Risk management and Insurance Lecture note/Ch2/

Chapter 2: Risk management

2.1. Definition of risk management

1. Risk management is the identification, measurement, and treatment of property, liability, and
personnel pure-risk exposures. It involves the application of general management concepts to a
specialized area.
2. Risk management is defined as a systematic process for the identification and evaluation of pure loss
exposures faced by an organization or individual, and for the selection and implementation of the most
appropriate techniques for treating such exposures.

Risk management is a scientific approach to dealing with pure risks by anticipating possible accidental
losses and designing and implementing procedures that minimize or avoid the occurrence of loss or the
financial impact of the losses that do occur.

As a general rule a risk management is concerned with the management of pure risks, not speculative
risks. The major functions of risk management are to help a business handle its exposures to accidental
and ordinary losses in most economic and effective way. It also helps individuals and family members to
identify and manage their pure risks.

Risk management is not an option. By managing exposures to potential losses we should be able to
achieve more acceptable results at a minimum cost. From the above definitions one can learn that Risk
management process which includes the following five steps.

1. Risk identification
The loss exposures of the business or family must be identified. Risk identification is the first and perhaps
the most difficult function that the risk manager or administrator must perform. Failure to identify all the
exposures of the firm or family means that the risk manager will have no opportunity to deal with these
unknown exposures intelligently.

2. Risk Measurement: -
After risk identification, the next important step is the proper measurement of the losses associated with
these exposures. This measurement includes a determination of:
a) the probability or chance that the losses will occur
b) the impact the losses would have upon the financial affairs of the firm or family, should they
occur.

Compiled By: Alemayehu Mulugeta

 Risk management and Insurance Lecture note/Ch2/
c) the ability to predict the losses that will actually occur during the budget period.

The measurement process is important because it indicates the exposures that are most serious and
consequently most in need of urgent attention. It also yields information needed in risk treatment.

3. Selecting the appropriate tools of Risk Management

Once the exposures has been identified and measured the various tools of risk management should be
considered and a decision made with respect to the best combination of tools to be used in attacking the
problem. These tools include:
a) avoiding the risk
b) reducing the chance that the loss will occur or reducing its magnitude if it does occur
c) transferring risk to some other party, and
d) retaining or bearing the risk internally

The third alternative includes, but not limited to the purchase of insurance. In selecting the proper tool or
combination of tools the risk manager must establish the cost and other consequences of using each tool or
combination of tools. He/she must also consider the present financial condition /position/ of the firm or
family, its over all policy with reference to risk management and its specific objectives.

4. Implementation:
After deciding among the alternative tools of risk treatment the risk manager must implement the
decisions made. If insurance is to be purchased for example, establishing proper coverage, obtaining
reasonable rates, and selecting the insurer are part of the implementation process.

5. Controlling/monitoring:
The results of the decisions made and implemented in the first four steps must be monitored to evaluate
the wisdom of those decisions and to determine whether changing conditions suggest different solutions.

2.2. Objectives of Risk Management

Objectives of risk management are achieved from the possible contributions of it. the following are some
of the contributions of risk management:

1. Ensuring survival of the firm.

firm. One of the main objectives of business firms is to exist as a business
enterprise as a going concern. However, some losses such as the destruction of the firm’s
manufacturing facilities and large liability suits may lead to the total dissolution of the firm. Thus
risk management enables the firm to make advance preparation for such events.

Compiled By: Alemayehu Mulugeta

 Risk management and Insurance Lecture note/Ch2/
2. It provides Peace of mind: risk management avoids/minimizes mental and physical strain of
uncertainty of a person.
person. Successful management of pure risk exposures of a firm will provide
peace of mind and confidence to mangers inviting them to assume and wisely manage attractive
speculative risks that they might otherwise seek to avoid.
3. It lowers risk management/handling costs and thus higher profits.
profits. Proper risk management
enables risk managers to select and apply the best method for handling each loss exposures. For
example, by assessing the frequency of occurrence of each loss and the associated monetary loss, the
risk manager can transfer some loss to insurance companies and cover the others by internally
organized funds.
4. Avoiding or minimizing the interruption of the firms operation, enabling fairly stable
earnings.
earnings. The risk handling tools if properly applied will provide the firm with some financial
means of recovering losses, and commencing operation as before. It also eliminates the fluctuating
nature of earnings due to fluctuating losses.
5. Maintaining (developing) good will.
will. Through the sound protection against pure risks, the firm can
develop its good will in the image that creditors, customers and employees have towards the firm.
6. Satisfying the firm’s sense of social responsibility.
responsibility. To the extent that the individual business and
families benefit from risk management, so does the society of which they are the members. Thus, by
handling its pure risks properly, firms can reduce the social costs within the businesses operations.
7. Satisfaction of externally imposed legal and other obligations. For example, labor law many
demand a firm to prepare a safe work place for employees and to devise a means for compensating
them for accidental loss they face in the work place. Other legal requirements include: insurance
requirements imposed by a secured creditor, employee benefit plan arrangement by a collective
bargaining agreement, safety regulations for workers in the work place etc.

2.3. Risk Identification

As it is stated above risk identification is the first step in the risk management process. In risk
identification, risk managers try to locate the areas where losses could happen due to a wide range of
perils. Unless the risk manager identifies all the potential losses confronting the firm, he or she will not
have any opportunity to determine the best way to handle the undiscovered risks.

Definition: Risk identification is the process by which a business systematically and continually identifies
property, liability, and personnel exposures as soon as or before they emerge.

