The Risk Management Decision in the Total Business Setting

Abstract

This paper attempts to (1) recast risk management theory in light of the complex objectives of modern corporations and (2) suggest that risk management theory needs to merge with traditional financial theory in order to bring added realism to the decision making process. In regard to the former, it is observed that normative risk management decision models overlook the behavioral realities and resulting complex corporate objectives involving considerations of profitability, growth, solvency, and social responsibility and such subsidiary issues as the trusteeship concept, satisficing, and the maintenance of financial mobility. In regard to the latter, the compartmentalization of the study of pure and dynamic risk behavior is inappropriate in light of modem financial theory which views the firm as an integrated unit where all of the cost and revenue aspects of a business problem are analyzed simultaneously through an appropriate model. Traditionally, risk management has been segregated from the remainder of financial theory, the reasoning being that the analytical and statistical problems surrounding the treatment of pure risks1 differ from those involving other production cost and revenue uncertainties. This isolation has implied that pure risk costs2 and production costs are unique, and therefore that optimal production deciRobert I. Mehr, Ph.D., is Professor of Finance in the University of Illinois. Dr. Mehr is a Past President of A.R.I.A., a founder of both the Risk Theory Seminar and of the Pacific Insurance Conference, and is a Past Director of the American Finance Association. Stephen W. Forbes, Ph.D., is Associate Professor of Finance in the University of Illinois. This paper was submitted in September, 1972. 1 Pure risks concern those events which usually involve only financial loss to a firm. These include destruction of property, theft, credit losses, death or disability of employees, legal liability, and failure of suppliers to perform. 2Pure risk costs include insurance premiums, administrative costs involving pure risks, costs involved in loss reduction or prevention, and the difference in the present values of the firm before and after a loss not compensated by insurance or other sources such as tort recoveries. sions can be reached by considering these factors separately rather than in combination. The traditional approach at best may result in nonoptimal business decisions and at worst may result in a complete disregard for the pure risk costs arising from such decisions. Such an unrealistic compartmentalization is especially inappropriate in light of modern financial theory which pictures the firm as a functioning totality. The modern executive has become a generalist. He no longer views his business problems through the narrow window of specialization, but instead applies quantitative and qualitative approaches to decision making which consider the accounting, marketing, production and financial aspects of a problem simultaneously. His responsibilities encompass the integrated operations of the firm rather than a narrow circle of subordinates. His information systems are designed to provide accurate and relevant data rapidly as an aid in solving multi-