Risk Management(As per the Revised Syllabus 2016-17 of Mumbai University for

T.Y. BMS, Semester – VI)

Pawan V. JhabakP.G.D.Ed.M., M.Com. (Finance)

Ex. Vice Principal, Rustomjee Business School,Dahisar (West), Mumbai – 68.

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First Edition : 2017

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PREFACE

“Genius is the ability to reduce the complicated to the simple”. – Albert EinstienI earnestly hope that the book will make the complicated but very enlightening Subject of ‘Risk

Management’ simple to understand and enable students to score high marks in exams.I look forward for constructive suggestion from the readers and teachers.I am thankful to one and all who have contributed directly or indirectly to make the new edition

possible.This book is user-friendly and different. As one goes through the book, one will feel the

difference, and this will help master ‘RM’ in an enjoyable manner, with lifetime utility.The book covers ‘University’ Prescribed Syllabus with Practical Dimension!!I recommend one reads the books “The Alchemist” by Neil Irwin and “Zero Sum World” by

Gideon Rachman to understand the subject from practical dimensions.Best Wishes!!Million Thanks.

Pawan JhabakM.Com., P.G.D.Ed.M.

scorejhabak@gmail.com

Visiting Faculty: Amity Business School Aditya Institute of Management Studies & Research Mumbai Educational Trust Lala Lajpatrai College

Ex. Visiting Faculty: Vivekanand Education Society Rajiv Gandhi Institute of Technology S.K Somaiya Narsee Monjee College Usha Pravin Gandhi Bhavan’s College (Andheri) Rizvi College Akbar Peerbhoy Bhurani College Poddar College, etc.

Ex. Vice Principal: Rustomjee Business School

SYLLABUS

Modules at a GlanceS.N. Modules No. of Lectures

1 Introduction, Risk Measurement and Control 152 Risk Avoidance and ERM 153 Risk Governance and Assurance 154 Risk Management in Insurance 15

Total 60

S.N. Modules/Units1 Foundation of Corporate Communication

(a) Foundation of Corporate Communication Definition, Risk Process, Risk Organization, Key Risks – Interest, Market, Credit, Currency,

Liquidity, Legal, Operational(b) Risk Management vs. Risk Measurement

Risk Management vs. Risk Measurement, Managing Risk, Diversification, Investment Strategies andIntroduction to Quantitative Risk Measurement and its Limitations

(c) Principals of Risk Principals of Risk, Alpha, Beta, R squared, Standard Deviation, Risk Exposure Analysis, Risk

Immunization, Risk and Summary Measures – Simulation Method, Duration Analysis, Linear andOther Statistical Techniques for Internal Control

2 Understanding Public Relations(a) Risk Hedging Instruments and Mechanism:

Forwards, Futures, Options, Swaps and Arbitrage Techniques, Risk Return Trade-off, Markowitz RiskReturn Model, Arbitrage Theory, System Audit Significance in Risk Mitigation

(b) Enterprise Risk Management: Risk Management vs. Enterprise Risk Management, Integrated Enterprise Risk Management, ERM

Framework, ERM Process, ERM Matrix, SWOT Analysis, Sample Risk Register3 Functions of Corporate Communication and Public Relations

(a) Risk Governance: Importance and Scope of Risk Governance, Risk and Three Lines of Defense, Risk Management and

Corporate Governance(b) Risk Assurance:

Purpose and Sources of Risk Assurance, Nature of Risk Assurance, Reports and Challenges of Risk(c) Risk and Stakeholders’ Expectations:

Identifying the Range of Stakeholders and Responding to Stakeholders’ Expectations4 Risk Management in Insurance

(a) Insurance Industry: Global Perspective, Regulatory Framework in India, IRDA – Reforms, Powers, Functions and Duties.

