CHAPTER TWO

2. RISK MANAGEMENT
 RISK MANAGEMENT

2.1. Risk Management

a scientific approach to dealing with risks by
anticipating possible losses and designing and
implementing procedures that minimize the
occurrence of loss or the financial impact of the
losses that do occur.
It is a process that identifies loss exposure faced
by an organization and selects the most
appropriate techniques for treating such
exposures.
 [

It is the process through which a company

protects its income and resource against losses
through identification, measurement and
controlling risks, so that organizational aims are
achieved without interruption thereby creating
stability and contributing to profit.
2.2. Objectives of Risk Management
Risk management has several important
objectives that can be classified in to two
categories:-
1. Pre-loss objectives and
2. Post –loss objectives
 Pre loss objectives:

A firm or organization has several risk management

objectives prior to occurrence of loss.
Pre loss objective include the goal of economy,
reduction of anxiety, and meeting legal obligations.
Economy- The firm should prepare for potential
losses in the most economical way possible.
This involves analysis of the cost of safety programs,
insurance premium paid, and the cost associated
with the different techniques for handling losses.
Reduction of an anxiety, the manager wants to
minimize the anxiety and fear associated with all
loss exposures.
 Cont…
Meet any legal obligation; government regulation
may require a firm to install safety device to
protect workers from harm, to dispose of
hazardous waste materials properly, and to label
consumer products appropriately. The risk
manager must see that these legal obligations are
met.
Post loss objectives:
 Risk management also has certain objectives after
a loss occurs. These objectives include: survival,
continued operation, stability of earning,
continued growth and social responsibility.
 Post loss objectives includes
1. The survival of the 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.
2. To continue operating: the ability to operate after a loss is
extremely important. Example, the firm must continue to
provide service. The firms must continue to operate after a loss.
Otherwise, business will be lost to competitors.
3. Stability of earnings: The firm wants to maintain its earnings
per share after a loss occurs.
4. To maintain continued growth of the 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.
5. To meet the goal of social responsibility: is to minimize the
impact that a loss has on other persons and on society
2.3 The Risk Management Process
Risk Management is defined as "the systematic
application of management policies, procedures
and practices to the tasks of establishing the
context, identifying, analyzing, assessing,
treating, monitoring and communicating”.
Risk management can be applied to all levels of
an organization, in both the strategic and
operational contexts, to specific projects,
decisions and recognized risk areas.
Risk is defined as 'the chance of something
happening that will have an impact on
 Risk management process
The risk management process involves four
steps:
1. Identifying potential loss
2. Evaluate (measuring) potential losses
3. Select the appropriate techniques for treating
loss exposures, and
4. Implement and administer the program
 Cont…

• .Identify potential loses Evaluate potential loses

•Select the appropriate

technique
•Risk control
Implement and administer the • Avoidance
program • Loss prevention
• Loss reduction
•Risk financing
• Retention
• Non insurance transfer
• Commercial insurance
 2.3.1 Identifying Potential Losses

 The first step in the risk management process is to

identify all major and minor loss exposures. This step
involves a painstaking review of all potential losses.
Important loss exposures include the following:
1) Property loss exposures 2 Liability loss exposures
 Building, plants, other Defective products
structures Environmental pollution (land, water,
Furniture, equipment, supplies air, noise)
Computers, computer software,  Sexual harassment of employees,
& data employment discrimination, wrongful
Inventory termination, and failure to promote
A/R, valuable papers, and records Premises and general liability loss
exposures
Company vehicles, planes, boats, Liability arising from company vehicles
and mobile equipment Misuse of the Internet and e-mail
transmissions
Directors’ and officers’ liability suits
 Identifying Potential Losses…

3) Business income loss exposures 6. Employee benefit loss exposures

Loss of income from a covered  Failure to comply with government
loss regulations
Continuing expenses after a loss Violation of fiduciary responsibilities
Extra expenses  Group life, health, and retirement plan
Contingent business income exposures
losses Failure to pay promised benefits
4. Human resources loss exposures 7 Foreign loss exposures
Death or disability of key Acts of terrorism
employees Plants, business property, inventory
Retirement or unemployment  Foreign currency and exchange rate
exposures Kidnapping of key personnel
Job-related injuries or disease Political risks
experienced by workers 8. Intangible property loss exposures
5. Crime loss exposures Damage to the company’s public image
 Holdups, robberies, and Loss of goodwill and market reputation
burglaries Loss or damage to intellectual property
Employee theft and dishonesty 9. Failure to comply with government
Fraud and embezzlement laws and regulations
 Internet crime exposures

