ABMF3273 INSURANCE MANAGEMENT

Chapter 2: Risk Management

What is Risk Management?

Risk management is a process that identifies loss exposures faced by an

organization and selects the most appropriate techniques for treating such
exposures.

OBJECTIVES OF RISK MANAGEMENT

Risk management has important objectives. These objectives can be classified

as follows:

■ Pre-loss objectives

■ Post-loss objectives

Pre-loss objectives

1. T o prepare for potential losses in the most economical way.

This preparation involves an analysis of the cost of safety programs,
insurance premiums paid, and the costs associated with the different
techniques for handling losses.

2. T o reduce anxiety.
Certain loss exposures can cause greater worry and fear for the risk
manager and key executives. For example, the threat of a catastrophic
lawsuit because of a defective product can cause greater anxiety than a
small loss from a minor fire.

3. T o meet any legal obligations.

For example, government regulations may require a firm to install safety
devices to protect workers from harm, to dispose of hazardous waste
materials properly, and to label consumer products appropriately.
Worker’s compensation benefits must also be paid to injured workers. The
firm must see that these legal obligations are met.
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Post-loss objectives

1. For the survival of the firm.

Survival means that after a loss occurs, the firm can resume at least
partial operations within some reasonable time period.

2. To continue operating.

For some firms, the ability to operate after a loss is extremely important.
For example, a public utility firm must continue to provide service. Banks,
bakeries, and other competitive firms must continue to operate after a
loss. Otherwise, the business will be lost to competitors.

3. To ensure the stability of earnings.

Earnings per share can be maintained if the firm continues to operate.

However, a firm may incur substantial additional expenses to achieve this
goal (such as operating at another location), and perfect stability of
earnings may be difficult to attain.

4. To continue the growth of the firm.

A company can grow by developing new products and markets or by

acquiring or merging with other companies. The risk manager must
therefore consider the effect that a loss will have on the firm’s ability to
grow.

5. To minimize the effects that a loss will have on other persons and on
society.

A severe loss can adversely affect employees, suppliers, customers,

creditors, and the community in general. For example, a severe loss that
shuts down a plant in a small town for an extended period can cause
considerable economic distress in the town.
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RISK MANAGEMENT:

A systematic process in dealing with pure risks with the purpose of

reducing/eliminating such risks. The risk management process involves 6 steps:

Step 1: Establish & determine risk management objectives

The objectives of risk management are identified as those that are consistent
with the financial objectives. To avoid financial disasters arising out of the
various pure risk loss exposures of an individual.

Step 2: Obtain the relevant information for the identification of risks.

Step 2 is to obtain all the relevant information with reference to the possible
risk exposures. Risk Identification involves gathering information and
identifying the whole range of possible risks (pure risks) and the likelihood of
the losses occurring.
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Direct property losses (Property Risk)

The first step is to gain as much information as possible about the firm and its
operations. A physical inspection of the property, plant and machinery can
reveal invaluable information about potential loss exposures. Information about
previous loss exposures can be gained from the following sources:

1. Checklist.

Property checklists enable the property to be identified and the value

assigned to potential losses.

2. Risk analysis questionnaires.

These questionnaires ask wide-ranging questions and can be distributed to

key employees to identify major and minor potential loss exposures.

3. Flow charts.

These charts show the production and distribution process graphically. By

analyzing the charts, it is possible to identify bottlenecks in production,
sole-source suppliers, or concentrations of valuable property. Flow charts
also reveal the consequential impact of losses. For example, a fire at a key
supplier who is the company’s only source of raw materials may bring the
entire production process to a halt if alternative sources of supply have
not been arranged.

4. Financial statements.

Analysis of these statements identifies the important assets that must

be protected.

5. Historical loss data.

An analysis of this data reveals any loss trends and loss exposures.
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Loss of income (Property Risk)

1. Indirect loss;
can be difficult to identify and quantify. It is relatively easy to identify
and value a particular machine, but it may be difficult to quantify the loss
of profits that may result from the machine’s remaining unproductive for
two or three months.

2. Direct loss;
The potential loss of income following a loss is the difference between
the forecast of pre-loss income under normal circumstances and the
estimate of the post-loss income. It is important to recognize that a
direct loss to property usually has the potential to cause an indirect loss
of income that in many cases could be far greater than the direct loss.
The financial consequences of failing to recognize that a direct loss can
cause indirect losses.

