Lecture 4

Enterprise risk management and

related topics

Dr. Dina Abu Qamar

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First topic: Financial Risk Management.
1. Commodity price risk.
2. Interest rate risk.
3. Currency exchange rate risk.
4. Managing Financial Risks.
 Contractual Provisions.
 Capital Market Instruments.
5. The Changing Scope of Risk Management.
 Integrated Risk Management Program.
 The chief risk officer.
 A double-trigger option.
Second Topic: Enterprise Risk Management.
1. ERM program.
Third Topic: Loss Forecasting.
1. Probability Risk Analysis.
 Individual Event
 Dependent Event
 Independent Event
 Mutually Exclusive
 Not Mutually Exclusive
2. Regression Analysis.
3. Forecasting Based on Loss Distribution.
Fourth Topic: Analyzing Insurance coverage bids.
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First topic: Financial Risk Management:
Business firms face a number of speculative financial risks.
Financial risk management refers to the identification, analysis, and
treatment of speculative financial risks. These risks include the following:

1. Commodity price risk

2. Interest rate risk
3. Currency exchange rate risk

Commodity Price Risk:

Commodity Price Risk is the losing of money if the price of commodity

changes. Producers and users of commodities face commodity price
risk.

Ex: consider an agricultural operation that will have thousands

of bushels of grain at harvest time. At harvest, the price of the
commodity may have increased or decreased, depending on the
supply and demand for grain. If little storage is available for the crop,
the grain must be sold at the current market price, even if the price is
low.

Hedging a Commodity Price Risk Using Futures Contracts:

For example: a corn grower estimates in May that his production

will total 20,000 bushels of corn, with the harvest completed by

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December. If the price of futures contracts, is $4.90 per bushel. The
futures contracts are traded in 5,000 bushel units. If the price of corn
in December has dropped to $4.50 per bushel or $ 5.

Future contract= 20000 * 4.90= 98000

Case1: 20000 * 4.50= 90000

Profit =98000-9000=9000

Case 2: 20000 * 5 = 100000

Loss = 98000 - 100000 = - 2000

Interest Rate Risk:

Financial institutions are especially susceptible to interest rate

risk. Interest rate risk is the risk of loss caused by adverse interest rate
movements. For example, consider a bank that has loaned money at
fixed interest rates to home purchasers with 15- and 30-year
mortgages. If interest rates increase, the bank must pay higher interest
rates on deposits while the mortgages are locked in at lower interest
rates.

Similarly, a corporation might issue bonds at a time when

interest rates are high. For the bonds to sell at their face value when
issued, the coupon interest rate must equal the investor-required rate

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of return. If interest rates later decline, the company must still pay the
higher coupon interest rate on the bonds.

Currency Exchange Rate Risk:

Currency Exchange Rate is the value for which one nation’s currency
may be converted to another nation’s currency.

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
nation’s currency. Ex: a U.S. company faces currency exchange rate risk
when it agrees to accept a specified amount of foreign currency in the
future as payment for goods sold or work performed.

Managing Financial Risks:

Pure risks were handled by the risk manager through risk

retention, risk transfer, and risk control. Speculative risks were
handled by the finance division through contractual provisions and
capital market instruments.

Examples of contractual provisions that address financial risks

include callable bonds that permit bonds with high coupon rates to be
retired early and adjustable interest rate provisions on mortgages
through which the interest rate varies with interest rates in the general
economy. A variety of capital market approaches (derivatives market)

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are also employed, including options contracts, forward contracts,
futures contracts, and interest rate swaps.

Using options in Hedging:

• Options on stocks can be used to protect against adverse stock

price movements.
• Call Option: gives its holder the right to buy an asset for a strike
price on or before the expiration date.
• Put Option: gives its holder the right to sell an asset for a strike
price on or before the expiration date.

If number of stocks (N) = 100. In case of (In the money) Profit =100
* 3.50 = 350, while in case of (Out the money) Loss = 100 * 1.50 =
150, which is profit for the writer and loss for the buyer.

• Strike Price: the price at which the holder of call option can buy,
or the holder of put option can sell.

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 • Premium: the purchase price of the option. It is the money
initially paid by the buyer to the writer. It is not refundable.
• In the Money: strike price > stock price at expiration date (put)
• Out of the Money: strike price < stock price at expiration date
(put).

The Changing Scope of Risk Management:

 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. EX: payments would be made only if a
large property claim and a large financial loss occurred. The cost of
such an arrangement is less than the cost of treating each risk
separately.

