Chapter 4s

7/17/2019 Chapter 4s

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4-1

Chapter 4

AdvancedTopics in Risk

Management



4-2

Agenda

• The Changing Scope of Risk Management

• Enterprise Risk Management

• Insurance Market Dynamics

• Loss Forecasting

• Financial nalysis in Risk ManagementDecision Making

• !ther Risk Management Tools

• I" case# $aring case%



4-3

Outcome

• &le to apply 'ifferent risk managementtechni(ues to manage risk e)posure

• *n'erstan' the causes of &ig losses in I"case an' $aring case%



4-4

The Changing Scope of Risk Management

• To'ay# the risk manager+s ,o&-

. In/ol/es more than simply purchasinginsurance

. Is not limite' in scope to pure risks• The risk manager may &e using-

. Financial risk management

. Enterprise risk management



4-5


• Financial Risk Management refers to the i'entification#analysis# an' treatment of speculati/e financial risks-

. Commo'ity price risk is the risk of losing money if theprice of a commo'ity changes# e%g% oil# gol'# cotton# etc%

. Interest rate risk is the risk of loss cause' &y a'/erseinterest rate mo/ements# e%g% &on' price changes 0ithinterest rate

. Currency e)change rate risk is the risk of loss of /aluecause' &y changes in the rate at 0hich one nation1s

currency may &e con/erte' to another nation+s currency#e%g% o/ersea su&si'iaries

• Financial risks can &e manage' 0ith capital marketinstruments



4-6

Exhibit 4.1 Managing Financial Risk2T0oE)amples



4-7

Exhibit 1 Managing Financial Risk2T0oE)amples

Should we use futures or option?



4-8


• n integrate' risk management program is a

risk treatment techni(ue that com&inesco/erage for pure an' speculati/e risks in thesame contract

• Some organi3ations ha/e create' a ChiefRisk !fficer CR!5 position

. The chief risk officer is responsi&le for thetreatment of pure an' speculati/e risks face' &ythe organi3ation



4-9

Entepise Risk Management

• Enterprise Risk Management ERM5 is a comprehensi/e risk

management program that a''resses the organi3ation+s pure#speculati/e# strategic# an' operational risks

. Strategic risk refers to uncertainty regar'ing an organi3ation+sgoals an' o&,ecti/es#

. !perational risks are risks that 'e/elop out of &usinessoperations# such as pro'uct manufacturing

. s long as risks are 66666positi/ely correlate'# the com&inationof these risks in a single program re'uces o/erall risk

. 7early half of all *S firms ha/e a'opte' some type of ERM

program. $arriers to the implementation of ERM inclu'e organi3ational#

culture an' turf &attles



4-10

The !inancia" Cisis andEntepise Risk Management

• The *S stock market 'roppe' &y morethan fifty percent &et0een !cto&er 899:an' March 899; ne)t sli'e5

. The melt'o0n raises (uestions a&out the use ofERM

. !nly <= percent of e)ecuti/es sur/eye' sai'they ha' a 0ell>formulate' an' fully>

implemente' ERM program

“Interesting” to learn that insurance company took the bet,

e.g. AIG



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Exhibit #Timeline of

E/ents Relate'to the FinancialCrisis



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$id ERM fai"% o did companies simp"& fai"to use it pope"& egu"ated'

• The falls of Lehman $rothers# Merrill Lynch an' merican

International "roup• ?illiam @% Aanning# e)ecuti/e /ice presi'ent at ?illis Re Inc%

. BIn the firms that really took a nose'i/e# the CE!s an'the 'irectors seeme' to care only a&out earnings# an'not a&out ho0 much risk 0as &eing taken% There 0as nopenalty for &etting the firm% They 'i'n1t take ERM /eryseriously%

. $laming ERM for a company1s failure is like ri'ing in a car0ithout a seat &elt# then &laming the seat &elt for yourin,uries

. I" asi'e# the insurance in'ustry has mostly a/oi'e' &iglosses so far &ecause propertycasualty firms ha/e al0aysemphasi3e' un'er0riting risk

Rea' Risking the Enterprise &y $onnie $re0er Ca/anaughat http://www.amper.com/publications/risk-enterprise-management.asp

http://www.amper.com/publications/risk-enterprise-management.asp

http://www.amper.com/publications/risk-enterprise-management.asp



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ERM

• Integrating enterprise risk management 0ithorgani3ational strategy- an ERM program mustalign 0ith corporate strategy to gi/e theorgani3ation a complete an' comprehensi/eapproach to managing risk#

