RMSC2001 Introduction to Risk Management

Topic 1: Introduction Term 2, 2014-15| Department of Statistics, The Chinese University of Hong Kong

References: 1. George E. Rejda, G. E. and McNamara, M. (2012) Principles of Risk Management and Insurance, 12th Edition: Pearson [Chapters 1-4] 2. Hull, J.C. (2001). Fundamentals of Futures and Options Markets, 4th Edition: Pearson [Chapters 1&4]

What is Risk?

The first question

2!

The first question

3!

What is risk?

4!

Etymology of Risk

- Perhaps from Latin resicum (that which cuts, rock, crag) or resec (cut off, loose, curtail), in the sense of that which is a danger to boating or shipping.

This is risk

- It may be traced back to classical Greek , meaning root, later used in Latin for cliff.

- The word risk is cognate with risque (French) and risco (Portguese/Italian).

5!

What exactly is risk management?

What is risk? - Broadly speaking, risk is defined as uncertainty of

having a bad outcome.

Meaning of risk

6!

Because there is NO uncertainty !

This is NOT a risk!

7!

Bad outcome related to finance and Economics1. Real estate market downfalls, global economic crisis, 2. Change in interest rate, Bit-coins exchange rate drop

Bad outcome related to the public3. Computer systems failure, power plants malfunction, MTR

system breakdown4. Health: Fukushima nuclear disaster, bird flu outbreak,

hazardous air pollution (in Beijing, Shanghai) 5. Politics: Thailand political crisis, Bad outcome related to natural phenomena6. Typhoons, snow storms on the US east cost, natural disaster,

Others7. Short pilings, sub-standard quality control,8. Fail in RMS 2001.

Examples of bad outcomes

8!

Risk management means taking deliberate actions to shift the odds in your favour: increasing the odds of a good outcome and reducing the odds of a bad outcome.

WE are all RISK MANAGERS

But, how to be a beqer one?

Future is uncertain, but not unmanageable!

Risk management

9!

Risk managers use all kinds of tools: mathematical, statistical, computational, conceptual Some synonyms of risk managers jobs: insurance, actuarial science, financial engineering, quantitative finance, , etc. Nowadays, many corporations have an independent department of risk management.

Tools used by risk managers

10!

Example: H = number of houses burnt E(H) = 100 sd(H) = 10 Expected loss On average there will be 100 houses burnt. But in reality the number of house burned

ranges from 80 to 120.

Probability of loss Usually E(H) 2 sd(H) covers approx. 95% of the possible

situations.

Risk You may prepare the resources for 100 houses. But the

uncertainty is that it may be in excess, or may not be enough. The risk refers to the variation from 80 to 120. Risk is uncertainty (variation), not expected loss, not probability

of loss!

Risk = Probability ?

11!

1. Subjective risk: Uncertainty bases on a persons state of mind. e.g. I forgot to do two questions in the exam, I have 99% chance of fail.

2. Objective risk: Relative variation of the actual loss from expected loss. e.g. The number of houses being burnt ranges from 80 to 120, based on the statistics obtained.

Classification of risk: (i) Perspective

12!

Which field(s) will be affected if

- there is an increase in the interest rate ? - there is an increase in the tax rate? - there is an volcano explosion? - a house is built in a country park?- President Obama/Xi is assassinated ?

Classification of risk: (ii) Field/Domain

13!

What will be affected if

- there is an increase in the interest rate ? (Business)

- there is an increase in the tax rate? (Business)- there is an volcano explosion? (Environment)- a house is built in a country park? (Environment)- President Obama/Xi is assassinated? (Political

aspect)

Classification of risk: (ii) Field/Domain

14!

- Does this risk cause a loss only?

- Typhoon - Earthquake- Invest in an HSBC warrant. - Bet on Argentina win in soccer world cup

1. Pure risks: situations where there are only two possible outcomes: loss or no loss. (No gain.)

2. Speculative risks: situations in which either profits or losses will occur.

Q: Why do we need to bother to distinguish pure risks from speculative risks?

Classification of risk: (iii) Possible outcome

15!

Q: Why is it important to distinguish between pure and speculative risks?

1.In general, private insurers insure only pure risks. With only few exceptions, speculative risks can only be handled by other risk management techniques.

2.The law of large numbers can be applied more easily to pure risks than to speculative risks.

3.Society may benefit from a speculative risk event even though a loss may occur but is harmed if a pure risk event occurs.

Classification of risk: (iii) Possible outcome

16!

LLN: The larger the sample size is, the sample mean estimates the population mean more accurately.

Law of large numbers (LLN)

17!

Chebyshevs inequality & LLN

18!

