Chapter 4

Advanced
Topics in Risk
Management

4-1

Agenda

The Changing Scope of Risk Management

Enterprise Risk Management
Insurance Market Dynamics
Loss Forecasting
Financial Analysis in Risk Management
Decision Making
Other Risk Management Tools
AIG case, Baring case.
4-2

Outcome
Able to apply different risk management
techniques to manage risk exposure
Understand the causes of big losses in AIG
case and Baring case.

4-3

The Changing Scope of Risk Management

Today, the risk managers job:
Involves more than simply purchasing
insurance
Is not limited in scope to pure risks

The risk manager may be using:

Financial risk management
Enterprise risk management

4-4

The Changing Scope of Risk Management

Financial Risk Management refers to the identification,
analysis, and treatment of speculative financial risks:
Commodity price risk is the risk of losing money if the
price of a commodity changes, e.g. oil, gold, cotton, etc.
Interest rate risk is the risk of loss caused by adverse
interest rate movements, e.g. bond price changes with
interest rate
Currency exchange rate risk is the risk of loss of value
caused by changes in the rate at which one nation's
currency may be converted to another nations currency,
e.g. oversea subsidiaries
Financial risks can be managed with capital market
instruments
4-5

Exhibit 4.1 Managing Financial RiskTwo

Examples

4-6

Exhibit 1 Managing Financial RiskTwo

Examples

Shouldweusefuturesoroption?
4-7

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

4-8

Enterprise Risk Management

Enterprise Risk Management (ERM) is a comprehensive risk
management program that addresses the organizations pure,
speculative, strategic, and operational risks
Strategic risk refers to uncertainty regarding an organizations
goals and objectives,
Operational risks are risks that develop out of business
operations, such as product manufacturing
As long as risks are _____positively correlated, the combination
of these risks in a single program reduces overall risk

Nearly half of all US firms have adopted some type of ERM

program
Barriers to the implementation of ERM include organizational,
culture and turf battles

4-9

The Financial Crisis and

Enterprise Risk Management
The US stock market dropped by more
than fifty percent between October 2007
and March 2009 (next slide)
The meltdown raises questions about the use of
ERM
Only 18 percent of executives surveyed said
they had a well-formulated and fullyimplemented ERM program
Interestingtolearnthatinsurancecompanytookthebet,
e.g.AIG

4-10

Exhibit 2
Timeline of
Events Related
to the Financial
Crisis

4-11

Did ERM fail, or did companies simply fail

to use it properly regulated?
The falls of Lehman Brothers, Merrill Lynch and American
International Group
William H. Panning, executive vice president at Willis Re Inc.
"In the firms that really took a nosedive, the CEOs and
the directors seemed to care only about earnings, and
not about how much risk was being taken. There was no
penalty for betting the firm. They didn't take ERM very
seriously.
Blaming ERM for a company's failure is like riding in a car
without a seat belt, then blaming the seat belt for your
injuries
AIG aside, the insurance industry has mostly avoided big
losses so far because property/casualty firms have always
emphasized underwriting risk

Read Risking the Enterprise by Bonnie Brewer Cavanaugh

at http://www.amper.com/publications/risk-enterprise-management.asp
4-12

ERM
Integrating enterprise risk management with
organizational strategy: an ERM program must
align with corporate strategy to give the
organization a complete and comprehensive
approach to managing risk,
The RMA Journal, May 1, 2009 by Killackey, Henry

4-13

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
One indicator of the status of the cycle is the combined
ratio:
Combined Ratio

Paid Lossess Loss Adjustment Expenses Underwriting Expenses

Premiums

4-14

Exhibit 3 Combined Ratio for All Lines of

Property and Liability Insurance, 19562008*

4-15

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
insurers 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
4-16

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
Owing 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
Cross-Industry Consolidation: the boundaries between insurance
companies and other financial institutions have been struck down
Financial Services Modernization Act of 1999
Some financial services companies are diversifying their
operations by expanding into new sectors
4-17

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:
A catastrophe bond* permits the issuer to skip or
defer scheduled payments if a catastrophic loss
occurs
An insurance option is an option that derives value
from specific insurance losses or from an index of
values.
A weather option provides a payment if a specified
weather contingency (e.g., high temperature)
occurs
A double-trigger option is a provision that provides
for payment only if two specified losses occur
4-18

Capital Market Risk Financing Alternatives

A double-trigger option example
often used for insurance purposes,
pays off only if 2 events occur.
buy this option to limit losses that are very
unlikely, but very expensive if they both
occurred.

The impact of risk securitization is an _______ in

capacity for insurers and reinsurers
It provides access to the capital of many
investors
*Cat_Bonds_Demystified (your reference)

4-19

Exhibit 4 Catastrophe Bonds: Annual Number of

Transactions and Issue Size

4-20

Loss Forecasting (A brief account)

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

4-21

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)
May be calculated with past loss data
Two events are considered independent events if
the occurrence of one event does not affect the
occurrence of the other event
Two events are considered dependent events if the
occurrence of one event affects the occurrence of
the other
Events are mutually exclusive if the occurrence of
one event precludes the occurrence of the second
event
4-22

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

4-23

Exhibit 5 Relationship Between Payroll and Number

of Workers Compensation Claims

4-24

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
Note: it can be very incorrect
If HSI does not follow normal distribution, how can you do
forecasting?
4-25

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

Risk managers use the time value of money when:

Analyzing insurance bids
Making loss control investment decisions
The net present value is the sum of the present values of the future
cash flows minus the cost of the project
The internal rate of return on a project is the average annual rate
of return provided by investing in the project

Stillrememberwhattheymean?RefertoyourFMtext.

