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Risk Management Concepts Chapter · January 1998 DOI: 10.1007/978-1-4615-6187-3_4

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RISK MANAGEMENT CONCEPTS

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Objective This chapter explains the objective of risk management and describes the framework in which financing decisions including insurance are taken and evaluated. Many of these concepts important in business risk management are also applicable to individual economic agents.

The Evolution of Risk Management In an originally french published book in 1916, Henry Fayol identified risk management as a security function among the six basic functions of a business firm.1 In 1931, the American Management Association established its Insurance Division for exchanging information among members. In 1950 the National Insurance Buyers Association was created which became in 1955 the American Society of Insurance Management (ASIM). In 1969 the name of the society's magazine was changed from the National Insurance Buyers to Risk Management and in 1975 the name of the Society was changed to the Risk and Insurance Management Society (RIMS).2 Risk management has been re-discovered by multinational firms in the United States after World War II. The general trend in the current usage of risk management probably began in the early 1950s. One of the earliest reference to the concept of risk management in the literature appeared in an article by Russel Callagher in the Harvard Business Review in 1956.3 In October 1988 the first world congress on risk management was sponsored by the International Federation of Risk and Insurance Management Associations (IFRIMA). Today, the Association has 22 members around the world. The latest national association were created at the end of the 1980s in Singapore, Malaysia and the Philippines.

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The risk manager evolved from the insurance manager because risk management is broader than insurance in that it deals with the choice of the appropriate techniques for dealing with pure risks including insurance. Felix Kloman argued recently that "organizations have been challenged by newer and more dynamic risks, risks that have not been addressed effectively by the risk management that is tied to the insurance industry."4 His argument is that risks in an organization are closely interrelated and that the risk management function should address all risks in a comprehensive approach. Despite its potential and scope, risk management is not yet recognized as a major element of corporate organizations. The approach of analyzing specific industry uncertainties in isolation from general environmental uncertainties has come more often under criticism. It is also arguable that to confine risk management only to handling pure risks is too restrictive a view of its function since pure risks are inevitably intermingled with decisions bearing on business risks. An integrated managerial approach should analyze all the sources of uncertainties that affect the total risk of a firm.

The Objective of Risk Management According to asset pricing models in Finance, the risks specific to a firm are diversifiable and therefore irrelevant except as it affects the firm's systematic risk. However, corporations are majors purchasers of insurance and financial futures and forward contracts, sign long-term purchase and sales contracts, and engage in a variety of activities to avoid or reduce risks. One explanation of this behavior is that asset pricing models are concerned only with the effect of risk on market discount rates and for the most part ignore its effect on expected cash-flows. Value of firm = ∑[ Cash Flows at period t / ( 1+k)t ] where k is the market discount rate. Property losses are often not the only losses that occur when property is damaged or destroyed. Until that property is replaced or restored to its initial condition, the business may suffer a reduction in its net income either because revenues are decreased or because expenses are increased or both. Any action taken by a firm that decreases risks, improves its prospects for survival and provides greater assurance to potential customers that the company will be around in the future to service and upgrade its products. 5 Obviously, the relative importance of risk management activities will vary according to the corporation ownership. The existence of other claims, such as those of employees and suppliers, creates incentive for risk management.6 In the following discussion, the management is willing to take any action to reduce the preloss fire hazard and the postloss consequences.

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_____________________________________________________ DISCUSSION: Suppose that 3 toys manufacturers, YOTOYS, B.S.TOY and ZODI are sharing the same closed market and that a fire destroys the total inventories of toys of ZODI on November 20th. Because of delays in the production, ZODI will be unable to supply the market for Christmas and the two competitors will mainly benefit from this situation. At the end of the year, ZODI will report losses whereas YOTOYS and B.S.TOY will enjoy unexpected higher profits. An investor holding a diversified portfolio of stocks of the three companies will be almost unaffected by the event ( assuming there is no tax effect ). On the other hand the lenders and bondholders may become concern about the future of the firm because they have prior claim to shareholders on the firm's revenues. They may expect a relative stability of revenues. Statistics show a number of firms going bankrupt after a major fire. Similarly there is in this case a conflict of interest between the owners of the firm and the managers and workers, because the later want to ensure their own survival. _____________________________________________________

The Survival Objective After the disaster at the Union Carbide plant in Bhopal, India that occurred in December 1984 and killed or injured thousands of individuals, the price of the stock on the market dropped by 40% overnight. The company's reputation came under intense attack by the news media worldwide and the accident threatened Union Carbide's survival. Institutional ownership of the company stock dropped from 60 percent to 35 percent. In the second half of 1985, to avoid takeover by GAF corporation, Union Carbide was forced to take a series of cost-cutting measures. Some plants were closed and Carbide had to sell its profitable consumer products division. Professors Robert Mehr and Bob Hedges in their risk management text have classified the objectives in risk management as postloss and preloss. Survival is often considered as the most important objective of a firm. The other possible objectives include (1) the continuity of operations, (2) the stability of earnings and preservation of growth, and (3) a good public image. They also explained how risk management activities inevitably reflect the anxiety level of the

