Risk Identification Measurement

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Risk Identification Measurement

© All Rights Reserved

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IDENTIFICATION AND

MEASUREMENT

Risk Management and Insurance

By Harrington & Niehaus

(Class 4)

AGENDA

Risk Identification

Identifying Business Risk Exposures

Identifying Individual Exposures

Statistics

Random Variables and Probability Distributions

Characteristics of Probability Distributions

Losses

Frequency, Severity, Expected Loss and

Standard Deviation

RISK IDENTIFICATION

The first step in the risk management process is

risk identification; the identification of loss

exposures.

There are various methods of identifying

business risk exposures, such as:

exposures from risk manager / consultant;

Analysis of the firms financial statements;

Discussion with the firms managers;

Surveys of employees etc.

RISK IDENTIFICATION

Valuation methods book value, market value, firm-specific

value, replacement cost.

Indirect losses business income exposures and extra expense

exposure.

Liability losses

Potential legal liability losses as a result of relationships with

many parties, such as suppliers, customers and members of the

public.

Losses in firm value due to worker injuries, disabilities, death and

retirement.

Outside of the firm, such as changes in the prices of inputs and

outputs, changes in exchange rates etc.

RISK IDENTIFICATION

One method of identifying individual / family

exposures is to analyze the sources and uses of

funds in the present and planned for the future.

Potential events that cause decreases in the

availability of funds or increases in uses of funds

represent risk exposures.

Important risks for most families are drop in

earnings prior to retirement due to death /

disability of breadwinner, physical and financial

assets, medical expenses, personal liability etc.

PROBABILITY AND STATISTICS

basic understanding of several concepts from

probability and statistics.

A random variable is a variable whose outcome

is uncertain.

Example: coin flip, variable X is defined to be

equal to $1 if heads appears and -$1 if tails

appears. Prior to the coin flip, the value of X is

unknown; that is, X is a random variable.

PROBABILITY AND STATISTICS

Information about a random variable can be

summarized by the random variables

probability distribution.

Probability distribution identifies all the possible

outcomes for the random variable and the

probability of the outcomes.

Sum of the probabilities must equal 1

There are 2 types of distributions:

Discrete;

Continuous.

PROBABILITY AND STATISTICS

distributions:

Numerical listing of outcomes and probabilities;

Graphically.

distributions:

Density function (not used in this course);

Graphically.

PROBABILITY AND STATISTICS

numerical listing where random variable =

damages from auto accidents.

Possible Outcomes for Damages Probability

$0

0.50

$500

0.30

$1,000

0.10

$5,000

0.06

$10,000

0.04

PROBABILITY AND STATISTICS

graphical where random variable = damages

from auto accidents.

PROBABILITY AND STATISTICS

where random variable = an automakers

profits.

PROBABILITY AND STATISTICS

important characteristic of density

functions:

Area under the entire curve equals one;

Area under the curve between two points

gives the probability of outcomes falling within

that given range;

We can graphically identify the probability

that profits are within certain interval.

PROBABILITY AND STATISTICS

In many applications, it is necessary to compare

probability distributions of different random

variables. Understanding how decisions affect

probability distributions will lead to better

decisions.

The problem is that most probability

distributions have many different outcomes and

are difficult to compare.

It is therefore common to compare certain key

characteristics of probability distributions.

PROBABILITY AND STATISTICS

Key characteristics of probability distributions:

Expected value of a probability distribution

provides info about where the outcomes tend

to occur, on average.

A distribution with a higher expected value will

tend to have a higher outcome, on average.

Formula to calculate the expected value = x1p1

+ x2p2 + + xMpM .

(x = denote as possible outcomes and p = denote as

probability)

PROBABILITY AND STATISTICS

Key characteristics of probability distributions:

PROBABILITY AND STATISTICS

Key characteristics of probability distributions:

The earlier figure illustrates 2 probability

distributions where distribution A has a higher

expected value than distribution B.

