A probabilistic outcome (chance of loss, likelihood of loss) that is known or estimated | Ranges from 0 to 1 (0% to 100%)
Loss (Must be Quantifiable (in $))
How often does a loss occur?
• The number of losses (such as fire, theft, collision) that occur within a
specified time period.
• Probability of a loss.
• Ex: Probability of a fire is 0.0071 per loss exposure per year.
How much does it cost when a loss does occur?
• The dollar amount of loss for a specific peril (fire, theft, collision).
• Example: Average structure fire loss is about $25,000
# of Losses / # of Exposures
Total Losses ($) / # of Losses
Cause of Loss
• Examples: Fire, windstorm, flood, collision, burglary, etc.
A condition that creates or increases the frequency and/or severity of a loss.
• Does not cause a loss.
• Four types:
3. Morale (attitudinal)
A physical condition that increases the frequency and/or severity of a loss
The presence of insurance changes the behavior of the insured
• Using a hammer to create “hail” damage to a roof.
• Exaggerating the value of the insured property.
Morale (Attitudinal) Hazard
Carelessness or indifference to a loss, which increases the frequency and/or severity of a loss.
• Leaving car keys in an unlocked car.
• Neglecting a tree limb growing over your roof.
Characteristics of legal system or regulatory environment that increase the
frequency and/or severity of a loss.
• Juries in some jurisdictions are more sympathetic than other areas (meaning larger damage awards in liability lawsuits).
• Georgia now requires Diminution in Value to be paid on property losses (meaning increased severity in Georgia).
• Pure Risk vs. Speculative Risk
• Diversifiable Risk
• Nondiversifiable Risk
• Enterprise Risk
• Systemic Risk
2) No Loss
Ex: Auto Accident, Fire, Flood, Cancer, Slip &
2) No Loss/No Gain
Ex: Investment, Gambling
Affects only individuals or small groups, not the entire economy.
• Can be reduced/eliminated through diversification. (Have multiple facilities, cloud/backup data centers)
• Risks are not correlated
(For example: fire at multiple locations, theft, vehicle collision).
Affects the entire economy or large numbers of groups/persons within the economy.
• Cannot be reduced/eliminated through diversification.
• Government assistance may be needed to insure.
• Risks are correlated (inflation, unemployment).
Encompasses all major risks faced by a business firm:
• Pure Risk
• Speculative Risk
• Strategic Risk*
• Operational Risk*
• Financial Risk*
Risk of collapse of an entire system or entire market due to the failure of a
single entity or group of entities that can result in the breakdown of the entire financial system.
• Instability in the financial system due to the interdependency between the players in the market.
Major Types of Pure Risks
• Personal Risk
• Property Risk
• Legal Liability Risk
• Loss of Business Income
Directly affects an individual or family; involves the possibility of loss of income, extra expenses, depletion of financial assets.
What perils might be involved?
• Premature Death
• Disability/Injury/Poor Health
• Inadequate Retirement Income
The possibility of losses associated with the destruction or theft of property.
Direct Loss (Property)
Cost to repair or replace property damaged by a peril.
Indirect Loss (Property)
Financial loss resulting as a consequence of a direct loss.
• Fire damages your home, you have to pay to live elsewhere while it’s repaired.
• Fire damages a business the firm experiences Business Interruption, Loss of Income, extra expenses et al.
Legal Liability Risk
Legal liability (financial consequences) resulting from injuries or damages
you caused to someone else.
• Defense costs
• No cap on losses (in most situations)
• Liens can be placed on income, assets seized.
Loss of Business Income
If a business has to shut down for a period of time due to a direct physical
damage loss, it is unable to generate an income.
• Is this a direct or indirect loss?
• Example – Grease fire in the kitchen causes a restaurant to close down for 4 weeks while repairs are made. The restaurant has no income while closed, but certain expenses continue.
Burden of Risk On Society
• Larger Emergency Fund
• Loss of Certain Good and Services
• Worry and Fear
Techniques for Managing Risks
1. Risk Control
2. Risk Financing
Techniques to reduce the frequency or severity of losses
Techniques for funding losses
Definition of Insurance
Insurance is the pooling of fortuitous losses by transfer of such risks to insurers, who agree to indemnify insureds for such losses, to provide
other pecuniary benefits on their occurrence, or to render services connected with the risk
Basic Characteristics of Insurance
1. Pooling of losses
2. Payment of fortuitous losses
3. Risk Transfer
Law of Large Numbers
The greater the number of exposures, the more closely
will actual results approach the probable results expected
from an infinite number of exposures.
• Example: A coin flip has a 50%/50% chance of heads
o But you could flip it 10 times and get 8 heads (80%).
o The more times you flip it, the closer the percentage of heads will get
Pooling of Losses
The spreading of losses incurred by a few over the entire group.
