FINRISK

Risk managementFINRISKTess R. DimayacyacSY 2015 2016 First SemFINANCIAL RISK MANAGEMENTFinancial Risk Management will introduce students to the risk management process and the implementation of an enterprise risk management programs or activities. The course will provide an introduction to the essentials of risk management , types of risks, measurement and estimation risk, facilities to shift or trade risk, assess effects of risk exposure and form risk mitigation strategies as well as evaluation of ERM performance.

Course Objectives:Interpret the types of risk and detect ways to measure themAssess the effects of risk on corporate performance Carry out methods used to manage risk Deconstruct the process and techniques used to evaluate riskStructure enterprise risk management plan, focusing on its benefit and impact to firm value and performanceFirst 2 weeksIdentify Risk ExposureDefinition of RiskTypes of RiskRisk ExposuresriskRISK can be defined as the threat or probability that an action or event, will adversely or beneficially affect an organization's ability to achieve its objectives*.

In simple terms risk is Uncertainty of Outcome, either from pursuing a future positive opportunity, or an existing negative threat in trying to achieve a current objective.

Characteristics of riskUncertainty the risk may or may not happen, that is, there are no 100% risks (those, instead, are called constraints)Loss the risk becomes a reality and unwanted consequences or losses occur

Types of risk

Pure versus speculativePure Risk exists when there is uncertainty as to whether loss will occur. No possibility of gain is presented - only the potential for loss.

Speculative risk exists when there is uncertainty about an event that can produce either a profit or a loss.

Both pure and speculative risks may be present in some situations.Subjective versus objectiveSubjective risk refers to the mental state of an individual who experiences doubt or worry as to the outcome of a given event It is essentially the psychological uncertainty that arises from an individuals mental attitude or state of mind Objective risk differs from subjective risk in the sense that it is more precisely observable and therefore measurable It is the probable variation of actual from expected experience

Sources of riskProperty risks Risk that property may be damaged, destroyed or stolen For example, lightning, tornadoes, hurricanes, explosions, riots, collisions, falling objects, floods, earthquakes, freezing, etc. Liability risks Legal judgments may result in payments made to compensate injured parties as well as to punish those responsible for the injuries Even if the individual is absolved of liability the expenses involved in the defense may be substantial All individuals who own or use real property are susceptible to liability losses if others are injured on their premises Sources of riskLife and health and loss of income risks The possibility of the untimely death of a star salesperson The potential death of a parent with young children Employees who become ill or injured in accidents Financial risk Include credit risk, foreign exchange risk, commodity risk, and interest rate risk These risks must be identified and assessed in order for the firm to achieve its business goals Sources of riskLife and health and loss of income risks The possibility of the untimely death of a star salesperson The potential death of a parent with young children Employees who become ill or injured in accidents Financial risk Include credit risk, foreign exchange risk, commodity risk, and interest rate risk These risks must be identified and assessed in order for the firm to achieve its business goals Why do Financial Institutions try to Manage Risk ?Global trends are leading to The rising importance of risk management In financial institutionsMore complex marketsGlobal marketsGreater product ComplexityNew businesses (e-banking, merchant banking,)Increasing competitionNew playersRegulatory imbalances

IncreasedRisk The leading institutions will be distinguished by their intelligent management of risk.In the future . . .Importance of risk managementBusinesses must manage risks in ways that support public interest, human safety, the environment, and state and federal laws. Risk management is necessary for effective financial, marketing, production, and human resource management decisions. Risk management reduces the adverse effects of risk on business resources, cash flow, and profits.Why do we need Risk Management?The only alternative to risk management is crisis management --- and crisis management is much more expensive, time consuming and embarrassing. JAMES LAM, Enterprise Risk Management, Wiley Finance 2003

Without good risk management practices, government cannot manage its resources effectively. Risk management means more than preparing for the worst; it also means taking advantage of opportunities to improve services or lower costs. Sheila Fraser, Auditor General of Canada

Business risk is the possibility of business loss or failure. There are three kinds of business risks:economicnaturalhumanEconomic riskEconomic risks occur from changes in overall business conditions. These changes can include: the amount or type of competitionchanging consumer lifestylespopulation changeslimited usefulness or style of some productsproduct obsolescenceinflationrecessiongovernment regulation

Natural risks are risks resulting from natural causes such as:

floodstornadoeshurricanesfiresLightningdroughtsearthquakesunexpected changes in weather conditionsUnexpected losses from some natural risks (e.g., fire) can be insured against; other natural risks (unpredictable weather) cannot be insured against.