Legal liability losses (Liability Risk)

Losses resulting from legal liability exposures arise from three sources:

1. Amount of legal damages awarded by a court to the injured party

2. Legal defense costs (which may include paying a proportion of the

plaintiff’s costs), and

3. Cost of loss prevention of potential legal liability actions.

Identifying potential sources of legal liability can be an expensive and time-

consuming process. Risk managers realize that their firms operate in an
increasingly litigious society in which many claims are brought against
businesses with the sole objective of obtaining a cash settlement from the
firm’s insurer rather than for genuine injuries suffered. The insurer may
make a cash settlement if it considers that the cost of investigating and
defending the action is higher than the actual amount of the third-party
claim.
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Examples of sources of liability losses are physical or personal injury to
customers, employees, clients or guests; damage to property belonging to a
third party; intentional damage to a person’s reputation; sexual harassment;
wrongful dismissal; and vicarious liability arising when a firm hires or
authorizes another party to act on its behalf and this party injures a third
party.

Loss of key personnel (Personal Risk)

Most businesses have a key person or persons in the organization whose

resignation, unplanned retirement, death or disablement could seriously affect
the cash flow of the business. They could be a salesperson servicing high net
worth clients, a research chemist, or even the board of directors, who could all
be killed in a single accident. Key personnel can be identified from a firm’s
organizational chart, with the cost. Exposure is represented by the cost of
finding, hiring, and training a replacement. Estimating the costs of key
employee losses can be difficult because finding a replacement is a function of
the job market and a suitable person may not be available. This is particularly
the case where the key employee has specialist knowledge, for example as the
operator of specialist machinery. Such an employee’s replacement may take
several years to fully train.

The result of the death or permanent disablement of a key person could be:

● creditors demanding repayment of loans and creditors withholding

payments

● customers and suppliers losing confidence in the firm

● lenders being unwilling to extend credit, or

● outstanding loans owed by the key person to the business called up for
payment.

While it is important to identify all potential risk exposures, it is also important

to estimate the impact that these loss exposures will have on the firm.
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Process of Understanding An Organization’s Risk Tolerance Potential Loss
based on the following Categories:

Step 3: Evaluation of risks that have been identified.

Evaluate/estimate the impact of the possible losses if they do occur. The

impact of such losses on the individual’s financial standing & whether he can
absorb such losses / if his financial position would suffer a serious setback
must be analyzed. In evaluating these risks, it is necessary to discuss the
probabilities of occurrence & severity of losses if they do occur.
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Step 4: Risk Management Technique Employed for Handling Pure Risk
Exposure

It is important to consider various techniques and select the most appropriate

ones.

Risk financing is the choice or selection method to pay for those losses that
result from various risk exposure. This is the last stage of the risk management
process of determination of how the risk should be financed.

The primary objective of undertaking risk management is to anticipate and

protect the individual or business from incurring financial losses arising from
unforeseen and untimely pure risk events.

This is the logical approach to financing and controlling loss exposure

i) Risk Avoidance

To eliminate an identified risk by not engaging in activities that might lead to a

loss. Not always practical or realistic and limited application. An action taken to
avoid entirely any possibility of an undesirable event taking place or to eliminate
the risk altogether. The action can be implemented in four ways:

1. Elimination (removal),

2. Substitution (replacement),

3. Separation (partition the items or activities)

4. Rational Planning (alternatives).

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ii) Risk / Loss Control / Prevention

The necessary steps are taken to reduce the possibility of the loss from
occurring if it should occur to reduce its severity. This is done through two
methods:

1. Risk/ Loss Reduction – process or steps to reduce the degree of hazard

presented by a risk which cannot be eliminated or the frequency with
which it may result in loss

2. Loss Prevention/ Minimization – the introduction of physical controls to

minimize or prevent the possibility of loss occurring or will lessen the
extent of the damage

iii) Risk Retention or Self Insurance

To establish or set aside funds (contingency funds) or other assets for the
purpose of having cash available to compensate for losses that might occur.
Often considered as a form of “self-insurance’’. This risk taken by individual or
organization either intentionally (deemed to be acceptable or active risk
retention) or unintentionally (unaware or passive risk retention) to meet
whole or part of losses resulting from a particular risk

iv) Risk Transfer

Action to transfer the consequences of a particular risk to another party via:

1) purchasing insurance or

2) transferring to 3rd party through contractual provisions

For individuals, this is essentially done through the purchase of insurance

contracts. In the business environment, other techniques may be used.
Example: Hedging & contractual arrangements (using indemnity obligations).
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Risk management on the basis of frequency/severity considerations

Step 5: Implementation

The most effective risk management technique is implementation. In most

cases when dealing with individuals, insurance contracts may be the most useful
tools for these purposes, although other techniques may already be in place.
This involves the following considerations:

1. The appropriate contracts according to the individual’s specific needs.

2. Quantum of the insured sum.

3. Priority of insurance policies to be in-forced due to limited budget.

Step 6: Review

Monitoring changing circumstances, needs and advise accordingly. Lastly

recommend the necessary adjustments. This process must be done periodically
or at least, once a year.