Risk Management Principles and Practices

hazard risk
risk from accidental loss, including the possibility of loss or no loss
risk profile
a set of characteristics common to all risk in a portfolio
systemic risk
the potential for a major disruption in the function of an entire market or financial system
cost of risk
the total cost incurred by an organization because of the possibility of accidental loss
value at risk
a threshold value such that the probability of loss on the portfolio over the given time horizon exceeds this value, assuming normal markets and no trading in the portfolio
exposure
any condition that presents a possibility of gain or loss, whether or not an actual loss occurs
volatility
frequent fluctuations, such as in the price of an asset
law of large numbers
a mathematical principle stating that as the number of similar but independent exposure units increases, the relative accuracy of predictions about future outcomes (losses) also increases
time horizon
estimated duration
correlation
a relationship between variables
pure risk
a chance of loss or no loss, but no chance of gain
speculative risk
a chance of loss, no loss, or gain
credit risk
the risk that customers or other creditors will fail to make promised payments as they come due
subjective risk
the perceived amount of risk based on an individual`s or organization`s opinion
objective risk
the measurable variation in uncertain outcomes based on facts and data
diversifiable risk
a risk that affects only some individuals, businesses, or small groups
non-diversifiable risk
a risk that affects a large segment of society at the same time
market risk
uncertainty about an investment’s future value because of potential changes in the market for that type of investment
liquidity risk
the risk that an asset cannot be sold on short notice without incurring a loss
risk management standard
a document published by a recognized authority that includes principles, criteria, and best practices for risk management
framework
a structure, including elements such as concepts, methods, procedures, and metrics, that supports the risk management process
risk governance
integration of the management principles governing the organization with the risk management process
risk management framework
a foundation for applying the risk management process throughout the organization
risk criteria
reference standards, measures, or expectations used in judging the significance of a given risk in contest with strategic goals.
inherent risk
risk to an entity apart from any action to alter either the likelihood or impact of the risk
residual risk
risk remaining after actions to alter the risk’s likelihood or impact
risk-based capital (RBC)
amount of capital an insurer needs to support its operations, given the insurer’s risk characteristics
modeling
in data analysis, a system of calculating known outcomes based on current data and then applying these calculations to new data to predict future outcomes
frequency
number of losses
severity
the size of a loss
avoidance
a technique that involves ceasing or never undertaking an activity so that the possibility of future gains or losses occurring from that activity is eliminated
separation
a risk control technique that isolates loss exposures from one another to minimize the adverse effect of a single loss.
duplication
a risk control technique that uses backups, spares, or copies of critical property information, or capabilities and keeps them in reserve.
diversification
a risk control technique that spreads loss exposures over numerous projects, products, markets or regions
insurance
a risk management technique that transfers the potential financial consequences of certain specified loss exposures from the insured to the insurer.
loss exposure
any condition or situation that presents a possibility of loss, whether or not an actual loss occurs
hazard
a condition that increases the frequency or severity of a loss
moral hazard
a condition that increases the likelihood that a person will intentionally cause or exaggerate a loss
morale hazard (attitudinal hazard)
a condition or carelessness or indifference that increases the frequency or severity of a loss
physical hazard
a tangible characteristic or property, persons, operations that tends to increase the frequency or severity of loss
property loss exposure
a condition that presents the possibility that a person or an organization will sustain a loss resulting from damage (including destruction, taking, or loss of use) to property in which that person or organization has a financial interest.
personal property
all tangible or intangible property that is not real property
tangible property
property that has a physical form
real property (realty)
tangible property consisting of land, all structures permanently attached to the land, and whatever is growing on the land
intangible property
property that has not got physical form
liability loss exposure
any condition or situation that presents the possibility of a claim alleging legal responsibility of a person or business for injury or damage suffered by another party.
personnel loss exposure
a condition that presents the possibility of loss caused by a persons death, disability, retirement, or resignation that deprives an organization of the persons special skill or knowledge that the organization cannot readily replace
personal loss exposure
any condition or situation that presents the possibility of a financial loss to an individual or a family by such causes as death, sickness, injury, or unemployment
net income loss exposure
a condition that presents the possibility of a loss caused by a reduction in net income
property-casualty insurance
one of the two main sectors of the insurance industry, encompassing numerous types of insurance, most of which cover the financial consequences of damage to ones own property or legal liability to others.
property
the real estate, buildings, objects or article, intangible assets, or rights with exchangeable value of which someone may claim legal ownership
liability
a legal responsibility for the consequences of an act or omission
line of business
a general classification of insurance, such as commercial property, commercial general liability, or commercial crime, or commercial auto.
