UNIT ONE

INTRODUCTION: RISK AND RELATED TOPICS

Learning Objectives
After studying this unit, you should be able to:

 Define risk
 Distinguish between risk and probability, risk and uncertainty, peril and hazard,
 Understand the differences among the following classes of risk:
– static risks and dynamic risks
– pure risks and speculative risks
– fundamental risks and particular risks
– objective risks and subjective risks

Risk exists whenever the future is unknown. Because the adverse effects of risk have plagued
mankind since the beginning of time, individuals, groups, and societies have developed various
methods for managing risk. Since no one knows the future exactly, everyone is a risk manager
not by choice, but by sheer necessity.

1.1. Risk Defined

The word risk is used in many different ways. It can refer to general uncertainty, doubt, an
insured object, or chance of loss.

Williams and Heins define risk as the variation in the outcomes that could occur over a specified
period in a given situation. If only one outcome is possible, the variation and hence the risk is 0.
If many outcomes are possible, the risk is not 0. The greater the variation, the greater the risk.
For the purpose of this course we will define risk as the possibility of an adverse deviation from
a desired outcome that is expected or hoped for. If you own a houre, you hope it will not catch
fire. When you make a wager, you hope the outcome will be favorable. The fact that the outcome
in either event may be something other than what you hope for constitutes a possibility of loss or
risk.

Note that the above definition is not subjective. Risk is a state of the external environment. This
possibility of loss must exist, even though the individual exposed to that possibility may not be
aware of it. If the individual believes that there is a possibility of loss where none is present,
there is only imagined risk, and not risk in the sense of the real world. Finally, there is not
requirement that the possibility of loss must be measurable, only that it must exist.

Risk is uncertainty as to loss. If a cost or a loss is certain to occur, it may be planned for in
advance and treated as a definite, known expense. It is when there is uncertainty about the
occurrence of a cost or loss that risk becomes an important problem.

When risk is said to exist there must always be at least two possible outcomes. If we know in
advance what the outcome will be, there is no risk. For example, investment in a capital asset
involves a realization that the asset is subject to physical depreciation and that its value will
decline. Here the outcome is certain so there is no risk.

The degree of risk is inversely related to the ability to predict which outcome will actually occur.
If the risk is 0, the future is perfectly predictable. If the risk in a given situation can be reduced,
the future becomes more predictable and more manageable.

In a two - outcome situation for which the probability of one outcome is 1 and the probability of
the second outcome is 0, the risk is 0 because the actual outcome is known.

1.2. Risk versus Probability

It is necessary to distinguish carefully between risk and probability. Probability refers to the
long-run chance of occurrence, or relative frequency of some event. Insurers are particularly
interested in the probability or chance of loss, or more accurately, the probability that a loss will
occur to one of a group of insured objects.
Risk as differentiated from probability, is a concept in relative variation. We are referring here
particularly to objective risk, which is the relative variation of actual from probable or expected
loss. Objective risk can be measured meaningfully only in terms of a group large enough to
analyze statistically. If the number of objects is too small, the range of probable variation is so
large that is virtually infinite as far as the insurer is concerned.

1.3. Risk versus Uncertainty

Uncertainty is the doubt a person has concerning his or her ability to predict which of the many
possible outcomes will occur. Uncertainty is a person's conscious awareness of the risk in a
given situation. It depends upon the person's estimated risk-what that person believes to be the
state of the world-and the confidence he or she has in this belief. A person may be extremely
uncertain about the future in a situation where in reality the risk is small; on the other hand, this
person may have great confidence in his or her ability to predict the future when in fact the future
is highly uncertain. Unlike probability and risk, uncertainty cannot be measured by any
commonly accepted yardstick

1.4. Risk Distinguished from Peril and Hazard

Many persons commonly employ the terms "risky," "hazardous," and "perilous" synonymously.
For clarity in thinking, however, the meanings of these words should be carefully distinguished

A peril is a contingency, which may cause a loss. We speak of the peril of "fire" or "windstorm,"
or "hail" or "theft". Each of these is the cause of a loss that may occur.

A hazard, on the other hand, is that condition which creates or increases the probability of loss
from a peril. For example, one of the perils that can cause loss to an auto is collision. A
condition that makes the occurrence of collisions more likely is an icy street. The icy street is
the hazard and collision is the peril. In winter the probability of collision is higher owing to the
existence of icy streets. In such a situation, the risk of loss is not necessarily any higher or lower,
since we have defined risk as the uncertainty that underlying probability will work out in
practice.
It is possible for something to be both a peril and hazard. For instance sickness is a peril causing
economic loss, but it is also a hazard that increase the chance of loss from the peril of premature
death.

There are three basic types of hazards: physical, moral, and morale.
1. Physical Hazard. A physical hazard is a condition stemming from the physical
characteristics of an object that increases the probability and severity of loss from given
perils. Physical hazards include such phenomena as the existence of dry forests (hazard for
fire), earth faults (hazard for earthquakes), and icebergs (hazard to ocean shipping). Such
hazards may or may not be within human control. For example, some hazards for fire can be
controlled by placing restrictions on building camp fires in forests during the dry season.
Some hazards, however, cannot be controlled. For example, little can be done to prevent or to
control air masses that produce ocean storms.

2. Moral Hazard. A moral hazard stems from the mental attitude of the insured. A moral
hazard is a condition that increases the chance that some person will intentionally (1) cause a
loss or (2) increase its severity. Some unscrupulous persons can make, or believe that they
can make, a profit by bringing about a loss. For example, arson, inspired by the possibility of
an insurance recovery, is a major cause of fires. A dishonest person, in the hope of collecting
money from the insurance company, may intentionally cause a loss.

