FIN320 Tutorial W2

Chapter 1
2. Risk may be classified in several ways. List the principal ways in which risk may be
categorized, and explain the distinguishing characteristics of each class.

- Static and Dynamic risks. Static risk involve those losses that occur even if there were no changes
in the macroeconomy. For example, changes to the natural environment such as war. These are not
sources of gain for a society and it is generally predictable. Static risks affect only individuals or
very few individuals. Dynamic risks are those resulting from changes in the macroeconomy. These
dynamic risks normally benefit society over the long run since they are the result of adjustments to
misallocation of resources. Dynamic risks affect a large number of individuals, they are generally
considerable less predictable than static risk. Because they are less predictable, static risk are more
suited to treatment by insurance than are dynamic risk.

- Fundamental and Particular risks. The distinction between fundamental and particular risks is
based on the difference in the origin and consequences of the losses. Fundamental risks involve
losses that are impersonal in origin and consequences. They are group risks caused. Unemployment,
war, inflation, earthquakes, and floods are all fundamental risks. Particular risks involves losses that
arise out of individual events and are felt by individuals rather than by the entire group. They may
be static or dynamic. The burning of a house and the robbery of a bank are particular risks.

- Pure and Speculative risks. It is a classification based on loss or gain characteristics. Speculative
risk reflect the possibility of loss or gain, such as gambling. Pure risk reflect the possibility of loss
or no loss, such as the possibility of loss surrounding the ownership of property. The distinction
between pure and speculative risks is an important one because normally only pure risk are insurable.

3. The distinction between “pure risk” and “speculative risk” is important because only pure
risks are normally insurable. Why is the distinction between “fundamental risk” and
“particular risk” important?

Fundamental risk ae those caused by conditions more or less beyond the control of the individuals
who suffer the losses and since they are not the fault of anyone in particular, it is held that society
rather than the individual has a responsibility to deal with them. For example, risk affect everybody
in society such as haze. While particular risk are considered to be the individual’s own responsibility,
inappropriate subjects for action by society as a whole. For example risk that affect individual such
as risk attach to smoking. In the final analysis, whether a risk is considered fundamental or particular
depends on current public opinion concerning the responsibility for the causes and consequences of
the risk.
5. List the four types of pure risk facing an individual or an organization and give an example
of each.

- Personal risks. These consists of possibility of loss of income or asset as a result of the loss of the
ability to earn income. For example, premature death, old age, disablement and unemployment.
- Property risks. Embrace two distinct types of losses, direct loss and indirect loss. For example,
(direct) the loss of the property and (indirect) loss of use of the property resulting in lost income or
additional expenses.
- Liability risks. The unintentional injury of other persons or damage to their property through
negligence or carelessness. It involve the possibility of loss of present assets or future income as a
result of damages assessed or legal liability arising out of either intentional or unintentional torts, or
invasion of the rights of others.
- Risks arising from failure of others. When another person agrees to perform a service for you, he
or she undertakes an obligation that you hope will be met. When the person’s failure to meet this
obligation would result in your financial loss, risk exists. For example, failure of a contractor to
complete a construction project as scheduled, or failure of debtors to make payments as expected.

7. Distinguish between “perils” and “hazards” and give two specific examples of each.

A peril is a cause of a loss. For example, the peril of fire, or windstorm, or flood, or theft. Each of
these is the cause of the loss that occurs. A hazard, is a condition that create or increase the chance
of a loss arising from a given peril. For example, physical hazards, smoking or skydiving. Moral
hazard, dishonesty, such as burning down the warehouse when your company goes bankrupt to
collect insurance money. Morale hazards, like a careless attitude since "insurance will pay for it."
It is possible for something to be both a peril and a hazard. For instance, sickness is a peril causing
economic loss, but it is also a hazard that increases the chance of loss from the peril of premature
death.

3. If risk is distasteful, how do you account for the existence of gambling, a pastime in which
the participants indicate they prefer the risk involved to the security of not gambling?

