CHAPTER TWO

THE RISK MANAGEMENT PROCESS

MEANING OF RISK MANAGEMENT
 Risk management is a systematic process that identifies
loss exposures faced by an organization and selects the
most appropriate techniques for treating such exposures.
 It is a scientific approach to deal with risks by anticipating
possible accidental losses and designing and implementing
procedures that minimize the occurrence of loss or the
financial impact of the losses that occur.
 In the past, risk managers generally considered only pure
loss exposures faced by the firm.
 However, newer forms of risk management are emerging
that consider certain speculative risks as well.
OBJECTIVES OF RISK MANAGEMENT
 Itdeals with deciding precisely what the
organization expects its risk management program
to do.
 Objectives serve as a prime source of guidance for
those charged with responsibility for the program,
and also means of evaluating performance.
 Risk management objectives can be classified as
either
(1) Pre loss Objectives
(2) Post loss Objectives
PRE LOSS OBJECTIVES
 A firm may have several risk management
objectives prior to the occurrence of the loss.
 These important objectives before a loss occurs
include;
 Economy,
 Reduction of anxiety, and
 Meeting legal obligations.
POST LOSS OBJECTIVES
 Important objectives after a loss occurs include;
 Survival,
 Continued operation,
 Stability of earnings,
 Continued growth, and
 Social responsibility.
STEPS IN THE RISK MANAGEMENT PROCESS

 The whole process of RM involves the following

four steps:
 Identifying potential losses (Risk Identification)
 Evaluate Potential losses (Risk Measurement)
 Select the appropriate techniques for treating loss
exposure, and
 Implement and administer the program.
RISK IDENTIFICATION
 Its the first step in the risk management process.
 Its to identify all major and minor loss exposures.

 It involves a thorough analysis of all potential losses.

 It is a phase where a firm systematically and
continually identifies property, liability, and personal
exposures as soon as or before they emerge.
 Unless the sources of possible losses are recognized,
its impossible to select appropriate, efficient methods
for dealing with those losses should they occur.
 A loss exposure is a potential loss that may be
associated with a specific type of risk.
 LOSS EXPOSURES/SOURCES OF RISKS
 Are classified as follows:
1. Property Loss Exposures
 Buildings, Plants, Furniture, Equip’s, Supplies, Electronic
data processing equip’s; Computer Software, Inventory,
A/R, boats, mobile equip’s.
2. Business Income Loss Exposures
 Loss of income from a covered loss , Continuing
exposures after a loss, Extra expenses, Contingent business
income losses.
3. Human Resources Exposures
 Death of key employees/disability of key employees,
Retirement or unemployment, Job-related injuries or
disease experienced by workers
4. CRIME LOSS EXPOSURES
Robberies, Employees theft and dishonesty, Fraud and
Embezzlement, Interest and computer crime exposures.
5. Employee Benefit Loss Exposures
Failure to comply with government regulation , Failure to
pay promised benefits, Group life and health and retirement
plan exposures.
6. Foreign Loss Exposures
Acts of terrorism, Foreign currency risks, Kidnapping of key
persons, Political risks
7. Liability Risks
Defective Products, Sexual harassment of employees,
discrimination against employees, wrongful termination,
Misuse of internet and e-mail transactions
 THE RISK IDENTIFICATION METHODS

 Loss exposure checklists;

 The financial statement method;
 The flow chart method;
 Contract analysis;
 Interactions with other departments;
 Interactions-with-outside-suppliers-and
professional organizations;
 Statistical Records of Losses and
 On Site Inspection
RISK MEASUREMENT (RISK EVALUATION)
 The risk management process is to evaluate and measure
the impact of potential losses on the firm.
 The exposures are to be measured in order to determine
their relative importance and to obtain information for the
risk manager to decide up on the most desirable
combination of risk management tools.
 It involves in estimation of the potential frequency and
severity of loss.
 Loss frequency refers to the probable number of losses
that may occur during the same given period of time.
CONT’D
 Loss severity refers to the probable magnitude/scale of
the losses that may occur.
 Once the risk manager estimates the frequency and
severity of loss for each type of loss exposure, the
various loss exposures can be ranked according to their
relative importance.
 In addition, the relative frequency and severity of each
loss exposure must be estimated in order the risk
manager to select the most appropriate technique or
combination of techniques for handling each exposure.
SELECT THE APPROPRIATE TECHNIQUES FOR TREATING
LOSS EXPOSURE

