Magazine article Risk Management

Risk: So What?

Magazine article Risk Management

Risk: So What?

Article excerpt

Many executives consider the inability to plan the most harmful result of risk. The lack of precise knowledge of what to expect means budgets are set, not at an assured mean value, but instead at some higher value reflecting the mean plus some additional increment of the standard deviation. Statisticians call this increment a "z-score." For example, assume a risky situation has an outcome with a normal probability distribution. This classic bell-shaped curve is normally obtained when insurance company or ISO actuaries observe a loss data base with a large number of independent, homogeneous exposure units. The actuary can then predict a loss confidence interval for any desired z-score. With a normal probability distribution, the actuary is about 84% certain a loss will not be greater than the mean value plus one z-score (standard deviation). When the loss data contains few observations (the fortunate case for most corporate risk managers) the distribution will often be negatively (left) skewed with a long loss tail. Now the mean loss plus one standard deviation ([S.sub.L]) is a very large value. To obtain the same 84% confidence interval, the (+1 [S.sub.L]) value will be much greater. The risk manager must either provide for this large loss cost in the budget or take a chance with some lower number. The inexact knowledge of the outcome creates the inability to precisely plan budgets and allocate scarce resources.

Not all risky situations have purely adverse outcomes, however. In the risk management world, the old adage of "no pain, no gain" translates to "no risk, no reward." Risk managers schooled in finance recognize this as the capital asset pricing model. For a project with a given level of risk, there is a commensurate level of return. That is why the goal for any risk manager is not to eliminate all risks, but instead to achieve the desired level of risk at the desired time so the organization can achieve the desired levels of return.

In theory, corporations should be risk neutral and pay only an "actuarially fair price" to take on or transfer risk. But in reality, some people, at some times, are risk takers. They actually pay money to take on new risks (investors and gamblers). …

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