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

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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

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 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.

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23RejdaPrinciplesofRiskManagementandInsurance,EleventhEdition
(b) Theriskmanagermayuseseveraltechniquestoforecastlosses.Probabilityanalysis,regression
analysis,andforecastingthroughlossdistributionsmaybeemployed.

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 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.

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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