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PART I
RISK MANAGEMENT

C H A P T E R I I –T H E R I S K M A N A G E M E N T
PROCESS
Risk is danger and the environment of businesses today is becoming more complex. For example,
advanced technology has brought about very complex new products and huge concentrations of
values in a single product, such as the supersonic airplane disaster. Therefore, we should give
special attention to risk.

The complexity of the business environment calls for or demand for a special attention to a risk
The special task to
- Identify
- Analyze and
- Combat the operating risks are referred to as risk management.
Some of the factors, which increase the complexity of environment, are:
- Inflation
- Growth of internal operation
- More complex technology
- Increasing government regulation
Hence, most large organization and many smaller ones employ specialized personnel in the field to
deal with or to handle the problems of increased risk. These individuals who are responsible for
the entire program of risk management (of which insurance buying is only a part) are risk
managers or insurance managers. These terms (risk manager and insurance manager) are often
used interchangeably.

• Steps in the risk management process

o Identification
o measurement
o Potential Risk Treatments
ƒ Risk avoidance
ƒ Risk reduction
ƒ Risk retention
ƒ Risk transfer
o Create the plan
o Implementation
o Review and evaluation of the plan

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2.1. RISK MANAGEMENT DEFINED

What is risk management? Risk management is a systematic way of protecting business
resources and income against losses so that the organization’s aims are reached without
interruption, creating stability and contributing to profit.
Another form of defining risk management:
- Risk management is the identification, measurement and treatment of liability, property
and personal pure risks that the business organization is facing.
- It is the science that deals with the techniques of forecasting future losses so as to plan,
organize, direct and control the adverse effect of risk.
• i.e., Risk management is defined on the base of managerial functions.
- It is the reduction and prevention of the unfavorable effects of risk at minimum cost through
its identification, measurement and control.
- It is a discipline / a profession that systematically identifies and analyzes the various loss
exposures faced by a firm or an organization and employees and the best method of
treating the loss exposures consistence with the goals and objectives of the organization.

Generally, risk manager is concerned with the pure risk, but not speculative risk.

Risk management is broader than insurance management in that it deals with both insurable
and uninsurable risks. Insurance management for most part it is restricted to the area of
those risks that are considered to be insurable.

Risk management also differs from insurance management in philosophy. Insurance

management includes the use of techniques other than insurance (for example, non-insurance
or retention, as an alternative to insurance) but for must part is restricted to the area of those
risks that are considered to be insurable.

The emphasis in the risk management concept is on reducing the cost of safe- guarding
against risk by whatever means.

In the risk management philosophy, it is insurance that must be justified.

Functions of risk management

In general, the basic functions of the risk manager in carrying out of the responsibilities
assigned are:
1. To recognize exposure to loss.
- Is also called as risk identification

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- This is a fundamental duty that must proceed all other functions.

- Is the 1st step of risk managers’ function
- Is the most vital task
- Failure to identify exposure to loss==> the risk manager will not have any chance of
handling the loss that identifies the risk.
2. To estimate the frequency and size of loss, i.e., to estimate the probability of loss from
various sources.
• Is also called as risk measurement.
Risk measurement means
i. Determination of the chance of an occurrence or relative frequency.
ii. Determination of the impact of losses upon financial affairs.
iii. The ability to predict the losses that will actually occur during the budget year.

3. To decide the best and most economical method of handling the risk of loss.
i.e: Selection of the proper tool for handling risk
4. To administer the programs of risk management, including the tasks of constant
revaluation of the programs, recordkeeping and the like.
i.e., - Implementing the decision and
- Revaluating the decision
Example:
ƒ Insurance is one option. If insurance is decided
our property, proper coverage is important.
ƒ Obtaining reasonable rate
ƒ Selecting the insurer such as Ethiopian
Insurance Corporation, etc.

2.2. RISK IDENTIFICATION AND MEASUREMENT

2.2.1. Risk Identification

:It s the first step in the risk management process. Here, the risk manager tries to locate the areas
where losses could happen due to a wide range of perils. It would be very difficult to deal with the
risks faced by a firm unless they are properly identified.
In the identification process, the risk manager places more emphasis on pure risks.
It is the process of identifying potential loss confronting the firm.
It is a fundamental / basic duty that must proceed all other functions of risk management.
It is the 1st step of risk manages’ function.

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Example: Potential losses include

• Property loss
• Business- income loss
• Liability loss
• Death or loss of key people
• Job related injuries
• Fraud
• Criminal acts
Poor identification leads to unplanned retention. Unplanned retention cannot be the right decision
unless it becomes right by chance.
In order to identify the potential loss, the risk manager should have sources. Some of the
systematic approaches / tools used by risk managers to the problem of risk identification are:
i. Insurance policy checklists
ii. Risk analysis questionnaires
iii. Flow process charts
iv. Analysis of financial statements and
v. Inspections of the organization’s operations or On-sight inspection.
i. Insurance Policy Checklists
o The checklists are available from insurance companies and from publishers
specializing in insurance related publications. Here, the risk manager initially collects a
specimen of insurance policy forms from various insurers. He, then, proceeds to
prepare a checklist of various types of pure risk that can be dealt with insurance.
Through close examination of the policy forms, the risk manager can identify the non-
insurable risks and accordingly will consider other risk handling tools.
o Typically, such lists include a catalogue of the various policies or types of insurance
that a given business might need.
o The principal defect/limitation of this approach is that concentrates on insurable risks
only, ignoring the uninsurable pure risks.
ii. Risk Analysis Questionnaires
o It also called as “fact finders” because it leads the risk manager to the discovery of
risks through series of detailed and penetrating questions.
o In most instances, these questionnaires are designed to identify both insurable and
uninsurable types of risks.
o This questionnaire directs the risk manager to secure the operation and the properties
of that organization.

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iii. Flow Process Charts

Flow process charts show all the operations of the firm starting with raw materials, electricity /
power and other inputs at suppliers’ location and ending with finished products in the hands of
customers is constructed.

Secondly, the checklist of potential property, liability and personnel losses is applied to each
property and operations showing the flow charts to determine which loss the organization faces.
• i.e., - Draw flow charts starting from raw materials and ending to finished products
in the hands of customers.
- Identify the potential loss

Supplies delivered from Receiving Manufacturing

warehouse – 1 in firm’s room Storage process
truck

Delivery in own truck

To warehouse -2 Retailer
Packaging

Delivery by a common
Carriers to warehouse - 3
Retailer

Flow Chart – Manufacturing Plant

The most positive benefit of using flow charts is that they force the risk manager to become familiar
with the technical aspects / matters of the organization’s operation.
Example: how the goods move from one place to another, etc.
iv. Analysis of Financial Statements
Analysis of the organizations financial statements can also aid in the process of risk identification.
i.e.
- The asset listing in the balance sheet and
- The income and expense classification in the income statement.
v. On – sight inspection / Inspection/
- It is a must for the risk manager.
- The risk manager will have firsthand information through direct inspection
“One picture is worth of a thousand words.”≈ “Seeing is believing”

Therefore, risk can be identified on different approaches as stated from i-v.

