Chapter 1 The Nature of Risk: Losses and Opportunities

Risk as a Consequence of Uncertainty

We all have a personal intuition about what we mean by the term “risk.” We all use and interpret the word daily. We have all felt the excitement, anticipation, or anxiety of facing a new and uncertain event (the “tingling” aspect of risk taking). Thus, actually giving a single unambiguous definition of what we mean by the notion of “risk” proves to be somewhat difficult. 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 uncertaintyHaving two potential outcomes for an event or situation.. We provide here a simple definition of uncertainty: Uncertainty is having two potential outcomes for an event or situation.

Certainty refers to knowing something will happen or won’t happen. We may experience no doubt in certain situations. Nonperfect predictability arises in uncertain situations. Uncertainty causes the emotional (or physical) anxiety or excitement felt in uncertain volatile situations. Gambling and participation in extreme sports provide examples. Uncertainty causes us to take precautions. We simply need to avoid certain business activities or involvements that we consider too risky. For example, 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. A person experiencing the flu is not necessarily the same as the virus causing the flu. Risk isn’t the same as the underlying prerequisite of uncertainty. RiskUncertainty about a future outcome, particularly the consequences of a negative outcome. (intuitively and formally) has to do with consequences (both positive and negative); it involves having more than two possible outcomes (uncertainty).See http://www.dhs.gov/dhspublic/. The consequences can be behavioral, psychological, or financial, to name a few. 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) as shown in Figure 1.2 "Uncertainty as a Precondition to Risk".

Figure 1.2 Uncertainty as a Precondition to Risk

In general, we widely believe in an a priori (previous to the event) relation between negative risk and profitability. Namely, we believe that in a competitive economic market, we must take on a larger possibility of negative risk if we are to achieve a higher return on an investment. Thus, we must take on a larger possibility of negative risk to receive a favorable rate of return. Every opportunity involves both risk and return.

The Role of Risk in Decision Making

In a world of uncertainty, we regard risk as encompassing the potential provision of both an opportunity for gains as well as the negative prospect for losses. See Figure 1.3 "Roles (Objectives) Underlying the Definition of Risk"—a Venn diagram to help you visualize risk-reward outcomes. For the enterprise and for individuals, risk is a component to be considered within a general objective of maximizing value associated with risk. Alternatively, we wish to minimize the dangers associated with financial collapse or other adverse consequences. The right circle of the figure represents mitigation of adverse consequences like failures. The left circle represents the opportunities of gains when risks are undertaken. As with most Venn diagrams, the two circles intersect to create the set of opportunities for which people take on risk (Circle 1) for reward (Circle 2).

Figure 1.3 Roles (Objectives) Underlying the Definition of Risk

Identify the overlapping area as the set in which we both minimize risk and maximize value.

Figure 1.3 "Roles (Objectives) Underlying the Definition of Risk" will help you conceptualize the impact of risk. Risk permeates the spectrum of decision making from goals of value maximization to goals of insolvency minimization (in game theory terms, maximin). Here we see that we seek to add value from the opportunities presented by uncertainty (and its consequences). The overlapping area shows a tight focus on minimizing the pure losses that might accompany insolvency or bankruptcy. The 2008 financial crisis illustrates the consequences of exploiting opportunities presented by risk; of course, we must also account for the risk and can’t ignore the requisite adverse consequences associated with insolvency. Ignoring risk represents mismanagement of risk in the opportunity-seeking context. It can bring complete calamity and total loss in the pure loss-avoidance context.

We will discuss this trade-off more in depth later in the book. Managing risks associated with the context of minimization of losses has succeeded more than managing risks when we use an objective of value maximization. People model catastrophic consequences that involve risk of loss and insolvency in natural disaster contexts, using complex and innovative statistical techniques. On the other hand, risk management within the context of maximizing value hasn’t yet adequately confronted the potential for catastrophic consequences. The potential for catastrophic human-made financial risk is most dramatically illustrated by the fall 2008 financial crisis. No catastrophic models were considered or developed to counter managers’ value maximization objective, nor were regulators imposing risk constraints on the catastrophic potential of the various financial derivative instruments.

