Risk Management Strategies - Business Finance - ثاني ثانوي

6.5 Risk Management Strategies Link digital lesson Key Terms Risk management Self-insurance Portfolio risk Correlation Since risk can be expected in almost all activities, efforts should be made to anticipate which risks are most likely, and then attempt to reduce the risk and minimize the possible loss. The process of systematically identifying potential uncertainties and making plans to reduce the impact of those uncertainties is known as risk management. Because most businesses face many risks that can cause significant financial harm or even result in business failure, risk specialists have the responsibility of planning and coordinating risk management programs. Risk management most often involves pure rather than speculative risk. Financial managers are responsible for decision-making about speculative risks or the investment decisions of a business. www.sen.edu.sa Risk management The process of systematically identifying potential uncertainties and making plans to reduce the impact of those uncertainties 6.5a Planning a Risk Management Program Risk management specialists work at all levels of a business to identify potential risks, determine the financial impact each risk may have, develop plans and programs to prevent controllable risks and reduce the financial impact of uncontrollable risks, and provide the necessary resources and training needed to manage the risks. Risk management programs are concerned with the security of computer systems, property protection, employee health, and plans to respond to the negative effects of natural and man-made disasters. The primary sources of risk faced by companies involve three categories: property risks, personnel risks, and liability risks. 1. Property risks are potential damage or loss to property owned, leased, and used by a business. If a business is responsible for the property of other businesses, that also is a source of property risk. For example, if a company supplies raw materials to a manufacturer, disruption of the supply or quality problems with the raw materials can result in financial loss for the manufacturer as well as the supplier. وزارة التعليم CHAPTER Risk and Its Measurements 245

P . FIGURE 6.3 The Risk Management Process 246 Business Finance 2. Personnel risks include factors that affect the health, life, or earnings of employees. Businesses are responsible for controlling risk by providing safe equipment and working conditions. Employee illness, injury, or death can result from poorly maintained equipment, unsafe working conditions, or lack of safety procedures. 3. Liability means an individual or business is responsible to others for negligence. Negligence can result from an action taken or from a failure to act. If people are injured or their property damaged due to the negligence of a business, the injured party can make a financial claim against the business. The injury or damage can result from the use of property or products or the actions of company personnel. 6.5b The Risk Management Process Companies face many risks. To address this uncertainty, Figure 6.3 shows four steps commonly taken to manage business risks. Step 1 Step 2 Step 3 Select m Step 4 unpaman the mas Step 1: Identify Potential Risks In the first step of the risk management process, managers list the factors that might affect a company's operations. Currency values local customs are some examples of risk-causing factors. Managers can use current reports, field interviews, and other data sources to discover situations that increase uncertainty.

Step 2: Evaluate Risks In this step, managers analyze possible effects of risks on the company. Will a change in environmental regulations create higher costs? Or could the company face new trade barriers when doing business in a certain country? At this stage, a manager must decide how and to what extent the risks will influence sales and profits. Step 3: Select a Risk Management Method Next, managers must determine how to address the identified risks. The four risk management methods commonly used are risk avoidance, risk reduction, risk transfer, and risk assumption. Step 4: Implement the Risk Management Program Finally, managers must put the risk management plan into action. This phase involves both taking appropriate actions and measuring the success of those actions. 6.5c Risk Management Methods When planning and implementing a risk management program, as shown in Figure 6.4, there are four possible ways to deal with risks: avoid, reduce, transfer, and assume. RISK RISK RISK RISK E ASSUME Risk Avoidance With careful planning, some risks can be avoided. To avoid risks, decision-makers need to be aware of risks that can threaten a business decision. They must determine the costs and possible rewards of their decisions. وزارة التعليدر 2921-1879 FIGURE 6.4 Possible Ways of Dealing With Risks CHAPTER Risk and Its Measurements 247

P 248 Business Finance 2922-1689 They must estimate the size of losses if anticipated problems occur. If the likelihood of risk or the amount of loss is too great, decision makers may prefer to avoid the action. This ensures that there will be no loss. Examples of risk avoidance include: If a country has an unstable economic environment, a business can choose to avoid operations in that country. ■If a certain manufacturer of production equipment has a poor safety record, equipment can be purchased from another supplier. ⚫ A company avoids the risks related to international business by only selling products in its home country. If market research suggests there may not be enough demand for a new product to cover the costs, a business can choose not to make that product. From a personal perspective, if you don't believe you have enough experience or skill to start your own business, you can decide not to become an entrepreneur. If severe weather is forecast, you can choose not to drive your car to avoid a possible accident. Risk Reduction When a company is unable or unwilling to avoid a risk, uncertainty may be reduced by taking preventive actions. For example: ■ Businesses use security systems and sprinklers to reduce the risk of theft and fire ⚫ Enhanced online protection can reduce data breaches and cybercrime. ⚫ Multinational companies can reduce business risks by only selling products that have been successful in other countries. Personal risk reduction can be the result of obeying traffic laws and wearing seatbelts when driving. Risk Transfer Often a business activity must occur even though there is a risk with significant financial consequences. If a business is not able to assume the risk, it may choose to transfer it. When a business transfers a risk, someone else assumes the risk. Examples of transferring risk include: ⚫ Hiring a company to handle sales and collections. The bank or financial service company accepts the risk of unpaid accounts in exchange for fees earned on each sale.