3. Morale Hazard. The morale hazard includes the mental attitude that characterizes an
accident-prone person. A morale hazard is a condition that causes persons to be less careful
than they would otherwise be. Some persons do not consciously seek be bring about a loss,
but the fact that they have insurance causes them to take more chances than they would if
they had no insurance. The purchase of insurance may create a morale hazard, since the
realization that the insurance company will bear the loss may lead the insured to exercise less
care than if forced to bear the loss alone. Morale hazard results from a careless attitude on the
part of insured persons toward the occurrence of losses.
1.5. Classes of Risk
Risks may be classified in several ways according to their cause, their economic effect, or some
other dimension. However, there are certain distinctions that are particularly important for our
purpose stated hereunder.
1.5.1. Financial Versus Non-Financial Risks
In its broadest context, the term risk includes all situations in which there is an exposure to
adversity. In some cases this adversity involves financial loss, while in others it does not. There
is some element of risk in every aspect of human endeavor and many of these risks have no (or
only incidental) financial consequences. In this course we are concerned with those risks which
involve a financial loss.

1.5.2. Static Risk versus Dynamic Risks

A second important distinction is between static and dynamic risks.

Dynamic risks are those resulting from change the economy. They are risks associated with
changes, especially changes in human wants and improvements in machinery and organization.
For example, changes in the price level, consumer tastes, income and output, and technology
may cause financial loss to members of the economy.

Static risks involve those losses, which would occur even if there are no change in the economy.
These are risks connected with losses caused by the irregular action of the forces of nature or the
mistakes and misdeeds of human beings.

Static risks are risks stemming from a level, unchanging society that is in stable equilibrium.
Examples include the uncertainties due to random events such as fire, windstorm, or death. They
would be present in an unchanging economy. If we could hold consumer taste, output, and
income, and the level of technology constant, some individuals would still suffer financial loss.
These losses arise from causes other than the changes in the economy, such as the perils of
nature and the dishonesty of other individuals.
Dynamic risks normally benefit society over the long-run since they are the result of adjustments
to misallocation of resources. They usually affect a large number of individuals and are
generally considered less predictable, since they occur with no precise degree of regularity.
Static risks, unlike dynamic risks usually result in a loss to society, affect directly few
individuals at most, exhibit more regularity over a specified period of time and, as a result, are
generally predictable.
1.5.3. Pure Risks versus Speculative Risks

A distinction has been made between pure risk and speculative risk, which further clarifies the
nature of risk. A pure risk exists when there is a chance of loss but no chance of gain. For
example, the owner of an automobile faces the risk associated with a potential collision loss. If a
collision occurs, the owner will suffer a financial loss. If there is no collision, the owner's
position remains unchanged.
A speculative risk exists when there is a chance of gains as well as a chance f loss. For instance,
expansion of an existing plant involves a chance of loss and chance of gain. Pure risks are
always distasteful, but speculative risks possess some attractive features. In the above example,
i.e., expansion of existing plant, the investment made may be lost if the product is not accepted
by the market at a price sufficient to cover costs but this risk is born in return for the possibility
of profit. Gambling is also a good example of speculative risk. In a gambling situation risk is
deliberately created in the hope of gain.

Pure risks also differ from speculative risks in that they generally are repeatable under essentially
the same condition and thus are more amenable to the law of large numbers (a basic law of
mathematics, which states that as the number of exposure units increases, the more certain it is
that actual loss experience will equal probable loss experience).

This means that one can more successfully predict the proportion of units that will be loss if they
are exposed to a pure risk than if they are subject to a speculative risk. One notable exception to
this statement is the speculative risks associated with games of chance, which are highly
amenable to this law.
In a situation involving a speculative risk, society may benefit even though the individual is hurt.
For example, the introduction of socially beneficial product may cause a firm manufacturing the
product it replaces to go bankrupt. In a pure-risk situation society almost always suffers if any
individual experiences a loss.

The distinction between pure and speculative risk is an important one, because normally pure
risks are insurable. Insurance is not concerned with the protection of individuals against those
losses arising out of speculative risks. Speculative risk is voluntarily accepted because of its two
dimensional nature, which includes the possibility of gain and loss.

Both pure and speculative risks commonly exist at the same time. For example, the ownership of
a building exposes the owner to both pure risks (for example, accidental damage to the property)
and speculative risk (for example, rise or fall in property values caused by general economic
conditions).

Classification of Pure Risks

While it would be impossible to list all the risks confronting an individual or business
organization, we can briefly outline the nature of the various pure risks that we face. For the
most part, these are also static risks. Pure risks that exist for individuals and business firms can
be classified under one of the following:
a) Personal Risks. These consist of the possibility of the loss of income or assets as a result of
loss of the ability to earn income. In general earning power is subject to four basic perils:
1. premature death
2. dependent old age
3. sickness or disability
4. unemployment
b) Property risks. Anyone who owns property faces risks simply because such possession can
be destroyed or stolen. Property risks embrace two distinct types of loss: direct loss and
indirect or consequential loss. Direct loss is the simplest to understand. If a house is
destroyed by fire, the property owner loses the value of the house. This is a direct loss.
However, in addition to losing the value of the building itself the property owner no longer
 has a place to live, and during the time required to rebuild the house, it is likely that the
owner will incur additional expenses living somewhere else. This loss of use of the
destroyed asset is an indirect or consequential loss.

