Risk Mgmt & Insurance
ACFN 2081
Chapter 1
RISK AND RELATED CONCEPTS
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Objectives
After completing this unit, students will be able to:
Define and understand the concept of risk.
Understand the difference between risk, uncertainty
and probability.
Understand the word hazard and peril and its
relationship with risk.
Identify the different types of risk.
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Risk …..meaning
 There is no single definition for risk:• Risk is the potential variations in the outcomes that
could occur over a specified period in a given
situation.
• Risk is objectified uncertainty about the occurrence
of an undesired event.
• Risk is condition in which there is a possibility of an
adverse (unfavorable) deviation(variations) from a
desired outcome that is expected or hoped for.
• Risk is the dispersion of actual from expected results.
• Risk is possibility of loss.
[[[[SO
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RISK AND UNCERTAINTY
• Uncertainty refers to a feelings characterized by doubt,
based on the lack of knowledge about what will or will
not happen in the future.
• Uncertainty is doubt about our ability to predict the future.
• Uncertainty arises when an individual perceives risk.
• Uncertainty is a subjective concept, so it cannot be
measured directly by any acceptable yardstick. Since it is
a state of mind, uncertainty varies across individuals.
• On the other hand, risk refers to a condition or
combination of circumstances in which there is a possibility
of loss.
• It is what a person believes to be the state of the world
and the confidence he/she has in this belief.
• Unlike uncertainty, risk can be measured.
Example 1: Take the risk of cancer from cigarette smoking,
Consider a child playing in the middle of a busy road
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RISK AND PROBABILITY
Probability is a chance that an event will occur in
a single possible event, While risk is the variation
in the possible outcomes. This means risk depends
on the entire probability distribution.
There is no risk if the probability of occurrence is 0
or 1.
• In between these two extremes there could be
several occurrences of the events with their
corresponding probability of occurrence. Under
this situation there is risk.
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RISK, PERIL AND HAZARD
Peril refers to a specific or prime cause of loss.
Example house burns because of fire, the peril is the
fire.
• Common perils that cause property damage included
fire, lightning, windstorm, hail, tornadoes, earth
quakes, theft and robbery.
• Thus, peril refers to the prime source of a specific loss.
Hazards are conditions that create or increase the
chance of loss arising from a given peril. It facilitates
the occurrence of perils. Example: location of building,
windy weather, house on a riverbank…etc
Activity: Mr. Biniyam built a house near by Beressa river;
a flood came and destroyed the house. What is the peril?
And what is the hazard?
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Types of hazards
A) Physical hazard is a physical condition that increases the
likelihood of loss. Example: Location of the property, Type of
construction , Existence of dry forest, the nature of the road,
etc
B) Moral hazard is dishonesty or character defects in an
individual that increases the frequency or severity of loss.
Examples: Faking an accident to collect from an insurer,
Inflating the amount of the claim, Intentionally burning unsold
merchandise that is insured etc.
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C) Morale hazard refers to the carelessness or indifference
to a loss because of the existence of insurance. Examples:
Leaving car keys in an unlocked car, Leaving a door
unlocked, failing to follow safety rule properly.
D) Legal Hazard
• Refers to characteristics of the legal system or
regulatory environment that increase the frequency or
severity of loss.
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THE CLASSIFICATION OF RISK
1. Pure Vs Speculative Risk
• Pure risk refers to a situation in which only a LOSS or NO LOSS
would occur. Example: Fire at a factory, Car accident, flood, theft,
etc. pure risk includes;
1. Personal risk is a risk that affects individuals. It includes;
Premature death, Insufficient retirement income, poor health, and
Unemployment.
2. Property risk is a risk when a property is damaged or lost. This
refers to losses associated with ownership of property.
• There are two major types of loss in the damage of property;
 Direct :- results from the physical damage, destruction, or theft of the
property, such as fire damage to a home.
 Indirect loss:- also called consequential loss. It results Indirectly from the
occurrence of a direct physical damage or theft loss, e.g., the additional
living expenses after a fire.
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3. Liability risk is the possibility of loss arising from intentional or
unintentional damage made to other persons or to their property.
• It involves the possibility of being held legally liable for bodily
injury or property damage to someone else.
• The court of law may order that person to pay substantial
damages to the person who is injured.
– Motorists are being held legally liable for the negligent
operation of their vehicles.