Compiled By: Alemayehu Mulugeta

 Risk management and Insurance Lecture note/Ch2/
Risk identification is not a one time task. Rather as changes in the organization and environment require
constant attention to the identification of new risks, the task is carried on continuously.

2.3.1. Sources of risk

In risk identification, the first important step is to identify the sources of risk which can be classified in
various ways.
1. Physical Environment
 This is a fundamental source of risk or loss
 Examples may include earthquake, drought, or excessive rain fall can lead to loss
2. Social environment
 Changing traditions and values, human behavior, social structure, and institutions are the
source of risk
3. Political environment
 Within a single country, the political environment can be an important source of risk
4. legal environment
 Unexpected laws and directives may be issued by the government which may render risky
environment to the businesses operating in the country.
5. Operational environment
 Processes and procedures of an organization generate risk and uncertainty
 A formal procedure for promoting, hiring, or firing employees may generate a legal problem
 The manufacturing process may put employees at risk of physical harm
 Activities of the organization may result in harm to the environment
6. Economic environment
 Inflation, recession, and depression, interest rates and credit policies etc also are the source of
many losses for an organization

2.3.2. Categories of Loss Exposure

In the risk identification process more emphasis is given to pure risks. The following three types of pure
losses are mainly considered by the risk managers viz., property losses, third party liability losses and
personal losses.

Compiled By: Alemayehu Mulugeta

 Risk management and Insurance Lecture note/Ch2/
1. Property losses (physical asset exposure)
Property loss a type of pure risk that arises simply because some one owns/posses a property. Property
exposure to risk can be classified in four ways; according to:
1. the class of property affected
2. the causes of the gain or loss
3. whether the outcome is direct, indirect, or time element in nature, and
4. the nature of the organization’s interest in the property

These classifications are explained in detail as follows. ------- (Refer: William and Heins, Pages 89 - 95)

2.3.1. Methods of Valuing Potential Direct Property Losses

1. Original Cost: Original cost is simply the amount of money paid for the property at its acquisition
by the business firm. However, it has many weakness to evaluate potential losses.
a. The value is completely dependent up on the price level and bargaining, position of the
business firm at the time of acquisition.
b. Original cost takes no account of the physical depreciation or wear and tear that has
occurred during the period of use since acquisition.
c. Original cost also ignores what may have occurred because of changes.

2. Original Cost less Accounting Depreciation: Accountants traditionally have valued plant and
equipment at original cost less depreciation, depreciation being the amount of the original cost that has
been charged as an expense against the income earned since the acquisition of the property. Original
cost less depreciation is not also a useful measure because of the deficiencies of the original cost
measure and because accounting depreciation may have little or no relationship to engineering or
physical depreciation.

3. Market Value: in the case of real estate, the market value established by obtaining offers to
purchase may be of value to the risk manager. The difficulty with this approach, however, is that
market value is closely linked to the supply and demand function for real estate of the particular kind
involved and the lot value, which usually is not destroyed by most contingent events. Market value is
also somewhat difficult to establish, since each building is unique, and completely duplicate facilities
seldom exist for most forms of real estate. Finally, the market value may be higher than the direct
property loss because it may include some payments for the right to use the property immediately.

Compiled By: Alemayehu Mulugeta

 Risk management and Insurance Lecture note/Ch2/
Personal property that is readily obtainable in established markets may be valued according to current
purchase or invoice prices from these market sources.

4. Tax-Appraised Value: the value placed up on property for tax purposes has been suggested by
some as a way of establishing potential loss to property interests; but these values have many
deficiencies. For example, some states and localities set the tax value at less than their estimate of the
true value. Tax value may also be closer to the true value on new properties that on old properties.
5. The Economics or Use Value: another way of valuing property loss is by measuring the present
value of the income it produces. For example, if a property produces a net income of Birr 50,000 at the
end of each year for three years, the present value of this income stream is the sum of the present
values of each of the three 50,000 Birr incomes. The approximate present value of the three incomes,
therefore, is 45,500 + 41,400 + 37,700 = 124,000. Thus, the value of the property loss will be Birr
124,000.

This capitalization procedure is often used when the property is rented or peculiarly designed and the
income and profit position of the firm would be directly affected by its destruction. The major
disadvantage associated with using this approach to determine direct losses is that, like the market
value, this economic value also reflects net income losses, which should be measured separately.
Furthermore, the value may be greatly affected by the location of a building and the skill of the
management. And finally, the valuation estimates of the future incomes and the discount rates are very
subjective.

6. Reproduction Value: reproduction cost is the cost of reproducing or replacing the existing
property exactly at current prices. This measure may produce an unrealistic value. For example, the
materials or design used to construct a building now twenty years old may be outdated. To produce a
computer that is ten years old may cost more than buying a more effective, modern computer.

7. Replacement Cost for New: replacement cost for new is the cost of replacing the property with
new property that is not exactly the same but meets current reasonable specifications. For example, a
risk manager may determine what it would cost to replace a building by another that is equivalent in
terms of space or volume at the same or another location but of reasonable, current design. The basic
problem here is that the business firm would be getting a new building for an old one. On the other
hand, the argument can be made that so long as the old building stands. It can be used in its present
design and construction.

Compiled By: Alemayehu Mulugeta

 Risk management and Insurance Lecture note/Ch2/
8. Replacement Cost New Less Physical Depreciation and Obsolescence: in many property loss
valuations risk managers subtract from replacement cost new an allowance for physical depreciation,
economic obsolescence, or both. Their reasoning is that the business will gain if a property is replaced
with new property. No loss will have occurred. The older the property, the more risk managers argue
that this is true. The firm should recognize, however, that a loss will force it into a replacement
decision that would normally not be made at that time and that replacement will require additional
financing.

