankruptcy

Important insures against losses that would

require resort to credit

Optional insures against losses that could

be met from assets or cash flow

3-43
 Large Loss Principle

1. Probability that a loss may or may not occur is

less important than potential severity of the loss.

2. Important question is not “can I afford the

insurance?” but “can I afford to be without it?”

3. When available dollars cannot provide all the

essential and important coverages required, a
part of the loss may be assumed through
deductibles.

3-44
 Insurance as a Last Resort

1. Insurance always costs more than the

expected value of the loss.

2. People who purchase coverage against small

loss exposures are trying to beat the
insurance company at its own game.

3. Insurance should be used as a last resort.

3-45