Risk Identification and

Measurement
Lesson 2
 Outline

✓Risk Identification

✓ Basic Concepts from Probability and Statistics

✓ Evaluating the Frequency and Severity of

Losses.
 Probability
✓ Probability theory, a branch of mathematics, is a
means of predicting random events by analyzing
large quantities of previous similar events.
✓ Probabilities in statistics are the mathematical
odds that an event will occur.
✓ To obtain a probability ratio, the number of
favorable results in a set is divided by the total
number of possible results in the set.
✓ The probability ratio expresses the likelihood that
the event will take place.
✓ This ratio is significant to insurance providers.
 Probability
✓ Risk is probability of happening unfavorable
event.
✓ If possibility of happening unfavorable event is
zero, it is assumed that there is no risk.
✓ So the probability is used to estimate the
degree of risk.
✓ For example: the probability of a severe
earthquake may be very small but the result are
so catastrophic that it would be categorized as
a high risk.
 Use of Probability in Insurance
✓Rates differ for policyholders contracting
identical insurance policies depending on several
analyzable rating factors.
✓Insurance providers have good reasons for this
practice. As part of the analytical procedures,
insurers study statistics to calculate and manage
risk when evaluating policy applications and
setting premium rates.
✓The results show that, based on probability,
some individuals simply pose a higher risk and
are more likely to file claims.
 Use of Probability in Insurance
✓ Companies that provide property and liability insurance
use probability to assess risks.
✓ Data show that the age and gender of the driver plays a
role in the likelihood of an auto accident.
✓ The type of vehicle insured, the driver's geographic
location and the number of miles driven regularly are
additional factors the insurer considers when setting
premium rates based on probability.
✓ The more miles a policyholder drives, for example, the
greater the probability he'll be involved in an accident.
Setting rates for homeowners insurance also involves
probability. Factors considered include the type of heating
system in the home, the location and age of the property
and any added security features it has
 Use of Discounted Cash Flow
✓ Discounted cash flow analysis often is used by
firms to compare the net present value of various
loss control and loss financing decisions.
✓ This procedure requires an estimation of the
expected value and timing of cash flows for each
alternative and the choice of an appropriate
discount rate in view of the risk of the cash flows.

✓ If the NPV is positive while establishing certain

measure for loss control then firm can increase
the firm’s value by establishing the measure and
vice versa.
 Use of Discounted Cash flow

Like wise, with multiple loss financing

options, it is customary to estimate the
discounted value of expected net cash
outflows for retained losses, insurance
premium and other costs and choose
the method with the lowest discounted
cost.
 Statistics
• Statistics is used to determine what risk an
insured poses to an insurance company, what
percentage of policies is likely to pay out, and
how much money a company can expect to pay
out in claims.
 Use of statistics in Insurance
Actuaries
✓ An actuary is a person trained in investment
strategies and statistical tools. Actuaries need
to know investment strategies in insurance
because of the diverse range of products in the
insurance field.
✓ For example, an actuary may be working with
pensions and retirements under a life insurance
umbrella. Actuaries are required to pass tough
examinations in almost every country to
demonstrate they have a sound knowledge of
probability and statistics.
 Use of statistics in Insurance
Making Decisions
✓ Statistics isn't an exact science: actuaries look at
statistical data and make a best guess at what the data is
telling them. In order to prepare for making decisions,
actuaries study decision theory, a subset of mathematics
and statistics that includes game theory. Game theory
helps an actuary to understand what a person is likely to
do and why.
✓ For example, if an auto insurance policy holder goes into
debt, he may be more likely to file a false claim on his
vehicle to make money. There are no definite figures for
this type of human behavior; the decision to charge a
higher premium for certain risks is made by the actuary
based on his knowledge base.
 Use of statistics in Insurance
Loss Distributions
✓ A loss distribution can give an actuary a picture of
claim behavior over a certain period or show how
categories of claims stack up against each other.
For example, an actuary might construct a
histogram, a type of bar graph that compares
categories.
✓ The bar graph might show how claims relate to age
groups for life insurance. The actuary will be able
to look at trends and see if higher premiums for
certain age groups are warranted.
 Use of statistics in Insurance
Linear Models
✓ A linear model can be used to see if one
category or item is related to another. An
example of a linear model is linear regression:
data points are plotted on a graph to see if they
have a linear relationship; in other words, can a
straight line be used to represent the data.
✓ If a straight line can be drawn, this indicates
that there is a relationship between the two
categories. A linear model can be used to find
out information about how age, gender, salary
and other characteristics relate to claim size.
 Use of statistics in Insurance
Time Series Models
✓ A time series model is where an actuary looks at
how a particular item performs over time.
✓ For example, they may look at how policyholders'
claims history changes over time to determine how
much to charge for specific policyholder
characteristics or they may study the performance
of investments over a period of time to determine
rates to charge for whole life insurance policies.
 Use of statistics in Insurance
✓ A correlation is simply defined as a relationship between two
variables. The whole purpose of using correlations
in research is to figure out which variables are connected. In
general, correlation tends to be used when there is no
identified response variable. It measures the strength
(qualitatively) and direction of the linear relationship between
two or more variables.

