Download VTU (Visvesvaraya Technological University) MBA 4th Semester (Fourth Semester) 16MBAFM402-Risk Management and Insurance RMI Module 3 Important Lecture Notes (MBA Study Material Notes)
measurement
MODULE 3
FirstRanker.com - FirstRanker's Choice
Risk
measurement
MODULE 3
Frequency and severity of
losses.
? Frequency of loss refers to number of times in a given period the
loss is likely to happen.
? Historical data will provide this info. (Eg: frequency of injury = no
of injuries in the past/no of worker-years) in the absence of
historical data, industry data can be used. Informed judgement
can be used as well.
? Severity of loss measures the magnitude of loss per occurrence.
One way to estimate is from historical data. (average
severity/occurrence)
? Expected loss = frequency of loss*severity of loss. Expected loss
affects business value and insurance pricing.
FirstRanker.com - FirstRanker's Choice
Risk
measurement
MODULE 3
Frequency and severity of
losses.
? Frequency of loss refers to number of times in a given period the
loss is likely to happen.
? Historical data will provide this info. (Eg: frequency of injury = no
of injuries in the past/no of worker-years) in the absence of
historical data, industry data can be used. Informed judgement
can be used as well.
? Severity of loss measures the magnitude of loss per occurrence.
One way to estimate is from historical data. (average
severity/occurrence)
? Expected loss = frequency of loss*severity of loss. Expected loss
affects business value and insurance pricing.
3.6
FirstRanker.com - FirstRanker's Choice
Risk
measurement
MODULE 3
Frequency and severity of
losses.
? Frequency of loss refers to number of times in a given period the
loss is likely to happen.
? Historical data will provide this info. (Eg: frequency of injury = no
of injuries in the past/no of worker-years) in the absence of
historical data, industry data can be used. Informed judgement
can be used as well.
? Severity of loss measures the magnitude of loss per occurrence.
One way to estimate is from historical data. (average
severity/occurrence)
? Expected loss = frequency of loss*severity of loss. Expected loss
affects business value and insurance pricing.
3.6
Note:
?Std deviation for high frequency
low severity is low while std
deviation for low frequency high
severity is high
?Infrequent but potentially large
losses are less predictable and
pose greater risk than more
frequent smaller losses.
FirstRanker.com - FirstRanker's Choice
Risk
measurement
MODULE 3
Frequency and severity of
losses.
? Frequency of loss refers to number of times in a given period the
loss is likely to happen.
? Historical data will provide this info. (Eg: frequency of injury = no
of injuries in the past/no of worker-years) in the absence of
historical data, industry data can be used. Informed judgement
can be used as well.
? Severity of loss measures the magnitude of loss per occurrence.
One way to estimate is from historical data. (average
severity/occurrence)
? Expected loss = frequency of loss*severity of loss. Expected loss
affects business value and insurance pricing.
3.6
Note:
?Std deviation for high frequency
low severity is low while std
deviation for low frequency high
severity is high
?Infrequent but potentially large
losses are less predictable and
pose greater risk than more
frequent smaller losses.
Risk control
? Risk control is the process of implementing
measures to reduce risk associated with a hazard.
? Benefits of risk/loss control:
Elimination of expenses associated with
- Repair or replacement of damaged property
- Income losses due to distruction of property
- Extra costs associated with maintaining operations
- Adverse liability judgements
- Medical costs to treat injuries
- Income losses due to death/disabilities
FirstRanker.com - FirstRanker's Choice
Risk
measurement
MODULE 3
Frequency and severity of
losses.
? Frequency of loss refers to number of times in a given period the
loss is likely to happen.
? Historical data will provide this info. (Eg: frequency of injury = no
of injuries in the past/no of worker-years) in the absence of
historical data, industry data can be used. Informed judgement
can be used as well.
? Severity of loss measures the magnitude of loss per occurrence.
One way to estimate is from historical data. (average
severity/occurrence)
? Expected loss = frequency of loss*severity of loss. Expected loss
affects business value and insurance pricing.
3.6
Note:
?Std deviation for high frequency
low severity is low while std
deviation for low frequency high
severity is high
?Infrequent but potentially large
losses are less predictable and
pose greater risk than more
frequent smaller losses.
Risk control
? Risk control is the process of implementing
measures to reduce risk associated with a hazard.
? Benefits of risk/loss control:
Elimination of expenses associated with
- Repair or replacement of damaged property
- Income losses due to distruction of property
- Extra costs associated with maintaining operations
- Adverse liability judgements
- Medical costs to treat injuries
- Income losses due to death/disabilities
Cost of risk control
? Installation and maintainance expenses eg
sprinkler system
? There are associated costs involved like employee
benefits apart from salary
? Some measures push up utility bills eg power bill
FirstRanker.com - FirstRanker's Choice
Risk
measurement
MODULE 3
Frequency and severity of
losses.
? Frequency of loss refers to number of times in a given period the
loss is likely to happen.
? Historical data will provide this info. (Eg: frequency of injury = no
of injuries in the past/no of worker-years) in the absence of
historical data, industry data can be used. Informed judgement
can be used as well.
? Severity of loss measures the magnitude of loss per occurrence.
One way to estimate is from historical data. (average
severity/occurrence)
? Expected loss = frequency of loss*severity of loss. Expected loss
affects business value and insurance pricing.
3.6
Note:
?Std deviation for high frequency
low severity is low while std
deviation for low frequency high
severity is high
?Infrequent but potentially large
losses are less predictable and
pose greater risk than more
frequent smaller losses.
Risk control
? Risk control is the process of implementing
measures to reduce risk associated with a hazard.
? Benefits of risk/loss control:
Elimination of expenses associated with
- Repair or replacement of damaged property
- Income losses due to distruction of property
- Extra costs associated with maintaining operations
- Adverse liability judgements
- Medical costs to treat injuries
- Income losses due to death/disabilities
Cost of risk control
? Installation and maintainance expenses eg
sprinkler system
? There are associated costs involved like employee
benefits apart from salary
? Some measures push up utility bills eg power bill
Risk control techniques
1
?Risk avoidance
2
?Risk prevention
3
?Risk reduction
FirstRanker.com - FirstRanker's Choice
Risk
measurement
MODULE 3
Frequency and severity of
losses.
? Frequency of loss refers to number of times in a given period the
loss is likely to happen.
? Historical data will provide this info. (Eg: frequency of injury = no
of injuries in the past/no of worker-years) in the absence of
historical data, industry data can be used. Informed judgement
can be used as well.
? Severity of loss measures the magnitude of loss per occurrence.
One way to estimate is from historical data. (average
severity/occurrence)
? Expected loss = frequency of loss*severity of loss. Expected loss
affects business value and insurance pricing.
3.6
Note:
?Std deviation for high frequency
low severity is low while std
deviation for low frequency high
severity is high
?Infrequent but potentially large
losses are less predictable and
pose greater risk than more
frequent smaller losses.
Risk control
? Risk control is the process of implementing
measures to reduce risk associated with a hazard.
? Benefits of risk/loss control:
Elimination of expenses associated with
- Repair or replacement of damaged property
- Income losses due to distruction of property
- Extra costs associated with maintaining operations
- Adverse liability judgements
- Medical costs to treat injuries
- Income losses due to death/disabilities
Cost of risk control
? Installation and maintainance expenses eg
sprinkler system
? There are associated costs involved like employee
benefits apart from salary
? Some measures push up utility bills eg power bill
Risk control techniques
1
?Risk avoidance
2
?Risk prevention
3
?Risk reduction
Risk avoidance
? Risk avoidance involves not performing an activity that could carry
risk. Eg: not buying a property, not flying, not travelling. This leas to
loss of opportunities arising out of performing such activities. Not
doing a business will avoid risk but one loses on opportunity to earn
profits.
? Advantages:
? Chances of risk is reduced to zero in case where loss exposure has
not started. In situations where exposure has already started it is
reduce to zero for future activities. Residual risks may still persist
? Disadvantages:
? A firm cannot avoid all losses like premature death of an executive
? It is not feasible/practical to avoid all losses without shutting the
business eg car factory cannot avoid all risks if it has to continue
producing cars
FirstRanker.com - FirstRanker's Choice
Risk
measurement
MODULE 3
Frequency and severity of
losses.
? Frequency of loss refers to number of times in a given period the
loss is likely to happen.
? Historical data will provide this info. (Eg: frequency of injury = no
of injuries in the past/no of worker-years) in the absence of
historical data, industry data can be used. Informed judgement
can be used as well.
? Severity of loss measures the magnitude of loss per occurrence.
One way to estimate is from historical data. (average
severity/occurrence)
? Expected loss = frequency of loss*severity of loss. Expected loss
affects business value and insurance pricing.
3.6
Note:
?Std deviation for high frequency
low severity is low while std
deviation for low frequency high
severity is high
?Infrequent but potentially large
losses are less predictable and
pose greater risk than more
frequent smaller losses.
Risk control
? Risk control is the process of implementing
measures to reduce risk associated with a hazard.
? Benefits of risk/loss control:
Elimination of expenses associated with
- Repair or replacement of damaged property
- Income losses due to distruction of property
- Extra costs associated with maintaining operations
- Adverse liability judgements
- Medical costs to treat injuries
- Income losses due to death/disabilities
Cost of risk control
? Installation and maintainance expenses eg
sprinkler system
? There are associated costs involved like employee
benefits apart from salary
? Some measures push up utility bills eg power bill
Risk control techniques
1
?Risk avoidance
2
?Risk prevention
3
?Risk reduction
Risk avoidance
? Risk avoidance involves not performing an activity that could carry
risk. Eg: not buying a property, not flying, not travelling. This leas to
loss of opportunities arising out of performing such activities. Not
doing a business will avoid risk but one loses on opportunity to earn
profits.
? Advantages:
? Chances of risk is reduced to zero in case where loss exposure has
not started. In situations where exposure has already started it is
reduce to zero for future activities. Residual risks may still persist
? Disadvantages:
? A firm cannot avoid all losses like premature death of an executive
? It is not feasible/practical to avoid all losses without shutting the
business eg car factory cannot avoid all risks if it has to continue
producing cars
Risk control techniques-
Risk prevention
? It refers to measures that reduce the frequency
of a particular loss. This focusses on stopping
losses from happening. Important to prevent
death/injury to people.
? Businesses employ loss control engineers to
identify sources of risks and institute corrective
actions. Like poor lighting, poor maintenance,
improper security, etc. training is given on safety
aspects
? Eg: changing slippery floor, building safety
enclosures to dangerous machinery etc
FirstRanker.com - FirstRanker's Choice
Risk
measurement
MODULE 3
Frequency and severity of
losses.
? Frequency of loss refers to number of times in a given period the
loss is likely to happen.
? Historical data will provide this info. (Eg: frequency of injury = no
of injuries in the past/no of worker-years) in the absence of
historical data, industry data can be used. Informed judgement
can be used as well.
? Severity of loss measures the magnitude of loss per occurrence.
One way to estimate is from historical data. (average
severity/occurrence)
? Expected loss = frequency of loss*severity of loss. Expected loss
affects business value and insurance pricing.
3.6
Note:
?Std deviation for high frequency
low severity is low while std
deviation for low frequency high
severity is high
?Infrequent but potentially large
losses are less predictable and
pose greater risk than more
frequent smaller losses.
Risk control
? Risk control is the process of implementing
measures to reduce risk associated with a hazard.
? Benefits of risk/loss control:
Elimination of expenses associated with
- Repair or replacement of damaged property
- Income losses due to distruction of property
- Extra costs associated with maintaining operations
- Adverse liability judgements
- Medical costs to treat injuries
- Income losses due to death/disabilities
Cost of risk control
? Installation and maintainance expenses eg
sprinkler system
? There are associated costs involved like employee
benefits apart from salary
? Some measures push up utility bills eg power bill
Risk control techniques
1
?Risk avoidance
2
?Risk prevention
3
?Risk reduction
Risk avoidance
? Risk avoidance involves not performing an activity that could carry
risk. Eg: not buying a property, not flying, not travelling. This leas to
loss of opportunities arising out of performing such activities. Not
doing a business will avoid risk but one loses on opportunity to earn
profits.
? Advantages:
? Chances of risk is reduced to zero in case where loss exposure has
not started. In situations where exposure has already started it is
reduce to zero for future activities. Residual risks may still persist
? Disadvantages:
? A firm cannot avoid all losses like premature death of an executive
? It is not feasible/practical to avoid all losses without shutting the
business eg car factory cannot avoid all risks if it has to continue
producing cars
Risk control techniques-
Risk prevention
? It refers to measures that reduce the frequency
of a particular loss. This focusses on stopping
losses from happening. Important to prevent
death/injury to people.
? Businesses employ loss control engineers to
identify sources of risks and institute corrective
actions. Like poor lighting, poor maintenance,
improper security, etc. training is given on safety
aspects
? Eg: changing slippery floor, building safety
enclosures to dangerous machinery etc
Risk control techniques-
Risk reduction
FirstRanker.com - FirstRanker's Choice
Risk
measurement
MODULE 3
Frequency and severity of
losses.
? Frequency of loss refers to number of times in a given period the
loss is likely to happen.
? Historical data will provide this info. (Eg: frequency of injury = no
of injuries in the past/no of worker-years) in the absence of
historical data, industry data can be used. Informed judgement
can be used as well.
? Severity of loss measures the magnitude of loss per occurrence.
One way to estimate is from historical data. (average
severity/occurrence)
? Expected loss = frequency of loss*severity of loss. Expected loss
affects business value and insurance pricing.
3.6
Note:
?Std deviation for high frequency
low severity is low while std
deviation for low frequency high
severity is high
?Infrequent but potentially large
losses are less predictable and
pose greater risk than more
frequent smaller losses.
Risk control
? Risk control is the process of implementing
measures to reduce risk associated with a hazard.
? Benefits of risk/loss control:
Elimination of expenses associated with
- Repair or replacement of damaged property
- Income losses due to distruction of property
- Extra costs associated with maintaining operations
- Adverse liability judgements
- Medical costs to treat injuries
- Income losses due to death/disabilities
Cost of risk control
? Installation and maintainance expenses eg
sprinkler system
? There are associated costs involved like employee
benefits apart from salary
? Some measures push up utility bills eg power bill
Risk control techniques
1
?Risk avoidance
2
?Risk prevention
3
?Risk reduction
Risk avoidance
? Risk avoidance involves not performing an activity that could carry
risk. Eg: not buying a property, not flying, not travelling. This leas to
loss of opportunities arising out of performing such activities. Not
doing a business will avoid risk but one loses on opportunity to earn
profits.
? Advantages:
? Chances of risk is reduced to zero in case where loss exposure has
not started. In situations where exposure has already started it is
reduce to zero for future activities. Residual risks may still persist
? Disadvantages:
? A firm cannot avoid all losses like premature death of an executive
? It is not feasible/practical to avoid all losses without shutting the
business eg car factory cannot avoid all risks if it has to continue
producing cars
Risk control techniques-
Risk prevention
? It refers to measures that reduce the frequency
of a particular loss. This focusses on stopping
losses from happening. Important to prevent
death/injury to people.
? Businesses employ loss control engineers to
identify sources of risks and institute corrective
actions. Like poor lighting, poor maintenance,
improper security, etc. training is given on safety
aspects
? Eg: changing slippery floor, building safety
enclosures to dangerous machinery etc
Risk control techniques-
Risk reduction
Risk financing techniques-
risk retention.
FirstRanker.com - FirstRanker's Choice
Risk
measurement
MODULE 3
Frequency and severity of
losses.
? Frequency of loss refers to number of times in a given period the
loss is likely to happen.
? Historical data will provide this info. (Eg: frequency of injury = no
of injuries in the past/no of worker-years) in the absence of
historical data, industry data can be used. Informed judgement
can be used as well.
? Severity of loss measures the magnitude of loss per occurrence.
One way to estimate is from historical data. (average
severity/occurrence)
? Expected loss = frequency of loss*severity of loss. Expected loss
affects business value and insurance pricing.
3.6
Note:
?Std deviation for high frequency
low severity is low while std
deviation for low frequency high
severity is high
?Infrequent but potentially large
losses are less predictable and
pose greater risk than more
frequent smaller losses.
Risk control
? Risk control is the process of implementing
measures to reduce risk associated with a hazard.
? Benefits of risk/loss control:
Elimination of expenses associated with
- Repair or replacement of damaged property
- Income losses due to distruction of property
- Extra costs associated with maintaining operations
- Adverse liability judgements
- Medical costs to treat injuries
- Income losses due to death/disabilities
Cost of risk control
? Installation and maintainance expenses eg
sprinkler system
? There are associated costs involved like employee
benefits apart from salary
? Some measures push up utility bills eg power bill
Risk control techniques
1
?Risk avoidance
2
?Risk prevention
3
?Risk reduction
Risk avoidance
? Risk avoidance involves not performing an activity that could carry
risk. Eg: not buying a property, not flying, not travelling. This leas to
loss of opportunities arising out of performing such activities. Not
doing a business will avoid risk but one loses on opportunity to earn
profits.
? Advantages:
? Chances of risk is reduced to zero in case where loss exposure has
not started. In situations where exposure has already started it is
reduce to zero for future activities. Residual risks may still persist
? Disadvantages:
? A firm cannot avoid all losses like premature death of an executive
? It is not feasible/practical to avoid all losses without shutting the
business eg car factory cannot avoid all risks if it has to continue
producing cars
Risk control techniques-
Risk prevention
? It refers to measures that reduce the frequency
of a particular loss. This focusses on stopping
losses from happening. Important to prevent
death/injury to people.
? Businesses employ loss control engineers to
identify sources of risks and institute corrective
actions. Like poor lighting, poor maintenance,
improper security, etc. training is given on safety
aspects
? Eg: changing slippery floor, building safety
enclosures to dangerous machinery etc
Risk control techniques-
Risk reduction
Risk financing techniques-
risk retention.
Risk financing techniques-
risk transfers.
FirstRanker.com - FirstRanker's Choice
Risk
measurement
MODULE 3
Frequency and severity of
losses.
? Frequency of loss refers to number of times in a given period the
loss is likely to happen.
? Historical data will provide this info. (Eg: frequency of injury = no
of injuries in the past/no of worker-years) in the absence of
historical data, industry data can be used. Informed judgement
can be used as well.
? Severity of loss measures the magnitude of loss per occurrence.
One way to estimate is from historical data. (average
severity/occurrence)
? Expected loss = frequency of loss*severity of loss. Expected loss
affects business value and insurance pricing.
3.6
Note:
?Std deviation for high frequency
low severity is low while std
deviation for low frequency high
severity is high
?Infrequent but potentially large
losses are less predictable and
pose greater risk than more
frequent smaller losses.
Risk control
? Risk control is the process of implementing
measures to reduce risk associated with a hazard.
? Benefits of risk/loss control:
Elimination of expenses associated with
- Repair or replacement of damaged property
- Income losses due to distruction of property
- Extra costs associated with maintaining operations
- Adverse liability judgements
- Medical costs to treat injuries
- Income losses due to death/disabilities
Cost of risk control
? Installation and maintainance expenses eg
sprinkler system
? There are associated costs involved like employee
benefits apart from salary
? Some measures push up utility bills eg power bill
Risk control techniques
1
?Risk avoidance
2
?Risk prevention
3
?Risk reduction
Risk avoidance
? Risk avoidance involves not performing an activity that could carry
risk. Eg: not buying a property, not flying, not travelling. This leas to
loss of opportunities arising out of performing such activities. Not
doing a business will avoid risk but one loses on opportunity to earn
profits.
? Advantages:
? Chances of risk is reduced to zero in case where loss exposure has
not started. In situations where exposure has already started it is
reduce to zero for future activities. Residual risks may still persist
? Disadvantages:
? A firm cannot avoid all losses like premature death of an executive
? It is not feasible/practical to avoid all losses without shutting the
business eg car factory cannot avoid all risks if it has to continue
producing cars
Risk control techniques-
Risk prevention
? It refers to measures that reduce the frequency
of a particular loss. This focusses on stopping
losses from happening. Important to prevent
death/injury to people.
? Businesses employ loss control engineers to
identify sources of risks and institute corrective
actions. Like poor lighting, poor maintenance,
improper security, etc. training is given on safety
aspects
? Eg: changing slippery floor, building safety
enclosures to dangerous machinery etc
Risk control techniques-
Risk reduction
Risk financing techniques-
risk retention.
Risk financing techniques-
risk transfers.
Risk management decision
methods
? Risk avoidance
? Loss control
? Risk retension
? Non-insurance transfers
? insurance
FirstRanker.com - FirstRanker's Choice
Risk
measurement
MODULE 3
Frequency and severity of
losses.
? Frequency of loss refers to number of times in a given period the
loss is likely to happen.
? Historical data will provide this info. (Eg: frequency of injury = no
of injuries in the past/no of worker-years) in the absence of
historical data, industry data can be used. Informed judgement
can be used as well.
? Severity of loss measures the magnitude of loss per occurrence.
One way to estimate is from historical data. (average
severity/occurrence)
? Expected loss = frequency of loss*severity of loss. Expected loss
affects business value and insurance pricing.
3.6
Note:
?Std deviation for high frequency
low severity is low while std
deviation for low frequency high
severity is high
?Infrequent but potentially large
losses are less predictable and
pose greater risk than more
frequent smaller losses.
Risk control
? Risk control is the process of implementing
measures to reduce risk associated with a hazard.
? Benefits of risk/loss control:
Elimination of expenses associated with
- Repair or replacement of damaged property
- Income losses due to distruction of property
- Extra costs associated with maintaining operations
- Adverse liability judgements
- Medical costs to treat injuries
- Income losses due to death/disabilities
Cost of risk control
? Installation and maintainance expenses eg
sprinkler system
? There are associated costs involved like employee
benefits apart from salary
? Some measures push up utility bills eg power bill
Risk control techniques
1
?Risk avoidance
2
?Risk prevention
3
?Risk reduction
Risk avoidance
? Risk avoidance involves not performing an activity that could carry
risk. Eg: not buying a property, not flying, not travelling. This leas to
loss of opportunities arising out of performing such activities. Not
doing a business will avoid risk but one loses on opportunity to earn
profits.
? Advantages:
? Chances of risk is reduced to zero in case where loss exposure has
not started. In situations where exposure has already started it is
reduce to zero for future activities. Residual risks may still persist
? Disadvantages:
? A firm cannot avoid all losses like premature death of an executive
? It is not feasible/practical to avoid all losses without shutting the
business eg car factory cannot avoid all risks if it has to continue
producing cars
Risk control techniques-
Risk prevention
? It refers to measures that reduce the frequency
of a particular loss. This focusses on stopping
losses from happening. Important to prevent
death/injury to people.
? Businesses employ loss control engineers to
identify sources of risks and institute corrective
actions. Like poor lighting, poor maintenance,
improper security, etc. training is given on safety
aspects
? Eg: changing slippery floor, building safety
enclosures to dangerous machinery etc
Risk control techniques-
Risk reduction
Risk financing techniques-
risk retention.
Risk financing techniques-
risk transfers.
Risk management decision
methods
? Risk avoidance
? Loss control
? Risk retension
? Non-insurance transfers
? insurance
Pooling arrangements and
diversification of risk
? Most popular risk management tool is diversification. Essential
part of insurance/financial markets
? Simple methods like pooling between two to diversification
amongst many
? Pooling arrangement reduces risk when losses are independent
(uncorrelated)
? Pooling refers to spreading losses incurred by a few over the
entire group so that everyone bears average loss instead of
actual loss.
FirstRanker.com - FirstRanker's Choice
Risk
measurement
MODULE 3
Frequency and severity of
losses.
? Frequency of loss refers to number of times in a given period the
loss is likely to happen.
? Historical data will provide this info. (Eg: frequency of injury = no
of injuries in the past/no of worker-years) in the absence of
historical data, industry data can be used. Informed judgement
can be used as well.
? Severity of loss measures the magnitude of loss per occurrence.
One way to estimate is from historical data. (average
severity/occurrence)
? Expected loss = frequency of loss*severity of loss. Expected loss
affects business value and insurance pricing.
3.6
Note:
?Std deviation for high frequency
low severity is low while std
deviation for low frequency high
severity is high
?Infrequent but potentially large
losses are less predictable and
pose greater risk than more
frequent smaller losses.
Risk control
? Risk control is the process of implementing
measures to reduce risk associated with a hazard.
? Benefits of risk/loss control:
Elimination of expenses associated with
- Repair or replacement of damaged property
- Income losses due to distruction of property
- Extra costs associated with maintaining operations
- Adverse liability judgements
- Medical costs to treat injuries
- Income losses due to death/disabilities
Cost of risk control
? Installation and maintainance expenses eg
sprinkler system
? There are associated costs involved like employee
benefits apart from salary
? Some measures push up utility bills eg power bill
Risk control techniques
1
?Risk avoidance
2
?Risk prevention
3
?Risk reduction
Risk avoidance
? Risk avoidance involves not performing an activity that could carry
risk. Eg: not buying a property, not flying, not travelling. This leas to
loss of opportunities arising out of performing such activities. Not
doing a business will avoid risk but one loses on opportunity to earn
profits.
? Advantages:
? Chances of risk is reduced to zero in case where loss exposure has
not started. In situations where exposure has already started it is
reduce to zero for future activities. Residual risks may still persist
? Disadvantages:
? A firm cannot avoid all losses like premature death of an executive
? It is not feasible/practical to avoid all losses without shutting the
business eg car factory cannot avoid all risks if it has to continue
producing cars
Risk control techniques-
Risk prevention
? It refers to measures that reduce the frequency
of a particular loss. This focusses on stopping
losses from happening. Important to prevent
death/injury to people.
? Businesses employ loss control engineers to
identify sources of risks and institute corrective
actions. Like poor lighting, poor maintenance,
improper security, etc. training is given on safety
aspects
? Eg: changing slippery floor, building safety
enclosures to dangerous machinery etc
Risk control techniques-
Risk reduction
Risk financing techniques-
risk retention.
Risk financing techniques-
risk transfers.
Risk management decision
methods
? Risk avoidance
? Loss control
? Risk retension
? Non-insurance transfers
? insurance
Pooling arrangements and
diversification of risk
? Most popular risk management tool is diversification. Essential
part of insurance/financial markets
? Simple methods like pooling between two to diversification
amongst many
? Pooling arrangement reduces risk when losses are independent
(uncorrelated)
? Pooling refers to spreading losses incurred by a few over the
entire group so that everyone bears average loss instead of
actual loss.
2-person pooling arrangement
?Shahrukh and Salman have a possibility
of an accident in the coming year, say.
?20% chance of an accident with a loss of
2500
?Probability distribution of accident losses
is highly skewed. (0 ? 0.8; 2500 ? 0.2)
?Their losses are uncorrelated.
?What is the expected loss and standard
deviation for each one of them?
FirstRanker.com - FirstRanker's Choice
Risk
measurement
MODULE 3
Frequency and severity of
losses.
? Frequency of loss refers to number of times in a given period the
loss is likely to happen.
? Historical data will provide this info. (Eg: frequency of injury = no
of injuries in the past/no of worker-years) in the absence of
historical data, industry data can be used. Informed judgement
can be used as well.
? Severity of loss measures the magnitude of loss per occurrence.
One way to estimate is from historical data. (average
severity/occurrence)
? Expected loss = frequency of loss*severity of loss. Expected loss
affects business value and insurance pricing.
3.6
Note:
?Std deviation for high frequency
low severity is low while std
deviation for low frequency high
severity is high
?Infrequent but potentially large
losses are less predictable and
pose greater risk than more
frequent smaller losses.
Risk control
? Risk control is the process of implementing
measures to reduce risk associated with a hazard.
? Benefits of risk/loss control:
Elimination of expenses associated with
- Repair or replacement of damaged property
- Income losses due to distruction of property
- Extra costs associated with maintaining operations
- Adverse liability judgements
- Medical costs to treat injuries
- Income losses due to death/disabilities
Cost of risk control
? Installation and maintainance expenses eg
sprinkler system
? There are associated costs involved like employee
benefits apart from salary
? Some measures push up utility bills eg power bill
Risk control techniques
1
?Risk avoidance
2
?Risk prevention
3
?Risk reduction
Risk avoidance
? Risk avoidance involves not performing an activity that could carry
risk. Eg: not buying a property, not flying, not travelling. This leas to
loss of opportunities arising out of performing such activities. Not
doing a business will avoid risk but one loses on opportunity to earn
profits.
? Advantages:
? Chances of risk is reduced to zero in case where loss exposure has
not started. In situations where exposure has already started it is
reduce to zero for future activities. Residual risks may still persist
? Disadvantages:
? A firm cannot avoid all losses like premature death of an executive
? It is not feasible/practical to avoid all losses without shutting the
business eg car factory cannot avoid all risks if it has to continue
producing cars
Risk control techniques-
Risk prevention
? It refers to measures that reduce the frequency
of a particular loss. This focusses on stopping
losses from happening. Important to prevent
death/injury to people.
? Businesses employ loss control engineers to
identify sources of risks and institute corrective
actions. Like poor lighting, poor maintenance,
improper security, etc. training is given on safety
aspects
? Eg: changing slippery floor, building safety
enclosures to dangerous machinery etc
Risk control techniques-
Risk reduction
Risk financing techniques-
risk retention.
Risk financing techniques-
risk transfers.
Risk management decision
methods
? Risk avoidance
? Loss control
? Risk retension
? Non-insurance transfers
? insurance
Pooling arrangements and
diversification of risk
? Most popular risk management tool is diversification. Essential
part of insurance/financial markets
? Simple methods like pooling between two to diversification
amongst many
? Pooling arrangement reduces risk when losses are independent
(uncorrelated)
? Pooling refers to spreading losses incurred by a few over the
entire group so that everyone bears average loss instead of
actual loss.
2-person pooling arrangement
?Shahrukh and Salman have a possibility
of an accident in the coming year, say.
?20% chance of an accident with a loss of
2500
?Probability distribution of accident losses
is highly skewed. (0 ? 0.8; 2500 ? 0.2)
?Their losses are uncorrelated.
?What is the expected loss and standard
deviation for each one of them?
?Expected loss = 0.8*0 + 0.2*2500
= 500
?Standard deviation
= Root 0.8(0-500)
2
+ 0.2(2500-
500)
2
= 1000
FirstRanker.com - FirstRanker's Choice
Risk
measurement
MODULE 3
Frequency and severity of
losses.
? Frequency of loss refers to number of times in a given period the
loss is likely to happen.
? Historical data will provide this info. (Eg: frequency of injury = no
of injuries in the past/no of worker-years) in the absence of
historical data, industry data can be used. Informed judgement
can be used as well.
? Severity of loss measures the magnitude of loss per occurrence.
One way to estimate is from historical data. (average
severity/occurrence)
? Expected loss = frequency of loss*severity of loss. Expected loss
affects business value and insurance pricing.
3.6
Note:
?Std deviation for high frequency
low severity is low while std
deviation for low frequency high
severity is high
?Infrequent but potentially large
losses are less predictable and
pose greater risk than more
frequent smaller losses.
Risk control
? Risk control is the process of implementing
measures to reduce risk associated with a hazard.
? Benefits of risk/loss control:
Elimination of expenses associated with
- Repair or replacement of damaged property
- Income losses due to distruction of property
- Extra costs associated with maintaining operations
- Adverse liability judgements
- Medical costs to treat injuries
- Income losses due to death/disabilities
Cost of risk control
? Installation and maintainance expenses eg
sprinkler system
? There are associated costs involved like employee
benefits apart from salary
? Some measures push up utility bills eg power bill
Risk control techniques
1
?Risk avoidance
2
?Risk prevention
3
?Risk reduction
Risk avoidance
? Risk avoidance involves not performing an activity that could carry
risk. Eg: not buying a property, not flying, not travelling. This leas to
loss of opportunities arising out of performing such activities. Not
doing a business will avoid risk but one loses on opportunity to earn
profits.
? Advantages:
? Chances of risk is reduced to zero in case where loss exposure has
not started. In situations where exposure has already started it is
reduce to zero for future activities. Residual risks may still persist
? Disadvantages:
? A firm cannot avoid all losses like premature death of an executive
? It is not feasible/practical to avoid all losses without shutting the
business eg car factory cannot avoid all risks if it has to continue
producing cars
Risk control techniques-
Risk prevention
? It refers to measures that reduce the frequency
of a particular loss. This focusses on stopping
losses from happening. Important to prevent
death/injury to people.
? Businesses employ loss control engineers to
identify sources of risks and institute corrective
actions. Like poor lighting, poor maintenance,
improper security, etc. training is given on safety
aspects
? Eg: changing slippery floor, building safety
enclosures to dangerous machinery etc
Risk control techniques-
Risk reduction
Risk financing techniques-
risk retention.
Risk financing techniques-
risk transfers.
Risk management decision
methods
? Risk avoidance
? Loss control
? Risk retension
? Non-insurance transfers
? insurance
Pooling arrangements and
diversification of risk
? Most popular risk management tool is diversification. Essential
part of insurance/financial markets
? Simple methods like pooling between two to diversification
amongst many
? Pooling arrangement reduces risk when losses are independent
(uncorrelated)
? Pooling refers to spreading losses incurred by a few over the
entire group so that everyone bears average loss instead of
actual loss.
2-person pooling arrangement
?Shahrukh and Salman have a possibility
of an accident in the coming year, say.
?20% chance of an accident with a loss of
2500
?Probability distribution of accident losses
is highly skewed. (0 ? 0.8; 2500 ? 0.2)
?Their losses are uncorrelated.
?What is the expected loss and standard
deviation for each one of them?
?Expected loss = 0.8*0 + 0.2*2500
= 500
?Standard deviation
= Root 0.8(0-500)
2
+ 0.2(2500-
500)
2
= 1000
Pooling arrangement?
?Pooling allows them to pool
their risk and split losses equally.
?What is the expected loss and
standard deviation for each
one of them?
FirstRanker.com - FirstRanker's Choice
Risk
measurement
MODULE 3
Frequency and severity of
losses.
? Frequency of loss refers to number of times in a given period the
loss is likely to happen.
? Historical data will provide this info. (Eg: frequency of injury = no
of injuries in the past/no of worker-years) in the absence of
historical data, industry data can be used. Informed judgement
can be used as well.
? Severity of loss measures the magnitude of loss per occurrence.
One way to estimate is from historical data. (average
severity/occurrence)
? Expected loss = frequency of loss*severity of loss. Expected loss
affects business value and insurance pricing.
3.6
Note:
?Std deviation for high frequency
low severity is low while std
deviation for low frequency high
severity is high
?Infrequent but potentially large
losses are less predictable and
pose greater risk than more
frequent smaller losses.
Risk control
? Risk control is the process of implementing
measures to reduce risk associated with a hazard.
? Benefits of risk/loss control:
Elimination of expenses associated with
- Repair or replacement of damaged property
- Income losses due to distruction of property
- Extra costs associated with maintaining operations
- Adverse liability judgements
- Medical costs to treat injuries
- Income losses due to death/disabilities
Cost of risk control
? Installation and maintainance expenses eg
sprinkler system
? There are associated costs involved like employee
benefits apart from salary
? Some measures push up utility bills eg power bill
Risk control techniques
1
?Risk avoidance
2
?Risk prevention
3
?Risk reduction
Risk avoidance
? Risk avoidance involves not performing an activity that could carry
risk. Eg: not buying a property, not flying, not travelling. This leas to
loss of opportunities arising out of performing such activities. Not
doing a business will avoid risk but one loses on opportunity to earn
profits.
