DEFINITIONS OF RISK The Law of Large Numbers

Definition
Risk is defined as uncertainty The law of large numbers states that
concerning the occurrence of a loss. The as the number of exposure units increases,
term risk is often used in situations where the more closely the actual loss experience
the probability of possible outcomes can be will approach the expected loss experience.
estimated with some accuracy, while Example: As the number of homes
“uncertainty” is used in situations where under observation increases, the greater is
such probabilities cannot be estimated. the degree of accuracy in predicting the
proportion of homes that will burn.
Loss exposure is any situation or
circumstance in which a loss is possible CLASSIFICATION OF RISK
regardless of whether a loss occurs.
Pure Risk and Speculative Risk
Objective Risk (also called degree of risk)
is defined as the relative variation of actual Pure risk is defined as a situation in which
loss from expected loss. there are only the possibilities of loss or no
loss.
Subjective risk is defined as uncertainty Speculative risk is defined as a situation in
based on a person’s mental condition or which either profit or loss is possible.
state of mind.
Diversifiable Risk and Nondiversifiable
Chance of loss is defined as the probability Risk
that an event will occur; it is not the same
thing as risk. Diversifiable risk is a risk that affects only
individuals or small groups and not the
Peril is defined as the cause of loss. entire economy. It is a risk that can be
reduced or eliminated by diversification.
Hazard is a condition that creates or
increases the frequency or severity of loss. Nondiversifiable risk is a risk that affects
There are four major types of hazard. the entire economy or large numbers of
a. Physical Hazard – is a physical condition persons or groups within the economy.
that increases the frequency or severity of
loss. Enterprise Risk
b. Moral Hazard – is dishonesty or
character defects in an individual that Enterprise risk is a term that encompasses
increase the frequency or severity of loss. all major risks faced by a business firm.
c. Attitudinal Hazard – is carelessness or Such risks include pure, speculative risk,
indifference to a loss, which increases the strategic risk, operational risk and financial
frequency or severity of a loss. risk.
d. Legal Hazard – refers to characteristics
of the legal system or regulatory Strategic risk refers to uncertainty
environment that increase the frequency or regarding the firm’s financial goals and
severity of losses. objectives. Example: if a firm enters a new
line of business, the line may be loss exposure, intangible property
unprofitable. Operational risk results from exposures, government exposures
the firm’s business operations.
BURDEN OF RISK ON SOCIETY
Financial risk refers to the uncertainty of -​ The size of an emergency fund must
loss because of adverse changes in be increased
commodity prices, interest rates, foreign -​ Society is deprived of certain goods
exchange rates and value of money. and services
-​ Worry and fear are present
MAJOR PERSONAL RISKS AND
COMMERCIAL RISKS TECHNIQUES FOR MANAGING RISK
1. Personal Risks are risks that directly 1.​ Risk control refers to techniques
affect an individual or family that reduce the frequency or severity
-​ Premature death of losses.
-​ Insufficient income during retirement -​ Avoidance
-​ Poor health -​ Loss prevention
-​ Unemployment -​ Loss reduction

2. Property Risks are the risk of having 2. Risk financing refers to techniques that
property damaged or lost from numerous provide for the funding of losses.
causes. Retention. This means that an
Direct Loss is defined as a financial individual or a business firm retains part of
loss that results from the physical damage, all of the losses that can result from a given
destruction, or theft of the property. risk. Risk retention can be active or Passive.
Indirect or Consequential Loss is Active retention means that an
a financial loss that results indirectly from individual is consciously aware of the risk
the occurrence of a direct physical damage and
or theft loss. deliberately plans to retain all or part of it.
Passive retention. Risk can also be
3. Liability Risks are another important retained passively. Certain risk may be
type of pure risk that most persons face. unknowingly retained because of ignorance,
Under our legal system, you can be held indifference, laziness, or failure to identify
legally liable if you do something that results an important risk. Passive retention is very
in bodily injury or property damage to dangerous if the risk retained has the
someone else. A court of law may order you potential for financial ruin.
to pay substantial damages to the person
you have injured. Self-insurance is a special form of planned
retention by which part of all of a
4. Commercial Risks given loss exposure is retained by the firm.
-​ Property risks Another name for self-insurance is
-​ Liability risks self-funding, which expresses more clearly
-​ Loss of Business Income the idea that losses are funded and
-​ Other risks (crime exposures, paid for by the firm.
human resource exposures, foreign
Noninsurance transfers. The risk is that average loss is substituted for actual
transferred to a party other than an loss. Finally, the risk may be reduced by
insurance company. A risk can be application of the law of large numbers by
transferred by several methods, including: which an insurer can predict
future loss experience with greater
Transfer of Risk by Contracts. accuracy.
