UNSW Business School

Fundamentals of Risk and

Risk Management

RISK5001

Dr Kevin Liu
 Course Intro
Course Aim
This course aims to introduce students to the complex and
diverse range of risks that organizations must manage in
today's fast-changing global environment, as well as the
fundamental principles, frameworks and practices of risk
management.

2
 Course Intro
Student Learning Outcomes
1. Describe and analyse the risks facing individuals and
organisations.
2. Explain and evaluate how these risks affect individuals
and organisations, and the main approaches to measure
and manage these risks.
3. Explain and assess the basic principles and frameworks
of risk management and the role of insurance industry.
4. Use and critically assess the standard approaches to
enterprise risk management.

3
 Course Intro
Learning and Teaching Activities
▪ Lecture (2 hours/week): Weeks 1-10
▪ Tutorial (1.5 hour/week): Weeks 1-10
– Weekly tutorial problems and exercises

▪ Tutorial program and reading list (to be posted on

Moodle)

4
 Course Intro
Teaching Staff

Dr Kevin Liu
School of Risk and Actuarial Studies
UNSW Business School
Email: [email protected]

Dr Shauna Ferris
School of Risk and Actuarial Studies
UNSW Business School
Email: [email protected]
5
 Course Intro
Textbook and References
▪ Fundamentals of Risk and Insurance, 11th edition,
Emmett J. Vaughan, Therese M. Vaughan, October 2013,
©2014, Wiley, Paperback ISBN : 978-1-118-53400-7, E-
Text ISBN : 978-1-118-80558-9.
▪ Students are also able to purchase the E-Book from this
link https://www.wiley.com/en-
au/Fundamentals+of+Risk+and+Insurance%2C+11th+Edition-p-
9781118805589
▪ The examinable content of this course is defined by the
content of the lectures, the designated readings and the
content of the tutorial program
▪ Readings will be posted on Moodle, including academic
6
papers, policy documents and articles
 Course Intro
Assessment
▪ 5% Tutorial Participation & Discussion

▪ 20% Discussion Questions (Weekly)

– The course offers discussions to reinforce your learning and help you
solidify the relevance of the course to the real world and to your lives.
– Therefore, there is no single right answer to these questions; what
counts is that you make a sincere attempt, reflect and learn as much as
possible from the discussions.

▪ 25% Assignment

▪ 50% Final Exam

7
 Course Intro
Student Feedback
▪ Giving Feedback
▪ End-of-session: myExperience
▪ In-class (lecture/tutorial) feedback
▪ Weekly Feedback Survey
▪ Consultation/Discussion Forum/Email
▪ Receiving Feedback
▪ Assessment - Review essay
▪ In-class (lecture/tutorial) feedback
▪ Peer feedback (discussion forum)

8
 What we will cover?
1. Introduction to Risk and Risk Management
2. Insurance and Risk
3. The Private Insurance Industry
4. Personal Risks, Social Insurance and Life Insurance
5. Actuarial Basis of Life Insurance and Longevity
Insurance
6. Credit Risk Management
7. Market Risk Management
8. Operational Risk Management
9. Bank Capital Adequacy and Other Risks

9
 UNSW Business School

Fundamentals of Risk and

Risk Management
Topic 1: Introduction to Risk and Risk
Management
Dr Kevin Liu
 Outline
1. The concept of risk
2. Introduction to risk management

Reading
✓ Textbook Chs. 1, 2

11
The concept
of risk

12
 What is risk?
▪ Risk has multiple connotations and operational
definitions
▪ Common elements in definitions of risk:

▪ Indeterminacy – at least two possible outcomes

▪ Adversity – at least one of the outcomes is

undesirable (i.e. loss)

13
 What is risk?
Risk is a condition in which there is the possibility
of an adverse deviation from a desired outcome
that is expected or hoped for
▪ Condition of the real world created by a combination
of circumstances (i.e. not subjective)
▪ Possibility of loss (i.e. 0<ρ<1)
▪ No requirement that the possibility or loss be
measurable (or recognised) but only that it must exist
▪ Loss - reference to a desired outcome
14
 Risk vs. Uncertainty
▪ Risk: a state of the real world in which a
possibility of loss exists

▪ Uncertainty: a state of mind

characterized by doubt or a lack of
knowledge about the outcome of an
event
▪ Risk can exist where there is no uncertainty
▪ Uncertainty can exist where there is no risk
15
 The degree of risk
What is more or less risk?
▪ Probability of the adverse deviation
▪ Single exposure: the probability of a single
occurrence or loss
▪ Aggregate exposures: the probability of some
outcome different from that predicted or expected (i.e.
inaccurate prediction)
▪ Higher probability → more risk