One difficulty associated with this measure is the task of measuring physical depreciation and
economic obsolescence. Physical depreciation is the result of age and wear and tear. Economic
obsolescence is illustrated by a change in fashion or the development of new, more efficient
machinery.

In valuing the cost of replacing personal property on either this basis or the basis of replacement cost
new, one must be careful to include all the costs (e.q., transporting, installing, and ticketing costs) that
would be incurred in obtaining the replacement. The risk manager should also recognize that the same
property has replacement costs as it moves through the channel of distribution from the manufacturer
to the wholesaler to the retailer to the ultimate consumer. Finally, in assessing either real or personal
property losses one should include the expenses associated with cleaning up the debris following an
accident.

2. Liability losses
Firms might get exposed to liability risks which refer to injuries caused to other people or damages caused
to their property, because of their operating activities. The following are some of the factors leading to
liability losses.

i) Product Liability: is associated with the manufacture and sell of a particular product. For
example, if a pharmaceutical company sells a drug or medicine that causes serious health problems,
the victim might file a law suit demanding compensation. This then may lead to a potential loss to
the firm producing the product. Quality problems, breach of warranty, misleading advertisement, etc
are some of the factors that lead to liability losses.
ii) Motor Vehicles: this is the most frequent factor a firm should expect liability losses as use of
various kinds of motor vehicles. Operation of motor vehicles could lead to killing of people or
injuries and damages of property of other people due to accidents such as collisions, fire, crash, etc.

Compiled By: Alemayehu Mulugeta

 Risk management and Insurance Lecture note/Ch2/
iii) Industrial Accidents: factory employees are likely to suffer physical injuries at work sites. In
some types of activities they may be exposed to job related diseases. This is common in the case of
laundries, chemical industries, cement factories, and others where employees are exposed to dust
inhalation and pungent chemical smell that can cause occupational diseases. Liability loss arises then
as the firm has to compensate employees for their injuries and job related diseases faced during the
course of employment.
iv) Industrial Waste: industrial wastes released into air or thrown into rivers and lakes are major
sources of environmental pollution. Following the development of environmental economics,
environmentalists are giving hard time to industries. There is then a potential liability loss if the
firm's activities pollute the environment and a law suit is filed against its activities.
v) Professional Activities: in the filed of consultancy, medicine, construction, and other
professional activities, liability losses are likely to emerge because of the deficiencies inherent in the
services rendered due to negligence, errors, intentional concealment and the like.
vi) Ownership of immovable: this refers to building, land and machinery owned. The use of such
immovable by people may bring liability losses for injuries might be caused by accidents. For
example, faulty electrical, connections, old building faulty elevators and escalators may cause injury
to people while they are using these facilities.

3. Personal losses
To identify all the potential losses the risk manager needs first a checklist of all the losses that could occur
to any business. Second, he or she needs a systematic approach to discover which of the potential losses
included in the checklist are faced by his/her business. The risk manager may personally conduct this two-
step procedure or may rely upon the services of an insurance agent, broker, or consultant.

After the checklist is developed, the second step is to discover and describe the types of losses faced by a
particular business. Because most business are complex, diversified, dynamic operations, a more
systematic method of exploring all facets of the specific firm is highly desirable. Seven methods that have
been suggested are:

1. The risk analysis questionnaire: - It does more than provide a checklist of potential losses. It directs
the risk manager to secure in systematic fashion specific information concerning the firm’s properties and
operations.

Eg. If a building is leased from some one else, does the lease make the firm responsible for repair or
restoration of damage not resulting from its own negligence?

Compiled By: Alemayehu Mulugeta

 Risk management and Insurance Lecture note/Ch2/

2. Financial statement method: - A second systematic method for determining which of the potential
losses in the checklist applies to a particular firm and in which way is the financial statement method. By
analyzing the balance sheet, operating statements and supporting records, the risk manager can identify all
the existing property, liability and personal exposures of the firm. By coupling these statements with
financial forecasts and budgets, the risk manager can discover future exposures.

3. Flow-chart method: - Is the 3rd systematic procedure for identifying the potential losses facing a
particular firm. First, a flow chart or series of flow charts is constructed, which shows all the operations of
the firm, starting with raw materials, electricity, and other inputs at supplies locations and ending with
finished products in the hands of customers. Second the checklist of potential property, liability, and
personal losses is applied to each property and operation shown in the flow chart to determine which
losses the firm faces.

4. On-site inspections: - are a must for the risk manager. By observing first hand the firm’s facilities and
the operations conducted thereon the risk manager can learn much about the exposures faced by the firm.

5. Interactions with other departments:- Through systematic and continuous interactions with other
departments in the business, the risk manager attempts to obtain a complete understanding of their
activities and potential losses created by these activities.

6. Statistical Records of losses: - Another approach that will probably suggest fewer exposures than the
others but which may identify some exposures not other wise discovered is to consult statistical records of
losses or near losses that may be repeated in the future.

7. Analysis of the environment: By analyzing the internal and external environment such as customers,
competitors, suppliers and government, the risk manager can identify the potential losses.
In identification process the risk manager gives more emphasis on pure risks: property losses, personal
and liability losses. No single method or procedure of risk identification is free of weaknesses or can be
called foolproof. The strategy of management must be to employ that method or combination of methods
that best fits the situation at the hand.