 Check list of potential losses

The risk manager should get a list of potential losses

or sources of risks before trying to deal with risks.
Sources of risk are the sources of factors or hazards
that may contribute to positive or negative outcomes.
And these sources of risk can be classified in several
ways.
1. Physical Environment: This is a fundamental source
of risks and losses as well as opportunities.
 Example: Earthquakes, drought, or excessive rainfall
that can all lead to loss and real estate investments,
agribusiness, weather, tourism development that can
be attributable to good physical environment.
 2. Social Environment:
changing traditions and values, human behavior,
social structures, and institutions that can lead to
losses or opportunities.
3. Political Environment:
 -can be an important source of risk.
 also can promote positive opportunities through
fiscal and monetary policy, enforcement of laws, and
the education of the population.
4. Legal Environment: Unexpected laws and
directives may be issued by the government which
may render risky environment to the businesses
operating in the country.
 5. Operational Environment

Processes and procedures of an organization may

generate risk and uncertainty.
6. Economic Environment
• Inflation, recession, and depression have negative
impacts on business operations;
• favorable interest rates and credit policies offer good
opportunities.
7. Cognitive Environment
• A risk manager’s ability to understand, see, measure,
and assess is far from perfect and an important source
of risk for organizations is the difference between the
perception of the risk manager and the reality.
 Categories of Loss Exposures

it is useful to develop categories of exposures for

analytical purposes.
1. Physical Asset Exposures
Ownership of property gives rise to possible losses or
gains to physical assets.
 For example property could be damaged, destroyed, lost,
or diminished in value.
2. Financial Asset Exposures
This occurs when ownership of securities such as common
stock and mortgages creates this type of exposure.
This exposure can occur either from own­ership of the
security or when the organization issues a security held by
others.
 3. Liability Exposures

These occur when obligations imposed by the

legal system create such type of exposure.
4. Human Asset Exposures
These exposures occur when possible injury or
death of managers, employees, or other
significant stakeholders (customers, secured
creditors, stockholders, and suppliers) are
exposed to risks.
Human asset exposures also can lead to gains, as
exemplified by improvements in productivity.
Potential losses to be handled by risk managers in
most organizations include:
1. Property loss exposures
 Depending on the class of property affected, causes of the
loss, whether the loss is direct or indirect and the nature of
the firm’s interest in the property, property losses can be
classified in to four.
Property class
 Property may be divided in to two broad classes:
 Real estate or land and its structures or attachments
 Personal property or property that is moveable and not
attached to land ( and this can be classified in to personal
property in use and personal property for sale)
 Causes of the loss
 Causes for property losses can be classified in to three:
Physical perils
 includes such natural forces as fires, wind storms, and
explosions that damage or destroy property.
Social perils
 include deviation from expected individual conduct such as
theft, vandalism, embezzlement or negligence or it may arise
from group behavior such as strikes or riots.
Economic perils
 arise due to external or internal forces.
 For example, a debtor may be unable to pay off an account
receivable because of an economic recession or a contractor
may not complete the project on schedule because of
management error.
 Direct or Indirect Loss

 Property suffers a direct loss when the property itself is

directly damaged or destroyed or disappears because of
contact with a physical or social peril.
 For example, a building is destroyed by fire, interior
walls are defaced by vandals, an automobile is damaged
in collision, or money or securities are stolen from a safe.
 Property suffers an indirect loss when its value is
lessened as a result of direct damage to some other
property.
 2. Net income Loss Exposure

The direct and indirect property losses discussed

previously are often not the only losses that occur
when property is damaged, destroyed or taken.
Until that property is replaced, or restored, to its
former position, the business may suffer a
reduction in its net income (revenues less
expenses) because it losses the use of the
property in whole or in part.
As a result, either revenues are decreased or
expenses are increased.
 A. Decreases in Revenues

 Loss of Rent
 Interruption of operation
 Contingent Business interruption
 Loss of profits on finished goods
 Smaller net collections on Accounts receivable
B. Increases in expenses
i. Rental value losses
ii. Extra Expenses
iii. Cancellation of lease
iv. Irremovable improvements and betterments
 3. Liability loss Exposures

