Risk Management Exam 1 (Topic 1, 2, & 3)

Risk =

Uncertainty

Higher uncertainty

Higher risk

Classifications of Risk (4)

1. Pure vs. Speculative

2. Static vs. Dynamic

3. Diversifiable vs Non-diversifiable

4. Subjective vs. Objective

Pure risk

Only two outcomes (no loss, loss)

Speculative risk

Three outcomes (loss, gain, neither)

Static risk

Risks that have always been present in society (eg. death, sickness, war, etc.)

Dynamic risk

Risks that arise out of changing circumstances (eg. rise of tech, cyber risks)

Diversifiable risk

Risks that are NOT highly correlated; random and not dependent on one another

Non-Diversifiable risk

Risks that are highly correlated; simultaneous occurrence from a single event (eg. inflation)

Subjective risk

Involves an individuals view of uncertainty/the situation involving risk

Objective risk

The measurable variation in uncertain outcomes based on facts and data.

Expected losses (EL)

based on experience, data, etc. -- i.e. what we expect to happen

Actual losses (AL)

Losses that actually occur

Example:

A.

- 10 buildings, 2 expected fires

- 0 < # of fires < 4

- 20% chance

B.

- 30 buildings, 4 expected fires

- 0 < # of fires < 12

- 30% chance

Find variation of loss to find out which is more risky

A.

(4-2)/2 = 100%

B.

(12-9)/9 = 33%

Higher variation = higher risk

A is more risky

Variation equation

(Al - EL) / EL.

Factors that affect risk (4)

1. Peril

2. Frequency

3. Severity

4. Hazards

Types of hazards (3)

1. Physical

2. Moral

3. Morale Hazards

Physical hazards

Includes location, construction, and use

If the peril is tsunami, the physical hazard is...

Distance to shore

If the peril is fire, the physical hazard is...

Distance to fire hydrant

Moral Hazards

Occur when people behave differently because of the existence of insurance

I.e. the frequency / severity increases because of the insurance

Morale Hazards

Result from carelessness concerning losses

What are the 3 financial burdens associated with risk?

1. What does it cost an organization?

2. How does it impact an organization?

3. How does it impact society?

What are the steps in risk management process? (6)

1. Identify exposures

2. Evaluate exposures to loss

3. Identify possible alternatives

4. Select among the alternatives

5. Implementation of chosen alternative

6. Re-evaluate periodically

Traditional Risk Management (TRM)

Focuses on specific types of risks, typically insurable

TRM focuses (4)

1. Property loss exposure

2. Net income exposure

3. Personnel loss exposure

4. Negligence & legal liability

Property loss exposure (TRM)

Damage to one's physical or financial assets; created by legal interest in property

Property loss exposure: legal interest in property

1. Ownership interest

2. Secured creditors

3. Buyers and sellers

4. Bailee interest (property for business)

5. Tenant interest

Net income exposure

Loss that results in indirect expenses; the normal productive process of a firm is interrupted

* secondary loss

If a store was robbed and $5000 dollars were stolen, what type of loss is this? (TRM)

Property loss exposure

A store was robbed and $5000 dollars were stolen. Because of this, a new cash register had to be purchased. What type of loss is the new cash register? (TRM)

Net income exposure

Personnel loss exposure

The risk that an organization will suffer losses due to key employee suffering a loss

Negligence and legal liability

Losses from liability exposure (legal fees)

Negligence is:

failure of a person to exercise proper degree of care

How do you measure loss to award damages? (4)

1. Property losses

2. Bodily injury (medical expense, loss of income)

3. General damages (intangible losses, pain & suffering)

4. Punitive damages (result of gross negligence)

Defenses to liability? (2)

1. Assumption of risk

2. Comparative/contributory

Res Ipsa Loquitur...