The choice depends on:

- the nature of the business
- the size of the business
- the availability of in house expertise, etc

Compiled By: Alemayehu Mulugeta

 Risk management and Insurance Lecture note/Ch2/

2.4. Risk Measurement

After the risk manager has identified the various types of potential losses faced by his or her firm, these
exposures must be measured in order to determine their relative importance and to obtain information that
will help the risk manager to decide upon most desirable combination of risk management tools.

2.4.1. Dimensions to be measured

Information is needed concerning two dimensions of each exposure
1. The loss frequency or the number of losses that will occur and
2. The loss severity

Both loss frequency and loss severity data are needed to evaluate the relative importance of an exposure to
potential loss. However, the importance of an exposure depends mostly upon the potential loss severity
not the potential frequency. A potential loss with catastrophic possibilities although infrequent, is far more
serious than one expected to produce frequent small losses and no large losses. On the other hand loss
frequency cannot be ignored.

If two exposures are characterized by the same loss severity, the exposure whose frequency is greater
should be ranked more important. There is no formula for ranking the losses in order of importance, and
different persons may develop different rankings. The rational approach, however, is to place more
emphasis on loss severity.

Loss-frequency Measures
One measure of loss frequency is the probability that a single unit will suffer one type of loss from a
single peril. Instead of estimating the probability that a single unit suffer one type of loss from a single
peril during the coming year, the risk manager can, in the same way estimate the probability that the unit
will suffer that type of loss from many perils. This probability will be higher because of the additional
possible causes of loss.

Loss-severity Measures
Two measures commonly used to measure loss severity are:
1. the maximum possible loss, and
2. the maximum probable loss

Compiled By: Alemayehu Mulugeta

 Risk management and Insurance Lecture note/Ch2/

The maximum possible loss is the worst loss that could possibly happen and the maximum probable loss is
the worst loss that is likely to happen. The maximum possible loss, therefore, is usually greater than the
maximum probable loss. Of these two measures, the maximum probable loss is the most difficult to
estimate but also the most useful.

In estimating the maximum possible loss and the maximum possible loss and the maximum probable loss
the risk manager, ideally, would consider all types of losses that might result from a given peril.

In determining loss severity the risk manager must be careful to include all the types of losses that might
occur as a result of a given event as well as their ultimate financial impact upon the firm: direct, indirect
and net income losses.

The potential direct property losses are rather generally appreciated in advance of any loss, but potential
indirect and net income losses that may result from the same event are commonly ignored until the loss
occurs. This same event may also cause liability and personnel losses.

2.4.2. Risk Management and Probability Distribution

A more sophisticated way to measure potential losses involves probability distributions. However, this
method is more difficult to explain and the data needed to construct the required probability distribution
are commonly not available. Nevertheless, probability distributions make possible more comprehensive
risk measurements than other techniques; and also, they are becoming a more common tool of modern
management, and data sources are improving. Furthermore, probability distributions improve one's
understanding of the more popular risk measurements and are extremely useful in determining which risk
management devices would be best in a given situation.

A probability distribution shows for each possible outcome, its probability of occurrence. It is used to
estimate numerically the potential loss from a risk. Using the probability distribution, it is possible to
measure the various aspects of a risk; such as:

1. the total dollar losses per year (fiscal period)

2. the number of occurrences per year
3. the dollar losses per occurrence

1. Total Dollar Losses per Year

Compiled By: Alemayehu Mulugeta

 Risk management and Insurance Lecture note/Ch2/
The probability distribution of the total dollar losses per year shows each of the total dollar losses that the
business may experience in the coming year and the probability that each of these totals might occur. For
example, assume that:

i) a business has five cars, each of which is valued at 10,000 Birr

ii) each car may be involved in more that one collision a year; and
iii) the physical damage may be partial or total.

Also assume prompt replacement of any car that goes out of service, thus reducing net income losses to a
minimal level. A hypothetical probability distribution that might apply in this situation is shown below:
Total Dollar Losses per Year Probability
Birr 0 0.606
500 0.273
1000 0.100
2000 0.015
5000 0.003
10,000 0.002
20,000 0.001
1.000
If the risk manager can estimate accurately the probability distribution of the total dollar losses per year,
he or she can obtain useful information concerning:

1. the probability that the business will incur some dollar loss,
2. the probability that "severe" losses will occur,
3. the average loss per year, and
4. The risk or variation in the possible results.

Given the above distribution, the probability that the business will suffer no dollar loss is almost 0.606.
Because the business must suffer either no loss or some loss, the sum of the probabilities of no loss and
some loss must equal 1. Consequently, the probability of some loss is equal to about 1 – 0.61 = 0.39. An
alternative way to determine the probability of some loss is to sum the probability for each of the possible
total dollar losses: i.e., 0.273 + 0.100 + 0.015 + 0.003 + 0.002 + 0.001 = 0.394 (1 – 0.606 = 0.394).

The potential severity of the total dollar losses can be measured by stating the probability that the total
losses will exceed various values.
values. For example, the risk manager may be interested in the probability that

Compiled By: Alemayehu Mulugeta

 Risk management and Insurance Lecture note/Ch2/
the dollar losses will equal or exceed 5,000 Birr. These probabilities can be calculated for each of the
values in which the risk manager is interested and for all higher values. For example, the probability that
the dollar losses will equal or exceed Birr 5000 is equal to 0.003 + 0.002 + 0.001 = 0.006.

