Chapter 4

Advanced Topics in Risk Management

.1 Teaching Note

Some instructors wanted a little more extensive treatment of risk management in the text, focusing more on business risk management. This chapter was added to address this concern. As many instructors teach this as a personal risk management course, this chapter can be skipped without loss of continuity. The chapter is organized as a collection of topics. The following topics are covered: (1) the changing scope of risk management, (2) insurance market dynamics, (3) loss forecasting, (4) financial analysis in risk management decision making, and (5) risk management tools. Instructors desiring some more quantitative work may cover the appendix at the end of the chapter.

.2
I.

Lecture Outline
The Changing Scope of Risk Management A. Financial Risk Management B. Enterprise Risk Management

II.

Insurance Market Dynamics A. The Underwriting Cycle B. Consolidation in the Insurance Industry C. Capital Market Risk Financing Alternatives

III. Loss Forecasting A. Probability Analysis B. Regression Analysis C. Forecasting with Loss Distributions IV. Financial Analysis in Risk Management Decision Making A. The Time Value of Money B. Financial Analysis Applications

2011 Pearson Education, Inc. Publishing as Prentice Hall

21RejdaPrinciples of Risk Management and Insurance, Eleventh Edition

V.

Other Risk Management Tools A. Risk Management Information Systems (RMIS) B. Risk Management Intranets C. Risk Maps D. Value at Risk (VAR) Analysis E. Catastrophe Modeling

.3

Answers to Case Application

1. (a) (1) GWS could buy oil futures contracts to hedge the fuel oil price risk. If the price of fuel oil is lower in the future, GWS will be able to purchase fuel oil at a lower price but lose money on its futures position. If the price of fuel oil increases in the future, GWS will lose money by having to pay a higher price for fuel oil, but it can offset the higher spot price with a gain on its futures position. (2) GWS may also consider a double-trigger option insurance arrangement using fuel oil prices and property losses as triggers. Under the double-trigger option, the insurer would only make a payment to GWS if both contingencieshigh fuel prices and high property losses occurred. The agreement would specify both the fuel price per gallon and the level of property losses that would jointly trigger payment. If only one contingency occurred or neither contingency occurred, the insurer would have no liability. (b) The net present value (NPV) of an investment project is equal to the present value of the future cash flows less the cost of the project. Using 10 percent as the discount rate, the NPV of this project is $22,171.30 as shown below: $25,000 $25,000 $25,000 + + 1 2 (1 + 0.10) (1 + 0.10) (1 + 0.10)3 NPV = $40,000 + $22,727.27 + $20,661.16 + $18,782.87 NPV = $22,171.30 NPV = $40,000 + As the NPV is positive, the project is acceptable. The NPV could also have been calculated by treating the three $25,000 cash flows as an ordinary annuity. (c) As the independent variable is thousands of miles traveled, the expected 640,000 miles is entered into the prediction as 640. Substituting this value into the regression equation yields an estimate of between 16 and 17 derailments, as shown below: Y (# of derailments) = 2.31 + 0.22 (640) = 2.31 + 14.08 = 16.39

2011 Pearson Education, Inc. Publishing as Prentice Hall

Chapter 4Advanced Topics in Risk Management22

.4

Answers to Review Questions

1. Three speculative financial risks that a risk manager may consider are commodity price risk, interest rate risk, and currency exchange rate risk. Traditionally, these risks were addressed by financial managers rather than risk managers. The role of some risk managers has expanded to consider not only pure risks, but also speculative financial risks. 2. Traditional risk management was limited in scope to property, liability, and personnel-related loss exposures. Enterprise risk management is a much broader concept, encompassing traditional risk management. In addition to considering property, liability, and personnel exposures, enterprise risk management considers speculative risks, strategic risks, and operational risks. 3. The underwriting cycle refers to the tendency for commercial property and liability insurance markets to fluctuate between periods of tight underwriting with high insurance premiums and periods of loose underwriting with low insurance premiums. When the property and liability insurance industry is in a strong surplus position, insurers can lower premiums and loosen underwriting standards to compete with other insurers. As competition increases, the surplus is depleted through underwriting losses that develop because of low premiums and less stringent underwriting. If investment income is not available to offset the underwriting losses, at some point premiums must be increased and underwriting standards tightened. Higher premiums and stricter underwriting help to restore the insurer to profitability. As profitability returns, the depleted surplus is restored, making it possible for insurers to enter into competition with lower premiums and less-strict underwriting. The market is hard when premiums are high and underwriting standards are tight. The market is soft when premiums are low and underwriting standards are loose. 4. Consolidation in the insurance industry refers to the combining of insurance business organizations through mergers and acquisitions. Three types of consolidation have been occurring. First, insurance companies have been merging with or acquiring other insurance companies. The combination of St. Paul Insurance with Travelers Insurance is an excellent example, as is the acquisition of Safeco Insurance by Liberty Mutual Insurance Company. Second, insurance brokerages have been merging with or acquiring other insurance brokerages (Marsh acquired Sedgwick, for example). Finally, there has been cross-industry consolidation. Cross-industry consolidation occurs when a company in one financial services area merges with or acquires a company in another financial services area. For example, a bank may acquire an insurance company or an insurance company may purchase an investment (mutual fund) company. 5. Securitization transfers insurable risk to the capital markets through the creation of a financial instrument, such as a catastrophe bond. Prior to securitization, the capacity of the insurance industry was limited to the capacity of insurers and reinsurers operating in the industry. Risk securitization provides an avenue through which insurable risk is spread to capital market participants (e.g., bondholders). 6 (a) Loss forecasting is necessary to enable the risk manager to make an informed decision about whether to retain or transfer loss exposures. The risk manager will be unable to evaluate an insurance coverage bid unless he or she has some level of confidence about the magnitude of expected losses and the reliability of the estimate. Based on the forecast, the risk manager may believe that an insurance bid is too high and opt for retention, or that the insurance bid is low relative to the expected losses, and opt for insurance. (b) The risk manager may use several techniques to forecast losses. Probability analysis, regression analysis, and forecasting through loss distributions may be employed.

