Risk managment and Insurance chap1-3 Addis Ababa University School of Commerce

CHAPTER ONE
RISK AND RELATED
TOPICS
Addis Ababa University, School of Commerce

Your Instructor
Ashenafi Abera (Ass. Prof.)
Certified Management Consultant
+251 912 16 21 08
ashujoshua85@yahoo.com

Topics to Be Covered
 Meaning of Risk
 Risk vs Uncertainty
 Risk vs Probability
 Risk, Peril and Hazard
 Classification of Risk
 Risk Related To Business Activities
 Burden of Risks on Society

1.1 Meaning of Risk
 There is no one universal and comprehensive definition of risk that exists so far
 Risk traditionally has been defined in terms of uncertainty, concerning the occurrence of a
loss.
 Consider the following definitions:
o Risk is the possibility of an unfortunate occurrence.
o Risk is a combination of hazards.
o Risk is unpredictability – the tendency that actual results may differ from predicted
results.
o Risk is uncertainty of loss.
o Risk is possibility of loss.

Common Elements In The
Definitions:-
 Indeterminacy:- means the outcome must be in question
o When risk is said to exist there must be at least two possible outcomes
o If we know for certain that a loss occurs, there is no risk.
 Loss:- at least one of the possible outcomes is undesirable may be loss.
*IF THE OUTCOME IS ONE AND KNOWN IN ADVANCE
THEREFORE, THERE IS NO RISK

1.2 Risks versus Uncertainty
Uncertainty
 Doubt about our ability to predict the future outcome
of current actions.
 Arises when an individual perceives that outcomes
cannot be known with certainty
 Describes a state of mind.
 The level and type of information on the nature of a
risky activity have an important effect on uncertainty.

Levels of Uncertainty
Level of Uncertainty Characteristics Examples
None (Certainty)
Level 1
(Objective Uncertainty)
Level 2
(Subjective Uncertainty)
Level 3
Outcomes can be predicted
with precision.
Outcomes are identified and
probabilities are known.
Outcomes are identified but
probabilities are unknown.
Outcomes are not fully
identifies and probabilities are
unknown.
Physical laws, natural sciences.
Games of chance, Cards, Dies.
Fire, automobile accident,
many investments.
Space exploration, genetic
research.

1.3 Risks versus Probability (Chance of Loss)
 Risk is the level of possibility that an action lead to a loss/undesirable outcome. But
 Probability (Chance of Loss) used to measure /estimation of how likely the event will occur.
 Probability has both objective and subjective aspects.
Objective Probability:
 Objective probability refers to the long-run relative frequency of an event based on the
assumptions of an infinite number of observations and of no change in the underlying
conditions
 Objective probabilities can be determined in two ways:-
 Inductive Reasoning
 Deductive Reasoning

1.3 Risks versus Probability (Chance of Loss)
Subjective Probability:
 Is the individual’s personal estimate of chance of loss
 A wide variety of factors can influence subjective probability, including
 A Person’s Age
 Gender
 Intelligence
 Education, And
 The Use of Alcohol.

1.4 RISK, PERIL AND HAZARD
Peril:
A peril is a potential event or factor that can cause a loss,
Common perils that cause property damage included fire, lightning,
windstorm, hail, tornadoes, earthquakes, theft and robbery.
Hazard:
A hazard is a condition that creates or increases the chance of loss.
it is possible for something to be both a peril and hazard

1.4 RISK, PERIL AND
HAZARD…
There are four major types of hazards:
 Physical hazard: physical condition that
increases the chance of loss
 Moral Hazard: dishonesty or character defects in
an individual that increase the frequency or
severity of loss
 Morale Hazard: carelessness or indifference to a
loss because of existence of insurance.
 Legal Hazard: characteristics of the legal system
or regulatory environment that increase the
frequency or severity of losses

Individual Assignment
(10%)
Conducting a Hazard Assessment
Hazard Assessments
A hazard assessment is a thorough assessment of
the workplace or specific task for the purpose of
identifying what actual and potential hazards exist.
with the intent, where possible, to first eliminate
the hazard or reduce the hazard by using
engineering controls, administrative controls, or
personal protective equipment

