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CHAPTER TWO
2. THE RISK MANAGEMENT
2.1. Introduction
We have looked at the nature of risk and the various classifications into which it can be put. The various
classifications that we have used all tend to support the view that risk is to be avoided at all costs. It
would be valuable to stop here for a moment and pose this question in mind - Are we to conclude that
risk has no beneficial side to it? Is it solely a negative concept, implying loss and not gain at all? Has
the world gained nothing from the existence of risk? These and all other related questions will be replied
in the discussion to follow.
Countless instances can be thought of where risk has a beneficial effect. We have already seen the extent
of risk in the business world. It enters into all aspects of business life, but does it have any beneficial
function at all. One view which could be taken is that risk is at the very heart of any free market
economy. Risk enables wealth to be created; it does this in a number of ways:
It creates the hope for profit. Entrepreneurs are encouraged to take risks of all kinds, in the hope that
the reward will be higher than they could achieve by choosing a safer option. Often, this risk taking will
be wealth creating in the form of employment, goods/services, and investment.
Risk is a bar to entry into the market place for ventures, which are unsound, or likely to be short-
lived. The cost of risk will be viewed as too high and potential players in the risk market place will look
elsewhere for a return. The result should be a more competitive market place, which is to the benefit of
the consumer and the national economy.
Risk encourages a safety culture. This means safety in its widest sense and includes employees,
consumers, the public and the environment. Those who operate in the market place cannot afford to run
too high of a risk.
All these points suggest a slightly more positive side to risk taking, but we should modify this by
including a form of ‘Health Warning: Risks can be positive or negative!. That is, businesses exist in part
because there is risk, but this risk can be their downfall. The answer must be to manage the risks to
which the business is exposed.
2.2. Risk Management Defined
The following definitions of risk management have been forwarded for convenience.
Definition 1: Risk Management refers to the identification, measurement and treatment of exposure to
potential accidental losses almost always in situations where the only possible outcomes are losses or no
change in the status (“loss” or “no loss” i.e. pure risks).

