Download Advanced Topics in Risk Management

Advanced Topics in Risk Management
Learning objectives:
1. Explain the meaning of financial risk management and
enterprise risk management.
2. Describe the impact of the underwriting cycle and
consolidation in the insurance industry on the practice of risk
management.
3. Explain capital market risk financing alternatives including risk
securitization through catastrophe bonds and weather options.
4. Explain the methods that a risk manager employs to forecast
losses.
5. Show how financial analysis can be applied to risk
management decision making.
6. Describe other risk management tools that may be of
assistance to risk managers.
Financial risk management:
refers to the identification, analysis, and
treatment of speculative financial risks.
It includes the following:
1. Commodity price risk: the risk of losing
money if the price of a commodity changes.
- producers and users of commodities face
commodity price risks.
- users and distributors of commodities face
commodity price risks.
Examples:
1. Consider an agricultural operation that will have
thousands of bushels of grain at harvest time. At
harvest, the price of the commodity may have
increased or decreased, depending on the
supply and demand for grain. Because little
storage is available for the crop, the grain must
be sold at the current market price, even if that
price is low.
2. Consider a cereal company that has promised to
deliver 500,000 boxes of cereal at an agreedupon price in six months. In the meantime, the
price of grain – a commodity needed to produce
cereal – may increase or decrease, altering the
profitability of the transaction.
2. Interest rate risk: the risk of loss by adverse
interest rate movements.
Ex: a. Consider a bank that has loaned money at
fixed interest rates to home purchasers under 15
and 30 year mortgages. If interest rates increase,
the bank must pay higher interest rates on
deposits while mortgages are locked-in at lower
interest rates.
3. Currency exchange rate risk: the risk of loss of
value caused by changes in the rate at which
one nation’s currency may be converted to
another nation’s currency.
Managing Financial Risks:
Pure risks: handled by the risk manager through risk
retention, risk transfer, and loss control.
Speculative risks: handled by the finance division through
contractual provisions and capital market instruments.
Integrated risk program: a risk treatment technique that
combines coverage for pure and speculative risks faced by
the organization.
A double-trigger option : a provision that provides for
payment only if two specified losses occur. Payments
would be made only if a large property claim and a large
exchange rate loss occurred.
Enterprise risk management: a comprehensive
risk management program that addresses an
organization’s pure risks, speculative risks,
strategic risks, and operational risks.
Strategic risk: refers to uncertainty regarding an
organization’s goals and objectives, and the
organization’s strengths, weaknesses,
opportunities, and threats.
Operational risks: develop out of business
operations, including the manufacture and
distribution of products and providing services
to customers.
Insurance Market Dynamics:
• When property and liability loss exposures are not
eliminated through risk avoidance, losses that occur must be
financed in some other way.
• The risk manager must choose between two methods of
funding losses:
–risk retention
–risk transfer
• Retained losses can be paid out of current earnings, from
loss reserves, by borrowing , or by captive insurance company.
• Risk transfer shifts the burden of paying for losses to
another party, most often a property and liability insurance
company.
• Decisions about whether to retain risks or to transfer them
are influenced by conditions in the insurance market place.
Factors influencing the insurance market:
1) Underwriting cycle: the cyclical pattern in
underwriting stringency, premium levels, and
profitability.
2) Hard insurance market: property and liability
insurance markets fluctuate between periods of
tight underwriting standards and high
premiums.
3) Soft insurance market: periods of loose
underwriting standards and low premiums.
4) Combined ratio for the property and liability
insurance industry over time:
Combined ratio: is the ratio of paid losses and
loss adjustment expenses plus underwriting
expenses to premiums.
If the combined ratio is greater than 1 (or
100%), underwriting operations are
unprofitable.
Factors that affect property and liability
insurance pricing and underwriting decisions:
1. Insurance industry capacity: refers to the
relative level of surplus.
Surplus: the difference between an insurer’s
assets and its liabilities.
With strong surplus position, insurers can
reduce premiums and loosen underwriting
standards.
External factors (such as earthquakes), may
increase the level of claims, reducing surplus.
The 9/11 attacks produced a clash loss in the
insurance industry.
Clash loss: occurs when several lines of
insurance simultaneously experience large
losses.
2. Investment returns:
Insurance companies are in two businesses:
a. underwriting risks
b. investing premiums
Cash flow underwriting: selling of insurance
coverage at lower premium rates, hoping to
offset underwriting losses with investment
income.
