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CORPORATE RISK MANAGEMENT

1. RISK What is it? DEFINITION Risk is a word used on a daily basis, its dictionary definition always refer to “chance of injury, harm or loss” as we always use this word on a negative context, referring to the risk of losing and the chance of winning. Risks are involved in everyday situations, from the Stock Exchange to the different decisions adopted on a small enterprise. There are different definitions of risk as stated by Vaughan (1997) (6):  Uncertainty of loss.  Possibility of loss.  combination of hazards.  risk is a condition in which a possibility of loss exists.  unpredictability – the tendency that actual results may differ from projected results.  probability of any outcome different from the one expected. Perception of risk may vary depending on what types of exposures we are considering. However, according to Vaughan (1997) and Allen (1995) there are two common elements: indeterminacy of outcome and loss. -By indeterminacy of outcome, it means that the outcome must be in question as for a risk to exist, there must always be at least two possible outcomes. And when an outcome is certain, there’s no risk. -Loss means that at least one of the outcomes is undesirable Dickson (1995) considers that there are three common threads: uncertainty, level or degree of risk and peril and hazard. A peril is an event or circumstance that causes or may potentially cause a loss, and hazard is an action or circumstance that makes a peril more likely to occur.

ELEMENTS and characteristics. What do we expect to see? 

Indeterminacy of outcome means that the outcome must be in question. For

CORPORATE RISK MANAGEMENT

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risk to exist there must always be at least two possible outcomes. Where an outcome is certain there is no risk. For example, a company car will depreciate in value due to wear and tear, passage of time, obsolescence, etc. the outcome is certain. On the other hand, we do not know if the car will be involved in an accident or be stolen, risk is present. Loss means that at least one of the outcomes is undesirable: the car may or may not be involved in an accident; the value of a share may rise, fall or remain steady. Vaughan stretches the definition of loss beyond that which is generally accepted and includes opportunity cost. For example, an investor who opts to buy share A in preference to share B may be considered to ‘lose’ if the gain in the share price of A turns out to be less than that of share B.

A PARTIR DE AQUI NO TAN IMPORTANTE Dickson (1995) considers that there are three common threads: uncertainty, level of risk, and peril and hazard, which will discuss in subsequent units Uncertainty : Uncertainty refers to a state of mind characterized by doubt, where there is lack of knowledge about what will or will not happen in the future. The word ‘doubt’ implies that an individual or organisation recognizes the possibility of different outcomes. However, risk may exist regardless of this recognition. For example, operators using a dangerous machine may be unaware that there is a fault likely to cause injury, pedestrians passing a building site may be unaware that scaffolding is about to collapse. Risk then involves a potential variation in outcomes, regardless of whether or not the individual/organisation facing a risk is aware of the existence of the potential variation, or the extent of such variation. This potential lack of awareness is an important feature so far as the process of risk management is concerned. In the above examples, the losses which could arise from claims for injuries may have been prevented by fixing guards on the machines or regular inspection of scaffolding. It is also possible that the individual or organisation may assume a risk where none exists, in which case the company could incur needless expenditure on risk prevention measures. This is can occur due to perception of risk which can be overstated due to individual attitudes. The cost may not only be a monetary penalty but also can be the cost of missed opportunities. An example is a senior member of staff perceives flying as unsafe and will only travel overland. There can be additional travel costs but also the cost of the time spent in additional travel time which may result in lost opportunities and business We need to distinguish between subjective risk, which is an individual’s or

CORPORATE RISK MANAGEMENT organisation’s perception of risk, and objective or actual risk. Corporate management decisions should be based on the latter and therefore it is important that we are able to analyse and evaluate risk systematically and control the exposure to risk within the organisation. To measure risk, we can use probability techniques. Certainty is the opposite of uncertainty and may be regarded as a situation in which the probability of an event happening is 100% or 1. Events are not possible (probability = 0), certain (probability = 1) or uncertain. Uncertainty, therefore, refers to probabilities between 0 and 1. To take this further, we should distinguish between objective uncertainty and subjective uncertainty. The former refers to situations where the events are identified and the probabilities are known. Examples are games of chance such as cards and dice. The probabilities are known as there are 52 cards in a full pack and six possible numbers on a die. Subjective uncertainty is where events are identified but the probabilities are unknown (Williams et al, 1997). Examples are fires, accidents and investments, so this Module is concerned with subjective uncertainty. In addition to considering the probability of risk we need to then estimate the possible outcomes in terms of loss or gain and make a reasoned decision based on all the information available to the organisation. Level or degree of risk From the examples and definitions that we have identified, we know that not all risks will result in a negative outcome. We also can say from experience that some activities are more risky than others. For example, we know that investment in shares is riskier than investment in debentures which is, in turn riskier than investing in a share account with a building society. What do we mean by ‘risky’? Do we mean that something is very likely to happen, or that if it happens it will have very serious consequences? For example, let us consider a company which wishes to expand into foreign markets and consequently employees will be expected to travel overseas on a regular basis. Is air travel risky? Some people regard air travel as being very dangerous, others point out that it is, in fact, one of the safest forms of travel. Who is right? The answer is both. Air travel is very safe in terms of the relatively small number of crashes, but is dangerous in terms of the potential consequences of a crash. Most air crashes result in substantial damage and loss of life.