In addition to the property loss exposures, a business

faces the possibility that it will be held legally liable
for property damage or personal injuries suffered by
others.
In addition to the above exposure, a business may be
exposed to two important exposures:
1. the liability of a business to its employees for job
related injuries or diseases and its liability for
bodily injuries or diseases and
2. its liability for bodily injuries or property damage
sustained as a result of a motor vehicle accident.
 Cont…
 Some of the liability exposures that organizations or individuals
face when a certain risk materializes.
A. Liability arising from ownership, use and
possession of land
B. Liability arising from maintaining a public or
private nuisance
C. Liability arising from sale, manufacture, and
distribution of products or services
D. Liability arising from fiduciary relationships
E. Professional Liability
F. Contract liability
G. Employment Liability
H. Work related injury
I. Motor vehicle liability
 4. Personnel loss Exposure

This refers to potential personnel loses: the

financial losses that occur when one or more
people ( usually employees in whom the firm has
some direct interest) die, reach and advanced age,
become ill, or lose their job for some other
reason.
Both the individual employees and the firm itself
face these loses, and managers including risk
managers, have good reason to be interested in
the losses to the employee as well as those to the
firm.
A risk manager can use several sources of information to
identify the preceding loss exposures. It includes:
i. Risk analysis questionnaires and checklists: It requires the risk
manager to answer numerous questions that identify major and
minor loss exposures.
ii. Physical inspection: inspection of company plants and
operations can identify major loss exposures.
iii. Flowcharts: It shows the flow of production and delivery can
reveal production and other bottlenecks as well as other areas
where a loss can have severe financial consequences for the firm.
iv. Financial statements: Analysis of f/s can identify the major
assets that must be protected, loss of income exposures, and key
customers and suppliers.
v. Historical loss data: Historical loss data can be invaluable in
identifying major loss exposures
 Risk Identification Techniques detail

Some of the methods or risk identification techniques

suggested include:
1. The risk Analysis questionnaire
The risk analysis questionnaire does more than
provide a check list of potential losses.
It directs the risk manager to secure in systematic
fashion specific information concerning the firm’s
properties and operations.
2. The financial statement method
By analyzing the balance sheet, operating statements
and supporting documents, the risk manager can
identify all the existing property, liability, and
personal exposures of the firm.
 3. The flow chart method

 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 suppliers’ locations
and ending with finished goods in the hands of customers.
4. Onsite inspection
 Onsite inspections are a must for the risk manager. By
observing firsthand the firm’s facilities and the operations
conducted there on, the risk manager can learn the exposures
faced by the firm.
5. Interactions with other departments
 A fifth way to identify the losses facing a business is through
systematic and continuous interactions with other departments
in the business.
 Included in these interactions are:
 Cont…
A. Extended visits with managers and employees
of other departments during which the risk
manager attempts to obtain a complete
understanding of their activities and potential
losses created by these activities, and
B. Oral or written reports from other departments
on their own initiative or in response to a regular
reporting system that keeps the risk manager
informed of all relevant developments.
6. Statistical Records of Losses
To consult statistical records of losses or near
losses that may be repeated in the future.
 7. Analysis of the Environment

Some writers have recommended a careful

analysis of the external environment as well as
internal exposures as an approach to identifying
the exposures of a particular firm.
The relevant environment includes:
Customers
Suppliers
Competitors
Regulators
 8. Use of outsiders to identify loss exposures

A risk manager may rely on insurance agents or brokers or

risks management consultants to do the detailed work of
risk identification.
9. Organizational Charts
Intended to highlight broad areas of risk rather than
specific, individual risks such as fire, security or liability.
It encourages the risk identifier to take a birds-eye view of
the organization:
 to stand back and above the day-to-day operation
and
 take stock of the risks which exist.
 2.3.2 Measure and Analyze the Loss
 It is important to measure and quantify the loss exposures in order
to manage them properly. This steps requires an estimation of the
frequency and severity of loss.
 Loss frequency refers to the probable number of losses that may
occur during some given time period.
 Loss severity refers to the probable size of the losses that may
occur.
 Once estimates the frequency and severity of loss for each type of
loss exposure, the various loss exposures can be ranked according
to their relative importance.
 For example, a loss exposure with the potential for bankrupting
the firm is much more important in a risk management program
than an exposure with a small loss potential.
 Measure and Analyze the Loss…
Risk measurement refers to the measurement of
potential loss as to its size and probability of
occurrence and it is the next step once the risk is
identified.
Risk Measurement includes a determination of:
The probability that the loss will occur,
 The impact that the losses would have up on
financial affairs of the firm, and
The ability to predict the losses that will actually
occur during the budget period.
 Statistical terms used in measuring risk

 Risks can be measured using different statistical measures.