An even better example is the case of a business firm. When a firm's facilities are destroyed,
it loses not only the value of these facilities but also the income that would have been earned
through their use. Property risks, then, can involve three types of losses.
i) the loss of the property
ii) loss of use of the property or its income and
iii) Additional expenses occasioned by the loss of the property.
c) Liability Risk. The basic peril in the liability risk is the unintentional injury of property of
others through negligence or carelessness. However, liability may also result from
intentional injuries or damage. Under our legal system, the laws provide that one who has
injured another or damaged another man's property through negligence or otherwise, can be
held responsible for the harm caused. Liability risks therefore, involve the possibility of loss
of present assets or future income as a result of damages assessed or legal liability arising
out of either intentional or unintentional torts or invasion of the rights of others.
d) Risk arising from failure of others. When another person agrees to perform a service for
you he/she undertakes an obligation which you hope will be met. When the person's failure
to meet this obligation would result in your financial loss risk exists. Example of risks in this
category includes failure of a contractor to complete a construction project as scheduled or
failure of debtors to make payments as expected.
1.5.4. Fundamental Risk versus Particular Risks
The distinction between fundamental and particular risks is based on the differences in origin and
consequences of the losses. Fundamental risks involve losses that are impersonal in origin and
consequence. They are group risks caused by economic, social, and political phenomena,
although they may also result from physical occurrences. They affect large segments or even all
of the population. Since these are group risks, impersonal in origin and effect they are, at least
for the individual, unpreventable.
Particular risks involve losses that arise out of individual events and that are felt by individuals
rather than by the entire group. They are risks personal in origin and effect and more readily
controlled. Examples of fundamental risks are those associated with extraordinary natural
disturbances such as drought, earthquake and floods. Examples of particular risks are the risk of
death or disability from non-occupational causes, the risk of property losses by such perils as
fire, explosion, theft, and vandalism, and the risk of legal liability for personal injury or property
damage to others.

Since fundamental risks are caused by conditions more or less beyond the control of the
individuals who suffer the losses and since they are not the fault of anyone in particular, it is held
that society rather than the individual has a responsibility to deal with them. Although some
fundamental risks are dealt with through private insurance (for example, earthquake insurance is
available from private insurers in many countries, and flood insurance is frequently included in
all risk contracts covering movable personal property) it is an inappropriate tool for dealing with
most fundamental risks, and some form of social insurance or other transfer program may be
necessary.

Particular risks are considered to be the individual's own responsibility, inappropriate subjects
for action by society as a whole. They are dealt with by the individual through the use of
insurance, loss prevention, or some other technique.

1.5.5. Objective Risks versus Subjective Risks

Objective risks, or statistical risk, applicable mainly to groups of objects exposed to loss, refer to
the variation that occurs when actual losses differ from expected losses. It may be measured
statistically by some concept in variation, such as the standard deviation. Subjective risk on the
other hand, refers to the mental state of individual who experiences doubt or worry as to the
outcome of a given event. It is a psychological uncertainty that stems from the individual's
mental attitude or state of mind.
Subjective risk has been measured by means of different psychological tests, but no widely
accepted or uniform tests of proven reliability have been developed. Thus, although we
recognize different degrees of risk-taking willingness in persons, it is difficult to measure these
attitudes scientifically and to predict risk-taking behavior, such as insurance-buying behavior,
from tests of risk-taking attitudes.

Subjective risk may affect a decision when the decision-maker is interpreting objective risk. One
risk manager may determine that some given level of risk is "high" while another may interpret
this same level as "low". These different interpretations depend on the subjective attitudes of the
decision-makers toward risk. Thus it is not enough to know only the degree of objective risk; the
risk attitude of the decision maker who will act on the basis of this knowledge must also be
known. A person who knows that there is only one chance in a million that a loss will occur may
still experience worry and doubt, and thus would buy insurance, while another would not. For
example, Business A insures the plant against fire even though the premium may be very high,
while Business B, a neighbor operating under similar conditions, refuses the insurance. In this
example A can be described as apparently perceiving a higher degree of risk in the given
situation and behaving more conservatively than B. A tends to be a risk averted and B, a risk
taker.
 UNIT TWO

RISK MANAGEMENT

Learning Objectives
After studying this unit, you should be able to:

 Define risk management

 Understand the objectives of risk management

 Explain the different steps and tools of risk management like, risk
identification, risk measurement, risk administration

The environment of modern business, particularly the large industrial unit, is becoming
increasingly complex. This increased complexity creates greater need for special attention to the
risks facing the enterprise. Most large corporations and many smaller ones employ specialized
managers to grapple with the problems of increased risk.

Several factors have contributed to the increased complexity of modern enterprise and have
greatly enlarged the risks faced by business. Among these factors are inflation, the growth of
international operations, more complex technology, and increasing government regulation.

2.1 What is Risk Management?

The increased complexity of modern enterprise called for special task to dealing with risks facing
modern enterprises. The special task to identify, analyze, and combat potential operating risks is
referred to as risk management. In other words, risk management is a systematic way of
protecting business resources and income against losses so that the organization's aims are
reached without interruption, creating stability and contributing to profit. It is a scientific
approach to the problem of dealing with risks faced by individuals and business. Because of the
pervasiveness of risk and its significant adverse economic effects, man is constantly searching
for ways in which he can manage risk to his advantage.

In brief, risk management is the science that deals with the techniques of forecasting
future losses so as to plan, organize, direct and control efforts made to minimize
(eliminate if possible) the adverse effects of those potential losses. It is the reduction
and prevention of the unfavorable effects of risk at minimum cost through its
identification, measurement and control.

In general, the risk manager deals with pure, not speculative, risk. Hence, risk management is
the identification, measurement, and treatment of pure risk exposures.

The Development of Risk Management

At one time business enterprises paid little attention to the problem of handling risk. Insurance
policies were purchased on a haphazard basis, with considerable overlapping coverage on one
hand, and wide gaps in coverage of important exposures on the other. Little control over the cost
of losses and insurance premium was exercised. Many risks were assumed when they should
have been insured and vice versa. It was gradually realized that greater attention to this aspect of
business management would yield great dividends. Instead of having insurance decision handled
by a busy executive whose primary responsibility lay in another area, management began to
assign this responsibility first as a part-time job to an officer, perhaps the treasurer, and later as a
full time position.
As the full scope of responsibility for risk management was realized, an insurance department
was established, with several people employed. At first the department manager was usually
known as the insurance buyer. Later the title was changed to insurance manager or risk manager.
Many different titles, including insurance buyer, are still used, but the tendency is to reflect the
broader nature of the manager's duties and responsibilities. Assistants to the insurance manager
often include specialists in various branches of insurance, law, statistics, and personnel relations.

