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Chapter1& 2-Risk MGMT & Insurance
Chapter1& 2-Risk MGMT & Insurance
ACFN 2081
Chapter 1
RISK AND RELATED CONCEPTS
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Objectives
After completing this unit, students will be able to:
Define and understand the concept of risk.
Understand the difference between risk, uncertainty
and probability.
Understand the word hazard and peril and its
relationship with risk.
Identify the different types of risk.
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Risk …..meaning
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C) Morale hazard refers to the carelessness or
indifference to a loss because of the existence of
insurance. Examples: Leaving car keys in an unlocked
car, Leaving a door unlocked, failing to follow safety rule
properly.
D) Legal Hazard
• Refers to characteristics of the legal system or
regulatory environment that increase the frequency or
severity of loss.
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THE CLASSIFICATION OF RISK
1. Pure Vs Speculative Risk
• Pure risk refers to a situation in which only a LOSS or NO
LOSS would occur. Example: Fire at a factory, Car accident,
flood, theft, etc. pure risk includes;
1. Personal risk is a risk that affects individuals. It includes;
Premature death, Insufficient retirement income, poor health,
and Unemployment.
2. Property risk is a risk when a property is damaged or lost.
This refers to losses associated with ownership of property.
• There are two major types of loss in the damage of property;
Direct :- results from the physical damage, destruction, or theft of
the property, such as fire damage to a home.
Indirect loss:- also called consequential loss. It results Indirectly
from the occurrence of a direct physical damage or theft loss, e.g.,
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the additional living expenses after a fire.
3. Liability risk is the possibility of loss arising from intentional
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2. Fundamental Vs Particular Risk
• Fundamental risk is a risk that affects the entire economy
or large number of persons or groups within the economy.
Examples: high inflation, social change, political intervention,
unemployment, war, famine, volcanoes and other natural
‘disasters’ like Hurricanes, Katrina, Tsunami.
Particular risk refers to a risk that affects only
individuals and not the entire community. Particular risks
are much more personal both in their cause and effect.
Examples: burning of a house, car theft
Particular risks are insurable while fundamental risks are not
insurable.
• Particular risks are insurable if they belong to the category
of pure risk only. For example, “loss in business” is a
particular risk since it affects only the owner of the business
but it is not insurable because it is not pure risk.
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3) Financial Vs Non-Financial Risk
• A financial risk is a risk that results in losses that can be
expressed in financial terms. Examples of financial risk
include physical damage to a property, theft of property
or lost business profit following a fire.
• Non-financial risk refers to a loss that does not have
financial implications. Examples: choice of a marriage
partner, the selection of an item from a restaurant menu,
the selection of a career, having children.
• The two risks can occur simultaneously. For example, in
the case of premature death the financial risk is loss of
income (salary), while the non-financial risks are loss of
emotional support, loss of moral, loss of motivation.
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4) Dynamic Vs Static Risk
Dynamic risk refers to losses originates from
changes in the overall economy such as price level
changes, changes in consumer tastes, income
distribution, technological changes, political changes
and the like. They are less predictable and hence
beyond the control of risk managers.
Static risks refer to those losses that can take place
even though there were no changes in the overall
economy. They are predictable and could be
controlled to some extent by taking loss prevention
measures.
• Static risks are insurable, because they are predictable
whereas dynamic risks are not insurable.
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5) Objective vs Subjective Risk
Objective risk is defined as the relative variation of the
actual loss from expected loss.
• Objective risk can be statistically measured by some
measure of dispersion, such as the standard deviation or the
coefficient of variation.
• For example assume that a property insurer has 10,000
houses insured over a long period and, on average, 1
percent, or 100 houses, burn each year. However, it would
be rare for exactly 100 houses to burn each year. In some
years, as few as 90 houses may burn, while in other years,
as many as 110 house my burn. Thus, there is a variation of
10 houses from the expected number of 100, or a variation
of 10 percent. This relative variation of actual loss from
expected loss is known as objective risk.
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Subjective risk is defined as uncertainty based on a
person’s mental condition or state of mind (mental
uncertainty).
• A subjective risk is a psychological uncertainty that
stems from the individual’s mental attitude or state of
mind.
• Some writers have used the word “uncertainty” to be
synonymous with subjective risk as defined here.
