- --- RIJk M41wigmiAt: AJsasmmt and Transfer II 237

objective risk is handled by insurance companies. The relevancy of measuring risk has been exhibited in
figure Z. I. An ex.planation of this proceae Involves three Important concepts that are chance of loss,
degree of risk, and the law of large numbers, related to the meuurcmcnt of objective risk are discussed
in following part of this section.
~
Risk Mana geme nt:
Assessment and Trans fer
After studying this chapter, you should be able to understand :
► Measurement of Risk ► Law of Large Numbers
► Risk Management ► Process of Risk Management
► Risk Mapping ► Risk Retention
► Risk Transfer
15.1 MEASUREMENT OF RISK
In the preceding chapter we have studied the concept of risk, its forms, and sources. Once risk sources
are identified, it is generally helpful to measure the extent of the risk that exists in particular economic
transaction or otherwise. We have studied various types of risks in the previous chapter, and it is well
understood that risk. especially under behavior form, varies with state of mind of the person. Thus it is
a subjective term and cannot be accurately measured. It's variation does not wholly depends upon the
perception of the person exposed to risk, besides the probability of occurrence of risk also varies due to
prevailing circumstances, and past experiences which tends to make risk more subjective. However, the
subjectivity on part of measurement of risk has less or no role in measurement of risk.
The risk computed accurately up to maximum extent possible with the help of robust statistical
techniques is taken as objective risk and often more readily observable. It is to keep in mind that
die objectively measurable risks are insurable. Therefore, form the point of view of insurance, only
.,
Change o f ~ Degree of Rilk
Law of large Number
Ar,ruracy of
Occurrence of Risk
Adequate Insurance
Cover is Possible
Figure 15.1: Relevance of Measurement of Risk
A. Chance of Loss
The term chance of loss also called as probability or likelihood. As discussed in the previous chapter,
chance of loss is one of the important features of risk. The chance of loss can be defined as the probable
number of losses out of a given number of loss exposures. This concept is widely used by insurance
companies to measure the chance of occurrence of loss actually against mere subjectivity of risk. The
probability of an event is simply the long-run relative frequency of the event, given an infinite number
of trials with no changes in the underlying conditions. In its simplest form, probability of occurrence of
any event can be measured on a flip of a coin, there would be 50 percent chance of happening of an event
and equal chance of non-happening of such event, for example, occurrence of accident on road, collision
of any car, set of fire etc.
It is important to note that use of probability in measuring risks is advantageous as this technique
is based on two important statistical measures viz., central tendency and dispersion. In practice, the
insurance companies use probability in its various versions, like, binominal, poisson, and exponential
distribution.
Insurance companies usually estimate chance of loss on the basis of what has happened in th
past. Because it is important that their estimates be as accurate as possible, the companies accum
huge amounts of data on the exposures they insure. The probability is also useful in setting insuran,
premiums and paying of insurance claims. The function of probability is stated as follow.
Exn
P=-
N
 238 11 Essentials ofBanking and Insurance Risk Management: Assessment and Transfer II 239
Where, Table 15.1: Data on Collision of Car of Company A and B
P = the probability of occurrence of any loss, Company/ ~:~:J; . . • , ••,·•·. .
Year l009..10
Ex,, = the expected number or actual number oflosses, 201e-11 2fll-~ ~~-~ ·'¥. -::-: .
N = total number exposed to loss.
For example, if an insurance company covered 2000 persons under accide~tal insuranc~ ~olicy in
150
Company A
CompanyB
4
10
6 - 5
~U.:,~,
4
a metropolitan city. It is expected in the last five years that on an average there is
15
causalities occur L3 Io Is I 7 j 25 j s
annually. Therefore, the probability of occurrence of an accidental risk is 0.075 (p .= 0/2000). It is the The chance of loss for both companies would be 0.05 (5/100) or 5%. lt means to say, company A will
possibility or the chance ofloss that creates the need for insurance. If there were either no possibility of have chance_ ofloss of 5 cars in the year 2014 _15, the likelihood remain same for company Bas well But
Joss or if losses were certain to occur, insurance would not exist. If the first instance, there would be no company B IS _much worried about collision to oceur in next year as its range of collision ~ ~ O~
need for it. In the second there would be no element of uncertainty about losses, and the result would be 10 in co~parison of company A which chance ofloss ranges from 4 to 6 and expected loss I S ~ ~
expense rather than Joss. expectation. Therefore, company A suspects no degree of risk as the chance ofloss is probable and within
its limit. But company B has degree of risk.
