Chapter 2
Risk Management
At the completion of studying this chapter, you will
be able to understand:
Meaning of Risk Management
Function of risk managers
Objectives of Risk Management
Steps in the Risk Management Process
Benefits of Risk Management
Chapter One
Risk is everywhere for people as well as
organizations
à Thus, people have to accept it as fact of life
Chapter Two
The whole of life is thus the
management of risk, not its
elimination.
Meaning of Risk
Management
Risk Management is a process that identifies loss exposures
faced by an organization and selects the most appropriate
techniques for treating such exposures
• It is 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.
A loss exposure is any situation or circumstance in which a loss is possible,
regardless of whether a loss occurs
E.g., a plant that may be damaged by an earthquake, or an
automobile that may be damaged in a collision
• It is the process whereby organizations methodically address
the risks attaching to their activities with the goal of achieving
sustained benefit within each activity and across the portfolio
cont’d
Risk management protects and adds value to the organization and its
stakeholders through supporting the organization’s objectives by:
providing a framework for an organization that enables future
activity to take place in a consistent and controlled manner
improving decision making, planning and prioritization by
comprehensive and structured understanding of business
activity, volatility and project opportunity/threat
contributing to more efficient use/allocation of capital and
resources within the organization
protecting and enhancing assets and company image
developing and supporting people and the organization’s
knowledge base
optimizing operational efficiency
Functions of Risk Management
The risk manager has certain specific duties. These include:
To recognize exposures to loss; the risk manager must, first
of all, be aware of the possibility of each type of loss. This is
a fundamental duty that must precede all other functions.
To estimate the frequency and size of loss; to estimate the
probability of loss from various sources.
To decide the best and most economical method of handling
the risk of loss, whether it be by assumption, avoidance, self-
insurance, reduction of hazards, transfer, commercial
insurance, or some combination of these methods.
To administer the programs of risk management, including
the tracks of constant revaluation of the programs,
recordkeeping and the like.
Objectives of Risk Management
Risk management has objectives
before and after a loss occurs
Pre-loss objectives:
Prepare for potential losses in the most
economical way
Reduce anxiety
Meet any legal obligations
Objectives of Risk Management
Post-loss objectives:
Survival of the firm
Continue operating
Stability of earnings
Continued growth of the firm
Minimize the effects that a loss will have on
other persons and on society
Risk Management Process
Identify potential losses
Measure and analyze the loss exposures
Select the appropriate combination of
techniques for treating the loss
exposures
Implement and monitor the risk
management program
Steps in the Risk Management Process
Step 1:Identify potential
losses
1. Nature of Risk Identification
The process by which an organization is able to learn areas in which it
is exposed to risk.
The most important element of the risk management process.
Involves analysis of the three elements of risk: hazards, perils, and
exposure to loss.
2. Sources of Risk
Physical Environment
Social Environment
Political Environment
Legal Environment
Operational Environment
Economic Environment
Cognitive Environment.
Categories of Loss Exposures
Property loss exposures
Liability loss exposures
Business income loss exposures
Human resources loss exposures
Crime loss exposures
Employee benefit loss exposures
Foreign loss exposures
Intangible property loss exposures
Failure to comply with government rules
and regulations
Risk identification techniques
Risk Managers have several sources of
information to identify loss exposures:
Risk analysis questionnaires and checklists
Physical inspection
Flowcharts
Check lists
Financial statements
Historical loss data
Organizational Charts
Industry trends and market changes can
create new loss exposures.
e.g., exposure to acts of terrorism
Step 2. Risk Measurement and analysis
Once 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.
Risk measurement refers to the
measurement of potential loss as to its size
and probability of occurrence.
Cont’d
This Measurement includes a determination of
frequency and severity of loss for each type of loss
exposure:
Loss frequency refers to the probable number of losses that
may occur during some given time period
Loss severity refers to the probable size of the losses that
may occur
Once loss exposures are analyzed, they can be ranked
according to their relative importance
Loss severity is more important than loss frequency:
The maximum possible loss is the worst loss that could
happen to the firm during its lifetime
The probable maximum loss is the worst loss that is likely to
happen
F
r
e
q
u
e
n
c
y
Severity
Left-Hand
High Number Middle Right-Hand
Medium Number Low Number
Low Cost Very high Cost
Medium Severity
Predictable Not easy to predict Extremely difficult to
Little potential for Aggregate cost could be Predict
catastrophe serious Catastrophe potential
Self financing Transfer Loss Exposure
Risks can be measured using different
statistical measures.
include:
probability distribution,
measures of central tendency
standard deviation and
coefficient of variation.
Click icon to add picture
Risk Measures
Risk relative to the mean
R
It indicates that the variability of the total annual
monetary losses from the expected value (the
mean).