. The RM ournal# May <# 899; &y Gillackey# @enry



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(nsuance Maket $&namics

• Decisions a&out 0hether to retain or transfer risks areinfluence' &y con'itions in the insurance marketplace

• The *n'er0riting Cycle refers to the cyclical pattern ofun'er0riting stringency# premium le/els# an' profita&ility. @ar' market- tight stan'ar's# high premiums#

unfa/ora&le insurance terms# more retention. Soft market- loose stan'ar's# lo0 premiums# fa/ora&leinsurance terms# less retention

. !ne in'icator of the status of the cycle is the com&ine'ratio-

Premiums

Expensesng Underwriti Expenses Adjustment Loss Lossess Paid RatioCombined

++=



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Exhibit ) Com&ine' Ratio for ll Lines ofAroperty an' Lia&ility Insurance# <;H.899=J



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• Many factors affect property an' lia&ility insurancepricing an' un'er0riting 'ecisions-. Insurance in'ustry capacity refers to the

relati/e le/el of surplus

• Surplus is the 'ifference &et0een aninsurer+s assets an' its lia&ilities

• Capacity can &e affecte' &y a clash loss#0hich occurs 0hen se/eral lines of insurancesimultaneously e)perience large losses

. In/estment returns may &e use' to offsetun'er0riting losses# allo0ing insurers to setlo0er premium rates



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• The tren' to0ar' consoli'ation in the financial ser/ices in'ustry iscontinuing

. Consoli'ation refers to the com&ining of &usinesses throughac(uisitions or mergers

• !0ing to mergers# the market is populate' &y fe0er# &ut

larger in'epen'ent insurance organi3ations• There are also fe0er large national insurance &rokerages

. n insurance &roker is an interme'iary 0ho representsinsurance purchasers

. Cross>In'ustry Consoli'ation- the &oun'aries &et0een insurance

companies an' other financial institutions ha/e &een struck 'o0n• Financial Ser/ices Mo'erni3ation ct of <;;;

• Some financial ser/ices companies are 'i/ersifying theiroperations &y e)pan'ing into ne0 sectors



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Capita" Maket Risk !inancingA"tenatives

• Insurers are making increasing use of capital markets toassist in financing risk. Securiti3ation of risk means that insura&le risk is

transferre' to the capital markets through creation ofa financial instrument-

• catastrophe &on'J permits the issuer to skip or'efer sche'ule' payments if a catastrophic lossoccurs

. n insurance option is an option that 'eri/es /aluefrom specific insurance losses or from an in'e) of/alues%• 0eather option pro/i'es a payment if a specifie'

0eather contingency e%g%# high temperature5occurs

• 'ou&le>trigger option is a pro/ision that pro/i'esfor payment only if t0o specifie' losses occur



4-19

Capita" Maket Risk !inancing A"tenatives

• 'ou&le>trigger option e)ample.often use' for insurance purposes#.pays off only if 8 e/ents occur%.&uy this option to limit losses that are /ery

unlikely# &ut /ery e)pensi/e if they &oth

occurre'%

. The impact of risk securiti3ation is an 6666666 in

capacity for insurers an' reinsurers• It pro/i'es access to the capital of many

in/estors

JCat6$on's6Demystifie' your reference5



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Exhibit 4 Catastrophe $on's- nnual 7um&er ofTransactions an' Issue Si3e



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*oss !oecasting &rief account5

• The risk manager can pre'ict losses usingse/eral 'ifferent techni(ues-. Aro&a&ility analysis

. Regression analysis. Forecasting &ase' on loss 'istri&ution

• !f course# there is no guarantee thatlosses 0ill follo0 past loss tren's



4-22

*oss !oecasting

• Aro&a&ility analysis- the risk manager can assignpro&a&ilities to in'i/i'ual an' ,oint e/ents. The pro&a&ility of an e/ent is e(ual to the num&er

of e/ents likely to occur K5 'i/i'e' &y the num&erof e)posure units 75

• May &e calculate' 0ith past loss 'ata. T0o e/ents are consi'ere' in'epen'ent e/ents if

the occurrence of one e/ent 'oes not affect theoccurrence of the other e/ent

. T0o e/ents are consi'ere' 'epen'ent e/ents if the

occurrence of one e/ent affects the occurrence ofthe other. E/ents are mutually e)clusi/e if the occurrence of

one e/ent preclu'es the occurrence of the secon'e/ent



4-23

*oss !oecasting

• Regression analysis characteri3es therelationship &et0een t0o or more /aria&lesan' then uses this characteri3ation to

