CH2

Question 1

The Nature of Risk Management

Answer 1

Risk management is a scientific approach to the problem of dealing with the risks facing individuals and organizations.

Risk man. evolved from insurance man. (corporate man.)

Question 2

Forms of Risk Management

Answer 2

Enterprise risk management: integrated management of all risks, pure and speculative

Financial risk management: the management of financial risks, including credit risk, market risk, and liquidity risk

Traditional risk management: the management of pure risks, both insurable and uninsurable

Question 3

ERM program include:

Answer 3

Market risk: The risk arising from adverse movements in market prices.

Credit risk: The risk arising from the potential that a borrower will fail to pay a debt.

Liquidity risk: The risk that the business will have insufficient liquid assets to meet obligations that come due.

Operational Risk: the risk of loss from inadequate or failed internal processes, people, or systems or from external events. It includes a variety of pure risks, including technology risks, events such as fire, worker injury, etc.

Other ERM risks: reputational risk, strategic, and compliance risk.

Question 4

Risk Management Defined

Answer 4

A scientific approach to dealing with risks by anticipating possible accidental losses and designing and implementing procedures that minimize the occurrence of loss or the financial impact of the losses that do occur.

Risk management depends on rules (laws) derived from general knowledge of experience, deduction, and from precepts drawn from other disciplines, especially decision theory.

Question 5

Risk Management Distinguished from Previous Approaches

Answer 5

The distinguishing characteristic of risk management is the way in which it differs from previous approaches to risk-related decisions
Instinctive reactions
Learned behavior
Institutional pressures and conventions

Question 6

Risk Management Tools

Answer 6

• Risk Control
  (all techniques aimed at reducing the number of risks facing the organization or the amount of loss that can arise from these exposures. )
  Avoidance
  (when decisions are made that prevent a risk from even coming into existence.

Reduction
set of efforts aimed at minimizing risk.
Other terms that were formerly used, and which have been displaced by the more generic term “risk reduction” include “loss prevention” and “loss control.”
aim at reducing frequency, others seek to reduce the severity of the losses that do occur.

• Risk Financing
  consists of those techniques designed to guarantee the availability of funds to meet those losses that do occur.

Retention
Risk retention is the “residual” or “default” risk management technique

Exposures that are not avoided, reduced, or transferred are retained.

When nothing is done about a particular exposure, the risk is retained.

Transfer

Question 7

Risk avoidance is a negative because:

Answer 7

If avoidance is used extensively, the firm may not be able to achieve its primary objectives.

Risk avoidance should be used in those instances in which the exposure has catastrophic potential and cannot be reduced or transferred.

Generally, these conditions will exist in the case of risks for which both the frequency and the severity are high.

Question 8

Risk Retention Techniques Classified

Answer 8

Intentional / Unintentional
Unintentional retention occurs when a risk is not recognized.Unintentional risk retention is always undesirable.

Voluntary / Involuntary Retention
Voluntary retention results from the judgment that retention is the most effective means of dealing with the risk.
Involuntary retention occurs when it is not possible to avoid, reduce, or transfer the exposure to an insurance company.

Funded / Unfunded
funded retention program, the firm earmarks assets and holds them in some liquid or semi-liquid form against the possible losses that are retained.
The need for segregated assets to fund the retention program will depend on the firm’s cash flow and the size of the losses that may result from the retained exposure

Question 9

Risk Transfer

Answer 9

Purchase of insurance
Hedging
Hold-harmless agreements
Subcontracting certain activities
Surety bonds

Question 10

Risk Sharing

Answer 10

Risk sharing is sometimes cited as an additional way of dealing with risk.
Risk sharing may be viewed as a special case of risk transfer and risk retention.
The risk of the individual is transferred to the group.
The risks of a number of individuals are retained collectively.

Question 11

Risk Management’s Contribution to the Organization

Answer 11

Guaranteeing that the organization will not be prevented from pursuing other goals as a result of losses associated with pure risks.
Controlling the cost of risk for the organization; that is, by achieving the goal of economy (reduced costs increase profits).
Reducing expenses through risk control measures (loss prevention and reduction).

Question 12

The Risk Management Process

Answer 12

1. Determination of objectives
2. Identification of risks
3. Evaluation of risks
4. Consideration of alternatives -selection of the tool
5. Implementing the decision
6. Evaluation and review

Question 13

Primary Objective of Risk Management

Answer 13

It is to guarantee that the attainment of these other goals will not be prevented by losses that might arise out of pure risks.
The primary objective of risk management— like the first law of nature—is survival.

Question 14

Value Maximization Objective

Answer 14

Neil Doherty has argued that

the ultimate goal of risk management is the same as that of other functions in a business—to maximize the value of the organization (maximize the value of common stocks).

Question 15

Risk identification is

Answer 15

the most difficult step in the risk management process.
It is difficult because it is a continual process and because it is virtually impossible to know when it has been done completely.

Risk identification requires a general knowledge of the goals and functions of the organization; what it does and where it does it.
This knowledge can be gained through
Inspections
interviews
analysis of records and documents
use of flow charts
an internal communication system

Question 16

Evaluating Risks

Answer 16

Evaluation implies some ranking in terms of importance, and ranking suggests measuring some aspect of the factors to be ranked.
In the case of loss exposures, there are two facets that must be considered;
the potential severity of loss
the possible frequency or probability of loss

Critical bankruptcy
Important would require borrowing
Unimportant could be met from existing assets or income

Question 17

Assigning individual exposures to one of these categories requires:
(Critical, important, unimportant)

Answer 17

determination of the amount of loss that might result from a given exposure, and
determination of the ability of the firm to absorb such losses.

Question 18

Probability and Priority Rankings

Answer 18

almost nil (in the opinion of the risk manager, the event is probably not going to happen)

slight (while the event is possible, it has not happened and is unlikely to occur in the future)

moderate, (the event has occasionally happened and will probably happen again)

definite (the event has happened regularly in the past and is expected to occur regularly in the future).

Question 19

Evaluation and Review

Answer 19

Evaluation and review of the risk management function is important for two reasons
(1) Things change - measures that were appropriate last year may not meet the current exposures
(2) Mistakes are made - evaluation and review create an opportunity to detect and correct mistakes before they become costly.

Question 20

How does one review a risk management program?

Answer 20

Basically, by repeating each of the steps in the risk management process to determine whether past decisions were proper in the light of existing conditions and if they were properly executed.