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Definition 2: Risk Management is a general management function that seeks to assess and address the
causes and effects of uncertainty and risk on an organization. The purpose of risk management is to
enable an organization to progress towards its goals and objectives in the most direct, efficient, and
effective path. It is concerned with all risks.
Definition 3: Risk Management is the executive function of dealing with specified risks facing the
business enterprise. In general, the risk manager deals with pure, not speculative, risk.
Definition 4: Risk Management is the identification, analysis and economic control of those risks which
can threaten the assets or earning capacity of an enterprise.
Definition 5: “Risk Management deals with the systematic identification of a company’s exposure to the
risk of loss.”
Definition 6: Risk management is defined as a systematic process for the identification and evaluation of
pure loss exposures faced by an organization or individual, and for the selection and implementation of the
most appropriate techniques for treating such exposures. It is a discipline that systematically identifies
and analyzes the various loss exposures faced by a firm or organization, and the best methods of treating
the loss exposures consistent with the organization’s goals and objectives. As a general rule, the risk
manager is concerned only with the management of pure risks, not speculative risks. All pure risks are
considered, including those that are uninsurable.
In order to summarize what has been said back and forth, the duties of a risk manager can be short listed
as under:
1. To recognize exposures to loss; the risk manager must, first of all, be aware of the possibility of
each type of loss. This is a fundamental duty that must precede all other functions.
2. To estimate the frequency and size of loss; to estimate the probability of loss from various
sources.
3. To decide the best and most economical method of handling the risk of loss, whether it be by
assumption, avoidance, self-insurance, reduction of hazards, transfer, commercial insurance, or some
combination of these methods.
4. To administer the programs of risk management including the tracks of constant revaluation of
the programs, recordkeeping and the like.
* Risk Management and Insurance Management
Risk management should not be confused with insurance management. Risk management is a much
broader concept and differs from insurance management in several aspects. Risk management places
greater emphasis on the identification and analysis of pure loss exposures. Insurance is only one of the
several methods that can be used to treat a particular loss exposure; as you will see later in this course, the
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techniques of avoidance, loss control, non-insurance transfers, and retention are also widely used in a
modern risk management program. Risk management also provides for the periodic evaluation of all
techniques for meeting losses, not just insurance. And a successful risk management program requires the
cooperation of a large number of individuals and departments throughout the firm. Risk management
decisions have a greater impact on the firm than insurance management decisions. Insurance management
affects a smaller number of persons.
2.3. Objectives of Risk Management
Risk management has several important objectives that can be classified into two categories; pre - loss
objectives and post - loss objectives.
1. Pre- loss objectives. A firm or organization has several risk management objectives prior to the
occurrence of a loss. The most important include economy, the reduction of anxiety, and meeting
externally imposed obligations.
a. Economy
The first goal means that the firm should prepare for potential losses in the most economical way possible.
This involves an analysis of safety program expenses, insurance premiums, and the costs associated with the
different techniques for handling losses.
b. The reduction of anxiety
The second objective, the reduction of anxiety, is more complicated. Certain loss exposures can cause
greater worry and fear for the risk manager, key executives, and stockholder than other exposures. For
example, the threat of a catastrophic lawsuit from a defective product can cause greater anxiety and
concern than a possible small loss from a minor fire accident. However, the risk manager wants to minimize
the anxiety and fear associated with all loss exposures.
c. Meeting externally imposed obligations
This means that the firm must meet certain obligations imposed on it by outsiders. For example,
government regulations may require a firm to install safety devices to protect workers from harm.
Similarly, a firm’s creditors may require that property pledged as collateral for a loan must be insured. The
risk manager must see that these externally imposed obligations are met.
2. Post – loss objectives: The first and most important post – loss objective is survival of the firm.
Survival means that after a loss occurs, the firm can at least resume partial operation within some
reasonable period of time if it chooses to do so.
The second post-loss objective is to continue operating. For some firms, the ability to operate after a
severe loss is an extremely important objective. This is particularly true of certain firms, such as public
utility firm, which must continue to provide service. The ability to operate is also important for firms that
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may lose customers to competitors if they cannot operate after a loss occurs. This would include banks,
bakeries, dairy farms, and other competitive firms.
Stability of earnings is the third post-loss objective. The firm wants to maintain its earnings per share
after a loss occurs. This objective is closely related to the objective of continued operations. Earning per
share can be maintained if the firm continues to operate. However, there may be substantial costs involved
in achieving this goal (such as operating at another location), and perfect stability of earnings may not be
attained.
The fourth post- loss objective is continued growth of the firm. A firm may grow by developing new
products and markets or by acquisitions and mergers. The risk manager must consider the impact that a
loss will have on the firm’s ability to grow.
Finally, the goal of social responsibility is to minimize the impact that a loss has on other persons and
on society. A sever loss can adversely affect employees, customers, suppliers, creditors, taxpayers, and the
community in general. For example, a severe loss that requires shutting down a plant in a small
community for an extended period can lead to depressed business conditions and substantial
unemployment in the community.
2.3.1. Possible Contributions of Risk Management
Because risk management, as defined in this reading material, is concerned with pure risks, it may be
regarded by some as the true ‘dismal science.” Pure risks have severe consequences. They hurt those
affected by it without resulting in any gain. They can only hurt a firm or family, and the purpose of risk
management is to minimize the hurt at minimum cost. Upon closer investigation, however, one
discovers that the possible contributions of risk management to businesses, families, and society are
highly significant.
a. Possible Contributions of Risk Management to a Business
The possible contributions of risk management to a business can be divided into five major categories.
The contributions that the risk manager will make in a particular case depend upon the objectives set
for this function and the extent to which these objectives are achieved.
First, risk management may make the difference between survival and failure. Some losses, such as
large liability suits or the destruction of a firm’s manufacturing facilities may damage a firm that
without proper advance preparation for such event the firm must close its doors. Hence, this
contribution of risk management is critical as those organizations that do not undertake proper risk
management may not even survive in their businesses.
Second, because profits can be improved by reducing expenses as well as increasing income, risk
management can contribute directly to business profits (or, in the case of nonprofit organizations or
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public agencies risk management improves the operating efficiency). For example, risk management
may lower expenses through preventing or reducing accidental losses as the result of certain low-cost
measures, through transferring potential serious losses to others at the lowest transfer fee possible,
through electing to take a chance on small losses unless the transfer fee is a bargain, and through
preparing the firm to meet most economically those losses that it has decided to retain. Hence, risk
management can make direct contribution to business profit.
Third, risk management can contribute indirectly to business profits in at least six ways.
i. If a business has successfully managed its pure risks, the peace of mind and confidence it
creates permits its managers to investigate and assume attractive speculative risks that they
might otherwise seek to avoid. For example, if a firm had to worry about windstorm damage to
its plants and industrial injuries to its employees, it might elect to limit itself to its present
markets. Freed of this worry, might expand to new markets.
ii. By alerting business managers to the pure-risk aspects of speculative ventures, risk
management improves the pure-risk aspects of speculative ventures, risk management
improves the quality of the decisions regarding such ventures. For example, a firm that was
deciding whether to lease or purchase a building might reach the wrong decision if it ignored
the differing economic impacts of accidental physical damage to the building.
iii. Once a decision is made to assume a speculative venture, proper handling of the pure-risk
aspects permits the business to handle the speculative risk more wisely and more efficiently.
For example, a business may develop its product lines more aggressively if it knows that it is
adequately protected against suits by persons who may be harmed accidentally by defective
products.
iv. Risk management can reduce the fluctuation in annual profits and cash flows. Keeping these
fluctuations within bounds aids planning and is a desirable goal in itself. Investors regard more
favorably a stable earnings record than an unstable one.
v. Through advance preparations, risk management can in many cases make it possible to
continue operations following a loss, thus retaining customers or suppliers who might
otherwise turn to competitors.
vi. Creditors, customers, and suppliers, all of whom contribute to company profits, prefer to do
business with a firm that has sound protection against pure risks. Employees also prefer to
work for such firms.

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Fourth, the peace of mind made possible by sound management of pure risks may by itself is a valuable
non-economic asset because it improves the physical and mental health of the management and
owners.
Fifth, because the risk management plan may also help others, such as employees, who would be
affected by losses to the firm, risk management can also help satisfy the firm’s sense of social
responsibility or desire for a good public image.
b. Possible Contributions of Risk Management to a family
Risk management can provide families with the same five major classes of benefits. For example, by
protecting the family against catastrophic losses, risk management may enable a family to continue a
lifestyle that might otherwise be severely threatened or disrupted. Indeed the continued existence of the
family unit might be at stake. Second, sound risk management may enable the family to reduce its
expenditures for insurance without reducing its protection. Because a family cannot deduct insurance
premiums from its taxable income, a birr reduction in insurance premiums may be worth more than an
additional birr of income. Third, if a family has adequate protection against the death or poor health of
the breadwinner, damage to or disappearance of their property, or a liability suit they may be willing to
assume greater risks in equity investments or career commitments would undoubtedly increase. Fourth,
family members are relieved of some physical and mental strain. Fifth, families may also gain some
satisfaction from a risk management program that helps others as well as themselves in improving their
image.
c. Possible Contributions of Risk Management to the Society
To the extent that individual businesses and families benefit from risk management, so does the society
of which they are members. Society also benefits from the more efficient use of risk management from
the reduction in social costs associated with business and family resources and from the reduction in
social costs associated with business and family financial reserves.
2.4. The Risk Management process
As we have observed in the previous few definitions forwarded to describe risk management, risk
management is the identification, measurement and treatment of pure-risk exposures (property, liability,
and personnel). What does the process specifically involve? What are the sequences of activities to be
performed in the risk management process? Such and other related questions will be replied in the forth-
coming discussions.
The Risk Management process involves five steps. These are:

