The word ‘Risk’ brings forth a sense of optimism as well as pessimism. It is the situation where the probability of occurrence of an event is known along with the nature and degree of harm associated with it. Consider, an investment in the stock market where the probability of profit can be predicted by analyzing the past performance of the stock. However, we can’t predict it with certainty as the stock market is subjected to several fluctuations.
To put it simply we can say that risk is the ‘unknown known’.
Risks can be broadly classified into:
- quantifiable, which can be measured
- unquantifiable, where numerical values cannot be assigned and probabilities of outcomes fall under categories such as low, medium and high.
In the business (financial) context:
Risk = (probability of something happening) x (the resulting cost or benefit)
Events which directly impact the finances of a business or its financial system come under financial risks while those which don’t have direct financial implications, are categorized as non-financial risks.
In the insurance context, actuarial risk is the risk that a calculated model of an insurance policy, which includes the frequency, severity and correlation of losses, may be subjected to unforeseen events.
The major types of risks faced by a financial organization are:
Market risk: The risk arising from the fluctuations in market values. It can be divided into:
- Changes in asset values
- Mismatching assets and liabilities
Credit risk: It is the risk of a third party defaulting on payments, such as policyholders who may default on their premiums.
Business risks: They are specific to the business undertaken. Considering an insurance company, the business risks faced by them are:
- Underwriting risk: a life or general insurer not having adequate underwriting standards which results in the insurer accepting bad risks
- Insurance risk: an insurer suffering more claims than anticipated
- Exposure risk: a reinsurer having greater exposure than planned to a particular risk event
Liquidity risk: It is the risk that the individual or company, although solvent, does not have sufficient financial resources to enable it to meet its obligations as they fall due, or can secure such resources only at an excessive cost.
Operational risk: It is the risk of loss resulting from inadequate or failed procedures, systems or policies, such as inappropriate actions of the board of directors / staff, inaccurate data etc.
An actuarial approach to risk considers the range of potential impacts and the interaction of risks rather than attaching a distinct probability to each risk. It deals with risk by considering some key principles and treating it as a continuous cycle as shown in Figure 1.
Key principles in an actuarial approach to risk management:
- Understanding of the stakeholders’ perspective and the risks they wish to knowingly minimize
- Collection of relevant data on the risks that exist; to get a fair idea of the risk-drivers and their potential impact. Consider, a fast food chain plans to open an outlet in a moderately populated village: the risk-drivers are the existing / potential competitors, local acceptability, consumer preferences, etc.
- Building a model of the system after clearly laying out the assumptions and risk drivers. The initial model should be set up to provide information about the range of most likely outcomes from the given set of inputs into a system. It is necessary to recognize extreme outcomes as the estimate could increase after having a better understanding of the causation factors which have not been recognized.
- Scenario analysis i.e. assessment of a range of scenarios to understand the resilience of the organization to particular risks and the possibility of several events happening together.
- In the fast food chain example, considering scenarios such as consumer preferences during different seasons, time horizons, offers and discounts by other competitor food outlets can prove helpful.
- Specific mitigations or controls can be used to reduce ongoing risks, provided that the value placed on this risk reduction is more than the cost of the mitigations and controls.
In our example, the fast food company may opt to avoid the risk to its reputation from not starting-up in an area with local resistance, but would then miss out on the potential profits it might otherwise have achieved in this area.
Rightly said by Gary Cohn, “If you don’t invest in risk management, it doesn’t matter what business you’re in, it’s a risky business”. Thus, it’s necessary to identify risks and approach them appropriately be it the actuarial context or any other.