▪ Possible size of the adverse deviation

▪ Greater deviation/loss → more risk
16
 Risk vs. Peril vs. Hazard
Risk distinguished from peril and hazard
▪ Peril: the cause of loss

▪ Hazard: a condition that creates or increases the

frequency or severity of loss
▪ Physical: physical condition
▪ Moral: dishonest or character defects
▪ Morale (attitudinal): careless or indifference to a loss
▪ Legal: characteristics of the legal system or
regulatory environment 17
 Classifications of risk
Risks can be categorised using various
classifications
▪ Fundamental and particular
▪ Pure and speculative
▪ Systemic risk

18
 Classifications of risk
Fundamental and particular risks
▪ Fundamental risk - impersonal in origin and
consequences (i.e. societal risks)
▪ Beyond the control of the individuals who suffer
the losses (not the fault of anyone in particular)
▪ Affect large segments or even all of the population
▪ Society (rather than individuals) normally deal with them

▪ Particular risk - arise out of individual events and are

felt by individuals rather than the entire group
▪ Individual’s own responsibility
▪ Addressed by individuals (use of insurance, loss
19
prevention etc.)
 Classifications of risk
Pure and speculative risks
▪ Pure risk - involve the possibility of loss or no loss
▪ Normally, insurance deals with pure risks only
▪ But not all pure risks are insurable
▪ Law of large numbers can be applied more easily

▪ Speculative risk - involve the possibility of loss, no

loss or gain
▪ Normally, speculative risk is borne voluntarily in
return for the possibility of gain
▪ Society may benefit from a speculative risk

20
 Classifications of risk
Classifications of pure risks

Personal risks

Property risks

Liability risks

Risks arising out of failure of others

21
 Classifications of risk
Classifications of pure risks

Personal risks - risks that directly affect an

individual or family
▪ Consist of the possibility of loss/reduction of
earned income, extra expenses and depletion of
assets
▪ Premature death
▪ Insufficient income during retirement
▪ Poor health (sickness or disability)
▪ Unemployment
22
 Classifications of risk
Classifications of pure risks

Property risks - the risk of having property

damaged or lost from numerous causes
▪ Direct loss: loss that results from the physical
damage, destruction, or theft of the property →
measured by the value of the property or the cost
of repairing the property
▪ Indirect (consequential) loss: loss results from
the loss of use of the property that is damaged or
destroyed, for the period required to repair or
replace the property
23
 Classifications of risk
Classifications of pure risks

Liability risks - the risk of damages

assessed or legal liability arising out of
either intentional or unintentional torts, or
invasion of the rights of others
▪ No maximum upper limit with respect to the
amount of the loss (unlike e.g. property risk)
▪ A lien can be placed on your income and
financial assets to satisfy a legal judgment
▪ Legal defence costs can be enormous
24
 Classifications of risk
Classifications of pure risks

Risks arising out of failure of others - a

person/entity who has agreed to meet an
obligation fails to do so
e.g.
▪ Failure of a contractor to complete a construction
project as scheduled
▪ Failure of debtors to make payments as expected
▪ Failure of counterparty to complete a transaction

25
 Classifications of risk
Systemic risk
▪ A localized shock could be transmitted
more broadly, causing catastrophic
disruption
▪ E.g. the failure of a large, interconnected
financial institution could cause disruption to
global financial markets
▪ Systemic risk has received more attention as a
result of the recent financial crisis (i.e. GFC)
▪ Institutions that pose systemic risk may be
called “too big to fail” (or sometimes “too
interconnected to fail”) 26
 The burden of risk
The presence of risk results in certain undesirable
social and economic effects
▪ Some losses will occur
▪ Larger reserve fund (in the absence of
insurance) – opportunity cost of
accumulated reserves
▪ Deterrent effect on capital accumulation
- greater risk → higher cost of capital →
higher cost of the goods and services
▪ Worry and fear - mental unrest
27
Increasing variety & severity of risks
▪ New risks appear, often as a result of social,
economical, technological development

▪ Increasing severity of losses as more people

and assets exposed to loss (more population,
more wealth, more capital intensive)

28
 Managing risk
No escape from risk → must seek ways of dealing
with it
Society and government can help alleviate the
burden of some risks (e.g. fundamental risks are
often met through the collective action of society
and government)
Other risks are individual responsibilities → a
systematic approach is desirable for dealing with
these risks
▪ What can we do about various risks?
▪ Which should be addressed first and what should
be done about them? 29
Introduction
to risk
management

