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Risk Management

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-uncertainty about future outcomes -outcomes may be good/desirable/positive or they may be bad/undesirable/negative

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4 Part to RM

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1.Identify- where is the risk 2.Measure- how much risk? Quantify the risk 3.Control- try to keep risk at appropriate level 4.Finance- preparing money to pay for the risk loss

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2 Basic Elements of Risk

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1. Uncertain outcomes: inability to predict the future. Such as what? How? Will events happen? 2. Possibility of negative outcome

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Probability

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(chance/likelihood)-a number i.e. between 0-1

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Possible

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not quantifiable, risk is simply identified but no likelihood or chance is indicated

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Does risk=loss?

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No

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Does loss=risk?

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No

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Prob(loss)=

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1 ---loss will certainly occur

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3 Basic Measurements of Risk

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-frequency -severity -total loss

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Pure

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=undesirable possible outcomes in the future are limited to a loss or no loss

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Speculative

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3 possible outcomes: Loss, No Loss, or Gain

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Objective Risk

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a measurable variation in uncertain outcomes based on facts and past data

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Subjective Risk

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the perceived amount of risk based on personal opinion, feelings, preferences

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Objective and Subjective Risk vary for what 3 reasons?

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1. Familiarity and control "the more familiar you are with a particular risk, the lower subjective risk you have regarding that risk" 2. If you underestimate risk subjective risk is lower. If you overestimate risk subjective risk is higher. 3. Taste of risk. Risk lovers vs Risk averse.

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Diversifiable Risk

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only affects a portion of the population, but not everyone if a loss occurs -aka non-systematic risk -not correlated...car accident vs defective car -"risk pool" -insurable risk

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Non-diversifiable

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risk affects the whole population once a loss occurs -aka systematic risk -not insurable traditionally

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Systematic

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(non-diversifiable) risks are correlated

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Systemic Risk

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the risk that an event will trigger a loss of economic value of confidence in a substantial segment of the financial system that may have significant adverse effect of Real Economy

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Static Risk

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always present over time i.e. ocean marine--death/health

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Dynamic Risk

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emerging from changing economic environment --cyber risk, terrorism risk, financial crisis

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Peril

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immediate cause of a loss

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Hazard

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a condition that increases (f) frequency, severity (s), or both f and s

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4 Types of Hazards

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Physical Moral Morale Legal

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Physical Hazard

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the condition of property, persons, operations (actions) that increase f or s or both

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Moral Hazard

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change in behavior in the presence of insurance

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Morale Hazard

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the condition of carlessnes or indifference -morale hazard is never intentional

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Legal Hazard

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the condition in legal environment that ^f,s, or both -i.e. medical malpractice

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3 Components of Cost of Risk

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1. Expected costs of losses 2. Expenditure on Risk Management 3. Cost of Residual Uncertainty

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Probability

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fractions, sample/pop. 0-1

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Degree of Risk

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variability concept, measures the variation of actual outcome from the expected outcome AC-EC/EL

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TRM

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silo approach--no evaluation of the correlations among risks -each department manages its own risk -focuses on pure risk

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ERM

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-non-silo approach -emphasizes the correlation among risks -analyzes the risks in an organization as a whole -focus' on both pure and speculative risks

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Types of TRM Risk?

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CEO>> reputation risk Finance>> financial risk, such as credit risk, interest rate risk HR>> employee benefits, workers compensation Marketing>> Sales, competition, advertising 60's-70's safety management, insurance management

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Pre-loss goals

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to be met even if a loss does not occur 1. Efficiency/economy of operation (MC=MR--profic maximization) 2. Maintain the managements uncertainty at a tolerable level 3. Legally or regulatory requirements 4 Ethical conduct/social responsibility (they need to do the right thing)

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Post Loss Goals

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1. Survival: loss will put firm out of business 2. Continuity of Operation: loss will not interrupt operations for an appreciable period of time 3. Profitability/earning stability 4. Growth 5. Ethical Conduct/social responsibility (the only post loss goal that always need to be met)

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Loss Exposure

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Crisis a condition or a situation that presents a possibility of loss, regardless of whether a loss actually

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3 Elements of Loss Exposure

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1. Asset exposed to loss 2. Peril 3. Financial consequence of the loss

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6 Step Risk Management Process

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1. Identify Loss Exposure 2. Analyze (measure) Loss Exposure 3. Identify Possible RM Options 4. Select the Appropriate RM Options 5. Implement the RM Option 6. Evaluation, revisit of the RM

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Step 1: Loss Exposure

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-On site inspections -talk to employees -use external expertise (e.g. risk management associations) -RMIS, URMIA -Document analysis -Survey, questionnaire -Financial Statements -Contracts -Review Insurance Policy -Flow Chart & Organization chart

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4 Types of TRM-loss exposure

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Property, Liability, Personal/Personnel, Net Income

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Property Loss Exposure

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asset: property >> real property and personal property -Real Property-land and anything permanently attached to the land, anything growing on the lan

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Personal Loss Exposure

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any property that is not a real property -tangible-physical property -in-tangible- non-physical form

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Who faces property loss exposure?

