In their middle 50s the contrast between Dennis and Joe could not be more distinct even though they work together. Dennis has remained in relatively good shape and has been frugal for many years and takes few personal risks. Joe lives by the philosophy “you only live once” and despite a good income saved very little. He also has very poor eating habits and risky hobbies. One of the key differences between the two men is risk management.
In the case of Dennis and Joe, others must manage risk based on their behaviors. Their employer must determine how much risk they are to the company. The insurance company must determine how much of a liability they are to the insurance company. In an extremely broad sense, society must also account for risk management associated with Dennis and Joe.
Risk Management Defined
Risk has been defined by nearly every discipline including economists, statisticians, behavioral scientists, and actuaries. Most often that definition involves uncertainty. Risk is defined as uncertainty concerning the occurrence of loss. That definition naturally breaks into two pieces which consist of uncertainty and probability. the uncertainty and probability are further divided into objective risk, subjective risk, objective probability and subjective probability.
Objective risk is the relative variation with actual loss from expected loss. If a local auto insurance agent can expect to have 10% of his 500 clients make a claim each year, then we should expect 50 claims per year. Having exactly 50 claims each year would be rare because some years there may be 44 claims and other years 58 claims. This is objective risk or the relative variation between the actual loss and expected loss. But the law of large numbers states that with greater exposure the closer it gets to the average. So, if the insurance company had 5,000,000 clients, we could expect a number very close to 10% each year.
Subjective risk is defined as the uncertainty based on a person’s mental condition or state of mind. The evaluation of Dennis and Joe represent 2 different subjective risks. The prudent behavior of Dennis makes him a better risk and the decisions of Joe make him a higher risk.
Objective probability is the relative frequency of an event occurring given a sufficiently large number of observations and no change in the conditions. The most common example of this is flipping a coin or rolling dice. By flipping a coin, you may get heads 3 or 4 times in a row but over many coin flips you would anticipate getting very close to 50% heads and 50% tails.
Subjective probability is the individuals personal estimate of their chance of loss. For example, the reason Dennis is so cautious is from a very high estimate of personal loss.
Basic Categories of Risk
There are several categories of risk, but the 3 most important categories are:
- Pure and Speculative Risk
- Fundamental and Particular Risk
- Enterprise Risk
Pure and Speculative Risk
Pure risk as the name implies only allows for two possibilities of loss or no loss. Some common examples of pure risk include medical expenses, unemployment, property damage from fire, premature death and auto accidents. Private insurance companies typically ensure pure risk because there is not benefit from pure risk.
Speculative risk provides the possibility of profit or loss. Common stocks represent speculative risk. Typically, speculative risk is not covered through private insurance because predicting future losses is very difficult.
Fundamental and Particular Risk
Fundamental risk effects an entire economy or many people within the economy. War, inflation, natural disasters, terrorist attacks and cyclical unemployment could be considered fundamental risk. Fundamental risk often exceeds the ability of private insurance companies to compensate for the damages and the government usually assist.
Particular risk affects only an individual or a very small group. Car thefts, house fires, car accidents and identity theft would be examples of particular risk. Typically, these will not require government intervention.
enterprise risk is a term that encompasses all major risks faced by business firm. These include strategic, operational, speculative, financial and pure risks. Risk management is becoming more important in business and many industries have associations dedicated to risk management.