? Advantages:
? Chances of risk is reduced to zero in case where loss exposure has
not started. In situations where exposure has already started it is
reduce to zero for future activities. Residual risks may still persist
? Disadvantages:
? A firm cannot avoid all losses like premature death of an executive
? It is not feasible/practical to avoid all losses without shutting the
business eg car factory cannot avoid all risks if it has to continue
producing cars
Risk control techniques-
Risk prevention
? It refers to measures that reduce the frequency
of a particular loss. This focusses on stopping
losses from happening. Important to prevent
death/injury to people.
? Businesses employ loss control engineers to
identify sources of risks and institute corrective
actions. Like poor lighting, poor maintenance,
improper security, etc. training is given on safety
aspects
? Eg: changing slippery floor, building safety
enclosures to dangerous machinery etc
Risk control techniques-
Risk reduction
Risk financing techniques-
risk retention.
Risk financing techniques-
risk transfers.
Risk management decision
methods
? Risk avoidance
? Loss control
? Risk retension
? Non-insurance transfers
? insurance
Pooling arrangements and
diversification of risk
? Most popular risk management tool is diversification. Essential
part of insurance/financial markets
? Simple methods like pooling between two to diversification
amongst many
? Pooling arrangement reduces risk when losses are independent
(uncorrelated)
? Pooling refers to spreading losses incurred by a few over the
entire group so that everyone bears average loss instead of
actual loss.
2-person pooling arrangement
?Shahrukh and Salman have a possibility
of an accident in the coming year, say.
?20% chance of an accident with a loss of
2500
?Probability distribution of accident losses
is highly skewed. (0 ? 0.8; 2500 ? 0.2)
?Their losses are uncorrelated.
?What is the expected loss and standard
deviation for each one of them?
?Expected loss = 0.8*0 + 0.2*2500
= 500
?Standard deviation
= Root 0.8(0-500)
2
+ 0.2(2500-
500)
2
= 1000
Pooling arrangement?
?Pooling allows them to pool
their risk and split losses equally.
?What is the expected loss and
standard deviation for each
one of them?
Pooling arrangement..
Possible
outcome
Total cost Cost paid by
each person
Probability
Neither Shahrukh
nor salman
0 0 0.8*0.8=0.64
Only Shahrukh 2500 1250 0.2*0.8=0.16
Only salman 2500 1250 0.2*0.8=0.16
Both of them 5000 2500 0.2*0.2=0.04
FirstRanker.com - FirstRanker's Choice
Risk
measurement
MODULE 3
Frequency and severity of
losses.
? Frequency of loss refers to number of times in a given period the
loss is likely to happen.
? Historical data will provide this info. (Eg: frequency of injury = no
of injuries in the past/no of worker-years) in the absence of
historical data, industry data can be used. Informed judgement
can be used as well.
? Severity of loss measures the magnitude of loss per occurrence.
One way to estimate is from historical data. (average
severity/occurrence)
? Expected loss = frequency of loss*severity of loss. Expected loss
affects business value and insurance pricing.
3.6
Note:
?Std deviation for high frequency
low severity is low while std
deviation for low frequency high
severity is high
?Infrequent but potentially large
losses are less predictable and
pose greater risk than more
frequent smaller losses.
Risk control
? Risk control is the process of implementing
measures to reduce risk associated with a hazard.
? Benefits of risk/loss control:
Elimination of expenses associated with
- Repair or replacement of damaged property
- Income losses due to distruction of property
- Extra costs associated with maintaining operations
- Adverse liability judgements
- Medical costs to treat injuries
- Income losses due to death/disabilities
Cost of risk control
? Installation and maintainance expenses eg
sprinkler system
? There are associated costs involved like employee
benefits apart from salary
? Some measures push up utility bills eg power bill
Risk control techniques
1
?Risk avoidance
2
?Risk prevention
3
?Risk reduction
Risk avoidance
? Risk avoidance involves not performing an activity that could carry
risk. Eg: not buying a property, not flying, not travelling. This leas to
loss of opportunities arising out of performing such activities. Not
doing a business will avoid risk but one loses on opportunity to earn
profits.
? Advantages:
? Chances of risk is reduced to zero in case where loss exposure has
not started. In situations where exposure has already started it is
reduce to zero for future activities. Residual risks may still persist
? Disadvantages:
? A firm cannot avoid all losses like premature death of an executive
? It is not feasible/practical to avoid all losses without shutting the
business eg car factory cannot avoid all risks if it has to continue
producing cars
Risk control techniques-
Risk prevention
? It refers to measures that reduce the frequency
of a particular loss. This focusses on stopping
losses from happening. Important to prevent
death/injury to people.
? Businesses employ loss control engineers to
identify sources of risks and institute corrective
actions. Like poor lighting, poor maintenance,
improper security, etc. training is given on safety
aspects
? Eg: changing slippery floor, building safety
enclosures to dangerous machinery etc
Risk control techniques-
Risk reduction
Risk financing techniques-
risk retention.
Risk financing techniques-
risk transfers.
Risk management decision
methods
? Risk avoidance
? Loss control
? Risk retension
? Non-insurance transfers
? insurance
Pooling arrangements and
diversification of risk
? Most popular risk management tool is diversification. Essential
part of insurance/financial markets
? Simple methods like pooling between two to diversification
amongst many
? Pooling arrangement reduces risk when losses are independent
(uncorrelated)
? Pooling refers to spreading losses incurred by a few over the
entire group so that everyone bears average loss instead of
actual loss.
2-person pooling arrangement
?Shahrukh and Salman have a possibility
of an accident in the coming year, say.
?20% chance of an accident with a loss of
2500
?Probability distribution of accident losses
is highly skewed. (0 ? 0.8; 2500 ? 0.2)
?Their losses are uncorrelated.
?What is the expected loss and standard
deviation for each one of them?
?Expected loss = 0.8*0 + 0.2*2500
= 500
?Standard deviation
= Root 0.8(0-500)
2
+ 0.2(2500-
500)
2
= 1000
Pooling arrangement?
?Pooling allows them to pool
their risk and split losses equally.
?What is the expected loss and
standard deviation for each
one of them?
Pooling arrangement..
Possible
outcome
Total cost Cost paid by
each person
Probability
Neither Shahrukh
nor salman
0 0 0.8*0.8=0.64
Only Shahrukh 2500 1250 0.2*0.8=0.16
Only salman 2500 1250 0.2*0.8=0.16
Both of them 5000 2500 0.2*0.2=0.04
?Expected cost =
0.64*0+0.32*1250+0.04*2500 = 500
?Standard Deviation =
Root of 0.64*(0-500)
2
+ 0.32*(1250-500)
2
+
(2500-500)
2
= 707
?Pooling arrangement doesn?t change
either person?s expected cost but it
reduces the standard deviation. (1000 to
707)
?This is how risk gets reduced by
diversification. Loss has become more
predictable.
FirstRanker.com - FirstRanker's Choice
Risk
measurement
MODULE 3
Frequency and severity of
losses.
? Frequency of loss refers to number of times in a given period the
loss is likely to happen.
? Historical data will provide this info. (Eg: frequency of injury = no
of injuries in the past/no of worker-years) in the absence of
historical data, industry data can be used. Informed judgement
can be used as well.
? Severity of loss measures the magnitude of loss per occurrence.
One way to estimate is from historical data. (average
severity/occurrence)
? Expected loss = frequency of loss*severity of loss. Expected loss
affects business value and insurance pricing.
3.6
Note:
?Std deviation for high frequency
low severity is low while std
deviation for low frequency high
severity is high
?Infrequent but potentially large
losses are less predictable and
pose greater risk than more
frequent smaller losses.
Risk control
? Risk control is the process of implementing
measures to reduce risk associated with a hazard.
? Benefits of risk/loss control:
Elimination of expenses associated with
- Repair or replacement of damaged property
- Income losses due to distruction of property
- Extra costs associated with maintaining operations
- Adverse liability judgements
- Medical costs to treat injuries
- Income losses due to death/disabilities
Cost of risk control
? Installation and maintainance expenses eg
sprinkler system
? There are associated costs involved like employee
benefits apart from salary
? Some measures push up utility bills eg power bill
Risk control techniques
1
?Risk avoidance
2
?Risk prevention
3
?Risk reduction
Risk avoidance
? Risk avoidance involves not performing an activity that could carry
risk. Eg: not buying a property, not flying, not travelling. This leas to
loss of opportunities arising out of performing such activities. Not
doing a business will avoid risk but one loses on opportunity to earn
profits.
? Advantages:
? Chances of risk is reduced to zero in case where loss exposure has
not started. In situations where exposure has already started it is
reduce to zero for future activities. Residual risks may still persist
? Disadvantages:
? A firm cannot avoid all losses like premature death of an executive
? It is not feasible/practical to avoid all losses without shutting the
business eg car factory cannot avoid all risks if it has to continue
producing cars
Risk control techniques-
Risk prevention
? It refers to measures that reduce the frequency
of a particular loss. This focusses on stopping
losses from happening. Important to prevent
death/injury to people.
? Businesses employ loss control engineers to
identify sources of risks and institute corrective
actions. Like poor lighting, poor maintenance,
improper security, etc. training is given on safety
aspects
? Eg: changing slippery floor, building safety
enclosures to dangerous machinery etc
Risk control techniques-
Risk reduction
Risk financing techniques-
risk retention.
Risk financing techniques-
risk transfers.
Risk management decision
methods
? Risk avoidance
? Loss control
? Risk retension
? Non-insurance transfers
? insurance
Pooling arrangements and
diversification of risk
? Most popular risk management tool is diversification. Essential
part of insurance/financial markets
? Simple methods like pooling between two to diversification
amongst many
? Pooling arrangement reduces risk when losses are independent
(uncorrelated)
? Pooling refers to spreading losses incurred by a few over the
entire group so that everyone bears average loss instead of
actual loss.
2-person pooling arrangement
?Shahrukh and Salman have a possibility
of an accident in the coming year, say.
?20% chance of an accident with a loss of
2500
?Probability distribution of accident losses
is highly skewed. (0 ? 0.8; 2500 ? 0.2)
?Their losses are uncorrelated.
?What is the expected loss and standard
deviation for each one of them?
?Expected loss = 0.8*0 + 0.2*2500
= 500
?Standard deviation
= Root 0.8(0-500)
2
+ 0.2(2500-
500)
2
= 1000
Pooling arrangement?
?Pooling allows them to pool
their risk and split losses equally.
?What is the expected loss and
standard deviation for each
one of them?
Pooling arrangement..
Possible
outcome
Total cost Cost paid by
each person
Probability
Neither Shahrukh
nor salman
0 0 0.8*0.8=0.64
Only Shahrukh 2500 1250 0.2*0.8=0.16
Only salman 2500 1250 0.2*0.8=0.16
Both of them 5000 2500 0.2*0.2=0.04
?Expected cost =
0.64*0+0.32*1250+0.04*2500 = 500
?Standard Deviation =
Root of 0.64*(0-500)
2
+ 0.32*(1250-500)
2
+
(2500-500)
2
= 707
?Pooling arrangement doesn?t change
either person?s expected cost but it
reduces the standard deviation. (1000 to
707)
?This is how risk gets reduced by
diversification. Loss has become more
predictable.
Many-people pooling
? Assume that now Amir khan who has the same
probability of risk also joins the pooling arrangement.
If anyone meets with an accident, each will share
one-thirds of the average loss or expected loss.
? As more and more people join the pool, the mean
loss remains the same but standard deviation comes
down hereby reducing the risk for each participant.
? Expected loss or mean remains the same but the
standard deviation further decreases making the
normal distribution less skewed and more bell shaped.
? Note that here the risk is not transferred to anyone
else, but it is reduced as a whole for each pool
participant.
FirstRanker.com - FirstRanker's Choice
Risk
measurement
MODULE 3
Frequency and severity of
losses.
? Frequency of loss refers to number of times in a given period the
loss is likely to happen.
? Historical data will provide this info. (Eg: frequency of injury = no
of injuries in the past/no of worker-years) in the absence of
historical data, industry data can be used. Informed judgement
can be used as well.
? Severity of loss measures the magnitude of loss per occurrence.
One way to estimate is from historical data. (average
severity/occurrence)
? Expected loss = frequency of loss*severity of loss. Expected loss
affects business value and insurance pricing.
3.6
Note:
?Std deviation for high frequency
low severity is low while std
deviation for low frequency high
severity is high
?Infrequent but potentially large
losses are less predictable and
pose greater risk than more
frequent smaller losses.
Risk control
? Risk control is the process of implementing
measures to reduce risk associated with a hazard.
? Benefits of risk/loss control:
Elimination of expenses associated with
- Repair or replacement of damaged property
- Income losses due to distruction of property
- Extra costs associated with maintaining operations
- Adverse liability judgements
- Medical costs to treat injuries
- Income losses due to death/disabilities
Cost of risk control
? Installation and maintainance expenses eg
sprinkler system
? There are associated costs involved like employee
benefits apart from salary
? Some measures push up utility bills eg power bill
Risk control techniques
1
?Risk avoidance
2
?Risk prevention
3
?Risk reduction
Risk avoidance
? Risk avoidance involves not performing an activity that could carry
risk. Eg: not buying a property, not flying, not travelling. This leas to
loss of opportunities arising out of performing such activities. Not
doing a business will avoid risk but one loses on opportunity to earn
profits.
? Advantages:
? Chances of risk is reduced to zero in case where loss exposure has
not started. In situations where exposure has already started it is
reduce to zero for future activities. Residual risks may still persist
? Disadvantages:
? A firm cannot avoid all losses like premature death of an executive
? It is not feasible/practical to avoid all losses without shutting the
business eg car factory cannot avoid all risks if it has to continue
producing cars
Risk control techniques-
Risk prevention
? It refers to measures that reduce the frequency
of a particular loss. This focusses on stopping
losses from happening. Important to prevent
death/injury to people.
? Businesses employ loss control engineers to
identify sources of risks and institute corrective
actions. Like poor lighting, poor maintenance,
improper security, etc. training is given on safety
aspects
? Eg: changing slippery floor, building safety
enclosures to dangerous machinery etc
Risk control techniques-
Risk reduction
Risk financing techniques-
risk retention.
Risk financing techniques-
risk transfers.
Risk management decision
methods
? Risk avoidance
? Loss control
? Risk retension
? Non-insurance transfers
? insurance
Pooling arrangements and
diversification of risk
? Most popular risk management tool is diversification. Essential
part of insurance/financial markets
? Simple methods like pooling between two to diversification
amongst many
? Pooling arrangement reduces risk when losses are independent
(uncorrelated)
? Pooling refers to spreading losses incurred by a few over the
entire group so that everyone bears average loss instead of
actual loss.
2-person pooling arrangement
?Shahrukh and Salman have a possibility
of an accident in the coming year, say.
?20% chance of an accident with a loss of
2500
?Probability distribution of accident losses
is highly skewed. (0 ? 0.8; 2500 ? 0.2)
?Their losses are uncorrelated.
?What is the expected loss and standard
deviation for each one of them?
?Expected loss = 0.8*0 + 0.2*2500
= 500
?Standard deviation
= Root 0.8(0-500)
2
+ 0.2(2500-
500)
2
= 1000
Pooling arrangement?
?Pooling allows them to pool
their risk and split losses equally.
?What is the expected loss and
standard deviation for each
one of them?
Pooling arrangement..
Possible
outcome
Total cost Cost paid by
each person
Probability
Neither Shahrukh
nor salman
0 0 0.8*0.8=0.64
Only Shahrukh 2500 1250 0.2*0.8=0.16
Only salman 2500 1250 0.2*0.8=0.16
Both of them 5000 2500 0.2*0.2=0.04
?Expected cost =
0.64*0+0.32*1250+0.04*2500 = 500
?Standard Deviation =
Root of 0.64*(0-500)
2
+ 0.32*(1250-500)
2
+
(2500-500)
2
= 707
?Pooling arrangement doesn?t change
either person?s expected cost but it
reduces the standard deviation. (1000 to
707)
?This is how risk gets reduced by
diversification. Loss has become more
predictable.
Many-people pooling
? Assume that now Amir khan who has the same
probability of risk also joins the pooling arrangement.
If anyone meets with an accident, each will share
one-thirds of the average loss or expected loss.
? As more and more people join the pool, the mean
loss remains the same but standard deviation comes
down hereby reducing the risk for each participant.
? Expected loss or mean remains the same but the
standard deviation further decreases making the
normal distribution less skewed and more bell shaped.
? Note that here the risk is not transferred to anyone
else, but it is reduced as a whole for each pool
participant.
Fig 4.2 page 59
? Graph with pooling
? Graph without pooling
FirstRanker.com - FirstRanker's Choice
Risk
measurement
MODULE 3
Frequency and severity of
losses.
? Frequency of loss refers to number of times in a given period the
loss is likely to happen.
? Historical data will provide this info. (Eg: frequency of injury = no
of injuries in the past/no of worker-years) in the absence of
historical data, industry data can be used. Informed judgement
can be used as well.
? Severity of loss measures the magnitude of loss per occurrence.
One way to estimate is from historical data. (average
severity/occurrence)
? Expected loss = frequency of loss*severity of loss. Expected loss
affects business value and insurance pricing.
3.6
Note:
?Std deviation for high frequency
low severity is low while std
deviation for low frequency high
severity is high
?Infrequent but potentially large
losses are less predictable and
pose greater risk than more
frequent smaller losses.
Risk control
? Risk control is the process of implementing
measures to reduce risk associated with a hazard.
? Benefits of risk/loss control:
Elimination of expenses associated with
- Repair or replacement of damaged property
- Income losses due to distruction of property
- Extra costs associated with maintaining operations
- Adverse liability judgements
- Medical costs to treat injuries
- Income losses due to death/disabilities
Cost of risk control
? Installation and maintainance expenses eg
sprinkler system
? There are associated costs involved like employee
benefits apart from salary
? Some measures push up utility bills eg power bill
Risk control techniques
1
?Risk avoidance
2
?Risk prevention
3
?Risk reduction
Risk avoidance
? Risk avoidance involves not performing an activity that could carry
risk. Eg: not buying a property, not flying, not travelling. This leas to
loss of opportunities arising out of performing such activities. Not
doing a business will avoid risk but one loses on opportunity to earn
profits.
? Advantages:
? Chances of risk is reduced to zero in case where loss exposure has
not started. In situations where exposure has already started it is
reduce to zero for future activities. Residual risks may still persist
? Disadvantages:
? A firm cannot avoid all losses like premature death of an executive
? It is not feasible/practical to avoid all losses without shutting the
business eg car factory cannot avoid all risks if it has to continue
producing cars
Risk control techniques-
Risk prevention
? It refers to measures that reduce the frequency
of a particular loss. This focusses on stopping
losses from happening. Important to prevent
death/injury to people.
? Businesses employ loss control engineers to
identify sources of risks and institute corrective
actions. Like poor lighting, poor maintenance,
improper security, etc. training is given on safety
aspects
? Eg: changing slippery floor, building safety
enclosures to dangerous machinery etc
Risk control techniques-
Risk reduction
Risk financing techniques-
risk retention.
Risk financing techniques-
risk transfers.
Risk management decision
methods
? Risk avoidance
? Loss control
? Risk retension
? Non-insurance transfers
? insurance
Pooling arrangements and
diversification of risk
? Most popular risk management tool is diversification. Essential
part of insurance/financial markets
? Simple methods like pooling between two to diversification
amongst many
? Pooling arrangement reduces risk when losses are independent
(uncorrelated)
? Pooling refers to spreading losses incurred by a few over the
entire group so that everyone bears average loss instead of
actual loss.
2-person pooling arrangement
?Shahrukh and Salman have a possibility
of an accident in the coming year, say.
?20% chance of an accident with a loss of
2500
?Probability distribution of accident losses
is highly skewed. (0 ? 0.8; 2500 ? 0.2)
?Their losses are uncorrelated.
?What is the expected loss and standard
deviation for each one of them?
?Expected loss = 0.8*0 + 0.2*2500
= 500
?Standard deviation
= Root 0.8(0-500)
2
+ 0.2(2500-
500)
2
= 1000
Pooling arrangement?
?Pooling allows them to pool
their risk and split losses equally.
?What is the expected loss and
standard deviation for each
one of them?
Pooling arrangement..
Possible
outcome
Total cost Cost paid by
each person
Probability
Neither Shahrukh
nor salman
0 0 0.8*0.8=0.64
Only Shahrukh 2500 1250 0.2*0.8=0.16
Only salman 2500 1250 0.2*0.8=0.16
Both of them 5000 2500 0.2*0.2=0.04
?Expected cost =
0.64*0+0.32*1250+0.04*2500 = 500
?Standard Deviation =
Root of 0.64*(0-500)
2
+ 0.32*(1250-500)
2
+
(2500-500)
2
= 707
?Pooling arrangement doesn?t change
either person?s expected cost but it
reduces the standard deviation. (1000 to
707)
?This is how risk gets reduced by
diversification. Loss has become more
predictable.
Many-people pooling
? Assume that now Amir khan who has the same
probability of risk also joins the pooling arrangement.
If anyone meets with an accident, each will share
one-thirds of the average loss or expected loss.
? As more and more people join the pool, the mean
loss remains the same but standard deviation comes
down hereby reducing the risk for each participant.
? Expected loss or mean remains the same but the
standard deviation further decreases making the
normal distribution less skewed and more bell shaped.
? Note that here the risk is not transferred to anyone
else, but it is reduced as a whole for each pool
participant.
Fig 4.2 page 59
? Graph with pooling
? Graph without pooling
summary
? As the number of participants in a pooling
arrangement goes up, the standard deviation starts
coming down as near to zero as possible for each
participant. Probability of extreme high or low
outcome is reduced. This leads to the law of large
numbers.
? Law of large numbers states that ?The greater the
number of exposures, the more closely will actual
results approach the probable result that are
expected from an infinite number of exposures eg:
tossing a coin a million times)
? Also, as the number increases the probability
distribution curve of average loss tends to become
more and more bell shaped tending towards a
Normal distribution. This reflects central limit theorem.
FirstRanker.com - FirstRanker's Choice
Risk
measurement
MODULE 3
Frequency and severity of
losses.
? Frequency of loss refers to number of times in a given period the
loss is likely to happen.
? Historical data will provide this info. (Eg: frequency of injury = no
of injuries in the past/no of worker-years) in the absence of
historical data, industry data can be used. Informed judgement
can be used as well.
? Severity of loss measures the magnitude of loss per occurrence.
One way to estimate is from historical data. (average
severity/occurrence)
? Expected loss = frequency of loss*severity of loss. Expected loss
affects business value and insurance pricing.
3.6
Note:
?Std deviation for high frequency
low severity is low while std
deviation for low frequency high
severity is high
?Infrequent but potentially large
losses are less predictable and
pose greater risk than more
frequent smaller losses.
Risk control
? Risk control is the process of implementing
measures to reduce risk associated with a hazard.
? Benefits of risk/loss control:
Elimination of expenses associated with
- Repair or replacement of damaged property
- Income losses due to distruction of property
- Extra costs associated with maintaining operations
- Adverse liability judgements
- Medical costs to treat injuries
- Income losses due to death/disabilities
Cost of risk control
? Installation and maintainance expenses eg
sprinkler system
? There are associated costs involved like employee
benefits apart from salary
? Some measures push up utility bills eg power bill
Risk control techniques
1
?Risk avoidance
2
?Risk prevention
3
?Risk reduction
Risk avoidance
? Risk avoidance involves not performing an activity that could carry
risk. Eg: not buying a property, not flying, not travelling. This leas to
loss of opportunities arising out of performing such activities. Not
doing a business will avoid risk but one loses on opportunity to earn
profits.
? Advantages:
? Chances of risk is reduced to zero in case where loss exposure has
not started. In situations where exposure has already started it is
reduce to zero for future activities. Residual risks may still persist
? Disadvantages:
? A firm cannot avoid all losses like premature death of an executive
? It is not feasible/practical to avoid all losses without shutting the
business eg car factory cannot avoid all risks if it has to continue
producing cars
Risk control techniques-
Risk prevention
? It refers to measures that reduce the frequency
of a particular loss. This focusses on stopping
losses from happening. Important to prevent
death/injury to people.
? Businesses employ loss control engineers to
identify sources of risks and institute corrective
actions. Like poor lighting, poor maintenance,
improper security, etc. training is given on safety
aspects
? Eg: changing slippery floor, building safety
enclosures to dangerous machinery etc
Risk control techniques-
Risk reduction
Risk financing techniques-
risk retention.
Risk financing techniques-
risk transfers.
Risk management decision
methods
? Risk avoidance
? Loss control
? Risk retension
? Non-insurance transfers
? insurance
Pooling arrangements and
diversification of risk
? Most popular risk management tool is diversification. Essential
part of insurance/financial markets
? Simple methods like pooling between two to diversification
amongst many
? Pooling arrangement reduces risk when losses are independent
(uncorrelated)
? Pooling refers to spreading losses incurred by a few over the
entire group so that everyone bears average loss instead of
actual loss.
2-person pooling arrangement
?Shahrukh and Salman have a possibility
of an accident in the coming year, say.
?20% chance of an accident with a loss of
2500
?Probability distribution of accident losses
is highly skewed. (0 ? 0.8; 2500 ? 0.2)
?Their losses are uncorrelated.
?What is the expected loss and standard
deviation for each one of them?
?Expected loss = 0.8*0 + 0.2*2500
= 500
?Standard deviation
= Root 0.8(0-500)
2
+ 0.2(2500-
500)
2
= 1000
Pooling arrangement?
?Pooling allows them to pool
their risk and split losses equally.
?What is the expected loss and
standard deviation for each
one of them?
Pooling arrangement..
Possible
outcome
Total cost Cost paid by
each person
Probability
Neither Shahrukh
nor salman
0 0 0.8*0.8=0.64
Only Shahrukh 2500 1250 0.2*0.8=0.16
Only salman 2500 1250 0.2*0.8=0.16
Both of them 5000 2500 0.2*0.2=0.04
?Expected cost =
0.64*0+0.32*1250+0.04*2500 = 500
?Standard Deviation =
Root of 0.64*(0-500)
2
+ 0.32*(1250-500)
2
+
(2500-500)
2
= 707
?Pooling arrangement doesn?t change
either person?s expected cost but it
reduces the standard deviation. (1000 to
707)
?This is how risk gets reduced by
diversification. Loss has become more
predictable.
Many-people pooling
? Assume that now Amir khan who has the same
probability of risk also joins the pooling arrangement.
If anyone meets with an accident, each will share
one-thirds of the average loss or expected loss.
? As more and more people join the pool, the mean
loss remains the same but standard deviation comes
down hereby reducing the risk for each participant.
? Expected loss or mean remains the same but the
standard deviation further decreases making the
normal distribution less skewed and more bell shaped.
? Note that here the risk is not transferred to anyone
else, but it is reduced as a whole for each pool
participant.
Fig 4.2 page 59
? Graph with pooling
? Graph without pooling
summary
? As the number of participants in a pooling
arrangement goes up, the standard deviation starts
coming down as near to zero as possible for each
participant. Probability of extreme high or low
outcome is reduced. This leads to the law of large
numbers.
? Law of large numbers states that ?The greater the
number of exposures, the more closely will actual
results approach the probable result that are
expected from an infinite number of exposures eg:
tossing a coin a million times)
? Also, as the number increases the probability
distribution curve of average loss tends to become
more and more bell shaped tending towards a
Normal distribution. This reflects central limit theorem.
Solve
?Suppose each participant in a pooling
arrangement has USD 0 to 4000 losses,
with each participants expected loss is
usd 1000, sketch the probability
distribution of average losses if the losses
across the participants are independent
and if
?1. there is 1 participant (no pooling)
?2. there are 100 participants
?3. there are 1000 participants.
FirstRanker.com - FirstRanker's Choice
Risk
measurement
MODULE 3
Frequency and severity of
losses.
? Frequency of loss refers to number of times in a given period the
loss is likely to happen.
? Historical data will provide this info. (Eg: frequency of injury = no
of injuries in the past/no of worker-years) in the absence of
historical data, industry data can be used. Informed judgement
can be used as well.
? Severity of loss measures the magnitude of loss per occurrence.
One way to estimate is from historical data. (average
severity/occurrence)
? Expected loss = frequency of loss*severity of loss. Expected loss
affects business value and insurance pricing.
3.6
Note:
?Std deviation for high frequency
low severity is low while std
deviation for low frequency high
severity is high
?Infrequent but potentially large
losses are less predictable and
pose greater risk than more
frequent smaller losses.
Risk control
? Risk control is the process of implementing
measures to reduce risk associated with a hazard.
? Benefits of risk/loss control:
Elimination of expenses associated with
- Repair or replacement of damaged property
- Income losses due to distruction of property
- Extra costs associated with maintaining operations
- Adverse liability judgements
- Medical costs to treat injuries
- Income losses due to death/disabilities
Cost of risk control
? Installation and maintainance expenses eg
sprinkler system
? There are associated costs involved like employee
benefits apart from salary
? Some measures push up utility bills eg power bill
Risk control techniques
1
?Risk avoidance
2
?Risk prevention
3
?Risk reduction
Risk avoidance
? Risk avoidance involves not performing an activity that could carry
risk. Eg: not buying a property, not flying, not travelling. This leas to
loss of opportunities arising out of performing such activities. Not
doing a business will avoid risk but one loses on opportunity to earn
profits.
? Advantages:
? Chances of risk is reduced to zero in case where loss exposure has
not started. In situations where exposure has already started it is
reduce to zero for future activities. Residual risks may still persist
? Disadvantages:
? A firm cannot avoid all losses like premature death of an executive
? It is not feasible/practical to avoid all losses without shutting the
business eg car factory cannot avoid all risks if it has to continue
producing cars
Risk control techniques-
Risk prevention
? It refers to measures that reduce the frequency
of a particular loss. This focusses on stopping
losses from happening. Important to prevent
death/injury to people.
? Businesses employ loss control engineers to
identify sources of risks and institute corrective
actions. Like poor lighting, poor maintenance,
improper security, etc. training is given on safety
aspects
? Eg: changing slippery floor, building safety
enclosures to dangerous machinery etc
Risk control techniques-
Risk reduction
Risk financing techniques-
risk retention.
Risk financing techniques-
risk transfers.
Risk management decision
methods
? Risk avoidance
? Loss control
? Risk retension
? Non-insurance transfers
? insurance
Pooling arrangements and
diversification of risk
? Most popular risk management tool is diversification. Essential
part of insurance/financial markets
? Simple methods like pooling between two to diversification
amongst many
? Pooling arrangement reduces risk when losses are independent
(uncorrelated)
? Pooling refers to spreading losses incurred by a few over the
entire group so that everyone bears average loss instead of
actual loss.
2-person pooling arrangement
?Shahrukh and Salman have a possibility
of an accident in the coming year, say.
?20% chance of an accident with a loss of
2500
?Probability distribution of accident losses
is highly skewed. (0 ? 0.8; 2500 ? 0.2)
?Their losses are uncorrelated.
?What is the expected loss and standard
deviation for each one of them?
?Expected loss = 0.8*0 + 0.2*2500
= 500
?Standard deviation
= Root 0.8(0-500)
2
+ 0.2(2500-
500)
2
= 1000
Pooling arrangement?
?Pooling allows them to pool
their risk and split losses equally.
?What is the expected loss and
standard deviation for each
one of them?
Pooling arrangement..
Possible
outcome
Total cost Cost paid by
each person
Probability
Neither Shahrukh
nor salman
0 0 0.8*0.8=0.64
Only Shahrukh 2500 1250 0.2*0.8=0.16
Only salman 2500 1250 0.2*0.8=0.16
Both of them 5000 2500 0.2*0.2=0.04
?Expected cost =
0.64*0+0.32*1250+0.04*2500 = 500
?Standard Deviation =
Root of 0.64*(0-500)
2
+ 0.32*(1250-500)
2
+
(2500-500)
2
= 707
?Pooling arrangement doesn?t change
either person?s expected cost but it
reduces the standard deviation. (1000 to
707)
?This is how risk gets reduced by
diversification. Loss has become more
predictable.
Many-people pooling
? Assume that now Amir khan who has the same
probability of risk also joins the pooling arrangement.
If anyone meets with an accident, each will share
one-thirds of the average loss or expected loss.
? As more and more people join the pool, the mean
loss remains the same but standard deviation comes
down hereby reducing the risk for each participant.
? Expected loss or mean remains the same but the
standard deviation further decreases making the
normal distribution less skewed and more bell shaped.
? Note that here the risk is not transferred to anyone
else, but it is reduced as a whole for each pool
participant.
Fig 4.2 page 59
? Graph with pooling
? Graph without pooling
summary
? As the number of participants in a pooling
arrangement goes up, the standard deviation starts
coming down as near to zero as possible for each
participant. Probability of extreme high or low
outcome is reduced. This leads to the law of large
numbers.
? Law of large numbers states that ?The greater the
number of exposures, the more closely will actual
results approach the probable result that are
expected from an infinite number of exposures eg:
tossing a coin a million times)
? Also, as the number increases the probability
distribution curve of average loss tends to become
more and more bell shaped tending towards a
Normal distribution. This reflects central limit theorem.
Solve
?Suppose each participant in a pooling
arrangement has USD 0 to 4000 losses,
with each participants expected loss is
usd 1000, sketch the probability
distribution of average losses if the losses
across the participants are independent
and if
?1. there is 1 participant (no pooling)
?2. there are 100 participants
?3. there are 1000 participants.
Pooling with correlated losses
Positive correlation because of:
? Catastrophe and epidemic hit a large population at
the same time
? When losses are correlated then increase/decrease in
one leads to increase/decrease in another.
? Therefore, Pooling arrangement reduces risk for each
participant even when the losses are positively
correlated but to a lesser degree.
? Assuming Shah Ruk and Salman?s accidents are
correlated, then probability of shah Ruk having an
accident knowing that Salman has had an accident is
> 0.04
FirstRanker.com - FirstRanker's Choice
Risk
measurement
MODULE 3
Frequency and severity of
losses.
? Frequency of loss refers to number of times in a given period the
loss is likely to happen.
? Historical data will provide this info. (Eg: frequency of injury = no
of injuries in the past/no of worker-years) in the absence of
historical data, industry data can be used. Informed judgement
can be used as well.
? Severity of loss measures the magnitude of loss per occurrence.
One way to estimate is from historical data. (average
severity/occurrence)
? Expected loss = frequency of loss*severity of loss. Expected loss
affects business value and insurance pricing.
3.6
Note:
?Std deviation for high frequency
low severity is low while std
deviation for low frequency high
severity is high
?Infrequent but potentially large
losses are less predictable and
pose greater risk than more
frequent smaller losses.
Risk control
? Risk control is the process of implementing
measures to reduce risk associated with a hazard.
? Benefits of risk/loss control:
Elimination of expenses associated with
- Repair or replacement of damaged property
- Income losses due to distruction of property
- Extra costs associated with maintaining operations
- Adverse liability judgements
- Medical costs to treat injuries
- Income losses due to death/disabilities
Cost of risk control
? Installation and maintainance expenses eg
sprinkler system
? There are associated costs involved like employee
benefits apart from salary
? Some measures push up utility bills eg power bill
Risk control techniques
1
?Risk avoidance
2
?Risk prevention
3
?Risk reduction
Risk avoidance
? Risk avoidance involves not performing an activity that could carry
risk. Eg: not buying a property, not flying, not travelling. This leas to
loss of opportunities arising out of performing such activities. Not
doing a business will avoid risk but one loses on opportunity to earn
profits.