8. Degree of Risk
Degree of risk is the extent of uncertainty about future losses. One should be careful while measuring
(. low of Lorge Number
risk and should not confuse chance of Joss with degree of risk. It is the extent of uncertainty to which Law of large number is a dimension of statistics to improve the results of probability distribution as well
losses are unpredictable. !flosses are predictable quite accurately, there is a small degree of risk regardless as other statistical techniques. The concept entails large number of actual data or past experiences to
of what the chances of loss may be. For instance, if losses are certain not to happen (i.e., chance of loss obtain more accurate results on risk. Like, above discussed that on flipping of a coin, there would be equal
is zero), the degree of risk is zero because there is no uncertainty. But notice that if it is certain that a chance of getting head or tail, or risk or no risk. But if the frequency of flipping of coin increases results
particular number of losses will happen, the degree of risk again is zero because there is no uncertainty would not necessarily be equal of head and tail. Similarly, if the frequency of above said car companies
in this situation either. The chance of Joss differs in these two cases, but the degree of risk is the same. It is increased from five to ten years or more then results may differ. In statistics, the law of large number
the same because in both situations the outcome is known in advance, meaning there is no uncertainty. is recognized as increase in sample space. Sample space is the mathematical result of total number of
In other words, till the determined chance of loss remains within a range of measure of dispersion possible outcome in a given circumstances. For example, ifyou have a dice with six sides bearing number
there would be no uncertainty. But movement any event lays down beyond the given range there will be on them, then the possibility of occurring six marks would be 1/6 as there is only single six digit on it,
a degree of risk. It could be better understood with the help of diagram presented in Figure 15.2 similar situation will happen for other numbers. But if you have two dice then chance of getting four
y
marks would be more as shown below in Table 15.2.
Degree of Risk Table 15.2: Law ofLarge Number: Sample Space of Two Dices
·#::://:'::--- Average Change of Risk
I '
.,
.><
a: ~,:i}
.::;::: .:::;. RangeofChangeofRisk
1,1 1,2 1,3

Dkel
1,4
-~
.. ~----:· _,:a:~~--~ . : -: . ._
•-
w
·~ ~
1,6
·._:.
~ 2,1, 2,2 2,3 0 2,5 2,6
I CE]
Probability of Risk X 3,1 3,4 3,5 3,6
3,2
Dice2
Figure 15.2: Degree of Risk
To understand the concept of degree of risk, let's take an illustration of transport industry. There
4,1 [£] I 4,3 I 4,4 4,5 4,6
are two companies, say company A and company B, providing car-cab services. Both companies
have 100 cars each. They want to get insurance of car running on roads against the risk of collision. ~ 5,2 I 5,3 I 5,4 5,5 5,6
Both companies recorded their past data on collision of last five years as presented in Table 15.l on - -
6,1 I 6,2 6,5 6,6
llatpage. I 6,3 I 6,4 I
 240 11 Essentials ofBanking and Insuran,~ Risk Management: Assessment and Transfer 11 241
t , Risk management· f . 'al• 'dical
So, the possibility of occurrence of six marks would be 5/.\6. Now ii could be underS ood that how d ul to all types of persons ranging from natural to arti6c1 Jun
person, sueh as ,indi•s •use
th 1
the likelihood ofloss changes with the increase in total or actual exposures. In summary, e two tnost
. organi7.ations, companies etc.
Risk management dv, Iua s,. hnon-profit
important applications of the law oflarge numbers in relation to objective risks are as follows: • ea s W1t pure nsk, whether they are insurable or not.
st
1. As the number of exposure units increases, the degree of risk decreases. 'Jhe udy of risk management has been evolved In 1960s. The corporations use this technique in
2. Given a constant number of exposure units, as the chance of loss increases, the degree of risk different w~y as compare to _old ,time. In earlier time, the purpose of risk manag~ment was r~~cted to
decreases. administering the corporatt?ns msurance program, malting sure that all the insur~ce policies were
roperlY prepared and covering expected loss. In contrast, in modern time, corporate nsk managers use
I5.2 RISKS MANAGEMENT P
insurance only as last resort, now they do not presume insurance to be the best method.
