Risk Management and Insurance

Chapter Two
The Risk Management Process

2.1 Meaning of Risk Management:

Risk management is a process that identifies loss exposures faced by an organization and selects the most
appropriate techniques for treating such exposures. Because the term risk is ambiguous and has different
meanings, risk managers typically use the term loss exposure to identify potential losses. A loss exposure is
any situation or circumstance in which a loss is possible, regardless of whether a loss occurs. 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.
2.2 Objectives of Risk Management:
It can be classified as either pre- loss objectives or post loss objectives.
1. Pre loss Objective:
It is an important objective before a loss occurs and includes economy, reduction of anxiety, and meeting
legal obligations.
a. Economy: this objective means that the firm should prepare for potential losses in the most
economical way. This preparation involves an analysis of the cost of safety programs, insurance
premiums paid, and the costs associated with different techniques for handling losses.
b. Reduction of Anxiety: Certain loss exposures can cause greater worry and fear for the risk manager
and key executives. For example, the threat of a terrible court case from a defective product can cause
greater anxiety than a small loss from a minor fire. Thus risk manager, however, wants to minimize
the anxiety and fear associated with all loss exposures.
c. Meeting legal obligations: The final objective is to meet any legal obligations. For example,
government regulations may require a firm to install safety devices to protect workers from harm, to
dispose of harmful waste material properly and to label consumer products appropriately. The risk
manager must see that these legal obligations are met.

2. Post loss Objective:

Important objectives after a loss occurs include survival, continued operation, stability of earnings,
continued growth, and social responsibility.
a. Survival: The most important post loss objective is survival of the firm. It means that after a loss
occurs, the firm can resume at least partial operations within some reasonable time period.

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b. Continued Operation: The second post loss objective is to continue operating. For some firms, the
ability to operate after a loss is extremely important. For example, a public utility firm must continue
to provide service like banks, post offices, dairies, and other competitive firms must continue to
operate after a loss. Otherwise, the firm/ business will lose its customers to competitors.
c. Stability of Earning: The third post loss objective is stability of earnings. Earnings per share can be
maintained if the firm continues to operate. However, a firm may incur substantial additional expenses
to achieve this goal (such as operating at another location), and perfect stability of earnings may not be
attained.
d. Continued Growth: The fourth post loss objective is continued growth of the firm. A company
can grow by developing new products and markets or by acquiring or merging with other companies.
The risk manager must therefore consider the effect that a loss will have on the firm’s ability to grow.
e. Social Responsibility: Finally, the objective of social responsibility is to minimize the effects that a
loss will have on other persons and on society. A severe loss can adversely affect employees,
suppliers, creditors and the community in general.
2.3 STEPS IN THE RISK MANAGEMENT PROCESS
The risk management process involves four steps:
Step 1: Identifying potential losses (Risk Identification)
Step 2: Evaluate Potential losses (Risk Measurement)
Step 3: Select the appropriate techniques for treating loss exposure, and
Step 4: Implement and administer the program.
Step 1: Risk Identification:
The first step in the risk management process is to identify all major and minor loss exposures. This step
involves a painstaking analysis of all potential losses. Unless the sources of possible losses are recognized,
it is impossible to consciously choose 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.
1. Loss Exposures (Sources of Risks):
Property Loss Exposures:
 Buildings, Plants, Other Structures
 Furniture, Equipment’s, Supplies
 Electronic data processing equipment’s; Computer Software
 Inventory
 Accounts receivables, Valuable papers and records

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 Company planes, boats, mobile equipment’s.

Business Income Loss Exposures:
 Loss of income from a covered loss
 Continuing exposures after a loss
 Extra expenses
 Contingent Business income losses.
Human Resources Exposures
 Death of key employees/disability of key employees
 Retirement or unemployment
 Job-related injuries or disease experienced by workers
Crime Loss Exposures:
 Holdup, robberies
 Employees theft and dishonesty
 Fraud and Embezzlement
 Interest and computer crime exposures.
Employee Benefit Loss Exposures:
 Failure to comply with government regulation
 Failure to pay promised benefits
 Group life and health and retirement plan exposures.
Foreign Loss Exposures:
 Acts of terrorism
 Plants, business property, inventory
 Foreign currency risks
 Kidnapping of key persons
 Political risks
Liability Risks:
 Defective Products
 Sexual harassment of employees, discrimination against employees, wrongful termination
 Misuse of internet and e-mail transactions
Intangible property loss exposure
 Damage to the company’s public image
 Loss of goodwill and market reputation

