Risk management is an integral part of the actuarial profession. So actuarial students need to understand the process of risk management. In this article, I will explain the risk management process in simple terms that can be easily understood by all 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.
Risk Identification
The 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 the OCCURRENCE OF an ADVERSE EVENT THAT has NOT OCCURRED BEFORE. For example, the Impact caused by the coronavirus pandemic.
As risks that are expected to occur, can be controlled through various techniques, to some extent.
Risk Classification
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 a risk manager to manage each of the risk categories. Risk managers would manage risks and would be accountable for inefficiency in managing them.
Risk Quantification
The next step involves, measuring the extent of risk. In other words, we would determine the probability of the occurrence of a risk event and the expected amount of loss if the risk event occurs.
For this, we use various kinds of statistical models
One way is to fit a probability distribution to:
- the number of risk events i.e. frequency: For example, Poisson distribution
- loss of risk event occurs i.e. severity: For example, Lognormal distribution, Weibull distribution
We can also perform scenario analysis, stress testing, and sensitivity testing. This would help in quantifying the financial impact of risk events.
Risk Controlling
There are two components of risk:
- Frequency and severity
To reduce risk exposure we have to reduce the probability, severity or combination of both
At this 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 a risk event occurs.
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 companies, not selling more policies
RISK MONITORING
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
- Changes in the availability of capital may require changes in the method of controlling risk etc
We would also consider how risk events that occur are managed. So that experience can be gained for future reference.
The post is written by Swati Jindal.