CHAPTER TWO

THE RISK MANAGEMENT PROCESS

Risk is danger and the environment of businesses today is becoming more complex. For
example, advanced technology has brought about very complex new products and huge
concentrations of values in a single product, such as the supersonic airplane disaster.
Therefore, we should give special attention to risk.

The complexity of the business environment calls for or demand for a special attention to
a risk
The special task to
- Identify
- Analyze and
- Combat the operating risks are referred to as risk management.
Some of the factors, which increase the complexity of environment, are:
- Inflation
- Growth of internal operation
- More complex technology
- Increasing government regulation
Hence, most large organization and many smaller ones employ specialized personnel in
the field to deal with or to handle the problems of increased risk. These individuals who
are responsible for the entire program of risk management (of which insurance buying is
only a part) are risk managers or insurance managers. These terms (risk manager and
insurance manager) are often used interchangeably.

• Steps in the risk management process

o Identification
o measurement
o Potential Risk Treatments
▪ Risk avoidance
▪ Risk reduction
▪ Risk retention
▪ Risk transfer
o Create the plan
o Implementation
o Review and evaluation of the plan

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2.1. RISK MANAGEMENT DEFINED
What is risk management? Risk management is a systematic way of protecting business
resources and income against losses so that the organization’s aims are reached without
interruption, creating stability and contributing to profit.
Another form of defining risk management:
- Risk management is the identification, measurement and treatment of liability,
property and personal pure risks that the business organization is facing.
- It is the science that deals with the techniques of forecasting future losses so as to
plan, organize, direct and control the adverse effect of risk.
• i.e., Risk management is defined on the base of managerial functions.
- It is the reduction and prevention of the unfavorable effects of risk at minimum
cost through its identification, measurement and control.
- It is a discipline /a profession that systematically identifies and analyzes the various
loss exposures faced by a firm or an organization and employees and the best
method of treating the loss exposures consistence with the goals and objectives of
the organization.

Generally, risk manager is concerned with the pure risk, but not speculative risk.

Risk management is broader than insurance management in that it deals with both
insurable and uninsurable risks. Insurance management for most part it is restricted to
the area of those risks that are considered to be insurable.
Risk management also differs from insurance management in philosophy. Insurance
management includes the use of techniques other than insurance (for example, non-
insurance or retention, as an alternative to insurance) but for must part is restricted to
the area of those risks that are considered to be insurable.

The emphasis in the risk management concept is on reducing the cost of safe-
guarding against risk by whatever means.
In the risk management philosophy, it is insurance that must be justified.

Functions of risk management

In general, the basic functions of the risk manager in carrying out of the
responsibilities assigned are:
1. To recognize exposure to loss.
- Is also called as risk identification
- This is a fundamental duty that must precede all other functions.
- Is the 1st step of risk managers’ function

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 - Is the most vital task
- Failure to identify exposure to loss==> the risk manager will not have any
chance of handling the loss that identifies the risk.
2. To estimate the frequency and size of loss, i.e., to estimate the probability of loss
from various sources.
• Is also called as risk measurement.
Risk measurement means
i. Determination of the chance of an occurrence or relative frequency.
ii. Determination of the impact of losses upon financial affairs.
iii. The ability to predict the losses that will actually occur during the budget
year.
3. To decide the best and most economical method of handling the risk of loss.
i.e: Selection of the proper tool for handling risk
4. To administer the programs of risk management, including the tasks of constant
revaluation of the programs, recordkeeping and the like.
i.e., - Implementing the decision and
- Revaluating the decision
Example:
▪ Insurance is one option. If insurance is decided
our property, proper coverage is important.
▪ Obtaining reasonable rate
▪ Selecting the insurer such as Ethiopian Insurance
Corporation, etc.

[Link] IDENTIFICATION AND MEASUREMENT

2.2.1. Risk Identification

It’s the first step in the risk management process. Here, the risk manager tries to locate
the areas where losses could happen due to a wide range of perils. It would be very
difficult to deal with the risks faced by a firm unless they are properly identified.
In the identification process, the risk manager places more emphasis on pure risks.
It is the process of identifying potential loss confronting the firm.
It is a fundamental / basic duty that must precede all other functions of risk management.
It is the 1st step of risk manages’ function.
Example: Potential losses include
• Property loss
• Business- income loss
• Liability loss
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 • Death or loss of key people
• Job related injuries
• Fraud
• Criminal acts
Poor identification leads to unplanned retention. Unplanned retention cannot be the
right decision unless it becomes right by chance.
In order to identify the potential loss, the risk manager should have sources. Some of the
systematic approaches / tools used by risk managers to the problem of risk identification
are:
i. Insurance policy checklists
ii. Risk analysis questionnaires
iii. Flow process charts
iv. Analysis of financial statements and
v. Inspections of the organization’s operations or On-sight inspection.
i. Insurance Policy Checklists
o The checklists are available from insurance companies and from publishers
specializing in insurance related publications. Here, the risk manager initially
collects a specimen of insurance policy forms from various insurers. He, then,
proceeds to prepare a checklist of various types of pure risk that can be dealt
with insurance. Through close examination of the policy forms, the risk
manager can identify the non-insurable risks and accordingly will consider
other risk handling tools.
o Typically, such lists include a catalogue of the various policies or types of
insurance that a given business might need.
o The principal defect/limitation of this approach is that concentrates on
insurable risks only, ignoring the uninsurable pure risks.
ii. Risk Analysis Questionnaires
o It also called as “fact finders” because it leads the risk manager to the discovery
of risks through series of detailed and penetrating questions.
o In most instances, these questionnaires are designed to identify both insurable
and uninsurable types of risks.
o This questionnaire directs the risk manager to secure the operation and the
properties of that organization.
iii. Flow Process Charts
Flow process charts show all the operations of the firm starting with raw materials,
electricity / power and other inputs at suppliers’ location and ending with finished
products in the hands of customers is constructed.

