CHAPTER 3

I N T R O D U C T I O N T O R I S K M A N AG E M E N T

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MEANING OF RISK MANAGEMENT

• “Risk Management is a process that identifies

loss exposures faced by an organization and
selects the most appropriate techniques for
treating such exposures”

• Difficult to identify risk  risk managers use “loss

exposure” to identify potential losses

(Page 62)

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MEANING OF RISK MANAGEMENT

• Loss exposure: “any situation or circumstance

in which a loss is possible, regardless of
whether a loss occurs”

• New forms of risk management consider both

pure and speculative loss exposures

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OBJECTIVES OF RISK MANAGEMENT
Risk Management
Objectives

Post-Loss
Pre-Loss Objectives
Objectives
1. Prepare for potential 1. Ensure survival of the
losses in the most firm
economical way 2. Continue operations
2. Reduce anxiety 3. Stabilize earnings
(concern, worry) 4. Maintain growth
3. Meet any legal 5. Minimize the effects
obligations that a loss will have on
other persons and (Page
on 63)
society 4
PRE-LOSS OBJECTIVES
1. Prepare for potential losses in the most
economical way
• Example : Prepare analysis for costs and premiums paid
for insurance.
2. Reduce anxiety
• Example: Anxiety (worry and fear) can be any threat to
the company such as a catastrophic lawsuit from a
defective product
3. Meet any legal obligations
• Example: label consumer products appropriately,
installing safety devices to protect workers from harm as
per government regulations

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POST-LOSS OBJECTIVES
1. Ensure survival of the firm
• Firms resume at least partial operations within
some reasonable time period after a loss occurs
2. Continue operations
• Banks, bakeries, dairies, and other competitive
firms must continue to operate after a loss
3. Stabilize earnings
• A firm may incur substantial additional
expenses to achieve this goal

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POST-LOSS OBJECTIVES

4. Maintain growth
• Developing new products, or acquiring and
merging with other businesses.

5. Minimize the effects that a loss will have on

other persons and on society (social
responsibility)
• Severe losses will affect employees,
creditors, suppliers and the whole
community.

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RISK MANAGEMENT PROCESS
• 4 steps:

1. Identify potential losses

2. Evaluate potential losses
3. Select the appropriate risk management
technique
4. Implement and monitor the risk management
program

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(Page 63-73)

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10
IDENTIFYING LOSS EXPOSURE

• Examples of loss exposures:

• Property loss exposures (Building, Plant,
Furniture, Inventory, Equipment, Supplies,
Computers, Computer Software)
• Liability loss exposures (Defective Products,
Environmental pollution, Sexual harassment of
employees, discrimination against employees,
Liability arising from company’s vehicle)
• Business income loss exposures (Loss of income
from a covered loss, Continuing expenses after a
loss, Extra Expenses)
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IDENTIFYING LOSS EXPOSURE
• Human resources loss exposures (Death or
Disability of key employees, Retirement or
Unemployment, Job-related injuries or disease
experienced by workers)
• Crime loss exposures (Robberies, Burglaries,
Employee theft or dishonesty, Fraud, Internet and
Computer crime exposures, Theft of Intellectual
property)
• Employee benefit loss exposures (Failure to
comply with government regulations, Failure to
pay promised benefits)

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IDENTIFYING LOSS EXPOSURE

• Foreign loss exposures (Acts of terrorism,

Foreign currency risks, kidnapping of key
personnel, political risks)
• Market reputation and public image of
company
• Failure to comply with government rules and
regulations

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IDENTIFYING LOSS EXPOSURE
• To identify loss exposures, information is needed.

• Sources of Information:
• Risk Analysis Questionnaires
• Physical inspection
• Flowcharts
• Financial statements
• Historical loss data

• Industry trends and market changes can create new

loss exposures.
• e.g., exposure to acts of terrorism (Protect company’s
assets and personnel)
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15
ANALYZING LOSS EXPOSURES
• Estimate the frequency and severity of loss
for each type of loss exposure

• 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 (in terms of
money)

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ANALYZING LOSS EXPOSURES

• Once loss exposures are analyzed, they can be

ranked according to their relative importance

• Example: A loss exposure with the potential

for bankrupting the firm is much more
important than an exposure with a small loss
potential.

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ANALYZING LOSS EXPOSURES
• Generally, loss severity is more important than
loss frequency:

• The maximum possible loss is the worst loss that could

happen to the firm during its lifetime

• The maximum probable loss is the worst loss that is likely

to happen

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19
SELECT THE APPROPRIATE RISK
MANAGEMENT TECHNIQUE

• Risk Control

• Risk Financing

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SELECT THE APPROPRIATE RISK
MANAGEMENT TECHNIQUE

1. Risk control refers to techniques

that reduce the frequency and severity
of losses
• Methods of risk control include:
1. Avoidance
2. Loss prevention
3. Loss reduction

