ARM 54: Risk Management Principles and Practices Exam Review

CAD007

Speakers:

• Ann E. Myhr, CPCU, ARM, AIM, ASLI, AU, Senior Director of Knowledge Resources, The Institutes

• Susan Kearney, CPCU, ARM, AAI, AU, Senior Director of Knowledge Resources, The Institutes

Learning Objectives

At the end of this session, you will:

• Anticipate the ARM 54 Exam Format

• Recall specific principles likely to appear on the ARM 54 exam

• Appraise your strengths and weaknesses applied to ARM 54 exam subjects

Session Overview

• Exam Basics – What to Expect

• Test Taking Tips

• Review of the “Top” Most Challenging Educational Objectives of ARM 54

Exam Basics – What to Expect

• Exam Length, Exam Format

• Educational Objectives

• Balanced Exam

• Formulas and Tables

Test Taking Tips

• Don’t get bogged down early

• Try the exam in “waves”

• Get the easy ones

• Eliminate the obviously wrong answers

• Use the mark for later review feature

• Use your scratch paper to keep track

Segment A

Segment A

● Intro to Risk Mgt.

● Risk Mgt. Standards and Guidelines

● Hazard Risk

● Operational, Financial and Strategic Risk

Segment B

● Risk Mgt. Framework and Process

● Risk Identification

● Risk Analysis

● Risk Treatment

Segment C

● Financial Statement Risk Analysis

● Capital Investment and Financial Risk

● Monitoring and Reporting on Risk

Assignment 1: Introduction to Risk Management

• The Risk Management Environment

• Benefits of Risk Management

• Risk Management Objectives and Goals

• Basic Risk Measures

• Risk Classifications

• Enterprise Risk Management

Classifications of Risk

Risk Quadrants

Risk can be classified as diversifiable or nondiversifiable. Which one of the following statements is true?

A: Inflation, unemployment, and natural disasters, such as hurricanes, are examples of diversifiable risk.

B: Diversifiable risks tend not to be correlated so they can be managed through diversification or spread of risk.

C: The distinction between diversifiable and nondiversifiablerisks is clear; risks cannot fall under both classifications simultaneously.

D: Private insurance tends to concentrate on nondiversifiablerisks; government insurance is often suitable for diversifiable risks.

Assignment 2: Risk Management Standards and Guidelines

• Intro to Risk Management Standards and Guidelines

• ISO 31000 Risk Management

• COSO Enterprise Risk Management

• Solvency II and Basel II and III Regulatory Standards

Risk Management Standards

• Standards

• Frameworks

• Major risk management standards and guidelines

Framework and Process

ISO 31000 Framework and Process

Source: ISO 31000:2009

COSO ERM

Source: COSO – Enterprise Risk Management – Integrated Framework

A key distinction between ISO 31000 and COSO ERM is that ISO

31000

A: takes an enterprise-wide approach.

B: involves elements of a risk management process.

C: defines “risk” as having both an upside and a downside.

D: requires the monitoring of treatment plans.

The Committee of Sponsoring Organizations’ (COSO 2004) risk

management standard

A: primarily employs root cause analysis to assess risk.

B: defines “risk” as the uncertainty on objectives.

C: was issued by a government agency.

D: originated with a focus on financial risk.

Assignment 3: Hazard Risk

• The Nature of Hazard Risk

• Loss Exposures

• Commercial Insurance Policies

A group of female employees at Third Federal Bank filed a lawsuit

against the bank. The lawsuit alleges that the bank consistently

failed to promote qualified women to senior management

positions because of their gender. If the lawsuit is successful,

which one of the following coverages would pay the damage

award?

A: Workers compensation insurance

B: Sistership liability insurance

C: Employment practices liability insurance

D: General liability insurance

Assignment 4: Operational, Financial, and Strategic Risk

• Operational Risk

• Operational Risk Indicators

• Financial Risk

• Value at Risk and Earnings at Risk

• Regulatory Capital

• Economic Capital

• Strategic Risk

Operational Risk

• People

• Process

• Systems

• External events

Risk Indicator

Financial Risks

• Market risk

• Currency price risk

• Interest rate risk

• Commodity price risk

• Equity price risk

• Liquidity risk

• Credit risk

• Price risk

Which one of the following types of financial risk measures an

organization’s ability to raise cash?

