CHAPTER 3

INTRODUCTION TO
RISK MANAGEMENT

“The essence of risk management lies in maximizing the

areas where we have some control over the outcome while
minimizing the areas where we have absolutely no control
over the outcome …”
Peter L. Bernstein
Against the Gods: The Remarkable Story of Risk

Learning Objectives

After studying this chapter, you should be able to

◆ Define risk management and explain the objectives of risk management.
◆ Describe the steps in the risk management process.
◆ Explain the major risk-control techniques, including
Avoidance
Loss prevention
Loss reduction
◆ Explain the major risk-financing techniques, including
Retention
Noninsurance transfers
Insurance
◆ Apply the principles of risk management to a personal risk management program.
43
 D elbert Williams is the owner and operator of Del’s Diner, a popular restaurant in
downtown Chicago. Last month, Del’s meat supplier recalled some hamburger
for fear of E. coli contamination. One of Del’s cooks was recently injured in a kitchen
fire and a waitress is complaining about pain in her elbow from carrying serving trays.
Del noticed two weeks ago that there was $60 missing from the cash register, and this
week another $80 is missing. Del’s has an excellent take-out business, and the diner
is considering providing delivery to a limited area using a vehicle owned by the diner.
Del’s bookkeeper suggested that Delbert should establish a risk management program
to address the many loss exposures faced by the business. Risk management is a
process that identifies and analyzes loss exposures, and uses a variety of techniques,
including insurance, to treat these loss exposures. Delbert hopes that by implementing
a risk management program, losses will decline and the business will be better
prepared when losses occur.
The above example shows how a business firm could benefit from a risk management
program. Today, risk management is widely used by corporations, small employers,
nonprofit organizations, and state and local governments. Families and students can
also benefit from a personal risk management program.
In this chapter—the first of two dealing with risk management—we discuss the
fundamentals of traditional risk management. The following chapter discusses the
newer forms of risk management that are rapidly emerging, including enterprise risk
management and financial risk management. In this chapter, we discuss the meaning
of risk management, objectives of risk management, steps in the risk management
process, and the various techniques for treating loss exposures. The chapter concludes
with a discussion of personal risk management.

MEANING OF RISK pure and speculative loss exposures. This chapter

MANAGEMENT discusses only the traditional treatment of pure loss
exposures. The newer forms of risk management—
Risk management is a process that identifies loss such as enterprise risk management—are discussed
exposures faced by an organization and selects in Chapter 4.
the most appropriate techniques for treating such
exposures. Because the term risk is ambiguous and
has different meanings, risk managers typically use
the term loss exposure to identify potential losses. As OBJECTIVES OF RISK
stated in Chapter 1, a loss exposure is any situation MANAGEMENT
or circumstance in which a loss is possible, regardless
Risk management has important objectives. These
of whether a loss actually occurs. In the past, risk
objectives can be classified as follows:1
managers generally considered only pure loss expo-
sures faced by the firm. However, new forms of ■ Pre-loss objectives
risk management are emerging that consider both ■ Post-loss objectives

44
 STEPS IN THE RISK MANAGEMENT PROCESS 45

Pre-Loss Objectives products and markets or by acquiring or merging with

other companies. The risk manager must therefore
Important objectives before a loss occurs include
consider the effect that a loss will have on the firm’s
economy, reduction of anxiety, and meeting legal
ability to grow.
obligations.
Finally, the objective of social responsibility is to
The first objective means that the firm should
minimize the effects that a loss will have on other
prepare for potential losses in the most economical
persons and on society. A severe loss can adversely
way. This preparation involves an analysis of the cost
affect employees, suppliers, customers, creditors,
of safety programs, insurance premiums paid, and
and the community in general. For example, a severe
the costs associated with the different techniques for
loss that shuts down a plant in a small town for an
handling losses.
extended period can cause considerable economic
The second objective is the reduction of anxiety.
distress in the town.
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 STEPS IN THE RISK
of a defective product can cause greater anxiety than MANAGEMENT PROCESS
a small loss from a minor fire.
The final objective is to meet any legal obligations. There are four steps in the risk management process
For example, government regulations may require a (see Exhibit 3.1):
firm to install safety devices to protect workers from ■ Identify loss exposures
harm, to dispose of hazardous waste materials prop- ■ Measure and analyze the loss exposures
erly, and to label consumer products appropriately. ■ Select the appropriate combination of techniques
Workers compensation benefits must also be paid to for treating the loss exposures
injured workers. The firm must see that these legal ■ Implement and monitor the risk management
obligations are met. program

Post-Loss Objectives Each of these steps is discussed in some detail in

the sections that follow.
Risk management also has certain objectives after a
loss occurs. These objectives include survival of the Exhibit 3.1
firm, continued operations, stability of earnings, Steps in the Risk Management Process
continued growth, and social responsibility.
The most important post-loss objective is survival Identify loss exposures.
of the firm. Survival means that after a loss occurs,
the firm can resume at least partial operations within
some reasonable time period. Measure and analyze the loss exposures.
The second post-loss objective is to continue
operating. For some firms, the ability to operate after
a loss is extremely important. For example, a public Select the appropriate combination of
utility firm must continue to provide service. Banks, techniques for treating the loss exposures:
bakeries, and other competitive firms must continue 1. Risk control
• Avoidance
to operate after a loss. Otherwise, business will be • Loss prevention
lost to competitors. • Loss reduction
The third post-loss objective is stability of earnings. 2. Risk financing
• Retention
Earnings per share can be maintained if the firm • Noninsurance transfers
continues to operate. However, a firm may incur sub- • Insurance
stantial additional expenses to achieve this goal (such as
operating at another location), and perfect stability of
earnings may be difficult to attain. Implement and monitor the risk
The fourth post-loss objective is continued growth management program.
of the firm. A company can grow by developing new
46 CHAPTER 3 / INTRODUCTION TO RISK MANAGEMENT

Identify Loss Exposures ■ Plants, business property, inventory

■ Foreign currency and exchange rate risks
The first step in the risk management process is to
■ Kidnapping of key personnel
identify all major and minor loss exposures. This step
■ Political risks
involves a painstaking review of all potential losses.
8. Intangible property loss exposures
Important loss exposures include the following:
■ Damage to the company’s public image

1. Property loss exposures ■ Loss of goodwill and market reputation

■ Building, plants, other structures ■ Loss or damage to intellectual property

■ Furniture, equipment, supplies 9. Failure to comply with government laws and

■ Computers, computer software, and data regulations
■ Inventory
A risk manager can use several sources of infor-
■ Accounts receivable, valuable papers, and
mation to identify the preceding loss exposures. They
records include the following:
■ Company vehicles, planes, boats, and mobile

equipment ■ Risk analysis questionnaires and checklists.