Risk Management and Insurance Management

Risk management should not be confused with insurance management. Risk management is
broader concept and differs from insurance management in several ways. First, risk management
places greater emphasis on the identification and analysis of pure loss exposures and techniques
for dealing with these exposures. Second, in addition to insurance, risk management uses other
techniques to treat loss exposures, which include avoidance, loss control, retention, and non-
insurance management. Finally, risk management has greater impact on the firm than insurance
management. A successful risk management program requires the cooperation of numerous
individuals and departments throughout the firm. Insurance management involves smaller
number of persons.

2.2 Objectives of Risk Management

The first step in the risk management process is the determination of the objectives of the risk
management program; that is, it is deciding precisely what the organization expects its risk
management program to do. This step is often overlooked, with the result that the risk
management program is less effective that it could be. In the absence of coherent objectives,
there os a tendency to view the risk management process as series of individual isolated
problems, rather than as one single problem, and there are no guidelines to provide for logical
consistency in dealing with the risks that the organizations faces. Risk management objectives
serve as a prime source of guidance for those charged with responsibility for the program, and
also serve as means of evaluating performance.

Risk management has several important objectives that can be classified in to two categories:
pre-loss objectives and post-loss objectives.

The pre-loss objectives are:

 Economy
 Reduction in anxiety
 Meeting external obligations

The post loss objectives are:

 Survival
 Continuity of operations
 Earning stability
 Continued growth
 Social responsibility
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 preopare for potential losses in the most economical
way possible. This involves analysis of safety program expenses, insurance premiums, and costs
associated with the different techniques for handling losses.

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

The third objective is to meet any externally imposed 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 management must
see that the externally imposed obligations are met.

Post-loss objectives

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

The second post loss objective is to continue operating. For some firms, the ability to operate
after 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 lose customer to competitors if they cannot operate after a loss
occurs. This would include banks, bakeries, dairies, etc.

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 objective of continued operation.
Earnings per share can be maintained if the firm continues to operate. However, there 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. 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 firms ability to grow.
Finally, the goal of social responsibility is to minimize the impact that a loss has on other persons
and society. A severe loss can adversely affect employees, customers, suppliers, creditors,
taxpayers, and the community in general. For example, a severe loss requires shutting down a
plant in small community for extended period which can lead to depressed business conditions
and substantial unemployment in the community.

2.3 Steps in Risk Management Process

In order to have an effective risk management program, the risk manager must take certain steps.
There are four steps in risk management process; they are:

 Identifying potential losses

 Evaluating potential losses
 Selecting appropriate techniques, or combination of technique, for treating loss exposures
 Implementing and administering the program

2.3.1 Risk Identification (Identifying Potential Losses)

The first step in business risk management is to identify the various types of potential losses
confronting the firm; the second step is to measure these potential losses with respect to such
matters as their likelihood of occurrence and their probable severity.

Risk identification is the process by which a business systematically and continuously identifies
property, liability, and personnel exposures as soon as or before they emerge. Unless the risk
manager identifies all the potential losses confronting the firm, he will not have any opportunity
to determine the best way to handle the undiscovered risks. The business will unconsciously
retain these risks, and this may not be the best or even a good thing to do.
In one way or another, the risk manager must dig into the operations of the concern and discover
the risks to which the organization is exposed. To identify all the potential losses the risk
manager should have a look at insurance policy checklists, risk analysis questionnaires, flow-
charts, analysis of financial statements, and inspections of the organization's operations.
a. Insurance policy checklists
Insurance policy checklists are available from insurance companies and from publishers
specializing in insurance related publications. Typically, such lists include a catalogue of the
various policies or types of insurance that a given business might need. The risk manager simply
consults such a list, picking out those policies applicable to the concern. A principal defect of
this approach is that it concentrates on insurable risks only, ignoring the uninsurable pure risks.

Loss exposure checklists are available from various sources, such as insurers, agencies, and risk
management associations. These checklists are possible sources of loss to the business firm from
destruction of physical and intangible assets. Sources of loss are organized according to whether
the loss is predictable or unpredictable, controllable or uncontrollable, direct or indirect, or from
different types of legal liability. After each item the user can ask the question, "It this a potential
source of loss in our firm?" Use of such a list reduces the likelihood of overlooking important
sources of loss.

b. Risk Analysis Questionnaire

Risk analysis questionnaires sometimes called "fact finders" are designed to lead the risk
manager to the discovery of risks through series of detailed and penetrating questions. Most of
the time these questionnaires are designed to identify both insurable and uninsurable risks. It
directs the risk manager to secure specific information concerning the firm's properties and
operations.

This questionnaire contains a list of questions designed to remind the risk manager of possible
loss exposures. For example, here are some sample questions:

i. 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?
ii. Are company-owned vehicles furnished to directors, executives, or employees for business
and personal use? If so, to what extent?
iii. Are there any key service facilities or warehouses whose function must continue even
though the structures and equipment may be damaged?
iv. Indicate the maximum amount of money, checks, and securities that may be on hand in any
one office during and outside business hours.
c. Flow-Charts
A third systematic procedure for identifying the potential losses facing a particular firm is the
flow-chart approach. 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 suppliers'
locations and ending with finished products in the hand of customers. Second, the checklist of
potential property, liability, and personnel losses is applied to each property and operation shown
in the flow chart to determine which losses the firm faces.