1.5 CLASSIFICATION OF RISK
Risk can be classified into several distinct categories. The major
categories are as follows:
 Objective and subjective Risks.
 Pure and Speculative Risks.
 Fundamental and Particular Risks.
 Financial and non-financial
 Static and dynamic Risks:

Objective Risk (Statistical Risk)
 Objective risk is defined as the relative variation of actual loss from
expected loss
 Objective risk declines as the number of exposures increases
 As the number of exposures increases, can predict future loss
experience more accurately because it can rely on the law of large
number

Subjective Risk
 uncertainty based on a person’s mental condition or state of mind
 High subjective risk often results in conservative and prudent
behavior, while
 low subjective risk may result in less conservative behavior.

1.5 CLASSIFICATION OF RISK…
Pure Risks:
 a situation in which there are only the possibilities
of loss or not loss.
 The only possible outcomes are adverse (loss) and
neutral (no loss)
 Examples: premature death, industrial accidents,
terrible medical expenses, and damage to property
from fire, lightning, flood, or earthquake.
The major types of pure risk that can create great
financial insecurity include
 Personal Risks.
 Property Risks.
 Liability Risks.

Personal Risks. There are four major personal risks.
 Risk of premature death.
 Risk of insufficient income during retirement.
 Risk of poor health.
 Risk of unemployment.

Property Risks:-
 Direct loss: financial loss that results from
the physical damage, destruction, or theft of
the property
 Indirect loss or consequential loss is
financial loss that results indirectly from the
occurrence of a direct physical damage or
theft loss.

Liability Risks:-
 legally liable if you do something that result in bodily
injury or property damage to someone else
 A court of law order

1.5 CLASSIFICATION
OF RISK…
Speculative Risks:-
 a situation in which
either profit or loss is
possible
 betting on horse race,
card games, investing in
real estate, and going
into business for your
self.

1.5 CLASSIFICATION
OF RISK…
Fundamental Risks:-
 a risk that affects the
entire economy or large
numbers of persons or
groups within the
economy
 rapid inflation, cyclical
unemployment, war,
Hurricanes, tornadoes,
earthquakes, floods, and
forest and grass fires .

1.5 CLASSIFICATION
OF RISK…
Particular Risks:-
 a risk that affects only
individuals and not the
entire community
 car thefts, gold thefts,
bank robberies, and
dwelling fires.

1.5
CLASSIFICATION
OF RISK…
Financial Risks
Market
Credit
Interest rate
Liquidity
Non-Financial Risks
Implementation
Operational
Reputation
Non-financial risks can have a financial
impact

Static Risks
 loss arises from cause other than change in the economy
 occur with a degree of regularity overtime and are
generally predictable
Dynamic Risks
 resulting from change in the economy.
 Change in the price level, consumer test, income and
output and technology may cause financial loss
 less predictable than static risks, as they do not occurred
with any precise degree of regularity

BURDEN OF RISKS ON
SOCIETY
 Large emergency fund
 Worry and fear
 Loss of Certain Goods and Services

RISK RELATED TO BUSINESS
ACTIVITIES
 Business Risk
 Financial Risk
 Interest Rate Risk
 Purchasing Power Risk
 Market Risk

End of Chapter One
“THERE IS NO TIME AND PLACE WHICH IS FREE FROM RISK,
AND VERY DIFFICULT TO AVOID IT, SO WHAT WOULD BE
BETTER?”
“MANAGING”

CHAPTER TWO
THE RISK
MANAGEMENT

Topics to Be Covered
 Meaning of Risk Management
 Objectives of Risk Management
 Steps in the Risk Management Process

2.1 Meaning of Risk Management
A systematic process for:
 The identification and evaluation of pure loss exposures faced by an
organization or individual
 and for the selection and administration of the most appropriate
technique for treating such exposures
 such that negative outcomes are minimized (or avoided altogether),
and positive outcomes are capitalized upon.

