Risk Quantification: Management, Diagnosis and Hedging

Forewords.

Introduction.

1 Foundations.

Risk management: principles and practice.

Definitions.

Systematic and unsystematic risk.

Insurable risks.

Exposure.

Management.

Risk management.

Risk management objectives.

Organizational objectives.

Other significant objectives.

Risk management decision process.

Step 1–Diagnostic of exposures.

Step 2–Risk treatment.

Step 3–Audit and corrective actions.

State of the art and the trends in risk management.

Risk profile, risk map or risk matrix.

Risk financing and strategic financing.

From risk management to strategic risk management.

From managing property to managing reputation.

From risk manager to chief risk officer.

Why is risk quantification needed?

Risk quantification – a knowledge-based approach.

Introduction.

Causal structure of risk.

Building a quantitative causal model of risk.

Exposure, frequency, and probability.

Exposure, occurrence, and impact drivers.

Controlling exposure, occurrence, and impact.

Controllable, predictable, observable, and hidden drivers.

Cost of decisions.

Risk financing.

Risk management programme as an influence diagram.

Modelling an individual risk or the risk management programme.

Summary.

2 Tool Box.

Probability basics.

Introduction to probability theory.

Conditional probabilities.

Independence.

Bayes’ theorem.

Random variables.

Moments of a random variable.

Continuous random variables.

Main probability distributions.

Introduction–the binomial distribution.

Overview of usual distributions.

Fundamental theorems of probability theory.

Empirical estimation.

Estimating probabilities from data.

Fitting a distribution from data.

Expert estimation.

From data to knowledge.

Estimating probabilities from expert knowledge.

Estimating a distribution from expert knowledge.

Identifying the causal structure of a domain.

Conclusion.

Bayesian networks and influence diagrams.

Introduction to the case.

Introduction to Bayesian networks.

Nodes and variables.

Probabilities.

Dependencies.

Inference.

Learning.

Extension to influence diagrams.

Introduction to Monte Carlo simulation.

Introduction.

Introductory example: structured funds.

Risk management example 1 – hedging weather risk.

Description.

Collecting information.

Model.

Manual scenario.

Monte Carlo simulation.

Summary.

Risk management example 2– potential earthquake in cement industry.

Analysis.

Model.

Monte Carlo simulation.

Conclusion.

A bit of theory.

Introduction.

Definition.

Estimation according to Monte Carlo simulation.

Random variable generation.

Variance reduction.

Software tools.

3 Quantitative Risk Assessment: A Knowledge Modelling Process.

Introduction.

Increasing awareness of exposures and stakes.

Objectives of risk assessment.

Issues in risk quantification.

Risk quantification: a knowledge management process.

The basel II framework for operational risk.

Introduction.

The three pillars.

Operational risk.

The basic indicator approach.

The sound practices paper.

The standardized approach.

The alternative standardized approach.

The advanced measurement approaches (AMA).

Risk mitigation.

Partial use.

Conclusion.

Identification and mapping of loss exposures.

Quantification of loss exposures.

The candidate scenarios for quantitative risk assessment.

The exposure, occurrence, impact (XOI) model.

Modelling and conditioning exposure at peril.

Summary.

Modelling and conditioning occurrence.

Consistency of exposure and occurrence.

Evaluating the probability of occurrence.

Conditioning the probability of occurrence.

Summary.

Modelling and conditioning impact.

Defining the impact equation.

Defining the distributions of variables involved.

Identifying drivers.

Summary.

Quantifying a single scenario.

An example – “fat fingers” scenario.

Modelling the exposure.

Modelling the occurrence.

Modelling the impact.

Quantitative simulation.

Merging scenarios.

Modelling the global distribution of losses.

Conclusion.

4 Identifying Risk Control Drivers.

Introduction.

Loss control – a qualitative view.

Loss prevention (action on the causes).

Eliminating the exposure.

Reducing the probability of occurrence.

Loss reduction (action on the consequences).

Pre-event or passive reduction.

Post-event or active reduction.

An introduction to cindynics.

Basic concepts.

Dysfunctions.

General principles and axioms.

Perspectives.

Quantitative example 1 – pandemic influenza.

Introduction.

The influenza pandemic risk model.

Exposure.

Occurrence.

Impact.

The Bayesian network.

Risk control.

Pre-exposition treatment (vaccination).

Post-exposition treatment (antiviral drug).

Implementation within a Bayesian network.

Strategy comparison.

Cumulated point of view.

Discussion.

Quantitative example 2 – basel II operational risk.

The individual loss model.

Analysing the potential severe losses.

Identifying the loss control actions.

Analysing the cumulated impact of loss control actions.

Discussion.

Quantitative example 3 – enterprise-wide risk management.

Context and objectives.

Risk analysis and complex systems.

An alternative definition of risk.

Representation using Bayesian networks.

Selection of a time horizon.

Identification of objectives.

Identification of risks (events) and risk factors (context).

Structuring the network.

Identification of relationships (causal links or influences).

Quantification of the network.

Example of global enterprise risk representation.

Usage of the model for loss control.

Risk mapping.

Importance factors.

Scenario analysis.

Application to the risk management of an industrial plant.

Description of the system.

Assessment of the external risks.

Integration of external risks in the global risk assessment.

Usage of the model for risk management.

Summary – using quantitative models for risk control.

5 Risk Financing: The Right Cost of Risks.

Introduction.

Risk financing instruments.

Retention techniques.

Current treatment.

Reserves.

Captives (insurance or reinsurance).

Transfer techniques.

Contractual transfer (for risk financing – to a noninsurer).

Purchase of insurance cover.

Hybrid techniques.

Pools and closed mutual.

Claims history-based premiums.

Choice of retention levels.

Financial reinsurance and finite risks.

Prospective aggregate cover.

Capital markets products for risk financing.

Securitization.

Insurance derivatives.

Contingent capital arrangements.

Risk financing and risk quantifying.

Using quantitative models.

Example 1: Satellite launcher.

Example 2: Defining a housing stock insurance programme.

A tentative general representation of financing methods.

Introduction.

Risk financing building blocks.

Usual financing tools revisited.

Combining a risk model and a financing model.

Conclusion.

Index.