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The Dimensions of Risk - May 1999 : Risk Management – an educational perspective (Part one)

By Michael Vincent

28 December, 2006

Risk management is the emerging management philosophy of tomorrow's successful company.  We are slowly eliminating the concept linking risk management and insurance.  Industry has been restructuring for over a decade and the emphasis has been on increasing efficiency and productivity whilst downsizing in terms of employee numbers.

A point has now been reached where all the benefits of restructuring are at risk unless the traditional management structure can embrace the new management paradigm of risk management.  The concept of project management overlaid with the principles of risk management enable an entity to manage effectively with a minimum of resources.  Failure to embrace the new paradigm will see companies shrivel and die because the restructuring has left no room for growth when opportunities allow.

A discussion with a colleague, Kevin Tant, produced the following outline for successful recognition of the concept of risk management as a new management discipline.   A lot of readers will see the obvious stated here, luckily you are the converted.  Risk management is the ability to identify, measure and finance the risks facing an entity in an effective way to ensure corporate growth and survival.

What do we mean by risk management?

Risk is a dynamic concept that requires identification and understanding.  It requires not just a professional and analytical approach, but also imagination and innovation.

Boards of Directors and risk managers should consider: -

Is risk good or bad?

How do we identify risk?

Should we avoid risk?

Should we transfer risk?

Should we retain risk? or

Should we manage risk in the most efficient manner?

Risk must be identified, understood, managed and controlled.

Risk will certainly not identify itself! 

There is no economic benefit to be derived from waiting until risk strikes.

Risk, as far as many financial managers are concerned, is the cost of insurance and no more.  Finance and treasury managers have traditionally focussed on the cash flows and cost of managing risk; it can either be managed in terms of financial risks (interest rate, risk, foreign exchange risk, liquidity risk, price risk, and credit risk) or in terms of operational risks via the insurance process.

The traditional insurance approach is no longer valid as the only alternative to managing and financing risk.  Finance directors and corporate treasurers are becoming increasingly aware that they must become involved in the "big picture" in terms of risk management.

Professional development in the treasury area is focussing their attention not just in terms of cost of managing financial risks, but also the need to focus on the increasing cash flows of managing other risks.

If management can control risks and their cost in a more efficient manner then the organisation will suffer fewer (potential) losses which will increase the benefits or profits to be gained from operations.

The 1990's, so far, have evidenced a difficult business environment.  Corporations have experienced difficulties in maintaining profitability in a recessive environment and traditional management practices have been under review in an endeavour to introduce more efficient ways of managing the underlying business.  This environment has impacted heavily upon the financial area where efficiencies in cost control have been sought.  Past philosophies such as:

insure everything,

react rather than proact,

don't worry about the cost because we have adequate financial resources,

Ignorance

cannot be tolerated.

There is now acceptance that the corporation must manage both opportunity and risk in a planned way.

Risk Defined

There is no single definition of risk.  It is traditionally defined as the uncertainty concerning the occurrence of loss.

Risk can be categorised as:

Objective Risk;  the relative variation of actual loss from expected loss.  It can be statistically measured.  In insurance terms, objective loss declines as the number of exposures increases due to the law of large numbers.

The law of large numbers states that as the number of exposure units increases, the more closely will the actual loss experience approach the probable loss experience.

Subjective Risk;  the uncertainty based on a person's mental condition or state of mind.

High subjective risk tends to result in conservative and prudent conduct whereas low subjective risk may result in less conservative conduct.

The chance of loss is considered to be the probability that an event will occur.  It can be categorised as: -

Objective Probability;  the long run relative frequency of an event occurring based on an infinite number of observations and no change in underlying conditions.

Subjective Probability;  an individual's estimate of the chance of loss.

Peril and hazard should not be confused with the concept of risk discussed earlier.

Peril is defined as the cause of loss whereas a hazard is a condition that creates or increases the chance of loss.  There are three types of hazard: -

Physical hazard;  a physical condition that increases the chance of loss.

Moral hazard;  dishonesty or character defects in an individual that increases the chance of loss.  It is usually the result of dishonesty.

Morale hazard;  the carelessness or indifference to a loss because of the existence of insurance.

There are three major categories of risk: -

Pure risk is a situation where there is only the possibility of loss or no loss.  There is usually no opportunity to profit from the loss.  These risks include personal risks, property risks and liability risks.

Speculative risk is a situation where either a profit or loss is possible.  It includes commercial and financial risks such as new product development, interest rate risk, foreign exchange risk, investment in the share market, etc.  Superannuation risk also includes gambling.

The law of large numbers can be applied more to pure risk than speculative risk.

2. Static and Dynamic Risks.

Static risks occur because of irregular actions by nature or individuals.

Dynamic risk is associated with a changing economy.

Most static risks are pure risks whereas all dynamic risks are speculative where both profit and loss are possible.

3. Fundamental and Particular Risks.

Fundamental risk, such as inflation relates to the entire economy or a large number of persons or groups within the community.

Particular risk affects generally individuals and not the entire community or country.

SUMMARY:

We have looked at the paradigm of risk management and suggested strongly that the future of companies will be based on the application of risk management principles.

Senior management and boards of directors have a duty of care to ensure correct management exists within the entities under their control.  Shareholders will be less forgiving in the future to those people who ignore developments in management that have the potential to make obsolete over night existing principles.  Especially since the restructuring of industry has created the environment where the application of new management methods will ensure survival.  Risk management supplies the framework for survival now and into the new century.

Over selected future issues the concept of definition of risk, methods of managing risk and risk financing will be examined.

About the Authors

Department of Accounting and Finance

Faculty of Business and Economics

Monash University