Risk Management

-Twesha Chharia

Management
It is the process of planning, organizing, directing and controlling the resources and activities of an organization in order to fulfill the objective of that organization at the least possible cost.

It minimize the adverse effects which accidental losses and price/rate volatilities may have on the organization.

Risk Management-Definition
It is the process of planning, organizing, directing and controlling the resources and activities of an organization in order to minimize the adverse effects of potential losses at the least possible cost

Risk Management-Objectives
Mere survival Peace of mind Lower risk management costs and thus higher profits. Little or no interruption of operation.

 Continued growth Satisfaction of the firms sense of social responsibility, desire for a good image Satisfaction of externally imposed obligations

Management of Pure Risk

3 Types of Pure risk:-

Personal Property Liability

Methods 1. Avoidance of risk 2. Loss Control a. Loss prevention b. Loss reduction 3. Risk retention

 4. Non insurance transfer a. Transfer of risk by contract b. Hedging price risk c. Incorporation of a business firm

Financial risk and its management

Classification of Financial risk 1.Credit 2.Market 3.Operational 4.Other

Market Risk
Market Risk is the change in value of assets due to changes in the underlying economic factors such as interest rates, foreign exchange rates, macroeconomic variables, stock prices, and commodity prices. For example, bills receivable of software exporters that are denominated in foreign currencies are exposed to exchange rate fluctuations.

Credit Risk
Credit Risk is the change in value of a debt due to changes in the perceived ability of counterparties to meet their contractual obligations (or credit rating). Alsoknown as default risk or counterparty risk, credit risk is faced by lending institutions like banks, investors in debt instruments of corporate houses, and by parties involved in contractual agreements like forward contracts.

Operational Risk
Operational Risk is defined as the risk of loss resulting from inadequate or failed internal processes, people, and systems or from external events. In this sense all organizations face operational risk.

 But for a financial institution/bank operational risk can be defined as the possibility of loss due to mistakes made in carrying out transactions such as settlement failures, failures to meet regulatory requirements, and untimely collections.

Risk Management Process

Risk Identification Risk measurement and evaluation Risk control Risk Finance

Risk Identification
Requires knowledge of Organization, Market in which it operates, Legal ,Social, Economic, Political environment Financial strength and weakness Its vulnerability to unplanned loses Manufacturing process Management system

Methods
Checklist method Financial statement method Flow chart method On site inspection Interaction with others Contract analysis Statistical record of losses

Checklist method
Checklists and Questionnaires is also a technique which is widely used to search and understand the risk internally. This technique is also used to understand the impact of the risk, its frequency and its severity.

Flow chart method

Example of paper making industry In which the raw material is collected which includes straw and used paper. These are then stored in store room. After that processing is done on the raw material and pulp is produced.

 From pulp, tissue paper, corrugated paper and fax paper will be made. From corrugated paper, corrugated sheets are prepared. Corrugated sheets are then converted into paper reels, which can be used internally for packing a product or can be used for selling it.

 Used paper is normally stored under the sheds and straw in not stored under sheds, straw can itself ignite when temperature is near 40 C, therefore the risk manager will try to reduce the risk of self ignition by installing a network of hydrants around straw, which sheds water twice a day

 Risk manager will try to locate the area of risk concentration and risk dependencies. Pulp making is a non-hazardous process as water is used as a raw material in it. This is how the risk manager will locate the risk in the production process by the help of a flow chart.

Financial statement method

Assets Fixed assets: 1. Intangible assets 2. Net plant and equipment 3. Long-term accounts receivable 4. Long-term investment Capital Equity capital: 1. Common stock 2. Additional paid-in capital 3. Retained profit

Current assets: 1. Inventory 2. Accounts receivable 3. Short-term investment

Debt capital: 1. Long-term debt capital 2. Current liabilities

On site inspection
By observing firms facilities and operation directly.

Interaction with others

The risk manager keeps continuous contact with the manager of other department. Obtain information about source of risk in other department.