The most positive benefit of using flow charts is that they force the risk manager to become
familiar with the technical aspects of the organization's operations, thereby increasing the
likelihood of recognizing special exposures.

d. Loss Exposure Checklists (same to a- above)

Loss exposure checklists provide listings of common risk exposures of a firm. An exposure
checklist is very simple yet effective tool for risk identification. In fact, it is one of the most
common tools used for identifying and analyzing risk. Loss exposure checklists are available
from various sources, such as insurers, agencies, and risk management associations. These
checklists contain possible source of loss to the business firm from destruction of physical and
intangible assets. Sources of loss are organized according to whether the loss is predictable or
unpredictable, controllable or uncontrollable, direct or indirect, or from different types of legan
liability. After each item, the user can ask the questions “is this potential source of loss in our
firm?” Use of such list reduces the likelihood of overlooking important sources of loss.

e. On-Site Inspections

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. Just as one picture is worth a thousand words one inspection tour may be worth a
thousand checklists. An examination of organization's various operation sites and discussions
with managers and workers will often uncover risks that might otherwise have gone undetected.
f. The financial Statement Method

By analyzing the balance sheet, operating statements, and supporting documents, the risk
manager can identify property, liability, and human asset exposures of the organization. By
coupling these statements with financial forecasts and budgets, the risk manager can discover
future exposures. Financial statements reveal this information because every organizational
transaction ultimately involves either money or property.

g. Interactions with other Departments

Frequent interactions with other departments provide another source of information on exposure
to risk. These interactions may include 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 development. The importance of such communications network should not be underestimated.
These debarments are constantly creating or becoming aware of exposures that might otherwise
escape the risk manager’s attention. Indeed the risk manager’s success in risk identification is
heavily dependent upon the cooperation he/she secures from other departments.

h. Contract Analysis

Many of an organization’s exposures to risk arise from contractual relationships with other
persons and organizations. An examination of these contracts may reveal area of exposures that
are not evident from organization’s operations and activities. In some cases, contracts may shift
the responsibility to other parties.

i. The best method

No single method or procedure of risk identification is free of weakness or can be called
foolproof. The strategy of management must be to employ the method or combination of
methods that best fits the situation at hand. The choice is a function of (a) the nature of the
business, (b) the size of the business, and (c) the availability of in house expertise.
The preferred approach to risk identification is combination approach, in which all available
tools listed are bought to bear on the problem.

2.3.2 Risk Measurement (Evaluating Potential Losses)

After the risk manager has identified the various types of potential losses faced by his firm, these
exposures must be measured. Risk measurement is required by the risk manager for two
purposes: a) to determine the relative importance of potential losses and b) to obtain information
that will help him to decide upon the most desirable combination of risk management tools.

a. Dimensions to be measured
Evaluating and measuring the impact of losses on firm involves an estimation of the potential
frequency and severity of loss. Information is needed concerning two dimension of each
exposure:
 The loss frequency or the number of losses that will occur and
 The severity of losses the total impact of these losses if they should be retained, not only
their dollar values, should be included in the analysis.

While loss of frequency refers to the probable number of losses that may occur during some
given period of time, the loss severity refers to the probable size of the losses that may occur.

b. Why We Need Each Dimension

Both loss-frequency and loss-severity data are needed to evaluate the relative importance of an
exposure to potential loss. Contrary to the views of most persons, however, the importance of an
exposure to loss depends mostly upon the potential loss severity, not the potential frequency. A
potential loss with catastrophic possibilities, although infrequent, is far more serious than one
expected to produce frequent small losses and no large losses.

On the other hand, loss frequency cannot be ignored. If two exposures are characterized by the
same loss severity, the exposure whose frequency is greater should be ranked more important.
An exposure with a certain potential loss severity may be ranked above a loss with a slightly
higher severity because the frequency of the first loss is much greater than that of the second.
There is no formula for ranking losses in order of importance, and different persons may develop
different rankings. The rational approach, however, is to place more emphasis on loss severity.

An example may clarify the point. The chance of an automobile collision loss may be greater
than the chance of being sued as a result of the collision, but the potential severity of the liability
loss is so much greater than the damage to the owned automobile that there should be no
hesitation in ranking a liability loss over the property loss.

A particular type of loss may also be subdivided into two or more kinds of losses depending
upon whether the loss exceeds a specified dollar amount. For example, consider the collision
loss cited in the preceding paragraph. This loss may be subdivided into two kinds of losses: i)
collision losses of $100 (or some other figure) or less and ii) losses over $100. Losses in the
second category are the more important, although they are less frequent. Another illustration
would be the losses associated with relatively small medical expenses as contrasted with
extremely large bills. Such a breakdown by size of loss shows clearly the desirability of
assigning more weight to loss severity than to loss frequency.

In determining loss severity the risk manager must be careful to include all the types of losses
that might occur as a result of a given event as well as their ultimate financial impact upon the
firm. Often, while the less important types of losses are obvious to the risk manager, the more
important types are much more difficult to identify. The potential direct property losses are
rather generally appreciated in advance of any loss, but the potential indirect and net income
losses (such as the interruption of business while the property is being repaired) they may result
from the same event are commonly ignored until the loss occurs.

The ultimate financial impact of the loss is even more likely to be ignored in evaluating the
dollar value of any loss. Relatively small losses, if retained, cause only minor problems because
the firm can meet these losses fairly easily out of liquid assets. Somewhat larger losses may
cause liquidity problems which in turn may make it more difficult or more costly for the firm to
borrow funds required for various purposes. Finally, very large losses may have serious adverse
effects upon the firm's financial planning, and their dollar impact may be much greater than it
would be for a firm that could more easily absorb these losses. Ultimately the loss could be the
ruin of the business as a going concern.

To illustrate, a fire could destroy a building and its contents valued at $300,000; the ensuing
shutdown of the firm for six months might cause another $360,000 loss. This $660,000 might
force the firm to shut its doors, an action that would result in an ultimate loss of the difference
between the going-concern value of the business, say $2,400,000, and the value for which the
remaining assets could be sold, say $1,500,000, causing a $900,000 loss.

