Chapter 4

UNIT 1
ADVANCED TOPICS
IN RISK MANAGEMENT
After studying this Chapter, you should be able to

Explain the meaning of Financial Risk

Management and Enterprise Risk Management.

Describe how the risks of terrorism and climate

change impact risk management.

Describe the impact of the underwriting cycle and

consolidation in the Insurance industry on the
practice of risk management.

Describe other risk management tools that may

be of assistance to risk managers.
 1. THE CHANGING SCOPE OF RISK MANAGEMENT

Traditionally, risk management was limited in

scope to pure loss exposures, including property
risks, liability risks, and personnel risks. An
interesting trend emerged in the 1990s, however,
as many businesses began to expand the scope
of risk management to include speculative
financial risks. Some businesses have gone a step
further, expanding their risk management
programs to consider all risks faced by the
organization and the strategic implications of the
risks.
 1. THE CHANGING SCOPE OF RISK MANAGEMENT

A. Financial Risk Management

Financial System is composed of the products and

services provided by Financial Institutions that
serve to facilitate economic transactions. Virtually
all economic transactions are effected by one or
more of these financial institutions. They create
financial instruments, such as stocks and bonds,
pay interest on deposits, lend money to
creditworthy borrowers, and create and maintain
the payment systems of modern economies.
 1. THE CHANGING SCOPE OF RISK MANAGEMENT

Financial Institutions are an institutions that

provide financial services (i.e. financial advice and
planning; foreign currency exchanges; money
management and/or advice; money transfers) for
their clients or members. Most financial
institutions are regulated by the government.

There are three major types of financial

institutions:
 1. THE CHANGING SCOPE OF RISK MANAGEMENT

-Depositary Institutions deposit-taking

institutions that accept and manage deposits and
make loans, including banks, building societies,
credit unions, trust companies, and mortgage loan
and companies;

-Contractual Institutions insurance companies

and pension funds; and

-Investment Institutions investment banks.

 1. THE CHANGING SCOPE OF RISK MANAGEMENT

These institutions may be affected by Risk.

Risk: in general, a probability or threat of

damage, liability, loss, or any other negative
occurrence that is caused by external or
internal influences.

-In Finance: the probability that an actual return

(profit) on an investment will be lower than the
expected return. This includes the possibility of
losing some or all of the original investment.
 1. THE CHANGING SCOPE OF RISK MANAGEMENT

Main Types of Financial Risks:

- Capital Risk: Losing your invested monies. The risk a

company faces that it may lose value on its capital. The
capital of a company can include equipment, factories and
liquid securities. For example, If a company does not insure
the value of some of its assets, it will face capital risk from
such things as fire, flood and theft.

- Credit Risk: is the risk of default on a debt that may arise

from a borrower failing to make required payments.
 1. THE CHANGING SCOPE OF RISK MANAGEMENT

- Inflationary Risk: called Purchasing Power Risk,

is the chance that the cash flows from an
investment won't be worth as much in the future
because of changes in purchasing power due to
inflation.
 1. THE CHANGING SCOPE OF RISK MANAGEMENT

- Market Risk: Selling an investment at an unfavourable price.

- Liquidity Risk: Limitations on the availability of funds for a specific

period of time.

- Default Risk: The failure of the institution where an investment is

made. It is the risk that a bond issuer will default on any type of debt
by failing to make payments which it is obligated to make. With
default risk, the risk is primarily that of the bondholder and includes
lost principal and interest, disruption to cash flows, and increased
collection costs.

- Legislative Risk: Changes in tax laws may make certain

investments less advantageous.
 1. THE CHANGING SCOPE OF RISK MANAGEMENT

- Trading Risk: Today banks hire traders to actively buy

and sell securities, loans, and derivatives using a portion
of the banks capital. It is risk that the instrument may
go down in value rather than up is called Trading Risk.

- Sovereign Risk (Country Risk)

It arises from the fact that some foreign borrowers may
not repay their loans because their government prohibits
them from doing so. If a foreign country is experiencing
a financial crisis, the government may decide to restrict
dollar-denominated payments.
 1. THE CHANGING SCOPE OF RISK MANAGEMENT

- Operational Risk

Is the risk of loss resulting from the inadequate or

failed internal processes, people and systems or
from external events. This definition includes legal
risklegal risk includes, but is not limited to,
exposure to fines, penalties, or punitive damages
resulting from supervisory actions, as well as
private settlements. Operational risks are specific to
the individual bank rather than indicating a
particular problem within the banking sector.
 1. THE CHANGING SCOPE OF RISK MANAGEMENT
- Commodity Price Risk

- Is the threat that a change in the price of a

production input will adversely impact a producer who
uses that input. So unexpected changes in commodity
prices can reduce a producer's profit. Producers and
users of commodities face commodity price risks.
- For example, consider an agricultural operation that
will have thousands of bushels of grain at harvest time.
At harvest, the price of the commodity may have
increased or decreased, depending on the supply and
demand for grain. Because little storage is available for
the crop, the grain must be sold at the current market
price, even if that price is low.
 1. THE CHANGING SCOPE OF RISK MANAGEMENT

