An Approach to Evaluating Risk

Businesses regularly face a range and variety of risks with gradations of variable severity and frequency. Some risks are minor and easily managed or mitigated while others may entail undesirable conditions and outcomes.

Measuring and evaluating risk is a multi-step process due to the variety of factors that must be taken into account in order to accurately assess the potential risks (gains and losses) associated with any given situation. These factors include the likelihood of an event occurring, the potential impact of the event, the ability to mitigate the risks, and the ability to transfer the risks to a third party. Measuring risk involves a thorough analysis of the legal consequences and related elements that contribute to the overall risk profile of a situation. Financial decision-making requires that we evaluate severity levels based upon what an individual or a firm can comfortably accept (attitudes towards risk, or risk appetite).

Risk and Consequence

Risky actions and activities can lead to a variety of legal consequences. Civil cases involve private disputes between individuals or organizations and are usually resolved by awarding monetary damages, but, in some cases, could involve criminal penalties. A criminal case involves a governmental decision—whether provincial or federal—to prosecute a defendant (a person or organization) for violating society’s laws. The penalties assessed in the case may include, imprisonment, financial compensation, loss of license or other sanctions.

In both civil and criminal actions, attorney fees may be expensive, regardless of the outcome of the matter. On the civil side, courts can also impose injunctions (an order to perform, or not perform, a specific action) and if the financial consequences are severe enough, a firm might risk bankruptcy.

Bankruptcy law governs the rights of creditors and insolvent debtors who cannot pay their debts. In broadest terms, bankruptcy deals with the seizure of the debtor’s assets and their distribution to the debtor’s various creditors. In bankruptcy, the firm might be liquidated or reorganized. This is explored in greater detail in a later section of this resource.

Typical Risk Attitudes

Different people and companies may view the legal risks described above very differently. Some individuals do not mind the prospect of personal bankruptcy, for instance, and some companies are structured to sustain substantial risk. Others view the prospect of being sued with trepidation. In other words, different people and firms have different attitudes toward the risk-return tradeoff.

People are risk averse when they avoid risks, preferring as much security and certainty as is reasonably affordable in order to lower their discomfort level. They may be willing to pay extra to have the security of knowing that unpleasant risks would be removed from their lives. Economists and risk management professionals consider most people to be risk averse.

A risk seeker is the person who hopes to maximize the value of retirement investments by investing in the stock market. Much like a gambler, a risk seeker is someone who will accept risk to access greater rewards despite limited probability and unfavourable odds.

A person or entity is said to be risk neutral when risk preference lies in between these two extremes. Risk neutral individuals will not pay extra to have the risk transferred to someone else, nor will they pay to engage in a risky endeavour. Economists consider most widely held or publicly traded corporations as making decisions in a risk-neutral manner since their shareholders have the ability to diversify away risk—to take actions that seemingly are not related or have opposite effects, or to invest in many possible unrelated products or entities such that the impact of any one event decreases the overall risk.