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Alternate methods for evaluating risk.

Alternate Methods For Evaluating Risk

The evaluation of risk has long been recognized as a separate and necessary step in the risk management process. Unfortunately, most of the attention in risk management literature has been directed toward the evaluation of loss potential as measured by loss frequency and loss severity. These usually include analyses of probability distributions, skewness of severity data, concepts of maximum probable and possible losses, and the severity of various losses from a single occurrence. As such, these considerations parallel those of insurance companies in the risk evaluation process. Perhaps because they have been adequate for insurance company purposes, their limitations for risk management purposes have not been fully recognized. Indeed, these vestiges of the insurance buying philosophy have largely obscured the need to examine two significant alternatives for evaluating risk: liquidity and timing and marginal utility considerations.

Liquidity and Timing

The significance of the timing of loss payment is usually recognized in discussions regarding the advantages of self-insurance. However, it is often ignored in the evaluation of risk.

The following example may illustrate its importance to risk evaluation.

In the chart, it is assumed that four different losses of identical amounts are suffered at a moment in time by a given firm. Further, for purposes of clarity, all considerations of indirect loss are ignored. Thus, for each loss the loss frequency is 1 and the loss severity is $1 million.

In evaluating each of these losses, however, it is obvious that significant differences exist, arising out of the need for funds to treat the loss. For the building destroyed by fire, the demand for funds to replace the building will not occur for several months, and will be extended over a period of time. The reason is that contractors are usually paid when construction is completed. For example, 25 percent of the total cost of construction may be paid when the building is 25 percent complete; the second 25 percent is paid when the building is 50 percent complete; 25 percent when 75 percent complete, and the final payment made when the replacement building is fully completed. In this situation, it may be several months before there is any demand to pay replacement funds, and final payment may not be required for a year or more.

For the loss of raw materials regularly used in manufacturing, however, the demand for funds is very different. Such materials are constantly being replaced. Usual purchase terms are 2/10, net 30. It is probable that within hours of the loss, a purchase order for replacement is placed. If advantage is taken of the discount, payment must be made within 10 days of receipt, and in any event, made for the replacement of the raw material within 30 days.

If a loss of cash from a payroll robbery occurs, replacement funds will be needed immediately. A delay of more than 24 hours may be completely unacceptable to employees. On the other hand, the discovery of the embezzlement of cash occurring over a period of time may well create no demand for replacement funds, since the loss has simply been reflected in lower reported profits over previous periods. As a consequence, any replacement funds made available by insurance are recognized as a non-reoccurring gain and constitute a net addition to assets, offsetting the losses incurred by embezzlement.

It is therefore evident that from the risk management perspective, the evaluation of risk must include considerations of timing of loss payments as well as those of loss frequency and loss severity. Its recognition solely as a factor in the selection of self-insurance blurs the distinction between evaluation and treatment. Further, it stresses the importance of return on capital and investment rather than on the evaluation of risk.

Marginal Utility

In addition, the evaluation of risk must include a consideration of the marginal utility of loss vis-a-vis the marginal utility of loss treatment.

The following example illustrates the importance of marginal utility of a loss in relation to the cost of risk treatment. Assume that 40 street people are brought together, each being given a different number. An announcement is made to the group that $20 will be given to each person except the holder of the number which is to be drawn from the hat. If number 17 is drawn, 39 are given $20, but the holder of number 17 receives nothing. The following week, when the group gathers again, an announcement is made that a slight modification in the previous procedure will be made. If any person wishes to accept $18, in lieu of $20, that person will be paid $18 even if his number is drawn. In evaluating the mathematical value of the risk, there is one chance in 40 (frequency) of losing $20 (severity). Thus, the mathematical value of the risk is 50 cents. The "premium" given to eliminate the risk, however, is $2. Since $18 may provide enough income for an individual to purchase a week's supply of food, and the loss of the promised $20 may threaten his survival, the evaluation of risk must not be made in terms of loss frequency and severity, per se, but in terms of the marginal utility of a certain $2 loss and the possibility of a $20 loss. Although the above example is hypothetical, it is applicable to the real world. Obviously the marginal utility of the loss is negligible relative to the marginal utility of the premium to be paid. Further note that decisions of risk managers made to treat risk by avoidance often are based on similar evaluations.

The recognition of this evaluation with reference to risk management goals, or the selection process in the treatment of risks, does not eliminate the necessity of recognizing it specifically as a necessary part of the risk evaluation process. Indeed, the confusion of the process of establishing goals or methods of treatment with the evaluation process may well have limited the development and application of techniques for the measurement of marginal utility by risk managers, consultants and educators. [Chart Omitted]

H. Wayne Snider is professor of risk management insurance at Temple University.
COPYRIGHT 1989 Risk Management Society Publishing, Inc.
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Title Annotation:risk management
Author:Snider, H. Wayne
Publication:Risk Management
Date:Jul 1, 1989
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