After studying various types of risks their sources and measurement, a decision can be made as to how l 5.3 PROCESS OF RISK MANAGEMENT
the risk should be handled. Once an individual or business entity or society is exposed to risk, there is
need to manage the risk by suitable techniques. The management of risk is a process with the objective 0~ f.S defined above, risk ma~age'.11ent is a process. Risk management activities occur before, during,
identifying risk exposures faced by them with a view to selecting the best available technique for treatin d after losses. Most plannmg 1s done before losses occur. Losses involving natural disaster and other
such exposures. The focus on risk management has undergone significant change over time. There hag an ergencies also require action while losses are happening. After the loss, the risk manager must file
been a change in regard to concern with gravity of risk. The corporate have become far less concernel :urance claims and analyze loss patterns. The whole process of risk management has been produced
with traditional high frequency, low severity risks but have started devoting greater attention to risks below in Figure 15.3.
that could lead to corporate collapse or bankruptcy. To understand the notion of risk management l ,
understand through following definitions. ' et s Detenninatlon of Risk Management
Definition Identification of Potential Loss Expsoures
"1he process used to systematically manage risk exposure is known as risk management."
-James S. Trieschmann, Robert E. Hoyt, and David W. Sommer Evaluation of Loss Exposures
"Risk management is a scientific approach to dealing with pure risks by anticipating possible accidental
losses and designing and implementing procedures that minimize the occurrence of loss or the financial Selection of Appropriate Techniques
impact of the losses that do occur." for Treating the Loss Exposures
-Emmett J. Vaughan, and Therese Vaughan
"Risk management is the logical development and execution of a plan to deal with potential losses.
Risk Financing
1he focus ofa risk management program is to manage an organization's exposure to accidental losses and Risk Control
to protect its assets. Risk management benefits all types of organizations facing potential losses, including
business firms, non-profit organizations, individuals, and families." -Mark S. Dorfman
"Risk management is the systematic and efficient handling of pure risks. It deals with all pure risks, Avoidance I \ Loss Control Retention I Risk Transfer
whether they are insurable or not, and uses whatever risk handling methods are most appropriate whether
they include insurance or not." -Frederic G. Crane
"Risk management is a process that identifies loss exposures faced by an organization and selects the
-George E. Rejda
I Loss Prevention I \ Loss Reduction Non-Insurance
Transfers
Commercial
Insurance
most appropriate techniques for treating such exposures."
Following characteristics may be drawn from the above definitions.
• Risk management is a systematic study of exposures.
Implementation and Administration the Program
• Risk management deals with pure risk only and not with speculative risk.
• Under risk management various scientific approaches are used to anticipate possible losses and
to minimize their financial impact.
I Evaluation and Review I
Figure 15.3: Steps Involved in Risk Management Process
 242 II Essentials ofBanking and Insurance - -----..
----In addition of ab . .
Risk Management: Assessment and 'lranefer II 243
J5.3. J Determination of Rislc Monogemenf Objective ove risk manager must take mto account foreign loss expos
. foreign currency risks, kidnapping of key personnel, political risk etc. Informati ures, like terrorism,
. . 'ective is the pre-requirement of risk management. As the concept IS based on proverb through prim.ary or secondary source of data and must be pre-analyud with on coul~ be collected
Dete~an_onbeofobJth ~•-• It means that would be better not to have suffered loss or avoid loss th,h
'prevention 1s tter an~-~- techniques. Risk manager must keep update himself on industry trends, market chanapprC>priate Statistical
..,.. daim under insurance policy. The objectives of the ns ·k management can "''
b ges etc.
to suffer Joss and coU"'-'. (i') pre-loss obiective • pre-Ioss ob'Jective
.. post-loss ob'iectiVe. · tnclud
. e
. and (u)
dassiJied into two parts VIZ., ' '
(a) Firm should prepare for potential losses in the most economical way.
es:
15,3.3 Evaluation of loss Exposure
(b) Firm should not react to loss in anxiety.
(c) Firm should meet out legal obligations.