Definitions of Risk

We previously noted that risk is a consequence of uncertainty—it isn’t uncertainty itself. To broadly cover all possible scenarios, we don’t specify exactly what type of “consequence of uncertainty” we were considering as risk. In the popular lexicon of the English language, the “consequence of uncertainty” is that the observed outcome deviates from what we had expected. Consequences, you will recall, can be positive or negative. If the deviation from what was expected is negative, we have the popular notion of risk. “Risk” arises from a negative outcome, which may result from recognizing an uncertain situation.

If we try to get an ex-post (i.e., after the fact) risk measure, we can measure risk as the perceived variability of future outcomes. Actual outcomes may differ from expectations. Such variability of future outcomes corresponds to the economist’s notion of risk. Risk is intimately related to the “surprise an outcome presents.” Various actual quantitative risk measurements provide the topic of Chapter 2 "Risk Measurement and Metrics". Another simple example appears by virtue of our day-to-day expectations. For example, we expect to arrive on time to a particular destination. A variety of obstacles may stop us from actually arriving on time. The obstacles may be within our own behavior or stand externally. However, some uncertainty arises as to whether such an obstacle will happen, resulting in deviation from our previous expectation. As another example, when American Airlines had to ground all their MD-80 planes for government-required inspections, many of us had to cancel our travel plans and couldn’t attend important planned meetings and celebrations. Air travel always carries with it the possibility that we will be grounded, which gives rise to uncertainty. In fact, we experienced this negative event because it was externally imposed upon us. We thus experienced a loss because we deviated from our plans. Other deviations from expectations could include being in an accident rather than a fun outing. The possibility of lower-than-expected (negative) outcomes becomes central to the definition of risk, because so-called losses produce the negative quality associated with not knowing the future. We must then manage the negative consequences of the uncertain future. This is the essence of risk management.

Our perception of risk arises from our perception of and quantification of uncertainty. In scientific settings and in actuarial and financial contexts, risk is usually expressed in terms of the probability of occurrence of adverse events. In other fields, such as political risk assessment, risk may be very qualitative or subjective. This is also the subject of Chapter 2 "Risk Measurement and Metrics".

Pure versus Speculative Risk Exposures

Some people say that Eskimos have a dozen or so words to name or describe snow. Likewise, professional people who study risk use several words to designate what others intuitively and popularly know as “risk.” Professionals note several different ideas for risk, depending on the particular aspect of the “consequences of uncertainty” that they wish to consider. Using different terminology to describe different aspects of risk allows risk professionals to reduce any confusion that might arise as they discuss risks.

As we noted in Table 1.2 "Examples of Pure versus Speculative Risk Exposures", risk professionals often differentiate between pure riskRisk that features some chance of loss and no chance of gain. that features some chance of loss and no chance of gain (e.g., fire risk, flood risk, etc.) and those they refer to as speculative risk. Speculative risksRisk that features a chance to either gain or lose. feature a chance to either gain or lose (including investment risk, reputational risk, strategic risk, etc.). This distinction fits well into Figure 1.3 "Roles (Objectives) Underlying the Definition of Risk". The right-hand side focuses on speculative risk. The left-hand side represents pure risk. Risk professionals find this distinction useful to differentiate between types of risk.

Some risks can be transferred to a third party—like an insurance company. These third parties can provide a useful “risk management solution.” Some situations, on the other hand, require risk transfers that use capital markets, known as hedging or securitizations. HedgingActivities that are taken to reduce or eliminate risks. refers to activities that are taken to reduce or eliminate risks. SecuritizationPackaging and transferring the insurance risks to the capital markets through the issuance of a financial security. is the packaging and transferring of insurance risks to the capital markets through the issuance of a financial security. We explain such risk retention in Chapter 4 "Evolving Risk Management: Fundamental Tools" and Chapter 5 "The Evolution of Risk Management: Enterprise Risk Management". Risk retentionWhen a firm retains its risk, self-insuring against adverse contingencies out of its own cash flows. is when a firm retains its risk. In essence it is self-insuring against adverse contingencies out of its own cash flows. For example, firms might prefer to capture up-side return potential at the same time that they mitigate while mitigating the downside loss potential.

