Chapter 4

Chapter 4
Risk Management 2:
Advanced Topic
• Three broad policy issues facing risk
– Risk Management Information Systems
– Determining the appropriate amount of loss
exposure to retain
– International loss exposures
• Risk managers use Risk Management Information
Systems (RMIS) to:
– record,
– track and analyze losses,
– Keep records to plant, property and equipment and how they are
protected from losses,
– Statistical Analysis, using past loss help to forecast losses
– RMIS must be adapted to the needs of the individual
organizations. Each organization facing different hazards (earth
quake or flooding), different liability exposures (some have
chemicals, some firms manufacture products) and differences in
property value fluctuations. (Some having significant annual
inventory annual changes)
RMIS should be tailored to the needs of the firms.
Loss Data
• Loss records including injuries to workers, liability claims,
or assets losses are the foundation of RMIS.
• Computerized data bases records on:
– Frequency, severity, causes, final outcome of the losses are
– Outcomes are analyzed by statistical techniques such as
regression analysis.
• E.g. P.73 Table 4-1 (RM analyses the data for developing an
effective way to lower the no. Of accidents and costs. Classification
such as: age, experience, weather conditions, time of the day)
• Operating RMIS is not easy as you may have inaccurate loss data,
loss data, subsequent analysis or misleading forecasts.
• Comp. Should be updated, data should be audited randomly to
enable accuracy.
Deductible and Policy Limits
• Problem:
– How much loss exposures to retain;
– How much to loss exposures to transfer.
Deductibles (Retentions): Cause insured to bear the
first dollars of a loss.
Policy Limits: determine maximum insurance recovery.
- If a loss is equal to or is less than the deductible, the
insured bears the cost.
- If a loss is greater than the policy limits, the insured
bears the cost of any applicable deductible and the
amount of loss above the policy limit. (example)
• A point where deductibles are so small that company is insuring
expenses or
so much insurance is purchased to protect itself against the max.
possible (worst case) loss rather than max. probable (average) loss
If the firm could not afford to pay its retentions and deductibles
available from “normal” flow
If a probable loss could result in the firm’s insolvency (inability to pay
currently due sums) or bankruptcy (the firms debts exceeds its
available assets).
Financial and Other Considerations
Risk manager should think:
1. Tax implications (Tax deductible
2. Ability to pay Losses
Usually lower policy limits is favoured but:
the liquidity of assests-is there sufficient cash?
The stability of net income.
The amount of net worth.
The increased cost of capital (Risky to lenders
and investors)
Financial and Other Considerations
3. Psychological Factors: experience, attitudes
toward risk, habit and intuition.
4. Social Ethical Concerns:
In the absence of adequate funding, uninsured
losses could bankrupt organizations producing
ethically undesired consequences. (e.g. Undercompensated dead, injured employees, polluted
environment, unemployed workers)
International Risk Management
Multinational and international firms operate worldwide. They face:
Foreign Currency: measurement and financing problems.
Political Risk: Trade embargoes cancellation of export licenses,
expropriation (nationalization of foreign-owned property, war, terrorism,
cultural differences)
Risk financing arrangements and practices vary widely throughout the
Movement of goods,
a) Marine Insurance (inland and ocean) are important.
b) Income Insurance: pays for losses caused by delays in receiving
shipment are popular.
Foreign Insurance
• Generalization about foreign insurance arrangements are difficult to
• Some countries allow foreigners to insure foreign owned property by
their own brokers and insurers (e.g. USA)
• Insurers authorized to do business in an other country is called
admitted insurers.
• Some foreign countries levy fines and other penalties on companies
using nonadmitted insurers.
• Admitted insurers can be desirable because premiums and losses
are dominated in local currency.
• Some RM may prefer nonadmitted insurers if they provide familiar
policies with a common language and laws and more, nonadmitted
insurer is providing international coverage for a large number of
foreign operations.
Foreign Insurance (cont.)
• Firms try to develop a global insurance program (e.g. US
– An international insurer (or broker) having an international
network of associations with local insurance companies.
– Using admitted insurers in each country or a region but
purchase a difference-in-conditions (DIC) policy from a for
example US insurer.
– DIC policy is written on a manuscript, tailor-made basis.
– DIC policy supplements the local (foreign) property
coverage by broadening the covered perils, increasing
policy limits or doing both.
– DIC policies allow e.g. the US firms to pay premiums to a
US insurer and collect losses in $s if foreign insurer do not
provide all the coverage the risk manager specifies.
– With the DIC policy, the US firm can appeal global
uniformity in coverage because the DIC supplement brings
all policies up to its limits.
Financial Risk Management
• In addition to pure risks, firms face contingencies
called financial risks.
– Cost of capital, cash flow mgmt issues.
Interest Rate Risk: caused by increasing interest rates
reducing market value of fixed income securities.
Credit Risk: caused by a borrower defaulting on a loan.
Currency Risk: caused by fluctuations in the value of
domestic currency against foreign currencies.
Liquidity Risk: caused by having to liquidate an
investment at an investment quickly.
Market Risk: caused by having to liquidate an
investment at an unfavorable price.
Financial Risk Management (Cont.)
Potential loss sources can be managed by
avoidance, assumption, and transfer. Since
these exposures are not predictable and some
exposures could prove catastrophic, insurance
is not thought to be an option. Among the
possible financial market transactions are:
1. Traded options
2. Futures contracts
3. Forward contracts
4. Swaps (Currency and interest swaps)