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

Dont 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.

Segment B
Risk Mgt. Framework

Risk Mgt. Standards

and Guidelines

and Process

Hazard Risk

Risk Analysis

Operational,
Financial and Strategic
Risk

Risk Treatment

Risk Identification

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 nondiversifiable
risks is clear; risks cannot fall under both classifications
simultaneously.
D: Private insurance tends to concentrate on nondiversifiable
risks; 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

organizations 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 Autumns 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 Autumns MVS?

2.

What is Autumns economic capital?

3.

Does Autumn have excess capital or a deficiency in capital?

Segment B

Segment A
Intro to Risk Mgt.

Segment B
Risk Mgt. Framework

Risk Mgt. Standards

and Guidelines

and Process

Hazard Risk

Risk Analysis

Operational, Financial
and Strategic Risk

Risk Treatment

Risk Identification

Segment C
Financial Statement
Risk Analysis
Capital Investment
and Financial Risk
Monitoring and
Reporting on Risk

Assignment 5: Framework and Process

ERM 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

.300

.350

.200

.147

.002

.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

30 %

0.00

35 %

.350

20 %

.400

14.7 %

.441

.02 %

.008

.01 %

.005

15

100 %

1.204

Mean

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 plants frequency or severity relatively more
variable?

Frequency
Severity

Mean

Standard
Deviation

40

10

$90,000

$45,000

Coefficient of
Variation

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 Vandenbergs workers
compensation medical expenses (the dependent variable) and its
payroll (the independent variable). The formula for Vandenbergs
linear regression line is y = 5.20 + .098 (x). Next years payroll is
estimated to equal $3,750,000. Based on this information what are
Vandenbergs 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.

Segment B
Risk Mgt. Framework

Risk Mgt. Standards

and Guidelines

and Process

Hazard Risk

Risk Analysis

Operational,
Financial and Strategic
Risk

Risk Treatment

Risk Identification

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
Assets
Current Assets
Noncurrent Assets

Total Assets

Liabilities and Shareholders Equity

Current Liabilities
Noncurrent Liabilities
Total liabilities
Shareholders Equity
Total 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 companys sales growth rate over the past
year. Using the following data, what is the growth rate?

Net Sales

End Yr. 2

End Yr. 1

$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 assets Current liabilities

Current ratio

Current assets / Current liabilities

Acid-test ratio

(Cash + Marketable securities +

Accounts receivable) / Current
liabilities

Balance Sheet
Current Assets

Current Liabilities

Cash

$50,000

Accts payable

A/R

125,000

Wages payable

Inventory

1,500,000

Supplies

75,000

Securities

Total:

Taxes payable
ST debt

$1,250,000
250,000

3,750,000
15,000,000

15,000,000

$16,750,000

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 +

n
r)

ABC Insurances 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 Table

n/r

8%

9%

10%

.9259

.9174

.9091

.8573

.8417

.8264

.7938

.7722

.7513

.7350

.7084

.6830

.6806

.6499

.6209

Present Value of an Annuity

Present Value of an Annuity of $1

Table
n/r

5%

6%

7%

8%

.9524

.9434

.9346

.9259

1.8594

1.8334

1.8080

1.7833

2.7232

2.6730

2.6243

2.5771

3.5460

3.4651

3.3872

3.3121

4.3295

4.2124

4.1002

3.9927

5.0757

4.9173

4.7665

4.6229

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

Payment

Present Value
Factor (7%)

-$10,000

1.0000

-$10,000

2,500

.9346

2,236

3,300

.8734

2,882

$4,700

.8163

3,837

Net present value

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
Expenses

$12,000
(600)

Before-tax CF

$11,400

Depreciation

(4,286)

Before-tax CF

11,400

Taxable income

Tax

(2,846)

Tax (40%)

After-tax CF

8,554

5.206

PV of AT CF

44,532

Initial invest.

(30,000)

NPV

$14,532

7,114

$2,846

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 companys
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!