2. Liability loss exposures Questionnaires and checklists require the risk
■ Defective products manager to answer numerous questions that
■ Environmental pollution (land, water, air, noise) identify major and minor loss exposures.
■ Sexual harassment of employees, employment ■ Physical inspection. A physical inspection of
discrimination, wrongful termination, and failure company plants and operations can identify
to promote major loss exposures.
■ Premises and general liability loss exposures ■ Flowcharts. Flowcharts that show the flow of
■ Liability arising from company vehicles production and delivery can reveal production
■ Misuse of the Internet and e-mail transmissions and other bottlenecks as well as other areas
■ Directors’ and officers’ liability suits where a loss can have severe financial conse-
3. Business income loss exposures quences for the firm.
■ Loss of income from a covered loss ■ Financial statements. Analysis of financial
■ Continuing expenses after a loss statements can identify the major assets that
■ Extra expenses must be protected, loss of income exposures,
■ Contingent business income losses and key customers and suppliers.
4. Human resources loss exposures ■ Historical loss data. Historical loss data can be
■ Death or disability of key employees invaluable in identifying major loss exposures.
■ Retirement or unemployment exposures
In addition, risk managers must keep abreast of
■ Job-related injuries or disease experienced by
industry trends and market changes that can create
workers new loss exposures and cause concern. Major risk
5. Crime loss exposures management issues include rising workers compen-
■ Holdups, robberies, and burglaries
sation costs, effects of mergers and consolidations
■ Employee theft and dishonesty
by insurers and brokers, increasing litigation costs,
■ Fraud and embezzlement
financing risk through the capital markets, cyber and
■ Internet and computer crime exposures
privacy risks, supply-chain security, repetitive motion
■ Theft of intellectual property
injury claims, and climate change. Protection of com-
6. Employee benefit loss exposures pany assets and personnel against acts of terrorism is
■ Failure to comply with government regulations
another important issue.
■ Violation of fiduciary responsibilities

■ Group life, health, and retirement plan

exposures
Measure and Analyze the Loss Exposures
■ Failure to pay promised benefits The second step is to measure and analyze the loss
7. Foreign loss exposures exposures. It is important to measure and quantify
■ Acts of terrorism the loss exposures in order to manage them properly.
 STEPS IN THE RISK MANAGEMENT PROCESS 47

This step requires an estimation of the frequency and Select the Appropriate Combination
severity of loss. Loss frequency refers to the probable of Techniques for Treating the Loss Exposures
number of losses that may occur during some given
The third step in the risk management process is to
time period. Loss severity refers to the probable size
select the appropriate combination of techniques
of the losses that may occur.
for treating the loss exposures. These techniques
Once the risk manager estimates the frequency
can be classified broadly as either risk control or
and severity of loss for each type of loss exposure,
risk financing.2 Risk control refers to techniques
the various loss exposures can be ranked accord-
that reduce the frequency or severity of losses. Risk
ing to their relative importance. For example, a loss
financing refers to techniques that provide for the
exposure with the potential for bankrupting the firm
funding of losses. Risk managers typically use a com-
is much more important in a risk management pro-
bination of techniques for treating each loss exposure.
gram than an exposure with a small loss potential.
In addition, the relative frequency and severity
Risk Control As noted above, risk control is a
of each loss exposure must be estimated so that the
generic term to describe techniques for reducing the
risk manager can select the most appropriate tech-
frequency or severity of losses. Major risk-control
nique, or combination of techniques, for handling
techniques include the following:
each exposure. For example, if certain losses occur
regularly and are fairly predictable, they can be budg- ■ Avoidance
eted out of a firm’s income and treated as a normal ■ Loss prevention
operating expense. If the annual loss experience of a ■ Loss reduction
certain type of exposure fluctuates widely, however,
an entirely different approach is required. Avoidance Avoidance means a certain loss exposure
Although the risk manager must consider both loss is never acquired or undertaken, or an existing loss
frequency and loss severity, severity is more important exposure is abandoned. For example, flood losses
because a single catastrophic loss could destroy the can be avoided by building a new plant on high
firm. Therefore, the risk manager must also consider ground, well above a floodplain. A pharmaceutical
all losses that can result from a single event. Both the firm that markets a drug with dangerous side effects
maximum possible loss and probable maximum loss can withdraw the drug from the market to avoid
must be estimated. The maximum possible loss is possible legal liability.
the worst loss that could happen to the firm during The major advantage of avoidance is that the
its lifetime. The probable maximum loss is the worst chance of loss is reduced to zero if the loss exposure is
loss that is likely to happen. For example, if a plant is never acquired. In addition, if an existing loss expo-
totally destroyed by a flood, the risk manager estimates sure is abandoned, the chance of loss is reduced or
that replacement cost, debris removal, demolition costs, eliminated because the activity or product that could
and other costs will total $25 million. Thus, the maxi- produce a loss has been abandoned. Abandonment,
mum possible loss is $25 million. The risk manager also however, may leave the firm with a residual liability
estimates that a flood causing more than $20 million exposure from the sale of previous products.
of damage to the plant is so unlikely that such a flood Avoidance has two major disadvantages. First,
would not occur more than once in 100 years. The risk the firm may not be able to avoid all losses. For
manager may choose to ignore events that occur so example, a company may not be able to avoid the
infrequently. Thus, for this risk manager, the probable premature death of a key executive. Second, it may
maximum loss is $20 million. not be feasible or practical to avoid the exposure.
Catastrophic losses are difficult to predict because For example, a paint factory can avoid losses arising
they occur infrequently. However, their potential from the production of paint. Without paint produc-
impact on the firm must be given high priority. In tion, however, the firm will not be in business.
contrast, certain losses, such as physical damage
losses to vehicles, occur with greater frequency, are Loss Prevention Loss prevention refers to measures
usually relatively small, and can be predicted with that reduce the frequency of a particular loss. For
greater accuracy. example, measures that reduce truck accidents include
48 CHAPTER 3 / INTRODUCTION TO RISK MANAGEMENT

driver training, zero tolerance for alcohol or drug ■ The worst possible loss is not serious . For
abuse, and strict enforcement of safety rules. Measures example, physical damage losses to vehicles in a
that reduce lawsuits from defective products include large firm’s fleet will not bankrupt the firm if the
installation of safety features on hazardous products, vehicles are separated by wide distances and are
placement of warning labels on dangerous products, not likely to be simultaneously damaged.
and use of quality-control checks. ■ Losses are fairly predictable. Retention can
be effectively used for workers compensation
Loss Reduction Loss reduction refers to measures that claims, physical damage losses to cars, and
reduce the severity of a loss after it occurs. Examples shoplifting losses. Based on past experience, the
include installation of an automatic sprinkler system risk manager can estimate a probable range of
that promptly extinguishes a fire; segregation of expo- frequency and severity of actual losses. If most
sure units so that a single loss cannot simultaneously losses fall within that range, they can be paid out
damage all exposure units, such as having warehouses of the firm’s income.
with inventories at different locations; rehabilitation
of workers with job-related injuries; and limiting the Determining Retention Levels If retention is used, the
amount of cash on the premises. risk manager must determine the firm’s retention
level, which is the dollar amount of losses that the
Risk Financing As stated earlier, risk financing firm will retain. A financially strong firm can have
refers to techniques that provide for the payment of a higher retention level than one whose financial
losses after they occur. Major risk-financing tech- position is weak.
niques include the following: Although a number of methods can be used to
determine the retention level, only two methods are
■ Retention summarized here. First, a corporation can determine
■ Noninsurance transfers the maximum uninsured loss it can absorb without
■ Commercial insurance adversely affecting the company’s earnings. One
rough rule is that the maximum retention can be set
Retention Retention means that the firm retains at 5 percent of the company’s annual earnings before
part or all of the losses that can result from a given taxes from current operations.
loss. Retention can be either active or passive. Active Second, a company can determine the maximum
risk retention means that the firm is aware of the loss retention as a percentage of the firm’s net working
exposure and consciously decides to retain part or capital—for example, between 1 and 5 percent. Net
all of it, such as collision losses to a fleet of com- working capital is the difference between a compa-
pany cars. Passive retention, however, is the failure ny’s current assets and current liabilities. Although
to identify a loss exposure, failure to act, or forget- this method does not reflect the firm’s overall finan-
ting to act. For example, a risk manager may fail to cial position for absorbing a loss, it does measure the
identify all company assets that could be damaged in firm’s ability to fund a loss.
an earthquake.
Retention can be effectively used in a risk man- Paying Losses If retention is used, the risk manager
agement program under the following conditions:3 must have some method for paying losses. The follow-
ing methods are typically used:4
■ No other method of treatment is available.
Insurers may be unwilling to write a certain ■ Current net income. The firm can pay losses
type of coverage, or the coverage may be too out of its current net income and treat losses as
expensive. Also, noninsurance transfers may not expenses for that year. A large number of losses
be available. In addition, although loss preven- could exceed current income, however, and other
tion can reduce the frequency of loss, all losses assets may have to be liquidated to pay losses.
cannot be eliminated. In these cases, retention ■ Unfunded reserve. An unfunded reserve is a
is a residual method. If the exposure cannot be bookkeeping account that is charged with actual
insured or transferred, then it must be retained. or expected losses from a given exposure.
 STEPS IN THE RISK MANAGEMENT PROCESS 49