Contract analysis
Looking into the contract the firm is into Assess the firm obligation and liability

Statistical record of losses

Looking at the record of losses. Find out the reason for the occurrence of loss, the nature of risk and degree to which the firm is being affected.

Risk Evaluation
2 conditions : A) Probability of loss occurring B) Its severity

VAR Techniques

Underlying logic is Risk reduce value , thus Value at Risk (VAR) is used.

VAR
VAR is measurable variable that depict ones desire or state of affairs in a given set of circumstance. Since circumstance never remain same for any identity, whatever value is preserved or created is always at risk ( value at risk)

 VAR measure worst expected loss over a given horizon under normal market condition at given confidence level. OR VAR measure potential loss in value of a risky asset or portfolio over a defined period for a given confidence interval.

 Thus if a VAR of an asset is 100 million at one week, 95% confidence level, there is only 5% chance that value of asset will drop more than 100 million over any given week. It is used mostly by commercial and investment bank to capture potential loss in value of their traded portfolio from adverse market movement over a specified period.

 This can be compared to their available capital and cash reserve to ensure that the losses can be converted without putting the firm at risk.

Other techniques
Stress testing by potential estimate of various market scenarios, valuation of impact, development of contingency plan.

 Sensitivity analysis- Hypothetical change in the value of individual market factor, use of pricing model to compete the actual value, formulating strategies for combined input. eg: identifying how portfolios respond to shifts in relevant economic variables or risk parameters

Risk Control
It examine the feasibility of risk management alternatives. This step facilitates the subsequent steps of selecting and implementing the appropriate risk management techniques.

 To make these selection decisions, an insurance or risk management professional must determine which risk management techniques most effectively address an organizations loss exposures.

 An insurance or risk management professional uses risk control techniques to reduce loss frequency and/or loss severity or to make losses more predictable.

Risk Control Techniques

Risk control is a conscious act or decision not to act that reduces the frequency and/or severity of losses or makes losses more predictable. 1. Avoidance 2. Loss prevention 3. Loss reduction 4. Separation 5. Duplication 6. Diversification

Avoidance
Avoidance is a risk control technique that involves ceasing or never undertaking an activity so that the possibility of a future loss occurring from that activity is eliminated. The aim of avoidance is not just to reduce loss frequency, but to eliminate any possibility of loss.

 For example, a toy manufacturer might decide not to produce a particular toy because the potential cost of products liability claims would outweigh the expected revenue from sales, no matter how cautious the manufacturer might be in producing and marketing the toy.

 Avoidance can either be proactive or reactive. Proactive avoidance seeks to avoid a loss exposure before it exists, such as when a medical student chooses not to become an obstetrician because he or she wants to avoid the large professional liability (malpractice) claims associated with that specialty.

 Reactive avoidance seeks to eliminate a loss exposure that already exists, such as when manufacturers of hand-held hair dryers stopped using asbestos insulation in their dryers once the cancer-causing properties of asbestos became known.

Loss Prevention
Loss prevention is a risk control technique that reduces the frequency of a particular loss. For instance, pressure relief valves on a boiler are intended to prevent explosions by keeping the pressure in the boiler from reaching an unsafe level.

 The valve is a type of loss prevention, not avoidance, because a boiler explosion is still possible, just not as likely.

Loss reduction
It refers to measure that reduces severity of loss after it occurs. Eg: installation of automatic sprinkler system that promptly extinguishes fire, rehabilitation of workers with job related injuries.

Separation
Separation is a risk control technique that disperses a particular asset or activity over several locations and regularly relies on that asset or activity as a part of the organizations working resources.

Duplication
Duplication is a risk control technique that uses backups, spares, or copies of critical property, information, or capabilities and keeps them in reserve.

Diversification
Diversification is a risk control technique that spreads loss exposures over numerous projects, products, markets, or regions.

Risk Financing
It refers to techniques that provide for the funding of losses after it occurs. 3 techniques: 1. Retention 2. Non insurance transfers 3. Commercial insurance