RM 357E Intro to Risk Management with McClellan

Uncertainty Concept

No universal definition

Majority of insurance authors define risk as

uncertainty

Risk and probability - if the probability of an event occurring is either zero or one...

There is no risk since there is no uncertainty.

Objective Risk is

1. Defined as the relative variation of actual loss from expected loss

2. Declines as the number of exposure units increases

3. Is measurable by using the standard deviation or coefficient of variation

Subjective Risk

1. Defined as: Uncertainty based on one's mental condition or state of mind.

2. Difficult to measure

A. Objective Probability

1. A priori - by logical deduction such as in games of chance

2. Empirically - by induction, through analysis of data

Subjective Probability

- a personal estimate of the chance of loss.

Need not coincide with objective probability

Influenced by a variety of factors including age, sex, intelligence, education, and personality.

Chance of Loss Distinguished from Risk

Although chance of loss may be the same for two groups, the relative variation of actual loss from expected loss may be quite different.

Peril is defined as:

cause of loss outside of our control

Hazard is defined as:

a condition that may create or increase a chance of loss of a given peril (outside or inside control)

Physical Hazard

-physical characteristics that cause risk

Examples are icy streets, poor designed intersections, and dimly lit stairways.

Moral Hazard

Dishonesty or characteristics of an individual that increase the chance of loss

Morale Hazard

Carelessness or indifference to a loss because of the existence of insurance

Pure risk

a situation where there are only the possibilities of loss or no loss

Speculative risk

a chance of profit (loss or gain)

Why is the distinction between pure risk and speculative risk important?

1) As a society we are primarily concerned with uncertainty as a loss

2) Society assumes party responsible for its own speculative risk as there is a chance of profit

3) Law of Large Numbers applies best to pure risks

4) Typically, 3^rd party risk takers such as insurance carriers prefer to handle pure risk

Diversifiable Risk

a risk that affects only individuals or small groups and not the entire economy

Non-Diversifiable Risk

A risk that affects society.

Enterprise RIsk

Risk that develop simply because different operations in your company

Dynamic Risk

Results from changes in the economy (inflation, unemployment)

Static Risk

No change in the economy (fires)

Personal Risks

Basic personal risks are: unemployment, poor health, ...

Types of losses are loss of earned income, extra expenses, and depletion of financial assets.

Property Risks

Types of losses include direct physical damage losses, theft losses, indirect pr consequential losses, and extra expenses.

Perils include: [insert perils]

Liability Risks

"Anyone can sue anyone"

1. The loss is legal liability for damages arising out of bodily injury or property damage to another party.

2. Perils include negligence, breach of warranty, and absolute liability.

Types of Pure Risks

1) Personal Risks

2) Property Risks

3) Liability Risks

4) Commercial Risks

Types of Commercial Risks

1) Property Risks

2) Liability Risks

3) Loss of business income

4) Other Risks - Crime/HR/Foreign Loss Exposure/Intangible Property Exposures/Government Exposures

Property Risks

Possibility of financial loss occurring as the result of owing a real estate investment

Liability Risks

Possibility of liability for damages resulting from the purchase, ownership, or use of a good/service offered by a company.

Loss of Business Income

Self explanatory, reduced capital to continue operation

Other types of Commercial Risks

Crime, Human Resources, Foreign, Loss Exposures, Intangible Property Exposures, Government Exposures

Burden of Risk on Society

A. Need for a Larger Emergency Fund

B. Loss of Needed Goods and Services

C. Fear and Worry

Methods of Handling Risk

1) Avoidance

2) Retention

3) Noninsurance Transfers

4) Loss Control

5) Insurance

Avoidance

(the safest route) *not always the best route

Retention

1. Active (desirable) is the deliberate choice to assume part or all of a loss exposure.

2. Passive (dangerous) often results from ignorance or inertia.

Noninsurance Transfers

1. Contracts

2. Hedging

3. Incorporation

Loss Control

1. Loss prevention

2. Loss reduction

Insurance

protection against possible financial loss

Definition of Risk Management

The Process in which we identify loss exposure faced by an organization and the decisions to handle them.

