Lecture 3

Introduction to Risk Management

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1. Definition of Risk Management.
2. Objectives of Risk Management.

 Pre-Loss Objectives.
 Post- Loss Objectives.

3. Steps in the Risk Management Process.

 Identify loss exposure.

 Measure and analysis the loss exposure.
 Select the appropriate combination of
techniques for treating the loss exposure.
 Implement and monitor the risk
management program.

4. Benefits of Risk Management.

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Definition of 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.

Risk managers typically use the term loss exposure to identify

potential losses. As stated in Chapter 1, a loss exposure is any
situation or circumstance in which a loss is possible, regardless of
whether a loss actually occurs. In the past, risk managers generally
considered only pure loss exposures faced by the firm. This chapter
discusses only the traditional treatment of pure loss exposures.

Objectives of Risk Management:

Risk management has important objectives. These objectives can

be classified as follows: Pre-loss objectives, and Post-loss objectives.

Pre-Loss Objectives:

1. The Firm Should Prepare for the 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.

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 2. The Reduction of 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. To Meet Legal Obligation:

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. Workers compensation benefits must also be paid to
injured workers. The firm must see that these legal obligations are met.

Post-Loss Objectives:

1. 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. Continue Operation:

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, dairies, bakeries, and other competitive firms must

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continue to operate after a loss. Otherwise, business will be lost to
competitors.

3. Stability of Earning:

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
earnings stability may be difficult to attain.

4. Continued 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. Social Responsibility:

The objective of social responsibility is to minimize the effects that

a loss will have on other persons and on society. A severe loss can
adversely affect employees, suppliers, customers, investors, creditors,
and the community in general. For example, a severe loss that shuts
down a factory in a small town for an extended period can cause
considerable economic distress in the local area.

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Steps in the Risk Management Process:

1. Identify loss exposure.

2. Measure and analyze the loss exposure.
3. Select the appropriate combination of techniques for treating the
loss exposure.
4. Implement and monitor the risk management program.

Step 1: Identify Loss Exposure:

The first step in the risk management process is to identify all

major and minor loss exposures. This step involves an exhaustive
review of all potential losses. Important loss exposures include the
following:

1. Property loss exposures: buildings, plants, furniture, equipment,

inventory, valuable paper, computer software, data, Inventory
Accounts receivable, valuable papers, records Company vehicles,
planes, boats, and mobile equipment.
2. Liability loss exposures: defective productive, environmental
pollution (land, water, air, noise), Sexual harassment of
employees, employment discrimination, wrongful termination,

and failure to promote.

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 3. Business income loss exposures: loss of income from a covered
loss, continuing expenses after a loss, and extra expenses.
4. Human recourses loss exposures: death of key employees,
retirement and unemployment, job-related injuries and disease
experienced by workers.
5. Crime loss exposure: employee theft and dishonesty, internet
and computer crime exposure, burglaries, and theft of intellectual
property.
6. Employee benefit loss exposure: failure to pay promised benefit,
retirement plan exposure, and failure to comply with government
regulations.
7. Foreign loss exposure: foreign currency and interest rate risks,
political risks, acts of terrorism.
8. Intangible property loss exposures: damage to the company’s
public image, loss of goodwill and market reputation, and loss or
damage to intellectual property.
9. Failure to comply with government rules and regulations.

Risk Managers have several sources of information to

identify loss exposures:

 Risk Analysis Questionnaires and Checklists: Questionnaires and

checklists require the risk manager to answer numerous
questions that identify major and minor loss exposures.
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  Physical Inspection. A physical inspection of company plants and
operations can identify major loss exposures.
 Flowcharts. Flowcharts that show the flow of production and
delivery can reveal production and other bottlenecks as well as
other areas where a loss can have severe financial consequences
for the firm.
 Financial Statements. Analysis of financial statements can
identify the major assets that must be protected, loss of income
exposures, key customers and suppliers, and other important
exposures.
 Historical loss data. Historical loss data can be invaluable in
identifying major loss exposures.

