RK&S SMART SOLUTIONS, INC.

EXCELLENT IDEAS, SMART SOLUTIONS

RISK MANAGEMENT
The economy and financial system may be in turmoil but your future doesnt have to be. If the information that the media has been reporting has increased your anxiety level than you havent considered the structural and economic causes and how you can prepare yourself to minimize their impact on you and your family. Accordingly, some background information is required. BACKGROUND Key factors of our economy are that it tends to travels in a cyclical course and is predominantly affected by political policy. Considering the cyclical nature of the economy first, there are basically three stages that the economy goes through: growth, stability and recession. The reason for this is that as an economy grows, it reaches a point when over borrowing, overinvestment and speculation reach a point that the economy can no longer absorb. At that point it seeks equilibrium by receding to a more practical point. This begins the recession which in the last ten recessions lasted approximately ten (10) months. During this period both businesses and governments are ridding themselves of excess and collectively reducing the problems that contributed to the recession. As these are rectified, the economy reaches a point of stability and business and individuals feel more confident that they can reinvest, borrow and speculate, which causes the economy to start growing again. Since the 1940s, the United States has suffered 10 recessions. Most could be seen at least one year before they began but no one wants to stop the train until it crashes. One interesting aspect of this cyclical nature is the perception that most individuals have. In a growth phase the optimism is that the growth will continue forever. Isnt that what caused the real estate melt down? Individuals believed that the price of real estate would continue to grow forever, speculation set in and borrowing became lax. As long as demand exceeded supply, that was true. But when everyone who could hold a hammer began building, supply exceeded demand and prices started to drop. Except this time as prices dropped, those individuals who thought they could sell their real estate at twice what they paid, found they could not hold onto their homes and the melt down began. In a recession, individuals believe the recession will never end and so they over compensate, causing businesses to lose their most important resource (labor) as they feverishly cut out anything that they dont need at the moment. This brings us to a truism that things will drop as fast as they rise. See the dot.com problem, the real estate melt down and the rise and fall of Washington Mutual (WaMu). Another truism is that as more and more individuals begin to think alike, they reach a critical mass that what 1|Page

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EXCELLENT IDEAS, SMART SOLUTIONS they think will happen, happens (re: Bears Stern, the credit crises, the down fall of investment banks). Now lets consider government policy. The depression was caused primarily by the Federal Reserve by permitting banking collapse and a disastrous drop in the money supply. In the 1930s the Feds limited lending to besieged banks under the flawed real bill doctrine, which sought to maintain the flow of funds based on the gold reserves maintained by the government.. But since then the financial world has changed. As Henry Paulson said in a recent interview, the challenge is the complexity of the system and all the interconnectivity and the size of the institutions. Todays crisis can be traced back to the Reagan Doctrine, which attempted to release the economy from the dysfunctional choking by red tape and spur the growth of the economy. The Reagan Doctrine was based on two basic concepts: First, that tax cuts would be self-financing, and second, that financial markets could be selfregulating. Reaganomics stated that virtually any tax cut would so stimulate growth that the government would end up taking in more revenue in the end. In fact the traditional view was correct, cutting taxes without cutting spending would create damaging deficits. The second article of faith, pushed by an unholy alliance of true believers and Wall Street firms was that long-standing regulations were stifling innovation and undermining the competiveness of U.S. financial institutions. Unfortunately deregulation produced a flood of innovative products that today are at the core of the current crisis. These factors were masked for many years by globalization which allowed foreigners to hold endless amounts of American dollars, allowing the government to run deficits while still enjoying high growth. The crisis has ended the Reagan Revolution because financial institutions are based on TRUST, which can only flourish if governments ensure they are transparent and constrained in the risks they can take with other peoples money. Throughout the mid nineties there were clear warnings that the Reagan Revolution had drifted dangerously and deregulation in various key markets produced unscrupulous companies and a high increase in greed. Times changed since the Reagan Doctrine was established and while it may have seemed right when first enacted, it should have ended some time ago. That it didnt was based on the power lock of the conservative side of the Republican Party, which turned once fresh ideas into dogma. By you understanding these fluctuations in the economy and the problems caused by unsound political and fiscal policy, you should start to become more pragmatic on factors that affect your everyday life and more activists in contacting your representatives when you see signs of problems developing in the economy.

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EXCELLENT IDEAS, SMART SOLUTIONS Although more often used in finance, the type of risk that is generated from the above mentioned factors is known as systemic risk. Systemic Risk is that risk which is common to an entire market and not to any individual entity or component thereof. It can be defined as "financial system instability, potentially catastrophic, caused or exacerbated by idiosyncratic events or conditions in financial intermediaries". It refers to the movements of the whole economy and has wide ranging effects. The next considerations are those that are unique to the individual or family. The first type of risk pertains to the amount of risk you are comfortable with. This is known as your Risk Profile. A risk profile describes the level of risk considered acceptable by an individual and considers how this will affect decision making. A portion of our risk profile in inherent in us. This portion says we would be very uncomfortable taking a risk above that which is inherently acceptable to us. Other portions of our risk profile evolve base on our responsibilities, age, understanding of the risk and financial factors. It is important for you to know that your risk profile dictates your comfort levels in all spheres of your life and not simply your financial sphere. The next section of individual risk is to understand what is meant by the term risk. Risk differs from Uncertainty as can be seen by the definitions and methods of measurement. Uncertainty: The lack of complete certainty, that is, the existence of more than one possibility. The "true" outcome/state/result/value is not known. Measurement of uncertainty: A set of probabilities assigned to a set of possibilities. Example: "There is a 60% chance this market will double in five years" Risk: A state of uncertainty where some of the possibilities involve a loss, catastrophe, or other undesirable outcome. Measurement of risk: A set of possibilities each with quantified probabilities and quantified losses. Example: "There is a 40% chance the proposed oil well will be dry with a loss of $12 million in exploratory drilling costs". Impacting on this definition of risk are two factors: optimism bias and strategic misrepresentation. Optimism bias is the demonstrated systematic tendency for people to be over-optimistic about the outcome of planned actions. This includes over-estimating the likelihood of positive 3|Page

