FINRISK

RISK MANAGEMENT

Tess R. Dimayacyac
SY 2015 2016 First

FINANCIAL RISK MANAGEMENT

Financial Risk Management will introduce
students to the risk management process and the
implementation of an enterprise risk
management programs or activities.
The course will provide an introduction to the
essentials of risk management , types of risks,
measurement and estimation risk, facilities to
shift or trade risk, assess effects of risk exposure
and form risk mitigation strategies as well as
evaluation of ERM performance.

COURSE OBJECTIVES:
Interpret the types of risk and detect ways to
measure them
Assess the effects of risk on corporate
performance
Carry out methods used to manage risk
Deconstruct the process and techniques used to
evaluate risk
Structure enterprise risk management plan,
focusing on its benefit and impact to firm value
and performance

FIRST 2 WEEKS

Identify Risk Exposure

Definition of Risk
Types of Risk
Risk Exposures

RISK
RISK can be defined as the threat or probability
that an action or event, will adversely or
beneficially affect an organization's ability to
achieve its objectives*.
In simple terms risk is Uncertainty of Outcome,
either from pursuing a future positive opportunity,
or an existing negative threat in trying to achieve
a current objective.

CHARACTERISTICS OF RISK
Uncertainty the risk may or may not happen,
that is, there are no 100% risks (those, instead, are
called constraints)
Loss the risk becomes a reality and unwanted
consequences or losses occur

TYPES OF RISK

PURE

VERSUS

SPECULATIVE

Pure Risk exists when there is uncertainty as to

whether loss will occur. No possibility of gain is
presented - only the potential for loss.
Speculative risk exists when there is uncertainty
about an event that can produce either a profit or
a loss.
Both pure and speculative risks may be present in
some situations.

SUBJECTIVE

VERSUS

OBJECTIVE

Subjective risk refers to the mental state of an

individual who experiences doubt or worry as to
the outcome of a given event
It is essentially the psychological uncertainty that
arises from an individuals mental attitude or state of
mind

Objective risk differs from subjective risk in the

sense that it is more precisely observable and
therefore measurable
It is the probable variation of actual from expected
experience

SOURCES OF RISK
Property risks
Risk that property may be damaged, destroyed or stolen
For example, lightning, tornadoes, hurricanes,
explosions, riots, collisions, falling objects, floods,
earthquakes, freezing, etc.

Liability risks
Legal judgments may result in payments made to
compensate injured parties as well as to punish those
responsible for the injuries
Even if the individual is absolved of liability the expenses
involved in the defense may be substantial
All individuals who own or use real property are susceptible
to liability losses if others are injured on their premises

SOURCES OF RISK
Life and health and loss of income risks
The possibility of the untimely death of a star
salesperson
The potential death of a parent with young children
Employees who become ill or injured in accidents

Financial risk
Include credit risk, foreign exchange risk, commodity
risk, and interest rate risk
These risks must be identified and assessed in order
for the firm to achieve its business goals

SOURCES OF RISK
Life and health and loss of income risks
The possibility of the untimely death of a star
salesperson
The potential death of a parent with young children
Employees who become ill or injured in accidents

Financial risk
Include credit risk, foreign exchange risk, commodity
risk, and interest rate risk
These risks must be identified and assessed in order
for the firm to achieve its business goals

WHY DO FINANCIAL INSTITUTIONS

TRY TO MANAGE RISK ?
Global trends are leading to
The rising importance of risk management In
financial institutions
More complex markets
Global markets
Greater product Complexity
New businesses (e-banking,
merchant banking,)
Increasing competition
New players
Regulatory imbalances

Increased
Risk

In the future . . .

The leading institutions will be

distinguished by their
intelligent management of
risk.

IMPORTANCE OF RISK MANAGEMENT

Businesses must manage risks in ways that support
public interest, human safety, the environment, and state
and federal laws.
Risk management is necessary for effective financial,
marketing, production, and human resource
management decisions.
Risk management reduces the adverse effects of risk on
business resources, cash flow, and profits.

WHY DO WE NEED RISK MANAGEMENT?

The only alternative to risk management is crisis
management --- and crisis management is much more
expensive, time consuming and embarrassing.
JAMES LAM, Enterprise Risk Management, Wiley Finance 2003

Without good risk management practices, government

cannot manage its resources effectively.
Risk
management means more than preparing for the worst;
it also means taking advantage of opportunities to
improve services or lower costs.
Sheila Fraser, Auditor General of Canada

 Business risk is the possibility of business

loss or failure. There are three kinds of
business risks:
economic
natural
human

ECONOMIC RISK
Economic risks occur from changes in overall business
conditions. These changes can include:
the amount or type of competition
changing consumer lifestyles
population changes
limited usefulness or style of some products
product obsolescence
inflation
recession
government regulation

NATURAL RISK
Natural risks are risks resulting from natural causes such as:
floods
tornadoes
hurricanes
fires
Lightning
droughts
earthquakes
unexpected changes in weather conditions
Unexpected losses from some natural risks (e.g., fire)
can be insured against; other natural risks
(unpredictable weather) cannot be insured against.