? Advantages:
? Chances of risk is reduced to zero in case where loss exposure has
not started. In situations where exposure has already started it is
reduce to zero for future activities. Residual risks may still persist
? Disadvantages:
? A firm cannot avoid all losses like premature death of an executive
? It is not feasible/practical to avoid all losses without shutting the
business eg car factory cannot avoid all risks if it has to continue
producing cars
Risk control techniques-
Risk prevention
? It refers to measures that reduce the frequency
of a particular loss. This focusses on stopping
losses from happening. Important to prevent
death/injury to people.
? Businesses employ loss control engineers to
identify sources of risks and institute corrective
actions. Like poor lighting, poor maintenance,
improper security, etc. training is given on safety
aspects
? Eg: changing slippery floor, building safety
enclosures to dangerous machinery etc
Risk control techniques-
Risk reduction
Risk financing techniques-
risk retention.
Risk financing techniques-
risk transfers.
Risk management decision
methods
? Risk avoidance
? Loss control
? Risk retension
? Non-insurance transfers
? insurance
Pooling arrangements and
diversification of risk
? Most popular risk management tool is diversification. Essential
part of insurance/financial markets
? Simple methods like pooling between two to diversification
amongst many
? Pooling arrangement reduces risk when losses are independent
(uncorrelated)
? Pooling refers to spreading losses incurred by a few over the
entire group so that everyone bears average loss instead of
actual loss.
2-person pooling arrangement
?Shahrukh and Salman have a possibility
of an accident in the coming year, say.
?20% chance of an accident with a loss of
2500
?Probability distribution of accident losses
is highly skewed. (0 ? 0.8; 2500 ? 0.2)
?Their losses are uncorrelated.
?What is the expected loss and standard
deviation for each one of them?
?Expected loss = 0.8*0 + 0.2*2500
= 500
?Standard deviation
= Root 0.8(0-500)
2
+ 0.2(2500-
500)
2
= 1000
Pooling arrangement?
?Pooling allows them to pool
their risk and split losses equally.
?What is the expected loss and
standard deviation for each
one of them?
Pooling arrangement..
Possible
outcome
Total cost Cost paid by
each person
Probability
Neither Shahrukh
nor salman
0 0 0.8*0.8=0.64
Only Shahrukh 2500 1250 0.2*0.8=0.16
Only salman 2500 1250 0.2*0.8=0.16
Both of them 5000 2500 0.2*0.2=0.04
?Expected cost =
0.64*0+0.32*1250+0.04*2500 = 500
?Standard Deviation =
Root of 0.64*(0-500)
2
+ 0.32*(1250-500)
2
+
(2500-500)
2
= 707
?Pooling arrangement doesn?t change
either person?s expected cost but it
reduces the standard deviation. (1000 to
707)
?This is how risk gets reduced by
diversification. Loss has become more
predictable.
Many-people pooling
? Assume that now Amir khan who has the same
probability of risk also joins the pooling arrangement.
If anyone meets with an accident, each will share
one-thirds of the average loss or expected loss.
? As more and more people join the pool, the mean
loss remains the same but standard deviation comes
down hereby reducing the risk for each participant.
? Expected loss or mean remains the same but the
standard deviation further decreases making the
normal distribution less skewed and more bell shaped.
? Note that here the risk is not transferred to anyone
else, but it is reduced as a whole for each pool
participant.
Fig 4.2 page 59
? Graph with pooling
? Graph without pooling
summary
? As the number of participants in a pooling
arrangement goes up, the standard deviation starts
coming down as near to zero as possible for each
participant. Probability of extreme high or low
outcome is reduced. This leads to the law of large
numbers.
? Law of large numbers states that ?The greater the
number of exposures, the more closely will actual
results approach the probable result that are
expected from an infinite number of exposures eg:
tossing a coin a million times)
? Also, as the number increases the probability
distribution curve of average loss tends to become
more and more bell shaped tending towards a
Normal distribution. This reflects central limit theorem.
Solve
?Suppose each participant in a pooling
arrangement has USD 0 to 4000 losses,
with each participants expected loss is
usd 1000, sketch the probability
distribution of average losses if the losses
across the participants are independent
and if
?1. there is 1 participant (no pooling)
?2. there are 100 participants
?3. there are 1000 participants.
Pooling with correlated losses
Positive correlation because of:
? Catastrophe and epidemic hit a large population at
the same time
? When losses are correlated then increase/decrease in
one leads to increase/decrease in another.
? Therefore, Pooling arrangement reduces risk for each
participant even when the losses are positively
correlated but to a lesser degree.
? Assuming Shah Ruk and Salman?s accidents are
correlated, then probability of shah Ruk having an
accident knowing that Salman has had an accident is
> 0.04
Changing scope of financial
management
FirstRanker.com - FirstRanker's Choice
Risk
measurement
MODULE 3
Frequency and severity of
losses.
? Frequency of loss refers to number of times in a given period the
loss is likely to happen.
? Historical data will provide this info. (Eg: frequency of injury = no
of injuries in the past/no of worker-years) in the absence of
historical data, industry data can be used. Informed judgement
can be used as well.
? Severity of loss measures the magnitude of loss per occurrence.
One way to estimate is from historical data. (average
severity/occurrence)
? Expected loss = frequency of loss*severity of loss. Expected loss
affects business value and insurance pricing.
3.6
Note:
?Std deviation for high frequency
low severity is low while std
deviation for low frequency high
severity is high
?Infrequent but potentially large
losses are less predictable and
pose greater risk than more
frequent smaller losses.
Risk control
? Risk control is the process of implementing
measures to reduce risk associated with a hazard.
? Benefits of risk/loss control:
Elimination of expenses associated with
- Repair or replacement of damaged property
- Income losses due to distruction of property
- Extra costs associated with maintaining operations
- Adverse liability judgements
- Medical costs to treat injuries
- Income losses due to death/disabilities
Cost of risk control
? Installation and maintainance expenses eg
sprinkler system
? There are associated costs involved like employee
benefits apart from salary
? Some measures push up utility bills eg power bill
Risk control techniques
1
?Risk avoidance
2
?Risk prevention
3
?Risk reduction
Risk avoidance
? Risk avoidance involves not performing an activity that could carry
risk. Eg: not buying a property, not flying, not travelling. This leas to
loss of opportunities arising out of performing such activities. Not
doing a business will avoid risk but one loses on opportunity to earn
profits.
? Advantages:
? Chances of risk is reduced to zero in case where loss exposure has
not started. In situations where exposure has already started it is
reduce to zero for future activities. Residual risks may still persist
? Disadvantages:
? A firm cannot avoid all losses like premature death of an executive
? It is not feasible/practical to avoid all losses without shutting the
business eg car factory cannot avoid all risks if it has to continue
producing cars
Risk control techniques-
Risk prevention
? It refers to measures that reduce the frequency
of a particular loss. This focusses on stopping
losses from happening. Important to prevent
death/injury to people.
? Businesses employ loss control engineers to
identify sources of risks and institute corrective
actions. Like poor lighting, poor maintenance,
improper security, etc. training is given on safety
aspects
? Eg: changing slippery floor, building safety
enclosures to dangerous machinery etc
Risk control techniques-
Risk reduction
Risk financing techniques-
risk retention.
Risk financing techniques-
risk transfers.
Risk management decision
methods
? Risk avoidance
? Loss control
? Risk retension
? Non-insurance transfers
? insurance
Pooling arrangements and
diversification of risk
? Most popular risk management tool is diversification. Essential
part of insurance/financial markets
? Simple methods like pooling between two to diversification
amongst many
? Pooling arrangement reduces risk when losses are independent
(uncorrelated)
? Pooling refers to spreading losses incurred by a few over the
entire group so that everyone bears average loss instead of
actual loss.
2-person pooling arrangement
?Shahrukh and Salman have a possibility
of an accident in the coming year, say.
?20% chance of an accident with a loss of
2500
?Probability distribution of accident losses
is highly skewed. (0 ? 0.8; 2500 ? 0.2)
?Their losses are uncorrelated.
?What is the expected loss and standard
deviation for each one of them?
?Expected loss = 0.8*0 + 0.2*2500
= 500
?Standard deviation
= Root 0.8(0-500)
2
+ 0.2(2500-
500)
2
= 1000
Pooling arrangement?
?Pooling allows them to pool
their risk and split losses equally.
?What is the expected loss and
standard deviation for each
one of them?
Pooling arrangement..
Possible
outcome
Total cost Cost paid by
each person
Probability
Neither Shahrukh
nor salman
0 0 0.8*0.8=0.64
Only Shahrukh 2500 1250 0.2*0.8=0.16
Only salman 2500 1250 0.2*0.8=0.16
Both of them 5000 2500 0.2*0.2=0.04
?Expected cost =
0.64*0+0.32*1250+0.04*2500 = 500
?Standard Deviation =
Root of 0.64*(0-500)
2
+ 0.32*(1250-500)
2
+
(2500-500)
2
= 707
?Pooling arrangement doesn?t change
either person?s expected cost but it
reduces the standard deviation. (1000 to
707)
?This is how risk gets reduced by
diversification. Loss has become more
predictable.
Many-people pooling
? Assume that now Amir khan who has the same
probability of risk also joins the pooling arrangement.
If anyone meets with an accident, each will share
one-thirds of the average loss or expected loss.
? As more and more people join the pool, the mean
loss remains the same but standard deviation comes
down hereby reducing the risk for each participant.
? Expected loss or mean remains the same but the
standard deviation further decreases making the
normal distribution less skewed and more bell shaped.
? Note that here the risk is not transferred to anyone
else, but it is reduced as a whole for each pool
participant.
Fig 4.2 page 59
? Graph with pooling
? Graph without pooling
summary
? As the number of participants in a pooling
arrangement goes up, the standard deviation starts
coming down as near to zero as possible for each
participant. Probability of extreme high or low
outcome is reduced. This leads to the law of large
numbers.
? Law of large numbers states that ?The greater the
number of exposures, the more closely will actual
results approach the probable result that are
expected from an infinite number of exposures eg:
tossing a coin a million times)
? Also, as the number increases the probability
distribution curve of average loss tends to become
more and more bell shaped tending towards a
Normal distribution. This reflects central limit theorem.
Solve
?Suppose each participant in a pooling
arrangement has USD 0 to 4000 losses,
with each participants expected loss is
usd 1000, sketch the probability
distribution of average losses if the losses
across the participants are independent
and if
?1. there is 1 participant (no pooling)
?2. there are 100 participants
?3. there are 1000 participants.
Pooling with correlated losses
Positive correlation because of:
? Catastrophe and epidemic hit a large population at
the same time
? When losses are correlated then increase/decrease in
one leads to increase/decrease in another.
? Therefore, Pooling arrangement reduces risk for each
participant even when the losses are positively
correlated but to a lesser degree.
? Assuming Shah Ruk and Salman?s accidents are
correlated, then probability of shah Ruk having an
accident knowing that Salman has had an accident is
> 0.04
Changing scope of financial
management
Changing scope of risk
management
? Traditionally risk management focused on pure
loss exposures including property risks, liability
risks and personal risks.
? In 1990s new trend emerged where risk
management included speculative financial
risks.
? Recently some businesses have expanded their
scope to include all risks.
FirstRanker.com - FirstRanker's Choice
Risk
measurement
MODULE 3
Frequency and severity of
losses.
? Frequency of loss refers to number of times in a given period the
loss is likely to happen.
? Historical data will provide this info. (Eg: frequency of injury = no
of injuries in the past/no of worker-years) in the absence of
historical data, industry data can be used. Informed judgement
can be used as well.
? Severity of loss measures the magnitude of loss per occurrence.
One way to estimate is from historical data. (average
severity/occurrence)
? Expected loss = frequency of loss*severity of loss. Expected loss
affects business value and insurance pricing.
3.6
Note:
?Std deviation for high frequency
low severity is low while std
deviation for low frequency high
severity is high
?Infrequent but potentially large
losses are less predictable and
pose greater risk than more
frequent smaller losses.
Risk control
? Risk control is the process of implementing
measures to reduce risk associated with a hazard.
? Benefits of risk/loss control:
Elimination of expenses associated with
- Repair or replacement of damaged property
- Income losses due to distruction of property
- Extra costs associated with maintaining operations
- Adverse liability judgements
- Medical costs to treat injuries
- Income losses due to death/disabilities
Cost of risk control
? Installation and maintainance expenses eg
sprinkler system
? There are associated costs involved like employee
benefits apart from salary
? Some measures push up utility bills eg power bill
Risk control techniques
1
?Risk avoidance
2
?Risk prevention
3
?Risk reduction
Risk avoidance
? Risk avoidance involves not performing an activity that could carry
risk. Eg: not buying a property, not flying, not travelling. This leas to
loss of opportunities arising out of performing such activities. Not
doing a business will avoid risk but one loses on opportunity to earn
profits.
? Advantages:
? Chances of risk is reduced to zero in case where loss exposure has
not started. In situations where exposure has already started it is
reduce to zero for future activities. Residual risks may still persist
? Disadvantages:
? A firm cannot avoid all losses like premature death of an executive
? It is not feasible/practical to avoid all losses without shutting the
business eg car factory cannot avoid all risks if it has to continue
producing cars
Risk control techniques-
Risk prevention
? It refers to measures that reduce the frequency
of a particular loss. This focusses on stopping
losses from happening. Important to prevent
death/injury to people.
? Businesses employ loss control engineers to
identify sources of risks and institute corrective
actions. Like poor lighting, poor maintenance,
improper security, etc. training is given on safety
aspects
? Eg: changing slippery floor, building safety
enclosures to dangerous machinery etc
Risk control techniques-
Risk reduction
Risk financing techniques-
risk retention.
Risk financing techniques-
risk transfers.
Risk management decision
methods
? Risk avoidance
? Loss control
? Risk retension
? Non-insurance transfers
? insurance
Pooling arrangements and
diversification of risk
? Most popular risk management tool is diversification. Essential
part of insurance/financial markets
? Simple methods like pooling between two to diversification
amongst many
? Pooling arrangement reduces risk when losses are independent
(uncorrelated)
? Pooling refers to spreading losses incurred by a few over the
entire group so that everyone bears average loss instead of
actual loss.
2-person pooling arrangement
?Shahrukh and Salman have a possibility
of an accident in the coming year, say.
?20% chance of an accident with a loss of
2500
?Probability distribution of accident losses
is highly skewed. (0 ? 0.8; 2500 ? 0.2)
?Their losses are uncorrelated.
?What is the expected loss and standard
deviation for each one of them?
?Expected loss = 0.8*0 + 0.2*2500
= 500
?Standard deviation
= Root 0.8(0-500)
2
+ 0.2(2500-
500)
2
= 1000
Pooling arrangement?
?Pooling allows them to pool
their risk and split losses equally.
?What is the expected loss and
standard deviation for each
one of them?
Pooling arrangement..
Possible
outcome
Total cost Cost paid by
each person
Probability
Neither Shahrukh
nor salman
0 0 0.8*0.8=0.64
Only Shahrukh 2500 1250 0.2*0.8=0.16
Only salman 2500 1250 0.2*0.8=0.16
Both of them 5000 2500 0.2*0.2=0.04
?Expected cost =
0.64*0+0.32*1250+0.04*2500 = 500
?Standard Deviation =
Root of 0.64*(0-500)
2
+ 0.32*(1250-500)
2
+
(2500-500)
2
= 707
?Pooling arrangement doesn?t change
either person?s expected cost but it
reduces the standard deviation. (1000 to
707)
?This is how risk gets reduced by
diversification. Loss has become more
predictable.
Many-people pooling
? Assume that now Amir khan who has the same
probability of risk also joins the pooling arrangement.
If anyone meets with an accident, each will share
one-thirds of the average loss or expected loss.
? As more and more people join the pool, the mean
loss remains the same but standard deviation comes
down hereby reducing the risk for each participant.
? Expected loss or mean remains the same but the
standard deviation further decreases making the
normal distribution less skewed and more bell shaped.
? Note that here the risk is not transferred to anyone
else, but it is reduced as a whole for each pool
participant.
Fig 4.2 page 59
? Graph with pooling
? Graph without pooling
summary
? As the number of participants in a pooling
arrangement goes up, the standard deviation starts
coming down as near to zero as possible for each
participant. Probability of extreme high or low
outcome is reduced. This leads to the law of large
numbers.
? Law of large numbers states that ?The greater the
number of exposures, the more closely will actual
results approach the probable result that are
expected from an infinite number of exposures eg:
tossing a coin a million times)
? Also, as the number increases the probability
distribution curve of average loss tends to become
more and more bell shaped tending towards a
Normal distribution. This reflects central limit theorem.
Solve
?Suppose each participant in a pooling
arrangement has USD 0 to 4000 losses,
with each participants expected loss is
usd 1000, sketch the probability
distribution of average losses if the losses
across the participants are independent
and if
?1. there is 1 participant (no pooling)
?2. there are 100 participants
?3. there are 1000 participants.
Pooling with correlated losses
Positive correlation because of:
? Catastrophe and epidemic hit a large population at
the same time
? When losses are correlated then increase/decrease in
one leads to increase/decrease in another.
? Therefore, Pooling arrangement reduces risk for each
participant even when the losses are positively
correlated but to a lesser degree.
? Assuming Shah Ruk and Salman?s accidents are
correlated, then probability of shah Ruk having an
accident knowing that Salman has had an accident is
> 0.04
Changing scope of financial
management
Changing scope of risk
management
? Traditionally risk management focused on pure
loss exposures including property risks, liability
risks and personal risks.
? In 1990s new trend emerged where risk
management included speculative financial
risks.
? Recently some businesses have expanded their
scope to include all risks.
Financial risk management
? Financial risk management refers to
identification, analysis and treatment of
speculative financial risks which includes
- commodity price risk
- interest rate risk
- currency exchange rate risk
? Commodity price risk: it is the risk of losing
money if the price of a commodity changes.
Both producers/sellers and users have this risk.
Eg: agri grains
Futures&options can be used to hedge this risk.
FirstRanker.com - FirstRanker's Choice
Risk
measurement
MODULE 3
Frequency and severity of
losses.
? Frequency of loss refers to number of times in a given period the
loss is likely to happen.
? Historical data will provide this info. (Eg: frequency of injury = no
of injuries in the past/no of worker-years) in the absence of
historical data, industry data can be used. Informed judgement
can be used as well.
? Severity of loss measures the magnitude of loss per occurrence.
One way to estimate is from historical data. (average
severity/occurrence)
? Expected loss = frequency of loss*severity of loss. Expected loss
affects business value and insurance pricing.
3.6
Note:
?Std deviation for high frequency
low severity is low while std
deviation for low frequency high
severity is high
?Infrequent but potentially large
losses are less predictable and
pose greater risk than more
frequent smaller losses.
Risk control
? Risk control is the process of implementing
measures to reduce risk associated with a hazard.
? Benefits of risk/loss control:
Elimination of expenses associated with
- Repair or replacement of damaged property
- Income losses due to distruction of property
- Extra costs associated with maintaining operations
- Adverse liability judgements
- Medical costs to treat injuries
- Income losses due to death/disabilities
Cost of risk control
? Installation and maintainance expenses eg
sprinkler system
? There are associated costs involved like employee
benefits apart from salary
? Some measures push up utility bills eg power bill
Risk control techniques
1
?Risk avoidance
2
?Risk prevention
3
?Risk reduction
Risk avoidance
? Risk avoidance involves not performing an activity that could carry
risk. Eg: not buying a property, not flying, not travelling. This leas to
loss of opportunities arising out of performing such activities. Not
doing a business will avoid risk but one loses on opportunity to earn
profits.
? Advantages:
? Chances of risk is reduced to zero in case where loss exposure has
not started. In situations where exposure has already started it is
reduce to zero for future activities. Residual risks may still persist
? Disadvantages:
? A firm cannot avoid all losses like premature death of an executive
? It is not feasible/practical to avoid all losses without shutting the
business eg car factory cannot avoid all risks if it has to continue
producing cars
Risk control techniques-
Risk prevention
? It refers to measures that reduce the frequency
of a particular loss. This focusses on stopping
losses from happening. Important to prevent
death/injury to people.
? Businesses employ loss control engineers to
identify sources of risks and institute corrective
actions. Like poor lighting, poor maintenance,
improper security, etc. training is given on safety
aspects
? Eg: changing slippery floor, building safety
enclosures to dangerous machinery etc
Risk control techniques-
Risk reduction
Risk financing techniques-
risk retention.
Risk financing techniques-
risk transfers.
Risk management decision
methods
? Risk avoidance
? Loss control
? Risk retension
? Non-insurance transfers
? insurance
Pooling arrangements and
diversification of risk
? Most popular risk management tool is diversification. Essential
part of insurance/financial markets
? Simple methods like pooling between two to diversification
amongst many
? Pooling arrangement reduces risk when losses are independent
(uncorrelated)
? Pooling refers to spreading losses incurred by a few over the
entire group so that everyone bears average loss instead of
actual loss.
2-person pooling arrangement
?Shahrukh and Salman have a possibility
of an accident in the coming year, say.
?20% chance of an accident with a loss of
2500
?Probability distribution of accident losses
is highly skewed. (0 ? 0.8; 2500 ? 0.2)
?Their losses are uncorrelated.
?What is the expected loss and standard
deviation for each one of them?
?Expected loss = 0.8*0 + 0.2*2500
= 500
?Standard deviation
= Root 0.8(0-500)
2
+ 0.2(2500-
500)
2
= 1000
Pooling arrangement?
?Pooling allows them to pool
their risk and split losses equally.
?What is the expected loss and
standard deviation for each
one of them?
Pooling arrangement..
Possible
outcome
Total cost Cost paid by
each person
Probability
Neither Shahrukh
nor salman
0 0 0.8*0.8=0.64
Only Shahrukh 2500 1250 0.2*0.8=0.16
Only salman 2500 1250 0.2*0.8=0.16
Both of them 5000 2500 0.2*0.2=0.04
?Expected cost =
0.64*0+0.32*1250+0.04*2500 = 500
?Standard Deviation =
Root of 0.64*(0-500)
2
+ 0.32*(1250-500)
2
+
(2500-500)
2
= 707
?Pooling arrangement doesn?t change
either person?s expected cost but it
reduces the standard deviation. (1000 to
707)
?This is how risk gets reduced by
diversification. Loss has become more
predictable.
Many-people pooling
? Assume that now Amir khan who has the same
probability of risk also joins the pooling arrangement.
If anyone meets with an accident, each will share
one-thirds of the average loss or expected loss.
? As more and more people join the pool, the mean
loss remains the same but standard deviation comes
down hereby reducing the risk for each participant.
? Expected loss or mean remains the same but the
standard deviation further decreases making the
normal distribution less skewed and more bell shaped.
? Note that here the risk is not transferred to anyone
else, but it is reduced as a whole for each pool
participant.
Fig 4.2 page 59
? Graph with pooling
? Graph without pooling
summary
? As the number of participants in a pooling
arrangement goes up, the standard deviation starts
coming down as near to zero as possible for each
participant. Probability of extreme high or low
outcome is reduced. This leads to the law of large
numbers.
? Law of large numbers states that ?The greater the
number of exposures, the more closely will actual
results approach the probable result that are
expected from an infinite number of exposures eg:
tossing a coin a million times)
? Also, as the number increases the probability
distribution curve of average loss tends to become
more and more bell shaped tending towards a
Normal distribution. This reflects central limit theorem.
Solve
?Suppose each participant in a pooling
arrangement has USD 0 to 4000 losses,
with each participants expected loss is
usd 1000, sketch the probability
distribution of average losses if the losses
across the participants are independent
and if
?1. there is 1 participant (no pooling)
?2. there are 100 participants
?3. there are 1000 participants.
Pooling with correlated losses
Positive correlation because of:
? Catastrophe and epidemic hit a large population at
the same time
? When losses are correlated then increase/decrease in
one leads to increase/decrease in another.
? Therefore, Pooling arrangement reduces risk for each
participant even when the losses are positively
correlated but to a lesser degree.
? Assuming Shah Ruk and Salman?s accidents are
correlated, then probability of shah Ruk having an
accident knowing that Salman has had an accident is
> 0.04
Changing scope of financial
management
Changing scope of risk
management
? Traditionally risk management focused on pure
loss exposures including property risks, liability
risks and personal risks.
? In 1990s new trend emerged where risk
management included speculative financial
risks.
? Recently some businesses have expanded their
scope to include all risks.
Financial risk management
? Financial risk management refers to
identification, analysis and treatment of
speculative financial risks which includes
- commodity price risk
- interest rate risk
- currency exchange rate risk
? Commodity price risk: it is the risk of losing
money if the price of a commodity changes.
Both producers/sellers and users have this risk.
Eg: agri grains
Futures&options can be used to hedge this risk.
Financial risk management
? Interest rate risk:
Risk of loss caused by averse interest rate
movements. Eg: a bank has loaned housing
loan for 20-30 years at a particular interest rate.
If rates go up, they have to borrow deposits at a
higher rate. Similarly a corporate may have
issued bond o public at a rate, they have to still
pay the coupon rate
? Currency exchange rate:
Exchange rate is the value at which one
country?s currency is converted to another
Nation?s currency. This affects both imports and
exports.
FirstRanker.com - FirstRanker's Choice
Risk
measurement
MODULE 3
Frequency and severity of
losses.
? Frequency of loss refers to number of times in a given period the
loss is likely to happen.
? Historical data will provide this info. (Eg: frequency of injury = no
of injuries in the past/no of worker-years) in the absence of
historical data, industry data can be used. Informed judgement
can be used as well.
? Severity of loss measures the magnitude of loss per occurrence.
One way to estimate is from historical data. (average
severity/occurrence)
? Expected loss = frequency of loss*severity of loss. Expected loss
affects business value and insurance pricing.
3.6
Note:
?Std deviation for high frequency
low severity is low while std
deviation for low frequency high
severity is high
?Infrequent but potentially large
losses are less predictable and
pose greater risk than more
frequent smaller losses.
Risk control
? Risk control is the process of implementing
measures to reduce risk associated with a hazard.
? Benefits of risk/loss control:
Elimination of expenses associated with
- Repair or replacement of damaged property
- Income losses due to distruction of property
- Extra costs associated with maintaining operations
- Adverse liability judgements
- Medical costs to treat injuries
- Income losses due to death/disabilities
Cost of risk control
? Installation and maintainance expenses eg
sprinkler system
? There are associated costs involved like employee
benefits apart from salary
? Some measures push up utility bills eg power bill
Risk control techniques
1
?Risk avoidance
2
?Risk prevention
3
?Risk reduction
Risk avoidance
? Risk avoidance involves not performing an activity that could carry
risk. Eg: not buying a property, not flying, not travelling. This leas to
loss of opportunities arising out of performing such activities. Not
doing a business will avoid risk but one loses on opportunity to earn
profits.
? Advantages:
? Chances of risk is reduced to zero in case where loss exposure has
not started. In situations where exposure has already started it is
reduce to zero for future activities. Residual risks may still persist
? Disadvantages:
? A firm cannot avoid all losses like premature death of an executive
? It is not feasible/practical to avoid all losses without shutting the
business eg car factory cannot avoid all risks if it has to continue
producing cars
Risk control techniques-
Risk prevention
? It refers to measures that reduce the frequency
of a particular loss. This focusses on stopping
losses from happening. Important to prevent
death/injury to people.
? Businesses employ loss control engineers to
identify sources of risks and institute corrective
actions. Like poor lighting, poor maintenance,
improper security, etc. training is given on safety
aspects
? Eg: changing slippery floor, building safety
enclosures to dangerous machinery etc
Risk control techniques-
Risk reduction
Risk financing techniques-
risk retention.
Risk financing techniques-
risk transfers.
Risk management decision
methods
? Risk avoidance
? Loss control
? Risk retension
? Non-insurance transfers
? insurance
Pooling arrangements and
diversification of risk
? Most popular risk management tool is diversification. Essential
part of insurance/financial markets
? Simple methods like pooling between two to diversification
amongst many
? Pooling arrangement reduces risk when losses are independent
(uncorrelated)
? Pooling refers to spreading losses incurred by a few over the
entire group so that everyone bears average loss instead of
actual loss.
2-person pooling arrangement
?Shahrukh and Salman have a possibility
of an accident in the coming year, say.
?20% chance of an accident with a loss of
2500
?Probability distribution of accident losses
is highly skewed. (0 ? 0.8; 2500 ? 0.2)
?Their losses are uncorrelated.
?What is the expected loss and standard
deviation for each one of them?
?Expected loss = 0.8*0 + 0.2*2500
= 500
?Standard deviation
= Root 0.8(0-500)
2
+ 0.2(2500-
500)
2
= 1000
Pooling arrangement?
?Pooling allows them to pool
their risk and split losses equally.
?What is the expected loss and
standard deviation for each
one of them?
Pooling arrangement..
Possible
outcome
Total cost Cost paid by
each person
Probability
Neither Shahrukh
nor salman
0 0 0.8*0.8=0.64
Only Shahrukh 2500 1250 0.2*0.8=0.16
Only salman 2500 1250 0.2*0.8=0.16
Both of them 5000 2500 0.2*0.2=0.04
?Expected cost =
0.64*0+0.32*1250+0.04*2500 = 500
?Standard Deviation =
Root of 0.64*(0-500)
2
+ 0.32*(1250-500)
2
+
(2500-500)
2
= 707
?Pooling arrangement doesn?t change
either person?s expected cost but it
reduces the standard deviation. (1000 to
707)
?This is how risk gets reduced by
diversification. Loss has become more
predictable.
Many-people pooling
? Assume that now Amir khan who has the same
probability of risk also joins the pooling arrangement.
If anyone meets with an accident, each will share
one-thirds of the average loss or expected loss.
? As more and more people join the pool, the mean
loss remains the same but standard deviation comes
down hereby reducing the risk for each participant.
? Expected loss or mean remains the same but the
standard deviation further decreases making the
normal distribution less skewed and more bell shaped.
? Note that here the risk is not transferred to anyone
else, but it is reduced as a whole for each pool
participant.
Fig 4.2 page 59
? Graph with pooling
? Graph without pooling
summary
? As the number of participants in a pooling
arrangement goes up, the standard deviation starts
coming down as near to zero as possible for each
participant. Probability of extreme high or low
outcome is reduced. This leads to the law of large
numbers.
? Law of large numbers states that ?The greater the
number of exposures, the more closely will actual
results approach the probable result that are
expected from an infinite number of exposures eg:
tossing a coin a million times)
? Also, as the number increases the probability
distribution curve of average loss tends to become
more and more bell shaped tending towards a
Normal distribution. This reflects central limit theorem.
Solve
?Suppose each participant in a pooling
arrangement has USD 0 to 4000 losses,
with each participants expected loss is
usd 1000, sketch the probability
distribution of average losses if the losses
across the participants are independent
and if
?1. there is 1 participant (no pooling)
?2. there are 100 participants
?3. there are 1000 participants.
Pooling with correlated losses
Positive correlation because of:
? Catastrophe and epidemic hit a large population at
the same time
? When losses are correlated then increase/decrease in
one leads to increase/decrease in another.
? Therefore, Pooling arrangement reduces risk for each
participant even when the losses are positively
correlated but to a lesser degree.
? Assuming Shah Ruk and Salman?s accidents are
correlated, then probability of shah Ruk having an
accident knowing that Salman has had an accident is
> 0.04
Changing scope of financial
management
Changing scope of risk
management
? Traditionally risk management focused on pure
loss exposures including property risks, liability
risks and personal risks.
? In 1990s new trend emerged where risk
management included speculative financial
risks.
? Recently some businesses have expanded their
scope to include all risks.
Financial risk management
? Financial risk management refers to
identification, analysis and treatment of
speculative financial risks which includes
- commodity price risk
- interest rate risk
- currency exchange rate risk
? Commodity price risk: it is the risk of losing
money if the price of a commodity changes.
Both producers/sellers and users have this risk.
Eg: agri grains
Futures&options can be used to hedge this risk.
Financial risk management
? Interest rate risk:
Risk of loss caused by averse interest rate
movements. Eg: a bank has loaned housing
loan for 20-30 years at a particular interest rate.
If rates go up, they have to borrow deposits at a
higher rate. Similarly a corporate may have
issued bond o public at a rate, they have to still
pay the coupon rate
? Currency exchange rate:
Exchange rate is the value at which one
country?s currency is converted to another
Nation?s currency. This affects both imports and
exports.
History of Managing financial risks
? Traditionally pure risk and speculative risks are
different and handled by separate departments.
? Pure risk by risk retention, risk transfer and loss
control.
? Speculative risk handled by finance division
through contractual provisions and capital market
instruments.
- contractual provisions include call features in
bonds and adjustable interest rate provisions in
mortgages
- capital market approaches include forwards,
futures options and swaps.
FirstRanker.com - FirstRanker's Choice
Risk
measurement
MODULE 3
Frequency and severity of
losses.
? Frequency of loss refers to number of times in a given period the
loss is likely to happen.
? Historical data will provide this info. (Eg: frequency of injury = no
of injuries in the past/no of worker-years) in the absence of
historical data, industry data can be used. Informed judgement
can be used as well.
? Severity of loss measures the magnitude of loss per occurrence.
One way to estimate is from historical data. (average
severity/occurrence)
? Expected loss = frequency of loss*severity of loss. Expected loss
affects business value and insurance pricing.
3.6
Note:
?Std deviation for high frequency
low severity is low while std
deviation for low frequency high
severity is high
?Infrequent but potentially large
losses are less predictable and
pose greater risk than more
frequent smaller losses.
Risk control
? Risk control is the process of implementing
measures to reduce risk associated with a hazard.
? Benefits of risk/loss control:
Elimination of expenses associated with
- Repair or replacement of damaged property
- Income losses due to distruction of property
- Extra costs associated with maintaining operations
- Adverse liability judgements
- Medical costs to treat injuries
- Income losses due to death/disabilities
Cost of risk control
? Installation and maintainance expenses eg
sprinkler system
? There are associated costs involved like employee
benefits apart from salary
? Some measures push up utility bills eg power bill
Risk control techniques
1
?Risk avoidance
2
?Risk prevention
3
?Risk reduction
Risk avoidance
? Risk avoidance involves not performing an activity that could carry
risk. Eg: not buying a property, not flying, not travelling. This leas to
loss of opportunities arising out of performing such activities. Not
doing a business will avoid risk but one loses on opportunity to earn
profits.
? Advantages:
? Chances of risk is reduced to zero in case where loss exposure has
not started. In situations where exposure has already started it is
reduce to zero for future activities. Residual risks may still persist
? Disadvantages:
? A firm cannot avoid all losses like premature death of an executive
? It is not feasible/practical to avoid all losses without shutting the
business eg car factory cannot avoid all risks if it has to continue
producing cars
Risk control techniques-
Risk prevention
? It refers to measures that reduce the frequency
of a particular loss. This focusses on stopping
losses from happening. Important to prevent
death/injury to people.
? Businesses employ loss control engineers to
identify sources of risks and institute corrective
actions. Like poor lighting, poor maintenance,
improper security, etc. training is given on safety
aspects
? Eg: changing slippery floor, building safety
enclosures to dangerous machinery etc
Risk control techniques-
Risk reduction
Risk financing techniques-
risk retention.
Risk financing techniques-
risk transfers.
Risk management decision
methods
? Risk avoidance
? Loss control
? Risk retension
? Non-insurance transfers
? insurance
Pooling arrangements and
diversification of risk
? Most popular risk management tool is diversification. Essential
part of insurance/financial markets
? Simple methods like pooling between two to diversification
amongst many
? Pooling arrangement reduces risk when losses are independent
(uncorrelated)
? Pooling refers to spreading losses incurred by a few over the
entire group so that everyone bears average loss instead of
actual loss.
2-person pooling arrangement
?Shahrukh and Salman have a possibility
of an accident in the coming year, say.
