1. Insurance and Risk Management Prof. Sudip Bhattacharya IISWBM

2. What is Risk? The chance of loss There must be a chance of loss for risk to exist. All transactions / Events have a liability / risk exposure

3. Risk Defined Chance/possibility of loss Uncertainty of occurrence of any unforeseen event Variation of actual from expected results Risk, in traditional terms, is “exposing to danger or hazard”. The Chinese give a much better description of risk. The 1 st is the symbol for “danger”, while the 2 nd is the symbol for “opportunity”

4. Understanding Risk Pure vs. Speculative Dynamic vs. Static Subjective vs. Objective Particular vs. Fundamental Financial vs. Nonfinancial Peril vs. Hazard Probability of Loss (Frequency, Severity) Law of Large Numbers Commercial Trade Risk Insurable vs. Non-insurable Risk

5. Risk Management (RM) Broadly defined, business RM is a method for making decisions On going plan to avoid circumstances and events that can cause loss & Minimize the operational and financial impact of loss, should it occur Regarding how to treat exposures to loss in business value from any source. Economic protection of Co’s Assets, Earnings & Liabilities.

6. It may require knowledge of chemical processes, Fundamentals of Fire Engg. Physical properties of Different materials But is more than that Requires Statistical Techniques But is more than Loss Statistics RM involves Multi-Disciplinary Approach. Insurance Managers, Statisticians, Fire Engrs and the like are dealing with many aspects of Risk, but no one takes overall view of Risk. RM Contd.

7. Risk Manager should look into overall view of the risk. Co-ordinate with various Line Managers to get the same. RM Contd.

8. RM - Definition “RM is the Identification, Analysis and Economic Control of those RISKS which can Threaten the Assets (Property, Human) or the Earning Capacity of an Enterprise”

9. Need for RM Uncertainty in Enterprise Growing Complexity in Business Environment Statutory Obligations Contractual Obligations Social Obligations

10. RM – Common Sense Disproportionate Emphasis on Risk Finance like Self Insurance Alternatives Non-Insurance option of Retention Assumption of Loss by Numerous Techniques But not much attention on Loss prevention, Safety and Loss control

11. Risk Types - Business Material Risk- Building, Plant & Machinery, Furniture, Fixtures, fittings, Stocks. Consequential Risk- Loss of production, Loss of profit, Loss of market, Good will. Social Risk Legal Risk- Product liability, Public liability. Political Risk- Subsidies, Sanctions etc.

12. Responses to Pure Risk Risk avoidance Risk reduction Risk retention or assumption Risk transfer

13. Loss Exposure Set of circumstances that presents the possibility of loss, whether or not a loss actually occurs. Implies the existence of something that may decline in value The object and the circumstances can be objectively verified

14. Elements of a Loss Exposure 1.The item subject to loss 2.The perils, or forces that may cause the loss 3.The Hazards 1.Physical 2.Moral 3.Morale 4.The potential financial impact of the loss

15. Direct Losses often Cause Indirect Losses –Ex: What are the direct and indirect losses if a manufacturing plant experiences a major fire?

16. The RM Process Determining the objectives of RM program identification and evaluation of pure loss exposures faced by an organization or individual Identifying the risk exposure Evaluating identified risks as to the probability of outcome and potential loss selection and administration of the most appropriate technique for treating such exposures

17. The RM Process (cont.) Determining & selecting the best RM alternative –Risk Avoidance –Risk reduction or Risk Control or Loss Control or Loss Prevention –Risk Retention or Assumption –Risk Transfer Implementing a RM plan based on selected alternatives Periodically evaluating and reviewing the RM program

18. RM Process (Visual view) Phase 1: Risk Analysis Risk Identification Evaluation & Measurement Phase 2: Risk Response Risk Control Financing & Communication Phase 3: Risk Review Monitor and Evaluate Risk Plans

19. The RM Process (In Gist) 1)Determine objectives of Risk program 2)Identification of risks 3)Evaluation of frequency and severity of losses 4)Choosing RM methods 5)Implementation of the chosen methods 6)Monitoring the performance and suitability of the methods.

