Chapter Two

THE RISK MANAGEMENT

2.1 Risk Management Defined
Definition 1
Risk Management refers to the identification; measurement and treatment of exposure to
potential accidental losses almost always in situations where the only possible out comes are
losses or no change in the status.

Definition 2
Risk Management is a general management function that seeks to assess and address the
causes and effects of uncertainty and risk on an organization. The purpose of risk management
is to enable an organization to progress towards its goals and objectives in the most direct,
efficient, and effective path. It is concerned with all risks.

Definition 3
Risk Management is the executive function of dealing with specified risks facing the business
enterprise. In general, the risk manager deals with pure, not speculative risk.

The risk manager has certain specific duties. These include:

1. To recognize exposures to loss; the risk manager must, first of all, be aware of the
possibility of each type of loss. This is a fundamental duty that must precede all other
functions.
2. To estimate the frequency and size of loss; to estimate the probability of loss from
various sources.
3. To decide the best and most economical method of handling the risk of loss, whether
it be by assumption, avoidance, self-insurance, reduction of hazards, transfer,
commercial insurance, or some combination of these methods.
4. To administer the programs of risk management, including the tracks of constant
revaluation of the programs, record keeping and the like.

1
2.2 Objectives of Risk Management
Risk management has several important objectives that can be classified into two categories:
pre-loss objectives and post-loss objectives.

Pre-loss objectives. A firm or organization has several risk management objectives prior to
the occurrence of a loss. The most important include economy, the reduction of anxiety, and
meeting externally imposed obligations.

The first goal means that the firm should prepare for potential losses in the most economical
way possible.
possible. This involves an analysis of safety program expenses, insurance premiums, and
the costs associated with the different techniques for handling losses.

The second objective, the reduction of anxiety,

anxiety, is more complicated. Certain loss exposures
can cause greater worry and fear for the risk manager, key executives, and stockholders than
other exposures. For example, the threat of a catastrophic lawsuit from a defective product
can cause greater anxiety and concern than a possible small loss from a minor fire. However,
the risk manager wants to minimize the anxiety and fear associated with all loss exposures.

The third objective is to meet any externally imposed obligations.

obligations. This means the firm must
meet certain obligations imposed on it by outsiders. For example, government regulations
may require a firm to install safety devices to protect workers from harm. Similarly, a firm’s
creditors may require that property pledged as collateral for a loan must be insured. The risk
manager must see that these externally imposed obligations are met.

Post-loss objectives. The first and most important post-loss objective is survival of the firm.
firm.
Survival means that after a loss occurs, the firm can at least resume partial operation within
some reasonable time period if it chooses to do so.

The second post-loss objective is to continue operating.

operating. For some firms, the ability to operate
after a severe loss is an extremely important objective. This is particularly true of certain
firms, such as public utility firm, which must continue to provide service. The ability to
operate is also important for firms that may loss customers to competitors if they cannot

2
operate after a loss occurs. This would include banks, bakeries, dairy farms, and other
competitive firms.

Stability of earnings is the third post-loss objective. The firm wants to maintain its earnings
per share after a loss occurs. This objective is closely related to the objective of continued
operations. Earning per share can be maintained if the firm continues to operate. However,
here may be substantial costs involved in achieving this goal (such as operating at another
location), and perfect stability of earnings may not be attained.

The fourth post-loss objective is continued growth of the firm.

firm. A firm may grow by
developing new products and markets or by acquisitions and mergers. The risk manager must
consider the impact that a loss will have on the firm’s ability to grow.
Finally, the goal of social responsibility is to minimize the impact that a loss has on other
persons and on society.
society. A sever loss can adversely affect employees, customers, suppliers,
creditors, taxpayers, and the community in general. For example, a severe loss that requires
shutting down a plant in a small community for an extended period can lead to depressed
business conditions and substantial unemployment in the community.

