The Human Race And Risk

The Human Race and Risk • From its beginning, the human species has faced the risks of misfortune and adversity. • The earliest risks included survival, not only individually, but as a species. • Our continued existence is testimony to the success of our ancestors in dealing with the risks of adversity and misfortune.

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Primitive Human’s Responses to Risk • Some human responses to risk were identical with those of other animals. • Some risks were avoided instinctively. • Other risks were reduced through the unique gift of human reason. • A distinguishing human feature is in the way 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 was an effort to deal with risk. • Business and commerce brought new risks, which required new techniques for dealing with them.

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Evolution of Business Risks Two innovations in particular are noteworthy • Money • Legal System

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Invention of Money • Important implications for commerce, private property, and accumulating wealth • Initially, the focus was on preservation and protection of self and tangible property from perils that could cause loss. • With introduction of money, tangible assets that were lost or damaged could be replaced if the owner had financial assets.

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Money - Credit • The invention of credit meant that assets could be acquired every by those who did not have financial assets, if someone was willing to to lend them money. • This, in turn, created risks for the lender, which they addressed by the interest charges they made for loans.

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The Legal System • Invention of laws was a distinctly human effort to deal with risk. • By defining individual rights and responsibilities, the legal system created a framework whose basic function was to protect those rights.

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OTHER COMMERCIAL INNOVATIONS 3000 BC Chinese merchants shared risk by distributing goods among each other’s boats Basically a method of risk sharing

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1800 BC - CODE OF HAMMURABI • Code of Hammurabi made provision for transfer of the risk of loss from merchants to moneylenders. • Borrower was excused from repayment of loan if property was taken by bandits • Babylonian moneylenders undoubtedly loaded their interest charges to compensate for this transfer of risk.

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Loan Forgiveness Provisions • Loan-forgiveness was adapted to risks of sea trade by Phoenicians and by Greeks • Loans to shipowners with the ship pledged as security were called bottomry contracts. • Loans to merchants where cargo was pledged as collateral were called respondentia contracts.

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900 BC: General Average Developed by seafarers from the Island of Rhodes as a method of sharing risk • a maritime convention for sharing losses among participants in a venture • participants share in loss of property intentionally sacrificed in proportion to their interest in the total venture. 1-12

GROWTH OF BUSINESS RISKS • Industrial revolution witnessed the application of steam to the production process, and with steam came new risks. • Early steam engines were hazardous devices and explosions were common. • Also caused injury to workers and eventually led to system of workers compensation

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GROWTH OF BUSINESS RISKS • Electric power followed steam and was in turn followed by nuclear power. • With each new era, new risks arose. • Because old risks remain, the inventory of risks increased geometrically. • Modern business corporations and not-forprofit entities face a profusion of risks.

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RISKS OF THE MODERN BUSINESS ENVIRONMENT • Many of the risks facing business today were unknown a generation ago. • Some of these new risks arise from changes 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 of the age of information technology; • interruptions of business resulting from computer failures, • privacy issues, and • computer fraud

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Nuclear Hazards • incident at the Three Mile Island nuclear facility in Pennsylvania in 1979 • Accident at the Soviet Union's Chernobyl plant 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 Andrew’s $22 billion plus in damages • 1993 floods that ravaged the Midwest United States in 1993 • Earthquakes in California and Kobi, Japan in 1993 and 1994.

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Increasing Dollar Amount of Loss • Increase in amount of losses not solely a function of increasing number of losses • Even those losses that arise from perils of nature--windstorms, earthquakes, floods-have exhibited increasing values. • There is simply more wealth, investment, and more assets exposed to loss. 1-20

Increasing Dollar Amount of Loss As business has become more capital intensive, as technology of production becomes more costly, capital investment increased.

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The Concept of Risk 1. The basic problem with which risk management deals. 2. Risk management theorists have not been able to agree on a definition of risk.