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2.2.2. Risk Measurement

Once the risks have been identified, the risk manager must evaluate them. i.e. measuring the
potential size of the loss and the probability that it is likely to occur.

Risk measurement is required by the risk manager for two purposes:

i. To determine their relative importance and
ii. To obtain information that will help him to decide upon the most desirable combination of
risk management tools or methods.

In order to arrive these two points, what dimensions to be measured?

Dimensions to be measured
i. The loss frequency or the probability that losses will occur.
ii. The severity of the losses that occur and
iii. The degree of variation in the losses experienced from one budget period to the next.

The dimensions are needed. The relative importance of a type of potential loss depends upon the
loss frequency and the loss severity.
If two losses are characterized by the same severity, the loss whose frequency is greater should be
ranked higher. There is no formula for ordering the losses in order of importance and different.

2.3. RISK MEASUREMENT AND PROBABILITY DISTRIBUTION

2.3.1. Risk Measurement

Once the risk is identified the risks that the firm is facing, his next step would be the evaluation and
measurement of the risks. Risk measurement refers to the measurement of the potential loss as to
its size and the probability of occurrence.

Probability theory is important in decision making because it provides a mechanism for measuring,
expressing and analyzing the uncertainties associated with future events.

Probability is the likelihood of a certain occurrence.

Note: a. Probability values are always assigned on a scale 0 to 1.
- The probability of an event can be written as:
0 ≤ P (A) ≤ 1
b. A probability near “zero” indicates that the event is very unlikely to occur.
Example: If the probability of getting rain is 0.0001

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c. A probability near “1” indicates that the event is very likely or almost certain to
occur.
d. If the probability of an occurrence is “0”, there is no occurrence of an event.
e. If the probability of an occurrence is “1”, there is an occurrence of an event.

Decreasing likelihood of occurrence

Increasing likelihood of occurrence

0.5
Probabilities: 0 1

Impossible The occurrence of certain

the event is just as likely
as it is unlikely.
Event (Outcome):
In probability theory, an event is one or more of the possible outcomes of doing things.
Example: If we toss a coin, getting a tail / head would be an event.

Experiment:
-Is the activity / any process that produces well defined outcomes / events.
Example: If you toss a coin, you are doing an experiment.
Each performance of an experiment is called a trial.

Methods or Approaches of assigning probabilities to experimental outcomes

There are five possible ways of assigning probabilities for events: These include:
- The classical approach
- Relative Frequency Approach
- Subjective Approach
- Anchoring and
- The Delphi Technique

1. Classical Method
Classical probability is also called as prior probability because before the experimentation, the
probability of the outcome is known.

This approach of assigning probabilities assumes that the outcomes of an experiment are equally
likely to happen.

Equally likely outcomes have the same chance of occurrence.

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If an experiment has “n” possible equally likely outcomes, the classical method would assign a
probability of n to each experimental outcome.
N

Example:
1. If you toss / flip a coin once, the sample space and sample points are:
S = {H, T}
N = Total No of possible outcomes = 2,
n = the No of outcome in which the event occurs out of N outcome.
1 1
P( H ) = andP (T ) =
2 2
2. In the experiment of rolling a die,
S = {1, 2, 3, 4, 5, 6}
N=6
1 1 1 1 1 1
P(1) = P(2) = , P(3) = , P(4) = , P(5) = & P(6) =
6, 6 6 6 6 6
Note: In many business problems, the assumption of equally likely outcomes is not valid.

2. Relative Frequency Approach

- This method assigns probabilities to the experimental outcomes based on
experimentation or historical data.
- Prior assumption of equally likelihood is not involved.
- Probability is assigned to an outcome after the fact from observation and experimentation.
Example:
Suppose that 800 houses from 50,000 fire insured houses had a fire. What probabilities the
fire insurance companies would take as:

a) The probability of fire (f)?

b) The probability of no fire (nf)?
Solution:
800
a) P (f) = = 0.016
50,000
49,200
b) P (nf) = = 0.984 or 1 – P (f) = 1 – 0.016 = 0.984
50,000
3. Subjective Approach
In situations where the experimental outcomes are not equally likely and relative frequency data
are unavailable or irrelevant, we use the subjective approach method.

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It is judgmental and expresses a degree of belief. Therefore; it differs from person to person.

Some basic relationship of probabilities:

Example: the table below shows a classification of workers in a firm. The performance of each
worker has been rated by a supervisor as high (H), average (A) and low (L). Moreover, employees
have taken a job aptitude test and have been classified as qualified (Q) or fail (F). The total No of
workers is 400 of which 300 qualified and 100 failed on the test as classified by test results.
Classification by performance indicates that 190 were high, 120 were average and 90 low.

Total Result Performance

High (H) Average (A) Low (L) Total

Qualified (Q) 150 90 60 300

Fail (F) 40 30 30 100
Total 190 120 90 400

1. Simple Events
In this case, we consider the probability of the happening or not happening of a single event.
Required:
What is the probability that a randomly selected worker,
a. Is average in performance?
b. Is qualified on the test?
c. Has a high performance?
d. Is a low performer?
e. Has failed on the test?

Solution

a. P (A) = 120 = 0.30

400
Interpretation: the probability that a randomly selected worker average in performance is 30%.
300
b. P (Q) = = 0.75
400
190
b. P (H) = = 0.475
400
90
c. P (L) = = 0.225
400

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100
d. P (F) = = 0.25
400

Note: P (Q) +P (F) = 1

P (H) +P (L) + P (A) = 1

2. Mutually Exclusive Events

/ Disjoint events /

The events cannot happen together or simultaneously in a single trial.

- The events cannot happen together.
- I.e., when one event occurs, the other cannot occur.
For any two events X and Y if X and Y are mutually exclusive, then:

P (XY) = 0

Required:
a. What is the probability that a randomly selected worker both qualified and failed on the
test?
b. Both perform H&L?

Solution:
a. P (QF) = 0
b. P (HL) = 0
E.g.: - - A house may be caught on fire and not==> P = 0
- Tossing a coin==> P (HT) =0

3. Non – Exclusive Events / Joint Events /

- Two or more outcomes occur at the same time.

Required:
What is the probability that a randomly selected workers,
a. Has both failed on the test and is a high performer?
b. Has both qualified on the test and is a low performer?
c. Has both failed on the test and is a low performer?
Solution:
40
a. P(FH) = P(HF) = = 0 .1
400
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Interpretation:
The probability that a person fails the test but has a high performance is 10%.
60
b. P (QL) =
400
30
c. P (FL) =
400
Example: 2
Illustration:
1. A business has a fleet of 5 cars each of which is valued as $10,000,000.
2. Each car may be involved in more than one collision in a year.
3. The physical damage may be partial or total.
Also assume that prompt replacement of any car that goes out of service.

