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ARM 54: Risk Management Principles and Practices Exam Review
CAD007
Speakers:
• Ann E. Myhr, CPCU, ARM, AIM, ASLI, AU, Senior Director of Knowledge Resources, The Institutes
• Susan Kearney, CPCU, ARM, AAI, AU, Senior Director of Knowledge Resources, The Institutes
Learning Objectives
At the end of this session, you will:
• Anticipate the ARM 54 Exam Format
• Recall specific principles likely to appear on the ARM 54 exam
• Appraise your strengths and weaknesses applied to ARM 54 exam subjects
Session Overview
• Exam Basics – What to Expect
• Test Taking Tips
• Review of the “Top” Most Challenging Educational Objectives of ARM 54
Exam Basics – What to Expect
• Exam Length, Exam Format
• Educational Objectives
• Balanced Exam
• Formulas and Tables
Test Taking Tips
• Don’t get bogged down early
• Try the exam in “waves”
• Get the easy ones
• Eliminate the obviously wrong answers
• Use the mark for later review feature
• Use your scratch paper to keep track
Segment A
Segment A
● Intro to Risk Mgt.
● Risk Mgt. Standards and Guidelines
● Hazard Risk
● Operational, Financial and Strategic Risk
Segment B
● Risk Mgt. Framework and Process
● Risk Identification
● Risk Analysis
● Risk Treatment
Segment C
● Financial Statement Risk Analysis
● Capital Investment and Financial Risk
● Monitoring and Reporting on Risk
Assignment 1: Introduction to Risk Management
• The Risk Management Environment
• Benefits of Risk Management
• Risk Management Objectives and Goals
• Basic Risk Measures
• Risk Classifications
• Enterprise Risk Management
Classifications of Risk
Risk Quadrants
Risk can be classified as diversifiable or nondiversifiable. Which one of the following statements is true?
A: Inflation, unemployment, and natural disasters, such as hurricanes, are examples of diversifiable risk.
B: Diversifiable risks tend not to be correlated so they can be managed through diversification or spread of risk.
C: The distinction between diversifiable and nondiversifiablerisks is clear; risks cannot fall under both classifications simultaneously.
D: Private insurance tends to concentrate on nondiversifiablerisks; government insurance is often suitable for diversifiable risks.
Assignment 2: Risk Management Standards and Guidelines
• Intro to Risk Management Standards and Guidelines
• ISO 31000 Risk Management
• COSO Enterprise Risk Management
• Solvency II and Basel II and III Regulatory Standards
Risk Management Standards
• Standards
• Frameworks
• Major risk management standards and guidelines
Framework and Process
ISO 31000 Framework and Process
Source: ISO 31000:2009
COSO ERM
Source: COSO – Enterprise Risk Management – Integrated Framework
A key distinction between ISO 31000 and COSO ERM is that ISO
31000
A: takes an enterprise-wide approach.
B: involves elements of a risk management process.
C: defines “risk” as having both an upside and a downside.
D: requires the monitoring of treatment plans.
The Committee of Sponsoring Organizations’ (COSO 2004) risk
management standard
A: primarily employs root cause analysis to assess risk.
B: defines “risk” as the uncertainty on objectives.
C: was issued by a government agency.
D: originated with a focus on financial risk.
Assignment 3: Hazard Risk
• The Nature of Hazard Risk
• Loss Exposures
• Commercial Insurance Policies
A group of female employees at Third Federal Bank filed a lawsuit
against the bank. The lawsuit alleges that the bank consistently
failed to promote qualified women to senior management
positions because of their gender. If the lawsuit is successful,
which one of the following coverages would pay the damage
award?
A: Workers compensation insurance
B: Sistership liability insurance
C: Employment practices liability insurance
D: General liability insurance
Assignment 4: Operational, Financial, and Strategic Risk
• Operational Risk
• Operational Risk Indicators
• Financial Risk
• Value at Risk and Earnings at Risk
• Regulatory Capital
• Economic Capital
• Strategic Risk
Operational Risk
• People
• Process
• Systems
• External events
Risk Indicator
Financial Risks
• Market risk
• Currency price risk
• Interest rate risk
• Commodity price risk
• Equity price risk
• Liquidity risk
• Credit risk
• Price risk
Which one of the following types of financial risk measures an
organization’s ability to raise cash?