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THE END
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CHAPTER TWO
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Objectives
• After completing this unit, students will be able to:
Explain the meaning and definition of risk management
Understand the role of risk managers
Elaborate steps in risk management process
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RISK MANAGEMENT DEFINED
• 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.
• 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.
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Duties of risk manager
1. To recognize exposures to loss; the risk manager
must be aware of the possibility of each type of loss.
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, record keeping and the like.
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OBJECTIVES OF RISK MANAGEMENT
1) Pre-loss objectives- risk management objectives prior to
the occurrence of the loss: These includes:-
- Economy: Economic way of handling potential risks or
losses.
-Analysis of the cost of safety programs
- Reduction of Anxiety: Peace of mind & the reduction of
anxiety.
- Meeting Legal obligations:- Eg. government regulations
2) Post-loss objectives -After the occurrence of the loss.
- Mere survival of the firm
- Continuation of operation
- Stability of earning
- Continued growth of the firm
- Meet social responsibility
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THE RISK MANAGEMENT PROCESSES
1. Identifying potential losses (risk
identification)
2. Evaluating potential losses (Measuring
the losses)
3. Selection of the risk management tools
4. Implementing the program
5. Controlling/monitoring
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1st Identifying potential losses (RI)
• RI is the process by which a business systematically and
continuously identifies personal, property and liability loss
exposures as soon as or before they emerge.
• 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.
• Identification technique are designed to develop
information on source of risk hazards, risk factors, peril,
and exposure to loss.
• The sources of risk includes physical, social, legal,
operational, political, economic and cognitive
environment.
• 10/31/2023
Risk exposures includes:- physical asset, financial asset,28
Techniques of risk identification
• Risk analysis questionnaire
• Financial statement method
• Flow-chart method: pdn, svc & money flows
• On-site inspection
• Planned interaction with other departments & also
outside suppliers and professional orgns.
• Statistical records of past losses
• Analysis of the environment
The choice of the technique depends on the nature of
the business, the size of the business, and the
availability of in house expertise.
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2nd Risk Measurement
• Risk measurement refers to the measurement of the
potential loss as to its size and the probability of
occurrence. 2 dimensions will be measured:
1. Loss frequency is the probability that a single unit
will suffer one type of loss from a single peril.
2. Loss severity: measured by maximum possible loss
(worst loss that could possibly happen) & maximum
probable loss (worst loss that is likely to happen)
• Probability is a measure of the likelihood that a given
event will take place. i.e. 0 ≤ p(A)≤ 1 for any event A
• The probability of any impossible event is 0, where as
the probability of any event that is certain to occur is 1.
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Method of valuing potential direct property
losses
• Original cost: paid at its acquisition
• Original cost less depreciation:
• Market value:
• Tax appraised value: value placed upon property for tax
• The economics/use value: measuring the PV of the
income e.g. NI=50,000 for 3 yrs change it to PV….
• Reproduction value: replacing at the exact current price
• Replacement cost for new: replacing with new property
that is not exactly the same
• Replacement cost for new less depn and obsolescence:
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Probability Distribution & risk measurement
• Probability distribution shows the probability of
occurrence for each outcome.
• Using PD it’s possible to measure
The total dollar losses per year (physical period)
The number of occurrences per year
The dollar losses per occurrence
The total dollar losses per year
Example: consider the following hypothetical
example of probability distribution of vehicle
accident repair costs in a fleet of vehicles(similar
in type of use) operated by a firm.
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Year No of Amount probability Expected
accidents of loss amount of loss
1 0 0 0.606 0
2 1 1,000 0.273 273
3 2 2,000 0.100 200
4 3 4,000 0.015 60
5 3 10,000 0.003 30
6 2 20,000 0.002 40
7 5 40,000 0.001 40
Sum 16 77,000 1.000 643
mean 2.29 11,000
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Solution:
• The probability of no birr loss is 0.606
• The probability of some loss = 1- 0.606 = 0.394
• The prob. Of 10,000 or more losses =
0.003+0.002+0.001 = 0.006
• The prob. that sever loss will occur (assume a
sever loss is a loss that is equal or higher than
10,000) = 0.003+0.002+0.001 = 0.006
• The expected (average)total birr loss = birr 643.
this value indicates the average annual birr loss
the business will sustain in the long run if it
retains this exposure.
• Average loss/yr= 11,000 br
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Binomial Probability Distribution
• The binomial probability distribution helps a risk manager
to measure the probability of exactly r accidents from n
number of exposures or number of items exposed to risk.
