A decision-theoretic approach to risk

The objective of analysing a company's risk exposures is to gain an understanding of the risks that the company faces. Only then can the likely level of future losses be estimated, and decisions about how best to manage these risks be made. To gain a full understanding, we first need to adjust for a number of external factors to ensure that all data are on a consistent basis. The historic data can then be analysed and the level of variability determined. After identifying appropriate probability distributions for the frequency and severity of the risks, simulations can be run to make forecasts. Once forecasts have been made, the best way to manage and finance the risks can be considered. As such decisions typically depend upon many factors, utility theory can be used to summarize the advantage that the company will obtain from each alternative in a given situation. This will involve defining a utility function for the company. Methods of eliciting these utility functions exist, including influence diagrams. Decision theory can consequently be applied to determine the best course of action using the company's utility function and its beliefs about the future. Uncertainty inherent in the information can therefore be incorporated in the decision process rather than be ignored. The decision will also depend upon the ability of the company to sustain a loss from retained risks and regulatory requirements relating to the risks.