i. Identifying loss exposures: The loss exposures of a business or family must be identified.
Risk identification is the first and perhaps the most difficult function that the risk manager or
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administrator must perform. Failure to identify all the exposures of the firm or family means that the
risk manager will have no opportunity to deal with these unknown exposures intelligently.
ii. Measuring the losses: After risk identification, the next important step is the proper
measurement of the losses associated with these exposures. This measurement includes a
determination of (a) the probability or chance that the losses will occur, (b) the impact the losses
would have upon the financial affairs of the firm or family, and (c) the ability to predict the losses
that will actually occur during the budget period. The measurement process is important because it
indicates the exposures that are most serious and consequently most in need of urgent attention. It
also yields information needed in step iii here under.
iii. Selection of the risk management tools: Once the exposure has been identified and
measured, the various tools of risk management should be considered and a decision must be made
with respect to the best combination of tools to be used in attacking the problem. These tools include
primarily (a) avoiding the risk, (b) reducing the chance that the loss will occur or reducing its
magnitude if it does occur, (c) transferring the risk to some other party, and (d) retaining or bearing
the risk internally. Selecting the proper tool or combination of tools requires considering the present
financial position of the firm or family, its overall policy with reference to risk management, and its
specific objectives.
iv. Implementing the decision made: After deciding among the alternative tools of risk
treatment, the risk manager must implement the decision made. If insurance is to be purchased, for
example, establishing proper coverage, obtaining reasonable rates, and selecting the insurer as part
of the implementation process.
v. Evaluating the result: The results of the decisions made and implemented in the first four
steps must be monitored to evaluate the wisdom of those decisions and to determine whether changing
conditions suggest different solutions.
As it is true of management in general, that risk management may be described as both an art and a
science. Risk managers must still rely heavily upon non quantitative techniques that depend upon
deductive and intuitive judgments. Yet, certain broad principles of risk management have been
developed. Furthermore, during the recent past, quantitative techniques have become more
commonplace and more sophisticated. These principles and some of the current developments in
scientific risk management will be presented at various points in this reading material. In the mean time
these guides to risk management will be improved and new ones will be created, but sound judgment
will continue to play an important role.

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2.4.1. Risk identification

Risk identification is the process by which an organization is able to learn areas in which it is exposed
to risk. Identification techniques are designed to develop information on sources of risk, hazards, risk
factors, perils, and exposures to loss. It seems quite logical to inquire in to the sources of organizational
risks at this particular moment. A discussion of the sources is presented below.
* Identification of Exposures
A given peril or hazard can originate in any one of several environments. Fire, for example, could arise
from the physical environment (a lightning strike) or the social environment (arson, civil unrest).
Sources of risk are essentially of no concern to an organization unless that organization is exposed or
vulnerable to the perils that arise from those environments. Therefore, an important aspect of risk
identification is exposure identification. Although in the broadest sense an entire organization is at
exposure to risk, it is useful to develop categories of exposures for analytical purposes. This reading
material considers four categories of risk exposures: physical asset exposures, financial asset exposures,
liability exposures, and human exposures
i. Physical Asset Exposures: Ownership of property gives rise to possible gains or loses to physical
assets and to intangible assets (goodwill, political support, intellectual property), that arise from
these exposures. Property may be damaged, destroyed, lost, or diminished in value in a number of
ways. The inability to use property for a period of time, the so-called time element loss, is often
overlooked by individuals and organizations. Conversely, property exposures to risk may result in
gain or enhancement.
ii. Financial Asset Exposures: Ownership of securities such as common stock and mortgages creates
this type of exposure. This exposure can occur either from ownership of the security or when the
organization issues a security held by others. A financial asset conveys rights that are enumerated in
financial terms, such as the right to receive income or the right to purchase an asset at a specified
price. Unlike physical property, loss or gain to a financial asset can occur without any physical
change in the asset itself. Often these gains and losses occur as a consequence of changing market
conditions or changes in the value of the rights conveyed by the security as perceived by investors.
iii. Liability Exposures: Obligations imposed by the legal system create this type of exposure. Civil
and criminal law detail obligations carried by citizens: state and federal legislatures impose statutory
limitations on activities; governmental agencies promulgate administrative rules and directives that
establish standards of care. Legal obligations that differ from country to country are an increasingly
important aspect of this area.

