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Chapter 4

Advanced Topics in Risk Management

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Agenda

• The Changing Scope of Risk Management• Enterprise Risk Management• Insurance Market Dynamics• Loss Forecasting• Financial Analysis in Risk Management

Decision Making• Other Risk Management Tools• AIG case, Baring case.

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Outcome

• Able to apply different risk management techniques to manage risk exposure

• Understand the causes of big losses in AIG case and Baring case.

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The Changing Scope of Risk Management

• Today, the risk manager’s job:– Involves 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

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The Changing Scope of Risk Management • Financial Risk Management refers 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, if you sell wheat and wheat price falls

– Interest rate risk is the risk of loss caused by adverse interest rate movements, bond price drops with rising interest rate

– 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, you have subsidiary in Japan, Yen drops and you get back less HK dollars

• Financial risks can be managed with capital market instruments

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Exhibit 4.1 Managing Financial Risk—Two Examples (textbook use $4.5 per bushel)

Try http://www.cmegroup.com/trading/agricultural/grain-and-oilseed/corn_contract_specifications.html , corn future contract size: 5000 bushels

Fully hedged

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Exhibit 1 Managing Financial Risk—Two Examples

Should we use futures or option?

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The Changing Scope of Risk Management• An integrated risk management program is a

risk treatment technique that combines coverage for pure and speculative risks in the same contract

• 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

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Enterprise Risk Management• Enterprise Risk Management (ERM) is a comprehensive risk

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, remember the Johnson Electric– 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 • That’s why diversification usually failed when stock market

crashes– 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

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The Financial Crisis and Enterprise Risk Management

• The US stock market dropped by more than fifty percent between October 2007 and March 2009 (next slide)– 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

“Interesting” to learn that insurance company took the bet,e.g. AIG

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Exhibit 2 Timeline of Events Related to the Financial Crisis

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Lehhman’s Exposure to the mortgage marketLehman borrowed significant amounts to fund its investing in the years leading to its bankruptcy in 2008, a process known as leveraging or gearing. A significant portion of this investing was in housing-related assets, making it vulnerable to a downturn in that market. One measure of this risk-taking was its leverage ratio, a measure of the ratio of assets to owners equity, which increased from approximately 24:1 in 2003 to 31:1 by 2007.[2]While generating tremendous profits during the boom, this vulnerable position meant that just a 3–4% decline in the value of its assets would entirely eliminate its book value of equity.[3] Investment banks such as Lehman were not subject to the same regulations applied to depository banks to restrict their risk-taking.[4]

http://en.wikipedia.org/wiki/Bankruptcy_of_Lehman_Brothers

Note: A leverage ratio about 10 is more reasonable

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In August 2007, Lehman closed its subprime lender, BNC Mortgage, eliminating 1,200 positions in 23 locations, and took a $25-million after-tax charge and a $27-million reduction in goodwill. The firm said that poor market conditions in the mortgage space "necessitated a substantial reduction in its resources and capacity in the subprime space".[5]

http://en.wikipedia.org/wiki/Bankruptcy_of_Lehman_Brothers

You may try to read A Colossal Failure of Common Sense: The Inside Story of the Collapse of Lehman Brothers by Lawrence G. McDonald and Patrick Robinson, Crown Business, 2010 or other related books.

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Did ERM fail, or did companies simply fail to use it properly regulated?• The falls of Lehman Brothers, Merrill Lynch and

American International Group • William H. Panning, executive vice president at Willis Re

Inc.– "In the firms that really took a nosedive, the CEOs

and the directors seemed to care only about earnings, and not about how much risk was being taken. There was no penalty for betting the firm. They didn't take ERM very seriously.“

– Blaming ERM for a company's failure is like riding in a car without a seat belt, then blaming the seat belt for your injuries

– AIG aside, the insurance industry has mostly avoided big losses so far because property/casualty firms have always emphasized underwriting risk

