Exam #1 Notes - Thomas Berry-Stoelzle PDF

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Principles of Risk Management and Insurance – Exam #1 Section 1 – Introduction to Risk Definitions of Risk  Risk (traditional) – uncertainty concerning the occurrence of a loss  Risk (alternative) – possibility of an adverse deviation from a desired outcome that is expected or hoped for  Risk is also used to identify the property or life that is being considered for insurance  In Econ and Finance: o Risk is used in situations where the probabilities of possible outcomes are known o Uncertainty is used in situations where such probabilities cannot be estimated  Loss Exposure: any situation or circumstance in which a loss is possible regardless of whether a loss occurs  Objective Risk: relative variation of actual loss from expected loss o Can be statistically calculated by some measure o dispersion such as the standard deviation  Subjective (perceived) Risk: uncertainty based on a person’s mental condition or state of mind Chance of Loss  Chance of loss: probability that an event will occur  Objective Probability: refers to the long-run relative frequency of an event based on the assumptions of an infinite number of observations and of no change in the underlying conditions  Subjective Probability: the individual’s personal estimate of the chance of loss Individual Attitude Toward Risk  Risk Neutral: indifferent toward risk; value of risky situation is expected loss  Risk Averse: prefer to avoid risk; willing to pay more than expected loss to avoid risk  Risk Seeker: prefer risk; would pay more than expected return to engage in risky situation Chance of Loss vs. Objective Risk  Chance of loss is probability that an event that causes loss will occur  Objective risk is relative variation of actual loss from expected loss  The chance of loss may be identical for two different groups but objective risk may be quite different

 Peril and Hazard  Peril: cause of the loss

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o Ex include property damage because of fire, windstorm, lighting, damage to car because of collision with another vehicle Hazard: condition that increases the chance of loss o Physical hazard is physical condition that increases the frequency or severity of loss o Moral hazard is dishonesty or character defects in an individual that lead to intentional actions designed either to cause loss or to increase severity Attitudinal Hazard (Morale Hazard): carelessness or indifference to a loss, which increases the frequency or severity of a loss o Taking less precautions because you know there is a backup, ex. Not going back to make sure you locked your car Legal Hazard: refers to characteristics of the legal systems or regulatory environment that increase the frequency or severity of losses

Classification of Risk  Pure Risk and Speculative Risk o Pure risk: situation in which there are only the possibilities of loss or no loss (earthquake) o Speculative risk: situation in which either profit or loss is possible (gambling) o Both pure and speculative risks may be present in some situations  Diversifiable Risk and Nondiversifiable Risk o Diversifiable risk: affects only individuals or small groups (car theft) it can be reduced or eliminated by diversification o Nondiversifiable risk: affects entire economy o large numbers of person or groups within the economy (hurricane), is also called fundamental risk o Gov’t assistance may be necessary to insure nondiversifiable risks  Enterprise Risk Management: combines into a single unified treatment program all major risks faced by the firm o Pure risk o Speculative risk o Strategic risk o Operational risk o Financial risk  Systemic Risk o Risk of collapse of an entire system or entire market due to the failure of a single entity or group of entities that can result in the breakdown of the entire financial system (housing market crash) o Especially important with respect to large financial institutions that are considered too large to fail without doing major financial harm to the US economy Major Personal Risks

Section 2 Risk Identification and Evaluation Meaning of Risk Management  RM is process that identifies loss exposures faced by an org and selects the most appropriate techniques for treating such exposures  Loss Exposure is any situation or circumstance in which a loss is possible, regardless of whether a loss occurs Objectives of Risk Management  Risk management has objectives before and after a loss occurs  Pre-loss objectives: o Prepare for potential losses in the most economical way o Reduce anxiety o Meet any legal obligations  Post-loss objectives o Survival of the firm o Continue operating o Stability of earnings o Continued growth of firm o Minimize effects that a loss will have on other persons and on society o Reputation of company Risk Management Process  Identify potential losses  Measure and analyze loss exposures  Select appropriate combination of techniques for treating the loss exposures  Implement and monitor the risk management program Important Loss Exposures  Property  Liability  Business income  Human resources  Crime  Employee benefits  Foreign  Intangible property  Failure to comply with gov’t rules and regs Identifying Loss Exposures  Risk managers have several sources of info to identify loss exposure o Risk analysis questionnaires and checklists o Physical inspection