Second Topic: Enterprise Risk Management.

(ERM) a comprehensive risk management program that
addresses all risks faced by organization pure risks, speculative
financial risks, strategic risks, operational risks, and other risks.

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 • Strategic risk refers to uncertainty regarding an organization’s
goals and objectives, and the organization’s strengths,
weaknesses, opportunities, and threats.
• Operational risks develop out of business operations, including the
supply chain, the manufacture and distribution of products,
providing services to customers, and cyber-security.
• Other risks: reputational risk.

As noted by the Risk and Insurance Management Society (RIMS), an ERM

program does the following:

• Prioritizes and manages those exposures as an interrelated risk

portfolio rather than as individual risks
• Evaluates the risk portfolio in the context of all significant
internal and external environments, systems, circumstances, and
stakeholders
• Recognizes that individual risks across the organization are
interrelated and can create a combined exposure that differs from
the sum of the individual risks.
• Provides a structured process for the management of all risks,
whether those risks are primarily quantitative or qualitative in
nature
• Views the effective management of risk as a competitive
advantage

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 • Seeks to embed risk management as a component in all critical
decisions through the organization

The ERM Process is similar to the risk management process discussed in

the previous chapter: risk identification, risk analysis, selection
combinations of techniques for treating the loss exposures, and
implementation and monitoring the program and taking corrective
actions. As with traditional risk management programs, enterprise risk
management is a continuous process. ERM Program includes new loss
exposures such as terrorism risk- Climate Change Risk- Cyber-security
Risk.

Third Topic: Loss Forecasting:

Although loss history provides valuable information, there is no

guarantee that future losses will follow past loss trends. Risk managers
can employ a number of techniques to assist in predicting loss levels,
including the following:

1. Probability Risk Analysis.

2. Regression analysis.
3. Forecasting based on loss distribution.

Probability Risk Analysis include individual event, dependent event,

independent event, mutually exclusive, and not mutually exclusive.

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 1. Individual Event:

Chance of loss is the possibility that an adverse event will occur.

The probability (P) of such an event is equal to the number of events
likely to occur (X) divided by the number of exposure units (N).

𝒙
𝑷=
𝑵

EX: if a car fleet has 500 cars and on average 100 vehicles suffer
physical damage each year, the probability that a fleet vehicle will be
damaged in any given year is:

𝟏𝟎𝟎
𝑷𝒑𝒉𝒚𝒔𝒊𝒄𝒂𝒍 𝒅𝒂𝒎𝒂𝒈𝒆 = = 𝟐𝟎%
𝟓𝟎𝟎

2. Independent Event:

If the occurrence of one event does not affect the occurrence of the
other event.

Ex: Suppose the probability of a fire at plant A is 4% and the

probability of a fire at plant B is 5%.

𝑷𝒇𝒊𝒓𝒆 𝒂𝒕 𝒃𝒐𝒕𝒉 𝒑𝒍𝒂𝒏𝒕𝒔 = 𝑷(𝒇𝒊𝒓𝒆 𝒂𝒕 𝒑𝒍𝒂𝒏𝒕 𝑨) × 𝑷(𝒇𝒊𝒓𝒆 𝒂𝒕 𝒑𝒍𝒂𝒏𝒕 𝑩)

𝑷𝒇𝒊𝒓𝒆 𝒂𝒕 𝒃𝒐𝒕𝒉 𝒑𝒍𝒂𝒏𝒕𝒔 = 𝟎. 𝟎𝟓 × 𝟎. 𝟎𝟒 = 𝟎. 𝟎𝟎𝟐 𝒐𝒓 𝟎. 𝟐%

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 3. Dependent Event:

If the occurrence of one event affects the occurrence of the other. If

two buildings are located close together, and one building catches on
fire, the probability that the other building will burn is increased.

For example, suppose that the individual probability of a fire loss at

each building is 3%. The probability that the second building will have
a fire given that the first building has a fire 40%

𝑷𝒃𝒐𝒕𝒉 𝒃𝒖𝒓𝒏 = 𝑷(𝒇𝒊𝒓𝒆 𝒂𝒕 𝒐𝒏𝒆 𝒃𝒍𝒅𝒈) × 𝑷(𝒇𝒊𝒓𝒆 𝒂𝒕 𝒔𝒆𝒄𝒐𝒏𝒅 𝒃𝒍𝒅𝒈 𝒈𝒊𝒗𝒆𝒏 𝒇𝒊𝒓𝒆 𝒂𝒕 𝒇𝒊𝒓𝒔𝒕 𝒃𝒍𝒅𝒈)

P= 0.03 × 0.40 =1.20%

4. Mutually Exclusive:

If the occurrence of one event precludes the occurrence of the second

event.

