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By: Seble T. 01/02/2025

 CHAPTER TWO

T H E R I S K M A N A G E M E N T P R O C E SS

By: Seble T. 01/02/2025

 Meaning of Risk
management
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 Risk management refers to the identification;
measurement and treatment of exposure to potential
accidental losses almost always in situations where the only
possible outcomes are losses or no change in the status
 It is a general management function that seeks to assess and
address the causes and effects of uncertainty and risk on an
organization
 Risk management is a systematic process that identifies and
evaluates loss exposures faced by an organizations or
individuals and selects the most appropriate techniques for
treating such exposures.
 It is a scientific approach to deal with risks by anticipating
possible accidental losses and designing and implementing
procedures that minimize the occurrence of loss or the
financial impact of the losses that occur.
 The purpose of risk management is to enable an organization
By: Seble T.
to progress towards its goals and objectives in the most 01/02/2025
 Objectives of Risk
Management
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 Risk management has many important objectives, which
can be classified as either
1. Pre loss Objectives
2. 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/legally imposed
obligations.
 Economy: The economy objective means that the firm
should prepare for potential losses in the most
economical way.
 This preparation involves an analysis of the cost of
safety programs, insurance premiums paid, and the
By: costs
Seble T. associated with different techniques for handling
01/02/2025
losses.
 Objectives of Risk
Management
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 Reduction of Anxiety: Certain loss exposures can cause
greater worry and fear for the risk manager and key
executives.
For example, the threat of a terrible court case from a
defective product can cause greater anxiety than a small
loss from a minor fire. The risk manager, however, wants
to minimize the anxiety and fear associated with all loss
exposures.
 Meeting legal obligations: The final objective is to meet
any legal obligations.
For example, government regulations may require a firm
to install safety devices to protect workers from harm, to
dispose of harmful waste material properly and to label
consumer products appropriately

By: Seble T. 01/02/2025

 Objectives of Risk Management
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2. Post- loss objectives: Likewise, a firm may have many risk
management objectives subsequent to the occurrence of the loss.
Important objectives after a loss occurs include survival, continued
operation, stability of earnings, continued growth, and social
responsibility.
 Survival: The most important post loss objective is survival of the
firm. Survival means that after a loss occurs, the firm can resume
at least partial operations within some reasonable time period.
 Continued Operation: 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 utility firm most continues to provide
service.
 Banks, post offices, dairies, and other competitive firms must
continue to operate after a loss. Otherwise, business will be lost to
By:competitors.
Seble T. 01/02/2025
 Objectives of Risk Management
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 Stability: The third post loss objective is stability of
earnings. Earnings per share can be maintained if the firm
continues to operate.
 However, a firm may incur substantial additional expenses
to achieve this goal (such as operating at another location),
and perfect stability of earnings may not be attained.
 Continued Growth: The fourth post loss objective is
continued growth of the firm. A company can grow by
developing new products and markets or by acquiring or
merging with other companies.
 Social Responsibility: Finally, the objective of social
responsibility is to minimize the effects that a loss will have
on other persons and on society.
 A sever loss can adversely affect employees, suppliers,
creditors and the community in general.
By: Seble T. 01/02/2025
 The Risk Management Process
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The risk management process involves the

following five steps:-
Step 1: Risk Identification
Step 2: Risk Measurement
Step 3: Select the appropriate techniques for treating
loss exposure, and
Step 4: Implementing and administering the program

By: Seble T. 01/02/2025

 The Risk Management Process
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Risk Identification: Risk identification is the