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EXCELLENT IDEAS, SMART SOLUTIONS events and under-estimating the likelihood of negative events. It is one of several kinds of positive illusions to which people are generally susceptible. Three types of positive illusions have been documented: self-aggrandizing, self-perceptions (the above-average- affect) where people consistently regard themselves more positively and less negatively than they regard others, and than others regard them), perceptions of mastery (where most people believe that they can exert more personal control over environmental circumstances than is actually the case), and unrealistic optimism (optimism bias, where people are optimistic and believe that the present is better than the past, and the future will be better than the present). For example, people could overestimate the likelihood that they will experience a wide variety of pleasant events, such as enjoying their first job or having a gifted child, and somewhat underestimate their risk of succumbing to negative events, such as getting divorce or falling victim to a chronic disease. While optimism bias adds to a persons sense of well being, it is also one of the factors that cause businesses to fail and individuals to go bankrupt (a perfect example during the dot.com crisis was day trading) Strategic misrepresentation is the planned, systematic distortion or misstatement of fact lyingin response to incentives. Strategic misrepresentation is a contingent strategy responsive to a system of rewards in a highly competitive game where resource constraints are present. Strategic misrepresentation is a predictable response to the incentive structure; it is used because it works under some circumstances. Strategic misrepresentation explains cost overruns, poor investment strategies, and unscrupulous advisers. MANAGING RISK Giving the background provided, it is apparent that each individual must set up risk management procedures to assist in guiding their decision making. Risk management is a structured approach to managing uncertainty related to a threat, a sequence of human activities including: risk assessment, strategies developed to manage it, and mitigation of risk using personal resources. Certain risk management procedures are focused on risks stemming from physical or legal causes (e.g. natural disasters or fires, accidents, ergonomics, death and lawsuits). Financial risk management, on the other hand, focuses on risks that can be managed using traded financial instruments. The objective of risk management is to reduce different risks related to a preselected domain to the level acceptable to you. It may refer to numerous types of threats caused by environment, technology, humans, organizations and politics. On the other hand it involves all means available to you. In ideal risk management, a prioritization process is followed whereby the risks with the greatest loss and the greatest probability of occurring are handled first, and risks with lower 4|Page

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EXCELLENT IDEAS, SMART SOLUTIONS probability of occurrence and lower loss are handled in descending order. In practice the process can be very difficult, and balancing between risks with a high probability of occurrence but lower loss versus a risk with high loss but lower probability of occurrence can often be mishandled. In financial planning we have established procedures to assist in developing a financial plan that in most respects serves as a sound basis for risk management. Initially, you must prioritize your concerns; develop your risk profile; and establish your goals and objectives. In prioritizing concerns, you should consider three basic categories: 1. Risk involving you and your family. 2. Risk involving property. 3. Risk involving injury to the person or property of others. Each category should than be further divided into specific areas, such as liquidity, death, disability, sickness, education, property loss and personal liability claims. After prioritizing your concerns, you must understand and develop your risk profile expressed as a desire to provide adequate resources to protect against the risk of unexpected loss such as death, disability, casualty loss, etc. This starts with the initial clarification of goals and objectives. Once you define your concerns and establish your risk profile, you can decide the best method of reducing your risks while obtaining your goals and objectives. Risk management is concerned only with risk of loss and exposure (other than investment risk). Risk control methods include: 1. Risk Avoidance 2. Risk Reduction. 3. Risk Retention. 4. Risk Transfer. Risk reduction involves reducing potential liabilities by encouraging risk reduction practices. Risk can often be reduced by preventive measures: keeping fire extinguishers in key locations, setting up fire and carbon monoxide detectors, setting up a home security system, having regular physical and dental exams, maintaining proper legal documents for business relationships and having a copy in a safety deposit box or with your attorney, budgeting your expenses so you save at least 15% of your salary, using credit cards only when you have the funds to repay the amounts charged (in todays environment we suggest using your debit card, so that funds are withdrawn from your checking account as soon as you purchase an

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EXCELLENT IDEAS, SMART SOLUTIONS item), maintaining minimum debt, paying bills on time or ahead of time and setting up an emergency fund to provide a cash reserve in the event of a liquidity crises. In establishing an emergency fund, you should consider a cash needs analysis, repositioning assets so more can readily be converted to cash, restructuring debts and performing other cash management strategies. Risk Transfer involves transferring your risk to a third party, generally in the form of insurance: home insurance, car insurance, medical insurance, disability insurance, life insurance, liability insurance and long-term health care insurance are all methods of transferring risk.. For risk transfer, prepare needs analyses to determine any deficits in the types of insurance you presently have and perform a policies review to determine if any changes are required in rating the strength of the insurance companies, identifying policy owner and beneficiaries. This is carried over to estate planning and review of estate documents as well as gift planning. Some risk you will retain. This is generally associated with systemic risk because it affects all individuals but by reducing your individual risks, you can feel more comfortable in coping with the present economic and financial crises. As an ending note, you must seek the knowledge and develop the experience to be able to properly establish risk management procedures. You must shy away from optimism bias and strategic misrepresentation and finally you must remember that risk management is an ongoing evaluation of your possible exposures and changes in your procedures to adjust for changes in your perceived risk.

We wish to thank all individuals and organizations who helped develop this white paper.

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