• The probability of exactly r accidents from n number of
items exposed to risk is given by:
1 5 2 Birr 10,000
2 5 2 10,000
3 5 3 15,000
4 5 2 10,000
5 5 1 5,000
SUM 25 10 50,000
MEAN
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Binomial Probability Distribution(cont…)
• Based on the above information answer the following questions;
1. What is the probability of an accident and no accident?
2. Construct the binomial probability distribution of the number of
accidents
3. Calculate the expected number of accidents
4. Find the mean and standard deviation of a binomial probability
distribution (number of accidents)
5. Calculate risk relative to the mean number of accidents and risk
relative to the number of exposure units
6. Calculate monetary loss per accident over the last five years
7. Calculate the expected total annual monetary loss
8 What is the probability that the firm will incur some birr loss
9. Calculate the standard deviation of total monetary loss
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Calculate risk relative to the mean monetary loss 38
Binomial PD…cont’d…
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3. The expected number of accidents can be calculated using the
following formula;
Where: r denotes number of accidents
p ( r ) denotes the probability of exactly r accidents
No of Accidents (r) Probability, P ( r ) Exp. No. of Accidents r. p (r)
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
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Binomial pd…….cont…
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Binomial PD……….cont…)
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3) TOOLS OF RISK MANAGEMENT
• There are two basic approaches:
• Risk control measures: it used;
1) To reduce the firm’s expected property, liability, and
personnel losses, or
2) To make the annual loss experience more predictable
• It includes avoidance, loss prevention and reduction
measures, separation, combination, & some transfers.
• Risk-financing measures: Funds may be required to
repair or restore damaged property, to settle liability
claims, or to replace the services of disabled or deceased
employees or owners.
• purchase of insurance, that are not considered under risk
control devices and retention, which includes, “self- 44
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Risk Control Tools: A) Avoidance
• Avoid the property, person, or activity with which the exposure is
associated.
• Proactive: never acquiring any interest in an exposure. Example,
not building a plant in a flood plain.
• Abandonment: avoid an existing loss. E.g. stop manufacturing a
highly toxic product, avoid third party liability by not owning a
car, Product liability can be avoided by dropping the product,
Leasing to avoid the risk of property ownership.
• Avoidance is impossible in the following situations
For production/service whose expected value exceeds
losses
Impossible to avoid properties like vehicles, building, inventory,
etc.
Avoiding risk may create another risk.
It may not be practical or feasible to avoid the exposure.
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Loss control Measures: LP &LR
• These measures refer to the safety actions taken by the firm to
prevent the chance occurrence of a loss or reduce its severity.
• Loss Prevention: used to reduce/eliminate the chance of loss.
Example: Construction using fire insensitive materials, fire
alarms, Burglar alarms, Location choice, Educational programs
to the public, inspection, Safety measures, Warning posters, etc.
• Loss reduction measures try to minimize the severity of the loss
once the peril happened. Examples: Installing automatic
sprinklers, First aid kit, Evacuation of people, Fire extinguishers,
etc.
• LP and LR measures must be considered before the Risk
manager considers the application of any risk financing
measures.
• To design effective LP and R measures, it may be helpful to
identify the causes of accidents.
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Causes of accident and possible LP and R measures
Causes of accidents Loss prevention measures
- Working on dangerous - Safety seminars, inspection at
equipment with less care regular times
- Improper use of equipment - Training, safety seminars
- Violating Safety Procedures - Safety seminars, warning,
and Regulations. dismissal
- Human error, Negligence - Training, safety seminars
- Use of inappropriate tools - Provide appropriate tools
- Lack of protective clothing - Provide necessary protective
- Use of defective equipment clothing
- Inadequate Knowledge about - Regular inspection and
the job maintenance
- Working while physically ill - Training
- Mental Disturbance of - Sick leave, don’t allow to work
employee
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until recovery 47
Risk Transfer
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Risk Management Matrix
Which method should be used?
• In determining the appropriate method or
methods of for handling losses, a matrix can
be used that classifies loss exposures
according to frequency and severity.
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4. Implement the risk management program
After deciding among the alternative tools of
risk treatment the risk manager must
implement the decisions made.
If insurance is to be purchased for example,
establishing proper coverage, obtaining
reasonable rates, and selecting the insurer are
part of the implementation process.
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THE END
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