4
Secondly, the checklist of potential property, liability and personnel losses is applied to
each property and operations showing the flow charts to determine which loss the
organization faces.
• i.e. - Draw flow charts starting from raw materials and ending to finished
products in the hands of customers.
- Identify the potential loss

Supplies delivered from Receiving Manufacturing

warehouse – 1 in firm’s room Storage process
truck

Delivery in own truck

To warehouse -2

Packaging Retailer

Delivery by a common
Carriers to warehouse - 3

Retailer

Flow Chart – Manufacturing Plant

The most positive benefit of using flow charts is that they force the risk manager to
become familiar with the technical aspects / matters of the organization’s operation.
Example: how the goods move from one place to another, etc.
iv. Analysis of Financial Statements
Analysis of the organizations financial statements can also aid in the process of risk
identification. i.e.
- The asset listing in the balance sheet and
- The income and expense classification in the income statement.
v. On – sight inspection / Inspection/
It is a must for the risk manager.
-
The risk manager will have firsthand information through direct inspection
-
“One picture is worth of a thousand words.”≈ “Seeing is believing”
Therefore, risk can be identified on different approaches as stated from i-v.
2.2.2. Risk Measurement
Once the risks have been identified, the risk manager must evaluate them. I.e. measuring
the potential size of the loss and the probability that it is likely to occur.

5
Risk measurement is required by the risk manager for two purposes:
i. To determine their relative importance and
ii. To obtain information that will help him to decide upon the most desirable
combination of risk management tools or methods.
In order to arrive these two points, what dimensions to be measured?

Dimensions to be measured
i. The loss frequency or the probability that losses will occur.
ii. The severity of the losses that occur and
iii. The degree of variation in the losses experienced from one budget period to the
next.
The dimensions are needed. The relative importance of a type of potential loss depends
upon the loss frequency and the loss severity.
➢ If two losses are characterized by the same severity, the loss whose frequency is
greater should be ranked higher. There is no formula for ordering the losses in
order of importance and different.
2.3. RISK MEASUREMENT AND PROBABILITY DISTRIBUTION
2.3.1. Risk Measurement
Once the risk is identified the risks that the firm is facing, his next step would be the
evaluation and measurement of the risks. Risk measurement refers to the measurement of
the potential loss as to its size and the probability of occurrence.
Probability theory is important in decision making because it provides a mechanism for
measuring, expressing and analyzing the uncertainties associated with future events.
Probability is the likelihood of a certain occurrence.
Note: a. Probability values are always assigned on a scale 0 to 1.
- The probability of an event can be written as:
0  P (A)  1
b. A probability near “zero” indicates that the event is very unlikely to occur.
Example: If the probability of getting rain is 0.0001
c. A probability near “1” indicates that the event is very likely or almost
certain to occur.
d. If the probability of an occurrence is “0”, there is no occurrence of an
event.
e. If the probability of an occurrence is “1”, there is an occurrence of an event.

Decreasing likelihood of occurrence

Increasing likelihood of occurrence

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 0.5
Probabilities: 0 1

Impossible The occurrence of certain

the event is just as likely
as it is unlikely.

Event (Outcome):
In probability theory, an event is one or more of the possible outcomes of doing things.
Example: If we toss a coin, getting a tail /head would be an event.
Experiment:
-Is the activity /any process that produces well defined outcomes /events.
Example: If you toss a coin, you are doing an experiment.
Each performance of an experiment is called a trial.

Three theoretical types of probability distributions that are particularly useful in

estimating the probability that a business will suffer a specified number of accidents
during the next year are the following:
Or:
The following types of probability distributions are used for measuring risk.
1. The Binomial probability distribution
2. The Normal probability distribution
3. The Poisson probability distribution
1. The Binomial Probability Distribution (BPD):
To use the Binomial probability distribution, the risk manager must be familiar with the
basic assumptions of the distribution to avoid misleading results.
Assumptions:
a) A firm or family has n units independently exposed to loss. i.e., a loss has no
connection with the other.
b) Each unit can experience at most one accident during the year.
c) The probability that any particular unit will suffer an accident during the year is ‘ p’,
thus the probability that the firm or family will suffer ‘r’ accidents during the year is:

P(r) = n! pr (1 – p) n-r
r! (n-r)!
Let 1-p = q

P (r) = n! pr q n-r
r! (n-r)!

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Illustration:
Suppose that a firm operates 5 delivery trucks. Assume that if an accident happens to a
particular truck, it become a total loss and assume further that new trucks are purchased
at the beginning of every year to make up the lost ones so that the firm always starts the
new fiscal period with a fleet of 5 delivery trucks. The experience of the firm over the
past 5 years is:

Year No of trucks No of Accidents Monetary Losses

1 5 2 $ 10,000
2 5 2 $ 10,000
3 5 1 $ 5,000
4 5 3 $15,000
5 5 2 $10,000
25 10 $50,000
Required:
a. The mean No of accident per year
10
= 2 [Link] /year
5
b. What is the probability of an accident?
• The probability of an accident can be estimated as:
2
p= = 0.4
5
q = the probability that any particular unit will not suffer
a loss during a year.
q= 1-p = 1-0.4 = 0.6
c. Probability distribution of the No of accidents.
i. What is the probability of exactly 0 accidents?
ii. What is the probability of exactly 1 accident?
iii. What is the probability of exactly 2, 3, 4, and 5s?

Solution:
i. P (r) = n! p r q n-r
r! (n-r)!
P (0) = 5! x (0.4) 0 (0.6) 5 -0 = 5 x 1x(0.6) 5 = 0.07776
0! (5-0)! 0! 5!
ii. P(1) = 5! x 0.4 x 0.6 = 0.2592
1 5-1

1! (5-1)!

