Question

Discuss each of the three (3) Rules of Risk Management. Select one (1) of the 4 boxes of the frequency/severity matrix (p. 59 of fundamentals of risk and insurance, 11th edition) and identify a peril that fits into that box and how a risk manager might handle that risk.

Answer 1

The three Rules of risk management are:

1. Know what you are doing.

This step involves understanding each and every aspect of the investment/business based on factual data, by stating the expected return and considering all the relevant risk associated with the project

2. Know the risk involved.

One has to understand what type of risk is involved and how much risk is involved. The most common approach her is the VaR method of measuring risk, which states for a given probability the minimum loss the business/investment will cause in the mentioned time period. A VaR has 3 numbers/variables, the probability of loss, the minimum amount of loss, and the period in which the loss will occur. For example, a 5% monthly VaR of $10,000 states that there is a 5% chance of having a minimum of $10,000 loss every month

3. Remove as much risk as possible.

The image shows the frequency/severity matrix and the inside "red-colored text" mentions what action should be taken in each of the circumstances.

The most common activity done by a risk manager is interest rate hedging on a regular basis as it falls in the category of High frequency, Low severity. Interest rates change for about 5-6 times in a year depending upon the country of operations and hence it is the most common hedging goal of a risk manager, Risk manager can go for various methods to do so, such as duration matching, interest rate risk immunization by forwards/futures, interest rate swap options, etc.