topic 1 - the human race and risk chap 1 vaughan.ppt

8/10/2019 TOPIC 1 - THE HUMAN RACE AND RISK CHAP 1 VAUGHAN.PPT

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Topic 1 - The Human Race and Risk(Chapter 1-Vaughan)

From its beginning, the human specieshas faced the risks of misfortune andadversity.

The earliest risks included survival, notonly individually, but as a species.

Our continued existence is testimony tothe success of our ancestors in dealingwith the risks of adversity and misfortune.


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Primitive Humans Responsesto Risk

Some human responses to risk wereidentical with those of other animals.

Some risks were avoided instinctively.

Other risks were reduced through theunique gift of human reason.

A distinguishing human feature is in theway 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


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Evolution of Business Risks

It can be argued that business itself wasan effort to deal with risk.

Business and commerce brought newrisks, which required new techniques fordealing with them.


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Evolution of Business Risks

Two innovations in particular arenoteworthy

Money

Legal System


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Invention of Money

Important implications for commerce,private property, and accumulating wealth

Initially, the focus was on preservationand protection of self and tangibleproperty from perils that could cause loss.

With introduction of money, tangibleassets that were lost or damaged could bereplaced if the owner had financial assets.


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The Legal System

Invention of laws was a distinctly humaneffort to deal with risk.

By defining individual rights andresponsibilities, the legal system created aframework whose basic function was to

protect those rights.


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OTHER COMMERCIALINNOVATIONS

3000 BC

Chinese merchants shared risk by distributinggoods among each others boats

Basically a method of risk sharing


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Loan Forgiveness Provisions

Loan-forgiveness was adapted to risks ofsea trade by Phoenicians and by Greeks

Loans to shipowners with the ship pledgedas security were called bottomrycontracts.

Loans to merchants where cargo waspledged as collateral were calledrespondentia contracts.


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900 BC: General Average

Developed by seafarers from the Island ofRhodes as a method of sharing risk

a maritime convention for sharing lossesamong participants in a venture

participants share in loss of propertyintentionally sacrificed in proportion to theirinterest in the total venture.


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GROWTH OF BUSINESS RISKS

Industrial revolution witnessed theapplication of steam to the productionprocess, and with steam came new risks.

Early steam engines were hazardousdevices and explosions were common.

Also caused injury to workers andeventually led to system of workerscompensation.


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GROWTH OF BUSINESS RISKS

Electric power followed steam and was inturn followed by nuclear power.

With each new era, new risks arose.

Because old risks remain, the inventory ofrisks increased geometrically.

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


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RISKS OF THE MODERNBUSINESS ENVIRONMENT

Many of the risks facing business todaywere unknown a generation ago.

Some of these new risks arise fromchanges 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 ofthe age of information technology;

interruptions of business resulting fromcomputer failures,

privacy issues, and

computer fraud


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Nuclear Hazards

incident at the Three Mile Island nuclearfacility in Pennsylvania in 1979

Accident at the Soviet Union's Chernobylplant 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 indamages

1993 floods that ravaged the MidwestUnited States in 1993

Earthquakes in California and Kobi, Japanin 1993 and 1994.


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Increasing Dollar Amount of Loss

Increase in amount of losses not solely afunction of increasing number of losses

Even those losses that arise from perils ofnature--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 capitalintensive, as technology of productionbecomes more costly, capital investment

increased.


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The Concept of Risk

1. The basic problem with which riskmanagement deals.

2. Risk management theorists have notbeen able to agree on a definition of risk.


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Common Elements in Definitionsof Risk

1. Indeterminancy - at least twopossible outcomes

2. Adversity - at least one of theoutcomes is undesirable


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The Texts Definition of Risk

Risk is a condition in which there is thepossibility of an adverse deviation from a

desired outcome that is expected or hopedfor.

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 andits Relationship to Risk

1. The most widely held meaning ofuncertaintyrefers to a state of mindcharacterized 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 toget.


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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 aggregatedata

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


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Risk Distinguished From Periland Hazard

Peril: the cause of loss

Hazard: a condition that createsor 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 inconstructing the building

Moral/criminaldishonest person claims more than

entitlement

Moralecareless attitude; leave car keys that increase thepossibility for car theft

Legal hazardarise from court decision; statutory liability;dishonest tendencies in humanfraudsters 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 theeconomy (e.g., changes in price levels,consumer taste, income, and output).

benefit society in the long run, by adjustingmisallocations of resources

2. Static risks would exist even in the absenceof economic change (from perils of nature orhuman dishonesty; sudden death).

not a source of gain to society


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Fundamental and ParticularRisks

1. Fundamental risks are impersonal in origin andconsequences. 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 individualevents and are felt by individuals rather than the entiregroup.

Particular risks are considered the individuals ownresponsibility that are properly addressed by theindividual.

E.g. Daylight robbery/fraudster misappropriate records andgained 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 thepossibility of gain. E.g. gambling

2. Pure risks involve the possibility of loss or no loss only. E.g. car accident

3. 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 risksloss of income/assets due to premature death,sickness/disability, unemployed

2. Property risks 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 reconstructionloss 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 issuperfluous and even counterproductive to theinterest of corporate owners.

Although the argument focuses on insurance,insurance is an alternative to other riskmanagement methods

The argument that businesses ought not insureis, in effect, an argument that risk managementis unnecessary.


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Diversification as a Solution forPure Risks

Capital asset pricing model (CAPM) suggeststhat the value of a firm is equal to thediscounted (present value) projected flow of

income it will generate for its owners.

According to the CAPM, sophisticated investorswill require a higher rate of return for stocksthat carry a higher degree of risk.


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Diversification and Pure Risk

Sophisticated investors do not considerdiversifiable risk and such risks thereforedo not affect a stocks rate of return.

Because investors can diversify assetholdings, they require a risk premium only

for systematic (non-diversifiable) risk.


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Systematic or market risks are priced, butdiversifiable risk is not.

Therefore, reducing risks at the corporatelevel which are diversifiable at theportfolio level does not benefit

stockholders.


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Following from this premise, it has beenargued that corporations should neverpurchase insurance.

In theory, stockholders can deal with purerisks in the same way as speculative risks,through diversification.

Purchase of insurance by a corporationreduces the return to stockholders by

more than the reduction in risk.


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Insurance always costs more than the amountpaid in losses

The return on investment will be higher in a

diversified portfolio of stocks that do not insurethan for the same stocks if insurance ispurchased.

Some corporations will suffer catastrophic lossand fail, but the overall return to investors willbe higher without insurance than with it.


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Although total risk may not affect therequired rate of return on stocks, a largeamount of diversifiable risk, if unmanaged,

can reduce the value of the firm.

While diversifiable risks may not affect the

investors discount rate (the denominatorin the discounted cash flow model), it cansignificantly reduce the expected cash

flows (the numerator).


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The higher the risks facing a firm, the less likelythat suppliers will offer preferential terms.

Customers become reluctant to deal with a firm

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

Riskier firms will have to pay employees more

than other firms to induce them to commit theirservices to the organization.

topic 1 - the human race and risk chap 1 vaughan.ppt

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