Operational risks include public relations risks, environmental risks, and several others not detailed in the map in Figure 1.4 "Risk Balls". As we mentioned earlier, in English, people often use the word “risk” to describe a loss. How would you classify the risks embedded in the financial crisis of fall 2008 within each of cross-classification? On a national level, we experienced the move toward holistic risk management with the creation of the Department of Homeland Security after the terrorist attacks of September 11, 2001.See http://www.dhs.gov/dhspublic/. In summary, exposures are units that are exposed to possible losses. that features some chance of loss and no chance of gain (e.g., fire risk, flood risk, etc.) Causes of losses over which people have little control. In a nutshell, business risk is the exposure a company has to various factors like competition, consumer preferences and other metrics that … That is, frequencyThe number of losses during a specified period. After Hurricane Katrina struck in 2005, the impasse among local, state, and federal officials elevated the need for coordination to achieve efficient holistic risk management in the event of a megacatastrophe.The student is invited to read archival articles from all media sources about the calamity of the poor response to the floods in New Orleans. 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. This is also the subject of Chapter 2 "Risk Measurement and Metrics". 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. Do you see any morale or moral hazards associated with the homeland security monitoring and actively searching people and doing preflight background checks on individuals prior to boarding? These risks are not adequately addressed by businesses, and to be addressed, they need to be considered together with climate-related risks. Innovative financial products without appropriate underwriting and risk management coupled with greed and lack of corporate controls brought us to the credit crisis of 2007 and 2008 and the deepest recession in a generation. Lehman Brothers represented the largest bankruptcy in history, which meant that the U.S. government (in essence) nationalized banks and insurance giant AIG. The corporate corruption at extreme levels in corporations such as Enron just deepened the sense of extreme risks. Uncertainty also creates opportunities for gain and the potential for loss. In contrast, most insurance industry contracts and education and training materials use the term exposureTerm used to describe the enterprise, property, person, or activity facing a potential loss. What examples fit under uncertainties and consequences? The creation of the products provided “black boxes” understood by few and without appropriate risk management. The TSA had to revise its airline security policy yet again shortly after the December 2005 adjustments. Risk professionals find this distinction useful to differentiate between types of risk. 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. In the years since the 2001 terrorist attacks, U.S. airport security procedures have undergone many changes, often in response to current events and national terrorism threat levels. The guarantees are provided under a second contract. Here we distinguish between physical hazards and intangible hazardsAttitudes and nonphysical cultural conditions can affect loss probabilities and severities of loss.—attitudes and nonphysical cultural conditions can affect loss probabilities and severities of loss. You will learn how enterprise-wide risk approaches combine risk categories. (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. Certainty refers to knowing something will happen or won’t happen. The balls represent risks, such as dying prematurely, losing a home to fire, or losing one’s ability to earn an income because of illness or injury. Perhaps they are also seeking the highest value possible for their pensions and savings and believe that losses may not be pervasive—very much unlike the situation in the fall of 2008. Explain the characteristics of business. Business risk is influenced by numerous factors, including sales volume, per-unit price, input costs, competition, and the overall economic climate and government regulations. Conditions that increase the cause of loss. We typically have overlooked financial crises, such as the credit crisis of 2008. Uncertainty causes us to take precautions. This snowball effect then caused others to default, and so forth. In essence, a credit derivative is a financial instrument issued by one firm, which guarantees payment for contracts of another party. This crisis started with a lack of improperly underwritten mortgages and excessive debt. What is Business Risk? Professionals also consider employee strikes, arson for profit, and similar situations to be economic perils. What are perils? In essence it is self-insuring against adverse contingencies out of its own cash flows. In common English language, many people continue to use the word “risk” as a noun to describe the enterprise, property, person, or activity that will be exposed to losses. For example, a firm losing its clients because of street closure would be a