process by which an organization is able to
learn areas in which it is exposed to risk.
Risk identification is the process by which a
business systematically and continuously
identifies pure risk (property, personal and
liability risk) exposures as soon as or before
they occur.
Risk identification is a very difficult process
and it is a continuous job for the risk manager
because the risk environment is dynamic.
By: Seble T. 01/02/2025
1. Risk identification techniques
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 The commonly used methods of risk
identification can be described as follows:
1. Loss Exposure Checklists: it can be used by both
business and by individuals.
 It specifies numerous common potential sources of
loss from destruction of assets and from legal liability.
 Loss exposure checklists are available from various
sources, such as insurers, agencies etc. the checklists
contain possible source of loss to the business firm
from the destruction of physical and intangible assets.
 Sources of loss are categorized according to
their being predictable or unpredictable,
controllable or uncontrollable, direct or indirect,
By:etc
Seble T. 01/02/2025
 CONT….
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Some loss exposure checklists are designed for
specific industries, such as manufacturers, retail
stores, educational institutions, or religious
organizations.
2. The Financial Statement Method: proposed by
A.H. Criddle (1962).
Although it was intended for private originations,
the concepts of the financial statements approach can
be generalized in public sector organizations as well.
By analyzing the balance sheet, operating
statements and supporting documents, the risk
manager can identify property, liability and human
exposures (losses) of the organizations.
By: Seble T. 01/02/2025
 Risk identification techniques
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3. The Flow Chart Method: An organization’s exposure to risk

also can be identified by studying flow chart of
organization’s activities and operations.
 Flow charts are representations of a sequential process.
 Flow charts describe the operations of a firm can guide a
risk manager to associate risks with those operations.
4. Contract Analysis: Many of an organization’s exposures to
risk arise from contractual relationships with other
persons and organizations.
5. Interactions with other Departments: Frequent
interactions with other departments provide another source of
information on exposures of risk.
 These interactions may include oral or written reports from
other departments on their own initiative or in response
to regular reporting system that keep the risk manager
informed
By: Seble T. of developments. 01/02/2025
 Risk identification techniques
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6. Interactions with Outside Suppliers

and Professional Organizations:
These outsiders may be, for
example, accountants, lawyers, risk
management consultants, actuaries,
or loss control specialists.
The objective would be to determine
or assess whether the outsiders have
identified exposures that otherwise
would be missed.
By: Seble T. 01/02/2025
 Risk identification techniques
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7. Statistical Records of Losses: When available, statistical records
of losses can be used to identify sources of risk.
 These records may be available from risk management information
systems developed by consultants or in some cases, the risk manager.
 These systems allow losses to be analyzed according to cause,
location amount and other issues to accident.
8. On Site Inspection: On site inspections are must for a risk
manager.
 By observing the firm’s facilities and the operations conducted
thereon the risk manager can learn much about the exposures
faced by firm.
Which method is the best?
 There is a range of techniques available and no one technique
can be used in all situations.
 No single method of risk identification is free of weakness , the
preferred is combination.
 The choice is function in nature & size of the business
By: Seble T. 01/02/2025
 2.Evaluating potential loss
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Evaluating and measuring the impact of

losses on the firm involves an estimation of
the potential frequency and severity of loss.
Loss frequency – it refers to the probable
number of losses that may occur during some
given time period.
Loss severity – it refers to the probable size
of the losses that may occur during some
given time period.

By: Seble T. 01/02/2025

3. Selecting appropriate techniques, or
combination of techniques for treating loss
exposures
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 The major techniques for treating loss exposures are the

following:
 Risk control techniques – attempt to reduce the frequency
and severity of accidental losses. It includes:
 avoidance
 loss control
 separation/ diversification
 combination
 Risk financing techniques – provides for funding of accidental
losses after they occur. It includes:
 Retention/assumption
 Self - insurance
 Non-insurance transfers
 Insurance

By: Seble T. 01/02/2025

 A. Risk control techniques
1. Avoidance – it means that certain
17 loss exposure is never acquired or
existing loss exposures is abandoned.
 It avoids property, person or activity that could be a source of risk. One way
to control a particular risk is to avoid the property, person or activity giving
rise to possible loss.
 Risk avoidance discontinues the source of risk. There are some
characteristics of avoidance. These are:
 Avoidance may be impossible
 It is an impractical approach
 Avoiding a risk may create another risk

2.Loss control – it assumes that the firm will retain the property,
person or activity creating the risk but the firm will conduct its operation in
the safest ways.
 It is designed to reduce both the frequency and severity of loss.
 Loss control deals with an exposure that the firm doesn’t wish to abandon. It
uses both loss prevention and reduction program.
Loss prevention program – seeks to reduce or eliminate the chance of loss.
Loss reduction program – seeks to reduce the potential severity of the loss.