Finally, in estimating loss severity, it is important to recognize the timing of any losses as well as
their total dollar amount. For example, a loss of $5,000 a year for 20 years is not as severe as an
immediate loss of $100,000 because of:
i) the time value of money, which can be recognized by discounting future dollar losses at
some assumed interest rate, and
ii) the ability of the firm to spread the cash outlay over a longer period.

Loss-frequency and loss-severity data do more than identify the important losses. They are also
extremely useful in determining the best way or ways to handle an exposure to loss. For
example, the average loss frequency times the average loss severity equals the total dollar losses
expected in an average year. These average losses can be compared with the premium the firm
would have to pay an insurer for complete or partial protection.

c. Priority Ranking Based on Severity

As mentioned earlier, the process of risk evaluation ranks risks as per the severity (importance)
of losses. The more severe the losses due to risk, the higher the rank.as the relative severity of
loss differs, not all losses warrant equal attention. Some are to give priority over others. Losses
in the same category need not be prioritized as each of them will lead to the same consequence.
For example, a financial catastrophe that can lead to bankruptcy can be due to liability loss,
floods or uninsured fire loss, but since the net result is the same, irrespective of the cause, there
is no need to rank them.
Under such circumstances, risks are classified in to three: critical, important, and unimportant.

 Critical risk: - they are exposures to loss where magnitude of losses could lead to
bankruptcy
 Important risks: - include those exposures in which the possible losses would not lead
to bankruptcy, but would require the individual or firm to borrow in order to continue
operations
 Unimportant risks: - include those exposures in which the possible losses could be met
out of the existing assets or current income without imposing undue financial strain.

2.3.3 Selecting the Appropriate Tools of Risk Management

The third step in the risk management process is to select the most appropriate techniques , or
combination of techniques, for treating each loss exposure. The major techniques for treating
loss exposures are the following:

Risk control techniques: - they attempt to reduce the frequency and severity of accidental losses
to the firm; they are:

 Avoidance
 Loss control
 Separation/diversification
 combination

Risk financing techniques: - they provide funds for accidental losses after they occur; they are:

 Retention/Self- insurance
 Non-insurance transfers
 Insurance

2.3.3.1 Risk Control Techniques

a. Avoidance

 Refusing to assume it even momentarily or

 Abandoning an exposure assumed earlier
To illustrate, if a business does not want to be concerned about potential property losses to a
building or to a fleet of cars, it can avoid these risks by never acquiring any interest in a building
or fleet of cars.

The method of avoidance is widely used, particularly by those with a high aversion toward risk.
Thus, a person may not enter a certain business at all, and avoid the risk of losing capital in that
business. A person may not use airplanes and thus avoid the risk of dying in an airplane crash.
Another example of avoidance is to delay taking responsibility for goods during transportation.
A customer may have choice of terms of sale, and may have the seller assume all the risks of loss
until the goods arive at the buyer's warehouse. In this way the buyer never assumes the risk
during transportation and has avoided an insurance problem.

Avoidance is a useful and common approach to the handling of risk. By avoiding a risk
exposure the firm knows that it will not experience the potential losses or uncertainties that
exposure might generate. On the other hand, it also loses the benefits that may have been derived
from that exposure.

Characteristics of avoidance should be noted:

i. Avoidance may be impossible. For example, the only way to avoid all liability exposures
is to cease to exist.

ii. The potential benefits to be gained from employing certain persons, owning a piece of
property, or engaging in some activity may so far outweigh the potential losses and
uncertainties involved that the risk manager will give little consideration to avoiding the
exposure. For example, most businesses would find it almost impossible to operate
without owning or renting a fleet of cars. Consequently they consider avoidance to be an
impractical approach.

iii. Avoiding a risk may create another risk. For example, a firm may avoid the risks
associated with air shipments by substituting train and truck shipments. In the process,
however, it has created some new risks.
Remember the characteristics of avoidance
 Avoidance may be impossible.
 The potential gains of owning a property may be greater than the potential losses.
 Avoiding a risk may create another risk.

b. Loss Control/Reduction

Loss-prevention and reduction measures attack risk by lowering the chance that a loss will occur
or by reducing its severity if it does occur. Prevention is defined as a measure taken before the
misfortune occurs. This would include fireproofing, burglar alarms, safety tires, and so on.

Loss reduction are measures taken to lower loss after the event occurs. Automatic sprinklers, for
example, are designed to minimize a fire loss by spraying water or some other substance upon a
fire soon after it starts in order to confine the damage to a limited area.

Other examples of loss-reduction programs include immediate first aid for persons injured on the
premises, fire alarms, internal accounting controls, and speed limits for motor vehicles.

Loss may be prevented or reduced in any of the following ways:-

i) Engineering Risks:- This approach of reducing loss emphasizes on the mechanical causes
of accidents such as defective wiring, improper disposal of waste products, poorly
designed highway intersections or automobiles, and unguarded machinery. Regulating
and elimination of the mechanical failures that may be the causes of potential losses is an
essential part of any loss prevention and reduction program.
ii) Training of Personnel:- Machines or equipment need to be operated or handled by
qualified personnel to eliminate or reduce the loss due to human failures. Workers should
be acquainted with the machines they are to operate through an adequate training to
reduce losses.
 Many risk managers are in direct charge of their companies accident prevention programs.
Among their varied duties are:
i. Keeping accurate records of all accidents by number, type, cause and total damage incurred
ii. Maintaining plant safety-inspection programs
iii. Devising ways and means to prevent recurrence of accidents
iv. Keeping top management accident conscious
v. Seeing that proper credits are obtained in the insurance premium for loss-prevention
measures
vi. Minimizing losses by proper salvage techniques and other action at the time of a loss
vii. Working with company engineers and architects in planning new construction to provide for
maximum safety and to secure important insurance premium credits when the structure is
completed and in use.
Although the prevention of all losses would be desirable it is not always possible or
economically feasible. The potential gains from any loss-prevention activity must be weighed
against the costs involved. Unless the gains equal or exceed the costs, the firm would be better
off not to engage in that activity. The firm, however, must be certain to consider all the gains and
all the costs.

c. Separation/Diversification

Another risk control tool is 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. For example, instead of
placing its entire inventory in one warehouse a firm may elect to separate this exposure by
placing equal parts of the inventory in ten widely separated warehouses. If fire destroys one
warehouse, the firm will have others from which to draw needed supplies. Another example is to
disperse work operations in such a way that explosion or other catastrophe would not injure more
than a limited number of persons.