We can also classify risk exposures into two categories based on the scope of persons affected:

1. Fundamental risks: a risk that affects the entire economy or a large number of people or groups within the economy.

2. Particular risks: only a limited number of individuals are affected.

Classification of risk: (iv) Scope

Q: Who will be affected?(i) earthquake in HK , (ii) your house collapses, (iii) Obama is assassinated, (iv) Prof. Yau is assassinated

19!

1. On which measure do we use to quantify the risk ?

objective vs subjective.

2. Which field/domain does it affect ?

business, political, environmental

3. What is the potential outcome? Does it create a loss only ?

pure vs speculative

4. Who is going to be affected ?

fundamental vs particular

Brief summary

20!

1. Personal risks- Premature death.- Insufficient income during retirement- Poor health

2. Property risks- Financial loss that results from physical damage, destruction or theft.- Indirect consequential loss

3. Liability risks- Cause damage/loss to other people

Further classification of pure risks

21!

Personal risks?Property risks?

Liability risks?

Further classification of pure risks

22!

Personal risks

Property risks

Liability risks Pure risks

Speculative risks

Risks

Further classification of pure risks

23!

Peril: an immediate, specific event causing a loss. Hazard: a condition that creates the chance of peril occurrence.

- Physical hazard: a physical condition

e.g.: Wet floor

- Moral hazard: Dishonesty of an individual. e.g.: fraudulent insurance claims, dishonest accounting practices

- Morale hazard: Carelessness or indifference to loss because of the existence of insurance.

Peril and hazard

24!

1. crashing your car

2. broken traffic light

3. fall down

4. ice on the road

5. fire

6. smoking

7. flooding

Peril and hazard

8. weak dam

9. penalty kick

10. heart disease

11. high cholesterol diet

12. skydiving

13. carelessness

25!

1. crashing your car

2. broken traffic light

3. fall down

4. ice on the road

5. fire

6. smoking

7. flooding

Peril and hazard

8. weak dam

9. penalty kick

10. heart disease

11. high cholesterol diet

12. skydiving

13. carelessness

Key: perils, hazards

26!

1. Risk control- reducing the frequency and severity of losses, usually handled by physical measures

install loss prevention facilitiesavoid doing something

2. Risk financing -techniques that provide for the funding of losses after control.

In this course we focus on the quantitative issue for two major aspects: (1) Insurance & (2) Financial risk management.

Methods of handling risks

27!

C1. Avoidance: To stay away from the risk. No smoking no fire

C2. Loss control: To reduce both the frequency and severity of losses. Install sprinkler reduce loss of fire

F1. Retention: The risk exposure(s) is/are retained.

a. Active Retention: an individual consciously aware of the risk and plans to retain all or part of it.b. Passive Retention: Certain risks may be unknowingly retained because of ignorance, indifference or laziness.

Methods of handling risks

28!

Risk financing

Risk con

trol

F2. Non-insurance Transfers: Risk is transferred to another party by

a. Contracts: e.g. warranty of electrical appliancesb. Hedging: use financial instruments to reduce riskc. Incorporation of Business Firm (c.f. sole proprietorship) the liability of the stockholders is limited, and the risk of the firm having insufficient assets to pay for its business debts is transferred to the creditors. F3. Insurance: Pure risk is transferred to the insurer.Pooling technique is used to spread the losses of the few over the entire group.

Methods of handling risks

29!

Risk financing

Insurance is the pooling of fortuitous1 losses by transfer of such risk to insurers, who agree to indemnify2 the insured of such losses, to provide other pecuniary3 benefits on their occurrence, or to render services connected with risk. 1fortuitous adjective FORMAL (of something that is to your advantage) not planned, happening by chance

2indemnify verb [T] to protect someone or something against possible damage or loss by paying an indemnity to cover the costs

3pecuniary adjective FORMAL relating to money (c.f. pecu = caqle and pecunia = money in Latin)

Definition of insurance

30!

1. Principle of Indemnity Insurers should pay no more than the actual loss.

2. Principle of Insurable interest The insured suffer from losses.

3. Principle of Subrogation The right for the insurer to claim the loss from a responsible third party.

It prevents the insured from collecting twice for the same loss. It is used to hold the guilty person responsible for the loss.

4. Principle of Utmost Good Faith A higher degree of honesty is imposed on both parties to an insurance contract.

Legal principles of insurance

31!

4. Principle of Utmost Good Faith A higher degree of honesty is imposed on both parties to an insurance contract. Insurer can deny payment if someone conceals correct material facts and/or commit dishonest conducts. (Concealment) Representations are statements made by the applicant for insurance. The insurance contract is voidable at the insurers option if the representation is i. material if the insurer knew the true facts, the policy would not have been issued, or it would have been issued on different terms.

ii. false misleading statements.

iii. relied on by the insurer the insurer relies on the misrepresentation in issuing the policy at a specified premium.

Legal principles of insurance

32!

