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CHAPTER 3: RISK

IDENTIFICATION AND
MEASUREMENT
Risk Management and Insurance
By Harrington & Niehaus
(Class 4)

AGENDA

Risk Identification
Identifying Business Risk Exposures
Identifying Individual Exposures

Basic Concepts from Probability and


Statistics
Random Variables and Probability Distributions
Characteristics of Probability Distributions

Evaluating the Frequency and Severity of


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:

Comprehensive checklist of common business


exposures from risk manager / consultant;
Analysis of the firms financial statements;
Discussion with the firms managers;
Surveys of employees etc.

RISK IDENTIFICATION

Property loss exposures


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 to human resources


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

Losses from external economic forces


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.

BASIC CONCEPTS FROM


PROBABILITY AND STATISTICS

Risk assessment and measurement require a


basic understanding of several concepts from
probability and statistics.

Random variables and probability distributions


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.

BASIC CONCEPTS FROM


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.

BASIC CONCEPTS FROM


PROBABILITY AND STATISTICS

2 ways of presenting discrete


distributions:
Numerical listing of outcomes and probabilities;
Graphically.

2 ways of presenting continuous


distributions:
Density function (not used in this course);
Graphically.

BASIC CONCEPTS FROM


PROBABILITY AND STATISTICS

Example of a discrete probability distribution in


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

BASIC CONCEPTS FROM


PROBABILITY AND STATISTICS

Example of a discrete probability distribution in


graphical where random variable = damages
from auto accidents.

BASIC CONCEPTS FROM


PROBABILITY AND STATISTICS

Example of a continuous probability distribution


where random variable = an automakers
profits.

BASIC CONCEPTS FROM


PROBABILITY AND STATISTICS

In continuous probability distribution,


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.

BASIC CONCEPTS FROM


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.

BASIC CONCEPTS FROM


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)

BASIC CONCEPTS FROM


PROBABILITY AND STATISTICS
Key characteristics of probability distributions:

BASIC CONCEPTS FROM


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.

BASIC CONCEPTS FROM


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

BASIC CONCEPTS FROM


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.

BASIC CONCEPTS FROM


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

*Formula, calculation and further workings as per pages 40


& 41 of Chapter 3

BASIC CONCEPTS FROM


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

BASIC CONCEPTS FROM


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.

BASIC CONCEPTS FROM


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.

BASIC CONCEPTS FROM


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.

BASIC CONCEPTS FROM


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.

BASIC CONCEPTS FROM


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.

Negative correlation implies that the random


variables tend to move the opposite directions
e.g. sales of sunglasses and umbrellas on a given
day.

EVALUATING THE FREQUENCY


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:

10,000 employees in each of the past five years;


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