In the business environment, when evaluating the expected financial returns from the introduction of a new product (which represents speculative risk), other issues concerning product liability must be considered. Product liabilitySituation in which a manufacturer may be liable for harm caused by use of its product, even if the manufacturer was responsible in producing it. refers to the possibility that a manufacturer may be liable for harm caused by use of its product, even if the manufacturer was reasonable in producing it.

Table 1.2 "Examples of Pure versus Speculative Risk Exposures" provides examples of the pure versus speculative risks dichotomy as a way to cross classify risks. The examples provided in Table 1.2 "Examples of Pure versus Speculative Risk Exposures" are not always a perfect fit into the pure versus speculative risk dichotomy since each exposure might be regarded in alternative ways. Operational risks, for example, can be regarded as operations that can cause only loss or operations that can provide also gain. However, if it is more specifically defined, the risks can be more clearly categorized.

The simultaneous consideration of pure and speculative risks within the objectives continuum of Figure 1.3 "Roles (Objectives) Underlying the Definition of Risk" is an approach to managing risk, which is known as enterprise risk management (ERM)The simultaneous consideration of all risks and the management of risks in an enterprise-wide (and risk-wide) context.. ERM is one of today’s key risk management approaches. It considers all risks simultaneously and manages risk in a holistic or enterprise-wide (and risk-wide) context. ERM was listed by the Harvard Business Review as one of the key breakthrough areas in their 2004 evaluation of strategic management approaches by top management.L. Buchanan, “Breakthrough Ideas for 2004,” Harvard Business Review 2 (2004): 13–16. In today’s environment, identifying, evaluating, and mitigating all risks confronted by the entity is a key focus. Firms that are evaluated by credit rating organizations such as Moody’s or Standard & Poor’s are required to show their activities in the areas of enterprise risk management. As you will see in later chapters, the risk manager in businesses is no longer buried in the tranches of the enterprise. Risk managers are part of the executive team and are essential to achieving the main objectives of the enterprise. A picture of the enterprise risk map of life insurers is shown later in Figure 1.5 "A Photo of Galveston Island after Hurricane Ike".

Within the class of pure risk exposures, it is common to further explore risks by use of the dichotomy of personal property versus liability exposure risk.

Personal Loss Exposures—Personal Pure Risk

Because the financial consequences of all risk exposures are ultimately borne by people (as individuals, stakeholders in corporations, or as taxpayers), it could be said that all exposures are personal. Some risks, however, have a more direct impact on people’s individual lives. Exposure to premature death, sickness, disability, unemployment, and dependent old age are examples of personal loss exposures when considered at the individual/personal level. An organization may also experience loss from these events when such events affect employees. For example, social support programs and employer-sponsored health or pension plan costs can be affected by natural or man-made changes. The categorization is often a matter of perspective. These events may be catastrophic or accidental.

Property Loss Exposures—Property Pure Risk

Property owners face the possibility of both direct and indirect (consequential) losses. If a car is damaged in a collision, the direct loss is the cost of repairs. If a firm experiences a fire in the warehouse, the direct cost is the cost of rebuilding and replacing inventory. Consequential or indirect lossesA nonphysical loss such as loss of business. are nonphysical losses such as loss of business. For example, a firm losing its clients because of street closure would be a consequential loss. Such losses include the time and effort required to arrange for repairs, the loss of use of the car or warehouse while repairs are being made, and the additional cost of replacement facilities or lost productivity. Property loss exposuresLosses associated with both real property such as buildings and personal property such as automobiles and the contents of a building. are associated with both real property such as buildings and personal property such as automobiles and the contents of a building. A property is exposed to losses because of accidents or catastrophes such as floods or hurricanes.

