RISK MANAGEMENT AND INSURANCE

RISK MANAGEMENT AND INSURANCE TOPIC 4 RISK MANAGEMENT 2: ADVANCED TOPICS

Introduction • Three broad policy issues facing risk managers: • Risk Management Information Systems (RMIS). • Determining the appropriate amount of loss exposure to retain. • International loss exposures.

RMIS • Risk managers use Risk Management Information Systems (RMIS) to: • Record, • Track and analyze losses, • Keep records to plant, property and equipment and how they are protected from losses, • Statistical Analysis, using past loss help to forecast losses. • RMIS must be adapted to the needs of the individual organizations. Each organization facing different hazards (earth quake or flooding), different liability exposures (some have chemicals, some firms manufacture products) and differences in property value fluctuations. (Some having significant annual inventory annual changes) • RMIS should be tailored to the needs of the firms.

Loss Data • Loss records including injuries to workers, liability claims, or assets losses are the foundation of RMIS. • Computerized data bases records on: • Frequency, severity, causes, final outcome of the losses are kept. • Outcomes are analyzed by statistical techniques such as regression analysis. • RM analyses the data for developing an effective way to lower the numberof accidents and costs. (Classification such as: age, experience, weather conditions, time of the day) • Operating RMIS is not easy, as you may have inaccurate loss data, subsequent analysis or misleading forecasts. • Comp. Should be updated, data should be audited randomly to enable accuracy.

Example1: RM analyisisoninformation system data for developing an effective way to lower the no. of accidents, no. of deaths due to accidents and costs.

Example 2: RM analyisisoninformation system data for developing an effective way to lower the no. of accidents, no. of deaths due to accidents and costs.

Deductible and Policy Limits • Problem: • How much loss exposures to retain; • How much loss exposures to transfer • Deductibles (Retentions): Cause insured to bear the first dollars of a loss. • Policy Limits: determine maximum insurance recovery. • if a loss is equal to or is less than the deductible, the insured bears the cost. • If a loss is greater than the policy limits, the insured bears the cost of any applicable deductible and the amount of loss above the policy limit. (example)

Deductible and Policy Limits contn’d.. Deuctible Size, Plolicy Limits and the Premium Payments • Increasing policy limits, increases the premium cost but the increase is not proportional. (when the limit doubles, we do not have double premium). • Increasing deductible, reduces the premium cost, but the reduction is not proportional. (when the deductible doubles, we do not have half premium).

The Two Extremes: Overinsurance and Underinsurance • For ‘lower premium - higher retention’ trade off we describe two extremes: • Overinsurance: • Is the situation in which insurance benefits exceed the actual loss of an insured. • Can be a problem for the insurer because it may tempt the insured to make a false claim inorder to profit financially.

The Two Extremes: Overinsurance and Underinsurance contn’d... UNDERINSURANCE: • Inadequate insurance coverage by the policy holder (the insured). • In the event of a claim, underinsurance may result in economic losses to the policy holder (the insured), since the claim would exceed the maximum amount that can be paid out by the insurance policy. • While underinsurance may result in lower premiums paid by the policy holder, the loss arising from from the claim may far exceed any marginal saving in insurance premiums. • Situation works as if there is a co-insuranceagreement between the insurer and the insured in case of a loss. This is why sometimes called co-insurance penalty. Risk is accepted to be shared between the insurer and the insured at the proportion of inadequacy in the insurance coverage.

Financial and Other Considerations Risk manager should think: 1. Tax implications (Tax deductible expenses) 2. Ability to pay Losses • Usually lower policy limits is favoured but: • the liquidity of assests-is there sufficient cash? • The stability of net income. • The amount of net worth. • The increased cost of capital (Risky to lenders and investors) 3. Psychological Factors: experience, attitudes toward risk, habit and intuition. 4. Social Ethical Concerns: In the absence of adequate funding, uninsured losses could bankrupt organizations producing ethically undesired consequences. (e.g. Under-compensated dead, injured employees, polluted environment, unemployed workers).

International Risk Management • Multinational and international firms operate worldwide. • They face: • Foreign Currency: measurement and financing problems. • Political Risk: Trade embargoes cancellation of export licenses, expropriation (nationalization of foreign-owned property, war, terrorism, cultural differences) • Risk financing arrangements and practices vary widely throughout the world. 4. Movement of goods, a) Marine Insurance (inland and ocean) are important. b) Income Insurance: pays for losses caused by delays in receiving shipment are popular.

Foreign Insurance • Generalization about foreign insurance arrangements are difficult to make. • Some countries allow foreigners to insure foreign owned property by their own brokers and insurers (e.g. USA). • Insurers authorized to do business in an other country is called admitted insurers. • Some foreign countries levy fines and other penalties on companies using non-admitted insurers. • Admitted insurers can be desirable because premiums and losses are dominated in local currency. • Some RMs may prefer non-admitted insurers if they provide familiar policies with a common language and laws and more, non-admitted insurer is providing international coverage for a large number of foreign operations.

Foreign Insurance contn’d... • Firms try to develop a global insurance program (e.g. US firms): • An international insurer (or broker) having an international network of associations with local insurance companies. • Using admitted insurers in each country or a region but purchase a difference-in-conditions (DIC) policy from a for example US insurer. • DIC policy is written on a manuscript, tailor-made basis. • DIC policy supplements the local (foreign) property coverage by broadening the covered perils, increasing policy limits or doing both. • DIC policies allow e.g. the US firms to pay premiums to a US insurer and collect losses in $s if foreign insurer do not provide all the coverage the risk manager specifies. • With the DIC policy, the US firm can appeal global uniformity in coverage because the DIC supplement brings all policies up to its limits.

Financial Risk Management • In addition to pure risks, firms face contingencies called financial risks. • Cost of capital, cash flow management issues. Interest Rate Risk: caused by increasing interest rates reducing market value of fixed income securities. Credit Risk: caused by a borrower defaulting on a loan. Currency Risk: caused by fluctuations in the value of domestic currency against foreign currencies. Liquidity Risk: caused by having to liquidate an investment at an investment quickly. Market Risk: caused by having to liquidate an investment at an unfavorable price.

Financial Risk Management contn’d.. • Potential loss sources can be managed by: • Avoidance, • Assumption • Transfer • Since these exposures are not predictable and someexposures could prove catastrophic, insurance is not thought to be an option. • Among the possible financial market transactions are: 1. Traded options 2. Futures contracts 3. Forward contracts 4. Swaps (Currency and interest swaps)

RISK MANAGEMENT AND INSURANCE