?20% chance of an accident with a loss of
2500
?Probability distribution of accident losses
is highly skewed. (0 ? 0.8; 2500 ? 0.2)
?Their losses are uncorrelated.
?What is the expected loss and standard
deviation for each one of them?
?Expected loss = 0.8*0 + 0.2*2500
= 500
?Standard deviation
= Root 0.8(0-500)
2
+ 0.2(2500-
500)
2
= 1000
Pooling arrangement?
?Pooling allows them to pool
their risk and split losses equally.
?What is the expected loss and
standard deviation for each
one of them?
Pooling arrangement..
Possible
outcome
Total cost Cost paid by
each person
Probability
Neither Shahrukh
nor salman
0 0 0.8*0.8=0.64
Only Shahrukh 2500 1250 0.2*0.8=0.16
Only salman 2500 1250 0.2*0.8=0.16
Both of them 5000 2500 0.2*0.2=0.04
?Expected cost =
0.64*0+0.32*1250+0.04*2500 = 500
?Standard Deviation =
Root of 0.64*(0-500)
2
+ 0.32*(1250-500)
2
+
(2500-500)
2
= 707
?Pooling arrangement doesn?t change
either person?s expected cost but it
reduces the standard deviation. (1000 to
707)
?This is how risk gets reduced by
diversification. Loss has become more
predictable.
Many-people pooling
? Assume that now Amir khan who has the same
probability of risk also joins the pooling arrangement.
If anyone meets with an accident, each will share
one-thirds of the average loss or expected loss.
? As more and more people join the pool, the mean
loss remains the same but standard deviation comes
down hereby reducing the risk for each participant.
? Expected loss or mean remains the same but the
standard deviation further decreases making the
normal distribution less skewed and more bell shaped.
? Note that here the risk is not transferred to anyone
else, but it is reduced as a whole for each pool
participant.
Fig 4.2 page 59
? Graph with pooling
? Graph without pooling
summary
? As the number of participants in a pooling
arrangement goes up, the standard deviation starts
coming down as near to zero as possible for each
participant. Probability of extreme high or low
outcome is reduced. This leads to the law of large
numbers.
? Law of large numbers states that ?The greater the
number of exposures, the more closely will actual
results approach the probable result that are
expected from an infinite number of exposures eg:
tossing a coin a million times)
? Also, as the number increases the probability
distribution curve of average loss tends to become
more and more bell shaped tending towards a
Normal distribution. This reflects central limit theorem.
Solve
?Suppose each participant in a pooling
arrangement has USD 0 to 4000 losses,
with each participants expected loss is
usd 1000, sketch the probability
distribution of average losses if the losses
across the participants are independent
and if
?1. there is 1 participant (no pooling)
?2. there are 100 participants
?3. there are 1000 participants.
Pooling with correlated losses
Positive correlation because of:
? Catastrophe and epidemic hit a large population at
the same time
? When losses are correlated then increase/decrease in
one leads to increase/decrease in another.
? Therefore, Pooling arrangement reduces risk for each
participant even when the losses are positively
correlated but to a lesser degree.
? Assuming Shah Ruk and Salman?s accidents are
correlated, then probability of shah Ruk having an
accident knowing that Salman has had an accident is
> 0.04
Changing scope of financial
management
Changing scope of risk
management
? Traditionally risk management focused on pure
loss exposures including property risks, liability
risks and personal risks.
? In 1990s new trend emerged where risk
management included speculative financial
risks.
? Recently some businesses have expanded their
scope to include all risks.
Financial risk management
? Financial risk management refers to
identification, analysis and treatment of
speculative financial risks which includes
- commodity price risk
- interest rate risk
- currency exchange rate risk
? Commodity price risk: it is the risk of losing
money if the price of a commodity changes.
Both producers/sellers and users have this risk.
Eg: agri grains
Futures&options can be used to hedge this risk.
Financial risk management
? Interest rate risk:
Risk of loss caused by averse interest rate
movements. Eg: a bank has loaned housing
loan for 20-30 years at a particular interest rate.
If rates go up, they have to borrow deposits at a
higher rate. Similarly a corporate may have
issued bond o public at a rate, they have to still
pay the coupon rate
? Currency exchange rate:
Exchange rate is the value at which one
country?s currency is converted to another
Nation?s currency. This affects both imports and
exports.
History of Managing financial risks
? Traditionally pure risk and speculative risks are
different and handled by separate departments.
? Pure risk by risk retention, risk transfer and loss
control.
? Speculative risk handled by finance division
through contractual provisions and capital market
instruments.
- contractual provisions include call features in
bonds and adjustable interest rate provisions in
mortgages
- capital market approaches include forwards,
futures options and swaps.
History
? In the 1990s some companies started taking a holistic
view of pure and speculative risk to achieve cost
advantage by combining both the risk coverages.
? In 1997, Honeywell became the first company to enter
into an ?integrated risk program? with AIG.
? An integrated risk program is a risk treatment technique
that combines coverage for pure and speculative risks
in the same contract. Honeywell covered traditional
property and casualty insurance as well as coverage
for currency exchange rate risk.
? Some companies created a new position called chief
risk officer(CRO) who is responsible for treatment of
pure and speculative risks in the organization.
FirstRanker.com - FirstRanker's Choice
Risk
measurement
MODULE 3
Frequency and severity of
losses.
? Frequency of loss refers to number of times in a given period the
loss is likely to happen.
? Historical data will provide this info. (Eg: frequency of injury = no
of injuries in the past/no of worker-years) in the absence of
historical data, industry data can be used. Informed judgement
can be used as well.
? Severity of loss measures the magnitude of loss per occurrence.
One way to estimate is from historical data. (average
severity/occurrence)
? Expected loss = frequency of loss*severity of loss. Expected loss
affects business value and insurance pricing.
3.6
Note:
?Std deviation for high frequency
low severity is low while std
deviation for low frequency high
severity is high
?Infrequent but potentially large
losses are less predictable and
pose greater risk than more
frequent smaller losses.
Risk control
? Risk control is the process of implementing
measures to reduce risk associated with a hazard.
? Benefits of risk/loss control:
Elimination of expenses associated with
- Repair or replacement of damaged property
- Income losses due to distruction of property
- Extra costs associated with maintaining operations
- Adverse liability judgements
- Medical costs to treat injuries
- Income losses due to death/disabilities
Cost of risk control
? Installation and maintainance expenses eg
sprinkler system
? There are associated costs involved like employee
benefits apart from salary
? Some measures push up utility bills eg power bill
Risk control techniques
1
?Risk avoidance
2
?Risk prevention
3
?Risk reduction
Risk avoidance
? Risk avoidance involves not performing an activity that could carry
risk. Eg: not buying a property, not flying, not travelling. This leas to
loss of opportunities arising out of performing such activities. Not
doing a business will avoid risk but one loses on opportunity to earn
profits.
? Advantages:
? Chances of risk is reduced to zero in case where loss exposure has
not started. In situations where exposure has already started it is
reduce to zero for future activities. Residual risks may still persist
? Disadvantages:
? A firm cannot avoid all losses like premature death of an executive
? It is not feasible/practical to avoid all losses without shutting the
business eg car factory cannot avoid all risks if it has to continue
producing cars
Risk control techniques-
Risk prevention
? It refers to measures that reduce the frequency
of a particular loss. This focusses on stopping
losses from happening. Important to prevent
death/injury to people.
? Businesses employ loss control engineers to
identify sources of risks and institute corrective
actions. Like poor lighting, poor maintenance,
improper security, etc. training is given on safety
aspects
? Eg: changing slippery floor, building safety
enclosures to dangerous machinery etc
Risk control techniques-
Risk reduction
Risk financing techniques-
risk retention.
Risk financing techniques-
risk transfers.
Risk management decision
methods
? Risk avoidance
? Loss control
? Risk retension
? Non-insurance transfers
? insurance
Pooling arrangements and
diversification of risk
? Most popular risk management tool is diversification. Essential
part of insurance/financial markets
? Simple methods like pooling between two to diversification
amongst many
? Pooling arrangement reduces risk when losses are independent
(uncorrelated)
? Pooling refers to spreading losses incurred by a few over the
entire group so that everyone bears average loss instead of
actual loss.
2-person pooling arrangement
?Shahrukh and Salman have a possibility
of an accident in the coming year, say.
?20% chance of an accident with a loss of
2500
?Probability distribution of accident losses
is highly skewed. (0 ? 0.8; 2500 ? 0.2)
?Their losses are uncorrelated.
?What is the expected loss and standard
deviation for each one of them?
?Expected loss = 0.8*0 + 0.2*2500
= 500
?Standard deviation
= Root 0.8(0-500)
2
+ 0.2(2500-
500)
2
= 1000
Pooling arrangement?
?Pooling allows them to pool
their risk and split losses equally.
?What is the expected loss and
standard deviation for each
one of them?
Pooling arrangement..
Possible
outcome
Total cost Cost paid by
each person
Probability
Neither Shahrukh
nor salman
0 0 0.8*0.8=0.64
Only Shahrukh 2500 1250 0.2*0.8=0.16
Only salman 2500 1250 0.2*0.8=0.16
Both of them 5000 2500 0.2*0.2=0.04
?Expected cost =
0.64*0+0.32*1250+0.04*2500 = 500
?Standard Deviation =
Root of 0.64*(0-500)
2
+ 0.32*(1250-500)
2
+
(2500-500)
2
= 707
?Pooling arrangement doesn?t change
either person?s expected cost but it
reduces the standard deviation. (1000 to
707)
?This is how risk gets reduced by
diversification. Loss has become more
predictable.
Many-people pooling
? Assume that now Amir khan who has the same
probability of risk also joins the pooling arrangement.
If anyone meets with an accident, each will share
one-thirds of the average loss or expected loss.
? As more and more people join the pool, the mean
loss remains the same but standard deviation comes
down hereby reducing the risk for each participant.
? Expected loss or mean remains the same but the
standard deviation further decreases making the
normal distribution less skewed and more bell shaped.
? Note that here the risk is not transferred to anyone
else, but it is reduced as a whole for each pool
participant.
Fig 4.2 page 59
? Graph with pooling
? Graph without pooling
summary
? As the number of participants in a pooling
arrangement goes up, the standard deviation starts
coming down as near to zero as possible for each
participant. Probability of extreme high or low
outcome is reduced. This leads to the law of large
numbers.
? Law of large numbers states that ?The greater the
number of exposures, the more closely will actual
results approach the probable result that are
expected from an infinite number of exposures eg:
tossing a coin a million times)
? Also, as the number increases the probability
distribution curve of average loss tends to become
more and more bell shaped tending towards a
Normal distribution. This reflects central limit theorem.
Solve
?Suppose each participant in a pooling
arrangement has USD 0 to 4000 losses,
with each participants expected loss is
usd 1000, sketch the probability
distribution of average losses if the losses
across the participants are independent
and if
?1. there is 1 participant (no pooling)
?2. there are 100 participants
?3. there are 1000 participants.
Pooling with correlated losses
Positive correlation because of:
? Catastrophe and epidemic hit a large population at
the same time
? When losses are correlated then increase/decrease in
one leads to increase/decrease in another.
? Therefore, Pooling arrangement reduces risk for each
participant even when the losses are positively
correlated but to a lesser degree.
? Assuming Shah Ruk and Salman?s accidents are
correlated, then probability of shah Ruk having an
accident knowing that Salman has had an accident is
> 0.04
Changing scope of financial
management
Changing scope of risk
management
? Traditionally risk management focused on pure
loss exposures including property risks, liability
risks and personal risks.
? In 1990s new trend emerged where risk
management included speculative financial
risks.
? Recently some businesses have expanded their
scope to include all risks.
Financial risk management
? Financial risk management refers to
identification, analysis and treatment of
speculative financial risks which includes
- commodity price risk
- interest rate risk
- currency exchange rate risk
? Commodity price risk: it is the risk of losing
money if the price of a commodity changes.
Both producers/sellers and users have this risk.
Eg: agri grains
Futures&options can be used to hedge this risk.
Financial risk management
? Interest rate risk:
Risk of loss caused by averse interest rate
movements. Eg: a bank has loaned housing
loan for 20-30 years at a particular interest rate.
If rates go up, they have to borrow deposits at a
higher rate. Similarly a corporate may have
issued bond o public at a rate, they have to still
pay the coupon rate
? Currency exchange rate:
Exchange rate is the value at which one
country?s currency is converted to another
Nation?s currency. This affects both imports and
exports.
History of Managing financial risks
? Traditionally pure risk and speculative risks are
different and handled by separate departments.
? Pure risk by risk retention, risk transfer and loss
control.
? Speculative risk handled by finance division
through contractual provisions and capital market
instruments.
- contractual provisions include call features in
bonds and adjustable interest rate provisions in
mortgages
- capital market approaches include forwards,
futures options and swaps.
History
? In the 1990s some companies started taking a holistic
view of pure and speculative risk to achieve cost
advantage by combining both the risk coverages.
? In 1997, Honeywell became the first company to enter
into an ?integrated risk program? with AIG.
? An integrated risk program is a risk treatment technique
that combines coverage for pure and speculative risks
in the same contract. Honeywell covered traditional
property and casualty insurance as well as coverage
for currency exchange rate risk.
? Some companies created a new position called chief
risk officer(CRO) who is responsible for treatment of
pure and speculative risks in the organization.
History
? Combining two risks in the same contract makes it cheaper.
Companies who can afford a certain level of loss can go for a double
trigger option where the insurance company pays only if two
specified losses occur like one property claim and another exchange
rate claim. Such contracts are cheaper.
Enterprise risk management
? some companies went a step further and covered pyre risk,
speculative risk, strategic risks and operational risks.
? Strategic risk refers to uncertainty regarding the organization goals
and objectives and the organization?s strengths, weaknesses,
opportunities and threats.
? Operational risk refers to risks that develop out of business operations
like manufacturing products and providing service to customers.
? Combining all these risks in one package reduces risk as long as they
are not positively correlated. If they are negatively correlated risk can
be reduced significantly.
FirstRanker.com - FirstRanker's Choice
Risk
measurement
MODULE 3
Frequency and severity of
losses.
? Frequency of loss refers to number of times in a given period the
loss is likely to happen.
? Historical data will provide this info. (Eg: frequency of injury = no
of injuries in the past/no of worker-years) in the absence of
historical data, industry data can be used. Informed judgement
can be used as well.
? Severity of loss measures the magnitude of loss per occurrence.
One way to estimate is from historical data. (average
severity/occurrence)
? Expected loss = frequency of loss*severity of loss. Expected loss
affects business value and insurance pricing.
3.6
Note:
?Std deviation for high frequency
low severity is low while std
deviation for low frequency high
severity is high
?Infrequent but potentially large
losses are less predictable and
pose greater risk than more
frequent smaller losses.
Risk control
? Risk control is the process of implementing
measures to reduce risk associated with a hazard.
? Benefits of risk/loss control:
Elimination of expenses associated with
- Repair or replacement of damaged property
- Income losses due to distruction of property
- Extra costs associated with maintaining operations
- Adverse liability judgements
- Medical costs to treat injuries
- Income losses due to death/disabilities
Cost of risk control
? Installation and maintainance expenses eg
sprinkler system
? There are associated costs involved like employee
benefits apart from salary
? Some measures push up utility bills eg power bill
Risk control techniques
1
?Risk avoidance
2
?Risk prevention
3
?Risk reduction
Risk avoidance
? Risk avoidance involves not performing an activity that could carry
risk. Eg: not buying a property, not flying, not travelling. This leas to
loss of opportunities arising out of performing such activities. Not
doing a business will avoid risk but one loses on opportunity to earn
profits.
? Advantages:
? Chances of risk is reduced to zero in case where loss exposure has
not started. In situations where exposure has already started it is
reduce to zero for future activities. Residual risks may still persist
? Disadvantages:
? A firm cannot avoid all losses like premature death of an executive
? It is not feasible/practical to avoid all losses without shutting the
business eg car factory cannot avoid all risks if it has to continue
producing cars
Risk control techniques-
Risk prevention
? It refers to measures that reduce the frequency
of a particular loss. This focusses on stopping
losses from happening. Important to prevent
death/injury to people.
? Businesses employ loss control engineers to
identify sources of risks and institute corrective
actions. Like poor lighting, poor maintenance,
improper security, etc. training is given on safety
aspects
? Eg: changing slippery floor, building safety
enclosures to dangerous machinery etc
Risk control techniques-
Risk reduction
Risk financing techniques-
risk retention.
Risk financing techniques-
risk transfers.
Risk management decision
methods
? Risk avoidance
? Loss control
? Risk retension
? Non-insurance transfers
? insurance
Pooling arrangements and
diversification of risk
? Most popular risk management tool is diversification. Essential
part of insurance/financial markets
? Simple methods like pooling between two to diversification
amongst many
? Pooling arrangement reduces risk when losses are independent
(uncorrelated)
? Pooling refers to spreading losses incurred by a few over the
entire group so that everyone bears average loss instead of
actual loss.
2-person pooling arrangement
?Shahrukh and Salman have a possibility
of an accident in the coming year, say.
?20% chance of an accident with a loss of
2500
?Probability distribution of accident losses
is highly skewed. (0 ? 0.8; 2500 ? 0.2)
?Their losses are uncorrelated.
?What is the expected loss and standard
deviation for each one of them?
?Expected loss = 0.8*0 + 0.2*2500
= 500
?Standard deviation
= Root 0.8(0-500)
2
+ 0.2(2500-
500)
2
= 1000
Pooling arrangement?
?Pooling allows them to pool
their risk and split losses equally.
?What is the expected loss and
standard deviation for each
one of them?
Pooling arrangement..
Possible
outcome
Total cost Cost paid by
each person
Probability
Neither Shahrukh
nor salman
0 0 0.8*0.8=0.64
Only Shahrukh 2500 1250 0.2*0.8=0.16
Only salman 2500 1250 0.2*0.8=0.16
Both of them 5000 2500 0.2*0.2=0.04
?Expected cost =
0.64*0+0.32*1250+0.04*2500 = 500
?Standard Deviation =
Root of 0.64*(0-500)
2
+ 0.32*(1250-500)
2
+
(2500-500)
2
= 707
?Pooling arrangement doesn?t change
either person?s expected cost but it
reduces the standard deviation. (1000 to
707)
?This is how risk gets reduced by
diversification. Loss has become more
predictable.
Many-people pooling
? Assume that now Amir khan who has the same
probability of risk also joins the pooling arrangement.
If anyone meets with an accident, each will share
one-thirds of the average loss or expected loss.
? As more and more people join the pool, the mean
loss remains the same but standard deviation comes
down hereby reducing the risk for each participant.
? Expected loss or mean remains the same but the
standard deviation further decreases making the
normal distribution less skewed and more bell shaped.
? Note that here the risk is not transferred to anyone
else, but it is reduced as a whole for each pool
participant.
Fig 4.2 page 59
? Graph with pooling
? Graph without pooling
summary
? As the number of participants in a pooling
arrangement goes up, the standard deviation starts
coming down as near to zero as possible for each
participant. Probability of extreme high or low
outcome is reduced. This leads to the law of large
numbers.
? Law of large numbers states that ?The greater the
number of exposures, the more closely will actual
results approach the probable result that are
expected from an infinite number of exposures eg:
tossing a coin a million times)
? Also, as the number increases the probability
distribution curve of average loss tends to become
more and more bell shaped tending towards a
Normal distribution. This reflects central limit theorem.
Solve
?Suppose each participant in a pooling
arrangement has USD 0 to 4000 losses,
with each participants expected loss is
usd 1000, sketch the probability
distribution of average losses if the losses
across the participants are independent
and if
?1. there is 1 participant (no pooling)
?2. there are 100 participants
?3. there are 1000 participants.
Pooling with correlated losses
Positive correlation because of:
? Catastrophe and epidemic hit a large population at
the same time
? When losses are correlated then increase/decrease in
one leads to increase/decrease in another.
? Therefore, Pooling arrangement reduces risk for each
participant even when the losses are positively
correlated but to a lesser degree.
? Assuming Shah Ruk and Salman?s accidents are
correlated, then probability of shah Ruk having an
accident knowing that Salman has had an accident is
> 0.04
Changing scope of financial
management
Changing scope of risk
management
? Traditionally risk management focused on pure
loss exposures including property risks, liability
risks and personal risks.
? In 1990s new trend emerged where risk
management included speculative financial
risks.
? Recently some businesses have expanded their
scope to include all risks.
Financial risk management
? Financial risk management refers to
identification, analysis and treatment of
speculative financial risks which includes
- commodity price risk
- interest rate risk
- currency exchange rate risk
? Commodity price risk: it is the risk of losing
money if the price of a commodity changes.
Both producers/sellers and users have this risk.
Eg: agri grains
Futures&options can be used to hedge this risk.
Financial risk management
? Interest rate risk:
Risk of loss caused by averse interest rate
movements. Eg: a bank has loaned housing
loan for 20-30 years at a particular interest rate.
If rates go up, they have to borrow deposits at a
higher rate. Similarly a corporate may have
issued bond o public at a rate, they have to still
pay the coupon rate
? Currency exchange rate:
Exchange rate is the value at which one
country?s currency is converted to another
Nation?s currency. This affects both imports and
exports.
History of Managing financial risks
? Traditionally pure risk and speculative risks are
different and handled by separate departments.
? Pure risk by risk retention, risk transfer and loss
control.
? Speculative risk handled by finance division
through contractual provisions and capital market
instruments.
- contractual provisions include call features in
bonds and adjustable interest rate provisions in
mortgages
- capital market approaches include forwards,
futures options and swaps.
History
? In the 1990s some companies started taking a holistic
view of pure and speculative risk to achieve cost
advantage by combining both the risk coverages.
? In 1997, Honeywell became the first company to enter
into an ?integrated risk program? with AIG.
? An integrated risk program is a risk treatment technique
that combines coverage for pure and speculative risks
in the same contract. Honeywell covered traditional
property and casualty insurance as well as coverage
for currency exchange rate risk.
? Some companies created a new position called chief
risk officer(CRO) who is responsible for treatment of
pure and speculative risks in the organization.
History
? Combining two risks in the same contract makes it cheaper.
Companies who can afford a certain level of loss can go for a double
trigger option where the insurance company pays only if two
specified losses occur like one property claim and another exchange
rate claim. Such contracts are cheaper.
Enterprise risk management
? some companies went a step further and covered pyre risk,
speculative risk, strategic risks and operational risks.
? Strategic risk refers to uncertainty regarding the organization goals
and objectives and the organization?s strengths, weaknesses,
opportunities and threats.
? Operational risk refers to risks that develop out of business operations
like manufacturing products and providing service to customers.
? Combining all these risks in one package reduces risk as long as they
are not positively correlated. If they are negatively correlated risk can
be reduced significantly.
History
Advantages of ERM:
? Holistic treatment of risks
? Advantages over competing businesses.
? Positive impact upon revenues
? Reduction in earnings volatility
? Compliance with corporate governance guidelines
Barriers to ERP:
? Organisation culture
? Turf battles
? Perception of not a priority
? Lack of formal process
? Deficiencies in intellectual capital and technology
FirstRanker.com - FirstRanker's Choice
Risk
measurement
MODULE 3
Frequency and severity of
losses.
? Frequency of loss refers to number of times in a given period the
loss is likely to happen.
? Historical data will provide this info. (Eg: frequency of injury = no
of injuries in the past/no of worker-years) in the absence of
historical data, industry data can be used. Informed judgement
can be used as well.
? Severity of loss measures the magnitude of loss per occurrence.
One way to estimate is from historical data. (average
severity/occurrence)
? Expected loss = frequency of loss*severity of loss. Expected loss
affects business value and insurance pricing.
3.6
Note:
?Std deviation for high frequency
low severity is low while std
deviation for low frequency high
severity is high
?Infrequent but potentially large
losses are less predictable and
pose greater risk than more
frequent smaller losses.
Risk control
? Risk control is the process of implementing
measures to reduce risk associated with a hazard.
? Benefits of risk/loss control:
Elimination of expenses associated with
- Repair or replacement of damaged property
- Income losses due to distruction of property
- Extra costs associated with maintaining operations
- Adverse liability judgements
- Medical costs to treat injuries
- Income losses due to death/disabilities
Cost of risk control
? Installation and maintainance expenses eg
sprinkler system
? There are associated costs involved like employee
benefits apart from salary
? Some measures push up utility bills eg power bill
Risk control techniques
1
?Risk avoidance
2
?Risk prevention
3
?Risk reduction
Risk avoidance
? Risk avoidance involves not performing an activity that could carry
risk. Eg: not buying a property, not flying, not travelling. This leas to
loss of opportunities arising out of performing such activities. Not
doing a business will avoid risk but one loses on opportunity to earn
profits.
? Advantages:
? Chances of risk is reduced to zero in case where loss exposure has
not started. In situations where exposure has already started it is
reduce to zero for future activities. Residual risks may still persist
? Disadvantages:
? A firm cannot avoid all losses like premature death of an executive
? It is not feasible/practical to avoid all losses without shutting the
business eg car factory cannot avoid all risks if it has to continue
producing cars
Risk control techniques-
Risk prevention
? It refers to measures that reduce the frequency
of a particular loss. This focusses on stopping
losses from happening. Important to prevent
death/injury to people.
? Businesses employ loss control engineers to
identify sources of risks and institute corrective
actions. Like poor lighting, poor maintenance,
improper security, etc. training is given on safety
aspects
? Eg: changing slippery floor, building safety
enclosures to dangerous machinery etc
Risk control techniques-
Risk reduction
Risk financing techniques-
risk retention.
Risk financing techniques-
risk transfers.
Risk management decision
methods
? Risk avoidance
? Loss control
? Risk retension
? Non-insurance transfers
? insurance
Pooling arrangements and
diversification of risk
? Most popular risk management tool is diversification. Essential
part of insurance/financial markets
? Simple methods like pooling between two to diversification
amongst many
? Pooling arrangement reduces risk when losses are independent
(uncorrelated)
? Pooling refers to spreading losses incurred by a few over the
entire group so that everyone bears average loss instead of
actual loss.
2-person pooling arrangement
?Shahrukh and Salman have a possibility
of an accident in the coming year, say.
?20% chance of an accident with a loss of
2500
?Probability distribution of accident losses
is highly skewed. (0 ? 0.8; 2500 ? 0.2)
?Their losses are uncorrelated.
?What is the expected loss and standard
deviation for each one of them?
?Expected loss = 0.8*0 + 0.2*2500
= 500
?Standard deviation
= Root 0.8(0-500)
2
+ 0.2(2500-
500)
2
= 1000
Pooling arrangement?
?Pooling allows them to pool
their risk and split losses equally.
?What is the expected loss and
standard deviation for each
one of them?
Pooling arrangement..
Possible
outcome
Total cost Cost paid by
each person
Probability
Neither Shahrukh
nor salman
0 0 0.8*0.8=0.64
Only Shahrukh 2500 1250 0.2*0.8=0.16
Only salman 2500 1250 0.2*0.8=0.16
Both of them 5000 2500 0.2*0.2=0.04
?Expected cost =
0.64*0+0.32*1250+0.04*2500 = 500
?Standard Deviation =
Root of 0.64*(0-500)
2
+ 0.32*(1250-500)
2
+
(2500-500)
2
= 707
?Pooling arrangement doesn?t change
either person?s expected cost but it
reduces the standard deviation. (1000 to
707)
?This is how risk gets reduced by
diversification. Loss has become more
predictable.
Many-people pooling
? Assume that now Amir khan who has the same
probability of risk also joins the pooling arrangement.
If anyone meets with an accident, each will share
one-thirds of the average loss or expected loss.
? As more and more people join the pool, the mean
loss remains the same but standard deviation comes
down hereby reducing the risk for each participant.
? Expected loss or mean remains the same but the
standard deviation further decreases making the
normal distribution less skewed and more bell shaped.
? Note that here the risk is not transferred to anyone
else, but it is reduced as a whole for each pool
participant.
Fig 4.2 page 59
? Graph with pooling
? Graph without pooling
summary
? As the number of participants in a pooling
arrangement goes up, the standard deviation starts
coming down as near to zero as possible for each
participant. Probability of extreme high or low
outcome is reduced. This leads to the law of large
numbers.
? Law of large numbers states that ?The greater the
number of exposures, the more closely will actual
results approach the probable result that are
expected from an infinite number of exposures eg:
tossing a coin a million times)
? Also, as the number increases the probability
distribution curve of average loss tends to become
more and more bell shaped tending towards a
Normal distribution. This reflects central limit theorem.
Solve
?Suppose each participant in a pooling
arrangement has USD 0 to 4000 losses,
with each participants expected loss is
usd 1000, sketch the probability
distribution of average losses if the losses
across the participants are independent
and if
?1. there is 1 participant (no pooling)
?2. there are 100 participants
?3. there are 1000 participants.
Pooling with correlated losses
Positive correlation because of:
? Catastrophe and epidemic hit a large population at
the same time
? When losses are correlated then increase/decrease in
one leads to increase/decrease in another.
? Therefore, Pooling arrangement reduces risk for each
participant even when the losses are positively
correlated but to a lesser degree.
? Assuming Shah Ruk and Salman?s accidents are
correlated, then probability of shah Ruk having an
accident knowing that Salman has had an accident is
> 0.04
Changing scope of financial
management
Changing scope of risk
management
? Traditionally risk management focused on pure
loss exposures including property risks, liability
risks and personal risks.
? In 1990s new trend emerged where risk
management included speculative financial
risks.
? Recently some businesses have expanded their
scope to include all risks.
Financial risk management
? Financial risk management refers to
identification, analysis and treatment of
speculative financial risks which includes
- commodity price risk
- interest rate risk
- currency exchange rate risk
? Commodity price risk: it is the risk of losing
money if the price of a commodity changes.
Both producers/sellers and users have this risk.
Eg: agri grains
Futures&options can be used to hedge this risk.
Financial risk management
? Interest rate risk:
Risk of loss caused by averse interest rate
movements. Eg: a bank has loaned housing
loan for 20-30 years at a particular interest rate.
If rates go up, they have to borrow deposits at a
higher rate. Similarly a corporate may have
issued bond o public at a rate, they have to still
pay the coupon rate
? Currency exchange rate:
Exchange rate is the value at which one
country?s currency is converted to another
Nation?s currency. This affects both imports and
exports.
History of Managing financial risks
? Traditionally pure risk and speculative risks are
different and handled by separate departments.
? Pure risk by risk retention, risk transfer and loss
control.
? Speculative risk handled by finance division
through contractual provisions and capital market
instruments.
- contractual provisions include call features in
bonds and adjustable interest rate provisions in
mortgages
- capital market approaches include forwards,
futures options and swaps.
History
? In the 1990s some companies started taking a holistic
view of pure and speculative risk to achieve cost
advantage by combining both the risk coverages.
? In 1997, Honeywell became the first company to enter
into an ?integrated risk program? with AIG.
? An integrated risk program is a risk treatment technique
that combines coverage for pure and speculative risks
in the same contract. Honeywell covered traditional
property and casualty insurance as well as coverage
for currency exchange rate risk.
? Some companies created a new position called chief
risk officer(CRO) who is responsible for treatment of
pure and speculative risks in the organization.
History
? Combining two risks in the same contract makes it cheaper.
Companies who can afford a certain level of loss can go for a double
trigger option where the insurance company pays only if two
specified losses occur like one property claim and another exchange
rate claim. Such contracts are cheaper.
Enterprise risk management
? some companies went a step further and covered pyre risk,
speculative risk, strategic risks and operational risks.
? Strategic risk refers to uncertainty regarding the organization goals
and objectives and the organization?s strengths, weaknesses,
opportunities and threats.
? Operational risk refers to risks that develop out of business operations
like manufacturing products and providing service to customers.
? Combining all these risks in one package reduces risk as long as they
are not positively correlated. If they are negatively correlated risk can
be reduced significantly.
History
Advantages of ERM:
? Holistic treatment of risks
? Advantages over competing businesses.
? Positive impact upon revenues
? Reduction in earnings volatility
? Compliance with corporate governance guidelines
Barriers to ERP:
? Organisation culture
? Turf battles
? Perception of not a priority
? Lack of formal process
? Deficiencies in intellectual capital and technology
Futures and option basics
? Spot market: delivery based
? Example- buy wheat at 30,000/ton, sell sugar at 45000/ton
Derivative contracts
? Futures market: right to buy/sell, usually no delivery, squaring up
position.
? Eg: as a buyer buy wheat futures for june at Rs 25,000/ton. In june
market price is 30,000. you square up position by selling spot. You
make Rs 5000. buy physical wheat at Rs 30,000 from spot market.
Effective price is Rs 25000 which is futures contracted price.
? As a seller, sell wheat at Rs 40,000 in the june futures market. June
price crashes to Rs 20,000. you square up your position by buying
spot. You make Rs 20,000. sell physical wheat at Rs 20,000 in the
spot market. Effective price is Rs 40,000
FirstRanker.com - FirstRanker's Choice
Risk
measurement
MODULE 3
Frequency and severity of
losses.
? Frequency of loss refers to number of times in a given period the
loss is likely to happen.
? Historical data will provide this info. (Eg: frequency of injury = no
of injuries in the past/no of worker-years) in the absence of
historical data, industry data can be used. Informed judgement
can be used as well.
? Severity of loss measures the magnitude of loss per occurrence.
One way to estimate is from historical data. (average
severity/occurrence)
? Expected loss = frequency of loss*severity of loss. Expected loss
affects business value and insurance pricing.
3.6
Note:
?Std deviation for high frequency
low severity is low while std
deviation for low frequency high
severity is high
?Infrequent but potentially large
losses are less predictable and
pose greater risk than more
frequent smaller losses.
Risk control
? Risk control is the process of implementing
measures to reduce risk associated with a hazard.
? Benefits of risk/loss control:
Elimination of expenses associated with
- Repair or replacement of damaged property
- Income losses due to distruction of property
- Extra costs associated with maintaining operations
- Adverse liability judgements
- Medical costs to treat injuries
- Income losses due to death/disabilities
Cost of risk control
? Installation and maintainance expenses eg
sprinkler system
? There are associated costs involved like employee
benefits apart from salary
? Some measures push up utility bills eg power bill
Risk control techniques
1
?Risk avoidance
2
?Risk prevention
3
?Risk reduction
Risk avoidance
? Risk avoidance involves not performing an activity that could carry
risk. Eg: not buying a property, not flying, not travelling. This leas to
loss of opportunities arising out of performing such activities. Not
doing a business will avoid risk but one loses on opportunity to earn
profits.
? Advantages:
? Chances of risk is reduced to zero in case where loss exposure has
not started. In situations where exposure has already started it is
reduce to zero for future activities. Residual risks may still persist
? Disadvantages:
? A firm cannot avoid all losses like premature death of an executive
? It is not feasible/practical to avoid all losses without shutting the
business eg car factory cannot avoid all risks if it has to continue
producing cars
Risk control techniques-
Risk prevention
? It refers to measures that reduce the frequency
of a particular loss. This focusses on stopping
losses from happening. Important to prevent
death/injury to people.
? Businesses employ loss control engineers to
identify sources of risks and institute corrective
actions. Like poor lighting, poor maintenance,
improper security, etc. training is given on safety
aspects
? Eg: changing slippery floor, building safety
enclosures to dangerous machinery etc
Risk control techniques-
Risk reduction
Risk financing techniques-
risk retention.
Risk financing techniques-
risk transfers.
Risk management decision
methods
? Risk avoidance
? Loss control
? Risk retension
? Non-insurance transfers
? insurance
Pooling arrangements and
diversification of risk
? Most popular risk management tool is diversification. Essential
part of insurance/financial markets
? Simple methods like pooling between two to diversification
amongst many
? Pooling arrangement reduces risk when losses are independent
(uncorrelated)
? Pooling refers to spreading losses incurred by a few over the
entire group so that everyone bears average loss instead of
actual loss.