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 iii. P(3) = 0.2304 , P(4) = 0.0768
P(2) = 0.3456, P(5) = 0.01024
d. The probability of more than 2 accidents?
P (> 2 accidents) = P (3) + P (4) + P (5)
= 0.2304 + 0. 0768 + 0.01024 = 0.31744
e. The probability of at least 2 accidents.
P (at least 2) = P (2) + P (3) + P (4) + P (5)
f. The probability of at most 2 accidents.
P ( 2) = P (0) + P (1) + P (2)
g. The mean or the expected value of the accidents
A B AxB
No of accidents Probability Expected No of the accident
0 0.07776 0
1 0.2592 0.2592
2 0.3456 0.6912
3 0.2304 0.6912
4 0.0768 0.3072
5 0.01024 0.0512
Mean: 2.000
Or: mean = np = 5 x 0.4 =2
SD = npq = 5x0.4 x0.6 = 1.2 =1.095
Or
D E
N of accident – mean (No of accident – mean) 2
o BxE
0 –2 4 0.31104
1 –2 1 0.2592
2 -2 0 0
3 -2 1 0.2304
4 –2 4 0.3072
5 –2 9 0.09216
Variance = 1.2

h. Risk relative to the maximum No of exposure

SD
Rmax = =SD/n=1.095/5 =0.219=21.9%
MaxLoss
i.e: The variation from that of the max loss is 0.219.

i. Risk relative to the mean

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 SD SD npq 5 x0.4 x0.6
Rm = = = = = 0.5475 = 54.75%
mean np np 5 x0.4
i.e: The variation from that of the mean s is0.5475.

Exercise:
A firm that ships finished goods to customers faces the possibility of damage to the goods
while in transit if goods damaged while in shipment are considered totally loss and the
probability of loss to a single item is 0.1. When a group of two items is considered,
calculate the probability of;
1. 0 losses
2. Exactly 1 loss
3. Exactly 2 losses

➢ Formula for mean and SD of a Binomial distribution

The mean and the standard deviation of a Binomial probability distribution can also
be determined using the following formula:
Mean = m = np
SD = SQRT(npq) = npq

➢ Risk Measures
i. Risk relative to mean (Coefficient of variation)
=>When SD is expressed as a percentage of the expected (average or mean) loss
=>Coefficient of variation==>Risk relative to the mean
SD
Coef .ofVariatio n =
Mean

ii. Risk relative to the number of exposure units

SD
Rn =
n

➢ Risk Vs the Law of Large Numbers

i. Risk relative to mean
SD SD npq
Rm = = = ==>R2m=npq/n2p2=q/np=1-p/np=1/n[(1-p)/p]
Mean np np

1 (1 − p )
Rm = ==>Rm decreases as n increases
n p
i.e: n↑==> Rm↓
n↓==> Rm↑

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ii. Risk relative to the number of exposure units

npq R 2 n npq p(1 − p) ==>Rn decreases as n increases

Rn = == = 2 == Rn =
n n n

Rn

Rn=Rmax

0 0.5 1 P

Rn=Rmax When P=0.5

Rn= Rmin When P=0 and 1
Exercise:
i. How does the mean be affected if the number of the exposure unit is increased by a?
ii. How does the SD be affected if the number of the exposure unit is increased by a?
iii. How does the risk relative to the number of exposure unit be affected if the number of the
exposure unit is increased by a?

2. The Normal probability distribution/NPD/

The risk manager may assume that the number of accidents or total annual monetary
losses is approximately normally distributed. Under such circumstances, he may use the
NPD in measuring the number of accidents or the total annual monetary losses.

If observations are normally distributed, the risk manager will have a good insight of the
size of possible losses at much greater ease. This is because the normal distribution can be
well explained by identifying only two parameters, the mean and the standard
deviation.

m
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The normal distribution is characterized by its shape. Its symmetry has led to it being
described as a bell-shaped type of curve. Besides having a nice "look", the symmetrical
feature of the normal distribution provides some benefits.

Normal Distribution or Normal Curve:

Normal distribution is probably one of the most important and widely used continuous
distribution. It is known as a normal random variable, and its probability distribution is
called a normal distribution.

Characteristics of the Normal Distribution:

1. It is bell shaped and is symmetrical about its mean.

2. It is asymptotic to the axis, i.e., it extends indefinitely in either direction from the
mean.
3. It is a continuous distribution.
4. It is a family of curves, i.e., every unique pair of mean and standard deviation defines
a different normal distribution. Thus, the normal distribution is completely described
by two parameters: mean and standard deviation. See the following figure.
5. Total area under the curve sums to 1, i.e., the area of the distribution on each side of
the mean is 0.5.
6. It is unimodal, i.e., values mound up only in the center of the curve.
7. The probability that a random variable will have a value between any two points is
equal to the area under the curve between those points.

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Figure
Note that the integral calculus is used to find the area under the normal distribution
curve. However, this can be avoided by transforming all normal distribution to fit the
standard normal distribution. This conversion is done by rescaling the normal distribution
axis from its true units (time, weight, dollars, and...) to a standard measure called Z score
or Z value. A Z score is the number of standard deviations that a value, X, is away from
the mean. If the value of X is greater than the mean, the Z score is positive; if the value
of X is less than the mean, the Z score is negative. The Z score or equation is as follows:

Z = (X - Mean) /Standard deviation

i.e: Any normal random variable X with mean (m or µ) and standard deviation ( ) is
converted to the standard normal distribution by the following formula:

Where, X=value of the random variable

µ or m =Mean of the random variable

13
 =the standard deviation of the random variable

Z=the standard normal random variable and can be interpreted as the number of
standard deviations that the normal random variable (X) is from its mean (µ)

Z = 0when  = 

Note: Different normal distributions have different means (µ or m) or SD ( )

A standard Z table can be used to find probabilities for any normal curve problem that
has been converted to Z scores. For the table, refer to the text. The Z distribution is a
normal distribution with a mean of 0 and a standard deviation of 1.