EX: Suppose the probability a plant is destroyed by a fire is 2% and

the probability a plant is destroyed by a flood is 1%.

𝑷(𝒇𝒊𝒓𝒆 𝒐𝒓 𝒇𝒍𝒐𝒐𝒅 𝒅𝒆𝒔𝒕𝒓𝒐𝒚𝒔 𝒑𝒍𝒂𝒏𝒕) = 𝑷(𝒇𝒊𝒓𝒆 𝒅𝒆𝒔𝒕𝒓𝒐𝒚𝒔 𝒑𝒍𝒂𝒏𝒕) + 𝑷(𝒇𝒍𝒐𝒐𝒅 𝒅𝒆𝒔𝒕𝒓𝒐𝒚𝒔 𝒑𝒍𝒂𝒏𝒕)

𝑷(𝒇𝒊𝒓𝒆 𝒐𝒓 𝒇𝒍𝒐𝒐𝒅 𝒅𝒆𝒔𝒕𝒓𝒐𝒚𝒔 𝒑𝒍𝒂𝒏𝒕) = 0.02+0.01 =0.03 or 3%

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 5. Not Mutually Exclusive:

If the independent events are not mutually exclusive, then more

than one event could occur.

Ex: if the probability of minor fire damage is 4 % and the probability

of minor flood damage is 3 %, then the probability of at least one of
these events occurring is:

𝑷(𝒂𝒕 𝒍𝒆𝒂𝒔𝒕 𝒐𝒏𝒆 𝒆𝒗𝒆𝒏𝒕) = 𝑷(𝒎𝒊𝒏𝒐𝒓 𝒇𝒊𝒓𝒆) + 𝑷(𝒎𝒊𝒏𝒐𝒓 𝒇𝒍𝒐𝒐𝒅) − 𝑷(𝒎𝒊𝒏𝒐𝒓 𝒇𝒊𝒓𝒆 𝒂𝒏𝒅 𝒇𝒍𝒐𝒐𝒅)

0.04 + 0.03 - (0.04 × 0.03) =0.0688 or 6.88%

Regression analysis:

RA characterizes the relationship between two or more variables

and then uses this characterization to predict values of a variable. One
variable— the dependent variable—is hypothesized to be a function of
one or more independent variables.

For example, consider workers compensation claims. It is logical to

hypothesize that the number of workers compensation claims should
be positively related to some variable representing employment (such
as the) number of employees, payroll, or hours worked.

𝒀=𝜶+𝜷𝑿

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 Y is the dependent variable, X is the dependent variable, α and β
are parameters. Y refers to claims, and X refers to payroll in thousand.

The coefficient of determination, R-square, ranges from 0 to 1 and

measures the model fit. An R-square value close to 1 indicates that the
model does a good job of predicting Y values.

Forecasting Based on Loss Distribution:

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.
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  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.

Fourth Topic: Analyzing Insurance Coverage Bids:

Assume that a risk manager would like to purchase property

insurance on a building. She is analyzing two insurance coverage bids,
the coverages are identical, and the policy limits are the same. The
premiums and deductibles, however, differ.

The risk manager wonders whether the additional $55,000 in

premiums is warranted to obtain the lower deductible.

Assume that premiums are paid at the start of the year, losses
and deductibles are paid at the end of the year, and 5 % is the
appropriate discount rate.

𝑭𝑽
𝑷𝑽 =
(𝑰 + 𝒊 )𝒏
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Comparison:

Company A

• 5000 for 20 loss

• 5000* 20= 100000
𝟏𝟎𝟎𝟎𝟎𝟎
• 𝑷𝑽 = = 𝟗𝟓, 𝟐𝟑𝟖
𝟏+𝟎.𝟎𝟓

• 95238 + 90000= 185238

Company B

• 7500 for 20 loss

• 7500 * 20 = 150000
𝟏𝟓𝟎𝟎𝟎𝟎
• 𝑷𝑽 = = 𝟏𝟒𝟐, 𝟖𝟓𝟕
𝟏+𝟎.𝟎𝟓

• 𝟏𝟒𝟐, 𝟖𝟓𝟕 + 35000= 177,857

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