Chapter 3

Introduction
to Risk
Management

Accident 1
April 2010
On April 5, the Massey Energy-owned Upper Big Branch
mine in Montcoal, West Virginia, exploded, killing 29 of the
31 miners at the site. The accident, the worst in the United
States since Kentucky's Finley Coal Company disaster in
1970, was blamed on high levels of methane, which caused
the explosion after a spark was generated from the mine's
mantrip, the shuttle used to transport workers through the
mine. The tragedy brought to light Massey's track of safety
violations and fatalities. In 2009, Massey Energy was fined
$382,000 for serious violations, some in reference to
improper ventilation. In the month before the explosion,
authorities cited the mine for 57 safety infractions, and the
day before the explosion, the mine received two additional
citations. The Upper Big Branch coal mine disaster put a
critical spotlight on the inadequacies of worker safety in
U.S. mines.

3-2

Accident 2
May 2010
Just before midnight on May 8, an explosion
occurred at Russia's largest underground coal
mine near Kemerovo Oblast, due to a buildup of
methane gas. The mine, owned by Russian coal
company Raspadskaya, had a history of safety
violations and deaths. In March 2001, a methane
explosion killed four miners and injured six, and in
January 2010 one worker was killed after a partial
mine collapse. The most recent explosion killed 66

3-3

Accident 3, 4
August 2010
Part of the San Jose copper/gold mine near Copiapo, Chile,
collapsed on August 5, leaving 33 miners trapped 2,300 feet
below ground for 69 days. The mine, owned by Compania
Minera San Esteban, had a history of instability and
accidents, including one death. Between 2004 and 2010, the
company received 42 fines for breaching safety
regulations..
October 2010
On October 16, 37 men were killed in an explosion caused
by a gas leak at a coal mine located in China's Henan
Province.
http://www.rmmag.com
Note: the recent one occurred in May 2014 in Turkey

3-4

Recent case:
UBS trader Adoboli held over $2bn loss
UBS has become the latest bank to experience a
rogue trading scandal as it revealed that a 31year-old trader had been arrested in London on
suspicion of blowing a $2bn hole in its books,
exactly three years after Lehman Brothers
collapsed
UBS warned that the discovery which drew
parallels with the 4.9bn ($6.8bn) hit caused to
Socit Gnrale by Jrme Kerviel in 2008
could push the group into a loss for the third
quarter
September 15, 2011 9:35 pm FT.com.
Note:UBS2014secondquarterprofitbeforetaxCHF1.2billion(about$1.3
billion)

3-5

FT said
The revelation that a trader in Delta One an area of
derivative trading activity that is one of the only
remaining ways for banks to take big bets with their
own money could cause such a catastrophic loss has
prompted calls for fresh restrictions on investment
banks.
Management doesnt understand whats going on in
the Delta One desks, said Terry Smith, chief executive
of Tullett Prebon, the interdealer broker. If you sat
down with a CEO and asked them to please explain
what happens they would try but they couldnt give you
an accurate answer because they dont understand.

3-6

Why these types of serious accident keep

on happening? What do you think?
Is there any risk management, apart from
the issues of safety?
Too expensive for risk management or they
just ignore it?
Safety precaution costs outweighed
expected losses in monetary term?
Judge Learned Hand's rules (BPL formula) to be
covered in the Pinto case
Lets look at The Ford Pinto Case.
3-7

Agenda
Meaning of Risk Management
Objectives of Risk Management
Steps in the Risk Management Process
Benefits of Risk Management
Personal Risk Management
Outcomes
Understand the processes and techniques
used to deal with different types of risk
Apply rules to the Pinto case
3-8

Meaning of Risk Management

Risk Management is a process that identifies loss
exposures faced by an organization and selects the
most appropriate techniques for treating such
exposures
A ________is any situation or circumstance in
which a loss is possible, regardless of whether a
loss occurs
E.g., a plant that may be damaged by an
earthquake, or an automobile that may be
damaged in a collision
New forms of risk management consider both pure
and speculative loss exposures
3-9

Objectives of Risk Management

Risk management has objectives before
and after a loss occurs
Pre-loss objectives:
Prepare for potential losses in the most
economical way
Reduce anxiety (miners are doing it?)
Meet any legal obligations

3-10

Objectives of Risk Management

Post-loss objectives:

Minimize the effects that a loss will have on

other persons and on society

CostaConcodia,
Italiancruiseshipsinking
14Jan.2012,http://www.dailymail.co.uk

3-11

Can BP survive the oil spill? Can its CEO?