The following steps are helpful when working with the normal curve problems:

1. Graph the normal distribution, and shade the area related to the probability you
want to find.
2. Convert the boundaries of the shaded area from X values to the standard normal
random variable Z values using the Z formula above.
3. Use the standard Z table to find the probabilities or the areas related to the Z values
in step 2

99.74%

95.45%
99.74% 68.26%
X µ -3 µ -2 . µ -1 µ µ +1 µ+2 µ +3

Z 0----------------------1

➢ The probability of loss that will fall within +1 standard deviation of the
mean=68.26%.
i.e: µ + 1 SD=68.26%.
➢ The probability of loss that will fall within +2 standard deviation of the
mean=95.45%
i.e: µ + 2 SD=95.45%

14
➢ The probability of loss that will fall within +3 standard deviation of the
mean=99.74%
i.e: µ + 3 SD=99.74%

Example:

15
1. A filling machine is set to pour 956 milliliters of wine into bottles. The amounts of fill
are normal distributed with a mean of 952ml and a standard deviation of 4ml.
Required:
a. What is the probability that a bottle contains between 952 and 956ml?
Solution:
µ=952ml and =4ml

P (0<Z<1)

X µ=952 956
Z 0 1

Note: At µ =X==> Z=0 Always

At X=952ml At X=956ml
X −  952 − 952 X −  956 − 952
Z= = =0 Z= = =1
 4  4

Refer the above table

Z 0.00
P (0 to 1) = 1 0.3413

Therefore: P (0 to 1) =P (0<Z<1) = 0.3413

Interpretation:
➢ There is 0.3413 probability that a bottle contains between 952 and 956 ml.
i.e:34.13% of filled bottles will contain between 952ml and 956ml.
Assume the company produced 100,000 filled bottles with wine. How many of these
bottles do you expect to contain between 952ml and 956ml.
(100,000)(0.3413)=34130 bottles
b. What percentage of filled bottles will contain between 948 and 956ml?
Solution:
µ=952ml and =4ml

At X=948ml At X=956ml

16
 X − 948 − 952 X − 956 − 952
Z= = = −1 Z= = =1
 4  4
P (0 to -1) =0.3413 P (0 to 1) =0.3413

Therefore, P (-1 to 1) = P (0 to -1) + P (0 to 1) = 0.6826

P (-1<Z<0) P (0<Z<1)

X (ml) 948 µ=952 956

Z -1 0 1

c. What would be the lower and upper values of X in ml for an interval extending from
2 SDs below the mean to 2SDs above the mean?
Solution:
µ+ 2
952+2(4) ==>Upper value of X=960ml
==>Lower value of X=944ml
d. What percentage of filled bottles will contain above 960ml?
Solution:
X=960ml, µ=952ml and =4ml==>Z=2

P (Z>2)

X (ml) µ=952 960

Z 0 2

P (0<Z < 2) =0.4772

P (Z > 2) = P (Z > 0) - P (0<Z < 2) =0.5-0.4772=0.0228

f. What percentage of filled bottles will contain below 960ml?

Answer: P (2 to ) =0.9772

17
g. What percentage of filled bottles will contain above 948ml?
Answer: P (-1 to ) =0.8413

2. If the firm has 100 units which are independently exposed a certain loss. The
probability of any of these get an accident is 1/10. What is the probability that the
mean number of accident is between 7 and 13?
Solution
1
p=1/10 n=100==> m = np = 100 x = 10
10
1 9
==> SD = npq = 100 x x =3
10 10

X − 7 − 10 X − 13 − 10
Z1 = = = −1 Z2 = = =1
 3  3

P (-1<Z < 1) = P (-1<Z < 0) + P (0<Z < 1) =0.3413+0.3413=0.6826=68.26%

P (-1<Z<1)

X 7 10 13
Z -1 0 1

3. Assume that the chance of an occurrence of a loss is 1/[Link] number of exposure

units must the risk manager possess for the probability to be 95.45% that the actual
number of occurrence will fall within the range whose boundaries are the expected
number of occurrence(the mean) + 10% ?
Solution
p=1/10 , n=?
Boundaries: + 10% mean

95.45%

X µ -10% µ µ +10%
Z

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 SD
Rm =
m
10 1 1 1 9
xnp = 2 npq == xnx = 2 nx x == n = 3600
+ 10%µ=: + 2SD==> 100 10 10 10 10

4. If the desired probability is 95.45% that the actual number of occurrence will fall in
the range defined as the expected number of occurrence + 5%. What number of
exposures should be possessed by the business organization?
Solution:

95.45%

X µ -5% µ µ +5%
Z

5 5 1 1 9
xnp = 2 npq == xnx = 2 nx x == n = 14,400
5% mean=2SD==> 100 100 10 10 10

Exercise:
[Link] that the chance of an occurrence is 1/[Link] number of exposure units must
the risk manager posses for the probability to be 95.45% that the actual number of
occurrence will fall with in the range whose boundaries are the expected number of
occurrence +60%?
2. If the chance of an occurrence is 4/10 and if the desired probability is 95.45% that the
actual number of occurrences will fall in the range is defined as the expected number of
occurrence +20%. What will be the number of exposures to be possessed by the risk
manager? Answer: n=50
If the desired probability is only
a.68.27%
b.99.74%
What will be the number of exposures to be handled by the risk manager?
Answer: a. n≈38 , b. n=338

19
 5. A firm has 50 department stores scattered all over the country. The risk manager
doesn’t know the probability distribution of the total annual monetary loses from theft
at all locations, but estimates the average monetary lose per year to be $62,500 with a
SD of $11,180.
a. If the risk manager assumes a normal probability distribution, what is the
probability that theft lose exceed $84,860?
b. If the firm increases its stores to 100, determine:
i. The new average monetary lose
ii. The new SD
iii. Risk related to the mean
iii. What will be the limits of the confidence interval for loses included in
2SD?
Solution;
n=50, µ=$62,500, SD =$11,180.
a. P ( >$84,860)
X −  84,860 − 62,500
Z= = =2
 11,180
P (Z>2) =0.5-0.4772=2.28%
n 100 n
b. i. n2 = 100, 2 = = 2,  2 = 1 2 = $125,000
n1 50 n1
n2 100
ii. SD2 = SD1 x = $11,180x = $15810.91
n1 50
iii.
1
Rm 2 = Rm1 x = 12.65%
n2
n1
SD2
Or : Rm 2 = = 12.65%
m2
µ+2SD is the confidence interval
µ+2SD=125000+2(15,810.9)
=125000+31,621.8==>125000-31,621.8< µ < 125000+31,621.8
==>93,378.2< µ < 156,621.80 (is the confidence
interval) The probability of
the confidence
interval

X 93,378.2 µ= 125000 156,621.80

Z -2 0 2

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3. The Poisson Probability Distribution/PPD/
The PPD is originated by Siméon Poisson is used to estimate the number of occurrences
over a specified interval of time or space.
: Is the most commonly used by insurance companies.

