RMIN 4000 Chapter 4 Financial Risk Management Traditionally risk management was limited in scope to pure loss exposures including property risks liability risks and personnel risks 1 Financial risk management refers to the identification analysis and treatment of speculative financial risks These risks include commodity price risk interest rate risk and currency exchange risk 2 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 3 4 Currency exchange risk a The currency exchange rate is the value for which one nation s currency may be converted to another nation s currency b US companies that have international operations are susceptible to currency exchange rate risk c 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 5 Managing financial risks a Pure risks were handled by the risk manager through risk retention risk transfer and loss control Speculative risks were handled by the finance division through contractual provisions and capital market instruments In 1997 Honeywell became the first company to enter into an integrated risk program with American International Group AIG b c An integrated risk program is a risk treatment technique that combines coverage for pure and speculative risks in the same contract d The chief risk officer is responsible for the treatment of pure and speculative risks e A double trigger option is a provision that provides for payment only if two specified faced by the organization losses occur Enterprise risk management 1 Enterprise risk management is a comprehensive risk management program that addresses an organization s pure risks speculative risks strategic risks and operational risks 2 Strategic risk refers to uncertainty regarding an organization s goals and objectives and the organization s strengths weaknesses opportunities and threats 3 Operational risks develop out of business operations including the manufacture and distribution of products and providing services to customers 4 Organizations adopt ERM for several reasons Among the reasons often cited are a Holistic treatment of risks facing the organization b Competitive advantage 5 Reasons cited in the RIMS Marsh survey for not adopting an ERM program include c Positive impact on revenues d A reduction in earnings volatility e Compliance with corporate governance guidelines a Not a priority b Risk is managed at operational or functional level Senior management does not see the need c Lace of personnel resources d Lack of demonstrated value e 6 3 bankruptcies Lehman Brothers Washington Mutual and Thornburg Mortgage occurred in the financial sector 7 The meltdown in the financial sector raises obvious questions about the use of ERM by financial companies and the value of ERM programs to the companies that experienced significant losses 8 Only 18 percent of the respondents said they had a well formulated and fully implemented ERM program 71 percent said they had an ERM strategy that was in the implementation stage 9 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 10 RIMS contends the financial crisis resulted from three general factors a Failure to embrace appropriate enterprise risk management behaviors b Failure to develop and reward internal risk management competencies c Failure to use enterprise risk management to inform management s decision making for both risk taking and risk avoiding decisions Random Definitions that are mentioned in Chapter 4 11 Hard insurance market is characteristic of tight underwriting standards and high premiums 12 Soft Insurance market is characteristic of loose underwriting standards and low premiums 13 Combined ratio is the ratio of paid losses and loss adjustment expenses plus the underwriting expenses to premiums 14 Capacity refers to the relative level of surplus 15 Surplus is the difference between an insurer s assets and its liabilities 16 Clash loss occurs when several lines of insurance simultaneously experience large losses 17 Consolidation means the combining of business organizations through mergers and acquisitions 18 Insurance brokers are intermediaries who represent insurance purchasers Insurance brokers offer an array of services to their clients including attempting to place their clients business with insurers 19 Securitization of risk means that the insurable risk is transferred to the capital markets through creation of a financial instrument such as a catastrophe bond future contract options contract or other financial instrument 20 Catastrophe bonds are corporate bonds that permit the issuer to skip or defer scheduled 21 An insurance option is an option that derives value from specific insurable losses or from an payments if a catastrophic loss occurs index of values 22 A weather option provides payment if a specified weather contingency occurs 23 Independent events the occurrence does not affect the occurrence of another event 24 Dependent events the occurrence of one event affects the occurrence of the other 25 Events are mutually exclusive if the occurrence of one event precludes the occurrence of the second event 26 Regression analysis characterizes the relationship between two or more variables and then uses this characterization to predict values of a variable 27 Loss distribution is a probability distribution of losses that could occur 28 The time value of money means that when valuing cash flows in different time periods the interest earning capacity of money must be taken into consideration 29 The operation through which a present value if converted to a future value is called 30 Bringing a future value back to present value is called discounting 31 Capital budgeting is a method of determining which capital investment projects a company compounding should undertake 32 The net present value of a project is the sum of the present value of the future net cash 33 The internal rate of return on a project is the average annual rate of return provided by flows minus the cost of the project investing in the project 34 A Risk Management Information System is a computerized database that permits the risk manager to store and analyze risk management data and to use such data to predict