■ Using the services of a transportation and storage company to transfer the risk of product damage for items in transit. ⚫ Creating a joint venture with an expenenced research company to transfer the risk of a costly or unsuccessful research process to plan a new product. Also called "risk sharing", a risk transfer strategy may involve insurance. Sharing risks among many companies that face similar risks is a common practice. Insurance is often purchased for financial protection from property losses, motor vehicle accidents, and other business activities. For risks that can be reasonably predicted, it is possible to purchase insurance. Businesses that face the risk of fire damage to their buildings, equipment, and inventories can pool those risks with other businesses by purchasing fire insurance. A few businesses may have losses from fires during a specific period. Based on the history of fires in businesses, experts can reasonably estimate the total amount of fire damage among several businesses for that amount of time. Each business will pay a small amount for insurance that will cover the losses of the businesses that may suffer a loss from fire. By purchasing insurance, the company pays a small percentage of the possible loss to an insurer for protection against the larger loss if the risk occurs. The greater the likelihood of the risk or the larger the possible loss, the more expensive the insurance will be. Taking steps to reduce the possibility or cost of the loss can reduce the insurance costs. How can businesses manage RISK Accept Tran Mitigate Avoid 249 حرارة العلم

P " Setting aside money to cover a potential financial loss Uncertainty associated with making a range of investments which involve both systematic and unsystematic risk 250 Business Finance ET Risk Assumption In some situations, avoiding, reducing, or transferring risk may not be possible. Or a company may decide to take responsibility for losses from certain risks. For example, a business may set aside funds for fire damage that may occur to its factories. This action, called sell-insurance, involves setting aside money to cover a potential financial loss. A company with many stores or factories in different locations may save money by using self-insurance. If a business decides to assume a risk, the business will bear the consequences of the damage a risk may cause if it occurs. The company believes funds will be available to cover the financial loss. Large companies may choose to set aside a small amount of money each month for unexpected expenses or unforeseen risks. Risk assumption may be used if a risk is unlikely to occur or if the possible financial loss is relatively small. If the cost to the business to insure or transfer the risk is high, it may be more reasonable for the company to assume the risk. Business operations of a company also involve risk assumption. Once a business offers an item for sale, it must be able to sell the product at a price to cover the costs. If the sales goal is not achieved, the business suffers a loss. Companies assume the risk of being able to make a profit. 6.5d Diversification of Risk Another strategy used for reducing business and investment risk is "diversification", which involves obtaining a variety of assets and securities. Instead of investing in a single stock, the selection of two or more companies can reduce your portfolio risk, the total risk of combined investments. For example, portfolio risk can be reduced when investing in a utility company and an oil company instead of just one of those industries. In times of higher interest rates and inflation, the earnings of the utility company may decline as costs rise and regulations limit the amount of price increases. In contrast, the oil company may benefit from higher prices resulting in higher earnings. The price of the utility company's stock may decline, producing negative returns, while the price of the oil company's stock may rise producing positive returns.

This inverse relationship between the two stocks, measured with correlation, results in a lower portfolio risk: 1. Positive correlation: If there is a positive correlation between two stocks, combining them in an investment portfolio would not reduce risk as the stocks would tend to move in the same direction. at the same time. 2. Negative correlation: If there is a negative correlation between two stocks, combining them in an investment portfolio would reduce risk as the stocks would not tend to move in the same direction at the same time. Characteristics of a diversified investment portfolio include: ⚫ Stocks should have returns that move in opposite directions; if the returns become positively correlated, combining the two stocks will not achieve a reduced investment portfolio risk. ⚫ Effective diversification results in reduced unsystematic risk, which is associated with individual events affecting a particular asset or company; firm-specific risk is reduced with the creation of a diversified investment portfolio. • Creating an investment portfolio with different industries does not eliminate the other sources of risk, such as changes in stock prices, inflation, changes in interest rates, or variations in exchange rates. • Reduction in risk, not the returns, is the goal of diversification. This risk reduction can be viewed by comparing the standard deviations of the individual stock returns and combined investment portfolio return. With an appropriate portfolio diversification, the total standard deviation for the portfolio would be lower than the standard deviations of the returns for any of the individual stock investments. Diversifying investments reduces the impact a risk may have on the total investment portfolio, even if one asset performs poorly. The strategy of diversification is also used by companies when offering an array of products and services. For example, an industrial manufacturing company may also be involved in selling consumer goods to diversify its revenue sources. Comtriton The relationship between two or more financial vanables over time وزارة التعليم 2922-1889 CHAPTER Risk and Its Measurements 251

252 Business Finance Exercises Choose the correct answer. 1. The first step of the risk management process is to a. evaluate risks. b. implement the risk management program. c. select a risk management method d. identify potential risks. 2. Self-insurance is considered to be an example of risk. a. avoidance. b. reduction. c. transfer. d. assumption. 3. Diversification is achieved by: a. buying Insurance. b. abtaining a variety of assets. c. creating a self-insurance program. d. risk avoidance.