of firms and governments

Risk definition, risk behavior,risk management and the roleof firms and governments.RISKUNCERTAINTYRISK BEHAVIOURRISK AVERSIONRISK MANAGEMENTINSURANCE

Risk and Insurance:A story as old as timeSocial and Private Insurance2/J.F. Outreville

References• ArticleG.A. Holton, Defining Risk, Financial Analysts Journal, 2004(6).• Text booksHarrington, S. et G. Niehaus, Risk Management and Insurance, McGraw-Hill, 2004J.F. Outreville, Theory and Practice of Insurance, Kluwer A.P., 1998H. Skipper et W.J. Kwon, Risk Management and Insurance: perspectivesin a global economy, Blackwell, 2007Social and Private Insurance3/J.F. Outreville

Classification of Risks• Pure• Static• Particular• SystematicSpeculativeDynamicFundamentalDiversifiableSocial and Private Insurance4/J.F. Outreville

Risk and uncertainty...concepts• Certainty (perfect information) (Prob=0 or 1)• Objective probability (statistical law)• Subjective probability• Ignorance (lack of information)Social and Private Insurance5/J.F. Outreville

Risk and uncertainty…historyFrank H. Knight (1885–1972) is usually credited for having presentedthe distinction between decisions under “risk” (known chance) anddecisions under “uncertainty” in his 1921 book.The remarkable story of risk and uncertainty touches on the mostprofound aspects of psychology, mathematics and statistics. Knightdiscussed several biases in human decision-making and describedfeatures of risky choice (a function of anticipatory futures) that were tobecome key components of prospect theory.Bernstein (1998) walks that path. “Against the Gods” follows theintellectual development of risk management and how peoplethroughout the centuries have changed their views of what constitutesrisk and how risk can be mitigated.Social and Private Insurance6/J.F. Outreville

Risk and uncertainty…policies• Risk = prevention• The role of risk management• Uncertainty = the precautionary principle• The role of politics• Unknown situation=exoneration fromresponsibility•Example: economic and social developmentSocial and Private Insurance7/J.F. Outreville

The precaution principle andcorporate social responsibility (CSR)• Examples:– Environmental risks:– Transports (tankers), products (many examples),mobile phones, …– Human and social risks– Health, safety at work• Role of the State, governments• Role of international organizationsSocial and Private Insurance8/J.F. Outreville

Risk behavior• Risk-taking- to engage in behaviors that have the potential to beharmful or dangerous, yet at the same time provide theopportunity for some kind of outcome that can beperceived as positive.• Attitudes towards risk– What are the factors affecting risk taking?– Individual– Group– Business (the prudent man rule)Social and Private Insurance9/J.F. Outreville

Risk Behavior…psychologySocial and Private Insurance10/J.F. Outreville

Utility theory and risk aversion• What is the shape of a utilityfunction?Social and Private Insurance11/J.F. Outreville

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RISK MANAGEMENT:An organizational settingRISK IDENTIFICATIONRISK MEASUREMENTRISK CONTROLRISK FINANCING

Risk management…historicalperspective• Multinational firms after World War II• American Society of Insurance Management(1955)• Risk and Insurance Management Society(RIMS) (1975)• From operational risks to financial risks andstrategic risksSocial and Private Insurance14/J.F. Outreville

Identification of Risks• The individual risk and the risks ofbusiness• Organization charts• Flows charts• Accounting information, operatingaccounts and balance sheetsSocial and Private Insurance15/J.F. Outreville

Identification of RisksSocial and Private Insurance16/J.F. Outreville

Classification of business risks• Operational risks• Market risks– Prices, exchange rates, rates of return• Credit risks– Bad debts, liquiditiesSocial and Private Insurance17/J.F. Outreville

Operational business risks• 10 important risks today– Occupational injuries– Fire– Machine breakdown– Wastage in the company– Theft, fraud and negligence– Industrial espionage– Product liability– Data processing risks– Environmental risks– Transport accidentsSocial and Private Insurance18/J.F. Outreville