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whoever has legal interest on the property will face a property loss exposure

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Legal Interest

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financial stake, so that if the property has a loss, that party will suffer a financial loss -Sources:ownership, franchise, secure creditor (bank mortgage), lease agreements

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Lease Agreement

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2-fold 1. tenants have a use interest in the property 2. landlord or tenants may have a Lease-hold interest

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Freight on Board

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(FOB) point at which financial responsibility for goods in transit shifts from seller to buyer

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Bailee Interest

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bailee receives property from bailer for a specific purpose, then returns the property to the bailer later e.g. pawn shop, dry cleaning, valet parking, auto repair

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Liability Loss Exposure

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condition that presents a possibility of loss due to alleged liability claims (mostly with lawsuits) *theoretically unlimited

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Personnel/Personal Loss Exposure

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person and the value that person added to the family(personal) or to the firm

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Key Person Insurance

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manages personnel loss

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Net-income Loss Exposure

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aka indirect loss exposure Net income= revenue-expenses If R decreases, or E increases, or both, Net Income decreases -"business interruption loss"-NI loss where the primary loss is your own -"contingent business interruption loss"-NI loss where the primary loss is other peoples loss

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4 Quadrants of ERM Loss Exposure

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1. Hazard Risk (TRM) 2. Financial Risk 3. Operational Risk 4. Strategic Risk

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Hazard Risks

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(pure risks) unforeseen events arise outside the normal operating environment. hazard risks often managed by TRM and insurance policies. e.g. Valuable property (pure, D), Product Liability (pure, D), D liability (pure, D), natural disaster (pure, d/nd), terrorism (d,nd)

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Financial Risks

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risk of a change of firm value arising from changes in market conditions e.g. Inflation Risk (spec, nd), Credit Risk (spec, d), Interest Rate Risk (spec, nd), Exchange Rate Risk (spec, nd), Commodity Price Risk (spec, nd) *asset valuation (spec, D)--stock price, franchise value

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Operational Risk

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related to ongoing day-to-day business e.g. Product Recal (pure, D), Workplace Violence (pure, D), Supplier Interrpution (pure d/nd) Power Outage (pure, d/nd)

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Strategic Risk

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associated with management decision e.g. Intellectual Property (spec, d), Product Design (sepc, d), Business ethics (spec, d), Reputation (spec, d), M--merger and acquisition (spec, d)

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ERM vs TRM Characteristics

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-There is no net income loss in ERM >> focuses on correlation of risks -only ERM uses a risk map (Y-axis= severity, X-axis=frequency) -Under TRM each risk is managed under different departments

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Probability Distribution

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A table or graph that indicates for each possible outcome of the RV, the corresponding probability of that outcome occuring

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Expected Loss

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E(x)= sum of RV(p)

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Gross Premium

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GP=EL+AC+RC

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Pure Premium

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the amount or portion of the gross premium that is estimated as being sufficient to pay for the EL (only)

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Administrative Cost

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payroll, fixed costs, taxes, marketing costs, commission, claim adjustment

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Risk Charge

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the monetary cushion for estimation errors -size based on the accuracy of the estimate of EL ex. going on vacation expending to spend 100 a day but bring 200 a day just in case

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Variance

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Sum of (outcomes-mean)^2*p

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Standard Deviation

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square root of variance

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Coefficient of Variation

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Standard Deviation/Mean -we always use CV in this class to measure risk -higher CV >> higher risk -CV is unit less

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Expected Loss

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EL=E(f) x E(s) aka Pure Premium

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Theoretical Probability

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derived from the nature of the event

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Empirical Probability

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based on past data, empirical estimation

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Avoidance

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Not to do it. Goal to reduce f and s to ZERO! -proactive avoidance: firm or individual never has/ will engage in activities that may cause losses -reactive avoidance (abandonment): firm or individual ceases the activities that may cause losses (eliminating an existing loss exposure) Problem: it will avoid losses only from future activities but it does not eliminate losses from past activities

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Disadvantage of Avoidance

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-avoidance may be associated with losing profit/ opportunities (do a cost benefit analysis) -some loss exposure are not able to avoided -avoiding one loss exposure may create another loss exposure -in general avoidance is most suitable for a high severity loss exposure

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Loss Prevention

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-primary goal is to decrease f to a lower level, but NOT zero -to make the loss less likely to happen and to break the chain of events leading to a loss -always implemented before a loss occurs ex. fire alarms, speed bump, safety training

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Loss Reduction

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-primary goal is to decrease s should a loss occur -pre-loss reduction: assume a loss will happen, what could have been done to decrease damage/injuries -post loss reduction: mainly focuses on loss recovery, and crisis management ex. medical team on hand, seatbelt

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Separation of Exposure Units

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separate the exposure units used in daily business activities, so that ONE peril will not affect all units

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Duplication of Exposure Units

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copy key assets/activities/responsibilities but the duplicates are held in reserve and not used until a loss actually occurs *duplicaiton without separation will not work well

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Diversification

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-similar to separation and duplication but more community applied to speculative risk -3 Common Types of Diversification: 1. Investment diversification (stock portfolios) 2. Product diversification (multiple product, brand names, etc) 3. Geographic diversification

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3 Risk Financing Options

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1. Risk Transfer 2. Risk Retention 3. Alternate Risk Financing

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Risk Financing Goals

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1. Pay for losses 2. Maintain appropriate liquidity level -avoid poor cash flow -maintain appropriate level of risk for the organization 3. Manage Cost of Risk 4. Compliance -legal or regulatory requirements (auto ins, workers comp, health ins, medical malpractice ins)

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Risk Transfer

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a third party assumes financial responsibility for the loss -only the financial responsibility is transferred, the assets or activity is NOT transferred INSURANCE: for a fee, an insurance company will agree to accept financial responsibility for your losses FEE=Gross Premium

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Non-insurance Risk Transfers

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-Lease -Hold Harmless Agreement *Contractor is made financially responsible for certain losses

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Risk Retention

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firm or individual assumes financial responsibility for losses and "generates" funds to pay for losses -Active retention: deliberate decision to engage in retention -Passive retention: retain the loss exposures but you are unaware of doing so (usually a result of failure to properly identify the loss exposure) -Complete retention: assume the full cost of losses -Partial retention: assume part of the losses and transfer the rest (deductibles, limit)

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