'fhe next step in the risk management process relates to analyzing. eval .
of losses on the individual or corporate unit by estimating the potential ':'18:d .
measunn~ the impact
Loss frequenc:r relates to the probable number of losses that may occur d ~ cy and~~ ofl~.
Risk management also entails certain objectives after a loss occur given below. These objectives laid
down the betterment of the firm already exposed to loss. and Joss seventy refers to the probable size of the loss that may occur. In addi~ some given time penod
tion the elativ freq
and severity of each loss exposure must be estimated so that the risk ' r e uency
(a) Survival of the firm
appropriate technique for handling such exposure. For example, a loss with~~can sel~e m~
(b) Continuation of operating activities of the firm
occurrence may be treated as expense. The loss must be estimated . qu~ certain
(c) Stability of earnings of the firm on mamnum and nurumum extent
(d) Continued growth of the firm The maximum loss represents the worst loss that could happen Th • .....J....IJ- .
. e maxunum Y'"""""' loss is loss
(e) Social responsibility to minimize the effects that loss will have on other persons and on society. that likely to happen. For example, a plant costing oHIO lacs lost by fire is the maximum loss. But loss
of such plant by flood is estimated only up to 70 percent thus maximum probable 1 . -1acs oth
. . . OSSISH .An er
J5.3.2 Identification of Potential Loss Exposure type of loss 1s catastrophic losses are difficult to predict because they occur infrequently but
·
loss must b e taken mto cons1'deration
• whi!· e evaluating loss. cause great
This step involves a systematic and careful analysis of all major and minor potential loss exposures. An
essential prerequisite for a conscious choice of appropriate and efficient methods for dealing with losses The actual estimation of the frequency and severity of losses may be done in various To
if they occur is the recognition of all sources of possible losses. This approach used for risk identification measure the likelihood of occurrence and gravity of losses, in modem times, the risk manag;:5"firm
include use of loss exposure checklists, flow charts, statistical analysis of historical data, field survey attempt to be more precise in evaluating risks. They classify the frequency of various losses in informal
etc. George E. Rejda provides comprehensive checklists for various types of loss exposures exhibited in categories such as 'slight', 'moderate', and 'certain' or may be termed as 'rare: 'occasional', and 'frequent'
Figure 15.4. etc. Similarly, the severity may also be classified into 'low', 'moderate', and 'catastrophic' or disastrous etc.
- IAlll&posma Liability Loss Exposures Business Loss Exposures
Cataloguing and making sense of so many risks requires a structured process. Such categorizations are
plotted on a graph, known as risks mapping or risks profiling.
• Building, plant and other • Defective products • Loss of income from covered Risk mapping or risk profiling involves arraying these risks in a matrix, with one dimension being
structure • Environment pollution loss the frequency of events and the other being the severity as shown in Figure 15.5. Each risk is then marked
• Furniture, equipments and • Sexual harassment of employees • Continuing expenses after loss to indicate whether it is covered by insurance or not, and their location is decided which resulted out as
supplies
• Gender discrimination • Additional expenses combination of likelihood and severity of loss. By this way, it becomes possible for the firm to identify
• Inventory • Vicarious liability • Contingent business income the risks that are most likely to seriously affect the firm's ability to achieve its goal.
• Electronic including computer • Directors' and officers' liability losses
devices A particular risk is put into particular place according to their best possible grouping. For example,
• Valuable paper and records theft from a grocery shopping centre is more frequent but th~ amount or severity ofloss ~ai:5«;<1 by s~ch
• Mobile equipments theft is, generally, low. Hence, theft loss in a grocery sh?ppmg centre could be placed m D location.
In another instance, collision of automobile is rare, but 1t may cau~e loss up to the_ ext~nt of moderate
11,oarce Lou lev I th • uld b t into 'C' location. An injury caused dunng the production 1s moderate but
Crime Loss Exposures Employee Benefit Loss e , us, it wo e pu uld be l ed . 'H' A . .;
' • Death or disability of key l·s 1·t caused serious
. 1oss lik death of a key personnel then it wo
e . . ocat m group. Sltuauon.