Another extremely useful measure that reflects both loss frequency and loss severity is the expected total
dollar loss or the average annual dollar loss in the long run. Because the probabilities above represent
the proportion of times each dollar loss is expected to occur in the long run, the expected loss can be
obtained by summing the products formed by multiplying each possible outcome by the probability
of its occurrence;
occurrence; i.e., 0(0.606) + 500(0.273) + 1000(0.100) + 2000(0.015) + 5000(0.003) +
10,000(0.002) + 20,000 (0.001) = 321 Birr.
Birr. This measure indicates the average annual dollar loss the
business will sustain in the long run if it retains this exposure.

Up to this point, no yardstick has been suggested for measuring risk but its relationship to the variation in
the probability distribution has been noted. Statisticians measure this variation in several ways. One of the
most popular yardsticks for measuring the dispersion around the expected values is the standard
deviation.
deviation. The standard deviation is obtained by subtracting the average value from each possible value of
the variable, squaring the difference, multiplying each squared difference by probability that the variable
will assume the value involved, summing the resulting products, and taking the square root of the sum.

The standard deviation for the example given above is calculated as follows:
(1) (2) (3) (4) 3x4
Value (xi) Value-average (Value-average)2 Probability
$0 0 – 321 $ (-321)2 0.606 62,443
500 500 – 321 (179) 2 0.273 8,747
1000 1000 – 321 (679) 2 0.100 46,104
2000 2000 – 321 (1679) 2 0.015 42,286
5000 5000 – 321 (4679) 2 0.003 65,679
10,000 10,000 – 321 (9679) 2 0.002 187,366
20,000 20,000 – 321 (19679) 2 0.001 387,263
799,888

Then the standard deviation is = $894.

Compiled By: Alemayehu Mulugeta

 Risk management and Insurance Lecture note/Ch2/
When there is much doubt about what will happen because there are many outcomes with some
reasonable chance of occurrence, the standard deviation will be large; when there is little doubt about what
will happen because one of the few possible outcomes is almost certain to occur, the standard deviation
will be small.

2. Number of Occurrences per Year

This refers to the number of accidents expected to occur per physical period (year). If each occurrence
produces the same dollar loss, the distribution of the number of occurrences per year can be transformed
into a distribution of the total dollar losses per year by multiplying each possible number of occurrences
by the uniform loss per occurrence. If the dollar loss per occurrence varies within a small range, the
distribution of the total dollar losses per year can be approximated by multiplying each possible number of
occurrences by the average dollar losses per occurrence. If the dollar losses per occurrence vary widely,
one needs the probability distributions of the dollar losses per occurrence and the number of occurrences
per year to develop information about the total dollar losses per year.

3. Dollar Losses per Occurrence

Researchers have also has some success describing the probability distribution of the dollar losses per
occurrence. This distribution would state the probabilities that the dollar losses in an occurrence would
assume various values. Generally dollar loss per occurrence refers to the average monetary loss expected
per accident (occurrence).

2.4.3. Risk Measurement Methods/techniques

There are various methods used to measure the different aspects of a risk. The three most commonly used
theoretical probability distributions are:

1. Poisson distribution method

2. Binomial distribution method, and
3. Normal distribution method

1. Poisson Distribution
The Poisson probability distribution can be used for the analysis of risk measurement. The Poisson
distribution works well when:
i) there are at least 50 units exposed independently to loss, and

Compiled By: Alemayehu Mulugeta

 Risk management and Insurance Lecture note/Ch2/
ii) The probability that any particular unit will suffer a loss is the same for all units less than 0.1
(1/10).

These conditions can be satisfied in two ways. First, the business can have at least 50 persons, properties,
or activities each of which can suffer at most one occurrence per year, and the probability being less than
0.1 (1/10) that any particular unit will have an occurrence. Second, the number of persons, properties, or
activities may be less than 50, but each unit can have more than one occurrence during the exposure
period.

The only information that is crucial in constructing a Poisson probability distribution is the expected
number of accidents (the
(the mean).
mean). Once the mean is determined, the probability of any number of accidents
will be easily calculated using the following formula:

P(r) =

Where: M = Expected number of accidents

r = number of occurrences
r! = r(r -1) (r-2) (r -3)… (2) (1), with 0! =1
e = a constant, a base of natural logarithms, equal to 2.71828

To illustrate the application of this formula, assume the following examples.

Example 1.
1. Assume that there are 5 cars and each has experiencing about one collision every two years.
years.
The mean therefore is ½ or 0.5 collision per year. Then the probability distribution is developed as
follows.

P (0) = = 0.6065

P (1) = = 0.3033

P (2) = = 0.0758

P (3) = = 0.0126

We continue like above until we found that the sum of probability of all accidents equal to 1. Thus the
probability distribution is:

Compiled By: Alemayehu Mulugeta

 Risk management and Insurance Lecture note/Ch2/

NO OF COLLISIONS PROBABILITY
0 0.6065
1 0.3033
2 0.0785
3 0.0126

Once the probability distribution is developed, it would not be difficult to determine the probability of any
number of accidents that are likely to occur. For example, the probability of no collisions is almost 0.61 or
61%; the probability of more than three collisions is 1- 0.9982 (0.6065 + 0.3033 + 0.758 + 0.0126) =
0.0018; and the probability of more than one collision is 1 – (0.6065 + 0.3033) = 0.0902 or 9.02%.