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Unlike property exposures to risk, liability exposures do not have an upside. That is, liability
exposures generally can be considered pure risks. It is true that the law establishes rights as well as
obligations, and the enforcement of a right can result in a gain.
iv. Human Asset Exposures: Part of the wealth of an organization arises from its investment in
humans - the human resources of the organization. Possible injury or death of managers, employees,
or other significant stakeholders (customers, secured creditors, stockholders, suppliers) exemplifies
this type of exposure. Human asset exposures can also lead to gains, as exemplified by
improvements in productivity. One might, for example, view a highly technical piece of machinery
as source of loss (worker injury) and gain (increased productivity). In such a case, the risk
management strategy is likely to incorporate elements that will reduce the potential for loss while
maximizing the likelihood of gain (employee training, for instance). As a final note, loss of human
assets does not always imply physical harm. Economic insecurity is a common type of loss,
unemployment and retirement being excellent examples. Both the physical and economic welfare of
human beings are components of this type of exposure to risk.
2.4.1.1. The range of Risk Identification Techniques
The world of industry and commerce is far too complex and sophisticated to allow for proper risk
identification simply by a ‘walk round the premises’.
Specific techniques will have to be employed to aid your identification of risk. However, no one method
for risk identification will be appropriate for all forms of risk, or even for similar forms of risk in
different situations. There is a range of techniques available and these techniques can be classified in a
number of ways.
 Some are best used on site, while others are desk based’ methods not requiring site visits.
 Some will be more appropriate to the development stages of a project, while others are best
used once the project has been commissioned and is up and running.
 There are qualitative techniques which make little or no use of statistical measurement and
others which are highly quantitative in their approach.
 Certain techniques are very general in their approach to risk, while others are extremely
detailed, even microscopic, in their approach.
 There are techniques, which are very appropriate for post-loss situations, while others are
primarily for use prior to any loss having taken place.
These divisions highlight the variety of techniques, which are available, but in themselves the divisions
have no practical value. What they do underline is the fact that there are different ways in which risk can
be identified and that techniques do exist to match particular needs. As we work our way through the
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techniques, we will suggest the advantages and disadvantages of each one and where each one could be
used.
Generally, risk identification methods include:
- On-site inspection
- Loss exposure checklist
- Insurance policy checklist
- Flow chart
- Statistical data analysis
- Financial statements
- Contract analysis
2.4.1.3 Common Features of Risk Identification
We have looked at a number of individual techniques and it is now necessary to say something of a
more general nature about the task of risk identification, regardless of the technique selected.
We can do this by commenting on a number of common features of risk identification.
 The task of risk identification must be given the proper priority in an organization. It’s an
important function, as many of the risks which are to be identified can put their way into the very
core of the existence of the organization itself.
 There is a range of techniques available and no one technique can be used in all situations. As we
have dealt with each techniques. We have commented on the relevant uses to which it can be put.
Thought must be given to the nature of each risk and the best technique, a combination of
techniques selected.
 The task of risk identification is a continuing one: the one-off exercise is of little value in many
practical cases. The nature of industry is such that it is constantly changing and it is therefore
essential that risk identification takes place at regular intervals.
 Efficient record keeping is an important part of identification of risk. A great deal of valuable
information is obtained at the time of risk identification, and this should be stored carefully for
later use and referral.
 Other people, in addition to the risk identifier, should be involved in the process of risk
identification whenever possible. Organizations are complex and no one person will have all the
knowledge which will be required to enable risks to be identified.
 The cost of risk identification must be remembered. There is little point in spending Br. 10 to
identify risks which in the worst case can only ever cost Br.1. Identifying risk is important, but it
costs money and this cannot be overlooked.
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 Finally, a measure of common sense and imagination are valuable attributes to have when flying
to identify risk.
2.5. Risk Measurement
Once the risk manager has identified the risks that the firm is facing, his next step would be the
evaluation and measurement of the risks. Risk measurement refers to the measurement of the
potential loss as to its severity (size) and the probability of occurrence.
occurrence. The risk manager, by using
available data from past experience, tries to construct a probability distribution of the number of
events and/or the probability distribution of total monetary losses. The probability distribution of
number of events and/or total monetary losses would enable the risk manager to estimate, among
other things, the size of possible monetary losses and the corresponding probabilities of occurrence.
Probability distributions:
distributions: - are used to measure the severity and frequency of loss to a firm or
individuals on the basis of past data. Different types of probability distributions can be used to
measure and evaluate loss exposures. But the selection of each depends on the nature of the risk
exposure and the available parameter to be used.
a) Poisson probability distribution
Is a discrete probability distribution that could be applied to a very large number of units exposed to
risk each facing very small chance of accidents. This approach allows the possibility of multiple
accidents to the same risk exposure unit, which the binomial probability distribution doesn't allow.
It is applicable truly for larger number of exposures which brings limitation to binomials. It is a
discrete probability distribution making it useful for describing the possible number of accidents.
Poisson distribution depends on a single parameter - the expected value - M.
M. The probability that an
event (accident) happens r times is given by:-
P (r) = probability of r accidents = M r e -M
r! ,
where e = 2.7182
x! = x*(x-1)*(x-2)*…….*1
M = Expected number of Accidents i.e. m= pn
P =probability of accident
n = No. of exposed units
Note:
Note: Standard deviation for the number of accidents =√M = √pn

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 Illustration:-
A firm wants to estimate what may happen in the sixth year based on the five years
experience regarding losses on cars. Following are data of the past recent five years.
Year No. of cars No. of accidents Amount of monetary loss (in $)
1 10 0 0
2 12 1 1200
3 14 3 4500
4 15 1 1000
5 19 2 6500
Total 70 7 13200
Mean 14 1.4 2640
The above data expresses the following: the number of cars operated in each year, the corresponding
number of accidents occurred, the total monetary losses incurred in connection with the accidents.
Probability of accident:-
accident:- using counting probability method probability of accident is given by:
Probability of accident = Mean No. of accidents
Mean No. of cars owned
= 1.4 =0.1
14
Monetary
onetary loss per accident over the period of time is given by:
Monetary loss per accident = Mean monetary loss
over the five years Mean No. of accidents
= 2640
1.4
= 1885.7 (approximately = 1886)
Assume in the 6th year the firm will increase the number of cars to 25. Based on the past data and the
currently available truth the risk manager can construct probability distribution by the use of Poisson
probability methods.
methods.
Required: what is the probability that;
a. No loss will occur
b. One loss will occur
c. Two losses will occur
d. Three losses will occur
e. Four losses will occur
f. Less than three losses will occur
g. Greater than four losses will occur
h. At least one but not more than four losses will occur
i. Some loss will occur

