Using a Business Simulation Game to Teach Risk ...

Using a Business Simulation Game to Teach Risk Management Author(s): Brian Schott Source: The Journal of Risk and Insurance, Vol. 43, No. 3 (Sep., 1976), pp. 526-532 Published by: American Risk and Insurance Association Stable URL: http://www.jstor.org/stable/251919 . Accessed: 09/05/2014 00:38 Your use of the JSTOR archive indicates your acceptance of the Terms & Conditions of Use, available at . http://www.jstor.org/page/info/about/policies/terms.jsp

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Using a Business Simulation Game to Teach Risk Management BRIAN

ScHorr

The most commonly used methods of teaching risk management have included the traditional techniques of lectures, cases, and field studies. In order to enhance this educational process, a computer simulation game, RISKM, was recently developed and played at Georgia State University. The benefits to be derived from management gaming have been recognized in other fields and apply to RISKM also: [although total realism cannot be achieved by any practical model] a dynamic situation provides more realism than a static case can provide. Computer simulation with rapid feedback makes possible instant analysis of management strategies and competition between those playing the game can stimulate creativity and interest. RISKM allows the students as individuals or teams to assume the role of the risk manager who must make insurance/self-insurance decisions and financial decisions. The students must determine the type of deductibles and deductible limits, the locations and risks covered by insurance, debt and investment strategies, dividend payouts, and reserve levels. In addition, the risk managers can design new insurance policies, safety programs, and loss prevention/reduction schemes. The computer permits the manager to interact "conversationally" with the model after a typed message prompts his responses at the teletype terminal, and management decisions are thus supplied as input to the model. Based on these decisions, a year's operation is then simulated by the computer; income statements, balance sheets, and risk reports are generated. The risk managers can evaluate their performance in each simulated year, with other students working in identical simulated environments. They can compare earnings, loss frequency, loss severity, premium expense, claims expense, reserve adequacy, safety and loss-reduction programs, deductible and aggregate loss limits, debt management, and other similar factors. RISKM was designed to resemble the Special Chemical Company which is the subject of Jerry S. Rosenbloom's book entitled A Case Study in Risk Management. Although RISKM is similar to the Special Chemical Company, some changes were necessary in order to make the Case into a dynamic situation. The Special Chemical Company is fictitious chemical firm of Brian Schott is Associate Professor of Quantitative Methods, Georgia State University. The author would like to acknowledge the help of Dr. Bruce Palmer and Mrs. Joan Schott in preparing and reviewing this paper. ( 526)

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Communications

527

moderate size ($160 million net sales, $120 million fixed assets) which operates in four markets: ethical drugs, chemicals, explosives, and government space exploration contracts. Manufacturing plants with varying asset values are located in a number of states in the United States. The Rosenbloom text describes many essential characteristics of the Special Chemical Company, such as the recent financial history, its markets, and the asset values and payrolls. Many risk areas and available insurance coverages are suggested by Rosenbloom for the Special Chemical Company. The Special Chemical Company in Rosenbloom's Case may be used alone as an environment for the study of the risk management profession. The RISKM player's manual provides additional information and instruction. Special Chemical Company's risks are grouped into seven categories in RISKM: property damage, indirect (profits) losses, crime exposures, general liability (including products liability), automobile liability, truck liability, and workmen's compensation and employee's liability. Claim histories are provided for each of these risks for each of the past five years and for all of the past five years combined. This recent loss history includes annual loss frequencies, total annual claim figures, and individual claims for each of the seven risk categories. The individual claims are described by giving the year's smallest and largest losses and by giving the year's mean, standard deviation, and skewness coefficient. That is, each risk category is described in terms of both frequency and severity. The risk manager/student's decisions are based on a careful analysis of the loss data. Player Strategies Several different deductible and stop-loss (annual aggregate) alternatives1 and associated annual premiums are provided for each of the seven risk categories, and self-insurance can also be elected. The players are instructed to select economical, but safe, insuring strategies from among these alternatives. The player's manual explains the rules of the game and includes sample input and readouts. Each of the decisions and other inputs is explained.2 In addition to controlling insurance limits (deductibles and stop-loss limits), student risk managers can regulate several other factors. Loss-reduction and safety schemes can be designed, and cost-cutting measures for claims adjusting and handling can be developed. By written memoranda, students can suggest any programs or management strategies to reduce the cost of risks. The memoranda must provide all the facts regarding costs, benefits, and implementation. For example, students can suggest sprinkler systems, 1 Actually, many more alternatives exist than are provided. A very productive class assignment can be to research local commercial insurers for more competitive rates for the Special Chemical Company's risks. 2 Since RISKM was designed so that students can execute the computer program themselves without the instructor'shelp, some of the execution instructions relate specifically to the computer at Georgia State University. Some instructions regarding the job control instructions in the player's manual are unique to the computer installation.

