Advanced Topics in

Risk Management
"The Changing Scope of Risk
Management"
The Changing Scope of Risk Management

Recently, some identification, analysis and treatment of speculative financial

risks. This includes the following:
❑ Commodity Price Risk
❑ Interest Rate Risk
❑ Currency Exchange Rate Risk
COMMODITY PRICE RISK

► It’s the risk of losing money, if price of commodity changes. Due to

price fluctuations

► Example: Automobiles manufacturers face commodity price risk,

because they use commodities like steel and rubber to produce cars.
Factors in commodity price fluctuations:

► Political- due to tariffs

► Weather- seasonal and weather fluctuations
► Technology- using the technology the price of the product decrease
its value due to the process and another alternatives or substitute
materials to lessen the cost.
Interest Rate Risk

► The probability of a decline in the value of an asset resulting from unexpected

fluctuations in interest rates.
► Financial Institution are especially susceptible
► Risk of loss caused by adverse interest rate movements.
► Example: Investor buy 5 years, $500 bond with 3% coupon. Interest rate
increase to 4%. Investor will have trouble to sell the bond when newer bond
offering with more attractive rates enter market.
Currency Exchange Rate Risk

► known as foreign exchange rate risk

► value for which one nation’s currency my converted to another nation’s
currency
► anticipated changes in exchange rate between two currencies
► Example: If interest rate are higher Canada, the U.S dollar will probably
decline in value relative to Canadian dollar
MANAGING FINANCIAL RISKS

► PURE RISK
For risk manager, through:
1.RISK RETENTION
► Planned acceptance of losses by deductibles, deliberate noninsurance, and loss-sensitive plans where
some, but not all, risk is consciously retained rather than transferred.
2. Risk Transfer
► A risk management and control strategy that involves the contractual shifting of a pure risk from one
party to another. Ex. Insurance
3. Loss Control
► A risk management technique that seeks to reduce the possibility that a loss will occur and reduce the
severity of those that do occur.
► SPECULATIVE RISK
For Finance Division through:
• Contractual Provision
► Call features on bonds that permit bonds with high coupon rates provision on mortgages
through with interest rate varies with interest rates in economy.
• Capital Market Instrument
► Option contract, forward contract, futures contract and interest rate swaps.
HEDGING

► Strategy tries to limit risk in financial asset

► Example: the farmer agrees to sell his future harvest corn to the
broker at a certain price.

► Example: Total production- 20,000

Price of corn during December- $2.90 per bushel
Sell 4 contracts in May, total 20,000 bushel
If market price of corn drops $2.50 per bushel in December
Revenue from sales of corn 20,000 x $2.50 $50,000
Sale of 4 contracts at $2.90 in May 58,000
Purchase of 4 contracts at $2.50 in Dec. 50,000
Gain on future transaction $8,000
Total Revenue $58,000

If market price of corn increases to $3.00 per bushel in Dec.

Revenue from sale of corn 20,000 x $3.00 $60,000
Sale of 4 contracts $2.90 in May 58,000
Purchase of 4 contracts at $3.00 in Dec. 60,000
Loss on futures transactions (2,000)
Total Revenue $58,000
USING OPTIONS TO PROTECT AGAINST
ADVERSE STOCKPRICE MOVEMENTS

► Option on stocks can be use to protect against adverse stock price movements.
► A call options gives owner right to buy 100 shares of stocks at given price during specified period.
► A put option gives owner right to sell 100 shares of stock at given price during specified period.
► Example: by purchasing a put option for $5, you now have the right to sell 100 shares to $100 per share. If
ABC company’s stocks drop to $80, the you could exercise the option and sell 100 shares at $100 per share
resulting in profit of $1500.
($20 profit - $5 premium x 100 shares = 1500)
► INTEGRATED RISK PROGRAM
Risk treatment technique combines coverage for pure and speculative risk in same
contract
► CHIEF RISK OFFICER (CRO)
Responsible for treatment of pure and speculative risk faced by organization.
► DOUBLE-TRIGGER OPTION
Provisions provides for payment only if 2 specified losses occur.
 ENTERPRISE RISK MANAGEMENT

Comprehensive risk management program that address an organization pure, and speculative risk,
strategic and operational risk.
► PURE RISK
Insurable, beyond human control, loss or no loss with no possibility of financial gain
► SPECULATIVE RISK
Not insurable, situation either profit of loss
► STRATEGIC RISK
Uncertainty regarding organizational goal and objectives and organizations SWOT.
► OPERATIONAL RISK
Risk development out of business operation such as manufacturing products and providing services
to customers.
Insurance Market Dynamics
Insurance Market Dynamics

Decisions about whether to retain or transfer risks are influenced by conditions

in the insurance marketplace.
► Three important factors influencing the insurance market:
► The underwriting cycle
► Consolidation in the insurance industry
► Securitization of risk
The Underwriting Cycle

► This cyclical pattern in 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:
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
Consolidation in the Insurance Industry