In addition, risk managers must keep abreast of industry trends and

market changes that can create new loss exposures and cause concern.

Step 2: Measure and Analyze the Loss Exposure:

It is important to measure and quantify the loss exposures in

order to manage them properly. This step requires an estimation of the
frequency and severity of loss. Loss frequency refers to the probable
number of losses that may occur during some given time period. Loss
severity refers to the probable size of the losses that may occur.

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 Once the risk manager estimates the frequency and severity of
loss for each type of loss exposure, the various loss exposures can be
ranked according to their relative importance. For example, a loss
exposure with the potential for bankrupting the firm is much more
important in a risk management program than an exposure with a
small loss potential.

If certain losses occur regularly and are fairly predictable, they can
be budgeted out of a firm’s income and treated as a normal operating
expense. Severity is more important because a single catastrophic loss could
destroy the firm.

Step 3: Select the Appropriate Combination of Techniques

for Treating the Loss Exposure:

These techniques can be classified broadly as either risk control or

risk financing.

Risk control refers to techniques that reduce the frequency or

severity of losses. Major risk-control techniques include: Avoidance,
Loss prevention, Loss reduction, Duplication, Separation, and
Diversification.

1. Avoidance: means a certain loss exposure is never acquired or

undertaken, or an existing loss exposure is abandoned. For example,

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 flood losses can be avoided by building a new plant on high
ground, well above a floodplain. A pharmaceutical firm that
markets a drug with dangerous side effects can remove the drug
from the market to avoid possible legal liability. The major
advantage of avoidance is that the chance of loss is reduced to
zero if the loss exposure is never acquired.
2. Loss Prevention refers to measures that reduce the frequency of a
particular loss. For example, measures that reduce truck accidents
include driver training, zero tolerance for alcohol or drug abuse,
and strict enforcement of safety rules.
3. Loss Reduction refers to measures that reduce the severity of a loss after
it occurs. Examples include installation of an automatic sprinkler
system that promptly extinguishes a fire; first-aid boxes in
production areas; and rehabilitation of workers with job-related
injuries; and limiting the amount of cash on the premises.
4. Duplication refers to having back-ups or copies of important documents
or property available in case a loss occurs. Examples include back-up
copies of key business records (e.g., accounts receivable) in case
the original records are lost or destroyed.
5. Separation means dividing the assets exposed to loss to minimize the
harm from a single event. A manufacturing company, for example,
may divide the production area of a plant into four quadrants by
using 6-foot-thick concrete walls. Similarly, a manufacturer may

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 store finished goods in two warehouses in different cities. If one
of the warehouses is damaged or destroyed, the finished goods
in the other warehouse are unharmed.
6. Diversification refers to reducing the chance of loss by spreading the
loss exposure across different parties (e.g., customers and suppliers),
securities (e.g., stocks and bonds), or transactions. Having
different customers and suppliers reduces risk. For example, if
the entire customer base consists of four domestic purchasers,
sales will be impacted adversely by a domestic recession. If there
are foreign and domestic customers, the risk is reduced.

Risk financing refers to techniques that provide for the funding of

losses after they occur. Major risk-financing techniques include:
Retention, Noninsurance transfers, Commercial insurance.

1. Retention means that the firm retains part or all of the losses that
can result from a given loss. Retention can be either active or
passive.

Active retention means that the firm is aware of the loss exposure and
consciously decides to retain part or all of it. For example, a risk
manager may decide to retain physical damage losses to a fleet of
company cars. Passive retention, however, is the failure to identify a loss
exposure, failure to act, or forgetting to act. For example, a risk

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manager may fail to identify all company assets that could be damaged
in an earthquake.

Retention can be effectively used in a risk management program

under the following conditions: A) No other method of treatment is
available, B) The worst possible loss is not serious, and C) Losses are fairly
predictable.