– Producers are also being sued because of defective
products that harm or injure customers.
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Speculative Risk
• Defined as a situation in which either
PROFIT or LOSS is possible. Investing money
in shares is a good example.
• People are more adverse to pure risks as
compared to speculative risks.
• In speculative risk situation, people may
deliberately create the risk when they
realize that the favorable outcome is,
indeed, so promising.
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Comparisons between pure risk and speculative risks
• Private insurers generally insure only pure risks. With
some exceptions, speculative risks are not considered
insurable and other techniques for coping with risk must
be used (i.e speculation )
• Only pure risks are predictable, i.e. the law of large
numbers can be applied more easily to pure risks than to
speculative risks. while, speculative risks are not
predictable; it is more difficult to apply the law of large
numbers in order to predict future loss experience.
• Society may benefit from a speculative risk even though a
loss occurs. eg. a firm produces computers more cheaply
which force a competitor into bankruptcy.
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2. Fundamental Vs Particular Risk
• Fundamental risk is a risk that affects the entire economy
or large number of persons or groups within the economy.
Examples: high inflation, social change, political intervention,
unemployment, war, famine, volcanoes and other natural
‘disasters’ like Hurricanes, Katrina, Tsunami.
 Particular risk refers to a risk that affects only individuals
and not the entire community. Particular risks are much more
personal both in their cause and effect.
Examples: burning of a house, car theft
Particular risks are insurable while fundamental risks are not
insurable.
• Particular risks are insurable if they belong to the category
of pure risk only. For example, “loss in business” is a
particular risk since it affects only the owner of the business
but it is not insurable because it is not pure risk.
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3) Financial Vs Non-Financial Risk
• A financial risk is a risk that results in losses that can be
expressed in financial terms. Examples of financial risk
include physical damage to a property, theft of property
or lost business profit following a fire.
• Non-financial risk refers to a loss that does not have
financial implications. Examples: choice of a marriage
partner, the selection of an item from a restaurant menu,
the selection of a career, having children.
• The two risks can occur simultaneously. For example, in the
case of premature death the financial risk is loss of
income (salary), while the non-financial risks are loss of
emotional support, loss of moral, loss of motivation.
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4) Dynamic Vs Static Risk
Dynamic risk refers to losses originates from changes
in the overall economy such as price level changes,
changes in consumer tastes, income distribution,
technological changes, political changes and the like.
They are less predictable and hence beyond the control
of risk managers.
Static risks refer to those losses that can take place
even though there were no changes in the overall
economy. They are predictable and could be controlled
to some extent by taking loss prevention measures.
• Static risks are insurable, because they are
predictable whereas dynamic risks are not insurable.
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5) Objective vs Subjective Risk
Objective risk is defined as the relative variation of the
actual loss from expected loss.
• Objective risk can be statistically measured by some
measure of dispersion, such as the standard deviation or
the coefficient of variation.
• For example assume that a property insurer has 10,000
houses insured over a long period and, on average, 1
percent, 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, while in other years,
as many as 110 house my burn. Thus, there is a variation
of 10 houses from the expected number of 100, or a
variation of 10 percent. This relative variation of actual
loss from expected loss is known as objective risk.
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Subjective risk is defined as uncertainty based on a
person’s mental condition or state of mind (mental
uncertainty).
• A subjective risk is a psychological uncertainty that
stems from the individual’s mental attitude or state of
mind.
• Some writers have used the word “uncertainty” to be
synonymous with subjective risk as defined here.
• Two persons in the same situation may have a
different perception of risk, and their conduct may
be altered accordingly.
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Risk related to business activities
Business risk: associated with physical operation
of risk including variation in sales, costs, profits, etc.
Financial risk: associated with debt financing
including debt payment, bankruptcy, stock price
decline, etc.
Interest rate risk: results from change in interest
rate.
Purchasing power risk: arises under inflationary
situation.
Market risk: refers to stock price variability caused
by market forces.
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Burden of risk on society
 The size of an emergency fund will be increased.
 Worry and fear are present
 Loss of certain goods and services.
 In the absence of insurance, individuals and business firms would
have to maintain large emergency funds to pay for unexpected
losses.
 The risk of a liability lawsuit may discourage innovation,
depriving society of certain goods and services.
