Risk Management and Insurance-18MBAFM402 AIT-2020

Module 2
Risk Measurement

Prof. Roopa Balavenu, Asst. Prof., Department of MBA, Acharya Institute of Technology, 1
Bangalore
Risk Management and Insurance-18MBAFM402 AIT-2020

Unit-2
Risk measurement
Once risk is identified, the next step in the risk management process is to estimate both the
frequency and severity of potential losses. In this way, the risk manager obtain information that
is helpful in determining the relative importance of identified risk and in selecting particular
technique for managing those risk.
Evaluating the frequency and severity of losses.
Consideration of risk involves frequency and severity.
Frequency means the probability of risk arising at individual level. Higher the frequency of
risk higher will be the response to the product. That is because people always like protection
against the risk that stick frequently. But its insurability will be reduced by higher frequency
as claims processing costs will increase.
Severity is the likely size of the loss. It is derived from expected losses of the group likely to
buy a policy. In simple terms, it is the average of losses suffered by members of a common
group divided by the expected number of member of the group.
Techniques of estimating frequency and severity.
1. Risk mapping
2. Statistical concepts
3. Loss distribution used in risk management
4. Integrated risk measurement

1. Risk mapping
A technique for profiling pure risk as a step towards analysis risks and prioritising them
is to map the risks in a matrix. The purpose of risk profiling is to identify those risks
that seems to be most significant, so that priority attention can be given to them.
Severity/Impact
Low High
Low Low probability, low High probability ,
Frequency/probability impact low impact
High Low probability, low High probability and
high impact high impact

Action for risk

Impact Probability Action

Prof. Roopa Balavenu, Asst. Prof., Department of MBA, Acharya Institute of Technology, 2
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Risk Management and Insurance-18MBAFM402 AIT-2020

High High Take immediate action to deal with the risk.

High Low Consider action have a contingency plan in the
event of an adverse outcome.
Low High Consider action to deal with the risk.
Low Low Keep the risk under periodic review, as part of
the regular risk assessment process.

2. Statistical concepts
Some essential from the field of probability and statistical are as follows:
1. Random variable: the value of the variable determined by the outcome of a random
experiment is called random variable. The example of discrete random variable are the
number of accident on a highway in a particular period, the number of telephone calls
received per day etc.,
2. Probability: a probability distribution is a mutually exclusive and collectively
exhaustive list of all events that can result from a chance process and contains the
probability associated with each event.
3. Measures of variation: Because risk is synonymous with uncertainty, an extremely
important statistical concept is that of variation from what is expected. For example a
manufacturer has 100 employees who are injured during a year. The amount loss from
these injuries ranges from Rs.500 to Rs. 25,000 with an expected value of Rs. 15,500.
4. Covariance and correlation: To compute the variance of a portfolio return, it is
important to understand covariance and correlation, which a pair of return tend to move
together.
3. Loss distribution used in Risk management
Probability distribution can be very useful tools for evaluating the expected frequency
and severity of losses due to identified risks. In risk management two types of
probability distribution, are used.
There are those theoretical probability distribution used widely in risk management.
a. Binomial distribution: In probability theory and statistical, the binomial distribution
is the discrete probability distribution of the number of successes in a sequence of
independent yes/no experiment each of success and failure experiment.
b. Poisson distribution: In probability theory and statistics, the Poisson distribution is
a discrete probability distribution that express the probability of a number of events
occurring in a fixed period of time if these events occur with a known average rate
and independently of the time since the last event.
c. Normal distribution: The most important continuous probability distribution used
in the entire field of statistics is the normal distribution. Its graph, called the normal
curve, is a bell-shaped curve that extended indefinitely in both directions, coming
closer and closer to the horizontal axis without ever reaching it.
4. Integrated risk measures
The assessment of risk in an integrated risk framework requires additional
quantification techniques. Two approaches are used for this purpose.