(1) (2)
Dollar less Probability
Per year of Loss
$ 0 0.606
500 0.273
1000 0.100
2000 0.015
5000 0.003
10,000 0.002
20,000 0.001
1.00

Required:
1. The probability that the business will suffer some dollar losses.

P (L) = 1 – P (NL) = 1- 0.606 = 0.39

Or: P (500) + ……+ P (20,000) = 0.39

2. The probability that “severe losses” will occur. Assume that $ 5,000 and above refer to severe
loss.
P (Severe Loss) = P (5000) +………. + P (20,000)
= 0. 003 + 0.002 + 0.001 = 0.006
3. The average loss per year.
Or: Mean loss per year or expected loss per year.
Average loss per year = ∑ np
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= $0 x 0.606 + $500 x 0.273 + $1000 x 0.100 +…..+$20,000 x 0.001= $ 321

n=dollar loss per year
p=Probability of loss
4. Risk or variation in the possible results:
[

Solution:
Variation can be measured by SD or variance or coefficient of variation.

™ Standard Deviation (SD) = Variance

= 799,888
= $ 894
SD
™ Coefficient of Variation = x100%
mean
894
= x100% =280% ==>the actual loss varies from the expected less by 280%
321

5. Risk relative to the maximum loss:

Solution:

(3) (4)
Value – mean: Value – mean) 2 (2) x (4)
$ 0 - $ 321 (- 321) 2 64,443
500 - 321 (179) 2 8,747
1000 - 321 (679) 2 46,104
2000 - 321 (1,679) 2 42,286
5000 - 321 (4,679) 2 65,679
10,000 - 321 (9,679) 2 187,366
20,000 - 321 (19,679) 2 387,263
Variance = 799,880

SD 894
Rmax = x100% = x100% = 4%
max .loss 20,000
i.e., the variation from that of the max loss is only 4%.

2.3.2. Probability Distributions

The risk manager, by using available data from past experience, tries to construct a probability
distribution of the number of events and/or the probability distribution of the total monetary losses.
This, would indeed, require knowledge of certain statistical techniques and concepts. The
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probability distribution of the number of events and /or total monetary losses would enable the risk
manager to estimate, among other things, the size of the possible monetary losses and the
corresponding probabilities of occurrence.
Three theoretical types of probability distributions that are particularly useful in estimating the
probability that a business will suffer a specified number of accidents during the next year are the
following:
Or:
The following types of probability distributions are used for measuring risk.
1. The Binomial probability distribution
2. The Normal probability distribution
3. The Poisson probability distribution

1. The Binomial Probability Distribution (BPD):

To use the Binomial probability distribution , the risk manager must be familiar with the basic
assumptions of the distribution to avoid misleading results.
Assumptions:
a. A firm or family has n units independently exposed to loss. i.e., a loss has no connection with the
other.
b. Each unit can experience at most one accident during the year.
c. The probability that any particular unit will suffer an accident during the year is ‘p’, thus the
probability that the firm or family will suffer ‘r’ accidents during the year is:

P(r) = n! pr (1 – p) n-r
r! (n-r)!

Let 1-p = q

P (r) = n! pr q n-r
r! (n-r)!

Illustration:
Suppose that a firm operates 5 delivery trucks. Assume that if an accident happens to a particular
truck, it become a total loss and assume further that 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 trucks. The experience of the firm over the past 5 years is:

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Year No of trucks No of Accidents Monetary Losses

1 5 2 $ 10,000
2 5 2 $10,000
3 5 1 $ 5,000
4 5 3 $15,000
5 5 2 $10,000
25 10 $50,000
Required:
a. The mean No of accident per year
10
= 2 Accident / year
5

b. What is the probability of an accident?

• The probability of an accident can be estimated as:
2
p= = 0.4
5
q = the probability that any particular unit will not suffer
a loss during a year.
q= 1-p = 1-0.4 = 0.6
c. Probability distribution of the No of accidents.
i. What is the probability of exactly 0 accidents?
ii. What is the probability of exactly 1 accident?
iii. What is the probability of exactly 2, 3, 4, and 5s?
Solution:
i. P (r) = n! p r q n-r
r! (n-r)!
P (0) = 5! x (0.4) 0 (0.6) 5 -0 = 5 x 1x(0.6) 5 = 0.07776
0! (5-0)! 0! 5!
ii. P(1) = 5! x 0.4 x 0.6 = 0.2592
1 5-1

1! (5-1)!
iii. P(3) = 0.2304 , P(4) = 0.0768
P(2) = 0.3456, , P(5) = 0.01024

d. The probability of more than 2 accidents?

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P (> 2 accidents) = P (3) + P (4) + P (5)

= 0.2304 + 0. 0768 + 0.01024 = 0.31744

e. The probability of at least 2 accidents.

P (at least 2) = P (2) + P (3) + P (4) + P (5)
f. The probability of at most 2 accidents.
P (≤ 2) = P (0) + P (1) + P (2)
g. The mean or the expected value of the accidents
A B AxB
No of accidents Probability Expected No of the accident
0 0.07776 0
1 0.2592 0.2592
2 0.3456 0.6912
3 0.2304 0.6912
4 0.0768 0.3072
5 0.01024 0.0512
Mean: 2.000
Or: mean = np = 5 x 0.4 =2
SD = npq = 5 x0.4 x0.6 = 1.2 =1.095

Or
D E
No of accident – mean (No of accident – mean) 2 B x E
0 –2 4 0.31104
1 –2 1 0.2592
2 -2 0 0
3 -2 1 0.2304
4 –2 4 0.3072
5 –2 9 0.09216
Variance = 1.2
h. Risk relative to the maximum N of exposure
o

SD
Rmax = =SD/n=1.095/5 =0.219=21.9% i.e: The variation from that of the max loss is 0.219.
MaxLoss

i. Risk relative to the mean

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SD SD npq 5 x 0 .4 x 0 .6
Rm = = = = = 0.5475 = 54.75% i.e: The variation from that of the mean s
mean np np 5 x 0 .4
is0.5475.

Exercise:
A firm that ships finished goods to customers faces the possibility of damage to the goods while in
transit if goods damaged while in shipment are considered totally loss and the probability of loss to
a single item is 0.1.When a group of two items is considered, calculate the probability of

1. 0 losses
2!
P (0) (0.1) 0 (0.9) 2 = 0.81
0!2!