■ Funded reserve. A funded reserve is the setting ■ Favorable regulatory environment. Some captives
aside of liquid funds to pay losses. A self-insurance are formed offshore to take advantage of a favorable
program (discussed later) that is funded is an exam- regulatory environment and to avoid undesirable
ple of a funded reserve. However, if not required financial solvency regulations. However, captives
to do so, many businesses do not establish funded are regulated under the insurance laws of the domi-
reserves because the funds may yield a higher cile, and in many domiciles, the regulation of cap-
return by being used elsewhere in the business. In tive insurers is rigorous. In particular, in Bermuda
addition, contributions to a funded reserve are not and Vermont, the regulation of captives is viewed
income-tax deductible. Losses, however, are tax as not being lax and permissive.6
deductible when paid. ■ Lower costs. Forming a captive may reduce
■ Credit line. A credit line can be established with insurance costs because of lower operating
a bank, and borrowed funds may be used to pay expenses, avoidance of an agent’s or broker’s
losses as they occur. Interest must be paid on the commission, and retention of interest earned on
loan, however, and loan repayments can aggra- invested premiums and reserves that commercial
vate any cash-flow problems a firm may have. insurers would otherwise receive. Also, the prob-
lem of wide fluctuations in commercial insurance
premiums is avoided.
Captive Insurer Losses can also be paid by a captive
■ Easier access to a reinsurer. A captive insurer has
insurer. A captive insurer is an insurer owned by a
easier access to reinsurance because reinsurers
parent firm for the purpose of insuring the parent
generally deal only with insurance companies,
firm’s loss exposures. There are different types of
not with insureds. A parent company can place
captive insurers. A single parent captive (also called
its coverage with the captive, and the captive can
a pure captive) is an insurer owned by only one par-
pass the risk to a reinsurer.
ent, such as a corporation. An association or group
■ Formation of a profit center. A captive insurer
captive is an insurer owned by several parents. For
can become a source of profit if it insures other
example, corporations that belong to a trade associa-
parties as well as the parent firm and its sub-
tion may jointly own a captive insurer.
sidiaries. It should be noted that there are costs
Globally, there were an estimated 6000 captive
involved in forming a captive insurance company
insurance companies in 2010. Many captive insurers
and that this option is not feasible for many
are located in the Caribbean because of the favorable
organizations. A firm is putting its capital at risk
regulatory climate, relatively low capital requirements,
when it insures through its captive.
and low taxes. In the U.S., over 25 states have enacted
captive insurance company statutes. Vermont remains
the leader in U.S.-based captives with nearly 600
Income Tax Treatment of Captives The Internal Revenue
active companies in 2012. This total includes 42 of the
Service (IRS) earlier took the position that premiums
Fortune 100 companies and 18 of the 30 companies
paid to a single parent captive (pure captive) are not
that comprise the Dow Jones Industrial Average. Other
income-tax deductible. The IRS argued that there
popular domestic domiciles include Utah, Kentucky,
is no substantial transfer of risk from an economic
Montana, and Delaware; each of which had double-
family to an insurer, and that the premiums paid are
digit growth in business between 2010 and 2011.5
similar to contributions to a self-insurance reserve,
Captive insurers are formed for several reasons,
which are not deductible.
including the following:
However, as a result of a number of complex
■ Difficulty in obtaining insurance. The parent court decisions and IRS rulings, premiums paid to
firm may have difficulty obtaining certain types captive insurers may be tax deductible under cer-
of insurance from commercial insurers, so it tain conditions. It is beyond the scope of this text
forms a captive insurer to obtain the coverage. to discuss in detail each of these rulings. However,
This pattern is especially true for global firms according to actuarial consulting firm, Towers
that often cannot purchase certain coverages at Watson (formerly Towers Perrin, Tillinghast),
reasonable rates from commercial insurers. premiums paid to captives are not income-tax
50 CHAPTER 3 / INTRODUCTION TO RISK MANAGEMENT

deductible unless some or all of the following Self-Insurance Self-insurance is widely used in risk
factors are present:7 management programs. As stated in Chapter 1,
self-insurance is a special form of planned retention
■ The transaction is a bona fide insurance trans-
by which part or all of a given loss exposure is
action, and the captive insurer takes some risk
retained by the firm. Another name for self-insurance
under a defensible business plan.
is self-funding.
■ The captive insurer’s owner is organized such
Self-insurance is widely used in workers com-
that subsidiaries, and not the parent, pay pre-
pensation insurance. Self-insurance is also used by
miums to the captive insurer under a “brother–
employers to provide group health, dental, vision,
sister” relationship. (The term “brother–sister”
and prescription drug benefits to employees. Firms
refers to separate subsidiaries owned by the same
often self-insure their group health insurance benefits
parent, such as a captive insurer and an operating
because they can save money and control health-care
subsidiary.)
costs. There are other benefits of self-insurance as
■ The captive insurer writes a substantial amount
well (see Insight 3.1).
of unrelated business. (If a captive insurer
Finally, self-insured plans are typically protected
receives 30 percent or more of the premiums
by some type of stop-loss limit that caps the employ-
from unrelated third parties, many tax experts
er’s out-of-pocket costs once losses exceed certain
view this requirement as being met.) In addi-
limits. For example, an employer may self-insure
tion, premiums for certain employee benefits are
workers compensation claims up to $1 million and
considered to be “unrelated business” if they are
purchase excess insurance for the amount exceeding
structured properly.
$1 million.
■ Ownership of the captive insurer is structured
so that the insureds are not the same as the
Federal legislation allows
Risk Retention Groups (RRGs)
shareholders.
employers, trade groups, governmental units, and
Finally, premiums paid to a group captive are other parties to form risk retention groups. A risk
usually income-tax deductible because the large retention group is a group captive that can write
number of insureds creates an essential element of any type of liability coverage except employers’
insurance, which is the pooling of loss exposures liability, workers compensation, and personal lines.
over a large group. For example, a group of physicians may find medical