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528

The Journal of Risk and Insurance

plant watchmen, safety programs, and so on. In each case, the ongoing costs should be distinguished from capital outlays because the accounting rules differ for each. To the extent that the instructor or umpire is convinced of the effects of each safety/cost reduction program, he may alter the firm's risk environment. The administrator's guide to RISKM explains how each risk is controlled by way of a computer data file. The instructor may alter the frequency and/or severity of any firm's losses by adjusting the firm's loss parameters. The level of loss contingency reserves is controlled by the risk manager in RISKM. The manager can see the effect on his financial statements of strategies such as increasing reserves and reducing retained earnings. When retained earnings increase to a suitable level, he can choose to raise reserve levels or pay dividends to stockholders or retain earnings for future capital growth. The risk manager can also control the mixture of borrowed funds and invested funds in order to handle uneven patterns of cash needs. In fiscal periods during which a largely self-insured firm encounters uncharacteristically high property/liability losses, cash is acquired by reducing investments to the extent it can be done economically, and then by borrowing money. In RISKM the risk manager can control these decisions regarding the levels of invested assets and borrowing. Although the borrowing can be achieved at a known interest rate, the return on invested assets is less predictable (the yield is determined by a random element). The Mechanics of RISKM Each student of risk management or group of students 3 manages a separate firm which it names. Each decision period, a fiscal year, is referred to as a "run" of RISKM. The game was designed so that the students can run it themselves each fiscal year.4 All groups have exactly the same financial and marketing environment. The risks and total claim amounts are identical among firms, except that some firms may alter their risk potential by devising safety programs and loss-reduction mechanisms. Since losses and earnings are the same for all of the risk management teams, they compete on the basis of total risk cost, on profit, or on other financial measures. Although RISKM has been written to provide for at most twelve fiscal years of simulation (and no limit to the number of trial runs of each fiscal year), minor programming changes would result in the ability to run more than twelve decision periods. 'The author has found that two and three person teams work very productively together, but other team sizes have been successful also. 4 In a few cases the instructor will change some risk parameters for an individual firm before the firm submits its decisions for a particular fiscal year's run. These cases occur when the finn devises a scheme which alters their firm's risk potentialsuch as an improved network of infirmariesat the manufacturing plants to reduce the lost time associated with work-related injuries and illnesses. The instructor reduces the loss potential by changing the risk parameters. The firm itself controls the costs by supplying the dollar amounts when the year is run.