► The trend toward consolidation in the financial services industry is continuing

► Consolidation refers to the combining of businesses through acquisitions or mergers
A number of consolidation trends have changed the insurance marketplace for risk managers:
► Insurance company mergers and acquisitions
► Insurance brokerage mergers and acquisitions
► Cross-industry consolidations
► Insurance company mergers and acquisitions
▪ Due to mergers, the market is populated by fewer, but larger independent insurance organizations
► Insurance brokerage mergers and acquisitions
▪ Insurance brokers are intermediaries who represents insurance purchasers.
▪ It offers an array of services to their clients, including attempting to place their client’s business with
insurers.
► Cross-industry consolidations
▪ Some financial services companies are diversifying their operations by expanding into new sectors.
▪ Consolidation in the financial services arena is not limited to mergers between insurance companies or
between insurance brokerage.
Securitization of Risk

► It means that insurable risk is transferred to the capital markets through

creation of a financial instrument, such as a catastrophe bond, future
contracts, options contract or other financial instruments.
► 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.
Loss Forecasting
Loss Forecasting

► The risk manager must also identify the risks the organization faces, and analyze the potential,
frequency and severity of these loss exposures, although loss history provides valuable
information, there is no guarantee that future losses will follow past loss trends.
► Can employ a number of techniques to assist in predicting loss levels including the following;
► Probability Analysis
► Regression Analysis
► Forecasting based on loss distributions
PROBABILITY ANALYSIS

► Chance of loss in the probability that an adverse event will occur.

P (physical damage) =100/500 = .20 or 20%
The risk manager must also be concerned with the characteristics of the event being analyzed.
► Independent events
► the occurrence does not affect the occurrence of another event.
P (fire at Louisiana plant) x P (fire at virginia plant) = P (fire at both plants)
.04 x .05 = .002 or 2%
► Dependent events
► the occurrence of one event affects the first event multiplied by the probability of the second event given
that the first event has occurred.
P (fire at one bldg) + P fire at second bldg given fire at first bldg) = P(both burn)
.03 + .40 = .012 or 1.20%
► Mutually exclusive
► if the occurrence of one event precludes the occurrence of the second event.
P (destroys at one bldg) + P (flood destroys bldg) = P(fire or flood destroys bldg)
.02 + .01 = .03 or 3%
► Not mutually exclusive
► more than one event could occur, care must be taken not to "double-count" when determining
the probability that at least one event will occur.
P (minor fire) + P (minor flood) - P (minor fire and flood) = P (at least one event)
.04 + .03 - (.04) x (.03) = .0688 or 6.88%
REGRESSION ANALYSIS

► another method for forecasting losses.

► characterizes the relationship between two or more variable and the uses
this characterization to predict value of a variable one variable - the
independent variable is hypothesized to be a function of one or more
independent variable.
► it's not difficult to envision a relationship that would be of interest to the
risk manager in which one variable is dependent upon another variable.
FORECASTING BASED ON LOSS
DISTRIBUTION
► another useful tool for the risk manager is loss forecasting based on loss distributions. A loss distribution
is a probability distribution of losses that could occur. Forecasting by using loss distributions works well if
losses tend to follow a specific distribution and the sample size is large.
Loss Forecasting

► Risk managers may employ probability distributions to assist in loss forecasting. Several distributions are
available, including the normal, binomial, exponential, possion, and others. Selection of the distribution is
often based upon loss history, especially when the number of losses is large. We will examine the
application of the normal distribution, which is used in many situations.
► The normal distribution is a symmetric bell curve summarized by two parameters. The area under the
curve is equal to one, with 50 percent of the distributions on either side of the expected value. Based on
the values of m and s, and an '' Areas under a Normal Curve table (see Exhibit A4.1), the probability of
any event (x) can be estimated based on the standard variate, z:
Z= x-m
S
 Financial Analysis in Risk
Management Decision Making
 FINANCIAL ANALYSIS IN RISK
MANAGEMENT DECISION MAKING

Risk managers must make a number of important decisions, including whether

to retain or transfer loss exposures, which insurance coverage bid is best, and
whether to invest in lost control projects. The risk manager's decisions are based
on economics weighing the costs and benefits of a course of action to see whether
it is in the economic interest of the company and its stockholders.
TIME VALUE OF MONEY

► The time value of money means that when valuing cash flows in different time periods, the
interest-earning capacity of money must be taken into consideration.
► A dollar received today is worth more than a dollar received one year from today, because the
dollar received today can be invested immediately to earn interest.
► Suppose you open a bank account today and deposit P100. The value of the account today the
present value is P100. Farther assume that the bank is willing to pay for person interest
compounded annually on your account what is the account balance one year from today?
► Formula:
PV (1 + i) = FV
100 (1 + .04) = 104
PV (1 + i)n = FV where "n" is the number of time periods
100 (1 + .04)2 = FV
100 (1.04)2 = FV
100 (1.08) = FV
108 = FV
PV = FV / (1 + i)n this is called discounting. Bringing a future value back to present value.
PV = 108 / (1 + .04)2
PV = 108 / 1.08
PV = 100
FINANCIAL ANALYSIS APPLICATIONS

