BBMF2083 INSURANCE MANAGEMENT

BACHELOR OF FINANCE & INVESTMENT

(HONOURS)

Lecturer /Tutorial Facilitator:

Richard Wee
email: richardwee.tarc2018@gmail.com
Whatsapp Mobile No: 0167226778
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CHAPTER 2:
RISK MANAGEMENT
(Risk Assessment/ Evaluation)
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Risk Management
• Define risk management
• Making pre-loss arrangements for
post-loss resources
• The logical approach to financing and
controlling loss exposures

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 Basic principles of “Risk Management”

• Risk management should create and protect value to a business

entity
• Risk management should be part of all processes and be the
responsibility of every manager
• Risk management should be a key element of decision-making
within the organization and management
• Risk management should be systematically and timely in an efficient
process that generates accurate and timely results
• Risk management should be based on accurate and reliable data
available to the organization
• Risk management should take into account human factors like
perception, capabilities, and intention
• Risk management should be transparent and inclusive eg. Represent
an open, visible and accessible approach to the management of risk
• Risk management should be responsive and interactive, eg be
capable of sensing change and adapting its response to it

(Source: MII, The Context of Risk Management)

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 RISK MANAGEMENT:

A systematic process in dealing with pure risks with the purpose of

reducing/eliminating such risks. The risk management process
involves 6 steps:

1. Establish & determine risk management objectives.

2. Obtain the relevant information for the identification of risks.
3. Evaluation of risks that have been identified.
4. Consideration of various techniques & selecting the most
appropriate ones.
5. Implementation of the chosen techniques.
6. Review & revaluation of the process.

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Step 1: Establish & determine risk
management objectives

The objectives of risk management are

identified as those that are consistent with
the financial objectives. To avoid financial
disasters arising out of the various pure risk
loss exposures of an individual.

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Step 2: Obtain the relevant information for the
identification of risks.

Step 2 is to obtain all the relevant information

with reference to the possible risk exposures.
Risk Identification involves gathering information
and identifying the whole range of possible risks
(pure risks) and the likelihood of the losses
occurring.

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Techniques of Risk Identification:
a) Surveys
b) Discussion
c) Examination of documents
d) Questionnaire

Source: ‘11)Risk Management’, Insurance Broking, The

Malaysia Insurance Institute, pp.11/1 – 1/13)

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Step 3: Evaluation of risks that have been
identified.

Evaluate/estimate the impact of the possible

losses if they do occur. The impact of such losses
on the individual’s financial standing & whether he
can absorb such losses / if his financial position
would suffer a serious setback must be analyzed.
In evaluating these risks, it is necessary to discuss
the probabilities of occurrence & severity of losses
if they do occur.

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Risk Analysis The evaluation process will include the following
/ Evaluation functions:
• Qualification of the effect and potential losses
will have on business
• Evaluation of a worst-case scenario in relation
to its effects on the future business plan.
• Reviewing the effect of previous losses both
significant and minor and measure their effect
on business with special consideration given to
cash flow and amended project
• Measure the estimated downtime following a
loss
• Evaluation of business’s ability to respond after
serious loss

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Step 4: Risk Management Technique Employed For
Handling Pure Risk Exposure
It is important to consider various techniques and select
the most appropriate ones. Study the techniques for
dealing with the risk. Risk financing is the choice or
selection method to pay for those losses that result from
various risk exposure. This is the last stage of the risk
management process of determination of how the risk
should be financed. The primary objective of undertaking
risk management is to anticipate and protect the
individual or business from incurring financial losses
arising from unforeseen and untimely pure risk events.
This is the logical approach to financing and controlling
loss exposure.

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 Risk Management Techniques

1. Risk avoidance
2. Risk (loss) control } Controlling Loss
Exposure

3.
4.
Risk-retention / self-insurance
Risk transfer
} Financing

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i) Risk Avoidance
To eliminate an identified risk by not engaging in
activities that might lead to a loss. Not always
practical or realistic and limited application. An
action is taken to avoid entirely any possibility of
an undesirable event taking place or to eliminate
the risk altogether. The action can be
implemented in four ways:
1. Elimination (removal),
2. Substitution (replacement),
3. Separation (partition the items or activities)
4. Rational Planning (alternatives).
(Source: ‘11)Risk Management’, Insurance Broking, The Malaysia Insurance Institute, pp.11/1 – 1/13)

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ii) Risk / Loss Control / Prevention
The necessary steps are taken to reduce the
possibility of the loss from occurring if it should occur
to reduce its severity. This is done through two
methods:
1. Risk/ Loss Reduction – process or steps to reduce
the degree of hazard presented by a risk which
cannot be eliminated or the frequency with which
it may result in loss
2. Loss Prevention/ Minimization – the introduction
of physical controls to minimize or prevent the
possibility of loss occurring or will lessen the
extent of the damage
(Source: ‘11)Risk Management’, Insurance Broking, The Malaysia
Insurance Institute, pp.11/1 – 1/13)