2-person pooling arrangement
?Shahrukh and Salman have a possibility
of an accident in the coming year, say.
?20% chance of an accident with a loss of
2500
?Probability distribution of accident losses
is highly skewed. (0 ? 0.8; 2500 ? 0.2)
?Their losses are uncorrelated.
?What is the expected loss and standard
deviation for each one of them?
?Expected loss = 0.8*0 + 0.2*2500
= 500
?Standard deviation
= Root 0.8(0-500)
2
+ 0.2(2500-
500)
2
= 1000
Pooling arrangement?
?Pooling allows them to pool
their risk and split losses equally.
?What is the expected loss and
standard deviation for each
one of them?
Pooling arrangement..
Possible
outcome
Total cost Cost paid by
each person
Probability
Neither Shahrukh
nor salman
0 0 0.8*0.8=0.64
Only Shahrukh 2500 1250 0.2*0.8=0.16
Only salman 2500 1250 0.2*0.8=0.16
Both of them 5000 2500 0.2*0.2=0.04
?Expected cost =
0.64*0+0.32*1250+0.04*2500 = 500
?Standard Deviation =
Root of 0.64*(0-500)
2
+ 0.32*(1250-500)
2
+
(2500-500)
2
= 707
?Pooling arrangement doesn?t change
either person?s expected cost but it
reduces the standard deviation. (1000 to
707)
?This is how risk gets reduced by
diversification. Loss has become more
predictable.
Many-people pooling
? Assume that now Amir khan who has the same
probability of risk also joins the pooling arrangement.
If anyone meets with an accident, each will share
one-thirds of the average loss or expected loss.
? As more and more people join the pool, the mean
loss remains the same but standard deviation comes
down hereby reducing the risk for each participant.
? Expected loss or mean remains the same but the
standard deviation further decreases making the
normal distribution less skewed and more bell shaped.
? Note that here the risk is not transferred to anyone
else, but it is reduced as a whole for each pool
participant.
Fig 4.2 page 59
? Graph with pooling
? Graph without pooling
summary
? As the number of participants in a pooling
arrangement goes up, the standard deviation starts
coming down as near to zero as possible for each
participant. Probability of extreme high or low
outcome is reduced. This leads to the law of large
numbers.
? Law of large numbers states that ?The greater the
number of exposures, the more closely will actual
results approach the probable result that are
expected from an infinite number of exposures eg:
tossing a coin a million times)
? Also, as the number increases the probability
distribution curve of average loss tends to become
more and more bell shaped tending towards a
Normal distribution. This reflects central limit theorem.
Solve
?Suppose each participant in a pooling
arrangement has USD 0 to 4000 losses,
with each participants expected loss is
usd 1000, sketch the probability
distribution of average losses if the losses
across the participants are independent
and if
?1. there is 1 participant (no pooling)
?2. there are 100 participants
?3. there are 1000 participants.
Pooling with correlated losses
Positive correlation because of:
? Catastrophe and epidemic hit a large population at
the same time
? When losses are correlated then increase/decrease in
one leads to increase/decrease in another.
? Therefore, Pooling arrangement reduces risk for each
participant even when the losses are positively
correlated but to a lesser degree.
? Assuming Shah Ruk and Salman?s accidents are
correlated, then probability of shah Ruk having an
accident knowing that Salman has had an accident is
> 0.04
Changing scope of financial
management
Changing scope of risk
management
? Traditionally risk management focused on pure
loss exposures including property risks, liability
risks and personal risks.
? In 1990s new trend emerged where risk
management included speculative financial
risks.
? Recently some businesses have expanded their
scope to include all risks.
Financial risk management
? Financial risk management refers to
identification, analysis and treatment of
speculative financial risks which includes
- commodity price risk
- interest rate risk
- currency exchange rate risk
? Commodity price risk: it is the risk of losing
money if the price of a commodity changes.
Both producers/sellers and users have this risk.
Eg: agri grains
Futures&options can be used to hedge this risk.
Financial risk management
? Interest rate risk:
Risk of loss caused by averse interest rate
movements. Eg: a bank has loaned housing
loan for 20-30 years at a particular interest rate.
If rates go up, they have to borrow deposits at a
higher rate. Similarly a corporate may have
issued bond o public at a rate, they have to still
pay the coupon rate
? Currency exchange rate:
Exchange rate is the value at which one
country?s currency is converted to another
Nation?s currency. This affects both imports and
exports.
History of Managing financial risks
? Traditionally pure risk and speculative risks are
different and handled by separate departments.
? Pure risk by risk retention, risk transfer and loss
control.
? Speculative risk handled by finance division
through contractual provisions and capital market
instruments.
- contractual provisions include call features in
bonds and adjustable interest rate provisions in
mortgages
- capital market approaches include forwards,
futures options and swaps.
History
? In the 1990s some companies started taking a holistic
view of pure and speculative risk to achieve cost
advantage by combining both the risk coverages.
? In 1997, Honeywell became the first company to enter
into an ?integrated risk program? with AIG.
? An integrated risk program is a risk treatment technique
that combines coverage for pure and speculative risks
in the same contract. Honeywell covered traditional
property and casualty insurance as well as coverage
for currency exchange rate risk.
? Some companies created a new position called chief
risk officer(CRO) who is responsible for treatment of
pure and speculative risks in the organization.
History
? Combining two risks in the same contract makes it cheaper.
Companies who can afford a certain level of loss can go for a double
trigger option where the insurance company pays only if two
specified losses occur like one property claim and another exchange
rate claim. Such contracts are cheaper.
Enterprise risk management
? some companies went a step further and covered pyre risk,
speculative risk, strategic risks and operational risks.
? Strategic risk refers to uncertainty regarding the organization goals
and objectives and the organization?s strengths, weaknesses,
opportunities and threats.
? Operational risk refers to risks that develop out of business operations
like manufacturing products and providing service to customers.
? Combining all these risks in one package reduces risk as long as they
are not positively correlated. If they are negatively correlated risk can
be reduced significantly.
History
Advantages of ERM:
? Holistic treatment of risks
? Advantages over competing businesses.
? Positive impact upon revenues
? Reduction in earnings volatility
? Compliance with corporate governance guidelines
Barriers to ERP:
? Organisation culture
? Turf battles
? Perception of not a priority
? Lack of formal process
? Deficiencies in intellectual capital and technology
Futures and option basics
? Spot market: delivery based
? Example- buy wheat at 30,000/ton, sell sugar at 45000/ton
Derivative contracts
? Futures market: right to buy/sell, usually no delivery, squaring up
position.
? Eg: as a buyer buy wheat futures for june at Rs 25,000/ton. In june
market price is 30,000. you square up position by selling spot. You
make Rs 5000. buy physical wheat at Rs 30,000 from spot market.
Effective price is Rs 25000 which is futures contracted price.
? As a seller, sell wheat at Rs 40,000 in the june futures market. June
price crashes to Rs 20,000. you square up your position by buying
spot. You make Rs 20,000. sell physical wheat at Rs 20,000 in the
spot market. Effective price is Rs 40,000
Options contract
? Options contract can be used to protect against adverse price
movements.
? Call option ? option to buy at a specified price during a specified
period
? Put option ? option to sell at a specified price during a specified period.
? Both call and put have buyers/writers and sellers (4 legs)
? Many strategies like straddle, strangle, butterfly,...
? Simple option to protect a price drop is ?covered put option?
? Eg: someone has 100 HUL shares at current market price of Rs 900. he
fears a price drop but feels it may also increase.
? He buys a put option for a strike price of 900 paying a premium of Rs 5.
? If market drops to 800, then he exercise his ?in the money? option and
makes 900-800-5 = Rs 95
? If market moves up to 1000, then the option is out-of-money and he
wishes not to exercise the option and loses only Rs 5 of premium paid.
FirstRanker.com - FirstRanker's Choice
Risk
measurement
MODULE 3
Frequency and severity of
losses.
? Frequency of loss refers to number of times in a given period the
loss is likely to happen.
? Historical data will provide this info. (Eg: frequency of injury = no
of injuries in the past/no of worker-years) in the absence of
historical data, industry data can be used. Informed judgement
can be used as well.
? Severity of loss measures the magnitude of loss per occurrence.
One way to estimate is from historical data. (average
severity/occurrence)
? Expected loss = frequency of loss*severity of loss. Expected loss
affects business value and insurance pricing.
3.6
Note:
?Std deviation for high frequency
low severity is low while std
deviation for low frequency high
severity is high
?Infrequent but potentially large
losses are less predictable and
pose greater risk than more
frequent smaller losses.
Risk control
? Risk control is the process of implementing
measures to reduce risk associated with a hazard.
? Benefits of risk/loss control:
Elimination of expenses associated with
- Repair or replacement of damaged property
- Income losses due to distruction of property
- Extra costs associated with maintaining operations
- Adverse liability judgements
- Medical costs to treat injuries
- Income losses due to death/disabilities
Cost of risk control
? Installation and maintainance expenses eg
sprinkler system
? There are associated costs involved like employee
benefits apart from salary
? Some measures push up utility bills eg power bill
Risk control techniques
1
?Risk avoidance
2
?Risk prevention
3
?Risk reduction
Risk avoidance
? Risk avoidance involves not performing an activity that could carry
risk. Eg: not buying a property, not flying, not travelling. This leas to
loss of opportunities arising out of performing such activities. Not
doing a business will avoid risk but one loses on opportunity to earn
profits.
? Advantages:
? Chances of risk is reduced to zero in case where loss exposure has
not started. In situations where exposure has already started it is
reduce to zero for future activities. Residual risks may still persist
? Disadvantages:
? A firm cannot avoid all losses like premature death of an executive
? It is not feasible/practical to avoid all losses without shutting the
business eg car factory cannot avoid all risks if it has to continue
producing cars
Risk control techniques-
Risk prevention
? It refers to measures that reduce the frequency
of a particular loss. This focusses on stopping
losses from happening. Important to prevent
death/injury to people.
? Businesses employ loss control engineers to
identify sources of risks and institute corrective
actions. Like poor lighting, poor maintenance,
improper security, etc. training is given on safety
aspects
? Eg: changing slippery floor, building safety
enclosures to dangerous machinery etc
Risk control techniques-
Risk reduction
Risk financing techniques-
risk retention.
Risk financing techniques-
risk transfers.
Risk management decision
methods
? Risk avoidance
? Loss control
? Risk retension
? Non-insurance transfers
? insurance
Pooling arrangements and
diversification of risk
? Most popular risk management tool is diversification. Essential
part of insurance/financial markets
? Simple methods like pooling between two to diversification
amongst many
? Pooling arrangement reduces risk when losses are independent
(uncorrelated)
? Pooling refers to spreading losses incurred by a few over the
entire group so that everyone bears average loss instead of
actual loss.
2-person pooling arrangement
?Shahrukh and Salman have a possibility
of an accident in the coming year, say.
?20% chance of an accident with a loss of
2500
?Probability distribution of accident losses
is highly skewed. (0 ? 0.8; 2500 ? 0.2)
?Their losses are uncorrelated.
?What is the expected loss and standard
deviation for each one of them?
?Expected loss = 0.8*0 + 0.2*2500
= 500
?Standard deviation
= Root 0.8(0-500)
2
+ 0.2(2500-
500)
2
= 1000
Pooling arrangement?
?Pooling allows them to pool
their risk and split losses equally.
?What is the expected loss and
standard deviation for each
one of them?
Pooling arrangement..
Possible
outcome
Total cost Cost paid by
each person
Probability
Neither Shahrukh
nor salman
0 0 0.8*0.8=0.64
Only Shahrukh 2500 1250 0.2*0.8=0.16
Only salman 2500 1250 0.2*0.8=0.16
Both of them 5000 2500 0.2*0.2=0.04
?Expected cost =
0.64*0+0.32*1250+0.04*2500 = 500
?Standard Deviation =
Root of 0.64*(0-500)
2
+ 0.32*(1250-500)
2
+
(2500-500)
2
= 707
?Pooling arrangement doesn?t change
either person?s expected cost but it
reduces the standard deviation. (1000 to
707)
?This is how risk gets reduced by
diversification. Loss has become more
predictable.
Many-people pooling
? Assume that now Amir khan who has the same
probability of risk also joins the pooling arrangement.
If anyone meets with an accident, each will share
one-thirds of the average loss or expected loss.
? As more and more people join the pool, the mean
loss remains the same but standard deviation comes
down hereby reducing the risk for each participant.
? Expected loss or mean remains the same but the
standard deviation further decreases making the
normal distribution less skewed and more bell shaped.
? Note that here the risk is not transferred to anyone
else, but it is reduced as a whole for each pool
participant.
Fig 4.2 page 59
? Graph with pooling
? Graph without pooling
summary
? As the number of participants in a pooling
arrangement goes up, the standard deviation starts
coming down as near to zero as possible for each
participant. Probability of extreme high or low
outcome is reduced. This leads to the law of large
numbers.
? Law of large numbers states that ?The greater the
number of exposures, the more closely will actual
results approach the probable result that are
expected from an infinite number of exposures eg:
tossing a coin a million times)
? Also, as the number increases the probability
distribution curve of average loss tends to become
more and more bell shaped tending towards a
Normal distribution. This reflects central limit theorem.
Solve
?Suppose each participant in a pooling
arrangement has USD 0 to 4000 losses,
with each participants expected loss is
usd 1000, sketch the probability
distribution of average losses if the losses
across the participants are independent
and if
?1. there is 1 participant (no pooling)
?2. there are 100 participants
?3. there are 1000 participants.
Pooling with correlated losses
Positive correlation because of:
? Catastrophe and epidemic hit a large population at
the same time
? When losses are correlated then increase/decrease in
one leads to increase/decrease in another.
? Therefore, Pooling arrangement reduces risk for each
participant even when the losses are positively
correlated but to a lesser degree.
? Assuming Shah Ruk and Salman?s accidents are
correlated, then probability of shah Ruk having an
accident knowing that Salman has had an accident is
> 0.04
Changing scope of financial
management
Changing scope of risk
management
? Traditionally risk management focused on pure
loss exposures including property risks, liability
risks and personal risks.
? In 1990s new trend emerged where risk
management included speculative financial
risks.
? Recently some businesses have expanded their
scope to include all risks.
Financial risk management
? Financial risk management refers to
identification, analysis and treatment of
speculative financial risks which includes
- commodity price risk
- interest rate risk
- currency exchange rate risk
? Commodity price risk: it is the risk of losing
money if the price of a commodity changes.
Both producers/sellers and users have this risk.
Eg: agri grains
Futures&options can be used to hedge this risk.
Financial risk management
? Interest rate risk:
Risk of loss caused by averse interest rate
movements. Eg: a bank has loaned housing
loan for 20-30 years at a particular interest rate.
If rates go up, they have to borrow deposits at a
higher rate. Similarly a corporate may have
issued bond o public at a rate, they have to still
pay the coupon rate
? Currency exchange rate:
Exchange rate is the value at which one
country?s currency is converted to another
Nation?s currency. This affects both imports and
exports.
History of Managing financial risks
? Traditionally pure risk and speculative risks are
different and handled by separate departments.
? Pure risk by risk retention, risk transfer and loss
control.
? Speculative risk handled by finance division
through contractual provisions and capital market
instruments.
- contractual provisions include call features in
bonds and adjustable interest rate provisions in
mortgages
- capital market approaches include forwards,
futures options and swaps.
History
? In the 1990s some companies started taking a holistic
view of pure and speculative risk to achieve cost
advantage by combining both the risk coverages.
? In 1997, Honeywell became the first company to enter
into an ?integrated risk program? with AIG.
? An integrated risk program is a risk treatment technique
that combines coverage for pure and speculative risks
in the same contract. Honeywell covered traditional
property and casualty insurance as well as coverage
for currency exchange rate risk.
? Some companies created a new position called chief
risk officer(CRO) who is responsible for treatment of
pure and speculative risks in the organization.
History
? Combining two risks in the same contract makes it cheaper.
Companies who can afford a certain level of loss can go for a double
trigger option where the insurance company pays only if two
specified losses occur like one property claim and another exchange
rate claim. Such contracts are cheaper.
Enterprise risk management
? some companies went a step further and covered pyre risk,
speculative risk, strategic risks and operational risks.
? Strategic risk refers to uncertainty regarding the organization goals
and objectives and the organization?s strengths, weaknesses,
opportunities and threats.
? Operational risk refers to risks that develop out of business operations
like manufacturing products and providing service to customers.
? Combining all these risks in one package reduces risk as long as they
are not positively correlated. If they are negatively correlated risk can
be reduced significantly.
History
Advantages of ERM:
? Holistic treatment of risks
? Advantages over competing businesses.
? Positive impact upon revenues
? Reduction in earnings volatility
? Compliance with corporate governance guidelines
Barriers to ERP:
? Organisation culture
? Turf battles
? Perception of not a priority
? Lack of formal process
? Deficiencies in intellectual capital and technology
Futures and option basics
? Spot market: delivery based
? Example- buy wheat at 30,000/ton, sell sugar at 45000/ton
Derivative contracts
? Futures market: right to buy/sell, usually no delivery, squaring up
position.
? Eg: as a buyer buy wheat futures for june at Rs 25,000/ton. In june
market price is 30,000. you square up position by selling spot. You
make Rs 5000. buy physical wheat at Rs 30,000 from spot market.
Effective price is Rs 25000 which is futures contracted price.
? As a seller, sell wheat at Rs 40,000 in the june futures market. June
price crashes to Rs 20,000. you square up your position by buying
spot. You make Rs 20,000. sell physical wheat at Rs 20,000 in the
spot market. Effective price is Rs 40,000
Options contract
? Options contract can be used to protect against adverse price
movements.
? Call option ? option to buy at a specified price during a specified
period
? Put option ? option to sell at a specified price during a specified period.
? Both call and put have buyers/writers and sellers (4 legs)
? Many strategies like straddle, strangle, butterfly,...
? Simple option to protect a price drop is ?covered put option?
? Eg: someone has 100 HUL shares at current market price of Rs 900. he
fears a price drop but feels it may also increase.
? He buys a put option for a strike price of 900 paying a premium of Rs 5.
? If market drops to 800, then he exercise his ?in the money? option and
makes 900-800-5 = Rs 95
? If market moves up to 1000, then the option is out-of-money and he
wishes not to exercise the option and loses only Rs 5 of premium paid.
Hedging with Futures
Hedging a commodity risk using futures contract:
? A corn grower estimates in May about 20,000 bushels of corn by
December. He notices a price of $2.90/bushel of futures price in
December. He fears that the actual spot price in December will
be lower. So he books 4 contracts of size 4000 bushels each at
$2.90/bushel. He will buy back 4 contracts to offset his position.
? If market price is 2.5/bushel in December.
? Sale of 4 contracts at 2.90 in may ?. 4*5000*2.90 = 58000
? Buy-back at 2.50 in December ?. 4*5000*2.50 = 50000
? Gain on futures contract = 58000-50000 = 8000
? Sale of physical stock in December = 4*5000*2.50 = 50000
? Total revenue = 50,000+8000 = 58000
FirstRanker.com - FirstRanker's Choice
Risk
measurement
MODULE 3
Frequency and severity of
losses.
? Frequency of loss refers to number of times in a given period the
loss is likely to happen.
? Historical data will provide this info. (Eg: frequency of injury = no
of injuries in the past/no of worker-years) in the absence of
historical data, industry data can be used. Informed judgement
can be used as well.
? Severity of loss measures the magnitude of loss per occurrence.
One way to estimate is from historical data. (average
severity/occurrence)
? Expected loss = frequency of loss*severity of loss. Expected loss
affects business value and insurance pricing.
3.6
Note:
?Std deviation for high frequency
low severity is low while std
deviation for low frequency high
severity is high
?Infrequent but potentially large
losses are less predictable and
pose greater risk than more
frequent smaller losses.
Risk control
? Risk control is the process of implementing
measures to reduce risk associated with a hazard.
? Benefits of risk/loss control:
Elimination of expenses associated with
- Repair or replacement of damaged property
- Income losses due to distruction of property
- Extra costs associated with maintaining operations
- Adverse liability judgements
- Medical costs to treat injuries
- Income losses due to death/disabilities
Cost of risk control
? Installation and maintainance expenses eg
sprinkler system
? There are associated costs involved like employee
benefits apart from salary
? Some measures push up utility bills eg power bill
Risk control techniques
1
?Risk avoidance
2
?Risk prevention
3
?Risk reduction
Risk avoidance
? Risk avoidance involves not performing an activity that could carry
risk. Eg: not buying a property, not flying, not travelling. This leas to
loss of opportunities arising out of performing such activities. Not
doing a business will avoid risk but one loses on opportunity to earn
profits.
? Advantages:
? Chances of risk is reduced to zero in case where loss exposure has
not started. In situations where exposure has already started it is
reduce to zero for future activities. Residual risks may still persist
? Disadvantages:
? A firm cannot avoid all losses like premature death of an executive
? It is not feasible/practical to avoid all losses without shutting the
business eg car factory cannot avoid all risks if it has to continue
producing cars
Risk control techniques-
Risk prevention
? It refers to measures that reduce the frequency
of a particular loss. This focusses on stopping
losses from happening. Important to prevent
death/injury to people.
? Businesses employ loss control engineers to
identify sources of risks and institute corrective
actions. Like poor lighting, poor maintenance,
improper security, etc. training is given on safety
aspects
? Eg: changing slippery floor, building safety
enclosures to dangerous machinery etc
Risk control techniques-
Risk reduction
Risk financing techniques-
risk retention.
Risk financing techniques-
risk transfers.
Risk management decision
methods
? Risk avoidance
? Loss control
? Risk retension
? Non-insurance transfers
? insurance
Pooling arrangements and
diversification of risk
? Most popular risk management tool is diversification. Essential
part of insurance/financial markets
? Simple methods like pooling between two to diversification
amongst many
? Pooling arrangement reduces risk when losses are independent
(uncorrelated)
? Pooling refers to spreading losses incurred by a few over the
entire group so that everyone bears average loss instead of
actual loss.
2-person pooling arrangement
?Shahrukh and Salman have a possibility
of an accident in the coming year, say.
?20% chance of an accident with a loss of
2500
?Probability distribution of accident losses
is highly skewed. (0 ? 0.8; 2500 ? 0.2)
?Their losses are uncorrelated.
?What is the expected loss and standard
deviation for each one of them?
?Expected loss = 0.8*0 + 0.2*2500
= 500
?Standard deviation
= Root 0.8(0-500)
2
+ 0.2(2500-
500)
2
= 1000
Pooling arrangement?
?Pooling allows them to pool
their risk and split losses equally.
?What is the expected loss and
standard deviation for each
one of them?
Pooling arrangement..
Possible
outcome
Total cost Cost paid by
each person
Probability
Neither Shahrukh
nor salman
0 0 0.8*0.8=0.64
Only Shahrukh 2500 1250 0.2*0.8=0.16
Only salman 2500 1250 0.2*0.8=0.16
Both of them 5000 2500 0.2*0.2=0.04
?Expected cost =
0.64*0+0.32*1250+0.04*2500 = 500
?Standard Deviation =
Root of 0.64*(0-500)
2
+ 0.32*(1250-500)
2
+
(2500-500)
2
= 707
?Pooling arrangement doesn?t change
either person?s expected cost but it
reduces the standard deviation. (1000 to
707)
?This is how risk gets reduced by
diversification. Loss has become more
predictable.
Many-people pooling
? Assume that now Amir khan who has the same
probability of risk also joins the pooling arrangement.
If anyone meets with an accident, each will share
one-thirds of the average loss or expected loss.
? As more and more people join the pool, the mean
loss remains the same but standard deviation comes
down hereby reducing the risk for each participant.
? Expected loss or mean remains the same but the
standard deviation further decreases making the
normal distribution less skewed and more bell shaped.
? Note that here the risk is not transferred to anyone
else, but it is reduced as a whole for each pool
participant.
Fig 4.2 page 59
? Graph with pooling
? Graph without pooling
summary
? As the number of participants in a pooling
arrangement goes up, the standard deviation starts
coming down as near to zero as possible for each
participant. Probability of extreme high or low
outcome is reduced. This leads to the law of large
numbers.
? Law of large numbers states that ?The greater the
number of exposures, the more closely will actual
results approach the probable result that are
expected from an infinite number of exposures eg:
tossing a coin a million times)
? Also, as the number increases the probability
distribution curve of average loss tends to become
more and more bell shaped tending towards a
Normal distribution. This reflects central limit theorem.
Solve
?Suppose each participant in a pooling
arrangement has USD 0 to 4000 losses,
with each participants expected loss is
usd 1000, sketch the probability
distribution of average losses if the losses
across the participants are independent
and if
?1. there is 1 participant (no pooling)
?2. there are 100 participants
?3. there are 1000 participants.
Pooling with correlated losses
Positive correlation because of:
? Catastrophe and epidemic hit a large population at
the same time
? When losses are correlated then increase/decrease in
one leads to increase/decrease in another.
? Therefore, Pooling arrangement reduces risk for each
participant even when the losses are positively
correlated but to a lesser degree.
? Assuming Shah Ruk and Salman?s accidents are
correlated, then probability of shah Ruk having an
accident knowing that Salman has had an accident is
> 0.04
Changing scope of financial
management
Changing scope of risk
management
? Traditionally risk management focused on pure
loss exposures including property risks, liability
risks and personal risks.
? In 1990s new trend emerged where risk
management included speculative financial
risks.
? Recently some businesses have expanded their
scope to include all risks.
Financial risk management
? Financial risk management refers to
identification, analysis and treatment of
speculative financial risks which includes
- commodity price risk
- interest rate risk
- currency exchange rate risk
? Commodity price risk: it is the risk of losing
money if the price of a commodity changes.
Both producers/sellers and users have this risk.
Eg: agri grains
Futures&options can be used to hedge this risk.
Financial risk management
? Interest rate risk:
Risk of loss caused by averse interest rate
movements. Eg: a bank has loaned housing
loan for 20-30 years at a particular interest rate.
If rates go up, they have to borrow deposits at a
higher rate. Similarly a corporate may have
issued bond o public at a rate, they have to still
pay the coupon rate
? Currency exchange rate:
Exchange rate is the value at which one
country?s currency is converted to another
Nation?s currency. This affects both imports and
exports.
History of Managing financial risks
? Traditionally pure risk and speculative risks are
different and handled by separate departments.
? Pure risk by risk retention, risk transfer and loss
control.
? Speculative risk handled by finance division
through contractual provisions and capital market
instruments.
- contractual provisions include call features in
bonds and adjustable interest rate provisions in
mortgages
- capital market approaches include forwards,
futures options and swaps.
History
? In the 1990s some companies started taking a holistic
view of pure and speculative risk to achieve cost
advantage by combining both the risk coverages.
? In 1997, Honeywell became the first company to enter
into an ?integrated risk program? with AIG.
? An integrated risk program is a risk treatment technique
that combines coverage for pure and speculative risks
in the same contract. Honeywell covered traditional
property and casualty insurance as well as coverage
for currency exchange rate risk.
? Some companies created a new position called chief
risk officer(CRO) who is responsible for treatment of
pure and speculative risks in the organization.
History
? Combining two risks in the same contract makes it cheaper.
Companies who can afford a certain level of loss can go for a double
trigger option where the insurance company pays only if two
specified losses occur like one property claim and another exchange
rate claim. Such contracts are cheaper.
Enterprise risk management
? some companies went a step further and covered pyre risk,
speculative risk, strategic risks and operational risks.
? Strategic risk refers to uncertainty regarding the organization goals
and objectives and the organization?s strengths, weaknesses,
opportunities and threats.
? Operational risk refers to risks that develop out of business operations
like manufacturing products and providing service to customers.
? Combining all these risks in one package reduces risk as long as they
are not positively correlated. If they are negatively correlated risk can
be reduced significantly.
History
Advantages of ERM:
? Holistic treatment of risks
? Advantages over competing businesses.
? Positive impact upon revenues
? Reduction in earnings volatility
? Compliance with corporate governance guidelines
Barriers to ERP:
? Organisation culture
? Turf battles
? Perception of not a priority
? Lack of formal process
? Deficiencies in intellectual capital and technology
Futures and option basics
? Spot market: delivery based
? Example- buy wheat at 30,000/ton, sell sugar at 45000/ton
Derivative contracts
? Futures market: right to buy/sell, usually no delivery, squaring up
position.
? Eg: as a buyer buy wheat futures for june at Rs 25,000/ton. In june
market price is 30,000. you square up position by selling spot. You
make Rs 5000. buy physical wheat at Rs 30,000 from spot market.
Effective price is Rs 25000 which is futures contracted price.
? As a seller, sell wheat at Rs 40,000 in the june futures market. June
price crashes to Rs 20,000. you square up your position by buying
spot. You make Rs 20,000. sell physical wheat at Rs 20,000 in the
spot market. Effective price is Rs 40,000
Options contract
? Options contract can be used to protect against adverse price
movements.
? Call option ? option to buy at a specified price during a specified
period
? Put option ? option to sell at a specified price during a specified period.
? Both call and put have buyers/writers and sellers (4 legs)
? Many strategies like straddle, strangle, butterfly,...
? Simple option to protect a price drop is ?covered put option?
? Eg: someone has 100 HUL shares at current market price of Rs 900. he
fears a price drop but feels it may also increase.
? He buys a put option for a strike price of 900 paying a premium of Rs 5.
? If market drops to 800, then he exercise his ?in the money? option and
makes 900-800-5 = Rs 95
? If market moves up to 1000, then the option is out-of-money and he
wishes not to exercise the option and loses only Rs 5 of premium paid.
Hedging with Futures
Hedging a commodity risk using futures contract:
? A corn grower estimates in May about 20,000 bushels of corn by
December. He notices a price of $2.90/bushel of futures price in
December. He fears that the actual spot price in December will
be lower. So he books 4 contracts of size 4000 bushels each at
$2.90/bushel. He will buy back 4 contracts to offset his position.
? If market price is 2.5/bushel in December.
? Sale of 4 contracts at 2.90 in may ?. 4*5000*2.90 = 58000
? Buy-back at 2.50 in December ?. 4*5000*2.50 = 50000
? Gain on futures contract = 58000-50000 = 8000
? Sale of physical stock in December = 4*5000*2.50 = 50000
? Total revenue = 50,000+8000 = 58000
Hedging with futures
? If market price is 3.00/bushel in December.
? Sale of 4 contracts at 2.90 in may ?. 4*5000*2.90 = 58000
? Buy-back at 3 in December ?. 4*5000*3 = 60000
? Gain on futures contract = 58000-60000 = (2000)
? Sale of physical stock in December = 4*5000*3 = 60000
? Total revenue = 60,000-2000 = 58000
? So, no matter what the price is in December the farmer get the
contracted price of may of $ 58,000.
FirstRanker.com - FirstRanker's Choice
Risk
measurement
MODULE 3
Frequency and severity of
losses.
? Frequency of loss refers to number of times in a given period the
loss is likely to happen.
? Historical data will provide this info. (Eg: frequency of injury = no
of injuries in the past/no of worker-years) in the absence of
historical data, industry data can be used. Informed judgement
can be used as well.
? Severity of loss measures the magnitude of loss per occurrence.
One way to estimate is from historical data. (average
severity/occurrence)
? Expected loss = frequency of loss*severity of loss. Expected loss
affects business value and insurance pricing.
3.6
Note:
?Std deviation for high frequency
low severity is low while std
deviation for low frequency high
severity is high
?Infrequent but potentially large
losses are less predictable and
pose greater risk than more
frequent smaller losses.
Risk control
? Risk control is the process of implementing
measures to reduce risk associated with a hazard.
? Benefits of risk/loss control:
Elimination of expenses associated with
- Repair or replacement of damaged property
- Income losses due to distruction of property
- Extra costs associated with maintaining operations
- Adverse liability judgements
- Medical costs to treat injuries
- Income losses due to death/disabilities
Cost of risk control
? Installation and maintainance expenses eg
sprinkler system
? There are associated costs involved like employee
benefits apart from salary
? Some measures push up utility bills eg power bill
Risk control techniques
1
?Risk avoidance
2
?Risk prevention
3
?Risk reduction
Risk avoidance
? Risk avoidance involves not performing an activity that could carry
risk. Eg: not buying a property, not flying, not travelling. This leas to
loss of opportunities arising out of performing such activities. Not
doing a business will avoid risk but one loses on opportunity to earn
profits.
? Advantages:
? Chances of risk is reduced to zero in case where loss exposure has
not started. In situations where exposure has already started it is
reduce to zero for future activities. Residual risks may still persist
? Disadvantages:
? A firm cannot avoid all losses like premature death of an executive
? It is not feasible/practical to avoid all losses without shutting the
business eg car factory cannot avoid all risks if it has to continue
producing cars
Risk control techniques-
Risk prevention
? It refers to measures that reduce the frequency
of a particular loss. This focusses on stopping
losses from happening. Important to prevent
death/injury to people.
? Businesses employ loss control engineers to
identify sources of risks and institute corrective
actions. Like poor lighting, poor maintenance,
improper security, etc. training is given on safety
aspects
? Eg: changing slippery floor, building safety
enclosures to dangerous machinery etc
Risk control techniques-
Risk reduction
Risk financing techniques-
risk retention.
Risk financing techniques-
risk transfers.
Risk management decision
methods
? Risk avoidance
? Loss control
? Risk retension
? Non-insurance transfers
? insurance
Pooling arrangements and
diversification of risk
? Most popular risk management tool is diversification. Essential
part of insurance/financial markets
? Simple methods like pooling between two to diversification
amongst many
? Pooling arrangement reduces risk when losses are independent
(uncorrelated)
? Pooling refers to spreading losses incurred by a few over the
entire group so that everyone bears average loss instead of
actual loss.
2-person pooling arrangement
?Shahrukh and Salman have a possibility
of an accident in the coming year, say.
?20% chance of an accident with a loss of
2500
?Probability distribution of accident losses
is highly skewed. (0 ? 0.8; 2500 ? 0.2)
?Their losses are uncorrelated.
?What is the expected loss and standard
deviation for each one of them?
?Expected loss = 0.8*0 + 0.2*2500
= 500
?Standard deviation
= Root 0.8(0-500)
2
+ 0.2(2500-
500)
2
= 1000
Pooling arrangement?
?Pooling allows them to pool
their risk and split losses equally.
?What is the expected loss and
standard deviation for each
one of them?
Pooling arrangement..
Possible
outcome
Total cost Cost paid by
each person
Probability
Neither Shahrukh
nor salman
0 0 0.8*0.8=0.64
Only Shahrukh 2500 1250 0.2*0.8=0.16
Only salman 2500 1250 0.2*0.8=0.16
Both of them 5000 2500 0.2*0.2=0.04
?Expected cost =
0.64*0+0.32*1250+0.04*2500 = 500
?Standard Deviation =
Root of 0.64*(0-500)
2
+ 0.32*(1250-500)
2
+
(2500-500)
2
= 707
?Pooling arrangement doesn?t change
either person?s expected cost but it
reduces the standard deviation. (1000 to
707)
?This is how risk gets reduced by
diversification. Loss has become more
predictable.
Many-people pooling
? Assume that now Amir khan who has the same
probability of risk also joins the pooling arrangement.
If anyone meets with an accident, each will share
one-thirds of the average loss or expected loss.
? As more and more people join the pool, the mean
loss remains the same but standard deviation comes
down hereby reducing the risk for each participant.
? Expected loss or mean remains the same but the
standard deviation further decreases making the
normal distribution less skewed and more bell shaped.