(June 2010)

BP's share price down by near 40% since the April 20th
accident.
Both Moody's and Fitch have downgraded their rating of
BP's bonds, with lower ratings forcing BP to pay a
higher rate of interest to finance projects.
BP says it's already spent over $1 billion on the spill.
Fine: uncertainty about what the cleanup, the fines, the
lawsuits and punitive fine from the federal government
ultimately will cost
the damage to the corporate image.

Investors dividend? (around $10 billion)/Effects on the

environment.
3-12

References
-The 1989 Exxon Valdez spill (occurred in Prince
William Sound, Alaska), which eventually cost
ExxonMobil $4.5 billion, including clean-up costs,
legal settlements and punitive damages.
-Dividend: about $10 billion
-BP will generate about $25 billion to $34 billion
operating income in year 2010, depending on oil
prices ranging from $60 per barrel to $80 per
barrel.
Wouldyoudoinsurancebasedonabovefigures?
3-13

Rising estimations
BP Spill Costs Raised to $33 Billion,
BP has spent $3.1 billion so far on containment efforts, cleanup and
legal claims.
Bloomberg, Jul 8, 2010
BP's clean-up costs for the Gulf of Mexico have now reached $6.1bn
The Telegraph, 10 Aug 2010 ,
By mid-September, the response effort alone, excluding damages
claims, had cost BP $8 billion.
Reuters, Dec 1, 2010
BP has lifted its estimate of the likely cost of the Gulf of Mexico oil
spill to $40 billion,
02/11/10 http://www.euronews.net

IsitbigenoughtodestroyBP?Ifnotthen

3-14

Risk Management Process

Identify potential losses
Measure and analyze the loss exposures
Select the appropriate combination of
techniques for treating the loss exposures
Implement and monitor the risk
management program

3-15

Exhibit 3.1 Steps in the Risk Management

Process

3-16

Identifying Loss Exposures

Property loss exposures
Liability loss exposures
Business income loss exposures
Direct & indirect

Human resources loss exposures

Crime loss exposures

3-17

Identifying Loss Exposures contd

Employee benefit loss exposures
E.g. Failure to
Retirement plan exposures like large corps. not
enough fund for pension
Foreign loss exposures
Exchange rate risks
Kidnapping of key personnel
Political risks or terrorism
Intangible property loss exposures
Damages to
; software or
movie industry
Damages of company image
BoeingreportedstrongfourthquarterresultsonWednesdaybutforecast
lowerthanexpectedprofitsfor2012becauseofrisingpensioncostsand3-18

Types of Risk Exposure in practice

Have a quick look at
Industry risk report auto manufacturing
Risk & Insurance.htm

3-19

3-20

Identifying Loss Exposures contd

Failure to comply with government rules and
regulations
A Russian court convicted Mikhail B.
Khodorkovsky, the embattled tycoon and founder
of the Yukos oil company, of criminal charges today
and sentenced him to nine years in a prison camp
Mr. Khodorkovsky, 41, who had been the wealthiest
man in Russia until he publicly challenged
President Vladimir V. Putin, was found guilty of six
charges, including fraud and tax evasion. (C.J.
Chivers and Erin Arvedlund , New York Times May
31st, 2005 http://www.corpwatch.org )