HUMAN RISK
Human risks are caused by human mistakes, as well
as the unpredictability of customers, employees, or the
work environment. Human risks include:
customer dishonestytheft, fraudulent payment, or
nonpayment
employee error, negligence, incompetence, and
theft
customer or employee accidents

34.1

Graphic Organizer

Types of Risk

RISK

21

Economic
Economic

Natural
Natural

Human
Human

Competition
Competition
Consumer
ConsumerLifestyle
LifestyleChanges
Changes
Population
Changes
Population Changes
Obsolescence
Obsolescence
Limited
LimitedProduct
ProductUsefulness
Usefulness
Government
GovernmentRegulation
Regulation
Inflation
Inflation
Recession
Recession

Floods
Floods
Tornadoes
Tornadoes
Hurricanes
Hurricanes
Fires
Fires
Lightning
Lightning
Snowstorms
Snowstorms
Earthquakes
Earthquakes
Droughts
Droughts

Mistakes
Mistakes
Theft
Theft
Fraud
Fraud
Computer
ComputerCrime
Crime
Customer/Employee
Customer/Employee
Unpredictability
Unpredictability
Work
WorkEnvironment
Environment
Unpredictability
Unpredictability

RISK MANAGEMENT
Risk is the possibility of financial loss.
Risk management is the systematic process of managing an
organization's risk exposure to achieve objectives in a manner
consistent with public interest, human safety, environmental
factors, and the law.

risk management is a continual process of

corporate risk reduction.
Risk management is really about how firms
actively select the type and level of risk that it is
appropriate for them to assume.

OBJECTIVES OF RISK MANAGEMENT

Risk management has objectives before
and after a loss occurs
Pre-loss objectives:
Prepare for potential losses in the most
economical way
Reduce anxiety
Meet any legal obligations

OBJECTIVES OF RISK MANAGEMENT

Post-loss objectives:
Ensure survival of the firm
Continue operations
Stabilize earnings
Maintain growth
Minimize the effects that a loss will have
on other persons and on society

WHATS THE PLAN?

Identification

Quantification

Response

Monitoring
and Control

RISK MANAGEMENT PROCESS

1. Identify potential losses
2. Measure and analyze the loss
exposures
3. Select the appropriate combination of
techniques for treating the loss
exposures
4. Implement and monitor the risk
management program

STEPS IN RISK MANAGEMENT

IDENTIFYING LOSS EXPOSURES

Property loss exposures

Liability loss exposures
Business income loss exposures
Human resources loss exposures
Crime loss exposures
Employee benefit loss exposures
Foreign loss exposures
Intangible property loss exposures
Failure to comply with government rules and
regulations

IDENTIFYING LOSS EXPOSURES

Risk Managers have several sources of
information to identify loss exposures:

Questionnaires
Physical inspection
Flowcharts
Financial statements
Historical loss data

Industry trends and market changes can create

new loss exposures.
e.g., exposure to acts of terrorism

MEASURE AND ANALYZE LOSS

EXPOSURES
Estimate the frequency and severity of loss for each
type of loss exposure
Loss
may
Loss
may

frequency refers to the probable number of losses that

occur during some given time period
severity refers to the probable size of the losses that
occur

Once loss exposures are analyzed, they can be

ranked according to their relative importance
Loss severity is more important than loss frequency:
The maximum possible loss is the worst loss that could
happen to the firm during its lifetime
The probable maximum loss is the worst loss that is likely to
happen

SELECT THE APPROPRIATE COMBINATION OF

TECHNIQUES FOR TREATING THE LOSS
EXPOSURES
Risk control refers to techniques that reduce the
frequency and severity of losses
Methods of risk control include:
Avoidance
Loss prevention
Loss reduction

Avoidance means a certain loss exposure is never

acquired, or an existing loss exposure is abandoned
The chance of loss is reduced to zero
It is not always possible, or practical, to avoid all losses

SELECT THE APPROPRIATE COMBINATION OF

TECHNIQUES FOR TREATING THE LOSS EXPOSURES

Loss prevention refers to measures that

reduce the frequency of a particular loss
e.g., installing safety features on hazardous
products
Loss reduction refers to measures that reduce
the severity of a loss after is occurs
e.g., installing an automatic sprinkler
system

SELECT THE APPROPRIATE RISK

MANAGEMENT TECHNIQUE
Risk financing refers to techniques that provide for
the funding of losses
Methods of risk financing include:
Retention
Non-insurance Transfers
Commercial Insurance

RISK FINANCING METHODS: RETENTION

Retention means that the firm retains part or all of
the losses that can result from a given loss
Retention is effectively used when:
No other method of treatment is available
The worst possible loss is not serious
Losses are highly predictable
The retention level is the dollar amount of losses
that the firm will retain
A financially strong firm can have a higher
retention level than a financially weak firm
The maximum retention may be calculated as a
percentage of the firms net working capital

RISK FINANCING METHODS: RETENTION

A risk manager has several methods for paying
retained losses:
Current net income: losses are treated as
current expenses
Unfunded reserve: losses are deducted from a
bookkeeping account
Funded reserve: losses are deducted from a
liquid fund
Credit line: funds are borrowed to pay losses
as they occur

