Class 2 Insurance and Risk Management

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Class 2Insurance and RiskManagement

• George D. Krempley
• Bus. Fin. 640
• Autumn Quarter 2005

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Risk Management

• Broadly defined, business risk management is a
  method for making decisions
• Regarding how to treat exposures to loss in
  business value from any source.

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The Risk Management Process

• Identification of risks
• Evaluation of frequency and severity of losses
• Choosing risk management methods
• Implementation of the chosen methods
• Monitoring the performance and suitability of the
  methods.

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Risk Management Questions

• What is the problem? (risk identification)
• 2. What is the magnitude of the problem?
  (measurement)
• 3. How should the problem be handled? (decision)

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Risk Management Vs. Insurance

• Risk management is a decision process insurance
  is a financial product
• Risk management focuses on identifying and
  measuring risks to select the most appropriate
  technique.
• Insurance is only one of several options to treat
  pure loss exposures.

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Major Risk Management Methods
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EXHIBIT 3.3 Risk Management Matrix
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EXHIBIT 3.1 Steps in the Risk Management Process
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Loss Exposure

• Set of circumstances that presents the
  possibility of loss, whether or not a loss
  actually occurs.
• Implies the existence of something that may
  decline in value
• The object and the circumstances can be
  objectively verified

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Elements of a Loss Exposure

• The item subject to loss
• The perils, or forces that may cause the loss
• The potential financial impact of the loss

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Direct Losses often Cause Indirect Losses

• Example What are the direct and indirect losses
  if a manufacturing plant experiences a major
  fire?

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Exposure Analysis Restaurant Example
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Risk Management Matrix
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Risk Exposures of aFisher Business Student

• Physical damage to 1996 Ford Taurus
• A liability lawsuit arising from the use of the
  vehicle
• Total loss of clothes, electronic equipment and
  personal property due to a kitchen fire in
  apartment
• Disappearance of a set of contact lens

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Risk Exposures of aFisher Business Student

• Bodily injury from being hit by a car while
  jogging on a busy residential street
• Liability when the family dog bites a child
• Malfunction and repair of a laptop or PDA
• Are there other risk exposures?

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The Changing Scope of Risk Management

• Financial Risk Management
• Commodity Price Risk
• Interest Rate Risk
• Currency Exchange Rate Risk
• Enterprise Risk Management
• Pure risk
• Speculative Risk
• Strategic Risk
• Operational Risk

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What is Enterprise Risk Management?

• ERM is the application of the basic risk
  management principles to all risks facing an
  organization
• Other names for ERM
• Enterprise-wide risk management
• Holistic risk management
• Integrated risk management
• Strategic risk management
• Global risk management

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Where Did ERM Come From?

• Traditional risk management
• Formally developed as a field in the 1960s
• Focused on pure risks
• Loss/no loss situation
• Often could be insured
• Developed from insurance purchasing area

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New Elements of Risk 1970s

• Foreign exchange risk
• End of Bretton Woods agreement in 1972
• Commodity price risk
• Oil price fluctuations of the 1970s
• Equity risk
• Development of option markets - 1973
• Interest rate risk
• Federal Reserve Board policy shift - 1979

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Failure to Manage Financial Risk

• Foreign exchange risk
• Laker Airlines 1970s
• Borrowing in dollars
• Revenue in pounds
• Interest rate risk
• U. S. Savings and Loans 1980s
• Borrowing short
• Lending long
• Commodity price risk
• Continental Airlines 1990
• Fuel costs not hedged
• Oil price doubled with Gulf War

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The New Risk Management -1980s

• Financial risk management
• Dealt with financial risk
• Foreign exchange risk
• Interest rate risk
• Equity risk
• Commodity price risk
• Use derivatives to hedge financial risk

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Financial Risk Management Toolbox

• Forwards
• Futures
• Options
• Swaps

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New Elements of Risk 1990s

• Failure to manage derivatives appropriately
• Financial model failures
• Improper accounting for derivatives

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Mismanagement of Financial Risk

• Mismanagement of derivatives
• Gibson Greetings
• Proctor and Gamble
• Barings Bank
• Orange County
• Model failure
• Long Term Capital
• Accounting improprieties
• Enron
• Cedant
• Arthur Andersen

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The New Risk Management - 1990s and beyond

• Enterprise Risk Management
• Initial focus on avoiding derivative disasters
• Developing into optimizing firm value
• Chief Risk Officer
• Sarbanes-Oxley Act 2002
• Increased focus on risk models

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Components of ERM

• Corporate governance
• Line management
• Portfolio management
• Risk transfer
• Risk analytics
• Data and technology resources
• Stakeholder management

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ERM Risk Categories

• Common risk allocation
• Hazard risk
• Financial risk
• Operational risk
• Strategic risk
• Bank view New Basel Accord
• Credit risk
• Loan and counterparty risk
• Market risk (financial risk)
• Operational risk

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Hazard Risk

• Pure loss situations
• Property
• Liability
• Employee related
• Independence of separate risks
• Risks can generally be handled by
• Insurance, including self insurance
• Avoidance
• Transfer

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Financial Risk

• Components
• Foreign exchange rate
• Equity
• Interest rate
• Commodity price
• Correlations among different risks
• Use of hedges, not insurance or risk transfer
• Securitization

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Operational Risk

• Causes of operational risk
• Internal processes
• People
• Systems
• Examples
• Product recall
• Customer satisfaction
• Information technology
• Labor dispute
• Management fraud

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Strategic Risk

• Examples
• Competition
• Regulation
• Technological innovation
• Political impediments

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Insurance Market Dynamics

• The Underwriting Cycle
• Hard Markets vs. Soft Markets
• Insurance Industry Capacity
• Investment Returns
• Consolidation in the Insurance Industry
• Insurance Company Mergers
• Insurance Brokerage Mergers
• Cross-Industry Consolidation

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EXHIBIT 4.2 Combined Ratio for All Lines of
Property and Liability Insurance, 19562002
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Securitization of Risk

• What is Securitization?
• Impact on Insurance Industry Capacity
• Examples of Securitization

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Other Risk Management Tools

• Risk Management Information Systems (RMIS)
• Risk Management Intranets and Websites
• Risk Maps
• Value at Risk (VAR) Analysis