commercial property insurance
insurance that covers commercial buildings and their contents against various types of property loss
monoline policy
policy that covers only one line of business
package policy
policy that covers two of more lines of business
named peril
a specific cause of loss listed and described in an insurance policy. also used to describe policies containing named perils
direct physical loss
a loss that physical (not just financial) and results immediately from the occurrence
all-risk policy
an insurance policy that covers any risk of physical loss unless the policy specifically excludes it
bailees’ customer’s policy
a policy that covers damage to customer’s goods while in the possession of the insured, regardless of whether the insured is legally liable for the damage
actual cash value
a method in valuing property which is calculated as the cost to replace or repair property minus depreciation, the fair market value, or a valuation determined by the broad evidence rule
insurance-to-value provision
a provision in property insurance policies that encourages insureds to purchase an amount of insurance that is equal to, or close to, the value of the covered property.
coinsurance clause
a clause that requires the insured to carry insurance equal to at least a specified percentage of the insured property’s value
business income insurance
insurance that covers the reduction in an organization’s income when operations are interrupted by damage to property caused by a covered peril
dependent property exposure
the possibility of incurring business income loss because of physical loss occurring on the premises of an organization that the insured depends on for materials, products, or sales
principal
the party to a surety bond whose obligation or performance the surety guarantees
surety
the party (usually an insurer) to a surety bond that guarantees to the oblige that the principal will fulfill an obligation or perform as required by the underlying contract, permit or law
obligee
the party to a surety bond that receives the surety’s guarantee that the principal will fulfill an obligation or perform as promised.
breach of contract
the failure, without legal excuse, to fulfill a contractual promise
tort
a wrongful act or an omission, other than a crime or a breach of contract, that invades a legally protected right
insuring agreement
a statement in an insurance policy that the insurer will, under described circumstances, make a loss payment or provide a service.
occurrence
an accident, including continuous or repeated exposure to substantially the same general harmful conditions
indemnify
to restore a party who has sustained a loss to the same financial position that party held before the loss occurred.
claims-made coverage form
a coverage form that provides coverage for bodily injury or property damage that is claimed during the policy period
occurrence coverage form
a coverage form that covers bodily injury or property damage occurring during the policy period
entity coverage
coverage extension of D&O liability policies for claims made directly against a corporation (the entity) for wrongful acts covered by the policy
claims-made coverage trigger
the event that triggers coverage under a claims-made coverage form; the first making of a claim against any insured during either the policy period or an extended reporting period.
fiduciary liability insurance
insurance that covers the fiduciaries of an employee benefit plan against liability claims alleging breach of their fiduciary duties involving discretionary judgement
perils of the sea
accidental causes of loss that are peculiar to the sea and other bodies of water
root cause
the event or circumstance that directly leads to an occurrence
key risk indicator (KRI)
a financial or nonfinancial metric used to help define and measure potential losses
exposure indicator
a metric used to identify risk inherent to an organization`s operations
loss ratio
a ratio that measures losses and loss adjustment expenses against earned premiums and that reflects the percentage of premiums being consumed by losses.
control indicator
a metric used to identify an organization`s management of risk
risk optimization
a state whereby risk and return are balanced so that a maximum return is achieved for the level of risk accepted by an organization
hedging
a financial transaction in which one asset is held to offset the risk associated with another asset
systematic risk
risk that is common to all securities of the same general class and that therefore cannot be eliminated by diversification
interest rate risk
the risk that a security`s future value will decline because of changes in interest rates
swap
an agreement between two organizations to exchange payments based on changes in the value of an asset, yield, or index over a specific period.
cash matching
the process of matching an investment`s maturity value with the amount of expected loss payments
zero-coupon bond
a corporate bond that does not pay periodic interest income
reinvestment risk
the risk that the rate at which periodic interest payments can be reinvested over the life of the investment will be unfavorable
commodity price risk
the risk associated with a change in the prices of commodities that are necessary to an organization`s operations
cash flow
cash inflow minus cash outflow
commodity futures contract
a contract either to make or to accept delivery of a specified quantity of a commodity on a given date
equity price risk
the risk that changes in the price of a stock or another security will increase or decrease
call option
an option to buy a set amount of the underlying security at any time within a specified period
put option
an option giving the holder the right to sell a set amount of the underlying security at anytime within a specified period
price risk
the potential for a change in revenue or cost because of an increase or a decrease in the price of a product or an input.