Insurance Management

Insurance management is simply a sub-set of risk management

Status of Risk Management Today

Importance is increasing. Business philosophy is changing from reactive to proactive.

Present in most large corporations (either formal or informal) - but obviously can be very different across industries.

Example - use of chemicals - printing industry differs from dry cleaners differs from manufacturing silicon chips

Increasingly regarded as a management specialty field - businesses have become aware that a risk to enterprise increase so does the business' risk premium - decreasing available cash for operations - investment for future - expansion, etc.

Objectives of Risk Management

Primary Objective is to minimize pure loss

1) Pre-loss objectives

2) Post-loss objectives

Pre-loss objectives

1. Economy goal - Businesses desire to prepare for loss in the most economical means available - so one must consider all available methods:

AVOIDANCE / RETENTION / TRANSFER TO 3RD PARTY /LOSS CONTROL / INSURANCE

Note - as cost to transfer to 3rd parties increases, businesses must consider use of Avoidance and Retention (Active) often require the greatest effort but typically lead to the greatest ultimate savings.

2. Reduction of anxiety - As mentioned last class - this is certainly a societal goal but also a goal within an enterprise or business - old adage = "A happy worker is a productive worker."

3. Meet externally imposed obligations

4. Creditors - For obvious reasons - creditors may conduct risk analysis of borrowers - can range from simple credit check to a full blown on-site investigation.

5. Legally imposed

Examples - building codes / worker's compensation

6. Contractually Imposed

Example - termination clause.

What are the 6 pre-loss objectives

1) Economy goal

2) Reduction of Anxiety

3) Meet externally imposed obligations

4) Creditors

5) Legally imposed

6) Contractually Imposed

Post-Loss objectives

1. Survival of the firm - clearly the primary objective - what seem like small exposures can bring catastrophic impact to the business.

2. Continued operations - differs from industry to industry and within a given industry from business to business.

Example - utilities/medical/ energy/transportation - auto vs. perishable goods.

3. Stability of earnings - risk redress shareholder value as more resources are used to handle the risk rather than for expansion or dividends.

4. Continued growth - must consider how loss could impact future growth - thus a business might choose to pay a high risk cost by purchasing insurance rather than returning the risk (and with it the chance that the risk forecast is wrong)

5. Social responsibility - As mentioned before - particularly acute in small communities with dominate employer but can clearly affect larger enterprises

Example - BP Gulf of Mexico disaster - huge PR campaign geared to demonstrate the positive attributes of BP.

What are the five post-loss objectives

1) Survival of the firm

2) Continued operations

3) Stability of earnings

4) Continued growth

5) Social responsibility

What are the 4 + 1 steps of the Risk Management Process

1. Identification

2. Analysis (measurement)

3. Selection of risk management techniques

4. Implementation.

(but should also add)

5. Continual Evaluation

Identifying Potential Losses

Critical step - cost of prevention almost always cheaper than loss

What are the 4 considerations necessary to identify potential losses?

1) Cost of Risk

2) Cost Trade Offs

3) Types of potential loss

4) Tools for recognizing loss exposures

Cost of risks

A. Cost of Risk -

1. Calculate expected cost

-direct loss

-indirect loss

-extra expenses

2. Determine possibility of loss control and cost associated with it - such as increased safety measures.

3. Determine possibility of loss financing

-insurance

-outsourcing activity

-increased line of credit (cost of capital)

4. Is Internal Risk Reduction Available?

-diversification - geopolitical/operational/ managerial

-transaction costs - employee re-training

5. Residual Uncertainty - what if insurance company fails?

¬ Note - Defense costs can be huge - even if ultimately unsuccessful

Mattel Case: Consumer class action lawsuit against Mattel's subsidiary, Fisher-Price, of having their Chinese made toys found to contain lead. 70 million loss.

Cost Trade Offs

= risks to not necessarily operate independently - hence enterprise risk.