R
Risk relative to the number of exposure
units Rn
It indicates the deviation from the
expected outcome as a percentage of the
Rn
total number of exposure units
n
Probability Distributions & Risk
Measurement
• The Poisson Probability Distribution
Characteristics
Ifthe total number of possible outcomes
cannot be determined, the Poisson
probability distribution can be used.
When one object is likely to experience
limitless number of exposures.
The events shall be rare events.
The accident shall be random and
independent of another accident.
Click icon to add picture
Constructing the Poisson Distribution
P(r )
r
.e
r!
Where e = 2.771828
r = number of accidents
= Expected number of
Accidents
nxp
Computing Measures of Risk
Risk Relative to the
mean:
R
Risk Relative to the number of exposure unit:
Rn
n
Illustration
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 connection with the
accidents.
Number of Amount of
Number of cars
Year
Accidents loss
1 10 1 Birr 2,500
2 12 2 4,200
3 14 3 4,500
4 15 3 6,000
5 20 2 6,500
6 20 3 6,600
7 25 4 6,000
Probability of Accident = 3/20 = 0.15
Monetary loss /accident over 10 years =
6180/3 = 2060,00
Suppose in year 11 the number of cars owned
by the firm increased to 40.
a = pxn= 0.15 * 40 = 6 accidents
σa = a = 6 = 2.45
m = a x Monetary Loss per Accident = 6 *
2060
= 12,360.00
• Determination of Probability of Occurrences
The probability of 3 car accidents or more:
P (x 3) = 1 – P (x=0) + P (x=1) +P (x=2)
= 1 - (.0025+. 0149+. 0445)
= 0.9381.
The probability that the number of accidents equal or exceed 13:
P (x 13) =p (x=13) + p (x=14) + p (x=15) + p (x=16)
+ p (x=17) + p (x=18)
= .0052+. 0022+. 0009+. 0003+. 0001+. 0001
= 0.0088
The probability that the number of car accidents is between 3 and
13:
P (3 < = x < 13) = 0.9381- 0.0088 = 0.9293
The Expected Monetary Loss Per Accident
(m):
= The expected annual total
monetary loss
The expected number of
accidents
= Birr 12,359.39/6
= Birr 2,059.90
Standard Deviation of Annual Monetary
Loss (m):
= a X Expected Monetary Loss per
Accident
= 2.45 x 2,059.90
= 5046.7
Accidents Monetary loss
(Mean) 6 12,359.39
Summary
statistic
(Standard 2.45 5,046.7
Deviation)
Computing Measures of Risk
Risk Relative to the Mean (Coefficient of
Variation)
Rm = m /m = 5046.4/12359.9
= 0.408
R of 0.408 indicates the variability of total annual
monetary losses from the expected value, (m).
The higher the R, the higher the risk, meaning
variability increases.
In this example total annual monetary losses could
deviate 40.8% from the mean in either direction.
Risk Relative to the number of Exposure Units
(Rn):
R n indicates the deviation from the expected outcome
as a percentage of the total number of exposure units.
Rn = a/n = 2.45/40
= .061
Rn of 0.061 indicates the variability of total number of
Risk Vs. Law of Large Numbers
How would measures of risk respond to changes in
n???
N a a R Rn
40 6 2.4495 .408 .06124
50 7.5 2.7386 .365 .05478
100 15 3.8730 .258 .03873
The Binomial Probability
Distribution
Characteristics
A process in which each trial or
observation can assume only one of the
two states is called a binomial process.
Binomial probability distribution could be
used in situations where:
Only two possible outcomes exist.
Events are independent.
Sample selected is relatively small.
Constructing the Binomial Probability
Distribution n!
P(r ) p r .q ( n r )
r!( n r )!
Where: p is the probability of accident
q is 1 – p (the probability of no
accident)
n is the number of items exposed
to risk
r is
the number
nxp of accidents.
nxpxq
Computing Measures of
Risk Risk Relative to the mean:
RM
Risk Relative to the number of exposure
unit:
Rn
n
Illustration
A fleet of 5 delivery trucks are operated
by a business. If an accident happens to
a particular track, 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 fiscal period with a fleet of 5
delivery tracks. First it is assumed that
monetary loss per accident is constant at
Birr 5,000. See the following table.
Number of Number of Total Monetary
Trucks Accidents Loss
Year
1 5 2 Birr 10,000
2 5 2 10,000
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
Monetary loss per accident =10,000/2 =
5,000
The probability of an accident (p) = 2/5
= .4
a = (5)* (0.4) = 2
a = (5*)(0.4* .6) = 1.095
m = Birr 10,000
The Expected Monetary Loss Per Accident
(m):
= The expected annual total
monetary loss
The expected number of
accidents
= Birr 10,000.00/2
= Birr 5,000.00
Standard Deviation of Annual Monetary
Loss (m):
= a X Expected Monetary Loss per
Accident
= 1.095 x 5,000
= 5,475
Accidents Monetary loss
Summary
(Mean) statistic 2 10,000.00
(Standard 1.095 5,475.00
Deviation)
Computing Measures of Risk
- Risk Relative to Mean,
(coefficient of variation)
R = 1.095/2 = .5475 Or
R = 5,475/10,000 =
0.5475
- Risk relative to the number of
exposure units
Rn = 1.095/5 = .219
The Normal Probability Distribution
Characteristics
When variations in occurrences occur due to random
variable.
