FIMA 40053 – RISK MANAGEMENT

MODULE 1: OVERVIEW OF RISK MANAGEMENT

THE NOTION OF RISK

The notion of “risk” and its ramifications permeate decision-making processes in each
individual’s life and business outcomes and of society itself. Indeed, risk, and how it is
managed, are critical aspects of decision making at all levels.

The word “risk” is used in many different contexts. Further, the word takes many different
interpretations in these varied contexts. In all cases, however, the notion of risk is inextricably
linked to the notion of uncertainty.

Uncertainty is having two potential outcomes for an event or situation.

- Uncertainty causes the emotional or physical anxiety or excitement felt in uncertain

volatile situations
(ex. gambling and participation in extreme sports)
- Uncertainty causes us to take precautions
(ex. uncertainty causes mortgage issuers to demand property purchase insurance. The
person or corporation occupying the mortgage-funded property must purchase
insurance on real estate if we intend to lend them money)

If we knew, without a doubt, that something bad was about to occur, we would call it
apprehension or dread. It wouldn’t be risk because it would be predictable. Risk will be forever,
inextricably linked to uncertainty.

As we all know, certainty is elusive. Uncertainty and risk are pervasive. While we typically
associate “risk” with unpleasant or negative events, in reality some risky situations can result
in positive outcomes. Take, for example, venture capital investing or entrepreneurial
endeavors. Uncertainty about which of several possible outcomes will occur circumscribes the
meaning of risk. Uncertainty lies behind the definition of risk.

While we link the concept of risk with the notion of uncertainty, risk isn’t synonymous with
uncertainty. Risk isn’t the same as the underlying prerequisite of uncertainty. Risk has to do
with consequences (both positive and negative); it involves having more than two possible
outcomes (uncertainty). Uncertainty also creates opportunities for gain and the potential for
loss. Nevertheless, if no possibility of a negative outcome arises at all, even remotely, then we
usually do not refer to the situation as having risk (only uncertainty)
DEFINITION OF RISK

Risk
- the “effect of uncertainty on objectives” and an effect is a positive or negative
deviationfrom what is expected (ISO 31000)

All of us operate in an uncertain world. Whenever we try to achieve an objective, there’s

alwaysthe chance that things will not go according to plan. Every step has an element of
risk that needs to be managed and every outcome is uncertain. Whenever we try to
achieve an objective, we don't always get the results we expect. Sometimes we get
positive results and sometimes we get negative results and occasionally we get both

Components that Characterize the Magnitude of Risk

1. Likelihood – the probability of an event occurring

2. Impact – outcome of an event

Pure and Speculative Risk

Pure Risk
- risk in which there is only a chance of loss not gain
- result of uncontrollable circumstances
- example: chance that someone’s home will be destroyed by an earthquake
-
Speculative Risk
- risk in which there is a chance of loss or gain
- result of choices can be controlled
- example: chance that a small business will not succeed

Fundamental and Particular Risk

Fundamental Risk
- affects the entire economy or large numbers of persons or groups (hurricane)

Particular Risk
- affects only the individual (car theft)

Business/Enterprise Risk
- encompasses all major risks faced by a business firm which include operational
risk,financial risk, strategy risk and hazard risk
-
Strategic Risk

- The risk that a company’s strategy becomes less effective and the company
strugglesto reach its goals as a result
- Risks that affect or are created by an organization's business strategy and
strategic objectives
 Everyone knows that a successful business needs a comprehensive, well-thought-out
business plan. But it’s also a fact of life that things change, and the best-laid plans can
sometimes come to look very outdated, very quickly. It could be due to technological
changes, a powerful new competitor entering the market, shifts in customer demand,
spikes in the costsof raw materials, or any number of other large-scale changes. History
is littered with examplesof companies that faced strategic risk. Some managed to adapt
successfully; others didn’t.

A classic example is Kodak, which had such a dominant position in the film photography
marketthat when one of its own engineers invented a digital camera in 1975, it saw the
innovation asa threat to its core business model, and failed to develop it. It’s easy to say
with hindsight, of course, but if Kodak had analyzed the strategic risk more carefully, it
would have concluded that someone else would start producing digital cameras
eventually, so it was better for Kodak to cannibalize its own business than for another
company to do it. Failure to adapt to a strategicrisk led to bankruptcy for Kodak. It’s now
emerged from bankruptcy as a much smaller company focusing on corporate imaging
solutions, but if it had made that shift sooner, it could have preserved its dominance.

Facing a strategic risk doesn’t have to be disastrous, however. Think of Xerox, which
became synonymous with a single, hugely successful product, the Xerox photocopier. The
developmentof laser printing was a strategic risk to Xerox’s position, but unlike Kodak, it
was able to adapt to the new technology and change its business model. Laser printing
became a multi-billion- dollar business line for Xerox, and the company survived the
strategic risk.

Operational Risk

- The prospect of loss resulting from inadequate or failed procedures, systems or

policies.
In some cases, operational risk has more than one cause. For example, consider the risk
that one of the employees writes the wrong amount on a check, paying out P100,000
instead of P10,000 from the company’s account.

That’s a “people” failure, but also a “process” failure. It could have been prevented by
having a more secure payment process, for example having a second member of staff
authorize every major payment, or using an electronic system that would flag unusual
amounts for review.

In some cases, operational risk can also stem from events outside the company’s control
suchas a power cut or a problem with website host. Anything that interrupts the company’s
core operations comes under the category of operational risk.

While the events themselves can seem quite small compared with the large strategic risks
wetalked about earlier, operational risks can still have a big impact on the company. Not
only is there the cost of fixing the problem, but operational issues can also prevent
customer orders from being delivered or make it impossible to contact the company,
resulting in a loss ofrevenue and damage to its reputation
Financial Risk

- It generally relates to the odds of losing money

- The unexpected variability or volatility of returns
- The probability of loss, inherent in financing methods which impair the ability to
provideadequate returns
- The existence of uncertainty regarding a company’s ability to meet its
financialobligations, such as interest payments, dividends, and repayment
obligations.

Types of Financial Risk

Risk that the value of 'on' or 'off' balance sheet

Market Risk positions will be adversely affected by movements
in equity and interest rate markets, currency
exchange rates and commodity prices
Risk that funds will not be available when needed
Liquidity Risk
Risk that a borrower or counterparty will fail to
Credit Risk meet its obligations in accordance with agreed
terms

Most categories of risk have a financial impact, in terms of extra costs or lost revenue. But
thecategory of financial risk refers specifically to the money flowing in and out of business,
and the possibility of a sudden financial loss.

For example, let’s say that a large proportion of revenue comes from a single large client,
andhe was extended 60 days credit.

In this case, there is a significant financial risk. If that customer is unable to pay, or delays
payment for whatever reason, then the business is in big trouble. Having a lot of debt also
increases financial risk, particularly if a lot of it is short-term debt that’sdue in the near
future. And if interest rates suddenly go up, and instead of paying 8% on the loan, you’re
now paying 15%? That’s a big extra cost for your business, and so it’s counted as a
financial risk.

Natural and Man-made Risks (Hazard Risks)

- Include unforeseen events that arise outside of the normal operating environment.
Poses a level of threat to life, health, property or the environment. Most hazards are
dormant or potential with only a theoretical risk of harm: however, once a hazard becomes
active, it can create an emergency situation