A: Price risk
B: Market risk
C: Liquidity risk
D: Interest rate risk
Value at Risk (VaR)
A $500,000, 2 percent VaR means losses are expected to be
A: $10,000.
B: less than $500,000 2 percent of the time.
C: $490,000.
D: greater than $500,000 2 percent of the time.
Earnings at Risk
Earnings at risk of $200,000 with 90 percent confidence are
projected to be
A: $180,000.
B: less than $200,000 10 percent of the time.
C: $200,000 90 percent of the time.
D: greater than $200,000 10 percent of the time.
EO 4.06
• Apply the concept of economic capital to insurers.
Market Value Surplus (MVS)
Economic Capital
Market Value Surplus Example
Autumn Assurance Group has assets at fair value of $100 million.
The present value of Autumn’s liabilities is $85 million. The market
value margin is $5 million. Using probability models, Autumn
determines that its VaR is $8 million because it expects to incur an
$8 million or greater loss of capital at a .5 percent probability over
a one-year period.
1. What is Autumn’s MVS?
2. What is Autumn’s economic capital?
3. Does Autumn have excess capital or a deficiency in capital?
Segment B
Segment A
● Intro to Risk Mgt.
● Risk Mgt. Standards and Guidelines
● Hazard Risk
● Operational, Financial and Strategic Risk
Segment B
● Risk Mgt. Framework and Process
● Risk Identification
● Risk Analysis
● Risk Treatment
Segment C
● Financial Statement Risk Analysis
● Capital Investment and Financial Risk
● Monitoring and Reporting on Risk
ERM Framework and Process
Assignment 5: Framework and Process
Traditional RM Process
Cromley has 30 stores located throughout the U.S. An increase in
the frequency and severity of general liability claims over the last
three years has encouraged Cromley's risk manager to design and
implement a risk management framework and process. Cromley
has decided to replace the carpeting at several locations,
purchase additional storage equipment, and train employees on
premises safety. Cromley is in which one of the following stages
of designing and implementing a risk management framework and
process?
A: Evaluation of internal and external environments
B: Gap analysis
C: Integration into existing processes
D: Commitment of resources
Assignment 6: Risk Identification
• Introduction to Risk Identification
• Team Approaches to Risk
Identification
• Risk Registers
• Risk Maps
• Identifying Loss Exposures
• Identifying Risk
Which one of the following team approaches to risk identification
involves a select group of experts in question-and-response
cycles until a consensus is achieved?
A: Delphi technique
B: SWOT analysis
C: HAZOP
D: Scenario analysis
Assignment 7: Risk Analysis
• Introduction to Risk Analysis
• Probability Analysis
• Characteristics of Probability
Distributions
• Trend Analysis
• Analyzing Event Consequences
• Analyzing Loss Exposures
Frequency Probability Distribution
Number of Hurricanes Probability
0 .300
1 .350
2 .200
3 .147
4 .002
5 .001
Total 1.00
EO 7.03
• Describe the following characteristics of probability distributions:
• Expected value
• Mean
• Standard deviation
• Coefficient of variation
• Normal distribution
Characteristics of Probability Distributions
• Central Tendency
• Expected Value
• Mean
• Dispersion (volatility)
• Standard Deviation
• Coefficient of Variation
Central Tendency
Number of Hurricanes Probability Expected Value Mean
0 30 % 0.00
1 35 % .350
2 20 % .400
3 14.7 % .441
4 .02 % .008
5 .01 % .005
15 100 % 1.204 15/6 = 2.5
Probability Distributions
Coefficient of Variation Example
A plant manager wants to compare the relative variability of the plants workers’ compensation frequency to its severity. Based on the data below, is the plant’s frequency or severity relatively more variable?
MeanStandard Deviation
Coefficient of Variation
Frequency 40 10
Severity $90,000 $45,000
Normal Distribution
Assume that the length of time a heating element can operate
safely conforms to a normal distribution with a mean of 5,000
hours and a standard deviation of 1,000 hours. If the element is
replaced after 5,000 hours, which one of the following represents
the chance that the heating element will become unsafe before
being replaced?