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managers and are directed toward specific goals and objectives, for example, a "quiet night's sleep" may be one of the managerial objectives. Because the management of a firm is often directly concerned with problems of injury or damage to employees and to the public in general, social responsibility or "good citizenship" is important. Mehr and Hedges argued "If results after a loss are a matter of indifference, no reason remains to consider the loss before it happens." 7 On the other hand, a firm may not be prepared to take a chance of polluting a river even though it may be able to accept the risk and its financial consequences. Similarly, any airline company places great emphasis on its safety record and prefer to avoid adverse publicity. Risk management is a specialized aspect of the overall financial management of an enterprise. The objectives must be consistent with the financial objectives and as in other financial management problems, alternatives are evaluated by considering their potential financial advantages and risks. While the objective of management in general is the conservation of assets and the maximization of the wealth of the shareholders, the objective of risk management is to make sure that losses that arise because of existing risks do not prevent management from meting its goal. Although risk management principles and procedures are applicable to a wide variety of problems, they are generally limited to the problems that arise from the existence of pure and static risks. Since risk management does not generate revenues, in the traditional sense of the term, the evaluation of alternative programs will be made on comparative costs. The objective of risk management has frequently been stated as the "minimization of costs".

Methods of Handling Risks It must be recognized that risk management is still in a development state. Willett considered that the ways of meeting risk for "a man in isolation" or a business firm, could be classified into avoidance, prevention and assumption. Then, he explained that "a man living in society" had the same opportunities but that he could also consider other courses of action such as distribution, transfer and combination of risks. Risk management like other areas of management, is concerned with establishing or identifying objectives, gathering relevant information regarding the nature of the problem and the environment, evaluating the costs and benefits of alternatives using modern analytical techniques, and choosing the alternative that is most consistent with the goals and objectives. Doherty (1982) suggests that the risk management process can be represented in terms of the responses to the following questions: 1. What is the problem? (identification) 2. What is the magnitude of the problem? (measurement) 3. What can be done about the problem? (decision)

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The Risk Management Process Hazard (or Risk) Identification One of the most critical functions of risk management is probably the identification process. A failure to recognize the existence of one or more potential events can result in financial disaster. The importance of being able to anticipate the existence of the problem before it materializes is recognized by everyone but unfortunately there is no scientific method or systemic approach to the identification process. In the extreme case, the very existence of the risk may be unknown. In the past, exposure identification has largely been exercised in terms of those exposures that are insurable and in terms of the company past experience. The most difficult part of the identification process is that it requires that the manager be clairvoyant and continually asks "what if" questions. Williams and Heins (1989) define risk identification as "the process by which a business systematically and continuously identifies property, liability and personnel exposures as soon as or before they emerge." 8 Several approaches to the identification process have been suggested and most of them consist of an evaluation of all the operational characteristics of the firm. Checklists of potential risks have been developed by risk management associations, risk management consulting firms or insurance companies and they are mainly based on a questionnaire approach. On-site inspections are usually an indispensable complement to a questionnaire. Other approaches have been suggested based on flow-chart methods, financial-statement methods or contracts analysis.9 Professor John O'Connell has identified four components in a systematic approach to identifying the exposures of a particular firm: (1) customers, (2) suppliers, (3) competitors and (4) regulators.10 The greatest difficulties for the identification function have probably occurred in the recent past in the area of legal liabilities. Job or position analysis is another area for risk identification. In dealing with job description, manpower management enumerates the duties of an employee, analyzes how the functions are performed and should also identify potential dangers to the employee or the organization. The Taylorism focused attention on the man and machine relations. Frederick Taylor's emphasis upon the physical environment of the job points out a natural area of interest to risk identification.11

Risk Measurement Once the risks have been identified, the risk manager must evaluate them. The process of creating data is known as measurement. This means measuring the potential size of the loss and the probability that it is likely to occur. Information is needed concerning two dimensions of each risk exposure:

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(1) the frequency of occurrence and (2) the severity of the losses that will occur. Information is collected for the purpose of description of a phenomena, evaluation and prediction. It is usually desirable to summarize the data by preparing frequency distributions. The presentation of data can bring a very useful information on the causes or consequences of a phenomena. Table 4.1 gives an example of the causes of accidental deaths in India. One difficulty that is encountered in the measurement process is that an event may give rise to both direct and indirect costs. Direct losses involve the direct costs associated with (1) property exposures, i.e. replacing or repairing damaged or destroyed property, (2) liability exposures and (3) personnel exposures, expenses resulting from death, injury or sickness. Indirect losses are those that arise as a consequence of direct losses.