The Poisson distribution can be derived as a limiting form of the binomial distribution in
which n is increased without limit as the product m = np is kept constant.

The Poisson distribution can also be derived directly in a manner that shows how it can
be used as a model of real situations. In this sense, it stands alone and is independent of
the binomial distribution. * Siméon D. Poisson, (1781-1840).

The following examples show where the Poisson distribution is useful:

➢ The government wants to know whether seat belts reduce the number of death in
car accidents.
➢ number of category four hurricanes that will strike the east coast
➢ number of misprints in a book
➢ the number of customers arriving
➢ the number of activations of a geiger counter.
Assumption:
➢ There is no limit as to the occurrence of the accident.
I.e: the Poisson probability distribution allows for unlimited number of accidents
occurring to the object under consideration, (Car). This means that a particular car can
possibly experience more than one accident. This is normally the case in real life
situation.

The only information that is crucial in constructing a Poisson probability distribution is

the expected number of accidents (the mean). Once the mean is determined, the
probability of any number of accident will be easily calculated using the following
formula:

P(r) = mre-m
r!

Where,
P(r) = probability that event occurs
m = mean = expected frequency (Number)
r = number of events for which the probability estimated is needed or: Number of
occurrence.

e = base of the natural logarithm = 2.71828

21
It has one important advantage. I.e. Mean=Variance

A useful property for the Poisson is that the mean = variance.

Note: SD = Variance ==> SD = m , m=mean

m=Expected number of accidents=pn

STD=Standard Deviation=SQRT (m)

n=No of exposed units

p=the probability of a success on any one trial

q=1-p=the probability of a failure on any one trial

Example:

1. The following example is considered for illustrative purpose. The data presented below
represents the number of cars operated (Similar in type of use) by a firm in each year,
the corresponding number of accidents occurred and the total monetary losses
incurred in

Year Number of Cars Number of Amount of Suppose in year 11 the

[[

accident loss number of cars owned by

1 10 1 Birr 2500 the firm increased to 40.
2 12 2 4200
3 14 3 4500
4 15 3 6000
5 20 2 6500
6 20 3 6600
7 25 4 6000
8 25 5 8000
9 29 3 7500
10 30 4 10000
SUM 200 30 61800
MEAN 20 3 61800
SD 1.15 2115
Required:

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a. How many accidents does the firm expect in the 11th year?

Probability of accident=Total number of accident =30/200=0.15/car

Total number of cars

(Expected number accident) m=np=40x0.15=6 Accidents

b. What is the total monitory loss of these accidents? Refer question No.a

Total Monitory loss=$61800=Birr2060 Therefore, 6x$2060=Birr12,360

Number of accident 30

c. What is the probability that the firm will face exactly 3 accidents?

P(r) = mre-m ==> P(3) = 63e-6 =0.0892

r! 3!

d. What is the SD of the annual monetary loss?

SD of the annual monetary loss=Monitory loss x SD=2060x m =2060x 6 = Birr5045.95

No of accident

e. Risk relative to the mean

SD m 6
Rm = = = = 0.408248
m m 6

f. Risk relative to the maximum No of exposure units

SD m 6
Rmax = = = = 0.061237
n 40 40

g. using the Poisson process, construct the probability distribution

23
 Re
Number of Accident Amount of loss Probability Expected No of Expected amount of loss mar
(1) (2) (3) Accidents (1)x(3) (2)x(3)
0 0 0.0025 0 0
k:
Moni
1 2060 0.0149 0.0149 30.69
tory
2 4120 0.0446 0.0892 183.75 loss
3 6180 0.0892 0.2679 551.26 per
4 8240 0.1339 0.5356 1103.34 accid
5 10300 0.1606 0.8030 1654.18 ent=
6 12360 0.1606 0.9636 1985.02 2060
7 14420 0.1377 0.9639 1985.63
A
8 16480 0.1033 0.8264 1702.38
mou
9 18540 0.0688 0.6192 1275.55
nt of
10 20600 0.0413 0.4130 850.78 loss
=No
11 22660 0.0225 0.2475 509.85
of
12 24720 0.0113 0.1356 279.34
accid
13 26780 0.0052 0.0676 139.26 ents
14 28840 0.0022 0.0308 63.45 x
15 30900 0.0009 0.0135 27.81 Moni
16 32960 0.0003 0.0048 9.89 tory
loss
17 35020 0.0001 0.0017 3.50 per
18 37080 0.0001 0.0018 3.71 accid
SUM 1.0000 5.9997 12359.39 ent

h. What is the probability that there would be at least three accidents in the year?

P(3) = 1 − (0.0025 + 0.0149 + 0.0446 = 0.938

i. What is the probability that the number of accidents equal or exceed 13?

P(13) = 0.052 + 0.0022 + 0.0009 + 0.0003 + 0.0001+ 0.0001+ .... = 0.9292

Exercise:

j. What is the probability that the number of accidents between3 and 13?

2. Mr. X has 10 trucks to insure and on the average a total of 1 loss occurs each year.
What is the probability of more than 2 accidents in a year?

Solution:

24
n=10, p=1/10 and m=np=10x1/10=1

Required: P(>2) ?