► Analyzing Insurance Coverage Bids

▪ Susan Carlet would like to purchase property insurance ana building.
▪ She analyzing two insurance coverage bids and the coverage amount are the same,
▪ However, insurer A's coverage requires an annual premium of $90,000 with a $5,000 pre-claim
deductible and the insurer B's coverage requires on annual premium of $35,000 with a $10,000
pre-claim deductible.
► Expected Number of Losses Expected Size of Losses
12 5,000
6 10,000
2 over 10,000
n=20
Assume that premiums are paid at the end of the year, losses and deductible are paid at the end of the year, and 5 percent is
the appropriate interest (discount).
Insurer A's bid, expected cash out flows in one year would be the fist $5,000 of 20 losses that are each $5,000 or more.
► 5,000 × 20 = 100,000
► Total of 100,000 in deductible.
► PV = 100,000
► (1+.05)1
=100,000
1.05
PV =95,238
Then present value of the total expected payment plus $90,000 insurance premium.
► 95,238 + 90,000 = 185,238

Insurer B's bid, cash out flows for deductible the end of the year.
► (5,000×12) + (10,000×6) + (10,000×2)
► = 60,000+60,000+20,000
► =140,00
► The we can find out the present value.
► PV = 140,000
(1+.05)1
=140,000
1.05
► PV =133,333
► Present value plus 35,000 insurance premium.
► 133,333 + 35,000
=168,333

► Susan should select the bid value from insurer B's because it minimizes the present value of the
cash outflow.
► Loss-control Investment Decisions are undertaken in an effort to reduce the
frequency and severity of losses. Such investments can be analyzed from a
capital budgeting perspective by employing time value of money analysis.
► Capital budgeting is a method of determining which capital investment
projects a company should undertake. Only those projects that benefit the
organization financially should be accepted.
► Methods that take into account time value of money, such as Net Present Value (NPV) and Internal Rate of
Return (IRR) should be employed.
▪ The Net Present Value of a project is the sum of the present values of the future cash flows minus the cost
of project.
▪ NPV = PV of future Cash flows - Cost of Project
▪ The Internal Rate of Return on a project is the average annual rate of return provided by investing in the
project.
▪ Cash flows are generated by increased revenues and reduced expenses.
To calculate the NPV, the cash flows are discounted at an interest rate that considers the rate of return
required by the organization's capital suppliers and the riskiness of the project.
► Susan Carley has noticed a distressing trend in premises-related liability claims from several of NPP's
service station. Patron Claims to have been injured on the premises, and they have sued NPP for their
injuries. Susan has decided install cameras surveillance systems at several of the "Problem" service
stations at a cost of P85,000 per system. She expects each surveillance system to generate an after-tax net
cash flow of P40,000 per year for the three years discounted at the appropriate interest rate (we assume 8
percent) is P103,084.
► NPV = PV of future Cash flows - Cost of Project
► NPV = P103,084 - P85,000
► NPV = 18,084
► If the project has positive Net Present Value, the investment is acceptable.
Other Risk Management Tools
Five Parts of Other Risk Management Tools

1. Risk management information systems (RMIS)

2. Risk management intranets and Web sites
3. Risk maps
4. Value at risk (VAR) analysis
5. Catastrophe modeling
Parts of Other Risk Management Tools

► Risk Management Information System (RMIS)

Is a computerized database that permits the risk manager to store and analyze risk
management data and to use such data to predict and attempt to control future loss levels.
Risk management information systems may be of great assistance to risk manager in
decision making.
► Risk Management Intranets and Web Sites
Some organizations have expanded the traditional risk management Web site into a
risk management intranet. An intranet is a Web site with search capabilities designed for
a limited, internal audience.
Parts of Other Risk Management Tools

► Risk Maps
Risk maps are grids detailing the potential frequency and severity of risk faced by the organization. Use
of risk maps varies from simply graphing the exposures to employing simulation analysis to estimate likely
loss scenarios.
► Value at Risk (VAR) Analysis
Value at Risk (VAR) is the worst probable loss likely to occur in a given time period under regular
market conditions at some level of confidence. The concept is often applied to a portfolio of assets, such as a
mutual fund or a pension fund, and is similar to the concept of “maximum probable loss” in traditional
property and liability risk management.
Parts of Other Risk Management Tools

► Catastrophe Modeling
Catastrophe modeling is a computer-assisted method of estimating losses that could occur as a
result of a catastrophic event. Input variables include such factors as seismic data, meteorological
data, historical losses, and values exposed to loss (e.g., structures, population, business income, etc.).
The output from the computer analysis is an estimate of likely results from the occurrence of a
catastrophic evet, such as category 5 hurricane or an earthquake of magnitude 7.8 on the Richter
scale.
THANK YOU!