1 Chapter 4 Risk Management 2: Advanced Topic

2 Introduction Three broad policy issues facing risk managers: –Risk Management Information Systems (RMIS) –Determining the appropriate amount of loss exposure to retain –International loss exposures

3 RMIS Risk managers use Risk Management Information Systems (RMIS) to: –record, –track and analyze losses, –Keep records to plant, property and equipment and how they are protected from losses, –Statistical Analysis, using past loss help to forecast losses –RMIS must be adapted to the needs of the individual organizations. Each organization facing different hazards (earth quake or flooding), different liability exposures (some have chemicals, some firms manufacture products) and differences in property value fluctuations. (Some having significant annual inventory annual changes) RMIS should be tailored to the needs of the firms.

4 Loss Data Loss records including injuries to workers, liability claims, or assets losses are the foundation of RMIS. Computerized data bases records on: –Frequency, severity, causes, final outcome of the losses are kept. –Outcomes are analyzed by statistical techniques such as regression analysis. E.g. P.73 Table 4-1 (RM analyses the data for developing an effective way to lower the no. Of accidents and costs. Classification such as: age, experience, weather conditions, time of the day) Operating RMIS is not easy as you may have inaccurate loss data, loss data, subsequent analysis or misleading forecasts. Comp. Should be updated, data should be audited randomly to enable accuracy.

5 Deductible and Policy Limits Problem: –How much loss exposures to retain; –How much to loss exposures to transfer. Deductibles (Retentions): Cause insured to bear the first dollars of a loss. Policy Limits: determine maximum insurance recovery. - If a loss is equal to or is less than the deductible, the insured bears the cost. - If a loss is greater than the policy limits, the insured bears the cost of any applicable deductible and the amount of loss above the policy limit. (example)

6 Overinsurance A point where deductibles are so small that company is insuring expenses or so much insurance is purchased to protect itself against the max. possible (worst case) loss rather than max. probable (average) loss Underinsurance  If the firm could not afford to pay its retentions and deductibles available from “normal” flow or If a probable loss could result in the firm’s insolvency (inability to pay currently due sums) or bankruptcy (the firms debts exceeds its available assets).

7 Financial and Other Considerations Risk manager should think: 1. Tax implications (Tax deductible expenses) 2. Ability to pay Losses  Usually lower policy limits is favoured but: a)the liquidity of assests-is there sufficient cash? b)The stability of net income. c)The amount of net worth. d)The increased cost of capital (Risky to lenders and investors)

8 Financial and Other Considerations (cont.) 3. Psychological Factors: experience, attitudes toward risk, habit and intuition. 4. Social Ethical Concerns: In the absence of adequate funding, uninsured losses could bankrupt organizations producing ethically undesired consequences. (e.g. Under- compensated dead, injured employees, polluted environment, unemployed workers)

9 International Risk Management Multinational and international firms operate worldwide. They face: 1)Foreign Currency: measurement and financing problems. 2) Political Risk: Trade embargoes cancellation of export licenses, expropriation (nationalization of foreign-owned property, war, terrorism, cultural differences) 3)Risk financing arrangements and practices vary widely throughout the world. 4) Movement of goods, a) Marine Insurance (inland and ocean) are important. b) Income Insurance: pays for losses caused by delays in receiving shipment are popular.

10 Foreign Insurance Generalization about foreign insurance arrangements are difficult to make Some countries allow foreigners to insure foreign owned property by their own brokers and insurers (e.g. USA) Insurers authorized to do business in an other country is called admitted insurers. Some foreign countries levy fines and other penalties on companies using nonadmitted insurers. Admitted insurers can be desirable because premiums and losses are dominated in local currency. Some RM may prefer nonadmitted insurers if they provide familiar policies with a common language and laws and more, nonadmitted insurer is providing international coverage for a large number of foreign operations.

11 Foreign Insurance (cont.) Firms try to develop a global insurance program (e.g. US firms): –An international insurer (or broker) having an international network of associations with local insurance companies. –Using admitted insurers in each country or a region but purchase a difference-in-conditions (DIC) policy from a for example US insurer. –DIC policy is written on a manuscript, tailor-made basis. –DIC policy supplements the local (foreign) property coverage by broadening the covered perils, increasing policy limits or doing both. –DIC policies allow e.g. the US firms to pay premiums to a US insurer and collect losses in $s if foreign insurer do not provide all the coverage the risk manager specifies. –With the DIC policy, the US firm can appeal global uniformity in coverage because the DIC supplement brings all policies up to its limits.

12 Financial Risk Management In addition to pure risks, firms face contingencies called financial risks. –Cost of capital, cash flow mgmt issues. Interest Rate Risk: caused by increasing interest rates reducing market value of fixed income securities. Credit Risk: caused by a borrower defaulting on a loan. Currency Risk: caused by fluctuations in the value of domestic currency against foreign currencies. Liquidity Risk: caused by having to liquidate an investment at an investment quickly. Market Risk: caused by having to liquidate an investment at an unfavorable price.

13 Financial Risk Management (Cont.) Potential loss sources can be managed by avoidance, assumption, and transfer. Since these exposures are not predictable and some exposures could prove catastrophic, insurance is not thought to be an option. Among the possible financial market transactions are: 1. Traded options 2. Futures contracts 3. Forward contracts 4. Swaps (Currency and interest swaps)