 These terms include:
 the concepts of probability distribution,
 measures of central tendency (especially the
arithmetic mean),
 standard deviation and coefficient of variation.
Probability
 The probability of an event refers to the frequency of
occurrence of an event.
 All events have a probability between zero and one.
 To calculate the probability of an event we divide the
number of times given event occurs by all possible events.
 Cont…
Example: Assume that a company has 2000 houses
and determined that 400 of these houses are
expected to be destroyed by fire accident.
Probability of an accident = 400 = 0.2 or 20%
2,000
 Probability Distribution (also called relative
frequency distribution)
 A probability distribution is a mutually exclusive and
collectively exhaustive list of all events (losses in our
case) that can result from a chance process and contains
the probability associated with each event (loss).
 It is a more sophisticated way to measure potential losses.
 Cont…
More difficult to explain and the data needed to
construct the required probability distribution are
commonly not available.
Nevertheless, probability distributions make possible
more comprehensive risk measurements than other
techniques; and also, they are becoming a more
common tool of modern management, and data sources
are improving.
Probability distributions improve one's understanding
of the more popular risk measurements and are
extremely useful in determining which risk
management devices would be best in a given situation.
 Cont…
A probability distribution shows for each possible
outcome, its probability of occurrence.
It is used to estimate numerically the potential
loss from a risk.
Using the probability distribution, it is possible to
measure the various aspects of a risk; such as:
The number of occurrences per year,
The monetary losses per occurrence, and
The total monetary losses per year (fiscal period).
 Arithmetic mean
 The arithmetic mean (X) can be defined as a sum of set of n
measurements X1, X2, X3--Xn divide by n:
:
_

X = X1 + X2 + X3 - - - Xn,
n
Where, X = arithmetic means
X= measurement
n= total number of measurements
In calculating the mean, equal weight is given for each observation
(measurement).
Example: The mean of the five numbers 0, 3, 5, 4 and 6
is 0 + 3 + 5 + 4 + 6 = 3.6.
5
 Expected value-
is a special case of the arithmetic mean and
similar to it.
It is obtained by multiplying each item or event
by the probability of its occurrences.
Example:
The following data relate to ABC Company for
the monetary loss of its automobiles because of
accidents and related probabilities.
 Cont…
Event Amount of loss Probability of loss
If event occurs
A Br 20,000 x
0.20 = Br 4,000
B 15,000 x
0.30 = 4,500
C 25,000 x
0.10 = 2,500
D 20,000 x 0.40 = 8,000
Total 19,000
So, expected value=19,000
Note that expected value of loss = the summation of each
loss amount x its probability of loss
= x (p(x))
 Standard deviation

 Standard deviation is a number that measures how close/ far

a group of individual measurements /losses/ is to its average
value (mean).
 Standard deviation – measures variability of values from the
mean. The higher the standard deviation the higher the risk.

 The standard deviation is obtained by subtracting the average

value from each possible value of the variable, squaring the
difference, multiplying each squared difference by
probability that the variable will assume the value involved,
summing the resulting products, and taking the square root of
the sum.
 Variance

Variance is the mean of the squared deviation or the

mean of the squared deviation multiplied by probability
of each occurrence.
That is, Standard deviation ( ) =variance.
Variance is obtained by subtracting the average value
from each possible value of the variable, squaring the
difference, multiplying each squared difference by
probability that the variable will assume the value
involved, summing the resulting products.
Taking the square root of the sum makes it standard
deviation, i.e. Standard deviation () is the square root of
variance.
 Coefficient of variation:
When the standard deviation is expressed as a percent
of the mean, the result is termed the coefficient of
variation, which is one way to characterize the
concept of mathematical risk to the insurer.
If losses from a group of exposure units have a low
coefficient of variation, there is less risk (less
variation) associated with this group of exposures
than with another group with high coefficient of
variation.
Coefficient of variation– the ratio of standard
deviation to the mean( expected value)
Example : Consider a project with the following set of NPV with different probabilities

NPV(in mill) Probabilities

Br 250 0.10
450 0.20
300 0.25
500 0.15
700 0.30

ത
𝑋
Expected value ( ) =(250x0.1)+(450x0.2) + (300 x0.25)+(500x0.15)+(700 x 0.3)
= Br 475mill
STDV = Br 168mill
Coefficient of Variation= 168/475
= 0.35
 The binomial distribution

 This is a two parameter distribution.

