You are on page 1of 6

20RejdaPrinciplesofRiskManagementandInsurance,EleventhEdition

Chapter4
AdvancedTopicsinRiskManagement

Teaching Note
Someinstructorswantedalittlemoreextensivetreatmentofriskmanagementinthetext,focusingmore
onbusinessriskmanagement.Thischapterwasaddedtoaddressthisconcern.Asmanyinstructorsteach
thisasapersonalriskmanagementcourse,thischaptercanbeskippedwithoutlossofcontinuity.

Thechapterisorganizedasacollectionoftopics.Thefollowingtopicsarecovered:(1)thechanging
scopeofriskmanagement,(2)insurancemarketdynamics,(3)lossforecasting,(4)financialanalysisin
riskmanagementdecisionmaking,and(5)riskmanagementtools.Instructorsdesiringsomemore
quantitativeworkmaycovertheappendixattheendofthechapter.

Lecture Outline
I. TheChangingScopeofRiskManagement
A. FinancialRiskManagement
B. EnterpriseRiskManagement

II. InsuranceMarketDynamics
A. TheUnderwritingCycle
B. ConsolidationintheInsuranceIndustry
C. CapitalMarketRiskFinancingAlternatives

III. LossForecasting
A. ProbabilityAnalysis
B. RegressionAnalysis
C. ForecastingwithLossDistributions

IV. FinancialAnalysisinRiskManagementDecisionMaking
A. TheTimeValueofMoney
B. FinancialAnalysisApplications

2011PearsonEducation,Inc.PublishingasPrenticeHall
21RejdaPrinciplesofRiskManagementandInsurance,EleventhEdition
V. OtherRiskManagementTools
A. RiskManagementInformationSystems(RMIS)
B. RiskManagementIntranets
C. RiskMaps
D. ValueatRisk(VAR)Analysis
E. CatastropheModeling

Answers to Case Application


1. (a) (1) GWScouldbuyoilfuturescontractstohedgethefueloilpricerisk.Ifthepriceoffueloilis
lowerinthefuture,GWSwillbeabletopurchasefueloilatalowerpricebutlosemoneyon
itsfuturesposition.Ifthepriceoffueloilincreasesinthefuture,GWSwilllosemoneyby
havingtopayahigherpriceforfueloil,butitcanoffsetthehigherspotpricewithagainon
itsfuturesposition.
(2) GWSmayalsoconsideradoubletriggeroptioninsurancearrangementusingfueloilprices
andpropertylossesastriggers.Underthedoubletriggeroption,theinsurerwouldonly
makeapaymenttoGWSifbothcontingencieshighfuelpricesandhighpropertylosses
occurred.Theagreementwouldspecifyboththefuelpricepergallonandthelevelof
propertylossesthatwouldjointlytriggerpayment.Ifonlyonecontingencyoccurredor
neithercontingencyoccurred,theinsurerwouldhavenoliability.
(b) Thenetpresentvalue(NPV)ofaninvestmentprojectisequaltothepresentvalueofthefuture
cashflowslessthecostoftheproject.Using10percentasthediscountrate,theNPVofthis
projectis$22,171.30asshownbelow:

$25,000 $25,000 $25,000


NPV = - $40,000 + + +
(1 + 0.10) (1 + 0.10)
1 2
(1 + 0.10)3
NPV = - $40,000 + $22,727.27 + $20,661.16 + $18,782.87
NPV = $22,171.30
AstheNPVispositive,theprojectisacceptable.
TheNPVcouldalsohavebeencalculatedbytreatingthethree$25,000cashflowsasanordinary
annuity.
(c) Astheindependentvariableisthousandsofmilestraveled,theexpected640,000milesis
enteredintothepredictionas640.Substitutingthisvalueintotheregressionequationyieldsan
estimateofbetween16and17derailments,asshownbelow:

Y(#ofderailments)=2.31+0.22(640)
=2.31+14.08
=16.39

2011PearsonEducation,Inc.PublishingasPrenticeHall
Chapter4AdvancedTopicsinRiskManagement22

Answers to Review Questions


1. Threespeculativefinancialrisksthatariskmanagermayconsiderarecommoditypricerisk,interest
raterisk,andcurrencyexchangeraterisk.Traditionally,theseriskswereaddressedbyfinancial
managersratherthanriskmanagers.Theroleofsomeriskmanagershasexpandedtoconsidernot
onlypurerisks,butalsospeculativefinancialrisks.

2. Traditionalriskmanagementwaslimitedinscopetoproperty,liability,andpersonnelrelatedloss
exposures.Enterpriseriskmanagementisamuchbroaderconcept,encompassingtraditionalrisk
management.Inadditiontoconsideringproperty,liability,andpersonnelexposures,enterpriserisk
managementconsidersspeculativerisks,strategicrisks,andoperationalrisks.