Why should a company beconcerned by risk management?• Business risks are diversifiable risks– Example (3 toys companies: Yotoys, B.S.Toys andZodi)• 3 major reasons– Bankruptcy costs– Taxes– Corporate stakeholders (managers, employees,clients, suppliers)…Corporate social responsibilitySocial and Private Insurance19/J.F. Outreville

Risk Measurement• Frequency and Severity• Maximum probable loss• Value at riskSocial and Private Insurance20/J.F. Outreville

Frequency and SeverityFrequency distributionNb accidents Nb insured0 8001 1602 303 104 05 01000Severity distributionLosses amount Average value Nb accidents0 00-400 200 150400-1,000 700 701,000-3,000 2,000 233,000-7,000 5,000 6>7,000 10,000 1250Social and Private Insurance21/J.F. Outreville

Frequency and Severity9008007006005004003002001000160140120100806040201 2 3 4 5 6 00 200 700 2,000 5,000 10,000Social and Private Insurance22/J.F. Outreville

Accidents : Poisson distributionPoisson probability distributionNb of car accidentsProbability0 0.006741 0.03372 0.084253 0.140424 0.175525 0.175526 0.146277 0.104488 0.06539 0.0362810 0.0181411 0.0082412 0.005140.20.180.160.140.120.10.080.060.040.0201 2 3 4 5 6 7 8 9 10 11 12 13Social and Private Insurance23/J.F. Outreville

Measurement problems• Overvaluation vs. under evaluation• Law of large numbers• Maximum probable lossSocial and Private Insurance24/J.F. Outreville

Distribution: extreme valuesLength of stay in an hospital for a givenpathology and for a sample of patientsFrequency1210864200 1 2 3 4 5 6 7 8 9 10 12 14 16 18 20 65 198 374Social and Private Insurance25/J.F. Outreville

Some distributions with heavy tailsLog normalA common example: the log normal distributionCauchyParetoSocial and Private Insurance26/J.F. Outreville

Maximum probable loss• In Finance, the Value at Risk (VaR)is the Maximum loss with a givenprobability (defined as the confidenceinterval), over a given period of time.Social and Private Insurance27/J.F. Outreville

The VaR is based on a normal distributionMean = 1.23% and Standard deviation = 4.3%Normal distribution confidence interval at 95% = 1.65 (at 99% 2.33)Absolute VaR (0) = −1,23 % + 1,65σ = 1.23% + 1,65(4,3 %) = 5,9 %Social and Private Insurance28/J.F. Outreville

Risk Control• Avoidance• Loss prevention (pre-loss)• Loss control (post-loss)Social and Private Insurance29/J.F. Outreville

Examples of risk control programs• Property conservation• Personnel safety and health• Product safety• Environmental protectionSocial and Private Insurance30/J.F. Outreville

Examples of risk control measuresPHYSICAL DEVICESSafety devices and protectiveequipmentsSecurity locks, boxes, etc.Alarms, sprinklers, etc..Any other risk reduction devicesPROCEDURESSeparation of potential hazardsMaintenance and repair systemProper procedures and trainingEnforcement of safety rulesInspection and auditFire brigade proceduresGuards, Patrols routineSocial and Private Insurance31/J.F. Outreville

Risk Financing• Retention (internal lossfinancing…planned or not planned)• Self Insurance• Captive insurance companies• Risk transfer– Non-insurance transfer (Contractualagreement)– Hedging (financial instruments)– InsuranceSocial and Private Insurance32/J.F. Outreville

• IdentificationRisk managementand social protection– Health, Death, Survival, Family, Education, …• Measurement• Control– Role of the government– Role of the firm• Financing– State programs– Role of firmsSocial and Private Insurance33/J.F. Outreville

Risk behavior and risk aversion:a complex postulate that affect demandand supply for social protection• Research in the field of behavioral finance andinsurance (experimental economics)• Insurance demand, public goods, free riderproblem• Moral hazard, behavior towards fraudSocial and Private Insurance34/J.F. Outreville