Actuarial Notes

Risk Control

Study guides: Exam DISC-RM, Exam GI-201

Risk control is the set of techniques that reduce the frequency or severity of losses, as distinct from risk financing, which pays for the losses that still occur. The techniques are avoidance, loss prevention, loss reduction, separation, duplication and diversification. Insurers also use the term for their risk control function, whose representatives survey accounts for underwriting and advise policyholders on preventing losses, in cooperation with the insurer's other functions.

\Delta E[L] = f_0\,s_0 - f_1\,s_1

\text{NPV} = \sum_{t=1}^{n} \frac{B_t}{(1+i)^t} - C_0

  • Symbols: f_0 and s_0 are the frequency and severity of losses before a measure, and f_1 and s_1 are their values after it, so \Delta E[L] is the reduction in expected loss a year. In the cost-benefit test, C_0 is the cost of putting the measure in place, B_t is its net benefit in year t, which is the reduction in expected loss plus any premium savings less running costs, i is the discount rate and n is the measure's useful life. A measure passes the test when its net present value is positive.
  • Avoidance: Avoidance eliminates an exposure by never undertaking the activity or by abandoning it, so the probability of loss from it becomes zero. It is often impractical, because the activity usually earns the income the organization exists for, and abandoning one activity can create another exposure.
  • Loss prevention and loss reduction: Loss prevention lowers frequency, as machine guarding, driver training and fire-resistive storage do. Loss reduction lowers severity once a loss has begun, as sprinklers, fire walls, seat belts and early return-to-work programs do.
  • Separation, duplication and diversification: Separation divides an exposure among several locations or units, such as two warehouses instead of one, so a single event damages less. Duplication keeps a spare or backup that is used only when the original is lost, such as off-site copies of records. Diversification spreads activity across products, customers or regions whose losses are not perfectly correlated. Separation and duplication reduce the severity of the largest loss a single event can cause.
  • The cost-benefit test: A measure is worth adopting when the present value of what it saves, in reduced losses or in premium savings, exceeds what it costs. An insured organization captures part of the saving through lower premiums.
  • Insurer risk control: Some insurers, primarily for commercial clients, offer engineering and loss control: methods of preventing and reducing loss wherever the effort is economically feasible. These services are particularly applicable to workers compensation and boiler and machinery exposures, and the facilities an insurer devotes to them, and how well they work, are an element a policyholder weighs in choosing an insurer.
  • Risk control and underwriting: Underwriters order loss control inspections to help assess an account and decide whether to accept it, and a policy may be written subject to the insured's compliance with the loss control recommendations. Some insurers also sell loss control separately from insurance, to businesses that retain their own losses.
  • Place in risk management: Risk control is one half of risk treatment, with risk financing through retention and transfer the other (Risk Mitigation). It works on the exposures found by risk identification and ranked by risk assessment, and it rarely removes the need for financing, because what it leaves behind still has to be paid for.

Should the Warehouse Install Sprinklers? A company retains its own fire losses. With illustrative figures, a fire at its warehouse has frequency 0.02 a year and would cost $2,000,000. Sprinklers would cost $250,000 to install, last 20 years and cost $3,000 a year to maintain, and they would limit a fire's cost to $400,000 without changing how often fires start. At a 6% discount rate, do the sprinklers pass the cost-benefit test?

Answer Sprinklers are loss reduction, so only severity changes.

\begin{align*}
\Delta E[L] &= 0.02(2{,}000{,}000) - 0.02(400{,}000) \\
&= 32{,}000 \\
B_t &= 32{,}000 - 3{,}000 \\
&= 29{,}000 \\
a_{\overline{20}|0.06} &= 11.4699 \\
\text{NPV} &= 29{,}000(11.4699) - 250{,}000 \\
&= 82{,}628
\end{align*}

The net present value is positive, so the sprinklers pass. They would break even if they cut a fire's cost by about $1,240,000, since that saves the $24,796 a year needed to cover maintenance and repay the installation over 20 years. If the company were insured, the premium credit for sprinklers would replace part of \Delta E[L] as its benefit.

Classifying a Trucking Company's Measures A trucking company is considering six measures:

  1. Stop hauling hazardous materials.
  2. Install fatigue-monitoring systems in its cabs.
  3. Fit fire suppression systems in its maintenance garage.
  4. Park its fleet at two depots instead of one.
  5. Keep a copy of its dispatch system at a second site.
  6. Add a warehousing business so that less of its income depends on freight rates.

Classify each measure as a risk control technique.

Answer Stopping hazardous materials hauling is avoidance, because the exposure ends with the activity. Fatigue monitoring is loss prevention, because it reduces how often accidents happen. Fire suppression is loss reduction, because it limits a fire that has already started. Two depots is separation, since one hail storm or fire can no longer damage the whole fleet. The second copy of the dispatch system is duplication, since it is used only when the original fails. The warehousing business is diversification, which reduces the company's dependence on one source of income.

Each measure is then tested on cost and benefit. Avoidance gives up the hazardous materials revenue, and the second depot adds rent and travel, so neither is right merely because it lowers risk.

How it appears on the exam

  • DISC-RM: The risk control and premium auditing section asks candidates to describe the insurer's risk control goals, the services risk control provides, and how risk control cooperates with the insurer's other functions. Scenario questions describe an account and ask which services or recommendations fit it, and how the information should flow to the other functions. The risk treatment sections ask candidates to classify measures by technique and to apply the cost-benefit test.

Exam traps

  • Prevention versus reduction: Loss prevention acts before a loss and lowers frequency, and loss reduction acts during or after one and lowers severity. Sprinklers do not stop fires starting, so they are loss reduction.
  • Separation versus duplication: Separation puts units that are all in daily use in different places, and duplication keeps a backup that sits idle until it is needed. A second working depot is separation and a standby generator is duplication.
  • Avoidance has a cost: Avoiding an activity gives up its income and can create new exposures in whatever replaces it. Recommending avoidance for every severe exposure ignores the cost side of the test.
  • Risk control is not financing: Risk control changes losses and risk financing pays for them. A deductible or a reinsurance treaty changes who pays, not how often or how badly losses occur.