Detailed

micael14

2013_ana_sec_1_intro.pdf

Home >Business & Finance homework help >Marketing homework help >Detailed

Introduction to Analysis of Risk

Learning Objectives

1. Discuss the definitions of risk and the general classes of risk. (p. 2)

2. Discuss the definition of risk management and the five steps of the risk management process. (p. 6)

3. Discuss the components of the total cost of risk and its use as a key risk management tool. (p. 15)

4. Discuss the uses of risk analysis and the necessary tools to perform a risk analysis. (p. 23)

Learning Objective #1: Discuss the definitions of risk and the general classes of risk.

I. What is Risk?

A. Definitions of risk

1. “Risk” is a term subject to various interpretations in risk management. The interpretations are usually dependent upon the perspective of the user and the purpose for which the term is applied.

2. Risk may take the form of

a. A probability

b. A degree of uncertainty

c. Varying outcomes

d. A variance from a forecast or prediction

3. Four broad definitions of “risk” used in risk management

a. Chance or probability of loss

b. Uncertainty concerning loss

c. Possibility of a variation of outcomes from a given set of circumstances

d. Difference between expected losses and actual losses

4. For purposes of the CRM program, the most useful definition of risk is:

“Uncertainty that may be either positive or negative arising from a given set of circumstances.”

B. Types of risk

1. Pure – chance of loss or no loss (break-even)

2. Speculative – chance of loss or gain; often referred to as a “business risk”

C. Risk management terms and definitions

1. Exposure – a situation, practice, or condition that gives rise to a loss from a given peril leading to an adverse financial consequence; an activity or resource; people and assets

2. Peril – the cause of a loss

3. Hazard – a condition or circumstance that may give rise to a loss from a given peril; physical, moral, or moral characteristics that make the likelihood of a loss from a given peril greater

4. Incident – an event that disrupts normal activities and may become a loss, claim or business interruption

5. Accident – an unplanned event, definite as to time and place, that results in injury or damage to a person or property

6. Occurrence – an accident with the limitation of time removed; an “accident” that is extended over a period of time rather than a single observable happening

7. Loss – a reduction in value

8. Claim – a demand or obligation for payment as a result of a loss

9. Frequency – the number of losses occurring in a given time period

10. Severity – the dollar amount of a given loss or the aggregate dollar amount of all losses for a given period

11. Expected losses – projection of the frequency and/or severity of losses based on loss history, probability distributions, and statistics; the expected loss projection is commonly called a “loss pic” or “loss pick”

Commentary: Risk management concepts should be viewed primarily from the eye of the organization. While insurance agents, brokers and insurance carriers may provide risk management services to the organization, the risk management concept is driven by the risks the organization must face.

D. General classes of risk

1. Six General Classes of Risk

1. Economic

2. Legal

3. Political

4. Social

5. Physical

6. Juridical

1. Economic – risks arising from operations, economy, financial marketplace or entrepreneurial activities

2. Legal – risks inherent in compliance or arising from statutory liability

3. Political – risks arising from changes in the law, government reinterpretations or changes in government policy

4. Social – risks arising from public relations, loss of reputation, damage to brand, cultural issues, social direction or social media

5. Physical – risks arising from property, people or information

6. Juridical – risks arising from a jury or judge’s decision or from court or jury attitudes

Learning Objective #2: Discuss the definition of risk management and the five steps of the risk management process.

II. Risk Management

A. Definition of risk management

Similar to “risk,” risk management has many definitions. For purposes of the CRM program, the definition of risk management is as follows:

“Process of managing uncertainty of exposures that affect an organization’s assets and financial statements using five steps: identification, analysis, control, financing and administration.”

This process can address pure risks only (traditional risk management), or pure and speculative risks (enterprise-wide risk management).

The focus of the process is two-fold:

1. Protect the assets of the organization, and

2. Protect the financial statements of the organization

Commentary: Protecting the organization’s assets and its financial statements may sound redundant, but they are different. Protecting the assets addresses the physical aspect of property and human resources. Protecting the financial statement addresses the financial impact on the organization arising out of loss to the assets and includes circumstances when the organization’s property and human resources are not involved in a loss.

B. The Risk Management Process

Five Steps of the Risk Management Process

1. Risk Identification

2. Risk Analysis

3. Risk Control

4. Risk Financing

5. Risk Administration

R is

k M

a n

a g

e m

e n

t P

ro c

e s

s Risk Identification

The process of identifying and examining exposures of

an organization

Risk Analysis The assessment of the

potential impact of various exposures on an organization

Risk Financing The acquisition of internal and external funds to pay

losses at the most favorable cost

Risk Control Any conscious action or

inaction to minimize at the optimal cost, the probability,

frequency, severity, or unpredictability of loss

Implementation Implementing the desired

actions and risk management plans

Monitoring Examining and evaluating the results of risk management

actions and plans

Risk Administration

feedback

1. Risk Identification – the process of identifying and examining exposures of an organization Identification is the most important step of the risk management process because an exposure and/or risk must be identified before it can be effectively analyzed, controlled, or financed. a. Four logical classifications of exposures

