Knowing Your Exposure Limitations

April 1, 2013

For those familiar with risk analysis – specifically the measurement [or estimate] of frequency and severity of loss – there are many scenarios where the severity of loss or resultant expected loss can have a long tail. In FAIR terms, we may have a scenario where the minimum loss is $1K, the most likely loss $10K and the maximum loss is $2M. In this type of a scenario – using Monte Carlo simulation and depending on the associated kurtosis of the estimated distribution – it is very easy for a severity distribution or aggregate distribution (that takes into account both frequency and severity) to be derived of which the resulting descriptive statistics don’t as accurately reflect the reality of exposure of the adverse event should it occur. While understanding the full range of severity or overall expected loss may be useful, a prudent risk practitioner should understand and account for the details of the organization’s business insurance policies to better understand when insurance controls will be invoked to limit financial loss for significant adverse events.

Using the example values above, an organization may be will willing to pay out of pocket for all adverse events –similar to the scenario above – up to $1M and then rely upon insurance to cover the rest. This in turn changes the maximum amount of loss the company is directly exposed to (per event); from $2M to $1M. In addition, this understanding could be a significant information point for decisions makers as they ponder how to treat an issue. Given this information consider the following:

1. How familiar you are with your organizations business or corporate insurance program?

2. Does your business insurance program cover the exposures you are responsible for or accountable for managing the risk of?

3. Are your risk analysis models flexible enough to incorporate limits of loss relative to potential loss?

4. When you talk with decisions makers, are you even referencing the existence of business insurance policies or other risk financing / transfer controls that limit your organization’s exposure when significant adverse events occur?

The more we can leverage other risk-related controls in the organization and paint a more accurate picture of exposure, the more we become a trusted advisor to our decision makers and other stakeholders in the larger risk management life-cycle.

Want to learn more?

AICPCU – Associate in Risk Finance (ARM) – http://www.aicpcu.org/comet/programs/arm/arm.htm

SIRA – Society of Information Risk Analysts – http://www.societyinforisk.org