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Introduction to Risk Management. Risk Management Fall 2013. Risk Defined. Risk – possibility of a deviation between actual and expected outcomes Comes from an early Italian word risicare, meaning “to dare” Thus, risk is considered a choice rather than a fate

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introduction to risk management

Introduction to Risk Management

Risk Management

Fall 2013

risk defined
Risk Defined
  • Risk – possibility of a deviation between actual and expected outcomes
  • Comes from an early Italian word risicare, meaning “to dare”
  • Thus, risk is considered a choice rather than a fate
  • Consider a risk that is not taken voluntary
  • Risk is not synonymous with “possibility of loss” or “cause of loss”
  • Example of starting a new business
    • Positive vs. negative risks
traditional vs contemporary view
Traditional vs. Contemporary View
  • Traditionally, risk and risk management focused on accidental and hazard exposures, with only negative outcomes
    • Pure risk exposures only
  • Risk and Risk Management has evolved to take a more holistic approach to encompass negative and positive possible outcomes
    • Pure and speculative risk exposures
impetus for change in risk management focus
Impetus for Change in Risk Management Focus
  • Numerous high-profile large organizations failures
    • Enron
    • Arthur Anderson
    • Washington Mutual
    • Tyco
    • WorldCom
  • Financial Crisis of the 2000’s
  • 2011 Tsunami in Japan – killed approximately 16,000 people
  • These events made it clear that organizations need to evaluate and manage supply chain risk
  • Sarbanes-Oxley Act of 2002
    • Requires controls to be disclosed and announced by public companies and their registered auditors in financial information.
    • OECD (Organization for Economic Co-operation and Development and World Bank initiatives and the European Union promoted initiatives and Solvency standards for risk management in financial organizations.
important risk dichotomies
Important Risk Dichotomies
  • Hazard (or pure) risks and speculative
    • Traditional focus on specific, catastrophic exposures
    • Examination of exposures in isolation
    • Speculative risks include Price and Credit Risk (p. 1.24)
  • Subjective and objective risk (table p. 1.24)
  • Diversifiable and non-diversifiable risk
    • Diversifiable – affects only some individuals, businesses or groups
      • Fire, theft, embezzlement
    • Non-diversifiable affects a large segment of society
      • Unemployment, inflation, and natural disasters
categories of risk
Categories of Risk
  • Hazard
    • Includes property, liability, or personnel loss exposures
  • Operational Risk
    • Result from the failure in processes, systems, or controls
  • Financial Risk
    • Result from the effect of market forces on financial assets or liability; includes market risk, credit risk, liquidity risk, and price risk
  • Strategic Risk
    • Arises from trends in the economy and society; changes in the demographic, economic, political, and competitive environments
why do we need risk management
Why Do We Need Risk Management?
  • “Ben Bernanke said in 2008 that a significant factor causing the 2008 financial crisis was risk-management weaknesses at large global financial institutions.
  • “Banks Bundled Bad Debt, Bet Against it and Won” article
  • Risk Mitigation and Risk Transfer benefit not only the individual organization but the economy as a whole.
benefits of risk managements to society
Benefits of Risk Managements to Society
  • Reduced waste in resources
  • Improved allocation of productive resources
  • Reduced systemic risk
rm tools
RM Tools
  • Risk Management techniques:
    • risk avoidance
    • risk control
      • hazard or loss reduction
    • risk retention
    • risk transfer
      • Hedging and sub-contracting
      • Insurance
total cost of hazard risk
Total Cost of Hazard Risk
  • Includes
  • Costs of losses not covered by insurance or other sources
  • Insurance premiums or expenses incurred for noninsurance indemnity
  • Costs of risk control techniques to reduce accidental losses
  • Costs of administering risk management initiatives
focus of risk management
Focus of Risk Management
  • Reduce the potential loss frequency and loss severity
  • Reduce deterrence effects of Hazard risks
  • Reduce and managing the downside risk
    • Potential loss from new product from delays, errors, cost increases, market decline.
    • May use stop-loss limits in insurance
  • Intelligent Risk Taking
  • Maximizing Profitability
risk management goals
Risk Management Goals
  • Tolerable Uncertainty
  • Legal and Regulatory Compliance
  • Survival
  • Business Continuity
  • Earnings Stability
  • Profitability and Growth
  • Social Responsibility
  • Economy of Risk Management Operations
changes and trade offs in goals
Changes and trade-offs in Goals?
  • Profitability and tolerable uncertainty
  • Economy of operations and legality or social responsibility
  • Growth vs. tolerable uncertainty
holistic risk management
Holistic Risk Management
  • Manages risk across all levels and functions within an organization
  • Provides a more complete picture of an organization’s risk portfolio and profile
  • Provides for better decisions and improved outcomes for senior management
  • Facilitates a complete understanding of the risks involved
regulatory requirements
Regulatory Requirements
  • Sarbanes-Oxley Act of 2002
    • Requires both the management of public companies and their auditors to assess and report on financial risk and controls
  • Dodd-Frank Act of 2010 requires that financial bank holding companies and certain other public companies have a risk committee and at least one member of the committee must be a risk management expert
  • Basel III and Solvency II in Europe provide risk management requirements for financial firms and insurers.
enterprise risk management erm
Enterprise Risk Management (ERM)
  • Holistic approach to risk management
  • Provides a way to manage all of an organization’s risks, including operational, financial, and strategic risk.
  • Three theoretical pillars to explain ERM
    • Interdependency – should not consider exposures as “silo events”
      • Eg., mortgage loans in different geographic areas are not independent
    • Correlation – increases risk
      • Eg., if all suppliers are in hurricane area
    • Portfolio Theory – assumes both individual risk and their interactions;
      • Eg., an airline may have increased portfolio risk with increased fuel prices; this will also impact consumer demand
organizational relationships
Organizational Relationships
  • CRO - Chief Risk Officer – reports to both the chief executive officer and the board risk committee
    • Responsibility includes helping create culture in which divisions, units, and employees become Risk Owners.
requirements for implementing erm
Requirements for Implementing ERM
  • Risk managers must have authority to make and enforce necessary changes, often against significant resistance
  • Effective Communication
  • Knowledge of the type of information the CEO and other senior managers need to understand the organization’s risk portfolio.
  • The ability to avoid “entrenched silos”, decisions made without considering the impact on other divisions or on the overall organization.
risk management framework and process chapter 5
Risk Management Framework and Process – Chapter 5
  • Components and sets of the RM model
traditional steps in the rm process
Traditional Steps in the RM Process
  • Identify and analyze loss exposures
  • Examine feasibility of alternative management techniques
  • Select risk management technique
  • Implement
  • Monitor and improve risk management program
how do we identify the risk management exposures
How do we identify the Risk Management exposures?
  • survey/questionnaire
  • loss history of an organization
  • financial statements
  • other records and documents
  • flowchart of organization’s operations
  • personal inspection of facilities
  • Professional experts
examine the feasibility of rm techniques
Examine the feasibility of RM Techniques
  • risk control techniques

