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risk management

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any effort to economically deal with uncertainty of outcomes (risk)

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RM for individuals

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- informal series of efforts, not a formalized process - purchase insurance policies to cover accidental or unexpected losses - contribute to savings plans so that they have money available to cover unforeseen events - may be viewed as part of the financial planning process that encompasses broader matters ex. capital accumulation, retirement planning, and estate planning

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RM for smaller organizations

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- not usually a dedicated function - one of many tasks carried out by the owner or senior manager

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RM for larger organizations

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- formalized risk management program

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risk management program

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a system for planning, organizing, leading, and controlling the resources and activities that an organization needs to protect itself from the adverse effects of accidental losses - built around RM process

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RM Process

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making, implementing, and monitoring decisions that minimize the adverse effects of risk on an firm - although each firms' plan is different

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TRM

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- traditionally focuses on pure risks - *excludes* all loss exposures that arise from *speculative risk* or business risk - *focuses* on managing safety, purchasing insurance, and controlling financial recovery from losses generated by *hazard risk*

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ERM

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- broader view of risk management that encompasses all types of risk - manages key risks and opportunities with intent of maximizing firm's value - allows a firm to integrate all of its risk management activities so that the risk management process occurs at the enterprise level rather than departmentally or business unit level

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Benefits for Organization

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- reduce cost of hazard risk - reduce deterrence effects of hazard risks - reduce downside risk - manage downside risk - intelligent risk taking - maximize profitability - holistic risk management - legal and regulatory requirements

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reduce cost of hazard risk

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- RM aims to reduce long term overall cost of risk w/o precluding or otherwise interfering with achieving goals or engaging in normal activities - reduction in the overall cost of risk can increase firm's profits - also supports safety while minimizing the financial effect of safety measures on the firm's productivity

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cost of risk includes

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- costs of accidental losses not reimbursed by insurance or other sources - insurance premiums or expenses incurred for noninsurance protection - costs of risk control techniques to prevent or reduce the size of accidental losses - costs of administering risk management activities

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reduce deterrence effects of hazard risks

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- fear of possible future losses tends to make senior management reluctant to undertake activities considered too risky - firm is often deprived of potential benefits - RM reduces deterrence effects of uncertainty about potential future accidental losses - makes losses less frequent, less severe, or more foreseeable

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benefits of reducing deterrence

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- alleviates or reduces management's fears about potential losses - ^ the feasibility of ventures that once appeared too risky - ^ profit potential by greater participation in investment or production activities - makes firm safer investment, and, therefore, more attractive to suppliers of investment capital through which the firm can expand

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reduce downside risk

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*downside risk* = *losses and failure* ex. firm faces downside risk whenever a new ex. financial institution faces downside

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manage downside risk

answer

ex. Metallgesellschaft Refining and Marketing - used strategy of agreements to sell petroleum products at prices above the current market price for 10 yrs - hedged long-term commitments by purchasing short-term energy futures - if prices would drop and fixed-price positions would gain while the futures positions would lose money - if prices rose, futures positions would gain while the fixed-price positions would lose - when oil prices actually dropped margin calls on the futures positions resulted in a cash flow crisis - RM failure included failure to recognize funding risk and a mismatch between long and short positions

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intelligent risk taking

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- firms often take risks to grow and increase profits - can create a positive or negative outcome - based on risk appetite - RM provides firm w/ a framework to analyze risks associated with an opportunity and then manage those risks ex. firm wants to launch new product, RM can help weigh rewards and downside risks as well as a process to manage associated risks if product is launched

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maximize profitability

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- RM can help firm achieve optimal risk-adjusted return on capital - not enough risk underutilizes capital while too much risk may exceed its capability to withstand potential losses ex. may consider whether to increase its dividend to shareholders vs investing in a new product

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holistic risk management

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- traditional TRM takes a silo approach - presents a more complete picture of firm's risk portfolio and profile - allows for better decisions and improved outcomes for senior management

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legal and regulatory requirements

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- legislation and regulation in the U.S. require public companies to use and report on risk management - the Securities and Exchange Commission (SEC) approved a rule requiring corporate disclosure about risk - *Sarbanes-Oxley Act* requires *both management and their auditors* to assess and *report on financial risk* and controls - *Dodd-Frank Act* 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 - inspired by Enron and financial crisis

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Steps in RM Process

answer

1. identifying loss exposures 2. analyzing loss exposures 3. examining feasibility of RM techniques 4. selecting appropriate RM techniques 5. implementing selected RM techniques 6. monitoring results and revising RM program

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1. identifying loss exposures

answer

applied individually but can overlap in use in function - document analysis - compliance reviews - inspections - expertise within and beyond firm some are better for certain situations ex. loss history documents may not reveal possibility of loss exposures related to flood, but studying a flood insurance rate map or a cause of loss checklist would

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document analysis

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- risk assessment questionnaires and checklists - financial statements and underlying account records - contracts - insurance policies - organizational policies and procedures - flowcharts and organizational charts - loss histories

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2. analyzing loss exposures

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estimating the likely significance of possible losses identified in step 1 using - loss frequency - loss severity - total dollar losses - timing enables RM professional to develop loss projections and prioritize loss exposures so resources can be properly allocated - expensive - cost of risk include cost of acquiring risk-related information

