Chapter 4 Advanced Topics in Risk Management

Review Questions

1. Three speculative financial risks that a risk manager may consider are commodity price
risk, interest rate risk, and currency exchange rate risk. Traditionally, these risks were
addressed by financial managers rather than risk managers. The role of some risk managers
has expanded to consider not only pure risks, but also speculative financial risks.

2. Traditional risk management was limited in scope to property, liability, and personnel-
related loss exposures. Enterprise risk management is a much broader concept, encompassing
traditional risk management. In addition to considering property, liability, and personnel
exposures, enterprise risk management considers speculative risks, strategic risks, and
operational risks.
3. The underwriting cycle refers to the tendency for commercial property and liability
insurance markets to fluctuate between periods of tight underwriting with high insurance
premiums and periods of loose underwriting with low insurance premiums. When the
property and liability insurance industry is in a strong surplus position, insurers can lower
premiums and loosen underwriting standards to compete with other insurers. As competition
increases, the surplus is depleted through underwriting losses that develop because of low
premiums and less stringent underwriting. If investment income is not available to offset the
underwriting losses, at some point premiums must be increased and underwriting standards
tightened. Higher premiums and stricter underwriting help to restore the insurer to
profitability. As profitability returns, the depleted surplus is restored, making it possible for
insurers to enter into competition with lower premiums and less-strict underwriting.
The market is “hard” when premiums are high and underwriting standards are tight. The
market is “soft” when premiums are low and underwriting standards are loose.
4. Consolidation in the insurance industry refers to the combining of insurance business
organizations through mergers and acquisitions. Three types of consolidation have been
occurring. First, insurance companies have been merging with or acquiring other insurance
companies. The combination of St. Paul Insurance with Travelers Insurance is an excellent
example, as is the acquisition of Safeco Insurance by Liberty Mutual Insurance Company.
Second, insurance brokerages have been merging with or acquiring other insurance
brokerages (Marsh acquired Sedgwick, for example). Finally, there has been cross-industry
consolidation. Cross-industry consolidation occurs when a company in one financial services
area merges with or acquires a company in another financial services area. For example, a
bank may acquire an insurance company or an insurance company may purchase an
investment (mutual fund) company.
5. Securitization transfers insurable risk to the capital markets through the creation of a
financial instrument, such as a catastrophe bond. Prior to securitization, the capacity of the
insurance industry was limited to the capacity of insurers and reinsurers operating in the
industry. Risk securitization provides an avenue through which insurable risk is spread to
capital market participants (e.g., bondholders).
6. (a) Loss forecasting is necessary to enable the risk manager to make an informed decision
about whether to retain or transfer loss exposures. The risk manager will be unable to evaluate
an insurance coverage bid unless he or she has some level of confidence about the magnitude
of expected losses and the reliability of the estimate. Based on the forecast, the risk manager
may believe that an insurance bid is too high and opt for retention, or that the insurance bid is
“low” relative to the expected losses, and opt for insurance.
Chapter 4 Advanced Topics in Risk Management

(b) The risk manager may use several techniques to forecast losses. Probability analysis,
regression analysis, and forecasting through loss distributions may be employed.
7. Using past losses alone to predict future losses is not wise. While past losses may have
some bearing upon future losses, underlying conditions may have changed. The company may
have sold off or acquired new operations, expanded into new markets, or altered production
processes. There may be other exposures that produce losses this year that did not produce
losses in the past. While past loss data may be helpful, additional information should be
considered.
8. Time value of money analysis is employed in risk management decision making to account
for the interest-earning capacity of money. The same amount of money to be received or paid
in different time periods is of different value in terms of today’s dollars, once the interest-
earning capacity of the money is considered. Failure to consider the interest-earning capacity
of money may lead to bad risk management decisions.
9. (a) Value at risk (VAR) is the worst probable loss likely to occur within a given time period
under regular market conditions at some level of confidence. VAR analysis is usually applied
to a portfolio of assets like a mutual fund or a pension fund.
(b) The technique is often applied to a portfolio of assets, such as a mutual fund, and is similar
to the concept of “maximum probable loss” in traditional property and liability risk
management.
10. (a) A risk management information system (RMIS) is a computerized database that
permits a risk manager to store and analyze risk management data and to use the data to
predict future loss levels. Many organizations use an RMIS as a tool to help manage claims.
(b) Some risk management departments have established their own websites. These sites
contain a wealth of risk management information about the company and answers to
frequently asked questions (FAQs). Risk management intranets are internal networks that
incorporate search capabilities. Company personnel can access the website and search for the
desired information.

Application Questions

1. Prior to the changing scope of risk management in the 1990s, insurers needed considerable
knowledge of property, liability, and personnel risks to write the insurance coverages
demanded. Given the changes that have occurred recently, insurers also need expertise in
financial, strategic, and operational issues. For example, an insurer designing a multiple-
trigger contract may need expertise in commodity pricing as well as traditional insurable loss
exposures. An insurer designing an enterprise risk management plan may need expertise in
currency exchange rate risk, the organization’s competitive environment, interest rate risk,
weather-related risk, and traditional property and liability insurance risks.
2. Property and liability insurance markets fluctuate. Sometimes premiums are high and
underwriting standards are tight; at other times, premiums are low and underwriting standards
are loose. In this case, self-insurance was probably used the first year because the risk
manager believed that the risk was best handled in this way as opposed to purchasing
insurance. The change in the second year likely reflects a downturn in insurance prices,
making commercial insurance the most cost-effective alternative.
3. There are hundreds of insurance companies operating in most states. If several of these
companies merge, or if one is acquired by another insurer, the marketplace still remains very
Chapter 4 Advanced Topics in Risk Management

competitive. However, broker consolidation leaves fewer larger players in the market. When
some large brokerages merge, there are fewer large brokers for a risk manager to contact
when putting an insurance program out for bids. For example, a risk manager was once able
to get competitive bids from Johnson & Higgins (J&H), Marsh, and Sedgwick. However,
Marsh acquired J&H and Sedgwick. Today, smaller national brokerages or regional
brokerages must often be contacted to obtain competitive bids.
4. The objective of loss control investment is to reduce the frequency and severity of losses.
Capital budgeting is a method of evaluating which investment projects are profitable and
should be accepted. It can assist the risk manager in determining the optimal set of projects to
invest in.
Time value of money and internal rate of return are the criteria that are commonly used to
determine the acceptability of investment proposals.
Internal rate of return (IRR) on a project is the average annual rate of return provided by
investing in the project. The project is accepted if the IRR is greater than or equal to the
required rate of return and rejected if the IRR is less than the required rate of return.
5. Self-insuring workers compensation is a common practice. Use of self-insurance increases
during hard insurance markets, as premiums are higher and underwriting standards are tighter.
Given the cyclical nature of the commercial property and liability insurance market, the risk
manager may want to purchase insurance next year if workers compensation insurance
premiums have dropped significantly. As workers compensation is an experience-rated
coverage, the risk manager wants to make sure that, if this year’s claims experience is
favorable, the risk manager will be able to document the superior performance to insurance
underwriters, and obtain a lower premium from the insurer.