• Holdups, robberies, burglaries • Failure to comply goverment . d ·
personnel of flood m and aroun nver-bed is occasional' and damage to building .or ,goods ,
of company havmg
. . . cv •
• Employee theft and dishonesty rules . • b d ·s moderate therefore, it would be placed m E location. Similarly, 1 IS
• Retirement or unemployment tounst hotel near to nver- e 1 ' • d · alm
• Fraud and embezzlement • Violation of fiduciary duties . .
• Job-related injuries or diseases the location which has comb'mafon
1 of high loss for example,
. .
death causality of any person an 1s
. •
ost
• Cyber crime • Failure to pay promised benefits . lik driving truck in alcoholic/intoXJcatmg situation.
certam or frequent, e
Figure 15.4: Checklists for Various type of Loss Exposures
 ~ II Essentials ofBanking and Insurance R/Jk Management: Antument and T~er II 245
Losa frequency Ci il l.011 prevention: Loss prevention refer• to measurea that reduce the frequency of a
parlicular Ion It provideJ a contro!Ung mechanism as pre-occurrence of•-··. ,
'' . . of usage. For example.
'·-, and. d'•.r«hon ,orm of
""'themcollision
r mandatory guidelines, statutory chec....
F18Quent/ I
I
------~'"ol._______m_______ _
Certain
I t
of lruclu rnay be reduced by putting speed hm1t, alcohol checlt at night, proper ligh .
road, etc. Similarly, the directions could be put on the product indicating imtruct::
r
I I
I I u,e to avoid any happening.
Oc:ca9ionaV I I
I
I
I
I (iii) Lose ri:ductlon: Loss reduction refers to measures that reduce the ,evll'ritv ( , ____,._.
Mod«ata I I • J f _,,.,O IIUllilUCJII
occurs. It actually aims to contro ~ spread over risk to other events or to avoid a peril to
-------~!Fl-------01-------·
Slight(
I
I
from ~~her to avoid any damage to good one or saved one; the injure:~
become hazard for subsequent pen!. For example, inventory lost by fir be ,eparated
be
Rare
r~]
I
I rehab1htated; any alarm at place which has already caused Jou and has ltlll " : to
[cl [YI Loss severity =~~ ~
0 low Moderate Calastrophic
2. Risk Financing: Risk financing covers all methods to fund either the probability of losa or
Figure 15.5: Risk Mapping or Risk Profiling potential size of losses that do occur. Fundamentally, riak financing takes the form of retmtion
or transfer. All risks that cannot be avoided or reduced must be transferred or retained. But,
there is cost involved in both of these exercises. Therefore, risk financing rden to the manner in
15.3.4 Selection of Appropriate Techniques for Treating and Forecasting loss Exposures which the risk control measures what have been implemented shall be financed. Risk linancing
The nm ,tep is to $elect appropriate technique$ for testing the loss exposures. These techniques may be has twin objectives, first, to spread more evenly over time cost of risk in ordff to reduce the
wed with the aid of mathematical or statistical techniques like, measure of central tendencies, measure financial strain, and second is to minimize risk costs.
of variation/dispersion, regrt$Sion, probability distribution (including nominal, binomial and Poisson (i) Risk Retention: Risk retention is also known as risk assumption. Risk rdmtion Is perhaps
distribution) etc. or may take help from computer modeling like simulation, programming, or robotic the most common method of dealing with risk. It means that the firm retains part or all
rt$ult,. In modern era varioUJ scientiJic method could be used for treating the loss exposure such as of the losses that can result from a given. Small organizations face unlimikd number of
whether forecasting. lab dt$igning and lab-testing etc. However to turn these exposure into financial risks and in most cases they do not do anything about them. When nothing is done about
terms, these technique$ are, further, classiJied into risk control and risk financing techniques. Risk a particular exposure, the risk is retained. An unintentional risk is retained when a risk
control refer• to techniq= that reduce frequency or severity oflosses. On the other hand, risk financing is not recognized. Unintentional risk is always undesirable, because It is not perceived.
relata to technique$ that provide for the funding of losses. It either not perceived or opportunity has not been afforded to calculate it appropriately.