Role and Importance of Actuary(b) Players of Insurance Business:

Life and Non-life Insurance, Reinsurance, Bancassurance, Alternative Risk Trance, InsuranceSecuritization, Pricing of Insurance Products, Expected Claim Costs, Risk Classification

(c) Claim Management: General Guidelines, Life Insurance, Maturity, Death, Fire, Marine, Motor Insurance and Calculation

of Discounted Expected Claim Cost and Fair Premium

PAPER PATTERN

Duration: 2.5 Hours 75 MarksN.B: 5 Questions of 15 Marks Each.All questions are compulsory

Attempt any 2Q1. (a) Theory – Foundation of Corporate Communication 7.5 marks

Q1. (b) Theory – Risk Management vs. Risk Measurement 7.5 marks

Q1. (c) Theory – Principals of Risk 7.5 marks

Attempt any 2Q2. (a) Theory – Risk Hedging Instruments and Mechanism 7.5 marks

Q2. (b) Theory – Enterprise Risk Management 7.5 marks

Q2. (c) Numerical/Theory – Risk Hedging Instruments and Mechanism 7.5 marks

Attempt any 2Q3. (a) Theory – Risk Governance 7.5 marks

Q3. (b) Theory – Risk Assurance 7.5 marks

Q3. (c) Theory – Risk and Stakeholders’ Expectations 7.5 marks

Attempt any 2Q4. (a) Theory – Insurance Industry 7.5 marks

Q4. (b) Theory – Players of Insurance Business 7.5 marks

Q4. (c) Theory – Claim Management 7.5 marks

Q5. (a) Numerical 5 marks(b) Case Study 10 marks

Note: For updates on sums and theory, send email 2 weeks before exam to scorejhabak@gmail.com

CONTENTS

UNIT IFoundation of Corporate Communication

1(a) Foundation of Corporate Communication 1 – 8

1(b) Risk Management vs. Risk Measurement 9 – 13

1(c) Principals of Risk 14 – 21

UNIT IIUnderstanding Public Relations

2(a) Risk Hedging Instruments and Mechanism 22 – 35

2(b) Enterprise Risk Management 36 – 43

UNIT IIIFunctions of Corporate Communication and Public Relations

3(a) Risk Governance 44 – 49

3(b) Risk Assurance 50 – 58

3(c) Risk and Stakeholders’ Expectations 59 – 64

UNIT IVRisk Management in Insurance

4(a) Insurance Industry 65 – 73

4(b) Players of Insurance Business 74 – 92

4(c) Claim Management 93 – 108

Unit I: Foundation of Corporate Communication

CHAPTER

1(a)Foundation of

CorporateCommunication

Structure:

1.1 Definition

1.2 Risk Process

1.3 Risk Organization

1.4 Key Risks–Interest, Market, Credit, Currency, Liquidity, Legal, Operational

1.1 DEFINITIONThe risk of an investment refers to the variability of its rate of return from the expected rate of

return. Statistically, it can be measured with variance, standard deviation, range, and beta.

Required Rate of Return (RRR)

Ris

kfre

era

te

Risk-less security

Corporate debt

Government bonds

Preference share capital

Mutual fund

Equity share capital

F & O

ORisk

2 Risk Management

1.2 RISK PROCESSRisk Management is a five step process:Step 1 – Establish the contextStep 2 – Identify the risksStep 3 – Analyse the risksStep 4 – Evaluate the risksStep 5 – Treat the risksThroughout each step, it is essential that there is consultation and communication with everyone

in organisation about its functions, activities and events (refer to diagram).

RISK MANAGEMENT PROCESS

Step 5

Ste

p4

Ste

p3

Ste

p2

Ste

p1

Monitorand

Review

Com

mun

icat

ean

dC

onsu

lt(o

ngoi

ngth

roug

hout

alls

teps

)

Establish the context

Identify risks

Analyse risks

Evaluate risks

Treat risks

Step 1 – Establish the ContextBefore risk can be clearly understood and dealt with, it is important to understand the context in

which it exists. You should define the relationship between your club and the environment that itoperates in, so that the boundaries for dealing with risks are clear.Establish the content by considering:

The strategic context – the environment within which the organisation operates The organisational context – the objectives, core activities and operation’s of the club.

Step 2 – Identify the RisksThe purpose of this step is to identify what could go wrong (likelihood) and what is the

consequence (loss or damage) of it occurring.

3Foundation of Corporate Communication

Key questions to ask include: What can happen? List risks, incidents or accidents that might happen by systematically

working through each competition, activity or stage of your event to identify what mighthappen at each stage.

How and why it can happen? List the possible causes and scenarios or description of therisk, incident or accident.

What is the likelihood of them happening? What will be the consequences if they do happen?

