Risk Analysis
What the exam tests
Risk Analysis tests measurement and prioritization. Expect questions on frequency versus severity, expected loss, maximum possible loss versus probable maximum loss, exposure bases, and data quality.
Core rules
- Frequency is how often; severity is how much per occurrence. They require different controls and different financing.
- Expected loss = frequency × average severity. Use it for budgeting, not for deciding whether a single severe loss is tolerable.
- Maximum possible loss (MPL) assumes all protection fails and the entire value is exposed. Probable maximum loss (PML) assumes protective features function but a large loss occurs.
- A risk matrix ranks exposures by frequency and severity; low-frequency/high-severity exposures usually call for transfer, while high-frequency/low-severity exposures may be retained and controlled.
- Use exposure bases: payroll, sales, vehicle miles, square footage, units produced. Raw claim counts without an exposure base mislead when operations grow or shrink.
- Data sources include loss runs, industry studies, actuarial projections, and internal incident reports. Check for trend, inflation, and changes in operations.
Worked example
A fleet of 18 vans has averaged six collisions per year at an average cost of $5,000, so expected loss is $30,000. One prior collision cost $300,000 because of a spinal injury. The expected loss suggests a $30,000 annual retention is affordable, but the severity distribution shows a $300,000 event is possible. Analysis should separate the predictable $30,000 layer from the catastrophic layer. A $25,000 per-occurrence retention with insurance above it may be reasonable if cash flow can absorb one bad year; the average alone does not justify dropping high-limit liability coverage.
Traps that cost marks
- Averaging away severity and ignoring the single large loss.
- Comparing claim counts without an exposure base.
- Confusing frequency reduction with severity reduction.
- Using stale loss data without inflation or operational trend.
Key points
- Frequency and severity drive different control and financing choices.
- Expected loss = frequency × average severity.
- MPL assumes total value exposed; PML assumes protection works.
- Use exposure bases such as payroll, sales, or miles.