 The two parameters determine the entire distribution i.e.
 The number of exposure units (n), and the probability
that a randomly selected unit be damaged (p)
 To use the binomial distribution, the risk manager must
be familiar with the following basic assumptions of the
distribution:
 the objects are independently exposed to loss.
 each exposed unit suffered (experience) at most one
accident in a year (or the budget period).
 Thus, the binomial formula for probability of r accidents
from n exposure units isncalculated
! using the formula:
P(r) = r!(p
n r(1r )!– p) n--r
 Cont…
Where:
n = number of exposures
r = number of accidents (occurrences)
P (r) = Probability of r accidents
n! = n factorial, computed by successive multiplication
of the numbers n (n-1) (n-2), - - - (n-k)!
Example: 3! = 3(3-1) (3-2)! = 6
o! is conventionally defined to be 1
p= probability that the event will occur and
q= probability that the event will not occur and q can be
computed by the equation q = 1-p.
 Example:
Suppose a company operates four delivery
trucks. Assume that if an accident happens to a
particular truck it become a total loss and
suppose further that new trucks are purchased at
the beginning of every year to replace the lost
ones. Records regarding the operation of the
company cover the last four years shows the
following information.(assume also that the
value of a truck is Br.6,000)
 Cont…
Year Number of Number Monetary
trucks accidents loss
1 4 2 Br.12,000
2 4 2 12,000
3 4 1 6,000
4 4 3 18,000
Total 4-years 16 8 Br.48,000
 Required:
A. Determine the average or expected/mean monetary loss
per accident
B. Determine average/mean/expected number of accidents
per year
C. Determine mean/average/expected monetary loss per
year
D. Determine probability accident, and
E. Develop probability distribution of the number of
accidents
A. Mean monetary loss =
/accident
=
 Cont…

B. Mean number of =
accident per year
=
C. Mean monetary =
loss per year
=

D. Probability of accident =
 Cont…
=
n!
E. P(r) = pr!(1
r
– p)
(n  r )!
n--r

P (0) = 4! (0.5)0 (0.5)4-0 = 0.0625

0! (4-0)!
P (1) = 4! (0.5)1 (0.5)4-1 = 0. 25
1! (4-1)!
P (2) = 4! (0.5)2 (0.5)4-2 = 0.375
2! (4-2)!
P (3) = 4! (0.5)3 (0.5)4-3 = 0. 25
3! (4-3)!
P (4) = 4! (0.5)4 (0.5)4-4 = 0.0625
4! (4-4)! Total probability =1
 b. Normal probability distribution

 As the number of observations increases, a mathematical

concept called central limit theory states that the
expected results for a pool or portfolio of independent
observations can be approximated by the normal
distribution, which is a very useful type of mathematical
distribution.
 It is perfectly bell shaped.
C. Poisson probability distribution
 The Poisson distribution is another theoretical
probability distribution that is useful in risk management
application.
 Cont…
For example, auto accidents, fires, and other losses tend
to occur in a way that can be approximated with the
Poisson distribution. One can determine the probability
of an event under a Poisson distribution using the
following formula:

Where p = the probability that an event n occurs

r = the number of events for which the
probability estimate is needed
m = mean = expected loss frequency
e = a constant, the base of the natural
 Cont…
The mean m of a Poisson distribution is also its
variance. Consequently, its standard deviation is
equal to

Example: Suppose that the Future Company owns 10

trucks. In a typical year, a total of one loss occurs,
thus allowing p to be estimated to be 1. What is the
probability of more than two accidents/what is the
probability of three or more accidents?
Number of exposure units = 10
Probability of loss = p = 0.1
Expected loss frequency = 0.1 x 10 = 1.0
 Cont…
Possible number probability
of accident
0

4
 Cont…
Probability of 3 or more losses = 1 – probability of
0, 1, or 2losses
= 1 – (0.3679 + 0.3679 +
0.1839)
= 0.0803
2.3.3 Selecting the appropriate techniques for

treating loss exposures

 The third step in the RM process is to select the
appropriate combination of techniques for treating the
loss exposures.
 These techniques can be classified broadly as either risk
control or risk financing
 Risk control refers to techniques that reduce the
frequency or severity of losses
 Risk financing refers to techniques that provide for the
funding of losses
 Risk managers typically use a combination of
techniques for treating each loss exposure.
 Cont…
 The major techniques for treating loss exposures are the
following:
Major risk control techniques:
 Avoidance
 Prevention measures
 Loss reduction
 Separation/diversification
 Combination
Major risk financing techniques:
 Loss retention /loss assumption
 Neutralization
 Non insurance transfer
 Avoidance:

