Chapter 1

The Nature of Risk:

Losses and Opportunities
 Uncertainty and Risk

• Uncertainty means having two or more

potential outcomes for an event or a situation
• Uncertainty is a precursor to risk
• Risk is a consequence of uncertainty (but risk
is not the same thing as uncertainty)
• If we have perfect certainty, we have no risk
 Understanding risk

• Risk can be emotional, financial, or

reputational
• Risk is anchored on a continuum of
maximizing value and minimizing losses
• Actual outcomes for an event or situation
often differ from expected outcomes: this
creates risk
 Attitudes Toward Risk (which impact
decisions)
• Different people have different attitudes
towards the risk-return tradeoff
• A risk-adverse person leans away from risk,
seeking as much security as possible
• A risk-neutral person remains equidistant
from the extremes of avoiding risk and
accepting risk
• A risk-seeking person embraces risk as long as
a gain is possible, although unlikely
 Types of Risks—Risk Exposures
• Risk exposure: the enterprise, property,
person or activity facing a potential loss
• Pure risk: facing loss with no chance of a gain
(purview of traditional risk management or
TRM)
• Speculative risk: a chance of either gain or loss
(purview of enterprise risk management or
ERM)
 Examples of Pure vs. Speculative
Risk Exposures
Pure Risk: potential loss but no
possible gain
• Physical damage to property
from fire, flood or other
natural disasters
• Liability risk: getting sued over
products; employment
practices
• Individual risk of mortality or
morbidity
• Manmade risks: war;
unemployment
• Global pandemics; social
program failure
Speculative risk: potential gain
or loss
• Market risk: interest rate
fluctuation, foreign
exchange volatility, stock
price
• Reputational risk
• Brand risk
• Individual credit risk
• Regulatory changes
• Accounting risk
 Main Sources of Loss
• Personal loss exposures: sickness, disability,
individual deaths; also impacts organizations
and society
• Property loss exposures
• Liability loss exposures: individuals and
organizations can get sued
• Catastrophic loss exposures
• Accidental loss exposures
Diversifiable vs. Non-diversifiable Risks
• Diversifiable risks: risks whose adverse
consequences can be mitigated simply by
having a diversified portfolio of risk exposures
• Non-diversifiable risks: risks, shared by all
persons or organizations, that cannot be
mitigated by adding exposures to the portfolio
 Examples of Diversifiable and Non-
Diversifiable risks
Diversifiable Risks Non-diversifiable Risks
• Reputational risk • Market risk
• Brand risk • Regulatory risk
• Credit risk • Environmental risk
• Product risk • Political risk
• Legal risk • Inflation and recession risk
• Physical damage risk • Accounting risk
• Operational risk • Pandemics, social security
• Strategic risk program risks
 Frequency and Severity
• Frequency is the number of times losses have
happened in a given time period, often 12
months
• Severity denotes how bad the loss has been in
both human and dollar terms
• Total cost of loss for a particular loss exposure
= (average severity) x (the frequency of loss)
 Perils and Hazards
• In risk management, a peril is the direct or
immediate cause of a loss (such as a fire or
automobile crash)
• A hazard is a condition that increases the
possible frequency or severity of a loss, or
both
– Moral hazard: deceit, often involves insurance
– Morale hazard: carelessness
– Physical hazard: tangible conditions (snow, ice)
 Enterprise Risk Management
• Enterprise risk management (ERM) is a newer
concept in risk management that takes a holistic
view of all of the possible risks an organization
faces.
• ERM considers speculative risks as well as pure
risks.
• ERM does not replace traditional risk
management (TRM), it expands upon TRM’s
practices and techniques to consider more risks
and offer additional solutions to finance or
manage them.
End of Chapter 1