1) Property

2) Human resources

3) Liability

4) Net income

b. Ten methods of exposure identification

1) Checklist and survey

2) Flowchart

3) Insurance policy review

4) Physical inspections

5) Compliance review

6) Procedures and policies review

7) Contract review

8) Experts

9) Financial statement analysis

10) Loss data analysis

2. Risk Analysis – the assessment of the potential impact of various exposures on an organization

a. Qualitative analysis –the “what” analysis

1) Risk assessment – used to identify and assess those loss exposures that cannot be easily measured by traditional statistical or financial methods and to understand their impact on the

organization’s ultimate risks and performance

2) Financial assessment – used to identify and assess those broad loss exposures that have a financial impact on the organization but that may be difficult to quantify

3) Loss data assessment – used to identify and apply various methods of assessing loss data and to analyze the impact those losses may have on the organization’s risk management policy and the ultimate total cost of risk

b. Quantitative analysis – the “how much” analysis; attempts to accurately measure risks by using acceptable traditional methodologies which calculate relative values

1) Loss projections or forecasts

2) Cash discounting and net present value (NPV) calculations

3) Cost-benefit analyses

4) Total cost of risk calculations and analyses

3. Risk Control – any conscious action or inaction to minimize, at the optimal cost, the probability, frequency, severity, or unpredictability of loss a. General theories of risk control

1) Human approach – people cause accidents

2) Engineering approach – things and energy cause accidents

3) Systems approach – systemic failures or weaknesses cause accidents

b. Five techniques of risk control

1) Avoidance

2) Prevention

3) Reduction (pre-loss and post-loss)

4) Segregation/separation/duplication

5) Transfer (contractual, physical or both)

Commentary: While there are five techniques of risk control, very few instances arise when the use of only one technique is appropriate. Two or more techniques are commonly used for the majority of applications. For example, a prevention technique may be applied to workers compensation injuries with a reduction technique to address the injuries that were not prevented.

4. Risk Financing – the acquisition of internal and external funds to pay losses at the most favorable cost a. Retention – internal funds used to pay losses

1. Active (planned)

2. Passive (unplanned)

b. Transfer of financial responsibility – external funds used to pay losses

1. Non-insurance contractual transfer of control or responsibility for an exposure

2. Non-insurance contractual indemnification or financial responsibility

c. Insurance – equitable financing of risks, from one entity to another, in exchange for payment

5. Risk Administration a. Implementation

b. Monitoring

The Risk Management Process Overview

Risk Identification Logical Classifications  Property  Human Resources

 Liability  Net Income

Identification Methods  Checklist and Survey  Flowchart  Insurance policy review  Physical inspections  Compliance review

 Procedures and policies review  Contract review  Experts  Financial statement analysis  Loss data analysis

Risk Analysis Qualitative Analysis  Risk assessment  Financial assessment  Loss data assessment

Quantitative Analysis  Loss projections or forecasts  Cash discounting and NPV

calculations

 Cost-benefit analyses  Cost of risk calculations and

analyses

Risk Control Five Techniques – Pre-Loss  Avoidance  Prevention  Reduction (pre-loss and post-loss)  Segregation/separation/duplication  Transfer (contractual, physical, or

both)

Post-Loss  Claims management  Litigation management  Disaster recovery

Risk Financing Retention  Active  Passive Insurance

Risk Administration

 Implementation  Monitoring

Transfer  Contractual transfer of control or

responsibility  Contractual indemnification or

financial responsibility

Learning Objective #3: Discuss the components of the total cost of risk and its use as a key risk management tool.

III. Total Cost of Risk (TCOR)

A. Definition: sum of all quantified costs and expenses associated with the risk management function of an organization

TCOR = insurance costs + retained losses + risk management departmental costs + outside services fees + quantified indirect costs

B. Components of TCOR 1. Insurance costs

2. Retained losses (passive or active) and associated loss adjustment expenses

3. Risk management departmental costs

a. Salaries

b. Administrative charges, e.g., training and travel expenses

c. Employee benefits

d. Risk management information system

e. Management overhead

f. Other departmental costs

4. Outside services fees

a. Risk management consultants

b. Third-party administrators and other providers

c. Loss control

d. Actuarial

e. Legal

f. Fee-for-service insurance brokers

5. Indirect costs – these costs cannot be precisely measured; therefore, their impact of non- quantifiable indirect costs should be included as part of the qualitative assessment of risk

a. Disruption in production/sales

b. Management time spent on loss-related activities

c. Overtime costs

d. Hiring and training replacement costs

e. Opportunity costs

f. Loss of goodwill

g. Social costs (public image, reputation, etc.)