1, Ruic Control: The method of risk control include risk avoidance and various approaches to For example, if a building costing oft I5 lacs is insured fort 12 lacs, it means in case of any
reducing ri.sk through prevention of loss and efforts of risk control. Risk reduction involves loss t3 lacs will be retained by company being undermining of risk.
techniq= that are aimed at reducing the likelihood ofloss or its gravity. The sub-classification The risk retention could be financed either through paying off losses. captive insurance,
ofrule control involve, risk avoidance and loss control techniques. or self insurance etc. A brief treatment of risk retention on above financing method is
(i) Avoidance: Risk avoidance means elimination of risk or abandoning or refusing discussed below.
to undertake any activity in which the risk seems to be too high. In other words, risk • The firm can pay losses out of its current net inc.ome and tr_eat losses.as expenses for
that year. Remember, the maximum extent of settmg off loss IS the net mcome, for that
of avoidance means the situation in which chance of loss has been eliminated. This is
3CCl>mplished by not engaging in the action that gives rise to risk at all. For example, purpose assets are not liquidated.
. pay such losses.
A f un ded reserve Can be set to keep liquid funds to . But these funds have
cosmetic producing companies withdraw their product from the market on the event of
,
to ,ace t he pro bl ms of various rules on accounting and taxation.
e .
knowing that these cause harm to skin; various automobile companies call back their car
- . b stablished with a bank to borrow funds to be used to mitigate such
when they find any defect in it which may cause peril of collision. 'fhe major advantage • A ered11 1me can e e . h ft
of avoidance ii that the chance of loss is reduced to 7..ero if the loss exposure is never losses. However, sueh borrowing arrangements may have adverse tmpact on cas ow
acquired. But it have major two disadvantages, first, the firm is n()t able to avoid these statement of the company. . . .
l0$&U u they generally come in the knowledge after t?eir occurrence. Second, it leaves •d by a captive insurer. Caphve insurance refers to insurance under
• Losses can aIso be pat . . • · be fi
impact on production of the company, for example, calhng back of car hinders the regular a group or associa · or 1
· 1100 · nsurance taken by a parent orgamzat1on extending 115 ne ts
production of car.
 246 II Essentials ofBanking and /nsurantt_
ttve of the captive Insurance
to subsidiary company or sister-concerns. The basic objec
based on economies of scale. S lflnsurance Is a
. , t·O!flosses. e • special
• The firm may formulate its own self-insurance to se • n loss exposure is retained
form of planned retention by which part or all of a g1ved. For example ere at. by
the firm. The better name of self insurance is self-fun mg, tribute a11,d . • •ng a
io"""s con • 111 ens
corpus for employees in which both empIoyer and emP ,--
occurrence ofloss, claim could be set-off out such created corpus.
Advantages of Retention . • ln~urance contracts are tough to understand, a layman cannot understand the complexity
• Firm may save money if the amount of actual loss is less as compared to insurance
premium.
The services provided by the insurer may be rendered by the firm at lower cost, as they
avoid expenses of insurer like, commission, brokerage, taxes and fees etc.
• It encourages firms to loss prevention
• Cash tlow may be increased because the firm can use the funds that normally would be
paid to the insurer at the beginning of the policy period.
Disadvantages of Retention
• The actual loss could be more and firm has to face high volatility or risk in short-run
period.
• Internal control expenses may be more as compared to insurance premium like
remuneration paid to safety engineers.
• Income tax Act does not allow to make any provision ofloss. However, insurance premium
paid to protect business-risk is allowed.
■ Tax paid on saved amount in form of non-payment of insurance premium could be high
in comparison of insurance premium itself.
(ii) Risk Transfer: If risk is not retainable then it can be transferred to other. Transfer may be done
either by way of purchase of an insurance policy or by way of non-insurance contracts. The
selected types of risk transfer have been explained below.
Commercial Insurance: Commercial insurance is a technique of transferring risk form one
party (for whom risk is costly) to another (who is willing and is able to bear the risk). For
example, if it is costly to bear medical treatment cost at later stage of life then such person can
take medical insurance policy and pay its premium to secure his expenses probable to occur at
later stage of life. In such cases, insurance companies hedge the risk of medical bills exposed to
an individual.
Advantages of Insurance
• Firm is entitled to claim compensation in case ofloss.
• No effect on its normal business operations.
• Reduction in uncertainty due to insurance increases the performance and productivity of
the workers particular and firm as whole.