Gambling includes the possibility of loss and a gain. The gambler may also find the possibility of
losing distasteful, but he or she incurs that possibility because it carries with it the possibility of a
gain that is attractive. Also, it is not necessarily true that all people find risk distasteful. There are
many who are risk-seekers. Generally, all forms of pure risk are distasteful, whereas risks of a
speculative nature find favor among many people, and it is the possibility of gain that accounts for
this difference.
Chapter 2
2. Identify the two broad approaches to dealing with risk recognized by modern risk
management theory.

Risk control and risk financing. Risk control focuses on minimizing the risk of loss to which the
firm is exposed and includes the techniques of avoidance and reduction. Risk financing concentrates
on arranging the availability of funds to meet losses arising from the risks that remain after the
application of risk control techniques and includes the tools of retention and transfer.

3. Identify and briefly describe the four basic techniques available to the risk manager for
dealing with the pure risks facing the firm. Give an example of each technique.

Risk control:
- Risk avoidance. Possible losses are avoided completely. For example, firms stop
manufacturing a dangerous or hazardous product because of inherent risk.
- Risk reduction. Focuses on reducing the likelihood of loss such as loss prevention (frequency)
and loss control (severity). For example, prohibition against smoking in areas where
flammables are present is a loss prevention measures.
Risk Financing:
- Risk retention. The “residual” or “default” risk management technique, any exposures that
are not avoided, reduced, or transferred are retained.
- Risk transfer. Primary transfer mechanism is insurance. Hedging, example futures and
options markets allow airline to hedge against increases in the price of fuel.

4. The text states the emergence of risk management was a revolution that signaled a dramatic
shift in philosophy. What was this change in philosophy?

The changes in philosophy was the shift from insurance purchasing to risk management. It occurred
when the attitude toward insurance changed and it lost its traditional status as the standard approach
to dealing with risk.

5. Identify and briefly describe the six steps in the risk management process.

1. Determination of objectives
- Deciding what the organization’s main goal of risk management. Such as firm value
maximization or firm survival.
2. Identification of risks
- dig into the operations of the company and discover the risks to which the firm is exposed
3. Evaluation of risks
- implies some ranking system based on the probability of loss and its magnitude
4. Consideration of alternatives and selection of the risk treatment device
- based on evaluation of risk, manager choses the best course of action. Used to deal with
risks and the selection of the technique that should be used for each one.
5. Implementation of the decision
- Decision is made to retain a risk. Implementation requires use of tools such as risk control
or risk financing. This may be accomplished with or without a reserve and with or without a
fund.
6. Evaluation and review
- goal of this is continuous improvement. Business constantly change, new risk come into
existence. Mistake are often made.

10. Distinguish among traditional risk management, financial risk management, and
enterprise risk management.

- Traditional risk management, which is the management of pure risks, insurable and uninsurable.
- Financial risk management often used to refer to the management of financial risks such as market
risk, credit risk, and liquidity risk, because these have traditionally been the responsibility of the
firm’s corporate financial officer or treasurer.
- Enterprise risk management which attempts to integrate the management of all of the firm’s pure
and speculative risks. Core features of ERM are market risk, credit risk, liquidity risk and operational
risk. Other risks frequently identified in an enterprise risk management program include reputational
risk, strategic risk and compliance risk. Interest in ERM is driven by a desire to better manage the
ways in which a firm’s capital is used.

4. Describe risk management’s direct contribution to profit.

- Risk management as a core element of their business strategy. Risk management is proactive,
helping you identify the possible events that could impact your business. It also increases the
likelihood of successfully achieving your businesses objectives. From protecting your reputation
through to driving resiliency.
- Improving efficiency.
- Reducing costs. Risk can give rise to unexpected costs. They often bring with them the need to pay
your staff overtime or buy in expensive expertise at short notice to resolve the issues.
- Enhancing stakeholder confidence / protecting reputation. Understanding the potential risks that
may impact your ability to deliver a product, service or project means you can set realistic
expectations on the delivery date and the cost. Increase competitiveness and profitability by being
able to demonstrate risk management processes and capability, especially when working with major
organizations or within the public sector.