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

d. Combination
Combination or pooling makes loss experience more predictable by increasing the number of
exposure units. Unlike separation, which spreads a specified number of exposure units,
combination increases the number of exposure units under the control of the firm.

When sufficiently large numbers are grouped, the actual loss experience over a period of time
will closely approximate the probable loss experience.

One way a firm can combine risks is to expand through internal growth. For example, a taxicab
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.

Combination of pure risks is seldom the major reason why a firm expands its operations, but this
combination may be an important by-product of merger or growth. (An example of pooling with
respect to speculative risks, which may be a primary objective of a merger or expansion, is the
diversification of products by a business.) Insurers, on the other hand, combine pure risks
purposefully; they insure a large number of persons in order to improve their ability to predict
their losses.

2.3.3.2 Risk Financing Techniques

a. Loss–Retention/self-insurance
The most common method of handling risk is retention by the individual or the firm itself.
Individuals or business firms face an almost unlimited array of risks; in most cases nothing is
done about them. Risk retention may be planned or unplanned. Planned risk retention, often
called self-insurance, is conscious and deliberate assumption of recognized risk. The individual
or firm decides to pay losses out of currently available funds. In some cases a reserve fund may
be established to cover expected losses.
Unplanned risk retention exists when a person does not recognize that a risk exists and
unknowingly believes that no loss could occur. Such a method does not deserve to be called a
risk management device. It stems from ignorance of risk.

Risk retention is a legitimate method of dealing with risk, in many cases it is the best way. Each
person must decide which risks to retain and which to avoid or transfer on the basis of his margin
for contingencies or personal ability to bear loss. A loss that might be a financial disaster for one
individual, family or business might easily be borne by another. As a general rule, risks that
should be retained are those that lead to relatively small losses.

Self-insurance is a special case of active retention. It is distinguished from the other type of
retention usually referred to as non-insurance in that the firm or family can predict fairly
accurately the losses it will suffer during some period because it has a large number of widely
scattered and fairly homogeneous exposure units. Self-insurance is not insurance, because there
is no transfer of the risk to an outsider. Self-insurer and insurer, however, share the ability,
though in different degrees, to predict their future loss experience.

Planned retention can be effectively used in a risk management when the following listed three
conditions are existed:
i. When it is impossible to transfer the risk to someone else or to prevent the loss from
occurring. The only possible alternative-avoidance-may be undesirable for various
reasons. For example, firms with plants located in river valley may find that no other
method of handling the flood risk is available. Other firms will find that they are exposed
to larger potential liability losses than they can prevent or transfer (most speculative risks
fall into this category.)

The businessman does not want to avoid the venture, because there are potential profits;
he cannot prevent the loss from occurring, although he may be able to reduce its
likelihood, and he cannot transfer the chance of loss to someone else.
 ii. The maximum possible loss is so small that the firm can safely absorb it as a current
operating expense or out of small reserve funds.
iii. The chance of loss is extremely low that it can be ignored or is so high that to transfer it
would cost almost as much as the worst loss that could occur. In some areas the chance of
a flood loss is so small that this peril can be safely ignored. The chance that a man, aged
97, will die within a year is so high that an insurer would demand a premium close to the
amount it would pay upon his death.
iv. The firm controls so many independent, fairly homogeneous exposure units that it can
predict fairly well what its loss experience will be; in other words, a retention program
for this firm could properly be called "self-insurance." In this instance one of the
principal reasons for transferring the risk to someone else does not exist.

b. Non-insurance transfers
Non-insurance transfers are methods other than insurance by which pure risk and its potential
financial consequences are transferred to another party. Neutralization or hedging and hold
harmless agreements are examples of non-insurance transfer of risk.

Neutralization or hedging

As generic terms, neutralization and hedging describe actions whereby a possible gain is
balanced against possible loss. Neutralization is the process of balancing a chance of loss against
a chance of gain. For example, a person who has bet that a certain team will win the world cup
may neutralize the risk involved by also placing a bet on the opposing team. In other words, he
transfers the risk to the person who accepts the second bet. A commercial example of
neutralization is hedging by manufacturers who are concerned about changes in raw material
prices. Because there is no chance of gain associated with pure risks, neutralization is not a tool
of pure-risk management.

Hedging is a process of making commitments on both sides of a transaction in such a way that
the risks compensate each other. It tries to avoid loss by making counterbalancing bets.
Neutralization reduces the risk of undesirable price rises from the buyer's point of view and
equally undesirable price declines for the seller.

Hold harmless agreements

They are contract entered into prior to a loss, in which one party agrees to assume second party’s
responsibility should a loss occur. For example, contractors may require subcontractors to
provide the contractor with liability protection if they are sued because of the subcontractor’s
activities. Likewise, vendors request to hold harmless agreements before selling manufacturer’s
goods.

c. Insurance

Commercial insurance is also used in risk management program. From the risk manager’s view
point, insurance represents contractual transfer of risk. Insurance is appropriate for loss
exposures that have low probability of loss but the severity of loss is high. If the risk manager
uses insurance to treat certain loss exposures, the following listed five key areas must be
emphasized:

 Selection of insurance cover ages

 Selection of an insurer
 Negotiation of terms
 Dissemination of information concerning insurance overages
 Periodic review of the insurance program

i. The risk manager must select the insurance coverage needed

Since there may not be enough money in the risk management budget to insure all possible
losses, the need for insurance can be divided in to in to several categories depending on
importance. One useful approach is to classify the need for insurance in to three categories:
 Essential
 Desirable
 Available

Essential insurance: - includes those coverages required by law or by contract, such as

workers compensation insurance. Essential insurance also includes those coverages that
will protect the firm against catastrophic loss or a loss that threatens the firm’s survival;
commercial general liability insurance would fall in that category.

