Risk Management in Turbulent Times

By Gilles Bénéplanc; Jean-Charles Rochet | Go to book overview

3
The Need for a Proper
Methodology

3.1 THE NECESSARY INGREDIENTS

Risk management has a long history. Various techniques have been developed for many years in all areas of human activities. Classical examples are the construction of dams that protect against floods and the organization of fire brigades to fight against fires. It is only recently that a common methodology has emerged. Recent crises have shown that several ingredients of this methodology are crucial: mishandling one of them can be sufficient to provoke the failure of an established company. This section presents a summary of this methodology.

The necessary ingredients of risk management are listed below.

The Identification step consists of identifying the entire spectrum of possible
risks that can hurt the firm.

The Quantification & Modeling step consists of estimating the frequency and
severity of each risk and also, very importantly, the correlations between
them. Ideally, one should be able to build a quantitative model giving the
cumulative distribution function of losses (or gains) conditionally on
external and internal variables.

The Loss Prevention & Protection step consists of the reduction of the
frequency (prevention) and consequences (protection) of the risks. Taking
the example of property risks, good maintenance of electricity systems
improves loss prevention, whereas maintaining a sufficient water pressure
on-site improves loss protection.

Finally, the Risks Financing & Transfer step consists of deciding which risks
have to be financed directly (when the corporation decides to keep them)
and which have to be financed indirectly (when the risk is transferred to
financial markets or an insurance company).1

For many years this traditional approach has been applied to each specific family of risks, the oldest examples being property and marine risks. The occurrence of new and larger risks, together with their growing complexity and multiple interdependencies, required some improvements in the risk management methodology and instruments. We now study these improvements by following each step of the risk management approach: risk mapping for the identification and quantitative steps, loss prevention in new areas like fraud or liability, and, finally, the impressive array of new financial tools that have been created in recent years to transfer and finance risks.

-16-

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