Liability Loss Exposures—Liability Pure Risk

The legal system is designed to mitigate risks and is not intended to create new risks. However, it has the power of transferring the risk from your shoulders to mine. Under most legal systems, a party can be held responsible for the financial consequences of causing damage to others. One is exposed to the possibility of liability lossLoss caused by a third party who is considered at fault. (loss caused by a third party who is considered at fault) by having to defend against a lawsuit when he or she has in some way hurt other people. The responsible party may become legally obligated to pay for injury to persons or damage to property. Liability risk may occur because of catastrophic loss exposure or because of accidental loss exposure. Product liability is an illustrative example: a firm is responsible for compensating persons injured by supplying a defective product, which causes damage to an individual or another firm.

Catastrophic Loss Exposure and Fundamental or Systemic Pure Risk

Catastrophic risk is a concentration of strong, positively correlated risk exposures, such as many homes in the same location. A loss that is catastrophic and includes a large number of exposures in a single location is considered a nonaccidental risk. All homes in the path will be damaged or destroyed when a flood occurs. As such the flood impacts a large number of exposures, and as such, all these exposures are subject to what is called a fundamental riskRisks that are pervasive to and affect the whole economy, as opposed to accidental risk for an individual.. Generally these types of risks are too pervasive to be undertaken by insurers and affect the whole economy as opposed to accidental risk for an individual. Too many people or properties may be hurt or damaged in one location at once (and the insurer needs to worry about its own solvency). Hurricanes in Florida and the southern and eastern shores of the United States, floods in the Midwestern states, earthquakes in the western states, and terrorism attacks are the types of loss exposures that are associated with fundamental risk. Fundamental risks are generally systemic and nondiversifiable.

Figure 1.5 A Photo of Galveston Island after Hurricane Ike

Accidental Loss Exposure and Particular Pure Risk

Many pure risks arise due to accidental causes of loss, not due to man-made or intentional ones (such as making a bad investment). As opposed to fundamental losses, noncatastrophic accidental losses, such as those caused by fires, are considered particular risks. Often, when the potential losses are reasonably bounded, a risk-transfer mechanism, such as insurance, can be used to handle the financial consequences.

In summary, exposures are units that are exposed to possible losses. They can be people, businesses, properties, and nations that are at risk of experiencing losses. The term “exposures” is used to include all units subject to some potential loss.

Another possible categorization of exposures is as follows:

• Risks of nature
• Risks related to human nature (theft, burglary, embezzlement, fraud)
• Man-made risks
• Risks associated with data and knowledge
• Risks associated with the legal system (liability)—it does not create the risks but it may shift them to your arena
• Risks related to large systems: governments, armies, large business organizations, political groups
• Intellectual property

Pure and speculative risks are not the only way one might dichotomize risks. Another breakdown is between catastrophic risks, such as flood and hurricanes, as opposed to accidental losses such as those caused by accidents such as fires. Another differentiation is by systemic or nondiversifiable risks, as opposed to idiosyncratic or diversifiable risks; this is explained below.

Diversifiable and Nondiversifiable Risks

As noted above, another important dichotomy risk professionals use is between diversifiable and nondiversifiable risk. Diversifiable risksRisks whose adverse consequences can be mitigated simply by having a well-diversified portfolio of risk exposures. are those that can have their adverse consequences mitigated simply by having a well-diversified portfolio of risk exposures. For example, having some factories located in nonearthquake areas or hotels placed in numerous locations in the United States diversifies the risk. If one property is damaged, the others are not subject to the same geographical phenomenon causing the risks. A large number of relatively homogeneous independent exposure units pooled together in a portfolio can make the average, or per exposure, unit loss much more predictable, and since these exposure units are independent of each other, the per-unit consequences of the risk can then be significantly reduced, sometimes to the point of being ignorable. These will be further explored in a later chapter about the tools to mitigate risks. Diversification is the core of the modern portfolio theory in finance and in insurance. Risks, which are idiosyncraticRisks viewed as being amenable to having their financial consequences reduced or eliminated by holding a well-diversified portfolio. (with particular characteristics that are not shared by all) in nature, are often viewed as being amenable to having their financial consequences reduced or eliminated by holding a well-diversified portfolio.