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o Flowcharts o Financial statements o Historical loss data Industry trends and market changes can create new loss exposures

Risk Identification  Loss exposure checklists o Specifies numerous potential sources of loss from the destruction of assets and from legal liability o Designed for specific industries  Manufacturers, retailers, educations institutions, religious orgs o Others focus on specific category of exposure  Such as real and personal property  Financial statement analysis o All items on firm’s balance sheet and income statement are analyzed in regard to risks that may be present  Flowcharts o Allows risk managers to pinpoint areas of potential loss o Only through careful inspection of entire production process can full range of loss exposure be identified  Contract analysis o Not unusual for contracts to state that some losses are to be borne by specific parties o Found in constructions & sales contracts and lease agreements o Ideally specification of who is to pay for various losses should be a conscious decision that is made as part of the overall contract negotiation process  Physical inspections o On-site visits can be helpful to talk with department managers and other employees regarding activities  Statistical analysis of historical loss data o Can use software to assist in this Measure and Analyze Loss Exposures  Estimate for each type of loss exposure o Loss Frequency  Refers to probable number of losses that may occur during some time period o Loss Severity  Refers to probable size of the losses that may occur  Rank exposures by importance  Loss severity is more important than loss frequency o Maximum Possible Loss  Worst loss that could happen to firm during its lifetime

o Probable Maximum Loss  Worst loss that is likely to happen Risk Mapping or Profiling  Involves arraying risks in a matrix o One dimension is frequency of events and the other dimension is severity  Each risk is marked to indicated whether it is covered by insurance or not Model Building

Section 3 Risk Management Techniques Avoidance Retention Transfer Steps in Risk Management Process 1. Identify loss exposures 2. Measure and analyze the loss exposures 3. Select the appropriate combination of techniques for treating the loss exposures a. Risk Control i. Avoidance ii. Loss Prevention iii. Loss Reduction 1. Loss control techniques a. Duplication b. Separation c. Diversification b. Risk Financing i. Retention ii. Noninsurance transfers (risk transfer) iii. Insurance (risk transfer) 4. Implement and monitor the risk management process Techniques for Treating the Loss Exposures

Risk control o Techniques that reduce the frequency and severity of losses o Methods include:  Avoidance  Loss prevention  Loss reduction  Duplication  Separation  Diversification  Avoidance o A certain loss exposure is never acquired or undertaken, or an existing loss exposure is abandoned  Chance of loss reduced to zero  Not always possible or practical to avoid all losses  Loss Prevention o Measures that reduce frequency of a particular loss  i.e., installing safety features on hazardous products, safety training, salting icy sidewalks  Loss Reduction o Measures that reduce the severity of a loss after it occurs  i.e., installing an automatic sprinkler system, safety belts, wearing helmet, fire alarm, airbags  doesn’t prevent the accident but it prevents further harm/risk/injury  Duplication o Having back-ups or copies of important documents or property available in case a loss occurs  Separation o Dividing the assets exposed to loss to minimize the harm from a single event  Diversification o Spreading the loss exposure across different parties, securities, or transactions, to reduce the chance of loss  Risk Financing o Techniques that provide for the payment of losses after they occur Methods of Risk Financing  Non-insurance transfers  Commercial insurance  Retention o The firm retains part or all of the losses that can result from a given loss o Planned vs unplanned retention: unplanned should be avoided o Retention is effectively used when  No other method of treatment is available  The worst possible loss is not serious  Losses are highly predictable 

