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Unformatted text preview: Managing Risk Managing Risk Should risk be managed? Pooling or diversification (reduce uncertainty of loss) Loss control (reduce expected value of loss) If risk is to be managed, how much should be invested, in order to reduce risk, by how much? What criteria should be used to decide? Risk can be Costly Risk can be Costly Negative effects of risk include Any losses that occur Secondary effects of losses that occur (indirect losses) Consequences of uncertainty itself Managing Risk can be Costly Managing Risk can be Costly Because risk is costly, reducing risk can increase the wellbeing of individuals, firms or societies Because risk management is also costly, must trade off the costs of risk and the costs of risk management There are cost tradeoffs Cost of Risk Management Cost of Risk Management
Total Costs Cost of Risk Management Amt of Risk Management Cost of Unmanaged Risk Cost of Unmanaged Risk
Total Costs E(L) + E(Indirect L) + Cost of uncertainty zero risk Amt of Risk Management Definition: Total Cost of Risk What is the total cost to a firm or individual of being in a situation of risk? The total “cost of risk” includes: The expected value of (direct and indirect) losses that will be experienced Any costs associated with uncertainty about the occurrence or value of losses The costs of risk management activities Total Cost of Risk (TCOR) Total Cost of Risk (TCOR)
Total Cost RM Cost+E(L)+E(Indirect L)+Uncert Cost Amt of Risk Management Total Cost of Risk Example Total Cost of Risk Example Consider a firm that faces a significant chance of workers being killed or severely injured on the job How might this risk create costs for the firm? Example, cont. Example, cont. Total cost of risk includes: E(direct loss) E(indirect loss) Costs associated with uncertainty Costs of risk management Total Cost of Risk Example Total Cost of Risk Example
E(direct loss) E(indirect loss) Uncertainty cost Risk mgmt cost Lower Revenue Higher Costs x x x x x x Risk Management Decisions Risk Management Decisions Including risk management costs in the total cost of risk means that we have defined a situation of risk as one that results in only costs (no benefits) to the individual or firm This means that we should make risk management decisions to minimize the cost of risk Minimizing TCOR Minimizing TCOR
Total Cost RM Cost+E(L)+E(Indirect L)+Uncert Cost R* Amt of Risk Management Minimizing Total Cost of Risk Minimizing Total Cost of Risk Do not use risk management to minimize risk minimize theTotal Cost of Risk Another way to think about it: Compare marginal costs and marginal benefits of risk management Costs of risk management are the direct costs of using risk management tools Benefits of risk management are the reduction in expected loss costs and costs of residual uncertainty Minimize Total: Set MC=MB Minimize Total: Set MC=MB
MC, MB MC of RM MB of RM R* MC = increment in risk mgmt costs MB = incremental reduction in E(L), E(Indirect L) and cost of uncertainty Amt of Risk Management Min TCOR Example Min TCOR Example The firm is faced with a 0.20 chance that a worker will be seriously injured. The cost of the injury, if it occurs, will be $10,000 in medical expenses and $50,000 lost wages compensation to the worker. The firm will also incur $2,000 costs in hiring a replacement worker and $5,000 in lost revenue due to reduced productivity What is the TCOR for the firm in the absence of risk management? Min TCOR Example Min TCOR Example The firm is considering three alternative risk management approaches to dealing with this risk: Engage in loss control that costs $5,000 and will reduce the probability of the loss to 0.10 Engage in loss control that costs $10,000 and will reduce the probability of the loss to 0.07 Engage in no loss control, but purchase insurance for $15,000 that will cover the full cost of the direct losses to the firm What is the effect of each risk management option on the total cost of risk? Cost of Uncertainty? Cost of Uncertainty? Discomfort or worry at being in a situation of uncertainty (riskaverse individuals) Real (opportunity) costs of being in a situation of uncertainty (even if not riskaverse) May need to hold more cash reserves Contractual terms are worsened May miss opportunities for increased earnings Increased uncertainty affects contractual terms with managers, workers, suppliers, customers, creditors Divert attention to managing risks Fail to gain outside resources needed ...
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This note was uploaded on 05/07/2009 for the course PAM 4230 taught by Professor Tennyson during the Spring '07 term at Cornell University (Engineering School).
- Spring '07