Risk Identification and

Measurement
Risk Identification

• The five major steps in the risk management decision-making process are:

1. Identify all significant risks that can be cause loss;

2. Evaluate the potential frequency and severity of losses;

3. Develop and select methods for managing risk;

4. Implement the risk management methods chosen; and

5. Monitor the suitability and performance of the chosen risk management methods and strategies on an
ongoing basis.

This focuses on the first two steps of this process.

Identifying Business Risk Exposures

• The first step in the risk management process is risk identification: the identification of loss exposure.
• Unidentified loss exposures most likely will result in an implicit retention decision, which may not be
optimal.
• There are various methods of identifying exposures.
• For example, comprehensive checklists of common business exposures can be obtained from risk
management consultants and other sources.
• Loss exposures also can be identified through analysis of the firm’s financial statements, discussion with
managers throughout the firm, survey with the firm’s employees, and discussion with the insurance agents
and risk management consultant.
Identifying Business Risk Exposures

• Regardless of the specific methods used, risk identification requires an overall understanding of the
business and the specific economic, legal, and regulatory factors that affect the business.

1. Property Loss Exposures

• In addition to identifying what property is exposed to loss and potential cause of loss, the firm must
consider how property should be valued for the purpose of making risk management decisions.
• Several valuation methods are available.
Identifying Business Risk Exposures

a. Book Value
• Book Value = (the purchase price - accounting depreciation)
• The book value for real and personal property is typically the original cost of the property less
depreciation.
• For Example, if you bought a machine for 50,000 and its associated depreciation was 10,000 per year, then
at the end of the second year, the machine would have a book value of 30,000.
• this the method commonly used for financial reporting purposes.
• However, since book value does not necessarily correspond to economic value.
Identifying Business Risk Exposures

b. Market Value
• Market value is the value that the next- highest-valued user would pay for the property.
• It differs from the replacement cost, actual cash value, trade-in value and other forms of valuation.
• For Example, When insurers calculate the market value of your car, they include many factors, including
age, model, kilometre travelled and the general condition of the car.

c. Firm-specific value
• Firm-specific value is the value of the property to current owner.
• It is the total value of the assets of the business (excluding cash).
• If the property does not provide firm-specific benefits, then firm-specific value will equal market value.
• Otherwise firm- specific value will exceed market value.
Identifying Business Risk Exposures

d. Replacement Cost New

• Replacement cost new is the cost of replacing the damaged property with new property.
• The amount required to reproduce the entire property in like utility and function.
• It is based on current market prices for materials, labor, equipment, contractor’s overhead, profit and fees.
• It does not include provision for overtime, bonuses, or premiums on materials.
• Due to the economic depreciation and improvements in quality, replacement cost new often will exceed
the market value of the property.
Identifying Business Risk Exposures

e. Business Income Exposures

• Indirect losses also can arise from damage to property that will be repaired or replaced.
• For example, if a fire shuts down a plant for five months, the firm not only incurs the cost of replacing the
damaged property, it also losses the profits from being able to produce. In addition to , some operating
expenses might continue despite the shutdown ( salaries for certain manager and employees and
advertising expenses).
• These exposures are known as business income exposures ( or, sometimes, business interruption
exposures), and they frequently are insured with business interruption insurance.
 Identifying Business Risk Exposures

f. Extra Expense Exposure

• Firms also may suffer losses after they resume operations if previous customers that have switched to
other sources of supply do not return.
• In the event that a long term loss of customers would occur and/ or a shutdown temporarily would impose
large costs on customers or suppliers, it might be optimal for the firm to keep operating following a loss
by arranging for the immediate use of alternative facilities at higher operating costs.
• The resulting exposure to higher cost is known as the extra expense exposure.
• Insurance purchased to reimburse the firm for these higher costs is known as extra expense coverage.
Identifying Business Risk Exposures

2. Liability Losses
• Firms face potential legal liability losses as a result of relationship with many parties, including suppliers,
customers, employees, shareholders, and members of the public.
• The settlements, judgments, and legal costs associated with liability suits can impose substantial losses on
firms.
• Lawsuits also may harm firms by damaging their reputation, and they may require expenditures to
maximize the costs of this damage.
• for example, in the case of liability to customers for injuries arising out of the firm’s products, the firm
might incur product recall expenses and higher marketing costs to rehabilitate a product.
Identifying Business Risk Exposures

3. Losses to Human Resources

• Losses in firms value due to worker injuries disabilities, death, retirement, and turnover .
• These can be grouped into two categories.
• First, as a result of contractual commitments and compulsory benefits, firms often compensate employees (
or their beneficiaries) for injuries, disabilities, death and retirement.
• Second, worker injuries, disabilities, death, retirement, and turnover can cause indirect losses when
production is interrupted and employees can not be replaced at zero cost with other employees of the same
quality.
• In some cases, firms purchase life insurance to compensate for the death or disability of important
employees.
Identifying Business Risk Exposures

4. Losses from External Economic Forces

• The final category of losses arises from factors that are outside of the firm.
• Losses can arise because of changes in the prices of inputs and outputs.
• For Example, increases in the price of oil can cause large losses to firms that use oil in the production
process.
• Large changes in the exchange rate between currencies can increase a multinational firm’s costs or
decrease its revenues.
• For Example, an important supplier or purchaser can go bankrupt, thus increasing costs or decreasing
revenues.
Evaluating Frequency and Severity

Frequency
• The frequency of loss measures the number of losses in a given period of time.
• If historical data exist on a large number of exposures, then the probability of a loss per exposure (or the
expected frequency per exposure) can be estimated by the number of losses divided by the number of
exposures.
• For Example, if X company had 10,000 employees in each of the past five years and over the five-year
period there were 1500 workers injured, then an estimate of the probability of a particular worker
becoming injured would be .03 per year (1500 injures, 50000 employee year)
• When historical data do not exist for a firm, frequency of losses can be difficult to quantify.
• In this case, industry data might be used , or an informed judgment would need to be made about the
frequency of losses.
Evaluating Frequency and Severity

Severity
• The severity of loss measures the magnitude of loss per occurrence. One way to estimate expected severity
is to use the average severity of loss per occurrence during a historical period.
• If the 1500 worker injuries for X company cost 3 million in total ( adjusted for inflation), then the expected
severity of worker injuries would be estimated at 2000 ( 3000000/1500).
• That is, on average, each worker injury imposed a 2000 loss on the firm.
• Due to the lack of historical data and the infrequency of losses , adequate data may not be available to
estimate precisely the expected severity per occurrence.
Basic Concept of Probability In Risk Calculation

Theory of probability
• The theory of probability reveals the possibility of occurring a certain event or not occurring a certain
event out of the given events.
• Thus, in insurance, the theory of probability reveals the chance of death of a person out of a group of
persons.
• The theory of probability can be of three types :

i. Certainty

ii. Simple probability and

iii. Compound probability

Basic Concept of Probability in Risk Calculation

i. Certainty
• The probability of certainty is expressed as one. It means the chance of happening a certain event, say
death, is 100 per cent.
• The probability of an event is a number between 0 and 1, where , roughly speaking, 0 indicates
impossibility of an event and 1 indicates certainty.
• The higher the probability of an event, the more likely it is that the event wili occur.
• It sure that the death will occur in this expression. Naturally factor, i.e. certainty is taken as the, basis of
comparison.
• In other words, the chance of death is related with the unity or one certainty.
Basic Concept of Probability in Risk Calculation

ii. Simple Probability

• When the events are mutually exclusive or when only event is present, the probability will be known as
simple probability.
• Simple probability is the calculation of an outcome or the chance of an event ever happening.
• Insurance companies use probability statistics to determine the chances of having to pay out a claim.
• A simple probability calculated by dividing a specific outcome by all the possible outcomes.
• For Example, When a die is rolled, the possible outcomes are 1,2,3,4,5 and 6…if a die is rolled once,
determine the probability of rolling a 4. Rolling a 4 is an event with 1 favorable outcome (a roll of 4) and
the total number of possible outcomes is 6 ( a roll of 1,2,3,4,5 or 6).
Basic Concept of Probability in Risk Calculation

• In Insurance, For example, if at the age of 40, 2 persons die out of 10,000 the probability of death of a
person, who is of 40 years, can be expressed as:
• 2/10,000 = .02 percent
• Generally, the probability is expressed in terms of unity or one, i.e. the probability is related with one
which can be expressed in the decimals.
• Similarly, if there are more than one person and the death rate of each person is to be calculated separately,
the simple probability is applied.
• For Example, if there are two persons of ages 40 and 42 years the causes of death of one person only can
be expressed as probability of death of first person plus probability of death of second person.
Basic Concept of Probability in Risk Calculation

iii. Compound Probability

• When two or more events occur together, their joints occurrence is called compound event.
• Compound probability = the probability of the first event × the probability of the second event.
• For Example, if the probability of death of A at the age of 42 is .002 and the probability of death of B at
the age of 42 is .0003, the compound probability shall be calculated when we are required to know the
probability of death of any of the persons.
• Thus, the probability of death of any of the, persons, will be .0002 × .0003 = .0000006
• In insurance, the simple probability is generally used to calculate death rate of one person.
Estimation of Probability

• The Probability can be estimated whether

i. Priori basis or

ii. Posteriori basis.

i. Priori Basis
• In this case, the probability is estimated merely on the basis of knowledge. It is not derived after
experiment or practice.
• It is also called deductive reasoning where estimation is based on from general to particular.

• Reasoning goes from general statement to particular statement and conclusion drawn from the known
premises.
Estimation Of Probability

ii. Posteriori probability

• The probability in this case is calculated on the basis of experiment.
• It is also called as inductive method because in this case, estimation is based from particular to general.
• Reasoning goes from particular statement to general statement.
• The posteriori probability can give correct result only when the experiment involves a large number of
units and the data are correct.
Thank You...