30
 History of risk management
▪ The actual practice of risk management is as old
as civilization itself
▪ Prudent individual - protect one’s person and assets
▪ Managerial function of business - use a scientific
approach to dealing with risks
▪ Modern risk management
▪ Began in early 1950s
▪ Focused on managing organization’s pure risk
▪ Evolved from corporate insurance buying
31
 Development of risk management
The attitude toward insurance changed and
insurance lost its traditional status as the standard
approach for dealing with risk
The introduction of operations research and
management science → decision theory
Insurance academics and insurance buyers
embraced decision theory → realized there might
be more cost-efficient ways of dealing with risk
than buying insurance
Modern risk management - taken over and applied
in the corporate world
32
 Risk management defined
Risk management is concerned with risk and it is a
process or function that involves managing those
risks
Risk management is a scientific approach
to dealing with risks by anticipating possible
losses and designing and implementing
procedures that minimize the occurrence of
loss or the financial impact of the losses
that do occur.

33
Scope of risk management
Traditional risk management - the
management of pure risks facing a business,
both insurance and uninsurable

Financial risk management - the management

of financial risks: market risk, credit risk and
liquidity risk
▪ traditionally been the responsibility of the firm’s
corporate financial officer or treasurer

Enterprise risk management (ERM) -

integrated management of all risks both pure and
speculative
34
 Risk treatment tools
Risk control - reduce the number of risks
facing the organization or the amount of loss
that can arise from these exposures
▪ Avoidance
▪ Reduction
Risk financing - designed to guarantee the
availability of funds to meet those losses that
do occur
▪ Transfer
▪ Retention
35
 Risk control
Avoidance - prevent a risk from even
coming into existence
▪ Risks are avoided when one refuses to
accept the risk even for an instant
▪ While avoidance is the only alternative for
dealing with some risks, it is a negative
rather than a positive approach
▪ Extensive use → the firm may not be able to
achieve its primary objective
▪ Appropriate - the exposure has catastrophic
potential & cannot be reduced or transferred
(e.g. risks that have both high frequency and
severity) 36
 Risk control
Reduction - a broad set of efforts aimed at
minimizing risk
▪ Risk reduction includes both loss prevention
and loss control efforts
▪ Loss prevention - efforts are aimed at
preventing the occurrence of the loss (i.e.
reducing frequency)
▪ Loss control - efforts are directed toward
reducing the severity of the losses that do
occur

37
 Risk financing
Transfer - transfer risks to another party
▪ Purchase of insurance is a primary means of
risk transfer (transfer to insurance company)
▪ Transfer of risk by contracts/agreements
▪ Hedging - protect against the risk of price
change by buying or selling an asset whose
price changes in an offsetting direction
▪ Subcontracting certain activities
▪ Incorporation of a business firm
▪ Risk sharing - a special case of risk transfer
(from individual to group) and risk retention
38
 Risk financing
Retention - retains part of all of the losses
that can result from a given risk
▪ Exposures that are not avoided, reduced, or
transferred are retained – the “residual” or
“default” risk management technique
▪ When nothing is done about a particular
exposure, the risk is retained
▪ Intentional vs. unintentional retention
Not recognised or improperly implemented
Always undesirable
▪ Voluntary vs. involuntary retention
Judgement Not possible to avoid, reduce, or transfer
the exposure to another party
▪ Funded vs. unfunded retention
Earmarks assets and holds them in some liquid or semi-liquid
form against the possible loses that are retained 39
 The risk management process
1. Establish the context – understand the organisation’s
mission and objectives: the primary objective of risk
management is to preserve the operating effectiveness
of the organization
2. Identification of risk exposures
3. Analyse risks – estimate the level of risks
4. Evaluation of risks - ranking risks in terms of
importance (severity and/or frequency)
5. Treat risks – consider alternatives (tools) and
implement
6. Monitor, evaluation and review
+ Communicate and consult 40
 Recap
1. The concept of risk
▪ Risk is a condition in which there is a possibility of an adverse
deviation from a desired outcome that is expected or hoped for
▪ Risk, uncertainty, peril and hazard
▪ Classifications of risk
2. Introduction to risk management
▪ Development of risk management
▪ Risk management is a scientific approach to dealing with risks
by anticipating possible losses and designing and implementing
procedures that minimize the occurrence of loss or the financial
impact of the losses that do occur
▪ Scope of risk management
▪ Risk management tools
▪ The risk management process
41