2. Exactly 1 loss
2!
P (1) = (0.1)1 (0.9)1 = 0.18
1!1!

3. Exactly 2 losses
2!
P ( 2) = (0.1) 2 (0.9) 0 = 0.01
2!0!

¾ Formula for mean and SD of a Binomial distribution

The mean and the standard deviation of a Binomial probability distribution can also be
determined using the following formula:
Mean = m = np
SD = SQRT (npq) = npq

¾ Risk Measures

i. Risk relative to mean (Coefficient of variation)

==>When SD is expressed as a percentage of the expected (average or mean) loss
==>Coefficient of variation==>Risk relative to the mean
SD
Coef .ofVariatio n =
Mean

ii. Risk relative to the number of exposure units

SD
Rn =
n

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¾ Risk Vs the Law of Large Numbers

i. Risk relative to mean
SD SD npq
Rm = = = ==>R2m=npq/n2p2=q/np=1-p/np=1/n[(1-p)/p]
Mean np np

1 (1 − p )
Rm = ==>Rm decreases as n increases
n p
i.e: n↑==> Rm↓
n↓==> Rm↑

ii. Risk relative to the number of exposure units

==>Rn decreases as n increases
npq R 2 n npq p(1 − p)
Rn = ==> = 2 ==> Rn =
n n n
Rn

Rn=Rmax

0 0.5 1 P

Rn=Rmax When P=0.5

Rn= Rmin When P=0 and 1

Exercise:
i. How does the mean be affected if the number of the exposure unit is increased by a?
ii. How does the SD be affected if the number of the exposure unit is increased by a?
iii. How does the risk relative to the number of exposure unit be affected if the number of the
exposure unit is increased by a?

2. The Normal probability distribution/NPD/

The risk manager may assume that the number of accidents or total annual monetary losses is
approximately normally distributed. Under such circumstances, he may use the NPD in measuring
the number of accidents or the total annual monetary losses.
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If observations are normally distributed, the risk manager will have a good insight of the size of
possible losses at much greater ease. This is because the normal distribution can be well
explained by identifying only two parameters, the mean and the standard deviation.

m
The normal distribution is characterized by its shape. Its symmetry has led to it being described as
a bell-shaped type of curve. Besides having a nice "look", the symmetrical feature of the normal
distribution provides some benefits.

Normal Distribution or Normal Curve:

Normal distribution is probably one of the most important and widely used continuous distribution. It
is known as a normal random variable, and its probability distribution is called a normal distribution.
The following are the characteristics of the normal distribution:

Characteristics of the Normal Distribution:

1. It is bell shaped and is symmetrical about its mean.

2. It is asymptotic to the axis, i.e., it extends indefinitely in either direction from the mean.
3. It is a continuous distribution.
4. It is a family of curves, i.e., every unique pair of mean and standard deviation defines a different
normal distribution. Thus, the normal distribution is completely described by two parameters: mean
and standard deviation. See the following figure.
5. Total area under the curve sums to 1, i.e., the area of the distribution on each side of the mean
is 0.5.
6. It is unimodal, i.e., values mound up only in the center of the curve.
7. The probability that a random variable will have a value between any two points is equal to the
area under the curve between those points.

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Figure

Note that the integral calculus is used to find the area under the normal distribution curve.
However, this can be avoided by transforming all normal distribution to fit the standard normal
distribution. This conversion is done by rescaling the normal distribution axis from its true units
(time, weight, dollars, and...) to a standard measure called Z score or Z value. A Z score is the
number of standard deviations that a value, X, is away from the mean. If the value of X is greater
than the mean, the Z score is positive; if the value of X is less than the mean, the Z score is
negative. The Z score or equation is as follows:
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Z = (X - Mean) /Standard deviation

i.e: Any normal random variable X with mean (m or µ) and standard deviation () is
converted to the standard normal distribution by the following formula:

Where, X=value of the random variable

µ or m =Mean of the random variable

=the standard deviation of the random variable

Z=the standard normal random variable and can be interpreted as the number of
standard deviations that the normal random variable (X) is from its mean (µ)

Z = 0 whenχ = μ

Note: Different normal distributions have different means (µ or m) or SD ()

A standard Z table can be used to find probabilities for any normal curve problem that has been
converted to Z scores. For the table, refer to the text. The Z distribution is a normal distribution with
a mean of 0 and a standard deviation of 1.

The following steps are helpful when working with the normal curve problems:
1. Graph the normal distribution, and shade the area related to the probability you want to find.
2. Convert the boundaries of the shaded area from X values to the standard normal random
variable Z values using the Z formula above.
3. Use the standard Z table to find the probabilities or the areas related to the Z values in step 2.

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99.74%

95.45%
68.26%

X µ -3 µ -2 µ -1 µ µ +1 µ+2 µ +3

Z 0----------------------1

¾ The probability of loss that will fall within +1 standard deviation of the mean=68.26%.
i.e: µ + 1 SD=68.26%.

¾ The probability of loss that will fall within +2 standard deviation of the mean=95.45%
i.e: µ + 2 SD=95.45%

¾ The probability of loss that will fall within +3 standard deviation of the mean=99.74%
i.e: µ + 3 SD=99.74%

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Example:

1. A filling machine is set to pour 956 milliliters of wine into bottles. The amounts of fill are normal
distributed with a mean of 952ml and a standard deviation of 4ml.
Required:
a. What is the probability that a bottle contains between 952 and 956ml?
Solution:
µ=952ml and =4ml

P (0<Z<1)

X µ=952 956
Z 0 1

Note: At µ =X==> Z=0 Always

At X=952ml At X=956ml
X − μ 952 − 952 X − μ 956 − 952
Z= = =0 Z= = =1
δ 4 δ 4

Refer the above table

Z 0.00
P (0 to 1) = 1 0.3413

Therefore: P (0 to 1) =P (0<Z<1) = 0.3413

Interpretation:
There is 0.3413 probability that a bottle contains between 952 and 956 ml.
i.e:34.13% of filled bottles will contain between 952ml and 956ml.
Assume the company produced 100,000 filled bottles with wine. How many of these bottles do you
expect to contain between 952ml and 956ml.
(100,000)(0.3413)=34130 bottles
b. What percentage of filled bottles will contain between 948 and 956ml?