Undesirable risks can be transferred by
contracts. For example, the risk of a Module 2: Insurance and Risk
defective television or stereo set can be 1. Insurance
transferred to the retailer by purchasing a a. Definition
service contract, which makes the retailer -​ the pooling of fortuitous losses by
responsible for all repairs after the warranty transfer of such risks to insurers,
expires. who agree to indemnify insurers for
such losses, to provide other
Hedging Price Risks. Hedging pecuniary benefits on their
price risks is another example of risk occurrence, or to render services
transfer. Hedging is the technique for connected with the risk.
transferring the risk of unfavorable price b. Basic characteristics
fluctuations to a speculator by purchasing -​ POOLING OF LOSSES - the
and selling futures contracts on an spreading of losses incurred by the
organized exchange. few over the entire group, average
loss is substituted
Incorporation of a business firms. -​ PAYMENT OF FORTUITOUS
Incorporation is another example of risk LOSSES - fortuitous loss is one that
transfer. If a firm is a sole proprietorship, the is unforeseen and unexpected by
owner’s personal assets can be attached by the insured and occurs as a result of
creditors for satisfaction of debts. If a firm chance.
incorporates, personal assets cannot be -​ RISK TRANSFER - pure risk is
attached by creditors for payment of the transferred from the insured to the
firm’s debts. In essence, by incorporation, insurer
the liability of the stockholders is limited, -​ INDEMNIFICATION - ​insured is
and the risk of the firm having insufficient restored to his or her approximate
assets to pay business debts is shifted to financial position prior to the
the creditors. occurrence of the loss.
c. Types of Insurance
Insurance. For most people, insurance is -​ LIFE INSURANCE - Pays death
the most practical method for handling benefits to designated beneficiaries
major risks. Although private insurance has when the insured dies.
several characteristics, three major -​ HEALTH INSURANCE - Medical
characteristics should be emphasized. First, expense plans pay for hospital and
risk transfer is used because a pure risk is surgical expenses, physician fees,
transferred to the insurer. Second, the prescription drugs, and a wide
pooling technique is used to spread the variety of additional medical costs
losses of the few over the entire group so
 -​ PROPERTY AND LIABILITY Loss Prevention - Insurance companies
INSURANCE are actively involved in numerous loss-
*PROPERTY INSURANCE - Indemnifies prevention programs and also employ a
property owners against the loss or damage wide variety of loss-prevention personnel,
of real or personal property caused by
various perils, such as fire, lightning, Enhancement of Credit- A final benefit is
windstorm, or tornado. that insurance enhances a person’s credit

*LIABILITY INSURANCE - Covers the COST OF INSURANCE TO SOCIETY

insured’s legal liability arising out of property
damage or bodily injury to others; legal Cost of doing business - Insurers
defense costs are also paid. consume scarce economic resources –
land, labor, capital, and business enterprise
CASUALTY INSURANCE - is a broad field – in providing insurance to society.
of insurance that covers whatever is not
covered by fire, marine, and life insurance; Fraudulent Claims - People fake or
casualty lines include auto, liability, burglary exaggerate losses to get insurance money
and theft, workers compensation and health
insurance. Inflated Claims - Legitimate losses are
exaggerated to get a higher payout
PROPERTY AND CASUALTY
INSURANCE COVERAGE 2. Characteristics of an ideally insurable risk
1. There must be a large number of
1.PERSONAL LINES - a type of insurance exposure units.
that protects individuals and their 2. The loss must be accidental and
families from financial losses due to unintentional.
death, injury, or property loss. 3. The loss must be determinable and
measurable.
d. Benefits and Costs 4. The loss should not be catastrophic.
Indemnification for Loss - a legal 5. The chance of loss must be calculable.
agreement where one party compensates 6. The premium must be economically
another for losses, damages, or liabilities. feasible.
