78106_23_Web_Ch23A_p01-05 - WEB EXTENSION 23A Risk...

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23A Risk Management with Insurance I 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. 23.1 R ISK I DENTIFICATION AND M EASUREMENT Risk identification 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 are many pages long, so we will not present one here. 1 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 identification process. After risks have been identified, it is necessary to measure the firm s degree of ex- posure to each risk. This involves estimating (1) loss frequency (or loss probability) and (2) loss severity (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 max- imum loss is the dollar loss associated with the worst-case scenario, while the average loss 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. 1 For one example, see C. Arthur Williams Jr., Michael L. Smith, and Peter C. Young, Risk Management and Insurance (New York: McGraw-Hill, 1998). 1
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This note was uploaded on 05/03/2010 for the course FRR 3032 taught by Professor Mr.wroshr during the Spring '10 term at Crafton Hills College.

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78106_23_Web_Ch23A_p01-05 - WEB EXTENSION 23A Risk...

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