2.3 The Risk Management Process

The process involves five steps. These are:

i. Identifying loss exposures. The loss exposures of the business or family must be
identified. Risk identification is the first and perhaps the most difficult function that
the risk manager or administrator must perform. Failure to identify all the exposures of
the firm or family means that the risk manager will have no opportunity to deal with
these unknown exposures intelligently.

ii. Measuring the losses. After risk identification, the next important step is the proper
measurement of the losses associated with these exposures. This measurement
includes a determination of (a) the probability or chance that the losses will occur, (b)
the impact the losses would have upon the financial affairs of the firm or family,
should they occur, and (c) the ability to predict the losses that will actually occur
during the budget period. The measurement process is important because it indicates

3
 the exposures that are most serious and consequently most in need of urgent attention.
It also yields information needed in step 3.

iii. Selection of the risk management tools. Once the exposure has been identified and
measured, the various tools of risk management should be considered and a decision
made with respect to the best combination of tools to be used in attacking the problem.
These tools include primarily (a) avoiding the risk, (b) reducing the chance that the
loss will occur or reducing its magnitude if it does occur, (c) transferring the risk to
some other party, and (d) retaining or bearing the risk internally. The third alternative
includes, but is not limited to, the purchase of insurance. Selecting the proper tool or
combination of tools requires considering the present financial position of the firm or
family, its overall policy with reference to risk management, and its specific
objectives.

iv. Implementing the decision made. After deciding among the alternative tools of risk
treatment, the risk manager must implement the decision made. If insurance is to be
purchased, for example, establishing proper coverage, obtaining reasonable rates, and
selecting the insurer are part of the implementation process.

v. Evaluating the result. The results of the decisions made and implemented in the first
four steps must be monitored to evaluate the wisdom of those decisions and to
determine whether changing conditions suggest different solutions.

2.3.1 Risk Identification

Risk identification is the process by which an organization is able to learn areas in which it is
exposed to risk. Identification techniques are designed to develop information on sources of
risk, hazards, risk factors, perils, and exposures to loss. It seems quite logical to inquire in to
the sources of organizational risks at this particular moment. A discussion of the sources is
presented below.

4
Risk identification is the process by which a business systematically and continually identifies
property, liability, and personnel exposures as soon as or before they emerge. The risk
manager tries to locate the areas where losses could happen due to a wide range of perils.
Unless the risk manager identifies all the potential losses confronting the firm, he or she will
not have any opportunity to determine the best way to handle the undiscovered risks.
To identify all the potential losses the risk manager needs first a checklist of all the losses that
could occur to any business. Second, he or she needs a systematic approach to discover which
of the potential losses included in the checklist are faced by his/her business. The risk
manager may personally conduct this two-step procedure or may rely upon the services of an
insurance agent, broker, or consultant.
After the checklist is developed, the second step is to discover and describe the types of losses
faced by a particular business. Because most business are complex, diversified, dynamic
operations, a more systematic method of exploring all facets of the specific firm is highly
desirable. Seven methods that have been suggested are:
1. the risk analysis questionnaire
2. the financial statement method
3. the flow-chart method
4. on-size inspection
5. planned interactions with other departments
6. statistical records of past losses
7. analysis of the environment
No single method or procedure of risk identification is free of weaknesses or can be called
foolproof. The strategy of management must be to employ that method or combination of
methods that best fits the situation at the hand.
The choice depends on:
- the nature of the business
- the size of the business
- the availability of in house expertise, etc
1. The risk analysis questionnaire: - It does more than provide a checklist of potential losses.
It directs the risk manager to secure in systematic fashion specific information concerning the
firm’s properties and operations.

5
Eg. If a building is leased from someone else, does the lease make the firm responsible for
repair or restoration of damage not resulting from its own negligence?
2. Financial statement method: - A second systematic method for determining which of the
potential losses in the checklist apply to a particular firm and in which way is the financial
statement method. By analyzing the balance sheet, operating statements and supporting
records, the risk manager can identify all the existing property, liability and personal
exposures of the firm. By coupling these statements with financial forecasts and budgets, the
risk manager can discover future exposures.
3. Flow-chart method: - Is the 3rd systematic procedure for identifying the potential losses
facing a particular firm. First, a flow chart or series of flow charts is constructed, which shows
all the operations of the firm, starting with raw materials, electricity, and other inputs at
supplies locations and ending with finished products in the hands of customers. Second the
checklist of potential property, liability, and personal losses is applied to each property and
operation shown in the flow chart to determine which losses the firm faces.
4. On-site inspections: - are a must for the risk manager. By observing firsthand the firm’s
facilities and the operations conducted thereon the risk manager can learn much about the
exposures faced by the firm.
5. Interactions with other departments:- Through systematic and continuous interactions
with other departments in the business, the risk manager attempts to obtain a complete
understanding of their activities and potential losses created by these activities.
6. Statistical Records of losses: - Another approach that will probably suggest fewer
exposures than the others but which may identify some exposures not otherwise discovered is
to consult statistical records of losses or near losses that may be repeated in the future.
7. Analysis of the environment: By analyzing the internal and external environment such as
customers, competitors, suppliers and government, the risk manager can identify the potential
losses.
In identification process the risk manager gives more emphasis on pure risks: property losses,
personal and liability losses.