3. The concept of adverse selection and
Reduction of Worry and Fear - A second insurance
benefit of insurance is that worry, and fear
are reduced because the insured's know Adverse selection occurs when individuals
that they have insurance that will pay for the with higher risks are more likely to purchase
loss. insurance, while those with lower risks avoid
it.
Sources of Investment Funds - The 4. Insurance vs. gambling and hedging
insurance industry is an important source of
funds for capital investment and INSURANCE is a technique for managing
accumulation. existing pure risks, providing financial
protection against potential losses.
GAMBLING involves creating new 3. The adverse financial impact of pure loss
speculative risks, where outcomes are exposures is reduced.
uncertain and based on chance. 4. Society benefits because both direct and
indirect (consequential) losses are reduced.
INSURANCE transfers pure (insurable)
risks through a contract, providing financial 2. The risk management process
protection. a. Identify loss exposure
HEDGING manages financial risks, often 1. Property loss exposure
using investments to offset potential losses. 2. Liability loss exposure
Both aim to reduce financial exposure. 3. Business loss income exposure
4. Human resource loss exposure
Module 2: Introduction to Risk Management 5. Crime loss exposure
1. Risk Management 6. Employee benefit loss exposure
a. Definition 7. Foreign loss exposure
Risk management is the identification, 8. Intangible property loss exposure
evaluation, and prioritization of risks, 9. Failure to comply with government
followed by the minimization, monitoring laws and regulations
and control of the impact or probability of 10. Sources of Information to Identify
those risks occuring. Loss Exposures
-​ can come from various sources, for
example threats including uncertainty in b. Measure and analyze risk exposure
international markets, and political
instability. Loss frequency refers to the probable
b. Objectives number of losses that might occur
Pre - loss Objectives: during some given time
-​ The firm should prepare for
​
potential losses in the most
Loss severity refers to the possible
economical way
-​ The reduction of anxiety
size of the losses that might occur.
-​ To meet any legal obligations
Post - loss objectives: c. Select the appropriate combination of
-​ To ensure the survival of the firm techniques for treating the loss exposure
-​ To continue operation 1. Risk control
-​ To ensure the stability of earnings -​ refers to techniques that
-​ To continue growth of the firm reduce the frequency and
-​ ​To minimize the effects that a loss severity of losses
will have on other persons or Methods of risk control include:
society -​ Avoidance
c. Benefits -​ Loss prevention
1. Enables firm to attain its pre-loss and -​ Loss reduction
post-loss objectives more easily.
2. Reduce a firm’s cost of risk, which may
increase the company’s profit.
2. Risk financing IV - Dissemination of information
-​ refers to techniques that provide concerning insurance coverage
for the funding of losses. V - Periodic review of the insurance
a. Retention program
-​ means that the firm retains part Advantages
or all of the losses that can result -​ Firm is indemnified for losses
from a given loss. -​ Uncertainty is reduced
-​ (No other method of treatment is -​ Insurers may provide other risk
available) management services
-​ (The worst possible loss is not -​ Premiums are tax- deductible
serious) Disadvantages
-​ (Losses are highly predictable) -​ Premiums may be costly
b. Non-insurance transfers – (opportunity cost should be
A non-insurance transfer is a considered)
method other than insurance by -​ Negotiation of contracts takes
which a pure risk and its time and effort
potential financial consequences -​ The risk manager may become
are transferred to another party. lax in exercising loss control
-​ Advantages
(Can transfer some losses that 3. Risk management matrix
are not insurable)
(Save Money) d. Implement and Monitor the Risk
(Can transfer loss to someone Management Program
who is in a better position losses -​ A successful risk
to control) management program
-​ Disadvantages requires active
(Contract language may be cooperation from other
ambiguous, so transfer may fail) departments in the firm
(If the other party fails to pay, firm -​ The risk management
is still responsible for the loss) program should be
(Insurers may not give credit for periodically reviewed and
transfers) evaluated to determine
whether the objectives are
c. Insurance – If the risk manager uses being attained
insurance to treat certain loss -​ The risk manager should
exposures, five key areas must be compare the costs and
emphasized. benefits of all risk
I - Selection of insurance coverage management activities
II - Selection of an insurer
III - Negotiation of terms
3. Personal Risk Management 2. Insurance Market Dynamics
Personal risk management refers Risk Retention - Retained losses
to "the identification of pure risks faced can be paid out of current earnings from
by an individual or family, and to the loss reserves, by borrowing or by captivate
selection of the most appropriate insurance company.