2.2 Objectives of Risk Management
Risk management has important objectives.
These objectives can be classified as either
(1) Pre loss Objectives
(2) Post loss Objectives

2.2 Objectives of Risk Management…
(1) Pre loss Objectives
Important objectives before a loss occurs include:-
 Economy: cost of safety programs, insurance premiums paid, and the
costs associate with different techniques for handling losses
 Reduction of Anxiety, and
 Meeting Legal Obligations: to install safety devices to protect workers
from harm, to dispose of harmful waste material properly and to label
consumer products appropriately

2.2 Objectives
of Risk
Management…
(2) Post loss Objectives
Important objectives after a loss occurs include:-
 Survival
 Continued Operation
 Stability of Earnings
 Continued Growth and
 Social Responsibility

2.3 Steps in the Risk Management Process
The Risk Management Process Involves Four Steps:
Step 1: Identifying potential losses (Risk
Identification)
Step 2: Evaluate Potential losses (Risk Measurement)
Step 3: Select the appropriate Techniques for treating
loss exposure, and
Step 4: Implement and administer the program.

Step 1: Identifying potential losses (Risk
Identification)
 Identify all major and minor loss exposures
 A loss exposure is any situation where a loss is possible, whether loss
occurs are not
 Loss exposures typically classified as (Sources of Risks)
 The sources of possible losses are recognized

Loss Exposures (Sources of
Risks):
 Property Loss Exposures
 Business Income Loss Exposures
 Human Resources Loss Exposures
 Crime Loss Exposures
 Employee Benefits Loss Exposures
 Foreign Loss Exposures
 Liability Loss Exposures

Loss Exposures (Sources of Risks)...
 Employee Benefit Loss Exposures:
Failure to comply with government regulation
Failure to pay promised benefits
Group life and health and retirement plan exposures.

Loss Exposures (Sources of Risks)…
 Foreign Loss Exposures:
 Acts of terrorism
 Plants, business property, inventory
 Foreign currency risks
 Kidnapping of key persons
 Political risks
 Liability Risks:
 Defective Products
 Sexual harassment of employees,
discrimination against employees,
wrongful termination
 Misuse of internet and e-mail
transactions

Techniques for Identifying Risks:
1. Loss Exposure Checklists:
2. Risk Analysis Questionnaires
3. The Financial Statement Method:
4. The Flow Chart Method:
5. Contract Analysis:
6. Physical Inspection
7. Interactions With Other Departments:
8. Interactions With Outside Suppliers
And Professional Organizations
9. Statistical Records Of Losses
10. Historical Loss Data

Techniques for Identifying Risks:
Loss Exposure Checklists:
 specifies numerous potential sources of loss from destruction of assets
and from legal liability
 Some are designed for specific industries
such as manufacturers, retail stores, educational institutions, or religious
organizations
 Others focuses on a specific category of exposure
such as real and personal property

Step 2: Risk Measurement
(Risk Evaluation)
 To evaluate and measure the impact
of losses on the firm.
 This step involves on estimation of
the potential frequency and severity
of loss.
Loss frequency
 Refers to the probable number of
losses that may occur during the
some given period.
Loss severity
 Refers to the probable size of the
losses that may occur.

Step 2: Risk Measurement (Risk
Evaluation)…
 This is important so that the various loss
exposures can be ranked according to their
relative importance
 In addition, the relative frequency and
severity of each loss exposure must be
estimated so that the risk manager can
select the most appropriate technique, or
combination of techniques, for treating the
loss exposure.

Guidelines for
Measuring Severity:
 Maximum possible loss
- is the worst loss that could possibly happen to
the firm during its lifetime.
- Is the "worst case scenario" and the most
pessimistic view
 Maximum probable loss (PML)
- is the worst loss that is likely to happen.
-is inversely proportional to the size of a
structure and the effectiveness of any
protective safeguards.