6
2.3.1.1 Sources of Risk
Sources of risk are the sources of factors or hazards that may contribute to positive or
negative outcomes. Sources of risk can be classified in several ways. For instance, the
following sources of risk represent one listing:

i. Physical Environment. Clearly, the physical environment is a fundamental source of

risk. Earthquakes, drought, or excessive rainfall can all lead to loss. The ability to fully
understand our environment and the effects we have on it - as well as those it has on us
- is a central aspect of this source of risk. The physical environment
environment may be the source
of opportunity as well, for example, real estate as an investment, agribusiness, and
weather as a contributing factor to tourism.
ii. Social Environment. Changing traditions and values, human behavior, social struc-
struc-
tures, and institutions are a second source of risk.
iii. Political Environment. Within a single country, the political environment can be an
important source of risk. A new party can move the nation into a policy di rection that
might have dramatic effects on particular organizations (new stringent regulations on
toxic waste disposal). In the international
international realm, the political environment is even more
complex. Not all nations are democratic in their form of government, and some have
very undemocratic attitudes
attitudes and policies toward business. Foreign assets might be
confiscated by a host government or tax policies might change dramatically. The
political environment also can promote positive opportunities through fiscal and
monetary policy, enforcement
enforcement of laws, and the education of the population.
iv. Legal Environment. the expected laws and directives may be issued by the government
which may render risky environment to the businesses operating in the country. In the
international domain, complexity increases because
because legal standards can vary
dramatically from country to country. The legal environment also produces positive
outcomes in the sense that rights are protected and that the legal system provides a
stabilizing influence on society.
v. Operational Environment.
Environment. Processes and procedures of an organization generate risk

7
 and uncertainty. A formal procedure for promoting, hiring, or firing employees may
generate a legal liability. The manufacturing process may put employees at risk of
physical harm. Activities of an organization may result in harm to the environment.
International businesses may suffer from risk or uncertainty due to unreliable
transportation systems. The operational environment also provides gains, as it is the
ultimate source of the goods and services by which an organization succeeds or fails.
vi. Economic Environment. Although the economic environment often flows directly
from the political realm, the dramatic expansion of the global marketplace has created
an environment that is greater than any single government. Although a particular
government’s actions may affect international capital markets, control of capital
markets is beyond the reach of a single nation. Inflation, recession, and depression are
now elements of interdependent economic systems. On a local level, interest rates and
credit policies can impose significant risk on an organization.
vii. Cognitive Environment. A risk manager’s ability to understand, see, measure, and
assess is far from perfect. An important source of risk for organizations is the
difference between the perception of the risk manager and reality. The cognitive
environment is a challenging source of risk to identify and analyze. The analyst must
contemplate such questions as “How do we understand the effect of uncertainty on the
organization? and “How do we know whether a perceived risk is real?” An evaluation
of the cognitive environment partly addresses the distinction between risk and
uncertainty as defined in Chapter 1.

