4. Risk Management Strategies

a. Risk Management Methods ii. Loss Financing Retention and Self-Insurance Overview

Company retains obligation to pay for losses - internal: cash flows, liquid assets; external: borrowing, issuing new stock - "self insurance" when retention with formal plan

b. Risk Modeling

Determine random distribution of individual risk Determine overall random distribution of economic entity (dependencies and interdependencies) Determine practical importance

a. Risk Management Methods iii. Internal Risk Reduction Overview

Diversification - asset and geographic diversification Investment in information - more accurate forecast = reducing variability of cash flows around predicted value - information dissemination

a. Risk Management Methods i. Loss Control Loss control techniques

Loss prevention (frequency control) Loss reduction (severity control) Combination Risk avoidance - no activity = no exposure to loss; used only when other methods inefficient

a. Risk Management Methods Overview

[img] Loss control Loss financing Internal risk reduction

a. Risk Management Methods ii. Loss Financing Retention and Self-Insurance Captives

- A captive insurance is an insurer owned by a parent firm for the purpose of insuring the parent firm's loss exposure - Classifications: single parent captive (pure) and group captive (association) - Reasons for captives: access to reinsurance; tax advantages; risk and cost reduction

a. Risk Management Methods ii. Loss Financing Hedging

- Derivatives in general: A derivative is a security whose characteristics and value are a function of the characteristics and values of other securities (underlying). - Forwards: A Forward contract specifies the price and delivery date of the underlying. - Futures: Like forward contracts, but: Futures are regulated, liquid and traded on organized exchanges. - Options: Gives the holder the right (but not the obligation) to purchase by some specified future date a commodity at a price that is set now. - Swaps: The exchange of one security for another.

a. Risk Management Methods ii. Loss Financing Insurance

- most important source of external loss financing - particularly important with high-severity loss exposure (beyond risk bearing capacity of organisation)

a. Risk Management Methods ii. Loss Financing Retention and Self-Insurance Fitting conditions

- no other method of treatment available - worst possible loss is not serious - losses are fairly predictable

a. Risk Management Methods ii. Loss Financing Retention and Self-Insurance Motivation

- stronger control of RM program - lower firm's cost of risk - better cash flow control - capture investment income - avoid inefficiencies with traditional insurance

a. Risk Management Methods i. Loss Control Loss control and risk map

[img] Reduction Prevention Avoidance

a. Risk Management Methods ii. Loss Financing Loss financing and risk map

[img] Risk transfer Risk sharing Risk retention