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Chapter 4

Enterprise Risk
Management and
Related Topics

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Agenda

Enterprise Risk Management


Insurance Market Dynamics
Loss Forecasting
Financial Analysis in Risk Management
Decision Making
Other Risk Management Tools

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Enterprise Risk Management


Financial Risk Management refers to the
identification, analysis, and treatment of
speculative financial risks:
Commodity price risk
Interest rate risk
Currency exchange rate risk

Financial risks can be managed with capital


market instruments

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The Changing Scope of Risk


Management
An integrated risk management program is a
technique that combines coverage for pure
and speculative risks in the same contract
Some organizations have created a Chief
Risk Officer (CRO) position
The chief risk officer is responsible for the
treatment of pure and speculative risks faced by
the organization

A double-trigger option is a provision that


provides for payment only if two specified
losses occur
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Enterprise Risk Management


Enterprise Risk Management (ERM) is a
comprehensive risk management program that
addresses all risks faced by the corporationpure risks, speculative financial risks, strategic
risks, operational risks, and other risks.
Strategic risk refers to uncertainty regarding an
organizations goals and objectives
Operational risks develop out of business
operations, such as manufacturing
As long as risks are not positively correlated, the
combination of these risks in a single program
reduces overall risk
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Enterprise Risk Management


(Continued)
Advantages of an ERM program include:

Improved risk assessment


Increased risk awareness
An integrated response to the full range of risks
Alignment of the organizations risk tolerance with
its strategies and practices
Fewer operational surprises and losses
Increased competitive advantage
Reduced earnings volatility
Better compliance with corporate governance
guidelines

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Enterprise Risk Management


(Continued)
Barriers to a successful ERM program
include:
Rigid organizational culture
Lack of committed leadership
Turf battles between departments over
responsibilities
Lack of a formal process
Lack of information sharing and transparency
Technological deficiencies
Lack of commitment to the design and
implementation of the program
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The ERM Process vs. the Traditional


Risk Management Process
Risk identification is broader under an ERM
program because additional risks are
considered
Risk analysis may involve additional
analysis tools, e.g., catastrophe modeling

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The ERM Process vs. the Traditional


Risk Management Process
(Continued)
Given the wider range of risks considered,
a wider range of treatment measures are
needed
Implementation requires a commitment to
the program and a fundamental change in
how the employees view risk
The process is continuous and dynamic

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Emerging Risks: Terrorism


The risk of terrorism is not new
Bombs and explosives
Computer viruses and cyber attacks on data
CRBN attacks: chemicals, radioactive material,
biological material, and nuclear material

These risks can be addressed with risk


control measures, such as:
Physical barriers
Screening devices
Computer network firewalls
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Emerging Risks: Terrorism


(Continued)
Congress passed the Terrorism Risk
Insurance Act (TRIA) in 2002 to create a
federal backstop for terrorism claims
The Act was extended in 2005, and again in
2007, and again in 2015 through the Terrorism
Risk Insurance Program Reauthorization Act of
2015 (TRIPRA 2015)

Terrorism insurance coverage is available


through standard insurance policies or
through separate, stand-alone coverage
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Emerging Risks: Climate Change


Losses attributable to natural catastrophes
have increased significantly in recent years
Demographic factors, such as population
growth, also contribute to the increasing
losses
Some insurers now provide discounts for
energy efficient buildings and premium
credits for structures with superior loss
control
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Emerging Risks: Cyber Liability


An organizations electronic data is exposed
to risk of unauthorized access
Hackers can:
Exploit trade secrets
Obtain customer data
Make unauthorized purchases
Introduce computer viruses on the organizations
network

Organizations can harden their networks


through greater access restrictions, data
encryption, and tougher network firewalls
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Insurance Market Dynamics


Decisions about whether to retain or
transfer risks are influenced by conditions
in the insurance marketplace
The Underwriting Cycle refers to the
cyclical pattern of underwriting stringency,
premium levels, and profitability
Hard market: tight standards, high premiums,
unfavorable insurance terms, more retention
Soft market: loose standards, low premiums,
favorable insurance terms, less retention

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Insurance Market Dynamics


(Continued)
One indicator of the status of the cycle is
the combined ratio:

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Insurance Market Dynamics


(Continued)
Many factors affect property and liability
insurance pricing and underwriting
decisions:

Insurance industry capacity refers to the


relative level of surplus
Surplus is the difference between an insurers
assets and its liabilities
Capacity can be affected by a clash loss, which
occurs when several lines of insurance
simultaneously experience large losses
Investment returns may be used to offset
underwriting losses, allowing insurers to set
lower premium rates

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Insurance Market Dynamics


(Continued)
The trend toward consolidation in the
financial services industry is continuing
Consolidation refers to the combining of
businesses through acquisitions or mergers
Due to mergers, the market is populated by
fewer, but larger independent insurance
organizations
There are also fewer large national insurance
brokerages
An insurance broker is an intermediary who
represents insurance purchasers
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Insurance Market Dynamics


(Continued)
The boundaries between insurance
companies and other financial institutions
have been struck down, allowing for crossindustry consolidation
Financial Services Modernization Act of 1999
Some financial services companies are
diversifying their operations by expanding into
new sectors

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Capital Market Risk-Financing