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THE END
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CHAPTER TWO
THE RISK MANAGEMENT
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Objectives
• After completing this unit, students will be able to:
 Explain the meaning and definition of risk management
 Understand the role of risk managers
 Elaborate steps in risk management process
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RISK MANAGEMENT DEFINED
• 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 the executive function of
dealing with specified risks facing the business
enterprise.
• In general, the risk manager deals with pure, not
speculative risk.
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Duties of risk manager
1. To recognize exposures to loss; the risk manager
must be aware of the possibility of each type of loss.
2. To estimate the frequency and size of loss; to
estimate the probability of loss from various sources.
3. 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.
4. To administer the programs of risk management,
including the tracks of constant revaluation of the
programs, record keeping and the like.
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OBJECTIVES OF RISK MANAGEMENT
1) Pre-loss objectives- risk management objectives prior to
the occurrence of the loss: These includes:- Economy: Economic way of handling potential risks or losses.
-Analysis of the cost of safety programs
- Reduction of Anxiety: Peace of mind & the reduction of
anxiety.
- Meeting Legal obligations:- Eg. government regulations
2) Post-loss objectives -After the occurrence of the loss.
-
Mere survival of the firm
Continuation of operation
Stability of earning
Continued growth of the firm
Meet social responsibility
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THE RISK MANAGEMENT PROCESSES
1. Identifying potential losses (risk
identification)
2. Evaluating potential losses (Measuring
the losses)
3. Selection of the risk management tools
4. Implementing the program
5. Controlling/monitoring
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1st Identifying potential losses (RI)
• RI is the process by which a business systematically and
continuously identifies personal, property and liability
loss exposures as soon as or before they emerge.
• 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.
• Identification technique are designed to develop
information on source of risk hazards, risk factors, peril,
and exposure to loss.
• The sources of risk includes physical, social, legal,
operational, political, economic and cognitive
environment.
• Risk exposures includes:- physical asset, financial
asset, liability & Human Asset exposures.
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Techniques of risk identification
•
•
•
•
•
Risk analysis questionnaire
Financial statement method
Flow-chart method: pdn, svc & money flows
On-site inspection
Planned interaction with other departments & also
outside suppliers and professional orgns.
• Statistical records of past losses
• Analysis of the environment
The choice of the technique depends on the nature
of the business, the size of the business, and the
availability of in house expertise.
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2nd Risk Measurement
• Risk measurement refers to the measurement of the
potential loss as to its size and the probability of
occurrence. 2 dimensions will be measured:
1. Loss frequency is the probability that a single unit will
suffer one type of loss from a single peril.
2. Loss severity: measured by maximum possible loss
(worst loss that could possibly happen) & maximum
probable loss (worst loss that is likely to happen)
• Probability is a measure of the likelihood that a given
event will take place. i.e. 0 ≤ p(A)≤ 1 for any event A
• The probability of any impossible event is 0, where as
the probability of any event that is certain to occur is 1.
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Method of valuing potential direct property
losses
•
•
•
•
•
•
•
•
Original cost: paid at its acquisition
Original cost less depreciation:
Market value:
Tax appraised value: value placed upon property for
tax
The economics/use value: measuring the PV of the
income e.g. NI=50,000 for 3 yrs change it to PV….
Reproduction value: replacing at the exact current
price
Replacement cost for new: replacing with new
property that is not exactly the same
Replacement cost for new less depn and
obsolescence:
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Probability Distribution & risk measurement
• Probability distribution shows the probability of
occurrence for each outcome.
• Using PD it’s possible to measure
The total dollar losses per year (physical period)
The number of occurrences per year
The dollar losses per occurrence
The total dollar losses per year
Example: consider the following hypothetical
example of probability distribution of vehicle
accident repair costs in a fleet of vehicles(similar in
type of use) operated by a firm.
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Year
No of
Amount
accidents of loss
probability Expected
amount of loss
1
0
0
0.606
0
2
1
1,000
0.273
273
3
2
2,000
0.100
200
4
3
4,000
0.015
60
5
3
10,000
0.003
30
6
2
20,000
0.002
40
7
5
40,000
0.001
40
Sum
16
77,000
1.000
643
mean
2.29
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11,000
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Solution:
• The probability of no birr loss is 0.606
• The probability of some loss = 1- 0.606 = 0.394
• The prob. Of 10,000 or more losses =
0.003+0.002+0.001 = 0.006
• The prob. that sever loss will occur (assume a sever
loss is a loss that is equal or higher than 10,000) =
0.003+0.002+0.001 = 0.006
• The expected (average)total birr loss = birr 643.
this value indicates the average annual birr loss
the business will sustain in the long run if it retains
this exposure.