- exposure avoidance

- loss prevention

- loss reduction

- segregation of loss exposures

- contractual transfers for risk control

  • risk financing techniques

- retention

- transfer

risk financing
Risk Financing
  • Retention
    • Current expensing of losses
    • Unfunded reserve
    • Funded reserve
    • Borrowing
    • Captive
  • Transfer
    • Contractual transfer for risk financing
    • Commercial insurance
    • Hedging
focus of analysis
Focus of Analysis
  • Potential loss frequency
  • Potential loss severity
  • Risk Control to Prevent losses
  • Risk financing to reimburse for losses
  • most risk control and risk financing techniques can be adapted to deal with business risks
select the rm technique
Select the RM Technique
  • forecasts
    • The frequency and severity of the expected loss
    • The effects of various RC and RF techniques will have on the predictability, frequency, and severity of loss
    • The cost of the technique
  • selection criteria
    • Financial and other constraints
implement the rm decision
Implement the RM Decision
  • technical decisions
  • managerial decisions
monitor the rm program
Monitor the RM Program
  • establish standards of acceptable performance
  • compare actual results with standards
  • correct substandard performance
steps to the enterprise wide rm process
Steps to the Enterprise-wide RM Process
  • Scan the Environment
  • Identify risks
  • Analyze risks
  • Treat risks
  • Monitor and make sure the process is effective
  • (chart p. 5.19)
four components of the erm framework
Four components of the ERM framework
  • Lead and establish accountability
  • Align and integrate
  • Allocate resources
  • Communicate and report
establishing accountability
Establishing Accountability
  • Identify RISK OWNERS and their roles in the organization
    • Someone who is accountable for the identification, assessment, treatment, and monitoring of risks in a specific environment
  • Establish Key performance Indicators (KPI)
    • A measurement that defines how successfully an organization is progressing toward its long term goal
  • Establish key risk indicators (KRI) and use them to evaluate performance
  • Develop risk criteria to evaluate the significance of risks
power inc case
Power, Inc. Case.
  • Page 5.22-5.5.30