? Note that here the risk is not transferred to anyone
else, but it is reduced as a whole for each pool
participant.
Fig 4.2 page 59
? Graph with pooling
? Graph without pooling
summary
? As the number of participants in a pooling
arrangement goes up, the standard deviation starts
coming down as near to zero as possible for each
participant. Probability of extreme high or low
outcome is reduced. This leads to the law of large
numbers.
? Law of large numbers states that ?The greater the
number of exposures, the more closely will actual
results approach the probable result that are
expected from an infinite number of exposures eg:
tossing a coin a million times)
? Also, as the number increases the probability
distribution curve of average loss tends to become
more and more bell shaped tending towards a
Normal distribution. This reflects central limit theorem.
Solve
?Suppose each participant in a pooling
arrangement has USD 0 to 4000 losses,
with each participants expected loss is
usd 1000, sketch the probability
distribution of average losses if the losses
across the participants are independent
and if
?1. there is 1 participant (no pooling)
?2. there are 100 participants
?3. there are 1000 participants.
Pooling with correlated losses
Positive correlation because of:
? Catastrophe and epidemic hit a large population at
the same time
? When losses are correlated then increase/decrease in
one leads to increase/decrease in another.
? Therefore, Pooling arrangement reduces risk for each
participant even when the losses are positively
correlated but to a lesser degree.
? Assuming Shah Ruk and Salman?s accidents are
correlated, then probability of shah Ruk having an
accident knowing that Salman has had an accident is
> 0.04
Changing scope of financial
management
Changing scope of risk
management
? Traditionally risk management focused on pure
loss exposures including property risks, liability
risks and personal risks.
? In 1990s new trend emerged where risk
management included speculative financial
risks.
? Recently some businesses have expanded their
scope to include all risks.
Financial risk management
? Financial risk management refers to
identification, analysis and treatment of
speculative financial risks which includes
- commodity price risk
- interest rate risk
- currency exchange rate risk
? Commodity price risk: it is the risk of losing
money if the price of a commodity changes.
Both producers/sellers and users have this risk.
Eg: agri grains
Futures&options can be used to hedge this risk.
Financial risk management
? Interest rate risk:
Risk of loss caused by averse interest rate
movements. Eg: a bank has loaned housing
loan for 20-30 years at a particular interest rate.
If rates go up, they have to borrow deposits at a
higher rate. Similarly a corporate may have
issued bond o public at a rate, they have to still
pay the coupon rate
? Currency exchange rate:
Exchange rate is the value at which one
country?s currency is converted to another
Nation?s currency. This affects both imports and
exports.
History of Managing financial risks
? Traditionally pure risk and speculative risks are
different and handled by separate departments.
? Pure risk by risk retention, risk transfer and loss
control.
? Speculative risk handled by finance division
through contractual provisions and capital market
instruments.
- contractual provisions include call features in
bonds and adjustable interest rate provisions in
mortgages
- capital market approaches include forwards,
futures options and swaps.
History
? In the 1990s some companies started taking a holistic
view of pure and speculative risk to achieve cost
advantage by combining both the risk coverages.
? In 1997, Honeywell became the first company to enter
into an ?integrated risk program? with AIG.
? An integrated risk program is a risk treatment technique
that combines coverage for pure and speculative risks
in the same contract. Honeywell covered traditional
property and casualty insurance as well as coverage
for currency exchange rate risk.
? Some companies created a new position called chief
risk officer(CRO) who is responsible for treatment of
pure and speculative risks in the organization.
History
? Combining two risks in the same contract makes it cheaper.
Companies who can afford a certain level of loss can go for a double
trigger option where the insurance company pays only if two
specified losses occur like one property claim and another exchange
rate claim. Such contracts are cheaper.
Enterprise risk management
? some companies went a step further and covered pyre risk,
speculative risk, strategic risks and operational risks.
? Strategic risk refers to uncertainty regarding the organization goals
and objectives and the organization?s strengths, weaknesses,
opportunities and threats.
? Operational risk refers to risks that develop out of business operations
like manufacturing products and providing service to customers.
? Combining all these risks in one package reduces risk as long as they
are not positively correlated. If they are negatively correlated risk can
be reduced significantly.
History
Advantages of ERM:
? Holistic treatment of risks
? Advantages over competing businesses.
? Positive impact upon revenues
? Reduction in earnings volatility
? Compliance with corporate governance guidelines
Barriers to ERP:
? Organisation culture
? Turf battles
? Perception of not a priority
? Lack of formal process
? Deficiencies in intellectual capital and technology
Futures and option basics
? Spot market: delivery based
? Example- buy wheat at 30,000/ton, sell sugar at 45000/ton
Derivative contracts
? Futures market: right to buy/sell, usually no delivery, squaring up
position.
? Eg: as a buyer buy wheat futures for june at Rs 25,000/ton. In june
market price is 30,000. you square up position by selling spot. You
make Rs 5000. buy physical wheat at Rs 30,000 from spot market.
Effective price is Rs 25000 which is futures contracted price.
? As a seller, sell wheat at Rs 40,000 in the june futures market. June
price crashes to Rs 20,000. you square up your position by buying
spot. You make Rs 20,000. sell physical wheat at Rs 20,000 in the
spot market. Effective price is Rs 40,000
Options contract
? Options contract can be used to protect against adverse price
movements.
? Call option ? option to buy at a specified price during a specified
period
? Put option ? option to sell at a specified price during a specified period.
? Both call and put have buyers/writers and sellers (4 legs)
? Many strategies like straddle, strangle, butterfly,...
? Simple option to protect a price drop is ?covered put option?
? Eg: someone has 100 HUL shares at current market price of Rs 900. he
fears a price drop but feels it may also increase.
? He buys a put option for a strike price of 900 paying a premium of Rs 5.
? If market drops to 800, then he exercise his ?in the money? option and
makes 900-800-5 = Rs 95
? If market moves up to 1000, then the option is out-of-money and he
wishes not to exercise the option and loses only Rs 5 of premium paid.
Hedging with Futures
Hedging a commodity risk using futures contract:
? A corn grower estimates in May about 20,000 bushels of corn by
December. He notices a price of $2.90/bushel of futures price in
December. He fears that the actual spot price in December will
be lower. So he books 4 contracts of size 4000 bushels each at
$2.90/bushel. He will buy back 4 contracts to offset his position.
? If market price is 2.5/bushel in December.
? Sale of 4 contracts at 2.90 in may ?. 4*5000*2.90 = 58000
? Buy-back at 2.50 in December ?. 4*5000*2.50 = 50000
? Gain on futures contract = 58000-50000 = 8000
? Sale of physical stock in December = 4*5000*2.50 = 50000
? Total revenue = 50,000+8000 = 58000
Hedging with futures
? If market price is 3.00/bushel in December.
? Sale of 4 contracts at 2.90 in may ?. 4*5000*2.90 = 58000
? Buy-back at 3 in December ?. 4*5000*3 = 60000
? Gain on futures contract = 58000-60000 = (2000)
? Sale of physical stock in December = 4*5000*3 = 60000
? Total revenue = 60,000-2000 = 58000
? So, no matter what the price is in December the farmer get the
contracted price of may of $ 58,000.
Solve,
1. You are having 100 shares of HUL and the current market price is
Rs 900. you fear that the market will crash and sell it in the june
futures market at Rs 950. in june the price of HUL comes to Rs 960.
Calculate your realisation
What is your realisation if the price comes down to Rs 900? What is
your gain in the whole transaction?
2. Colgate palmolive is quoting at Rs 1000/share. You expect the
market to go up. So you buy futures at Rs 1050 for June. In june
market goes to Rs 1250. what is your profit? What would have
happened if you had bought spot?
FirstRanker.com - FirstRanker's Choice
Risk
measurement
MODULE 3
Frequency and severity of
losses.
? Frequency of loss refers to number of times in a given period the
loss is likely to happen.
? Historical data will provide this info. (Eg: frequency of injury = no
of injuries in the past/no of worker-years) in the absence of
historical data, industry data can be used. Informed judgement
can be used as well.
? Severity of loss measures the magnitude of loss per occurrence.
One way to estimate is from historical data. (average
severity/occurrence)
? Expected loss = frequency of loss*severity of loss. Expected loss
affects business value and insurance pricing.
3.6
Note:
?Std deviation for high frequency
low severity is low while std
deviation for low frequency high
severity is high
?Infrequent but potentially large
losses are less predictable and
pose greater risk than more
frequent smaller losses.
Risk control
? Risk control is the process of implementing
measures to reduce risk associated with a hazard.
? Benefits of risk/loss control:
Elimination of expenses associated with
- Repair or replacement of damaged property
- Income losses due to distruction of property
- Extra costs associated with maintaining operations
- Adverse liability judgements
- Medical costs to treat injuries
- Income losses due to death/disabilities
Cost of risk control
? Installation and maintainance expenses eg
sprinkler system
? There are associated costs involved like employee
benefits apart from salary
? Some measures push up utility bills eg power bill
Risk control techniques
1
?Risk avoidance
2
?Risk prevention
3
?Risk reduction
Risk avoidance
? Risk avoidance involves not performing an activity that could carry
risk. Eg: not buying a property, not flying, not travelling. This leas to
loss of opportunities arising out of performing such activities. Not
doing a business will avoid risk but one loses on opportunity to earn
profits.
? Advantages:
? Chances of risk is reduced to zero in case where loss exposure has
not started. In situations where exposure has already started it is
reduce to zero for future activities. Residual risks may still persist
? Disadvantages:
? A firm cannot avoid all losses like premature death of an executive
? It is not feasible/practical to avoid all losses without shutting the
business eg car factory cannot avoid all risks if it has to continue
producing cars
Risk control techniques-
Risk prevention
? It refers to measures that reduce the frequency
of a particular loss. This focusses on stopping
losses from happening. Important to prevent
death/injury to people.
? Businesses employ loss control engineers to
identify sources of risks and institute corrective
actions. Like poor lighting, poor maintenance,
improper security, etc. training is given on safety
aspects
? Eg: changing slippery floor, building safety
enclosures to dangerous machinery etc
Risk control techniques-
Risk reduction
Risk financing techniques-
risk retention.
Risk financing techniques-
risk transfers.
Risk management decision
methods
? Risk avoidance
? Loss control
? Risk retension
? Non-insurance transfers
? insurance
Pooling arrangements and
diversification of risk
? Most popular risk management tool is diversification. Essential
part of insurance/financial markets
? Simple methods like pooling between two to diversification
amongst many
? Pooling arrangement reduces risk when losses are independent
(uncorrelated)
? Pooling refers to spreading losses incurred by a few over the
entire group so that everyone bears average loss instead of
actual loss.
2-person pooling arrangement
?Shahrukh and Salman have a possibility
of an accident in the coming year, say.
?20% chance of an accident with a loss of
2500
?Probability distribution of accident losses
is highly skewed. (0 ? 0.8; 2500 ? 0.2)
?Their losses are uncorrelated.
?What is the expected loss and standard
deviation for each one of them?
?Expected loss = 0.8*0 + 0.2*2500
= 500
?Standard deviation
= Root 0.8(0-500)
2
+ 0.2(2500-
500)
2
= 1000
Pooling arrangement?
?Pooling allows them to pool
their risk and split losses equally.
?What is the expected loss and
standard deviation for each
one of them?
Pooling arrangement..
Possible
outcome
Total cost Cost paid by
each person
Probability
Neither Shahrukh
nor salman
0 0 0.8*0.8=0.64
Only Shahrukh 2500 1250 0.2*0.8=0.16
Only salman 2500 1250 0.2*0.8=0.16
Both of them 5000 2500 0.2*0.2=0.04
?Expected cost =
0.64*0+0.32*1250+0.04*2500 = 500
?Standard Deviation =
Root of 0.64*(0-500)
2
+ 0.32*(1250-500)
2
+
(2500-500)
2
= 707
?Pooling arrangement doesn?t change
either person?s expected cost but it
reduces the standard deviation. (1000 to
707)
?This is how risk gets reduced by
diversification. Loss has become more
predictable.
Many-people pooling
? Assume that now Amir khan who has the same
probability of risk also joins the pooling arrangement.
If anyone meets with an accident, each will share
one-thirds of the average loss or expected loss.
? As more and more people join the pool, the mean
loss remains the same but standard deviation comes
down hereby reducing the risk for each participant.
? Expected loss or mean remains the same but the
standard deviation further decreases making the
normal distribution less skewed and more bell shaped.
? Note that here the risk is not transferred to anyone
else, but it is reduced as a whole for each pool
participant.
Fig 4.2 page 59
? Graph with pooling
? Graph without pooling
summary
? As the number of participants in a pooling
arrangement goes up, the standard deviation starts
coming down as near to zero as possible for each
participant. Probability of extreme high or low
outcome is reduced. This leads to the law of large
numbers.
? Law of large numbers states that ?The greater the
number of exposures, the more closely will actual
results approach the probable result that are
expected from an infinite number of exposures eg:
tossing a coin a million times)
? Also, as the number increases the probability
distribution curve of average loss tends to become
more and more bell shaped tending towards a
Normal distribution. This reflects central limit theorem.
Solve
?Suppose each participant in a pooling
arrangement has USD 0 to 4000 losses,
with each participants expected loss is
usd 1000, sketch the probability
distribution of average losses if the losses
across the participants are independent
and if
?1. there is 1 participant (no pooling)
?2. there are 100 participants
?3. there are 1000 participants.
Pooling with correlated losses
Positive correlation because of:
? Catastrophe and epidemic hit a large population at
the same time
? When losses are correlated then increase/decrease in
one leads to increase/decrease in another.
? Therefore, Pooling arrangement reduces risk for each
participant even when the losses are positively
correlated but to a lesser degree.
? Assuming Shah Ruk and Salman?s accidents are
correlated, then probability of shah Ruk having an
accident knowing that Salman has had an accident is
> 0.04
Changing scope of financial
management
Changing scope of risk
management
? Traditionally risk management focused on pure
loss exposures including property risks, liability
risks and personal risks.
? In 1990s new trend emerged where risk
management included speculative financial
risks.
? Recently some businesses have expanded their
scope to include all risks.
Financial risk management
? Financial risk management refers to
identification, analysis and treatment of
speculative financial risks which includes
- commodity price risk
- interest rate risk
- currency exchange rate risk
? Commodity price risk: it is the risk of losing
money if the price of a commodity changes.
Both producers/sellers and users have this risk.
Eg: agri grains
Futures&options can be used to hedge this risk.
Financial risk management
? Interest rate risk:
Risk of loss caused by averse interest rate
movements. Eg: a bank has loaned housing
loan for 20-30 years at a particular interest rate.
If rates go up, they have to borrow deposits at a
higher rate. Similarly a corporate may have
issued bond o public at a rate, they have to still
pay the coupon rate
? Currency exchange rate:
Exchange rate is the value at which one
country?s currency is converted to another
Nation?s currency. This affects both imports and
exports.
History of Managing financial risks
? Traditionally pure risk and speculative risks are
different and handled by separate departments.
? Pure risk by risk retention, risk transfer and loss
control.
? Speculative risk handled by finance division
through contractual provisions and capital market
instruments.
- contractual provisions include call features in
bonds and adjustable interest rate provisions in
mortgages
- capital market approaches include forwards,
futures options and swaps.
History
? In the 1990s some companies started taking a holistic
view of pure and speculative risk to achieve cost
advantage by combining both the risk coverages.
? In 1997, Honeywell became the first company to enter
into an ?integrated risk program? with AIG.
? An integrated risk program is a risk treatment technique
that combines coverage for pure and speculative risks
in the same contract. Honeywell covered traditional
property and casualty insurance as well as coverage
for currency exchange rate risk.
? Some companies created a new position called chief
risk officer(CRO) who is responsible for treatment of
pure and speculative risks in the organization.
History
? Combining two risks in the same contract makes it cheaper.
Companies who can afford a certain level of loss can go for a double
trigger option where the insurance company pays only if two
specified losses occur like one property claim and another exchange
rate claim. Such contracts are cheaper.
Enterprise risk management
? some companies went a step further and covered pyre risk,
speculative risk, strategic risks and operational risks.
? Strategic risk refers to uncertainty regarding the organization goals
and objectives and the organization?s strengths, weaknesses,
opportunities and threats.
? Operational risk refers to risks that develop out of business operations
like manufacturing products and providing service to customers.
? Combining all these risks in one package reduces risk as long as they
are not positively correlated. If they are negatively correlated risk can
be reduced significantly.
History
Advantages of ERM:
? Holistic treatment of risks
? Advantages over competing businesses.
? Positive impact upon revenues
? Reduction in earnings volatility
? Compliance with corporate governance guidelines
Barriers to ERP:
? Organisation culture
? Turf battles
? Perception of not a priority
? Lack of formal process
? Deficiencies in intellectual capital and technology
Futures and option basics
? Spot market: delivery based
? Example- buy wheat at 30,000/ton, sell sugar at 45000/ton
Derivative contracts
? Futures market: right to buy/sell, usually no delivery, squaring up
position.
? Eg: as a buyer buy wheat futures for june at Rs 25,000/ton. In june
market price is 30,000. you square up position by selling spot. You
make Rs 5000. buy physical wheat at Rs 30,000 from spot market.
Effective price is Rs 25000 which is futures contracted price.
? As a seller, sell wheat at Rs 40,000 in the june futures market. June
price crashes to Rs 20,000. you square up your position by buying
spot. You make Rs 20,000. sell physical wheat at Rs 20,000 in the
spot market. Effective price is Rs 40,000
Options contract
? Options contract can be used to protect against adverse price
movements.
? Call option ? option to buy at a specified price during a specified
period
? Put option ? option to sell at a specified price during a specified period.
? Both call and put have buyers/writers and sellers (4 legs)
? Many strategies like straddle, strangle, butterfly,...
? Simple option to protect a price drop is ?covered put option?
? Eg: someone has 100 HUL shares at current market price of Rs 900. he
fears a price drop but feels it may also increase.
? He buys a put option for a strike price of 900 paying a premium of Rs 5.
? If market drops to 800, then he exercise his ?in the money? option and
makes 900-800-5 = Rs 95
? If market moves up to 1000, then the option is out-of-money and he
wishes not to exercise the option and loses only Rs 5 of premium paid.
Hedging with Futures
Hedging a commodity risk using futures contract:
? A corn grower estimates in May about 20,000 bushels of corn by
December. He notices a price of $2.90/bushel of futures price in
December. He fears that the actual spot price in December will
be lower. So he books 4 contracts of size 4000 bushels each at
$2.90/bushel. He will buy back 4 contracts to offset his position.
? If market price is 2.5/bushel in December.
? Sale of 4 contracts at 2.90 in may ?. 4*5000*2.90 = 58000
? Buy-back at 2.50 in December ?. 4*5000*2.50 = 50000
? Gain on futures contract = 58000-50000 = 8000
? Sale of physical stock in December = 4*5000*2.50 = 50000
? Total revenue = 50,000+8000 = 58000
Hedging with futures
? If market price is 3.00/bushel in December.
? Sale of 4 contracts at 2.90 in may ?. 4*5000*2.90 = 58000
? Buy-back at 3 in December ?. 4*5000*3 = 60000
? Gain on futures contract = 58000-60000 = (2000)
? Sale of physical stock in December = 4*5000*3 = 60000
? Total revenue = 60,000-2000 = 58000
? So, no matter what the price is in December the farmer get the
contracted price of may of $ 58,000.
Solve,
1. You are having 100 shares of HUL and the current market price is
Rs 900. you fear that the market will crash and sell it in the june
futures market at Rs 950. in june the price of HUL comes to Rs 960.
Calculate your realisation
What is your realisation if the price comes down to Rs 900? What is
your gain in the whole transaction?
2. Colgate palmolive is quoting at Rs 1000/share. You expect the
market to go up. So you buy futures at Rs 1050 for June. In june
market goes to Rs 1250. what is your profit? What would have
happened if you had bought spot?
Insurance market dynamics
? Risk control, risk retention and risk transfer are the three
methods of risk management
? Risk retention by current earnings, loss reserves,
borrowings or captive insurance
? Risk transfer by a property and liability insurance
company.
? Decision needs to be taken about risk retention or risk
transfer. It depends upon conditions in the insurance
market-place.
? 3 imp factors influencing insurance market are:
? - underwriting cycle
? - consolidation in the insurance industry
? - securitisation of risk
FirstRanker.com - FirstRanker's Choice
Risk
measurement
MODULE 3
Frequency and severity of
losses.
? Frequency of loss refers to number of times in a given period the
loss is likely to happen.
? Historical data will provide this info. (Eg: frequency of injury = no
of injuries in the past/no of worker-years) in the absence of
historical data, industry data can be used. Informed judgement
can be used as well.
? Severity of loss measures the magnitude of loss per occurrence.
One way to estimate is from historical data. (average
severity/occurrence)
? Expected loss = frequency of loss*severity of loss. Expected loss
affects business value and insurance pricing.
3.6
Note:
?Std deviation for high frequency
low severity is low while std
deviation for low frequency high
severity is high
?Infrequent but potentially large
losses are less predictable and
pose greater risk than more
frequent smaller losses.
Risk control
? Risk control is the process of implementing
measures to reduce risk associated with a hazard.
? Benefits of risk/loss control:
Elimination of expenses associated with
- Repair or replacement of damaged property
- Income losses due to distruction of property
- Extra costs associated with maintaining operations
- Adverse liability judgements
- Medical costs to treat injuries
- Income losses due to death/disabilities
Cost of risk control
? Installation and maintainance expenses eg
sprinkler system
? There are associated costs involved like employee
benefits apart from salary
? Some measures push up utility bills eg power bill
Risk control techniques
1
?Risk avoidance
2
?Risk prevention
3
?Risk reduction
Risk avoidance
? Risk avoidance involves not performing an activity that could carry
risk. Eg: not buying a property, not flying, not travelling. This leas to
loss of opportunities arising out of performing such activities. Not
doing a business will avoid risk but one loses on opportunity to earn
profits.
? Advantages:
? Chances of risk is reduced to zero in case where loss exposure has
not started. In situations where exposure has already started it is
reduce to zero for future activities. Residual risks may still persist
? Disadvantages:
? A firm cannot avoid all losses like premature death of an executive
? It is not feasible/practical to avoid all losses without shutting the
business eg car factory cannot avoid all risks if it has to continue
producing cars
Risk control techniques-
Risk prevention
? It refers to measures that reduce the frequency
of a particular loss. This focusses on stopping
losses from happening. Important to prevent
death/injury to people.
? Businesses employ loss control engineers to
identify sources of risks and institute corrective
actions. Like poor lighting, poor maintenance,
improper security, etc. training is given on safety
aspects
? Eg: changing slippery floor, building safety
enclosures to dangerous machinery etc
Risk control techniques-
Risk reduction
Risk financing techniques-
risk retention.
Risk financing techniques-
risk transfers.
Risk management decision
methods
? Risk avoidance
? Loss control
? Risk retension
? Non-insurance transfers
? insurance
Pooling arrangements and
diversification of risk
? Most popular risk management tool is diversification. Essential
part of insurance/financial markets
? Simple methods like pooling between two to diversification
amongst many
? Pooling arrangement reduces risk when losses are independent
(uncorrelated)
? Pooling refers to spreading losses incurred by a few over the
entire group so that everyone bears average loss instead of
actual loss.
2-person pooling arrangement
?Shahrukh and Salman have a possibility
of an accident in the coming year, say.
?20% chance of an accident with a loss of
2500
?Probability distribution of accident losses
is highly skewed. (0 ? 0.8; 2500 ? 0.2)
?Their losses are uncorrelated.
?What is the expected loss and standard
deviation for each one of them?
?Expected loss = 0.8*0 + 0.2*2500
= 500
?Standard deviation
= Root 0.8(0-500)
2
+ 0.2(2500-
500)
2
= 1000
Pooling arrangement?
?Pooling allows them to pool
their risk and split losses equally.
?What is the expected loss and
standard deviation for each
one of them?
Pooling arrangement..
Possible
outcome
Total cost Cost paid by
each person
Probability
Neither Shahrukh
nor salman
0 0 0.8*0.8=0.64
Only Shahrukh 2500 1250 0.2*0.8=0.16
Only salman 2500 1250 0.2*0.8=0.16
Both of them 5000 2500 0.2*0.2=0.04
?Expected cost =
0.64*0+0.32*1250+0.04*2500 = 500
?Standard Deviation =
Root of 0.64*(0-500)
2
+ 0.32*(1250-500)
2
+
(2500-500)
2
= 707
?Pooling arrangement doesn?t change
either person?s expected cost but it
reduces the standard deviation. (1000 to
707)
?This is how risk gets reduced by
diversification. Loss has become more
predictable.
Many-people pooling
? Assume that now Amir khan who has the same
probability of risk also joins the pooling arrangement.
If anyone meets with an accident, each will share
one-thirds of the average loss or expected loss.
? As more and more people join the pool, the mean
loss remains the same but standard deviation comes
down hereby reducing the risk for each participant.
? Expected loss or mean remains the same but the
standard deviation further decreases making the
normal distribution less skewed and more bell shaped.
? Note that here the risk is not transferred to anyone
else, but it is reduced as a whole for each pool
participant.
Fig 4.2 page 59
? Graph with pooling
? Graph without pooling
summary
? As the number of participants in a pooling
arrangement goes up, the standard deviation starts
coming down as near to zero as possible for each
participant. Probability of extreme high or low
outcome is reduced. This leads to the law of large
numbers.
? Law of large numbers states that ?The greater the
number of exposures, the more closely will actual
results approach the probable result that are
expected from an infinite number of exposures eg:
tossing a coin a million times)
? Also, as the number increases the probability
distribution curve of average loss tends to become
more and more bell shaped tending towards a
Normal distribution. This reflects central limit theorem.
Solve
?Suppose each participant in a pooling
arrangement has USD 0 to 4000 losses,
with each participants expected loss is
usd 1000, sketch the probability
distribution of average losses if the losses
across the participants are independent
and if
?1. there is 1 participant (no pooling)
?2. there are 100 participants
?3. there are 1000 participants.
Pooling with correlated losses
Positive correlation because of:
? Catastrophe and epidemic hit a large population at
the same time
? When losses are correlated then increase/decrease in
one leads to increase/decrease in another.
? Therefore, Pooling arrangement reduces risk for each
participant even when the losses are positively
correlated but to a lesser degree.
? Assuming Shah Ruk and Salman?s accidents are
correlated, then probability of shah Ruk having an
accident knowing that Salman has had an accident is
> 0.04
Changing scope of financial
management
Changing scope of risk
management
? Traditionally risk management focused on pure
loss exposures including property risks, liability
risks and personal risks.
? In 1990s new trend emerged where risk
management included speculative financial
risks.
? Recently some businesses have expanded their
scope to include all risks.
Financial risk management
? Financial risk management refers to
identification, analysis and treatment of
speculative financial risks which includes
- commodity price risk
- interest rate risk
- currency exchange rate risk
? Commodity price risk: it is the risk of losing
money if the price of a commodity changes.
Both producers/sellers and users have this risk.
Eg: agri grains
Futures&options can be used to hedge this risk.
Financial risk management
? Interest rate risk:
Risk of loss caused by averse interest rate
movements. Eg: a bank has loaned housing
loan for 20-30 years at a particular interest rate.
If rates go up, they have to borrow deposits at a
higher rate. Similarly a corporate may have
issued bond o public at a rate, they have to still
pay the coupon rate
? Currency exchange rate:
Exchange rate is the value at which one
country?s currency is converted to another
Nation?s currency. This affects both imports and
exports.
History of Managing financial risks
? Traditionally pure risk and speculative risks are
different and handled by separate departments.
? Pure risk by risk retention, risk transfer and loss
control.
? Speculative risk handled by finance division
through contractual provisions and capital market
instruments.
- contractual provisions include call features in
bonds and adjustable interest rate provisions in
mortgages
- capital market approaches include forwards,
futures options and swaps.
History
? In the 1990s some companies started taking a holistic
view of pure and speculative risk to achieve cost
advantage by combining both the risk coverages.
? In 1997, Honeywell became the first company to enter
into an ?integrated risk program? with AIG.
? An integrated risk program is a risk treatment technique
that combines coverage for pure and speculative risks
in the same contract. Honeywell covered traditional
property and casualty insurance as well as coverage
for currency exchange rate risk.
? Some companies created a new position called chief
risk officer(CRO) who is responsible for treatment of
pure and speculative risks in the organization.
History
? Combining two risks in the same contract makes it cheaper.
Companies who can afford a certain level of loss can go for a double
trigger option where the insurance company pays only if two
specified losses occur like one property claim and another exchange
rate claim. Such contracts are cheaper.
Enterprise risk management
? some companies went a step further and covered pyre risk,
speculative risk, strategic risks and operational risks.
? Strategic risk refers to uncertainty regarding the organization goals
and objectives and the organization?s strengths, weaknesses,
opportunities and threats.
? Operational risk refers to risks that develop out of business operations
like manufacturing products and providing service to customers.
? Combining all these risks in one package reduces risk as long as they
are not positively correlated. If they are negatively correlated risk can
be reduced significantly.
History
Advantages of ERM:
? Holistic treatment of risks
? Advantages over competing businesses.
? Positive impact upon revenues
? Reduction in earnings volatility
? Compliance with corporate governance guidelines
Barriers to ERP:
? Organisation culture
? Turf battles
? Perception of not a priority
? Lack of formal process
? Deficiencies in intellectual capital and technology
Futures and option basics
? Spot market: delivery based
? Example- buy wheat at 30,000/ton, sell sugar at 45000/ton
Derivative contracts
? Futures market: right to buy/sell, usually no delivery, squaring up
position.
? Eg: as a buyer buy wheat futures for june at Rs 25,000/ton. In june
market price is 30,000. you square up position by selling spot. You
make Rs 5000. buy physical wheat at Rs 30,000 from spot market.
Effective price is Rs 25000 which is futures contracted price.
? As a seller, sell wheat at Rs 40,000 in the june futures market. June
price crashes to Rs 20,000. you square up your position by buying
spot. You make Rs 20,000. sell physical wheat at Rs 20,000 in the
spot market. Effective price is Rs 40,000
Options contract
? Options contract can be used to protect against adverse price
movements.
? Call option ? option to buy at a specified price during a specified
period
? Put option ? option to sell at a specified price during a specified period.
? Both call and put have buyers/writers and sellers (4 legs)
? Many strategies like straddle, strangle, butterfly,...
? Simple option to protect a price drop is ?covered put option?
? Eg: someone has 100 HUL shares at current market price of Rs 900. he
fears a price drop but feels it may also increase.
? He buys a put option for a strike price of 900 paying a premium of Rs 5.
? If market drops to 800, then he exercise his ?in the money? option and
makes 900-800-5 = Rs 95
? If market moves up to 1000, then the option is out-of-money and he
wishes not to exercise the option and loses only Rs 5 of premium paid.
Hedging with Futures
Hedging a commodity risk using futures contract:
? A corn grower estimates in May about 20,000 bushels of corn by
December. He notices a price of $2.90/bushel of futures price in
December. He fears that the actual spot price in December will
be lower. So he books 4 contracts of size 4000 bushels each at
$2.90/bushel. He will buy back 4 contracts to offset his position.
? If market price is 2.5/bushel in December.
? Sale of 4 contracts at 2.90 in may ?. 4*5000*2.90 = 58000
? Buy-back at 2.50 in December ?. 4*5000*2.50 = 50000
? Gain on futures contract = 58000-50000 = 8000
? Sale of physical stock in December = 4*5000*2.50 = 50000
? Total revenue = 50,000+8000 = 58000
Hedging with futures
? If market price is 3.00/bushel in December.
? Sale of 4 contracts at 2.90 in may ?. 4*5000*2.90 = 58000
? Buy-back at 3 in December ?. 4*5000*3 = 60000
? Gain on futures contract = 58000-60000 = (2000)
? Sale of physical stock in December = 4*5000*3 = 60000
? Total revenue = 60,000-2000 = 58000
? So, no matter what the price is in December the farmer get the
contracted price of may of $ 58,000.
Solve,
1. You are having 100 shares of HUL and the current market price is
Rs 900. you fear that the market will crash and sell it in the june
futures market at Rs 950. in june the price of HUL comes to Rs 960.
Calculate your realisation
What is your realisation if the price comes down to Rs 900? What is
your gain in the whole transaction?
2. Colgate palmolive is quoting at Rs 1000/share. You expect the
market to go up. So you buy futures at Rs 1050 for June. In june
market goes to Rs 1250. what is your profit? What would have
happened if you had bought spot?
Insurance market dynamics
? Risk control, risk retention and risk transfer are the three
methods of risk management
? Risk retention by current earnings, loss reserves,
borrowings or captive insurance
? Risk transfer by a property and liability insurance
company.
? Decision needs to be taken about risk retention or risk
transfer. It depends upon conditions in the insurance
market-place.
? 3 imp factors influencing insurance market are:
? - underwriting cycle
? - consolidation in the insurance industry
? - securitisation of risk
1. Underwriting cycle
? Underwriting means ?sign and accept liability under (an
insurance policy), thus guaranteeing payment in case loss
or damage occurs?
? Underwriting cycle ? property and liability insurance market
fluctuate between periods of tight underwriting standards
and high premiums called ?hard? insurance market and
periods of loose underwriting standards called ?soft?
insurance market.
? This is measured in terms of combined ratio which is ratio of
paid losses and loss adjustment expenses plus underwriting
expenses to premiums
? If combined ratio is more than 1 (100%) then underwriting
operation is profitable. Less than 1 is loss making.
? Risk managers must study current status of the cycle before
making retention-transfer decisions. Buy when market is soft
and retain when the market is hard
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Risk
measurement
MODULE 3
Frequency and severity of
losses.
? Frequency of loss refers to number of times in a given period the
loss is likely to happen.
? Historical data will provide this info. (Eg: frequency of injury = no
of injuries in the past/no of worker-years) in the absence of
historical data, industry data can be used. Informed judgement
can be used as well.
? Severity of loss measures the magnitude of loss per occurrence.
One way to estimate is from historical data. (average
severity/occurrence)
? Expected loss = frequency of loss*severity of loss. Expected loss
affects business value and insurance pricing.
3.6
Note:
?Std deviation for high frequency
low severity is low while std
deviation for low frequency high
severity is high
?Infrequent but potentially large
losses are less predictable and
pose greater risk than more
frequent smaller losses.
Risk control
? Risk control is the process of implementing
measures to reduce risk associated with a hazard.
? Benefits of risk/loss control:
Elimination of expenses associated with
- Repair or replacement of damaged property
- Income losses due to distruction of property
- Extra costs associated with maintaining operations
- Adverse liability judgements
- Medical costs to treat injuries
- Income losses due to death/disabilities
Cost of risk control
? Installation and maintainance expenses eg
sprinkler system
? There are associated costs involved like employee
benefits apart from salary
? Some measures push up utility bills eg power bill
Risk control techniques
1
?Risk avoidance
2
?Risk prevention
3
?Risk reduction
Risk avoidance
? Risk avoidance involves not performing an activity that could carry
risk. Eg: not buying a property, not flying, not travelling. This leas to
loss of opportunities arising out of performing such activities. Not
doing a business will avoid risk but one loses on opportunity to earn
profits.
? Advantages:
? Chances of risk is reduced to zero in case where loss exposure has
not started. In situations where exposure has already started it is
reduce to zero for future activities. Residual risks may still persist
? Disadvantages:
? A firm cannot avoid all losses like premature death of an executive
? It is not feasible/practical to avoid all losses without shutting the
business eg car factory cannot avoid all risks if it has to continue
producing cars
Risk control techniques-
Risk prevention
? It refers to measures that reduce the frequency
of a particular loss. This focusses on stopping
losses from happening. Important to prevent
death/injury to people.