Consolidation in the Insurance Industry:
Consolidation: the combining of business
organizations through mergers and acquisitions.
Consolidation trends in the insurance
marketplace:
a. Insurance company mergers and
acquisitions / Insurance brokerage mergers
and acquisitions:
Insurance brokers : are intermediaries who
represent insurance purchasers.
b. Cross-Industry Consolidation:
Capital Market Risk Financing Activities:
1. Securitization of Risk: means that the insurable
risk is transferred to the capital markets through
creation of a financial instrument, such as
catastrophe bond, futures contract, options
contract, or other financial instrument.
- The impact upon the insurance marketplace is an
immediate increase in capacity for insurers and
reinsurers.
- Provides access to the capital of many investors.
Catastrophe bonds : are corporate bonds that
permit the issuer to skip or defer scheduled
payments if a catastrophe loss occurs.
2. Insurance Options: an option that derives
value from specific insurable losses or from an
index of values.
- Profitability of business is determined by
weather conditions.
- Utility companies, farmers, ski resorts face
weather-related risk and uncertainty.
Weather option: provides payment if a specified
weather contingency occurs.
Loss Forecasting:
Techniques in predicting loss levels:
1. Probability analysis:
- Chance of loss is the possibility 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).
P (physical damage) = X / N
Ex: If a vehicle fleet has 500 vehicles and on
average 100 vehicles suffer physical damage
each year, the probability that a fleet vehicle will
be damaged in any given year is:
P = X / N = number of events likely to occur
number of exposures
= 100 / 500 = 20%
Independent events: the occurrence does not affect the
occurrence of another event.
Ex: Assume that a business has production facilities in
Louisiana and Virginia, and that the probability of a fire at
the Louisiana plant is 5% and the probability of fire at the
Virginia plant is 4%.
The occurrence of one of these events does not
influence the occurrence of the other event. If events are
independent, the probability that they will occur together
is the product of the individual probabilities.
The probability that both production facilities will be
damaged is:
P (fire at L) X P (fire at V) = P (fir at both plants)
= 0.04 x 0.05
= 0.002 or 0.2%
Dependent events: the occurrence of one event affects the
occurrence of the other.
If two buildings are located close together, and one building
catches on fire, the probability that the other building will
burn is increased.
Ex: Suppose that the individual probability of a fire loss at
each building is 3 percent. The probability that the second
building will have a fire given that the first building has a
fire, may be 40%.
What is the probability of two fires?
This probability is a conditional probability that is equal to
the probability of the first event multiplied by the probability
of the second event, given the first event has occurred:
P (fire on one bldg.) x P (fire at 2nd bldg. given fire at 1st bldg) = P ( both burn)
0.03 x 0.40 = 0.012 or 1.20%
Events are “mutually exclusive” if the
occurrence of one event precludes the
occurrence of the second event.
Ex: If a building is destroyed by fire, it cannot
also be destroyed by flood.
Mutually exclusive probabilities are additive.
If the probability that a building will be
destroyed by fire is 2% and the probability that
the building will be destroyed by flood is 1%,
then the probability the building will be
destroyed by either fire or flood is:
P (fire destroys bldg.) + P(flood destroys bldg.) = P (fire or flood destroys bldg.)
.02 + .01 = .03 or 3 %
If the independent events are not mutually
exclusive, then more than one event could
occur.
Ex: If the probability of minor fire damage is 4%
and the probability of minor flood damage is
3%, then the probability of at least one of these
events occurring is:
P(minor fire) + P(minor flood) – P(minor fire and flood) = P(at least one event)
.04 + .03 - ( .04 x .03 ) = 0.0688 or 6.88%
Assigning probabilities to
individual and joint events and
analyzing the probabilities can
assist the risk manager in
formulating a risk treatment
plan.
Loss Forecasting Techniques: cont’d
2. Regression Analysis: characterizes the
relationship between two or more variables
and then uses this characterization to predict
values of a variable.
One variable – the dependent variable – is
hypothesized to be a function of one or more
independent variables.
Exhibit 1: Provides the data for a company’s annual payroll in thousands of
dollars and the corresponding number of workers compensation claims during the
year.