Example 2.
2. (Refer the lecture note)

2. Binomial Distribution
Another method used by the risk manager to measure risk is binomial probability distribution. To use the
binomial distribution the risk manager must be familiar with the basic assumption of the distribution.

The first assumption is that the objects are independently exposed to loss. The other assumption is that
each exposed unit suffered (experience) only one loss in a year (or other budget period). Thus the
probability that the firm will suffer r occurrences during the year is calculated using the formula:

P(r) = pr(1 – p)n-r

Where: n = number of exposures

r = number of accidents (occurrences)
p = probability of occurrence

To illustrate, assume that there are 5 trucks which are operated by a business and if an accident happens to
a particular truck, it becomes a total loss. New trucks are purchased at the beginning of every year to make
up the lost ones so that the firm always starts the new physical period with 5 trucks.

First it is assumed that monetary loss per accident is constant and it is Birr 5000.

Year No of trucks No of accidents Total monetary loss

1 5 2 Br 10,000
2 5 2 10,000

Compiled By: Alemayehu Mulugeta

 Risk management and Insurance Lecture note/Ch2/
3 5 3 15,000
4 5 2 10,000
5 5 1 5,000
Sum 25 10 50,000
Mean 5 2 10,000

Thus, the average monetary loss per accident = = 5,000, and the probability of an accident can be
estimated as P = 2/5 = 0.4

With this information as a point of departure it would be possible to construct a binomial probability
distribution for the following variables of interest:
1. number of accidents, and
2. total monetary losses

Given: n = 5 p = 0.4 q = 0.6 (1 – p)

Using the formula [p(r) = pr q(n – r)]the following probability distribution can be constructed.

No of Monetary loss Probability Expected no of Expected

accidents accidents monetary loss
0 0 0.07776 0 Birr 0
1 5,000 0.25920 0.2592 1296
2 10,000 0.34560 0.6912 3456
3 15,000 0.23040 0.6912 3456
4 20,000 0.07680 0.3072 1536
5 25,000 0.01024 0.0512 256
Sum 1.00 2.00 10,000

Then from the above probability distribution we can determine the following:
1. the expected number of accidents or the average accidents to occur is 2.
2. the expected total monetary loss is Birr 10,000.

In addition, we can determine various aspects of the risk. For example, the probability that the firm will
face some accident is 0.92224 = 1 – 0.7776. This probability is so high that implies the risk manager
should take appropriate measures to handle the risk. The probability that the firm will face some monetary

Compiled By: Alemayehu Mulugeta

 Risk management and Insurance Lecture note/Ch2/
loss is also 0.92224. And the probability that monetary loss equals or exceeds Birr 10,000 is 0.66304 = (1
– (0.07776 + 0.25920).

Formula for the Mean and Standard Deviation (SD)

For Poisson Distribution

Mean (M) = nxp
SD =
Where: n = number of exposure units
p = probability

For Binomial Distribution

Mean (M) = np
SD =
Where: n = number of exposure units
p = probability
q=1-p

Risk Measures
1. Risk relative to the mean (coefficient of variation). It indicates that the variability of the total
annual monetary losses from the expected value (the mean). It is calculated by dividing standard
SD
deviation with mean. RM = /M. The higher the coefficient of variation (RM), the higher the
risk, meaning variability increases.
2. Risk relative to the number of exposure units (Rn). It indicates the deviation from the expected
outcome as a percentage of the total number of exposure units. It is also calculated by dividing
standard deviation with number of exposure units
Rn = SD/n. The higher the value, the higher the variability, and consequently, the higher the risk.

3. Normal Distribution
The risk manager may also use a normal distribution method to measure risks. The assumption here is the
number of accidents or total annual monetary losses are approximately normally distributed. The normal
distribution can be well explained by identifying only two parameters: the mean and the standard
deviation.

The normal distribution has the following assumptions:

1. (1).
68.27% of the observations fall within the range of one standard deviation of the mean (

Compiled By: Alemayehu Mulugeta

 Risk management and Insurance Lecture note/Ch2/
2. (2).
95.45% of the observations fall within the range of two standard deviation of the mean (
3. (3).
99.73% of the observations fall within the range of three standard deviations of the mean (
For this movement it is not important to go to the detail of normal distribution.

Risk and Law of Large Number

Law of large number states that as the number of exposure units increases, risk decreases. That means risk
and number of exposure units are inversely related but not proportional.

2.8 Risk Measurement Methods/Tools

This section takes our attention away from the risks themselves towards the methods, resources,
techniques, and strategies for managing risks and the principles governing the management of the risk.

After the risks facing the firm are identified and measured, the risk manager must decided how to
handle/manage them. Risk can be handled in several ways. However, we can classify them into two broad
measures / approaches. They are risk control tools and risk financing tools.

2.8.1 Risk Control Tools

Risk control approaches are designed to reduce the firm’s expected losses and to make the annual loss
experience more predictable. More specifically, risk control efforts help individuals and organizations
avoid a risk, prevent loss, lessen the amount of damage if a loss occurs, or reduce undesirable effects of
risk on an organization. The application of risk control techniques to achieve these ends may range from
simple and low cost to complex and costly approaches.

The activities that constitute one organization’s risk control efforts may vary from those of a similar
organization in another part of the world. Although risk control programs vary from organization to
organization as a consequence of creativity and innovation, a typology of risk control tools and methods
still exist. Risk control tools and techniques can be categorized as:

Avoidance
Avoidance of risk exists when the individual or the firm frees itself from the exposure through (1)
abandonment, or (2) refusal to accept the risk from the very beginning (proactive avoidance). To avoid the
risk the individual or the firm need to avoid the property, person or activity with which the exposure is
associated.