A: 70 percent
B: 50 percent
C: 40 percent
D: 20 percent
If 95.44 percent of all outcomes are within two standard deviations
above and below the mean and 2.15 percent of all outcomes are
between two and three standard deviations above and 2.15
percent of all outcomes are between two and three standard below
the mean, the percentage of all outcomes that lie beyond three
standard deviations from (above and below) the mean is
A: .13
B: .26
C: 2.15
D: 4.30
EO 7.04
• Explain how regression analysis can be used to forecast gains and losses.
Regression Analysis Equation
y = a + b(x)
Vandenberg ‘s risk manager uses regression analysis to
determine the relationship between Vandenberg’s workers
compensation medical expenses (the dependent variable) and its
payroll (the independent variable). The formula for Vandenberg’s
linear regression line is y = 5.20 + .098 (x). Next year’s payroll is
estimated to equal $3,750,000. Based on this information what are
Vandenberg’s estimated workers compensation medical expenses
next year?
A: $367,495
B: $367,500
C: $367,505
D: $375,520
Decision Tree
Assignment 8: Risk Treatment
• Risk Treatment
• Introduction to Risk Financing
The CEO of GBB Co.,in consultation with the head of the human
resources department, decided to begin to offer off-site day care
as an employee benefit for GBB employees. The risk manager
learned of the day care operation two weeks after the service to
employees had begun. He reviewed the company's liability
insurance contracts and determined that the company had no
coverage for liability arising out of the day care operations. This
risk, as it was not identified and treated, is being handled through
A: Unplanned transfer.
B: Unplanned mitigation.
C: Unplanned avoidance.
D: Unplanned retention.
Segment C
Segment A
● Intro to Risk Mgt.
● Risk Mgt. Standards and Guidelines
● Hazard Risk
● Operational, Financial and Strategic Risk
Segment B
● Risk Mgt. Framework and Process
● Risk Identification
● Risk Analysis
● Risk Treatment
Segment C
● Financial Statement Risk Analysis
● Capital Investment and Financial Risk
● Monitoring and Reporting on Risk
Assignment 9: Financial Statement Risk Analysis
• Balance sheet
• Income statement
• Statement of changes in shareholders equity
• Statement of cash flows
Balance Sheet
AssetsCurrent AssetsNoncurrent Assets
Total Assets
Liabilities and Shareholders’ EquityCurrent LiabilitiesNoncurrent Liabilities
Total liabilities
Shareholders’ EquityTotal Liabilities and Shareholders’ Equity
Income Statement
Revenue
- Cost of goods sold
Gross profit
- General operating expenses
Operating income
+/- Other income/expenses
Net income before taxes
- Income taxes
Net Income
Statement of Comprehensive Income
Net income + Other comprehensive income (OCI)
Components of OCI
Change in unrealized appreciation/depreciation of investments
Foreign currency gains/losses
Minimum pension liability changes
EO 9.04
• Describe the content and purpose of the statement of changes in shareholders’ equity and the statement of cash flows.
Owners’ Equity (OE)
OE Components
Paid-in capital
Retained earnings
Accumulated other comprehensive income
Treasury stock
Change in OE (year over year)
+ common stock issued
+ net income – dividends
+/- other comprehensive income/loss
+/- share issuance/ repurchase
The portion of net income that is not distributed to
stockholders is added to
A: comprehensive income.
B: retained earnings.
C: treasury stock.
D: paid-in capital.
Statement of Cash Flows
Operating activities
Investing activities
Financing activities
Increase/decrease in cash for year
EO 9.06
• Apply trend analysis to income statements over multiple periods.
Trend Analysis
12/31/2013 12/31/2012 12/31/2011
Revenue $25,000 $30,000 $33,000
Net income $1,200 $1,500 $1,800
Lisa wants to quantify her company’s sales growth rate over the past
year. Using the following data, what is the growth rate?
End Yr. 2 End Yr. 1
Net Sales $500,300 $450,200
A: 8 percent.
B: 9 percent.
C: 10 percent.
D: 11 percent.
Which one of the following statements best describes a trend in the financial data above?
A: The low growth in the cost of sales is adversely affecting gross profit.
B: Operating profit is negative during each of these three years.
C: Operating expenses are increasing at a faster rate than sales causing operating profit to decline.
D: The cost of sales is increasing at a faster rate than operating expenses.
EO 9.07
• Explain how ratio analysis can be used to evaluate liquidity.
