Almir Tahirovic October 15, 2009Risk ManagementReading Assignment 1

The first article discusses the definition of risk proposed by the Committee for Insurance Terminology. The Committee defined the risk as “uncertainty as to the outcome of an event when two or more possibilities exist”. Author notes that there are three main facts that have to be tied up to the risk as the reason not to define risk only as uncertainty. First, the word uncertainty is ambiguous and its meanings can confuse a scholar. From one stand point it reflects condition where you cannot predict, or you do not know the probability of some outcome. Moreover, in psychology uncertainty represents state of mind and that fact makes the uncertainty subjective. Author does not accept the risk as subjective. Second, this definition can make readers and scholars to bring wrong and contrary conclusions. Third, uncertainty cannot be quantified properly, and we know how risk is important in risk management when we talk about calculating the costs and losses of risk. In order to figure out the cost of risk, we need to have basic fundaments of how to do that. How to measure something if you do not have a measure? It is impossible. Finally, they imply that risk is close to be defined as “objective probability that the actual outcome of an event will differ significantly”. Second article focuses on pulling the reader closer to the meaning of risk through certain analysis of risk components and other definition of risk which is “the possibility that sentient entity will incur loss”.

I must say that I have found myself in the author’s story about Joe College guy who did not understand the definition of risk as uncertainty about what outcome will occur. As author said that uncertainty is a word that can have many meanings, I think that is in right. Uncertainty can be used as a component of risk, but it cannot define the risk as it is. It is too general, to be definition of one term which is applied in economical analysis. This generality or objectivity of word uncertainty reduces the way of quantifying the risk in economy which is one of the main critics of author to the Committee’s definition. I agree completely with the author’s way of elaborating the negative characteristics of defining the risk as uncertainty, especially with the one where author concludes that uncertainty is compared as the state of mind, and lack of knowledge. I can add that risk can add as one of its components the lack of knowledge, but this statement has already maintained through the definition of uncertainty. Everything what we do in today’s world is risky, but is everything what we do uncertain? No, it is not. Uncertainty needs to be defined a little bid more in order for scholars as me to understand it in a proper way. I rather prefer the proposed definition by author: “risk is the objective probability that the actual outcome of the event will differ signalcantly from the expected outcome”. This definition states and puts risk in clearer situation where we can sort it in our minds within practical examples, so later it would be easier to apply it in analysis and further readings. First, I think that this definition helps us to quantify the risk. This quantification of risk is important because it will enable us to calculate the cost of risk and its components. In calculating the cost of loss control, the cost of loss financing and other components of pure risk, we have to use mathematical measures so that we can predict, control, and organize the diversification of risk within the company’s operations.

I do not agree with the author’s arguments for disadvantage of this definition of risk as objective probability. Author states first example of a man who claims that he is going to be ill, but there are no medical symptoms which can assert to that statement. According to the autor's argument we have to include morbidity data in calculating the probability about the outcome. I do not agree with this, because I think that we have to catch any facts and connect it with the calculation of probability. In this case the fact is that there are no any symptoms which can reason the true diagnose of future illness. Here we talk only about the man’s uncertainty and his state of mind in certain moment where he thinks that he is going to be ill. We cannot quantify the risk in this situation, because there are no quantifiable data to help us determine the measurements for further risk analysis. When the author supports its thesis that objective probability of risk changes as the knowledge changes with the example of Truman election, I have to say that probability of one event such as elections depends on a deep preanalysis and analysis of voting body. There are not any changes in knowledge necessary if the candidate who is not preferred by media is being elected, and there was a low probability of him winning in the elections. Relevant data makes the probability data to become more accurate and media as a channel for deduction of facts is not a reliable tool. So the author’s second argument against this definition of risk cannot be reliable. I can freely say that the objective probability that the event will occur differently than expected is one of the closest definition of risk, especially in business.

Reading Assignment 2

Risk manager’s ability to manage risk is being expressed through the responsibility in three basic areas: insurance, loss control and property preservation. I must say that these areas can sometimes overlap and support each other. Risk manager have to control the cost of risk through the insurance program controlled and adjusted through the three types of financial tools: self – insurance, deductibles and full insurance.

In order to use any of these tools the risk manager needs to be familiar with the financial situation in his company. If the company is financially healthy entity, and if they conclude that there is a lower risk for some loss to happen, they will try to insure themselves through the usage of self – insurance tool. On this way the company will not give financial means to the insurance company, but they will establish loss fund which will absorb certain amount of money each period. Positive side of this is that the company will not have to give that money and get nothing in return if the loss does not happen, but the company will still have that money and it can stop transferring the money into the fund when the sum in the fund equals the cost of possible loss. This means that for the long term the self – insurance is a good way to avoid risk and for the short term the company’s profit is about to be reduced by the sum transferred into the self – insurance fund until the amount in the fund is equal to the cost of possible loss. This type of risk management should be used in situations where a company needs to insure themselves of possible loss which is affordable to the company, or for the loss that the company’s liquid capital can cover and for which the cost of risk is not too big. This type of reducing the risk can be used in the insurance of company’s assets, labor and other possible financial losses.

If risk manager have analysis results which reflects possible future losses, but the company’s policy at that moment is to save as much as they can, because the liquidity is a shaken, therefore management has to comply with those goals through all possible tools. In this situation the deductible is one of the best solutions to insure the company from the possible loss. First, risk manager has to be aware of financial strength of the company, that is, he must know how much company can bare in order to pay the premiums, and how much can save from deductibles, on a periodically basis. This also is connected with the historical data of possible losses and costs of risk. After this is done, the company will be able to operate beside the fact that the premium is being paid after all. This balance between the premium paid, and savings from deductibles is determined by the risk manager, and directly short term profits are being influenced by that decision. Certain period the short term profit will be increased by the deductibles, and long term profits will not be effected under some losses which are expected to happen, and even not under some severe, because the company is insured, and the financial loss will be covered partially by the insurance, too. The main positive side of this tool is that enables companies in certain situation to preserve its operating power and still to insure, preserve themselves from loss. Every company is sometimes in a situation in which some things are not affordable, while some danger is threatening them at the same moment. This is an excellent tool to leverage the risk and to use the financial means in a proper way until the company becomes more financially powerful. Cons are if the risk manager makes mistake during the analysis and predict wrongly reduced risk, while there is a high risk, there might happen that company could not cover the loss, and go bankrupt. Loss control, loss financing and other methods are considered under the analysis which serves risk manager to preserve assets, reduce the cost of risk, avoid the risk, and to insure the company’s operation in general. In this text I use “insure” in more general sense.

Risk manager must use these tools in order to make the preventive measures and plan of possible losses for the future, so that company’s operations, investments cannot be affected to that level where it will be necessary to bankrupt or to lose more than expected. Last tool is full insurance. The usage of this tool affects the short term profit as the long term, too. The effect is negative, what is concludable because the premium has to be paid at regular base, and the possibility of loss stays the same as predicted. The full insurance erases the negative sides and uncertainty related to the deductibles and self insurances if the losses occur. This type of insurance is necessary when the company needs to cover all the risk, and the financial strength allows that, or better financial means can handle that expense (premiums). These tools are advantageous for every company, because a risk is unavoidable partner of every project, operation and event that is going on within business entity. We can avoid risk, increase our profits, prevent losses, and reduce expenses at the moment, and in the future. We also use full insurance in cases where premiums are smaller, but cover all assets, for example company’s cars. Risk manager should be near CEO, because to have decisions which will be risk managed in proper way, especially in big corporations where cost of risk is in millions.