P(r) = mre-m ==> P(0) =0.3679 ,P(1)=0.3679, and P(2)=0.1839

r!

P (>2) =1-[P (0) +P (1) +P (2)]= 0.0803

3. Suppose that you had 20 vehicles in your fleet. The probability of loss based on your
historical data = .1 and the E (loss) = mean = (.1)(20) = 2 losses

The table shows the probabilities associated with 0, 1, 2, and more than 2 losses.

Possible Losses Probability

2 or more = 1-P(0 or 1 loss) = 1-.1353-.2706 = .5941

Required:

What is the probability of more than one loss?

P (more than 1 loss) = 1-.1353-.2706= .5491 which is the same probability of having 2
or more losses.

TOOLS OF RISK MANAGEMENT

Once the risk manager has identified and measured the risks facing the firm, the next task
is to seek for appropriate tools and decide how best to handle them. Risk can be
handled through the following tools.
1. Avoidance
2. Retention
3. Loss prevention and reduction
4. Combination or increasing the No of units exposed to the loss
5. Separation / Diversification

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 6. Neutralization
7. Transfer

1. Avoidance
Risk avoidance

: Includes not performing an activity that could carry risk. An example would be not
buying a property or business in order to not take on the liability that comes with it.
Another would be not flying in order to not take the risk that the airplane where to be
hijacked. Avoidance may seem the answer to all risks, but avoiding risks also means
losing out on the potential gain that accepting (retaining) the risk may have allowed. Not
entering a business to avoid the risk of loss also avoids the possibility of earning profits.

One way to handle a particular pure risk is to avoid the property, person or activity with
which the risk is associated.
- Two approaches of risk avoidance:
i. Abandonment of previously assumed activities
ii. Refusing to assume an activity
i. Refusing
Example:
For instance, a firm can avoid a flood loss by not building a plant in a flood plain.
ii. Abandonment
Example: A firm that produces a highly toxic product may stop manufacturing that
product.
Avoidance occurs when the individual or business removes himself / itself from exposure
to a risk.
To illustrate,
- A business can avoid a product’s liability exposure by discontinuing the product.
- An individual can avoid the liability exposure resulting from owning a car by selling
the car.
- Subcontracting part of a manufacturing, contracting or distribution task before the
job is accepted.
- To delay taking responsibility for goods during their transportation may enable a
business to avoid risks associated with that job.
Avoidance is a useful and common approach to the handling of risk. Often, however, it
is impossible or clearly empirical to use this approach.
For example:
- Most business would not be able to operate unless they either owned or rent a
fleet of cars.

26
 - The potential benefits to be gained from employing certain persons, owning a
piece of property, or engaging in some activity may so far out weigh the
potential losses and the risks involved that the decision maker gives little
consideration to avoiding the associated risks.
- The major advantage of avoidance is that the chance of loss is reduced to zero if
the loss exposure is not acquired. In addition, if an existing loss exposure is
abandoned, the possibility of loss is either eliminated or reduced because the
activity or product that could produce a loss has been abandoned.

Disadvantage of avoidance
i. It may not be possible to avoid all losses.
Example: - A company cannot avoid the premature death of a key executive.
- A business has to own vehicles, building, machinery, inventory; etc …
without them operations would become impossible.
ii. It may not be practical or feasible to avoid the exposure.
Example:-A paint factory can avoid losses arising from the production of paint.
However, with out any paint production, the firm will not be in business.

2. Retention
- It is the most common method of handling risk by the individual or the firm itself.
- When the individual or the business does not take positive action to avoid, reduce
or transfer the risk, the possibility of loss involved in that risk is retained.
- Bearing all the risk by that person/organization.
Risk retention

Involves accepting the loss when it occurs. True self insurance falls in this category. Risk
retention is a viable strategy for small risks where the cost of insuring against the risk
would be greater over time than the total losses sustained. All risks that are not avoided
or transferred are retained by default. This includes risks that are so large or catastrophic
that they either cannot be insured against or the premiums would be infeasible. War is an
example since most property and risks are not insured against war, so the loss attributed
by war is retained by the insured. Also any amount of potential loss (risk) over the
amount insured is retained risk. This may also be acceptable if the chance of a very large
loss is small or if the cost to insure for greater coverage amounts is so great it would
hinder the goals of the organization too much.

Types of retention
a Planned/Couscous/ Active risk retention

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 - It characterized by the recognition that the risk exists, and a tacit agreement to
assume the losses involved.
- The decision to retain a risk actively is made because there are no alternatives more
attractive.
- Self-insurance is a special case of active retention
- Self-insurance is not insurance, because there is no transfer of the risk to an outsider.
Example: A firm may keep some money to retain the risk.
Prerequisites of Active Retention
Active/planned retention should be considered only when at least one of the following
conditions exists:
a) It is impossible to transfer the risk to someone else or to prevent the loss from
occurring
b) When the maximum possible loss is so small
-Thus, the firm can safely absorb it as a current operating expense or out of
small reserve funds.
c) When the chance of loss is so extremely low
d) The firm controls so many independent, fairly homogeneous exposure units that it
can predict fairly well what its loss experience will be.
- In other words, a retention program for this firm could properly be called ‘self-
insurance’.
- The firm can predict fairly well what its loss experience will be.
ii. Unplanned/Unconscious/ Passive Retention
- Passive risk retention takes place when the individual exposed to the risk does not
recognize its existence.
- In these cases, the person so exposed retains the financial consequence of the
possible loss without realizing that he does so.