3-21

Identifying Loss Exposures

Risk Managers have several sources of information to
identify loss exposures:
Questionnaires
Physical inspection
Flowcharts
show production flow to identify potential loss
exposure e.g. the IC chips of mobile phone may of
high demand (see the case next slide)
Financial statements
Historical loss data
Industry trends and market changes can create new
loss exposures.
e.g.,

3-22

Your Leadership Approach Must Anticipate Crisis

Feb 10, 2009

Early Recognition Can Keep Crisis From Becoming

Chaos
As reported in the Wall Street Journal, the reversal of
fortunes started with a lightning strike at a semiconductor
plan owned by Philips Electronics. The resulting fire was
out in ten minutes, but its market-changing
disruptive consequences to Nokia and Ericsson were
not apparent for weeks to come. Both Nokia and
Ericsson depended on the same chip produced by the
plant, but Nokia prospered while Ericsson
suffered tremendously. In fact, Ericsson ended up
permanently shuttering its cell phone manufacturing and
relying upon subcontractors.
The difference in business outcome can be attributed to
the leadership culture differences between the two
companies. Nokias culture promoted flexibility through
open and rapid communication inside and outside the
company. Ericssons culture fostered complacency and
rigidity.
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http://garybclayton.com/leadership/2009/02/crisischaosleadershipapproach2/

Your Leadership Approach Must Anticipate Crisis

Nokia was alert for emerging problems, with a
philosophy of We encourage bad news to travel fast.
We dont want to hide problems. Nokia noticed
changes to its supply stream within 72 hours of the
fire and quickly elevated its awareness to the head of
the division. When the enormity of the disruption
became apparent just two weeks later (chip
production disrupted for an unknown time into the
future), Nokia assembled a crisis management team
and immediately swung into action. The team created
alternative designs to eliminate the part in some
products and worked actively with Philips to create
emergency sourcing for the component.
3-24

http://garybclayton.com/leadership/2009/02/crisischaosleadershipapproach2/

Measure and Analyze Loss Exposures

Estimate the frequency and severity of loss for each
type of loss exposure
Loss ________refers to the probable number of
losses that may occur during some given time period
Loss ________ refers to the probable size of the
losses that may occur
Once loss exposures are analyzed, they can be ranked
according to their relative importance
Loss severity is more important than loss frequency:
The maximum possible loss is the worst loss that
could happen to the firm during its lifetime
The probable maximum loss is the worst loss that is
likely to happen
3-25

Example:EstimatingProbabilityandSeverity
Qualitative

Quantitative

Very high

Number of Death 1-10

Catastrophic

Loss > $10 billion

High

Critical

Medium

Serious

3-26

Select the Appropriate Combination of

Techniques for Treating the Loss Exposures
Risk control refers to techniques that reduce the
frequency and severity of losses
Methods of risk control include:
Avoidance
Loss prevention
Loss reduction
Avoidance means a certain loss exposure is never
acquired, or an existing loss exposure is abandoned
The chance of loss is reduced to zero
It is not always possible, or practical, to avoid all
losses
3-27

Select the Appropriate Combination of

Techniques for Treating the Loss Exposures
Loss prevention refers to measures that
reduce the frequency of a particular loss
e.g., installing safety features on
hazardous products
Loss reduction refers to measures that reduce
the severity of a loss after is occurs
e.g., installing an automatic sprinkler
system

3-28

Select the Appropriate Risk Management

Technique
Risk financing refers to techniques that
provide for the funding of losses
Methods of risk financing include:
Retention
Non-insurance Transfers
Commercial Insurance

3-29

Risk Financing Methods: Retention

Retention means that the firm retains part or all of
the losses that can result from a given loss
Retention is effectively used when:

The retention level is the dollar amount of losses

that the firm will retain
A financially strong firm can have a higher
retention level than a financially weak firm
The maximum retention may be calculated as a
percentage of the firms net working capital
ThelossofBPisestimatedtobeinbillions.Itcanonly
receiveatmostmillionsfromitscaptive,BPkeepsmostofthe
lossestoherself.
3-30