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Solution:
Solution:
Poisson probability methods is an easy tool of measuring and evaluating risk and it only depends on
mean or expected value of occurrence to drive the remaining probability distribution.
The average number of accidents in the sixth year =pn
= 0.1 * 25 =2.5
Standard deviation for the number of accidents =√ M = √pn = √2.5 = 1.58
Based on the above facts and the Poisson probability distribution the following solutions are computed.
The Poisson formula is, P(r) = Mr e -M
r!
a. P(0) = 2.50 * e -2.5 =0.0821
0!
This is similar to; P (No. accident) = P(0) = 1 - P(r > 1) = 0.0821
b. P(1) = 2.51 * e -2.5 = 0.2052
1!
c. P(2) = 2.52 * e-2.5 = 0.2565
2!
d. P(3) = 2.53 * e -2.5 =0.2138
3!
e. P(4) = 2.54 * e-2.5 = 0.1336
4!
f. P(r < 3) = P(0) + P(1) + P(2)
g. P(r > 4) = 1- {P(0) + P(1) + P(2) + P(3) + P(4)}
h. P( at least 1 and at most 4 accidents = P(1 < r < 4)= P(1) + p(2) + p(3) + p(4)
= 0.2052 + 0.2565 + 0.2138 + 0.1336
= 0.8091
There is almost 81% chance of facing between 1 and 4 accidents.
i. - P( some accident) = P(r > 0) = 1 - P(0) = 1- 0.0821 = 0.9179

 Risk relative to the mean and relative to the number of exposure units

a ) Risk Relative to the mean (RM) or (coefficient of variation) –

RM. measures how the total periodic monetary loss varies with the expected monetary loss (value). It
measures the deviations per unit monetary value.
RM = Standard deviation of total monetary loss
Expected value of loss

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NB:
NB: The higher the RM, the higher the risk becomes because the deviation is high. i.e. the higher the
variability, the higher the risk is and the higher attention it demands from risk managers.
b) Risk Relative to number of Exposures - (Rn)
Risk relative to number of exposures indicates the variations from the expected outcome as a percentage
of the total number of exposure units hence it measures deviations per unit of risk exposure.
Rn = Standard dev. of accidents
No of risk exposures
NB: The higher the Rn, the higher the variability and hence higher the risk. RM and Rn helps to compare
the risky ness of different loss exposures enabling to pay attention on the one with higher RM and R n for
controlling purpose and on the one with lower RM and Rn for investing in.
c) The Law of large number: States that as the number of exposure units increases, the more closely
the actual loss experience will approach the expected loss experience.
It has great practical value to an insurer who can reduce objective risk to the vanishing point in some
cases by securing an ever larger number of units in his insured group.
As the number of exposure units increases in an insured group, objective risk decreases. Specifically,
objective risk varies inversely with the square root of the number of exposure units, other things remain
the same.
The law of large number is, therefore, an issue to be praised by insurers to minimize loss by
incorporating very large exposure units in the insured group.
Exercise 1
Consider the following historical data available for a firm regarding fleet of trucks and
accidental losses.
Year Number of Number of Monetary
trucks accident loss
1 5 2 12,000
2 5 3 14,600
3 6 2 12,004
4 8 3 15,000
5 8 2 13,000

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For the coming year the firm is intending to operate a fleet of 10 trucks. Assume, a truck will experience
only a single accident within a particular year.
Required:
- Construct the appropriate probability distribution.
- What is the probability that the firm experience an accident next year?
- Calculate the amount of expected loss
- Determine the range by which the actual monetary loss may exceed the expected loss.
- Calculate the risk related to the mean
b) Binomial Probability Distribution
The Risk Manager may also use the Binomial probability distribution to measure risk. To use the
Binomial distribution the Risk Manager must be familiar with the basic assumptions of the distribution
to avoid misleading results. The first assumption is that the objects are independently exposed to loss.
And the other assumption is that each exposed unit suffers only one loss in a year.
It is a two parameter distribution that enables determine the entire distribution. These parameters are:
i. The number of units exposed to risk – “n”
“n”
ii. The probability that a randomly selected unit will be damaged – “p”
“p”
The probability of facing ‘r’ accidents out of “n” number of risk exposed units with probability of
accident p is:

P(r)= pr . qn-r , where by q = 1 - p

The mean and the standard deviation of a binomial probability distribution can also be determined using
the following formula;
Mean = M = np
SD = SD = √npq
Illustration
Assume there are 100 automobiles being insured by Awash Insurance, Adama Branch. Calculate the
probability that 5 accidents will occur provided that past data show the probability of an accident is 0.02.

Solution:- . P(x)
P(x = px. qn – x

(100)!. 0.025 X 0.98 95 = 0.0353

5!95!
There is 3.53 % chance of facing loss on 5 accidents under the given situation.
Illustration

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A fleet of 5 delivery trucks are operated by a business. If an accident happens to a particular track, it
becomes a total loss. New trucks are purchased at the beginning of every year to make up the lost ones
so that the firm always starts the new fiscal period with a fleet of 5 delivery trucks. First it is assumed
that monetary loss per accident is constant at Birr 5000.
Number of NUMBER OF Total Monetary
Year Trucks ACCIDENTS Loss
1 5 2 Birr 10000
2 5 2 10000
3 5 3 15000
4 5 2 10000
5 5 1 5000
SUM 25 10 50000
MEAN 5 2 10000
SD 0.707 3162.27

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Monetary loss per accident = 10000 / 2 = 5000

The probability of an accident can be estimated as:
p = 2/5 = 0.4
With this information as a point of departure, it would be possible to construct a binomial probability
distribution for the following variables of interest:
Probability distribution of Number of accidents
Probability distribution of Total monetary losses
PROBABILITY DISTRIBUTION OF NUMBER OF ACCIDENTS
Under the binomial probability distribution, the probability of observing exactly r occurrences is given
by:

P (r) = pr . qn-r , where by q = 1 - p

Where p(r) is the probability of r accident

q is 1 –p
n is the number of items exposed to risk
Using this formula, the following probability distribution is constructed.
Number of Probability Expected No.
Accidents of Accidents
0 0.07776 0
1 0.25920 0.2592
2 0.34560 0.6912
3 0.23040 0.6912
4 0.07680 0.3072
5 0.01024 0.0512
SUM 1.00000 2.0000

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The expected number of accidents is 2. The standard deviation can be determined as follows √n.p.q,
which turns out to be 1.095.
The probability that the firm will face some accident is 0.92224, (1 - 0.07776) which is (1 minus the
probability of no accident). This probability is so high that the risk manager should take appropriate
measures to handle the risk.
M = 5 * 0.4 =2
SD = SQRT(5*0.4*0 .6) = 1.095
Risk measures for the binomial probability distribution:-
Risk Relative to Mean, (coefficient of variation)
RM = 1.095/2 = .5475
Risk relative to the number of exposure units
Rn = 1.095/5 = 0.219
c) Normal Distribution
The risk Manager may assume that the number of accidents or total annual monetary losses are
approximately normally distributed. Under such circumstances, he/she may use the Normal distribution
in measuring the number of accidents or the total annual monetary losses.
If observations are normally distributed, the Risk Manager will have a good insight of the size of
possible losses at much grater ease. This is because the normal distribution can be well explained by
identifying only two parameters, the mean (M) and the standard deviation (SD). The normal deviate(Z)
is thus computed by the following formula:
Z = X – M , where: Z= the value that. X is away from the exp. value - M.
SD M = is the expected value – Or- mean
SD= Standard deviations
X = an amount required.
Probability is easily obtained once Z is determined and hence the possible loss is calculated.
Note: it is generally believed that,
The Normal distribution has the following properties:
68.27
68.27%
% of the observations fall within the range of one standard deviation of the mean.
95.45 % of the observations fall within the range of two standard deviation of the mean.
99.73% of the observations fall within the range of three standard deviations of the mean.
The implication of this for the Risk Manager, in the case of monetary losses is that, he would construct
the following interval estimation about the true mean monetary loss.

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* The true mean monetary loss is expected to fall in the range of M-1SD and M+1SD with a probability
of 0.6827.
* The true mean monetary loss is expected to fall in the ranges of Birr M-2SD and M+2SD with a
probability of 0.9545.
* The true mean monetary loss is expected to fall in the range of Birr M-3SD and M+3SD with a
probability of 0.9973.
Illustration
A business has 40 retail outlets scattered in Ethiopia. The risk manager does not know the probability
distribution of the total monetary losses. From the experience, he estimated the average total loss and
standard deviation to be Br. 50,000 Br. 10,000.
If the manager assumes that the probability distribution of losses to be normal, what will be the
probability that
What is the probability that;
a. the business will face loss exceeding Br. 67,500?
b. the loss will fall within the range of 40,000 and 70,000 Br.?
c. the loss will be less than Br. 40,000?
Solution

a. Z = = = 0.4599

= P (X > 67,500) = 0.5 – P (50000 X 67500)

= 0.5 – 0.4599
= 1.75 = 0.0401
 The probability of facing loss exceeding 67,500 birr in 0.0401.

0.4599

0.0401

50,000 67,500

b. Z1 = , Z2 = , where X1 = 40,000

X2 = 70,000

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= =

= =

= - 0.3413 = 0.4772

0.3413
0.4772

x
40,000 50,000 70,000

 P (40,000 X 70000) = P(40000 X1 50000) + P(50000 X2 70000)

= 0.3413 + 0.4772
= 0.8185
Hence, the business has almost 82% chance of facing loss ranging from 40,000 to 70,000 birr.
c. Based on the above two examples you are encouraged to attempt this question.
AREAS UNDER THE NORMAL CURVE