Risks can be physical, financial, ethical or legal.Physical risks are those involving personal injuries, environmental and weather conditions and the

physical assets of the organisation such as property, buildings, equipment, vehicles, stock and grounds.Financial risks are those that involve the assets of the organisation and include theft, fraud, loans,

license fees, attendances, membership fees, insurance costs, lease payments, pay-out of damagesclaims or penalties and fines by the government.

Ethical risks involve actual or potential harm to the reputation or beliefs of your club, while legalrisks consist of responsibilities imposed on providers, participants and consumers arising from lawsmade by federal, state and local government authorities.

Step 3 – Analyse the Risks (& Evaluate)This involves analysing the likelihood and consequences of each identified risk and deciding

which risk factors will potentially have the greatest effect and should, therefore, receive priority withregard to how they will be managed. The level of risk is analysed by combining estimates oflikelihood (table 1) and consequences (table 2), to determine the priority level of the risk (table 3).

It is important to consider the consequences and the likelihood of risk in the context of the activity,the nature of your club and any other factors that may alter the consequences of likelihood of risk.

Risk evaluation involves comparing the level of risk found during the analysis process withpreviously established risk criteria, and deciding whether risks can be accepted. If the risk falls intothe low or acceptable categories, they may be accepted with minimal further treatment. These risksshould be monitored and periodically reviewed to ensure they remain acceptable. If risks do not fallinto the low or acceptable category, they should be treated using one or more of the treatment optionsconsidered in step 4.

The criteria for evaluating the risks at your club are shown below:Table 1: Likelihood Scale

Question – what is the likelihood of the risk event occurring?

Rating LIKELIHOOD: The potential for problems to occur in a year5 ALMOST CERTAIN: will probably occur, could occur several times per year4 LIKELY: high probability, likely to arise once per year3 POSSIBLE: reasonable likelihood that it may arise over a five-year period2 UNLIKELY: plausible, could occur over a five to ten year period1 RARE: very unlikely but not impossible, unlikely over a ten year period

4 Risk Management

Table 2: Loss or Damage Impact Scale

Question: what is the loss or damage impact if the risk event occurred (severity?)

Rating POTENTIAL IMPACT: In terms of the objectives of the club5 CATASTROPHIC: most objectives may not be achieved, or, several severely affected4 MAJOR: most objectives threatened, or, one severely affected3 MODERATE: some objectives affected, considerable effort to rectify i.e. sport injury – requires

medical attention and has some impact on participation in sport and/or other activity2 MINOR: easily remedied, with some effort the objectives can be achieved i.e. sport injury

requires first aid treatment and prevents immediate participation in sport and/or other activity1 NEGLIGIBLE: very small impact, rectified by normal processes

i.e. sport injury but does not prevent participation

Risk PriorityThe risk priority scale determines the nature of the risk and the action required. They are

indicators to assist in the decision making of what action is warranted for the risks.Question: what is the risk priority?

Table 3: Risk Priority ScaleIMPACT

5Catastrophic

4Major

3Moderate

2Minor

1Negligible

5Almost certain

Extreme(1)

Extreme(1)

Major(2)

Major(2)

Medium(3)

4Likely

Extreme(1)

Extreme(1)

Major(2)

Medium(3)

Minor(4)

3Possible

Extreme(1)

Major(2)

Major(2)

Medium(3)

Minor(4)

2Unlikely

Major(2)

Major(2)

Medium(3)

Minor(4)

Minor(4)

1Rare

Medium(3)

Medium(3)

Minor(4)

Minor(4)

Minor(4)

Key:Extreme Extreme risks that are likely to arise and have potentially serious consequences requiring

urgent attentionMajor Major risks that are likely to arise and have potentially serious consequences requiring urgent

attention or investigationMedium Medium risks that are likely to arise or have serious consequences requiring attentionMinor Minor risks and low consequences that may be managed by routine procedures

An example of how to use the risk rating tables is included in Attachment A.

5Foundation of Corporate Communication

Step 4 – Treat the RisksRisk treatment involves identifying the range of options for treating the risk, evaluating those

options, preparing the risk treatment plans and implementing those plans. It is about considering theoptions for treatment and selecting the most appropriate method to achieve the desired outcome.

Options for treatment need to be proportionate to the significance of the risk, and the cost oftreatment commensurate with the potential benefits of treatment.