 Avoidance is a risk management strategy of not taking on or

getting out of risky ventures.
 For example, flood losses can be avoided by not building a
new plant in a flood plain, preferring going by plane to by
bus.
 The major advantage of avoidance is:
 The chance of loss is reduced to zero if the loss exposure is
never acquired.
 If an existing loss exposure is abandoned, the chance of loss
is reduced or eliminated because the activity or product that
could produce a loss has been abandoned.
 Avoidance has two major disadvantages;
 The firm may not be able to avoid all losses
 Cont…
 Loss Prevention: refers to measures that reduce the
frequency of a particular loss.
 For example, measures that reduce truck accidents include
driver examinations, zero tolerance for alcohol or drug abuse
and strict enforcement of safety rules.
 Loss reduction: refers to measures that reduce the severity
of the loss after it occurs.
 For example constructing a building with fire extinguisher,
buying television with power resist, limiting the amount of
cash on the premises.
 Separation/Diversification: This tool relates to scattering
the exposure of an organization to different places instead of
concentrating in one location.
 For example having warehouse with inventories at different
 Cont…
Combination/pooling: make loss experience more
predictable by increasing the number of exposure units.
Unlike separation, which spreads a specified number of
exposure, combination/pooling increases the number of
exposure units under the control of the company.
Retention/ Risk assumption: Occurs when the person
or the organization consciously or unconsciously
decides to assume the risk.
The firm retains part or all of the loss that can result
from a given loss.
 Loss Retention is of two types:

Planned/ active/ conscious retention: Occurs when ever

the organization has carefully identified its risks and
decided to retain the loss as the best way of handling the
risk.
Unplanned /passive/ retention: occurs when ever the
organization has failure or miss calculation in
identifying its risks and assumes losses unconsciously.
Such type of loss retention cannot be a right decision
unless it occurs by chance and hence cannot be rational
decision.
Retention can also be called self insurance: the
insurance service that is be given by the firm itself.
 Requirements or prerequisites of planned retention

1. It is used when it is impossible to transfer the

loss risk to someone or impossible to prevent it
from occurring.
Example firms located near Rift Valley.
2. It is used to when the maximum possible loss is
so small to the company and better to retain.
3. It is used when the chance of loss is extremely
low or
4. When the cost of transfer is almost equal to the
maximum loss.
 Cont…
Non insurance transfer: transfer is methods other
than insurance by which a pure risk and its potential
consequences are transferred to another party.
In the transfer or shifting method one individual
pays another to assume a risk that the transferor.
The risk bearer agrees to assume the risk for price.
Examples of noninsurance transfers include
contracts, leases, and hold-harmless agreement.
Neutralization is the process of balancing the
chance of gain against the chance of loss.
Example-Gambling
 Transfer of a risk may be accomplished in three ways:

The property of the activity responsible for the risk may

be transferred to someone or group of persons.
The risk, but not the property or activity, may be
transferred.
Transferring the risks to an insurance company by paying
some amount of money (premium) for getting protection.
Insurance: commercial insurance is also used in risk
management program.
Insurance is appropriate for loss exposures that have a
low probability of loss but for which the severity of loss
is high.
 Risk management matrix

Type Loss Loss Appropriate risk

of loss frequency severity management Example
technique
1 Low Low Retention Potential theft of office
supplies
2 High Low -Loss prevention -Physical damage losses to
& retention automobiles
- food spoilage
3 Low High Insurance Fire, explosions, natural
disasters, and liability
lawsuits
4 High High avoidance -a truck driver with several
convictions for drunk
driving may apply for a job
 2.3.4 Implementing and administering the risk
management program
 A risk management policy statement is necessary to have an
effective risk management program.
 This statement outlines the risk management objectives of the
firm, as well as company policy with respect to treatment of loss
exposures.
 The risk manger does not work alone.
 Other functional departments within the firm are extremely
important in identifying pure loss exposures and methods for
treating these exposures.
 To be effective the risk management program must be
periodically reviewed and evaluated to determine whether the
objectives are being attained.
 In particular risk management costs, safety programs, and loss
 F
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