 Afteridentifying and evaluating exposures to risk,

systematic consideration can be given to
alternative methods for managing each
exposure.
 The third step in the risk management process is to
select the most appropriate technique/tool or
combination of techniques/tools for treating each
loss exposure.
RISK MEASUREMENT AND PROBABILITY DISTRIBUTION
MEANING OF PROBABILITY
 Probability theory is the body of knowledge concerned
with measuring the likelihood that something will happen
and making predictions on the basis of this likelihood.
 The likelihood of an event is assigned a numerical value
between 0 and 1.
 Zero is assigned for impossible and one for definitely
possible events.
 In general 0 ≤ P(A) ≤1; where P designates the probability
of an event and P(A) for probability of an event A to occur
in a single observation.
DETERMINING THE PROBABILITY OF AN EVENT
 There are two common methods to obtain an estimate of the
probability of an event.
 Prior probabilities: these probabilities are determined before an
experiment.
 A number of equally likely outcomes must exist, some of which
represent the particular outcome whose probability is being
determined.
 For example the probability of obtaining a head when a coin is
tossed is ½ because there are two equally likely outcomes; a tail or a
head, and one of these outcomes is a head.
 The probability of drawing the king from a full playing card is 4/52
or 1/13 as there are 52 cards and of which 4 are kings.
 But the probability of drawing a king of hearts is 1/52.
CONT’D
 Empirical probabilities: these probabilities are computed after a
study of past experience.
 When we do not know the underlying probability of an event and
cannot deduce it from the nature of the event, we can estimate it on
the basis of past experience.
 For example, Assume that we are told that the probability of a
student will fail in English course is 0.01.
 This indicates that someone has gone through the records and
discovered that in the past 1 man of every 100 men failed the English
course.
 In situations where it is not possible to use either prior or empirical
methods, subjective probability estimates may be used.
LAW OF LARGE NUMBERS
 The law of large numbers is a basic principle of
mathematics which states that as the number of the
exposure units increases, the more certain it becomes that
actual loss experience will equal probable loss experience.
 It states that the greater the numbers of exposures, the more
closely will the actual results approach the probable results
that are expected from an infinite number of exposures.
CONT’D
 By applying the law of large numbers, the insurance
company can predict accurately the birr amount of
losses it will experience in a given period.
 The relative accuracy of the company’s prediction
increases as the number of exposures in the insurance
policy increases.
 If the loss amounts are predicted in advance, the company
could take its own arrangements for safe operation.
TOOLS OF RISK MANAGEMENT
 The major techniques for handling risks are categories in to
two;
 Risk control techniques
Risk Avoidance

Loss Control

Diversification(Separation)

Combination

 Risk financing techniques

Risk- Retention

Self- insurance

Non insurance risk Transfer

Insurance
RISK CONTROL TECHNIQUES
 RISK AVOIDANCE
 One way to control a particular risk is to avoid the
property, person or activity giving rise to possible by either
refusing to assume it even temporarily (called proactive
avoidance) or by abandoning an exposure to a loss
assumed earlier (abandonment).
 Avoidance stands to mean that a certain loss exposure is
never acquired, or an existing loss exposure is abandoned.
 Risk avoidance is conscious decision not to expose oneself
or one’s firm to a particular risk of loss.
 In this way, risk avoidance can be said to decrease one’s
chance of loss to zero.
LOSS CONTROL
 When particular losses/ risks cannot be avoided,
actions may be taken to reduce the losses associated
with them.
 This method of dealing with risk is known as “Loss
Control”.
 Loss control activities are designed to reduce both the
frequency and severity of losses.
 Loss control measures do counteract risks by
lowering the chance the loss will occur or by
reducing its severity if the loss is to occur.
CONT’D
 Loss control can be classified based on two factors called
focus and timing.
 Based on Focus, Loss Control can be classified as

Loss Prevention

Loss Reduction

 Based on Timing, Loss Control can be classified as

Pre-Loss Activities

Concurrent Activities

Post – Loss Activities.

