Analyzing Loss Exposures Estimate the frequency and severity of loss for each type of loss exposure Loss frequency refers to the probable number of losses that may occur during some given time period Losses/#Exposures Loss severity refers to the probable size of the losses that may occur (LOsses/#Losses) Expected Loss=(LOsses/#EXposures) Once loss exposures are analyzed, they can be ranked according to their relative importance Loss severity is more important than loss frequency The maximum possible loss is the worst loss that could happen to the firm during its lifetime The maximum probable loss is the worst loss that is likely to happen 3-16
3-16 Analyzing Loss Exposures • Estimate the frequency and severity of loss for each type of loss exposure – Loss frequency refers to the probable number of losses that may occur during some given time period (#Losses / #Exposures) – Loss severity refers to the probable size of the losses that may occur ($Losses / #Losses) – Expected Loss = ($Losses / #Exposures) • Once loss exposures are analyzed, they can be ranked according to their relative importance • Loss severity is more important than loss frequency: – The maximum possible loss is the worst loss that could happen to the firm during its lifetime – The maximum probable loss is the worst loss that is likely to happen
Ratios Example Data ·1000 Restaurants ·23 Fires Minor Fires: 20, $25,000 -Major Fires: 3, $500,000 Severity=20($25,000)+3($500,000)23 86957 Frequency =23 /1000=.023 Expected LOss=.023($86,957)=$2,000 3-17
3-17 Ratios Example • Data • 1000 Restaurants • 23 Fires –Minor Fires: 20, $25,000 –Major Fires: 3, $500,000 • Severity = 20($25,000) + 3($500,000)/23 = $86,957 • Frequency = 23 / 1000 = .023 • Expected Loss = .023($86,957) = $2,000
Loss Severity Measures Maximum Possible loss Probable Maximum LOSS(PML) Prob LOSS> PML)<5% Probability Actual losses will be less than PMl 95%of the time 5% Possible 0 PML Max. Losses 3-18
3-18 Loss Severity Measures • Maximum Possible Loss Possible Losses Probability 5% Max. • Probable Maximum Loss (PML): – Prob.(Loss > PML) < 5% 0 PML Actual losses will be less than PML 95% of the time
EX-Insight 4.2 Figure 3 Products Liability Risk Profile Probability (%/o) 10 Expected 8 9 5th Percentile 99th Percentile 6 10 3-19 osses($ Millions
3-19 Ex-Insight 4.2 Figure 3: Products Liability Risk Profile
Select the Appropriate Risk Management Technique Risk control refers to techniques that reduce the frequency and severity of losses Methods of risk control include Avoidance Loss prevention Loss reduction 3-20
3-20 Select the Appropriate Risk Management Technique • Risk control refers to techniques that reduce the frequency and severity of losses • Methods of risk control include: – Avoidance – Loss prevention – Loss reduction