Relationship Between Payroll and Number od Workers Compensation Claims:
Payroll in thousands
Year
Workers
Compensation Claims
1998
$ 400
18
1999
52
26
2000
710
48
2001
84
96
2002
1200
110
2003
1500
150
2004
1630
228
2005
1980
250
2006
2300
260
2007
2900
300
2008
3400
325
2009
400
412
Hypothesized relationship:
Number of workers compensation Claims = Bo + (B1 x Payroll)
Where:
Bo is a constant
B1 is the coefficient of the independent
variable.
Regression results: Y = -6.1413 + .1074 X
R² = .9519
Predicted number of claims next year, if the payroll is $ 4.8 million:
Y = - 6.1413 + ( .1074 x 4800)
Y = 509.38
Coefficient of determination, R² ranges from 0 to 1 measures the
model fit.
R-square value close to 1 indicates that the model does a good job in
predicting Y values.
The risk manager estimates that 509 workers compensation claims will
occur in the next year.
3. Forecasting Based on Loss Distributions:
Loss distribution : a probability distribution of
losses that could occur.
- Works well if losses tend to follow a specified
distribution and the sample size is large.
Financial Analysis in Risk
Management Decision Making:
1. 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 received today is worth more than a
dollar received one year from today, because
the dollar received today can be invested
immediately to earn interest.
Ex: Suppose you open a bank account today and
deposit $100. The value of the account todaythe present value – is $100. Further assume that
the bank is willing to pay 4% interest,
compounded annually, on your account. What is
the account balance one year from today?
Future Value:
FV = PV x (1 + i)
FV = $100 x (1 + .04) = $104 or
$100 + ($100 x .04) = $ 104
Account Balance after 2 years:
(Future value of the present amount):
PV (1 + i )ᵑ = FV
where n is the number of time periods
Compounding: the operation through which a
present value is converted to a future value.
(earning interest on interest: compound
interest)
Compounding also works in reverse:
Ex: Assume that you know the value of a future
cash flow, but you want to know what he cash
flow is worth today, adjusting for the time value
of money.
Divide both sides of the compounding equation
by (1 + I ) ᵑ yields the following expression:
PV = FV / (1 + I ) ᵑ
Discounting : the operation of bringing a future
value back to present value.
Financial Analysis Applications:
1. Analyzing Insurance Coverage Bids:
Assume that risk manager would purchase property
insurance on a building. She is analyzing two insurance
coverage bids. The bids are from comparable insurance
companies, and the coverage amounts are the same. The
premiums and deductibles differ. Insurer A’s coverage
requires an annual premium of $90,000 with a $5000 per
claim deductible. Insure B’s coverage requires an annual
premium of $35,000 with a $10,000 per-claim deductible.
The risk manager wonders whether the additional
$55,000 in premiums is warranted to obtain the lower
deductible. Using some of the loss forecasting methods,
the risk manager predicts the following losses will occur:
Expected Number of
Losses
12
6
2
N = 20
Expected Size of Losses
$
$
5000
10,000
over $ 10,000
Which coverage bid should be selected, based
on the number of expected claims and the
magnitude of these claims?
--------------------------------------------------Assume the premiums are paid at the start of
the year, losses and deductibles are paid at the
end of the year, and 5 percent is the appropriate
interest (discount ) rate.
Insurer A’s bid:
Expected cash flows in one year would be the
first $5000 of 20 losses that are each $5000 or
more, for a total of $100,000 in deductibles.
Present value of these payments:
PV = 100,000 / (1 + 0.05)ᶦ = $95,238
The present value of the total expected
payments ($90,000 insurance premium at the
start of the year plus the present value of the
deductibles) would be $185,238.
Insurer B’s bid:
Expected cash outflows for deductibles at the end
of the year :
($5000x12)+($10,000x6)+($10,000x2)=$140,000
The present value of these deductible payments is:
PV = 140,000 / (1 + .05) ᶦ = $133,333
The present value of the total expected payments
($35,000 insurance premium at the start of the year
plus the present value of the deductibles) would be
$168,333.
Because the present values calculated represent the
present values of cash outflows, the risk manager
should select the bid from Insurer B, because it
minimizes the present value of the cash outflows.
2. Loss-Control Investment Decisions:
Loss-control investments are undertaken in an effort to
reduce the frequency and severity of losses.
Such investments can be analyzed from a capital
budgeting perspective by employing time value of money
analysis.
Capital budgeting : a method of determining which
capital investment projects a company should undertake.
Only those projects that benefit the organization
financially should be accepted. If not enough capital is
available to undertake all of the acceptable projects, then
capital budgeting can assist the risk manager in
determining the optimal set of projects to consider.
