CHAPTER TWO

RISK MANAGEMENT

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 Meaning of Risk Management
• A process that identifies loss exposures faced
by an organization and selects the most
appropriate techniques for treating such
exposures.
• A loss exposure is any situation or
circumstance in which a loss is possible,
regardless of whether a loss occurs
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Objectives of Risk Management
Risk management has objectives before and after a
loss occurs

1. Pre-loss objectives

Economy: Prepare for potential losses in the

most economical way

Reduction of anxiety (worries & fear) and

Meeting legal obligations: such as using

safety devices
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Post-loss objectives:

Ensure survival of the firm

Continue operations

Stabilize earnings (EPS)

Maintain growth

Minimize the effects that a loss will have

on other persons and on society
(employees, creditors, customers ……)
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 Steps in Risk Management
1. Identify potential losses (Risk Identification)

2. Measure and analyze the loss exposures

(Risk Measurement)

3. Select the appropriate combination of

techniques for treating the loss exposures

4. Implement and monitor the risk

management program
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 Step 1: Risk Identification
• Here, at this 1st step, the risk manager tries to
locate the areas where losses could happen due to
a wide range of perils.
• The three types of loss exposures (risks) that are
mainly considered by the risk manager are:

1. Property Losses

2. Third Party Liability Losses and

3. Personal Losses 7
 1. Property Losses
• Ownership of property puts a person or a
firm to property exposure, i.e., the property
will be exposed to a wide range of perils.
• Thus, in the identification process he will
find it helpful to prepare a checklist of the
property exposed to various types of risks.

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 Property Checklist
• Listing of the various assets owned by the firm
in major categories that are exposed to risk .

Insurance Policy Checklists

• Listing of various types of pure risks that can
be dealt with insurance after collecting
specimen of insurance policy.

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 2. LIABILITY LOSSES

• Includes both injuries caused to other people

and/or damages caused to their property.
• So the risk manager is responsible to identify
the possible liability losses that the firm may
be exposed to
• Some of the factors leading to liability losses
are discussed below.
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• Product Liability Risk : associated with the
manufacture and sell of a particular product.
Ex: Expired products & misleading Advertisements

• Motor Vehicles :Such as killing people,

injuries and damages caused to property of
other people during deriving

• Industrial Accidents: Job related accidents

when employees are injured at worksite
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• Industrial Waste: industrial garbage’s thrown
into rivers and lakes thereby polluting the
environment
• Professional Activities :which may emerge
because of deficiencies in the service industry
• Ownership of Immovables: buildings; land
and machinery owned the use of such
immovables by people may bring liability
losses for injuries caused by accidents
Example: Faulty Electrical connection
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 3. PERSONNEL LOSSES
• losses to a firm regarding its employees and
their families.
• The risks include death and bodily injury
due to accidents while off duty, industrial
accident, occupational disease, kidnapping,
retirement, sickness, etc…

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 2.3.2.RISK MEASURMENT
• Refers to the measurement of the potential loss
as to its size and the probability of occurrence.
• Probability distribution is used to estimate the
size of monetary losses and probability of
occurrences.
• The following example is considered for
illustrative purpose.

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• Probability of Accident
= 3/20 = 0.15
• Loss per accident over 10 years
= 6,180/3 =2,060
• Suppose in year 11 the number of cars
owned by the firm increased to 40.
• The risk manager wants to construct a
probability distribution of accidents on the
basis of the data collected above.

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 1. POISSON DISTRIBUTION
• The Poisson probability distribution can be
used for the analysis.
• The only information that is crucial in
constricting a Poisson probability
distribution is the expected number of
accidents (the Mean).
• Once the mean is determined the probability
of any number of accidents will be easily
calculated using the following formula:

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• Where:
e = 2.71828
r = number of occurrences
M =Expected number of Accidents = (pn)
STD = Standard Deviation = √ (M)
n = Number of Exposed Units = 40
• Accordingly,
• M =np = 0.15 * 40 = 6 accidents and
STD = √ (M) = 2.45

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• The Poisson probability distribution
allows for unlimited number of accidents
occurring to the object under
consideration, (car).
• This means that a particular car can
possibly experience more than one
accident.
• This is normally the case in real life
situation.

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• Once the probability distribution is developed,
it would not be difficult to determine the
probability of any number of
• Let x represent the number of accidents,
P(r ≥ 3) = 1- (.0025 + .0149 + .0446)
= 0.938
Similarly, the probability that the number of
accidents equal or exceed 13 is given by:
P(r ≥13)= .0052+ .0022+.0009+.0003+.0001+. 0001
= 0.0088
Accordingly, P (3 ≤ r < 13) = 0.938 –0.0088
= 0.9292
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• The expected annual total monetary loss is Birr
12,359. 39 as determined on the table above
• Thus, the Expected Monetary Loss per Accident
= 12,359.39 = 2,059.90
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Given that, P = 0.15 n = 40

Expected Number of Accidents = M = np = 0.15 x 40 = 6

SD of Accidents = SD = √ (M) = √ (6) = 2.4495

Standard Deviation of Annual Monetary Loss

= 2.4495 x 2,060 = 5,046.4

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 Risk Relative to the Mean (Coefficient of Variation)

RM 0.408 indicates the variability of total annual monetary losses from

the expected value, (the mean).
The higher the Coefficient of Variation (RM), the higher, the risk,
meaning variability increases.
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Risk Relative to the Number of Exposure Units
Rn

Accordingly, given one standard deviation, the actual

accidents could vary from the expected accidents by
about 6.1% of the total number of exposure units.
The higher the percentage, the higher the variability
(higher variance), and consequently, the higher the risk.

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POSSIBLE DECISIONS
• Self-Insurance
1. To keep reserve fund equal to the expected total
annual monetary loss.
Reserved Fund = Birr 12,360
2. To keep reserve fund equal to the expected
value of the loss plus an amount to cover for
one standard deviation of the expected value.
Reserved Fund = 12,360 + 5,046 = Birr 17,406
3. To keep reserve fund equal to the maximum
probable loss
Reserved Fund = Birr 24,720
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 RISK AND LAW OF LARGE NUMBER

It is possible to simulate this process to see how risk

decrease as the number of exposure units increase.
Here is the summary.

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