A: Price risk

B: Market risk

C: Liquidity risk

D: Interest rate risk

Value at Risk (VaR)

A $500,000, 2 percent VaR means losses are expected to be

A: $10,000.

B: less than $500,000 2 percent of the time.

C: $490,000.

D: greater than $500,000 2 percent of the time.

Earnings at Risk

Earnings at risk of $200,000 with 90 percent confidence are

projected to be

A: $180,000.

B: less than $200,000 10 percent of the time.

C: $200,000 90 percent of the time.

D: greater than $200,000 10 percent of the time.

EO 4.06

• Apply the concept of economic capital to insurers.

Market Value Surplus (MVS)

Economic Capital

Market Value Surplus Example

Autumn Assurance Group has assets at fair value of $100 million.

The present value of Autumn’s liabilities is $85 million. The market

value margin is $5 million. Using probability models, Autumn

determines that its VaR is $8 million because it expects to incur an

$8 million or greater loss of capital at a .5 percent probability over

a one-year period.

1. What is Autumn’s MVS?

2. What is Autumn’s economic capital?

3. Does Autumn have excess capital or a deficiency in capital?

Segment B

Segment A

● Intro to Risk Mgt.

● Risk Mgt. Standards and Guidelines

● Hazard Risk

● Operational, Financial and Strategic Risk

Segment B

● Risk Mgt. Framework and Process

● Risk Identification

● Risk Analysis

● Risk Treatment

Segment C

● Financial Statement Risk Analysis

● Capital Investment and Financial Risk

● Monitoring and Reporting on Risk

ERM Framework and Process

Assignment 5: Framework and Process

Traditional RM Process

Cromley has 30 stores located throughout the U.S. An increase in

the frequency and severity of general liability claims over the last

three years has encouraged Cromley's risk manager to design and

implement a risk management framework and process. Cromley

has decided to replace the carpeting at several locations,

purchase additional storage equipment, and train employees on

premises safety. Cromley is in which one of the following stages

of designing and implementing a risk management framework and

process?

A: Evaluation of internal and external environments

B: Gap analysis

C: Integration into existing processes

D: Commitment of resources

Assignment 6: Risk Identification

• Introduction to Risk Identification

• Team Approaches to Risk

Identification

• Risk Registers

• Risk Maps

• Identifying Loss Exposures

• Identifying Risk

Which one of the following team approaches to risk identification

involves a select group of experts in question-and-response

cycles until a consensus is achieved?

A: Delphi technique

B: SWOT analysis

C: HAZOP

D: Scenario analysis

Assignment 7: Risk Analysis

• Introduction to Risk Analysis

• Probability Analysis

• Characteristics of Probability

Distributions

• Trend Analysis

• Analyzing Event Consequences

• Analyzing Loss Exposures

Frequency Probability Distribution

Number of Hurricanes Probability

0 .300

1 .350

2 .200

3 .147

4 .002

5 .001

Total 1.00

EO 7.03

• Describe the following characteristics of probability distributions:

• Expected value

• Mean

• Standard deviation

• Coefficient of variation

• Normal distribution

Characteristics of Probability Distributions

• Central Tendency

• Expected Value

• Mean

• Dispersion (volatility)

• Standard Deviation

• Coefficient of Variation

Central Tendency

Number of Hurricanes Probability Expected Value Mean

0 30 % 0.00

1 35 % .350

2 20 % .400

3 14.7 % .441

4 .02 % .008

5 .01 % .005

15 100 % 1.204 15/6 = 2.5

Probability Distributions

Coefficient of Variation Example

A plant manager wants to compare the relative variability of the plants workers’ compensation frequency to its severity. Based on the data below, is the plant’s frequency or severity relatively more variable?

MeanStandard Deviation

Coefficient of Variation

Frequency 40 10

Severity $90,000 $45,000

Normal Distribution

Assume that the length of time a heating element can operate

safely conforms to a normal distribution with a mean of 5,000

hours and a standard deviation of 1,000 hours. If the element is

replaced after 5,000 hours, which one of the following represents

the chance that the heating element will become unsafe before

being replaced?