Prof. Roopa Balavenu, Asst. Prof., Department of MBA, Acharya Institute of Technology, 3
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Risk Management and Insurance-18MBAFM402 AIT-2020

a. Value-at-risk: One approach being used in Value at risk has been used by banks to
quantify financial risk, but is increasingly being considered by other types of firms
that wish to assess all type of risks in a coordinated framework.
b. Risk adjusted return on capital: Another measure sometime used in an enterprise
wide assessment of risk is risk adjusted return on capital. This approach attempts to
allocate risk costs to the many different activites of the firm, such as products,
projects, loans and so on.
Risk control
A major issue for risk managers is the decision about how much money to spend on the various
forms of loss control. The general rule is that to justify the expenditure, the expected gains
from an investment is loss control should be at least equal to the expected costs. This
comparison of costs.
Types of loss control
1. Loss prevention
2. Loss reduction

1. Loss prevention: It refers to measures that reduce the frequency of a particular loss.
Loss prevention as its name implies, focuses on stopping loss from happening. The
foremost purpose of loss prevention is to preserve human life. That is a risk manger’s
first goal in a loss prevention program is to reduce or eliminate the change of death or
injury to people.
2. Loss reduction: risk reduction involves methods that reduces the security of the loss or
the likelihood of the loss from occurring. In this method, the business reduce risk by
taking appropriate steps include adaptions of safely programs installation burglar alarm
extinguisher, employment of right security guard.

Timing of loss reduction

a. Pre-loss activities: some loss control methods are implemented before any losses
occur all measure with a frequency reduction focus, as well as some based on
severity reduction are of this type are called pre-loss activities.
b. Concurrent loss control: the second timing classification for loss control measure
is that of activities that take place concurrently with losses. The activation of
building sprinkler system explain the concept of concurrent loss control. Such
system are trigged only after a fire begins and are designed to extinguish the fire
quickly and thereby decrease the severity of the resultant loss.
c. Post-loss activities: the third timing category is that of post-loss activities. As with
concurrent loss control, post loss activities always have a severity reduction focus.

Techniques of Loss control

1. Risk avoidance: the most effective way of manging any loss exposure is to avoid the
exposure completely. If a loss exposure has successfully been avoided, then the

Prof. Roopa Balavenu, Asst. Prof., Department of MBA, Acharya Institute of Technology, 4
Bangalore
Risk Management and Insurance-18MBAFM402 AIT-2020

probability of loss exposure is zero. Avoidance is risk control technique that involves
ceasing or never undertaking an activity is eliminated. The aim of avoidance is not just
to reduce loss frequency, but to eliminate any possibility of loss.

2. Loss prevention: accepts a risk but attempts to minimize the loss rather than eliminate
it. For example, inventory stored in a warehouse is susceptible to theft. Since there is
no way to avoid it, a loss prevention program is put in place. The program includes
patrolling security guards, video cameras and secured storage facilities. Insurance is
another example of risk prevention that is outsourced to a third party by contract.
3. Loss reduction: accepts the risk and seeks to limit losses when a threat occurs. For
example, a company storing flammable material in a warehouse installs state-of-the-art
water sprinklers for minimizing damage in case of fire.
4. Separation: involves dispersing key assets so that catastrophic events at one location
affect the business only at that location. If all assets were in the same place, the business
would face more serious issues. For example, a company utilizes a geographically
diverse workforce so that production may continue when issues arise at one warehouse.
5. Duplication: involves creating a backup plan, often by using technology. For example,
because information system server failure would stop a company’s operations, a backup
server is readily available in case the primary server fails.
6. Diversification: allocates business resources for creating multiple lines of business
offering a variety of products or services in different industries. A significant revenue
loss from one line will not result in irreparable harm to the company’s bottom line. For
example, in addition to serving food, a restaurant has grocery stores carry its line of
salad dressings, marinades, and sauces.

No one risk control technique will be a golden bullet to keep a company free from potential
harm. In practice, these techniques are used in tandem with one another to varying degree and
change as the corporation grows, as the economy changes, and as the competitive landscape
shifts.