earnings at risk
the maximum expected loss of earnings within a specific degree of confidence
conditional value at risk
a model to determine the likelihood of a loss given that the loss is greater than or equal to the VaR
monte carlo simulation
a computerized statistical model that simulates the effects of various types of uncertainty
capital
the accumulated assets of a business or an owners equity in a business
equity capital
preferred stock, surplus, common stock, undivided profits and capital reserves, and net unrealized holding gains (or losses) on securities that are not available for sale.
leverage
the practice of using borrowed money to invest
generally accepted accounting principles (GAAP)
a common set of accounting standards and procedures used in the preparation of financial statements to ensure consistency of presentation and reported results.
statutory accounting principles (SAP)
the accounting principles and practices that are prescribed or permitted by an insurers domiciliary state an that insurers must follow
market value surplus
the fair value of assets minus the fair value of liabilities
enterprise risk management
an approach to managing all of an organizations key business risks and opportunities with the intent of maximizing shareholder value
tariff
a tax that shields domestic producers from foreign competition
demographics
the statistical characteristics of human populations
political risk
any action by a government that favors domestic over foreign organizations or poses a threat to foreign organizations
risk owner
an individual accountable for the identification, assessment, treatment, and monitoring of risks in a specific environment
key performance indicator (KPI)
financial or nonfinancial measurement that defines how successfully an organization is progressing toward its long-term goals
risk control
a conscious act of decision not to act that reduces the frequency and/or severity of losses or makes losses more predictable
risk financial techniques
risk management techniques, such as retention or transfer, that generate funds to finance losses that risk control techniques cannot entirely prevent or reduce.
risk register
a tool developed at the risk owner level that links specific activities, processes, projects, or plans to a list of identified risks and results of risk analysis and evaluation and that is ultimately consolidated at the enterprise level.
risk map
a template depicting the likelihood and potential impact/consequences of risks
optimum risk
the level of risk that is within an organization’s risk appetite
balance sheet
the financial statement that reports the assets, liabilities, and owners’ equity of an organization as of a specific date
income statement
the financial statement that reports an organization’s profit or loss for a specific period by comparing the revenues generated with the expenses incurred to produce those revenues
hold-harmless agreement (or indemnity agreement)
a contractual provision that obligates on of the parties to assume the legal liability of another party.
indemnification
the process of restoring an individual or organization to a pre-loss financial condition
hazard analysis
a method of analysis that identifies conditions that increase the frequency or severity of loss
theoretical probability
probability that is based on theoretical principles rather than actual experience
empirical probability (a posteriori probability)
a probability measure that is based on actual experience through historical data or from the observation of facts
probability analysis
a technique for forecasting events, such as accidental and business losses, on the assumption that they are governed by an unchanging probability distribution
probability distribution
a presentation (table, chart, or graph) of probability estimates of a particular set of circumstances and of the probability of each possible outcome.
central tendency
the single outcome that is the most representative of all possible outcomes included within a probability distribution
dispersion
the variation among values in a distribution
expected value
the weighted average of all of the possible outcomes of a probability distribution
mean
the sum of the values in a data set divided by the number of values
standard deviation
a measure of dispersion between the values in a distribution and the expected value (or mean) of that distribution, calculated by taking the square root of the variance
coefficient of variation
a measure of dispersion calculated by dividing a distribution’s standard deviation by its mean
normal distribution
a probability distribution that, when graphed, generates a bell-shaped curve.
trend analysis
an analysis that identifies patterns in past data and then projects these patterns into the future
regression analysis
a statistical technique that is used to estimate relationships between variables
linear regression analysis
a form of regression analysis that assumes that the change in the dependent variable is constant for each unit of change in the independent variable
loss prevention
a risk control technique that reduces the frequency of a particular loss
loss reduction
a risk control technique that reduces the severity of a particular loss
retention
a risk financing technique that involves assumption of risk in which gains and losses are retained within the organization
risk financing
a conscious act or decision not to act that generates the fund to offset the variability in cash flows that may occur as an outcome of risk
transfer
in the context of risk management, a risk financing technique by which the financial responsibility for losses and variability in cash flows is shifted to another party
risk
uncertainty about outcomes that can be either negative or positive
futures contract
an exchange-traded agreement to buy or sell a commodity or security at a future date at a price that is fixed at the time of the agreement
accounting
the classification, analysis, and determination of the appropriate method of reporting the effects of the bookkeeping records in an organization’s financial statements
current assets
a balance sheet asset classification that includes cash and other assets that are expected to be converted into cash, sold, or exchanged within the business’s normal operating cycle, usually one year.