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Solution:
µ=952ml and =4ml
At X=948ml At X=956ml
X − μ 948 − 952 X − μ 956 − 952
Z= = = −1 Z= = =1
δ 4 δ 4
P (0 to -1) =0.3413 P (0 to 1) =0.3413

Therefore, P (-1 to 1) = P (0 to -1) + P (0 to 1) = 0.6826

P (-1<Z<0) P (0<Z<1)

X (ml) 948 µ=952 956

Z -1 0 1

c. What would be the lower and upper values of X in ml for an interval extending from 2 SDs below
the mean to 2SDs above the mean?
Solution:
µ+ 2
952+2(4) ==>Upper value of X=960ml
==>Lower value of X=944ml
d. What percentage of filled bottles will contain above 960ml?
Solution:
X=960ml, µ=952ml and =4ml==>Z=2

P (Z>2)

X (ml) µ=952 960

Z 0 2

P (0<Z < 2) =0.4772

P (Z > 2) = P (Z > 0) - P (0<Z < 2) =0.5-0.4772=0.0228

f. What percentage of filled bottles will contain below 960ml? Answer: P (2 to ∞) =0.9772

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g. What percentage of filled bottles will contain above 948ml? Answer: P (-1 to ∞) =0.8413

2. If the firm has 100 units which are independently exposed a certain loss. The probability of any
of these gets an accident is 1/10.What is the probability that the mean number of accident is
between 7 and 13?
Solution
1
p=1/10 n=100==> m = np = 100 x = 10
10
1 9
==> SD = npq = 100 x x =3
10 10

X −μ 7 − 10 X −μ 13 − 10
Z1 = = = −1 Z2 = = =1
δ 3 δ 3
P (-1<Z < 1) = P (-1<Z < 0) + P (0<Z < 1) =0.3413+0.3413=0.6826=68.26%

P (-1<Z<1)

X 7 10 13
Z -1 0 1

3. Assume that the chance of an occurrence of a loss is 1/10.What number of exposure units must
the risk manager possess for the probability to be 95.45% that the actual number of occurrence
will fall with in the range whose boundaries are the expected number of occurrence(the mean) +
10% ?
Solution
p=1/10 , n=?
Boundaries: + 10% mean

95.45%

X µ -10% µ µ +10%
Z

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SD
Rm =
m

10 1 1 1 9
xnp = 2 npq ==> xnx = 2 nx x ==> n = 3600
+ 10%µ=: + 2SD==> 100 10 10 10 10

4. If the desired probability is 95.45% that the actual number of occurrence will fall in the range
defined as the expected number of occurrence + 5%.What number of exposures should be
possessed by the business organization?
Solution:

95.45%

X µ -5% µ µ +5%
Z

5 5 1 1 9
xnp = 2 npq ==> xnx = 2 nx x ==> n = 14,400
5% mean=2SD==> 100 100 10 10 10

Exercise:
1.Assume that the chance of an occurrence is 1/10.What number of exposure units must the risk
manager posses for the probability to be 95.45% that the actual number of occurrence will fall
with in the range whose boundaries are the expected number of occurrence +60%?
2. If the chance of an occurrence is 4/10 and if the desired probability is 95.45% that the actual
number of occurrences will fall in the range is defined as the expected number of occurrence
+20%. What will be the number of exposures to be possessed by the risk manager? Answer: n=50

If the desired probability is only

a.68.27%
b.99.74%
What will be the number of exposures to be handled by the risk manager?
Answer: a. n≈38 , b. n=338

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5. A firm has 50 department stores scattered all over the country. The risk manager doesn’t know
the probability distribution of the total annual monetary loses from theft at all locations, but
estimates the average monetary lose per year to be $62,500 with a SD of $11,180.
a. If the risk manager assumes a normal probability distribution, what is the probability that
theft lose exceed $84,860?
b. If the firm increases its stores to 100, determine:
i. the new average monetary lose
ii. the new SD
iii. risk related to the mean
iii. What will be the limits of the confidence interval for loses included in 2SD?

Solution;
n=50, µ=$62,500, SD =$11,180.
a. P ( >$84,860)
X −μ 84,860 − 62,500
Z= = =2
δ 11,180
P (Z>2) =0.5-0.4772=2.28%
n 2 100 n
b. i. n 2 = 100, = = 2, μ 2 = μ1 2 = $125,000
n1 50 n1
n2 100
ii. SD2 = SD1 x = $11,180 x = $15810.91
n1 50
iii.
1
Rm 2 = Rm1 x = 12.65%
n2
n1
SD 2
Or : Rm 2 = = 12.65%
m2
µ+2SD is the confidence interval
µ+2SD=125000+2(15,810.9)
=125000+31,621.8==>125000-31,621.8< µ < 125000+31,621.8
==>93,378.2< µ < 156,621.80 (is the confidence interval)
The probability of
the confidence
interval

X 93,378.2 µ= 125000 156,621.80

Z -2 0 2

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3. The Poisson Probability Distribution/PPD/

The PPD is originated by Siméon Poisson is used to estimate the number of occurrences over a
specified interval of time or space.
: Is the most commonly used by insurance companies.
The Poisson distribution can be derived as a limiting form of the binomial distribution in which n is
increased without limit as the product m = np is kept constant.

The Poisson distribution can also be derived directly in a manner that shows how it can be used as
a model of real situations. In this sense, it stands alone and is independent of the binomial
distribution. * Siméon D. Poisson, (1781-1840).

The following examples show where the Poisson distribution is useful:

¾ The government wants to know whether seat belts reduce the number of death in car
accidents.
¾ number of category four hurricanes that will strike the east coast
¾ number of misprints in a book
¾ the number of customers arriving
¾ the number of activations of a geiger counter.
Assumption:
¾ There is no limit as to the occurrence of the accident.
I.e: the Poisson probability distribution allows for unlimited number of accidents occurring to the
object under consideration, (Car).This means that a particular car can possibly experience more
than one accident. This is normally the case in real life situation.

Before you attempt to describe a physical process by the Poisson distribution, you must
The only information that is crucial in constructing a Poisson probability distribution is the expected
number of accidents (the mean).Once the mean is determined, the probability of any number of
accident will be easily calculated using the following formula:

P(r) = mre-m
r!

Where,

P(r) = probability that event occurs

m = mean = expected frequency (Number)
r = number of events for which the probability estimated is needed Or: Number of occurrence
e = base of the natural logarithm = 2.71828

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It has one important advantage. Ie : Mean=Variance

A useful property for the Poisson is that the mean = variance.

Note: SD = Variance ==> SD = m , m=mean

m=Expected number of accidents=pn

STD=Standard Deviation=SQRT (m)

n=No of exposed units

p=the probability of a success on any one trial

q=1-p=the probability of a failure on any one trial

Example:

1. The following example is considered for illustrative purpose. 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

Year Number of Cars Number of accident Amount of loss

1 10 1 Birr 2500
2 12 2 4200
3 14 3 4500
4 15 3 6000
5 20 2 6500
6 20 3 6600
7 25 4 6000
8 25 5 8000
9 29 3 7500
10 30 4 10000
SUM 200 30 61800
MEAN 20 3 61800
SD 1.15 2115
Suppose in year 11 the number of cars owned by the firm increased to 40.
[[

Required:

a. How many accidents does the firm expect in the 11th year?
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Probability of accident=Total number of accident =30/200=0.15/car

Total number of cars

(Expected number accident) m=np=40x0.15=6 Accidents

b. What is the total monitory loss of these accidents? Refer question No.a

Total Monitory loss=$61800=Birr2060 Therefore, 6x$2060=Birr12,360

Number of accident 30

c. What is the probability that the firm will face exactly 3 accidents?

