Topic 1 - The Human Race and Risk

(Chapter 1-Vaughan)

From its beginning, the human species

has faced the risks of misfortune and
adversity.

The earliest risks included survival, not

only individually, but as a species.

Our continued existence is testimony to

the success of our ancestors in dealing
with the risks of adversity and misfortune.
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Primitive Humans Responses

to Risk

Some human responses to risk were

identical with those of other animals.

Some risks were avoided instinctively.

Other risks were reduced through the

unique gift of human reason.

A distinguishing human feature is in the

way we deal with risk
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Primitive Responses to Risk

Creation

of tools

Banding

together - for strength & sharing

Saving

- which led to private property

Evolution of Business Risks

It can be argued that business itself was

an effort to deal with risk.

Business and commerce brought new

risks, which required new techniques for
dealing with them.

Evolution of Business Risks

Two innovations in particular are

noteworthy
Money
Legal System

Invention of Money

Important implications for commerce,

private property, and accumulating wealth

Initially, the focus was on preservation

and protection of self and tangible
property from perils that could cause loss.

With introduction of money, tangible

assets that were lost or damaged could be
replaced if the owner had financial assets.
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Money - Credit

The invention of credit meant that assets

could be acquired every by those who did
not have financial assets, if someone was
willing to to lend them money.

This, in turn, created risks for the lender,

which they addressed by the interest
charges they made for loans.
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The Legal System

Invention of laws was a distinctly human

effort to deal with risk.

By defining individual rights and

responsibilities, the legal system created a
framework whose basic function was to
protect those rights.

OTHER COMMERCIAL
INNOVATIONS
3000

BC

Chinese merchants shared risk by distributing

goods among each others boats
Basically a method of risk sharing

1800 BC - CODE OF
HAMMURABI

Code of Hammurabi made provision for

transfer of the risk of loss from merchants
to moneylenders.

Borrower was excused from repayment of

loan if property was taken by bandits

Babylonian moneylenders undoubtedly

loaded their interest charges to
compensate for this transfer of risk.
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Loan Forgiveness Provisions

Loan-forgiveness was adapted to risks of

sea trade by Phoenicians and by Greeks

Loans to shipowners with the ship pledged

as security were called bottomry

contracts.

Loans to merchants where cargo was

pledged as collateral were called

respondentia contracts.

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900 BC: General Average

Developed

by seafarers from the Island of

Rhodes as a method of sharing risk
a maritime convention for sharing losses
among participants in a venture
participants share in loss of property
intentionally sacrificed in proportion to their
interest in the total venture.
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GROWTH OF BUSINESS RISKS

Industrial revolution witnessed the

application of steam to the production
process, and with steam came new risks.

Early steam engines were hazardous

devices and explosions were common.

Also caused injury to workers and

eventually led to system of workers
compensation.
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GROWTH OF BUSINESS RISKS

Electric power followed steam and was in

turn followed by nuclear power.

With each new era, new risks arose.

Because old risks remain, the inventory of

risks increased geometrically.

Modern business corporations and not-forprofit entities face a profusion of risks.

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RISKS OF THE MODERN

BUSINESS ENVIRONMENT
Many of the risks facing business today
were unknown a generation ago.
Some of these new risks arise from
changes in the legal environment

environmental damage,
discrimination in employment,
sexual harassment, and
violence in the workplace.
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MODERN BUSINESS RISKS

Other

risks accompanied the emergence of

the age of information technology;
interruptions of business resulting from
computer failures,
privacy issues, and

computer fraud
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Nuclear Hazards

incident at the Three Mile Island nuclear

facility in Pennsylvania in 1979

Accident at the Soviet Union's Chernobyl

plant in April 1987

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Terrorism

Bombing

World Trade Center in 1993

Oklahoma Federal Building in 1995

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Perils of Nature

Hurricane Andrews $22 billion plus in

damages

1993 floods that ravaged the Midwest

United States in 1993

Earthquakes in California and Kobi, Japan

in 1993 and 1994.
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Increasing Dollar Amount of Loss

Increase in amount of losses not solely a

function of increasing number of losses

Even those losses that arise from perils of

nature--windstorms, earthquakes, floods-have exhibited increasing values.

There is simply more wealth, investment,

and more assets exposed to loss.
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Increasing Dollar Amount of Loss

As

business has become more capital

intensive, as technology of production
becomes more costly, capital investment
increased.

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The Concept of Risk

1. The basic problem with which risk

management deals.

2. Risk management theorists have not

been able to agree on a definition of risk.

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Common Elements in Definitions

of Risk

1.
Indeterminancy - at least two
possible outcomes

2.
Adversity - at least one of the
outcomes is undesirable

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The Texts Definition of Risk

Risk

is a condition in which there is the

possibility of an adverse deviation from a
desired outcome that is expected or hoped
for.
1. Risk is not subjective - a state of the real world
2. Risk can exist whether or not it is perceived
3. Risk can be imagined where possibility of loss
does not exist
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Uncertainty and
its Relationship to Risk

1. The most widely held meaning of

uncertainty refers to a state of mind
characterized by doubt.

2. It is contrasted with certainty, as in

I am certain I will get an A in this course
I am uncertain what grade I am going to
get.
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The Degree of Risk

1.

What is more risk or less risk?