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Communications

529

The firm must maintain a minimum level of cash. In the event that random losses are unusually high, or if earnings are very low in a fiscal year so that the level of cash reaches a specified threshold (4 percent of annual disbursements), cash is automatically acquired for the firm. An algorithm within RISKM determines an economical amount of cash to acquire from reducing investments and the remainder of the required cash is borrowed at a high rate of interest. An assumption is made that initially the most liquid investments are retired and larger cash needs require greater reductions in long term investments. The algorithm assumes that the further one reduces investments from any starting level, the greater will be the loss of principal. Beyond some point the loss in principal is so great that it becomes more economical to borrow funds than to cut investment levels. Loss frequencies and severities in the seven risk categories are simulated separately in RISKM. Random samples of frequency are selected by the computer first. The sample frequency for each risk category indicates the number of losses which occur in the simulated year. The sample frequency is then used to trigger a computer processing loop which samples from the loss severity probability model the required number of times. The computer adds up all the losses (after subtracting dollar amounts which exceed the firm's deductible limits, if applicable) and simulates any administrative expenses. Several other elements which relate to commercial (uninsurable) risks also employ random sampling in RISKM. However, the apparent chance variation is not a frequency-severity simulation. Rather, these fluctuations are determined by randomness in "severity" only. The financial statement accounting in RISKM is very crude. Especially simple is the tax accounting regarding the fortuitous losses. Taxes are 25 percent for profits up to $25,000, and 48 percent for all additional earnings. The tax accounting will be enriched as soon as it is practical. Expected sales volume is based on an annual percentage growth rate but variations from the average are permitted. Any variation from average affects inventories, earnings, cash flow, and receivables. Depreciation of fixed assets is similarly very crude. Depreciation is always 8 percent of the year end value of long term assets. The uncomplicated financial accounting in RISKM was necessitated by the author's wish to get a working model rapidly. Hopefully students and other educators will contribute to the improvement of RISKM in this area and in others. Teaching Risk Management with RISKM RISKM was created with rather specific goals in mind. Simulating reality accurately was not the primary goal. Rather, the purpose of RISKM was to produce an integrative, dynamic model which would increase the interest of students by way of the dynamic and competitive environment of a game. In other words, the prime goal was to have a relevant model which

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The Journal of Risk and Insurance

530

FIGURE 1 I AM UNSURE, LTD. RISK REPORT LOSSES,

AND COSTS

EXPENSES,

FOR YEARENDING 1976 LOSS CATEGORY ( PROPERTY DAMAGE INDIRECT RISKS CRIMEEXPOSURES GEN'LLIABILITY AUTOLIABILITY WORKMEN'S COMP TRUCK LIABILITY TOTAL

LOSS CATEGORY

(I7)

PREMIUM (2)

LOSS REDUCTION EXPENSES (3V)T4T 0. 0. 0. 0. 0. 0. 0. 0.

S7000. 42009. 20000. 11000. 2000. 2000. 0. 134009.

INSURED LOSS

(5)

PROPERTY DAMAGE 105403. INDIRECTRISKS 3756. CRIMEEXPOSURES 0. GEN'LLIABILITY 0. AUTOLIABILITY 36564. WORKMEN'S COMP 0. TRUCK LIABILITY 0. TOTAL 4723.

# OP LOSSES

SELFINSURED LOSS

(6) 600000. 4857. 45576. 183045. 156330. 79787. 233838. 1303432.

19 2 59 63 115 447 42

CLAIM EXPENSES -_

(7)F

14103. 331. 2440. 1784S. 14704. 8305. 14079. 71806.

TOTAL COST OF RISKS 2+3+6+7

() 671103. 47197. 68016. 211889. 173034. 90092. 247916. 1509248.

provides feedback to students regarding their risk management strategies without creating undue complexity. As such, the elements which impact the risk manager are treated in somewhat more detail than are other aspects of the firm. The model can be used to show some of the tradeoffs a risk manager encounters. Usually the risk manager sacrifies predictability of cash flows when he chooses to economize by retaining more risk rather than transferring risk. Figures 1, 2, and 3 show the summary risk reports and financial reports automatically printed by RISKM. The risk report records the costs and losses by risk category. For each risk category, the premium paid, expenses (not the capital outlays which are reported on the balance sheet) of loss reduction activities, the annual loss frequency, the year's losses which are paid by an insurer, the portion of the year's losses paid by the firm, and the year's expenses growing out of nonspeculative losses are reported on the risk report. In addition to these figures the risk report shows the total risk cost for each risk category and for all risk categories combined. The income statement and balance sheet indirectly reflect the total cost of risk from the risk report. The year's total insurance premiums, loss reduction expenses, uninsured losses, other income (from interest on investments), and interest expense are all itemized on the income statement. The interest earned and interest expense may be partially related to the risk manager's actions, although these items may result from other factors in the firm. On the balance sheet, cash, investments, capital expendi-