INSIGHT 3.1
Advantages of Self Insurance
A self-funded employee benefit plan has a number of advan- • Interest earned on the claim account is considered
tages over a more traditional insured plan. They include: income to a non-qualified plan. A qualified plan may use
this interest for future benefit payment.
• The self-funded plan may be tailored to fit the needs of • Benefit plan administration through a professional third-
the group. party administrator is reasonably and competitively
• The self-funded plan has lower fixed costs than a fully priced. Only slightly more involvement by the employer
insured plan. Most expenses are variable based on the is required, such as verifying eligibility, printing employee
actual claims. communication materials, and distributing claim checks.
• The self-funded employer may use the independent, • Self-funding with stop-loss coverage simplifies budgeting
managed-care measures, such as preferred provider because the employer always knows its maximum expend-
organizations, pre-certification, and utilization review, iture for group health coverage.
that save the most money, rather than simply those the • Administrative services such as claims handling are often
carrier offers. simpler, faster, and performed on a more personal and
• Any leftover funds in the claim account may be reconciled professional basis. Bureaucratic red tape is eliminated.
against future contributions. Source: TPA of Georgia.
 STEPS IN THE RISK MANAGEMENT PROCESS 51

malpractice liability insurance difficult to obtain or Noninsurance Transfers Noninsurance transfers

too expensive to purchase. The physicians can form a are another risk-financing technique. Noninsurance
risk retention group to insure their medical malprac- transfers are methods other than insurance by which
tice loss exposures. a pure risk and its potential financial consequences
Risk retention groups are exempt from many are transferred to another party. Examples of non-
state insurance laws that apply to other insurers. insurance transfers include contracts, leases, and
Nevertheless, every risk retention group must be hold-harmless agreements. For example, a company’s
licensed as a liability insurer in at least one state. contract with a construction firm to build a new plant
can specify that the construction firm is responsible
Advantages and Disadvantages of RetentionThe risk for any damage to the plant while it is being built. A
retention technique has both advantages and disad- firm’s computer lease can specify that maintenance,
vantages in a risk management program.8 The major repairs, and any physical damage loss to the com-
advantages are as follows: puter are the responsibility of the computer firm. A
firm may insert a hold-harmless clause in a contract,
■ Save on loss costs. The firm can save money in
by which one party assumes legal liability on behalf
the long run if its actual losses are less than the
of another party. For example, a publishing firm may
loss component in a private insurer’s premium.
insert a hold-harmless clause in a contract, by which
■ Save on expenses. The services provided by the
the author, not the publisher, is held legally liable if
insurer may be provided by the firm at a lower
the publisher is sued for plagiarism.
cost. Some expenses may be reduced, including
In a risk management program, noninsurance
loss-adjustment expenses, general administra-
transfers have several advantages:9
tive expenses, commissions and brokerage fees,
risk-control expenses, taxes and fees, and the ■ The risk manager can transfer some potential
insurer’s profit. losses that are not commercially insurable.
■ Encourage loss prevention. Because the exposure ■ Noninsurance transfers often cost less than
is retained, there may be a greater incentive for insurance.
loss prevention. ■ The potential loss may be shifted to someone who
■ Increase cash flow. Cash flow may be increased is in a better position to exercise loss control.
because the firm can use some of the funds that
However, noninsurance transfers have several
normally would be paid to the insurer at the
disadvantages:
beginning of the policy period.
■ The transfer of potential loss may fail because
The retention technique, however, has several
the contract language is ambiguous. Also, there
disadvantages:
may be no court precedents for the interpretation
■ Possible higher losses. The losses retained by the of a contract tailor-made to fit the situation.
firm may be greater than the loss allowance in the ■ If the party to whom the potential loss is trans-
insurance premium that is saved by not purchas- ferred is unable to pay the loss, the firm is still
ing insurance. Also, in the short run, there may be responsible for the claim.
great volatility in the firm’s loss experience. ■ An insurer may not give credit for the transfers,
■ Possible higher expenses. Expenses may actually and insurance costs may not be reduced.
be higher. Outside experts such as safety engineers
may have to be hired. Insurers may be able to pro-
Insurance Commercial insurance is also used in a
vide risk control and claim services at a lower cost.
risk management program. Insurance is appropriate
■ Possible higher taxes. Income taxes may also be
for loss exposures that have a low probability of loss
higher. The premiums paid to an insurer are imme-
but the severity of loss is high.
diately income-tax deductible. However, if reten-
If the risk manager uses insurance to treat certain
tion is used, only the amounts paid out for losses
loss exposures, five key areas must be emphasized:10
are deductible, and the deduction cannot be taken
until the losses are actually paid. Contributions to a ■ Selection of insurance coverages
funded reserve are not income-tax deductible. ■ Selection of an insurer
52 CHAPTER 3 / INTRODUCTION TO RISK MANAGEMENT

■ Negotiation of terms the size of the policyholders’ surplus, underwriting

■ Dissemination of information concerning insur- and investment results, adequacy of reserves for
ance coverages outstanding liabilities, types of insurance written,
■ Periodic review of the insurance program and the quality of management. Several trade
publications are available to the risk manager for
First, the risk manager must select the insurance determining the financial strength of a particular
coverages needed. The coverages selected must be insurer. One of the most important rating agencies is
appropriate for insuring the major loss exposures the A.M. Best Company, which rates insurers based
identified in step one. To determine the coverages on their relative financial strength.
needed, the risk manager must have specialized The risk manager must also consider the avail-
knowledge of commercial property and liability insur- ability of risk management services in selecting a
ance contracts. Commercial insurance is discussed in particular insurer. An insurance agent or broker
Chapters 25 through 27. can provide the desired information concerning the
The risk manager must also determine if a risk management services available from different
deductible is needed and the size of the deductible. A insurers. These services include risk-control services,
deductible is a provision by which a specified amount assistance in identifying loss exposures, and claim
is subtracted from the loss payment otherwise adjustment services.
payable to the insured. A deductible is used to elimi- The cost and terms of insurance protection must
nate small claims and the administrative expense of be considered as well. All other factors being equal,
adjusting these claims. As a result, substantial pre- the risk manager would prefer to purchase insurance
mium savings are possible. In essence, a deductible is at the lowest possible price. Many risk managers will
a form of risk retention. solicit competitive premium bids from several insur-
Most risk management programs combine the ers to get the broadest possible coverage and terms at
retention technique discussed earlier with commercial the most cost-effective price.
insurance. In determining the size of the deductible, Third, after the insurer or insurers are selected, the
the firm may decide to retain only a relatively small terms of the insurance contract must be negotiated.
part of the maximum possible loss. The insurer nor- If printed policies, endorsements, and forms are used,
mally adjusts any claims, and only losses in excess of the risk manager and insurer must agree on the docu-
the deductible are paid. ments that will form the basis of the contract. If a
Another approach is to purchase excess specially tailored manuscript policy11 is written for
insurance—a plan in which the insurer does not the firm, the language and meaning of the contractual
participate in the loss until the actual loss exceeds the provisions must be clear to both parties. In any case,
amount a firm has decided to retain. A firm may be the various risk management services the insurer will
financially strong and may wish to retain a relatively provide must also be determined. Finally, the premi-
larger proportion of the maximum possible loss. The ums may be negotiable between the firm and insurer.
retention limit may be set at the probable maximum In many cases, an agent or broker will be involved in
loss (not maximum possible loss). For example, a the negotiations.
retention limit of $1 million may be established for a In addition, information concerning insurance
single fire loss to a plant valued at $25 million. The coverages must be disseminated to others in the
$1 million would be viewed as the probable maximum firm. The firm’s employees and managers must be
loss. In the unlikely event of a total loss, the firm would informed about the insurance coverages, the various
absorb the first $1 million of loss, and the commercial records that must be kept, and the risk management
insurer would pay the remaining $24 million. services that the insurer will provide. Those persons
Second, the risk manager must select an insurer responsible for reporting a loss must also be informed
or several insurers. A number of important factors of the process for reporting claims and the appropri-
come into play here, including the financial strength ate contact information. The firm must comply with
of the insurer, risk management services provided policy provisions concerning how notice of a claim is
by the insurer, and the cost and terms of protection. to be given and how the necessary proof of loss will
The insurer’s financial strength is determined by be presented.
 STEPS IN THE RISK MANAGEMENT PROCESS 53