Risk Financing Methods: Retention

A risk manager has several methods for paying
retained losses:
Current net income: losses are treated as
current expenses
Unfunded reserve: losses are deducted from
a bookkeeping account
Funded reserve: losses are deducted from a
liquid fund
Credit line: funds are borrowed to pay losses
as they occur
3-31

Risk Financing Methods: Retention

A captive insurer is an insurer owned by a parent firm for the
purpose of insuring the parent firms loss exposures
A single-parent captive is owned by only one parent
An association or group captive is an insurer owned by
several parents
Many captives are located in the Caribbean because the
regulatory environment is favorable
Captives are formed for several reasons, including:
The parent firm may have difficulty obtaining insurance
To take advantage of a favorable regulatory environment
Costs may be lower than purchasing commercial insurance
A captive insurer has easier access to a reinsurer
A captive insurer can become a source of profit
Premiums paid to a captive may be tax-deductible under
certain conditions

3-32

PetroChina (00857) to invest $3B in captive

insurance JV , 05 Jan 2012 Infocast
PetroChina (00857) announced that it has agreed with
its controlling shareholder, China National Petroleum
Corporation (CNPC), on the establishment of CNPC
Captive Insurance Company Limited, a captive
insurance company, that has a registered capital of
RMB5 billion (HK$6.135 billion).
The JV company would be held as to 51% by CNPC and
49% by PetroChina and its registered capital will be
contributed as to RMB2.55 billion (HK$3.129 billion) by
CNPC and RMB2.45 billion (HK$3.006 billion) by
PetroChina.

3-33

PetroChina (00857) to invest $3B in captive

insurance JV
05 Jan 2012 Infocast contd
It is proposed that the JV company should principally
engage in property insurance, liability insurance, credit
insurance, guarantee insurance, short term health
insurance, accident insurance, the reinsurance of those
insurance businesses and the use of insurance funds.

PetroChina said that it decided to set up the JV company

for the purpose of satisfying its risk management
requirements of highly risky and overseas projects,
reasonably mitigating its operational risks, balancing the
business insurance costs, improving its ability to withstand
the risks, and ensuring the insurance enforcement effect
after the occurrence of certain covered incidents.

3-34

REASONS FOR THE FORMATION OF THE JOINT

Duetothefeatureofhighrisksandspecialityinthepetroleum
VENTURE COMPANY
industry,thenormalbusinessinsurancecannotcoverallbusiness
operationsoftheCompanyatthecurrentstage.Forthepurposeof
satisfyingitsriskmanagementrequirementsofhighlyriskyand
overseasprojects,reasonablymitigatingitsoperationalrisks,
balancingthebusinessinsurancecosts,improvingitsabilityto
withstandtherisks,andensuringtheinsuranceenforcementeffect
aftertheoccurrenceofcertaincoveredincidents,theCompany
decidestosetuptheJointVentureCompanyandthedetailed
reasonsareasfollows:
(a)theformationoftheJointVentureCompanyishelpfulto
providemorecomprehensive,
saferandmoreefficientinsuranceservicesfortheCompanyandits
subsidiaries;
3-35

http://www.hkexnews.hk/listedco/listconews/sehk/2012/0104/LTN201201041173.pdf

 (b) the formation of the Joint Venture Company is able to steadily

support the segmental
operations and overseas businesses of the Company which
increases its overall
capabilities to react to risks;
(c) the formation of the Joint Venture Company is able to save the
total insurance costs of the Company which will decrease operation
costs; and
(d) the formation of the Joint Venture Company is helpful for the
Company to accumulate
experiences to withstand the risks, to broaden the channel of
reinsurance, and to upgrade
its specialised risk management operations which will finally
maximise the shareholders'
interests of the Company as a whole.