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Retention Level o Dollar amount of losses that the firm will retain Risk Manager methods for paying retained losses o Unfunded retention  Current net income: losses treated as current expenses  Unfunded reserve: losses are deducted from a bookkeeping account o Funded retention (pre-loss arrangements)  Funded reserve: losses are deducted from a liquid fund  Credit line: funds are borrowed to pay losses as they occur  Self-insurance: funded retention for a large group of similar exposure units (risk pooling works) Captive insurer o Insurer owned by a parent firm for the Non-insurance transfer o Method other than insurance by which a pure risk and its potential financial consequences are transferred to another party  Ex: contracts, leases, hold-harmless agreements o Advantages:  Can transfer some losses that are not insurable  Less expensive  Can transfer loss to someone who is in a better position to control losses o Disadvantages:  Contract language may be ambiguous, so transfer may fail  If the other party fails to pay, firm is still responsible for the loss  Insurers may not give credit for transfers Insurance o Appropriate for low probability, high severity loss exposures  Risk manager selects coverages needed and policy provisions  Deductible  Specified amount subtracted from the loss payment otherwise payable to the insured  Excess Insurance Policy  Insurer pays only if the actual loss exceeds the amount a firm has decided to retain  Risk manager selects the insurer, or insurers, to provide the coverages o Risk manager negotiates the terms of the insurance contract o Manuscript policy  Policy specifically tailored for the firm o Parties must agree on the contract provisions, endorsements, forms, and premiums o Information concerning insurance coverages must be disseminated to others in the firm o Risk manager must periodically review the insurance program

o Advantages:  Firm is indemnified for losses, can continue to operate  Uncertainty is reduced  Firm may receive valuable risk management services  Premiums are income-tax deductible o Disadvantages:  Premiums may be costly  Negotiation of contracts takes time and effort  The risk manager may become lax in exercising loss control Selecting Risk Management Techniques o Steps for select among available risk management techniques for a given situation may be summarized as follows  Avoid risks if possible  Implement appropriate loss control measures  Select the optimal mix of risk retention and risk transfer

o Avoid Risks if Possible o Risks that can be eliminated without adverse effect on the goals of an individual or business probably should be avoided o Without a systematic identification of pure risk exposures  Some risks that easily could be avoided may inadvertently be retained Implement Appropriate Loss Control Measures o For risks that a business or individual cannot or does not wish to avoid  Consideration should be given to available loss control o In analyzing the likely costs and benefits of loss control alternatives  Should recognize that loss control will always be used in conjunction with either risk retention or risk transfer o Therefore, part of the cost/benefit analysis regarding potential loss control is recognition of the likely effects on the transfer or retention of the risk existing after loss control measures are implemented o Selection between risk retention and risk transfer as the optimal risk management technique may change after loss control expenditures are made Analyzing Loss Control Decisions o Capital budgeting techniques from finance and accounting can be applied to risk management decisions regarding loss control

o Dept store experiencing substantial shoplifting losses and occasional vandalism to building  Considering hiring 24 hr security guards to decrease frequency and severity of losses  Annual cost of the protection is 60,000 in salaries and employee benefits for guards  Cole estimates the presence will decrease shoplifting losses by 30,000 and vandalism by 20,000  Should they hire guards?  Since estimated 55,000 in savings is less than estimated 60,000 cost of hiring guards  Should not hire guards Select Optimal Mix of Risk Retention and Risk Transfer  As a rule, risk retention is optimal for losses that have a low expected severity o Rule becomes especially appropriate when expected frequency is high  Another general guideline applied to risks that have a low expected frequency but a high potential severity o Risk transfer is often the optimal choice here  When losses have both high expected severity and high expected frequency o Is likely that risk transfer, risk retention, and loss control all will need to be used in varying degrees  What constitutes as “high” and “low” loss frequency and severity in applying the preceding guidelines must be established on an individual basis  In many situations, both risk retention and risk transfer will be used in varying degrees o What is the appropriate mix between these two techniques?  Both capital budgeting methods and statistical procedures may be used in selecting and appropriate retention level o With a risk transfer (ex insurance) for losses in excess of that level  But because price of risk transfers do not necessarily vary proportionately with different levels of retention, appropriate mix is not an exact science  Selecting a particular deductible level is one way of mixing risk retention and risk transfer, deductibles help lower the cost of insurance as well as increase its availability  Deductibles may also make management more loss conscious o Because a firm must absorb losses within the deductible level  However, as a general rule, risk managers do not accept a deductible unless o the firm can afford the associated losses o sufficient premiums savings will result  choice of techniques may need to be modified depending on market conditions in the insurance markets  insurance market experiences an underwriting cycle o in a “hard” market, profitability is declining, underwriting standards are tightened, premiums increase, and insurance is hard to obtain

