Risk management is an integral part of the actuarial profession. So it’s very important for actuarial students to understand the process of risk management. In this article, I would explain the process of risk management in simple terms that can be easily understood by all the actuarial students. To understand what actuaries do under Risk management, read a Peek into Actuarial Risk Consulting.
Risk arises when the future event is not certain, there is a probability associated with various possible future outcomes. We are particularly interested in managing possible adverse scenarios that may arise.
First step is to identify all the possible sources of uncertainty that can impact our business, investment, project, career etc.
BIGGEST RISK IS THE POSSIBILITY OF OCCURRENCE OF ADVERSE EVENT THAT hAS NOT OCCURRED BEFORE. For example, Impact caused by coronavirus pandemic.
As risks that are expected to occur, can be controlled through various techniques, to some extent.
After identifying the risk, we would group the risks identified into some categories. For example, Market Risk, Credit Risk, Liquidity Risk, Business Risk etc.
This would facilitate ease in management. In addition we can appoint risk manager to manage each of the risk categories. Risk manager would manage risk and would be accountable for inefficiency in managing them.
Next step involves, measuring the extent of risk. In other words we would determine probability of occurrence of risk event and expected amount of loss if risk event occurs.
For this we use various kinds of statistical models
One way is to fit probability distribution to:
- the number of risk event i.e. frequency : For example, Poisson distribution
- loss if risk event occurs i.e. severity : For example, Lognormal distribution, Weibull distribution
We can also perform scenario analysis, stress testing, sensitivity testing. This would help in quantifying the financial impact of risk event.
There are two components of risk:
- Frequency and severity
To reduce risk exposure we have to reduce probability, severity or combination of both
At this decide we have to decide which option to choose:
- Fully accept the risk
- Partially accept the risk
- Fully transfer the risk
- Mitigate the risk
- Avoid the risk
- RISK FINANCING
This involves allocating sufficient funds that can cover the cost of transferring the risk and financial impact if risk event occur.
We would accept the risk only if we have sufficient capital to finance the cost of risk, Otherwise, we would avoid taking that risk. In terms of insurance company, not selling more policies
This stage involves re-examining the risk exposure to ensure that risks are efficiently managed.
- Some risks may leave unidentified
- New risks may emerge
- There may be errors in the statistical model used for risk quantification
- The risk may be allocated to the wrong category
- Its financial impact may not be appropriately analyzed
- Change in the availability of capital may require changes in the method of controlling risk etc
We would also consider that how risk event that occurred are managed. So that experience can be gained for future reference.
The post is written by Swati Jindal.