Example:
If Z = 1.96, then
P(0 to z) =
0.4750
0.4750

Z 0 1.96

Z -Table
How to use Z table: For example, to determine the area under the curve between 0 and 2.36, look
in the intersecting cell for the row labeled 2.30 and the column labeled 0.06. The area is .4909.
z 0 0.01 0.02 0.03 0.04 0.05 0.06 0.07 0.08 0.09
0 0 0.004 0.008 0.012 0.016 0.0199 0.0239 0.0279 0.0319 0.0359
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0.1 0.0398 0.0438 0.0478 0.0517 0.0557 0.0596 0.0636 0.0675 0.0714 0.0753
0.2 0.0793 0.0832 0.0871 0.091 0.0948 0.0987 0.1026 0.1064 0.1103 0.1141
0.3 0.1179 0.1217 0.1255 0.1293 0.1331 0.1368 0.1406 0.1443 0.148 0.1517
0.4 0.1554 0.1591 0.1628 0.1664 0.17 0.1736 0.1772 0.1808 0.1844 0.1879
0.5 0.1915 0.195 0.1985 0.2019 0.2054 0.2088 0.2123 0.2157 0.219 0.2224
0.6 0.2257 0.2291 0.2324 0.2357 0.2389 0.2422 0.2454 0.2486 0.2517 0.2549
0.7 0.258 0.2611 0.2642 0.2673 0.2704 0.2734 0.2764 0.2794 0.2823 0.2852
0.8 0.2881 0.291 0.2939 0.2967 0.2995 0.3023 0.3051 0.3078 0.3106 0.3133
0.9 0.3159 0.3186 0.3212 0.3238 0.3264 0.3289 0.3315 0.334 0.3365 0.3389
1 0.3413 0.3438 0.3461 0.3485 0.3508 0.3531 0.3554 0.3577 0.3599 0.3621
1.1 0.3643 0.3665 0.3686 0.3708 0.3729 0.3749 0.377 0.379 0.381 0.383
1.2 0.3849 0.3869 0.3888 0.3907 0.3925 0.3944 0.3962 0.398 0.3997 0.4015
1.3 0.4032 0.4049 0.4066 0.4082 0.4099 0.4115 0.4131 0.4147 0.4162 0.4177
1.4 0.4192 0.4207 0.4222 0.4236 0.4251 0.4265 0.4279 0.4292 0.4306 0.4319
1.5 0.4332 0.4345 0.4357 0.437 0.4382 0.4394 0.4406 0.4418 0.4429 0.4441
1.6 0.4452 0.4463 0.4474 0.4484 0.4495 0.4505 0.4515 0.4525 0.4535 0.4545
1.7 0.4554 0.4564 0.4573 0.4582 0.4591 0.4599 0.4608 0.4616 0.4625 0.4633
1.8 0.4641 0.4649 0.4656 0.4664 0.4671 0.4678 0.4686 0.4693 0.4699 0.4706
1.9 0.4713 0.4719 0.4726 0.4732 0.4738 0.4744 0.475 0.4756 0.4761 0.4767
2 0.4772 0.4778 0.4783 0.4788 0.4793 0.4798 0.4803 0.4808 0.4812 0.4817
2.1 0.4821 0.4826 0.483 0.4834 0.4838 0.4842 0.4846 0.485 0.4854 0.4857
2.2 0.4861 0.4864 0.4868 0.4871 0.4875 0.4878 0.4881 0.4884 0.4887 0.489
2.3 0.4893 0.4896 0.4898 0.4901 0.4904 0.4906 0.4909 0.4911 0.4913 0.4916
2.4 0.4918 0.492 0.4922 0.4925 0.4927 0.4929 0.4931 0.4932 0.4934 0.4936
2.5 0.4938 0.494 0.4941 0.4943 0.4945 0.4946 0.4948 0.4949 0.4951 0.4952
2.6 0.4953 0.4955 0.4956 0.4957 0.4959 0.496 0.4961 0.4962 0.4963 0.4964
2.7 0.4965 0.4966 0.4967 0.4968 0.4969 0.497 0.4971 0.4972 0.4973 0.4974
2.8 0.4974 0.4975 0.4976 0.4977 0.4977 0.4978 0.4979 0.4979 0.498 0.4981
2.9 0.4981 0.4982 0.4982 0.4983 0.4984 0.4984 0.4985 0.4985 0.4986 0.4986
3 0.4987 0.4987 0.4987 0.4988 0.4988 0.4989 0.4989 0.4989 0.499 0.499
3.1 0.499 0.4991 0.4991 0.4991 0.4992 0.4992 0.4992 0.4992 0.4993 0.4993
3.2 0.4993 0.4993 0.4994 0.4994 0.4994 0.4994 0.4994 0.4995 0.4995 0.4995
3.3 0.4995 0.4995 0.4995 0.4996 0.4996 0.4996 0.4996 0.4996 0.4996 0.4997
3.4 0.4997 0.4997 0.4997 0.4997 0.4997 0.4997 0.4997 0.4997 0.4997 0.4998

2.6. TOOLS OF RISK HANDLING

Risk is handled in several ways. Most authors cite the following risk handling tools: Avoidance, Loss
Prevention and Reduction, Separation, Combination/Diversification, Transfer, Retention and insurance. These
tools are classified as Risk Control Tools and Risk Financing Tools.
2.6.1. RISK CONTROL TOOLS
1. Avoidance

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Avoidance of risk exists when the individual or the organization frees itself from the exposure through
abandonment or refusal to accept the risk. An individual can avoid third person liability by not owning a car.
Product liability can be avoided by dropping the product leasing avoids the risk originating from property
ownership.
Avoidance, however, may not be a sound risk handling tool. For example, a business has to own vehicles
building, machinery, inventory, etc.. Without them operations would become impossible. Under such
circumstances avoidance is impossible.
In other situations, avoidance could be a viable alternative. For example, it may be better to avoid the
construction of a company near river banks, volcanic areas, valleys, etc because the risk is so great Moreover,
a research laboratory may abandon a highly dangerous experiment similarly, and dangerous sport activities
like skiing, mountain climbing, and motor racing could be avoided to escape the risk of injury or death.
2. Loss Control (Loss Prevention and Reduction)
These measures refer to the safety actions taken by the firm to prevent the occurrence of loss or reduce its
severity if the loss has already occurred. Prevention measures in some cases eliminate the loss totally although
their major effect is to reduce the probability of loss substantially. Loss reduction measures try to minimize
the severity of the loss once the peril happened. For example, auto accidents can be prevented or reduced by
having good roads, better lights and sound traffic regulation and control, fast first-aid service and the like. LP
& R measures must be considered before the Risk Manager considers the application of any risk financing
measures.
Following are some examples of loss prevention and reduction plans
 Loss Control Function
 Occupational health and safety
 Environmental protection
 Fire control & property conservation
 Public safety (general liability)

Loss Prevention Measures that might be employed by a co. may involve:

 Research on fire protection equipment and appliances.
 Construction using fire insensitive materials.
 Automatics smoke detectors, fire alarms
 Burglar alarms in costly business situation, jewels, diamonds
 Location choice avoiding construction near petrol stations, chemical reservoirs, waste disposal areas,
etc…
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 Tight quality control to prevent risk of product liability.