Compiled By: Alemayehu Mulugeta

 Risk management and Insurance Lecture note/Ch2/
Avoidance through abandonment is not quite as common as proactive avoidance, but it does occur. For
example, suppose a firm finds out that one of its product has a serious health problem on customers.
Therefore, to avoid liability risk that could arise, the firm can abandon the production and sale of that
specific product.

Proactive avoidance or refusal to accept the risk from the very beginning can be explained by the
following example; ABC has planned to build a 50 story building around Arada area but while
consultant’s finds out that the area cannot support more than a 20 story building. Thus the company can
refuse to under take construction.

Avoidance is an effective approach to the handling of risk. By avoiding a risk, the company can avoid the
uncertainty that the company experiences. However, the company losses the benefit that might have been
derived from that risk.

In general, it would be impossible to use avoidance in the following situations.

1) The production of some products and the provision of some service may provide rewards whose
expected value far exceeds potential loss pr costs at the margin.
2) It is impossible to avoid all the properties such as vehicles, buildings, machinery, inventory etc.
Without them operations of business would become impossible.
3) The context of the decision also may make avoidance impossible. A risk does not exist in a vacum,
and a decision to avoid a risk might actually create a new risk else ware or enhance some existing
risk. For example, if the Addis Ababa city Administration learned that Ras Tefere Bridge is in a
state of serious disrepair, in response the administration decided to close the bridge and divert all
traffic to the other alternative bridge. The traffic load will made failure of the second alternative
bridge more likely to occur, and within a year the second bridge will collapse. That means the
measure taken to avoid risk in the first bridge bring another risk in the second road.
4) The risk may be so fundamental to the organization’s reason for being that avoidance cannot be
contemplated. A mining concern may not avoid the risk of tunnel collapse, but true avoidance
would mean leaving the mining business, which is the reason for existence.

Loss Control Measures

Loss control measures attack risk by lowering the chance a loss will occur (loss frequencies) or by
reducing the amount of damage when the loss does occur (loss severity). Loss control tools can be
classified as: loss prevention and loss reduction measures.

Compiled By: Alemayehu Mulugeta

 Risk management and Insurance Lecture note/Ch2/

a) Loss Prevention (LP)

Loss prevention programs seek to reduce the number of losses or to eliminate them entirely. Loss
prevention activities are focused on:
i) Altering or modifying the hazard
ii) Altering or the modifying the environment in which the hazard exists
iii) Intervening in the process whereby hazard and environment interacts.

The following are examples of low prevention activities.

Hazard Loss prevention activities

1. Careless house keeping * Training and monitoring program
2. Flood * Construction of dams
3. Smoking and * Prohibition, enforcement of law, prison
Drunk driving sentence

ENVIRONMENT
4. Improperly trained worker * Training (on the job and off the job)
5. Building susceptible to fire * Fire resistive construction
6. Slippery shop floor * Installation of absorbent mats
7. Dangerous working environment * Regular inspection and Internal control
warning poster.

Tight quality control can avoid a product liability risk that might arise due to product’s quality.

b) Loss Reduction Measures

Loss reduction activities on the other hand are designed to reduce the potential severity of a loss once the
peril happened. Such a system does not reduce the probability of loss, instead, they reduce the amount of
damage if a peril occurs. Loss reduction activities are post loss measures.

The best examples of loss Reduction measures are:

 employing fire extinguishers
 using active and trained guards
 installing automatic sprinkler

A sprinkler system is a classic example of loss reduction effort; because fire is required to activate the
sprinklers.

Compiled By: Alemayehu Mulugeta

 Risk management and Insurance Lecture note/Ch2/

A firm that employees an effective risk prevention and risk reduction programs is benefiting not only itself
but the society as well. For instance, the firm that makes strict quality control to prevent liability losses is
safeguarding the society from possible harms. A destruction of inventory of a firm may affect society
because those goods are no more available to the society.

Therefore, effective loss prevention and reduction measures should be designed to benefit both the firm
and the society. However, these measures involve costs which include expenditures for the acquisition of
safety equipments and devices, operating expenses such as salary payments to guards, inspectors, and
other employees engaged in safety work and training and seminar costs. The risk manager will have to
design the most efficient measures in order to minimize such costs without reducing the desired safety
level.

Neutralization

Neutralization is the process of balancing a chance of loss against a chance of gain. For example, a person
who has bet that a certain team will win the national cup series may neutralize the risk involved by also
placing a bet on the opposing team. The risk is transferred to the person who accepts the second bet.

Information Management
Information emanating from an organization’s risk management department can have important effects in
reducing uncertainty in an organization’s stakeholders such as, suppliers, customers, creditors, employees
etc.

Risk transfer
Transfer as a risk control tool refers to transferring the loss that causes a loss to some entity other than the
one experiencing it to bear the burden of the loss. Transfer may be accomplished in two ways:

1. The activity or property responsible for the risk can be transferred to some other person or groups of
persons.
For example, an organization that sells one of its buildings can transfer the risk associated with ownership
of the building to the new owner. The main contractor can transfer some of the risks by hiring sub-
contractor who can handle some part of the project.

One may ask a question “what makes transfer different from avoidance?” Risk transfer measure attempt to
transfer risk that results in an exposure to a particular peril for some other person or organization, whereas
in the case of avoidance through abandonment the risk is passed to no one.

