RMI Lecture March 12

Introduction to Risk Financing

• Discussion of moving down the decision tree toward risk financing

• Importance of understanding how to pay for residual risk after controlling it

• Connection to overarching objectives: Efficient resource allocation and minimizing adverse consequences

Impact of Risk Avoidance

• Risks of avoiding opportunities due to fear of high risks leading to lost opportunities

• Need for proper knowledge and understanding of risks before making avoidance decisions

• Value of decision-making based on accurate risk assessment versus inefficiency in spending money on unnecessary controls

Overview of Risk Financing

• Key focus: Financing residual risk after effective controls are implemented

• Importance of risk financing for successful risk management in industry (insurance, brokers, advising firms)

• Discussion of retention as a primary way of managing risks

Types of Risk Financing

Retention

• Retention defined as holding onto the risk and absorbing negative outcomes independently

• Options within retention: voluntary (intentional acceptance) vs involuntary (forced acceptance)

Non-Insurance Risk Transfer

• Risk can be transferred through contractual agreements between businesses

• Involves transferring risk to another party without insurance, often leading to strategic partnerships that share equally in financial burdens

Insurance Risk Transfer

• Utilizing insurance to transfer risk, involving premiums paid to an insurance company in return for coverage

• Important method in overall risk financing strategy for protecting against catastrophic losses, such as natural disasters or liability claims

Key Decision Factors in Risk Financing

• Analyzing when to retain versus transfer risk

• Critical to assess both retention methods and compare costs, potential liabilities, and long-term implications

• Establishing metrics to guide decisions based on potential risk exposure, such as risk tolerance and regulatory requirements

Income Statement Insights

• Definition: An income statement reflects company revenues minus expenses over a specific period (usually annual)

• Expenses can rise significantly due to retained risks when negative outcomes occur, impacting net income through increased liability costs or claims payouts

Balance Sheet Overview

• Definition: A balance sheet shows a snapshot of assets, liabilities, and shareholders' equity at a point in time

• Importance of documenting potential losses and expected liabilities through proper reserves to ensure stabilization in financial reporting

Creating Reserves for Risk Financing

Unfunded Reserves

• Definition and implications: expected losses booked as liabilities without readily available cash

• Impact on company balance sheets, documenting potential risks without liquidity; affects investors' perception due to uncertainty in covering liabilities

• Allows for acknowledgment of risk presence but requires future cash flows for handling

Funded Reserves

• Definition and implications: converting non-liquid assets into liquid ones to effectively manage risk

• Provides a ready cash flow during adverse events for quick operational recovery, thereby ensuring business continuity

• Balancing cash liquidity with potential investment returns; opportunity costs must be analyzed during reserve preparation

Opportunity Cost Considerations

• Understanding trade-offs between liquidity of assets and investment returns

• Importance of opportunity cost in decision-making between funded and unfunded reserves

• Example discussions about potential impacts of immediate cash availability on recovery capabilities during adverse events, influencing how companies determine reserve levels

Liquidity Impacts on Risk Management

• Importance of liquidity in maintaining operational capabilities post-losses

• Recognizing that illiquid assets complicate immediate cash flow during emergencies and need to be managed wisely to avoid operational disruptions

Current Expensing vs Passive Retention

Current Expensing

• Concept detailed as paying for ongoing small expenses through operational cash flow

• Suitable for minor repairs, regular supplies, and utilities without requiring reserve creation, allowing for more agile financial management

Passive Retention

• Definition as risks not identified or anticipated, leading to unfunded liabilities

• Passive retention creates a need to establish buffers against unforeseen risks, emphasizing the necessity for proactive risk management

Conclusion and Importance of Risk Identification

• Making informed decisions on risk management involves identifying potential risks earlier and mitigating passive retention through strategic foresight

• Importance of trained professionals in identifying risk and optimizing decision-making processes in corporate environments to enhance resilience against uncertainties.