Chapter: 3

Risk identification & Measurement

 Risk Identification
 Basic Concepts from probability and statistics
 Evaluating the frequency & severity of losses

Year question
1. How do you measure the risk through risk management
Matrix?
2. Discuss the different categories of severity & Frequency of loss
with an example of banking Industry?

5 major steps in the risk management decision making process are:

1. Identify all significant risk that can causes loss
2. Evaluate the potential frequency and severity of losses
3. Develop and select methods for managing risk
4. Implement the risk management chosen
5. Monitor the suitability and performance of the chosen risk
management methods and strategies on an ongoing basis.

 Risk Identification (step – 1)

Risk identification is the process of documenting any risks that could keep
an organization or program from reaching its objective. It's the first step in
the risk management process, which is designed to help companies
understand and plan for potential risks. Examples of risks include theft,
business downturns, accidents, lawsuits or data breaches.
There are several situations for which you might need to identify risks,
including:
1. To support an investment decision
2. To assess cost uncertainty or operational costs
3. To analyze multiple alternatives
 4. To test a program before its acquisition

What is risk exposure in business?

Risk exposure is the quantified potential loss from business activities
currently underway or planned. The level of exposure is usually calculated
by multiplying the probability of a risk incident occurring by the amount of
its potential losses.
1.Identifying business risk exposures
2.Identifying individual exposure

How do you manage risk exposure?

The following techniques and tactics are commonly used by organizations
to manage risk exposure:
1. Risk avoidance. Organizations can alter choices and decisions to
avoid risky activities.
2. Risk mitigation. Controls and processes can be implemented that help
mitigate and minimize risk in many different areas.
3. Risk transfer. Through insurance and third-party service
arrangements, organizations can transfer some risk to outside parties.
4. Risk retention. Organizations can always choose to accept risk and
accommodate it as part of ongoing operations.

1.Identifying business risk exposures: First step is the identification of loss

exposures. Loss exposures can be identified through:
’s financial statements
th managers throughout the firm
There are various methods of identifying the loss exposures. These are:
a) Property loss exposures
b) Liability losses
c) Losses to human resources
d) Losses from external economic forces

a) Property loss exposures: Several valuation methods are

 Book value
 Market value
 Firm specified value
 Replacement cost new
 Business income exposures
 Extra expense coverage
b) Liability losses:
 Firms face potential legal liability losses (as a relationship with many
parties, including suppliers, customers, employees, shareholders and
members of the public)
 Lawsuits (it also may harm firms by damaging their reputation, and
they may require expenditures to minimize the costs of this damage)

c) Losses to human resources:

 Worker injuries
 Disabilities
 Death
 Retirement
 Turnover
d)Losses from external economic forces:
 Changes in the prices of inputs and outputs
  Large changes in the exchange rate between currencies

2.Identifying individual exposure:

To analyze the sources and uses of funds in the present and planned for
the future. Such as
 Earnings prior to retirement
 Medical expenses
 Personal liability exposures
 Social security

BASIC CONCEPTS FROM PROBABILITY AND STATISTICS

• Random variables and probability distributions:

 A random variable is a variable whose outcome is uncertain.
For example, suppose a coin is to be flipped and the variable X is defined to
be equal to $1 if heads appears and- $1 if tails appears.
 A probability distribution identifies all the possible outcomes for the
random variable and the probability of the outcomes.

1. CHARACTERISTICS OF PROBABILITY DISTRIBUTIONS

Expected value: the expected value of a probability
distribution provides information about where the output
comes tend to occur, on average.
To calculate the expected value, you multiply each possible outcome
by its probability and then add up the results.
 Expected value of X= (0.5) ($1) + (0.5) (-$1) = $0
 2. Variance and standard deviation
Variance measures the probable variation in outcomes around the
expected value.
 High variance –difficult to predict.
 Variance =∑Pi(Xi-μ)2
 Standard deviation: square root of the variance.
 standard deviation =√∑Pi(Xi-μ)2

EVALUATING THE FREQUENCY AND SEVERITY OF LOSSES

1. Frequency: The frequency of loss measures the number losses in
a given period of time.
2.Severity: The severity of loss measures the magnitude of loss per
occurrence.
1.Discuss the different categories of severity & Frequency of loss with an
example of banking Industry?
The frequency-severity method is an actuarial method for determining the
expected number of claims an insurer will receive during a time period and
the average claim's cost.
Frequency refers to the number of claims an insurer anticipates will occur
over a given period of time.
Severity refers to the costs of a claim—a high-severity claim is more
expensive than an average claim, and a low-severity claim is less expensive.
The frequency-severity method is one option that insurers use to develop
models.
 Loss Frequency = Total Amount of Losses divided by Total Number of
Accidents
• Loss Severity = Total Number of Accidents divided by Total Units
Analyzed.
The Risk Management Decision—Return to the Example
Dana, the risk manager of Energy Fitness Centers, also uses a risk management matrix to
decide whether or not to recommend any additional loss-control devices. Using the data
in Table 4.3 "Net Present Value (NPV) of Workers’ Compensation Premiums Savings for
Energy Fitness Centers When Purchasing Innovative Safety Belts for $50,000" and Figure
4.3 "Workers’ Compensation Frequency and Severity of Energy Fitness Centers—Actual
and Trended", Dana compared the forecasted frequency and severity of the worker’s
compensation results to the data of her peer group that she obtained from the Risk and
Insurance Management Society (RIMS) and her broker. In comparison, her loss
frequency is higher than the median for similarly sized fitness centers. Yet, to her
surprise, EFC’s risk severity is lower than the median. Based on the risk management
matrix she should suggest to management that they retain some risks and use loss
control as she already had been doing. Her cost-benefit analysis from above helps
reinforce her decision. Therefore, with both cost-benefits analysis and the method of
managing the risk suggested by the matrix, she has enough ammunition to convince
management to agree to buy the additional belts as a method to reduce the losses.

2.How do you measure the risk through risk management Matrix?

 One of the most important tools in risk management is a road map
using projected frequency and severity of losses of one risk only.

 Within a framework of similar companies, the risk manager can tell

when it is most appropriate to use risk transfer, risk reduction, retain
or transfer the risk.

The Traditional Risk Management Matrix (for One Risk)

Pure Risk Solutions

Low Frequency of Losses High Frequency of Losses
Low Severity of Losses Retention—self-insurance Retention
with loss control—risk reduction.
High Severity of Losses Transfer—insurance Avoidance
To understand the risk management matrix alternatives, we now concentrate on each
of the cells in the matrix.

Risk Transfer—Insurance
The lower-left corner of the risk management matrix represents situations
involving low frequency and high severity.
In essence, risk transference involves paying someone else to bear some or
all of the risk of certain financial losses that cannot be avoided, assumed, or
reduced to acceptable levels. Some risks may be transferred through the
formation of a corporation with limited liability for its stockholders. Others
may be transferred by contractual arrangements, including insurance.

Risk Reduction
The quadrant characterized by high frequency and low severity, we find
retention with loss control. If frequency is significant, risk managers may
find efforts to prevent losses useful. If losses are of low value, they may be
easily paid out of the organization’s or individual’s own funds. Risk
retention usually finances highly frequent, predictable losses more cost
effectively. An example might be losses due to wear and tear on
equipment. Such losses are predictable and of a manageable, low-annual
value. We described loss control in the case of the fitness center above.

Risk Avoidance
at the intersection of high frequency and high severity, we find avoidance.
Managers seek to avoid any situation falling in this category if possible. An
example might be a firm that is considering construction of a building on
the east coast of Florida in Key West. Flooding and hurricane risk would be
high, with significant damage possibilities.