✓ Consumers face positive correlation in their assets (health,

wealth, wisdom i.e., skills), causing them to demand a great
deal of insurance coverage.

✓ Correlated risk refers to the simultaneous occurrence of many

losses from a single event. ... If the losses are
perfectly correlated, then there will be either two losses with
probability of 0.1, or no losses with a probability of 0.9.
 Identifying Business Risk Exposures
✓ The first step in the risk management process is risk
identification: the identification of loss exposures.
✓ Unidentified loss exposure most likely will result in
an implicit retention decision, which may not be
favorable.
✓ Loss exposures can be identified through analysis of
the firm’s financial statements, discussions with
managers throughout the firm, surveys of
employees, and discussions with insurance agents
and risk management consultants.
 Identifying Business Risk Exposures
✓ Despite of the specific methods, risk identification
requires an overall understanding of the business
and the specific economic, legal and regulatory
factors that affect the business.

Property loss Exposures

✓ Some of the major practical questions asked when
identifying property loss exposures for business are
listed below:
 Identifying Business Risk Exposures
✓ Several valuation methods are used for the purpose
of making risk management decisions like
1. Book value: purchase price minus accounting
depreciation is used for financial reporting
purposes.
2. Market value: It is the value that the next highest
valued users would pay for the property.’
3. Firm specific value: is the value of the property to
the current owner.
4. Replacement cost: is the cost of replacing the
damaged property with new property.
 Identifying Business Risk Exposures
5. Business income exposures: it includes exposures
like shutdown of business and no profit and unable
to pay salary to employees due to fire.
6. Extra Expense exposure: it is the exposure that
arise from closing down of business for sometime
and customer are shifted to competitors and they
don't return to your business.
 Identifying Business Risk Exposures
Liability losses:
✓ firm faces potential legal liability losses as a result
of relationship with many parties including
suppliers,customers,employees,shareholders and
members of the public.
✓ The settlements,judgements 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
minimize the costs of this damage
 Identifying Business Risk Exposures
Losses to Human Resources:
✓ Losses to firm value due to worker
injuries,death,retirement and turnover can be grouped
into two categories, first as a result of contractual
commitments and compulsory benefits, firms often
compensate employees for injuries,disabilities,death
and retirement and
✓ Other due to worker injuries,disabilities,death
retirement and turnover can cause indirect losses
when production is interrupted and employees cannot
be replaced at zero cost with other employees of the
same quality.
 Identifying Business Risk Exposures
Losses from External Economic forces:
✓ Losses can arise because of changes in the prices of
inputs and outputs due to fluctuation in foreign
exchange rates affects multinational companies.
✓ Changes in business environment like
political,economic,socio-cultural,technological
changes affects the revenue of the company either
purchase or supplier
 Identifying Individual Exposures
✓ One method of identifying individual exposure is to
analyze the sources and uses of funds in the
present and planned for the future.
✓ Potential events that cause decreases in the
availability of funds or increases in uses of funds
represents risk exposures.
✓ Both physical and financial assets represent
potential future sources of fund, potential losses in
asset values also represent risk exposures.
 Identifying Individual Exposures
✓ An important risk for families or individual is a drop
in earning prior to retirement due to the death or
disability of a breadwinner.
✓ Risk also arises from important sources of risk like
medical expenses which is costly
✓ Another major sources of expense risk is from
personal liability exposures when driving and
owning property with potential hazards.
✓ Retirements also result in drop of earning which is
also a risk for families since reduction of earning
also affects to overcome expense of a family.
 Evaluating the Frequency and Severity of Losses.
1. Identify the potential loss:
✓ The company identifies potential losses such as
property damage due to fire or natural disasters,
product liability claims due to defects, employee
injuries due to accidents, and business interruption
due to equipment breakdown.
2. Determine the likelihood of the loss: The company
analyzes historical data and industry statistics to assess
the likelihood of each potential loss. For example, they
may find that the likelihood of a fire in their
manufacturing facility is low, but the likelihood of a
product liability claim due to a defect is moderate.
 Evaluating the Frequency and Severity of Losses.
3. Assess the severity of the loss:
✓ The company estimates the severity of each potential
loss. For example, they may estimate that a fire could
cause $500,000 in property damage, while a product
liability claim could result in a $1 million legal
settlement.
4. Calculate the frequency of loss:
✓ The company uses historical data and statistical models
to estimate the frequency of each potential loss. For
example, they may estimate that a fire occurs once
every 10 years, while a product liability claim occurs
once every 3 years.
 Evaluating the Frequency and Severity of Losses.
5. Determine the overall risk:
✓ The company weighs the likelihood and severity of
each potential loss against the resources available
to mitigate the risk.
✓ For example, they may decide to purchase
insurance to cover potential losses, implement risk
management strategies such as fire prevention
measures and quality control procedures, or accept
the risk of certain losses that are deemed unlikely
or less severe.