Chapter 4

Advanced
Topics in Risk
Management
Agenda

• The Changing Scope of Risk Management

• Insurance Market Dynamics
• Loss Forecasting
• Financial Analysis in Risk Management
Decision Making
• Other Risk Management Tools

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The Changing Scope of Risk
Management

• Today, the risk manager:

– Is involved with more than simply purchasing
insurance
– Considers both pure and speculative financial
risks
– Considers all risks across the organization and
the strategic implications of the risks

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The Changing Scope of Risk
Management
• Financial Risk Management refers to the
identification, analysis, and treatment of
speculative financial risks:
– Commodity price risk
– Interest rate risk
– Currency exchange rate risk
• Financial risks can be managed with capital
market instruments

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Exhibit 4.1: Managing Financial Risk
– Example 1

• A corn grower estimates in May that he will

harvest 20,000 bushels of corn by
December.
– The price on futures contracts for December corn
is $4.90 per bushel.
– Corn futures contracts are traded in 5000 bushel
units
• How can he hedge the risk that the price of
corn will be lower at harvest time?

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Exhibit 4.1: Managing Financial Risk
– Example 1

• He would sell four contracts in May totaling

20,000 bushels in the futures market.
– 20,000 x $4.90 = $98,000
• In December, he would buy four contracts to
offset his futures position.
– If the market price of corn drops to $4.50 per
bushel, cost is 20,000 x $4.50 = 90,000
– If the market price of corn increases to $5.00 per
bushel, cost is 20,000 x $5.00 = $100,000

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Exhibit 4.1: Managing Financial Risk
– Example 1

• Note: it doesn’t matter whether the price of corn

has increased or decreased by December.
If Price is $4.50 in December:
Revenue from sale $90,000

Sale of four contracts at $4.90 in May $98,000

Purchase of four contracts at $4.50 in December $90,000

Gain on futures transaction $8,000

Total revenue $98,000

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Exhibit 4.1: Managing Financial Risk
– Example 1

If Price is $5.00 in December:

Revenue from sale $100,000

Sale of four contracts at $4.90 in May $98,000

Purchase of four contracts at $5.00 in December $100,000

Loss on futures transaction ($2,000)

Total revenue $98,000

• By using futures contracts and ignoring transaction

costs, he has locked in total revenue of $98,000.

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Exhibit 4.1: Managing Financial Risk
– Example 2

• Options on stocks can be used to protect

against adverse stock price movements.
– A call option gives the owner the right to buy 100
shares of stock at a given price during a specified
period.
– A put option gives the owner the right to sell 100
shares of stock at a given price during a specified
period.
• One option strategy is to buy put options to
protect against a decline in the price of
stock that is already owned.

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Exhibit 4.1: Managing Financial Risk
– Example 2

• Consider someone who owns 100 shares of

a stock priced at $43 per share.
• To reduce the risk of a price decline, he
buys a put option with a strike (exercise)
price of $40.
– If the price of the stock increases, he has lost the
purchase price of the option (called the
premium), but the stock price has increased.

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Exhibit 4.1: Managing Financial Risk
– Example 2

• But what if the price of the stock declines,

say to $33 per share?
– Without the put option, the stock owner has lost
$10 ($43–$33) per share on paper.
– With the put option, he has the right to sell 100
shares at $40 per share. Thus, the option is “in
the money” by $7 per share ($40–$33), ignoring
the option premium.

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The Changing Scope of Risk
Management
• An integrated risk management program is
a risk treatment technique that combines
coverage for pure and speculative risks in
the same contract
• Some organizations have created a Chief
Risk Officer (CRO) position
– The chief risk officer is responsible for the
treatment of pure and speculative risks faced by
the organization
• A double-trigger option is a provision that
provides for payment only if two specified
losses occur

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Enterprise Risk Management

• Enterprise Risk Management (ERM) is a

comprehensive risk management program
that addresses the organization’s pure,
speculative, strategic, and operational risks
– Strategic risk refers to uncertainty regarding an
organization’s goals and objectives
– Operational risks develop out of business
operations, such as manufacturing
– As long as risks are not positively correlated, the
combination of these risks in a single program
reduces overall risk

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Enterprise Risk Management

– Roughly 80 percent of all large US firms have

developed, or are in the process of developing
some type of ERM program
– The presence of an ERM program does not
guarantee that an organization will be successful
– Barriers to the implementation of ERM include
organizational, culture and turf battles

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The Financial Crisis and Enterprise
Risk Management

• The US stock market dropped by more than

fifty percent between October 2007 and
March 2009
– The meltdown raises questions about the use of
ERM
– Only 18 percent of executives surveyed said
they had a fully-implemented ERM program
– AIG mentions an active ERM program in its 2007
10-K Report

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Emerging Risks: Terrorism

• The risk of terrorism is not new

– Bombs and explosives
– Computer viruses and cyber attacks on data
– CRBN attacks: chemicals, radioactive material,
biological material, and nuclear material
• These risks can be addressed with risk
control measures, such as:
– Physical barriers
– Screening devices
– Computer network fire walls

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Emerging Risks: Terrorism

• Congress passed the Terrorism Risk

Insurance Act (TRIA) in 2002 to create a
federal backstop for terrorism claims.
– The Act was extended in 2005, and again in 2007
through the Terrorism Risk Insurance Program
Reauthorization Act (TRIPRA).
• Terrorism insurance coverage is available
through standard insurance policies or
through separate, stand-alone coverage.

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Emerging Risks: Climate Change

• Losses attributable to natural catastrophes

have increased significantly in recent years.
• Demographic factors, such as population
growth, also contribute to the increasing
losses.
• Some insurers now provide discounts for
energy efficient buildings and premium
credits for structures with superior loss
control.