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531

Communications FIGURE 2 I AM UNSURE,LTD. As

POSITION STATEMENT OF DECEMBER 31, 1976

(000 OMITTED) ASSETS CURRENT ASSETS CASH RECEIVABLES INVENTORIES INTERESTRECEIVABLE

$

14,271 33,838 23,093 3,997

$ 75,199 $ 21,800

INVESTMENTS PROPERTY,PLANT, AND EQUIPMENT BUILDINGS,EQUIPMENT CAPITALEXPENDITURES MISCELLANEOUS LOSS REDUCTION LESS DEPR& AMORT TOTALASSETS

121,050 7,263 0,000 9,684

$118,629 $215 ,628

LIABILITIES CURRENT LIABILITIES INTERESTPAYABLE PAYABLE ACCOUNTS DISTRESS LOAN SHORTTERMLOANS LONGTERMLOAN

$

S EQUITY STOCKHOLDER' PAID IN CAPITAL RESERVEFOR LOSSES RETAINEDEARNINGS TOTALLIABILITIES tures

for loss reduction

activities,

3,424 22,176 0,000 6,000

120,580 3,900 26,838

distress

loans,

and reserves

$ 31,600 $ 32,710

$151,318 $215,628 for losses

may

each be controlled in some measure by the risk manager. Although the risk report represents the "total cost of risk," other costs of risk are imbedded in the other financial reports, and the risk manager can learn to identify them, to the extent it is possible, in RISKM. RISKM can provide the motivation and data for students to learn about the contribution of statistics to risk management. The application of regression analysis, descriptive statistics, statistical inference, (Bayesian) decision theory, graphing, correlation, and tests of goodness-of-fit are some of the statistical topics which RISKM can support by supplying data and a realistic context. A great deal of the data which RISKM generates is summarized in the risk reports and the financial reports (see Figures 1, 2 and 3). The detail of each loss can also be requested. It has been this author's experience that it is quite burdensome to acquire loss histories from actual companies. When the firm is willing to provide its history, the complications associated with assimilating the data from a different computer and the inevitable other complications pose quite a deterrent. The accessibility of RISKM's detailed loss figures invites statistical analysis.

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The Journal of Risk and Insurance

532

FIGURE 3

I AM UNSUR, LTD. INCOME STATEMtENT FOR VIE YEAR ENDING 1976 (000 OMITrDm) CHONICAL EXPLOSIVES SALES LABOR MATERIAL GROSSMRGN

89535. 30080, 30289. 29167,

33202. 12848. 13151. 7203.

EXPENSES OPERATING SALARIES PREMIUMS INSURANCE EXPENSES LOSS REDUCTION LOSSES CASUALTY DEPRECIATION ADVERTISING SHIPPING MISCELLANEOUS 0OTR OPERATIN INCOME NET OPERATING OTHERINCOME TOTALINCOME INTERESTEXPENSE INCWE BEFORETAXES TAXES INCO TO STOCKHOLDERS

PHARMACEUT SPACE 31657. 13222. 15296. 3143.

19701. 9470. 7339. 2892. $ 900, 134, 0. 1303. 9684. 1000. 1500. 72. 2600.

TOTAL $174095, $ 6S620. $ 66070. $ 42405.

$17193. $2S212, $ 3997, $29208, $ 3424. $25784, $ 6446. $19338.

Advanced students of risk management may wish to use RISKM as a model rather than a game. The computer program, RISKM, is explained in Monograph 66-A published by the Publishing Services Division of the College of Business Administration of Georgia State University.5 The monograph supplies the program listing and extensive information on the model's design. Individual students or the class as a whole might try to change the parameters of RISKM and simulate another firm. Instead of a model of the mythical Special Chemical Company, the class can develop a model of an actual firm from the business community. Another alternative would be to develop a risk model of an organization such as a state or local government, a public utility, a group of churches, and so on. Conclusions RISKM was designed in order to make available a risk management learning laboratory. Student risk managers can compete with their peers in selecting and even inventing management policies and decisions. The decisions are input on common timesharing computers and financial reports are output at the same computer terminal. A great number of chance factors are held constant (although random) among students, so that comparisons of student performance are facilitated. The financial reports create a means of presenting the effects of risk management strategies in perspective with the firm's overall operations. 5Requestsshouldbe addressed toe Marketing Manager, Publishing Serices Division, Georgia State University, University Plaza, Atlanta, Georgia 30303.

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