The thing speaks for itself

I.e. modification to law of negligence

Types of liability (6)

1. Vicarious liability

2. Joint & several liability

3. Product liability

4. Premise liability

5. Liquor liability

6. Animal liability

Vicarious liability

One person becomes liable for another person (e.g. a employer)

Joint & several liability

negligence of two or more parties contribute to the injury or damage

Product liability

Manufacturers of a faulty product that injures someone or damages property

Premise liability

Owner or tenant may be held liable for damages if someone is injured on property, or if something on their property damages someone else's property

Trespasser Premise Liability

Only obligated to abstain from intentionally harming the trespasser

Licensee Premise Liability

Only obligated to abstain from intentionally harming and to warm of any hidden dangers

Invitee Premise Liability

Obligated to keep premise safe so no harm comes to the invitee

Liquor liability

Injuries resulting to patrons/guests from selling alcohol

Dram shop laws

Allow businesses to be held liable if they over serve someone and they subsequently leave and injure someone

Animal liability

Exotic animals (strict liability)

Dogs (some states have strict liability, some states - if a dog never bit before - could escape liability)

Enterprise Risk Management (ERM)

Risk based approach to managing an enterprise; integrated and strategic approach

Four quadrants of ERM

1. Hazard Risks

2. Financial Risks

3. Operational risks

4. Strategic risks

Hazard Risks (ERM)

Traditional "pure" risks (fires, floods, issues with key employees, etc.)

Financial Risks (ERM)

Speculative risks (inflation, foreign exchange rates, stock market, interest rates, volatility of markets, liquidity, etc.)

Operational Risks (ERM)

Pure + speculative risks associated with business operations (manufacturing issues, regulatory issues, "HR" issues)

Strategic/business/SWOT Risk (ERM)

Speculative risks associated with SWOT (customer service, PR, reputation, competition, ethics, etc.)

Difference between TRM and ERM?

TRM is more individual, ERM is more integrated.

How do we identify exposure? (8)

1. Inspection

2. Contract analysis

3. Look at past data

4. Benchmarking

5. Safety checklist

6. Flow chart approach

7. Ask (employees or managers)

8. Financial statement approach

The core of RM decision making is the measurement of :

expected outcomes (how much loss)

Expected Outcome = ___ * ___

E(Frequency) * E(Severity)

Law of Large numbers

The more data you collect, the closer you get to the accurate result

Problem Solving example:

Alamo car rental is debating setting up a self-insured pool. They have 100,000 automobiles. They collect data from 1000 cars.

How do you calculate frequency?

Frequency = #oflosses(prob) + #oflosses(prob) + #oflosses(prob)

Problem Solving example:

Alamo car rental is debating setting up a self-insured pool. They have 100,000 automobiles. They collect data from 1000 cars.

How do you calculate severity?

Severity = $ofloss(prob) + $ofloss(prob) + $ofloss(prob)

Problem Solving example:

Alamo car rental is debating setting up a self-insured pool. They have 100,000 automobiles. They collect data from 1000 cars.

How do you calculate EO?

EO = Frequency * Severity

Problem Solving example:

Alamo car rental is debating setting up a self-insured pool. They have 100,000 automobiles. They collect data from 1000 cars.

How do you calculate the EO for the company?

Company EO = EO per auto * total inventory

What is Gross Premium?

the paid per unit of coverage to insure a risk; i.e. the price of product

* Calculated based on EO

What are the three components of gross premium?

1. Pure premium

2. Risk charges

3. Administrative costs

Pure Premium (1/3)

The expected losses; the estimated portion of gross premium sufficient to pay for loss

Risk charges (2/3)

Extra amount charged by the insurer to represent the estimation risk

Risk charge is about confidence in estimate -- not whether someone/something is a good or bad risk

Do all insurance gross premiums have risk charges?

No.

if there is a lot of data (i.e. car insurance, home insurance) the level of confidence in the estimation is more accurate, so there is no need for a risk charge

How do you know how much to charge for risk charge?

The size of risk charge varies inversely with the level of confidence in the estimate

Administrative cost (3/3)

expense loading costs for insurance companies (i.e. wages, marketing, sales tax, etc.)

Maximum possible loss

The highest loss that could possible occur, regardless of probability (as long as probably > 0)

Maximum probable loss

the largest loss that is most likely to occur; not always and xact answer (subjective)

Which is more beneficial to study: max possible loss or max probable loss?

Max probable loss

measure of central tendencies

Mean = expected outcome = weighted average

Measures of dispersion

Variance

S Dev

Coefficient of variation (COV)

Variance =

sum of (outcome - EO)^2 * (probability)

EO = mean

S dev =

sqrt of variance

Coefficient of variation (COV) =

s dev / EO

EO = mean

The HIGHER the COV....

The more risk a company faces

Why? More variation.