Alternatives
Insurers are making increasing use of
capital markets to assist in financing risk
Securitization of risk means that insurable risk is
transferred to the capital markets through
creation of a financial instrument, such as a
catastrophe bond
An insurance option is an option that derives
value from specific insurance losses or from an
index of values (e.g., a weather option based on
temperature).
The impact of risk securitization is an increase in
capacity for insurers and reinsurers
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Loss Forecasting
The risk manager can predict losses using
several different techniques:
Probability analysis
Regression analysis
Forecasting based on loss distribution

Of course, there is no guarantee that


losses will follow past loss trends

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Loss Forecasting (Continued)


Probability analysis: the risk manager can
assign probabilities to individual and joint
events.
The probability of an event is equal to the
number of events likely to occur (X) divided by
the number of exposure units (N)
P=X/N
P(physical damage) = 100/500 = .20 or 20%

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Loss Forecasting (Continued)


Two events are considered independent events if
the occurrence of one event does not affect the
occurrence of the other event.
Suppose the probability of a fire at plant A is 4%
and the probability of a fire at plant B is 5%. Then,

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Loss Forecasting (Continued)


Two events are considered dependent events if the
occurrence of one event affects the occurrence of
the other.
Suppose the probability of a fire at the second
plant, given that the first plant has a fire, is 40%.
Then,

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Loss Forecasting (Continued)


Two events are mutually exclusive if the
occurrence of one event precludes the occurrence
of the second event.
Suppose the probability a plant is destroyed by a
fire is 2% and the probability a plant is destroyed
by a flood is 1%. Then,

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Loss Forecasting (Continued)


Regression analysis characterizes the
relationship between two or more variables
and then uses this characterization to
predict values of a variable
For example, the number of physical damage
claims for a fleet of vehicles is a function of the
size of the fleet and the number of miles driven
each year

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Loss Forecasting (Continued)


A loss distribution is a probability distribution
of losses that could occur
Useful for forecasting if the history of losses tends
to follow a specified distribution, and the sample
size is large
The risk manager needs to know the parameters
of the loss distribution, such as the mean and
standard deviation
The normal distribution is widely used for loss
forecasting

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Financial Analysis in Risk Management


Decision Making
The time value of money must be
considered when decisions involve cash
flows over time
Considers the interest-earning capacity of
money
A present value is converted to a future value
through compounding
FV = PV(1 + i)n

A future value is converted to a present value


through discounting
PV = FV / (1 + i)n
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Financial Analysis in Risk


Management Decision Making
(Continued)

Risk managers use the time value of money


when analyzing insurance bids or making riskcontrol investment decisions
Capital budgeting is a method for determining which
capital investment projects a company should
undertake.
The net present value (NPV) is the sum of the
present values of the future cash flows minus the
cost of the project
The internal rate of return (IRR) on a project is the
average annual rate of return provided by investing
in the project
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Financial Analysis in Risk


Management Decision Making
(Continued)
Net Present Value

Security System Cost = $85,000


Cash Flow = $40,000 per year
Number of years = 3
Discount Rate = 8%

PV = 40,000/1.081 + 40,000/1.082 + 40,000/1.083


PV = $103,084
NPV = $103,084 - $85,000
NPV = $18,084
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Other Risk Management Tools


A risk management information system
(RMIS)
A risk management intranet
Predictive analytics
A risk map
Value at risk (VAR) analysis
Catastrophe modeling

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Other Risk Management Tools


A risk management information system
(RMIS) is a computerized database that
permits the risk manager to store, update,
and analyze risk management data
A risk management intranet is a web site
with search capabilities designed for a
limited, internal audience

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Other Risk Management Tools


(Continued)
Predictive analytics is the analysis of data
to generate information that will help make
more informed decisions
Insurers use of credit scoring is an example of
predictive analytics

A risk map is a grid detailing the potential


frequency and severity of risks faced by the
organization
Each risk must be analyzed before placing it on
the map
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Other Risk Management Tools


(Continued)
Value at risk (VAR) analysis involves
calculating the worst probable loss likely to
occur in a given time period under regular
market conditions at some level of
confidence
The VAR is determined using historical data or
running a computer simulation
Often applied to a portfolio of assets
Can be used to evaluate the solvency of insurers

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Other Risk Management Tools


(Continued)
Catastrophe modeling is a computerassisted method of estimating losses that
could occur as a result of a catastrophic
event
Model inputs include seismic data, historical
losses, and values exposed to losses (e.g.,
building characteristics)
Models are used by insurers, brokers, and large
companies with exposure to catastrophic loss

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In-class Assignment
Case Application (pg. 86 - 87)
20-25 minutes to complete
Turn in at the end of class

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In-class Assignment
(a)
(1) GWS could sell oil futures contracts to
hedge the fuel oil price risk.

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In-class Assignment
(a)
(2) GWS may also consider a double-trigger
option insurance arrangement using fuel oil
prices and property losses as triggers.
Under the double-trigger option, the insurer
would only make a payment to GWS if both
contingencieshigh fuel prices and high
property lossesoccurred.
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In-class Assignment
(b)Using 10 percent as the discount rate,
the NPV of this project is $22,171.30 as
shown below:

As the NPV is positive, the project is acceptable

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In-class Assignment
(c) As the independent variable is thousands
of miles traveled, the expected 640,000
miles is entered into the prediction as 640.

Y (# of derailments) = 2.31+ 0.22(640)


= 2.31 + 14.08
= 16.39

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