A: 70 percent

B: 50 percent

C: 40 percent

D: 20 percent

If 95.44 percent of all outcomes are within two standard deviations

above and below the mean and 2.15 percent of all outcomes are

between two and three standard deviations above and 2.15

percent of all outcomes are between two and three standard below

the mean, the percentage of all outcomes that lie beyond three

standard deviations from (above and below) the mean is

A: .13

B: .26

C: 2.15

D: 4.30

EO 7.04

• Explain how regression analysis can be used to forecast gains and losses.

Regression Analysis Equation

y = a + b(x)

Vandenberg ‘s risk manager uses regression analysis to

determine the relationship between Vandenberg’s workers

compensation medical expenses (the dependent variable) and its

payroll (the independent variable). The formula for Vandenberg’s

linear regression line is y = 5.20 + .098 (x). Next year’s payroll is

estimated to equal $3,750,000. Based on this information what are

Vandenberg’s estimated workers compensation medical expenses

next year?

A: $367,495

B: $367,500

C: $367,505

D: $375,520

Decision Tree

Assignment 8: Risk Treatment

• Risk Treatment

• Introduction to Risk Financing

The CEO of GBB Co.,in consultation with the head of the human

resources department, decided to begin to offer off-site day care

as an employee benefit for GBB employees. The risk manager

learned of the day care operation two weeks after the service to

employees had begun. He reviewed the company's liability

insurance contracts and determined that the company had no

coverage for liability arising out of the day care operations. This

risk, as it was not identified and treated, is being handled through

A: Unplanned transfer.

B: Unplanned mitigation.

C: Unplanned avoidance.

D: Unplanned retention.

Segment C

Segment A

● Intro to Risk Mgt.

● Risk Mgt. Standards and Guidelines

● Hazard Risk

● Operational, Financial and Strategic Risk

Segment B

● Risk Mgt. Framework and Process

● Risk Identification

● Risk Analysis

● Risk Treatment

Segment C

● Financial Statement Risk Analysis

● Capital Investment and Financial Risk

● Monitoring and Reporting on Risk

Assignment 9: Financial Statement Risk Analysis

• Balance sheet

• Income statement

• Statement of changes in shareholders equity

• Statement of cash flows

Balance Sheet

AssetsCurrent AssetsNoncurrent Assets

Total Assets

Liabilities and Shareholders’ EquityCurrent LiabilitiesNoncurrent Liabilities

Total liabilities

Shareholders’ EquityTotal Liabilities and Shareholders’ Equity

Income Statement

Revenue

- Cost of goods sold

Gross profit

- General operating expenses

Operating income

+/- Other income/expenses

Net income before taxes

- Income taxes

Net Income

Statement of Comprehensive Income

Net income + Other comprehensive income (OCI)

Components of OCI

Change in unrealized appreciation/depreciation of investments

Foreign currency gains/losses

Minimum pension liability changes

EO 9.04

• Describe the content and purpose of the statement of changes in shareholders’ equity and the statement of cash flows.

Owners’ Equity (OE)

OE Components

Paid-in capital

Retained earnings

Accumulated other comprehensive income

Treasury stock

Change in OE (year over year)

+ common stock issued

+ net income – dividends

+/- other comprehensive income/loss

+/- share issuance/ repurchase

The portion of net income that is not distributed to

stockholders is added to

A: comprehensive income.

B: retained earnings.

C: treasury stock.

D: paid-in capital.

Statement of Cash Flows

Operating activities

Investing activities

Financing activities

Increase/decrease in cash for year

EO 9.06

• Apply trend analysis to income statements over multiple periods.

Trend Analysis

12/31/2013 12/31/2012 12/31/2011

Revenue $25,000 $30,000 $33,000

Net income $1,200 $1,500 $1,800

Lisa wants to quantify her company’s sales growth rate over the past

year. Using the following data, what is the growth rate?

End Yr. 2 End Yr. 1

Net Sales $500,300 $450,200

A: 8 percent.

B: 9 percent.

C: 10 percent.

D: 11 percent.

Which one of the following statements best describes a trend in the financial data above?

A: The low growth in the cost of sales is adversely affecting gross profit.

B: Operating profit is negative during each of these three years.

C: Operating expenses are increasing at a faster rate than sales causing operating profit to decline.

D: The cost of sales is increasing at a faster rate than operating expenses.

EO 9.07

• Explain how ratio analysis can be used to evaluate liquidity.

