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
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 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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Year Number of Cars Number of Accident Amount of Loss
1 10 1 Birr 2,500
2 12 2 4,200
3 14 3 4,500
4 15 3 6,000
5 20 2 6,500
6 20 3 6,600
7 25 4 6,000
8 25 5 8,000
9 28 3 7,500
10 30 4 10,000
SUM 200 30 61,800
Mean 20 3 6,180
S.D 1.15 2,115
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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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 No of Amount Probability Expected Expected
Accidents of Loss* No. of Accidents Amount of Loss**
0 0 0.0025 0 0
1 2,060 0.0149 0.0149 30.69
2 4,120 0.0446 0.0892 183.75
3 6,180 0.0892 0.2676 551.26
4 8,240 0.1339 0.5356 1103.34
5 10,300 0.1606 0.8030 1654.18
6 12,360 0.1606 0.9636 1985.02
7 14,420 0.1377 0.9639 1985.63
8 16,480 0.1033 0.8264 1702.38
9 18,540 0.0688 0.6192 1275.55
10 20,600 0.0413 0.4130 850.78
11 22,660 0.0225 0.2475 509.85
12 24,720 0.0113 0.1356 279.34
13 26,780 0.0052 0.0676 139.26
14 28,840 0.0022 0.0308 63.45
15 30,900 0.0009 0.0135 27.81
16 32,960 0.0003 0.0048 9.89
17 35,020 0.0001 0.0017 3.50
18 37,080 0.0001 0.0018 3.71
SUM 1.0000 5.9997 12,359.39 20
• 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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 No. of Monetary Mean Deviation Deviation Probability DS times

Accidents Loss From Mean Squared probability

0 0 12,360 -12360 152,769,600.000 0.0025 3,81,924.000

1 2,060 12,360 -10300 106,090,000.000 0.0149 1,580,741.000

2 4,120 12,360 -8240 67,897,600.000 0.0446 3,028,232.960

3 6,180 12,360 -6180 38,192,400.000 0.0893 3,410,581.320

4 8,240 12,360 -4,120 16,974,400.000 0.1339 2,272,872.160

5 10,300 12,360 -2,060 4,243,600.000 0.1606 681,522.160

6 12,360 12,360 0 0.000 0.1606 0.000

7 14,420 12,360 2,060 4,243,600.000 0.1377 584,343.720

8 16,480 12,360 4,120 16,974,400.000 0.1033 1,753,455.520

9 18,540 12,360 6,180 38,192,400.000 0.0688 2,627,637.120

10 20,600 12,360 8,240 67,897,600.000 0.0413 2,804,170.880

11 22,660 12,360 10,300 106,090,000.000 0.0225 2,387,025.000

12 24,720 12,360 12,360 152,769,600.000 0.0113 1,726,296.480

13 26,780 12,360 14,,420 207,936,400.000 0.0052 1,081,269.280

14 28,840 12,360 16,480 271,590,400.000 0.0022 597,498.880

15 30,900 12,360 18,540 343,731,600.000 0.0009 309,358.440

16 32,960 12,360 20,600 424,360,000.000 0.0003 127,308.440

17 35,020 12,360 22,660 513,475,600.000 0.0001 51,347.560

18 37,080 12,360 24,720 611,078,000.000 0.0001 61,107.840

SUM 25,466,692.320
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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.

N M Sd Rm Rn
40 6 2.4495 0.408 0.06124
50 7.5 2.7386 0.365 0.05478
100 15 3.8730 0.258 0.03873

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