• Average loss/yr= 11,000 br
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Binomial Probability Distribution
• The binomial probability distribution helps a risk manager to
measure the probability of exactly r accidents from n
number of exposures or number of items exposed to risk.
• The probability of exactly r accidents from n number of
items exposed to risk is given by:
• Where: r denotes number of accidents from n
independently exposed units
p (r) denotes the probability of getting exactly r number
of accidents from n exposed units
n denotes number of exposures or items exposed to risk
p denotes probability of an accident
q=(1-p) denotes the probability of getting no accident
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Binomial Probability Distribution(cont…)
• Mean (µ) = n.p
• Variance (δ^2) = n. p. q
• Standard deviation (σ) = √(n.p.q)
To use the Binomial probability distribution, the risk
manager must be familiar with the following basic
assumptions of the distribution to avoid misleading
results.
1. A firm has n units independently exposed to risk
2. Each exposure experiences at most one loss during a
year
3. There are n trials, each classifiable as "success" or
"failure“, i.e. each trial must have 2 possible outcomes
4. Probability must remain constant for each trial
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Binomial Probability Distribution(cont…)
Example 1. 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.
NUMBEROF
NUMBER OF ACCIDENTS
TOTAL MONETARY
YEAR
TRUCKS
LOSS
1
5
2
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
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2
10,000
Birr 10,000
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Binomial Probability Distribution(cont…)
• Based on the above information answer the following
questions;
1. What is the probability of an accident and no accident?
2. Construct the binomial probability distribution of the number
of accidents
3. Calculate the expected number of accidents
4. Find the mean and standard deviation of a binomial
probability distribution (number of accidents)
5. Calculate risk relative to the mean number of accidents and
risk relative to the number of exposure units
6. Calculate monetary loss per accident over the last five years
7. Calculate the expected total annual monetary loss
8 What is the probability that the firm will incur some birr loss
9. Calculate the standard deviation of total monetary loss
10. Calculate risk relative to the mean monetary loss
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Binomial PD…cont’d…
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3. The expected number of accidents can be calculated using the
following formula;
Where: r denotes number of accidents
p ( r ) denotes the probability of exactly r accidents
No of Accidents (r)
Probability, P ( r )
Exp. No. of Accidents r. p (r)
0
0.07776
0
1
0.25920
0.2592
2
0.34560
0.6912
3
0.23040
0.6912
4
0.07680
0.3072
5
0.01024
0.0512
SUM
1.00000
2.0000
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Binomial pd…….cont…
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Binomial PD……….cont…)
6. Monetary loss per accident = Total monetary loss
Total Number of accidents
= 50,000/10 = 5,000 birr
7. expected amount of annual monetary loss
No of Accidents
Monetary Loss
Probability
Expected M. Loss
0
0
0.07776
0
1
5,000
0.25920
1,296
2
10,000
0.34560
3,456
3
15,000
0.23040
3,456
4
20,000
0.07680
1,536
5
25,000
0.01024
256
SUM
1.000
10,000
So, the expected numbers of accidents in year 6 are 2, and the
expected
amount of annual monetary loss is 10,000.
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8. P (some birr loss) = 1 –p (no birr loss) = 1- 0.7776 = 0.9224
• An alternative way to determine the probability that the
business will incur some birr loss is to sum the probabilities for
each of the possible total birr loss
• 0.25920 + 0.34560 + 0.23040 + 0.07680 + 0.01024 =
0.9224
9. SD of total monetary loss = SD of number of accidents x
expected monetary loss per accident = 1.095 X 5,000 = 5,475
10. Risk relative to the mean monetary loss (RM)
= SD of total monetary loss = 5475/10,000 = 0.5475
Expected amount of monetary loss (mean)
The actual total annual monetary loss could deviate by 54.7%
from the expected total annual monetary loss in either direction.
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3) TOOLS OF RISK MANAGEMENT
• There are two basic approaches:
• Risk control measures: it used;
1) To reduce the firm’s expected property, liability,
and personnel losses, or
2) To make the annual loss experience more
predictable
• It includes avoidance, loss prevention and reduction
measures, separation, combination, & some transfers.