Compiled By: Alemayehu Mulugeta

 Risk management and Insurance Lecture note/Ch2/

2. The risk, but not the property or activity, may be transferred. For example, a manufacturer may be able
to force a retailer to assume responsibility for any damage to products that occur after the products leave
the manufacturer’s premises.

Separation

This refers to scattering the firm’s property exposed to risk to different places. The principle is “ do not put
all your eggs in one basket.”
basket.” For example, instead of placing its entire inventories in one warehouse, a
firm may put them in different warehouses and separate exposure. Another example, a firm can store files
depending on their respective importance. Top secret files, say, can be put in fire proof cabinets, others in
locked cabinets and the less importance once can be left on tables.
Combination
This is some how similar to separation as it involves increasing the number of exposure units to make loss
exposures more predictable. Their difference lies on the fact that unlike separation, which simply spreads
a specified number of exposure units, combination (pooling) increases the number of exposure units under
the control of the firm. Combination follows the law of large numbers, which states that when the
exposure units increase, the loss will be more predictable with high degree of accuracy and then reduces
risk.

Examples:
- A taxi owner increasing the number of fleets
- Merger with other firms (the merger of Lion Insurance and Hibret Insurance). In this case
combination results in the pooling of resources of the two companies. This leads to financial
strength, thereby reducing the adverse effect of the potential loss.
- Use of spare parts and reserve machines

Diversification

Diversification is another risk control tool used to handle most speculative risks. For example, businesses
can diversify their product line so that a decline in profit of one product could be compensated by profits
form other product lines. Here we can take our country as an example. Ethiopia can minimize
international trade risk by producing and selling different types of products in addition to coffee export
which accounts the lion share in our export trade. This can be noticed from the current situation. The
country has lost thousands of foreign exchange from coffee export because of the decline in the world
price of coffee.

Compiled By: Alemayehu Mulugeta

 Risk management and Insurance Lecture note/Ch2/
2.8.2 Risk Financing Tools

In most risk management programs, some losses occur in spite of the best risk control efforts. This means
some measures must be used to finance losses that do occur. Risk control measures by altering the loss
itself, either reduce the potential losses or make those losses more predictable. The risk financing tools, on
the other hand, are ways of financing the losses that do occur. It includes:

Retention (Self-Insurance)
The most common and easiest method of risk handling tools used by firm is retention. It is an arrangement
under which the firm or an individual experiencing the loss bears the direct financial consequences. In
other words, the person or the firm consciously or unconsciously, decides to assume the risk and pays for
the loss without any attempt to transfer it to somebody else. The sources of the funds is the firm itself.
Retention may be passive or active, unconscious or conscious, unplanned or planned.

The retention is passive or unplanned when the risk manager is not aware that exposure exists and
consequently does not attempt to handle it. By default, therefore, the firm has elected to retain the risk
associated with that exposure. Retention is active or planned when the risk manager considers other
methods of handling the risk and consciously decides not to transfer the potential losses. For this, the firm
may set aside a fund for the contingencies (self Insurance).

Why person or a firm decides to retain the risk? Planned retention exist for a number of reasons. Some of
these are:

1. It is probability impossible to transfer the risk, as in the case of speculative and dynamic risks: In
some cases retention is the only possible tool. The firm cannot prevent the loss, avoidance is
impossible or undesirable, and no transfer possibilities (including insurance) exist. Consequently,
the firm has no choice other than retaining the risk. Example, a factory located in a river valley
may find no other method of handling the flood risk is feasible. Abandonment and loss control
would be too costly, and flood insurance for such situation may not be available.
2. Attitudes of individuals or firms towards risk: Usually risk lovers prefer to assume (retain)
considerable risk than do risk avoiders.
3. The value of the goods to be insured and insurance costs: If the value of the property insured is
less than the cost of insurance the firm may prefer to retain the risk.

In most cases retention is not the only possible tool. The choice is between retention and insurance. The
major factors to be considered in making the choice are:

Compiled By: Alemayehu Mulugeta

 Risk management and Insurance Lecture note/Ch2/
a) The maximum probable cost relative to the firm’s capacity for bearing the risk.
b) Expected loss and risk
If the business believes that its expected losses are less than those assumed by the insurer in
calculating its premium, it may reason that in the long run it can save the difference between the
two expected losses estimated by retaining the loss
c) Restrictions or legal limitations applying to risk transfers. In such types of situation the only option
may be retention.
d) Opportunity costs related to investment of funds that is going to be paid as a premium if the risk is
transferred to the insurance companies.
e) Quality of service provided by the insurance companies.

4. The risk may be remote: If the risk manager knows that the risk is so remote that cannot exist in
the near future, then he/she may prefer to retain the loss.

Transfer

Transfer as a risk-financing tool is an arrangement under which some entity other than the one
experiencing the loss bears the direct financial consequences. Under "risk financing transfer”, the
transferor seeks external funds that will pay for the losses that do occur. In this arrangement, unlike the
risk "control transfer”, the risk itself is not shifted rather it is assumed by somebody else.

The most common form of risk transfer is by way of insurance. Insurance is so important in the
management of pure risks. We will explore insurance as a risk transfer mechanism in more detail in the
next three units.

selections of Risk management tools

In the previous section, we have discussed large number of risk management tools. These tools may not be
appropriate in all situations to all firms or individuals at all times. As a result, a risk manager should be
knowledgeable enough to make analysis and select the “best” risk handling tool(s). Cost-benefit analysis
is important in selecting an appropriate risk management tool(s).

Compiled By: Alemayehu Mulugeta