Ratio Analysis
Working capital
Current ratio
Acid-test ratio
Current assets – Current liabilities
Current assets / Current liabilities
(Cash + Marketable securities + Accounts receivable) / Current liabilities
Balance Sheet
Current Assets
Cash $50,000
A/R 125,000
Inventory 1,500,000
Supplies 75,000
Securities 15,000,000
Total: $16,750,000
Current Liabilities
Accts payable $1,250,000
Wages payable 250,000
Taxes payable 3,750,000
ST debt 15,000,000
Total: $20,250,000
Assignment 10: Capital Investment and Financial Risk
• Present Value and Discounting
• Present Value of an Annuity
• Present Value of Unequal Payments
• Net Present Value
• Evaluating Capital Investment Proposals
• Evaluating Cash Flows From Treating Hazard Risk
• Using Call Options to Limit Financial Risk
EO 10.04
• Calculate the net present value of a series of cash outflows and inflows, given the applicable rate of return and number of periods.
Present Value Considerations
• Single or multiple periods?
• Single or multiple sums?
• Equal or unequal amounts for each period?
• Cash inflows, outflows, or both?
• How many periods (n)?
• What is the interest rate (r)?
Present Value Formula
PV = FVn ÷ (1 + r)n
ABC Insurance’s financial officer wants to set aside sufficient
funds to pay a lump sum claim settlement of $250,000 two
years from today. Assuming the fund earns 10 percent per year,
how much will the financial officer need to place in the fund
today?
A: $375,000
B: $302,500
C: $225,000
D: $206,600
Present Value of $1 Tablen/r 8% 9% 10%
1 .9259 .9174 .9091
2 .8573 .8417 .8264
3 .7938 .7722 .7513
4 .7350 .7084 .6830
5 .6806 .6499 .6209
Present Value of an Annuity
Present Value of an Annuity of $1 Tablen/r 5% 6% 7% 8%
1 .9524 .9434 .9346 .9259
2 1.8594 1.8334 1.8080 1.7833
3 2.7232 2.6730 2.6243 2.5771
4 3.5460 3.4651 3.3872 3.3121
5 4.3295 4.2124 4.1002 3.9927
6 5.0757 4.9173 4.7665 4.6229
7 5.7864 5.5824 5.3893 5.2064
EO 10.05
• Evaluate capital investment proposals using the net present value method.
Net Present Value (NPV)
• The present value of all future net cash flows (including salvage value) discounted at the cost of capital, minus the cost of the initial investment, also discounted at the cost of capital.
Net Present Value of an Investment
Year PaymentPresent Value
Factor (7%) Present Value
0 -$10,000 1.0000 -$10,000
1 2,500 .9346 2,236
2 3,300 .8734 2,882
3 $4,700 .8163 3,837
Net present value -$945
Net Present Value Example
Should your company invest $10,000 today in loss control equipment that is expected to save losses and expenses of $3,000 at the end of the first year, $3,200 at the end of the second year, and $4,100 at the end of the third year. Assume your company requires a rate of return on its investments of 5 percent.
Risk Information System – NPV
• Initial investment = $30,000
• Useful life = 7 years
• Operating expenses $600 per year
• Savings = $12,000 per year
• Expected rate of return = 8%
Risk Information System – NPV
Revenue $12,000 Before-tax CF $11,400
Expenses (600) Depreciation (4,286)
Before-tax CF 11,400 Taxable income 7,114
Tax (2,846) Tax (40%) $2,846
After-tax CF 8,554
X 5.206
PV of AT CF 44,532
Initial invest. (30,000)
NPV $14,532
Omicron Manufacturing is considering the purchase of new
extrusion equipment that costs $150,000 and has a useful life of
10 years with no salvage value. It will generate differential cash
revenues of $35,000 per year and will add $4,000 to the company’s
annual maintenance costs and $1,500 to its insurance premium.
Omicron uses straight-line depreciation and has a 40 percent tax
rate. What is the differential annual after-tax net cash flow if
Omicron purchases the equipment?
A: $5,800
B: $11,800
C: $23,700
D: $29,500
Assignment 11: Monitoring and Reporting on Risk
• Board Risk Oversight
• Internal Controls Support to Risk Monitoring
• Internal Audit Support to Risk Monitoring
• Risk Assurance to Evaluate Risk Management Performance
• Risk Management Monitoring and Reporting
GOOD LUCK ON EXAM!