Fall 2008 Version Professor Dan C. Jones FINA 4355 Homework, Handout

Risk Management and Insurance: Perspectives in a Global Economy 1. Introduction to Risk Management and Insurance Professor Dan C. Jones FINA 4355 Homework, Handout

3 Study Points The importance of an international perspective Risk management and economic growth The language of risk and insurance internationally The environment for risk and insurance internationally

4 Risk and Economic Development (Figure 1.1) Level of Economic Development Risk

The Importance of an International Perspective

6 Decisions about how to deal with some risky activities and processes have become incredibly complex. The world is getting smaller! In most markets, a significant proportion of goods and services competes directly or indirectly with those of other countries. The proportion of cross-border trade continues to grow worldwide.

7 The Importance “Foreign direct investment (FDI)” inflows tend to grow at rates greater than merchandise trade Competitiveness is heightened as price differentiation becomes a less feasible alternative to improved operating efficiency. Even firms not directly involved in international activities are affected. In a global economy, the way risk is dealt with naturally differs to suit each country’s socio-cultural, demographic, political, and economic circumstances.

8 The Importance Decisions about how to deal with some risky activities and processes have become incredibly complex. The world is getting smaller! In most markets, a significant proportion of goods and services competes directly or indirectly with those of other countries. The proportion of cross-border trade continues to grow worldwide. See Figure 1.2

9 World Merchandise Trade and GDP (Figure 1.2) Source: WTO

10 The Importance The importance of “foreign direct investment (FID)” FDI inflows tend to grow at rates greater than merchandise trade Competitiveness is heightened as price differentiation becomes a less feasible alternative to improved operating efficiency. Even firms not directly involved in international activities are affected. In a global economy, the way risk is dealt with naturally differs to suit each country’s sociocultural, demographic, political, and economic circumstances.

Risk Management and Economic Growth

12 Growing Importance of Risk Management A rise in the number of high-value (highly protected) risks Resource concentration Pollution as another externality Risk management has assumed greater importance as its scope continues to expand. Today, it finds application in minimizing financial risks to business and in helping governments resolve public policy issues.

13 Role of Risk Management in Economic Growth By reducing long-term financial variability, risk management can render firms more competitive. From a macroeconomic standpoint, risk management techniques can reduce the number of commercial and industrial enterprises that would otherwise become insolvent. Effective loss control measures can reduce the frequency and severity of work-related injuries and illnesses, work interruption, and other causes of economic losses. It can reduce production costs, which in turn can make goods and services available to consumers at lower cost.

The Language of Risk and Insurance Internationally

15 Defining Risk and Insurance “International risk” and “international insurance” commonly refer to (1) unintended outcomes and (2) insurance transactions that transcend or cross national boundaries. International risk can also flow from the consequences of international business activities. The importance of the concepts on both a cross-border and comparative basis.

16 Country Classifications By stage of economic development Developed market economies Also known as high-income countries, advanced countries, economically advanced countries, industrialized countries, the north, and the first world. “Newly industrialized economies” Developing economies Also known as underdeveloped countries, undeveloped countries, low- (or middle-) income countries, the south and the third world. Emerging markets Economies in transition

17 Country Classifications By stage of economic development (continued) Least developed countries Centrally planned economies Also known as planned economies, Communist countries, and the second world

18 World’s Distribution of GDP, Trade and Population

19 Country Classifications By membership in international organizations Global organizations The United Nations The International Monetary Fund The World Bank The World Trade Organization (WTO) The World Health Organization (WHO)

20 Country Classifications By membership in international organizations (continued) Regional organizations The Organization for Economic Cooperation and Development The European Union The North American Free Trade Agreement Association of Southeast Asian Nations Asia-Pacific Economic Cooperation Southern Cone Common Market Common Market for Eastern and Southern Africa Ask Students to find information about other organizations.

21 OECD Member Countries

22 E.U. Members and Applicants

23 Risk Classifications Risk Loss exposure Peril Hazard Physical hazard Moral hazard

24 Risk Classifications – Risks Pure risk Financial risk Market risk Interest rate risk Exchange rate risk Other systematic risk Credit (counterparty) risk Price risk

25 Risk Classifications – Risks Operational (internal) risk Personal risk Personnel risk Property risk Liability risk Concentration risk Reputational risk Strategic risk

26 Risk Management Process The process Risk analysis Identification and evaluation of the possible outcomes associated with events or activities Risk control Exploration of techniques to control adverse outcomes Risk financing How to finance the costs of adverse outcomes that occur The view of risk management is changing A fragmented approach to the management of risk is less effective and efficient than an integrated approach that involves all the risks to which an entity is exposed.

27 Insurance Classifications Social vs. private insurance Life vs. nonlife insurance Nonlife insurance also known as general insurance, property- casualty and property-liability insurance Life insurance dealing with: Death Living a certain period Incapacity (disability and long-term care need) Injury or incurring a disease Chap 9 (Social Insurance) Chap 20 (Insurance Globally)

28 Insurance Classifications Personal vs. commercial insurance Industrial insurance Large risks and mass risks in the E.U. Direct insurance vs. reinsurance Direct (writing) insurer, primary insurer Direct premium Reinsurer, assuming company Reinsurance premium Retrocession and retrocessionaire Chap 21 (Life Insurance) Chap 22 (Nonlife Insurance) Chap 23 (Reinsurance)

29 The Changing Environment and Risk Management Rapidly Changing Environment  Greater Uncertainty  Increased Need for Effective Risk Management

Discussion Questions

31 Discussion Question 1 Is an appreciation for international events important to students of risk management and insurance, even if they intend to work exclusively for domestic firms with no international operations?

32 Discussion Question 2 Is the study of risk management becoming more or less important in your country?

33 Discussion Question 3 What special risks would you expect multinational corporations to encounter that purely national firms ordinarily would not encounter? Speculate about some of the ways of dealing with such special risks.

34 Discussion Question 4 Randomly select one economically developed country and one developing country, and compare classification of insurance between the two countries.

35 Discussion Question 5 What do you think are the prerequisites for the development of insurance in economically underdeveloped countries?