1. Expected Losses/Loss Control - typically more spent in loss control - less risk - but not always

Example - Leaking underground storage tank

2. Loss Financing of Expected Indirect Loss - installing fire door minimizes risk of fire spreading to other operations

3. Loss Financing of Residual Uncertainty -pay more to avoid residual uncertainty - pay higher premium for financial stronger insurance company.

What are the eight types of potential loss?

1) Physical damage to property

2) Loss of income

3) Liability lawsuits

4) Death or disability of key persons

5) Losses from job-related injuries or disease

6) Losses from fraud, criminal acts, and employee dishonesty

7) Employee benefits loss exposures

8) International loss exposures (political risk)

Types of potential loss (full copy and paste)

C. Types of potential loss

1. Physical damage to property -

2. Loss of income -

3. Liability lawsuits -

4. Death or disability of key persons -

5. Losses from job-related injuries or disease

Typical examples - Asbestos/Carpal Tunnel/ Coal Dust. Recently a court held that exposure to diesel fumes harmful even if less than EPA standards

6. Losses from fraud, criminal acts, and employee dishonesty

Typically seen as issue to retail operations but what about trade secrets (know-how)

Example-recent Wall Street Journal - most fraud involved banks and for less than $150K.

7. Employee benefits loss exposures - besides actual injuries - residual costs such as worker's compensation insurance rates are impacted for 3 years.

General Rule - Business suffers $4 additional cost for every $1 direct loss - so if $500,00 loss...

Total Loss = $ 2,500,000

8. International loss exposures (political risk) - for obvious reasons this area is becoming increasingly important - bedsides commodity costs - must consider local regulations and customers - just look at recently discussed differences between US and Europe for Google (right to be forgotten)

What are five tools for recognizing loss exposures? (These are always evolving / changing)

1) Physical Inspection

2) Survey form

3) Flow chart

4) Financial Statements

5) Past loss experience

Know the definition of these key concepts of evaluating potential losses.

1) Loss frequency

2) Variance

3) Skewedness

4) Correlation

5) Loss severity

Loss Frequency

the probable number of losses that may occur during some given time period

Variance

(n.) - a difference between what is expected and what actually occurs

Skewedness

a measure of the asymmetry of the probability distribution of a real-valued random variable about its mean

(Statistics o.o!)

Correlation

A measure of the extent to which two factors vary together, and thus of how well either factor predicts the other.

Example used in class: U.S. GDP + Berlin Zoo's Pink Flamingos

(Search up Flamingo by Kero Kero Bonito, muy bien song)

Loss severity

How big is the loss? For risk manager, understanding both frequency and severity are critical in evaluating risk.

Example: Increased technology may decrease frequency but increase sevrity. By the time issue is discovered - more product manufactured and distributed.

What are two guidelines for measuring severity?

1) Maximum possible loss

2) Maximum probable Loss

Maximum possible loss

no " chance" element - simply what is largest loss possible for this activity. "Cement Truck"

Maximum Probable Loss

The worst loss that is likely to happen to the firm

Insurance companies uses this one to plan, the other to gain nightmares

When to select risk management techiniques

1. Avoidance - again, if possible, always the best approach.

2. Retention - critical, if used, that it is an Active Retention - use when losses are predictable.

Marsh Mac claims - insurance deductible but also insurance policy limit

Umbrella policies -

3. Noninsurance transfers

4. Loss control - typically used in combination with other methods.

5. Insurance - by a wide margin - most used technique to transfer risk

But insurance is multi-faceted - standard insurers but also captive companies/risk retention groups - offer differing protections

Selecting the appropriate technique: Avoidance

again, if possible, always the best approach

Selecting the appropriate technique: Retention

critical, if used, that it is an Active Retention - use when losses are predictable.

Marsh Mac claims - insurance deductible but also insurance policy limit

umbrella policies - DON"T WORRYYYYY

Selecting the appropriate technique: Noninsurance transfer

(didn't say)

Selecting the appropriate technique: Loss control

typically used in combination with other methods

Selecting the appropriate technique: Insurance

by a wide margin - most used technique to transfer risk

Policy statement

formal document outlining the ways in which organization intends to conduct its affairs and act in specific circumstances.