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Common Elements in Definitions of Risk 1. Indeterminancy - at least two possible outcomes 2. Adversity - at least one of the outcomes is undesirable

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The Text’s Definition of Risk Risk is a condition in which there is the possibility of an adverse deviation from a desired outcome that is expected or hoped for. 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 and its Relationship to Risk 1. The most widely held meaning of uncertainty refers to a state of mind characterized 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 to get.” 1-25

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 aggregate data • from what is hoped for (no loss) in case of individual

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Risk Distinguished From Peril and Hazard Peril:

the cause of loss

Hazard:

a condition that creates or increases the chance of loss

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Classifications of Hazards Physical Moral Morale

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Classifications of Risk 1. Financial and non-financial 2. Static and dynamic 3. Fundamental and particular 4. Pure and speculative

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Static and Dynamic Risks 1. Dynamic risks result from changes in the economy (e.g., changes in price levels, consumer taste, income, and output). • benefit society in the long run, by adjusting misallocations of resources 2. Static risks would exist even in the absence of economic change (from perils of nature or human dishonesty). • not a source of gain to society 1-30

Fundamental and Particular Risks 1. Fundamental risks are impersonal in origin and consequences. They are societal risks. • It is held that society (rather than the individual) should deal with them. 2. Particular risks involve losses that arise out of individual events and are felt by individuals rather than the entire group. • Particular risks are considered the individual’s own responsibility that are properly addressed by the individual. 1-31

Pure and Speculative Risks 1. Speculative risks involve the possibility of loss or gain. They are voluntarily accepted because of the possibility of gain. 2. Pure risks involve the possibility of loss or no loss only. 3. In general, insurance deals with pure risks only. 1-32

Classifications of Pure Risk 1. Personal risks 2. Property risks 3. Liability risks 4. Risks arising out of failure of others

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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 1-34

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 is superfluous and even counterproductive to the interest of corporate owners. • Although the argument focuses on insurance, insurance is an alternative to other risk management methods • The argument that businesses ought not insure is, in effect, an argument that risk management is unnecessary. 1-36

Diversification as a Solution for Pure Risks • Capital asset pricing model (CAPM) suggests that the value of a firm is equal to the discounted (present value) projected flow of income it will generate for its owners. • According to the CAPM, sophisticated investors will require a higher rate of return for stocks that carry a higher degree of risk.

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Diversification and Pure Risk • Sophisticated investors do not consider diversifiable risk and such risks therefore do not affect a stock’s rate of return. • Because investors can diversify asset holdings, they require a risk premium only for systematic (nondiversifiable) risk.

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Diversification and Pure Risk • Systematic or market risks are priced, but diversifiable risk is not. • Therefore, reducing risks at the corporate level which are diversifiable at the portfolio level does not benefit stockholders.

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Diversificaiton and Pure Risk • Following from this premise, it has been argued that corporations should never purchase insurance. • In theory, stockholders can deal with pure risks in the same way asspeculative risks, through diversification. • Purchase of insurance by a corporation reduces the return to stockholders by more than the reduction in risk. 1-40

Diversification and Pure Risk • Insurance always costs more than the amount paid in losses • The return on investment will be higher in a diversified portfolio of stocks that do not insure than for the same stocks if insurance is purchased. • Some corporations will suffer catastrophic loss and fail, but the overall return to investors will be higher without insurance than with it. 1-41

Diversification and Pure Risk • Although total risk may not affect the required rate of return on stocks, a large amount of diversifiable risk, if unmanaged, can reduce the value of the firm. • While diversifiable risks may not affect the investor’s discount rate (the denominator in the discounted cash flow model), it can significantly reduce the expected cash flows (the numerator). 1-42

Diversification and Pure Risk The impact of risk on the firm’s projected cash flows stems from the effect of risk on the variety of constituencies with which the firm must deal. • Suppliers • Customers • Employees 1-43

Diversification and Pure Risk • The higher the risks facing a firm, the less likely that suppliers will offer preferential terms. • Customers become reluctant to deal with a firm when they perceive that it has excessive risk and might face distress in the future. • Riskier firms will have to pay employees more than other firms to induce them to commit their services to the organization 1-44