• Purpose is to reduce variation (as measured by standard deviation) which reduces uncertainty (risk).
• Think of standard deviation as the average distance from the mean.
unforeseen and unexpected by the insured and occurs a result of chance
Pure risk is transferred from the insured to the insurer, who typically is in a stronger financial position
The insured is restored to its approximate financial position prior to the occurrence of the loss
Characteristics of an IDEALLY Insurable Risk
1) Large number of exposure units.
2) Loss must be accidental and unintentional.
3) Loss must be determinable and measurable.
4) Loss should not be catastrophic.
5) Chance of loss must be calculable.
6) Premium must be economically feasible.
Large Number of Exposure Units
Enables the insurer to predict average loss based on the Law of Large Numbers.
• Large number of similar exposure units needed.
Loss Must be Accidental and
Loss should be outside of insured’s control
o Law of Large Numbers is based on randomness
Can you determine if a loss occurred?
Can you determine the amount of the loss?
Loss Should Not be Catastrophic (to
Allows pooling technique to work
Examples of catastrophes
• Hurricane / Named Windstorm
Chance of Loss Must be Calculable
Must be able to calculate average frequency and average severity
Premium Must be Economically
Insured must be able to afford it
The tendency of persons with a higher-than- average chance of loss to seek insurance at standard (average) rates, which, if not controlled by underwriting, results in higher than expected loss levels
• Typically results from asymmetric information.
Occurs when one party has information that is relevant to a
transaction that the other party does not have.
Process of selecting and classifying applicants for insurance
• Standards met
• Coverage terms/exclusions to consider
Types of Insurance
Life, Health, Property & Casualty
Social insurance programs
Pays a death benefit to beneficiaries when an insured dies
Pays medical expenses because of sickness or injury. (Non work related injuries)
indemnifies property owners against the loss or damage of real or personal property
covers the insured’s legal liability arising out of property damage or bodily injury to others
broad term that refers to insurance that covers whatever is not covered by fire, marine, and life insurance. Frequently it includes auto, liability and
Categories of Property & Liability Insurance
• Private passenger auto
• Homeowners’ “package”
• Personal Umbrella Liability
• Coastal Windstorm
Found at both the federal and state level.
o Federal Deposit Insurance Corporation (FDIC)
o National Flood Insurance Program (NFIP)
o Fair Access to Insurance Requirements Plans (FAIR)
o Beach and Windstorm Plans
Process that identifies loss exposures faced by an organization and selects the most appropriate techniques for treating such exposures
Pre-Loss Objectives to RM
• Efficient cost of risk
• Permits better decision making
• Meet legal obligations
Post-Loss Objectives to RM
• Survival of firm
• Business continuity, earnings, growth
Steps in the Risk Management Process
1. Identify loss exposures.
2. Measure and analyze the loss exposures.
3. Consider and select the appropriate risk
4. Implement and monitor the chosen techniques.
Step 1: Identify Loss Exposures
• What assets need to be protected?
• What perils are those assets exposed?
• Business Income
• Human Resources
• Employee Benefits
Sources for Identifying Loss Exposures
• Meeting with management including risk manager
• Financial statements
• Loss history
• Other firms/competitors
• Risk management consultants
• Site Inspections
• Review sales and purchase agreements
Step 2: Measure and Analyze the Loss
Estimate the frequency and severity of loss exposures.
• Frequency (probability) – How often does the loss occur?
• Severity (outcome) – How much does it cost when a loss does occur?
• Rank loss exposures according to relative importance.
• Severity is more important.
Maximum Possible Loss (MPL)
the worst loss that could happen to the firm during its lifetime
Probable Maximum Loss (PML)
the worst loss that is likely to happen.
Step 3: Consider and Select the Appropriate Risk Management Techniques
Techniques that reduce the frequency or severity of losses
Techniques that provide for the funding of losses
Risk Control - Avoidance
A certain loss exposure is never acquired (proactive), or an existing loss exposure is abandoned (reactive)
Risk Control - Avoidance (Advantage)
Frequency is reduced to 0
Risk Control - Avoidance (Disadvantage)
• May not be possible.
• Usually has an opportunity cost.
• Avoiding one loss exposure may create another.
Risk Control – Loss Prevention
• Measures that reduce the frequency of a particular loss.
• Does NOT completely eliminate risk.
Risk Control – Loss Reduction
• Measures that reduce the severity of a loss.
• No effect on the frequency of a loss
Risk Control - Duplication
Having back-ups or copies of important documents or property available in case a loss occurs
Risk Control - Separation
Dividing the assets exposed to loss to minimize the harm from a single event.