Risk Assessment Loss-frequency and loss-severity data do more than identify the important losses. They are also extremely useful in determining the way to handle the situation. Risk assessment aims to determine how serious a hazard is and whether individuals or the society should be exposed to it. One aspect to the idea of risk measurement relates to the basic premise that the ability to predict the outcome of a risk is critically dependent upon the quantity and reliability of information relating to the phenomenon that is being investigated. In some cases, however, the uniqueness of the situation is such that it is difficult to measure and hence to assess the risk. In all risky situations, there are three important determinants which are information, control and time. Crisis management often refers to the lack of time to assess the risk and take a decision. Lack of control and/or lack of information about the risk in a crisis management situation are also usually the rule. Despite an appearance of objectivity, risk assessment is inherently subjective. The motion picture "Jaws", has increased the availability (and perceived likelihood) of sharks attacks. Some nuclear power proponents feel that the risk of that technology are exaggerated in the public' eye because of excessive medium coverage. Fischhoff et al.(1981) consider that the acceptability of a risk is a relative concept rather than an absolute one and therefore, there can be no single, all-purpose number that expresses the acceptable risk for a group or a society.

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Table 4.1 Incidence of Accidental Deaths in India Classified According to Causes During 1982 Causes of Accidental Deaths

Number

Percentage to total Number

A. Natural Causes Lighting Heat Strokes Floods Land Slides Cold and Exposure Cyclone

1,754 492 699 596 391 505

1.4 0.4 0.6 0.5 0.3 0.4

1,874 356 1,157 22,199 735 624 12,789 102 161 14,555 22,632 6,864 3,299 1,437 32,790 ________

1.5 0.3 0.9 17.6 0.6 0.5 10.1 0.1 0.1 11.6 18.0 5.4 2.6 1.1 26.0 ______

125,993

100.0

B. Other Causes By Fire Arms By Explosion By House Collapse On Road In Factories In Mines/Quarry Disaster In Railways In Air Crashes By Boat Capsize By Fire By Drowning By Poisoning By Snake Biting By Animal Killing/Biting Miscellaneous Causes

TOTAL

Source: Accidental Deaths and Suicides in India, Bureau of Police Research and Development, Ministry of Home Affairs, 1982.

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_____________________________________________________ DISCUSSION: In 1982 in the Chicago area, several bottles of Tylenol capsules, a pain remedy, contained cyanide that caused the death of seven people. There was little information about what was happening and what was causing it? Was the problem a local problem only? Johnson and Johnson, the pharmaceutical company, had inadequate control of the situation and action had to be taken immediately. J&J decided to recall and test all Tylenol capsules in Chicago and to test samples from other marketing areas (a total of 31 million bottles). Three months after the tragedy had begun, J&J announced to the public that Tylenol products were being distributed in a new "tamper-resistant" package that had three safety features: 1) A cellophane wrap on the box, 2) The cap is sealed with a plastic ring and, 3) The bottle is foil sealed. Despite losing most of its very large 35% share of the market of pain remedy (an estimated $100 millions in losses), within one year the product had bounced back to over 25%. _____________________________________________________ Risk perception differs greatly according to personal experience, but also psychological anxieties of a subjective nature. For example Cohen (1964) found that English football players tended to overestimate their abilities to score a goal from a long distance but underestimate their abilities to score from a short distance. Usually the level of perceived risk drops when the event has become "acceptable" in society. Furthermore, risk perception is linked to the appropriateness of a technical solution. 12 Availability bias is illustrated in numerous studies in which subjects are asked to judge potential hazards or risky situations. Contemporary issues in risk analysis have look at public perceptions, determinants of "perceived risks" and what makes a risk "acceptable".13 An interesting series of studies on perceived risks have been done by Professors Fischoff, Lichtenstein and Slovic, at the University of Oregon, USA. For example, to determine perceived risk, subjects were ask to judge the annual frequencies of death from each of 41 causes, including diseases, accidents, homicide, suicide and natural hazards. Table 4.2 lists the causes whose frequencies were most seriously misjudged. Overestimated death rates are the well-publicized causes of death such as botulism, tornadoes and flood. People underestimate chronic causes that are unspectacular, undramatic or events that are common in non-fatal form.

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Table 4.2 Bias in Judged Frequency of Death Most Overestimated

Most Underestimated

Motor vehicle accidents Pregnancy, Childbirth, Abortion Tornadoes Flood Botulism Homicide

Diabetes Stomach cancer Lightning Stroke Tuberculosis Asthma

Source: Lichtenstein S., Slovic , P., Fischhoff, B., Layman , M. and Combs, B., "Judged Frequency of Lethal Events," Journal of Experimental Psychology: Human Learning and Memory, vol. 4, 1978, pp. 551- 578. See also Slovic, P., Fischhoff, B. and S. Lichtenstein, "Facts and Fears: Understanding Perceived Risks," in R.C. Schwing and W.A. Albers (Eds.) (1980) for an extended analysis.

Risk may be avoided: Risk is avoided when an individual economic agent refuses to take an action that gives rise to the risk. This is not possible in many situations and very unsatisfactory at the level of the society. Avoidance through abandonment is much less common but it does occur ...