RIJk Management: Aumment and Transfer II 247
• Besides lnsuran I ,
Is services Ilk I8k~ c aim, maurance companies alao provide other risk management
management. e r Identification, rlak analysis, historical analysis, and post-losa operation
• The greatest advant Of
Tax Act. age Insurance is that Insurance premium Is deductible under Income
e of Disadvantages of Insurance
• Insurance premi · ·h
um 1s e1t er regular expense or may bear high cost expense.
of msurance agreements, and generally accept to what he does not require at all.
• ~sk manager has no incentive to control risk, if such risk is insured by company from an
insurance company.
Non-insurance Transfer: These are techniques (other than insurance) by which a risk
exposure and its potential financial losses are transferred to another party who is in a better
position to exercise loss control. For example, outsourcing security and safety of a company
ensures company any unwanted theft and compensation to be paid in case of Injury to any
staff appointed by company itself in case of self maintenance of security and safety. Another
example, leasing out electronic repair and maintenance of a computer laboratory transfers the
risk of any loss from laboratory owner to another party who agrees to maintain it.
Advantages of Non-insurance Transfer
• The risk manager can transfer some potential losses that are not commercially insurable.
• The potential loss is shifted to someone who has either expertise in handling such
exposures or specialized in exercise of control over these situations.
• These often cost less than insurance.
Disadvantages of Non-insurance Transfer
• Insurance cost is always high, especially in cases where there chance of occurs are bless or
no loss.
• There is no set formula to transfer each and every type of exposure to ~other; therefore,
any has to either high charge to lawyer or litigation fee in case of incorrect contract.
. ed · till sponsible to pay
• comp
In case of failure of party to whom loss is transferred, the msur IS s re
such loss.
15.3.5 Selection of Appropriate Methods
In determining the appropriate method(s) for handling losses, a matrix (suggested by Rejda) can be used
that classifies the various loss exposures according to frequency and severity. This matrix is useful in
determining which risk management method should be used, reproduced in Table 15.3 below:
 248 11 Essentials ofBanking and Insurance - --... --- Risk Management: Assessment and Transfer II 249
Table 15.3: Risk Management Matrix
~ -
.,. After risks are identified, they should be evaluated regarding their expected fr
Retention the probable severity of associated losses, the maximum probable loss, and ~4:ency_ofoceurrence,
Loss Prevention and Retention loss.
2
3
4
I High
Low
High
/
/

Low
High
High
IInsurance
Avoidance
.,. 'Ihe variance, standard deviation, and coefficient of variation are im rtan
variation of actual from expected experience.

lllaXimum possible
po t ways of measunng the
Source: Rejda, George E. (2011) Principle of Risk Management and Insurance, p.52 .,. 'Jhree theoretical distributions that are useful to ascertain likelihood f .
binominal and Poisson distributions. 0
nsk are the normal,
It can be noticed, for the purpose of selection of the method for h~ndling losses, both severity and
frequency of loss has to be considered. When the frequency ~d seventy of loss a~e low, i.e., where the .,. 'Ihe law of large numbers shows that as the sample size increases or number of sur .
loss is small and occurs infrequently such as loss of grocery items from a shoppmg mall, retentio . the degree of risk decreases. expo es mcreases,
the most appropriate techni~ue. When th~ frequency of loss is high but severity of loss is high sue~ ~s .,_ When the probability of loss is very small, a larger number of exposure units" • eeded
· k when the probability ofloss is large. .
physical damage to automobiles, food spoilage etc. could be covered under loss prevention or reten . s the same degree of ns IS n to achieve
techniques. In the third type of loss, where frequency is low but severity is high, like, fire, explos~lon
.,. 'Ihe chance of loss is the probable number oflosses out of given number ofloss sh uld
natural disaster, legal suits etc, the insurance is the best technique to cover damages. In fourth typion,
be distinguished from degree of risk, which is the extent of uncertainty about ~~ I 0
loss in which both frequency as well as severity ofloss is high, it is suggested to avoid such type of!e of
for example, it would be better to avoid .,. The law oflarge numbers is a statistical principle stating that as the number ofexposures is increased
hiring a truck driver who is exposed to drug addiction or ro ~ss,
alcohol taker to avoid risk of truck collision while his driving. the actual results tend to come closer to the expected results.
utme
.,. Risk management is the systematic and efficient handling of pure risks.
