Risk Management Techniques — methods for treating risks.

Traditional risk
management techniques for handling event risks include risk retention, contractual or
noninsurance risk transfer, risk control, risk avoidance, and insurance transfer. Other
techniques used for other types of risk (e.g., credit, operational, interest rate risks)
include financial tools such as hedges, swaps, and derivatives.

Select the appropriate techniques for treating the loss exposures :-

The third step in the risk management process is to select the most appropriate technique,
or 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 and severity of losses. Risk
financing refers to techniques that provide for the funding of losses. Many risk managers
use a combination of techniques for treating each loss exposures.

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A. Risk Control

As noted above, risk control is a generic term to describe techniques for reducing the frequency or
severity of losses. Major risk control techniques include the following:

I. Avoidance
II. Loss Prevention
III. Loss reduction

I. Avoidance

Avoidance means a certain loss exposure is never acquired, or an existing loss exposure is abandoned.
For example, flood losses can be avoided by not building a new plant in a floodplain. A pharmaceutical
firm that markets a drug with dangerous side effects can withdraw the drug from the market.

The major advantage of avoidance is the change of loss is reduced to zero if the loss exposure is never
acquired. In addition, if an existing loss exposure is neglected the chance of loss is reduced or eliminated
because the activity or product that could produce a loss has been abandoned. Abandonment, however,
may still leave the firm with a residual liability exposure from the sale of previous products.

Avoidance, however, has two major disadvantages. First the firm may not be able to avoid all losses. For
example, a company may not be able to avoid the premature death of a key executive. Second, it may
not be feasible or practical to avoid the exposure. For example, a paint factory can avoid losses arising
from the production of paint. Without paint production, however, the firm will not be in business.

Avoidance is one method of handling risk. For example, you can avoid the risk of being
mugged in a high-crime rate area by staying out of the area; you can avoid the risk of
divorce by not marrying; and a business firm can avoid the risk of being sued for a

defective product by not producing the product. Not all risks should be avoided, however.
For example, you can avoid the risk of death or disability in a plane crash by refusing to fly.
But is this choice practical or desirable? The alternatives driving or taking a bus or train
often are not appealing. Although the risk of a plane crash is present, the safety record of
commercial airlines is excellent, and flying is a reasonable risk to assume.

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II. Loss prevention

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. Measures that reduce lawsuits from detective products include
installation of safety features on hazardous products, placement of warning labels on dangerous
products, and institution of quality control checks.
Loss prevention aims at reducing the probability of loss so that the frequency of losses is
reduced. Several examples of personal loss prevention can be given. Auto accidents can be
reduced if motorists take a safe-driving course and drive defensively. The number of heart
attacks can be reduced if individuals control their weight, give up smoking, and eat healthy
diets.
Loss prevention is also important for business firms. For example, strict security measures at
airports and aboard commercial flights can reduce hijacking by terrorists. Boiler explosions can
be prevented by periodic inspections by safety engineers; occupational accidents can be reduced
by the elimination of unsafe working conditions and by strong enforcement of safety rules; and
fires can be prevented by forbidding workers to smoke in a building where highly flammable
materials are used. In short, the goal of loss prevention is to prevent the loss from occurring.

III. Loss reduction

Loss reduction refers to measures that reduce the severity of a loss after it occurs. Examples include
installation of an automatic sprinkler system that promptly extinguishes a fire, segregation of exposure
units so that a single loss cannot simultaneously damage all exposure units, such as having warehouses
with inventories at different locations, rehabilitation of workers with job- related injuries and limiting
the amount of cash on the premises.
Strict loss-prevention efforts can reduce the frequency of losses, yet some losses will
inevitably occur. Thus, the second objective of loss control is to reduce the severity of a loss
after it occurs. For example, a department store can install a sprinkler system so that a fire will
be promptly extinguished, thereby reducing the loss; a plant can be constructed with fire-
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 resistant materials to minimize fire damage; fire doors and fire walls can be used to prevent a
fire from spreading; and a community warning system can reduce the number of injuries and
deaths from an approaching tornado.
From the viewpoint of society, loss control is highly desirable for two reasons. First, the
indirect costs of losses may be large, and in some instances can easily exceed the direct costs.
For example, a worker may be injured on the job. In addition to being responsible for the
worker’s medical expenses and a certain percentage of earnings (direct costs), the firm may
incur sizable

indirect costs: a machine may be damaged and must be repaired; the assembly line may have to
be shut down; costs are incurred in training a new worker to replace the injured worker; and a
contract may be canceled because goods are not shipped on time. By preventing the loss from
occurring, both indirect costs and direct costs are reduced.

Second, the social costs of losses are reduced. For example, assume that the worker in the
preceding example dies from the accident. Society is deprived forever of the goods and services
the deceased worker could have produced. The worker’s family loses its share of the worker’s
earnings and may experience considerable grief and financial insecurity. And the worker may
personally experience great pain and suffering before dying. In short, these social costs can be
reduced through an effective loss control program.

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 In conclusion, effective risk control techniques can reduce significantly the frequency and
severity of claims

How is loss prevention different from loss reduction? Give some example of each.
Risk management purpose is to prevent and reduce the frequency and severity of potential
losses. Loss prevention programs promote avoidance of losses, measuring the loss frequency.
Some examples are safety programs implemented to prevent workplace injuries, fire detectors,
burglar alarms, and other protective devices to prevent losses caused by fire and theft.
Insurance companies offer discounts to organization or individuals taking loss prevention
measures as incentive for their participation.
While, in loss reduction the scope of the programs limit the extent of losses, when they do
happen. Decreasing the severity, helps to minimize the impact of the loss in the organization.
Examples, clear procedures and warning signs postings, airbags in the vehicle, firewalls and
fire doors.
Both risk controls are only justified when savings exceed loss..

