FINA 341, Exam 1

Risk

1. Situation in which there is an expected loss

• how much loss expected on average

• car wreck averages are 6k per year, but that does not mean every car wreck is 6k dollars

2. Situation in which there is variability around an expected result/value/loss

• Uncertainty concerning the occurrence of a loss

• Also used to identify the property or life that is being considered for insurance

• How far could the result be from what we expected

• Property A experiences loss of 8,000-14,000/year

Insurance v gambling

• Insurance: handles an already existing pure risk and is always socially productive

• Gambling: creates a new speculative risk and is not socially productive (winner's gain comes at the expense of the loser)

3 major burdens because of risk

1. Liability/Lawsuits and resulting in maintaining large emergency funds

2. Can discourage innovation

3. Worry and fear

Pure risk

A chance of loss or no loss, but no chance of gain

Typically trying to insure against

Do not get anything for not getting an accident, neither outcome produces a gain

Always undesirable

Ex: Fire occurs — loss, Fire doesnt occur — no loss

Speculative Risk

Ex: gambling

Involves the chance of gain

Things such as

• Price risk:

• Credit risk

• Market risk

• Interest rate risk

• Liquidity risk

• Exchange rate risk

Price risk

risk associated with change in the price of inputs (what your company buys goes up) as well as the market price for completed outputs (selling price goes down)

• Ex (input): Oil rises from $80 to $100 per barrel → jet fuel becomes more expensive → the airline’s costs rise and profits fall.

• Ex(output): A mining comapny loses revenue because the price of copper drops from 4.5/lb to 3.75/lb.

Credit risk

risk that customers and parties to whom the company has lent money delay or fail to make promised payments

• Ex: the bank lends 100,000 for a retail construction project they take on the risk that development is never finishes or the owner fails to be able to make his payments and the loan doesn’t get paid off completely.

Market risk

risk associated with change in price of financial securities (stocks and bonds)

• Ex: A company owns 1mil in tech stocks, but the tech sector takes a takes a downward turn and the stock falls 15% so the return drops significantly.

Interest rate risk

risk that changing interest rates hurt the value of an investment or make borrowing more expensive., Federal Funds rate (interest rate banks charge each other for very short-term loans)

• Ex: A bank makes a fixed-rate loan at 3%. Later, market interest rates rise to 5%. The bank is still stuck earning only 3% on that existing loan, while new loans and other investments could earn around 5%.

• Ex: A company has a variable-rate loan at 5%. Interest rates rise and the loan resets to 7% → the company’s interest expense increases → profits fall.

Liquidity risk

risk that a person or company doesn’t have enough cash available when it needs to make payments

• Ex

Exchange rate risk

currency valuation fluctuations

• Ex

Objective risk

Risk where the degree of variation in uncertain outcomes can be measured (quantified) based on facts, data and analysis

• Examples: hurricane risk (insures losses, catastrophe modeling, climate science), mortality risk

Data does not always fully represent actuality

Subjective risk

Perceived degree of risk is based on an individual or organization's opinion

• Examples: accessing risk of flying/shark/terrorism (overestimate), flood/smoking/health (underestimate)

Diversifiable risk

Affects only some individuals or small groups, not the entire portfolio. Can significantly be reduced through diversification.

• Dont put all your eggs in one bask

• This is risk you are able to control by diversifying

• Ex: If your whole portfolio is tech companies that portfolio is likely to do very bad when the tech sector does bad. But if you diversify and add other sectors you can manage that risk.

Non diversifiable risk

Highly correlated. This risk affects many companies, groups, and people all at the same time.

• Ex: Cyclical unemployment, rapid inflation, or large pandemic. These areas all affect major companies, cause layoffs, affect prices and you cant diversify that risk away.