15.3.6 Implementation, Evaluation and Review of Risk Management Program .,. Risk management is a process to identify loss exposures faced by an organization or individual and
to select the most appropriate techniques for treating such exposures.
Assessment of risk and its measurement is useless if it is not implemented in true spirit. Following points
.,. Subjective risk refers to the mental state of an individual. Objective risk, which is measurable, is the
may be noted to implement risk management program effectively.
probable variation of actual from expected experience.
■ The decision is made to either retain risk, with or without funds, or loss prevented or transfer .,. Loss severity is the size of the potential losses.
must be communicated to all concerned persons or departments.
'§lo Loss frequency means the probable number oflosses.
■ A risk management manual may be prepared and used in the program describing the details on
'§lo Risk management has several important objectives. Pre-loss objectives include
objective, processes, technicalities, responsibilities, costs, and claims etc. the goals ofeconomy,
reduction of anxiety, and meeting legal obligations. Post-loss objectives include survival of the firm,
• The risk manager does not work alone. Being a function of organization, risk management
continued operations, stability of earnings, continued growth, and social responsibility.
policy has to share with other departments.
'9- There are four types of risk management process:
• For example, accounting and finance department to record cost of insurance premium,
allocation of funds, creation of reserves, and claim of compensation has to be noticed. '9- Identify loss exposures.
• Marketing and advertising department to ensure packaging and dissemination of correct '9- Analyze the loss exposures.
information to customers or direction of use. l{Jo Select appropriate techniques for treating the loss exposures.
• Production department to maintain quality standards and safety mechanism. '9- Implement and monitor the risk management program.
• Such risk implementation must be periodically evaluated on the basis of standard laid down in l{Jo Insurance is most suitable for handling risks with high loss severity and low
loss frequency.
risk management manual. l{Jo Risk control refers to techniques that reduce the frequency and severity oflo~es.
.
• The coordination among department must be validated on different occasion to confirm the l{Jo Risk financing refers to techniques involving risk retention, and risk transfer
m form of msurance
flow of information.
and non-insurance contracts. th
• Any mistake, flaw, or shortcomings found at any stage must be corrected with appropriate . . th t · owned and established by a firm (called as parent firm) for e
l{Jo Captive insurer 1s an msurer a is .
measures timely and must be reported for future references. . . th bsi"diary firm or any sister concern.
• The implementation of the decision must be verified to make sure they were executed as Purpose of msunng e su • •· ti of a risk management - ,.
':I'- An important part of the admm1stra on program is a regular review to ...eep
intended.
it up date.
t~
~25~0~11LE~s~se~n~ti~als~o?}_if~B~a~nk~in~g~a~n~d~In~s~ur;~a~nc=e- _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ ___

. ethods other than insurance by which a pure risk and its financial
'P- Non-msurance transfers aredm ther party. Hedging technique is one of the non-insuranc
consequences are transferre to ano e
techniques.

REVIEW QUESTIONS._________~ - -
1. Distinguish between chance ofloss and degree of risk.
2. Why is the law oflarge numbers important in measuring risk?
3. A company owns 1000 cars and has determined that it is likely to suffer betwee_n 60 and ~O collision
losses this year. x company also own same number of cars a~d has determmed that IS l~kely to
experience SO to 80 collision this year. Compute the degree of nsk for each company assummg that
the companies expect to suffer 65 losses each.
4. Identify and briefly describe the four basic techniques available to the risk manager dealing with
pure risks facing the firm. Give suitable examples.
5. Define the term risk management. Give its features.
6. What are the objectives of risk management to be considered by risk manager in respect of pre and
post occurrence of loss?
7. How would you identify the sources of information, being a risk manager, to identify loss exposures?
8. Explain the meaning of risk control and elucidate its techniques.
9. Explain the term risk mapping with appropriate examples.
10. What do you understand from risk financing technique? Illustrate its various forms.
11. How does a frequency and severity of loss exposure matrix help in selecting appropriate risk
management technique?
12. What do you understand from risk-retention and self-insurance techniques?
13. Explain the insurance risk technique and its advantages and disadvantages.
14. What are the advantages and disadvantages of non-insurance technique?
· process.
15. Briefly describe the risk management implementation, evaluat·10n and reVIew

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