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ERM

• Integrating enterprise risk management with organizational strategy: an ERM program must align with corporate strategy to give the organization a complete and comprehensive approach to managing risk, – The RMA Journal, May 1, 2009 by Killackey, Henry

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Insurance Market Dynamics

• Decisions about whether to retain or transfer 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:

PremiumsExpensesngUnderwritiExpensesAdjustmentLossLossessPaidRatioCombined

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Exhibit 3 Combined Ratio for All Lines of Property and Liability Insurance, 1956–2008*

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Insurance Market Dynamics

• Many factors affect property and liability insurance pricing 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

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Insurance Market Dynamics• The trend toward consolidation in the financial services industry is

continuing– Consolidation refers to the combining of businesses through

acquisitions or mergers• Owing 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

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Capital Market Risk Financing Alternatives• Insurers are making increasing use of 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 issuer 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

• A double-trigger option is a provision that provides for payment only if two specified losses occur

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Capital Market Risk Financing Alternatives• A double-trigger option example

– often used for insurance purposes, – pays off only if 2 events occur. – buy this option to limit losses that are very

unlikely, but very expensive if they both occurred.

– E.g. a large property loss in a foreign country, the changes in the FX rate made the loss much more expensive.

– The impact of risk securitization is an increase in capacity for insurers and reinsurers• It provides access to the capital of many investors

*Cat_Bonds_Demystified (your reference)

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Exhibit 4 Catastrophe Bonds: Annual Number of Transactions and Issue Size

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Loss Forecasting (A brief account)

• The risk manager can predict losses using several different techniques:– Probability analysis– Regression analysis– Forecasting based on loss distribution

• Of course, there is no guarantee that losses will follow past loss trends

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Loss Forecasting

• Probability analysis: the risk manager can assign probabilities to 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

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Loss Forecasting

• Regression analysis characterizes the relationship between two or more 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

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Exhibit 5 Relationship Between Payroll and Number of Workers Compensation Claims

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Loss Forecasting

• A loss distribution is a probability distribution of losses 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

• Note: it can be very incorrect• If HSI does not follow normal distribution, how can you do

forecasting?

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Financial Analysis in Risk Management Decision Making

• The time value of 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

Still remember what they mean? Refer to your FM text.

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Insurance bids exampleTwo bids1. Annual Premium:

$80,000, per-claim deductible $5,000

2. Annual Premium: $30,000, per-claim deductible $10,000

R=4%

Expected Number of

LossesExpected Size

of Lossess

11 $5,000

6 $10,000

3 > $10,000

Which bid is better?

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Insurance bids example• Bid 1: expected cash outflows in one year =• 20x $5000 =100,000 why?• PVdeductible = 100,000/(1.04) =96,154• Total outlflow: PVdeductible + Plus premium

96,154+ 80,000= 176, 154• Bid 2:• Outflows: 11x5000+ 9x10000=145,000• PVdeductible= 145,000/1.04=139,423• Total outlflow:30000+139423=169,429

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Making loss control investment decisions

• The installation of leakage control system is expected to generate an after-tax net cash flow of $100,000 per year for 5 year, r=6%, the installation cost is $400,000. Should the system be installed?

• NPV = PV of the five $100,000 – cost of the installation(note: PV annuity at 6%=4.21236)

=421,236 -400,000 =$21,236• OR IRR =7.93%

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Other Risk Management Tools• A risk management information system (RMIS) is 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

High 　 　 　Probability

Medium 　 　 　Low 　 　 　

Low Medium High

Impact

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Other Risk Management Tools• Value at risk (VAR) analysis involves calculating 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

– A financial firm may determine that it has a 5% one month value at risk of $100 million. This means that there is a 5% chance that the firm could lose more than $100 million in any given month. Therefore, a $100 million loss should be expected to occur once every 20 months. http://www.investopedia.com/terms/v/var.asp

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Other Risk Management Tools• 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

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Other Risk Management Applications• An accurate forecast of the timing and magnitude of

claims is especially important when losses are retained• The ability to forecast ultimate claims for liability lines is

an important skill for the risk manager– Loss development factors (LDFs) are multipliers that

can be applied to claims settled to date to estimate the ultimate claims for a period

– general upward trend in liability and workers compensation claim totals after the initial reporting period called "loss development”.