- Interest Rate Risk

Financial institutions usually face the interest rate

risk. Interest Rate Risk is the risk of loss
caused by adverse interest rate movements. For
example, consider a bank that has loaned money
at fixed interest rates to home purchasers
through 15 to 30-year mortgages. If interest
rates increase, the bank must pay higher interest
rates on deposits while the mortgages are locked-
in at lower interest rates.
 1. THE CHANGING SCOPE OF RISK MANAGEMENT

- Currency Exchange Rate Risk

- The Currency Exchange Rate is the value for

which one nations currency may be converted to
another nations currency. For example, one
Canadian dollar might be worth the equivalent of
two-thirds of one U.S. dollar. At this currency
exchange rate, one U.S. dollar may be converted
to one and one-half Canadian dollars.
1. THE CHANGING SCOPE OF RISK MANAGEMENT

- The companies that have international

operations face the currency exchange rate risk.

- Currency Exchange Rate Risk is the risk of

loss of value caused by changes in the rate at
which one nations currency may be converted to
another nations currency. For example, a U.S.
company faces currency exchange rate risk when
it agrees to accept a specified amount of foreign
currency in the future as payment for goods sold
or work performed.
 1. THE CHANGING SCOPE OF RISK MANAGEMENT

- All these Risks and others lead to:

Systemic Risk: the risk of collapse of an entire

financial system or entire market, as opposed
to risk associated with any one individual entity,
group or component of a system that can be
contained therein without harming the entire
system.
 1. THE CHANGING SCOPE OF RISK MANAGEMENT

* Financial Risk Management

- Risk can never be eliminated, but it can be

managed. To avoid risk, financial Institutions need
to be regulated, managed and controlled. This is
by using an effective risk management system to
keep the financial system safe, stable and efficient.
 1. THE CHANGING SCOPE OF RISK MANAGEMENT

- Financial Risk Management is the task of monitoring

financial risks and managing their impact. It is a sub-
discipline of the wider function of risk management and
an application of modern financial theory and practice.

- Financial Risk Manager is a qualification for risk

management professionals, particularly those who are
involved in analyzing, controlling, or assessing potential
financial risks as well as non-market related financial
risks. Financial Risk Manager holders perform a broad
variety of functions related to risk management within
investment banks, asset management firms, as well as
in corporations and government agencies.
 1. THE CHANGING SCOPE OF RISK MANAGEMENT

- Financial Risk Manager Responsibilities:

making recommendations to reduce or control risk,
which may involve an insurance strategy;
working with traders to calculate the risk

associated with specific transactions;

forecasting and monitoring market trends;

considering proposed business decisions;

conducting research to assess the severity of risk;

conducting statistical analysis to evaluate risk and

using statistical software;
 1. THE CHANGING SCOPE OF RISK MANAGEMENT

presenting ideas via reports and presentations,

outlining findings and making recommendations for
improvements;
reviewing legal documents;
using financial packages and software, including
portfolio management software;
studying government legislation, which may affect a
company, and advising on compliance;
protecting the organisation's assets and public
image;
developing contingency plans to deal with
emergencies.
 1. THE CHANGING SCOPE OF RISK MANAGEMENT

- Financial Risk Analysts: identify and analyse the

areas of potential risk threatening the assets, earning
capacity or success of organisations in the industrial,
commercial or public sector.

- A financial risk analyst's role then is to formalise the

process of risk management within an organisation.
This involves business decision-making and enabling
the process of risk taking.
 1. THE CHANGING SCOPE OF RISK MANAGEMENT

- Thus Financial Risk Management then refers to the

identification, analysis, and treatment of speculative
financial risks.

- The traditional separation of Pure and Speculative Risks

meant that different business departments addressed
these risks. Pure Risk (situation in which there are only
the possibilities of loss or no loss) were handled by the
risk manager through risk retention, risk transfer, and
risk control. Speculative Risk (situation in which either
profit or loss is possible) were handled by the finance
division through contractual provisions and capital
market instruments.
 1. THE CHANGING SCOPE OF RISK MANAGEMENT

- In recognition of the fact that they are treating

these risks jointly, some organizations have
created a new position. The Chief Risk Officer
(CRO) who is responsible for the treatment of
pure and speculative risks faced by the
organization.
 1. THE CHANGING SCOPE OF RISK MANAGEMENT

- The CRO is responsible for identifying, analysing

and mitigating internal and external events that
could threaten a company. The CRO works to
ensure that the company is compliant with
government regulations and reviews factors that
could negatively affect investments or a company's
business units.
 1. THE CHANGING SCOPE OF RISK MANAGEMENT

Effective Financial Risk Management strategies allow

to identify the strengths, weaknesses, and threats.
By planning for unexpected events, the financial
system can be ready to respond if they arise. To
ensure that the financial system is success, there is
need to define how the system will handle potential
risks so the system can identify, mitigate or avoid
problems before they occur (Proactive System).
 1. THE CHANGING SCOPE OF RISK MANAGEMENT

Some important steps:

-Internal Control System by Risk Management Committee,

regular meetings, evaluation, disclosure.

-Liquidity sufficient

-Capital Adequacy (Basel Committee %8)