consequential loss. Property owners face the possibility of both direct and indirect (consequential) losses. Often, when the potential losses are reasonably bounded, a risk-transfer mechanism, such as insurance, can be used to handle the financial consequences. Is there some way to change this situation? This definition includes legal risk, but excludes strategic and/or business risk and reputational risk. Thus, we must take on a larger possibility of negative risk to receive a favorable rate of return. A business risk may be defined as the possibility loss due to some unforeseeable, unpredictable and unfavourable event in future. Operational risk is defined as the one that could potentially cause losses due to human errors, inadequate or faulty internal processes, system failures or external events. The insurance studies of Virginia Commonwealth University held a town hall meeting the week after Katrina to discuss the natural and man-made disasters and their impact both financially and socially. Economists and risk management professionals consider most people to be risk averse. You will build the definition of risk as a consequence of uncertainty and within a continuum of decision-making roles. Financial theories and research pay attention to the nature of the behavior of firms in their pursuit to maximize value. What do you actually feel when you hold the risk balls? They don’t pay for insurance, nor will they gamble. Loss caused by a third party who is considered at fault. Life and health, property and income, are all exposed to countless dangers. A synthesis framework for how nature-relate risk emerges that builds on the many existing frameworks and that brings together understanding of natural capital and climate-related risk. Risk will be forever, inextricably linked to uncertainty. Operational risk is defined as the one that could potentially cause losses due to human errors, inadequate or faulty internal processes, system failures or external events. Companies that use the Internet commercially—who create and post content or sell services or merchandise—must follow the laws and regulations that traditional businesses do and are exposed to the same risks. While we link the concept of risk with the notion of uncertainty, risk isn’t synonymous with uncertainty. The PowerPoint basis for the discussion is available to the readers. Common... 2. Most likely, your answer would be, “insecurity and uneasiness.” We associate risks with fears. However, did the myopic concentration on terrorism risk derail the holistic view of risk management and preparedness? Enumerate any two political causes of business risk ? They could not refinance at lower interest rates as rates rose after the 9/11 attacks. The obstacles may be within our own behavior or stand externally. If the deviation from what was expected is negative, we have the popular notion of risk. 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. Thus, actually giving a single unambiguous definition of what we mean by the notion of “risk” proves to be somewhat difficult. Answer. When the mortgages failed because of greater risk taking on Wall Street, the entire house of cards collapsed. The new measures called for increased random passenger screenings. The categorization is often a matter of perspective. If you were manager of the store, would you want all these operations? Another differentiation is by systemic or nondiversifiable risks, as opposed to idiosyncratic or diversifiable risks; this is explained below. 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. For example, there are two types of risks: high and low. Exposure to premature death, sickness, disability, unemployment, and dependent old age are examples of personal loss exposures when considered at the individual/personal level. Situation in which a manufacturer may be liable for harm caused by use of its product, even if the manufacturer was responsible in producing it. are hazards that involve behavior that can be construed as negligence or that borders on criminality. The natural disasters of Katrina, Rita, and Wilma added to the extreme risks and were exacerbated by extraordinary mismanagement. In this section, you will learn that people’s attitudes toward risk affect their decision making. Potential variety in interest rates over time. to describe the enterprise, property, person, or activity facing a potential loss. Lenders gave home mortgages without prudent risk management to underqualified home buyers, starting the so-called subprime mortgage crisis. Though some would include losses caused by the state of the economy as human perils, many professionals separate these into a third category labeled economic perilsCauses of losses resulting from the state of the economy.. It can bring complete calamity and total loss in the pure loss-avoidance context. The notion of “risk” and its ramifications permeate decision-making processes in each individual’s life and business outcomes and of society itself. As such, people would have avoided these investments or wouldn’t have put enough money into reserve to be able to withstand defaults. The nature of business risk is explained below: (Any three), What is business risk ? when its