– LDFs are used to arrive at the ultimate value that can be expected for a claim. For example, an LDF of 1.50 means that for every $1 of current claims, the ultimate payout will be $1.50. A total of $50,000 in current claims would result in an ultimate payout of $75,000. http://www.irmi.com/online/

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The Financial Crisis and Enterprise Risk Management, the AIG case• AIG mentions an active 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 (CDS) 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 (pooling?)

• 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

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The use of derivatives to obscure balance sheet risks is a manifestation of that approach

• “Derivatives, AIG and the Future of Enterprise Risk Management” by Michael G. Wacek– Derivatives are attractive because they can often be

structured to replicate traditional asset transactions but with a much lighter balance sheet impact.

– Remember: a corporate bond can be replaced by a default free bond obligation (e.g. treasuries) and a short put option related to the firm value. Don’t worry if you have no knowledge on this.

• What would happen if bond default occurs– Let’s look at http://www.soa.org/library/essays/rm-essay-

2008-wacek.pdf to investigate what’s happening.

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AIG and CDS

• At a congressional hearing last week, Rep. Gary Peters (D., Mich.) asked AIG Chief Executive Edward Liddy, “Where was the risk management of your company? Where was the failure of your own internal risk-management procedures?”

• Mr. Liddy responded, “We had risk-management practices in place. They generally were not allowed to go up into the financial-products business.”http://wheelhouseadvisors.wordpress.com MARCH 30, 2009

Reading: ISDA-AIGandCDS.pdf

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Notes:

• Models for RM are important, however, you have to ask yourselves what if many CDS holders claim you for loses (extremely unlikely to happen according to the models).

• No complicated maths. are required!• Then your basic knowledge should tell it is

very likely in financial crisis!

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CDS as insurance, recent development• Wall St looks to boost market in US muni CDS, FT: February

6 2011 – Wall Street is seeking to expand the market for

derivatives – allow banks and investors to profit from/or hedge

against bond defaults by struggling US states and local governments

• Banks Look to Profit on Muni-Bond Fears– DECEMBER 21, 2010, http://online.wsj.com– For the first time in two years, Switzerland's UBS AG has

begun making markets in derivatives tied to municipal bonds and other securities.

– Separately, five large derivatives dealers—Bank of America Corp.'s Bank of America Merrill Lynch, Citigroup Inc., Goldman Sachs Group Inc., J.P. Morgan Chase & Co., and Morgan Stanley—met last month in New York to discuss standardizing the paperwork for "muni CDSs" in an effort to attract more buyers and sellers.

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The U.S. cities that have gone bankrupt• 8 cities and towns have filed for bankruptcy since 2010 — and two

of the filings were rejected:• -- Detroit

-- San Bernardino, Calif.-- Mammoth Lakes, Calf. (Dismissed)-- Stockton, Calif.-- Jefferson County, Ala.-- Harrisburg, Pa. (Dismissed)-- Central Falls, R.I.-- Boise County, Idaho (Dismissed)

• An additional 28 utilities, water districts, hospital authorities, and other municipal units have also gone bankrupt in the wake of the financial crisis.

http://www.washingtonpost.com/blogs/wonkblog/wp/2013/07/18/detroit-isnt-alone-the-u-s-cities-that-have-gone-bankrupt-in-one-map/

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Still a tiny market

• The size of the municipal CDS market is about $50 billion,

• The size of the overall municipal-bond market is about $2.8 trillion.

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Exercise before the Barring case

• Building A and building B are located close together. The probability that either of these buildings will experience a fire loss is 4 percent. However, if one building has a fire, the probability that the second building will have a fire is 80 percent. What is the probability that both buildings will have a fire? (study the text examples)

• 0.04*0.8

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The barring case

• Let’s look at barring case