Internal Audit

2. EVOLVING RISK MANAGEMENT

3. Risk Management Process
1) Identify all risks.
2) Assess the risks, forecasting future frequency
and severity of losses.
3) Find risk management solutions to all of the
risks (create programs and conduct
cost/benefit analyses on them).
4) Implement the chosen solutions.
5) Evaluate the results.

4. Risk Management Solutions
Low Frequency of losses High Frequency of Losses
Low severity of losses Retention Retention with loss control
High severity of losses Transfer—
Insurance/Reinsurance
(Newer: Cat bonds &
securitization for
catastrophic risks)
Avoidance
Pure Risk Solutions

5. Risk Management Solutions
(Continued)
Other Influences Solutions for Other Risks
- Financial condition of the firm - Cash flow management using value at
risk (VaR)
- The nature of the risk - Using derivative instruments such as
futures, swaps and options
- External market conditions
- The size of the firm

6. Risk Map
• A risk map is a visual tool used to
compare and contrast risk
management alternatives.

7. ONE FIRM’s RISK MAP
Severity
In
$ million
Credit Risk
(Financial Risk)
Frequency (Number of Annual
Events)

8. Common Risk Management Guidelines
• Write a risk management mission statement
• Communicate with every section of the
organization to promote safe behavior
• Identify risk management processes
• Pinpoint all risks (what “keeps employees
awake at night”)
• Assess risk management & financing
alternatives (and external insurance market
conditions)

9. Common Risk Management Guidelines
(Continued)
• Allocate costs from losses and loss expenses
• Negotiate insurance coverage and terms
• Adjust claims administration in self-funded
firms
• Keep accurate records of losses and payments

10. Risk Management Process for a
Property Exposure
1) Find all properties exposed to loss. This includes
real property and other tangible property (e.g.
computers) as well as intangible property (e.g.
trademarks).
2) Evaluate the potential causes of losses, such as
natural disasters (e.g. hurricanes) and accidents
(e.g. fires and explosions).
3) Evaluate property value by different methods:
book value, market value, reproduction cost and
replacement cost.

11. Risk Management Process for
Property (Continued)
4) Evaluate legal interest: owned or leased?
5) Identify loss exposures through loss runs,
flow charts, personal inspection,
questionnaires and accounting records.
6) Based on loss data, compute frequency and
severity of losses for each property exposure.
7) Forecast future losses for each property
exposure.

12. Risk Management Process for
Property (Continued)
8) Create specific risk map based on forecasted
frequency and severity
9) Develop risk management alternatives (such as
loss control techniques) based on cost/benefit
analysis or insurance
10) Compare potential solutions to existing
solutions
11) Communicate solutions with entire organization

13. Risk Profiling and Mapping
• Risk profiling evaluates all of an organization’s
risks, measuring the frequency and severity of
each risk.
• Risk mapping charts entire spectrums of risk,
not individual risk “silos” from each separate
business unit.

14. Plotting the Risk Map: Four Basic
Risk Categories
• Natural and man-made risks (i.e. hurricane;
anthrax threat)
• Financial risks:
-Prices -Credit risk
-Volatility -Foreign exchange risk
-Liquidity -Major market
recession

15. Plotting the Risk Map
(Continued)
• Business risks: reputation risk is a major
concern
• Operational risks: day-to-day issues such as IT
systems failure risk

16. Forecast Frequency & Severity
& Cost Benefit Analysis
• Risk management matrix: provides
alternative financial action for each
frequency/severity combination on risk map
• Forecasting: Projects the frequency and
severity of losses into the future based on
current data and statistical assumptions

17. Budgeting
• Cash flow analysis: looks at the amount of
cash that will be saved; brings it into the
present-day world
• Risk management information systems:
computerized data systems that allows a risk
manager to quantify a firm’s loss history

18. The Traditional Risk
Management Matrix
Pure Risk Solutions
Low Severity of
Losses
Retention—Self-insurance
(Self-funding)
Retention with Loss
Control—Risk
Reduction
High Severity of
Losses
Transfer--Insurance Avoidance

19. Definition of Terms in
the Risk Management Matrix
• Transfer of risk: displacement of risk to a
third, unrelated party
• Loss reduction: efforts to lessen loss severity
• Risk avoidance: stopping or not starting an
activity due to concerns of catastrophic losses
– One cannot avoid all risks
– Avoiding one risk (traveling in airplanes) often
triggers another risk (traveling in automobiles)

20. Main Risk Mapping Objectives
1) Aid identification of risks and their interactions
2) Provide a mechanism to select best risk
management strategy
3) Compare, evaluate and optimize current
strategies
4) Evaluate leftover risks once all strategies are in
place
5) Clearly communicate strategies to management
and employees

21. Linear Regression of Fire Claims
Fire Claims:
Red Line
Linear Trend:
Blue Line

22. Linear Regression of Fire Losses
Losses
In
$1,000
Units