2.
Varies with the probability of
deviation
from what is expected in case of aggregate
data

from what is hoped for (no loss) in case of

individual
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Risk Distinguished From Peril

and Hazard

Peril:

the cause of loss

Hazard: a condition that creates

or increases the chance of loss

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Classifications of Hazards
- probability of loss
Physical peril of fire due to low grade of materials used in
constructing the building

Moral/criminal
entitlement

Morale

dishonest person claims more than

careless attitude; leave car keys that increase the

possibility for car theft

Legal

hazard arise from court decision; statutory liability;

dishonest tendencies in human fraudsters on the loose

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Classifications of Risk

Business involves investment of assets

Possibility of loss in investments (risk)
(Vaughan, 1997, p/13)

Financial and non-financial risks

Loss of assets in money as invested
Loss of animals and greens lead loss of quality living

Static and dynamic risks

Fundamental and particular risks
Pure and speculative risks

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Static and Dynamic Risks

1. Dynamic risks result from changes in the

economy (e.g., changes in price levels,
consumer taste, income, and output).
benefit society in the long run, by adjusting
misallocations of resources

2. Static risks would exist even in the absence

of economic change (from perils of nature or
human dishonesty; sudden death).
not a source of gain to society
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Fundamental and Particular

Risks
1. Fundamental risks are impersonal in origin and
consequences. They are societal risks.
It is held that society (rather than the individual)
should deal with them.
E.g. unemployment, build factory in a residential area

2. Particular risks involve losses that arise out of individual

events and are felt by individuals rather than the entire
group.
Particular risks are considered the individuals own
responsibility that are properly addressed by the
individual.
E.g. Daylight robbery/fraudster misappropriate records and
gained money/benefit

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Pure and Speculative Risks

1.

Speculative risks involve the possibility of loss or gain.

They are voluntarily accepted because of the
possibility of gain.

2.

Pure risks involve the possibility of loss or no loss only.

3.

E.g. gambling

E.g. car accident

In general, insurance deals with pure risks only.

Homework: observe insurance policies and underwriting

clauses

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Classifications of Pure Risk

p16

1. Personal risks loss of income/assets due to premature death,

2. Property risks

sickness/disability, unemployed

Direct: in a fire, value of the building diminishes

Indirect loss: As a consequence of this fire, the owner loses the use of
building during the period of reconstruction loss of sales

3. Liability risks

Unintentional/intentional injury to other persons (protected by law)

Car accident: person at fault to cover/compensate losses suffered by
the 3rd party

4. Risks arising out of failure of others

Agreement violated and non-compliance

Contracts not accomplished; building not finished; contractors run
away
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The Burden of Risk

1. Some losses will occur

2. The cost of accumulated reserves

3. Deterrent effect on capital accumulation

4. Higher cost of capital

5. Feeling of frustration and mental unrest

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Methods of Dealing With Risk

1.

Avoidance

2.

Reduction

3.

Retention

4.

Transfer

5.

Sharing
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BUSINESS RISK MANAGEMENT

Some people suggest that risk management is

superfluous and even counterproductive to the
interest of corporate owners.

Although the argument focuses on insurance,

insurance is an alternative to other risk
management methods

The argument that businesses ought not insure

is, in effect, an argument that risk management
is unnecessary.
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Diversification as a Solution for

Pure Risks

Capital asset pricing model (CAPM) suggests

that the value of a firm is equal to the
discounted (present value) projected flow of
income it will generate for its owners.

According to the CAPM, sophisticated investors

will require a higher rate of return for stocks
that carry a higher degree of risk.

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Diversification and Pure Risk

Sophisticated investors do not consider

diversifiable risk and such risks therefore
do not affect a stocks rate of return.

Because investors can diversify asset

holdings, they require a risk premium only
for systematic (non-diversifiable) risk.

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Diversification and Pure Risk

Systematic or market risks are priced, but

diversifiable risk is not.

Therefore, reducing risks at the corporate

level which are diversifiable at the
portfolio level does not benefit
stockholders.

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Diversification and Pure Risk

Following from this premise, it has been

argued that corporations should never
purchase insurance.

In theory, stockholders can deal with pure

risks in the same way as speculative risks,
through diversification.

Purchase of insurance by a corporation

reduces the return to stockholders by
more than the reduction in risk.

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Diversification and Pure Risk

Insurance always costs more than the amount

paid in losses

The return on investment will be higher in a

diversified portfolio of stocks that do not insure
than for the same stocks if insurance is
purchased.

Some corporations will suffer catastrophic loss

and fail, but the overall return to investors will
be higher without insurance than with it.
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Diversification and Pure Risk

Although total risk may not affect the

required rate of return on stocks, a large
amount of diversifiable risk, if unmanaged,
can reduce the value of the firm.

While diversifiable risks may not affect the

investors discount rate (the denominator
in the discounted cash flow model), it can
significantly reduce the expected cash
flows (the numerator).

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Diversification and Pure Risk

The

impact of risk on the firms projected

cash flows stems from the effect of risk on
the variety of constituencies with which the
firm must deal.
Suppliers
Customers
Employees
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Diversification and Pure Risk

The higher the risks facing a firm, the less likely

that suppliers will offer preferential terms.

Customers become reluctant to deal with a firm

when they perceive that it has excessive risk and
might face distress in the future.

Riskier firms will have to pay employees more

than other firms to induce them to commit their
services to the organization.

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