1. Aleatory contract (c.f. commutative contract)The values exchanged depend on an uncertain event.

2. Unilateral contractOnly one party (insurer) makes a legally enforceable promise.

3. Conditional contractThese are provisions inserted in the policy that qualify or place limitations on the insurer's promise to perform.

4. Personal contractThe contract is dealt between the insured and the insurer.

5. Contract of adhesionThe insured accept the entire contract, with all its terms and conditions. If the terms are ambiguous, benefit of the doubt goes to the insured due to the principle of reasonable expectation.

Legal characteristics of insurance contracts

33!

1. There must be a large number of exposure units. - Compare the following two cases: A group of 10 people, each of whom pays $1,000 VS another group of 10,000 people, each of whom pays $10 for one loss of $10,000.

2. The loss must be accidental and unintentional. - The insured do not make money from insurance.

3. The loss should not be catastrophic. - The insurers will go bankrupt otherwise.

Requirements of insurable risks

34!

4. The loss should be determinable and measurable. - Premium can therefore be fairly evaluated.

5. The chance of loss should be calculable. - Premium can therefore be fairly evaluated.

6. Economically feasible premiums. - You can afford purchasing.

Requirements of insurable risks

35!

Q: When the pool of policy holder (N) is larger, the risk of the insurer is easier to be managed. Why?

Consider the following case:

Individual Loss Xi: Pr(Xi=100)=0.02, Pr(Xi=0)=0.98 Expected loss: E(Xi) = 2 S.D. of loss: SD(Xi) = 14

Premium charged per policy= 2.1 (say) Total loss Xi

Expected loss = NE(Xi)=2NS.D. of loss = N SD(Xi)=14N

Total premium received = 2.1N Insurer has low risk of bankrupt when 2.1N > 2N+2x14 N What if N=10, N=100, N=1000, .?

Law of large numbers (LLN)

36!

Adverse selection is the tendency of persons with a higher than average chance of loss to seek insurance at standard rates, which if not controlled by underwriting, results in higher than average loss levels.

Examples: i. Alcohol-addicted driver seeking auto insurance at standard rates. ii. A life insurance applicant who plans to commit suicide.

Control Measure:i. Underwriting: the process of selecting and classifying applicants of insurance. ii. Policy provisions: e.g. suicide clause in life insurance / pre-existing conditions clause in health insurance.

Adverse selection

37!

Market Risk The risk of change in value of the investment/trading portfolio due to the changes in market factors, for example (i) stock prices, (ii) interest rates, (iii) foreign exchange rate

Credit Risk Borrowers do not make payment as promised.

Operational Risk Risks arising from people/systems errors during operations. e.g. Fat-finger: A trader inputs $10 instead of $100 when selling stocks

Liquidity risk Security cannot be traded quickly enough to prevent a loss.

Financial risk management

38!

Hedging with financial instruments

- establishing a position in one market in an aqempt to offset exposure to price fluctuations in some opposite position in another market with the goal of minimizing one's exposure to unwanted risk.

- e.g. Futures contract: exchange asset with cash at a fixed time

Jet fuel current price $ 10 / gallon

cannot tolerate >$ 12 / gallon

Crude oil futures buy oil at $11/gallon next mth

avoid the risk of fuel price inc.

How to handle financial risks?

39!

1. Identify loss exposure- Death/property loss/pollution/copyright- How?

1. Physical inspection / questionnaires2. Historical loss statistics

2. Evaluation of Potential Losses-Loss frequency-Loss severity

Steps in risk management processRisk Id

entifi

catio

n

40!

3. Selection of loss treatment- Risk Control

1. Avoidance2. Loss control

- Risk Financing1. Retention2. Non-insurance transfer3. Insurance

4. Implementation- Establishing co-operation with other departments

1. Accounting: Internal accounting control2. Marketing: preventing liability lawsuits from sub-standard packaging3. Production: Quality control of product4. Human resources: Employee benefit.

Steps in risk management process

41!

Treatm

ent

Which risk management technique should I use?

Risk management matrix

42!

Meaning of risk

Types of risk - objective / subjective - business / environmental / political - pure / speculative - fundamental / particular

Perils and hazards

Risk treatment methods- Risk control: Avoidance / Loss control - Risk financing: Retention/ Non-insurance transfer /Insurance

Summary

43!

Insurance- Principles

i. Principle of Indemnity ii. Principle of Insurable interest iii. Principle of Subrogation iv. Principle of Utmost Good Faith

- Law of Large numbers- Adverse selection, underwriting, policy provisions

Financial risk management- Market / Credit / Operational / Liquidity risk

Steps in risk managementi. Identify loss exposureii. Evaluation of potential lossesiii. Selection of loss treatment: risk control and/or risk financingiv. Implementation

Summary

44!