3-36

Captive Insurance Domiciles Worldwide

Domiciles

Number

Bermuda

1150

Cayman Islands

694

Vermont

524

Guernsey

410

British Virgin Islands

350

Barbados

257

Luxembourg

219

Dublin

214
Total 4842

Source:BusinessInsurance2005captivespotlight(pleaseupdate
thefigures)

3-37

Number of Captive Insurance Owned by Countries

Parent Country
US

Number
3485

England

465

Canada

145

Sweden

108

France

97

Germany

53

Netherland

59

Switzerland

57

Hong Kong

12

Japan

65

Chinese Mainland

Source:BusinessInsurance2005captivespotlight
3-38

Captive
In 2009, global captive numbers reaching
5,390
new formations totaled 345 in 2009
Singapore and Hong Kong, the minimum
registered capital of establishing a captive
is S$0.4m and HK$2m respectively
China: RMB200m

3-39

Risk Financing Methods: Retention

Self-insurance is a special form of planned retention
Part or all of a given loss exposure is retained by the firm
Another name for self-insurance is self-funding
Widely used for workers compensation and group health
benefits
A risk retention group is a group captive that can write any type
of liability coverage except employer liability, workers
compensation, and personal lines
Federal regulation allows employers, trade groups,
governmental units, and other parties to form risk retention
groups
They are exempt from many state insurance laws

current law: restricts a commercial insured to obtaining only

liability coverage from a risk retention group
the Risk Retention Modernization Act of 2010 (Act), the
legislation seeks to expand the authority of risk retention groups to
write commercial property insurance coverage, in addition to their
current authority to write liability coverage.
3-40

Risk retention group: background

The Federal Product Liability and Risk
Retention Act of 1981 (LRRA), modified in
1986, created another form of captive: the
risk retention group.
The original goal: to provide a market for
insurance for manufacturers to offer relief
from crippling litigation against products
they produced, but which may have been
misused, modified, etc.
3-41

Risk Financing Methods: Retention

Advantages
Save on loss costs
Save on expenses
Encourage loss
prevention
Increase cash flow

Disadvantages
Possible higher
losses
Possible higher
expenses
Possible higher
taxes

3-42

Risk Financing Methods: Non-insurance

Transfers
A non-insurance transfer is a method other than
insurance by which a pure risk and its potential
financial consequences are transferred to another
party
Examples include:
Contracts, leases, hold-harmless agreements
Subcontractor might be responsible for
damages caused during construction
Physical losses of photocopier are borne
by leasing company
3-43

Risk Financing Methods: Non-insurance

Transfers
Advantages
Can transfer some
losses that are not
insurable
Save money
Less expensive
than insurance
Can transfer loss
to someone who is
in a better position
to control losses

Disadvantages
Contract language
may be ambiguous,
so transfer may fail
If the other party
fails to pay, firm is
still responsible for
the loss
Insurers may not
give credit for
transfers
3-44

Risk Financing Methods: Insurance

Insurance is appropriate for loss exposures that have a low
probability of loss but for which the severity of loss is high
The risk manager selects the coverages needed, and
policy provisions:
A deductible is a provision by which a specified
amount is subtracted from the loss payment
otherwise payable to the insured
An excess insurance policy is one in which the insurer
does not participate in the loss until the actual loss
exceeds the amount a firm has decided to retain
The risk manager selects the insurer, or insurers, to
provide the coverages

3-45

Risk Financing Methods: Insurance

The risk manager negotiates the terms of the insurance
contract
A manuscript policy is a policy specially tailored for the
firm
Language in the policy must be clear to both
parties
The parties must agree on the contract provisions,
endorsements, forms, and premiums
Policy Form: gives you information about your
policy coverages, terms and limitations.
Endorsements: may contain information about
optional coverages
The risk manager must periodically review the insurance
program
3-46

Risk Financing Methods: Insurance

Advantages
Firm is indemnified
for losses
Uncertainty is
reduced
Insurers may provide
other risk
management
services
Premiums are taxdeductible

Disadvantages
Premiums may be
costly
Opportunity cost
should be
considered

Negotiation of
contracts takes time
and effort
The risk manager
may become lax in
exercising loss
control
3-47

