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Chapter – 04 Advance Topics in Risk Management . T he Changing Scope of Risk Management:
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The Changing Scope of Risk Management: Traditionally, risk management was limited in scope to pure loss exposures, including property risks, liabilities risks & personal risks. An interesting trend emerged in the 1990s, however, as many businesses began to expand the scope of risk management to include speculative financial risks. Recently, some businesses have gone a step further, expending their risk management programs to consider all risks faced by the organization.
Financial risk management: Business firm face a number of speculative financial risks. Financial risk management refers to the identification, analysis, and treatment of speculative financial risks. These risks including the following: • Commodity price risk. • Interest rate risk. • Currency exchange rate risk.
Commodity price risk: Commodity price risk is the risk of losing money if the price of a commodity changes. Producers and users of commodities face commodity price risks. For example, consider an agricultural operation that ill have thousands of bushels of grain at harvest time. At harvest, the price of commodity may have increased or decreased , depending on the supply and demand for gain .
Commodity price risk: Financial institutions are especially susceptible to interest rate risk. Interest rate risk is the risk of loss caused by adverse interest rate movement. For example, consider a bank that has loaned money at fixed interest rate to home purchasers under 15- and 30- year mortgage. If interest rates increase, the bank must pay higher interest rates on deposits while the mortgages are locked- in at lower interest rates.
Currency exchange rate risk: TheCurrency exchange rate is the value for which one nation’s currency may be converted to another nation’s currency. For example, one Canadian dollar might be worth the equivalent of two-thirds of one U.S dollar. At this currency exchange rate, one U.S dollar may be converted to one and one-half Canadian dollar.
Managing Financial Risks: The traditional separation of pure and speculative risks meant that different business departments addressed these risks. Pure risks were handled by the risk manager through risk retention, risk transfer, and loss control. Speculative risks were handled by the finance division through contractual provision and capital market instruments. Example of contractual provision that address financial risks include call features on bonds that permit bonds with high coupon rates to be retired early and adjustable interest rate provisions on mortgages through which the interest rate varies with interest rate in the general economy.
Enterprise Risk Management: Encouraged by the success of financial risk management, some organizations are taking the next logical step. Enterprise risk management is a comprehensive risk management program that address an organization’s pure risks, speculative risks, strategic risks, and operational risks. Pure and speculative risks were defined previously. Strategic risk refers to uncertainly regarding the organization’s goals and objectives, and the organization’s strength, weaknesses, opportunities, and threats. operational risks are risks that develop out of business operations, including such things as manufacturing product and providing services to customer.
Insurance Market Dynamics: When property & liabilities loss exposures are not eliminated through risk avoidance, losses that occur must be financed some other way. The risk manager must choose between two methods of funding losses: risk retention and risk transfer. Retained losses can be paid out of current earnings, from loss reserves, by borrowing, or by a captive insurance company. Risk transfer shifts the burden of paying for losses to another party, most often a property & liabilities insurance company. There are three important factors influencing the insurance market. There are: • The underwriting cycle • Consolidation in the insurance industry • Securitization of risk
The underwriting cycle: For many years, a cyclical pattern has been observed in a number of underwriting results and profitability measures in the property and liability insurance industry. This cyclical pattern in underwriting stringency, premium levels, and profitability is referred to as the unwitting cycle. A number of measures can be used to ascertain the status of the underwriting cycle.
Insurance Industry Capacity: In the insurance industry, capacity refers to the relative level of surplus. Surplus is the different between an insurers assets and its liabilities. When the property and casualty insurance industry is in a strong surplus position, insurers can reduce premium and loosen underwriting standards, because they have a cushion to draw on if underwriting results prove unfavorable.
Consolidation in the insurance industry: When changes were occurring in insurance product markets, changes were also occurring among the organizations operating in this sector of the economy. Consolidation means the combining of business organizations through mergers and acquisitions. A number of Consolidation trends have changed the insurance market place for risk managers: • Insurance company mergers and acquisition • Insurance brokerage mergers and acquisition • Cross-industry consolidation.
Insurance company mergers and acquisition: Give the market structure of the property & liability insurance company (numerous companies, relatively low barriers to entry given the flexibility of financial capital, and relatively homogenous products),insurance company consolidations do not have severe consequences for risk managers. Risk managers may notice ,however, that the market place is populated by fewer but larger, independent insurance organizations as a result of consolidation.