2.3.1.2 Identification of Exposures

A given peril or hazard can originate in any one of several environments. Fire, for example,
could arise from the physical environment (a lightning strike) or the social environment
(arson, civil unrest). Sources of risk are essentially of no concern to an organization unless
that organization is exposed or vulnerable to the perils that arise from those environments.
Therefore, an important aspect of risk identification is exposure identification. Although in
the broadest sense an entire organization is at exposure to risk, it is useful to develop
categories of exposures for analytical purposes. This reading material considers four
categories of risk exposures: physical asset exposures, financial asset exposures, liability

8
exposures, and human exposures.

i Physical Asset Exposures. Ownership of property gives rise to possible gains

or losses to physical assets and to intangible assets (goodwill, political support, intel-
intel-
lectual property), that arise from these exposures. Property may be damaged, de stroyed,
lost, or diminished in value in a number of ways. The inability to use property for a period
of time, the so-called time element loss, is often overlooked by individuals and
organizations. Conversely, property exposures to risk may result in gain or enhancement.
ii Financial Asset Exposures. Ownership of securities such as common stock
and mortgages creates this type of exposure. This exposure can occur either from own -
ership of the security or when the organization issues a security held by others. A financial
asset conveys rights that are enumerated in financial terms, such as the right to receive
income or the right to purchase an asset at a specified price. Unlike physical property, loss
or gain to a financial asset can occur without any physical change in the asset itself. Often
these gains and losses occur as a consequence of changing market conditions or changes
in the value of the rights conveyed by the security as perceived by investors.
iii Liability Exposures. Obligations imposed by the legal system create this type
of exposure. Civil and criminal law detail obligations carried by citizens; state and federal
legislatures impose statutory limitations on activities; governmental agencies
agencies promulgate
administrative rules and directives that establish standards of care. Legal obligations that
differ from country to country are an increasingly important aspect of this area.

Unlike property exposures to risk, liability exposures do not have an upside. That is, liability
exposures generally can be considered pure risks. It is true that the law establishes rights
as well as obligations, and the enforcement of a right can result
result in a gain.

iv Human Asset Exposures. Part of the wealth of an organization arises from its
investment in humans: the human resources of the organization. Possible injury or death
of managers, employees, or other significant stakeholders (customers, Secured
Secured creditors,
stockholders, suppliers) exemplifies this type of exposure. Human asset exposures also
can lead to gains, as exemplified by improvements in productivity.
productivity. One might, for
example, view a highly technical piece of machinery as source of loss (worker injury) and

9
 gain (increased productivity). In such a case, the risk management strategy is likely to
incorporate elements that will reduce the potential for loss while maximizing the
likelihood of gain (employee training, for instance). As a final note, loss of human assets
does not always imply physical harm. Economic insecurity is a common type of loss,
unemployment and retirement
retirement being excellent examples. Both the physical and economic
welfare of human beings are components of this type of exposure to risk.
2. 4 Risk Management Tools
After the risk manager has identified and measured the risks facing the firm, he or she must
decide to handle them. There are two basic approaches. First, the risk manger can use risk
control measures to alter the exposures in such a way as (1) to reduce the firm’s expected
property, liability, and personnel losses, or (2) to make the annual loss experience more
predictable. Risk control measures include avoidance loss prevention and reduction measures,
separation, combination, & some transfers.

Second, the risk manger can use risk-financing measures to finance the losses that do occur.
Funds may be required to repair or restore damaged property, to settle liability claims, or to
replace the services of disabled or deceased employees or owners. In some, the firm will
decide not to restore the damaged property or replace the disabled or decreased person.
Nevertheless, it may also have suffered a financial loss through a reduction in its assets or its
future earning power. The tools in this second category include those transfers, including the
purchase of insurance, that are not considered under risk control devices and retention, which
includes, “self insurance”.
2.4.1 Risk Control Tools
i. Avoidance
One way to control a particular pure risk is to avoid the property, person, or activity with
which the exposure is associated by (1) refusing to assume it even momentarily or (2) an
exposure assumed earlier, most examples of risk avoidance fall in the risk category. To
illustrate a firm can avoid a flood loss by not building a plant in a flood plain. An existing loss
exposure may also be abandoned. For example, a firm that produces a highly toxic product
may stop manufacturing that product. Similarly, an individual can avoid third party liability
by not owning a car. Product liability can be avoided by dropping the product. Leasing avoids
the risk originating from property ownership.
10
The major advantage of avoidance is that the chance of loss is reduced to zero if the loss
exposure is not acquired. In addition, if an existing loss exposure is abandoned, the possibility
of loss is either eliminated or reduced because the activity or product that could produce a loss
has been abandoned.

