Fatema Afreen

Department of Business Administration

Finance Discipline, Premier University.

CHAPTER- THREE
RISK IDENTIFICATION and MEASUREMENT

Chapter Outline

 Risk identification

 Identification of risk exposures

 Risk identification methodologies

 Risk identification tools

 Risk management and probability distribution

 Frequency of loss and severity of loss

 Expected loss

 Expected value
 Fatema Afreen
Department of Business Administration
Finance Discipline, Premier University.

RISK IDENTIFICATION:
Risk identification is the process of determining risks that could potentially prevent the
program, enterprise or investment from achieving its objectives.

IDENTIFICATION OF RISK EXPOSURES:

1. Identifying Business Risk Exposures

2. Identifying Individual Exposures

1. Identifying Business Risk Exposures:

a) Property loss exposures

b) Liability losses

c) Losses to human resources

d) Losses from external economic forces

a) Property loss exposures:

A condition that presents the possibility that a person or an organization will sustain a
loss resulting from damage (including destruction, taking, or loss of use) to property in
which that person or organization has a financial interest.

b) Liability losses:

Liability can occur when an individual or an organization is held legally responsible for
the injury or damage suffered by another person or organization. The possibility of
being sued is a liability loss exposure.

c) Losses to human resources:

Losses in firm value due to worker injuries, disabilities, death, retirement , are known
as losses to human resources.
 Fatema Afreen
Department of Business Administration
Finance Discipline, Premier University.
d) Losses from external economic forces:

This form of losses arises because of changes in the prices of inputs and outputs from
the factors that are outside the firm.

2. Identifying Individual Exposures:

 Earnings

 Physical assets

 Financial assets

 Medical expenses

 Longevity

 Liability

RISK IDENTIFICATION METHODOLOGIES:

 Traditional Approach:

…. observe past events that caused losses and then find out measures to prevent their
occurrence.

 Modern Approach:

…. identify the possibility of losses or reasons for the occurrence of the losses before
the losses actually occur.
 Fatema Afreen
Department of Business Administration
Finance Discipline, Premier University.

RISK IDENTIFICATION TOOLS:

1. The Financial Statement Method

2. The Flow- Chart Method

3. On- Site Inspections

4. Interactions With Other Departments

5. Contract Analysis

6. Statistical Records of Losses

7. Incident Reports

1. The Financial Statement Method:

 reflect the firm’s real assets, liability, financial budget, etc.

 risk managers can assess the risk by assessing the firm’s financial situation.

2. The Flow- Chart Method:

 investigating the firm’s business and its internal operation

 assess the firm bears what type of risk

 looking for the flowcharts and using risk analysis questionnaire.

3. On- Site Inspections:

 by observing the firm’s facilities and operation directly.

4. Interactions With Other Departments:

 the risk manager keeps continuous contact with the managers from other
department.

 obtain information about the source of risk in other department.

 Fatema Afreen
Department of Business Administration
Finance Discipline, Premier University.
5. Contract Analysis:

 looking into the contract the firm entered into

 assess the firm’s obligation and liability.

6. Statistical Records of Losses:

 looking for the records of losses

 find out the reasons for the occurrence of the loss, the nature of the risk, the
degree to which the firm is being affected, etc.

7. Incident Reports:

 report daily losses and casualties

 obtain information about the whole events that caused the losses.

RISK MANAGEMENT & PROBABILITY DISTRIBUTION:

 Ideally, a risk manager would have information about the probability distribution
of losses

 Then assess how different risk management approaches would change the
distribution

 Summery measures of probability distributions:

• frequency

• severity

• expected loss

 standard deviation
 Fatema Afreen
Department of Business Administration
Finance Discipline, Premier University.

FREQUENCY OF LOSS & SEVERITY OF LOSS:

Frequency of loss measures the number of losses in a given period of time.

Severity of loss measures the magnitude of loss per occurrence.

EXPECTED LOSS:
When the frequency and severity of losses is uncorrelated with each other then:

Expected Loss = Frequency * Severity

EXAMPLE:

 50,000 employees in each of the past 5 years

 1,500 injuries over the 5 year period

 $ 3 million in total injury cost

So,

 Frequency of injury per year

= 1,500/50,000 = 0.03

 Average severity of injury

= $ 3 million/1,500 = $2,000

 Annual expected loss per employee

= 0.03 * $ 2,000 = $ 60
 Fatema Afreen
Department of Business Administration
Finance Discipline, Premier University.

EXPECTED VALUE:
The expected value of a probability distribution is the weighted average of the possible
outcomes where the weights are the probabilities.
 Fatema Afreen
Department of Business Administration
Finance Discipline, Premier University.
 Fatema Afreen
Department of Business Administration
Finance Discipline, Premier University.