P(r) = mre-m ==> P(3) = 63e-6 =0.0892

r! 3!

d. What is the SD of the annual monetary loss?

SD of the annual monetary loss=Monitory loss x SD=2060x m =2060x 6 = Birr5045.95

No of accident

e. Risk relative to the mean

SD m 6
Rm = = = = 0.408248
m m 6

f. Risk relative to the maximum No of exposure units

SD m 6
Rmax = = = = 0.061237
n 40 40

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g. using the Poisson process, construct the probability distribution

Number of Accident Amount of loss Probability Expected No of Expected amount of loss

Accidents
(1) (2) (3) (2)x(3)
(1)x(3)
0 0 0.0025 0 0
1 2060 0.0149 0.0149 30.69
2 4120 0.0446 0.0892 183.75
3 6180 0.0892 0.2679 551.26
4 8240 0.1339 0.5356 1103.34
5 10300 0.1606 0.8030 1654.18
6 12360 0.1606 0.9636 1985.02
7 14420 0.1377 0.9639 1985.63
8 16480 0.1033 0.8264 1702.38
9 18540 0.0688 0.6192 1275.55
10 20600 0.0413 0.4130 850.78
11 22660 0.0225 0.2475 509.85

12 24720 0.0113 0.1356 279.34

13 26780 0.0052 0.0676 139.26

14 28840 0.0022 0.0308 63.45

15 30900 0.0009 0.0135 27.81

16 32960 0.0003 0.0048 9.89

17 35020 0.0001 0.0017 3.50

18 37080 0.0001 0.0018 3.71
SUM 1.0000 5.9997 12359.39

Remark: Monitory loss per accident=2060

Amount of loss=No of accidents x Monitory loss per accident

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h. What is the probability that there would be at least three accidents in the year?

P ( >3) = 1 − (0.0025 + 0.0149 + 0.0446 = 0.938

i. What is the probability that the number of accidents equal or exceed 13?

P ( >13) = 0.052 + 0.0022 + 0.0009 + 0.0003 + 0.0001 + 0.0001 + .... = 0.9292

Exercise:

j. What is the probability that the number of accidents between3 and 13?

2. Mr. X has 10 trucks to insure and on the average a total of 1 loss occurs each year. What is the
probability of more than 2 accidents in a year?

Solution:

n=10, p=1/10 and m=np=10x1/10=1

Required: P(>2) ?

P(r) = mre-m ==> P(0) =0.3679 ,P(1)=0.3679, and P(2)=0.1839

r!

P (>2) =1-[P (0) +P (1) +P (2)]= 0.0803

3. Suppose that you had 20 vehicles in your fleet. The probability of loss based on your historical
data = .1 and the E (loss) = mean = (.1)(20) = 2 losses

The table shows the probabilities associated with 0, 1, 2, and more than 2 losses.

1
Possible Losses Probability

0
2

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2 or more = 1-P(0 or 1 loss) = 1-.1353-.2706 = .5941

Required:

What is the probability of more than one loss?

P (more than 1 loss) = 1-.1353-.2706= .5491 which is the same probability of having 2 or more
losses.

2.4. TOOLS OF RISK MANAGEMENT

Once the risk manager has identified and measured the risks facing the firm, the next task is to
seek for appropriate tools and decide how best to handle them. Risk can be handled through the
following tools.
1. Avoidance
2. Retention
3. Loss prevention and reduction
4. Combination or increasing the No of units exposed to the loss
5. Separation / Diversification
6. Neutralization
7. Transfer

1. Avoidance

Risk avoidance

: Includes not performing an activity that could carry risk. An example would be not buying a
property or business in order to not take on the liability that comes with it. Another would be not
flying in order to not take the risk that the airplane where to be hijacked. Avoidance may seem
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the answer to all risks, but avoiding risks also means losing out on the potential gain that accepting
(retaining) the risk may have allowed. Not entering a business to avoid the risk of loss also avoids
the possibility of earning profits.

One way to handle a particular pure risk is to avoid the property, person or activity with which the
risk is associated.
- Two approaches of risk avoidance:
i. Abandonment of previously assumed activities
ii. Refusing to assume an activity

i. Refusing
Example:
For instance, a firm can avoid a flood loss by not building a plant in a flood plain.
• In case of refusing, we are discontinuing the activity

ii. Abandonment
Example: A firm that produces a highly toxic product may stop manufacturing that product.
• In case of abandonment, we may continue after some time.

Avoidance occurs when the individual or business removes himself / itself from exposure to a risk.
To illustrate,
- A business can avoid a product’s liability exposure by discontinuing the product.
- An individual can avoid the liability exposure resulting from owning a car by selling the car.
- Subcontracting part of a manufacturing, contracting or distribution task before the job is
accepted.
- To delay taking responsibility for goods during their transportation may enable a business to
avoid risks associated with that job.

Avoidance is a useful and common approach to the handling of risk. Often, however, it is
impossible or clearly empirical to use this approach.
For example:
- Most business would not be able to operate unless they either owned or rent a fleet of
cars.
- The potential benefits to be gained from employing certain persons, owning a piece of
property, or engaging in some activity may so far out weigh the potential losses and the
risks involved that the decision maker gives little consideration to avoiding the
associated risks.
- The major advantage of avoidance is that the chance of loss is reduced to zero if the
loss exposure is not acquired. In addition, if an existing loss exposure is abandoned, the
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possibility of loss is either eliminated or reduced because the activity or product that
could produce a loss has been abandoned.

Disadvantage of avoidance
i. It may not be possible to avoid all losses.
Example: - A company cannot avoid the premature death of a key executive.
- A business has to own vehicles, building, machinery, inventory; etc …
without them operations would become impossible.
ii. It may not be practical or feasible to avoid the exposure.
Example:-A paint factory can avoid losses arising from the production of paint. However,
with out any paint production, the firm will not be in business.

2. Retention
- It is the most common method of handling risk by the individual or the firm itself.
- When the individual or the business does not take positive action to avoid, reduce or transfer
the risk, the possibility of loss involved in that risk is retained.
- Bearing all the risk by that person/organization.
Risk retention

:Involves accepting the loss when it occurs. True self insurance falls in this category. Risk
retention is a viable strategy for small risks where the cost of insuring against the risk would be
greater over time than the total losses sustained. All risks that are not avoided or transferred are
retained by default. This includes risks that are so large or catastrophic that they either cannot be
insured against or the premiums would be infeasible. War is an example since most property and
risks are not insured against war, so the loss attributed by war is retained by the insured. Also any
amounts of potential loss (risk) over the amount insured is retained risk. This may also be
acceptable if the chance of a very large loss is small or if the cost to insure for greater coverage
amounts is so great it would hinder the goals of the organization too much.