 Educational programs to the public using available media.
 Multiple suppliers, buffer stocks.
 Safety measures adequate lighting, ventilation, special work clothes to prevent industrial accidents.
 Regular inspection of machinery to prevent explosions, breakdowns etc..
 Accounting controls (Internal Control)
 Electronic metal detectors to check passengers for arms and explosives in the airline business.
Automatic gates at crossing lines to prevent collisions of train and motor vehicles.
 Warning posters. These are posted at strategic places within the organization (notice board mess hall,
shop floor, etc.) Consider the following messages:
- NO SMOKING DANGER ZONE!!
- “A Fire on the job can send your job, income, health, and life up in smoke”
- “Let’s step up our safety effort”
- “Don’t learn safety by ACCIDENTS”
- “The price of an accident is always high”
 An individual can prevent himself from COVID-19 by using frequent hand-wash, physical
distancing, staying at home etc.
Loss Reduction Measures may involve:
They are intended to reduce the extent of loss once the adverse incident happened, i.e. to reduce the severity
of the loss.
 Installing automatic sprinklers.
 First aid kit
 Evaluation of people
 Immediate clean-up operations,
 Fire extinguishers, guards.
Appropriate measures taken to prevent accidents bring benefits not only to the firm but to the society as well.
For example, a destruction of inventory of a firm could be a fatal loss to the firm in particular. The society
also faces a real economic loss because those goods are no more available to people. Thus the importance of
LP&R measures should not be underestimated by a firm. To design effective LP&R measures, it may be
helpful to identify the causes of accidents.
Some of the causes of accidents and the possible LP & R measures are indicated below.

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Causes of Accidents Loss Prevention measures

Working on dangerous equipment with less
Safety seminar, Inspection at regular time
care
Improper use of equipment Training, Safety seminar
Violating Safety Procedures and Regulations
Safety Seminar, Warning, dismissal
Human error, Negligence Training, safety seminar
Use of inappropriate tools Provide appropriate tools
Lack of protective clothing Provide necessary protective clothing
Use of defective equipment Regular inspection and maintenance
Inadequate Knowledge about the job Training
Working while physically ill Sick-leave, don’t allow to work until
recovery
Mental Disturbance of employee Date-off to the employee
Data should be kept regarding accidents occurred. The causes of these accidents must be investigated. Pre-
designed forms may be employed to report on accidents and their causes. This would allow for the design of a
much better LP &R measures.
Loss control measures entail costs. These costs include expenditures for the acquisition of safety equipment
and devices, operating expenses such as salary payments to guards, inspectors, safety engineers and other
employees engaged in safety work. Other costs are also incurred in connection with safety training and
seminars. The Risk manager will have to design the LP &R measures in the most efficient way in order to
minimize such costs without reducing the desired safety level.
3. Separation (diversification)
The exposed property is scattered to different places. The principle is “don’t put all your eggs in one basket”.
This could be regarded as a loss reduction measure. For example, a firm’s inventories could be kept in
warehouses located in different areas. In another case, the inventories could be grouped according to their
value or importance and be kept in separate places with differing safety measures ABC analysis of inventories
is a clear example.
4. Combination
Combination is a basic principle of insurance that follows the law of large numbers. Combination increases
the number of exposure units since it is a pooling process. It reduces risk by making losses more predictable
with a higher degree of accuracy.

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In the case of firms, combination results in the pooling of resources of two or more firms. This leads to
financial strength thereby minimizing the adverse effect of the potential loss. For example, a merger in the
same or different lines of business increases the available resources to meet the probable loss.
5. Non-Insurance Transfer
Risk is transferred to another party through insurance or non-insurance means. Non-insurance transfer may
take two forms.
i. Transfer of the hazardous activity
ii. Transfer of the probable loss.
Transfer of the Activity or the Property
 Operating a staff lounge in an organization may be given to outside contractor.
 Certain activities may be given to subcontractors to avoid the probable increase in costs.
 Factoring of accounts receivable without recourse. Some premiums are paid but collection
expenses are saved. Default risk is transferred.
 Delivery of goods at the warehouse rather than at the buyer’s premises. Transit risk is transferred
to the buyer.
 Purchase of goods at terms f.o.b. Destination.
Transfer of the Probable Loss
 Leasing rather than buying
 Consignment shipments rather than purchase. If the goods remain unsold or expired, they will be
returned to the consignor.
2.6.2. RISK FINANCING TOOLS
1. Retention
This is the easiest method of handling risk. The person or the firm, consciously or unconsciously, decides to
assume the risk. The loss is to be borne by the person or the firm, and no specific measures are taken to
transfer the risk to others.

A person or a firm decides to retain the risk for a number of reasons. It is probability impossible to transfer the
risk, as in the case of gambling. Besides, the attitude of the individual or the firm towards risk than do risk
will influence risk assumption. Risk lovers prefer to assume considerable risk than do risk-avoiders. The value
of goods to be insured compared to insurance cost is another factor that may force businesses to assume risk,
cost-benefit analysis. One also may think that the risk is so remote that retention is a better alternative. In
other situations, some risks are minor as compared to the size of the business that the business can absorb the
loss.
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It is important to be aware of the underlying risk if retention is to be adopted (active retention). This is
because the person or the firm, being aware of the risk may take necessary precautions to finance the probable
loss. For example, finds may be set aside for contingencies (self- insurance), or some form of financial
planning would be made to finance the loss. Retention can also happen because the person is unaware of the
risk. Thus, he will take no action (passive retention is inevitable since it is difficult to identify all the firm’s
exposures.
2. Insurance
Here the risk is transferred to an insurance company for a consideration. The insurer normally has a better
knowledge regarding loss prediction and a sound financial resources to accept the risk. He is also in a better
position to get the advantage of the law of large numbers.

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