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iii) Risk Retention or Self Insurance
To establish or set aside funds (contingency
funds) or other assets for the purpose of having
cash available to compensate for losses that
might occur. Often considered as a form of “self-
insurance’’. This risk taken by individual or
organization either intentionally (deemed to be
acceptable or active risk retention) or
unintentionally (unaware or passive risk
retention) to meet whole or part of losses
resulting from a particular risk

(Source: ‘11)Risk Management’, Insurance Broking, The Malaysia

Insurance Institute, pp.11/1 – 1/13)

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iv) Risk Transfer
Action to transfer the consequences of a particular
risk to another party via:
1) purchasing insurance or
2) transferring to 3rd party through contractual
provisions

For individuals, this is essentially done through the purchase of

insurance contracts. In the business environment, other
techniques may be used. Example: Hedging & contractual
arrangements (using indemnity obligations).

(Source: ‘11)Risk Management’, Insurance Broking, The Malaysia

Insurance Institute, pp.11/1 – 1/13)

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Step 5: Implementation
The most effective risk management technique is
implementation. In most cases when dealing with
individuals, insurance contracts may be the most
useful tools for these purposes, although other
techniques may already be in place. This involves
the following considerations:
1. The appropriate contracts according to the
individual’s specific needs.
2. Quantum of the insured sum.
3. Priority of insurance policies to be in-forced
due to limited budget.

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Step 6: Review
Monitoring changing circumstances needs
and advising accordingly. Lastly,
recommend the necessary adjustments.
This process must be done periodically or at
least, once a year

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Risk Assessment:
Making Pre-Loss Arrangements
for Post Loss Resources
(Step 3: Evaluation of risks that have been identified)

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BASIC
STATISTICAL
The third step in the risk management process is
CONCEPTS
risk assessment. The broad range of risk
exposures has a financial impact on each risk.
Having an accurate forecast of future losses
enables the risk manager to manage the risk and
select the most appropriate risk management
techniques. Therefore, risk assessment relies
heavily on concepts developed in the field of
statistics to calculate the two (2) key statistical
measures used to evaluate loss exposure:
1. Frequency of Loss
2. Severity of loss

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1. Random Variable: A variable whose future value is not
known with certainty. Random factors can affect these
measures.
2. Probability Distributions: A table / graph that shows
all possible outcomes for a random variable & their
respective probabilities of occurring. Example, the
probability distributions for the number that will
result from a given roll of a die:

Value on die 1 2 3 4 5 6
Probability 1/6 1/6 1/6 1/6 1/6 1/6

NOTE: When we do not know the probability of a random variable in

advance, we must estimate it, often from prior experience or industry
data.

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All Probability Distributions share some
important characteristics:

1) The maximum probability for any 1 outcome

of a random variable is always less than 1
(>1)
2) The minimum probability for any 1 outcome
is always greater than zero (>0)
3) The probability distribution must include all
possible values of the random variable with
probabilities greater than zero.
4) The sum of their probabilities equals 1.0.

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 Expected Value:
Sum of the multiplication of each possible outcome of
the variable with its probability.
σ = E[R] = Σ Ri * Pi

Variance & Standard Deviation:

There are two (2) measures of risk:
a. Variance: Measures how the outcomes of a
random variable vary around the expected
value of that variable.
b. Standard deviation: Square root of the
variance.

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Question 1:
Rick, the owner of Rick’s Restaurant. Based on conversations with
attorneys, risk consultants & other restaurant owners, Rick estimates
that he has a 10% chance of losing a RM100,000 lawsuit in the next
year, compared to a 90% chance that he will not be sued.

Required:
a. Estimate a loss distribution for Rick’s Restaurant
b. Based on Rick’s loss distribution, calculate the expected value or
loss for Rick’s restaurant.
c. Calculate the variance and standard deviation of Rick’s restaurant
for the year

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Q1a. Estimate a loss distribution for Rick’s Restaurant

Working:
Loss Distribution for Rick’s Restaurant is

Loss outcome RM0 RM100,000

Probability of loss outcome 0.9 0.1

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b. Based on Rick’s loss distribution, calculate the
expected value or loss for Rick’s restaurant.
Working:
Expected Value / Loss, E[R] = Σ Ri * Pi
Expected loss = (RM100,000 x 0.1) + (RM0 x 0.9)
= RM10,000
Therefore the expected loss is RM10,000.

Note:
An insurer would use the RM10,000 expected loss as a
starting point in calculating the premium that it
needs to charge Rick to insure his liability risk.

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c. Calculate the variance and standard deviation of Rick’s restaurant
for the year

RM0 - RM10,000 RM100,000,000 RM90,000,000

RM100,000 RM90,000 RM8,100,000,000 RM810,000,000

Therefore the Variance : RM

Standard deviation, σ=
= √ 900,000,000
= RM30,000

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 RISK ASSESSMENT: ESTIMATING LOSS
FREQUENCY & LOSS SEVERITY

Average = Total amount of losses

Loss Total no. of units

= Total amount of losses x Total no. of incidents

Total no. of incidents Total no. of losses

= Average loss severity. x Average loss frequency

The average size of loss Frequency with which losses occur

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 CONVOLUTION

Calculates all possible combinations

of losses indicated by the frequency
& severity loss distributions & their
corresponding probabilities of
occurring. Often done by computer
simulation due to the complexity of
calculations.

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Question 2:

Suppose that Rebecca, the risk manager for a large car rental firm, wants to estimate the per-car
average cost to repair damage from collisions & other related causes of loss in her vehicle fleet for
the coming year. Suppose that Rebecca has gathered the information shown in Columns 1 – 3
(refer to Table 3-2) about the number of losses incurred by her fleet of 1,000 cars in the past year.

a. Use the information in the above table to find the average frequency of losses per car

b. Use the information in the above table to find the average severity per claim and average
loss per car
c. From the above two tables, use convolution (not formula) to find the average loss per car

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 Q 2a. Use the information in the table to find the average frequency of losses per car

Two Workings:
Average loss frequency per car = Total no. of losses
AVERAGE LOSS
FREQUENCY

Total no. of cars

= 100 / 1,000. = 0.1 accidents per car

Average loss frequency = No. of losses per car x Estimated probability

= (0 x 0.91) + (1 x 0.08) + (2 x 0.01) = 0.10 accidents per car

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 b. Use the information in the above table to find the average severity per claim and average
loss per car

Two Workings:
Average Severity per accident = Total amount of losses
Total no. of losses
= $320,000/100 = $3,200 per accident
Average Severity = Amount of loss x Estimated probability
= ($2,000 x 0.75) + ($6,000 x 0.20) + ($10,000 x 0.05) = $3,200 per accident

Two Workings:
Average Loss per car = Total dollar amount of losses
AVERAGE
LOSS

Total no. of cars

= $320,000 / 1,000. = $320 loss per car
Average Loss per car = Average severity x Average frequency
= $3,200 per accident x 0.10 accidents per car = $320 per car

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b. From the above two tables, use convolution (not formula) to find the average loss

Convolution

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b. From the above two tables, use convolution (not formula) to find the average loss

Workings:

Therefore, the average loss is RM 320.00

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Workings:

Row A: Probability of no loss occurring = 0.91

Rows B, C & D: If only 1 loss occurs, there are 3 possible outcomes.
Joint probabilities = Probability of each severity value x 0.08
Rows E to M: 2 losses occur.
Joint probabilities = Probability for the severity of the 1st loss x Probability for the severity of the 2nd loss x 0.01
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 DIVERSIFICATION OF RISK USING RISK POOLING

Exposure units: Persons / objects exposed to risk. The

more exposure units in a pool, the more accurately
the insurer can predict any individual unit’s risk of
loss.
Risk pooling: The ability to reduce each exposure
unit’s risk by making more accurate predictions about
a large pool of units.

Each person
entering the pool = ∑ All losses incurred by pool members
agrees to pay the
mean loss of the No. of people in the pool
pool

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Question 3: (Referring to Question 1)
Assume that Rick’s agrees to pool his risk with Vic, a second
restaurant owner, which has an identical Loss distribution.
Vic’s losses are independent of Rick’s RIsk. Both agree to split
the total losses in the pool equally.
a. Show a revised probability distribution for the mean loss
from the pool
b. Based on the new mean loss distribution, calculate the
expected value or loss.
c. Calculate the variance and standard deviation of pooled
mean losses

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 Loss outcome RM0 RM100,000
Probability of loss outcome 0.9 0.1

a. Show a revised probability distribution for the mean loss from the pool
Workings:

There fore the new mean loss distribution for the pool is

Mean loss outcome RM0 RM50,000 RM100,000

Probability of mean loss outcome 0.81 0.18 0.01

b. Based on the new mean loss distribution, calculate the expected value or loss.
Working:
Expected Value / Loss, E[R] = Σ Ri * Pi
Expected value of mean loss = (RM0 x 0.81) + (RM50,000 x 0.18) + (RM100,000 x 0.01)
= RM10,000
Therefore the expected loss is RM10,000.

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c. Calculate the variance and standard deviation of pooled mean losses

Workings:

RM0 - RM10,000 RM100,000,000 RM81,000,000

RM50,000 RM40,000 RM1,600,000,000 RM288,000,000
RM100,000 RM90,000 RM8,100,000,000 RM81,000,000
Variance : RM

Therefore, Standard deviation, σ=

= √ 450,000,000
= RM21,213.20

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 Change in Risk Through Pooling
Rick’s expected loss & risk in the pool versus not in the pool:

Remains same
Expected value Standard deviation

Risk is REDUCED
Mean loss
Unpooled loss distribution RM10,000 RM30,000
Pooled loss distribution RM10,000 RM21,213

Most importantly, the probability of the largest loss amount (RM100,000)

has decreased dramatically from 10% to 1%. It is extremely unlikely that
Rick & Vic will both lose a lawsuit in the same year. A further reduction in
risk will result from increasing the size of the poo

Standard deviation of mean loss distribution = Unpooled standard deviation

√ No. of pool members

Standard deviation decreases with an increased number of pool members.

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