Types of retention
a Planned/Couscous/ Active risk retention
- It characterized by the recognition that the risk exists, and a tacit agreement to assume the
losses involved.
- The decision to retain a risk actively is made because there are no alternatives more
attractive.
- Self-insurance is a special case of active retention
- Self-insurance is not insurance, because there is no transfer of the risk to an outsider.
Example: A firm may keep some money to retain the risk.
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Prerequisites of Active Retention

Active/planned retention should be considered only when at least one of the following conditions
exists:
a) It is impossible to transfer the risk to someone else or to prevent the loss from occurring
b) When the maximum possible loss is so small
-Thus, the firm can safely absorb it as a current operating expense or out of small
reserve funds.
c) When the chance of loss is so extremely low
d) The firm controls so many independent, fairly homogeneous exposure units that it can
predict fairly well what its loss experience will be.
- In other words, a retention program for this firm could properly be called ‘self-
insurance’.
- The firm can predict fairly well what its loss experience will be.

ii. Unplanned/Unconscious/ Passive Retention

- Passive risk retention takes place when the individual exposed to the risk does not recognize
its existence.
- In these cases, the person so exposed retains the financial consequence of the possible loss
without realizing that he does so.

3. Loss Prevention and Reduction Measures

Prevention is defined as a measure taken before the misfortune occurs.
- Generally speaking, loss prevention programs intend to reduce the chance of
occurrence.
Example:
- Constricting a building with a fire resistance material / fire proofing.
- Constructing a building in a place where there is little danger.
- Regularly inspecting the machine/area
- The existence of automatic loss detection programs.
™ Fire alarms
™ Warning posters /No Smoking!! And DANGER ZONE!!/……
- Loss reduction measures try to minimize the severity of the loss once the peril happened/ after
the event occurs.
For Example:
™ Automatic sprinkler
™ An immediate first aid
™ Medical care and rehabilitation service
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™ Guards
™ Cover
™ Fire extinguisher
™ Fire alarms
Risk reduction

: Involves methods that reduce the severity of the loss. Examples include sprinklers designed to
put out a fire to reduce the risk of loss by fire. This method may cause a greater loss by water
damage and therefore may not be suitable. Halon fire suppression systems may mitigate that risk,
but the cost may be prohibitive as a strategy.

Modern software development methodologies reduce risk by developing and delivering software
incrementally. Early methodologies suffered from the fact that they only delivered software in the
final phase of development; any problems encountered in earlier phases meant costly rework and
often jeopardized the whole project. By developing in increments, software projects can limit effort
wasted to a single increment. A current trend in software development, spearheaded by the
Extreme Programming community, is to reduce the size of increments to the smallest size
possible, sometimes as little as one week is allocated to an increment.

- Loss may be prevented or reduced in any of the following ways:

a Engineering Risks

- This approach of reducing loss/risk emphasizes on/by focusing on the mechanical

causes of accidents such as: defective wiring, improper disposal of waste
products, poorly designed high ways…
ii. Training of Personnel
- In addition to the process of regulating and elimination of the mechanical failures
the machine or equipment need to be operated by qualified personnel to eliminate
or reduce the loss of due to human failures.
- Workers should be acquainted with the machines they are to operate through an
adequate training to reduce losses.
iii. Diversification
- Losses may be reduced by distributing the loss to various types of exposure units
possessed may reduce losses.
- Relying on a single product or process or line of activity is hazardous. Example:
Farmers have learnt from experience the need for having more type of crops to
reduce the loss emanating from focusing in any single crop.

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4. Separation /Diversification
- 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.
- Separation==>Dispersion/Scattering the exposure in different places.
The principle is “Don’t put all your eggs in one basket”
Example: -Instead of placing its entire inventory in one warehouse, the firm may
elect to separate this exposure by placing equal parts of the inventory in
ten widely separated warehouses.
- Crop rotation
- It is considered as a loss reduction measure.
This separation of exposures reduces the maximum probable loss to one event; it may be
regarded as a form of loss reduction.

5.Combination
- It is a pooling or combination process.
- Risks are pooled when the number of independent exposure units under observation is
increased.
- Unlike separation, which spreads a specified number of exposure units, combination
increases the No of exposure units under the control of the firm.
- In the case of firms, combination results in the pooling of resources of two or more firms. The
new firm has more building, more automobiles, and more employees than either of the
original companies. This leads to financial strength, thereby minimizing the adverse effect of
the potential loss.
- Combination of pure risks is not generally the major reason why a firm expands its
operations, but this combination may be an important by- product or merger or growth.
- Insurers, on the other hand, combine pure risks purposefully; they insure a large No of
persons in order to improve their ability to predict their losses.

6. Neutralization
- Neutralization, which is very closely related to transfer.
- It is the process of balancing a chance of loss against a chance of gain.
Example: An excellent example is the process of hedging. Hedging is the process of making
commitments on both sides of transaction in such a way the risks compensate each other.

7.Transfer
- It is also called as shifting method.
- When a business organization cannot afford to cover the loss by itself, it may look
for/transfer to other institutions.
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- Transfer or risk may be accomplished in two ways.

a Transfer of the activity or the property.
- The property or activity responsible for the risks may be transferred to some
other person or group of persons.
Example: -A firm that sells one of its buildings transfers the risks associated
with ownership of the building to the new owner.
-Hiring a subcontract for the portion of the project.
- This type of transfer is closely related to avoidance. The difference is that to
transfer a risk, a firm must already posses it and wants to pass it to someone
else.
b. Transfer of the probable loss
- I.e. the risk, but not the property or activity, may be transferred.
Example: Under a lease, the tenant may be able to shift to the land lord. Any
responsibility the tenant may have for damage to the landlord’s
premises caused by the tenant’s negligence.

Transfers of risk may be grouped in two classifications.

i. Transfer to an insurance company/Insurer
ii. Transfer to parties other than insurance company.

o Insurance is a means of shifting or transferring risk.

Risk transfer

:Means causing another party to accept the risk, typically by contract or by hedging. Insurance
is one type of risk transfer that uses contracts. Other times it may involve contract language that
transfers a risk to another party without the payment of an insurance premium. Liability among
construction or other contractors is very often transferred this way. On the other hand, taking
offsetting positions in derivatives is typically how firms use hedging to financially manage risk.

Some ways of managing risk fall into multiple categories. Risk retention pools are technically
retaining the risk for the group, but spreading it over the whole group involves transfer among
individual members of the group. This is different from traditional insurance, in that no premium is
exchanged between members of the group up front, but instead losses are assessed to all
members of the group.

