RISK MEASUREMENT

MODULE-3
 CONTENTS
Evaluating the frequency and severity of losses.
Risk control.
Risk financing techniques.
Risk management decision methods.
Pooling arrangements & diversification of risk.
Advanced issues in risk management.
The changing scope of risk management.
Insurance market dynamics.
Loss forecasting.
Financial analysis in risk management.
Decision making.
Other risk management tools.
 EVALUATING THE FREQUENCY

Frequency- Since standard deviation is the most common proxy for risk, the
easiest way to approach the problem of risk measurement is to catalogue the
various inadequacies of standard deviation as a risk measure.
 SEVERITY METHOD
An actuarial method for determining the expected number of claims that an insurer will
receive during a given time period, and how much the average claim will cost.
Frequency-severity method uses historical data to estimate the average number of
claims and the average cost of each claim.
The method multiplies the average number of claims by the average cost of a claim.
Insurers use sophisticated models to determine the likelihood that they will have to pay
out a claim.
Ideally, the insurer would prefer receiving premiums for underwriting new insurance
policies without ever having to pay out a claim, but this is a very unlikely scenario.
Instead, insurers develop estimates as to how many claims they may expect to see and
how expensive the claims will be based on the types of policies they provide to
policyholders.
 The frequency-severity method is one option that insurers use to develop models.
Frequency refers to the number of claims that an insurer expects to see. High frequency
means that a large number of claims is expected to come in. Severity refers to the cost
of a claim, with high severity claims being more expensive than average estimates and
low severity claims being less expensive than the average. The average cost of claims
may be estimated based on historical cost figures.
Because the frequency-severity method looks at past years in determining average
costs for future years it is less influenced by more volatile recent periods. This means
that it is not reliant on loss development factors based on more recent years. However,
this means that the method is also slower to adapt to increases in volatility.
For example, an insurer providing flood insurance will adapt more slowly to an increase
in the severity or frequency of flood damage claims caused by recent rising water levels.
 RISK CONTROL

Risk management is a series of steps whose objectives are to identify,

address, and eliminate software risk items before they become either threats
to successful software operation or a major source of expensive rework.
(Boehm, 1989)
 RISK FINANCING TECHNIQUES:

Retention of Risk:
The financing of risks and losses is said to be retained if the funding source
for payment of the losses originates from and remains within the
organization until the loss is actually paid. Financing risks through retention
can be accomplished by any of the following techniques.
 Expensing of Losses
Current expensing of losses involves the payment of losses directly from the current
operating budget or appropriation. That is, the loss is expended or paid out of the
current years operating funds. Current expensing typically does not provide for a
formally recognized funding source from which losses are paid. Therefore, expensing of
losses is suitable only for payment of small losses such as repairing or replacing a
broken typewriter. Expensing is not suitable for funding large losses.
Reserves
Reserves may be established in two ways.
(1) Unfunded Reserve An unfunded reserve is established when the state agency
recognizes a loss will occur, but specific funds or assets are not set aside from which the
loss may be paid. An example of an unfunded reserve is an account that is established to
track uncollectible fees or taxes owed to the state.
(2) Funded Reserve A funded reserve is created when funds are set aside specifically for
payment of losses. The funded reserve cannot be utilized for any other purpose than
payment of claims.
An example of a funded reserve might be the establishment of a fund from which tort
claims against the organization are paid.

Borrowing
Borrowing is a method that may be utilized by an organization to pay for losses that
have not been previously funded or insured. However, state agencies are not able to
borrow since all appropriations and funding sources must be approved by the
Legislature. Therefore, borrowing is not an option for state agencies as a risk financing
technique.
Self Insurance
Self insurance by the state involves the establishment of an entity within
state government which functions in the same manner as a commercial
insurer. Premiums are collected from the various agencies, commissions,
and institutions of higher education, etc. within the state, and claims and
losses are adjusted and paid from the fund created by the premiums paid.
Self insurance is practical only for large entities. An example of this is the
Workers Compensation Payment program.
Transfer of Risk
The financial burden of losses can be transferred from the entity incurring the
loss to an outside entity. This may be accomplished through the purchase of
commercial insurance or through a contractual transfer.
Insurance as a Transfer of Risk
Insurance is a contractual relationship that exists when one party (the
Insurer) for a consideration (the Premium) agrees to reimburse another party
(the Insured or third party on behalf of the Insured) for a loss to a specified
subject (the Risk) caused by designated contingencies (the Hazards or Perils).
 When commercial insurance is purchased the insured entity pays premiums
to the insurer. The insurer then pools the premiums paid by all insured
entities that have purchased the same type of insurance. In this manner the
risks are spread among all insured, and premiums are kept to a minimum.
The insurer is then legally responsible for payment of all claims and losses,
subject to the terms, exclusions and limitations of the policy, rather than the
entity incurring the claim or loss.
Contractual Transfer of Risk
Contractual transfer of risk involves a legal transfer of the financial responsibility
for payment of losses, but does not involve the purchase of insurance. Such non-
insurance transfers typically involve the use of a hold harmless agreement.
Such an agreement may be required by a state agency that allows the use of
public facility by a third party. The state agency would require the third party to
sign a contract to hold the state agency harmless for losses that may arise due
to the third partys use of the facility. The contract would need to specify the type
of losses that fall within the contract. A state agency should check with the
agencys general counsel regarding applicability of hold harmless agreements.
 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, Net Present Value (NPV) of
Workers Compensation Premiums Savings for Energy Fitness Centers When Purchasing Innovative
Safety Belts for $50,000 and, Workers Compensation Frequency and Severity of Energy Fitness
CentersActual and Trended, Dana compared the forecasted frequency and severity of the
workers 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, EFCs 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.
 POOLING ARRANGEMENTS AND
DIVERSIFICATION OF RISK
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 persons risk is reduced but each persons
expected accident cost is unchanged.
 ADVANCED ISSUES IN RISK MANAGEMENT

