Topic 2. Risk and Risk Management Bus 200 Introduction to Risk Management and Insurance Jin Park

Overview Terminology Risk Perils, Hazards ERM, IRM Risk Management process

Terminology Risk Deviation from expectation Worse than expected Better than expected Uncertainty concerning a loss Uncertainty Loss (cf. Loss exposure) Pure vs Speculative Fundamental vs Particular Systematic vs Nonsystematic (Diversifiable) Objective vs Subjective

Terminology Pure Risk Loss or no loss Fire Risk management & Insurance Speculative Risk Loss or gain No loss/gain Investment Finance Enterprise Risk Management deals with managing both risks in a firm

Terminology Perils (Immediate) Causes of loss Hazards Physical hazards Moral hazards Morale hazards

Risk Management Risk management A systematic process for managing (pure) risks faced by an individual or organization. Pre-loss risk management Should prepare for potential loss in the economical way possible Post-loss risk management Survival of the organization Continuation of operation Stability of earnings

Risk Management Process Identify risks or exposures to loss Evaluate risks or exposures to loss Identify and select risk management techniques Implement and monitor

Identify Risks Organization Property Liability Business income Death or disability of key persons Job-related injuries or disease Fraud, dishonesty, crime International operation Individual Property Liability Premature death or disability Unemployment Sickness Liability

Identify Risks Physical inspection Questionnaire Financial statement analysis Flowchart Contract analysis Statistical analysis of past losses Risk management information system (RMIS)

Evaluate Risks Risk management matrix Frequency Severity High Low Frequency Severity

Evaluate Risks Risk mapping High Low Frequency Severity

Identify and select RM techniques Risk avoidance Risk retention (Risk assumption) Self-insured Captive Risk reduction (control) Loss prevention – frequency Loss reduction – severity Risk transfer Insurance Non-insurance Example: Sprinkler, Hold-harmless agreement, ignorance, safety education, smoke alarm, deductible, warm-up, rent

Identify and select RM techniques Risk mapping Critical issue tolerance boundary or risk- tolerance boundary Prioritize risks

Implement and Monitor Are techniques implemented correct? If not, …

Insurance Advantages Uncertainty is reduced Insurers can provide. their expertise such as loss control services. Insurance premium is tax-deductible. Insurance proceeds are tax-free. Disadvantages Insurance premium may be a major cost. Moral and morale hazards may be created. Time and effort have to be spent. Insurance may not be renewed.

Others CAT bonds Forward/Future Swaps Options Securitizations CDO, CMO, CBO, CLO

Enterprise risk management Integrated risk management The process of planning, leading and controlling the activities of an organization to minimize the effects of risk on earnings and capital A holistic approach to risks faced by a firm Risk management has to be integrated among various players in a firm Requires a (strategic) risk management policy Needs support from the top level of a firm

The Three Faces of Risk Management Although most companies have their bases covered should they meet with fire, theft or flood, such hazards represent … Explains about ERM allows organizations to examine all the risks they face measure the potential impact of those risks on the long-term viability of the company take the appropriate steps to manage or mitigate those risks. "The goal is to ensure the continuity of the enterprise“ "This is an opportunity to get to know your risks better than your competitors. It can also leave you in a position to be able to take on more risk — the type of risk that can help improve company performance." An example of an electronics manufacturer

Top Cops Explains about CRO Explains about ERM "We're building the capability internally to identify all risks, analyze and quantify them, and then determine the optimum means of mitigating, absorbing, or transferring them.” “When that's done, we will decide on an ongoing basis which risks to keep and which to transfer. Then we can effect the transfer through our trading desks, financial markets, insurance carriers, integrated risk policies, OTC [over-the- counter] transactions, or a contractual transfer to another party entirely.“ other CROs are working closely with insurance brokers, accounting firms, and risk management consultants to lead the way,

Illinois Power The Risk Register a comprehensive risk-assessment system a formal process that identifies, quantifies and categorizes the risks facing Illinois Power, develops cost- effective methods to control them and positions the company to achieve its stated goals

Illinois Power Benefits of the Risk Register aware of the catastrophic risks aware of the fact that its pre-loss risk management was not adequate developed a more efficient and effective post-loss risk management program built risk-related database

Illinois Power IDENTIFYING THE RISKS regardless of insurability CONSIDERING CONTROL TECHNIQUES disregarding cost or appropriateness of any method SELECTING RISK CONTROLS subjected to a reasonableness test and a thorough economic evaluation IMPLEMENTATION MONITORING

UPS Why small firms? Why not large firms? Why not pharmaceutical firms? Lessons "Use more than one delivery company.“ "August is a good time for a strike, because there is not a lot of stuff being done."

Domino effects ???

Next- Loss Exposures ETTI: Chapter 1, pp. 16 – 18 ETTI: Chapter 8, pp. 162 – 164, 170 – 172, 173 – 176 ETTI: Chapter 9, pp Business continuity planning: Preparing for the worst, KPMG Insiders, June 10, 2002Business continuity planning: Preparing for the worst 2. U.S. firms underestimate IT risks, Insurance Day, June 14, 2002U.S. firms underestimate IT risks 3. Prudent Man with a Plan, CFO Magazine, June 18, 2002.Prudent Man with a Plan 4. Warning: A batman cape won’t help you fly, New York Times, March 5, 1997.Warning: A batman cape won’t help you fly 5. Jury awards $12 million in voic hang-up, Chicago Tribune, April 3, 2003.Jury awards $12 million in voic hang-up 6. $36 million awarded to heirs of 2 killed in freak accident, Chicago Tribune, date unknown.$36 million awarded to heirs of 2 killed in freak accident