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RISK CONTROL METHODS

1. Avoidance means a certain loss exposure is

never acquired, or an existing loss exposure
is abandoned
• Major Advantages:
• The chance of loss is reduced to zero if
the loss exposure is never acquired.
• Major Disadvantage:
• It is not always possible,
• or practical, to avoid all losses

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RISK CONTROL METHODS

2. Loss prevention refers to measures that reduce

the frequency of a particular loss

• e.g., measures that reduce truck accidents include:

- Driver examinations
- zero tolerance for alcohol or drug abuse

• Where as measures that reduce lawsuits from defective

products include:
- installation of safety features on hazardous products

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RISK CONTROL METHODS

3. Loss reduction refers to measures that reduce the

severity of a loss after it occurs

- Installing an automatic sprinkler system

- Segregation of exposure units so that a single loss cannot
simultaneously damage all exposure units such as
warehouses with inventories at different locations.

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SELECT THE APPROPRIATE RISK
MANAGEMENT TECHNIQUE

• Risk Control

• Risk Financing

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SELECT THE APPROPRIATE RISK
MANAGEMENT TECHNIQUE

2. Risk financing refers to

techniques that provide for the
funding of losses
• Methods of risk financing include:
1. Retention
2. Non-insurance Transfers
3. Commercial Insurance

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RISK FINANCING METHODS: RETENTION

1. Retention means that the firm

retains part or all of the losses that can
result from a given loss

• Retention is effectively used when:

1. No other method of treatment is available

2. The worst possible loss is not serious
3. Losses are highly predictable

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RISK FINANCING METHODS: RETENTION

• The retention level is the dollar amount

of losses that the firm will retain
• A financially strong firm can have a higher retention
level than a financially weak firm

• First, The maximum retention may be calculated as a

percentage of the firm’s net working capital (between 1
– 5 %).

• Or they can determine the maximum uninsured loss a

company can absorb without adversely affecting the
company’s earnings

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RISK FINANCING METHODS: RETENTION

• A risk manager has several methods

for paying retained losses:
1. Current net income: losses are
treated as current expenses
2. Unfunded reserve: losses are
deducted from a bookkeeping
account
3. Funded reserve: losses are
deducted from a liquid fund
4. Credit line: funds are borrowed to
pay losses as they occur
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RISK FINANCING METHODS: RETENTION

• A captive insurer is an insurer owned by a parent

firm for the purpose of insuring the parent firm’s
loss exposures

• A single-parent captive is owned by only one

parent
• An association or group captive is an insurer
owned by several parents

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RISK FINANCING METHODS: RETENTION

• Captives are formed for several reasons,

including:

1. The parent firm may have difficulty obtaining

insurance
2. Costs may be lower than purchasing commercial
insurance
3. A captive insurer has easier access to a reinsurer
4. A captive insurer can become a source of profit

• Premiums paid to a captive may be tax-

deductible under certain conditions

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RISK FINANCING METHODS: RETENTION

• A risk retention group is a group captive that can

write any type of liability coverage except
employer liability, workers compensation, and
personal lines

• Federal regulation allows employers, trade

groups, governmental units, and other parties
to form risk retention groups
• They are exempt from many state insurance
laws

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RISK FINANCING METHODS: RETENTION

• Self-insurance is a special form of planned

retention

• Part or all of a given loss exposure is

retained by the firm
• A more accurate term would be self-funding
• Widely used for workers compensation and
group health benefits

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RISK FINANCING METHODS: RETENTION

Advantages Disadvantages

• Save money in the • Possible higher

long-run losses: great
• Lower expenses volatility in the
• Encourage loss short-run
prevention • Possible higher
• Increase cash flow expenses
• Possible higher
taxes
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RISK FINANCING METHODS: NON
INSURANCE TRANSFERS
2. A non-insurance transfer is a method other than
insurance by which a pure risk and its potential
financial consequences are transferred to another
party

• Examples include:
- Contracts
- Leases
- Hold-harmless agreements

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RISK FINANCING METHODS: NON
INSURANCE TRANSFERS
• Contracts – e.g. A company’s contract with a
construction firm to build a new plant can specify that
the construction firm is responsible for any damage to
the plant while it is being built.
• Leases – e.g. A firm’s computer lease can specify that
maintenance, repairs, and any physical damage loss to
the computer are the responsibility of the computer firm.
• Hold-harmless Clause – e.g. A publishing firm
may insert a hold-harmless clause in a contract, where
by the author, not the publisher, is held legally liable if
the publisher is sued for plagiarism.