3. Theunderwritingcyclereferstothetendencyforcommercialpropertyandliabilityinsurancemarkets
tofluctuatebetweenperiodsoftightunderwritingwithhighinsurancepremiumsandperiodsofloose
underwritingwithlowinsurancepremiums.Whenthepropertyandliabilityinsuranceindustryisina
strongsurplusposition,insurerscanlowerpremiumsandloosenunderwritingstandardstocompete
withotherinsurers.Ascompetitionincreases,thesurplusisdepletedthroughunderwritinglossesthat
developbecauseoflowpremiumsandlessstringentunderwriting.Ifinvestmentincomeisnot
availabletooffsettheunderwritinglosses,atsomepointpremiumsmustbeincreasedandunderwriting
standardstightened.Higherpremiumsandstricterunderwritinghelptorestoretheinsurerto
profitability.Asprofitabilityreturns,thedepletedsurplusisrestored,makingitpossibleforinsurers
toenterintocompetitionwithlowerpremiumsandlessstrictunderwriting.

Themarketishardwhenpremiumsarehighandunderwritingstandardsaretight.Themarketis
softwhenpremiumsarelowandunderwritingstandardsareloose.

4. Consolidationintheinsuranceindustryreferstothecombiningofinsurancebusinessorganizations
throughmergersandacquisitions.Threetypesofconsolidationhavebeenoccurring.First,insurance
companieshavebeenmergingwithoracquiringotherinsurancecompanies.Thecombinationof
St.PaulInsurancewithTravelersInsuranceisanexcellentexample,asistheacquisitionofSafeco
InsurancebyLibertyMutualInsuranceCompany.Second,insurancebrokerageshavebeenmerging
withoracquiringotherinsurancebrokerages(MarshacquiredSedgwick,forexample).Finally,there
hasbeencrossindustryconsolidation.Crossindustryconsolidationoccurswhenacompanyinone
financialservicesareamergeswithoracquiresacompanyinanotherfinancialservicesarea.For
example,abankmayacquireaninsurancecompanyoraninsurancecompanymaypurchasean
investment(mutualfund)company.

5. Securitizationtransfersinsurablerisktothecapitalmarketsthroughthecreationofafinancial
instrument,suchasacatastrophebond.Priortosecuritization,thecapacityoftheinsuranceindustry
waslimitedtothecapacityofinsurersandreinsurersoperatingintheindustry.Risksecuritization
providesanavenuethroughwhichinsurableriskisspreadtocapitalmarketparticipants
(e.g.,bondholders).

6 (a) Lossforecastingisnecessarytoenabletheriskmanagertomakeaninformeddecisionabout
whethertoretainortransferlossexposures.Theriskmanagerwillbeunabletoevaluatean
insurancecoveragebidunlessheorshehassomelevelofconfidenceaboutthemagnitudeof
expectedlossesandthereliabilityoftheestimate.Basedontheforecast,theriskmanagermay
believethataninsurancebidistoohighandoptforretention,orthattheinsurancebidislow
relativetotheexpectedlosses,andoptforinsurance.

2011PearsonEducation,Inc.PublishingasPrenticeHall
23RejdaPrinciplesofRiskManagementandInsurance,EleventhEdition
(b) Theriskmanagermayuseseveraltechniquestoforecastlosses.Probabilityanalysis,regression
analysis,andforecastingthroughlossdistributionsmaybeemployed.

2011PearsonEducation,Inc.PublishingasPrenticeHall
Chapter4AdvancedTopicsinRiskManagement24
7. Usingpastlossesalonetopredictfuturelossesisnotwise.Whilepastlossesmayhavesomebearing
uponfuturelosses,underlyingconditionsmayhavechanged.Thecompanymayhavesoldoffor
acquirednewoperations,expandedintonewmarkets,oralteredproductionprocesses.Theremaybe
otherexposuresthatproducelossesthisyearthatdidnotproducelossesinthepast.Whilepastloss
datamaybehelpful,additionalinformationshouldbeconsidered.

8. Timevalueofmoneyanalysisisemployedinriskmanagementdecisionmakingtoaccountforthe
interestearningcapacityofmoney.Thesameamountofmoneytobereceivedorpaidindifferent
timeperiodsisofdifferentvalueintermsoftodaysdollars,oncetheinterestearningcapacityofthe
moneyisconsidered.Failuretoconsidertheinterestearningcapacityofmoneymayleadtobadrisk
managementdecisions.

9. Thefuturecashflowsthataprojectwillgenerateareestimatedinthecapitalbudgetingprocess.In
additiontothecashbenefits(reducedcostsandincreasedrevenues),somevaluesthataredifficultto
quantifymaybeconsidered.Forexample,alosscontrolinvestmentmayresultinfewerlostwork
days,improvedmoraleofemployees,reducedabsenteeism,reducedpainandsuffering,animproved
publicimageofthecompany,andlessdowntimewhenareplacementworkermustbetrainedto
substituteforaninjuredworker.Theseitemsaredifficulttoquantifyincapitalbudgeting.

