The Economics of Risk: Why It Matters More Now Than Ever

George Tranter

We come across all kinds of risks every day; crossing a busy road, trying a new exotic food or just walking home without a coat when there’s a chance of rain. Even though we may not realise it, risk is always playing a part in our decision making process. It is also very important in the world of economics and finance, where it influences everything from the price of insurance premiums, interest rates and even government policies. Because of this, it is crucial to understand how risk fits into economics, how it’s managed and why it matters now more than ever as the world and the possible risks we could face continue to develop and become more complex.

What Is Economic Risk?

In the Economic World, risk is defined as the chance of an outcome being different from what is expected. This means that it’s not just about things going wrong: it’s also about the uncertainty of all the possible outcomes.

There are two main types of risk: systematic and unsystematic. Systematic risks are ones that affect the entire economy like a pandemic or inflation. Unsystematic risks are specific to an individual company or sector. This could be something like a small start up failing or the workers going on strike.

Businesses and governments try to manage risk by weighing up any potential rewards the risk could bring with the cost and losses that they would face if taking the risk did not work out. Probability and statistics are essential to analysts and economists as they are used to produce models which will simulate thousands of years to try and predict the likelihood of as many different outcomes as possible. This then helps them to make much more informed decisions especially when it comes to things such as setting the price of an insurance premium as they know roughly how much they are likely going to have to pay off in the next few years.

Risk in Financial Markets

Investors are constantly looking at risks and weighing up the potential costs and return. High-risk investments such as a new cryptocurrency could lead to huge profits if invested into but could just as easily lead to really significant losses. On the other hand, cheaper low risk investments such as government bonds will offer a much smaller but also much more reliable payoff.

Modern Economics relies heavily on the ability to measure and understand any potential financial risks. Businesses are constantly having to look at ideas such as how much a products’ value is likely to change, spreading money across businesses and the size of returns expected on certain investments. These are used by professionals such as actuaries, risk analysts and financial advisors to make the best decisions and help others to invest their money as smartly as possible.

Insurance: Risk Management in Action

One of the most obvious examples of risk economics in action is insurance. Insurance companies pool any risks among many individuals, which allows them to offer the financial protection to someone that suffers an unexpected costly loss without it costing the insurance company itself too much to cover it. The price of this insurance premium is decided based on the probability of a claim being made. This is calculated using the statistical models.

For example, in health insurance the probabilities are calculated based on key, influencing factors such as age, lifestyle and the client's medical history. Car insurers will use different factors such as driving history and the type of vehicle being driven, using these factors to calculate the probabilities are needed to help the companies remain financially sustainable while also always being able to provide the financial aid when it is needed.

Global Challenges and the Future of Risk

As the world continues to develop, so does risk. Things such as climate change and cyber threats are creating new complex, long-term risks that traditional models can often struggle to keep up with. Risk management now involves sustainability, resilience, and constantly planning for the future thus meaning it has to be much more in-depth than ever before.

All financial companies such as banks, stock brokers and insurance companies are now having to consider risks that go way beyond just money. With the increased worries surrounding climate change, climate stress tests are now carried out to see how things such as floods or heat waves could possibly affect any investments. There is also now an increase in the checks surrounding cybersecurity as risks like data breaches can cause expensive costs and also damage a company's reputation.

Risks also play a huge part in how the government thinks when making important decisions. It is especially important when it comes to topics such as taxes and spending. Issues like rising inflation and unemployment can have a huge negative impact on the economy as they can affect the cost of living, business profits and even the budget available for the government's future plans. Inflation is a big problem as it reduces the value of a household's income and thus puts lots of pressure on families all over the country. Unemployment leads to less spending by consumers which leads to less profits for businesses and an increase in the support needed by the government. There can also be disruptions to supply chains which causes shortages and delays then leading to an increased cost for both the businesses and consumers.

Covid-19 and the war in Ukraine are two of the biggest examples of events that highlight how quickly things can change and just how much the impact can be felt all over the world. This is why risk management is so important as it helps to prepare for the worst before it actually happens.

Conclusion

Overall understanding risks is fundamental to how almost all businesses operate in the modern world. Maths and logic are brought together and used to make more calculated decisions that help businesses stay afloat. As the world continues to develop and the challenges we will face become bigger and more complicated, it is vital to be able to measure and manage any risks that could be faced. Risk is going to keep playing a huge role in how almost all decisions are made, not just by businesses and governments but by all of us.