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Insurance Market Dynamics

• Decisions about whether to retain or

transfer risks are influenced by conditions in
the insurance marketplace
• The Underwriting Cycle refers to the cyclical
pattern of underwriting stringency,
premium levels, and profitability
– “Hard” market: tight standards, high premiums,
unfavorable insurance terms, more retention
– “Soft” market: loose standards, low premiums,
favorable insurance terms, less retention

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Insurance Market Dynamics

• One indicator of the status of the cycle is

the combined ratio:

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Exhibit 4.2 Combined Ratio for All Lines of
Property and Liability Insurance, 1956–2011*

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Insurance Market Dynamics

• Many factors affect property and liability

insurance pricing and underwriting
decisions:
– Insurance industry capacity refers to the relative
level of surplus
– Surplus is the difference between an insurer’s
assets and its liabilities
– Capacity can be affected by a clash loss, which
occurs when several lines of insurance
simultaneously experience large losses
– Investment returns may be used to offset
underwriting losses, allowing insurers to set
lower premium rates

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Insurance Market Dynamics

• The trend toward consolidation in the

financial services industry is continuing
– Consolidation refers to the combining of
businesses through acquisitions or mergers
– Due to mergers, the market is populated by
fewer, but larger independent insurance
organizations
– There are also fewer large national insurance
brokerages
– An insurance broker is an intermediary who
represents insurance purchasers

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Insurance Market Dynamics

• The boundaries between insurance

companies and other financial institutions
have been struck down, allowing for cross-
industry consolidation
– Financial Services Modernization Act of 1999
– Some financial services companies are
diversifying their operations by expanding into
new sectors

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Capital Market Risk Financing
Alternatives
• Insurers are making increasing use of
capital markets to assist in financing risk
– Securitization of risk means that insurable risk is
transferred to the capital markets through
creation of a financial instrument, such as a
catastrophe bond
– An insurance option is an option that derives
value from specific insurance losses or from an
index of values (e.g., a weather option based on
temperature).
– The impact of risk securitization is an increase in
capacity for insurers and reinsurers

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Exhibit 4.3 Catastrophe Bonds: Annual Number of
Transactions and Issue Size

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Loss Forecasting

• The risk manager can predict losses using

several different techniques:
– Probability analysis
– Regression analysis
– Forecasting based on loss distribution
• Of course, there is no guarantee that losses
will follow past loss trends

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Loss Forecasting

• Probability analysis: the risk manager can

assign probabilities to individual and joint
events.
– The probability of an event is equal to the
number of events likely to occur (X) divided by
the number of exposure units (N)

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Loss Forecasting

• Two events are considered independent events if

the occurrence of one event does not affect the
occurrence of the other event.
• Suppose the probability of a fire at plant A is 4%
and the probability of a fire at plant B is 5%. Then,

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Loss Forecasting

• Two events are considered dependent events if the

occurrence of one event affects the occurrence of
the other.
• Suppose the probability of a fire at the second
plant, given that the first plant has a fire, is 40%.
Then,

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Loss Forecasting

• Two events are mutually exclusive if the

occurrence of one event precludes the occurrence
of the second event.
• Suppose the probability a plant is destroyed by a
fire is 2% and the probability a plant is destroyed
by a flood is 1%. Then,

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Loss Forecasting

• Regression analysis characterizes the

relationship between two or more variables
and then uses this characterization to
predict values of a variable
– For example, the number of physical damage
claims for a fleet of vehicles is a function of the
size of the fleet and the number of miles driven
each year

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Exhibit 4.4 Relationship Between Payroll and
Number of Workers Compensation Claims

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Loss Forecasting

• A loss distribution is a probability

distribution of losses that could occur
– Useful for forecasting if the history of losses
tends to follow a specified distribution, and the
sample size is large
– The risk manager needs to know the parameters
of the loss distribution, such as the mean and
standard deviation
– The normal distribution is widely used for loss
forecasting

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Financial Analysis in Risk Management
Decision Making

• The time value of money must be

considered when decisions involve cash
flows over time
– Considers the interest-earning capacity of
money
– A present value is converted to a future value
through compounding
– A future value is converted to a present value
through discounting

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Financial Analysis in Risk
Management Decision Making

• Risk managers use the time value of money

when analyzing insurance bids or making
risk-control investment decisions
– Capital budgeting is a method for determining
which capital investment projects a company
should undertake.
– The net present value (NPV) is the sum of the
present values of the future cash flows minus the
cost of the project
– The internal rate of return (IRR) on a project is
the average annual rate of return provided by
investing in the project
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Other Risk Management Tools

• A risk management information system

(RMIS) is a computerized database that
permits the risk manager to store, update,
and analyze risk management data
• A risk management intranet is a web site
with search capabilities designed for a
limited, internal audience
• A risk map is a grid detailing the potential
frequency and severity of risks faced by the
organization
– Each risk must be analyzed before placing it on
the map

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Other Risk Management Tools

• Value at risk (VAR) analysis involves

calculating the worst probable loss likely to
occur in a given time period under regular
market conditions at some level of
confidence
– The VAR is determined using historical data or
running a computer simulation
– Often applied to a portfolio of assets
– Can be used to evaluate the solvency of insurers

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Other Risk Management Tools

• Catastrophe modeling is a computer-

assisted method of estimating losses that
could occur as a result of a catastrophic
event
– Model inputs include seismic data, historical
losses, and values exposed to losses (e.g.,
building characteristics)
– Models are used by insurers, brokers, and large
companies with exposure to catastrophic loss

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Exhibit 4.1
Managing
Financial
Risk—Two
Examples

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