10. (a) Ariskmanagementinformationsystem(RMIS)isacomputerizeddatabasethatpermitsarisk


managertostoreandanalyzeriskmanagementdataandtousethedatatopredictfutureloss
levels.ManyorganizationsuseanRMISasatooltohelpmanageclaims.
(b) SomeriskmanagementdepartmentshaveestablishedtheirownWebsites.Thesesitescontain
awealthofriskmanagementinformationaboutthecompanyandanswerstofrequentlyasked
questions(FAQs).Riskmanagementintranetsareinternalnetworksthatincorporatesearch
capabilities.CompanypersonnelcanaccesstheWebsiteandsearchforthedesiredinformation.

Answers to Application Questions


1. Priortothechangingscopeofriskmanagementinthe1990s,insurersneededconsiderable
knowledgeofproperty,liability,andpersonnelriskstowritetheinsurancecoveragesdemanded.
Giventhechangesthathaveoccurredrecently,insurersalsoneedexpertiseinfinancial,strategic,
andoperationalissues.Forexample,aninsurerdesigningamultipletriggercontractmayneed
expertiseincommoditypricingaswellastraditionalinsurablelossexposures.Aninsurerdesigning
anenterpriseriskmanagementplanmayneedexpertiseincurrencyexchangeraterisk,the
organizationscompetitiveenvironment,interestraterisk,weatherrelatedrisk,andtraditional
propertyandliabilityinsurancerisks.

2. Propertyandliabilityinsurancemarketsfluctuate.Sometimespremiumsarehighandunderwriting
standardsaretight;atothertimes,premiumsarelowandunderwritingstandardsareloose.Inthis
case,selfinsurancewasprobablyusedthefirstyearbecausetheriskmanagerbelievedthattherisk
wasbesthandledinthiswayasopposedtopurchasinginsurance.Thechangeinthesecondyear
likelyreflectsadownturnininsuranceprices,makingcommercialinsurancethemostcosteffective
alternative.

2011PearsonEducation,Inc.PublishingasPrenticeHall
25RejdaPrinciplesofRiskManagementandInsurance,EleventhEdition
3. Therearehundredsofinsurancecompaniesoperatinginmoststates.Ifseveralofthesecompanies
merge,orifoneisacquiredbyanotherinsurer,themarketplaceremainsverycompetive.Broker
consolidationleavesfewerlargerplayersinthemarket.Whensomelargebrokeragesmerge,thereare
fewerlargebrokers(e.g.,MarshandAon)forariskmanagertocalluponwhenputtinganinsurance
programoutforbids.Forexample,ariskmanagerwasonceabletogetcompetitivebidsfrom
Johnson&Higgins(J&H),Marsh,andSedgwick.However,MarshacquiredJ&HandSedgwick.
Oftensmallernationalbrokeragesorregionalbrokeragesmustbeemployedinacompetitivebidding
process.

4. (a) Ignoringthetimevalueofmoneyinriskmanagementdecisionmakingmayleadtowrong
decisionsoratleastlessthanoptimaldecisions.Theresultisespeciallytrueincapitalbudgeting
whereinvestmentexpendituresareusuallymadeupfront,butthebenefitsoftheprojectsarenot
realizeduntilthefuture.Ifthefuturecashflowswerenotadjustedfortimevalueofmoney
considerations,thevalueofthefuturecashflowswouldbeoverstated.Projectsthatare
unacceptablewhenthetimevalueofmoneyisconsideredmayappeartobegoodprojectswhen
thetimevalueofmoneyisignored.
(b) TheNPVofaprojectisthevalueaddedtothebusinessiftheprojectisundertaken.Asthenet
presentvalueiscalculatedusingtheorganizationsrequiredrateofreturntodiscountthefuture
cashflowsbacktopresentvalue,projectsthathaveapositivenetpresentvalueprovidearateof
returnhigherthantheorganizationsminimumacceptablereturn.Assuch,theNPVisthevalue
addedtotheorganizationbyundertakingtheproject.

5. Selfinsuringworkerscompensationisacommonpractice.Useofselfinsuranceincreasesduring
hardinsurancemarkets,aspremiumsarehigherandunderwritingstandardsaretighter.Giventhe
cyclicalnatureofthecommercialpropertyandliabilityinsurancemarket,theriskmanagermay
wanttopurchaseinsurancenextyearifworkerscompensationinsurancepremiumshavedropped
significantly.Asworkerscompensationisanexperienceratedcoverage,theriskmanagerwantsto
makesurethatifthisyearsclaimsexperienceisfavorable,theriskmanagerwillbeabletodocument
thesuperiorperformancetoinsuranceunderwritersandobtainalowerpremiumfromtheinsurer.

2011PearsonEducation,Inc.PublishingasPrenticeHall