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total dollar losses

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total dollar amount of losses for *all occurrences* during a specific time period

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3. examining feasibility of RM techniques

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- not usually used in isolation - risk control alters estimated frequency and severity of loss - risk financing pays for losses that occur despite the controls

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risk control

answer

avoidance, loss prevention, loss reduction, separation, duplication, diversification

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risk financing

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transfer, retention

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4. selecting appropriate RM techniques

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- usually based on quantitative financial considerations as well as qualitative, nonfinancial considerations

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financial considerations

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- effective and economical - potential costs if loss exposures are left completely untreated must be compared with costs of possible risk management techniques three forecasts are used - forecast of dimensions of expected losses (frequency, severity, timing of payment, and total dollar losses) - forecast, for each feasible combination of risk management techniques, of effect on dimensions of expected losses - forecast of after-tax costs involved in applying various risk management techniques ex. cost of insurance premiums, cost of installing and maintaining various risk control devices

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nonfinancial considerations

answer

- include ethical considerations - can constrain financial goals - RM techniques best for firm may be inconsistent with its value maximization goal ex. firm wants stability over time rather than max earnings in any one period, may over-invest in RM practices rather than absorbing losses

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5. implementing selected RM techniques

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- does not end with initial implementation of selected technique includes - purchasing loss reduction devices - contracting for loss prevention services - funding retention programs - implementing and continually reinforcing loss control programs - selecting agents or brokers, insurers, third-party administrators, and other providers for insurance programs - requesting insurance policies and paying premiums

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6. monitoring results and revising RM program

answer

- establish standards of acceptable performance - compare actual results with these standards - correct substandard performance or revise standards that prove to be unrealistic - evaluate standards that have been substantially exceeded

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establish standards of acceptable performance

answer

- focus on both results and activities (TRM) - focus on results alone acknowledges achievement of goals regardless of efforts required to achieve them ex. RM professional may judge program's performance in terms of a decline in frequency or severity of employee injuries - these are chance events - focusing on the activities involved in reducing injuries acknowledges fefforts made to achieve a goal regardless of actual results

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loss is uncontrollable

answer

RM professionals are as successful in years with many losses as in years with few losses - losses themselves are beyond their control - may even be more valuable when losses are sever because of the assistance they can give

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compare actual results with these standards

answer

- proper standard for evaluating performance includes specifications for how results or performance will be measured - good standards include *target activity levels* or results or desired directions os change ex. if firm wants to reduce employee injuries, a good standard could be formulated as a max number of accidents per employee hour worked - comparison of the actual number of accidents with estimated results standard will indicate whether activities are achieving the desired results

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correct substandard performance or revise standards that prove to be unrealistic

answer

- substandard performance does not necessarily indicate that performance itself is the problem - standards may be inappropriate - standards must be reexamined and altered if environment within which program operates also changes ex. increases in inflation, changes in the volume or nature of an firm's activities, and cyclical or long-term movements in insurance markets or money markets may require adjustments in standards

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evaluate standards that have been substantially exceeded

answer

- employees involved in implementing standard may have superior skills - standard may not be *sufficiently demanding* - often first step for RM professional taking control of an firm's RM program

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Pre-Loss Goals

answer

- economy of operations - tolerable uncertainty - legality - social responsibility

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economy of operations

answer

- program should operate economically and efficiently - should not incur substantial costs in exchange for slight benefits - can be measured using benchmarking

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benchmarking

answer

firm's risk management costs are compared with those of similar firms

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tolerable uncertainty

answer

- managers should be able to make and implement decisions effectively without being unduly affected by uncertainty

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legality

answer

- some public and charitable entities immune from negligence claims because of long-standing constitutional and other judicial doctrines that exempt them - RM professional should be aware of firm's contractual obligations as well as the contractual obligations that others owe to it legal obligations based on - standard of care that is owed to others - contracts entered into by the firm - federal, state, and local laws and regulations

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social responsibility

answer

- acting ethically and fulfilling obligations to the community and society as a whole - potential to enhance the firm's reputation - overriding pre-loss goals for public entities and not-for-profit firms

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Post Loss Goals

answer

- survival - continuity of operations - profitability - earnings stability - social responsibility - growth

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survival

answer

resuming operations to some extent after an adverse event losses that could prevent survival - only office or plant is destroyed - legal liability judgment drains cash and credit resources - death or disability of a key employee deprives firm of essential leadership

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continuity of operations

answer

- no loss can be allowed to interrupt firm's operations for any appreciable time - appreciable time is relative

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steps for continuity of operations

answer

- identify activities whose interruptions cannot be tolerated - identify types of events that could interrupt such activities - determine standby resources that must be immediately available to counter effects of those losses - ensure availability of the standby resources at even the most unlikely and difficult times (^ expenses)

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profitability

answer

- for profits want to generate net income, not for profits want to work within a budget - RM program likely emphasizes insurance and other means of transferring financial consequences of loss

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earnings stability

answer

- requires precision in forecasting RM costs - requires lower retention levels and a willingness to spend more on risk transfer mechanisms - rather than highest possible level of profit

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social responsibility

answer

- losses interfere with ability to fulfill obligations to community and society

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growth

answer

- includes ^ market share, size and scope of activities or products, or assets

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