Consequently, when we talk about the level of risk, we need to take the following into account:

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how often an event is likely to happen, specifically the probability of it happening, (this will be based on observations of the frequency with which a particular event has happened in the past)

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the extent of the potential outcome, specifically the likely cost, (this will be based on observations of the severity of past events). In practice, when we make observations of the types of losses which occur, two relationships tend to predominate.

High frequency, low severity This is where the majority of losses tend to be of a relatively small amount, for example, property damage of various kinds. If we consider damage to property, whether belonging to individuals or businesses, due to occurrences such as fires, thefts, storm damage, small losses tend to occur fairly often (burnt carpets, stolen videos, a few roof tiles dislodged), as compared to the major losses (houses burnt to the ground, whole house contents removed, roofs blown off) which are relatively infrequent. High frequency, high severity This is where the majority of the losses which occur are serious, such as air crashes, satellite failures, terrorist bombs. Note that we are referring to high relative frequency here. There are more serious fires than plane crashes, but a higher proportion of plane crashes are serious compared to the proportion of serious fires, in that the event of an occurrence the outcome of a plane crash is more likely to more serious than that of a fire. This shows that for every one major injury, there are 30 minor injuries and 300 noninjury incidents. The shape of the triangle indicates the relative frequency of serious losses. The first type of relationship described above – high frequency, low severity will have a distribution which is broad based with more minor losses, while the second relationship will have a much narrower base. These are shown in Figures 1.5 and 1.6 respectively. There is a further aspect to level or degree of risk – utility. This relates very much to the economic theory of utility in that it refers to the value an individual or business attaches to a risky situation. The disruption caused by a fire in the business premises will be highly significant to a company operating from a single outlet but will be much less so where the company has a large number of retail outlets and the fire is only in one of the retail stores. The loss of the only outlet belonging to a sole trader will be highly significant and may be catastrophic but the loss of an individual store to an organisation such as Marks & Spencer would be much less severe. In monetary terms,

CORPORATE RISK MANAGEMENT a loss of profits of £500,000 is devastating to a small company with an annual turnover of £1,000,000 in comparison with a large company with a turnover of £100,000,000. Cause of loss The third thread which enables us to analyze risk is the cause of the loss. Firstly, there is the prime cause of the loss, otherwise known as the peril. This is a term used to refer to the event which may cause a loss such as a fire, storm or motor accident. However, even where the same peril is likely to occur, the frequency and severity of the losses may differ because of various factors which can influence the final outcome. For example, a fire is likely to do much more damage to a timber framed building than to a stone building; a fire is more likely to occur in a factory where welding is taking place than in one where peas are being canned. These factors which can affect the outcome are known as hazards, and are usually categorised as physical and moral. Physical hazards relate to the physical characteristics of the risk being considered: the construction of a building, the type of goods being stored, the size of engine in a motor van. Moral hazard refers to the attitude and conduct of people which may affect the outcome: this may arise through carelessness, unreasonableness, or even criminal behaviour. Vaughan (1997) refers to a third type - morale hazard although many writers cover this whole area under the term moral hazard. This relates to the increase in the frequency and severity of losses when such losses are covered by insurance. It refers to the possibility that people who know that an outcome is insured against may take a different attitude to loss. For example, a business might concern itself less with loss prevention measures if it knows that the insurance company will cover the loss. There are also examples of morale hazard by third parties. In medicine, more expensive treatments may be authorised by doctors and consultants where medical insurance is involved. And juries may be inclined to agree bigger awards in damages, etc. where the loss is covered by insurance. Individual invest in financial products in the belief that the central authorities will protect them from loss or harm so will invest in riskier assets without considering the true nature of the investment risk For the purposes of this Module, since morale hazard is a sub-set of moral hazard, we shall restrict our classification to two types – physical and moral.

CLASSIFICATIONS AND AREAS OF RISK (4). BE ABLE TO CLASSIFY ONE RISK There are different ways of classifying risk. Almost all risks can be placed in one of the