o in a “soft” market, profitability is improving, standards are loosened, premiums decline, and insurance becomes easier to obtain Subjective Risk Management  Objective and subjective risks are often both present in the same situation o Some consideration must also be given to managing subjective risk  In one sense, techniques applied to objective risk also should affect subjective risk  Obtaining more information o Best way of handling subjective risk is by adding knowledge through research, training, or education o Risk averter may be more willing to accept risk once there is a better understanding of the uncertainties  Better knowledge means one is likely to perceive less risk in a given situation o Risk taker may be willing to assume even greater risks as knowledge increases  Group discussion o Perceived subjective risk declines after group discussion of the problem Implement and Monitor the Risk Management Program  Implementation of a risk management program begins with a risk management policy statement that: o Outlines firms objectives and policies o Educates top-level executives o Gives the risk manager greater authority o Provides standards for judging the risk manager’s performance  A risk management manual may be used to: o Describe the risk management program o Train new employees  Successful risk mgmt program requires active cooperation from other depts. In firm  Risk mgmt. program should be periodically reviewed and evaluated to determine whether the objectives are being attained o Risk manager should compare costs and benefits of all risk mgmt. activities Benefits of Risk Management  Enables firm to attain its pre-loss and post-loss objectives more easily  Risk mgmt. program can reduce a firms cost of risk  Reduction in pure loss exposures allows a firm to enact an enterprise risk mgmt. program to treat both pure and speculative loss exposures  Society benefits because both direct and indirect losses are reduced Personal Risk Management  Personal risk management refers to the identification and analysis of pure risks faced by an individual or family and to the selected of the most appropriate techniques for treating such risks  Same principles applied to corporate risk management apply to personal risk management

Chapter 4 Enterprise Risk Management Enterprise Risk Management  Today, the risk manager o Is involved with more than simply purchasing insurance o Considers both pure and speculative financial risks o Considers all risks across the organization and the strategic implications of the risks  Financial Risk Management o Refers to identification, analysis, and treatment of speculative financial risks:  Commodity price risk  Interest rate risk  Currency exchange rate risk o Financial risks can be managed with capital market instruments Using Options to Protect Against Stock Price Movements  Options on stocks can be used to protect against adverse stock price movements o Call option gives the owner the right to buy 100 shares of stick at a given price during a specified period o Put option gives the owner the right to sell 100 shares of stick at a given price during a specified period  One option strategy is to buy put options to protect against a decline in the price of stock that is already owned The Changing Scope of Risk Management  Integrated risk management programs o A technique that combines coverage for pure and speculative risks in the same contract  Some orgs have created a Chief Risk Officer (CRO) position o CRO is responsible for the treatment of pure and speculative risks faced by the organization  Double-Trigger Option o Provision that provides for payment only if two specified losses occur Enterprise Risk Management  Comprehensive risk management program that addreses all risks faced by the corporation-pure risks, speculative financial risks, strategic risks, operational risks, and other risks o Strategic risk  Refers to uncertainty regarding an organizations goals and objectives o Operational risks  Develop out of business operations, such as manufacturing  As long as risks are not positively correlated, the combination of these risks in a single program reduces overall risk  Advantages of an ERM program include:

o Improved risk assessment o Increased risk awareness o An integrated response to the full range of risks o Alignment of the orgs risk tolerance with its strategies a...