Definition of Risk

What is risk anyway?
I read this paper already some time ago. It is very important to have a clear definition of the terms used in research. But from my previous experience I know that also in business a clear understanding of the different aspects of risks is important to stay consistent.

Case Study

At a client I was involved in a company wide risk assessment. The participating middle managers were required to list and assess relevant risks using an Excel sheet. There were predefined categories for impact (eg. less than €1m, between €1m and €10m and above €10m) and probability (eg. p < 5%, 5% < p < 50% and p > 50%).
The survey was therefore aimed at high impact, low probability events. One of the biggest tasks during this assignment was to train the managers on how these categories should be interpreted. But honestly, this categorization does not make this task very easy. Suppose the following disruption: missing employees due to an outbreak of the swine flu. The line in Excel might look like this:

Swine Flu: p < 5%, Loss < €1m

But if you think about it, this task is not very straight forward, the following questions remain:

• There is of course also a more remote chance that the outbreak cannot be contained so quickly as assumed here and the loss might be larger than € 1m. How should you account for this? Add another line, with p < 1%, Loss < €10m? Or should you draw a distribution of the impacts to assess the risk adequately?
• What support is there to calculate the probabilities? Should you rely on data where possible or leave it all to gut feel?
• How is the loss calculated? What about events which losses in several consecutive years? Isn’t it necessary to calculate the present value?

Research

Kaplan (1980) did some early conceptual research about what risk is. I just want to highlight the key aspects of this work here.

• Different kinds of risks
  Risks can be differentiated into different kinds like business risk, social risk, economic risk, safety risk
• Risk and uncertainty
  There is a difference between risk and uncertainty, where risk is when you know about the probabilities and uncertainties when you don’t. So most real life situations (beside the Casino) you are in the realm of uncertainty. If you are using uncertainty, then you have to think about the probabilities of the probability, how likely is it that your estimated probabilities are correct?
• Relativity of risks
  There is usually no objective measure for risk, only perceived risks.

  The notion of absolute risk always ends up being somebody else’s perceived risk quantitative definition of risk

• Risk should be view using the following triplet
  Scenario, Likelihood and Consequence
• There are different types of damage
  There is no continuous measure which you can use for loss of life vs. loss of property

Conclusion

Kaplan shows several important factors of risks that are relevant when applying the concept of risk in a business setting. Several other researchers have built on his work, and for example extended the definition of the consequence of risk, to not only contain a single digit for the impact but also aspects as duration, etc.