Risk financing technique

It is the technique for the funding of losses after they occur. Major risk financing technique
include the following:

1. Risk retention:
It involves accepting the loss or benefit of gain, from a risk when it occurs true self-
insurance falls in this category. Risk retention is a viable strategy for small risks where
the cost of insuring against the risk would be greater over time than the total losses
sustained. All risk that are not avoided or transferred are retained by default. This
includes risks that are so large or catastrophic that they either cannot be insured against
or the premium would be infeasible.
Forms of risk retention:
a. Planned retention
b. Unplanned retention
c. Funded retention
d. Unfunded retention
2. Risk transfers:

Prof. Roopa Balavenu, Asst. Prof., Department of MBA, Acharya Institute of Technology, 5
Bangalore
Risk Management and Insurance-18MBAFM402 AIT-2020

These are other risk fianancing technique. Risk transfers are methods other than
insurance by which a pure risk and its potential fianancial consequences are transferred
to another party. In other words, under this method, a preson who is subject to risk may
induce another person to assume the risk. Some of the techniques used for transfer of
risk are hedging, sub-contracting, getting surety, bonds, entering into indemnity
contract etc.
Methods of risk trasnsfers
a. Hold-harmless agreements
b. Incorporation
c. Diversification
d. Hedging
e. Insurance

3. Commercial insurance:
Commercial insurance is the method of managing and spreading the risk among many
business owners. Premium is collected from number of covered businesses by the
insurance companies further a pool of money is created and invested to pay out to a
covered business if that business has a covered loss. Commercial insurance is actually
broad name given for different types of coverages available to the business owner to
protect against losses and to insure the continuing operations of the business.

Risk management decision making

Following are methods of risk management decision making
1. Risk avoidance
2. Loss control
3. Risk retention
4. Non- Insurance transfer
5. Insurance

Explanation already given in 1 and 2 module.

Risk pooling arrangement and diversification

Diversification is a risk management technique that mixes a variety of investment

within a portfolio. The rationale behind this technique contents that a portfolio of
different kinds of investments will on average. Yield higher return and pose a lower
risk that any individual investment found within the portfolio.

Pooling arrangement means sharing loss and risks equally or split evenly any accident
costs. As a result pooling arrangements reduce risks (standard deviation) for each
participant. In pooling arrangements the average loss is paid by each person.

The probability distribution of accident costs facing each person is reduced by pooling
arrangements. The pooling arrangement decreases the probabilities of the extreme
outcomes. In pooling arrangements each person’s risk is reduced but each person’s
expected accident cost is unchanged.

The pooling arrangement reduces risks through diversification. In pooling

arrangements, the cost has become more predictable. Normally the average loss is much
more predictable than each individual’s loss.

Prof. Roopa Balavenu, Asst. Prof., Department of MBA, Acharya Institute of Technology, 6
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Risk Management and Insurance-18MBAFM402 AIT-2020

Pooling arrangement also decreases the additional risks by adding people. By adding
more people the probability distribution of each person accident cost will continue to
be changed. In all the factors being held constant the risk that can be reduced through
pooling arrangement increases as the number of participant’s increases. In this case the
pooling arrangement decreases risk for each participant. The probability distribution
would become more and more bell shaped if more participants are added.

Two persons pooling arrangement

This type of risk division where losses of one are borne by another also. Here the losses
are divided among two people. This concept can be shown with this mathematical
example for example: Ram and sham each are exposed to the possibility of an accident
in the coming year. In particular assume that each person has a 20 percent chance of an
accident that will cause a loss of Rs 2500 and an 80 percent chance of no accident.
Because both ram and sham each have a 20 percent chance of having an accident that
cause Rs 2500 in losses, the expected costs.

Pooling arrangement with many people or business

The pooling arrangement can be done with many people also where the losses are
divided or spread through more than two people. Pooling arrangement also decrease the
additional risky by adding people. By adding more people the probability distribution
of each person accident cost will continue to be changed.

For example in ajay who has the same probability distribution fro accident cost as ram
and sham joins the pooling arrangements. So at the end of the year each person will pay
one third of the total losses (the average loss). The addition of a third person whose
losses are independent of the two causes an additional reduction in the probability of
extreme outcome.

In order for ram to pay Rs.2500 in accident costs at these individuals must experience
a Rs 2500 loss. The probability of this occurring is 0.2*0.2*0.2= 0.008. As a
consequence the standard deviation for each individual decrease with the addition of
another participant.

Advances issues in Risk management

Changing scope of risk management

Today, the risk manager: Is involved with more than simply purchasing insurance,
Considers both pure and speculative financial risks, Considers all risks across the
organization and the strategic implications of the risks.

