Chapter 17: Advanced Topics In Risk Management

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Chapter 17Advanced Topics In Risk Management
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Advanced Topics In Risk Management

• Overview of Chapter
• Financial risk management
• Enterprise risk management
• Variables in the retention / insurance decision
• International risk management
• Risk management information systems (RMISs)

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Financial Risk Management - Financial Risk

• Interest Rate Risk - increased interest rates
  reduces the value of fixed income securities
• Credit Risk - loss caused by borrowers defaulting
  on loans

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Financial Risk Management - Financial Risk

• Currency Risk - loss caused by an unfavorable
  change in the value of a foreign currency
  relative to a domestic currency
• Liquidity Risk - loss caused by having to take a
  discount to liquidate an investment quickly

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Financial Risk Management - Financial Risk

• Market Risk - loss caused by having to liquidate
  an investment at an unfavorable price

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Financial Risk Management - Tools

• Avoidance and Assumption
• Avoidance A perfect tool if you do not want
  to be subject to currency exchange fluctuations
  do not get involved in international
  transactions.
• Assumption everything that is not avoided if
  no other tools in operations is assumed. You pay
  for the losses out of your cash flow.

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Financial Risk Management - Tools

• Transfer (Hedging) - use of financial tools
  including
• Traded Options - legal right to buy or sell an
  asset at a set price before a specified time
• Futures Contracts - an advance order to buy or
  sell a commodity at a specific price
• Forward Contracts - same as futures but not
  traded on organized exchanges
• Swaps - two companies lend each other different
  currencies (currency swap) or different interest
  rates, one fixed and one floating (interest rate
  swap)

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Convergence

• Financial transactions and Insurance transactions
  are coming together
• Common thread Financial Intermediation
• Forces promoting
• Graham-Leach-Bliley Act of 1999
• Sophistication of mathematical models
• Globalization of insurance and capital markets
• Technology advances

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Catastrophic Risk Transfer

• Allows insurers to accept exposures that they
  would or could not ordinarily accept.
• Contingent Surplus Notes Treasury securities
  held in trust swapped (and sold) with other
  securities when losses occur
• Catastrophic Bonds Bond repayment or
  performance a function of losses
• Exchange Traded Options losses are hedged using
  exchange traded options

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The Retention / Insurance Decision

• How much loss to retain versus transfer
• Deductibles and policy limits
• Increases in deductibles and policy limits do not
  cause proportional increases / decreases in
  premium cost
• Try to avoid overinsurance - small deductibles
  cause company to be insuring expenses
• Try to avoid underinsurance - cant afford to pay
  for deductibles and retention from available cash
  flow event could cause insolvency or bankruptcy

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Types of Retention

• Each occurrence retention
• Once for each loss with no annual limit of times
  it can be applied
• Each occurrence aggregate retention
• Retention disappears or is reduced after a
  specified amount of loss
• Multi-line aggregate retention
• Combines various types of insurance and once
  limit exceeded, insurer begins to make payments

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The Retention / Insurance Decision

• Tax implications
• Ability to pay for loss
• Psychological factors
• Social and ethical concerns

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Tax Implications - Commercial

• Insurance premiums tax deductible when paid
• Uninsured losses tax deductible when incurred
• When loss occurs, book value deductible
• Indemnity greater than book value causes taxable
  income

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Ability to Pay for Loss

• Liquidity - cash or near cash on hand to cover
  retention
• Stability of net income - if cyclical business
  high retention amounts might be dangerous
• Amount of net worth - firms ability to absorb
  uninsured losses out of retained earnings cost
  of capital problems, borrowing problems, solvency
  might be at risk

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Psychological Factors

• People make the decisions
• Experience
• Attitudes toward risk
• Habit, corporate policy
• Ability to explain and sell ideas
• Intuition

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Social and Ethical Concerns

• Uninsured losses can produce
• Bankruptcy
• Unemployment
• Under- or uncompensated workers or members of the
  public
• Environmental concerns

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International Risk Management

• Identification and Measurement
• Foreign currency fluctuations
• Political risks
• US Export - Import Bank set up FCIA Foreign
  Credit Risk financing, safety, insurance and
  other practices vary widely
• Perils frequency and severity different
• Terrorism, kidnapping
• Legal systems differ liability losses differ
• Transportation takes on more importance

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Transportation

• FOB - free on board
• Exporter not responsible after good transferred
  onto the foreign dock
• FAS - free along side
• Exporters responsibility ends at domestic dock
• Open-cargo forms - automatic coverage for high
  volume shippers

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Development and Implementation

• Foreign Insurance
• Admitted v. non-admitted insurers
• DIC coverage (Difference in Conditions)

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Risk Management Information Systems

• What is a RMIS?
• Computer system to record, track, and analyze
  losses
• Records plant, property, and equipment and how
  they are protected / insured for loss
• Statistical analysis of past losses and allows
  forecasting
• Communications OSHA, court documents, proposed
  federal and state legislation, intra-company
• No standard RMIS - typically tailor made for the
  unique exposures / structure of the individual
  company

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Risk Management Information Systems

• Loss Records and Analysis
• Liability claims
• Asset losses
• Employee injuries
• Frequency, severity, date, location, individuals
  involved, final disposition

• Acquisition and disposal of property
• Cost, replacement values, preferred vendors
• Lease agreements
• Contracts
• Accurate inventory, location, amounts
• Property in transit
• Multiple locations, international operations
• Agents, brokers, insurance policies and companies