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 Loss or damage to intellectual property

Failure to comply with government laws and regulations

2. Techniques for Identifying Risks:

A risk manager has several techniques that he or she can use to identify the preceding loss exposures. They
include the following:
Loss Exposure Checklists:
One risk identification tool that can be used both by business and by individuals is a loss exposure checklist,
which specifies numerous potential sources of loss from destruction of assets and from legal liability. For
each item of checklist, the user asks the question, “Is this a potential source of the loss to me or my firm?”
In this way, the systematic use of loss exposure checklists reduces the likelihood of overlooking important
sources of risks.
Some loss exposure checklists are designed for specific industries, such as manufacturers, retail stores,
educational institutions, or religious organizations. Such list tend to the quite lengthy, as they attempt to
cover all the exposures that various entities are likely to face.
A second type of checklists focuses on a specific category of exposure. The questions included in the
checklists usually address specific exposures in considerable detail. Thus, these checklists can be helpful
not only in risk identification but also in compiling information necessary for an in depth evaluation of risks
that are identified.
The Financial Statement Method:
The financial statement method was proposed by A.H. Criddle (1962). Although this approach was
intended for private organizations, the concepts of this financial statements approach can be generalized in
public sector organizations as well. By analyzing the balance sheet, operating statements and supporting
documents, he maintains the risk manager can identify property, liability and human exposures (losses) of
the organizations.
By coupling these statements with financial forecast and budgets, the risk manager can discover future
exposures. Financial statements reveal this information because every organizational transaction ultimately
involves either money or property.
The Flow Chart Method:
An organization’s exposure to risk also can be identified by studying flow chart of organization’s activities
and operations. These flow charts are studies alongside the checklists of possible exposures to determine
which items apply.

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Contract Analysis:
Many of an organization’s to risk arise from contractual relationships with other persons and organizations.
An examination of these contracts may reveal are of exposures that are not evident from the organization’s
operations and activities. In some cases, contracts may shift responsibility to other parties.
Interactions with other Departments:
Frequent interactions with other departments provide another source of information on exposures of risk.
These interactions may include oral or written reports from other departments on their own initiative or in
response to regular reporting system that keep the risk manager informed of developments. The importance
of such a communications network should not be underestimated. These departments are consistently
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 on the co-operation of other
departments.
Interactions with Outside Suppliers and Professional Organizations:
In addition to communicating with other departments, the risk manager normally interacts with outsiders
who provide services to the organizations. These outsiders, for example, accountants, lawyers, risk
management consultants, actuarie, or loss control specialists. The objective would be to determine whether
the outsiders have identified exposures that otherwise would be missed. Possibly, the outsiders themselves
may create new exposures.
Statistical Records of Losses:
Where it is available, statistical records of losses can be used to identify sources of risk. These records may
be available from risk management information systems developed by consultants or in some cases, the risk
manager. These systems allow losses to be analyzed according to cause, location, amount and other issues
to interest.
Statistical records allow the risk manager to assess trends in the organization’s loss experience and to
compare the organization’s loss experience with the experience of others. In addition, these records enable
the risk manager to analyze issues such as the cause, time and location of the accidents, identification of the
insured individual and the supervisions, and any hazards or other special factors affecting the nature of the
accident.
Step 2:Risk Measurement (Risk Evaluation)
The second step in the risk management process is to evaluate and measure the impact of losses on the firm.
This step involves on estimation of the potential frequency and severity of loss.