2011 Pearson Education, Inc. Publishing as Prentice Hall

23RejdaPrinciples of Risk Management and Insurance, Eleventh Edition

7. Using past losses alone to predict future losses is not wise. While past losses may have some bearing upon future losses, underlying conditions may have changed. The company may have sold off or acquired new operations, expanded into new markets, or altered production processes. There may be other exposures that produce losses this year that did not produce losses in the past. While past loss data may be helpful, additional information should be considered. 8. Time value of money analysis is employed in risk management decision making to account for the interest-earning capacity of money. The same amount of money to be received or paid in different time periods is of different value in terms of todays dollars, once the interest-earning capacity of the money is considered. Failure to consider the interest-earning capacity of money may lead to bad risk management decisions. 9. The future cash flows that a project will generate are estimated in the capital budgeting process. In addition to the cash benefits (reduced costs and increased revenues), some values that are difficult to quantify may be considered. For example, a loss control investment may result in fewer lost work days, improved morale of employees, reduced absenteeism, reduced pain and suffering, an improved public image of the company, and less down time when a replacement worker must be trained to substitute for an injured worker. These items are difficult to quantify in capital budgeting. 10. (a) A risk management information system (RMIS) is a computerized database that permits a risk manager to store and analyze risk management data and to use the data to predict future loss levels. Many organizations use an RMIS as a tool to help manage claims. (b) Some risk management departments have established their own Web sites. These sites contain a wealth of risk management information about the company and answers to frequently asked questions (FAQs). Risk management intranets are internal networks that incorporate search capabilities. Company personnel can access the Web site and search for the desired information.

.5
1.

Answers to Application Questions

Prior to the changing scope of risk management in the 1990s, insurers needed considerable knowledge of property, liability, and personnel risks to write the insurance coverages demanded. Given the changes that have occurred recently, insurers also need expertise in financial, strategic, and operational issues. For example, an insurer designing a multiple-trigger contract may need expertise in commodity pricing as well as traditional insurable loss exposures. An insurer designing an enterprise risk management plan may need expertise in currency exchange rate risk, the organizations competitive environment, interest rate risk, weather-related risk, and traditional property and liability insurance risks. Property and liability insurance markets fluctuate. Sometimes premiums are high and underwriting standards are tight; at other times, premiums are low and underwriting standards are loose. In this case, self-insurance was probably used the first year because the risk manager believed that the risk was best handled in this way as opposed to purchasing insurance. The change in the second year likely reflects a downturn in insurance prices, making commercial insurance the most cost-effective alternative.

2.

2011 Pearson Education, Inc. Publishing as Prentice Hall

Chapter 4Advanced Topics in Risk Management24

3.

There are hundreds of insurance companies operating in most states. If several of these companies merge, or if one is acquired by another insurer, the marketplace remains very competive. Broker consolidation leaves fewer larger players in the market. When some large brokerages merge, there are fewer large brokers (e.g., Marsh and Aon) for a risk manager to call upon when putting an insurance program out for bids. For example, a risk manager was once able to get competitive bids from Johnson & Higgins (J&H), Marsh, and Sedgwick. However, Marsh acquired J&H and Sedgwick. Often smaller national brokerages or regional brokerages must be employed in a competitive bidding process. (a) Ignoring the time value of money in risk management decision making may lead to wrong decisions or at least less than optimal decisions. The result is especially true in capital budgeting where investment expenditures are usually made up front, but the benefits of the projects are not realized until the future. If the future cash flows were not adjusted for time value of money considerations, the value of the future cash flows would be overstated. Projects that are unacceptable when the time value of money is considered may appear to be good projects when the time value of money is ignored. (b) The NPV of a project is the value added to the business if the project is undertaken. As the net present value is calculated using the organizations required rate of return to discount the future cash flows back to present value, projects that have a positive net present value provide a rate of return higher than the organizations minimum acceptable return. As such, the NPV is the value added to the organization by undertaking the project. Self-insuring workers compensation is a common practice. Use of self-insurance increases during hard insurance markets, as premiums are higher and underwriting standards are tighter. Given the cyclical nature of the commercial property and liability insurance market, the risk manager may want to purchase insurance next year if workers compensation insurance premiums have dropped significantly. As workers compensation is an experience-rated coverage, the risk manager wants to make sure that if this years claims experience is favorable, the risk manager will be able to document the superior performance to insurance underwriters and obtain a lower premium from the insurer.

4.

5.

2011 Pearson Education, Inc. Publishing as Prentice Hall