Objectives of Risk Management

							 Objectives of Risk Management

   Maximize business value
     coherentwith minimizing risk costs
     major components of the cost of risk

 Goal for individuals and society
 conflicts between business and societal
  goals
    Business value maximization

 Consistent with economic profit max
 measured by stock price
                Cost of Pure Risk

 Pure Risk: reduction in SH value due to
  the presence of PR
 CPR = Value w/o PR - Value w PR
     impliesValue w PR = Value w/o PR - CPR
     Therefore decrease in CPR increases value
Components of Cost of Pure Risk

 E(Cost of losses)
 Cost of loss control
 Cost of loss financing
 Cost of reducing risk through
     diversification
     investing   in information
   Cost of residual uncertainty
               E(Cost of Losses)

   Direct
     property   damage
     WC
     defending   and settling liability claims
   Indirect
     loss of normal profits
     continuing expenses
     legal costs of reorganization or bankruptcy
          Cost of Loss Control

   Costs of precautionary measures
     safety  programs
     safety equipment
     limits on production to decrease exposure

   Inversely related to cost of E(L)
        Cost of Loss Financing

   Cost of self insurance
     taxes on investment income from
      contingency funds
     opportunity costs of capital

   Cost of insurance
     Premium   minus E(L)
    Cost of Internal Risk Reduction

 Diversification
 Investing in information
    Cost of Residual Uncertainty

 Higher employee wages
 Reluctant suppliers or customers
                    Question

   Why is risk not reduced to zero?
     because it is too costly to do so!
     example: driving a tank, literally

   Tradeoffs
     losses  vs loss control expenditures
     loss financing/internal risk reduction vs.
      E(Cost indirect losses)
    “    “            “      “ vs. cost of
      residual uncertainty
Measuring the Cost of Pure Risk

 It is costly to measure
 Some components are difficult
  (complex) to measure
 Small businesses have fewer options,
  and therefore often choose to not
  measure
    Other goals of business risk
           management

 Keep uninsured losses < x% TR
 Insure large, potentially disruptive losses
 Meet loan indenture provisions
 Spend on loss control when NPV > 0
    Objectives for Non-Profits and
            Governments

   Max value of products or services
    provided
     consistent   with minimizing the costs of risk
       – May care more about an interruption in service
       – greater access to capital for government
    RM Objectives for Individuals
           and Society

   Individuals
     max   E(U(W))
     since the cost of risk decreases wealth, this
      is resonant with min cost of risk
   Min Total cost of pure risk for society
     costs of losses, loss control, financing,
      internal risk reduction, and residual
      uncertainty
    Efficient level of risk in society

 pursue activities until MB = MC
 implies pursuit of loss control, financing
  and internal reduction until decrease in
  E(loss costs) = MC
 Is efficiency desirable goal?
     increases size of pie
     may redistribute slices
Objectives of Risk Management


    Questions?

    Thank you