Natural riskHuman riskHuman risks are caused by human mistakes, as well as the unpredictability of customers, employees, or the work environment. Human risks include:customer dishonestytheft, fraudulent payment, or nonpaymentemployee error, negligence, incompetence, and theft customer or employee accidents21

34.1Graphic OrganizerTypes of RiskEconomicNaturalHumanRISKCompetitionConsumer Lifestyle ChangesPopulation ChangesObsolescenceLimited Product UsefulnessGovernment RegulationInflationRecessionFloodsTornadoesHurricanesFiresLightningSnowstormsEarthquakesDroughtsMistakesTheftFraudComputer CrimeCustomer/Employee UnpredictabilityWork Environment UnpredictabilityRisk managementRisk is the possibility of financial loss. Risk management is the systematic process of managing an organization's risk exposure to achieve objectives in a manner consistent with public interest, human safety, environmental factors, and the law. risk management is a continual process of corporate risk reduction. Risk management is really about how firms actively select the type and level of risk that it is appropriate for them to assume.

Objectives of risk managementRisk management has objectives before and after a loss occursPre-loss objectives:Prepare for potential losses in the most economical wayReduce anxietyMeet any legal obligationsObjectives of risk managementPost-loss objectives:Ensure survival of the firmContinue operationsStabilize earningsMaintain growthMinimize the effects that a loss will have on other persons and on societyWhats the Plan?IdentificationQuantificationResponseMonitoring and Control

25Risk management processIdentify potential lossesMeasure and analyze the loss exposuresSelect the appropriate combination of techniques for treating the loss exposuresImplement and monitor the risk management program

Steps in risk management

Identifying Loss ExposuresProperty loss exposuresLiability loss exposuresBusiness income loss exposuresHuman resources loss exposuresCrime loss exposuresEmployee benefit loss exposuresForeign loss exposuresIntangible property loss exposuresFailure to comply with government rules and regulations28Identifying Loss ExposuresRisk Managers have several sources of information to identify loss exposures:QuestionnairesPhysical inspectionFlowchartsFinancial statementsHistorical loss dataIndustry trends and market changes can create new loss exposures.e.g., exposure to acts of terrorism 29Measure and Analyze Loss ExposuresEstimate the frequency and severity of loss for each type of loss exposureLoss frequency refers to the probable number of losses that may occur during some given time periodLoss severity refers to the probable size of the losses that may occurOnce loss exposures are analyzed, they can be ranked according to their relative importanceLoss severity is more important than loss frequency:The maximum possible loss is the worst loss that could happen to the firm during its lifetimeThe probable maximum loss is the worst loss that is likely to happen30Select the Appropriate Combination of Techniques for Treating the Loss ExposuresRisk control refers to techniques that reduce the frequency and severity of lossesMethods of risk control include:AvoidanceLoss preventionLoss reductionAvoidance means a certain loss exposure is never acquired, or an existing loss exposure is abandonedThe chance of loss is reduced to zeroIt is not always possible, or practical, to avoid all losses31Select the Appropriate Combination of Techniques for Treating the Loss ExposuresLoss prevention refers to measures that reduce the frequency of a particular losse.g., installing safety features on hazardous productsLoss reduction refers to measures that reduce the severity of a loss after is occurse.g., installing an automatic sprinkler system32Select the Appropriate Risk Management TechniqueRisk financing refers to techniques that provide for the funding of lossesMethods of risk financing include:RetentionNon-insurance TransfersCommercial Insurance

33Risk Financing Methods: RetentionRetention means that the firm retains part or all of the losses that can result from a given lossRetention is effectively used when:No other method of treatment is availableThe worst possible loss is not seriousLosses are highly predictableThe 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 firmThe maximum retention may be calculated as a percentage of the firms net working capital