Insurance brokerage mergers and acquisition: Unlike the consolidation of insurance companies, consolidation of insurance brokerages does have consequences for risk managers. Insurance brokers are intermediaries who represent insurance purchasers. Insurance brokers offer an array of services to their clients, including attempting to place their clients business with insurers.
Cross-industry consolidation: Consolidation in the financial services arena is not limited to mergers between insurance companies or between insurance brokerages. Boundaries separating institutions with depository functions, institutions that underwrite risk, and securities businesses were enacted in depression-era legislation. The divisions between banks, insurance companies, and securities firms began to blur in the 1990s.
Securitization of Risk: Another important development in insurance and risk management is the accelerating use of securitization of risk means that insurable risk is transferred to the capital markets through creation of financial instrument, such as a catastrophe bond, future contract, options contract, or other financial instruments.
Loss Forecasting: The risk manager must also identify the risk the organization faces, and then analyze the potential frequency and severity of these loss exposures. Although loss history provides valuable information, there no guarantee that future losses will follow past lost trends. Risk managers can employ a number of techniques to assist in predicting loss levels, including the following: • Probability analysis . • Regression analysis. • Forecasting based on lost distributions.
Probability Analysis: Chance of loss is the Probability that an adverse event will occur. The probability (P) of such an event is equal to the number of events likely to occur (X) divided by the number of exposure units (N). Thus, If a vehicle fleet has 500 vehicles and on average 100 vehicles suffer physical damage each year, The probability of that fleet vehicle will be damaged in any given year is: P ( physical damage ) = (100/500) = .20 or 20%
Regression Analysis: Regression analysis is a method for forecasting losses. Regression analysis characterizes the relationship between two or more variables and then uses this characterization to predict values of a variables. • Forecasting based on lost distributions: Another useful tool for the risk manager is loss forecasting based on loss distributions. A loss distribution is a probability distribution of losses that could occur. Forecasting by using loss distributions works well if losses tend to follow a specified and the sample size is large. Knowing the parameters that specify the loss distribution (e.g. mean, standard deviation) enables the risk manager to estimate the number of events, severity, and condition intervals.
Financial Analysis In risk Management Decision Making: Risk manager must make a number of important decision, including whether to retain or transfer loss exposures, which insurance coverage bid is best, and whether to invest in loss control projects. The risk manager’s decision are based on economics-weighing the costs and benefits of a course of action to see whether it is in the economic interest of the company & its stockholders. Finally analysis can be applied to assist in risk management decision making. To make decisions involving cash flows in different time periods, the risk manager must employ time value of money analysis.
The Time Value Of Money: The time value of money means that when valuing cash flows in different time periods, the interest –earning capacity of money must be taken into consideration. A dollar receive today is worth more than a dollar received one year from today, because the dollar received today can be invested immediately to earn interest. Therefore, when evaluating cash flows in different time periods, it is important to adjust dollar values to reflect the earning of interest.
Other Risk Management Tools: Our discussion of advanced risk management topics would not be complete without a brief discussion of some other risk management tools. We will divide our discussion into five parts: • Risk Management Information System(RMIS) • Risk Management internet & web sites. • Value At Risk (VAR) analysis. • Catastrophe modeling.
Risk Management Information System(RMIS): A Risk Management Information System(RMIS) is a computerized database that permits the risk manager to store and analyze risk management data and to use such data to predict and attempt to control future loss levels. Risk Management Information System(RMIS) may be of great assistance to risk managers in decision making. • Risk Management internet & web sites: Some risk management departments have established their own Web sites, which include answer to frequently ask question. In addition, some organization have expanded the traditional risk management web site into a risk management internet.
Risk Maps: Some organization have developed or are developing sophisticated “ risk maps”. Risk maps are grids detailing the potential frequency and severity of risks faced by the organization. Construction of these maps requires risk managers to analyze each risk that the organization faces before plotting it on the map. • Value At Risk (VAR) analysis: A popular risk assessment technique in financial risk management is value at risk(VAR) analysis. Value At Risk (VAR) is the worst probable loss likely to occur in a given time period under regular market conditions at some levels of confidence.
Catastrophe modeling: Catastrophe modeling is a computer-assisted method of estimating losses that could occur as a result of catastrophic event. Input variables include such factors as seismic data, meteorological data, historical losses, and values exposed to loss (e.g. structures, population, business income etc.). The output from the computer analysis is in estimate of likely results from the occurrence of a catastrophic event. Catastrophe models are employed by insurers, brokers, rating agencies, and large companies with exposure to Catastrophic loss.