• Firewalls in buildings
• Have multiple data centers or warehouses
Risk Control - Diversification
Reducing the chance of loss by spreading the loss exposure across different parties (customers, suppliers), securities (stocks, bonds), or
• Expanding customer base
• Using multiple suppliers
Risk Financing - Retention
A firm or individual retains part or all of the losses that can occur from a
• Retention level
the dollar amount of losses that the individual/firm will retain
Deliberately retaining risk
Unknowingly retaining risk
When should risk be retained?
• No other option more attractive or available.
• Worst possible losses are not serious (low severity).
• Losses are predictable (high frequency; not catastrophic).
Risk Financing – Retention (Types)
• Unfunded; cash flow
• Funded Reserve
• Captive Insurer
• Self-Insurance Plan
• Risk Retention Group / Group Captive
A captive insurer is an insurer owned by a parent firm for the purpose of insuring the parent firm’s loss exposures.
• Single-parent captive is owned by only one parent.
• Association or group captive is an insurer owned by
Advantages of a Captive Insurance Company
• Can help a firm when insurance is too expensive or
difficult to obtain.
• Lower Costs
o No agent or broker commissions.
o Interest earned on invested premium.
• Easier access to reinsurance market.
• Possibility tax advantages.
• Possibility of favorable regulatory environment.
A special form of planned retention by which part or all of a
given loss exposure is retained by the firm
Risk Retention Group
• Group captives that can write any type of liability coverage except employers’ liability, workers' compensation, and personal lines.
• Exempt from many state insurance laws.
Risk Financing – Noninsurance Transfer
Methods other than insurance by which a pure risk and its potential financial consequences are transferred to another party.
• Hold-harmless agreements
Risk Financing – Commercial Insurance
Appropriate for low-frequency, high-severity loss exposures
These areas must be emphasized:
1. Selection of insurance coverages.
2. Selection of an insurer.
3. Negotiation of terms and services (risk control, claims, et al)
4. Dissemination of information concerning insurance coverages.
5. Periodic review of the insurance program.
A specified amount subtracted from the loss payment otherwise payable to the insured
A plan in which the insurer pays only if the actual loss exceeds the amount a firm has decided to retain
• Premiums may be more costly
• Negotiation of policies takes time and effort
• Most policies are annual
• The risk manager may become lax in exercising loss control
Hard Insurance Market
Soft Insurance Market
Hard Insurance Market
Insurer profitability is declining, underwriting standards are tightened, premiums increase, and insurance is hard to obtain
Soft Insurance Market
profitability is improving, standards are loosened, premiums decline, and insurance become easier to obtain
Step 4: Implement and Monitor the
Risk Management Policy Statement
o The risk management objectives of the firm.
o The company policy with respect to treatment of loss exposures.
• Provides standards for judging the risk manager’s performance.
Benefits of Risk Management
• Enables a firm to attain its pre-loss and post-loss
objectives more easily.
• Society benefits because both direct and indirect losses
• Can reduce a firm’s total cost of risk.
Traditional Risk Management
• Risks evaluated in a “silo” approach.
• Loss exposures are usually insurable “pure”
o Business Interruption
o Personnel (for example, worker injuries)
Enterprise Risk Management
A strategic business discipline that supports the achievement of an organization’s business objectives by addressing the full spectrum of its
risks and managing the combined impact of those risks as an integrated risk portfolio.
• Considers all risks an organization faces across the entire
• Holistic/interconnected view of risk.
• Typically headed by Chief Risk Officer (CRO) and used in
• Creates a “risk culture” within the organization in which
everyone is responsible for identifying and managing risk.
Aon 2021 Global Risk Report US Top 10
1. Cyber Attacks/Data Breach
2. Business Interruption
3. Economic Slowdown/Slow Recovery
4. Commodity Price Risk/Scarcity of materials
5. Damage to Reputation/Brand
6. Regulatory/Legislative Changes
7. Pandemic Risk/Health Crises
8. Supply Chain or Distribution Failure
9. Increasing Competition
10. Failure to Innovate/Meet Customer Needs
Allianz 2022 Risk Barometer Top 10
2. Business interruption
3. Natural catastrophes
5. Changes to legislation and “ESG” (Environmental, Social & Governance)
6. Climate change
7. Fire, explosion
8. Market developments
9. Shortage of skilled workforce
10. Macroeconomic developments
• Increase awareness and assessment of risk
• Integrated response to the full range of risks
• Alignment with organization’s risk tolerance and its strategies
• Fewer operational surprises and losses
• Greater compliance with regulatory and legal requirements
• Improved accountability, efficiency and decision making
• Increase value of the organization
Challenges / Barriers to an ERM Program
• Dynamic; always changing
• Lack of commitment from senior leadership
• Resistance to change / disagreement over
responsibilities / turf war
Why should an organization use
By combining all risks into a single risk management
program, the organization may be able to offset one risk
against another and reduce its overall risk.