According to the standard, treatment options include: Accepting the risk – for example, most people would consider minor injuries in

participating in the sporting activity as being an inherent risk. Avoiding the risk – is about your club deciding either not to proceed with an activity, or

choosing an alternate activity with acceptable risk, which meets the objects of your club.For example, a cricket club wishing to raise funds, may decide that a rock climbingcompetition without a properly trained and accredited instructor, equipment, etc. may berisky and may decide on a safer way of raising funds.

Reducing the risk – likelihood, or consequences, or both, is commonly practiced treatmentof a risk within sport; for example use of mouth guards for players in some sports (i.e.contact sports).

Transferring the risk – in full or in part, will generally occur through contracts or notices, forexample your insurance contract is perhaps the most commonly used risk transfer form used.Other examples include lease agreements, waivers, disclaimers, tickets, and warning signs.

Retaining the risk – is knowing that the risk treatment is not about risk elimination, ratherit is about acknowledging, the risk is an important part of the sport activity, and some mustbe retained because of the inherent nature of the sport activity. It is important to considerthe level of risk which is inherent and acceptable.

Financing the risk – means the club funding the consequences of risk i.e. providing fundsto cover the costs of implementing the risk treatment. Most community nonprofit sportclubs would not consider this option.

Whichever option you choose to treat a risk, if the risk has rated highly, you will need tocarefully consider necessary policies, procedures and strategies to treat the risk. These will include:

what is needed to treat the risk? who has responsibility? what is the timeframe? how you will know when the risk has been successfully managed?

Also, seek independent advice from your broker, insurer, solicitor, financial advisor and/oraffiliated state body.

Step 5 – Monitor and ReviewAs with communication and consultation, monitoring and review is an ongoing part of risk

management that is integral to every step of the process. It is also the part of risk management that ismost often given inadequate focus, and as a result, the risk management programs of manyorganisations become irrelevant and ineffective over time. Monitoring and review ensure that theimportant information generated by the risk management process is captured, used and maintained.

6 Risk Management

Few risks remain static. Factors that may affect the likelihood and consequences of an outcomemay change, as may the factors that affect the suitability or cost of the various treatment options.Review is an integral part of the risk management treatment plan.

As discussed earlier, risk management is an integral part of all core business functions, and itshould be seen and treated as such. Risk management should be fully incorporated into theoperational and management processes at every level of the organisation and should be driven fromthe top down.

1.3 RISK ORGANIZATION

Definition of Risk OrganizationRisk Organization is the process of identifying, quantifying, and managing the risks that an

organisation faces. As the outcomes of business activities are uncertain, they are said to have someelement of risk. These risks include strategic failures, operational failures, financial failures, marketdisruptions, environmental disasters, and regulatory violations. Risk is a statistical concept that ismeasured using statistical concepts that are related to the unknown future. Almost all investments areexposed to it.

Risk Organization involves identifying the types of risk exposure within the company, measuringthose potential risks, proposing means to hedge, insure or mitigate some of the risks and estimatingthe impact of various risks on the future earnings of the company.

While it is impossible that companies remove all risk from the organisation, it is important thatthey properly understand and manage the risks that they are willing to accept in the context of theoverall corporate strategy. The Organization of the company is primarily responsible for riskOrganization, but the board of directors, internal auditor, external auditor, and general counsel alsoplay critical roles.

Risk can be managed in a number of ways: by the buying of insurance, by using derivativeinstruments as hedges, by sharing risks with others, or by avoiding risky positions altogether.

1.4 KEY RISKS-INTEREST, MARKET, CREDIT, CURRENCY, LIQUIDITY,LEGAL, OPERATIONAL

1. Market RiskThe risk of investments declining in value because of economic developments or other events

that affect the entire market. The main types of market risk are equity risk, interest rate risk andcurrency risk.

Equity risk – applies to an investment in shares. The market price of shares varies all thetime depending on demand and supply. Equity risk is the risk of loss because of a drop inthe market price of shares.

Interest rate risk – applies to debt investments such as bonds. It is the risk of losingmoney because of a change in the interest rate. For example, if the interest rate goes up, themarket value of bonds will drop.