Exhibit 3.2 Risk Management Matrix

Youmightwanttocomparethetechniquesmentionedabove
withthoseemployedbyBP.
3-48

Market Conditions and the Selection of

Risk Management Techniques
Risk managers may have to modify their choice of
techniques depending on market conditions in the
insurance markets
The insurance market experiences an underwriting
cycle
In a ______market, when profitability is
declining, underwriting standards are tightened,
premiums increase, and insurance becomes more
difficult to obtain
In a ______market, when profitability is
improving, standards are loosened, premiums
decline, and insurance become easier to obtain
3-49

Implement and Monitor the Risk

Management Program
Implementation of a risk management program
begins with a risk management policy statement
that:
Outlines the firms risk management objectives
Outlines the firms policy on loss control
_______ top-level executives in regard to the risk
management process
Gives the risk manager greater authority
Provides standards for judging the risk managers
performance
A risk management manual may be used to:
Describe the risk management program
Train new employees
3-50

Implement and Monitor the Risk

Management Program
A successful risk management program
requires active cooperation from other
departments in the firm
The risk management program should be
periodically reviewed and evaluated to
determine whether the objectives are being
attained
The risk manager should compare the costs and
benefits of all risk management activities
3-51

Benefits of Risk Management

Pre-loss and post-loss objectives are attainable
A risk management program can reduce a firms cost of
risk
The cost of risk includes premiums paid, retained
losses, outside risk management services, financial
guarantees, internal administrative costs, taxes, fees,
and other expenses
Reduction in pure loss exposures allows a firm to enact
an enterprise risk management program to treat both
pure and speculative loss exposures
Society benefits because both direct and indirect losses
are reduced
3-52

Insight Show Me the MoneyRisk Manager Salaries

Rise

3-53

Personal Risk Management

Personal risk management refers to the
identification of pure risks faced by an
individual or family, and to the selection of
the most appropriate technique for treating
such risks
The same principles applied to corporate
risk management apply to personal risk
management

3-54

Example in Risk Management (ref.)

RISK MANAGEMENT
The Group (We) are developing an improved framework for the
management and control of risk in the Group.
Risks are in the process of being more formally identified and
recorded in the Risk Register for key operations, and we are
evaluating the inherent risks and residual risks after mitigating
controls are considered. The Risk Register will be updated regularly
and used to plan the Groups audit and risk strategy. Specific risks
that we proactively manage are detailed below:
STRATEGIC RISK
We differentiate our products primarily through technology and
innovation, and by being the safe choice for our customers.
We actively focus on innovation in technology and product design.
This leads to competitive advantage in markets which are
characterized by constant developments in technology, changes in
industry standards and continuing demand for product and service
enhancements.

Source:AnnualReport2010,JohnsonElectricHoldingsLimited

3-55

Example in Risk Management

OPERATIONAL RISK
We continue to develop high quality
engineering and manufacturing processes
across our operations which enable us to
minimize the risk of warranty claims.
We actively seek to attract and retain high
calibre management and key personnel by
building effective networks of key
employees and partners to safeguard our
ongoing business success.
Source:AnnualReport2010,JohnsonElectricHoldingsLimited

3-56

Example in Risk Management

MANAGEMENTS DISCUSSION AND ANALYSIS
FINANCIAL RISK
We control working capital and the risk of bad
debts by carefully evaluating credit risk with our
customers and a low tolerance for delinquent
payment. We continue to monitor our receivables
carefully as the economic recovery continues.
COMPLIANCE RISK
We manage compliance with taxation regulations
world-wide through our Corporate Tax department
which also ensures that our legal and tax structure
optimizes tax liabilities within the constraints set
by tax regulations and laws.
Source:AnnualReport2010,JohnsonElectricHoldingsLimited

3-57

Risk Register or risk log

Risk
Category

Risk
Name

Nature

Fire

Risk
Number

Probability

Impact

Risk
Score

Mitigation

Contingency

Action
By

3-58