20. Steps in the RM Process

21. RM Questions 1.What is the problem? (risk identification) 2. What is the magnitude of the problem? (measurement) 3. How should the problem be handled? (decision)

22. A written RM PS offers several advantages and is Necessary to have effective administration of the RM program. PS states the RM objectives of the firm and co. policy about treatment of loss exposures. PS educates top-level executives in the firm about the RM process. The written PS enables the risk manager to have greater authority throughout the firm. Finally, PS provides a standard for judging the risk manager's performance Objectives of RM – Policy Statement (PS)

23. -Economy goal -Reduction of anxiety -Meet any legal obligations Pre-loss Objectives:

24. -Survival of the firm -Continued operation -Stability of earnings -Continued growth -Social responsibility Post-loss Objectives:

25. Risk Evaluation Arrange them in order of priority Provide info. for deciding the most appropriate way of handling. Ranking risks according to : 1.Frequency of loss ; and 2.Potential severity of loss.

26. Carried out with proper perception of risk and cost involved in Analysis. Not to stick to one method Understand co. & industry Should be financially reasonable Accurate record keeping Amount of imagination of required Risk Analysis

27. Risk Reduction / Loss Prevention Reduce probability of loss and its severity. Most important for RM process. Risk Reduction / Prevention can be from – Loss prevention Safety measures Fire protection / Detection Environmental protection

28. Risk Retention If, Charge losses against normal operation cost. Contingency fund Borrow the cost of any loss, repaying over agreed period. Risk Transfer : To insurers – Pure risks Risk Retention / Risk Transfer

29. 29 Risk Transfer Contractual risk transfer –Hold harmless –Indemnification –Additional Assured status –Waiver of Subrogation Insurance

30. RM Matrix

31. Major RM options

32. Various Methods - Some are Quantitative, Some Qualitative Check List Flow chart Risk Inspection HAZOP HAZAN Fault Tree Method Hazard Indices RM – Various methods

33. Other RM Tools RM Information Systems (RMIS) RM Intranets and Websites Risk Maps Value at Risk (VAR) Analysis

34. The Universe of Risk

35. Analysis Elements 2 key elements are:  A statement of impact relative to how badly a specific difficulty would hurt if it happens.  A statement of the probability of encountering that difficulty within a specific period of time. Both parameters are needed to describe risk in terms of cost per unit of time such as dollars per year. Note: The probability of an undesirable thing happening is usually more difficult to determine with confidence than is a measure of the consequence of its happening. However, statements of the potential economic impact of events without regard to their relative probability cannot lead to the identification of exposures worthy of corrective action.

36. Risk Assessment Financial Impact Probability Very High Risk High RiskLow Risk Medium Risk FINANCIAL IMPACT: Threshold Limit to be decided based on Size of the corporate PROBABILITY OF OCCURRENCE: Organization history & Industry Experience to be considered

37. Risk Options Once an exposure to risk has been identified, we have three options to address it. We can: 1.Tolerate it 2.Lower the potential cost by implementing measures costing less than the total loss in dollars per year 3. Lower the probability of loss occurring by implementing protective measures costing less than the exposure Unless we quantify both the potential cost & the probability of occurrence, we can not be in a position to make an informed selection of any of the 3 options.

38. Handling Risk Risk Levels Low & Medium Normal Monitoring at operational level HighClose control of all potential contributing factors by RM Team Very HighActively tracked for decisions by RM Team

39. Exposure Analysis: Restaurant Ex. 1.Valued ThingFreedom from legal liability Building 2.PerilCustomer slips and injures herself Fire 3.Financial Consequence Cost to defend and settle claim Loss in building value Loss of income

40. Risk Exposures of a B-school Student Physical damage to 1996 Ford Taurus A liability lawsuit arising from the use of the vehicle Total loss of clothes, electronic equipment and personal property due to a kitchen fire in apartment Disappearance of a set of contact lens Bodily injury from being hit by a car while jogging on a busy residential street Liability when the family dog bites a child Malfunction and repair of a laptop or PDA Are there other risk exposures?

