Risk management and analysis is a management function that mainly functions to identify and assess risks and prepare an organization or individual to be well adapted in handling and mitigating the consequences of the risk. This serves the reduce the reduce the negative impact of an event to levels that are acceptable to an individual or society. The initial step in risk management and analysis is risk assessment which involves the qualitative and quantitative determination of the anticipated risk values. The probability (p) of the occurrence of a loss and the magnitude (R) of the probable loss are the prerequisite parameters applied in the calculation of risk assessment.
The risk management and insurance simulation game explores the various aspects of risk management decision-making process using a simulated real-life case example. In the simulated case study, the Smith family’s insurable exposures are evaluated and the possible risk outcomes and losses outlined in four stages of the year (quarterly). The Smith family have devoted $18,000 for insurance and loss mitigation for the whole year, which translates to $4,500 quarterly. A large part of this designated sum is to be spent on insurances and premiums against the possible risks. According to the family’s risk evaluation, a 40% probability of occurrence means that the risk event is frequent, while those events that result in loses equal to or more than $2,500 are severe. Following the assessment, the family’s net worth significantly reduces throughout the four stages because of the expenses dedicated to managing risks and averting the loses.
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Stage 1
Possible Loses
Risk of fire that would result in loses equivalent to 25% of the replacement cost. This means that the loss resulting from the fire is equivalent to $40,000. This means that the risk is of high severity, even if there is no damage to personal property. On the other hand, the loss has a low probability of occurrence (35%).
Earthquake loss to the family’s dwelling is of high severity as it might result in complete loss of use (loss > $2,500). The loss is however of low frequency (10%) chance of occurrence.
Loss resulting from physical damage to the Toyota Camry in which the vehicle is scrapped by a fire hydrant is of high severity because the loss value is $6,300. The is also of low frequency because it has a 45% chance of occurrence.
The costs incurred in the maintenance of the home’s air conditioning system by replacing the air filters and cleaning of air ducts are of low severity ($200) but high frequency (80%) probability of occurrence.
Risk Management Options
(a). Full coverage of the dwelling provided by the HO-3 homeowner’s insurance plan. This will also include a 50% coverage on personal property. The family will incur a $1500 annual premium for this coverage.
(b). A 50% on the property value coverage plus an automatic 50% coverage on personal property for the purchase of HO-3 homeowner’s insurance. The family will incur a $900 annual premium on this coverage.
(a) Insurance against loss of the property resulting from earthquakes purchased at an annual premium of $500.
(b) No purchase of the earthquake coverage.
(a) Protection against loss resulting from vehicle damage due to other than collision and collision accidents. The annual premiums for these coverages are $1,140. A coverage of lower annual premium ($720) but higher deductibles can also be purchased.
(b) Failure to purchase any automobile physical damage coverages.
(a) Insuring the air conditioning system maintenance by purchasing a special HO-3 coverage at an annual premium of $750 and no deductibles.
(b) Retaining the financial maintenance cost by failing to purchase the coverage.
Decisions and Decision-Making Process
The choice of the financing options was made based on the severity and frequency of the potential loss. The severity was high if the loss value was equal to or greater than $2,500, while losses with over 40% chance of occurrence were considered high frequency. The frequency was determined by calculating the probabilities from the resulting die roll outcomes.
Probability = (roll outcome/total outcome) * 100%
Fire loss to attached garage
Probability of occurrence = (7/20)*100 = 35%, thus low frequency
Severity = 25% of 160,000 = $40,000, thus high severity.
Earthquake loss to Smith’s dwelling
Probability of occurrence = (2/20)*100 = 10%. This means low frequency.
Severity = $160,000 + 18,000 = $178,000 (> $2,500) This mean the loss is of high severity.
Physical vehicle damage (OTC damage)
Probability of occurrence = (9/20)*100 = 45%
Severity = $6,300 (> $2,500).
Air conditioning system maintenance costs
Probability of occurrence = (16/20)*100 = 80%
Severity = $200 (<$2,500).
| Low Frequency | High Frequency | |
| Low Severity | - | Cost of Air conditioning system maintenance |
| High Severity |
Fire Earthquake |
Physical vehicle damage |
Risk Matrix 1
The risk matrix above was used in arriving at the decisions. The decisions made were purchasing a full coverage against fire loss and the special endorsement insurance to cover the air conditioning system maintenance and purchasing an OTC and collision automobile insurance with an annual premium of $720, OTC and collision deductibles of $500 and $1000 respectively. The earthquake loss was retained.
The total risk management costs incurred by the family at this stage was $2,970. The total retained losses from these decisions were $178,000.
Stage 2
Possible Losses
Loss as a result of the Smiths being sued involve both the loss value and the defense costs incurred in the lawsuit.
The loss that results from an automobile accident due to a family’s member fault. The loss is due to bodily damages sustained by a third-party individual.
Loss resulting from a lawsuit filed by a neighbor against the family, in which John is accused of posting injurious information about their neighbor on his blog.
Risk Management Options
The Smith’s could purchase either an HO-3 coverage E policy with $25,000 liability limit and annual premiums of $500; or a policy with $100,000 liability coverage and an annual premium of $1,000.