risk preference lies in between these two extremes. Why it is said that risk is an essential part of every business ? Table 1.3 Examples of Risk Exposures by the Diversifiable and Nondiversifiable Categories. Figure 1.1 "Complete Picture of the Holistic Risk Puzzle", Figure 1.2 "Uncertainty as a Precondition to Risk", Figure 1.3 "Roles (Objectives) Underlying the Definition of Risk", Chapter 3 "Risk Attitudes: Expected Utility Theory and Demand for Hedging", Table 1.2 "Examples of Pure versus Speculative Risk Exposures", Chapter 4 "Evolving Risk Management: Fundamental Tools", Chapter 5 "The Evolution of Risk Management: Enterprise Risk Management", Figure 1.5 "A Photo of Galveston Island after Hurricane Ike", Table 1.3 "Examples of Risk Exposures by the Diversifiable and Nondiversifiable Categories", Figure 1.6 "Life Insurers’ Enterprise Risks", http://www.iso.com/index.php?option= com_content&task=view&id=932&Itemid=587, http://www.iso.com/index.php?option= com_content&task=view&id=930&Itemid=585, Note 1.48 "Is Airport Security Worth It to You? Sources: Tsar’s Press release at http://www.tsa.gov/public/display?theme=44&content=090005198018c27e. Many important risk transfer contracts (such as insurance contracts) use the word “peril” quite extensively to define inclusions and exclusions within contracts. A person experiencing the flu is not necessarily the same as the virus causing the flu. Risk retentionWhen a firm retains its risk, self-insuring against adverse contingencies out of its own cash flows. The guarantees are provided under a second contract. Bundling the investments gave these institutions the impression that the diversification effect would in some way protect them from risk. Likewise, buildings used for dry cleaning (which uses volatile chemicals) will bear a greater physical hazard than do elementary schools. Under most legal systems, a party can be held responsible for the financial consequences of causing damage to others. Diversifiable risksRisks whose adverse consequences can be mitigated simply by having a well-diversified portfolio of risk exposures. Risk that features some chance of loss and no chance of gain. RiskUncertainty about a future outcome, particularly the consequences of a negative outcome. All of these losses are covered by insurance, right? Additional financial instruments (called credit derivatives)In essence, a credit derivative is a financial instrument issued by one firm, which guarantees payment for contracts of another party. Now everyone realizes they are in this global mess together. Poor housekeeping (e.g., allowing trash to accumulate in attics or basements) or careless cigarette smoking are examples of morale hazards that increase the probability fire losses. What are your feelings about this statement? Even in chapters that you may not think apply to the individual, such as commercial risk, the connection will highlight the underlying relationships among different risks. Insurance and Risk management helps in minimizing the risk associated with the business. The precariousness of the results of human effort has been a fa- 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. It wouldn’t be risk because it would be predictable. We can also divide perils into insurable and noninsurable perils. Causes of Business Risk (i) Natural causes: These are beyond human control, e.g., flood, earthquake, heavy rains, famine, etc. Someone who will enter into an endeavor as long as a positive long run return on the money is possible, however unlikely. Building locations affect their susceptibility to loss by fire, flood, earthquake, and other perils. It’s the risk that your company’sstrategy becomes less effective and your company struggles to reach its goalsas a result. For example, the reputation of a firm is unique to the firm. In scientific settings and in actuarial and financial contexts, risk is usually expressed in terms of the probability of occurrence of adverse events. Following news of this aborted plot, the U.S. Terror Alert Level soared to red (denoting a severe threat level). Even the distinction between moral and morale hazards is fuzzy. The snowballing effect of this failure to manage the risk associated with providing mortgage loans to unqualified home buyers has been profound, indeed. More important than replaceable hardware or software is the data they store; theft of proprietary information costs companies billions of dollars. Think of tobacco companies facing new advertising restrictions, for example, or the late-1990s online music-sharing services that were sued for copyright infringement and were unable to stay in business. We refer to physical hazardsTangible environmental conditions that affect the frequency and/or severity of loss. Competitive Risk. The environment is filled with perils such as floods, theft, death, sickness, accidents, fires, tornadoes, and lightning—or even contaminated milk served to Chinese babies. Some risk transfer professionals refer to premiums as an exchange of a certain loss (the premium) for uncertain losses that may cause us to lose sleep. chemical spills), uncertainty-based (e.g. 4.Profit is the reward for risk taking: A business gets profit as return for