Beginning in the 1990s and continuing into the 25 century, risk managers have started
focusing on new type of risks and have begun using new methods of risk analysis.

Risk manager of corporations have stared focusing more on verifying their companies
compliance with federal environment regulations. According to Risk management risk
managers began to assess environmental risk such as those arising from population,

Prof. Roopa Balavenu, Asst. Prof., Department of MBA, Acharya Institute of Technology, 7
Bangalore
Risk Management and Insurance-18MBAFM402 AIT-2020

waste management and environment liability to help make their companies more
profitable and competitive.

Financial risk

Financial risk is the risk of losses inherent in financial transaction, following are the
risks which are classified as under financial risk.

a. Interest rate risk

b. Currency risk

Insurance market Dynamics

Until 1st April 2000 the Indian insurance industry comprised of mainly two state insurers. Post
de-regulation, after the private insurance players started entering the competition, it has been
seen that market changes in the market dynamics. However, till today the public sector insurers
control the dominant share while their competition are trying hard to find their footing. The
global scenario of course is different, and it has been anticipated that increased levels of
consumer awareness as the Indian scenario will stimulate the rest of the firms, small market
shares, undifferenced products. Now, understand that how insurance cycle works. The
insurance industry is highly cyclical and goes through alternated period of underwriting profit
and loss- the insurance market is characterised as hard and soft depending on the phases of the
cycle which are as follows.

Insurance market dynamics

a. Underwriting cycle
b. Consolidation in the insurance industry
c. securitisation risk

Underwriting cycle:

The underwriting cycle refers to the tendency for commercial property and liability insurance
market to fluctuate between periods of tight underwriting with high insurance premiums and
loose underwriting with low insurance premiums

1. Soft market: in this phase there are lower insurance premiums, broader coverage,
reduced underwriting criteria, which means underwriting is easier, insured capacity,
which means insurance carriers write more policies and higher limits and increased
competition among insurance carriers.
2. Hard market: during this phase there are higher insurance premiums, more stringent
underwriting criteria, which means underwriting is more difficult, reduced capacity,
which means insurance carriers write less insurance policies and less competition
insurance carriers.

.
Consolidation in the insurance industry

The consolidation in the insurance industry refers to amalgamating insurance business

Prof. Roopa Balavenu, Asst. Prof., Department of MBA, Acharya Institute of Technology, 8
Bangalore
Risk Management and Insurance-18MBAFM402 AIT-2020

organisation through mergers and acquisition. A number of consolidations trends have changed
the insurance marketplace for risk managers there types of consolidations have been generally
occurring.

1. Insurance company mergers and acquisitions: Insurance company mergers refers to a

combination of two or more companies into a single new company, where the new
company survives and other loose the corporate identity.
2. Insurance brokerage mergers and acquisitions: Insurance brokerages have been mergers
with or acquiring other insurance companies.
3. Cross industry consolidations: It is occurs when company in one financial services area
mergers with or acquires a company or an insurance company may purchase an
investment company.

Securitisation of risk

It is the process of conversion of existing assets or future cash flows into marketable securities.
For the purpose of distinction, the conversion of existing assets into marketable securities is
known as asset backed securitization and the conversion of future cash flows into marketable
securities is known as future flows securities

In securitisation, insurable risk is transferred to the capital markets through creation of financial
instruments such as catastrophe bonds, derivative contract, options, swaps, futures or other
financial instruments.

Loss forecasting

An important risk identification tool is that of statistical analysis of past losses. This method is primarily
applicable to very large firms. Some of the characteristics of past losses that may prove to be important
in this regard include cause of loss, the absolute amount of loss and particular employees involved in
such loss.

The risk manager may use several technique to forecast losses they are:

Probability analysis Statistical analysis Law of large number Probability analysis

The probability of an event refers to its long-term frequency of occurrence. All event have a probability
between zeros. To calculate the probability of an event, the number of times occurs is divided by all
possible events of that type.