Determining Retention Levels: if retention is used, the risk manager

must determine the firm’s retention level, which is the dollar amount
of losses that the firm will retain. A financially strong firm can have a
higher retention level than one whose financial position is weak.

2. Noninsurance Transfers are methods other than insurance by which

a pure risk and its potential financial consequences are transferred to
another party. Examples of noninsurance transfers include
contracts, leases, hold- harmless agreements, and incorporation
of a business. For example, a company’s contract with a
construction firm to build a new plant can specify that the
construction firm is responsible for any damage to the plant
while it is being built. A firm’s computer lease can specify that
maintenance, repairs, and any physical damage loss to the
computer are the responsibility of the computer firm.
3. Commercial insurance is also used in a risk management
program. Insurance is appropriate for loss exposures that have a low
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 probability of loss but the severity of loss is high. If the risk manager
uses insurance to treat certain loss exposures, five key areas must
be emphasized: 1) Selection of insurance coverages, 2) Selection
of an insurer, 3) Negotiation of terms, 4) Dissemination of
information concerning insurance coverages, 5) Periodic review
of the insurance program.

Step 4: Implement and Monitor the Risk Management Program.

This step begins with a policy statement.

1. A risk Management Policy Statement is necessary to have

an effective risk management program.
 This statement outlines the risk management objectives of the
firm, as well as company policy with respect to treatment of loss
exposures.
 It also educates top-level executives in regard to the risk
management process.
 It establishes the importance, role, and authority of the risk
manager
 It provides standards for judging the risk manager’s performance.
2. Risk Management Manual
 The manual describes in some detail the risk management
program of the firm.

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 It can be a very useful tool for training managers, supervisors,
and new employees who will be participating in the program.
 It forces the risk manager to state precisely his or her
responsibilities, objectives, and available techniques.
 A risk management manual often includes a list of insurance
policies, agent and broker contact information, who to contact
when a loss occurs, emergency contact numbers, and other
relevant information.
3. Cooperation with Other Departments
The risk manager does not work alone. Other functional
departments within the firm are extremely important in
identifying loss exposures.
 Accounting: Internal accounting controls can reduce employee
fraud and theft of cash.
 Finance: Information can be provided showing the effect that
losses will have on the firm’s balance sheet and profit and loss
statement.
 Operations: Quality control can prevent the production of
defective goods and lawsuits. Effective safety programs in the
plant can reduce injuries and accidents.
 Marketing: Accurate packaging and product-use information can
prevent lawsuits. Safe distribution procedures can prevent
accidents.
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  Human resources. This department is responsible for employee
benefit programs, retirement programs, safety programs, and the
company’s hiring, promotion, and dismissal policies.
4. Periodic Review and Evaluation:

The risk management program must be periodically reviewed and

evaluated to determine whether the objectives are being attained or if
corrective actions are needed. In particular, risk management costs,
safety programs, and loss-prevention programs must be carefully
monitored.

Loss records must also be examined to detect any changes in

frequency and severity. Retention and transfer decisions must also be
reviewed to determine if these techniques are being properly used.
Finally, the risk manager must determine whether the firm’s overall
risk management policies are being carried out, and whether the risk
manager is receiving cooperation from other departments.

Benefits of Risk Management:

1. Enables firm to attain its pre-loss and post-loss objectives more easily.
2. Reduce a firm’s cost of risk, which may increase the company’s
profit. The cost of risk is a risk management tool that measures the
costs associated with treating the organization’s loss exposures.
These costs include insurance premiums paid, retained losses,
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 loss control expenditures, outside risk management services,
financial guarantees, internal administrative costs, and taxes,
fees, and other relevant expenses
3. Because the adverse financial impact of pure loss exposures is
reduced, the firm may be able to implement an enterprise risk
management program to treat both pure and speculative loss
exposures.
4. Society benefits because both direct and indirect (consequential)
losses are reduced

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