Chapter One

Introduction to Risk Management

When we take a risk, we are betting on an outcome
that will result from a decision we have made, though
we do not know for certain what the outcome will be.

• Peter L. Bernstein
যখন আমরা একটি ঝুঁ কক কনই, তখন
আমরা এমন একটি ফলাফললর উপর
বাকি ধকর যা আমালের ননওযা
একটি কিদ্ধালের ফলল হলব, যকেও
আমরা কনকিতভালব িাকন না নয
ফলাফল কী হলব।

• Peter L. Bernstein
 Rejda – Principles of Risk
Basic Texts Management & Insurance (12th
edition)
 Meaning of Risk

Major types of risk that threaten our financial security

Learning Risk faced by business and individuals

Burden of risk on society

Outcomes Basic methods for managing risk

Concept of Risk

• There is no single definition of risk.

• Economists, behavioral scientists, risk theorists,
statisticians, and actuaries each have their own concept of
risk.
• However, risk historically has been defined in terms of
uncertainty.
• Based on this concept, risk is defined as uncertainty
concerning the occurrence of a loss.
What does an actuary do?

• Actuaries assess risk and determine its financial cost.

• They use mathematics, statistics, and financial theory to assess the risk of
potential events, and they help businesses and clients develop policies that
minimize the cost of that risk.
• Actuaries' work is essential to the insurance industry.
Concept of Risk (contd….)
• For example, the risk of being killed in an auto
accident is present because uncertainty is present.
The risk of lung cancer for smokers is present
because uncertainty is present.

• Employees in the insurance industry often use the

term risk in a different manner to identify the
property or life that is being considered for
insurance.
Concept of Risk (contd….)
• Finally, in the ECONOMICS and FINANCE literature, authors often
make a distinction between risk and uncertainty.
• The term “risk” is often used in situations where the probability of
possible outcomes can be estimated with some accuracy, While
“uncertainty” is used in situations where such probabilities can’t be
estimated.
• Risk is the situation where there is a set of possible outcomes from
the project, and the probability of each outcome is known (as in
Figure 1(a)). Uncertainty is the situation where there is a set of
possible outcomes, but the probability of each one is not known (as
in Figure 1(b)).
Concept of Risk (contd….)
• Loss exposure
• ”Loss exposure” is used instead of risk due to ambiguity
and different meaning in risk definition.
• A loss exposure is any situation or circumstance in which a
loss is possible, regardless of whether a loss occurs.

• Examples: If you drink when you are in a party and then

you drive home, there is the possibility of making
accident, killing somebody or heavy bodily injured
because of less consciousness and willing to drive in high
speed.
• Possible theft of company property because of
inadequate security, and potential injury to employees
because of unsafe working conditions.
Concept of Risk (contd….)
• Objective risk /degree of risk
• Objective risk is defined as the relative variation of actual loss from
expected loss.
• E.g., A property insurer has 10,000 houses over a long period, and on
average, 1% or 100 houses, burn each year.
• However, it would be rare for exactly 100 houses to burn each year.
• In some years, as few as 90 houses may burn; in other years, as many as
110 houses may burn. Thus, there is a variation of 10 houses from
expected number of 100, or variation of 10%.
• This relative variation of actual loss from expected loss is known as
objective risk.
Concept of Risk (contd….)
• Subjective risk:
• Subjective risk is defined as uncertainty based on a person’s
mental condition or state of mind.
• E.g., A drunk driver may be uncertain whether he will arrive
home safely without being arrested by the police.
• This mental uncertainty is called subjective risk.
Objective Risk Vs. Subjective Risk
• Objective risk differs from subjective risk in the sense that it is more
precisely observable and therefore measurable.
• It is the probable variation of actual from expected experience. It can
be statistically calculated using a measure of dispersion, such as
standard deviation, the law of large numbers.
• On the other hand, Two persons in the same situation may have
different perception of risk.
Driving risk
Chance of Loss

Chance of loss is closely related to the Probability

concept of risk. Chance of loss is defined
as the probability that an event will occur.
Objective Subjective
probability probability
Like risk, probability has both objective
and subjective aspects.
 Deductive and inductive
Priori Probability reasoning also called Priori
Probability.
Formula for a Priori Probability
Mutually Exclusive

• Mutually exclusive is a statistical term

describing two or more events that
cannot happen simultaneously. It is
commonly used to describe a situation
where the occurrence of one outcome
supersedes the other. For example, war
and peace cannot coexist at the same
time.
Fair Dice Roll