Step 3: Select the appropriate techniques
for treating loss exposure (Risk Control)
The major techniques to handling risks are:
1. Risk Control
 Risk Avoidance
 Loss Control
2. Risk Financing Technics
 Risk Retention
 Insurance
 Non-Insurance Transfer

1. Risk Control
 Risk Avoidance
- Avoidance means a certain loss exposure is never
acquired, or
- An existing loss exposure is abandoned
- Conscious decision not to expose oneself or one’s firm
to a particular risk of loss
- To decrease one’s chance of loss to zero
- The firm may not avoid all the losses and may not be
feasible or practical to avoid all the exposures

1. Risk Control …
 Loss Control
- When losses cannot be avoided, actions may be taken to reduce the
probability of losses or to decrease the cost of losses that do occur
- Involves making conscious decisions regarding the ways those
activities will be conducted

1. Risk Control …
 Loss Control:
-Two methods of classifying loss control involve focus and timing.
Focus of Loss Control:
- Designed primarily to reduce loss frequency
- Referred to as frequency reduction or Loss Prevention
For example:- measurers that reduce truck accidents include driver
examinations, zero tolerance for alcohol or drug abuse and strict
enforcement of safety rules or installation of safety features, placement of
warning labels on dangerous products

1. Risk Control …
 Loss Control:
-Two methods of classifying loss control involve Focus and Timing.
Timing of Loss Control:
 Pre-Loss Activities
o Loss Prevention
o Loss Reduction
 Concurrent Activities: activities that take place concurrently with losses
 Post – Loss Activities: always have a severity-reduction focus

Potential Benefits of Loss Control
Include the reduction or elimination of expense associated with the following:
 Repair or replacement of damaged property
 Income losses due to destruction of property
 Extra costs to maintain operations following a loss.
 Adverse liability of judgments
 Medical costs to threat injuries
 Income losses due to deaths or disabilities

 Risk Retention
- The firm’s retains part, or all activities exposed to a loss
- can be effectively used in a risk management program under the
following conditions:
o No other method of treatment is available.
o The worst possible loss is not serious.
o Loss are highly predictable

 Risk Retention
The following methods are typically used for paying losses
o Current Net Income
o Unfunded Reserve
o Funded Reserve
o Credit Line

 Advantages of Risk Retention
o Save Money
o Lower Expenses
o Encourage Loss Prevention
o Increase Cash Flow

 Disadvantages of Risk Retention
o Possible higher losses
o Possible higher expenses
o Possible higher taxes

2. Risk Financing Technics…
 Risk Transfer- Insurance
- A contractual transfer of risk
- five key areas must be emphasized. They are the following;
o Selection of insurance coverage
o Selection of an insurer
o Negotiation of terms
o Dissemination of information concerning insurance coverage
o Periodic review of the insurance program

2. Risk Financing Technics…
 Non-Insurance Transfer
- Transfer of the activity or the property
- Transfer of the probable loss
- Hedging

Step 4: Implement and Administer the
Program
 Risk Management Policy Statement
 Risk Management Manual
 Cooperate With Other Department
 Periodic Review And Evaluating

End of Chapter Two

CHAPTER THREE
INSURANCE: AN
OVERVIEW

Exhibit 3.1 Risk Management Matrix

3.1 Definition of Insurance
insurance is contractual agreement between
two parties: the person (Insured) and
Insurance companies. When a person buys
private insurance, she/he is entering into a
contract with the insurer that entitles the
person (Insured) to certain advantages but
also imposes certain responsibilities such as
payment of a premium and satisfying certain
conditions specified in the policy.