Avoidance, however, has two disadvantages. First, it may not be possible to avoid all losses.
For example, a company cannot avoid the premature death of a key executive. Similarly, a
business has to own vehicles, building, machinery, inventory, etc… Without them operations
would become impossible. Under such circumstances avoidance is impossible. In fact there
are circumstances where avoidance is a viable alternative. For example, it may be better to
avoid the construction of a company near river bank, volcano-prone areas, valleys, etc.
because the risk is so great.

The second disadvantage of avoidance is that it may not be practical or feasible to avoid the
exposure. For example, a paint factory can avoid losses arising from the production of paint.
However, without any paint production, the firm will not be in business.

ii. Loss Prevention and Reduction Measures

These measures refer to the safety actions taken by the firm to prevent the occurrence of a loss
or reduce its severity if the loss has already occurred. Prevention measures, in some cases,
eliminate the loss totally although their major effect is to reduce the probability of loss
substantially. Loss reduction measures try to minimize the severity of the loss once the peril
happened. For example, auto accidents can be prevented or reduced by having good roads,
better lights and sound traffic regulation and control, fast first-aid service and control, fast
first-aid service and the like. Loss prevention and Retention measures must be considered
before the Risk manager considers the application of any risk financing measures.

Following are some examples of loss prevention and reduction plans.

Loss Prevention Measures:

 Research on fire protection equipment and appliances.

 Construction using fire insensitive materials.
 Automatic smoke detectors, fire alarms.

11
  Burglar alarms in costly business situation, jewelry, diamonds.

 Locational choice, avoiding construction near petrol stations, chemical reservoirs,

waste disposal areas, etc.

 Tight quality control to prevent risk of product liability.

 Educational programs to the public using available media.

 Multiple suppliers, buffer stocks.

 Safety measures, adequate lighting, ventilation, special work clothes to prevent

industrial accidents.

 Regular inspection of machinery to prevent explosions, breakdowns, etc..

 Accounting controls (Internal Control).

 Electronic metal detectors to check passengers for arms and explosives in the airline
business.

 Automatic gates at crossing lines to prevent collisions train and motor vehicles.

 Warning posters (NO SMOKING!! DANGER ZONE!!)

Loss Reduction Measures:

 Installing automatic sprinklers.

 First aid kit

 Evacuation of people, CHERNOBYL

 Immediate clean-up operations, EXXON – VALDEZ, Alaska oil spill

 Fire extinguishers, guards.

Appropriate measures take to prevent accidents bring benefits not only to the firm, but also to
the society as well. For example, a destruction of inventory of a firm, could be a total loss to
the firm in particular. The society also faces a real economic loss because those goods are no
more available to people. Thus, the importance of Loss Prevention and Reduction measures
should not be underestimated by a firm. To design effective LP and R measures, it may be
helpful to identify the causes of accidents.

12
Some of the causes of accident and the possible Loss Prevention and Reduction measures are
indicated below.

Causes of accidents Loss prevention measures

- Working on dangerous equipment with less care - Safety seminars, inspection at regular times
- Improper use of equipment - Training, safety seminars
- Violating Safety Procedures and Regulations. - Safety seminars, warning, dismissal
- Human error, Negligence - Training, safety seminars
- Use of inappropriate tools - Provide appropriate tools
- Lack of protective clothing - Provide necessary protective clothing
- Use of defective equipment - Regular inspection and maintenance
- Inadequate Knowledge about the job Training
- Working while physically ill - Sick leave, don’t allow to work until recovery
- Mental Disturbance of employee Day-off to the employee

Date should be kept regarding accidents occurred. The causes of these accidents must be
investigated. Pre-designed forms may be employed to report on accidents and their causes.
This could allow for the design of a much better LP and R measures.