Ratio Analysis

Working capital

Current ratio

Acid-test ratio

Current assets – Current liabilities

Current assets / Current liabilities

(Cash + Marketable securities + Accounts receivable) / Current liabilities

Balance Sheet

Current Assets

Cash $50,000

A/R 125,000

Inventory 1,500,000

Supplies 75,000

Securities 15,000,000

Total: $16,750,000

Current Liabilities

Accts payable $1,250,000

Wages payable 250,000

Taxes payable 3,750,000

ST debt 15,000,000

Total: $20,250,000

Assignment 10: Capital Investment and Financial Risk

• Present Value and Discounting

• Present Value of an Annuity

• Present Value of Unequal Payments

• Net Present Value

• Evaluating Capital Investment Proposals

• Evaluating Cash Flows From Treating Hazard Risk

• Using Call Options to Limit Financial Risk

EO 10.04

• Calculate the net present value of a series of cash outflows and inflows, given the applicable rate of return and number of periods.

Present Value Considerations

• Single or multiple periods?

• Single or multiple sums?

• Equal or unequal amounts for each period?

• Cash inflows, outflows, or both?

• How many periods (n)?

• What is the interest rate (r)?

Present Value Formula

PV = FVn ÷ (1 + r)n

ABC Insurance’s financial officer wants to set aside sufficient

funds to pay a lump sum claim settlement of $250,000 two

years from today. Assuming the fund earns 10 percent per year,

how much will the financial officer need to place in the fund

today?

A: $375,000

B: $302,500

C: $225,000

D: $206,600

Present Value of $1 Tablen/r 8% 9% 10%

1 .9259 .9174 .9091

2 .8573 .8417 .8264

3 .7938 .7722 .7513

4 .7350 .7084 .6830

5 .6806 .6499 .6209

Present Value of an Annuity

Present Value of an Annuity of $1 Tablen/r 5% 6% 7% 8%

1 .9524 .9434 .9346 .9259

2 1.8594 1.8334 1.8080 1.7833

3 2.7232 2.6730 2.6243 2.5771

4 3.5460 3.4651 3.3872 3.3121

5 4.3295 4.2124 4.1002 3.9927

6 5.0757 4.9173 4.7665 4.6229

7 5.7864 5.5824 5.3893 5.2064

EO 10.05

• Evaluate capital investment proposals using the net present value method.

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.

Net Present Value of an Investment

Year PaymentPresent Value

Factor (7%) Present Value

0 -$10,000 1.0000 -$10,000

1 2,500 .9346 2,236

2 3,300 .8734 2,882

3 $4,700 .8163 3,837

Net present value -$945

Net Present Value Example

Should your company invest $10,000 today in loss control equipment that is expected to save losses and expenses of $3,000 at the end of the first year, $3,200 at the end of the second year, and $4,100 at the end of the third year. Assume your company requires a rate of return on its investments of 5 percent.

Risk Information System – NPV

• Initial investment = $30,000

• Useful life = 7 years

• Operating expenses $600 per year

• Savings = $12,000 per year

• Expected rate of return = 8%

Risk Information System – NPV

Revenue $12,000 Before-tax CF $11,400

Expenses (600) Depreciation (4,286)

Before-tax CF 11,400 Taxable income 7,114

Tax (2,846) Tax (40%) $2,846

After-tax CF 8,554

X 5.206

PV of AT CF 44,532

Initial invest. (30,000)

NPV $14,532

Omicron Manufacturing is considering the purchase of new

extrusion equipment that costs $150,000 and has a useful life of

10 years with no salvage value. It will generate differential cash

revenues of $35,000 per year and will add $4,000 to the company’s

annual maintenance costs and $1,500 to its insurance premium.

Omicron uses straight-line depreciation and has a 40 percent tax

rate. What is the differential annual after-tax net cash flow if

Omicron purchases the equipment?

A: $5,800

B: $11,800

C: $23,700

D: $29,500

Assignment 11: Monitoring and Reporting on Risk

• Board Risk Oversight

• Internal Controls Support to Risk Monitoring

• Internal Audit Support to Risk Monitoring

• Risk Assurance to Evaluate Risk Management Performance

• Risk Management Monitoring and Reporting

GOOD LUCK ON EXAM!