When distributions are symmetric (like this),

identifying the expected value is relatively easy;

it is the midpoint in the range of possible

outcomes and vise-versa.

Similarly, to distribution of losses, the

distribution is called a loss distribution and the

expected value is called the expected loss.

PROBABILITY AND STATISTICS

Key characteristics of probability distributions:

Variance measures the probable variation in

outcomes around the expected value.

If a distribution has low variance, then the

actual outcome is likely to be close to the

expected value and vise-versa. A high variance

therefore implies that outcomes are difficult to

predict.

Variance = (Standard Deviation)2

PROBABILITY AND STATISTICS

Key characteristics of probability distributions:

Standard deviation measure the likelihood that

and magnitude by which an outcome from the

probability distribution will deviate from the

expected value.

Standard deviation (variance) is higher when:

the outcomes have a greater deviation from

the expected value;

the probabilities of the extreme outcomes

increase.

PROBABILITY AND STATISTICS

Key characteristics of probability distributions:

Comparing standard deviation of 3 distributions

(distribution 1 has the lowest standard deviation and

distribution 3 has the highest):

Distribution 1

Outcome Prob.

$250

0.33

$500

0.34

$750

0.33

Distribution 2

Outcome Prob.

$0

0.33

$500

0.34

$1000 0.33

Distribution 3

Outcome Prob.

$0

0.4

$500

0.2

$1000 0.4

& 41 of Chapter 3

PROBABILITY AND STATISTICS

Key characteristics of probability distributions:

The below figure illustrates 2 distributions for accident

losses. Both have an expected value of $ 1,000, but they

differ in their standard deviations

PROBABILITY AND STATISTICS

Key characteristics of probability distributions:

Sample mean is the average value from a sample of

outcomes from a distribution.

Sample standard deviation reflects the variation in

outcomes of a particular sample from a distribution.

It is calculated with the same formula that we used

above for the standard deviation but with 3

differences:

Only the outcomes that occur in the sample are used;

Sample mean is used instead of the expected value;

Squared deviations between the outcomes and the sample

mean are multiplied by the proportion of times that the

particular outcome actually occurs in the sample.

PROBABILITY AND STATISTICS

Key characteristics of probability distributions:

Another statistical concept that is important in

the practice of risk mgt is the skewness of a

probability distribution. Skewness measures the

symmetry of the distribution.

If the distribution is symmetric, it has no

skewness and vise-versa.

Example of skewness can be seen in Figure 3.7

page 44 of Chapter 3

Most loss distributions exhibit skewness.

PROBABILITY AND STATISTICS

Key characteristics of probability distributions:

A frequently used measure of risk is maximum

probable loss or value-at-risk.

Maximum probable loss usually describes a loss

distribution, whereas value-at-risk describes the

probability distribution for the value of a

portfolio or the value of a firm subject to loss.

PROBABILITY AND STATISTICS

Key characteristics of probability distributions:

Correlation between random variables

measures how random variables are related.

Correlation = 0, random variables are not

related (independent / uncorrelated). Example:

correlation between steel prices and product

liability costs of an automaker.

In many cases, random variables will be

correlated. Example: correlation between

demand of new car and steel price.

PROBABILITY AND STATISTICS

Key characteristics of probability distributions:

Positive correlation implies that the random

variables tend to move in the same direction

e.g. stocks of different companies.

variables tend to move the opposite directions

e.g. sales of sunglasses and umbrellas on a given

day.

AND SEVERITY OF LOSSES

The frequency of loss measures the number of

losses in a given period of time.

The severity of loss measures the magnitude of

loss per occurrence.

Example:

1,500 injuries over the five-year period;

$3 million in total injury costs.

Frequency of injury per year = 1,500 / 50,000 = 0.03

Average severity of injury = $3m/ 1,500 = $2,000

Annual expected loss per employee = 0.03 x $2,000 = $60

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