Advanced Topics in Risk Management

The following topics will be covered: (1) the changing scope of risk management (2) insurance market dynamics (3) loss forecasting (4) financial analysis in risk management decision making (5) use of technology in risk management programs

The Changing Scope of Risk Management

Financial Risk Management Enterprise Risk Management

Financial Risk Management

Three financial risks that a risk manager may consider are: - commodity price risks - interest rate risk - currency exchange rate risk Traditionally, such risks were not considered in risk management.

Managing Financial Risks

Given the changes that have occurred recently, insurers will also need expertise in financial, strategic, and operational issues.

For example, an insurer designing a dual trigger option package will need to possess expertise in commodity prices.

An insurer designing an enterprise risk management plan may need expertise in currency exchange rate risk, the organization’s competitive environment, interest rate risk, weather-related risks, and traditional property and liability insurance risks.

Enterprise Risk Management

Traditional risk management is limited in scope to considering property, liability, and personnel loss exposures. Enterprise risk management is a much broader concept, encompassing traditional risk management.

In addition to the considering property, liability, and personnel loss exposures; enterprise risk management also considers: - speculative risks - strategic risks - operational risks.

Insurance Market Dynamics

The Underwriting Cycle Consolidation in the Insurance Industry

The Underwriting Cycle

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 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.

Competition sets in, and the surplus is depleted through underwriting losses arising from low premiums and loose underwriting standards.

If investment income is not available to offset underwriting losses, at some point premiums must be increased and tighter underwriting employed.

Higher premiums and tighter underwriting standards will help to restore surplus, making it possible once again for insurers to reduce premiums and loosen underwriting standards.

The insurance market is "hard" when premiums are high and underwriting standards are tight. The insurance market is "soft" when premiums are low and underwriting standards are loose.

Insurance Industry Capacity Investment Returns

Investment Returns

The future cash flows that a project will generate are merely estimates of the benefits of investing in the project. In addition to cash benefits (reduced expenses and increased revenues), some values are very difficult to quantify.

For example, employee morale, reduced pain and suffering, public perceptions of the company, and lost productivity when a new worker must be hired to replace an injured worker are difficult to measure.

Consolidation in the Insurance Industry

Consolidation in the insurance industry refers to the combining of insurance business organizations through mergers and acquisitions. Three types of consolidation have been taking place.

Insurance Company Mergers and Acquisitions Insurance Brokerage Mergers and Acquisitions Cross-industry Consolidation

First, insurance companies have been merging with or acquiring other insurance companies. Second, insurance brokerages have been merging with or acquiring other insurance brokerages. Finally, there has been cross-industry consolidation.

Cross-industry consolidation refers to businesses in one financial services area are merging with or acquiring firms in another financial services area. For example, a bank may acquire an insurance company and a stock brokerage company.

There are hundreds of insurance companies operating in most states. Should several of these insurance companies merge or if one insurer is acquired by another insurer, there are still hundreds of insurance companies from which to choose.

There are fewer large insurance brokerages. When some of the large insurance brokers merge (e.g. the consolidation of Sedgwick, Marsh-Mac, and Johnson & Higgins), there are fewer large brokers for the risk manager to call upon for coverage bids.

In the case of insurance brokerage mergers, there are fewer large brokers to begin with, and even fewer after these consolidations.

Loss Forecasting

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 a handle on what the loss levels are most likely to be and the reliability of the estimate.

Using past losses alone to predict future losses is not wise. While past losses may have some bearing upon future losses, 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 losses may be helpful, additional information should also be considered.

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 risk transfer.

The risk manager may employ several techniques to forecast losses. Probability analysis, regression analysis, and forecasting using loss distributions may be employed.

Probability Analysis Regression Analysis Forecasting Using Loss Distributions

Financial Analysis in Risk Management Decision Making

The Time Value of Money Financial Analysis Applications

The Time Value of Money

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 today’s 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.

Ignoring the time value of money in risk management decisions may lead to wrong decisions or, at least, less than optimal decisions. This result is especially true in capital budgeting where investment expenditures are usually made at "time zero," but the benefits of the investment are not realized until the future.

If the future cash flows are not adjusted for the time value of money, the value of the cash flows will be over-stated. 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.

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. As the NPV is positive, this project is acceptable.

The net present value of a project is the value added to the business if the project is undertaken. As the net present value is calculated using the organization’s required rate of return to discount the future cash flows back to present value, projects that have positive net present values provide a rate of return higher than the organization’s minimum acceptable return.

As such, the NPV is the "value added" to the organization by undertaking the project.

Financial Analysis Applications

Analyzing Insurance Coverage Bids Loss Control Investment Decisions

Use of Technology in Risk Management Programs

Risk Management Information Systems (RMIS) Other Technology Applications

A risk management information system is a computerized database that permits the risk manager to store and analyze risk management data and to use the data to predict future loss levels. Some risk management departments have established their own Web sites.

These Internet locations contain a wealth of risk management information about the company and answers to frequently asked questions (FAQs).

Risk management intranets are Web sites that incorporate search capabilities designed for an internal audience. Company personnel can access the Web site and search for the desired information.

A claims management database can hold a wealth of claims information. It can list all of the claims currently outstanding against the organization and the status of each of the individual claims (e.g. filed, in negotiation, in litigation, in the appeals process, or settled).

The claims database may also contain historical claims data, exposure bases, and liability insurance coverages and coverage terms.

Exhibit 4.2 Combined Ratio for All Lines of Property and Liability Insurance, 1956-2000

Exhibit 4.3 Relationship Between Payroll and Number of Workers Compensation Claims

Insight 4.2 Figure 1 Model Corporation with 900 Historical Claims

Insight 4.2 Figure 2 Enhanced Risk Map

Insight 4.2 Figure 3 Products Liability Risk Profile