Ball shape
Symmetric.
Asymptotic to the x-axis.
In specific areas under the curve lie certain standard
deviations above and below the mean.
68.2% of the observations fall within the range of
one standard deviation of the mean.
95.45 % of the observations fall within the range of
two standard deviation of the mean.
99.73% of the observations fall within the range of
three standard deviations of the mean.
Year Number of Accidents Total Monetary
Loss
1 2 Birr 10,000
2 2 10,000
3 15,000
4 2 10,000
5 2 10,000
SUM 55,000
MEAN 11,000
Standard Deviation 2,000
This implies that:
The true mean monetary loss is expected
to fall in the range of Birr 9,000 and Birr
13,000 with a probability of .6827.
The true mean monetary loss is expected
to fall in the ranges of Birr 7,000 and Birr
15,000 with a probability of .9545.
The true mean monetary loss is expected
to fall in the range of Birr 5,000 and Birr
17,000 with a probability of .9973.
Step 3 Tools of Risk
Management
Select the Appropriate Combination of
Techniques for Treating the Loss Exposures
Risk Control Risk Financing
Tools 1. RetentionTools
a. Planned vs Un
1. Avoidance planned
2. Loss control measures b. Funded vs
3. Separation Unfunded
4. Combination c. Captive insurer
5. Diversification 2. Non insurance transfer
3. Insurance
Risk control tools
The purpose is to reduce the likelihood
of loss occurrence and the severity of
the incident should it occur, in other
words
to reduce the firm’s expected property,
liability, and personnel losses, or to make
the annual loss experience more
predictable.
1. Avoidance
to avoid the property, person, or activity
with which the exposure is associated by
(1) refusing to assume it even momentarily or
(2) an exposure assumed earlier
The major advantage of avoidance is that
the chance of loss is reduced to zero
disadvantages;
it may not be possible to avoid all losses
it may not be practical or feasible to avoid the
exposure.
2. Loss control measures
actions may often be taken to reduce the losses
associated with them.
2.1. Loss prevention refers to measures that reduce the frequency of a
particular loss
e.g., installing safety features on hazardous products
2.2. Loss reduction refers to measures that reduce the severity of a loss after it
occurs
e.g., installing an automatic sprinkler system
Types of Loss Control
Focus of Loss Control
frequency reduction or
loss (severity) prevention
Timing of loss control
pre-loss activities
concurrently with losses
post-loss activities
3. Separation
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.
4. Combination
Combination is a basic principle of insurance that
follows the low of large numbers.
Combination increases the number of exposure
units since it is a pooling process.
5. Diversification
Businesses diversify their product lines so that a
decline in profit of one product could be
compensated by profits form others.
Risk Financing tools
1. Retention
Retention means that the firm retains part or
all of the losses that result from a given loss
exposure.
Used when:
First, no other method of treatment is
available.
Second, the worst possible loss is not serious.
Finally, losses are highly predictable.
Methods for Retention
Credit
Reserve funds
Self insurance
Captive insurer
A captive insurer is an insurer
established and owned by a parent
firm for the purpose of insuring the
parent firm's loss exposures.
Used when:
Difficulty in obtaining insurance.
Greater stability of earnings.
Easier access to a reinsurer.
Profit center.
2. Non-insurance Transfer
Non-insurance transfers may be
accomplished in two ways:
Transfer of the activity or the
property.
Transfer of the probable loss.
Three specific forms of risk transfer
are:
Hold harmless agreements
Incorporation
3. Insurance
Insurance is a risk transfer mechanism by which an
organization can exchange its uncertainty for certainty.
One useful approach is to classify the need for
insurance into three categories:
Essential insurance
coverage required by law or by contract
Desirable insurance
losses that may cause the firm financial
difficulty
Available insurance
coverage for slight losses
Step 4 Monitoring and Review of the Risk
Management Process
Effective risk management requires a reporting
and review structure to ensure that risks are
effectively identified and assessed and that
appropriate controls and responses are in place.
Regular audits of policy and standards compliance
Any monitoring and review process should also
determine whether:
the measures adopted resulted in what was intended
the procedures adopted and information gathered for
undertaking the assessment were appropriate
improved knowledge would have helped to reach
better decisions and identify what lessons could be
learned for future assessments and management of
risks