B. Risk Financing

Risk financing is the determination of how an organization will pay for loss events in the
most effective and least costly way possible. Risk financing involves the identification of
risks, determining how to finance the risk, and monitoring the effectiveness of the
financing technique that is chosen.Risk financing refer to techniques that provide for the
funding of losses after they occur. Major risk-financing techniques include the
following:-

 Retention

 Non-insurance transfers

 Commercial insurance

 Retention

Retention means that, all of the losses that can result from a given loss. An individual or a

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business firm retains all or part of a given risk.
Retention can be either active or passive.
Active risk retention means that the firms aware of the loss exposure and plans
to retain part or all of it, such as collision losses to a fleet of company cars.
Active risk retention means that an individual is consciously aware of the risk
and deliberately plans to retain all or part of it. For example, a motorist may
wish to retain the risk of a small collision loss by purchasing an auto insurance
policy with a $250 or higher deductible. A homeowner may retain a small part of
the risk of damage to the home by purchasing a homeowners policy with a
substantial deductible. A business firm may deliberately retain the risk of petty
thefts by employees, shoplifting, or the spoilage of perishable goods. In these
cases, a conscious decision is made to retain part or all of a given risk.

Active risk retention is used for two major reasons. First, it can save money.
Insurance may not be purchased at all, or it may be purchased with a deductible;
either way, there is often a substantial saving in the cost of insurance. Second,
the risk may be deliberately retained because commercial insurance is either
unavailable or unaffordable.

Passive retention, however, is the failure to identify a loss exposure, failure to act, or
forgetting to act. For example, a risk manger may fail to identify all company assets that
could be damaged in an earthquake.

Risk can also be retained passively. Certain risks may be unknowingly retained
because of ignorance, indifference, or laziness. Passive retention is very
dangerous if the risk retained has the potential for destroying you financially.
For example, many workers with earned incomes are not insured against the risk
of total and permanent disability under either an individual or group disability
income plan. However, the adverse financial consequences of total and
permanent disability generally are more severe than the financial consequences
of premature death. Therefore, people who are not insured against this risk are
using the technique of risk retention in a most dangerous and inappropriate
manner.

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In summary, risk retention is an important technique for handling risk, especially
in a modern corporate risk management program, however, is appropriate
primarily for high-frequency, low- severity risks where potential losses are
relatively small. Except under unusual circumstances, risk retention should not
be used to retain low frequency, high-severity risks, such as the risk of
catastrophic medical expenses, long-term disability, or legal liability.

individual or group disability income plan. However, the adverse financial

consequences of total and permanent disability generally are more severe than
the financial consequences of premature death. Therefore, people who are not
insured against this risk are using the technique of risk retention in a most
dangerous and inappropriate manner.

 Noninsurance Transfers: - Noninsurance transfers are another

technique for handling risk. The risk is transferred to a party other than an
insurance company. A risk can be transferred by several methods, among
which are the following:
 Transfer of risk by contracts
 Hedging price risks
 Incorporation of a business firm
 Transfer of Risk by Contracts: Unwanted risks can be transferred by
contracts. For example, the risk of a defective television or stereo set can be
transferred to the retailer by purchasing a service contract, which makes the
retailer responsible for all repairs after the warranty expires. The risk of a rent
increase can be transferred to the landlord by a long-term lease. The risk of a
price increase in construction costs can be transferred to the builder by having a
fixed price in the contract.
Finally, a risk can be transferred by a hold harmless clause. For example, if a
manufacturer of scaffolds inserts a hold-harmless clause in a contract with a
retailer, the retailer agrees to hold the manufacturer harmless in case a scaffold
collapses and someone is injured.

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  Hedging Price Risks: - Hedging price risks is another example of risk
transfer. Hedging is a technique for transferring the risk of unfavorable price
fluctuations to a speculator by purchasing and selling futures contracts on an
organized exchange, such as the Chicago Board of Trade or New York Stock
Exchange.
 Incorporation of a Business Firm: - Incorporation is another example
of risk transfer. If a firm is a sole proprietorship, the owner’s personal assets
can be attached by creditors for satisfaction of debts. If a firm incorporates,
personal assets cannot be attached by creditors for payment of the firm’s debts.
In essence, by incorporation, the liability of the stockholders is limited, and the
risk of the firm having insufficient assets to pay business debts is shifted to the
creditors.

Insurance: - For most people, insurance is the most practical method for
handling a major risk. Although private insurance has several characteristics,
three major characteristics should be emphasized. First, risk transfer is used
because a pure risk is transferred to the insurer. Second, the pooling technique is
used to spread the losses of the few over the entire group so that average loss is
substituted for actual loss. Finally, the risk may be reduced by application of the
law of large numbers by which an insurer can predict future loss experience with
greater accuracy.

Describe the advantages and disadvantages of using insurance as a loss-financing techniques.

Insurance use as a loss-financial technique provide financial advantage. Business write the
insurance premiums cost as a tax deduction expense. As long as the premiums are fix for the
duration of the policy the budget is not. In addition, when the organization loss frequency is low
and severity probability is high, insurance provide the require funds in case if loss. Which, will be
impossible for some individuals and organization to provide on their own.
For the contrary the loading change (fee to cover the incurred administrative expenses) can be
expensive. Also, the insurance sometime fails to meet demand providing limited protection, this
insurance shortage can lead to ineffective insurance regulations. As well as, for consumer with
minimum loss experience, their premium will be high, because their probability