Finally, the insurance program must be periodically a lax attitude toward risk control could increase
reviewed. This review is especially important when the number of noninsured losses as well.
the firm has a change in business operations or is
involved in a merger or acquisition of another firm. Which Technique Should Be Used? In determining
The review includes an analysis of agent and broker the appropriate technique or techniques for handling
relationships, coverages needed, quality of risk control loss exposures, a matrix can be used that classifies
services provided, whether claims are paid promptly, the various loss exposures according to frequency
and numerous other factors. Even the basic decision— and severity. This matrix can be useful in determin-
whether to purchase insurance or retain the risk—must ing which risk management method should be used
be reviewed periodically. (see Exhibit 3.2).
The first loss exposure is characterized by both
Advantages of Insurance The use of commercial insur- low frequency and low severity of loss. One exam-
ance in a risk management program has certain ple of this type of exposure would be the potential
advantages.12 theft of office supplies. This type of exposure can be
handled by retention because the loss occurs infre-
■ The firm will be indemnified after a loss occurs.
quently and, when it does occur, it seldom causes
The firm can continue to operate and fluctua-
financial harm.
tions in earnings are minimized.
The second type of exposure is more serious.
■ Uncertainty is reduced, which permits the firm
Losses occur frequently, but severity is relatively low.
to lengthen its planning horizon. Worry and fear
Examples of this type of exposure include physical
are reduced for managers and employees, which
damage losses to automobiles, workers compensa-
should improve performance and productivity.
tion claims, shoplifting, and food spoilage. Loss pre-
■ Insurers can provide valuable risk management
vention should be used here to reduce the frequency
services, such as risk-control services, loss expo-
of losses. In addition, because losses occur regularly
sure analysis, and claims adjusting.
and are predictable, the retention technique can also
■ Insurance premiums are income-tax deductible
be used. However, because small losses in the aggre-
as a business expense.
gate can reach sizable levels over a one-year period,
excess insurance could also be purchased.
Disadvantages of Insurance The use of insurance also
The third type of exposure can be met by trans-
entails certain disadvantages and costs.
fer, including insurance. As stated earlier, insurance
■ The payment of premiums is a major cost is best suited for low-frequency, high-severity losses.
because the premium consists of a component High severity means that a catastrophic potential
to pay losses, an amount to cover the insurer’s is present, while a low probability of loss indicates
expenses, and an allowance for profit and con- that the purchase of insurance is economically feasi-
tingencies. There is also an opportunity cost. ble. Examples of this type of exposure include fires,
Under the retention technique discussed earlier, explosions, natural disasters, and liability lawsuits.
the premium could be invested or used in the
business until needed to pay claims. If insurance Exhibit 3.2
is used, premiums must be paid in advance, and Risk Management Matrix
the opportunity to use the funds is forgone.
■ Considerable time and effort must be spent in Appropriate Risk
negotiating the insurance coverages. An insurer Type of Loss Management
or insurers must be selected, policy terms and Loss Frequency Loss Severity Technique
premiums must be negotiated, and the firm 1. Low Low Retention
must cooperate with the risk-control activities of 2. High Low Loss prevention
the insurer. and retention
■ The risk manager may have less incentive to
3. Low High Transfer
implement loss-control measures because the
insurer will pay the claim if a loss occurs. Such 4. High High Avoidance
54 CHAPTER 3 / INTRODUCTION TO RISK MANAGEMENT

The risk manager could also use a combination of A risk management policy statement is necessary to
retention and commercial insurance to deal with have an effective risk management program. This
these exposures. statement outlines the risk management objectives of
The fourth and most serious type of exposure is the firm, as well as company policy with respect to
one characterized by both high frequency and high treatment of loss exposures. It also educates top-level
severity. This type of exposure is best handled by executives in regard to the risk management process;
avoidance. For example, a pharmaceutical company establishes the importance, role, and authority of the
might be concerned about the harmful side effects risk manager; and provides standards for judging the
of a new drug that it is developing. The exposure to risk manager’s performance.
liability arising from this drug can be avoided if the In addition, a risk management manual may
drug is not produced and sold. be developed and used in the program. The manual
describes in some detail the risk management pro-
Market Conditions and Selection of Risk Management gram of the firm and can be a very useful tool for
Techniques The risk management techniques training managers, supervisors, and new employees
shown in Exhibit 3.2 are general guidelines that risk who will be participating in the program. Writing
managers modify depending on market conditions in the manual also forces the risk manager to state pre-
the insurance markets. In property and casualty insur- cisely his or her responsibilities, objectives, available
ance, an underwriting cycle exists, which is the term techniques, and the responsibilities of other parties.
used to describe the cyclical pattern in underwriting A risk management manual often includes a list of
standards, amount of premiums charged, and profit- insurance policies, agent and broker contact informa-
ability in the industry. In particular, “hard” or “soft” tion, who to contact when a loss occurs, emergency
market conditions can influence the selection of the contact numbers, and other relevant information.
risk management techniques used to treat loss expo-
sures. During a period of hard market conditions, Cooperation with Other Departments
profitability is declining, or the industry is experi-
The risk manager does not work alone. Other func-
encing underwriting losses. As a result, underwriting
tional departments within the firm are extremely impor-
standards tighten, premiums increase, and insurance
tant in identifying loss exposures, methods for treating
becomes expensive and more difficult to obtain.
these exposures, and ways to administer the risk man-
Because of unfavorable market conditions, a risk
agement program. These departments can cooperate in
manager may decide to retain more of a given loss
the risk management process in the following ways:
exposure and cut back on the amount of insurance
purchased. ■ Accounting . Internal accounting controls
In contrast, in a soft market, profitability is improv- can reduce employee fraud and theft of cash.
ing, underwriting standards loosen, premiums decline, Accounting can also provide information on the
and insurance is easier to obtain. Insurance may be tax treatment of risk finance alternatives.
viewed as relatively inexpensive. Because of favorable ■ Finance. Information can be provided show-
market conditions, a risk manager may decide to retain ing the effect that losses will have on the firm’s
less of a given loss exposure and increase the amount balance sheet and profit and loss statement.
of insurance purchased. The underwriting cycle is dis- ■ Marketing. Accurate packaging and product-use
cussed in greater detail in Chapter 4. information can prevent lawsuits. Safe distribu-
tion procedures can prevent accidents.
■ Production. Quality control can prevent the pro-
IMPLEMENT AND MONITOR THE duction of defective goods and lawsuits. Effective
safety programs in the plant can reduce injuries
RISK MANAGEMENT PROGRAM and accidents.
At this point, we have discussed three of the four ■ Human resources. This department is responsi-
steps in the risk management process. The fourth step ble for employee benefit programs, retirement
is to implement and monitor the risk management programs, safety programs, and the company’s
program. This step begins with a policy statement. hiring, promotion, and dismissal policies.
 PERSONAL RISK MANAGEMENT 55