• A six-sided fair dice is rolled. What is the a

priori probability of rolling a 2, 4, or 6, in a
dice roll?
• The number of desired outcomes is 3
(rolling a 2, 4, or 6), and there are 6
outcomes in total. The a priori probability
for this example is calculated as follows:
• A priori probability = 3 / 6 = 50%.
Therefore, the a priori probability of
rolling a 2, 4, or 6 is 50%.
•
 Inductive reasoning
• Inductive reasoning is when you start with
specific observations or fact and infer a general
rule or conclusion from them. For example, if
you notice that every time you eat spicy food,
you get a stomach ache, you might use
inductive reasoning to conclude that spicy food
causes stomach aches

• The probability that a person age 21 will die

before age 26 cannot be logically deduced.
However, by a careful analysis a post mortality
experience, life insurers can estimate the
probability of death and sell a five-year life
insurance policy issued at age 21.
Peril

Peril is defined as the cause of loss. If your

house is burns because of a fire, the peril, or
cause of loss, is the fire. If your car is
damaged in a collision with another car,
collision is the peril, cause of loss.

Common perils that cause loss to property,

including:
• Fire, Lightning, Windstorm, Hail, Tornado,
Earthquake, Flood, Burglary and theft.
Hazard
Hazard is a condition that creates or increases the frequency
or severity of loss.
• There are four major types of hazards.
1. Physical hazard (e.g., roads that increase the
chance of an auto accident)
2. Moral hazard (individual dishonesty or character
that increase the chance of loss).
3. Attitudinal hazard (morale hazard) (e.g.,
carelessness or indifference ). Example, leaving
car keys in an unlocked car, which increases the
chance of theft.
4. Legal hazard (e.g., lawsuits, adverse jury verdicts).
Classification of risk

1 2 3
Pure and Diversifiable risk Enterprise risk
speculative risk and nondiversifiable
risk
Pure risk

• Pure risk is defined as a situation in which

there are only the “possibilities of loss” or “no
loss”.
• The only possible outcomes are adverse (loss)
and neutral (no loss).
• Example, premature death, job-related
accidents, catastrophic medical expenses, and
damage of property from fire, lightning, flood,
or earthquake.
Speculative risk

• Speculative risk is defined as a situation in which

either profit or loss is possible.
• Example, if you purchase 100 shares of common
stock, you would profit if the price of the stock
increases but would loss if the price declines.
 Distinguish
between
“pure” and
“speculative”
risk
Diversifiable
risk / Non-
diversifiable
risk
Enterprise risk

• Enterprise risk is a term that

encompasses all major risks faced by a
business firm.
• Such risks include:
− Financial risk.
Enterprise risk
Management

• ERM is a process that combines into a

single unified treatment program all
major risks faced by a firm.
• Such risks include:
− Pure risk,
− Speculative risk
− Strategic risk
− Operational risk
− Financial risk.
Major Types of Personal Risks
• The risks faced by individuals and families can be classified in a variety of ways.
• Premature death
• Insufficient income during retirement
• Poor health
• Unemployment
• Property risks
• Liability risks
Major Types of Personal Risks
Commercial Risks
• Property risks
• Liability risks
• Loss of business income
• others
 • It is a managerial function of business that
uses a scientific approach to dealing with
Risk risks by anticipating possible losses and
Management designing and implementing procedures that
minimize the occurrence of loss or the
financial impact of the losses that do occur.
 1. Identify all significant risks.
2. Evaluate the potential frequency and severity of
losses.
The Risk 3. Develop and select methods or techniques for
managing risk
Management 4. Implement the risk management methods
Process chosen.
5. Monitor the performance and suitability of the
risk management methods and strategies on an
ongoing basis.
 Risk Management Methods/ Techniques

1. Risk control
Risk control is a generic term to describe techniques for reducing the frequency
and severity of losses.
Major risk-control techniques include the following:
• Avoidance
• Loss control
✓ Loss prevention (e.g., safe driving course, healthy diet inspection)
✓ Loss reduction ( to reduce severity of loss, e.g., fire sprinkle system, application of fire-
resistant materials)
Risk Financing
• Risk financing refers to the techniques that
ensure the availability of funds to cover any
potential losses.
• Major risk financing techniques, such as:
(i) Retention,
(ii) Noninsurance transfer,
(iii) Insurance