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RISK FINANCING METHODS: NON
INSURANCE TRANSFERS

Advantages Disadvantages

• Can transfer • Contract language

some losses that may be ambiguous,
are not insurable so transfer may fail
• Save money • If the other party
• Can transfer loss fails to pay, firm is
to someone who still responsible for
is in a better the loss
position to • Insurers may not
control losses give credit for
transfers 37
RISK FINANCING METHODS: INSURANCE

• Insurance is appropriate for loss exposures

that have a low probability of loss but the
severity is high

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RISK FINANCING METHODS: INSURANCE

• If insurance is used, five key areas

should be stressed on:
1. Selection of insurance coverage
2. Selection of an insurer
3. Negotiation of terms
4. Dissemination of information
concerning insurance coverages
5. Periodic review of the program
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RISK FINANCING METHODS: INSURANCE

1. Selection insurance coverage:

a. Appropriate and needed for loss exposure
b. Deductible: The amount you have to pay
out-of-pocket for expenses before the
insurance company will cover the remaining
costs ( from Investopedia.com)
- ‘A provision by which a specified amount is
subtracted from the loss payment otherwise
payable to the insured’ ( book)

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RISK FINANCING METHODS: INSURANCE

- Deductible is used to eliminate small claims and

to cover for administrative expenses
c. Excess Insurance: a plan in which the insurer
does not participate in the loss until the actual loss
exceed the amount a firm has decided to retain

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RISK FINANCING METHODS: INSURANCE

2. Selection of an insurer
One insurer or several insurers?
Decision will depend on:
1. Financial strength of the insurer (i.e. investment results,
adequacy of reserves)
2. Services provided (insurance agent can facilitate)
3. Costs and terms of protection (get best deal)

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RISK FINANCING METHODS: INSURANCE

3. Negotiation of terms
a. Agreement on documentation (if printed)
b. Manuscript policy: a tailored policy
c. Negotiate premium

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RISK FINANCING METHODS: INSURANCE

4. Information concerning the insurance must be

disseminated (distributed) to others in the firm
a. Employees and managers must know about the
terms (i.e. insurance coverage, records to be kept,
risk management services provided by insurer, how
to report a loss).
5. Periodic review of insurance program
b. Important to happen, especially at times where
changes in business operations are happening, or at
times of merges and acquisitions
c. Things to be discussed: Analysis of relationship,
terms, services.

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RISK FINANCING METHODS: INSURANCE

Advantages Disadvantages

• Firm is indemnified • Premiums may be

for losses costly
• Uncertainty is • Opportunity cost
reduced should be considered

• Insurers may provide • Negotiation of

other risk contracts takes time
management and effort
services • The risk manager
• Premiums are tax- may become lax in
deductible exercising loss 45
WHICH METHOD SHOULD BE USED?

• A matrix can be used that classifies the

various loss exposures according to
frequency and severity

Harassment

Delay in
delivery
Fire

Factory that
pollutes
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47
IMPLEMENT AND MONITOR THE RISK
MANAGEMENT PROGRAM

• Three main points

1. Risk Management Policy Statements
2. Cooperation With Other Departments
3. Periodic Review and Evaluation

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IMPLEMENT AND MONITOR THE RISK
MANAGEMENT PROGRAM
1. Risk Management Policy Statements

• Outlines the firm’s risk management objectives

• Outlines the firm’s policy on loss control
• Educates top-level executives in regard to the
risk management process
• Gives the risk manager greater authority
• Provides standards for judging the risk
manager’s performance

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IMPLEMENT AND MONITOR THE RISK
MANAGEMENT PROGRAM
- Risk Management Manual

• Describe the risk management program

• Train new employees
• Force manager to precisely state his or
her responsibilities , objectives and
available techniques

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IMPLEMENT AND MONITOR THE RISK
MANAGEMENT PROGRAM
2. Cooperation with other Departments
- A successful risk management program requires
active cooperation from other departments in the
firm
- Other departments are important to identify pure
loss exposures and methods to treat these
exposures

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IMPLEMENT AND MONITOR THE RISK
MANAGEMENT PROGRAM
3. Periodic Review and Evaluation
- costs, safety programs, loss-prevention programs
- Loss records
- Risk management policies are carried out
- Receiving cooperation from other departments

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BENEFITS OF RISK MANAGEMENT

1. Pre-loss and post-loss objectives are attainable

2. A risk management program can reduce a firm’s
cost of risk
• The cost of risk includes premiums paid,
retained losses, outside risk management
services, financial guarantees, internal
administrative costs, taxes, fees, and other
expenses

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BENEFITS OF RISK MANAGEMENT

3. Reduction in pure loss exposures allows a

firm to enact an enterprise risk management
program to treat both pure and speculative loss
exposures

4. Society benefits because both direct and

indirect (consequential) losses are reduced

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 PERSONAL RISK
MANAGEMENT
• refers to the identification of pure risks faced by an
individual or family, and to the selection of the most
appropriate technique for treating such risks
• the same steps of risk management program are
used

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 PERSONAL RISK MANAGEMENT

1. Identification of Loss Exposures:

a. Personal loss exposures: loss of income,
retirement, medical bills, unemployment, theft
b. Property loss exposure: fire, lighting, windstorm,
flood, theft of valuable personal property, car,
motorcycles ( damage or theft)
c. Liability loss exposure: legal from damaging
others’ property, negligent operations of a
property, business, attorney fees

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PERSONAL RISK MANAGEMENT

- The three proceeding steps follow the exact

manner of the process discussed earlier.
- Please read the book in pages 55-56

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END OF CHAPTER 3

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