Capital Budgeting Techniques:
1. Net Present Value: the sum of the present
values of the future net cash flows minus the
cost of the project.
To calculate the NPV, the cash flows are discounted
at an interest rate that considers the rate of return
required by the organization’s capital suppliers and
the risk of the project.
A positive net present value represents an increase
in value for the firm.
A negative net present value would decrease the
value of the firm is the investment were made.
Ex: The risk manager of an oil company that owns
service stations may notice a disturbing trend in
premises-related liability claims. Patrons may claim
to have been injured on the premises (slip-and-fall
injuries near gas pumps or inside the service
station) and sue the oil company for their injuries.
The risk manager decides to install camera
surveillance systems at several of the problem
service stations at a cost of $85,000 per system. The
risk manager expects each surveillance system to
generate an after-tax net cash flow of $40,000 per
year for three years. The present value of $40,000
per year for three years discounted at the
appropriate interest rate (assume 8%) is $103,084.
NPV =PV of future cash flows – Cost of project
= $103,000 - $85,000
= $ 18,084.
As the project has a positive net present value,
the investment is acceptable.
The project’s internal rate of return can be
compared to the company’s required rate of
return on investment.
IRR : the interest rate that makes the net
present value equal zero.
When the IRR is used to discount the future cash
flows back to time zero, the sum of the
discounted cash flows is the cost of the project.
IRR = 19.44 percent , greater than the required rate
of return, 8%, the project is acceptable.
Future cash flows are estimates of the benefits that
will be obtained by investing the project.
Benefits may come in the form of increased
revenues, decreased expenses, or a combination of
the two.
Although some revenues and expenses associated
with the project are easy to quantify, other values
such as employee morale, reduced pain and
suffering, public perceptions of the company, and
lost productivity when a new worker is hired to
replace an injured experienced worker – can prove
difficult to measure.
OTHER RISK MANAGEMENT TOOLS:
1. Risk Management Information Systems
(RMS):
- 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.
2. Risk Management Intranets: a private
network with search capabilities designed for a
limited, internal audience.
3. Risk Maps: grids detailing the potential
frequency and severity of risks faced by the
organization.
4. Value at risk (VAR) analysis: the worst
probable loss likely to occur in a given time
period under regular market conditions at some
level of confidence.
5. Catastrophe modeling: a computer-assisted
method of estimating losses that could occur as
a result of a catastrophic event.
SUMMARY:
Financial risk management is the identification,
analysis, and treatment of speculative financial
risks. Risks include commodity price risk, interest
rate risk, and currency exchange rate risk.
An Integrated risk program is a risk treatment
technique that combines coverage for pure and
speculative risks within the same contract.
Enterprise risk management is a comprehensive
risk management program that addresses an
organization’s pure, speculative, strategic, and
operational risks.
A cyclical pattern – called the “underwriting cycle”
– has been observed in underwriting stringency,
premium levels, and the profitability in the property
and casualty insurance industry.
In a “hard” insurance market, premiums are high
and underwriting standards are tight.
In a “soft” insurance market, premiums are low
and underwriting standards are loose.
Two important factors that affect property and
casualty insurance company pricing and
underwriting decisions are the level of capacity in
the insurance industry and investment returns.
The insurance industry has been experiencing
consolidation through insurance company mergers
and acquisitions, insurance brokerage mergers and
acquisitions, and cross-industry consolidation.
Insurers, reinsurers are using capital market risk
financing alternatives. These arrangements
include: securitizing risk by issuing catastrophe
bonds and insurance options.
Risk managers can use a number of options to
predict losses. These techniques include probability
analysis, regression analysis, and forecasting by
using loss distributions.
When analyzing events, the characteristics of the
events must be considered. Events may be
independent, dependent, or mutually exclusive.
Regression analysis is a method of characterizing
the relationship that exists between two or more
variables and using the characteristics as a
predictor.
In analyzing cash flows in different periods, the
time value of money must be considered.
Changing a present value into a future value is
called compounding, determining the present value
of a future amount is called discounting.
Risk managers can apply time value of money
analysis in many situations, including insurance
coverage bid analysis and loss-control
investment analysis.
A risk management information system (RMIS)
is a computerized database that permits risk
managers to store and analyze risk management
data and to use such data to predict future
losses.
Risk managers may use intranets, risk maps,
value at risk (VAR) analysis, and catastrophe
modeling in their risk management programs.