This list indicates how the risk management program that treats both pure and speculative
process involves the entire firm. Indeed, without loss exposures.
the active cooperation of the other departments, the ■ Society also benefits since both direct and indi-
risk management program will fail. It is essential for rect (consequential) losses are reduced. As a
there to be open communication between the risk result, pain and suffering are reduced.
management department and other functional areas
In conclusion, it is clear that risk managers
of the firm.
are extremely important to the financial success
of business firms in today’s economy. In view of
Periodic Review and Evaluation their importance, risk managers are paid relatively
high salaries. A recent survey found average total
To be effective, the risk management program must risk manager compensation (salary plus bonus) was
be periodically reviewed and evaluated to determine $138,100 in 2011. The survey found variation in
whether the objectives are being attained or if cor- compensation levels across industries and a positive
rective actions are needed. In particular, risk man- relationship between risk manager compensation
agement costs, safety programs, and loss-prevention and the size of the firm.13 The financial crisis and
programs must be carefully monitored. Loss records large loss events (e.g. the 9/11 terrorist attacks and
must also be examined to detect any changes in fre- Hurricane Katrina) helped to focus attention on the
quency and severity. Retention and transfer deci- critical role of risk management.
sions must also be reviewed to determine if these
techniques are being properly used. Finally, the risk
manager must determine whether the firm’s overall PERSONAL RISK MANAGEMENT
risk management policies are being carried out, and
whether the risk manager is receiving cooperation The principles of corporate risk management are also
from other departments. applicable to a personal risk management program.
Personal risk management refers to the identification
and analysis of pure risks faced by an individual or
family, and to the selection and implementation of
BENEFITS OF RISK MANAGEMENT the most appropriate technique(s) for treating such
The previous discussion shows that the risk man- risks. Personal risk management considers other
agement process involves a complex and detailed methods for handling risk in addition to insurance.
analysis. Despite the complexities, an effective risk
management program yields substantial benefits to Steps in Personal Risk Management
the firm or organization. Major benefits include the
A personal risk management program involves
following:
four steps: (1) identify loss exposures, (2) measure
■ A formal risk management program enables a and analyze the loss exposures, (3) select appropri-
firm to attain its pre-loss and post-loss objectives ate techniques for treating the loss exposures, and
more easily. (4) implement and review the risk management
■ The cost of risk is reduced, which may increase program periodically.
the company’s profits. The cost of risk is a risk
Identify Loss Exposures The first step is to identify
management tool that measures certain costs.
all loss exposures that can cause serious financial
These costs include premiums paid, retained
problems. Serious financial losses can result from the
losses, loss control expenditures, outside risk
following:
management services, financial guarantees, inter-
nal administrative costs, and taxes, fees, and 1. Personal loss exposures
other relevant expenses. ■ Loss of earned income to the family because of

■ Because the adverse financial impact of pure the premature death of the family head
loss exposures is reduced, a firm may be able ■ Insufficient income and financial assets during

to implement an enterprise risk management retirement

56 CHAPTER 3 / INTRODUCTION TO RISK MANAGEMENT

■ Catastrophic medical bills and the loss of tornado, or hurricane is relatively small, but the
earnings during an extended period of dis- severity of the loss can be catastrophic. Such losses
ability should be insured because of their catastrophic
■ Loss of earned income from unemployment potential. On the other hand, if loss frequency is
■ Identity theft high, but loss severity is low, such losses should not
be insured (such as minor scratches and dents to
2. Property loss exposures your car). Other techniques such as retention are
■ Direct physical damage to a home and personal
more appropriate for handling these types of small
property because of fire, lightning, windstorm, losses. For example, minor physical damage losses
flood, earthquake, or other causes to your car can be retained by purchasing collision
■ Indirect losses resulting from a direct physical
insurance with a deductible.
damage loss, including extra expenses, mov-
ing to another apartment or home during the Select Appropriate Techniques for Treating the
period of reconstruction, loss of rents, and loss Loss Exposures The third step is to select the
of use of the building or property most appropriate techniques for treating each loss
■ Theft of valuable personal property, includ-
exposure. The major methods are avoidance, risk
ing money and securities, jewelry and furs, control, retention, noninsurance transfers, and
paintings and fine art, cameras, computer insurance.
equipment, coin and stamp collections, and
antiques 1. Avoidance. Avoidance is one method for treat-
■ Direct physical damage losses to cars, motor-
ing a loss exposure. For example, you can avoid
cycles, and other vehicles from a collision and being mugged in a high-crime area by staying out
other-than-collision losses of the area. You can avoid the loss from the sale
■ Theft of cars, motorcycles, or other vehicles
of a home in a depressed real estate market by
renting instead of buying.
3. Liability loss exposures 2. Risk control. Risk control refers to activities
■ Legal liability arising out of personal acts that reduce the frequency or severity of loss. For
that cause bodily injury or property damage example, you can reduce the chance of an auto
to others accident by driving within the speed limit, tak-
■ Legal liability arising out of libel, slan- ing a safe driving course, and driving defensively.
der, defamation of character, and similar Car theft can be prevented by locking the car,
exposures removing the keys from the ignition, and install-
■ Legal liability arising out of the negligent ing anti-theft devices.
operation of a car, motorcycle, boat, or recrea- Risk control can also reduce the severity of a
tional vehicle loss. For example, wearing a helmet reduces the
■ Legal liability arising out of business or profes- severity of a head injury in a motorcycle acci-
sional activities dent. Wearing a seat belt reduces the severity of
■ Payment of attorney fees and other legal an injury in an auto accident. Having a fire extin-
defense costs guisher on the premises can reduce the severity
of a fire.
Analyze the Loss Exposures The second step is to 3. Retention. Retention means that you retain part
measure and analyze the loss exposures. The fre- or all of a loss. As noted earlier, risk retention
quency and severity of potential losses should be can be active or passive. Active risk retention
estimated so that the appropriate techniques can be means you are aware of the risk and plan to
used to deal with the exposure. For example, the retain part or all of it. For example, you can
chance that your home will be destroyed by a fire, retain small collision losses to your car by buy-
 PERSONAL RISK MANAGEMENT 57