Systemic risk

Similar to non-diversifiable risk but has the potential to severely disrupt or lead to the collapse of an entire market, the financial system or major segments of the economy

• Ex: 9/11, 2008, Covid

Chance of loss

Probability that an event that causes loss will occur

Diversification

As long as risk are not perfectly correlated the firm can offset risk

• Use of hedging, financial derivatives, futures contracts

• Diversify products, geography, suppliers, customers, portfolio/asset, business activities

Internal risk reduction

Uncertainty

Where such probabilities cannot be estimated, variability

Loss exposure

Any situation or circumstance in which a loss is possible regardless of whether a loss occurs

Example: serving alcohol in a restaurant (liability suits, injuries, damages, theft), owning a car (liability or collision), employees (workers comp claims)

Insurers try to minimize these, always in dollars

Ex: loss exposure is $____ if Johnny gets in a collision

Enterprise risk

Encompass all major risks faced by a business firm

• all risk a businesses face

Strategic risk: is the risk that a company makes a bad business decision or that its overall strategy fails

• Ex: A company (Tesla) expands into a new country/market (India) but have found sales to be underperforming

Operational risk: he risk of loss because something goes wrong in the company’s day-to-day operations.

• Ex: A truck driver for a trucking company fell asleep at the wheel on a night run

Financial risk: losing money because of things like debt, interest rates, exchange rates, credit problems, or investment/market changes.

• Ex: Price of oil rises from $80 to $90 per barrel, causing jet fuel to rise, and profits to fall

Enterprise risk management

Comprehensive risk management program that addresses all risks faced by the corporation (pure, speculative, strategic, operational)

Combines into a single unified treatment program all major risks faced by the firm

Must be continuous and dynamic

Personal risk

Directly affect an individual or family

Possibility of a loss or reduction in income, extra expenses (premature death, inadequate retirement income, health, unemployment)

Can be mitigated against

Handle by buying life insurance

Property risk

Possibility of losses associated with the destruction or theft of property

Damage to buildings, furniture, and office equipment

Direct loss

Financial loss that results from the physical damage, destruction, or theft of the property such as fire damage to a home

Theft of files from computer system

Indirect loss

Consequential

Financial loss that results indirectly from the occurrence of a direct physical damage or theft

Business interruption loss: loss of business due to physical loss or damage occuring

Liability risk

Possibility of being held legally liable for bodily injury, property damage to someone else, defective productions, pollution, sexual harassment

Commercial risks

Foreign loss, intangible property exposures, government exposures, human resources, loss of business income, cybersecurity, identity theft, human resources

Risk control

Techniques that reduce the frequency or severity of losses

Avoidance (#1), loss prevention (activities to reduce the frequency of losses)

Loss reduction

Activities to reduce the severity of losses

Duplication (back up), separation (do not put factories next to each other), diversification (not all clients in one state)

Loss financing

Techniques that provide payment of losses after they occur

Retention

Active retention

Passive retention

Retention

Type of risk financing

An individual or business firm retains part or all of the losses that can result from a given risk (deductible)

Retain the obligation to pay some or all of the losses

Active retention

Type of risk financing

An individual is aware of the risk and deliberately plans to retain all or part of it

Know about the risk, willingly take on the risk of potentially having your laptop stolen

Passive retention

Type of risk financing

Risks may be unknowingly retained because of ignorance, indifference, or laziness

Think employer will pay for something when they actually do not

Self insurance

Special form of planned retention by which part or all of a given loss exposure is retained by the firm

Pay out of pocket for losses, risky

Non-insurance transfer

Transfers a risk to another party

Can be made through contract (hold-harmless clause: giving the risk to the roofer when getting a new roof)

Hedging

Technique for transferring the risk of unfavorable price (used by businesses) fluctuations to a speculator. Airlines are concerned with the price of jet fuel, so they hedge against the price of jet fuel in order to lock in the price of jet fuel for a certain amount of time.