C. Objective of the risk manager – to minimize the TCOR by identifying those factors from each component that can be more effectively managed and controlled

Impact of a Loss on TCOR and Sales/Revenue Regardless of whether or not the organization includes the TCOR in the pricing of its products or services, any loss that is prevented or reduced improves the financial results of the organization.

Steps to measure the impact of a loss on sales or revenue:

1. Determine the profit margin of the organization

2. Divide the loss cost by the profit margin. The result is the

sales or revenue required to pay for the loss.

Sales/Revenue Required to Pay for Losses

Loss Cost

Profit Margin 1% 2% 3% 4% 5%

$1,000 $100,000 $50,000 $33,000 $25,000 $20,000 $5,000 $500,000 $250,000 $167,000 $125,000 $100,000

$10,000 $1,000,000 $500,000 $333,000 $250,000 $200,000 $25,000 $2,500,000 $1,250,000 $833,000 $625,000 $500,000

$100,000 $10,000,000 $5,000,000 $3,333,000 $2,500,000 $2,000,000 Which is easier for an organization to accomplish: preventing a loss of $10,000 or increasing sales or revenue by $1,000,000?

Example of TCOR (direct costs only)

Insurance costs (net of commissions) $ 800,000 (42%) Retained losses and settlement expenses 850,000 (45%) Risk management departmental costs Salaries, benefits, expenses 100,000 ( 5%) Outside services Consulting, brokerage services 50,000 ( 3%) Claims administration 85,000 ( 4%) Loss control expenses 25,000 ( 1%) Total $ 1,910,000 f(100%)

Questions to consider:

Is this good or bad?

How does this compare with revenue from year to year?

How does it compare with the competitors?

How can we pass this TCOR to the customers through product pricing?

Outside Services

Claims Administration

Consulting

Other Risk Control

Retained Losses and ALAE

Risk Management Department Costs

Insurance Premiums

Outside Services

Claims Administration

Consulting

Other Risk Control

Retained Losses and ALAE

Risk Management Department Costs

Insurance Premiums

D. The TCOR is used as a key risk management tool to assist with:

1. Making effective risk management decisions

2. Measuring progress toward risk management objectives

3. Focusing on and promoting safety and loss control by communicating the financial impact of a loss on the TCOR and sales/revenue

4. Providing management and employee incentives

5. Pricing of products and services

6. Assisting with effective management of financial budgets

Visualization Exercises

1. Jumping Jacks, Ltd. is a manufacturer of jump ropes with a five-year frequency of losses as follows:

X1 120

X2 383

X3 247

X4 301

X5 199

What will predicted losses be in Year X6?

What is the range of losses that might be expected to occur in Year X6?

What is the degree of certainty of these predictions?

2. Robert is a regional distributor of Jumping Jacks products. He stores his inventory in a warehouse his organization owns. Robert is considering either installing smoke detectors, to reduce the impact of possible fire losses, at a cost of $50,000 or renting additional space at another location to separate his inventory at an additional cost of $60,000.

Which should he do?

3. A safety consultant suggests Robert also consider a sprinkler system that will cost $16,000 to install. Its installation will reduce Robert’s property insurance premiums by $2,000 annually. The expected life of the sprinkler system is 15 years. Robert’s CFO states the company should earn 16% on its investment.

Should Robert install the sprinkler system? 4. Jumping Jacks, Ltd. has just hired you as its first risk

manager. During your first week, the CFO has presented you with a list of losses that occurred over the last five years. He states that he believes Jumping Jacks, Ltd. would save money by reducing controllable losses and retaining the remainder instead of buying very expensive insurance.

a. How would you verify the loss data?

b. How would you classify the loss data?

c. How would you determine the viability of a possible retention program?

d. How much should you retain?

e. Would you continue to buy insurance, and if so, how much would you buy?

f. What level of deductible would you buy?

Learning Objective #4: Discuss the uses of risk analysis and the necessary tools to perform a risk analysis.

IV. Risk Analysis

A. Uses of risk analysis

1. Prioritization of risk factors

2. Verification of loss data

3. Classification of loss data

4. Prediction of losses and ranges of losses

5. Cost-benefit decision making

6. Net present value (NPV) analysis

7. Review of insurance program structure to determine:

a. Viability of a retention program

b. Amount of retention

c. Insurance purchasing decisions, including limits of liability

B. Risk analysis tools

1. Tools used to assess the likelihood an event will occur

a. Loss analysis

b. Risk mapping or risk factor analysis

c. Probability analysis

d. Linear regression

2. Tools used to assess the impact of the event should it occur

a. Payback analysis and accounting rate of return

b. Cost-benefit analysis

c. NPV analysis

d. Internal rate of return (IRR) method

Review of Learning Objectives

1. Discuss the definitions of risk and the general classes of risk. (p. 2)

2. Discuss the definition of risk management and the five steps of the risk management process. (p. 6)

3. Discuss the components of the total cost of risk and its use as a key risk management tool. (p. 15)

4. Discuss the uses of risk analysis and the necessary tools to perform a risk analysis. (p. 23)