Current Issues in Risk Management Structure of the Presentation:

1. What are we good at?
2. Where may we see improvements?
3. What are we bad at?
4. Where are we most vulnerable?
 INSURANCE MARKET DYNAMICS

Insurance markets have changed radically and deeply in the past twenty
years. Deregulation, globalization of insurance institutions, intensified
competition, electronic commerce, bancassurance, and the emergence of
new risks are among the challenges faced by insurance markets. Although
important global trends are reshaping insurance markets, the emphasis on
globalization overlooks the local diversity of insurance markets worldwide.
 LOSS FORECASTING

The use of historic data to determine the direction of future trends.

Forecasting is used by companies to determine how to allocate their budgets
for an upcoming period of time. This is typically based on demand for the
goods and services it offers, compared to the cost of producing them.
Investors utilize forecasting to determine if events affecting a company, such
as sales expectations, will increase or decrease the price of shares in that
company. Forecasting also provides an important benchmark for firms which
have a long-term perspective of operations.
 FINANCIAL RISK MANAGEMENT AND
DECISION MAKING
Financial risk management is the practice of economic value in a firm by
using financial instruments to manage exposure to risk, particularly credit
risk and market risk. Other types include Foreign exchange risk,Volatility risk,
Sector risk, Liquidity risk, Inflation risk, etc. Similar to general risk
management, financial risk management requires identifying its sources,
measuring it, and plans to address them.
 RISK ASSESSMENT TOOLS

Risks must be identified correctly before an organization can take the next
step. Assessing the wrong list of risks or an incomplete list of risks is futile.
Organizations should make every possible effort to ensure they have
identified their risks correctly using some or all of the approaches discussed.
The act of identifying risks is itself a step on the risk assessment road. Any
risks identified, almost by default, have some probability of influencing the
organization.
 CATEGORIES
Once risks are identified, some organizations find it helpful to categorize them. This
may be a necessity if the risk identification process produces hundreds of risks, which
can be overwhelming and seem unmanageable. Risk categories include hazard,
operational, financial, and strategic. Other categories are controllable or non-
controllable and external or internal. Categorizing risk requires an internal risk language
or vocabulary that is common or unique to the organization in total, not just to a
particular subunit. Studies have shown that an inconsistent language defining risks
across an organization is an impediment to an effective ERM strategy. Risk terms would
certainly vary between a pharmaceutical company and a technology company or
between a nonprofit and an energy company. Several risks could be grouped around a
broader risk, such as reputation risk. Other methods for categorizing risk can be
financial or nonfinancial and insurable or non-insurable. Some companies also
categorize risks as quantifiable or non-quantifiable.
 QUALITATIVE VS. QUANTITATIVE

Risk assessment techniques can vary from qualitative to quantitative. The

qualitative techniques can be a simple list of all risks, risk rankings, or risk
maps. A list of risks is a good starting point. Even though no quantitative
analysis or formal assessment has been applied to the initial list of risks, the
list and accompanying knowledge is valuable. Some risks on the list may not
be quantifiable. For these risks, identifying them and adding them to a
priority list may be the only quantification possible. Organizations should not
be concerned that they cannot apply sophisticated modeling to every risk.
 RISK RANKINGS

Once an organization has created its list of risks, it can begin to rank them. Ranking
requires the ERM team to prioritize the risks on a scale of importance, such as low,
moderate, and high.
Although this seems unsophisticated, the results can be dramatic. Organizations find
considerable value in having conversations about the importance of a risk. The
conversations usually lead to questions about why one group believes the risk is
important and why others disagree. Again, this process should use a cross-functional risk
team so that perspectives from across the entire organization are factored into the
rankings. This is a critical task requiring open debate, candid discussion, and data (e.g.,
tracking, recording, and analysis of historical error rates on a business process) where
possible.