Cooperation with other departments

critical that risk manager has cooperation of other departments

periodic review

must determine if choice = effective

Continual Evaluation of every Step

Especially base assumptions - text books refer to periodic review but needs to be continual - so many factors today affect enterprise risk exposures.

Insurance offers several advantages in handling risk

•Greater Predictability of Actual Losses due to application of Law of Large Numbers

•Transfer of Risk (of an Unknown Amount and perhaps, Nature) to Another Party for a Sum Certain (i.e. Premium)

•Specialized Approach to Analyzing, Assessing and Handling Risk

Two Basic Premises

1. Business should purchase insurance coverage if the premium is less than the risk adjusted present value of the Expected Loss.

2. Businesses should also consider whether or not the asset for which insurance coverage is sought, is redundant. Many businesses purchase insurance on assets for which it can better handle through one of the other means of handling risk.

Effect of Insurance

As mentioned several times - insurance is by far the most prevalent means of handling risk.

Definition of Insurance

the pooling of fortuitous losses by transfer of such risk to third parties who agree to identify the transferee for such losses & provide services their to.

Four Basic Characteristics of Insurance

1) Pooling of losses

2) Payment of fortuitous losses

3) Risk transfer

4) Indemnification

General Requirements of an Insurable Risk

1) Large number of exposure units

2) Accidental and unintentional loss

Accidental and unintentional loss must be

1) Determinable and measurable loss

2) No catastrophe loss

3) Calculable chance of loss

4) Economically feasible premium

Adverse Selection and Insurance

Underwriting helps eliminate adverse selection.

1) Nature of adverse selection

2) Consequences of adverse selection

Three categories of Insurable Risks are:

1) Personal

2) Property

3) Liability

Four generally uninsurable risks

1) Market

2) Financial

3) Production

4) Political

How Insurance Differs from Gambling

1) Insurance eliminates a pure risk, while gambling creates a new speculative risk.

2) Insurance is socially productive, while gambling is socially unproductive.

How Insurance Differs from Hedging

1) Insurance transfers a pure risk, while hedging involves the transfer of a speculative risk.

2) Insurance reduces objectives risk, while hedging does not.

Two Types of Insurance

1) Private Insurance

2) Government Insurance

Private Insurance

1) Life and health insurance

2) Property and liability insurance

Government Insurance

1) Social insurance

2) Other government insurance programs

Five Benefits of Insurance to Society:

1) Indemnification for loss

2) Less worry and fear

3) Source of investment funds

4) Loss prevention

5) Enhancement of credit

Three costs of insurance to society

1) Cost of doing business

2) Fraudulent claims

3) Inflated claims

The Changing Scope of Risk Management (not sure what to put for answer)

A) Financial Risk Management

B) Enterprise Risk Management

C) Insurance Market Dynamics

Underwriting Cycle

know what this is maybe? Didn't talk much about this.

Consolidation in the Insurance Industry

It will affect the premium choices

Capital Market Risk Financing Alternatives

Minimizing variance (end goal)

Three types of loss forecasting

A) Probability Analysis - dependent or independent

B) Regression Analysis - looks between the correlation of variables

C) Forecasting with Loss Distributions

Financial Analysis in Risk Management Decision Making

Do the time value of money problem which makes you choose between policy A and B

Legal wrong is defined as:

the failure to perform a legal duty owed to another party

Types of legal wrongs include

Crime and Breaches of contract.

Types of Torts

1) Intentional Tort = Patent Infringement, Copyright, etc

2) Strict (Absolute) Liability = Responsibility is imposed regardless of fault, dynamite example

3) Negligence = failure to perform a legal duty, and alongside the damages

Negligence is

Individual or entity's conduct. The failure to exercise the standard of care required by law to protect others from harm.

Elements of Negligence

1) Legal duty to exercise due care

2) Don't fail the duty of care

3) Has to have damages & Industry in a 3rd party