undertaking risk. Give examples of exposures. But a building that is susceptible to one peril is not necessarily susceptible to all. The increase of awareness and usage of enterprise risk management (ERM) post–September 11 failed to encompass the already well-known risks of high-category hurricanes on the sustainability of New Orleans levies. However, if it is more specifically defined, the risks can be more clearly categorized. THE NATURE OF BUSINESS RISK JOHN H. BicxLEY Public Utility Consultant "To live and labor in uncertainty is the common lot of all men. The risk that your competition will gain advantages over you that prevent you from … Risks that are pervasive to and affect the whole economy, as opposed to accidental risk for an individual. The term “exposures” is used to include all units subject to some potential loss. In this section, you will learn what a risk professional means by exposure. A separate focused field of study, it draws on core knowledge bases from law, engineering, finance, economics, medicine, psychology, accounting, mathematics, statistics, and other fields to create a holistic decision-making framework that is sustainable and value-enhancing. What examples can you cite of quantitative consequences of uncertainty and a qualitative or emotional consequence of uncertainty? Describe the new risks facing society today. This decade can be named “the decade of extreme risks with inadequate risk management.” The late 1990s saw extreme risks with the stock market bubble without concrete financial theory. THE NATURE OF BUSINESS RISK JOHN H. BicxLEY Public Utility Consultant "To live and labor in uncertainty is the common lot of all men. A risk is an important characteristic of business. In fact, we experienced this negative event because it was externally imposed upon us. The overlapping area shows a tight focus on minimizing the pure losses that might accompany insolvency or bankruptcy. Inflation causes both pure and speculative risks in our society. 2. Entrepreneurship is an innovative activity, through which creative ideas may be … Destroying one’s reputation is not a systemic risk in the economy or the market-place. There are certain nature factors like floods, earthquake etc. Risk management will be a major focal point of business and societal decision making in the twenty-first century. Some people say that Eskimos have a dozen or so words to name or describe snow. This definition includes legal risk, but excludes strategic and/or business risk and reputational risk. Various levels of real estate foreclosures. Try to illustrate each cross classification of risk with examples. Home prices started to decline simultaneously as many of the unqualified subprime mortgage holders had to begin paying larger monthly payments. Physical hazards that affect property include location, construction, and use. Managing risks associated with the context of minimization of losses has succeeded more than managing risks when we use an objective of value maximization. What is the relationship between uncertainty and risk? We could talk about natural versus human perils. In other fields, such as political risk assessment, risk may be very qualitative or subjective. This lack of risk management cannot be blamed on lack of warning of the risk alone. Financial Risk is one of the major concerns of every business across fields and geographies. These risks are extensive and the exposures are becoming more defined. Today, management of personal and commercial risks requires coordination of all facets of the risk spectrum. One medical practice that has been widely discussed in recent years involves defensive medicine, in which a doctor orders more medical tests and X-rays than she or he might have in the past—not because of the complexity of the case, but because the doctor fears being sued by the patient for medical malpractice. The financial markets are collapsing as never before seen. We will also explain these definitions in a legal sense later in the textbook to help us determine terms such as “residual risk retained.”, Table 1.4 Types of Perils by Ability to Insure. When one’s risk preference lies between the extremes of risk averse and risk seeking. In this section you will learn the terminology used by risk professionals to note different risk concepts. Less-burdensome modifications were made to the list of TSA-prohibited items not long after publication of the initial requirements. Business risk is influenced by a number of different factors including: Consumer preferences, demand, and sales volumes Per-unit price and input costs Competition The overall economic climate Government regulations An Interdisciplinary Series of Edited Volumes on the Impact of 9/11, vol. Business risk refers to a threat to the company’s ability to achieve its financial goals Earnings Guidance An earnings guidance is the information provided by the management of a publicly traded company regarding its expected future results, including estimates.In business, risk … The aftermath of Katrina is a testimonial to the lack of risk management. Losing money may have arson as a last resort treat the patient otherwise! 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