• Risk-financing measures: Funds may be required to
repair or restore damaged property, to settle liability
claims, or to replace the services of disabled or
deceased employees or owners.
• purchase of insurance, that are not considered under
risk control devices and retention, which includes, “selfinsurance”.
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Risk Control Tools: A) Avoidance
• Avoid the property, person, or activity with which the exposure is
associated.
• Proactive: never acquiring any interest in an exposure. Example, not
building a plant in a flood plain.
• Abandonment: avoid an existing loss. E.g. stop manufacturing a
highly toxic product, avoid third party liability by not owning a car,
Product liability can be avoided by dropping the product, Leasing
to avoid the risk of property ownership.
• Avoidance is impossible in the following situations
 For production/service whose expected value exceeds
losses
 Impossible to avoid properties like vehicles, building, inventory,
etc.
 Avoiding risk may create another risk.
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 It may not be practical or feasible to avoid the exposure.
Loss control Measures: LP &LR
• These measures refer to the safety actions taken by the firm to
prevent the chance occurrence of a loss or reduce its severity.
• Loss Prevention: used to reduce/eliminate the chance of loss.
Example: Construction using fire insensitive materials, fire alarms,
Burglar alarms, Location choice, Educational programs to the
public, inspection, Safety measures, Warning posters, etc.
• Loss reduction measures try to minimize the severity of the loss
once the peril happened. Examples: Installing automatic
sprinklers, First aid kit, Evacuation of people, Fire extinguishers,
etc.
• LP and LR measures must be considered before the Risk manager
considers the application of any risk financing measures.
• To design effective LP and R measures, it may be helpful to
identify the causes of accidents.
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Causes of accident and possible LP and R measures
Causes of accidents
- Working on dangerous
equipment with less care
- Improper use of equipment
- Violating Safety Procedures
and Regulations.
- Human error, Negligence
- Use of inappropriate tools
- Lack of protective clothing
- Use of defective equipment
- Inadequate Knowledge about
the job
- Working while physically ill
- Mental Disturbance of
employee
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Loss prevention measures
- Safety seminars, inspection at
regular times
- Training, safety seminars
- Safety seminars, warning, dismissal
- Training, safety seminars
- Provide appropriate tools
- Provide necessary protective
clothing
- Regular inspection and maintenance
- Training
- Sick leave, don’t allow to work until
recovery
- Day-off to the employee
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•
•
•
•
•
Risk Transfer
Accomplished in two ways;
Transfer of the activity or the property: For
example sells of buildings, hiring a subcontractor
for the portion of the project, etc.
It differs from avoidance through abandonment in
that, to transfer a risk the firm must pass it to
someone else.
Transfer of the probable loss. The risk, but not
the property or activity, may be transferred.
Hedging/neutralization: balancing the chance of
loss against gain.
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Separation and diversification
• Separation of the firm’s exposures to loss instead of
concentrating them at one location. For example, instead of
placing its entire inventory in one warehouse the firm may
elect to separate this exposure.
• Through this separation the firm increases the number of
independent exposure units under its control.
• Other things being equal, because of the law of large
number, this increase reduces the risk, thus improving the firm’s
ability to predict what its loss experience will be.
• Diversification: Businesses diversify their product lines so that
a decline in profit of one product could be compensated by
profits from others.
• Deals with most speculative risks and has limited use in
dealing with pure losses.
• For example farmers diversify their products by growing d/t
crops
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Risk Financing Tools
Retention
• The firm retains part or all of the losses that result
from a given loss exposure.
• Retention can be effectively used in a risk
management program when;
 No other method of treatment(insurance, transfer) is
available.
 The worst possible loss is not serious.
 Losses are highly predictable.
• Retention is passive(unplanned) and active(planned).
• Based on past experience, the risk manager can
estimate a probable range of frequency and severity
of actual losses. If most losses fall within that range,
they can be budgeted out of the firm's income.
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Insurance
• 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.
• Unlike the risk control transfer, the risk itself is not
shifted rather its assumed by somebody else.
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Risk Management Matrix
Which method should be used?
• In determining the appropriate method or
methods of for handling losses, a matrix can be
used that classifies loss exposures according to
frequency and severity.
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4. Implement the risk management program
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.
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