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2.5. SELECTION OF RISK MANAGEMENT TOOLS

This section will discuss a few of the more important considerations that enter into the selection of
the technique to be used in handling a particular risk.

Rules of Risk Management

These guidelines for risk management decision-making are quite simple common-sense principles
applied to the pure risk situation. Mehr and Hedges propose the following three basic rules of risk
management:
i. Don’t risk more than you can afford to lose
ii. Consider the odds
iii. Don’t risk a lot for a little
Consider the odds. If the risk managers can determine the probability that a loss may take place,
he is in a better position to deal with the risk than would be the case without such information; but
is impossible to attach undue significance to such probabilities. The probability of a loss occurring
is less important to the risk manager than the financial consequences if it does happen. Even if the
risk manager knows that the probability of loss from a given exposure is remote, the decision must
still be based on its possible severity. If the risk carries a possible catastrophic loss, the fact that
the probability is small is of little significance.

In determining the appropriate method or methods for handling losses, a matrix can be used that
classifies loss exposures according to frequency and severity. The following matrix can determine
which risk management be used.

Loss Frequency Loss Severity Appropriate risk

Management technique
Low Low Retention
High Low Retention & Reduction
Low High Insurance
High High Avoidance

- 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.

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2.6. CREATE THE PLAN

Decide on the combination of methods to be used for each risk. Each risk management decision
should be recorded and approved by the appropriate level of management. For example, a risk
concerning the image of the organization should have top management decision behind it whereas
IT management would have the authority to decide on computer virus risks.

The risk management plan should propose applicable and effective security controls for managing
the risks. For example, an observed high risk of computer viruses could be mitigated by acquiring
and implementing anti virus software. A good risk management plan should contain a schedule for
control implementation and responsible persons for those actions. The risk management concept is
old but is still not very effectively measured.

2.7. IMPLEMENTATION

Follow all of the planned methods for mitigating the effect of the risks. Purchase insurance policies
for the risks that have been decided to be transferred to an insurer, avoid all risks that can be
avoided without sacrificing the entity's goals, reduce others, and retain the rest.

2.8. REVIEW AND EVALUATION OF THE PLAN

Initial risk management plans will never be perfect. Practice, experience, and actual loss results will
necessitate changes in the plan and contribute information to allow possible different decisions to
be made in dealing with the risks being faced.

Risk analysis results and management plans should be updated periodically. There are two
primary reasons for this:

1. to evaluate whether the previously selected security controls are still applicable and
effective, and
2. to evaluate the possible risk level changes in the business environment. For example,
information risks are a good example of rapidly changing business environment.

2.9. LIMITATIONS

If risks are improperly assessed and prioritized, time can be wasted in dealing with risk of losses
that are not likely to occur. Spending too much time assessing and managing unlikely risks can
divert resources that could be used more profitably. Unlikely events do occur but if the risk is

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unlikely enough to occur it may be better to simply retain the risk and deal with the result if the loss
does in fact occur.

Prioritizing too highly the Risk management processes could keep an organization from ever
completing a project or even getting started. This is especially true if other work is suspended until
the risk management process is considered complete.

It is also important to keep in mind the distinction between risk and uncertainty. Risk can be
measured by Impacts x Probability.

Frequently Asked Questions about Risk Management

1. What is all-risk coverage?

Coverage is provided for direct loss by those perils which are not specifically excluded by the policy.

2. What types of perils (causes of loss) are not covered?

Such perils include loss or damage caused by dishonest acts, unexplained disappearance,
inventory shortage, wear and tear, mechanical breakdown, rust or corrosion, latent defect, settling
or cracking of any part of a building, artificially generated electric currents which damage electrical
devices (except electronic data processing systems), insects, birds animals, freezing (ensuing
water damage may be covered), sewage backup, faulty workmanship, terrorism, cyber risks
(computer viruses), mold, and asbestos.

3. What differentiates an Independent Risk Management/Insurance Consultant from other so-called

"consultants"?

Independent Risk Management/Insurance Consultants do not sell insurance, nor are they affiliated
or associated with firms or individuals that do. Independent Consultants never work on a
commission basis, and do not accept money or gifts from brokers, agents or insurance carriers.
They work on a fee for service basis only and their recommendations are never clouded by the
potential gain or loss of commission income.

4. What kind of work does a Risk Management/Insurance Consultant perform?

Risk Management/Insurance Consultants can be called upon to perform a wide variety of tasks.
Risk Management or Insurance Evaluations or Audits are among the most prevalent kinds of work.
Risk Management Evaluations generally involve a review of insurable loss exposures, the
adequacy of insurance protection, the extent of risk retention, the effectiveness of contractual risk
transfers, and the effectiveness of the risk management function within the organization whereas
Insurance Evaluations focus primarily on the insurance protection and pricing.
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When consultants conclude that their client's insurance policies do not afford the necessary
coverage and/or the pricing is high for the scope of coverage afforded the consultant may
recommend taking the insurance program out for a competitive marketing. The consultant would
then design insurance specifications, interview potential participants, supervise the process, review
the proposals and make recommendations to the client of the most effective insurance program.
The consultant's job does not end there either. The consultant must make sure that when the
policies redelivered, they contain all of the protection that was promised during the proposal
process. This is accomplished by performing a review of the ultimately issued policies.

Consultants are often retained for other special projects on an ``as needed" basis. Such projects
can include alternative risk financing studies, assistance with mergers and acquisitions, cost of risk
allocations and renewal negotiations.

Some consultants are also available to provide continuing service as your part-time insurance/risk
management department. This service is often provided to firms where, for example, the CFO
cannot devote sufficient time to risk management issues, yet the cost of staffing a risk
management department is impractical.

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RISK MANAGEMENT AND INSURANCE

CHAPTER II
ASSIGNMENT

1) Suppose that TANA TRANSPORT SHARE COMPANY operates 8 delivery trucks. Assume that
if an accident happens to a particular truck, it becomes a total loss. And assume further that new
trucks are purchased at the beginning of every year to replace the lost one.

Form the past six years experience of the company, the following information is gathered, being
the value of a truck $10,000.
Year No of Accidents
1 3
2 4
3 2
4 4
5 3
6 2

Given this information construct a binomial distribution of

a) The probability distribution of the number of accidents
b) The probability distribution of the total monetary loss per accident
c) The probability of incurring some losses
d) Compute the probability that the total losses would exceed $50,000.
e) Risk relative to the maximum possible monetary loss.
f) Risk relative to the mean

2) Consider the following information:

Potential Loss Probability
0 0.05
3000 0.15
7000 0.24
15000 0.38
25000 0.16
40000 0.02
Required:
a) What is the probability that the business will face Birr 15000 loss or less?
b) What is the probability that the business will have some amount of loss?

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