Chapter 3 Introduction to Risk Management Meaning of Risk Management Objectives of Risk Management Steps in the RM Process Benefits of Risk Management Personal RM Corporate RM ERM （FMEA）

Meaning of Risk Management Risk Management is a process that identifies loss exposures faced by an organization and selects the most appropriate techniques for treating such exposures A loss exposure is any situation or circumstance in which a loss is possible, regardless of whether a loss occurs E.g., a manufacturing plant that may be damaged by an earthquake, or an automobile that may be damaged in a collision

Objectives of Risk Management Risk management has objectives before and after a loss occurs Pre-loss objectives: Prepare for potential losses in the most economical way Reduce anxiety Meet any legal obligations

Objectives of Risk Management Post-loss objectives: Ensure survival of the firm Continue operations Stabilize earnings Maintain growth Minimize the effects that a loss will have on other persons and on society

Risk Management Process Transparency Master 1.2 Risk Management Process Identify potential losses Evaluate potential losses Select the appropriate risk management technique Implement and monitor the risk management program

Exhibit 3.1 Steps in the Risk Management Process

Identifying Loss Exposures (1) Property loss exposures (2) Liability loss exposures (3) Business income loss exposures (4) Human resources loss exposures (5) Crime loss exposures (6) Employee benefit loss exposures (7) Foreign loss exposures (8) Market reputation and public image of company (9) Failure to comply with government rules and regulations

Important Loss Exposures: I Property loss exposures Building, plants, other structures Furniture, equipment, supplies Electronic data processing (EDP) equipment; computer software Inventory Accounts receivable, valuable papers and records Company planes, boats, mobile equipment

Important Loss Exposures: II Liability loss exposures Defective products Environmental pollution (land, water, air, noise) Sexual harassment of employees, discrimination against employees, wrongful termination Liability arising from company vehicles Misuse of the Internet and e-mail transmissions, transmission of porno material Directors’ and officers' liability suits Inherent Virtue or Inevitable Evil: The Effects of Directors' and Officers' Insurance on Firm Value, Derrick W. H. Fung and  Jason J. H. Yeh, 03 September 2018, https://doi.org/10.1111/rmir.12104

Important Loss Exposures: III Business income loss exposure Loss of income from a covered loss Continuing expenses after a loss Extra expenses Contingent business income losses

Important Loss Exposures: IV Human resources loss exposure Death or disability of key employees Retirement or unemployment Job-related injuries or disease experienced by workers (謝婉雯：The Miracle Box)

Important Loss Exposures: V Crime loss exposures Holdups, robberies, burglaries Employee theft and dishonesty Fraud and embezzlement Internet and computer crime exposures

Important Loss Exposures: VI Employee benefit loss exposures Failure to comply with government regulations Violation of fiduciary responsibilities Group life and health and retirement plan exposures Failure to pay promised benefits

Important Loss Exposures: VII Foreign loss exposures Plants, business property, inventory Foreign currency risks Kidnapping of key personnel Political risks

Identifying Loss Exposures Risk Managers have several sources of information to identify loss exposures: Surveys and Questionnaires Physical inspection Flowcharts (external and internal) Financial statements Historical loss data Interaction with External Resources Industry trends and market changes can create new loss exposures. e.g., exposure to acts of terrorism

Analyzing Loss Exposures Estimate the frequency and severity of loss for each type of loss exposure Loss frequency refers to the probable number of losses that may occur during some given time period (#Losses / #Exposures) Loss severity refers to the probable size of the losses that may occur ($Losses / #Losses) Expected Loss = ($Losses / #Exposures) Once loss exposures are analyzed, they can be ranked according to their relative importance Loss severity is more important than loss frequency: The maximum possible loss is the worst loss that could happen to the firm during its lifetime The maximum probable loss is the worst loss that is likely to happen

Ratios Example Data Minor Fires: 20, $25,000 Major Fires: 3, $500,000 1000 Restaurants 23 Fires Minor Fires: 20, $25,000 Major Fires: 3, $500,000 Severity = 20($25,000) + 3($500,000)/23 = $86,957 Frequency = 23 / 1000 = .023 Expected Loss = .023($86,957) = $2,000

Loss Severity Measures Maximum Possible Loss Probable Maximum Loss (PML): Prob.(Loss > PML) < 5% Probability Actual losses will be less than PML 95% of the time 5% Possible Losses PML Max.

