Risk Management with
n Chapter 23, we explained risk management techniques that employ derivative
securities. In this extension we discuss an alternative technique for managing risk:
insurance. The first step in a corporate insurance program is to identify all poten-
tial losses, and the second step is to assess their likelihoods of occurrence and loss
potentials. We begin by discussing risk identification and measurement.
is the process by which a business systematically and continu-
ously identifies those current and potential risks that might affect it adversely. Most
corporate risk managers use a checklist to identify risks, and smaller firms without
risk managers usually rely on the risk management services of insurance companies
or else hire risk management consultants to identify and measure the risks that they
face. The checklists
which are published by insurance companies, the American
Management Association, and the Risk and Insurance Management Society
many pages long, so we will not present one here.
For small firms, it may be possi-
ble for a single individual to apply the checklist to his or her firm to identify the
risks, but larger, multidivisional firms must involve a number of people in the risk
After risks have been identified, it is necessary to measure the firm
s degree of ex-
posure to each risk. This involves estimating (1)
(or loss probability)
(dollar value of each loss). In general, loss exposure is more a
function of the severity of losses than of their frequency. A potential catastrophic
loss, even though its frequency is rare, is far more serious than frequent small losses.
For example, suppose a company uses trucks to deliver its products. In any year, the
probability of an accident that damages one of its trucks is relatively high, whereas
the probability of a death or injury liability claim is relatively low. However, the po-
tential severity of the liability loss is so much greater than potential damage losses
that virtually all firms consider their liability risk exposure to be greater than their
collision risk exposure.
There are several approaches to measuring loss severity. Two of the most com-
mon are (1) the maximum loss approach and (2) the average loss approach. The
is the dollar loss associated with the worst-case scenario, while the
is the average dollar loss associated with a particular peril, such as a
plant fire, considering that a wide range of possible losses can occur.
For one example, see C. Arthur Williams Jr., Michael L. Smith, and Peter C. Young,
(New York: McGraw-Hill, 1998).