The family could purchase a range of automobile liability limits, ranging from $10,000 to $100,000 and with annual premiums ranging from $1,080 to $2,400. They also had an option of retaining the loss by not purchasing the limits.
A personal injury liability endorsement that covers against $100,000 and an annual premium of $300. They could also fail to purchase the cover.
Purchasing an accident cover with a $1,000,000 per accident limit and annual premium of $200. This coverage, however, requires that the family purchases the maximum automobile liability limit coverage. The family could also opt to not purchase this accident cover.
The Smith could either choose to enroll their dog in professional dog obedience classes at the cost of $300 or opt to leave the dog as it was, thereby incurring no expenses.
Decisions and Decision-Making Process
Loss 1
Probability of occurrence = (6/20)*100 = 30%
Severity = $50,000 + $240,000 = $290,000 (>$2,500).
Loss 2
Probability of occurrence = (9/20*100) = 45%
Severity = $ 120,000 + $150,000 = $270,000 (>2,500)
Loss 3
Probability of occurrence = (4/20 * 100) = 25%
| Low Frequency | High Frequency | |
| Low Severity | - | - |
| High Severity |
Loss 1 Loss 3 |
Loss 2 |
Severity = $5,000 + $14,000 = $19,000 (>$2,500)
Risk Matrix 2
The risks are all of high severity. Decisions made tend towards the family purchasing coverages for the losses. From the loss financing and control options available these decisions were 1(A), 2(C), 3(A), 4(A), and 5(A). The total costs spent on risk management at this stage is $3,700. This means that $800 was left from the $4,500 loss control account, while there are no retained losses in this stage.
Stage 3
Possible Losses
The loss resulting from the skiing accident which John suffers. The accident requires surgery to be provided by an out of network surgeon in which the Smith’s will incur medical expenses and loss of wages for the disabled period (5 months).
The medical condition which Tristan suffers results in the family incurring medical expenses for the diagnosis and treatment of their infant.
Risk Management Options
The family may opt to purchase supplemental LTD insurance which covers losses due to lost wages. On the other hand, the family may opt to rely on John’s workplace insurance plan (Kentucky Power’s standard LTD plan).
(a) A PPO health insurance plan which provides cover for the whole family both for the in-network and out-of-network treatments with varying deductibles and out-of-pocket limits. The annual premium for this plan is $1,800
(b) An HMO plan with an annual premium of $1,200 that covers the entire family and provides a 100% coinsurance for in-network health services and no deductibles.
Skiing lessons and purchase of skiing safety equipment at the cost of $300. John may also opt to forego the skiing lessons and the purchase of the protective equipment, increasing the chances of fatality during skiing.
Decisions and Decision-Making Process
Loss 1
Probability of occurrence = (4/20 * 100) = 20%
Severity = $13,000 + $30,000 = $43,000 (>2,500).
Loss 2
Probability of occurrence = (5/20 * 100) = 25%
| Low Frequency | High Frequency | |
| Low Severity | - | - |
| High Severity |
Loss 1 Loss 2 |
- |
Severity = $ 5,500 (>2,500)
Risk Matrix 3
Both losses are of low frequency and high severity. The decisions made are to rely on the Kentucky’s Power Standard LTD plan, purchase a PPO health coverage and to forego the skiing lessons and purchase of protective gear. The total premium spent out of these decisions is $1,800, while there are no retained losses resulting from the decisions. The family’s net worth remains intact, while $2,700 is left from the designated $4,500 risk amount.
Stage 4
Possible Losses
John’s death, which would result in a loss value of $400,000
Karen’s death, which would result in a loss value of $100,000
Loss Financing Options
The family may opt to purchase additional term life insurance covers on both John’s and Karen’s life. The premium rates vary with the benefits of the coverage. They may also opt not to purchase the additional life coverage and instead rely on the insurance provided by John’s employer on his life.
Decision and Decision Making
Loss 1
Probability of occurrence = (5/20 * 100) = 25%
Severity = $400,000 (>$2,500)
Loss 2
Probability of occurrence = (4/20 * 100) = 20%
| Low Frequency | High Frequency | |
| Low Severity | - | - |
| High Severity |
Loss 1 Loss 2 |
- |
Severity = $100,000 (>$2,500).
Risk Matrix 4
Both losses are of low frequency but very high severity. The decision made is to purchase additional individual coverages, valued at $500,00 and $200,000 on John’s and Karen’s lives respectively, with an annual premium of $720. This means that there are no resulting retained losses, while $3,780 is left from the $4,500 allocated for insurance and loss control.
The new total net worth is obtained by subtracting the retained losses from the initial net worth. The amount remaining from the loss control account is also included in the final calculations. The total premiums and costs incurred was $8,810. $ 9,190 remained from the loss control account. The overall game experience provided an insight into the whole decision-making process in the case or risks and uncertainties. From the game analysis, it can be concluded that the decisions are made based on the severity and frequency of the loss. The costs of retained losses are higher than the expenses incurred in risk control and insurance purchases. Risks, both controlled and uncontrolled, results in a reduction of an individual’s, company or family’s net worth.