ing a collision insurance policy with a deduct- to the retailer by purchasing an extended-war-
ible. Likewise, you can retain part of a loss to ranty contract that makes the retailer respon-
your home or to personal property by buying a sible for labor and repairs after the warranty
homeowners policy with a deductible. expires.
Risk can also be retained passively because 5. Insurance. In a personal risk management pro-
of ignorance, indifference, or laziness. This gram, most people rely heavily on insurance
practice can be dangerous if the retained risk as the major method for dealing with risk.
could result in a catastrophic loss. For example, Common purchases include life insurance,
many workers are not insured against the risk health insurance, homeowners insurance, auto
of long-term disability, even though the adverse insurance, and a personal umbrella liability
financial consequences from a long-term perma- policy. The use of insurance in a personal risk
nent disability generally are more severe than management program is discussed in greater
the financial consequences of premature death. detail later in the text when specific insurance
Thus, workers who are not insured against this contracts are analyzed.
risk are using risk retention in a potentially dan-
gerous manner.
4. Noninsurance transfers. Noninsurance trans- Implement and Monitor the Program Periodically
fers are methods other than insurance by which The final step is to implement the personal risk man-
a pure risk is transferred to a party other than agement program and review the program periodi-
an insurer. For example, the risk of damage cally. At least every two or three years, you should
to rental property can be transferred to the determine whether all major loss exposures are ade-
tenant by requiring a damage deposit and by quately covered. You should also review your pro-
inserting a provision in the lease holding the gram at major events in your life, such as a divorce,
tenant responsible for damages. Likewise, the birth of a child, purchase of a home, change of jobs,
risk of a defective television can be transferred or death of a spouse or family member.

Case Application
City Bus Corporation provides school bus transportation to b. Identify the major loss exposures faced by City Bus.
public schools in Lancaster County. City Bus owns 50 buses c. For each of the loss exposures identified in (b),
that are garaged in three different cities within the county. identify a risk management technique or combina-
The firm faces competition from two larger bus companies tion of techniques that could be used to handle the
that operate in the same area. Public school boards gener- exposure.
ally award contracts to the lowest bidder, but the level of d. Describe several sources of funds for paying
service and overall performance are also considered. losses if retention is used in the risk management
a. Briefly describe the steps in the risk management program.
process that should be followed by the risk manager e. Identify other departments in City Bus that would
of City Bus. also be involved in the risk management program.
58 CHAPTER 3 / INTRODUCTION TO RISK MANAGEMENT

SUMMARY ■ A captive insurer is an insurer that is owned and estab-

lished by a parent firm for the purpose of insuring the
■ Risk management is a process to identify loss expo- parent firm’s loss exposures. Captive insurers are often
sures faced by an organization or individual and to formed because of difficulty in obtaining insurance, or to
select the most appropriate techniques for treating take advantage of a favorable regulatory environment.
such exposures. They can also provide for lower costs; easier access to a
■ Risk management has several important objectives. Pre-loss reinsurer; and the formation of a profit center.
objectives include the goals of economy, reduction of anxi- ■ Self-insurance or self-funding is a special form of
ety, and meeting legal obligations. Post-loss objectives planned retention by which part or all of a given loss
include survival of the firm, continued operation, stability exposure is retained by the firm.
of earnings, continued growth, and social responsibility.
■ Noninsurance transfers are methods other than insur-
■ There are four steps in the risk management process: ance by which a pure risk and its financial consequences
Identify loss exposures. are transferred to another party.
Measure and analyze the loss exposures. ■ Noninsurance transfers have several advantages. The
Select the appropriate combination of techniques risk manager may be able to transfer some uninsur-
for treating the loss exposures. able exposures; noninsurance transfers may cost less
Implement and monitor the risk management than insurance; and the potential loss may be shifted to
program. another party who is in a better position to exercise loss
■ Risk control refers to techniques that reduce the frequency control.
or severity of losses. Major risk-control techniques include ■ Noninsurance transfers also have several disadvantages.
avoidance, loss prevention, and loss reduction. The transfer of a potential loss may fail because the con-
■ Risk financing refers to techniques that provide for the tract language is ambiguous; the firm is still responsible
funding of losses after they occur. Major risk-financing for the loss if the party to whom the potential loss is
techniques include retention, noninsurance transfers, transferred is unable to pay the loss; and an insurer may
and commercial insurance. not give sufficient premium credit for the transfers.

■ Avoidance means that a loss exposure is never acquired ■ Commercial insurance can also be used in a risk manage-
or an existing loss exposure is abandoned. Loss preven- ment program. Use of insurance involves the selection
tion refers to measures that reduce the frequency of a of insurance coverages, selection of an insurer, negotia-
particular loss. Loss reduction refers to measures that tion of contract terms with the insurer, dissemination
reduce the severity of a loss after it occurs. of information concerning the insurance coverages, and
periodic review of the insurance program.
■ Retention means that the firm retains part or all of
the losses that result from a given loss exposure. This ■ The major advantages of insurance include indemni-
technique can be used if no other method of treatment fication after a loss occurs, reduction of uncertainty,
is available, the worst possible loss is not serious, and availability of valuable risk management services, and
losses are fairly predictable. Losses can be paid out of the income-tax deductibility of the premiums. The
the firm’s current net income; an unfunded or funded major disadvantages of insurance include the cost of
reserve can be established to pay losses; a credit line insurance, time and effort that must be spent in negoti-
with a bank can provide funds to pay losses; or the firm ating for insurance, and a possible lax attitude toward
can form a captive insurer. loss control because of the existence of insurance.

■ The advantages of retention are the saving of money ■ A risk management program must be properly imple-
on insurance premiums, lower expenses, greater incen- mented and administered. This effort involves preparation
tive for loss prevention, and increased cash flow. Major of a risk management policy statement, close cooperation
disadvantages are possible higher losses that exceed the with other individuals and departments, and periodic
loss component in insurance premiums, possible higher review of the entire risk management program.
expenses if loss-control and claims personnel must be ■ The principles of corporate risk management can also
hired, and possible higher taxes. be applied to a personal risk management program.
 APPLICATION QUESTIONS 59

KEY CONCEPTS AND TERMS 9. a. What is self-insurance?

b. What is a risk retention group?
Association or group Personal risk management
captive (49) (55) 10. a. Explain the advantages of using insurance in a risk
Avoidance (47) Probable maximum loss (47) management program.
Captive insurer (49) Retention (48) b. Explain the disadvantages of using insurance in a
Cost of risk (55) Retention level (48) risk management program.
Deductible (52) Risk control (47)
Excess insurance (52) Risk financing (47)
Loss exposure (44) Risk management (44)
Loss frequency (47) Risk management APPLICATION QUESTIONS
Loss prevention (47) manual (54) 1. Scaffold Equipment manufactures and sells scaffolds
Loss reduction (48) Risk management policy and ladders that are used by construction firms. The
Loss severity (47) statement (54) products are sold directly to independent retailers in
Manuscript policy (52) Risk retention group (50) the United States. The company’s risk manager knows
Maximum possible Self-insurance (50) that the company could be sued if a scaffold or ladder
loss (47) Single parent captive is defective, and someone is injured. Because the cost
Noninsurance transfers (51) (pure captive) (49) of products liability insurance has increased, the risk
manager is considering other techniques to treat the
company’s loss exposures.
a. Describe the steps in the risk management process.
REVIEW QUESTIONS b. For each of the following risk management tech-
niques, describe a specific action using that technique
1. What is the meaning of risk management? that may be helpful in dealing with the company’s
2. Explain the objectives of risk management both before products liability exposure.
and after a loss occurs. 1. Avoidance
2. Loss prevention
3. Describe the steps in the risk management process.
3. Loss reduction
4. a. Identify the sources of information that a risk 4. Noninsurance transfers
manager can use to identify loss exposures.
2. The Swift Corporation has 5000 sales representatives
b. What is the difference between the maximum pos-
and employees in the United States who drive company
sible loss and probable maximum loss?
cars. The company’s risk manager has recommended
5. a. Explain the meaning of risk control. to the firm’s management that the company should
b. Explain the following risk-control techniques. implement a partial retention program for physical
1. Avoidance damage losses to company cars.
2. Loss prevention a. Explain the advantages and disadvantages of a par-
3. Loss reduction tial retention program to the Swift Corporation.
6. a. Explain the meaning of risk financing. b. Identify the factors that the Swift Corporation
b. Explain the following risk-financing techniques. should consider before it adopts a partial reten-
1. Retention tion program for physical damage losses to
2. Noninsurance transfers company cars.
3. Insurance c. If a partial retention program is adopted, what
are the various methods the Swift Corporation
7. What conditions should be fulfilled before retention is
can use to pay for physical damage losses to
used in a risk management program?
company cars?
8. a. What is a captive insurer? d. Identify two risk-control measures that could be
b. Explain the advantages of a captive insurer in a risk used in the company’s partial retention program
management program. for physical damage losses.
60 CHAPTER 3 / INTRODUCTION TO RISK MANAGEMENT

