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Topics in
Risk
Managemen
t

The following topics will be covered:

(1) the changing scope of risk management
(2) insurance market dynamics
(3) loss forecasting
(4) financial analysis in risk management
decision making
(5) use of technology in risk management
programs

The Changing Scope of Risk

Management

Financial Risk Management

Enterprise Risk Management

Financial Risk Management

Three financial risks that a risk

manager may consider are:
- commodity price risks
- interest rate risk
- currency exchange rate risk
Traditionally, such risks were not
considered in risk management.

Managing Financial
Risks

Given the changes that have occurred

recently, insurers will also need
expertise in financial, strategic, and
operational issues.

For example, an insurer designing a

dual trigger option package will need
to possess expertise in commodity
prices.

An insurer designing an enterprise

risk management plan may need
expertise in currency exchange rate
risk, the organizations competitive
environment, interest rate risk,
weather-related risks, and traditional
property and liability insurance risks.

Enterprise Risk Management

Traditional risk management is

limited in scope to considering
property, liability, and personnel loss
exposures.
Enterprise risk management is a
much broader concept,
encompassing traditional risk
management.

In addition to the considering

property, liability, and personnel loss
exposures;
enterprise risk management also
considers:
speculative risks
strategic risks
operational risks.

Insurance Market Dynamics

The Underwriting Cycle

Consolidation in the Insurance Industry

The Underwriting Cycle

The underwriting cycle refers to the

tendency for commercial property and
liability insurance markets to fluctuate
between periods of tight underwriting
with high insurance premiums and
loose underwriting with low insurance
premiums.

When the property and liability

insurance industry is in a strong
surplus position, insurers can lower
premiums and loosen underwriting
standards.

Competition sets in, and the surplus

is depleted through underwriting
losses arising from low premiums
and loose underwriting standards.

If investment income is not available

to offset underwriting losses, at
some point premiums must be
increased and tighter underwriting
employed.

Higher premiums and tighter

underwriting standards will help to
restore surplus, making it possible
once again for insurers to reduce
premiums and loosen underwriting
standards.

The insurance market is "hard" when

premiums are high and underwriting
standards are tight.
The insurance market is "soft" when
premiums are low and underwriting
standards are loose.

Insurance Industry
Capacity
Investment Returns

Investment
Returns

The future cash flows that a project

will generate are merely estimates
of the benefits of investing in the
project.
In addition to cash benefits (reduced
expenses and increased revenues),
some values are very difficult to
quantify.

For example, employee morale,

reduced pain and suffering, public
perceptions of the company, and
lost productivity when a new worker
must be hired to replace an injured
worker are difficult to measure.

Consolidation in the Insurance Industry

Consolidation in the insurance

industry refers to the combining of
insurance business organizations
through mergers and acquisitions.
Three types of consolidation have
been taking place.

Insurance Company Mergers and

Acquisitions
Insurance Brokerage Mergers and
Acquisitions
Cross-industry Consolidation

First, insurance companies have

been merging with or acquiring
other insurance companies.
Second, insurance brokerages have
been merging with or acquiring
other insurance brokerages.
Finally, there has been crossindustry consolidation.

Cross-industry consolidation refers

to businesses in one financial
services area are merging with or
acquiring firms in another financial
services area.
For example, a bank may acquire an
insurance company and a stock
brokerage company.

There are hundreds of insurance

companies operating in most
states.
Should several of these insurance
companies merge or if one insurer
is acquired by another insurer, there
are still hundreds of insurance
companies from which to choose.

There are fewer large insurance

brokerages.
When some of the large insurance
brokers merge (e.g. the
consolidation of Sedgwick, MarshMac, and Johnson & Higgins), there
are fewer large brokers for the risk
manager to call upon for coverage
bids.

In the case of insurance brokerage

mergers, there are fewer large
brokers to begin with, and even
fewer after these consolidations.

Loss Forecasting

Loss forecasting is necessary to

enable the risk manager to make an
informed decision about whether to
retain or transfer loss exposures.

The risk manager will be unable to

evaluate an insurance coverage bid
unless he or she has a handle on
what the loss levels are most likely
to be and the reliability of the
estimate.

Using past losses alone to predict

future losses is not wise.
While past losses may have some
bearing upon future losses,
conditions may have changed.

The company may have sold-off or

acquired new operations, expanded
into new markets, or altered
production processes.
There may be other exposures that
produce losses this year that did not
produce losses in the past.

While past losses may be helpful,

additional information should also be
considered.

Based on the forecast, the risk

manager may believe that an
insurance bid is too high and opt for
retention, or that the insurance bid is
low relative to the expected losses
and opt for risk transfer.

The risk manager may employ several

techniques to forecast losses.
Probability analysis, regression
analysis, and forecasting using loss
distributions may be employed.

Probability Analysis
Regression Analysis
Forecasting Using Loss Distributions

Financial Analysis in Risk Management

Decision Making

The Time Value of Money

Financial Analysis Applications

The Time Value of Money

Time value of money analysis is

employed in risk management
decision making to account for the
interest-earning capacity of money.

The same amount of money to be

received or paid in different time
periods is of different value in terms
of todays dollars, once the interestearning capacity of the money is
considered.
Failure to consider the interestearning capacity of money may lead
to bad risk management decisions.

Ignoring the time value of money in

risk management decisions may lead
to wrong decisions or, at least, less
than optimal decisions.
This result is especially true in
capital budgeting where investment
expenditures are usually made at
"time zero," but the benefits of the
investment are not realized until the
future.

If the future cash flows are not adjusted

for the time value of money, the value
of the cash flows will be over-stated.
Projects that are unacceptable when
the time value of money is considered
may appear to be good projects when
the time value of money is ignored.

The net present value (NPV) of an

investment project is equal to the
present value of the future cash
flows less the cost of the project.
As the NPV is positive, this
project is acceptable.

The net present value of a project is

the value added to the business if
the project is undertaken.
As the net present value is
calculated using the organizations
required rate of return to discount
the future cash flows back to present
value, projects that have positive net
present values provide a rate of
return higher than the organizations
minimum acceptable return.

As such, the NPV is the "value

added" to the organization by
undertaking the project.

Financial Analysis Applications

Analyzing Insurance Coverage

Bids
Loss Control Investment
Decisions

Use of Technology in Risk

Management Programs

Risk Management Information

Systems (RMIS)
Other Technology Applications

A risk management information

system is a computerized database
that permits the risk manager to
store and analyze risk management
data and to use the data to predict
future loss levels.
Some risk management
departments have established their
own Web sites.

These Internet locations contain a

wealth of risk management
information about the company and
answers to frequently asked
questions (FAQs).

Risk management intranets are Web

sites that incorporate search
capabilities designed for an internal
audience.
Company personnel can access the
Web site and search for the desired
information.

A claims management database can

hold a wealth of claims information.
It can list all of the claims currently
outstanding against the organization
and the status of each of the
individual claims (e.g. filed, in
negotiation, in litigation, in the
appeals process, or settled).

The claims database may also

contain historical claims data,
exposure bases, and liability
insurance coverages and coverage
terms.

Exhibit 4.2 Combined Ratio for All

Lines of Property and Liability
Insurance, 1956-2000

Exhibit 4.3 Relationship Between

Payroll and Number of Workers
Compensation Claims

Insight 4.2 Figure 1 Model

Corporation with
900 Historical Claims

Insight 4.2 Figure 2 Enhanced Risk

Map

Insight 4.2 Figure 3 Products

Liability Risk Profile