4-26

Insurance bids example

Two bids
1. Annual Premium:
$80,000, per-claim
deductible $5,000
2. Annual Premium:
$30,000, per-claim
deductible $10,000

Expected
Number of
Losses

Expected Size
of Lossess

11

$5,000

$10,000

> $10,000

R=4%
Whichbidisbetter?
4-27

Insurance bids example

Bid 1: expected cash outflows in one year =
PVdeductible =
Total outlflow: PVdeductible + Plus premium

Bid 2:
Outflows:
Pvdeductible=
Total outlflow:
4-28

Making loss control investment decisions

The installation of leakage control system is
expected to generate an after-tax net cash
flow of $100,000 per year for 5 year,
r=6%, the installation cost is $400,000.
Should the system be installed?
NPV = PV of the five $100,000 cost of the
installation
=421,236 -400,000 =$21,236
OR IRR =7.93%
4-29

Other Risk Management Tools

A risk management information system (RMIS) is a
computerized database that permits the risk manager to store
and analyze risk management data
The database may include listing of properties, insurance
policies, loss records, and status of legal claims
Data can be used to predict and attempt to control future
loss levels
Risk Management Intranets and Web Sites
An 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
Probabili
ty

High

Medium

Low

Low

Medium

High

4-30

4-31

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
A financial firm may determine that it has a 5% one
month value at risk of $100 million. This means that
there is a 5% chance that the firm could lose more
than $100 million in any given month. Therefore, a
$100 million loss should be expected to occur once
every 20 months.
http://www.investopedia.com/terms/v/var.asp
4-32

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

4-33

Other Risk Management Applications

An accurate forecast of the timing and magnitude of
claims is especially important when losses are retained
The ability to forecast ultimate claims for liability lines is
an important skill for the risk manager
Loss development factors (LDFs) are multipliers that
can be applied to claims settled to date to estimate
the ultimate claims for a period
general upward trend in liability and workers
compensation claim totals after the initial reporting period
called
.
LDFs are used to arrive at the ultimate value that can be
expected for a claim. For example, an LDF of 1.50 means
that for every $1 of current claims, the ultimate payout
will be $1.50. A total of $50,000 in current claims would
result in an ultimate payout of $75,000.
http://www.irmi.com/online/
4-34

The Financial Crisis and Enterprise

Risk Management, the AIG case

AIG mentions an active ERM program in its 2007 10-K

Report
Riskiness of the Financial Products Division was not
fully appreciated
The division was issuing credit default swaps
A credit default swap (CDS) is an agreement in
which the risk of default of a financial instrument is
transferred from the owner of the financial
instrument to the issuer of the swap (pooling?)
The default rate on mortgages soared and the
company did not have the capital to cover
guarantees
The lessons learned by risk managers from the financial
crisis will influence ERM in the future
4-35

The use of derivatives to obscure balance sheet

risks is a manifestation of that approach
Derivatives, AIG and the Future of Enterprise Risk
Management by Michael G. Wacek
Derivatives are attractive because they can often be
structured to replicate traditional asset transactions but
with a much lighter balance sheet impact.
Remember: a corporate bond can be replaced by a
default free bond obligation (e.g. treasuries) and a short
put option related to the firm value
What would happen if bond default occurs
Lets look at
http://www.soa.org/library/essays/rm-essay-2008-wacek
.pdf
to investigate whats happening.
4-36

AIG and CDS

At a congressional hearing last week, Rep. Gary
Peters (D., Mich.) asked AIG Chief Executive
Edward Liddy, Where was the risk management of
your company? Where was the failure of your own
internal risk-management procedures?
Mr. Liddy responded, We had risk-management
practices in place. They generally were not allowed
to go up into the financial-products business.
http://wheelhouseadvisors.wordpress.comMARCH30,2009
Reading:ISDAAIGandCDS.pdf
4-37

CDS as insurance, recent development

Wall St looks to boost market in US muni CDS, FT: February 6
2011
Wall Street is seeking to expand the market for derivatives
allow banks and investors to profit from/or hedge against
bond defaults by struggling US states and local
governments
Banks Look to Profit on Muni-Bond Fears
DECEMBER 21, 2010, http://online.wsj.com
For the first time in two years, Switzerland's UBS AG has
begun making markets in derivatives tied to municipal
bonds and other securities.
Separately, five large derivatives dealersBank of America
Corp.'s Bank of America Merrill Lynch, Citigroup Inc.,
Goldman Sachs Group Inc., J.P. Morgan Chase & Co., and
Morgan Stanleymet last month in New York to discuss
standardizing the paperwork for "muni CDSs" in an effort
to attract more buyers and sellers.
4-38

Still a tiny market

The size of the municipal CDS market is
about $50 billion,
The size of the overall municipal-bond
market is about $2.8 trillion.

4-39