receivables
an asset classification that consists of the amounts owed to a company by customers and other outsiders
marketable securities
an asset classification that includes temporary investments that can easily be converted into cash
inventory
an asset classification that consists of goods available for sale to customers; for a manufacturing company, also includes raw materials and finished goods
prepaid expenses
an asset classification that represents the amount that has already been paid for services that have not been received or used
current liabilities
a balance sheet liability classification that includes obligations whose payments are reasonably expected to require the use of cash or the creation of other current liabilities within one year
retained earnings
the cumulative net income that an organization has retained, after payment of dividends, for reinvestment in the organization’s operations
revenue
the inflow of assets, usually cash or accounts receivable, resulting from the sale of products or the rendering of services to customers
gross profit
an income statement value that represents sales or operating revenue minus the cost of goods sold
gross margin (gross profit margin)
the percentage of sales remaining after deducting the cost of goods sold from sales, calculated by dividing gross profit by sales.
operating income
an income statement value that reflects income that results from the normal operations of the business during the period covered by the statement; calculated as the gross profit less selling, general, and administrative expenses
comprehensive income
a measure of income that goes beyond that reported on the income statement by including items such as unrealized gains and losses
statement of changes in shareholders’ equity
the financial statement that explains any changes that have occurred in the organization’s capital accounts during a specific period
paid-in capital
the total amount invested in an organization by the owners
treasury stock
a corporate stock issued as fully paid to a stockholder and subsequently reacquired by the corporation to use for business purposes
depreciation expense
an accounting method that spreads out the expense of a purchase over the life expectancy of the item.
Sarbanes-Oxley act of 2002
a federal statutory law governing corporate directors in the areas of investor protection, internal controls, and penalties, both civil and criminal
transparency
in the context of financial accounting, the provision of sufficient detail regarding transactions to enable a prudent investor to understand the economic effect of those transactions on the company’s financial statements
trend analysis
a comparison of financial statement data across to or more periods
ratio analysis
a financial analysis tool used to study the financial condition of an account; two or more data items from accounting records of a company are related to one another and the result is compared to results for prior accounting periods or for similar businesses
liquidity
the ease with which an asset can be converted to cash with little or no loss of value
working capital
a liquidity measure that s calculated by subtracting current liabilities from current assets. it is used to determine a company’s ability to finance immediate operations (to buy inventory, finance growth, and obtain credit)
current ratio
a liquidity ratio that indicates the company’s ability to meet its short-term financial obligations; calculated by dividing current assets by current liabilities
acid-test ratio (quick ratio)
a liquidity ratio that provides a measure of a company’s ability to meet its current obligations if it cannot sell its inventory
LIFO method
an inventory valuing method that assumes that the last items brought into inventory are the first items taken out
FIFO method
an inventory valuing method that assumes that the first items purchased are the first items sold
return on equity (ROE)
a profitability ratio expressed as a percentage by dividing a company’s net income by its net worth (book value). depending on the context, net worth is sometimes called shareholders’ equity, owners’ equity, or policyholders’ surplus
present value
the value today of money that will be received in the future
discounting
the process of calculating the present value of a future amount
discount rate
the rate of return used in determining the present value of a future item
annuity
a series of fixed payments made on specified dates over a set period
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
capital budgeting
the process of evaluating alternative capital investment proposals in terms of the cash outlays that the proposals require and the present values of the cash inflows that the proposals are likely to generate
operating expenditures
disbursements for assets that will be consumed in a relatively short period, usually within one year or a single accounting period
capital expenditures
disbursements for assets that will be consumed over a relatively long period, usually over multiple accounting periods
salvage value
an amount that an insurer can recover by selling or otherwise disposing of insured property for which the insurer has paid a total loss or a constructive total loss
risk-return trade-off
the tendency for the potential return to increase as risk increases
differential (incremental) annual after-tax net cash flow
the change in an organization’s aggregate annual net cash flows resulting from implementing a proposal
straight-line depreciation method
an accounting method of calculating depreciation by taking an equal amount of an asset’s cost as an expense for each year of the asset’s expected useful life
sensitivity analysis
a method to investigate the effect of a change in one or more variables on the results of a financial analysis
forward contract
a contract that obligates one party to buy and another party to sell a specific financial instrument or physical commodity at a specified future date and price
Statement of Cash Flows
The financial statement that summarizes the cash effects of an organization’s operating, investing, and financing activities during a specific period