Definitions of Risk and Risk Management A single definition of risk will not serve all risk management purposes. Risk management is carried out in such diverse areas as transport, health and safety, finance, and insurance. In mathematics, there is no single definition for the idea of a number; a similar situation arises in risk management when it comes to defining risk and risk management. Each of the disciplines above makes use of the idea of risk in the context of its particular objectives. So, for transport, risk is taken to be an accident or damage; for health, it is taken to be illness, injury or loss of life.
The term risk originates from the Italian riskare, which means ‘to dare’. The dictionary lists risk as both a noun and a verb. When used as a noun it has the connotation of danger, hazard, the chance of loss, an enterprise that can lead to profit or loss, the amount of a loss (hence the ‘sum at risk’), a gamble or a bet. When used as a verb, risk means to expose oneself to the potential for loss, to make a bet or a wager, to gamble, to undertake an uncertain enterprise or venture. Both uses imply that there is the possibility of gains as well as losses. There is also a psychological meaning to risk: it is that state of uncertainty or doubt in the face of a situation with beneficial and adverse consequences (gains and losses).
A simple definition of risk that includes the meanings above is: The chance (or probability) of a deviation from an anticipated outcome. The implications of this definition are given below.
· We can attach probabilities to risk. Therefore, it can be measured, estimated or calculated in some way. Risk can therefore be quantified and expressed as a parameter, number or value.
· Risk is concerned not just with the extent or probabilities of potential losses but with deviations from the expected outcome. It is the extent to which the actual result may deviate from the expected result that makes a situation risky.
· Risk is a function of objectives. It is the consequences of the actual result deviating from the expected result that leads to risk. Without an objective or intended outcome, there is only uncertainty. A rider to this is that risk arises only where the deviation from the objective matters; that is, if it affects individuals or firms financially, or entails some other adverse consequence. It can also provide an opportunity.
Within the discipline of risk management, of which financial risk management forms a sub-element, the following additional concepts for risk are in use:
Possibility of a gain or loss
Where there is a possibility of a gain or loss, this is often referred to as a risk. Note that this usage does not necessarily attempt to quantify the degree of loss.
Probability of a gain or loss
This defines risk as the chance or probability of a gain or loss. In terms of risk theory, the probability of an event occurring takes a value that can range from zero to one. An event is impossible if it has a probability of zero; an event is certain if it has a probability of one. Risk will be greatest if the gainor loss-making event has a probability of one; that is, it is certain to occur. In practice, the probability of loss (ρ) will lie above zero and be less than one, i.e. 0 < ρ < 1.0. Often people will talk of the odds of gains and losses. This is the ratio of unfavourable to favourable outcomes. So, if the probability of gain is 0.25, the odds are 0.75:0.25, which are more often expressed as 3 to 1. Hence we would say that the odds are 3 to 1 against success.
Cause of loss or peril
Peril is a term used in the insurance industry for the source of a risk. It is the cause of a loss. For instance, fires, floods, explosions, accidents, death and so on are all perils. In finance, the more common term is risk factor.
Another term common in insurance. It is a condition or action of the insured party that increases the likelihood or likely magnitude of a loss. There are three common types of hazard:
· Physical hazard: the condition of the insured property, person or operations that has the effect of increasing the likelihood and/or severity of the loss.
· Moral hazard: a condition where the insured intentionally seeks to take advantage of insurance cover either by deliberately causing an accident or by inflating the value of a loss.
· Morale hazard: actions taken by the insured party that increase the likelihood and/or severity of a loss. Morale hazard arises because the consequences of the action are borne by the insurer rather than the insured. For instance, car owners with fully comprehensive theft insurance are less likely to lock their cars when they leave them. Such persons are likely to own more expensive vehicles and experience higher theft rates than individuals who are not similarly insured.
(Note that these last two concepts bring in the behavioural aspect of risk.)
Potential gain or loss
The exposure or potential for gain or loss is also referred to as a risk. Practitioners may use the term ‘risk’ to refer to the values that are exposed to gains and losses. An example is the financial services industry’s ‘value-atrisk’ metrics used to quantify the extent of an expected future loss within a given confidence limit.
Range and variability of outcomes
The actual range of potential outcomes, or a measure of that range (for instance, the variance of a particular set of outcomes), is used to define a particular risk. A more sophisticated approach may specify the exact nature of the probability distribution (such as the normal or Gaussian distribution). Finance professionals will often refer to markets as being ‘highly volatile’. The term volatility comes from the derivatives markets and is the standard deviation of continuously compounded returns. The intellectual foundation is the mean-variance approach derived from modern portfolio theory and option pricing.
Risk management is the identification, assessment and decisions made regarding the treatment by an organisation (or an individual) of particular risks faced by the organisation (or the individual). It can be a formal process involving procedures, quantitative and qualitative assessments leading to review and minuted decision, or it can be informal.