3.1 Definition of
Insurance…
Insurance is the pooling of
accidental losses by transfer
of such risks to insurers,
who agree to indemnify
insureds for such losses, to
provide other financial
benefits on their occurrence,
or to render services
connected with the risk

3.2 BASIC CHARACTERISTICS OF
INSURANCE
There are four basic characteristic of
insurance
 Pooling of Losses
 Payment of Accidental Losses
 Risk Transfer
 Indemnification

INSURANCE…
Pooling or Sharing of Losses
 The spreading of losses incurred by the few over the
entire group, so that in the process, average loss is
substituted for actuarial
 pooling implies (1) the sharing of losses by the entire
group, and (2) prediction of future losses with some
accuracy based on the law of large numbers
 The larger the risk pool, the more predictable and
stable the premiums can be

3.2 BASIC CHARACTERISTICS
OF INSURANCE…
Payment of Accidental Losses
 An accidental loss is one that the unforeseen
and unexpected and occurs randomly as a
result of chance

INSURANCE…
Risk Transfer:
 Risk transfer means that a pure risk is
transferred from the insured to the insurer,
who typically is in a stronger financial
position to pay the loss than the insured
 Pure risk Include the risk of premature
death, poor health, disability, destruction
and theft of property, and liability lawsuits.

INSURANCE…
Indemnification
 Indemnification refers to a situation in which
one party (the “indemnifying” party) agrees or
is required to cover the costs, losses and/or
expenses experienced by another party (the
“indemnified” party)
 Indemnification means that the insured is
restored to his or her approximate financial
position prior to the occurrence of the loss

3.3 REQUIREMENTS (FUNDAMENTALS)
OF AN INSURABLE RISK
 Large Number of Exposure Units
 Determinable and Measurable Loss
 Accidental and Unintentional Loss
 No Catastrophic Loss
 Calculable Chance of Loss
 Economically Feasible Premium

OF AN INSURABLE RISK…
 Large Number of Exposure Units
THE THEORY OF INSURANCE IS BASED ON THE LAW OF LARGE NUMBERS
o Therefore, the prime necessity for a risk to be insurable is that there
must be a sufficiently large number of homogeneous exposures to
combine reasonably predictable losses
o Lost data can be compiled over time, and losses for the group can be
predicted with some accuracy. The loss costs can then be spread over all
insured in the underwriting class.

The rich and famous
who insured their body
parts for a fortune

WHAT ABOUT US ?

 Determinable and Measurable Loss
o Loss should be definite as to cause, time, place and amount
o The basic purpose of this requirement is to enable an insurer to
determine if the loss is covered under the policy, and if it is
covered, how much should be paid

Accidental and Unintentional Loss
 The loss should be accidental and
outside the insured’s control
 if an individual deliberately causes a
loss, he or she should not be
indemnified for the loss.
.
Haile and Alem International Coffee Farm in Sheka Zone,
Tepi town, Southern Regional State, has suffered a property
loss of more than 28 million birr due to vandalism

3.3 REQUIREMENTS
(FUNDAMENTALS) OF
AN INSURABLE RISK…
No Catastrophic Loss
 loss should not be
catastrophic
 large proportion of exposure
units should not incur losses
at the same time.
 catastrophic losses
periodically result from the
floods, hurricanes,
tornadoes, earthquakes,
terrorism, forest fires, and
other natural disasters.

Approaches For Meeting The
Problems of Catastrophic Loss
Reinsurance
Shifting of part or all of the insurance originally written by
one insurer to another
Geographically Dispersed Loss Exposures
Insurers can avoid the concentration of risk by dispersing
their coverage over a large geographical area
Catastrophe Bonds (CAT-Bond)
New financial instruments designed to pay for a catastrophic
loss
•.

Reinsurance
Shifting of part or all of the insurance
originally written by one insurer to
another

Catastrophe Bonds (CAT-Bond)
• Insurance securitization, creating risk-linked
securities which transfer a specific set of risks
(typically catastrophe and natural disaster risks)
from an issuer or sponsor (ceding company) to
capital market investors.