? Businesses employ loss control engineers to
identify sources of risks and institute corrective
actions. Like poor lighting, poor maintenance,
improper security, etc. training is given on safety
aspects
? Eg: changing slippery floor, building safety
enclosures to dangerous machinery etc
Risk control techniques-
Risk reduction
Risk financing techniques-
risk retention.
Risk financing techniques-
risk transfers.
Risk management decision
methods
? Risk avoidance
? Loss control
? Risk retension
? Non-insurance transfers
? insurance
Pooling arrangements and
diversification of risk
? Most popular risk management tool is diversification. Essential
part of insurance/financial markets
? Simple methods like pooling between two to diversification
amongst many
? Pooling arrangement reduces risk when losses are independent
(uncorrelated)
? Pooling refers to spreading losses incurred by a few over the
entire group so that everyone bears average loss instead of
actual loss.
2-person pooling arrangement
?Shahrukh and Salman have a possibility
of an accident in the coming year, say.
?20% chance of an accident with a loss of
2500
?Probability distribution of accident losses
is highly skewed. (0 ? 0.8; 2500 ? 0.2)
?Their losses are uncorrelated.
?What is the expected loss and standard
deviation for each one of them?
?Expected loss = 0.8*0 + 0.2*2500
= 500
?Standard deviation
= Root 0.8(0-500)
2
+ 0.2(2500-
500)
2
= 1000
Pooling arrangement?
?Pooling allows them to pool
their risk and split losses equally.
?What is the expected loss and
standard deviation for each
one of them?
Pooling arrangement..
Possible
outcome
Total cost Cost paid by
each person
Probability
Neither Shahrukh
nor salman
0 0 0.8*0.8=0.64
Only Shahrukh 2500 1250 0.2*0.8=0.16
Only salman 2500 1250 0.2*0.8=0.16
Both of them 5000 2500 0.2*0.2=0.04
?Expected cost =
0.64*0+0.32*1250+0.04*2500 = 500
?Standard Deviation =
Root of 0.64*(0-500)
2
+ 0.32*(1250-500)
2
+
(2500-500)
2
= 707
?Pooling arrangement doesn?t change
either person?s expected cost but it
reduces the standard deviation. (1000 to
707)
?This is how risk gets reduced by
diversification. Loss has become more
predictable.
Many-people pooling
? Assume that now Amir khan who has the same
probability of risk also joins the pooling arrangement.
If anyone meets with an accident, each will share
one-thirds of the average loss or expected loss.
? As more and more people join the pool, the mean
loss remains the same but standard deviation comes
down hereby reducing the risk for each participant.
? Expected loss or mean remains the same but the
standard deviation further decreases making the
normal distribution less skewed and more bell shaped.
? Note that here the risk is not transferred to anyone
else, but it is reduced as a whole for each pool
participant.
Fig 4.2 page 59
? Graph with pooling
? Graph without pooling
summary
? As the number of participants in a pooling
arrangement goes up, the standard deviation starts
coming down as near to zero as possible for each
participant. Probability of extreme high or low
outcome is reduced. This leads to the law of large
numbers.
? Law of large numbers states that ?The greater the
number of exposures, the more closely will actual
results approach the probable result that are
expected from an infinite number of exposures eg:
tossing a coin a million times)
? Also, as the number increases the probability
distribution curve of average loss tends to become
more and more bell shaped tending towards a
Normal distribution. This reflects central limit theorem.
Solve
?Suppose each participant in a pooling
arrangement has USD 0 to 4000 losses,
with each participants expected loss is
usd 1000, sketch the probability
distribution of average losses if the losses
across the participants are independent
and if
?1. there is 1 participant (no pooling)
?2. there are 100 participants
?3. there are 1000 participants.
Pooling with correlated losses
Positive correlation because of:
? Catastrophe and epidemic hit a large population at
the same time
? When losses are correlated then increase/decrease in
one leads to increase/decrease in another.
? Therefore, Pooling arrangement reduces risk for each
participant even when the losses are positively
correlated but to a lesser degree.
? Assuming Shah Ruk and Salman?s accidents are
correlated, then probability of shah Ruk having an
accident knowing that Salman has had an accident is
> 0.04
Changing scope of financial
management
Changing scope of risk
management
? Traditionally risk management focused on pure
loss exposures including property risks, liability
risks and personal risks.
? In 1990s new trend emerged where risk
management included speculative financial
risks.
? Recently some businesses have expanded their
scope to include all risks.
Financial risk management
? Financial risk management refers to
identification, analysis and treatment of
speculative financial risks which includes
- commodity price risk
- interest rate risk
- currency exchange rate risk
? Commodity price risk: it is the risk of losing
money if the price of a commodity changes.
Both producers/sellers and users have this risk.
Eg: agri grains
Futures&options can be used to hedge this risk.
Financial risk management
? Interest rate risk:
Risk of loss caused by averse interest rate
movements. Eg: a bank has loaned housing
loan for 20-30 years at a particular interest rate.
If rates go up, they have to borrow deposits at a
higher rate. Similarly a corporate may have
issued bond o public at a rate, they have to still
pay the coupon rate
? Currency exchange rate:
Exchange rate is the value at which one
country?s currency is converted to another
Nation?s currency. This affects both imports and
exports.
History of Managing financial risks
? Traditionally pure risk and speculative risks are
different and handled by separate departments.
? Pure risk by risk retention, risk transfer and loss
control.
? Speculative risk handled by finance division
through contractual provisions and capital market
instruments.
- contractual provisions include call features in
bonds and adjustable interest rate provisions in
mortgages
- capital market approaches include forwards,
futures options and swaps.
History
? In the 1990s some companies started taking a holistic
view of pure and speculative risk to achieve cost
advantage by combining both the risk coverages.
? In 1997, Honeywell became the first company to enter
into an ?integrated risk program? with AIG.
? An integrated risk program is a risk treatment technique
that combines coverage for pure and speculative risks
in the same contract. Honeywell covered traditional
property and casualty insurance as well as coverage
for currency exchange rate risk.
? Some companies created a new position called chief
risk officer(CRO) who is responsible for treatment of
pure and speculative risks in the organization.
History
? Combining two risks in the same contract makes it cheaper.
Companies who can afford a certain level of loss can go for a double
trigger option where the insurance company pays only if two
specified losses occur like one property claim and another exchange
rate claim. Such contracts are cheaper.
Enterprise risk management
? some companies went a step further and covered pyre risk,
speculative risk, strategic risks and operational risks.
? Strategic risk refers to uncertainty regarding the organization goals
and objectives and the organization?s strengths, weaknesses,
opportunities and threats.
? Operational risk refers to risks that develop out of business operations
like manufacturing products and providing service to customers.
? Combining all these risks in one package reduces risk as long as they
are not positively correlated. If they are negatively correlated risk can
be reduced significantly.
History
Advantages of ERM:
? Holistic treatment of risks
? Advantages over competing businesses.
? Positive impact upon revenues
? Reduction in earnings volatility
? Compliance with corporate governance guidelines
Barriers to ERP:
? Organisation culture
? Turf battles
? Perception of not a priority
? Lack of formal process
? Deficiencies in intellectual capital and technology
Futures and option basics
? Spot market: delivery based
? Example- buy wheat at 30,000/ton, sell sugar at 45000/ton
Derivative contracts
? Futures market: right to buy/sell, usually no delivery, squaring up
position.
? Eg: as a buyer buy wheat futures for june at Rs 25,000/ton. In june
market price is 30,000. you square up position by selling spot. You
make Rs 5000. buy physical wheat at Rs 30,000 from spot market.
Effective price is Rs 25000 which is futures contracted price.
? As a seller, sell wheat at Rs 40,000 in the june futures market. June
price crashes to Rs 20,000. you square up your position by buying
spot. You make Rs 20,000. sell physical wheat at Rs 20,000 in the
spot market. Effective price is Rs 40,000
Options contract
? Options contract can be used to protect against adverse price
movements.
? Call option ? option to buy at a specified price during a specified
period
? Put option ? option to sell at a specified price during a specified period.
? Both call and put have buyers/writers and sellers (4 legs)
? Many strategies like straddle, strangle, butterfly,...
? Simple option to protect a price drop is ?covered put option?
? Eg: someone has 100 HUL shares at current market price of Rs 900. he
fears a price drop but feels it may also increase.
? He buys a put option for a strike price of 900 paying a premium of Rs 5.
? If market drops to 800, then he exercise his ?in the money? option and
makes 900-800-5 = Rs 95
? If market moves up to 1000, then the option is out-of-money and he
wishes not to exercise the option and loses only Rs 5 of premium paid.
Hedging with Futures
Hedging a commodity risk using futures contract:
? A corn grower estimates in May about 20,000 bushels of corn by
December. He notices a price of $2.90/bushel of futures price in
December. He fears that the actual spot price in December will
be lower. So he books 4 contracts of size 4000 bushels each at
$2.90/bushel. He will buy back 4 contracts to offset his position.
? If market price is 2.5/bushel in December.
? Sale of 4 contracts at 2.90 in may ?. 4*5000*2.90 = 58000
? Buy-back at 2.50 in December ?. 4*5000*2.50 = 50000
? Gain on futures contract = 58000-50000 = 8000
? Sale of physical stock in December = 4*5000*2.50 = 50000
? Total revenue = 50,000+8000 = 58000
Hedging with futures
? If market price is 3.00/bushel in December.
? Sale of 4 contracts at 2.90 in may ?. 4*5000*2.90 = 58000
? Buy-back at 3 in December ?. 4*5000*3 = 60000
? Gain on futures contract = 58000-60000 = (2000)
? Sale of physical stock in December = 4*5000*3 = 60000
? Total revenue = 60,000-2000 = 58000
? So, no matter what the price is in December the farmer get the
contracted price of may of $ 58,000.
Solve,
1. You are having 100 shares of HUL and the current market price is
Rs 900. you fear that the market will crash and sell it in the june
futures market at Rs 950. in june the price of HUL comes to Rs 960.
Calculate your realisation
What is your realisation if the price comes down to Rs 900? What is
your gain in the whole transaction?
2. Colgate palmolive is quoting at Rs 1000/share. You expect the
market to go up. So you buy futures at Rs 1050 for June. In june
market goes to Rs 1250. what is your profit? What would have
happened if you had bought spot?
Insurance market dynamics
? Risk control, risk retention and risk transfer are the three
methods of risk management
? Risk retention by current earnings, loss reserves,
borrowings or captive insurance
? Risk transfer by a property and liability insurance
company.
? Decision needs to be taken about risk retention or risk
transfer. It depends upon conditions in the insurance
market-place.
? 3 imp factors influencing insurance market are:
? - underwriting cycle
? - consolidation in the insurance industry
? - securitisation of risk
1. Underwriting cycle
? Underwriting means ?sign and accept liability under (an
insurance policy), thus guaranteeing payment in case loss
or damage occurs?
? Underwriting cycle ? property and liability insurance market
fluctuate between periods of tight underwriting standards
and high premiums called ?hard? insurance market and
periods of loose underwriting standards called ?soft?
insurance market.
? This is measured in terms of combined ratio which is ratio of
paid losses and loss adjustment expenses plus underwriting
expenses to premiums
? If combined ratio is more than 1 (100%) then underwriting
operation is profitable. Less than 1 is loss making.
? Risk managers must study current status of the cycle before
making retention-transfer decisions. Buy when market is soft
and retain when the market is hard
Y underwriting cycle fluctuates?
? 1. Insurance industry capacity - capacity refers to
relative level of surplus which is assets less liabilities.
They reduce premium and go soft when they are
surplus and increase premium and go hard when they
are deficit. Competition hastens this process.
External factors like earthquake, 9/11, katrina can also
increase claims and reduce surplus and harden the
market.
? 2. Investment returns- insurance business also is an
investor generating revenues from premium collected.
They sell insurance at lower premiums expecting better
investment returns. this is called ?cashflow underwriting?
FirstRanker.com - FirstRanker's Choice
Risk
measurement
MODULE 3
Frequency and severity of
losses.
? Frequency of loss refers to number of times in a given period the
loss is likely to happen.
? Historical data will provide this info. (Eg: frequency of injury = no
of injuries in the past/no of worker-years) in the absence of
historical data, industry data can be used. Informed judgement
can be used as well.
? Severity of loss measures the magnitude of loss per occurrence.
One way to estimate is from historical data. (average
severity/occurrence)
? Expected loss = frequency of loss*severity of loss. Expected loss
affects business value and insurance pricing.
3.6
Note:
?Std deviation for high frequency
low severity is low while std
deviation for low frequency high
severity is high
?Infrequent but potentially large
losses are less predictable and
pose greater risk than more
frequent smaller losses.
Risk control
? Risk control is the process of implementing
measures to reduce risk associated with a hazard.
? Benefits of risk/loss control:
Elimination of expenses associated with
- Repair or replacement of damaged property
- Income losses due to distruction of property
- Extra costs associated with maintaining operations
- Adverse liability judgements
- Medical costs to treat injuries
- Income losses due to death/disabilities
Cost of risk control
? Installation and maintainance expenses eg
sprinkler system
? There are associated costs involved like employee
benefits apart from salary
? Some measures push up utility bills eg power bill
Risk control techniques
1
?Risk avoidance
2
?Risk prevention
3
?Risk reduction
Risk avoidance
? Risk avoidance involves not performing an activity that could carry
risk. Eg: not buying a property, not flying, not travelling. This leas to
loss of opportunities arising out of performing such activities. Not
doing a business will avoid risk but one loses on opportunity to earn
profits.
? Advantages:
? Chances of risk is reduced to zero in case where loss exposure has
not started. In situations where exposure has already started it is
reduce to zero for future activities. Residual risks may still persist
? Disadvantages:
? A firm cannot avoid all losses like premature death of an executive
? It is not feasible/practical to avoid all losses without shutting the
business eg car factory cannot avoid all risks if it has to continue
producing cars
Risk control techniques-
Risk prevention
? It refers to measures that reduce the frequency
of a particular loss. This focusses on stopping
losses from happening. Important to prevent
death/injury to people.
? Businesses employ loss control engineers to
identify sources of risks and institute corrective
actions. Like poor lighting, poor maintenance,
improper security, etc. training is given on safety
aspects
? Eg: changing slippery floor, building safety
enclosures to dangerous machinery etc
Risk control techniques-
Risk reduction
Risk financing techniques-
risk retention.
Risk financing techniques-
risk transfers.
Risk management decision
methods
? Risk avoidance
? Loss control
? Risk retension
? Non-insurance transfers
? insurance
Pooling arrangements and
diversification of risk
? Most popular risk management tool is diversification. Essential
part of insurance/financial markets
? Simple methods like pooling between two to diversification
amongst many
? Pooling arrangement reduces risk when losses are independent
(uncorrelated)
? Pooling refers to spreading losses incurred by a few over the
entire group so that everyone bears average loss instead of
actual loss.
2-person pooling arrangement
?Shahrukh and Salman have a possibility
of an accident in the coming year, say.
?20% chance of an accident with a loss of
2500
?Probability distribution of accident losses
is highly skewed. (0 ? 0.8; 2500 ? 0.2)
?Their losses are uncorrelated.
?What is the expected loss and standard
deviation for each one of them?
?Expected loss = 0.8*0 + 0.2*2500
= 500
?Standard deviation
= Root 0.8(0-500)
2
+ 0.2(2500-
500)
2
= 1000
Pooling arrangement?
?Pooling allows them to pool
their risk and split losses equally.
?What is the expected loss and
standard deviation for each
one of them?
Pooling arrangement..
Possible
outcome
Total cost Cost paid by
each person
Probability
Neither Shahrukh
nor salman
0 0 0.8*0.8=0.64
Only Shahrukh 2500 1250 0.2*0.8=0.16
Only salman 2500 1250 0.2*0.8=0.16
Both of them 5000 2500 0.2*0.2=0.04
?Expected cost =
0.64*0+0.32*1250+0.04*2500 = 500
?Standard Deviation =
Root of 0.64*(0-500)
2
+ 0.32*(1250-500)
2
+
(2500-500)
2
= 707
?Pooling arrangement doesn?t change
either person?s expected cost but it
reduces the standard deviation. (1000 to
707)
?This is how risk gets reduced by
diversification. Loss has become more
predictable.
Many-people pooling
? Assume that now Amir khan who has the same
probability of risk also joins the pooling arrangement.
If anyone meets with an accident, each will share
one-thirds of the average loss or expected loss.
? As more and more people join the pool, the mean
loss remains the same but standard deviation comes
down hereby reducing the risk for each participant.
? Expected loss or mean remains the same but the
standard deviation further decreases making the
normal distribution less skewed and more bell shaped.
? Note that here the risk is not transferred to anyone
else, but it is reduced as a whole for each pool
participant.
Fig 4.2 page 59
? Graph with pooling
? Graph without pooling
summary
? As the number of participants in a pooling
arrangement goes up, the standard deviation starts
coming down as near to zero as possible for each
participant. Probability of extreme high or low
outcome is reduced. This leads to the law of large
numbers.
? Law of large numbers states that ?The greater the
number of exposures, the more closely will actual
results approach the probable result that are
expected from an infinite number of exposures eg:
tossing a coin a million times)
? Also, as the number increases the probability
distribution curve of average loss tends to become
more and more bell shaped tending towards a
Normal distribution. This reflects central limit theorem.
Solve
?Suppose each participant in a pooling
arrangement has USD 0 to 4000 losses,
with each participants expected loss is
usd 1000, sketch the probability
distribution of average losses if the losses
across the participants are independent
and if
?1. there is 1 participant (no pooling)
?2. there are 100 participants
?3. there are 1000 participants.
Pooling with correlated losses
Positive correlation because of:
? Catastrophe and epidemic hit a large population at
the same time
? When losses are correlated then increase/decrease in
one leads to increase/decrease in another.
? Therefore, Pooling arrangement reduces risk for each
participant even when the losses are positively
correlated but to a lesser degree.
? Assuming Shah Ruk and Salman?s accidents are
correlated, then probability of shah Ruk having an
accident knowing that Salman has had an accident is
> 0.04
Changing scope of financial
management
Changing scope of risk
management
? Traditionally risk management focused on pure
loss exposures including property risks, liability
risks and personal risks.
? In 1990s new trend emerged where risk
management included speculative financial
risks.
? Recently some businesses have expanded their
scope to include all risks.
Financial risk management
? Financial risk management refers to
identification, analysis and treatment of
speculative financial risks which includes
- commodity price risk
- interest rate risk
- currency exchange rate risk
? Commodity price risk: it is the risk of losing
money if the price of a commodity changes.
Both producers/sellers and users have this risk.
Eg: agri grains
Futures&options can be used to hedge this risk.
Financial risk management
? Interest rate risk:
Risk of loss caused by averse interest rate
movements. Eg: a bank has loaned housing
loan for 20-30 years at a particular interest rate.
If rates go up, they have to borrow deposits at a
higher rate. Similarly a corporate may have
issued bond o public at a rate, they have to still
pay the coupon rate
? Currency exchange rate:
Exchange rate is the value at which one
country?s currency is converted to another
Nation?s currency. This affects both imports and
exports.
History of Managing financial risks
? Traditionally pure risk and speculative risks are
different and handled by separate departments.
? Pure risk by risk retention, risk transfer and loss
control.
? Speculative risk handled by finance division
through contractual provisions and capital market
instruments.
- contractual provisions include call features in
bonds and adjustable interest rate provisions in
mortgages
- capital market approaches include forwards,
futures options and swaps.
History
? In the 1990s some companies started taking a holistic
view of pure and speculative risk to achieve cost
advantage by combining both the risk coverages.
? In 1997, Honeywell became the first company to enter
into an ?integrated risk program? with AIG.
? An integrated risk program is a risk treatment technique
that combines coverage for pure and speculative risks
in the same contract. Honeywell covered traditional
property and casualty insurance as well as coverage
for currency exchange rate risk.
? Some companies created a new position called chief
risk officer(CRO) who is responsible for treatment of
pure and speculative risks in the organization.
History
? Combining two risks in the same contract makes it cheaper.
Companies who can afford a certain level of loss can go for a double
trigger option where the insurance company pays only if two
specified losses occur like one property claim and another exchange
rate claim. Such contracts are cheaper.
Enterprise risk management
? some companies went a step further and covered pyre risk,
speculative risk, strategic risks and operational risks.
? Strategic risk refers to uncertainty regarding the organization goals
and objectives and the organization?s strengths, weaknesses,
opportunities and threats.
? Operational risk refers to risks that develop out of business operations
like manufacturing products and providing service to customers.
? Combining all these risks in one package reduces risk as long as they
are not positively correlated. If they are negatively correlated risk can
be reduced significantly.
History
Advantages of ERM:
? Holistic treatment of risks
? Advantages over competing businesses.
? Positive impact upon revenues
? Reduction in earnings volatility
? Compliance with corporate governance guidelines
Barriers to ERP:
? Organisation culture
? Turf battles
? Perception of not a priority
? Lack of formal process
? Deficiencies in intellectual capital and technology
Futures and option basics
? Spot market: delivery based
? Example- buy wheat at 30,000/ton, sell sugar at 45000/ton
Derivative contracts
? Futures market: right to buy/sell, usually no delivery, squaring up
position.
? Eg: as a buyer buy wheat futures for june at Rs 25,000/ton. In june
market price is 30,000. you square up position by selling spot. You
make Rs 5000. buy physical wheat at Rs 30,000 from spot market.
Effective price is Rs 25000 which is futures contracted price.
? As a seller, sell wheat at Rs 40,000 in the june futures market. June
price crashes to Rs 20,000. you square up your position by buying
spot. You make Rs 20,000. sell physical wheat at Rs 20,000 in the
spot market. Effective price is Rs 40,000
Options contract
? Options contract can be used to protect against adverse price
movements.
? Call option ? option to buy at a specified price during a specified
period
? Put option ? option to sell at a specified price during a specified period.
? Both call and put have buyers/writers and sellers (4 legs)
? Many strategies like straddle, strangle, butterfly,...
? Simple option to protect a price drop is ?covered put option?
? Eg: someone has 100 HUL shares at current market price of Rs 900. he
fears a price drop but feels it may also increase.
? He buys a put option for a strike price of 900 paying a premium of Rs 5.
? If market drops to 800, then he exercise his ?in the money? option and
makes 900-800-5 = Rs 95
? If market moves up to 1000, then the option is out-of-money and he
wishes not to exercise the option and loses only Rs 5 of premium paid.
Hedging with Futures
Hedging a commodity risk using futures contract:
? A corn grower estimates in May about 20,000 bushels of corn by
December. He notices a price of $2.90/bushel of futures price in
December. He fears that the actual spot price in December will
be lower. So he books 4 contracts of size 4000 bushels each at
$2.90/bushel. He will buy back 4 contracts to offset his position.
? If market price is 2.5/bushel in December.
? Sale of 4 contracts at 2.90 in may ?. 4*5000*2.90 = 58000
? Buy-back at 2.50 in December ?. 4*5000*2.50 = 50000
? Gain on futures contract = 58000-50000 = 8000
? Sale of physical stock in December = 4*5000*2.50 = 50000
? Total revenue = 50,000+8000 = 58000
Hedging with futures
? If market price is 3.00/bushel in December.
? Sale of 4 contracts at 2.90 in may ?. 4*5000*2.90 = 58000
? Buy-back at 3 in December ?. 4*5000*3 = 60000
? Gain on futures contract = 58000-60000 = (2000)
? Sale of physical stock in December = 4*5000*3 = 60000
? Total revenue = 60,000-2000 = 58000
? So, no matter what the price is in December the farmer get the
contracted price of may of $ 58,000.
Solve,
1. You are having 100 shares of HUL and the current market price is
Rs 900. you fear that the market will crash and sell it in the june
futures market at Rs 950. in june the price of HUL comes to Rs 960.
Calculate your realisation
What is your realisation if the price comes down to Rs 900? What is
your gain in the whole transaction?
2. Colgate palmolive is quoting at Rs 1000/share. You expect the
market to go up. So you buy futures at Rs 1050 for June. In june
market goes to Rs 1250. what is your profit? What would have
happened if you had bought spot?
Insurance market dynamics
? Risk control, risk retention and risk transfer are the three
methods of risk management
? Risk retention by current earnings, loss reserves,
borrowings or captive insurance
? Risk transfer by a property and liability insurance
company.
? Decision needs to be taken about risk retention or risk
transfer. It depends upon conditions in the insurance
market-place.
? 3 imp factors influencing insurance market are:
? - underwriting cycle
? - consolidation in the insurance industry
? - securitisation of risk
1. Underwriting cycle
? Underwriting means ?sign and accept liability under (an
insurance policy), thus guaranteeing payment in case loss
or damage occurs?
? Underwriting cycle ? property and liability insurance market
fluctuate between periods of tight underwriting standards
and high premiums called ?hard? insurance market and
periods of loose underwriting standards called ?soft?
insurance market.
? This is measured in terms of combined ratio which is ratio of
paid losses and loss adjustment expenses plus underwriting
expenses to premiums
? If combined ratio is more than 1 (100%) then underwriting
operation is profitable. Less than 1 is loss making.
? Risk managers must study current status of the cycle before
making retention-transfer decisions. Buy when market is soft
and retain when the market is hard
Y underwriting cycle fluctuates?
? 1. Insurance industry capacity - capacity refers to
relative level of surplus which is assets less liabilities.
They reduce premium and go soft when they are
surplus and increase premium and go hard when they
are deficit. Competition hastens this process.
External factors like earthquake, 9/11, katrina can also
increase claims and reduce surplus and harden the
market.
? 2. Investment returns- insurance business also is an
investor generating revenues from premium collected.
They sell insurance at lower premiums expecting better
investment returns. this is called ?cashflow underwriting?
2. Consolidation in industry
? Consolidation means combining of business organisations
through mergers and acquisitions.
? A number of trends have changed the insurance market place
like
? - insurance company mergers and acquisitions
? - insurance brokerage mergers and acquisitions
? - cross-industry consolidations
? (Read george rejda page 68 for examples)
FirstRanker.com - FirstRanker's Choice
Risk
measurement
MODULE 3
Frequency and severity of
losses.
? Frequency of loss refers to number of times in a given period the
loss is likely to happen.
? Historical data will provide this info. (Eg: frequency of injury = no
of injuries in the past/no of worker-years) in the absence of
historical data, industry data can be used. Informed judgement
can be used as well.
? Severity of loss measures the magnitude of loss per occurrence.
One way to estimate is from historical data. (average
severity/occurrence)
? Expected loss = frequency of loss*severity of loss. Expected loss
affects business value and insurance pricing.
3.6
Note:
?Std deviation for high frequency
low severity is low while std
deviation for low frequency high
severity is high
?Infrequent but potentially large
losses are less predictable and
pose greater risk than more
frequent smaller losses.
Risk control
? Risk control is the process of implementing
measures to reduce risk associated with a hazard.
? Benefits of risk/loss control:
Elimination of expenses associated with
- Repair or replacement of damaged property
- Income losses due to distruction of property
- Extra costs associated with maintaining operations
- Adverse liability judgements
- Medical costs to treat injuries
- Income losses due to death/disabilities
Cost of risk control
? Installation and maintainance expenses eg
sprinkler system
? There are associated costs involved like employee
benefits apart from salary
? Some measures push up utility bills eg power bill
Risk control techniques
1
?Risk avoidance
2
?Risk prevention
3
?Risk reduction
Risk avoidance
? Risk avoidance involves not performing an activity that could carry
risk. Eg: not buying a property, not flying, not travelling. This leas to
loss of opportunities arising out of performing such activities. Not
doing a business will avoid risk but one loses on opportunity to earn
profits.
? Advantages:
? Chances of risk is reduced to zero in case where loss exposure has
not started. In situations where exposure has already started it is
reduce to zero for future activities. Residual risks may still persist
? Disadvantages:
? A firm cannot avoid all losses like premature death of an executive
? It is not feasible/practical to avoid all losses without shutting the
business eg car factory cannot avoid all risks if it has to continue
producing cars
Risk control techniques-
Risk prevention
? It refers to measures that reduce the frequency
of a particular loss. This focusses on stopping
losses from happening. Important to prevent
death/injury to people.
? Businesses employ loss control engineers to
identify sources of risks and institute corrective
actions. Like poor lighting, poor maintenance,
improper security, etc. training is given on safety
aspects
? Eg: changing slippery floor, building safety
enclosures to dangerous machinery etc
Risk control techniques-
Risk reduction
Risk financing techniques-
risk retention.
Risk financing techniques-
risk transfers.
Risk management decision
methods
? Risk avoidance
? Loss control
? Risk retension
? Non-insurance transfers
? insurance
Pooling arrangements and
diversification of risk
? Most popular risk management tool is diversification. Essential
part of insurance/financial markets
? Simple methods like pooling between two to diversification
amongst many
? Pooling arrangement reduces risk when losses are independent
(uncorrelated)
? Pooling refers to spreading losses incurred by a few over the
entire group so that everyone bears average loss instead of
actual loss.
2-person pooling arrangement
?Shahrukh and Salman have a possibility
of an accident in the coming year, say.
?20% chance of an accident with a loss of
2500
?Probability distribution of accident losses
is highly skewed. (0 ? 0.8; 2500 ? 0.2)
?Their losses are uncorrelated.
?What is the expected loss and standard
deviation for each one of them?
?Expected loss = 0.8*0 + 0.2*2500
= 500
?Standard deviation
= Root 0.8(0-500)
2
+ 0.2(2500-
500)
2
= 1000
Pooling arrangement?
?Pooling allows them to pool
their risk and split losses equally.
?What is the expected loss and
standard deviation for each
one of them?
Pooling arrangement..
Possible
outcome
Total cost Cost paid by
each person
Probability
Neither Shahrukh
nor salman
0 0 0.8*0.8=0.64
Only Shahrukh 2500 1250 0.2*0.8=0.16
Only salman 2500 1250 0.2*0.8=0.16
Both of them 5000 2500 0.2*0.2=0.04
?Expected cost =
0.64*0+0.32*1250+0.04*2500 = 500
?Standard Deviation =
Root of 0.64*(0-500)
2
+ 0.32*(1250-500)
2
+
(2500-500)
2
= 707
?Pooling arrangement doesn?t change
either person?s expected cost but it
reduces the standard deviation. (1000 to
707)
?This is how risk gets reduced by
diversification. Loss has become more
predictable.
Many-people pooling
? Assume that now Amir khan who has the same
probability of risk also joins the pooling arrangement.
If anyone meets with an accident, each will share
one-thirds of the average loss or expected loss.
? As more and more people join the pool, the mean
loss remains the same but standard deviation comes
down hereby reducing the risk for each participant.
? Expected loss or mean remains the same but the
standard deviation further decreases making the
normal distribution less skewed and more bell shaped.
? Note that here the risk is not transferred to anyone
else, but it is reduced as a whole for each pool
participant.
Fig 4.2 page 59
? Graph with pooling
? Graph without pooling
summary
? As the number of participants in a pooling
arrangement goes up, the standard deviation starts
coming down as near to zero as possible for each
participant. Probability of extreme high or low
outcome is reduced. This leads to the law of large
numbers.
? Law of large numbers states that ?The greater the
number of exposures, the more closely will actual
results approach the probable result that are
expected from an infinite number of exposures eg:
tossing a coin a million times)
? Also, as the number increases the probability
distribution curve of average loss tends to become
more and more bell shaped tending towards a
Normal distribution. This reflects central limit theorem.
Solve
?Suppose each participant in a pooling
arrangement has USD 0 to 4000 losses,
with each participants expected loss is
usd 1000, sketch the probability
distribution of average losses if the losses
across the participants are independent
and if
?1. there is 1 participant (no pooling)
?2. there are 100 participants
?3. there are 1000 participants.
Pooling with correlated losses
Positive correlation because of:
? Catastrophe and epidemic hit a large population at
the same time
? When losses are correlated then increase/decrease in
one leads to increase/decrease in another.
? Therefore, Pooling arrangement reduces risk for each
participant even when the losses are positively
correlated but to a lesser degree.
? Assuming Shah Ruk and Salman?s accidents are
correlated, then probability of shah Ruk having an
accident knowing that Salman has had an accident is
> 0.04
Changing scope of financial
management
Changing scope of risk
management
? Traditionally risk management focused on pure
loss exposures including property risks, liability
risks and personal risks.
? In 1990s new trend emerged where risk
management included speculative financial
risks.
? Recently some businesses have expanded their
scope to include all risks.
Financial risk management
? Financial risk management refers to
identification, analysis and treatment of
speculative financial risks which includes
- commodity price risk
- interest rate risk
- currency exchange rate risk
? Commodity price risk: it is the risk of losing
money if the price of a commodity changes.
Both producers/sellers and users have this risk.
Eg: agri grains
Futures&options can be used to hedge this risk.
Financial risk management
? Interest rate risk:
Risk of loss caused by averse interest rate
movements. Eg: a bank has loaned housing
loan for 20-30 years at a particular interest rate.
If rates go up, they have to borrow deposits at a
higher rate. Similarly a corporate may have
issued bond o public at a rate, they have to still
pay the coupon rate
? Currency exchange rate:
Exchange rate is the value at which one
country?s currency is converted to another
Nation?s currency. This affects both imports and
exports.
History of Managing financial risks
? Traditionally pure risk and speculative risks are
different and handled by separate departments.
? Pure risk by risk retention, risk transfer and loss
control.
? Speculative risk handled by finance division
through contractual provisions and capital market
instruments.
- contractual provisions include call features in
bonds and adjustable interest rate provisions in
mortgages
- capital market approaches include forwards,
futures options and swaps.
History
? In the 1990s some companies started taking a holistic
view of pure and speculative risk to achieve cost
advantage by combining both the risk coverages.
? In 1997, Honeywell became the first company to enter
into an ?integrated risk program? with AIG.
? An integrated risk program is a risk treatment technique
that combines coverage for pure and speculative risks
in the same contract. Honeywell covered traditional
property and casualty insurance as well as coverage
for currency exchange rate risk.
? Some companies created a new position called chief
risk officer(CRO) who is responsible for treatment of
pure and speculative risks in the organization.
History
? Combining two risks in the same contract makes it cheaper.
Companies who can afford a certain level of loss can go for a double
trigger option where the insurance company pays only if two
specified losses occur like one property claim and another exchange
rate claim. Such contracts are cheaper.
Enterprise risk management
? some companies went a step further and covered pyre risk,
speculative risk, strategic risks and operational risks.
? Strategic risk refers to uncertainty regarding the organization goals
and objectives and the organization?s strengths, weaknesses,
opportunities and threats.
? Operational risk refers to risks that develop out of business operations
like manufacturing products and providing service to customers.
? Combining all these risks in one package reduces risk as long as they
are not positively correlated. If they are negatively correlated risk can
be reduced significantly.
History
Advantages of ERM:
? Holistic treatment of risks
? Advantages over competing businesses.
? Positive impact upon revenues
? Reduction in earnings volatility
? Compliance with corporate governance guidelines
Barriers to ERP:
? Organisation culture
? Turf battles
? Perception of not a priority
? Lack of formal process
? Deficiencies in intellectual capital and technology
Futures and option basics
? Spot market: delivery based
? Example- buy wheat at 30,000/ton, sell sugar at 45000/ton
Derivative contracts
? Futures market: right to buy/sell, usually no delivery, squaring up
position.
? Eg: as a buyer buy wheat futures for june at Rs 25,000/ton. In june
market price is 30,000. you square up position by selling spot. You
make Rs 5000. buy physical wheat at Rs 30,000 from spot market.
Effective price is Rs 25000 which is futures contracted price.