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i. Loss frequency refers to the probable number of losses that may occur during the some given
period of time and
ii. Loss severity refers to the probable size 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. For example, a loss exposure
with the potential for bankrupting the firm is much more important in a risk management program than an
exposure with a small loss potential.
In addition, the relative frequency and severity of each loss exposure must be estimated so that the risk
manager can select the most appropriate technique or combination of techniques for handling each
exposure. For example, if certain losses occur regularly and are fairly predictable, they can be budgeted out
of a firm income and treated as normal operating expenses. If certain type of exposure fluctuates widely,
however, an entirely different approach is required.
Although the risk manager must consider both loss frequency and loss severity, severity is more important,
because a singly catastrophic loss could wipe out the firm. Therefore, the risk manager must also consider
all losses that can result from a singly events. Both the maximum possible loss and maximum probable loss
must be estimated.
The maximum possible loss is the worst loss that could possibly happen to the firm during its lifetime and
the maximum probable loss is the worst loss that is likely to happen to the firm during its lifetime.
The actual estimation of the frequency and severity of loses may be done in various ways. Some risk
manager considers these concepts informally in evaluation of identified risks. They may broadly classify
the frequency of various losses into categories such as “Slight”, “moderate”, and “certain” and many have
similarly broad estimates for loss severity. Even this type of informal evaluation is better than none at all.
But as risk management becomes increasingly sophisticated, most large firms, attempts to be more precise
in evaluation of risk. It is now common to use probability distributions and statistical techniques in
estimating both loss frequency and severity.
Step 3:Tools of Risk Management.
After identifying and evaluating exposures to risk, systematic consideration can be given to alternative
methods for managing each exposure. The appropriate techniques can be broadly classified as either risk
control or risk finance.
1. Risk control
Risk control refers to techniques that reduce the frequency or severity of losses. Major risk control
techniques include the following:

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 Risk Avoidance
 Loss prevention
 Loss reduction
A. Risk Avoidance:
Avoidance means 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.
Example: A pharmaceutical firm that markets a drug with dangerous side effects can withdraw the drug
from the market.
The major advantage of risk avoidance is that the chance of loss is reduce to zero if the loss exposure is
never acquired. In addition, if an existing loss exposure is abandoned, the chance of loss is reduced or
eliminated because the activity or product that could produce a loss has been abandoned.
Avoidance, however has two major disadvantages first, the firm may not be able to avoid all losses.
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. A paint factory can avoid losses arising from the production
of paint. Without paint production, however, the firm will not be in business.
B. 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 defective products include installation of
safety features on hazardous products, placement of warning labels on dangerous products, and institution of
quality control checks.
C. 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.
2. Risk Financing
Risk financing refers to techniques that provide for the payment of losses after they occur. Major risk-
financing techniques include the following:
 Retention

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 Noninsurance transfers
 Commercial insurance
A. Risk Retention
Retention means that the firm retains part or all of the losses that can result from a given loss. Retention can
be Actives (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.
For example, a risk manager may fail to identify all company assets that could be damaged in an earthquake.
Retention can be effectively used in a risk management program under the following conditions:
 No other method of treatment is available
 The worst possible loss is not serious
 Losses are highly predictable.
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. Funded reserves are net widely used by
private employers, because the funds may yield a much higher rate of return by being used in the business.
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. Interest must be paid on the loan, however, and loan repayments can aggravate
any cash flow problems a firm may have.
Advantages of Retention:

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1. Save Money: The firm can save money in the long run if its actual loses are less than the loss
component in the insurance’s premium.
2. Lower Expenses: The services provided by the insurer may be provided by the firm at a lower cost.
Some expenses may be reduced, including loss adjustment expenses, general administrative
expenses, commissions and brokerage fees, loss control expenses, taxes and fees and the insurer’s
profit.
3. Encourage Loss Prevention: Because the exposure is retained, there may be a greater incentive for
loss prevention.
4. Increase Cash Flow: Cash flow may be increased because the firm can use the funds that normally
would be paid to the insurer at the beginning of the policy period.
Disadvantages of Retention:
1. Possible higher losses: The losses retained by the firm may be greater than the loss allowance in the
insurance premium that is saved by net purchasing the insurance.
2. Possible higher expenses: Expenses may actually be higher outside experts such as safety engineers
may have to be hired. Insurers may be able to provide loss control and claim services less
expensively.
3. Possible higher taxes: Income taxes may also be higher. The premium paid to an insurer are
immediately income-tax deductible. However, if retention is used, only the amounts paid out for
losses are deductible, and the deduction cannot be taken until the losses are actually paid.
Contribution to a funded reserve is not income-tax deductible. Income taxes may also be higher.
B. Noninsurance Transfer
Noninsurance transfers are methods other than insurance by which a pure risk and its potential financial
consequences are transferred to another party. Example of non-insurance transfers includes contracts, leases,
and hold-harmless agreements. For example, a company’s contract with a construction firm to build a new
plant can specify that the construction firm is responsible for any damage to the plant while it is being built.
Hold-Harmless Agreements:
Provisions inserted into many different kinds of contracts can transfer responsibility for some types of losses
to a party different than the one that would otherwise bear it. Such provisions are called hold-harmless
agreements or sometimes indemnity agreements. The following are three different forms of hold-harmless
agreements.
(a) Limited Form: The limited form merely clarifies that all parties are responsibilities for liabilities
arising from their own activities/actions