3. Loss Prevention and Reduction Measures

Prevention is defined as a measure taken before the misfortune occurs.
- Generally speaking, loss prevention programs intend to reduce the chance of
occurrence.
Example:
- Constricting a building with a fire resistance material / fire proofing.
- Constructing a building in a place where there is little danger.
- Regularly inspecting the machine/area
- The existence of automatic loss detection programs.
❖ Fire alarms
❖ Warning posters /No Smoking!! And DANGER ZONE!!/……

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- Loss reduction measures try to minimize the severity of the loss once the peril
happened/ after the event occurs.
For Example:
❖ Automatic sprinkler
❖ An immediate first aid
❖ Medical care and rehabilitation service
❖ Guards
❖ Cover
❖ Fire extinguisher
❖ Fire alarms
Risk reduction

: Involves methods that reduce the severity of the loss. Examples include sprinklers
designed to put out a fire to reduce the risk of loss by fire. This method may cause a
greater loss by water damage and therefore may not be suitable. Halon fire suppression
systems may mitigate that risk, but the cost may be prohibitive as a strategy.

Modern software development methodologies reduce risk by developing and delivering

software incrementally. Early methodologies suffered from the fact that they only
delivered software in the final phase of development; any problems encountered in
earlier phases meant costly rework and often jeopardized the whole project. By
developing in increments, software projects can limit effort wasted to a single increment.
A current trend in software development, spearheaded by the Extreme Programming
community, is to reduce the size of increments to the smallest size possible, sometimes as
little as one week is allocated to an increment.

- Loss may be prevented or reduced in any of the following ways:

a Engineering Risks
- This approach of reducing loss/risk emphasizes on/by focusing on the
mechanical causes of accidents such as: defective wiring, improper disposal
of waste products, poorly designed high ways…
ii. Training of Personnel
- In addition to the process of regulating and elimination of the mechanical
failures the machine or equipment need to be operated by qualified
personnel to eliminate or reduce the loss of due to human failures.
- Workers should be acquainted with the machines they are to operate
through an adequate training to reduce losses.
iii. Diversification

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 - Losses may be reduced by distributing the loss to various types of exposure
units possessed may reduce losses.
- Relying on a single product or process or line of activity is hazardous.
Example: Farmers have learnt from experience the need for having more
type of crops to reduce the loss emanating from focusing in any single crop.
4. Separation /Diversification
- Separation of the firm’s exposures to loss instead of concentrating them at one
location where they might all be involved in the same loss.
- Separation==>Dispersion/Scattering the exposure in different places.
The principle is “Don’t put all your eggs in one basket”
Example: -Instead of placing its entire inventory in one warehouse, the firm
may elect to separate this exposure by placing equal parts of the
inventory in ten widely separated warehouses.
- Crop rotation
- It is considered as a loss reduction measure.
This separation of exposures reduces the maximum probable loss to one event; it may
be regarded as a form of loss reduction.

5. Combination
- It is a pooling or combination process.
- Risks are pooled when the number of independent exposure units under
observation is increased.
- Unlike separation, which spreads a specified number of exposure units, combination
increases the No of exposure units under the control of the firm.
- In the case of firms, combination results in the pooling of resources of two or more
firms. The new firm has more building, more automobiles, and more employees
than either of the original companies. This leads to financial strength, thereby
minimizing the adverse effect of the potential loss.
- Combination of pure risks is not generally the major reason why a firm expands its
operations, but this combination may be an important by- product or merger or
growth.
- Insurers, on the other hand, combine pure risks purposefully; they insure a large No
of persons in order to improve their ability to predict their losses.

6. Neutralization
- Neutralization, which is very closely related to transfer.
- It is the process of balancing a chance of loss against a chance of gain.

30
 Example: An excellent example is the process of hedging. Hedging is the process of
making commitments on both sides of transaction in such a way the risks compensate
each other.

7. Transfer
- It is also called as shifting method.
- When a business organization cannot afford to cover the loss by itself, it may look
for/transfer to other institutions.
- Transfer or risk may be accomplished in two ways.
a Transfer of the activity or the property.
- The property or activity responsible for the risks may be transferred to
some other person or group of persons.
Example: -A firm that sells one of its buildings transfers the risks
associated with ownership of the building to the new
owner.
-Hiring a subcontract for the portion of the project.
- This type of transfer is closely related to avoidance. The difference is that
to transfer a risk, a firm must already posses it and wants to pass it to
someone else.
b. Transfer of the probable loss
- I.e. the risk, but not the property or activity, may be transferred.
Example: Under a lease, the tenant may be able to shift to the land lord.
Any responsibility the tenant may have for damage to the
landlord’s premises caused by the tenant’s negligence.

Transfers of risk may be grouped in two classifications.

i. Transfer to an insurance company/Insurer
ii. Transfer to parties other than insurance company.

o Insurance is a means of shifting or transferring risk.

Risk transfer

: Means causing another party to accept the risk, typically by contract or by hedging.
Insurance is one type of risk transfer that uses contracts. Other times it may involve
contract language that transfers a risk to another party without the payment of an
insurance premium. Liability among construction or other contractors is very often
transferred this way. On the other hand, taking offsetting positions in derivatives is
typically how firms use hedging to financially manage risk.

31
Some ways of managing risk fall into multiple categories. Risk retention pools are
technically retaining the risk for the group, but spreading it over the whole group
involves transfer among individual members of the group. This is different from
traditional insurance, in that no premium is exchanged between members of the group
up front, but instead losses are assessed to all members of the group.

SELECTION OF RISK MANAGEMENT TOOLS

This section will discuss a few of the more important considerations that enter into the
selection of the technique to be used in handling a particular risk.

Rules of Risk Management

These guidelines for risk management decision-making are quite simple common-sense
principles applied to the pure risk situation. Mehr and Hedges propose the following
three basic rules of risk management:
i. Don’t risk more than you can afford to lose
ii. Consider the odds
iii. Don’t risk a lot for a little
Consider the odds. If the risk managers can determine the probability that a loss may
take place, he is in a better position to deal with the risk than would be the case without
such information; but is impossible to attach undue significance to such probabilities. The
probability of a loss occurring is less important to the risk manager than the financial
consequences if it does happen. Even if the risk manager knows that the probability of
loss from a given exposure is remote, the decision must still be based on its possible
severity. If the risk carries a possible catastrophic loss, the fact that the probability is small
is of little significance.
In determining the appropriate method or methods for handling losses, a matrix can be
used that classifies loss exposures according to frequency and severity. The following
matrix can determine which risk management be used.