BENEFITS OF LOSS CONTROL
 These may include the reduction or elimination of
expense associated with the following:
 Repair or replacement of damaged property;
 Income losses due to destruction of property;
 Extra costs to maintain operations following a loss;
 Adverse liability of judgments;
 Medical costs to threat injuries and
 Income losses due to deaths or disabilities.
SEPARATION AND DUPLICATION
 Separation involves the reduction of maximum probable
loss associated with some kinds of risks.
 This method deals with 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.
 Example, a firm may disperse its inventory in to different
warehouses than keeping it in one store.
 If fire destroys one of the warehouses, the firm will save
some of its inventories placed in the other warehouses.
 The likely severity of overall firm losses by reducing the
size of the exposure in any one location.
CONT’D
 Duplication is a very similar technique, in which spare
parts or supplies are maintained to replace immediately
damaged equipment and or inventories.
 This type of loss control also helps to reduce the
severity of losses that would occur.
COMBINATION
 This method makes loss experiences 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.
RISK FINANCING TECHNIQUES
RISK RETENTION
 It means that the firm’s retains part or all of the
losses that can result from a given loss.
 Retention can be Active (Planned) or Passive
(Unplanned).
 Active risk retention means that the firm is aware
of the loss exposure and plans to retain part or all of
it, such as automobile crash losses to a fleet of
company cars.
 Passive risk retention, however, is the failure to
identify a loss exposure, failure to act or forgetting
to act.
FUNDING LOSSES
 If retention is used, the risk manager must have some
method for paying losses. The following methods are
typically used:
1. Current Net Income
 The firm can pay losses out of its current net income and
treat losses as exposure for that year.
 A large number of losses could exceed current income,
however, and other assets may then have to be liquidated to
pay losses.
2. Unfunded Reserve
 An unfunded reserve is a bookkeeping account that is
charged with actual or expected losses from a given
exposure.
3. FUNDED RESERVE

 A funded reserve is the setting aside of liquid funds to pay

losses.
 Also, contributions to funded reserves are net income tax
deductible losses, however, are tax deductible when paid.
4. Credit Line
 A credit line can be established with a bank, and borrowed
funds may be used to pay losses as they occur.
NON INSURANCE RISK TRANSFER
 Risk transfer involves in payments by one party (the
transferor) to another (the transferee or risk bearer) when
the transferee agrees to assume a risk that the transferor
desires to escape.
 Non insurance transfers are methods other than insurance
by which a pure risk and its potential financial
consequences are transferred to another party.
 The most common forms of non- insurance risk transfers
are hedging, hold-harmless agreements and
incorporation.
HEDGING
 Hedging involves the transfer of speculative risk.
 It is a business transaction in which the risk of
price fluctuations is transferred to a third party
known as a speculator.
 This is the process of balancing a chance of loss
against the chance of gain.
INSURANCE
 The most widely used form of risk transfer is
insurance.
 Insurance represents a contractual transfer of risk.
 Insurance is appropriate for loss exposures that have
a low probability of loss but the severity of loss is
high.
 If insurance is used to treat certain loss exposures,
five key areas must be emphasized.
 They are;
1. SELECTION OF INSURANCE COVERAGE
 The need for insurance can be divided in to several
categories depending on importance.
 Approach used to classify the need for insurance in
to three categories: essential, desirable, and
available.
 Essential insurance includes those coverages
required by law or by contract, such as the works
compensation insurance.
 It includes coverages that will protect the firm
against a catastrophic loss or a loss that threatens the
firm’s survival; commercial general liability
insurance would fall in to that category.
CONT’D
 Desirable insurance is protection against losses that may
cause the firm financial difficulty, but not bankruptcy.
 It includes those that protect against loss exposures that
would force the firm to borrow or restore to credit.
 Available insurance is coverage for slight losses that
would merely inconvenience the firm.
 Optional insurance coverage includes those that protect
against losses that could be met out of existing assets or
current income.
2. SELECTION OF AN INSURER
 In selecting the insurer a risk manager should pay due attention to
several factors such as the financial strength of the firm, service
provided by the insurer, and cost and terms of protection.
3. Negotiation of terms
 The risk manager and the insurer must agree on the documents and
the terms should be clear to both parties.
4. Dissemination of information concerning insurance coverage
 The firm’s managers and employees must be informed about the
insurance coverage, the various records to be kept, the services of
the insurer etc.
5. Periodic review of insurance program
 The entire process of obtaining insurance must be evaluated
periodically. This involves an analysis of agent and broker
relationship, coverage needed, cost of insurance, pace of claim
payment and etc.
RISK MANAGEMENT MATRIX

 Which method should be used for a particular exposure

depends on the frequency and severity of the loss.
 The following matrix may help in determining which risk
management tool is to be used, considering the nature of
the loss: