PBBF 303: FINANCIAL RISK MANAGEMENT AND INSURANCE LECTURE ONE FUNDAMENTALS AND TERMINOLOGY

1. PBBF 303: FINANCIAL RISK MANAGEMENT AND INSURANCE LECTURE ONE FUNDAMENTALS AND TERMINOLOGY

2. COURSE OBJECTIVES • Different meaning of risk • Definition of Perils, Hazard, Insurance • The Cost of Risk • Burden of risk on society • Direct and indirect losses • Basic categories of risk

3. Different Meaning Of Risk • The term risk has a variety of meanings in business and everyday life. At its most general level, risk is used to describe any situation where there is uncertainty about what outcomes will occur. • In probability and statistics, financial management, and investment management, risk is often used in a more specific sense to indicate possible variability in outcomes around some expected value.

4. Cont. • In other situations, the term risk may refer to the expected losses associated with a situation. In insurance markets e.g. it is common to refer to high-risk policy holders. (meaning of risk in this context is that the expected value of losses to be paid by the insurer is high) • Risk is also defined as uncertainty concerning the occurrence of a loss. Some authors make a careful distinction between objective risk and subjective risk.

5. Objective Risk • Also called degree of risk is defined as the relative variation of actual loss from expected loss. • E.g. A property insurer has 10,000 houses insured over a long period and, on average, 1% or 100 houses, burn each year. • In some years, as few as 90 houses may burn; in other years, as many as 110 houses may burn. Thus, there is a variation of 10 houses from expected number of 100, or variation of 10%. • This relative variation of actual loss from expected loss is known as objective risk.

6. Subjective Risk • Is defined as uncertainty based on a person’s mental condition or state of mind. • E.g. A driver who drinks heavily in a bar may foolishly attempt to drive home. The driver may be uncertain whether he will arrive home safely without being arrested by the police for drink driving. This mental uncertainty is called subjective risk. • In summary risk is sometimes used in a specific sense to describe variability around the expected value and other times to describe the expected losses.

7. Other Terminologies • Risk averse: The assumption that people find the possibility of suffering a large loss unpleasant, so they take minimum risk or avoid the risk. • Insurance is a financial arrangement that redistributes the costs of unexpected losses. Insurance involves the transfer of potential losses to an insurance pool. The pool combines all the potential losses and then transfers the cost of predicted losses back to those exposed.

8. Cont. • Peril is defined as the cause of the loss. Examples are fire, heart attacks and criminal acts. • If your house burns because of fire, the peril or cause of loss is the fire.

9. Cont. • A hazard is a condition that creates or increases the chance of loss. They are conditions that increase the frequency or the severity of losses. • There are four major types of hazards. • Physical hazard • Moral hazard • Morale hazard • Legal hazard

10. Physical Hazard • A physical hazard is a physical condition that increases the chances of loss. • E.g. of physical hazards include, defective wiring in a building that increases the chance of fire, a defective lock on a door that increases the chance of theft.

11. Moral Hazard • Moral hazard is dishonesty or character defect in an individual that increases the frequency or severity of loss. • E.g. include faking an accident to collect from an insurer, submitting a fraudulent claim, inflating the amount of a claim and intentionally burning unsold merchandise that is insured. • Moral hazard is present in all forms of insurance, and its difficult to control. Dishonest individuals often rationalize their actions on the grounds that the insurer has plenty of money.

12. Morale Hazard • Morale hazard is carelessness or indifference to a loss because of the existence of insurance. • Some insureds are careless or indifferent to a loss because they have insurance. • E.g. leaving car keys in an unlocked car, which increases the chance of theft; leavinga door unlocked that allows a burglar to enter. Careless acts like these increase the chance of loss.

13. Legal Hazard • Legal hazard refers to characteristics of the legal system or regulatory environment that increase the frequency or severity of losses. • E.g. large damage awards in liability lawsuit • The duration of settling court cases (in terms of defaulters owing a bank)

14. Risk Is Costly • Greater risk usually implies greater cost. E.g. suppose two identical homes are in different but equally attractive locations. The structures have the same value (GHc100,000), and initially there is no risk damage to either houses. • Then Accra Meteorologist announce that there is going to be severe storms which will flood one house which is in the potential impact area within the next week. (one house now has greater risk than the other) • Assume the probability of ones house being flooded is 0.1 (10%) and that the probability of the other house being flooded is zero (0%)

15. Cont. • Assume the house would be completely destroyed if the storm is to come (all GHc100,000 would be lost). Then the expected property loss at one house is greater by an amount equal to 0.1 times GHc100,000 or GHc10,000. • If the owner were to sell the house immediately following the release of news about the storm, potential buyers would naturally pay less than GHc100,000 for the house. Rational people would pay at least GHc10,000 less, because that is the expected loss from the storm. • Thus, greater risk – in the sense of higher expected losses- is costly to the original homeowner. The value of the house would drop by at least the expected loss.

16. Burden of Risk on Society • The presence of risk results in certain undesirable social and economic effects. Risk entails three major burdens on society: • The size of an emergency fund must be increased • Society is deprived of certain goods and services • Worry and fear are present

17. Larger Emergency Fund • It is prudent to set aside funds for an emergency. However, in the absence of insurance, individuals and business firms would have to increase the size of their emergency fund to pay for unexpected losses. • Ebola outbreak, government of Ghana set as ghc6m

18. Loss of Certain Goods and Services • A second burden of risk is that society is deprived of certain goods and services. • E.g. because of the risk of a liability lawsuit, many corporations have discontinued manufacturing certain products. Some 250 companies in the world once manufacture childhood vaccines; today, only a small number of firms manufacture vaccines, due to the threat of liability suits. • Other firms have discontinued the manufacture of certain birth-control devices because of fear of legal liability.

19. Worry and Fear • A final burden of risk is that worry and fear are present. • E.g. In the case of the 2008 financial crisis, there was worry and fear present as it was demonstrated in people running on banks for their monies, leading to most of the banks failing and anxiety was also present since the risk of losing ones job was very high because of companies filing for bankruptcy. Greece, Italy, Eurozone Crisis Ebola outbreak (doctors reaction)

20. Direct Versus Indirect Expected Losses • When considering the potential losses from a risky situation, you must consider indirect losses that arise in addition to direct losses. • In the previous example, if the storm destroys the house, the direct loss would be (GHc100,000). • Indirect losses arise as a consequence of direct losses. If the house were destroyed, the owner would likely have additional expenses, such as hotel and restaurants cost; these additional expenses would be indirect losses. The time spent in getting it repaired is also an indirect expense. Banks suing defaulters at court, as a result of credit risk, time spent at courts.

21. Cont. • The possibility of indirect losses is one of the main reasons that businesses try to reduce risk. E.g. damage to productive assets can produce an indirect loss by reducing the normal profit (net cash flow), that the asset would have generated if the damage had not occurred. • Large direct losses also can lead to indirect losses if they threaten the viability of the business and there by reduce the willingness of customers and suppliers to deal with the business or change the terms (prices) at which they transact.

22. Cont. • A long interruption in production would cause many customers to switch suppliers. • Or if a firm has binding contractual commitments to supply products, it also may be desirable for the firm to increase operating costs above normal levels following direct losses. • for instance, some businesses might find it desirable to maintain production by leasing replacement equipment at a higher cost so as to avoid loss of sales. The increased operating cost would create an indirect loss.

23. Cont. • Other forms of indirect losses include the possibility that the business will face a higher cost of obtaining funds from lenders or from new equity issues following large direct losses. • In some cases, the higher costs of raising capital will cause the firm to forgo making otherwise profitable investments. • Finally, in the case of severe direct and indirect losses, the firm might have to reorganize or be liquidated through costly legal proceedings under bankruptcy law.

24. Basic Categories of Risk • Risk can be classified into several distinct categories. The most important categories are the following: • Pure and Speculative risk • Fundamental risk and Particular risk • Enterprise risk

25. Pure risk and Speculative risk • Pure risk is defined as a situation in which there are only the possibilities of loss or no loss. • The only possible outcomes are adverse (loss) and neutral (no loss). • Examples of pure risks include premature death, job-related accidents, catastrophic medical expenses and damage to property from fire, lighting, flood, or earthquake.

26. Speculative Risk • Speculative risk is defined as a situation in which either profit or loss is possible. • For example, if you purchase 100 shares of common stock, you would profit if the price of the stock increases but would lose if the price declines. • Other examples include, betting on a horse race, investing in real estate, and going into business for your self.

27. Three reasons for the distinction between pure and speculative risk • 1. Private insurers typically insure only pure risks. With certain exceptions, private insurers generally do not insure speculative risks. (one exception is that some insurers will insure institutional portfolio investments and municipal bonds against loss) • 2. The law of large numbers can be applied more easily to pure risks than to speculative risks. The law of large numbers is important because it enables insurers to predict future loss experience. According to the law, the average of the results obtained from a large number of trials should be close to the expected value, and will tend to become closer

28. Cont. • In contrast, it is generally more difficult to apply the law of large numbers to speculative risks to predict future loss experience. An exception is the speculative risk of gambling, where casino operators can apply the law of large numbers in a most efficient manner. • 3. Society may benefit from a speculative risk even though a loss occurs, but it is harmed if a pure risk is present and a loss occurs.

29. Cont. • For example, a firm may develop new technology for producing inexpensive computers. • As a result some competitors may be forced into bankruptcy. Despite the bankruptcy, society benefits because the computers are produced at a lower cost. • However, society normally does not benefit when a loss from a pure risk occurs, such as a flood or earthquake that devastates an area.

30. Fundamental Risk and Particular Risk • A fundamental risk (Systematic risk) is a risk that affects the entire economy or large numbers of persons or groups within the economy. • Examples include inflation, cyclical unemployment and war because of large numbers of individuals affected. The risk of natural disaster is another important fundamental risk. Examples are earth quake, hurricanes, tornadoes and floods. • More recently, the risk of terrorist attack is rapidly emerging as a fundamental risk. Examples the terrorist attack in USA on 9/11/ 2001, resulted in four commercial jets, destruction of the world trade centre in New York City, substantial damage to the Pentagon and thousands of dead or injured persons.

31. Cont. • A Particular risk (unsystematic risk) is a risk that affects only individuals and not the entire community. Examples include car thefts, bank robberies, and dwelling fires. Only individuals experiencing such losses are affected, not the entire economy or large groups of people. • The distinction between a fundamental and particular risk is important because government assistance may be necessary to insure a fundamental risk.

32. Enterprise Risk • Enterprise risk is a term that encompasses all major risks faced by a business firm. Such risk include pure risks, speculative risk, strategic risk, operational risk and financial risk. • Strategic risk refers to uncertainty regarding the firm’s financial goals and objectives. For example if a firm enters a new line of business, the line may be unprofitable.

33. Cont. • Operational risk results from the firm’s business operations; for example, a bank that offers online banking services may incur losses if “hackers break into the bank’s computer”. • Financial risk refers to the uncertainty of loss because of adverse changes in commodity prices, interest rates, foreign exchange rates, and the value of money.