7Foundation of Corporate Communication

Currency risk – applies when you own foreign investments. It is the risk of losing moneybecause of a movement in the exchange rate. For example, if the U.S. dollar becomes lessvaluable relative to the Canadian dollar, your U.S. stocks will be worth less in Canadiandollars.

2. Liquidity RiskThe risk of being unable to sell your investment at a fair price and get your money out when you

want to. To sell the investment, you may need to accept a lower price. In some cases, such as exemptmarket investments, it may not be possible to sell the investment at all.

3. Concentration RiskThe risk of loss because your money is concentrated in 1 investment or type of investment.

When you diversify your investments, you spread the risk over different types of investments,industries and geographic locations.

4. Credit RiskThe risk that the government entity or company that issued the bond will run into financial

difficulties and won’t be able to pay the interest or repay the principal at maturity. Credit risk appliesto debt investments such as bonds. You can evaluate credit risk by looking at the credit rating of thebond. For example, long-term Canadian government bonds have a credit rating of AAA, whichindicates the lowest possible credit risk.

5. Reinvestment RiskThe risk of loss from reinvesting principal or income at a lower interest rate. Suppose you buy a

bond paying 5%. Reinvestment risk will affect you if interest rates drop and you have to reinvest theregular interest payments at 4%. Reinvestment risk will also apply if the bond matures and you haveto reinvest the principal at less than 5%. Reinvestment risk will not apply if you intend to spend theregular interest payments or the principal at maturity.

6. Inflation RiskThe risk of a loss in your purchasing power because the value of your investments does not keep

up with inflation. Inflation erodes the purchasing power of money over time – the same amount ofmoney will buy fewer goods and services. Inflation risk is particularly relevant if you own cash ordebt investments like bonds. Shares offer some protection against inflation because most companiescan increase the prices they charge to their customers. Share prices should therefore rise in line withinflation. Real estate also offers some protection because landlords can increase rents over time.

7. Horizon RiskThe risk that your investment horizon may be shortened because of an unforeseen event, for

example, the loss of your job. This may force you to sell investments that you were expecting to holdfor the long term. If you must sell at a time when the markets are down, you may lose money.

8. Longevity RiskThe risk of outliving your savings. This risk is particularly relevant for people who are retired, or

are nearing retirement.

8 Risk Management

9. Foreign Investment riskThe risk of loss when investing in foreign countries. When you buy foreign investments, for

example, the shares of companies in emerging markets, you face risks that do not exist in India, inyour home country, for example, the risk of nationalization. (Bank Nationalization in India)

10. Manager RiskThe chance that a pooled fund will underperform due to poor investment decisions of the fund

manager.

11. Business RiskThis refers to the risk of a particular business failing and thereby loosing its investment. Poor

business performance may be caused by a variety of factors like heightened competition, emergenceof new technologies, etc.

12. Financial RiskThe financial risk is a result of over dependence on borrowed funds. If a company uses a large

amount of debt, then it has to pay a relatively large amount of fixed interest. During recession due tolower revenue, risk of non-payment of fixed interest increases and exposes the company to financialrisk.

13. Systematic and Unsystematic RiskThe risk of any individual stock can be separated into two components: non-diversifiable and

diversifiable risk. Non-diversifiable risk is that part of the total risk that is in relation to the generaleconomy or the stock market as a whole and hence, cannot be eliminated by diversification.Non-diversifiable risk is also referred to as market or systematic risk.

Diversifiable risk, on the other hand, is margin of the company or industry and hence canbe eliminated by diversification. Diversifiable risk is also called as unsystematic risk orspecific risk.

Example of non-diversifiable or market risk factors: Major change in tax rates, war andother calamities, an increase or decrease in inflation rates, a change in economic/environmental policy, industrial recession, an increase in international oil prices, etc.

Example of diversifiable or specific risk factor: Strike in company, bankruptcy of amajor supplier, death/resignation of key company officer, unexpected entry of newcompetitor into the market, etc.

14. Legal RiskLegal risk is the risk arising from failure to comply with statutory or regulatory obligations.

Generally, all laws in the host country will apply to an entrepreneur’s local business operations.Examples include filing procedures, employment law, environmental law, tax law, and ownershiprequirements.

Review QuestionsQ1. Short Note

(a) Risk Process(b) Risk Organisation

Q2. What is Risk? Explain various types of Risk.