pre'ict /alues of a /aria&le. For e)ample# the num&er of physical 'amage

claims for a fleet of /ehicles is a function of thesi3e of the fleet an' the num&er of miles 'ri/en

each year



4-24

Exhibit + Relationship $et0een Aayroll an' 7um&erof ?orkers Compensation Claims



4-25

*oss !oecasting

• loss 'istri&ution is a pro&a&ility 'istri&ution oflosses that coul' occur. *seful for forecasting if the history of losses ten's to

follo0 a specifie' 'istri&ution# an' the sample si3e is

large. The risk manager nee's to kno0 the parameters of

the loss 'istri&ution# such as the mean an' stan'ar''e/iation

. The normal 'istri&ution is 0i'ely use' for lossforecasting• 7ote- it can &e /ery incorrect

• If @SI 'oes not follo0 normal 'istri&ution# ho0 can you 'oforecasting



4-26

!inancia" Ana"&sis in Risk Management$ecision Making

• The time /alue of money must &e consi'ere' 0hen'ecisions in/ol/e cash flo0s o/er time

. Consi'ers the interest>earning capacity of money

. present /alue is con/erte' to a future /alue throughcompoun'ing

. future /alue is con/erte' to a present /alue through'iscounting

• Risk managers use the time /alue of money 0hen-

. naly3ing insurance &i's

. Making loss control in/estment 'ecisions

• The net present /alue is the sum of the present /alues of the futurecash flo0s minus the cost of the pro,ect

• The internal rate of return on a pro,ect is the a/erage annual rateof return pro/i'e' &y in/esting in the pro,ect

Still remember what they mean? Refer to your FM text.



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(nsuance bids examp"e

T0o &i's

<% nnual Aremium-=9#999# per>claim'e'ucti&le H#999

8% nnual Aremium-N9#999# per>claim'e'ucti&le <9#999

RO4P

Expected

Number of

Losses

Expected Size

of Lossess

11 $5,000

6 $10,000

3 > $10,000

Which bid is better?



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(nsuance bids examp"e

• $i' <- e)pecte' cash outflo0s in one year O

• AQ'e'ucti&le O

• Total outlflo0- AQ'e'ucti&le Alus premium

• $i' 8-

• !utflo0s-• A/'e'ucti&leO

• Total outlflo0-



4-29

Making "oss conto" investment decisions

• The installation of leakage control system ise)pecte' to generate an after>ta) net cashflo0 of <99#999 per year for H year#rOP# the installation cost is 499#999%Shoul' the system &e installe'

• 7AQ O AQ of the fi/e <99#999 . cost of the

installation O48<#8N >499#999 O8<#8N

• !R IRR O:%;NP



4-30

Othe Risk Management Too"s• risk management information system RMIS5 is a

computeri3e' 'ata&ase that permits the risk manager to store

an' analy3e risk management 'ata. The 'ata&ase may inclu'e listing of properties# insurance

policies# loss recor's# an' status of legal claims. Data can &e use' to pre'ict an' attempt to control future

loss le/els• Risk Management Intranets an' ?e& Sites

. n intranet is a 0e& site 0ith search capa&ilities 'esigne'for a limite'# internal au'ience

• risk map is a gri' 'etailing the potential fre(uency an'se/erity of risks face' &y the organi3ation. Each risk must &e analy3e' &efore placing it on the map

High

!rob"bi#i

t%edium

Lo&

Lo& %edium High



4-31



4-32

Othe Risk Management Too"s

• Qalue at risk QR5 analysis in/ol/es calculating the0orst pro&a&le loss likely to occur in a gi/en time perio'un'er regular market con'itions at some le/el ofconfi'ence. The QR is 'etermine' using historical 'ata or

running a computer simulation. !ften applie' to a portfolio of assets

. Can &e use' to e/aluate the sol/ency of insurers

. financial firm may 'etermine that it has a HP onemonth /alue at risk of <99 million% This means thatthere is a HP chance that the firm coul' lose more

than <99 million in any gi/en month% Therefore# a<99 million loss shoul' &e e)pecte' to occur oncee/ery 89 months%http-000%in/estope'ia%comterms//ar%asp



4-33

Othe Risk Management Too"s

• Catastrophe mo'eling is a computer>assiste'

metho' of estimating losses that coul' occur as aresult of a catastrophic e/ent. Mo'el inputs inclu'e seismic 'ata# historical

losses# an' /alues e)pose' to losses e%g%#&uil'ing characteristics5

. Mo'els are use' &y insurers# &rokers# an' largecompanies 0ith e)posure to catastrophic loss