By: Seble T. 01/02/2025

 Cont.…
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 Loss Prevention is a classification of loss control

that are designed primarily to reduce loss
frequency.
 For example, measures that reduce truck
accidents include driver examinations, zero
tolerance for alcohol or drug abuse and strict
enforcement of safety rules.
 For instance, a measures that reduce lawsuits from
defective products include installation of safety
features on hazardous products, placement of
warning labels on dangerous products, and
institution of quality control checks.
By: Seble T. 01/02/2025
 Cont.….
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Severity reduction: Is refers to measure

that reduce the severity of a loss.
Consider an auto manufacturer having airbags
installed in the company fleet off automobiles.
This form is engaging in “severity reduction”
(Loss Reduction).
The air bags will not prevent accidents
from occurring, but they will reduce the
probable injuries that employees will
suffer if an accident does happen.

By: Seble T. 01/02/2025

 Risk control techniques - Loss
Control
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By: Tahir D. 01/02/2025

 CONT……
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3.Separation/diversification
 involves the reduction of maximum probable loss
associated with some kinds of risks.
“Do not put all your eggs in one basket”
 Separation of the firm’s exposures to loss instead of
concentrating them at one location.
 Example, a firm may disperse its inventory in to different
warehouses than keeping it in one store. If fire destroys
one of the warehouses, the firm will save some of its
inventories placed in the other warehouses.
 Through such separation, the firm is reducing the likely
severity of overall firm losses by reducing the size of the
exposure in any one location.
By: Seble T. 01/02/2025
 Cont…
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4. Combination
Combination is a basic principle of insurance that
follows the law of large number.
Combination increases the number of exposure units
since it is a pooling process.
 It reduces losses by making losses more predictable
with higher degree of accuracy.
Unlike separation which spreads a specified number
of exposure units, combination increases the number
of exposure units under the control of the firm.
 Eg. Expand through internal growth, merger and
acquisition

By: Seble T. 01/02/2025

 B. Risk financing techniques
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1.Retention/ assumption
 It is a method of handling risks by the organization and the source of the
fund is the organization itself.
 Retention may be passive or active, unconscious or conscious, and
unplanned or planned.
 Retention is passive, unconscious and unplanned when the risk manager is
not aware that the exposure exists and doesn’t attempt to handle it.
 Retention is active, conscious and planned when the risk manger considers
other methods of handling the risk and consciously decides not to transfer
the potential loss. Eg. Self – insurance
2.Self – insurance
 It is a special form of planned retention by which part or all a given loss
exposure is retained by the firm.
 It requires risk retention and there should be adequate financial
arrangement in advance to provide funds to pay for losses should they occur.
 It is widely used in workers compensation insurance, used by employers to
provide group health, prescription of drug benefits to employees.

By: Seble T. 01/02/2025

 CONT….
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3.Non-insurance transfers
 Risk transfer involves in payments by one party (the
transferor) to another (the transferee or risk bearer) when
the transferee agrees to assume a risk that the transferor
desires to escape.
 It is a method other than insurance by which Pure risk and
its potential financial consequences are transferred to
another party.
 The most common forms of non insurance risk transfers are
hedging, hold-harmless agreements and incorporation.
4. Insurance
 It represents a contractual transfer of risks. It is appropriate
for loss exposures that have low frequency and high
severity.
By: Seble T. 01/02/2025
 Risk Management Matrix
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Which method should be used?

In determining the appropriate method or
methods of for handling losses, a matrix can
be used that classifies loss exposures
according to frequency and severity.
Loss frequency
Low High
low retention Loss control and
retention

Loss severityhigh insurance Avoidance

By: Seble T. 01/02/2025

 4. Implementing and administering the risk management program
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It is the last step in the risk management

process. To be effective, the risk management
must be periodically reviewed and evaluated
to determine if the objectives are being
attained.

By: Seble T. 01/02/2025

End of chapter
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