3. Avoidance is a risk-control technique that can be used INTERNET RESOURCES

effectively in a risk management program.
a. What is the major advantage of using the technique ■ Captive.com provides considerable information about
of avoidance in a risk management program? captive insurers. The site provides answers to fre-
b. Is it possible or practical for a firm to avoid all quently asked questions about captives. The site also
potential losses? Explain your answer. has experts who will answer questions pertaining to
captives or alternative retention techniques. Visit the
4. A risk management program must be implemented site at
and periodically monitored to be effective. This step
requires the preparation of a risk management policy captive.com
statement. The cooperation of other departments is ■ The Institutes are a leading provider of educational
also necessary. material and property and liability insurance designa-
a. What benefits can the firm expect to receive tion programs. In addition to the American Institute
from a well-prepared risk management policy for Chartered Property Casualty Underwriters (CPCU)
statement? designation, the Institutes provide several associate pro-
b. Identify several departments within a firm that grams, including the Associate in Risk Management
are especially important in a risk management (ARM) program. Visit the site at
program. aicpcu.org
5. Chris and Karen are married and own a three-bedroom ■ The International Financial Risk Institute (IFRI) provides
home in a large Midwestern city. Their son, Christian, financial risk management opportunities for senior
attends college away from home and lives in a frater- risk practitioners, especially the chief risk officers of
nity house. Their daughter, Kelly, is a senior in high the world’s major financial institutions, to discuss and
school. Chris is an accountant who works for a local exchange ideas on the principles and practical applica-
accounting firm. Karen is a marketing analyst and is tion of financial risk management. Visit the site at
often away from home several days at a time. Kelly
earns extra cash by babysitting on a regular basis. riskinstitute.ch

The family’s home contains household furniture, ■ The International Risk Management Institute (IRMI) seeks
personal property, a computer that Chris uses to pre- to be the premier authority in providing expert advice
pare business tax returns on weekends, and a laptop and practical strategies for risk management, insurance,
computer that Karen uses while traveling. The Swifts and legal professionals. IRMI has a large online library
also own three cars. Christian drives a 2004 Ford; with information about property and liability insurance
Chris drives a 2009 Pontiac for both business and and risk management. Visit the site at
personal use; and Karen drives a 2011 Toyota and a irmi.com
rental car when she is traveling. Although the Swifts ■ The Nonprofit Risk Management Center conducts
have owned their home for several years, they are con- research and provides education on risk management
sidering moving because of the recent increase in vio- and insurance issues that are of special concern to
lent crime in their neighborhood. nonprofit organizations. The organization provides
a. Describe briefly the steps in the personal risk man- technical assistance, a newsletter, online software
agement process. programs, and conferences related to risk management
b. Identify the major pure risks or pure loss exposures and insurance. Visit the site at
to which Chris and Karen are exposed with respect
to each of the following: nonprofitrisk.org
1. Personal loss exposures ■ The Public Risk Management Association represents risk
2. Property loss exposures managers of state and local governmental units. The
3. Liability loss exposures organization provides practical training and education
c. With respect to each of the loss exposures men- for risk managers in the public sector. Visit the site at
tioned above, identify an appropriate personal risk primacentral.org
management technique that could be used to treat
the exposure.
 NOTES 61

■ The Risk Management Society (RIMS) is the premier NOTES

professional association in the United States for risk
managers and corporate buyers of insurance. RIMS 1. Robert I. Mehr and Bob A. Hedges, Risk
discusses common risk management issues, supports Management: Concepts and Applications
loss-prevention activities, and makes known to insur- (Homewood, IL: Richard D. Irwin, 1974), chs.
ers the insurance needs of its members. RIMS has local 1–2; see also Eric A. Wiening, Foundations of
chapters in major cities and publishes Risk Management Risk Management and Insurance (Malvern, PA:
magazine. Visit the site at American Society for Chartered Casualty Property
rims.org
Underwriters/Insurance Institute of America,
2002), ch. 3, and George L. Head and Stephen
■ The Self-Insurance Institute of America is a national asso- Horn II, Essentials of Risk Management, 3rd ed.,
ciation that promotes self-insurance as an alternative vol. 1 (Malvern, PA: Insurance Institute of America,
method for financing losses. The organization publishes 1997), pp. 70–79.
technical articles on self-insurance, holds educational 2. This section is based on Head and Horn, pp. 36–44,
conferences, and promotes the legislative and regulatory and C. Arthur Williams, Jr., et al., Principles of
interests of the self-insurance industry at both the fed- Risk Management and Insurance, 2nd ed., vol. 1
eral and state levels. Visit the site at (Malvern, PA: American Institute for Property and
siia.org Liability Underwriters, 1981), chs. 2–3.
3. Williams et al., pp. 125–126.
4. Head and Horn, pp. 40–42.
SELECTED REFERENCES 5. Statistics presented in this paragraph were obtained
from vermontcaptive.com, captiveexperts.com,
Baranoff, Etti G., Scott E. Harrington, and Gregory R.
captive.com, and propertycasualty360.com
Niehaus. Risk Assessment, 1st ed. Malvern, PA:
6. Towers Perrin, Tillinghast, Captives 101: Managing
American Institute for Chartered Property Casualty
Cost and Risk, October 2003.
Underwriters/Insurance Institute of America, 2005.
7. Ibid.
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9. Ibid., pp. 103–104.
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10. Ibid., pp. 107–123, 146–151.
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11. A manuscript policy is one specifically designed for
Elliott, Michael W. (editor), Risk Management Principles
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and Practices, Malvern, PA: American Institute for
12. Williams et al., pp. 108–116.
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Management and Insurance, 2nd ed. Boston, MA:
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Risk and Insurance Management Society. The 2008
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Management, 2008.
Students may take a self-administered test on
Wade, Jared, “The Risks of 2012,” Risk Management,
this chapter at
January/February 2012, pp. 36-42.
Wiening, Eric A. Foundations of Risk Management and
www.pearsonhighered.com/rejda
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Chartered Property Casualty Underwriters/Insurance
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Wiening, Eric A., and George E. Rejda. Risk Management
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