RISK FINANCING by Dr A Gordon

Ch.1 : The Nature of Risk Financing

Learning Objectives

At the end of this chapter, you should be able to: explain the importance of risk financing as an integral part of an organisations overall management. identify and discuss key risk financing variables and the relationship of frequency and severity to the risk financing decision identify and discuss the effect of introducing pure risk in the form of random losses on the value of a company and how this risk can be controlled explain the rationale of retention, reduction and transfer of risks discuss the relationship of risk financing and the risk management process to the interrelationships between various functional areas in a modern organisation formulate some ideas on how and where a risk financing function may most effectively fit, in the overall management of your organisation

Notes to Students 1. In this introduction, it is important to understand the process of risk management, decision-making by a risk manager where the decision of whether to retain, transfer or reduce the risk is made, and how various options available can be used in the most efficient manner.

The process of risk management can broadly be divided into the stages of analysis, control and financing. The most effective manner of handling risks identified can be reached by measuring their impact of those risks occurring (usually in financial terms) and reaching a decision on whether to retain, reduce or transfer these risks. Look at figure 1.1 in the text for an illustration. Quantification of risks is a financial function, therefore it requires decisions on investment of funds available till they are required, or alternately sources and costs of funds which need to be obtained for risk expenditures.

Remember, risk financing has traditionally been identified with insurance but a good risk financing programme would most certainly involve a mix of various risk financing techniques other than insurance.

2. Once a risk materialises, you should be able to ascertain direct and indirect costs of that event. Many times, you may not be able to accurately classify these costs, this may be because of the complexity involved in each risky event. As a general rule, you can group direct costs as the ones immediately incurred in repairing or replacing the damage. Indirect costs on the other hand would be those which may follow on from that one risky event occurring. For example, in case of fire damage to a production facility, the direct cost would be an immediate impact of the shutdown of that facility - it may be fairly straightforward to measure this. But, on the other hand indirect costs could pertain to the loss of customers, market reputation etc. far more difficult to estimate accurately. Although it can be said that modern production processes have contributed to greater efficiency and cost reductions, it can also be said that these processes will have contributed to greater loss severities or indirect costs which may be difficult to measure. Consider geographic diversification for a multinational manufacturing company. Production operations partly located abroad may contribute to overall efficiency, but a shutdown of a facility in foreign country may be more difficult to manage because of local laws, customs etc. than it may be in the home country. 3. The hypothetical case of a company called Paper Clip plc is illustrated on page 5 of the text, to show the effect of introducing a random pattern of losses on the value of a company, in contrast to a theoretical no-loss situation. Look at figure 1.2. If Paper Clip operates without any losses (not a realistic assumption) after ten years, the net-worth of the company would have reached 140mn. In contrast, random losses over the ten year period would impact on the net-worth, returning a figure of approximately 15mn after ten years. A combination of loss control and insurance has been used at various points between A and B to illustrate the effect of these on the final net-worth of the company.

4. Risk financing objectives are divided into pre-loss and post-loss objectives. Pre-loss objectives are concerned with the management and operation of the risk management function. These should normally be set at the outset by a responsible risk manager. These may be for example, to achieve optimum operating efficiency, assuming acceptable levels of

risk to ease the burden of insurance costs, and conforming to various statutory and legal constraints and provisions relating to the purchase of insurance.

The most important post-loss objective would naturally be the ultimate survival of the organisation and how to ensure its continuity. In other words, as a risk manager, although you would want to achieve efficiency and reduction of costs, this should by no means be at the expense of not having sufficient resources available after the loss occurs, to meet immediate requirements like financial and management costs and continuity of operations.

5. No two losses are the same. We would tend to use some key variables to determine the nature of the risk financing technique that will be used. In analysing a loss and reaching a decision on financing it, the frequency (when is it likely to occur) and severity (how bad the financial impact is on the firm) are two important attributes to study. The relationship between frequency and severity is represented by Fig. 1.3. page 13. The upper most layer consists or rare catastrophic losses, followed by infrequent serious loss, and at the bottom frequent minor losses. As a risk manager it might be wise to arrange insurance for catastrophic losses, use a mixture of insurance and retention for infrequent losses and perhaps retain all of the minor losses. An example of the latter would be the relatively minor expense of shoplifting to a supermarket, which can be retained and for which insurance would be very expensive. Fig 1.3 should be studied in conjunction with Tables 1.1 and 1.2 and Fig. 1.4 (pages 14 & 15 in the text). Further Reading a) Head L., Elliot M, Blinn J - Essentials of Risk Financing Third Edition Vol 1-Insurance Institute of America - Chapter 1 b) Banks, Erik (2004) Alternative Risk Transfer, Wiley Finance, Chapter 1 Self-Assessed Questions 1) How is the process of risk management divided? (S.1.1) 2) What are the different types of financial function involved in the risk financing decision? (S.1.1) 3) What does the role of risk financing involve? (S.1.2) 4) How would you define the cost of risk to an organisation? (S.1.2.1) 5) What is the difference between direct costs and indirect costs? (S.1.2.1.1) 6) What management issues are demonstrated by the Paper Clip example? (S.1.2.3)

7) Distinguish between the main pre-loss objectives and post-loss ones. (S.1.2.4.1 & 1.2.4.2) 8) What do you understand by risk financing variables? (S.1.3) 9) Illustrate the impact of frequency and severity of losses on a risk managers decision. (S.1.3.1.2) 10) What are the four categories of risk financing techniques? (S.1.4)

Specimen Exam/Test Question Describe and evaluate post-loss sources of finance available to a business and indicate circumstances where post-loss financing would be resorted to, rather than pre-loss provisions.

Institute of Risk Management and M. S. Nawaz