Chapter 2

Objective of Risk
Management
 The need for risk management objective
• Risk refers to either variability around the expected value or, in
other contexts, the expected value of losses. Holding all else
being equal, both type of risk - variability and expected losses
- are costly. At a broad level, risk management seeks to mitigate
this reduction in value and thus increase welfare.
• Risk is costly and so is the management of risk. We therefore need
some guiding principles to determine how much and what type of
risk management should be pursued. That is, we need to identify
the underlying objective of risk management.
• The guiding principles or fundamental objective of risk
management is to minimize the cost of risk. When we consider
the business risk management decision, the objective is to
minimize the firm’s cost of risk. When we consider the individual
risk management, the objective is to minimize the individual’s cost
of risk. And, if we consider the public policy risk management
decisions, the objective is to minimize society’s cost of risk.
 Understanding the cost of risk
• Most risk management decision must be made before losses
are known. The magnitude of actual losses during a given
time period can be determined after the fact (i.e., after the
number and severity of accidents are known).
• Before losses occur, the cost of direct and indirect losses
reflects the predicted or expected value of losses during an
upcoming time period.
• Thus, the cost of losses can be determined ex post (after
the fact) and estimated ex ante (before the fact).
• Most risk management decision must be made based on ex
ante estimates of the cost of losses and thus the cost of risk.
 Components of the cost of risk
• The cost of risk has five components as shown in the
following figure:
• Expected Cost of Losses
• The expected cost of losses includes the expected cost
of both direct and indirect losses. Direct losses include the
cost of repairing or replacing damaged assets, the cost of
paying workers’ compensation claims to injured workers and
the cost of defending against and settling liability claims.
Indirect losses include reduction in net profit that occur as a
consequence of direct losses.
• Cost of Loss Control
• The cost of loss control reflects the cost of increased
precautions and limits on risky activity designed to
reduce the frequency and severity of accidents. For
example, the cost of loss control for the pharmaceutical
company would include the cost of testing the product for
safety prior to its introduction and any lost profit from limiting
distribution of the product in order to reduce exposure to
lawsuits.
• Cost of loss Financing
• The Cost of loss financing includes the cost of self finance,
the loading in insurance premiums, and the transaction cost
in arranging, negotiating and enforcing hedging arrangement
and other contractual risk arrangements.
• Cost of internal risk reduction Methods
• The cost of internal risk reduction includes transaction
costs associated with achieving diversification and
investing in information to obtain better forecasts of
losses. It also includes the cost of obtaining and analyzing
data and other type of information to obtain more accurate
cost of forecasts. In some cases this may involve paying
another firm for this information, for example, the
pharmaceutical company may pay a risk management
consultant to estimate the firm’s expected liability costs.
• Cost of residual Uncertainty
• Uncertainty about the magnitude of losses seldom will be
completely eliminated through loss control, insurance,
hedging, other contractual risk transfers, and internal risk
reduction. The cost of uncertainty that remain (i.e., left
over) once the firm has selected and implemented loss
control, loss financing and internal risk reduction is
called the cost of residual uncertainty. This cost arises
because uncertainty generally is costly to risk averse
individuals and investors.
 Cost Tradeoffs
• A number of tradeoffs exist among the components of the
cost of risk. The three most important cost tradeoffs are
those between:
• (1) The expected cost of direct/indirect losses and loss control
cost.
• (2) The cost of loss financing/internal risk reduction and the
expected cost of indirect losses, and
• (3) The cost of loss financing/ internal risk reduction and the
cost of residual uncertainty
• First, tradeoff normally exist between expected loss
(both direct and indirect) and loss control cost.
Increasing loss control costs should reduce
expected losses. In case of the pharmaceutical
company, for example, expenditures on developing a
safer drug will reduce the expected cost of liability
suits.
• Minimizing the cost of risk requires the firm to
invest in loss control until the marginal benefit -
in the form of lower expected costs resulting
from direct and indirect losses - equals the
marginal cost of loss control.
• The second major tradeoff among the components
of the cost of risk is the tradeoff between the costs of
loss financing/internal risk reduction and the
expected cost of indirect losses. As the more
money is spent on loss financing/ internal risk
reduction, variability in the firm’s cash flows
decline. Lower variability reduces the probability of
costly bankruptcy and the probability that the firm will
forgo profitable investment as a result of large
uninsured losses. As a result, the expected cost of
these indirect losses declines.
• The third tradeoff is that which often occurs between
the cost of loss financing/ internal risk reduction and
the cost of residual uncertainty. For example, if the
firm incures higher loss financing costs by
purchasing insurance, residual uncertainty
declines. Greater and more costly internal risk
reduction also reduces residual uncertainty.
 Firm Value Maximization and the Cost of Risk
• Determinants of Value
• Business value to shareholders determines
fundamentally on the expected magnitude, timing and
risk (variability) associated with future net cash flows that
will be available to provide shareholders with a return on their
investment.
• Business value and the effect of risk on value reflect an ex
ante perspective: Value depends on expected future net
cash flows and risk associated with these cash flows.
• Because most investor are risk averse, the risk of cash
flows reduces the price they are willing to pay for the
firm’s stock and thus its value. Thus, a fundamental
principle of business valuation is that risk reduces value
and increases the expected return required by investors.
 Maximizing value by Minimizing the cost of Risk
• If the firm’s cost of risk is defined to include all risk-related
costs from the perspective of shareholders, a business can
maximizes its value to shareholders by minimizing the
cost of risk. To see this more clearly, we define:
Cost of risk = Value without risk -Value with risk (1)
• Writing this expression in terms of the firm’s value to
shareholders in the presence of risk gives:
Value with risk = Value without risk -cost of risk (2)
• The value of the firm without risk is a hypothetical and
abstract concept. It equals the hypothetical value of the
business in a world in which uncertainty associated with net
cash flows could be eliminated at zero cost. This value is
entirely hypothetical because risk is inherent in real-world
business activities.
• To illustrate the cost of risk, consider the product liability
risk.
• For the pharmaceutical company, the value of the firm
without risk is the hypothetical value that would arise
• if (1) it were impossible for the drug to hurt consumers
and thus produce lawsuits and
• (2) the firm did not have to incur any cost to achieve this
state of riskless bliss. The reality of injury risk and cost of
loss control give rise to risk related costs, thus reducing the
value of the business.
• Equation (2) implies that if the firm seeks to maximize value, it
can do so by minimizing the cost of risk.
Individual Risk Management and the Cost of
Risk
Thank You