Ex-Insight 4.2 Figure 3: Products Liability Risk Profile

Select the Appropriate Risk Management Technique Risk control refers to techniques that reduce the frequency and severity of losses Methods of risk control include: Avoidance Loss prevention Loss reduction

Risk Control Methods Avoidance means a certain loss exposure is never acquired, or an existing loss exposure is abandoned The chance of loss is reduced to zero It is not always possible, or practical, to avoid all losses

Risk Control Methods Loss prevention refers to measures that reduce the frequency of a particular loss e.g., installing safety features on hazardous products, salting to prevent icy road; using fire-resistive materials in construction, etc. Loss reduction refers to measures that reduce the severity of a loss after it occurs e.g., installing an automatic sprinkler system; contingency plans; duplication, separation, etc.

Framework for Decisions Loss Control without Insurance Cost of loss control: $2,000 Interest rate: .05 Time period: 10 years Prob. Loss before Loss after .98 $0 $0 .02 $100,000 $65,000 2

Framework for Decisions B = St p x (reduction in loss)/(1+r)t B = [.02 x (35,000/1.05) + [.02 x (35,000/1.052) + … + [.02 x (35,000/1.0510)] B = $5,405.21 Benefit/cost ratio = 5405/2000 = 2.7 => Benefit of $5,405 more than justifies cost of $2,000.

Framework for Decisions Loss Control with Insurance Premium w/o loss control: $1,000 Premium with loss control: $850 Cost of loss control: $1,000 Interest rate: .05 Benefit of investing in loss control? 2

Framework for Decisions B = St p x (reduction in premium)/(1+r)t B = 1.0 x [(150/1.05) + (150/1.052) + … + 150/1.05t)] B/C > 1 when t = ? This corresponds to a(n) ? year payback period.

Loss Control: Questions for Discussion If the Benefit/Cost ratio is less than 1.0, it is never beneficial to invest in loss control. Agree/Disagree. Explain. Reducing the level of risky activity to zero is always more cost effective than investing in loss control. Agree/Disagree. Explain. 23

Select the Appropriate Risk Management Technique Risk financing refers to techniques that provide for the funding of losses Methods of risk financing include: Retention Non-insurance Transfers Commercial Insurance

Risk Financing Methods: Retention Retention means that the firm retains part or all of the losses that can result from a given loss Retention is effectively used when: No other method of treatment is available The worst possible loss is not serious Losses are highly predictable The retention level is the dollar amount of losses that the firm will retain A financially strong firm can have a higher retention level than a financially weak firm The maximum retention may be calculated as a percentage of the firm’s net working capital

Risk Financing Methods: Retention A risk manager has several methods for paying retained losses: Current net income: losses are treated as current expenses Unfunded reserve: losses are deducted from a bookkeeping account Funded reserve: losses are deducted from a liquid fund Credit line: funds are borrowed to pay losses as they occur Captive insurer

Risk Financing Methods: Retention A captive insurer is an insurer owned by a parent firm for the purpose of insuring the parent firm’s loss exposures A single-parent captive is owned by only one parent An association or group captive is an insurer owned by several parents Many captives are located in the Caribbean because the regulatory environment is favorable Captives are formed for several reasons, including: The parent firm may have difficulty obtaining insurance Costs may be lower than purchasing commercial insurance A captive insurer has easier access to a reinsurer A captive insurer can become a source of profit (AllState of Sears) Premiums paid to a captive may be tax-deductible under certain conditions

Types of Captive Insurers: Pure Captive

Types of Captive Insurers: Group Captive Parent Corporation 1 Parent Corporation 2 Captive Insurer Parent Corporation 3

Types of Captive Insurers: Broad Captive Parent Corporation 1 Parent Corporation 2 Captive Insurer Parent Corporation 3

Top Ten Captive Insurance Locations 100% 4458 Worldwide 14.6% 649 Others 1.6% 73 10. Hawaii 3.9% 173 9. Isle of Man 4.0% 178 8. Ireland 4.1% 184 7. British Virgin Island 5.3% 237 6. Barbados 6.1% 273 5. Luxembourg 8.3% 370 4. Guernsey 8.5% 381 3. Vermont 12.0% 535 2. Cayman 31.5% 1405 1. Bermuda % of Total Total captives

Hong Kong - Ideal Captive Centre Turning Crisis into Opportunities: Hong Kong as an Insurance Hub with Development Focuses on Reinsurance, Marine and Captive