Loss Frequency Loss Severity Appropriate risk

Management technique
Low Low Retention
High Low Retention & Reduction
Low High Insurance
High High Avoidance

- Insurance can be advantageously used for the treatment of loss exposures that have a
low probability of loss but the severity of a potential loss is high.

32
 CREATE THE PLAN

Decide on the combination of methods to be used for each risk. Each risk management
decision should be recorded and approved by the appropriate level of management. For
example, a risk concerning the image of the organization should have top management
decision behind it whereas IT management would have the authority to decide on
computer virus risks.

The risk management plan should propose applicable and effective security controls for
managing the risks. For example, an observed high risk of computer viruses could be
mitigated by acquiring and implementing anti virus software. A good risk management
plan should contain a schedule for control implementation and responsible persons for
those actions. The risk management concept is old but is still not very effectively
measured.

IMPLEMENTATION

Follow all of the planned methods for mitigating the effect of the risks. Purchase
insurance policies for the risks that have been decided to be transferred to an insurer,
avoid all risks that can be avoided without sacrificing the entity's goals, reduce others,
and retain the rest.

REVIEW AND EVALUATION OF THE PLAN

Initial risk management plans will never be perfect. Practice, experience, and actual loss
results will necessitate changes in the plan and contribute information to allow possible
different decisions to be made in dealing with the risks being faced.

Risk analysis results and management plans should be updated periodically. There are
two primary reasons for this:

1. to evaluate whether the previously selected security controls are still applicable
and effective, and
2. to evaluate the possible risk level changes in the business environment. For
example, information risks are a good example of rapidly changing business
environment.

33
 LIMITATIONS

If risks are improperly assessed and prioritized, time can be wasted in dealing with risk of
losses that are not likely to occur. Spending too much time assessing and managing
unlikely risks can divert resources that could be used more profitably. Unlikely events do
occur but if the risk is unlikely enough to occur it may be better to simply retain the risk
and deal with the result if the loss does in fact occur.

Prioritizing too highly the Risk management processes could keep an organization from
ever completing a project or even getting started. This is especially true if other work is
suspended until the risk management process is considered complete.

It is also important to keep in mind the distinction between risk and uncertainty. Risk can
be measured by Impacts x Probability.

Frequently Asked Questions about Risk Management

1. What is all-risk coverage?

Coverage is provided for direct loss by those perils which are not specifically excluded by the policy.

2. What types of perils (causes of loss) are not covered?

Such perils include loss or damage caused by dishonest acts, unexplained disappearance,
inventory shortage, wear and tear, mechanical breakdown, rust or corrosion, latent
defect, settling or cracking of any part of a building, artificially generated electric currents
which damage electrical devices (except electronic data processing systems), insects, birds
animals, freezing (ensuing water damage may be covered), sewage backup, faulty
workmanship, terrorism, cyber risks (computer viruses), mold, and asbestos.

3. What differentiates an Independent Risk Management/Insurance Consultant from other so-called

"consultants"?

Independent Risk Management/Insurance Consultants do not sell insurance, nor are they
affiliated or associated with firms or individuals that do. Independent Consultants never
work on a commission basis, and do not accept money or gifts from brokers, agents or
insurance carriers. They work on a fee for service basis only and their recommendations
are never clouded by the potential gain or loss of commission income.

4. What kind of work does a Risk Management/Insurance Consultant perform?

34
Risk Management/Insurance Consultants can be called upon to perform a wide variety of
tasks. Risk Management or Insurance Evaluations or Audits are among the most prevalent
kinds of work. Risk Management Evaluations generally involve a review of insurable loss
exposures, the adequacy of insurance protection, the extent of risk retention, the
effectiveness of contractual risk transfers, and the effectiveness of the risk management
function within the organization whereas Insurance Evaluations focus primarily on the
insurance protection and pricing.

When consultants conclude that their client's insurance policies do not afford the
necessary coverage and/or the pricing is high for the scope of coverage afforded the
consultant may recommend taking the insurance program out for a competitive
marketing. The consultant would then design insurance specifications, interview potential
participants, supervise the process, review the proposals and make recommendations to
the client of the most effective insurance program. The consultant's job does not end
there either. The consultant must make sure that when the policies redelivered, they
contain all of the protection that was promised during the proposal process. This is
accomplished by performing a review of the ultimately issued policies.

Consultants are often retained for other special projects on an ``as needed" basis. Such
projects can include alternative risk financing studies, assistance with mergers and
acquisitions, cost of risk allocations and renewal negotiations.

Some consultants are also available to provide continuing service as your part-time
insurance/risk management department. This service is often provided to firms where,
for example, the CFO cannot devote sufficient time to risk management issues, yet the
cost of staffing a risk management department is impractical.

RISK MANAGEMENT AND INSURANCE

CHAPTER II
ASSIGNMENT

1) Suppose that TANA TRANSPORT SHARE COMPANY operates 8 delivery trucks.

Assume that if an accident happens to a particular truck, it becomes a total loss. And
assume further that new trucks are purchased at the beginning of every year to replace
the lost one.
Form the past six years experience of the company, the following information is
gathered, being the value of a truck $10,000.
Year No of Accidents

35
 1 3
2 4
3 2
4 4
5 3
6 2

Given this information construct a binomial distribution of

a) The probability distribution of the number of accidents
b) The probability distribution of the total monetary loss per accident
c) The probability of incurring some losses
d) Compute the probability that the total losses would exceed $50,000.
e) Risk relative to the maximum possible monetary loss.
f) Risk relative to the mean

2) Consider the following information:

Potential Loss Probability
0 0.05
3000 0.15
7000 0.24
15000 0.38
25000 0.16
40000 0.02
Required:
a) What is the probability that the business will face Birr 15000 loss or less?
b) What is the probability that the business will have some amount of loss?

36