RISK FINANCING METHODS: RETENTION

A captive insurer is an insurer owned by a parent firm for the
purpose of insuring the parent firms loss exposures
A single-parent captive is owned by only one parent
An association or group captive is an insurer owned by
several parents
Many captives are located in the Caribbean because the
regulatory environment is favorable
Captives are formed for several reasons, including:
The parent firm may have difficulty obtaining insurance
To take advantage of a favorable regulatory environment
Costs may be lower than purchasing commercial insurance
A captive insurer has easier access to a reinsurer
A captive insurer can become a source of profit
Premiums paid to a captive may be tax-deductible under
certain conditions

RISK FINANCING METHODS: RETENTION

Self-insurance is a special form of planned
retention
Part or all of a given loss exposure is retained
by the firm
Another name for self-insurance is self-funding
Widely used for workers compensation and
group health benefits
A risk retention group is a group captive that can
write any type of liability coverage except
employer liability, workers compensation, and
personal lines
Federal regulation allows employers, trade
groups, governmental units, and other parties
to form risk retention groups
They are exempt from many state insurance
laws

RISK FINANCING METHODS: RETENTION

Advantages
Save on loss costs
Save on expenses
Encourage loss
prevention
Increase cash flow

Disadvantages
Possible higher losses
Possible higher expenses
Possible higher taxes

RISK FINANCING METHODS: NON-INSURANCE

TRANSFERS
A non-insurance transfer is a method other than
insurance by which a pure risk and its potential
financial consequences are transferred to another
party
Examples include:
Contracts, leases, hold-harmless agreements

RISK FINANCING METHODS: NON-INSURANCE

TRANSFERS
Advantages
Can transfer some
losses that are not
insurable
Save money
Can transfer loss
to someone who is
in a better
position to control
losses

Disadvantages
Contract language
may be ambiguous, so
transfer may fail
If the other party fails
to pay, firm is still
responsible for the
loss
Insurers may not give
credit for transfers

RISK FINANCING METHODS: INSURANCE

Insurance is appropriate for loss exposures that have
a low probability of loss but for which the severity of
loss is high
The risk manager selects the coverages needed,
and policy provisions:
A deductible is a provision by which a specified
amount is subtracted from the loss payment
otherwise payable to the insured
An excess insurance policy is one in which the
insurer does not participate in the loss until the
actual loss exceeds the amount a firm has
decided to retain
The risk manager selects the insurer, or insurers,
to provide the coverage.

RISK FINANCING METHODS: INSURANCE

The risk manager negotiates the terms of the
insurance contract
A manuscript policy is a policy specially
tailored for the firm
Language in the policy must be clear to
both parties
The parties must agree on the contract
provisions, endorsements, forms, and
premiums
The risk manager must periodically review the
insurance program

RISK FINANCING METHODS: INSURANCE

Advantages
Firm is indemnified for
losses
Uncertainty is
reduced
Insurers may provide
other risk
management services
Premiums are taxdeductible

Disadvantages
Premiums may be
costly
Opportunity cost
should be considered

Negotiation of
contracts takes time
and effort
The risk manager may
become lax in
exercising loss control

MARKET CONDITIONS AND THE SELECTION OF

RISK MANAGEMENT TECHNIQUES
Risk managers may have to modify their choice of
techniques depending on market conditions in the
insurance markets
The insurance market experiences an
underwriting cycle
In a hard market, when profitability is
declining, underwriting standards are tightened,
premiums increase, and insurance becomes
more difficult to obtain
In a soft market, when profitability is
improving, standards are loosened, premiums
decline, and insurance become easier to obtain

IMPLEMENT AND MONITOR THE RISK

MANAGEMENT PROGRAM
Implementation of a risk management program
begins with a risk management policy statement
that:
Outlines the firms risk management objectives
Outlines the firms policy on loss control
Educates top-level executives in regard to the risk
management process
Gives the risk manager greater authority
Provides standards for judging the risk managers
performance
A risk management manual may be used to:
Describe the risk management program
Train new employees

IMPLEMENT AND MONITOR THE RISK

MANAGEMENT PROGRAM
A successful risk management program requires
active cooperation from other departments in the
firm
The risk management program should be
periodically reviewed and evaluated to determine
whether the objectives are being attained
The risk manager should compare the costs and benefits of
all risk management activities

BENEFITS OF RISK MANAGEMENT

Pre-loss and post-loss objectives are attainable
A risk management program can reduce a firms cost
of risk
The cost of risk includes premiums paid, retained losses,
outside risk management services, financial guarantees,
internal administrative costs, taxes, fees, and other
expenses

Reduction in pure loss exposures allows a firm to

enact an enterprise risk management program to
treat both pure and speculative loss exposures
Society benefits because both direct and indirect
losses are reduced

PERSONAL RISK MANAGEMENT

Personal risk management refers to the
identification of pure risks faced by an individual
or family, and to the selection of the most
appropriate technique for treating such risks
The same principles applied to corporate risk
management apply to personal risk management