41. Mom and Pop BusinessLarge Risk Light at night to prevent Burglary Burglary Alarms, Surveillance, Petrol’s, Electronic Sensors House Keeping Loss Finance from Insurance Proceeds Withdrawal of savingsSurplus (Savings) Loan from Bank Risk Mgt principles for small & large risks are basically same.

42. RM Vs. Insurance RM is a decision process; insurance is a financial product RM focuses on identifying and measuring risks to select the most appropriate technique. Insurance is one of several methods the risk manager can use to treat loss exposures. RM provides for the periodic evaluation of all techniques for meeting losses, not just insurance. Insurance is only one of several options to treat pure loss exposures. So RM is a broader concept

43. The Changing Scope of RM Financial RM –Commodity Price Risk –Interest Rate Risk –Currency Exchange Rate Risk Enterprise RM –Pure risk –Speculative Risk –Strategic Risk –Operational Risk

44. What is Enterprise RM? ERM is the application of the basic RM principles to all risks facing an organization Other names for ERM Enterprise-wide RM Holistic RM Integrated RM Strategic RM Global RM

45. Enterprise Risk Management Safeguard existing value Risk optimization Financial engineering of risk and capital

46. Components of ERM Corporate governance Line management Portfolio management Risk transfer Risk analytics Data and technology resources Stakeholder management

47. RM as part of Corporate Governance Business is synonymous with Risk Structured definition and mgt. of risks. Board to be fully aware of the risks facing the co Shareholders to know the process by which the cos. manage their risks

48. ERM Risk Categories Common risk allocation Hazard risk Financial risk Operational risk Strategic risk Bank view – New Basel Accord Credit risk –Loan and counterparty risk Market risk (financial risk) Operational risk

49. Hazard Risk “Pure” loss situations Property Liability Employee related Independence of separate risks Risks can generally be handled by –Insurance, including self insurance –Avoidance –Transfer

50. Financial Risk Components –Foreign exchange rate –Equity –Interest rate –Commodity price Correlations among different risks Use of hedges, not insurance or risk transfer Securitization

51. Operational Risk Causes of operational risk Internal processes People Systems Examples Product recall Customer satisfaction Information technology Labor dispute Management fraud

52. Strategic Risk Ex: Competition Regulation Technological innovation Political impediments

53. Liability Legally bound or responsible. Something for which one is liable; an obligation, a responsibility, or a debt Negligence Failure to use that degree of care which an ordinary person of reasonable prudence would use under the given or similar circumstances. Assault and battery False arrest and imprisonment Invasion of privacy Defamation (libel and slander) Violation of constitutional rights

54. Where Did ERM Come From? Traditional RM Formally developed as a field in the 1960s Focused on “pure” risks Loss/no loss situation Often could be insured Developed from insurance purchasing area

55. New Elements of Risk – 1970s Foreign exchange risk End of Bretton Woods agreement in 1972 Commodity price risk Oil price fluctuations of the 1970s Equity risk Development of option markets - 1973 Interest rate risk Federal Reserve Board policy shift - 1979

56. Failure to Manage Financial Risk Foreign exchange risk –Laker Airlines – 1970s Borrowing in dollars Revenue in pounds Interest rate risk –U. S. Savings and Loans – 1980s Borrowing short Lending long Commodity price risk –Continental Airlines – 1990 Fuel costs not hedged Oil price doubled with Gulf War

57. The “New” RM -1980s Financial RM Dealt with financial risk Foreign exchange risk Interest rate risk Equity risk Commodity price risk Use derivatives to hedge financial risk

58. New Elements of Risk – 1990s Failure to manage derivatives appropriately Financial model failures Improper accounting for derivatives

59. Mismanagement of Financial Risk Mismanagement of derivatives –Gibson Greetings –Proctor and Gamble –Barings Bank –Orange County Model failure –Long Term Capital Accounting improprieties –Enron –Cedant –Arthur Andersen

60. The “New” RM - 1990s and beyond Enterprise RM –Initial focus on avoiding derivative disasters –Developing into optimizing firm value Chief Risk Officer Sarbanes-Oxley Act – 2002 Increased focus on risk models

61. Financial RM Toolbox Forwards Futures Options Swaps