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sec_1_intro.pptAnalysis of Risk
Introduction to Analysis of Risk
Learning Objectives
Discuss the definition of risk and the general classes of risk.
Discuss the definition of risk management and the five steps of the risk management process.
Discuss the components of the total cost of risk and why it is used as a key risk management tool.
Discuss the uses of risk analysis and the necessary tools to perform a risk analysis.
Learning Objective #1:
Discuss the definitions of risk and the general classes of risk.
I. What is Risk?
Definitions of risk
“Risk” is a term subject to various interpretations in risk management. The interpretations are usually dependent upon the perspective of the user and the purpose for which the term is applied.
What is Risk?
Risk may take the form of:
A probability
A degree of uncertainty
Varying outcomes
A variance from a forecast or prediction
Four broad definitions of “risk” used in risk management:
Chance or probability of loss
Uncertainty concerning loss
Possibility of a variation of outcomes from a given set of circumstances
Difference between expected losses and actual losses
What is Risk?
What is Risk?
For purposes of the CRM program, the most useful definition of “risk” is:
“Uncertainty that may be either positive or negative arising out of a given set of circumstances.”
What is Risk?
Types of risk
Pure – chance of loss or no loss (break-even)
Speculative – chance of loss or gain; often referred to as a “business risk”
Risk Management Terms
Exposure – a situation, practice, or condition that gives rise to a loss from a given peril leading to an adverse financial consequence; an activity or resource; people and assets
Peril – the cause of a loss
Hazard – a condition or circumstance that may give rise to a loss from a given peril; physical, moral, or moral characteristics that make the likelihood of a loss from a given peril greater
Incident – an event that disrupts normal activities and may become a loss, claim or business interruption
Accident – an unplanned event, definite as to time and place, that results in injury or damage to a person or property
Occurrence – an accident with the limitation of time removed (an “accident” that is extended over a period of time rather than a single observable happening)
Risk Management Terms
Loss – a reduction in value
Claim – a demand or obligation for payment as a result of a loss
Frequency – the number of losses occurring in a given time period
Severity – the dollar amount of a given loss or the aggregate dollar amount of all losses for a given period
Risk Management Terms
Expected losses – projection of the frequency and/or severity of losses based on loss history, probability distributions, and statistics; the expected loss projection is commonly called a “loss pic” or “loss pick”
Risk Management Terms
General Classes of Risk
Economic – risks arising from operations, economy, financial marketplace or entrepreneurial activities
Legal – risks inherent in compliance or arising from statutory liability
Political – risks arising from changes in the law, government reinterpretations or changes in government policy
General Classes of Risk
Social – risks arising from public relations, loss of reputation, damage to brand, cultural issues, social direction or social media
Physical – risks arising from property, people, or information
Juridical – risks arising from a jury or judge’s decision or from court or jury attitudes
Learning Objective #2:
Discuss the definition of risk management and the five steps of the risk management process.
II. Risk Management
Definition of risk management
Similar to “risk,” risk management has many definitions. For purposes of the CRM program, the definition of risk management is as follows:
“The process of managing uncertainty of exposures that affect an organization’s assets and financial statements using five steps: identification, analysis, control, financing and administration.”
Risk Management
This process can address pure risks only (traditional risk management) or pure and speculative risks (enterprise-wide risk management).
The focus of the process is two-fold:
Protect the assets of the organization, and
Protect the financial statements of the organization
The Risk Management Process
Five Steps of the RM Process
Risk Identification
Risk Analysis
Risk Control
Risk Financing
Risk Administration
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The Risk Management Process
Risk Identification – the process of identifying and examining exposures of an organization.
Identification is the most important step of the risk management process because an exposure and/or risk must be identified before it can be effectively analyzed, controlled, or financed.
