Chapter 4

Forecasting
Financial Analysis in Risk Management Decision Making
Other Risk Management Tools

more than simply purchasing insurance
Is not limited in scope to

pure risks
The risk manager may be using:
Financial risk management
Enterprise risk management

to the identification, analysis, and treatment of speculative financial risks:
Commodity

price risk is the risk of losing money if the price of a commodity changes
Interest rate risk is the risk of loss caused by adverse interest rate movements
Currency exchange rate risk is the risk of loss of value caused by changes in the rate at which one nation's currency may be converted to another nation’s currency
Financial risks can be managed with capital market instruments

is a risk treatment technique that combines coverage for pure

and speculative risks in the same contract
A double-trigger option is a provision that provides for payment only if two specified losses occur
Some organizations have created a Chief Risk Officer (CRO) position
The chief risk officer is responsible for the treatment of pure and speculative risks faced by the organization

management program that addresses the organization’s pure, speculative, strategic, and

operational risks
Strategic risk refers to uncertainty regarding an organization’s goals and objectives
Operational risks are risks that develop out of business operations, such as product manufacturing
As long as risks are not positively correlated, the combination of these risks in a single program reduces overall risk
Nearly half of all US firms have adopted some type of ERM program
Barriers to the implementation of ERM include organizational, culture and turf battles

dropped by more than fifty percent between October 2007 and

March 2009
The meltdown raises questions about the use of ERM
Only 18 percent of executives surveyed said they had a well-formulated and fully-implemented ERM program

ERM program in its 2007 10-K Report
Riskiness of the Financial

Products Division was not fully appreciated
The division was issuing credit default swaps
A credit default swap is an agreement in which the risk of default of a financial instrument is transferred from the owner of the financial instrument to the issuer of the swap
The default rate on mortgages soared and the company did not have the capital to cover guarantees
The lessons learned by risk managers from the financial crisis will influence ERM in the future

risks are influenced by conditions in the insurance marketplace
The Underwriting

Cycle refers to the cyclical pattern of underwriting stringency, premium levels, and profitability
“Hard” market: tight standards, high premiums, unfavorable insurance terms, more retention
“Soft” market: loose standards, low premiums, favorable insurance terms, less retention
One indicator of the status of the cycle is the combined ratio:

Liability Insurance, 1956–2008*

and underwriting decisions:
Insurance industry capacity refers to the relative level

of surplus
Surplus is the difference between an insurer’s assets and its liabilities
Capacity can be affected by a clash loss, which occurs when several lines of insurance simultaneously experience large losses
Investment returns may be used to offset underwriting losses, allowing insurers to set lower premium rates

industry is continuing
Consolidation refers to the combining of businesses through

acquisitions or mergers
Due to mergers, the market is populated by fewer, but larger independent insurance organizations
There are also fewer large national insurance brokerages
An insurance broker is an intermediary who represents insurance purchasers
Cross-Industry Consolidation: the boundaries between insurance companies and other financial institutions have been struck down
Financial Services Modernization Act of 1999
Some financial services companies are diversifying their operations by expanding into new sectors

capital markets to assist in financing risk
Securitization of risk means

that insurable risk is transferred to the capital markets through creation of a financial instrument:
A catastrophe bond permits the issue to skip or defer scheduled payments if a catastrophic loss occurs
An insurance option is an option that derives value from specific insurance losses or from an index of values.
A weather option provides a payment if a specified weather contingency (e.g., high temperature) occurs
The impact of risk securitization is an increase in capacity for insurers and reinsurers
It provides access to the capital of many investors

Size

techniques:
Probability analysis
Regression analysis
Forecasting based on loss distribution
Of course, there is

no guarantee that losses will follow past loss trends

individual and joint events
The probability of an event is

equal to the number of events likely to occur (X) divided by the number of exposure units (N)
May be calculated with past loss data
Two events are considered independent events if the occurrence of one event does not affect the occurrence of the other event
Two events are considered dependent events if the occurrence of one event affects the occurrence of the other
Events are mutually exclusive if the occurrence of one event precludes the occurrence of the second event

variables and then uses this characterization to predict values of

a variable
For example, the number of physical damage claims for a fleet of vehicles is a function of the size of the fleet and the number of miles driven each year

Claims

that could occur
Useful for forecasting if the history of

losses tends to follow a specified distribution, and the sample size is large
The risk manager needs to know the parameters of the loss distribution, such as the mean and standard deviation
The normal distribution is widely used for loss forecasting

money must be considered when decisions involve cash flows over

time
Considers the interest-earning capacity of money
A present value is converted to a future value through compounding
A future value is converted to a present value through discounting
Risk managers use the time value of money when:
Analyzing insurance bids
Making loss control investment decisions
The net present value is the sum of the present values of the future cash flows minus the cost of the project
The internal rate of return on a project is the average annual rate of return provided by investing in the project

a computerized database that permits the risk manager to store

and analyze risk management data
The database may include listing of properties, insurance policies, loss records, and status of legal claims
Data can be used to predict and attempt to control future loss levels
Risk Management Intranets and Web Sites
An intranet is a web site with search capabilities designed for a limited, internal audience
A risk map is a grid detailing the potential frequency and severity of risks faced by the organization
Each risk must be analyzed before placing it on the map

the worst probable loss likely to occur in a given

time period under regular market conditions at some level of confidence
The VAR is determined using historical data or running a computer simulation
Often applied to a portfolio of assets
Can be used to evaluate the solvency of insurers
Catastrophe modeling is a computer-assisted method of estimating losses that could occur as a result of a catastrophic event
Model inputs include seismic data, historical losses, and values exposed to losses (e.g., building characteristics)
Models are used by insurers, brokers, and large companies with exposure to catastrophic loss