? As a seller, sell wheat at Rs 40,000 in the june futures market. June
price crashes to Rs 20,000. you square up your position by buying
spot. You make Rs 20,000. sell physical wheat at Rs 20,000 in the
spot market. Effective price is Rs 40,000
Options contract
? Options contract can be used to protect against adverse price
movements.
? Call option ? option to buy at a specified price during a specified
period
? Put option ? option to sell at a specified price during a specified period.
? Both call and put have buyers/writers and sellers (4 legs)
? Many strategies like straddle, strangle, butterfly,...
? Simple option to protect a price drop is ?covered put option?
? Eg: someone has 100 HUL shares at current market price of Rs 900. he
fears a price drop but feels it may also increase.
? He buys a put option for a strike price of 900 paying a premium of Rs 5.
? If market drops to 800, then he exercise his ?in the money? option and
makes 900-800-5 = Rs 95
? If market moves up to 1000, then the option is out-of-money and he
wishes not to exercise the option and loses only Rs 5 of premium paid.
Hedging with Futures
Hedging a commodity risk using futures contract:
? A corn grower estimates in May about 20,000 bushels of corn by
December. He notices a price of $2.90/bushel of futures price in
December. He fears that the actual spot price in December will
be lower. So he books 4 contracts of size 4000 bushels each at
$2.90/bushel. He will buy back 4 contracts to offset his position.
? If market price is 2.5/bushel in December.
? Sale of 4 contracts at 2.90 in may ?. 4*5000*2.90 = 58000
? Buy-back at 2.50 in December ?. 4*5000*2.50 = 50000
? Gain on futures contract = 58000-50000 = 8000
? Sale of physical stock in December = 4*5000*2.50 = 50000
? Total revenue = 50,000+8000 = 58000
Hedging with futures
? If market price is 3.00/bushel in December.
? Sale of 4 contracts at 2.90 in may ?. 4*5000*2.90 = 58000
? Buy-back at 3 in December ?. 4*5000*3 = 60000
? Gain on futures contract = 58000-60000 = (2000)
? Sale of physical stock in December = 4*5000*3 = 60000
? Total revenue = 60,000-2000 = 58000
? So, no matter what the price is in December the farmer get the
contracted price of may of $ 58,000.
Solve,
1. You are having 100 shares of HUL and the current market price is
Rs 900. you fear that the market will crash and sell it in the june
futures market at Rs 950. in june the price of HUL comes to Rs 960.
Calculate your realisation
What is your realisation if the price comes down to Rs 900? What is
your gain in the whole transaction?
2. Colgate palmolive is quoting at Rs 1000/share. You expect the
market to go up. So you buy futures at Rs 1050 for June. In june
market goes to Rs 1250. what is your profit? What would have
happened if you had bought spot?
Insurance market dynamics
? Risk control, risk retention and risk transfer are the three
methods of risk management
? Risk retention by current earnings, loss reserves,
borrowings or captive insurance
? Risk transfer by a property and liability insurance
company.
? Decision needs to be taken about risk retention or risk
transfer. It depends upon conditions in the insurance
market-place.
? 3 imp factors influencing insurance market are:
? - underwriting cycle
? - consolidation in the insurance industry
? - securitisation of risk
1. Underwriting cycle
? Underwriting means ?sign and accept liability under (an
insurance policy), thus guaranteeing payment in case loss
or damage occurs?
? Underwriting cycle ? property and liability insurance market
fluctuate between periods of tight underwriting standards
and high premiums called ?hard? insurance market and
periods of loose underwriting standards called ?soft?
insurance market.
? This is measured in terms of combined ratio which is ratio of
paid losses and loss adjustment expenses plus underwriting
expenses to premiums
? If combined ratio is more than 1 (100%) then underwriting
operation is profitable. Less than 1 is loss making.
? Risk managers must study current status of the cycle before
making retention-transfer decisions. Buy when market is soft
and retain when the market is hard
Y underwriting cycle fluctuates?
? 1. Insurance industry capacity - capacity refers to
relative level of surplus which is assets less liabilities.
They reduce premium and go soft when they are
surplus and increase premium and go hard when they
are deficit. Competition hastens this process.
External factors like earthquake, 9/11, katrina can also
increase claims and reduce surplus and harden the
market.
? 2. Investment returns- insurance business also is an
investor generating revenues from premium collected.
They sell insurance at lower premiums expecting better
investment returns. this is called ?cashflow underwriting?
2. Consolidation in industry
? Consolidation means combining of business organisations
through mergers and acquisitions.
? A number of trends have changed the insurance market place
like
? - insurance company mergers and acquisitions
? - insurance brokerage mergers and acquisitions
? - cross-industry consolidations
? (Read george rejda page 68 for examples)
Securitisation of risk
? Securitisation of risk means that insurance risk is transferred to
the capital market through creation of financial instruments
such as catastrophe bond, futures contract, options contract,
and other financial instruments.
? This increases capacity for insuraers and provides access to
capital of many investors.
? Weather is another factor that determines risk in insurance and
weather bonds are floated to securitise it. A weather option
provides a payment if a specified weather contingency occurs
FirstRanker.com - FirstRanker's Choice
Risk
measurement
MODULE 3
Frequency and severity of
losses.
? Frequency of loss refers to number of times in a given period the
loss is likely to happen.
? Historical data will provide this info. (Eg: frequency of injury = no
of injuries in the past/no of worker-years) in the absence of
historical data, industry data can be used. Informed judgement
can be used as well.
? Severity of loss measures the magnitude of loss per occurrence.
One way to estimate is from historical data. (average
severity/occurrence)
? Expected loss = frequency of loss*severity of loss. Expected loss
affects business value and insurance pricing.
3.6
Note:
?Std deviation for high frequency
low severity is low while std
deviation for low frequency high
severity is high
?Infrequent but potentially large
losses are less predictable and
pose greater risk than more
frequent smaller losses.
Risk control
? Risk control is the process of implementing
measures to reduce risk associated with a hazard.
? Benefits of risk/loss control:
Elimination of expenses associated with
- Repair or replacement of damaged property
- Income losses due to distruction of property
- Extra costs associated with maintaining operations
- Adverse liability judgements
- Medical costs to treat injuries
- Income losses due to death/disabilities
Cost of risk control
? Installation and maintainance expenses eg
sprinkler system
? There are associated costs involved like employee
benefits apart from salary
? Some measures push up utility bills eg power bill
Risk control techniques
1
?Risk avoidance
2
?Risk prevention
3
?Risk reduction
Risk avoidance
? Risk avoidance involves not performing an activity that could carry
risk. Eg: not buying a property, not flying, not travelling. This leas to
loss of opportunities arising out of performing such activities. Not
doing a business will avoid risk but one loses on opportunity to earn
profits.
? Advantages:
? Chances of risk is reduced to zero in case where loss exposure has
not started. In situations where exposure has already started it is
reduce to zero for future activities. Residual risks may still persist
? Disadvantages:
? A firm cannot avoid all losses like premature death of an executive
? It is not feasible/practical to avoid all losses without shutting the
business eg car factory cannot avoid all risks if it has to continue
producing cars
Risk control techniques-
Risk prevention
? It refers to measures that reduce the frequency
of a particular loss. This focusses on stopping
losses from happening. Important to prevent
death/injury to people.
? Businesses employ loss control engineers to
identify sources of risks and institute corrective
actions. Like poor lighting, poor maintenance,
improper security, etc. training is given on safety
aspects
? Eg: changing slippery floor, building safety
enclosures to dangerous machinery etc
Risk control techniques-
Risk reduction
Risk financing techniques-
risk retention.
Risk financing techniques-
risk transfers.
Risk management decision
methods
? Risk avoidance
? Loss control
? Risk retension
? Non-insurance transfers
? insurance
Pooling arrangements and
diversification of risk
? Most popular risk management tool is diversification. Essential
part of insurance/financial markets
? Simple methods like pooling between two to diversification
amongst many
? Pooling arrangement reduces risk when losses are independent
(uncorrelated)
? Pooling refers to spreading losses incurred by a few over the
entire group so that everyone bears average loss instead of
actual loss.
2-person pooling arrangement
?Shahrukh and Salman have a possibility
of an accident in the coming year, say.
?20% chance of an accident with a loss of
2500
?Probability distribution of accident losses
is highly skewed. (0 ? 0.8; 2500 ? 0.2)
?Their losses are uncorrelated.
?What is the expected loss and standard
deviation for each one of them?
?Expected loss = 0.8*0 + 0.2*2500
= 500
?Standard deviation
= Root 0.8(0-500)
2
+ 0.2(2500-
500)
2
= 1000
Pooling arrangement?
?Pooling allows them to pool
their risk and split losses equally.
?What is the expected loss and
standard deviation for each
one of them?
Pooling arrangement..
Possible
outcome
Total cost Cost paid by
each person
Probability
Neither Shahrukh
nor salman
0 0 0.8*0.8=0.64
Only Shahrukh 2500 1250 0.2*0.8=0.16
Only salman 2500 1250 0.2*0.8=0.16
Both of them 5000 2500 0.2*0.2=0.04
?Expected cost =
0.64*0+0.32*1250+0.04*2500 = 500
?Standard Deviation =
Root of 0.64*(0-500)
2
+ 0.32*(1250-500)
2
+
(2500-500)
2
= 707
?Pooling arrangement doesn?t change
either person?s expected cost but it
reduces the standard deviation. (1000 to
707)
?This is how risk gets reduced by
diversification. Loss has become more
predictable.
Many-people pooling
? Assume that now Amir khan who has the same
probability of risk also joins the pooling arrangement.
If anyone meets with an accident, each will share
one-thirds of the average loss or expected loss.
? As more and more people join the pool, the mean
loss remains the same but standard deviation comes
down hereby reducing the risk for each participant.
? Expected loss or mean remains the same but the
standard deviation further decreases making the
normal distribution less skewed and more bell shaped.
? Note that here the risk is not transferred to anyone
else, but it is reduced as a whole for each pool
participant.
Fig 4.2 page 59
? Graph with pooling
? Graph without pooling
summary
? As the number of participants in a pooling
arrangement goes up, the standard deviation starts
coming down as near to zero as possible for each
participant. Probability of extreme high or low
outcome is reduced. This leads to the law of large
numbers.
? Law of large numbers states that ?The greater the
number of exposures, the more closely will actual
results approach the probable result that are
expected from an infinite number of exposures eg:
tossing a coin a million times)
? Also, as the number increases the probability
distribution curve of average loss tends to become
more and more bell shaped tending towards a
Normal distribution. This reflects central limit theorem.
Solve
?Suppose each participant in a pooling
arrangement has USD 0 to 4000 losses,
with each participants expected loss is
usd 1000, sketch the probability
distribution of average losses if the losses
across the participants are independent
and if
?1. there is 1 participant (no pooling)
?2. there are 100 participants
?3. there are 1000 participants.
Pooling with correlated losses
Positive correlation because of:
? Catastrophe and epidemic hit a large population at
the same time
? When losses are correlated then increase/decrease in
one leads to increase/decrease in another.
? Therefore, Pooling arrangement reduces risk for each
participant even when the losses are positively
correlated but to a lesser degree.
? Assuming Shah Ruk and Salman?s accidents are
correlated, then probability of shah Ruk having an
accident knowing that Salman has had an accident is
> 0.04
Changing scope of financial
management
Changing scope of risk
management
? Traditionally risk management focused on pure
loss exposures including property risks, liability
risks and personal risks.
? In 1990s new trend emerged where risk
management included speculative financial
risks.
? Recently some businesses have expanded their
scope to include all risks.
Financial risk management
? Financial risk management refers to
identification, analysis and treatment of
speculative financial risks which includes
- commodity price risk
- interest rate risk
- currency exchange rate risk
? Commodity price risk: it is the risk of losing
money if the price of a commodity changes.
Both producers/sellers and users have this risk.
Eg: agri grains
Futures&options can be used to hedge this risk.
Financial risk management
? Interest rate risk:
Risk of loss caused by averse interest rate
movements. Eg: a bank has loaned housing
loan for 20-30 years at a particular interest rate.
If rates go up, they have to borrow deposits at a
higher rate. Similarly a corporate may have
issued bond o public at a rate, they have to still
pay the coupon rate
? Currency exchange rate:
Exchange rate is the value at which one
country?s currency is converted to another
Nation?s currency. This affects both imports and
exports.
History of Managing financial risks
? Traditionally pure risk and speculative risks are
different and handled by separate departments.
? Pure risk by risk retention, risk transfer and loss
control.
? Speculative risk handled by finance division
through contractual provisions and capital market
instruments.
- contractual provisions include call features in
bonds and adjustable interest rate provisions in
mortgages
- capital market approaches include forwards,
futures options and swaps.
History
? In the 1990s some companies started taking a holistic
view of pure and speculative risk to achieve cost
advantage by combining both the risk coverages.
? In 1997, Honeywell became the first company to enter
into an ?integrated risk program? with AIG.
? An integrated risk program is a risk treatment technique
that combines coverage for pure and speculative risks
in the same contract. Honeywell covered traditional
property and casualty insurance as well as coverage
for currency exchange rate risk.
? Some companies created a new position called chief
risk officer(CRO) who is responsible for treatment of
pure and speculative risks in the organization.
History
? Combining two risks in the same contract makes it cheaper.
Companies who can afford a certain level of loss can go for a double
trigger option where the insurance company pays only if two
specified losses occur like one property claim and another exchange
rate claim. Such contracts are cheaper.
Enterprise risk management
? some companies went a step further and covered pyre risk,
speculative risk, strategic risks and operational risks.
? Strategic risk refers to uncertainty regarding the organization goals
and objectives and the organization?s strengths, weaknesses,
opportunities and threats.
? Operational risk refers to risks that develop out of business operations
like manufacturing products and providing service to customers.
? Combining all these risks in one package reduces risk as long as they
are not positively correlated. If they are negatively correlated risk can
be reduced significantly.
History
Advantages of ERM:
? Holistic treatment of risks
? Advantages over competing businesses.
? Positive impact upon revenues
? Reduction in earnings volatility
? Compliance with corporate governance guidelines
Barriers to ERP:
? Organisation culture
? Turf battles
? Perception of not a priority
? Lack of formal process
? Deficiencies in intellectual capital and technology
Futures and option basics
? Spot market: delivery based
? Example- buy wheat at 30,000/ton, sell sugar at 45000/ton
Derivative contracts
? Futures market: right to buy/sell, usually no delivery, squaring up
position.
? Eg: as a buyer buy wheat futures for june at Rs 25,000/ton. In june
market price is 30,000. you square up position by selling spot. You
make Rs 5000. buy physical wheat at Rs 30,000 from spot market.
Effective price is Rs 25000 which is futures contracted price.
? As a seller, sell wheat at Rs 40,000 in the june futures market. June
price crashes to Rs 20,000. you square up your position by buying
spot. You make Rs 20,000. sell physical wheat at Rs 20,000 in the
spot market. Effective price is Rs 40,000
Options contract
? Options contract can be used to protect against adverse price
movements.
? Call option ? option to buy at a specified price during a specified
period
? Put option ? option to sell at a specified price during a specified period.
? Both call and put have buyers/writers and sellers (4 legs)
? Many strategies like straddle, strangle, butterfly,...
? Simple option to protect a price drop is ?covered put option?
? Eg: someone has 100 HUL shares at current market price of Rs 900. he
fears a price drop but feels it may also increase.
? He buys a put option for a strike price of 900 paying a premium of Rs 5.
? If market drops to 800, then he exercise his ?in the money? option and
makes 900-800-5 = Rs 95
? If market moves up to 1000, then the option is out-of-money and he
wishes not to exercise the option and loses only Rs 5 of premium paid.
Hedging with Futures
Hedging a commodity risk using futures contract:
? A corn grower estimates in May about 20,000 bushels of corn by
December. He notices a price of $2.90/bushel of futures price in
December. He fears that the actual spot price in December will
be lower. So he books 4 contracts of size 4000 bushels each at
$2.90/bushel. He will buy back 4 contracts to offset his position.
? If market price is 2.5/bushel in December.
? Sale of 4 contracts at 2.90 in may ?. 4*5000*2.90 = 58000
? Buy-back at 2.50 in December ?. 4*5000*2.50 = 50000
? Gain on futures contract = 58000-50000 = 8000
? Sale of physical stock in December = 4*5000*2.50 = 50000
? Total revenue = 50,000+8000 = 58000
Hedging with futures
? If market price is 3.00/bushel in December.
? Sale of 4 contracts at 2.90 in may ?. 4*5000*2.90 = 58000
? Buy-back at 3 in December ?. 4*5000*3 = 60000
? Gain on futures contract = 58000-60000 = (2000)
? Sale of physical stock in December = 4*5000*3 = 60000
? Total revenue = 60,000-2000 = 58000
? So, no matter what the price is in December the farmer get the
contracted price of may of $ 58,000.
Solve,
1. You are having 100 shares of HUL and the current market price is
Rs 900. you fear that the market will crash and sell it in the june
futures market at Rs 950. in june the price of HUL comes to Rs 960.
Calculate your realisation
What is your realisation if the price comes down to Rs 900? What is
your gain in the whole transaction?
2. Colgate palmolive is quoting at Rs 1000/share. You expect the
market to go up. So you buy futures at Rs 1050 for June. In june
market goes to Rs 1250. what is your profit? What would have
happened if you had bought spot?
Insurance market dynamics
? Risk control, risk retention and risk transfer are the three
methods of risk management
? Risk retention by current earnings, loss reserves,
borrowings or captive insurance
? Risk transfer by a property and liability insurance
company.
? Decision needs to be taken about risk retention or risk
transfer. It depends upon conditions in the insurance
market-place.
? 3 imp factors influencing insurance market are:
? - underwriting cycle
? - consolidation in the insurance industry
? - securitisation of risk
1. Underwriting cycle
? Underwriting means ?sign and accept liability under (an
insurance policy), thus guaranteeing payment in case loss
or damage occurs?
? Underwriting cycle ? property and liability insurance market
fluctuate between periods of tight underwriting standards
and high premiums called ?hard? insurance market and
periods of loose underwriting standards called ?soft?
insurance market.
? This is measured in terms of combined ratio which is ratio of
paid losses and loss adjustment expenses plus underwriting
expenses to premiums
? If combined ratio is more than 1 (100%) then underwriting
operation is profitable. Less than 1 is loss making.
? Risk managers must study current status of the cycle before
making retention-transfer decisions. Buy when market is soft
and retain when the market is hard
Y underwriting cycle fluctuates?
? 1. Insurance industry capacity - capacity refers to
relative level of surplus which is assets less liabilities.
They reduce premium and go soft when they are
surplus and increase premium and go hard when they
are deficit. Competition hastens this process.
External factors like earthquake, 9/11, katrina can also
increase claims and reduce surplus and harden the
market.
? 2. Investment returns- insurance business also is an
investor generating revenues from premium collected.
They sell insurance at lower premiums expecting better
investment returns. this is called ?cashflow underwriting?
2. Consolidation in industry
? Consolidation means combining of business organisations
through mergers and acquisitions.
? A number of trends have changed the insurance market place
like
? - insurance company mergers and acquisitions
? - insurance brokerage mergers and acquisitions
? - cross-industry consolidations
? (Read george rejda page 68 for examples)
Securitisation of risk
? Securitisation of risk means that insurance risk is transferred to
the capital market through creation of financial instruments
such as catastrophe bond, futures contract, options contract,
and other financial instruments.
? This increases capacity for insuraers and provides access to
capital of many investors.
? Weather is another factor that determines risk in insurance and
weather bonds are floated to securitise it. A weather option
provides a payment if a specified weather contingency occurs
Loss forecasting
Done on the basis of statistical analysis of past losses.
Risk profiling or risk mapping refers to analyzing the severity and
frequency of various risks involved in the business.
Based on loss forecasting the manager is able to decide of risk
control measures.
Loss forecasting is done on the basis of
? Probability analysis:
? Probability or chance of loss of an event refers to the long term
frequency of accurrence. Probability distribution is mutually
exclusive and collectively exhaustible list of all outcomes arising
out of an event along with probability associated with each
outcome.
?
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Risk
measurement
MODULE 3
Frequency and severity of
losses.
? Frequency of loss refers to number of times in a given period the
loss is likely to happen.
? Historical data will provide this info. (Eg: frequency of injury = no
of injuries in the past/no of worker-years) in the absence of
historical data, industry data can be used. Informed judgement
can be used as well.
? Severity of loss measures the magnitude of loss per occurrence.
One way to estimate is from historical data. (average
severity/occurrence)
? Expected loss = frequency of loss*severity of loss. Expected loss
affects business value and insurance pricing.
3.6
Note:
?Std deviation for high frequency
low severity is low while std
deviation for low frequency high
severity is high
?Infrequent but potentially large
losses are less predictable and
pose greater risk than more
frequent smaller losses.
Risk control
? Risk control is the process of implementing
measures to reduce risk associated with a hazard.
? Benefits of risk/loss control:
Elimination of expenses associated with
- Repair or replacement of damaged property
- Income losses due to distruction of property
- Extra costs associated with maintaining operations
- Adverse liability judgements
- Medical costs to treat injuries
- Income losses due to death/disabilities
Cost of risk control
? Installation and maintainance expenses eg
sprinkler system
? There are associated costs involved like employee
benefits apart from salary
? Some measures push up utility bills eg power bill
Risk control techniques
1
?Risk avoidance
2
?Risk prevention
3
?Risk reduction
Risk avoidance
? Risk avoidance involves not performing an activity that could carry
risk. Eg: not buying a property, not flying, not travelling. This leas to
loss of opportunities arising out of performing such activities. Not
doing a business will avoid risk but one loses on opportunity to earn
profits.
? Advantages:
? Chances of risk is reduced to zero in case where loss exposure has
not started. In situations where exposure has already started it is
reduce to zero for future activities. Residual risks may still persist
? Disadvantages:
? A firm cannot avoid all losses like premature death of an executive
? It is not feasible/practical to avoid all losses without shutting the
business eg car factory cannot avoid all risks if it has to continue
producing cars
Risk control techniques-
Risk prevention
? It refers to measures that reduce the frequency
of a particular loss. This focusses on stopping
losses from happening. Important to prevent
death/injury to people.
? Businesses employ loss control engineers to
identify sources of risks and institute corrective
actions. Like poor lighting, poor maintenance,
improper security, etc. training is given on safety
aspects
? Eg: changing slippery floor, building safety
enclosures to dangerous machinery etc
Risk control techniques-
Risk reduction
Risk financing techniques-
risk retention.
Risk financing techniques-
risk transfers.
Risk management decision
methods
? Risk avoidance
? Loss control
? Risk retension
? Non-insurance transfers
? insurance
Pooling arrangements and
diversification of risk
? Most popular risk management tool is diversification. Essential
part of insurance/financial markets
? Simple methods like pooling between two to diversification
amongst many
? Pooling arrangement reduces risk when losses are independent
(uncorrelated)
? Pooling refers to spreading losses incurred by a few over the
entire group so that everyone bears average loss instead of
actual loss.
2-person pooling arrangement
?Shahrukh and Salman have a possibility
of an accident in the coming year, say.
?20% chance of an accident with a loss of
2500
?Probability distribution of accident losses
is highly skewed. (0 ? 0.8; 2500 ? 0.2)
?Their losses are uncorrelated.
?What is the expected loss and standard
deviation for each one of them?
?Expected loss = 0.8*0 + 0.2*2500
= 500
?Standard deviation
= Root 0.8(0-500)
2
+ 0.2(2500-
500)
2
= 1000
Pooling arrangement?
?Pooling allows them to pool
their risk and split losses equally.
?What is the expected loss and
standard deviation for each
one of them?
Pooling arrangement..
Possible
outcome
Total cost Cost paid by
each person
Probability
Neither Shahrukh
nor salman
0 0 0.8*0.8=0.64
Only Shahrukh 2500 1250 0.2*0.8=0.16
Only salman 2500 1250 0.2*0.8=0.16
Both of them 5000 2500 0.2*0.2=0.04
?Expected cost =
0.64*0+0.32*1250+0.04*2500 = 500
?Standard Deviation =
Root of 0.64*(0-500)
2
+ 0.32*(1250-500)
2
+
(2500-500)
2
= 707
?Pooling arrangement doesn?t change
either person?s expected cost but it
reduces the standard deviation. (1000 to
707)
?This is how risk gets reduced by
diversification. Loss has become more
predictable.
Many-people pooling
? Assume that now Amir khan who has the same
probability of risk also joins the pooling arrangement.
If anyone meets with an accident, each will share
one-thirds of the average loss or expected loss.
? As more and more people join the pool, the mean
loss remains the same but standard deviation comes
down hereby reducing the risk for each participant.
? Expected loss or mean remains the same but the
standard deviation further decreases making the
normal distribution less skewed and more bell shaped.
? Note that here the risk is not transferred to anyone
else, but it is reduced as a whole for each pool
participant.
Fig 4.2 page 59
? Graph with pooling
? Graph without pooling
summary
? As the number of participants in a pooling
arrangement goes up, the standard deviation starts
coming down as near to zero as possible for each
participant. Probability of extreme high or low
outcome is reduced. This leads to the law of large
numbers.
? Law of large numbers states that ?The greater the
number of exposures, the more closely will actual
results approach the probable result that are
expected from an infinite number of exposures eg:
tossing a coin a million times)
? Also, as the number increases the probability
distribution curve of average loss tends to become
more and more bell shaped tending towards a
Normal distribution. This reflects central limit theorem.
Solve
?Suppose each participant in a pooling
arrangement has USD 0 to 4000 losses,
with each participants expected loss is
usd 1000, sketch the probability
distribution of average losses if the losses
across the participants are independent
and if
?1. there is 1 participant (no pooling)
?2. there are 100 participants
?3. there are 1000 participants.
Pooling with correlated losses
Positive correlation because of:
? Catastrophe and epidemic hit a large population at
the same time
? When losses are correlated then increase/decrease in
one leads to increase/decrease in another.
? Therefore, Pooling arrangement reduces risk for each
participant even when the losses are positively
correlated but to a lesser degree.
? Assuming Shah Ruk and Salman?s accidents are
correlated, then probability of shah Ruk having an
accident knowing that Salman has had an accident is
> 0.04
Changing scope of financial
management
Changing scope of risk
management
? Traditionally risk management focused on pure
loss exposures including property risks, liability
risks and personal risks.
? In 1990s new trend emerged where risk
management included speculative financial
risks.
? Recently some businesses have expanded their
scope to include all risks.
Financial risk management
? Financial risk management refers to
identification, analysis and treatment of
speculative financial risks which includes
- commodity price risk
- interest rate risk
- currency exchange rate risk
? Commodity price risk: it is the risk of losing
money if the price of a commodity changes.
Both producers/sellers and users have this risk.
Eg: agri grains
Futures&options can be used to hedge this risk.
Financial risk management
? Interest rate risk:
Risk of loss caused by averse interest rate
movements. Eg: a bank has loaned housing
loan for 20-30 years at a particular interest rate.
If rates go up, they have to borrow deposits at a
higher rate. Similarly a corporate may have
issued bond o public at a rate, they have to still
pay the coupon rate
? Currency exchange rate:
Exchange rate is the value at which one
country?s currency is converted to another
Nation?s currency. This affects both imports and
exports.
History of Managing financial risks
? Traditionally pure risk and speculative risks are
different and handled by separate departments.
? Pure risk by risk retention, risk transfer and loss
control.
? Speculative risk handled by finance division
through contractual provisions and capital market
instruments.
- contractual provisions include call features in
bonds and adjustable interest rate provisions in
mortgages
- capital market approaches include forwards,
futures options and swaps.
History
? In the 1990s some companies started taking a holistic
view of pure and speculative risk to achieve cost
advantage by combining both the risk coverages.
? In 1997, Honeywell became the first company to enter
into an ?integrated risk program? with AIG.
? An integrated risk program is a risk treatment technique
that combines coverage for pure and speculative risks
in the same contract. Honeywell covered traditional
property and casualty insurance as well as coverage
for currency exchange rate risk.
? Some companies created a new position called chief
risk officer(CRO) who is responsible for treatment of
pure and speculative risks in the organization.
History
? Combining two risks in the same contract makes it cheaper.
Companies who can afford a certain level of loss can go for a double
trigger option where the insurance company pays only if two
specified losses occur like one property claim and another exchange
rate claim. Such contracts are cheaper.
Enterprise risk management
? some companies went a step further and covered pyre risk,
speculative risk, strategic risks and operational risks.
? Strategic risk refers to uncertainty regarding the organization goals
and objectives and the organization?s strengths, weaknesses,
opportunities and threats.
? Operational risk refers to risks that develop out of business operations
like manufacturing products and providing service to customers.
? Combining all these risks in one package reduces risk as long as they
are not positively correlated. If they are negatively correlated risk can
be reduced significantly.
History
Advantages of ERM:
? Holistic treatment of risks
? Advantages over competing businesses.
? Positive impact upon revenues
? Reduction in earnings volatility
? Compliance with corporate governance guidelines
Barriers to ERP:
? Organisation culture
? Turf battles
? Perception of not a priority
? Lack of formal process
? Deficiencies in intellectual capital and technology
Futures and option basics
? Spot market: delivery based
? Example- buy wheat at 30,000/ton, sell sugar at 45000/ton
Derivative contracts
? Futures market: right to buy/sell, usually no delivery, squaring up
position.
? Eg: as a buyer buy wheat futures for june at Rs 25,000/ton. In june
market price is 30,000. you square up position by selling spot. You
make Rs 5000. buy physical wheat at Rs 30,000 from spot market.
Effective price is Rs 25000 which is futures contracted price.
? As a seller, sell wheat at Rs 40,000 in the june futures market. June
price crashes to Rs 20,000. you square up your position by buying
spot. You make Rs 20,000. sell physical wheat at Rs 20,000 in the
spot market. Effective price is Rs 40,000
Options contract
? Options contract can be used to protect against adverse price
movements.
? Call option ? option to buy at a specified price during a specified
period
? Put option ? option to sell at a specified price during a specified period.
? Both call and put have buyers/writers and sellers (4 legs)
? Many strategies like straddle, strangle, butterfly,...
? Simple option to protect a price drop is ?covered put option?
? Eg: someone has 100 HUL shares at current market price of Rs 900. he
fears a price drop but feels it may also increase.
? He buys a put option for a strike price of 900 paying a premium of Rs 5.
? If market drops to 800, then he exercise his ?in the money? option and
makes 900-800-5 = Rs 95
? If market moves up to 1000, then the option is out-of-money and he
wishes not to exercise the option and loses only Rs 5 of premium paid.
Hedging with Futures
Hedging a commodity risk using futures contract:
? A corn grower estimates in May about 20,000 bushels of corn by
December. He notices a price of $2.90/bushel of futures price in
December. He fears that the actual spot price in December will
be lower. So he books 4 contracts of size 4000 bushels each at
$2.90/bushel. He will buy back 4 contracts to offset his position.
? If market price is 2.5/bushel in December.
? Sale of 4 contracts at 2.90 in may ?. 4*5000*2.90 = 58000
? Buy-back at 2.50 in December ?. 4*5000*2.50 = 50000
? Gain on futures contract = 58000-50000 = 8000
? Sale of physical stock in December = 4*5000*2.50 = 50000
? Total revenue = 50,000+8000 = 58000
Hedging with futures
? If market price is 3.00/bushel in December.
? Sale of 4 contracts at 2.90 in may ?. 4*5000*2.90 = 58000
? Buy-back at 3 in December ?. 4*5000*3 = 60000
? Gain on futures contract = 58000-60000 = (2000)
? Sale of physical stock in December = 4*5000*3 = 60000
? Total revenue = 60,000-2000 = 58000
? So, no matter what the price is in December the farmer get the
contracted price of may of $ 58,000.
Solve,
1. You are having 100 shares of HUL and the current market price is
Rs 900. you fear that the market will crash and sell it in the june
futures market at Rs 950. in june the price of HUL comes to Rs 960.
Calculate your realisation
What is your realisation if the price comes down to Rs 900? What is
your gain in the whole transaction?
2. Colgate palmolive is quoting at Rs 1000/share. You expect the
market to go up. So you buy futures at Rs 1050 for June. In june
market goes to Rs 1250. what is your profit? What would have
happened if you had bought spot?
Insurance market dynamics
? Risk control, risk retention and risk transfer are the three
methods of risk management
? Risk retention by current earnings, loss reserves,
borrowings or captive insurance
? Risk transfer by a property and liability insurance
company.
? Decision needs to be taken about risk retention or risk
transfer. It depends upon conditions in the insurance
market-place.
? 3 imp factors influencing insurance market are:
? - underwriting cycle
? - consolidation in the insurance industry
? - securitisation of risk
1. Underwriting cycle
? Underwriting means ?sign and accept liability under (an
insurance policy), thus guaranteeing payment in case loss
or damage occurs?
? Underwriting cycle ? property and liability insurance market
fluctuate between periods of tight underwriting standards
and high premiums called ?hard? insurance market and
periods of loose underwriting standards called ?soft?
insurance market.
? This is measured in terms of combined ratio which is ratio of
paid losses and loss adjustment expenses plus underwriting
expenses to premiums
? If combined ratio is more than 1 (100%) then underwriting
operation is profitable. Less than 1 is loss making.
? Risk managers must study current status of the cycle before
making retention-transfer decisions. Buy when market is soft
and retain when the market is hard
Y underwriting cycle fluctuates?
? 1. Insurance industry capacity - capacity refers to
relative level of surplus which is assets less liabilities.
They reduce premium and go soft when they are
surplus and increase premium and go hard when they
are deficit. Competition hastens this process.
External factors like earthquake, 9/11, katrina can also
increase claims and reduce surplus and harden the
market.
? 2. Investment returns- insurance business also is an
investor generating revenues from premium collected.
They sell insurance at lower premiums expecting better
investment returns. this is called ?cashflow underwriting?
2. Consolidation in industry
? Consolidation means combining of business organisations
through mergers and acquisitions.
? A number of trends have changed the insurance market place
like
? - insurance company mergers and acquisitions
? - insurance brokerage mergers and acquisitions
? - cross-industry consolidations
? (Read george rejda page 68 for examples)
Securitisation of risk
? Securitisation of risk means that insurance risk is transferred to
the capital market through creation of financial instruments
such as catastrophe bond, futures contract, options contract,
and other financial instruments.
? This increases capacity for insuraers and provides access to
capital of many investors.
? Weather is another factor that determines risk in insurance and
weather bonds are floated to securitise it. A weather option
provides a payment if a specified weather contingency occurs
Loss forecasting
Done on the basis of statistical analysis of past losses.
Risk profiling or risk mapping refers to analyzing the severity and
frequency of various risks involved in the business.
Based on loss forecasting the manager is able to decide of risk
control measures.
Loss forecasting is done on the basis of
? Probability analysis:
? Probability or chance of loss of an event refers to the long term
frequency of accurrence. Probability distribution is mutually
exclusive and collectively exhaustible list of all outcomes arising
out of an event along with probability associated with each
outcome.
?
? Statistical analysis:
? It talks about a distribution of losses and parameters associated
with it like mean mode median regression analysis and moratlity
tables.
? Regression talks about relationship between one or more
dependent variables and an independent variable. Eg Y = a+bX
? Mortality table indicates probability of death at a particular age. A
mortality rate of 0.001at an age of 25 indicates that 1 out of 1000
insured will die during that year. If all the 1000 are insured fro 1 lakh
each then the company has to pay 1 lakh. In order to do that the
company has to collect Rs 1 lakh from 1000 insured which comes
to 100 per lakh of sum assured or 1 per 1000 sum assured.
? Law of large numbers:
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This post was last modified on 18 February 2020