CNOOC Insurance @ HK

Risk Financing Methods: Retention Self-insurance is a special form of planned retention Part or all of a given loss exposure is retained by the firm A more accurate term would be self-funding Widely used for workers compensation and group health benefits A risk retention group is a group captive that can write any type of liability coverage except employer liability, workers compensation, and personal lines Federal regulation allows employers, trade groups, governmental units, and other parties to form risk retention groups They are exempt from many state insurance laws

Risk Financing Methods: Retention Advantages Save money Lower expenses Encourage loss prevention Increase cash flow Disadvantages Possible higher losses Possible higher expenses Possible higher taxes

Risk Financing Methods: Non-insurance Transfers A non-insurance transfer is a method other than insurance by which a pure risk and its potential financial consequences are transferred to another party Examples include: Contracts, leases, hold-harmless agreements

Risk Financing Methods: Non-insurance Transfers Advantages Can transfer some losses that are not insurable Save money Can transfer loss to someone who is in a better position to control losses Disadvantages Contract language may be ambiguous, so transfer may fail If the other party fails to pay, firm is still responsible for the loss Insurers may not give credit for transfers

Risk Financing Methods: Insurance Insurance is appropriate for loss exposures that have a low probability of loss but for which the severity of loss is high The risk manager selects the coverages needed, and policy provisions: A deductible is a provision by which a specified amount is subtracted from the loss payment otherwise payable to the insured An excess insurance policy is one in which the insurer does not participate in the loss until the actual loss exceeds the amount a firm has decided to retain The risk manager selects the insurer, or insurers, to provide the coverages

Risk Financing Methods: Insurance The risk manager negotiates the terms of the insurance contract A manuscript policy is a policy specially tailored for the firm Language in the policy must be clear to both parties The parties must agree on the contract provisions, endorsements, forms, and premiums The risk manager must periodically review the insurance program

Risk Financing Methods: Insurance Advantages Firm is indemnified for losses Uncertainty is reduced Insurers may provide other risk management services Premiums are tax-deductible Disadvantages Premiums may be costly Opportunity cost should be considered Negotiation of contracts takes time and effort The risk manager may become lax in exercising loss control

Exhibit 3.2 Risk Management Matrix

Market Conditions and the Selection of Risk Management Techniques Risk managers may have to modify their choice of techniques depending on market conditions in the insurance markets The insurance market experiences an underwriting cycle In a “hard” market, profitability is declining, underwriting standards are tightened, premiums increase, and insurance is hard to obtain In a “soft” market, profitability is improving, standards are loosened, premiums decline, and insurance become easier to obtain

Implement and Monitor the Risk Management Program Implementation of a risk management program begins with a risk management policy statement that: Outlines the firm’s risk management objectives Outlines the firm’s policy on loss control Educates top-level executives in regard to the risk management process Gives the risk manager greater authority Provides standards for judging the risk manager’s performance A risk management manual may be used to: Describe the risk management program Train new employees

Implement and Monitor the Risk Management Program A successful risk management program requires active cooperation from other departments in the firm The risk management program should be periodically reviewed and evaluated to determine whether the objectives are being attained The risk manager should compare the costs and benefits of all risk management activities

Benefits of Risk Management Pre-loss and post-loss objectives are attainable A risk management program can reduce a firm’s cost of risk The cost of risk includes premiums paid, retained losses, outside risk management services, financial guarantees, internal administrative costs, taxes, fees, and other expenses Reduction in pure loss exposures allows a firm to enact an enterprise risk management program to treat both pure and speculative loss exposures Society benefits because both direct and indirect losses are reduced

Choosing the Right Alternative TRANSFER RETENTION RISK MANAGER 12

Risk and Value Produces Variable Demand for Insurance 0 Assets 14

Insight 3.2 Show Me the Money–Risk Manager Salaries Rise

Small RM Department Source: Essentials of Risk Management 20

Medium-sized Department Source: Essentials of Risk Management 21

Large Department Source: Essentials of Risk Management 22

Activities of Typical Risk Managers Assisting with risk identification Implementing loss prevention & control Reviewing contracts & related documents Providing training & safety education Assuring governmental compliance Arranging non-insurance financing Claims management and defense 19

Knowledge of Risk Manager SAFETY Non-INSURANCE ALTERNATIVES FINANCE INSURANCE Your INDUSTRY 6

… also known as CRO Source: Tools and Techniques of Risk Management and Insurance

Insight 3.2 Show Me the Money–Risk Manager Salaries Rise 59

Personal Risk Management Personal risk management refers to the identification of pure risks faced by an individual or family, and to the selection of the most appropriate technique for treating such risks The same principles applied to corporate risk management apply to personal risk management