LP and R measures entail costs. These costs include expenditures for the acquisition of safety
equipment and services, operating expenses such as salary payments to guards, inspectors,
safety engineers and other employees engaged in safety work. Other costs are also incurred in
connection with safety training and seminars. The risk manager will have to design the LP
and R measures in the most efficient way in order to minimize such costs without reducing
the desired safety level.

iii. Separation
Separation of the firm’s exposures to loss instead of concentrating them at one location where
they might all be involved in the same loss is the third risk control tool. For example, instead
of placing its entire inventory in one warehouse the firm may elect to separate this exposure
by placing equal parts of the inventory in ten widely separated warehouse. To the extent that
this separation of exposures reduces the maximum probable loss to one event, it may be
regarded as a form of loss reduction. Emphasis is placed here, however, on the fact that
through this separation the firm increases the number of independent exposure units under its

13
control. Other things being equal, because of the law of large number, this increase reduces
the risk, thus improving the firm’s ability to predict what its loss experience will be.

iv. Combination/Diversification
Combination is a basic principle of insurance that follows the low of large numbers.
Combination increases the number of exposure units since it is a pooling process. It reduces
risk by making loses more predictable with a higher degree of accuracy. The difference is that
unlike separation, which spreads a specified number of exposure units, combination increases
the number of exposure units under the control of the firm.

In the case of firms, combination results in the pooling of resources of two or more firms. One
way a firm can combine risks is to expand through internal growth. For example, a taxi-cab
company may increase its fleet of automobiles. Combination also occurs when two firms
merge or one acquires another. The new firm has more buildings, more automobiles, and
more employees than either of the original companies. This leads to financial strength,
thereby minimizing the adverse effect of the potential loss. For example, a merger in the same
or different lines of business increases the available resources to meet the probable loss.

Diversification is another risk handling tool, most speculative risk in business can be dealt
with diversification. Businesses diversify their product lines so that a decline in profit of one
product could be compensated by profits form others. For example farmers diversify their
products by growing different crops on their land. Diversification however, has limited use in
dealing with pure losses.

VI. Non-insurance Transfer

Transfer, the final tools to be discussed, may be accomplished in two ways. These are:

 Transfer of the activity or the property. The property or activity responsible for the
risks may be transferred to some other person or group of persons. For example, a firm
that sells one of its buildings transfers the risks associated with ownership of the building
to the new owner. A contractor who is concerned about possible increase in the cost of
labor and materials needed for the electrical work on a job to which he/she is already
committed can transfer the risk by hiring a subcontractor for this portion of the project.

14
 This type of transfer, which is closely related to avoidance through abandonment, is a risk
control measure because it eliminates a potential loss that may strike the firm. It differs
from avoidance through abandonment in that to transfer a risk the firm must pass it to
someone else.

 Transfer of the probable loss. The risk, but not the property or activity, may be
transferred. For example, under a lease, the tenant may be able to shift to the landlord any
responsibility the tenant may have for damage to the landlord’s premises caused by the
tenant’s negligence. A manufacture may be able to force a retailer to assume
responsibility for any damage to products that occurs after the products leave the
manufacturer’s premises even if the manufacturer would otherwise be responsible. A
business may be able to convince a customer to give up any rights the customers might
have to give the business for bodily injuries and property damage sustained because of
defects in a product or a service.
2.4.2 Risk Financing Tools
i. Retention
Retention means that the firm retains part or all of the losses that result from a given loss
exposure. Retention can be effectively used in a risk management program when certain
conditions exist. First, no other method of treatment is available. Insurers may be unwilling to
write a certain type of coverage, or the coverage may be too expensive. Noninsurance
transfers may not be available. Loss control can reduce the frequency of loss, but not all
losses can be eliminated. In these cases, retention is a residual method. If the exposure cannot
be insured or transferred, then it must be retained.

Second, the worst possible loss is not serious. For example, physical damage losses to
automobiles in a large firm's fleet will not bankrupt the firm if the automobiles are separated
by wide distances and are not likely to be simultaneously damaged.

Finally, losses are highly predictable. Retention can be effectively used for workers'
compensation claims, physical damage losses to automobiles, and shoplifting losses. Based on
past experience, the risk manager can estimate a probable range of frequency and severity of
actual losses. If most losses fall within that range, they can be budgeted out of the firm's
income.

15
 ii. Insurance

Commercial insurance can also be used in a risk management program. Insurance can be
advantageously used for the treatment of loss exposures that have a low probability of loss but
the severity of a potential loss is high.

If the risk manager decides to use insurance to treat certain loss exposures, five key areas
must be emphasized.

- Selection of insurance coverage’s

- Selection of an insurer

- Negotiation of terms

- Dissemination of information concerning insurance

coverage

- Periodic review of the insurance programs

16