Risk Transfer - shifts burden of
technique for treating such risks.
paying for losses to another party, most
The same principles applied to
often a property and liability insurance
corporate risk management apply to company.
personal risk management a. Factors influencing the insurance
market
Module 3: Advance topics in Risk 1.​ The underwriting cycle refers to the
Management cyclical pattern of underwriting results
1. The Changing Scope of Risk and profitability.
Management -​ Insurance Industry Capacity In the
a. Financial risk management – definition insurance industry, capacity refers to
and types the relative level of surplus.
-​ Investment Returns Property and
Financial Risk Management refers to the casualty insurance can, and often
identification, analysis, and treatment of do, sell coverages at an expected
speculative financial risks: loss, hoping to offset underwriting
-​ Commodity price risk losses with investment income.
-​ Interest rate risk 2.​ Consolidation in the Insurance
-​ Currency exchange rate risk Industry While changes were occuring
-​ in insurance product markets, changes
b. Enterprise risk management – were also accuring among the
definition and types organization operating in this sector of
ERM takes a broader view by addressing all the economy.
types of risks strategic, operational, -​ Cross-Industry Consolidation
financial, and reputational that can impact Consolidation in the financial
an organization. services arena is not limited to
-​ Strategic risk mergers between insurance
-​ Operational risks companies or between insurance
As long as risks are not positively brokerages.
correlated, the combination of these risks in 3.​ Capital Market Risk Financing
a single program reduces overall risk Alternatives Insurers and risk
managers are looking increasingly to
c. Emerging risks the capital markets to assist in
Emerging risks are new or evolving financing risk.
risks that are difficult to predict but can -​ Securitization of Risk Another
significantly impact organizations. important development in insurance
-​ Terrorism and risk management is the
-​ Climate change accelerating use of securitization of
risk.
 Financial Risks
3. Loss Forecasting
Loss forecasting refers to Market risk is the possibility of an investor
predicting future losses through an analysis experiencing losses due to factors that
of past losses. affect the overall performance of the
THE RISK MANAGER CAN PREDICT financial markets.
LOSSES USING SEVERAL TECHNIQUES: Credit risk is the potential for a lender to
Probability Analysis - is a technique used lose money when they provide funds to a
by risk managers for forecasting future Borrower.
events, such as accidental and business Operational risk summarizes the
losses. uncertainties and hazards a company faces
when it attempts to do its day-to-day
Regression Analysis - the main uses of business activities within a given field or
regression analysis are forecasting, time industry.
series modeling and finding the cause and Liquidity risk refers to the potential
effect relationship between variables. difficulty an entity may face in meeting its
short-term financial obligations due to an
Forecasting Based on Loss Distribution - inability to convert assets into cash without
a probability distribution of losses that could incurring a substantial loss
occur. Works well if losses tend to follow a
specified distribution and the sample size is 5. Other Risk Management Tools
large.
SWOT – Strengths, Weaknesses,
4. Financial Analysis in Risk Opportunities, and Threats or SWOT helps
Management Decision Making identify risks by assessing each area of the
Financial analysis is the process of company.
evaluating businesses, projects, budgets, Root Cause Analysis – It is a method of
and other finance-related transactions to identifying the main source of a problem or
determine their performance and suitability. risk and finding a solution to resolve it.
This is done through the synthesis of Risk Register – A risk register is useful for
financial numbers and data. identifying potential risks in a project
(e.g.,construction projects) or organization –
2 TYPES OF FINANCIAL ANALYSIS which can come in handy for avoiding any
Fundamental analysis Fundamental potential issues that could throw a wrench in
analysis uses ratios and financial statement your intended outcomes
data to determine the intrinsic value of a Probability and Impact Matrix – A
security. probability and impact matrix is a way to
Technical Analysis Technical analysis is prioritize risks. It’s important to prioritize risk
the use of historical market data to predict because you don’t want to waste time
future price movements. chasing a small risk and exhaust your
resources.
Brainstorming – This tool allows you to
assess any insights that can help resolve
any issues that occur inside the company.