CORPORATE RISK MANAGEMENT first two categories described below. These categories are not mutually exclusive, that is, risks are financial or non-financial, and pure or speculative and so on.  Financial/non-financial: -Financial risks are those where the outcome can be measured in monetary terms such as loss or damage to property or legal damages awarded. -Non- financial risks are those where the outcome cannot be measured financially and where it may result in negative effects such as dissatisfaction or loss of comfort. Examples could include dissatisfaction at making the wrong kind of purchase, embarrassment or loss of reputation as a result of our actions. Financial loss may also result from non-financial risks but may be incapable of measurement directly. For example, a jeweller (Gerald Ratner) comments that what his shops sell is ‘trash’. The result may be a loss of reputation and a fall in sales which subsequently contributed to the demise of Ratners Jewellers in the UK. However, it is impossible to attribute the total fall directly to the statement, since other factors may be involved such as the economic climate.  Pure/speculative: -Pure risks are those where the only possible outcomes are a loss or no change in the status quo. Fires, thefts, motor accidents are all pure risks; there is either a loss or no loss. -Speculative risks are those where the outcome may be a loss, no loss or a gain. They are sometimes known as business risks since many of them arise as a consequence of business decisions such as producing new products, entering new markets, investing in machinery or in shares. A business intends that these will result in a gain, but they may result in a loss or a break-even situation.  Fundamental/particular: -Fundamental risks are those which arise outwith the control of any one individual, or group of individuals. Their effects are usually widespread, and are felt by the whole of society, or a large number of people. They include natural causes or weather such as floods, earthquakes and famines, but also include social, political and economic changes such as inflation and unemployment. Difficult to control. -Particular risks are those which are more personal both in their causes and their consequences. They are to some degree under the control of the individual/organisation incurring the risk, and include risks such as fire, theft, legal liabilities and so on. The classification between fundamental and particular will have implications for the management of the risk. In the case of particular risks, much can be done to prevent the risk occurring such as fire precautions, secure locks and safety procedures. An

CORPORATE RISK MANAGEMENT organisation can do little to prevent fundamental risks, but can do much to ensure that their consequences are limited through flood barriers, emergency plans, redundancy insurance, and so on.  Diversifiable/non-diversifiable: This classification is in many ways concerned with the response to particular and fundamental risks. -Diversifiable risks (usually particular) are those which it is possible to reduce through pooling with other risks, in other words spread the impact of the risk across a number of risks or areas. -Non-diversifiable (usually fundamental) are those which cannot be reduced through pooling. Responses to diversifiable risks can include the following (3): ->Hedging - Where an investor or business holds a diversified portfolio of shares so that losses on one or more share(s) is offset by gains on other(s). Any technique designed to reduce or eliminate financial risk; for example, taking two positions that will offset each other if prices change. ->Loss sharing agreements - Where those facing similar risks group together to share the risks. This may be where individuals have similar interests: an example is the early days of insurance when ship owners grouped together to share losses. Later in the course we will see that one way in which organisations can handle risk is to form a group with other organisations in similar areas of work to share losses. ->Internal diversification - Where an organisation can spread the costs of losses among several units facing similar risks. For example, a business running a large fleet of cars may spread the costs of repairs among all the cars owned, so that the contribution for each car is relatively small. However, even in the examples given, non-diversifiable risk may still exist. Shares will be subject to systematic risk that is a risk which affects all shares, such as a stock market crash. Many ships or vehicles may be damaged at one time by extreme weather conditions such as a hurricane. Insurance companies’ can, to some extent, convert non-diversifiable risk into diversifiable risk by spreading the risk even wider by, for example, insuring a large number of cars. This can be achieved in some respects by the economies of scale that can be achieved by the insurance companies. This is a aspect that we shall return to later in the module when we consider Captive Insurance Companies. Even so, insurance companies will still be subject to non- diversifiable risk from, for example, a severe storm which results in a very large number of motor accidents.

CORPORATE RISK MANAGEMENT

RISKS FACED BY AN ORGANISATION (12) There are various risks which an organisation faces. However different writers may classify the risks in a number of different groupings although the following classification of risks mentions the most important (12): 

Physical risks: Loss or damage to the organisation’s physical assets due to natural perils such as fire, storm, flood, earthquakes and so on. Loss or damage may also arise through human actions such as accidental damage, theft, terrorism or vandalism.

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Interruption risks: Consequent upon the physical risk outlined, loss will include not only the cost of replacing the assets but the time involved in replacing them and returning to pre-loss levels of activity. During this time, the organisation’s earnings may be lost or reduced and increased costs may be incurred in ensuring the business continues to operate during the period. Caused by some perils.

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Personnel risks: Death or injury of employees can involve the organisation in the costs of compensation payments, time lost due to an accident and possible fines if breaches of safety legislation are involved. There will also be indirect costs, including the time spent in investigation of an accident and the costs of recruiting and training a replacement employee. The latter can be considerable if a key employee is involved. Right people, knowledge, skills, training.

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Labour risks: Apart from the risk of accident to employees, the organisation faces risks with regard to the quantity and quality of employees. It is dependent on the availability of suitable labour. Satisfaction and morale of the workforce is also important in maintaining productivity at target levels. In extreme circumstances organisations may be faced with the withdrawal of labour due to unsatisfactory conditions in the work place as the result of overtime bans; work to rule or strike action. Number of people, labour relations, union.

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Legal and liability risks: All organisations can be faced with very large potential legal liabilities to other parties. In addition to employees as mentioned, there may be claims for compensation from customers, neighbours, or members of the public generally who can be affected by their actions. In many cases this can be much greater where negligence can be proved on the part of the organisation For example, an incident involving physical harm to several individuals can result in compensation claims for millions of pounds, possibly considerably in excess of the net worth of the organisation. Legal liabi...