Incorporation of a business firm transfers to the creditors the risk of having insufficient assets

Use of derivative contracts for risks that are typically uninsurable

Used by larger businesses

Insurance

Most practical method for handling major risks for individuals and businesses

Pure risk is transferred to the insurer

Pooling technique: used to spread losses of the few over the entire group, spreading losses incurred by the few over the entire group so that the average loss is substituted for actual loss

Application of the law of large numbers

Method of of risk financing

Pooling of fortuitous losses by transfer of risk to insurers who agree to pay insureds for such losses to provide benefits on their occurence

Internal risk reduction

Diversification

Invest in Informaiton

Invest in information

Obtain superior forecasts in terms of expected losses (works for speculative and pure risks)

Type of internal risk reduction

Risk management process

1. Identify all significant risks

2. Evaluation of potential frequency and severity losses

3. Develop and select methods of managing risk

4. Implementation of chosen risk management methods

5. Monitoring the performance and suitability of the methods on an ongoing basis

Pooling of losses

Spreading losses incurred by the few over the entire group

Based on the law of large numbers

Ideally insurable risk

Large number of exposure units

Accidental and unintentional loss

Determinable and measurable loss

No catastrophic loss

Calculable chance of loss

Economically feasible premium

Most personal, property, and liability risk can be insured (harder for market/financial/political)

Adverse Selection

Tendency of persons with a higher than average chance of loss to seek insurance at standard rates

Can be controlled with careful underwriting and policy provisions

Private insurance

Life

Health

Property

Liability

Causality

Personal and commercial lines

Personal lines of private insurance

Insure the real estate and personal property of individuals and families or provide protection against legal liability

Personal auto, homeowners, personal umbrella

Commercial lines of private insurance

Coverages for business firms, nonprofits, and government agencies

Property, auto, workers' comp, aviation

Social insurance programs

Financed entirely or in large part by contributions from employers

Heavily weighted in favor of low income groups

Eligibility and benefits are prescribed by statute

Medicare, Medicaid

Social costs of insurance

Cost of doing business

Fraudulent claims

Inflated claims

Expense loading

Amount needed to pay all expenses including commissions, admin expenses, taxes, acquisition, and allowances for contingencies and profit

Risk management, social welfare

The private cost of risk (total cost to businesses) will differ from the social cost of business (total cost to society)

Efficient level of risk

Requires that individuals, businesses pursue risk management activities until the marginal reduction in the expected cost of losses equals the marginal cost of these management activities

Risk management tradeoffs

1. The more spent on loss control, lower the direct and indirect expected losses

2. The more spent on loss financing/internal risk reduction, the lower the residual uncertainty

Risk can never be reduced to 0

Not technologically feasible

Not feasible in terms of cost

Not feasible in terms of consumer tastes and preferences

Value of a business

Expected magnitude, timing and risk (variability) associated with future net cash flows (inflows minus outflows) that will be available to provide shareholders (owners) with a return on their investment

Volatility (risk) in cash flows

A fundamental business principle of business valuation that increased risk reduces firm value and increases the expected return required by investors

Cost of risk

= value without risk - value with risk

Value of the firm is maximized when its cost of risk is minimized

Probability distributions

Expected value

Variance and standard deviation

Skewness

Correlation

Characterized by a measure of central tendency (mean) and variance (measure of dispersion)

Identify all the possible outcomes for a random variable the probability of each outcome

Higher standard deviations

Relative to the mean are associated with greater uncertainty of loss, therefore the risk is greater

Profitability

Long run relative frequency of the event, given an infinite number of trials with no changes in the underlying conditions

Law of large numbers

Mathematical foundation of insurance

Average losses for a random sample of n exposure units will follow a normal distribution because of the Central Limit Theorem

If an insurer increases the size of the sample of the insureds

Underwriting risk increases because more insured units could suffer a loss

Underwriting risk does not increase proportionately, increases by the square root of the increase in the sample size

Continuous distributions

Area under the entire curve always equals one and gives the probability of outcomes falling within that given range

Left and right are tail probabilities

Loss distribution

Loss expected for all possible losses

Skewness

Most loss distributions exhibit skewness

Most are skewed right: preponderance of the losses are skewed

Maximum probable loss

Describes a loss distribution

Dollar value that corresponds to loss

Value at risk

Describes the probability distribution for the value of a portfolio and how much it changes over a given time

Usually applied to the value of a portfolio

Refers to the change in portfolio value from the expected portfolio value

Correlation

Measures the strength and direction of the relationship between two random variables.