Systemic risks that are shared by all, on the other hand, such as global warming, or movements of the entire economy such as that precipitated by the credit crisis of fall 2008, are considered nondiversifiable. Every asset or exposure in the portfolio is affected. The negative effect does not go away by having more elements in the portfolio. This will be discussed in detail below and in later chapters. The field of risk management deals with both diversifiable and nondiversifiable risks. As the events of September 2008 have shown, contrary to some interpretations of financial theory, the idiosyncratic risks of some banks could not always be diversified away. These risks have shown they have the ability to come back to bite (and poison) the entire enterprise and others associated with them.

Table 1.3 "Examples of Risk Exposures by the Diversifiable and Nondiversifiable Categories" provides examples of risk exposures by the categories of diversifiable and nondiversifiable risk exposures. Many of them are self explanatory, but the most important distinction is whether the risk is unique or idiosyncratic to a firm or not. For example, the reputation of a firm is unique to the firm. Destroying one’s reputation is not a systemic risk in the economy or the market-place. On the other hand, market risk, such as devaluation of the dollar is systemic risk for all firms in the export or import businesses. In Table 1.3 "Examples of Risk Exposures by the Diversifiable and Nondiversifiable Categories" we provide examples of risks by these categories. The examples are not complete and the student is invited to add as many examples as desired.

Enterprise Risks

As discussed above, the opportunities in the risks and the fear of losses encompass the holistic risk or the enterprise risk of an entity. The following is an example of the enterprise risks of life insurers in a map in Figure 1.6 "Life Insurers’ Enterprise Risks".Etti G. Baranoff and Thomas W. Sager, “Integrated Risk Management in Life Insurance Companies,” an award winning paper, International Insurance Society Seminar, Chicago, July 2006 and in Special Edition of the Geneva Papers on Risk and Insurance.

Since enterprise risk management is a key current concept today, the enterprise risk map of life insurers is offered here as an example. Operational risks include public relations risks, environmental risks, and several others not detailed in the map in Figure 1.4 "Risk Balls". Because operational risks are so important, they usually include a long list of risks from employment risks to the operations of hardware and software for information systems.

Figure 1.6 Life Insurers’ Enterprise Risks

Risks in the Limelight

Our great successes in innovation are also at the heart of the greatest risks of our lives. An ongoing concern is the electronic risk (e-risk) generated by the extensive use of computers, e-commerce, and the Internet. These risks are extensive and the exposures are becoming more defined. The box Note 1.32 "The Risks of E-exposures" below illustrates the newness and not-so-newness in our risks.

Today, there is no media that is not discussing the risks that brought us to the calamity we are enduring during our current financial crisis. Thus, as opposed to the megacatastrophes of 2001 and 2005, our concentration is on the failure of risk management in the area of speculative risks or the opportunity in risks and not as much on the pure risk. A case at point is the little media coverage of the devastation of Galveston Island from Hurricane Ike during the financial crisis of September 2008. The following box describes the risks of the first decade of the new millennium.

Hazards

Risk professionals refer to hazardsConditions that increase the cause of loss. as conditions that increase the cause of losses. Hazards may increase the probability of losses, their frequency, their severity, or both. That is, frequencyThe number of losses during a specified period. refers to the number of losses during a specified period. SeverityThe average dollar value of a loss per claim. refers to the average dollar value of a loss per occurrence, respectively. Professionals refer to certain conditions as being “hazardous.” For example, when summer humidity declines and temperature and wind velocity rise in heavily forested areas, the likelihood of fire increases. Conditions are such that a forest fire could start very easily and be difficult to contain. In this example, low humidity increases both loss probability and loss severity. The more hazardous the conditions, the greater the probability and/or severity of loss. Two kinds of hazards—physical and intangible—affect the probability and severity of losses.