3.3 REQUIREMENTS
(FUNDAMENTALS) OF
Calculable Chance of Loss
 The insurer must be able to
calculate both the average
frequency and the average
severity of future losses with
some accuracy
 so that a proper premium can be
charged that is sufficient to pay
all claims and expenses and yield
a profit during the policy period

3.3 REQUIREMENTS
(FUNDAMENTALS) OF
Economically Feasible
Premium
 The insurance premium
is defined as the amount
of money the insurance
company is going to
charge you for the
insurance policy you are
purchasing
 The insured must be able
to pay the premium

Individual Assignment (10%)
Explain whether the following risks and perils are insurable
by private insurers:
 A hailstorm that destroys your roof
 The life of an eighty-year-old man
 A flood
 Mold
 Biological warfare
 Dirty bombs

3.4 INSURANCE vs GAMBLING
COMPARED
GAMBLING
 Creates a new speculative
risk
 Socially unproductive
 The goal of gambling, is to
come out ahead
INSURANCE
 Handling an already existing
pure risk
 Always socially productive
 The goal of insurance is to
put you in the same financial
position you were in before
the loss

3.4 INSURANCE vs SPECULATION
COMPARED
SPECULATION
 Involves speculative risks
 Create a risk deliberately
in the anticipation of
profits.
 Involves only risk transfer
 Socially unproductive
INSURANCE
 Involves pure risks
 Accidental risk
 Involves risk reduction
 Always socially productive

BENEFITS OF INSURANCE
Indemnification
Less Worry and
Fear
Promotes loss
control system
Stimulates
international
trade and
commerce
Source of
Investment
Funds
Encourages
saving
Loss Prevention
Enhancement
of Credit
Economic
growth

BENEFITS
OF
INSURANCE

COSTS OF INSURANCE
TO SOCIETY
Cost of Doing
Business
Fraudulent
(inflated) Claims
Increase Morale
hazard:

Functions of Insurers
PRODUCTION
(SELLING)
UNDERWRITING
(SELECTION OF
RISKS)
RATE MAKING MANAGING
CLAIMS
INVESTMENT

Functions of
Insurers
PRODUCTION (SELLING)
UNDERWRITING
(SELECTION OF RISKS)
RATE MAKING
MANAGING CLAIMS
INVESTMENT

PRODUCTION
(SELLING)
 The term production refers to the sales and
marketing activities of insurers
 Securing enough applicants for insurance to
enable the company to operate
 Agents and brokers who sell insurance are
frequently referred to as producers

UNDERWRITING
 Refers to the process of selecting, classifying, and
pricing applicants for insurance
 The underwriter is the person who decides to accept
or reject an application
 An insurer must establish an underwriting policy
that specifies acceptable, borderline, and prohibited
business; amounts of insurance to be written

UNDERWRITING
 The underwriter must obtain as much information
about the subject of the insurance
 The four sources from which the underwriter obtains
information are:
o The Application
o Agent or Broker
o Investigations
o Physical Examinations or Inspections

UNDERWRITING

RATE MAKING
 The process of predicting future losses and
future expenses, and allocating these costs
among the various classes of insureds
 It is the determination of what rates, or
premiums, to charge for insurance

RATE MAKING
 The premium is designed to cover two major
costs:
(I) The expected loss and
(II) The cost of doing business
 These are known as the pure premium and the
loading, respectively

RATE MAKING
PURE PREMIUM
 The pure premium is determined by dividing the
total expected loss by the number of exposures.
 Pure premium consists of that part of the
premium necessary to pay for losses and loss
related expenses

RATE MAKING
LOADING
 Loading is the part of the premium necessary to
cover other expenses, particularly sales expenses,
and to allow for a profit

Functions of
Insurers
RATE MAKING

MANAGING
CLAIMS
Provide indemnity to the members of the group who
suffer losses.
This is accomplished on the loss settlement process,
but it is sometimes more complicated than just passing
out money

Functions of
Insurers
MANAGING
CLAIMS

INVESTMENT
 Advance payment of premiums gives rise
to funds that must be invested in some
manner
 Not all the money collected by the insurer
is to be invested

INVESTMENT

END OF CHAP- 3

Risk managment and Insurance chap1-3 Addis Ababa University School of Commerce

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Risk managment and Insurance chap1-3 Addis Ababa University School of Commerce