4-34

Othe Risk Management App"ications

• n accurate forecast of the timing an' magnitu'e of

claims is especially important 0hen losses are retaine'• The a&ility to forecast ultimate claims for lia&ility lines is

an important skill for the risk manager. Loss 'e/elopment factors LDFs5 are multipliers that

can &e applie' to claims settle' to 'ate to estimate

the ultimate claims for a perio'. general up0ar' tren' in lia&ility an' 0orkerscompensation claim totals after the initial reporting perio'calle' %

. LDFs are use' to arri/e at the ultimate /alue that can &e

e)pecte' for a claim% For e)ample# an LDF of <%H9 meansthat for e/ery < of current claims# the ultimate payout0ill &e <%H9% total of H9#999 in current claims 0oul'result in an ultimate payout of :H#999%http-000%irmi%comonline



4-35

The !inancia" Cisis and EntepiseRisk Management% the A(, case• I" mentions an acti/e ERM program in its 899: <9>G

Report

. Riskiness of the Financial Aro'ucts Di/ision 0as notfully appreciate'

• The 'i/ision 0as issuing cre'it 'efault s0aps

• cre'it 'efault s0ap CDS5 is an agreement in0hich the risk of 'efault of a financial instrument istransferre' from the o0ner of the financialinstrument to the issuer of the s0ap pooling5

• The 'efault rate on mortgages soare' an' thecompany 'i' not ha/e the capital to co/erguarantees

• The lessons learne' &y risk managers from the financialcrisis 0ill influence ERM in the future



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The use of deivatives to obscue ba"ance sheetisks is a manifestation of that appoach

• Deri/ati/es# I" an' the Future of Enterprise RiskManagement &y Michael "% ?acek

. Deri/ati/es are attracti/e &ecause they can often &estructure' to replicate tra'itional asset transactions &ut

0ith a much lighter &alance sheet impact%. Remem&er- a corporate &on' can &e replace' &y a

'efault free &on' o&ligation e%g% treasuries5 an' a shortput option relate' to the firm /alue

• ?hat 0oul' happen if &on' 'efault occurs

. Let+s look athttp-000%soa%orgli&raryessaysrm>essay>899=>0acek

%p'f to in/estigate 0hat+s happening%

http://www.soa.org/library/essays/rm-essay-2008-wacek.pdf






4-37

A(, and C$S

• t a congressional hearing last 0eek# Rep% "aryAeters D%# Mich%5 aske' I" Chief E)ecuti/eE'0ar' Li''y# ?here 0as the risk management ofyour company ?here 0as the failure of your o0n

internal risk>management proce'ures • Mr% Li''y respon'e'# ?e ha' risk>management

practices in place% They generally 0ere not allo0e' to go up into the financial>pro'ucts &usiness%

http://wheelhouseadvisors.wordpress.com MARCH 30, 2009

Reading: ISDA-AIGandCDS.pdf

http://wheelhouseadvisors.wordpress.com/

http://wheelhouseadvisors.wordpress.com/



4-38

C$S as insuance% ecent deve"opment

• ?all St looks to &oost market in *S muni CDS# FT- Fe&ruary 89<<. ?all Street is seeking to e)pan' the market for 'eri/ati/es. allo0 &anks an' in/estors to profit fromor he'ge against

&on' 'efaults &y struggling *S states an' localgo/ernments

• $anks Look to Arofit on Muni>$on' Fears. DECEM$ER 8<# 89<9# http-online%0s,%com

. For the first time in t0o years# S0it3erlan'1s *$S " has&egun making markets in 'eri/ati/es tie' to municipal&on's an' other securities%

. Separately# fi/e large 'eri/ati/es 'ealers2$ank of merica

Corp%1s $ank of merica Merrill Lynch# Citigroup Inc%#"ol'man Sachs "roup Inc%# %A% Morgan Chase Co%# an'Morgan Stanley2met last month in 7e0 ork to 'iscussstan'ar'i3ing the paper0ork for Bmuni CDSsB in an effortto attract more &uyers an' sellers%

http://online.wsj.com/

http://online.wsj.com/



4 39

Sti"" a tin& maket

• The si3e of the municipal CDS market isa&out H9 &illion#

• The si3e of the o/erall municipal>&on'

market is a&out 8%= trillion%

Chapter 4s

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