Risk Identification
Four logical classifications of exposures
Property
Human Resources
Liability
Net income
Risk Identification
Ten methods of exposure identification
Checklist and survey
Flowchart
Insurance policy review
Physical inspections
Compliance review
Procedures and policies review
Contract review
Experts
Financial statement analysis
Loss data analysis
Risk Analysis
Risk Analysis – the assessment of the potential impact of various exposures to an organization
Qualitative analysis – the “what” analysis
Risk assessment – used to identify and assess those loss exposures that cannot be easily measured by traditional statistical or financial methods and to understand their impact on the organization’s ultimate risks and performance
Risk Analysis
Financial assessment – used to identify and assess those broad loss exposures that have a financial impact on the organization but that may be difficult to quantify
Loss data assessment – used to identify and apply various methods of assessing loss data and to analyze the impact those losses may have on the organization’s risk management policy and the ultimate total cost of risk
Risk Analysis
Quantitative analysis – the “how much” analysis; attempts to accurately measure risks by using acceptable traditional methodologies which calculate relative values
Loss projections or forecasts
Cash discounting and net present value (NPV) calculations
Cost-benefit analyses
Total cost of risk calculations and analyses
Risk Control
Risk Control – any conscious action or inaction to minimize, at the optimal cost, the probability, frequency, severity, or unpredictability of loss
General theories of risk control
Human approach – people cause accidents
Engineering approach – things and energy cause accidents
Systems approach – systemic failures or weaknesses cause accidents
Risk Control
Five techniques of risk control
Avoidance
Prevention
Reduction (pre-loss and post-loss)
Segregation/separation/duplication
Transfer (contractual, physical or both)
Risk Financing
Risk Financing – the acquisition of internal and external funds to pay losses at the most favorable cost
Retention – internal funds used to pay losses
Active (planned)
Passive (unplanned)
Risk Financing
Transfer of financial responsibility – external funds used to pay losses
Non-insurance contractual transfer of control or responsibility for an exposure
Non-insurance contractual indemnification or financial responsibility
Insurance – equitable financing of risks, from one entity to another, in exchange for payment
Risk Administration
Risk Administration
Implementation
Monitoring
Learning Objective #3:
Discuss the components of the total cost of risk and its use as a key risk management tool.
III. Total Cost of Risk (TCOR)
Definition: sum of all quantified costs and expenses associated with the risk management function of an organization
TCOR = insurance costs + retained losses + risk management departmental costs + outside services fees + quantified indirect costs
TCOR
Components of TCOR
Insurance costs
Retained losses (passive or active) and associated loss adjustment expenses
TCOR
Risk management departmental costs
Salaries
Administrative charges, e.g., training and travel expenses
Employee benefits
Risk management information system
Management overhead
Other departmental costs
TCOR
Outside services fees
Risk management consultants
Third-party administrators and other vendors
Loss control
Actuarial
Legal
Fee-for-service insurance brokers
TCOR
Indirect costs – these costs cannot be precisely measured; therefore, the impact of non-quantifiable indirect costs should be included as part of the qualitative assessment of risk
Disruption in production/sales
Management time spent on loss-related activities
Overtime costs
Hiring and training replacement costs
Opportunity costs
Loss of goodwill
Social costs (public image, reputation, etc.)
TCOR
Objective of the risk manager – to minimize the TCOR by identifying those factors from each component that can be more effectively managed and controlled
TCOR
Impact of a Loss on TCOR and Sales/Revenue
Regardless of whether or not the organization includes the TCOR in the pricing of its products or services, any loss that is prevented or reduced improves the financial results of the organization.
TCOR
Steps to measure the impact of loss on sales or revenue
Determine the profit margin of the organization
Divide the loss cost by the profit margin. The result is the sales or revenue required to pay for the accident.
TCOR
TCOR
The TCOR is used as a key risk management tool to:
Making effective risk management decisions
Measuring progress toward risk management objectives
Focusing on and promoting safety and loss control by communicating the financial impact of a loss on the TCOR and sales/revenue
TCOR
Providing management and employee incentives
Pricing of products and services
Assisting with effective management of financial budgets
Learning Objective #4:
Discuss the uses of risk analysis and the necessary tools to perform a risk analysis.
IV. Risk Analysis
Uses of risk analysis
Prioritization of risk factors
Verification of loss data
Classification of loss data
Prediction of losses and ranges of losses
Cost-benefit decision making
IV. Risk Analysis
Net present value (NPV) analysis
Review of insurance program structure to determine:
Viability of a retention program
Amount of retention
Insurance purchasing decisions, including limits of liability
Risk Analysis
Risk analysis tools
Tools used to assess the likelihood an event will occur
Loss analysis
Risk mapping or risk factor analysis
Probability analysis
Linear regression
Risk Analysis
Tools used to assess the impact of the event should it occur
Payback analysis and accounting rate of return
Cost-benefit analysis
NPV analysis
Internal rate of return (IRR) method
Review of Learning Objectives
- Discuss the definitions of risk and the general classes of risk.
- Discuss the definition of risk management and the five steps of the risk management process.
- Discuss the components of the total cost of risk and its use as a key risk management tool.
- Discuss the uses of risk analysis and the necessary tools to perform a risk analysis.
Thank you!
Introduction to Analysis of Risk
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