0 = uncorrelated

1 = perfectly positively correlated

-1 = perfectly negatively correlated

Correlation examples

Males are correlated with higher auto claim severity

Youthful and elderly drivers have higher auto claim frequency

Inexperienced work have a higher frequency of workplace injury

Covariance

Related to correlation and is helpful in explaining how risk reduction works in pooling arrangements

Financial risk management

Identification, analysis, and treatment of speculative financial risk

Can be managed with capital market instruments

Types of speculative financial risks

Commodity price risk

Interest rate risk

Currency exchange rate risk

Call option

Gives the owner the right to buy shares of stock at a given price during a specified period of time

Put option

Gives the owner the right to sell shares of stock at a given price during a specified period of time

Integrated risk management program

Technique that combines coverage for pure and speculative risks in the same contract

CRO

Responsible for the treatment of pure and speculative risks faced by the organization

Advantages of ERM

Improved risk assessment

Increased risk awareness

Integrated response to the full range of risks

Reduced earnings volatility

Few operational surprises

Barriers of ERM

Rigid organizational culture

Lack of formal process/information/information sharing/commitment

Technological deficincies

Publix example

Shoplifting: medium/high frequency, low severity

Hurricane: low frequency, high severity

Food poisoning/food outbreaks: low frequency, high severity

Power loss: low frequency, high severity

Employee injury: low/medium frequency, low/medium severity

Terrorism

Emerging Risk

Bombs/explosives

Nature of terrorism risk is dynamic

Can be reduced with physical barriers, screening services, computer network firewalls

Terrorism Risk Insurance Act: federal backstop for terrorism claims

Available through standard insurance policies

Climate Change

Emerging Risk

Losses attributable to natural catastrophes

Diminished by the existence of government programs that subsidize living in dangerous areas

Insurance Market Dynamics

Decisions about whether to retain or transfer risks are influenced by conditions in the insurance marketplace

Hard market

Period of time when premiums tend to be rising

Tight standards, high premiums, unfavorable insurance terms, more retention

Soft market

Looser standards, low premiums, favorable insurance terms, less retention

Earn more on investments

Can charge less

Combined ratio

Paid losses + loss adjustment expenses + underwriting expenses / premiums

Indicator the status of the cycle

Ratio of what the insurer pays out in losses and expenses to what it earns in premiums

1.5 combined ratio: for every $1 the insurance company spent it paid out $1.50

Clash loss

Event impacts many different types of insurance experience large losses simultaneously

Consolidation

Combining of businesses through acquisitions or mergers

Insurance broker

Intermediary who represents insurance purchasers

Securitization of risk

Insurable risk is transferred to the capital markets through creation of a financial instrument (catastrophe bond)

Insurance option

Derives value from specific insurance losses or from an index of values

Loss forecasting

Risk manager can predict losses using probability analysis, regression analysis, forecasting based on loss distribution

Probability analysis

Risk manager can assign probabilities to individual and joint event

Regression analysis

Characterizes the relationship between two or more variables and then uses his characterization to predict values of a variable

Loss distribution

Probability distribution of losses that could occur

Time value of money

Considered when decisions involve cash flows over time

Interest earning capacity of money

Risk management information system

Computerized database that permits the risk manager to store, update, and analyze risk management data

Risk management tool

Predictive analytics

Analysis of data to generate information that will help make more informed decisions

Risk map

Grid detailing the potential frequency and severity faced by the organization

Catastrophe modeling

Computer assisted method of estimating losses that occur as a result of a catastrophic event