34Risk Financing Methods: RetentionA risk manager has several methods for paying retained losses:Current net income: losses are treated as current expensesUnfunded reserve: losses are deducted from a bookkeeping accountFunded reserve: losses are deducted from a liquid fund Credit line: funds are borrowed to pay losses as they occur35Risk Financing Methods: RetentionA captive insurer is an insurer owned by a parent firm for the purpose of insuring the parent firms loss exposuresA single-parent captive is owned by only one parentAn association or group captive is an insurer owned by several parentsMany captives are located in the Caribbean because the regulatory environment is favorableCaptives are formed for several reasons, including:The parent firm may have difficulty obtaining insuranceTo take advantage of a favorable regulatory environmentCosts may be lower than purchasing commercial insuranceA captive insurer has easier access to a reinsurerA captive insurer can become a source of profit Premiums paid to a captive may be tax-deductible under certain conditions36Risk Financing Methods: RetentionSelf-insurance is a special form of planned retention Part or all of a given loss exposure is retained by the firmAnother name for self-insurance is self-fundingWidely used for workers compensation and group health benefitsA risk retention group is a group captive that can write any type of liability coverage except employer liability, workers compensation, and personal linesFederal regulation allows employers, trade groups, governmental units, and other parties to form risk retention groupsThey are exempt from many state insurance laws

37Risk Financing Methods: RetentionAdvantages

Save on loss costsSave on expensesEncourage loss preventionIncrease cash flow

Disadvantages

Possible higher lossesPossible higher expensesPossible higher taxes38Risk Financing Methods: Non-insurance TransfersA 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 agreements39Risk Financing Methods: Non-insurance TransfersAdvantages

Can transfer some losses that are not insurableSave moneyCan transfer loss to someone who is in a better position to control lossesDisadvantages

Contract language may be ambiguous, so transfer may failIf the other party fails to pay, firm is still responsible for the lossInsurers may not give credit for transfers 40Risk Financing Methods: InsuranceInsurance is appropriate for loss exposures that have a low probability of loss but for which the severity of loss is highThe 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 insuredAn 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 retainThe risk manager selects the insurer, or insurers, to provide the coverage.

41Risk Financing Methods: InsuranceThe risk manager negotiates the terms of the insurance contractA manuscript policy is a policy specially tailored for the firmLanguage in the policy must be clear to both partiesThe parties must agree on the contract provisions, endorsements, forms, and premiumsThe risk manager must periodically review the insurance program42Risk Financing Methods: InsuranceAdvantages

Firm is indemnified for lossesUncertainty is reducedInsurers may provide other risk management servicesPremiums are tax-deductibleDisadvantages

Premiums may be costlyOpportunity cost should be consideredNegotiation of contracts takes time and effortThe risk manager may become lax in exercising loss control

43Market Conditions and the Selection of Risk Management TechniquesRisk managers may have to modify their choice of techniques depending on market conditions in the insurance marketsThe insurance market experiences an underwriting cycleIn a hard market, when profitability is declining, underwriting standards are tightened, premiums increase, and insurance becomes more difficult to obtainIn a soft market, when profitability is improving, standards are loosened, premiums decline, and insurance become easier to obtainImplement and Monitor the Risk Management ProgramImplementation of a risk management program begins with a risk management policy statement that:Outlines the firms risk management objectives Outlines the firms policy on loss controlEducates top-level executives in regard to the risk management processGives the risk manager greater authority Provides standards for judging the risk managers performanceA risk management manual may be used to:Describe the risk management programTrain new employees 45Implement and Monitor the Risk Management ProgramA 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 attainedThe risk manager should compare the costs and benefits of all risk management activities46Benefits of Risk ManagementPre-loss and post-loss objectives are attainableA risk management program can reduce a firms cost of riskThe cost of risk includes premiums paid, retained losses, outside risk management services, financial guarantees, internal administrative costs, taxes, fees, and other expensesReduction in pure loss exposures allows a firm to enact an enterprise risk management program to treat both pure and speculative loss exposuresSociety benefits because both direct and indirect losses are reduced 47Personal Risk ManagementPersonal 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 risksThe same principles applied to corporate risk management apply to personal risk management48