Desirable or important insurance: - it is protection against losses that may cause the
firm financial difficulty, but not bankruptcy. Desirable insurance coverages include those
that protect against loss exposures that would face the firm to borrow or resort to credit.

Available or optional insurance: - it is coverage for slight losses that would merely
inconvenience the firm. Optional insurance coverage’s include those that protect against
losses that could be met out of existing asset or current income.

ii. The risk manager must select an insurer or several insurers

Several important factors come in to play here. Those include the financial strength of the
insurer, risk management provided by the insurer, and the cost and terms of protection.

iii. After the insurer or insurers are selected, the terms of the insurance contract must
be negotiated

If printed policies, endorsements, and forms are used, the risk manager and insurer must
agree on the documents that will form the basis of the contract. If specially tailored
manuscript policy is written for the firm, the language and meaning of the contractual
provisions must be clear to both parties. In any case, the various risk management
services the insurer will provide must be clearly stated in the contract. Finally, if the firm
is large, the premiums may be negotiated between the firm and insurer.

iv. Information concerning insurance coverage must be disseminated to others in the

firm

The firm’s employees and managers must be informed about the insurance coverages, the
various records that must be kept, the risk management services that the insurer will
provide, and the changes in the hazards that could result in suspension of insurance.
Those persons responsible for reporting a loss must also be informed. The firm must
comply with policy provisions concerning how notice of claim is to be given and how the
necessary proofs of losses are to be presented.

v. The insurance program must be periodically reviewed

The entire process of obtaining insurance must be eventually evaluated periodically. This
involves an analysis of agent broker relationships, coverages needed, cost of insurance,
quality of loss-control, services provided, whether claims are paid promptly, and
numerous other factors. Even the basic decision- whether to purchase insurance- must be
reviewed periodically.

d. Which method should be used?

In determining the appropriate method or methods for handling losses, a matrix can be
used that classifies the various loss exposures according to frequency and severity. The
matrix can be useful in determining which risk management method should be used;
observe the following table.

Frequency of loss

low high

Low Retention Loss control

Severity of loss
and retention

High Insurance Avoidance

The first loss exposure is characterized by both low frequency and low severity of loss.
One example of this type of exposure would be the potential theft of secretary’s
dictionary. This type of exposure can be best handled by retention, since the loss occurs
frequently, when it occurs, it seldom causes financial harm.

The second type of exposure which is characterized by high frequency and low severity
of losses is more serious. Example of this type of exposure includes physical damage
losses to automobiles, workers compensation claims, and food spoilage. Loss control
should be used here to reduce the frequency of losses. In addition, since losses occur
regularly and are predictable, the retention technique can also be used.

The third type of exposure can be met by insurance. Insurance is best suited for low
frequency, high severity losses. High severity means that a catastrophic potential is
present, while low probability of loss indicates that the purchase of insurance is
economically feasible. Example of this type of exposure includes fires, explosions, and
liability lawsuits. The risk manager could also use a combination of retention and
commercial insurance to deal with those exposures.

The fourth and most serious type of exposure is one characterized by both high frequency
and high severity. This type of exposure is best handled by avoidance.

2.3.4 Risk Administration

At this point, 75% of steps in the risk management process have been discussed. The
fourth step is implementation and administration of th e risk management.
Typical activities of risk manager include identifying and evaluating loss exposures,
establishing procedures for handling insurance claims, designing and installing employee
benefit plans, participating in loss control and safety programs. Thus, risk managers are
an important part of the management team.

a. Risk management policy Statement

A risk management policy statement is necessary in order 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.it also
educates top-level executives in regard to risk management process, gives the risk
manager greater authority in the firm, and provides standards for judging the risk
manager’s performance.

In addition, a risk management manual may be developed and used in the program. The
manual describes in some detail the risk management program of the firm and can be
very useful tool for training new employees who will be participating in the program.
Wring the manual also forces the risk manager to state precisely his/her responsibilities,
and available techniques.

b. Cooperation with other departments

The risk manager doesn’t work alone. Other functional departments within the firm are
extremely important in identifying pure loss exposures and methods for treating these
exposures. These departments can cooperate in the risk management process in the
following ways:

 Accounting: - internal accounting controls can reduce employee fraud and theft of
cash
 Marketing: - accurate packing can prevent liability lawsuits. Safe distribution
procedures can prevent accidents.
 Production: - quality control can prevent the production of defective goods and
liability lawsuits. Effective safety programs in the plant can reduce injuries and
accidents
 Personnel:- the department may be responsible for employee benefit [programs,
pension programs, and safety programs.

This lost indicates how the risk management process involves the entire firm. Indeed without the
active cooperation of the other departments, the risk management program will be failure.
c. Periodic Review and Evaluation

To be effective, the risk management program must be periodically reviewed and evaluated to
determine if the objectives are being attained. In particular, risk management costs, safety
programs, and loss prevention programs must be carefully monitored. Loss records must also be
examined to detect any changes in frequency and severity. In addition, new developments that
affect the original decision on handling a loss exposure must be examined. Finally, the risk
manager must determine if the firm’s overall risk management policies are being carried out, and
if the risk manager is receiving the total cooperation of the other departments in carrying out the
risk management functions.