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(b) Intermediate Form: A second type of hold-harmless agreement is the intermediate form, in which the
transferee agrees to pay for any losses in which both the transferee and transferor are jointly liable.
(c) Broad Form: The broad form is the third type of hold-harmless agreements. It requires the transferee
to be responsible for all losses arising out of particular situations regardless of fault.
Incorporation: Another way for a business to transfer risk is to incorporate. In this way, the most that an
incorporated firm can ever lose is the total amount of its assets. Personal assets of the owners cannot be
attached to help pay for business losses, as can be the case with sole proprietorships and partnerships.
Through this act of incorporation, a firm transfers to its creditors the risk that it might net has sufficient
assets to pay for losses and other debts.
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.
Advantages of non-insurance transfers:
o The risk manager can transfer some potential losses that are not commercially insurable
o Noninsurance transfers often cost less than insurance
o The potential loss may be shifted to someone who is in a better position to exercise loss control.
Disadvantages of non-insurance transfers:
o The transfer of potential loss may fail because the contract language is ambiguous. Also, there may
be no court precedents for the interpretation of a contract tailor-made to fit the situation.
o If the party to whom the potential loss is transferred is unable to pay the loss, the firm is still
responsible for the claim.
o An insurer may not give credit for the transfer, and insurance costs may not always be reduced.
C. Commercial Insurance
The most widely used form of risk transfer is insurance. Insurance is appropriate for loss exposures that
have a low probability of loss but the severity of loss is high.
Five key areas to be emphasized in using insurance:
Selection of insurance coverage
Selection of an insurer
Negotiation of terms
Dissemination of information concerning insurance coverages
Periodic review of the program

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Risk Management Matrix

Types of Loss Frequency Loss Appropriate Risk management
loss Severity technique
1 Low Low Retention
2 High Low Loss Prevention and Retention
3 Low High Insurance
4 High High Avoidance

Step 4: Implement And Monitor The Risk Management Program.

This step begins with a policy statement.
1. Risk management policy statement
This statement outlines the risk management objectives of the firm, as well as company policy with respect
to treatment of loss exposure. It also educates top-level executives in regard to the 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.
2. Cooperation with other department
The risk manager does not work alone. Other functional departments within the firm are extremely
important in identifying pure loss exposure and methods for treating these exposures.
3. Periodic review and evaluation
To be effective, the risk management program must be periodically reviewed and evaluated to determine
whether the objectives are being attained. In particular, risk management costs, safety programs, and loss-
prevention program must be carefully monitored. Loss records must also be examined to detect any changes
in frequency and severity. Finally, the risk manager must determine whether the firm’s overall risk
management policies are being carried out, and whether the risk manager is receiving cooperation from
other departments.
2.4 Benefits of Risk Management
 A formal risk management program enables a firm to attain its pre-loss objectives more easily.
 The cost of risk is reduced, which may increase the company’s profits. The cost of risk is a risk
management tool that measures certain costs including premium paid, losses, loss control
expenditures, outside risk management services, financial guarantees, internal administrative costs,
and taxes, fees, and certain other expenses.
 Because the adverse financial impact of pure loss exposures is reduced, a firm may be able to enact
an enterprise risk management program that treats both pure and speculative loss exposures.
 Society also benefits since both direct and indirect (consequential) losses are reduced. As a result,
pain and suffering are reduced.

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