Statistical analysis

It is probability distribution of losses that occur. Forecasting by using loss distribution works well, if
the history of losses tends to follows a specified loss distribution and the sample size is large. Knowing
the parameters that specify the loss distribution enable the risk managers to events, severity and
confidence intervals. Many loss distribution can be employed, depending on the pattern of losses. Some
of the statistical method for loss forecasting as follows:

a. Mean
b. Median
c. Mode
d. Regression method

Prof. Roopa Balavenu, Asst. Prof., Department of MBA, Acharya Institute of Technology, 9
Bangalore
Risk Management and Insurance-18MBAFM402 AIT-2020

Law of large numbers

Predictions of future losses with some accuracy is based on the law of large numbers. By pooling or
combining the loss experience of a large number of exposure units, an insurer may be able to predict

future losses with greater accuracy. From the viewpoint of the insurer, if future losses can be predicated,
objective risk is reduced. Thus another characterise often found in many lines of insurance is risk
reduction based on the law of large number.

The law of large number states that the greater the number of exposures the more closely will the actual
results approach the probable results that are expected from an infinite number of exposures.

Financial analysis in risk management

Financial analysis can be in risk management can be done through following ways:

1. Time value of money

2. Financial analysis application

Time value of money

Risk management decision are likely to involve cash flows in different time periods, therefore the time
value of money must be considered. The time value of money means that when valuing cash flows in
different periods, the interest earning capacity of money must be taken into consideration. A rupee
received today is worth more than a rupee received one year form today, because the rupee received
today can be invested immediately to earn interest. Therefore, when evaluating cash flows in different
time periods, it is important to adjust rupee values to reflect the earning of interest.

Financial analysis application

In the financial analysis of application time value of money is considered while risk management
decision making. The two types of application involved in it are

1. Analysing insurance coverage bids

2. Loss control investment decision

Analysing insurance coverage bids

Insurance coverage bids analyse with the help of following example, assume that Mr D would like to
purchase property insurance on a building. He is analysing two insurance coverage bids. The bids are
from comparable insurance companies, and the coverage amounts are the same. The premiums and
deductibles, however, differ.

Loss control investment decision

Capital budgeting for taking an investment decision is the most effective and powerful tool. Investment
decision pertaining to long term assets for the purpose of generating revenues for the business entity is
called capital budgeting. It involves long-term planning and monitoring of capital expenditure, besides
examining each proposal in a very logical scientific manner so as to finalise the best proposal. The two
types of capital technique which help in loss control in the projects are as follows:

1. Net present value.

2. Internal rate of return.

Prof. Roopa Balavenu, Asst. Prof., Department of MBA, Acharya Institute of Technology, 10
Bangalore
Risk Management and Insurance-18MBAFM402 AIT-2020

Other risk management tools

Apart from the advance risk management tools, other types of risk management tools are as follows:

a. Risk management information system

b. Risk maps
c. Intranet and risk management web sites
d. Value at risk analysis

Risk management information system

Accurate and accessible data are the key concern of risk managers. Risk management information
system is computerised database that enables risk manager to store and analyse risk management data
and to use that data for forecasting and control future losses. RMIS can be greater help for making
decision in risk management. RIMS are often offered by independent RMIS vendors or they can be
development within the company.

Risk maps

Some organisations are developed or they are developing sophisticated risk maps. Risk maps are nets
of detailed potential frequencies and intensity of risk facing organisations. Risk manager must analyse
every risk that organisation is facing in order to define a risk map. Usage of risk maps vary from simple
graphic presentation of exposures to risk to simulating analyses for estimating scenarios of probable
losses. Additionally, other risk like property risk, liabilities risks, personal risk, financial risks and many
more that pertain in enterprise risks, can be included in the risk maps.

Intranet and risk management websites

Some risk management departments have establishment their own websites. Additionally, some
organisation expanded their traditional risk management website into risk management intranet. Intranet
is the website designed for limited, internal public with a search capability. Through intranet, employees
can get list of tracking procedures along with set of forms to be signed and completed before an event
can take place.

Value at risk analysis

Value at risk is another tool to measure the likelihood that the loss of a given portfolio of assets or
liabilities exceeds some threshold based on normal market conditions. The measurement is static is that
the likelihood is based on a fixed time period with a confidence level of the analysts choice. The
different between the expected loss and the actual loss over a certain period represented the volatility
of the portfolio, thus value at risk.

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Prof. Roopa Balavenu, Asst. Prof., Department of MBA, Acharya Institute of Technology, 11
Bangalore