1. Chapter Outline 12.1Risk Identification and Evaluation Identifying Exposures Property Loss Exposures Liability Losses Losses to Human Capital Losses from External Economic Forces Evaluating the Frequency And Severity of Loss Frequency Severity Expected Loss and Standard Deviation

2. Chapter Outline 12.2Retention and Insurance Revisited Benefits of Increased Retention Savings on Premium Loadings Reducing Exposure to Insurance Market Volatility Reducing Moral Hazard Avoiding High Premiums Caused by Asymmetric Information Avoiding Implicit Taxes due to Insurance Price Regulation Maintaining Use of Funds Costs of Increased Retention Closely-held vs. Publicly-Traded Firms with Widely Held Stock Firm Size and Correlation Among Losses Correlation of Losses with Other Cash Flows and with Investment Opportunities Financial Leverage A Basic Guideline for Optimal Retention

3. Chapter Outline 12.3Benefits and Costs of Loss Control Basic Cost-Benefit Tradeoff Examples of Identifying Benefits and Costs Installation of Automatic Sprinkler System Installation of Safety Guards Child-Resistant Packaging of Non-Prescription Drugs Qualitative vs. Quantitative Decision-Making 12.4Statistical Analysis in Risk Management Approximating Loss Distributions with the Normal Distribution Illustration Problems and Limitation Computer Simulation of Loss Distributions Illustration Comparison of Results to Assuming the Normal Distribution Limitations of Computer Simulation

4. Chapter Outline 12.5Use of Discounted Cash Flow Analysis The Net Present Value Criterion Example: Forming a Captive Insurer The Appropriate Cost of Capital 12.6Summary

5. Benefits of Increased Retention – Savings on insurance premium loadings Administrative costs Reducing ______ hazard Avoid being pooled with higher risk policyholders Avoid implicit _____ from insurance regulation – Reducing exposure to _______ market volatility – Allows firm to maintain use of funds ___________

6. Costs of Increased Retention – Increased probability of financial _______ Bankruptcy is costly Possibility of distress affects contractual terms with other claimants – Increased probability of raising ________ capital – Forego _____ benefits – Forego ________ in bundling services

7. Factors Affecting Costs of Increased Retention – ________ structure (closely-held vs. widely-held firms) – Firm size – Correlation among _______ – Correlation of losses with other______flows – Correlation of losses with investment opportunities – Financial leverage

8. Basic Guideline for Optimal Retention Retain reasonably predictable losses and _______ potentially large disruptive losses – Not always right (BP case) – But often is

9. British Petroleum Case British Petroleum – Perspective risk management strategy 1990 – Basic Businesses Exploration Oil Refining, Distribution, and Retailing Chemicals (small) Nutrition (small)

10. British Petroleum Case Financial Data – Capital Structure Equity = $35 billion Debt = $15 billion – After-tax profit average = $1.9 billion standard deviation = $1.1 billion – Assets Diversified: 13,000 service stations in 50 countries Undiversified: ____ ________

11. British Petroleum Case Loss Exposures (in $ million) E xpected Range Number Average Annual Standard $ million per year Severity Loss Deviation $0 - $10 1845 0.03 52 12 (vehicle accidents, injuries, small fires, equipment failures) $10 - $500 1.7 40.0 70 98 (refinery fires, explosions, minor oil spills) $500 + 0.03 1000 35 233 (major oil spills, tort claims from release of chemicals, major loss of life, defective fuel causing airplane disaster)

12. British Petroleum Case Previous Strategy Range Approach $0 - $10 centralized insurance purchases and _____ ________ $10 - $500 externally insured $500 + ____________

13. British Petroleum Case Conclusions for First Range of Exposures – _________ insurance decisions – More insurance (Why?) local insurers are more ________ in –loss control –claims processing insurance markets are __________ insurer insolvency not a concern

14. British Petroleum Case Conclusions for Second Range of Exposures – _____________ (Why?) impact of losses on equity and income is small little competition in insurance market insurer _________ a concern contract enforcement is costly BP has ____________ advantage in loss control

15. British Petroleum Case Conclusions for Third Range of Exposures – Continue to Self-Insure insurance _________ (not credible)