CHAPTER THREE

RISK CONTROL TOOLS AND SELECTING OF RISK MANAGEMENT TOOLS

Once the risk manager has identified and measured the risks facing the firm, he must decide how
to handle them.
Risk can be controlled (handled) through the following tools:
Avoidance
Loss Retention (Assumption)
3. Reduction/Prevention
4. Separation/Diversification
5. Combination /Pooling
6. Neutralization
Transfer
3.1. 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 arrive 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:
Avoidance may be impossible. For example, the only way to avoid all liability exposures is to
cease to exist.

The potential benefits to be gained from employing certain persons, owning a piece of property,
or engaging in some activity may of 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.
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.
3.2. LOSS- RETENTION
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 re-tension. 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.
Prerequisites of Planned Retention
Planned retention should be considered only when at least one of the following conditions
exists:-
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.
The maximum possible loss is so small that the firm can safely absorb it as a current operating or
out of small reserve funds.
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.

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:-
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.
Training or 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:
Keeping accurate records of all accidents by number, type, cause and total damage incurred.
Maintaining plan safety-inspection programs.
Devising ways and means to prevent recurrence of accidents.
Keeping top management accident conscious.
Seeing that proper credits are obtained in the insurance premium for loss-prevention measures.
Minimizing losses by proper salvage techniques and other action at the time of a loss. 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 an 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 non to engage in that activity. The firm, however, must be certain to consider all the gains
and all the costs.
Separation/Diversification
Another risk control tool is separation of the firms' 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 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.

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.

Neutralization
Neutralization, which is closely related to transfer, 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 non-chance of gain associated with pure risks, neutralization is not a tool
of pure-risk management.

Hedging is 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.

Transfer
Risk may be transferred from one individual to another who is more willing to bear the risk.
Transfer of risk may be accomplished in three ways.

First, the property or activity responsible for the risk may be transferred to some other person or
group of persons. For example, a firm that sells one of its buildings transfers the risks associated
with ownership of the building to the new owner. A contractor who is concerned about possible
increases in the cost of labor and materials needed for the electrical work on a job to which he is
already committed can transfer the risk by hiring a subcontractor for this portion of the project.
This type of transfer, which is closely related to avoidance through abandonment, eliminates
potential loss that may strike the firm. It differs from avoidance through abandonment in that to
transfer a risk the firm must pass it to someone else.
Second, the risk, but not the property or activity may be transferred. For example, under a lease,
the tenant may be able to shift to the landlord any responsibility the tenant may have for damage
to the landlord's premises caused by the tenant's negligence.

A person who leases or rents property rather than owns it shifts to the lessor the ownership risk.
The cost of shifting the risk is contained in the rental payments, which must be high enough to
compensate the lessor for the risks as well as the costs of owning the property.

Third, insurance is also a means of shifting or transferring risk. In consideration of a specific

payment (premium) by one party, the second party contracts to indemnify the first party up to a
certain limit for the specified loss, which may or may not occur. Hence, transfers of risk may be
grouped under two classifications: those involving transfer to an insurance company, and those
involving transfer to parties other than insurance company.

It is easy to confuse the transfer method of handling risk with the combination method. The
essential difference between the two lies in the fact that in the transfer method, the risk is not
necessarily reduced or eliminated; where as in the combination method, the risk is actually
greatly reduced or perhaps completely. For Example, A furniture retailer may not wish to stock
large quantities of furniture for fear that prices may fall before the stock can be sold, or that the
stock will be unsalable due to style changes. The retailer therefore buys only limited quantities of
goods at a time, thus forcing, a wholesaler to carry sufficient inventories to meet demand. The
wholesaler in this case is the bearer of risk of loss due to price changes.

II Selecting of Risk Management Tools

3.8. Conventional Approach (Insurance method)

This approach, insurance coverage serves as a focal point of the analysis. This approach is based
on the assumption that the firm will prefer to buy insurance whenever this mechanism is
available. The "insurance–method" is a two–step procedure:
Preparation of initial listing, and
Preparation of revised listing
I. Preparation of initial listing
The risk manager must determine first what combination of insurance coverage would provide
the best protection against the losses to which the business is exposed, on the assumption that the
business would prefer to buy insurance whenever it is available.

To make this determination the risk manager must understand insurance contracts (policies) and
insurance pricing, i.e., the risk manager must identify the insurance policies, that would best
cover the loss exposures of the firm. The objective is to provide the most complete protection at
minimum cost. Because some of the risks faced by the firm may not be insurable. Also the risk
management must select policy limits that provide as complete protections as possible.

After the risk manager has determined the best combination of coverage and policy limits, he/she
divides (classifies) the insurance contracts (policies) in this combination into three groups:
1. Essential coverage or Essential policies
2. Desirable coverage or Desirable policies, and
3. Available coverage or Available policies.

Essential contracts (Polices)

Essential insurance contracts (policies) include those that are compulsory because they are
required by law or by contract. For Example, automobile liability insurance in some cases is
required by low, a group life insurance contract required under a union contract.

Coverage against high – severity losses that could result in a financial catastrophe for the firm,
For Example, liability losses are often included under these contracts

Desirable Contracts (policies)

Desirable policies provide protection against losses that could seriously impair the operations of
the firm but probably would not put it out of business, For Example, automobile physical
damage.

Available Contracts
Available policies include all the types of protection that have not been included in the first two
classes. These contracts protect against types of losses that would inconvenience the firm but
would not seriously impair its operations unless several of them occurred within one year. It is
also called plate – glass policy. For Example, insurance against breakage of glass due to riots,
fighting, etc. Hence, When a risk manager is to decide upon the insurance policies, he should
give priority to the compulsory ones and then to the other polices according to their importance.

II Preparation of Revised Listing

After the initial listing has been completed, the risk manager then reviews the contracts in each
group to determine which of these losses might be more satisfactorily handled in other ways.

For example, contracts that might be dropped form the essential – category would include
contracts covering:
Losses that can be transferred to someone other than an insurer at a smaller cost than the
insurance premium.
Some contracts included in the essential class but can be transferred to another body at a smaller
cost than the insurance premium be dropped by the risk manager from insuring in the insurer.
Losses that can be prevented or reduced to such an extent that they are no longer severe.
Losses that happen so frequently that they are fairly predictable, thus
making self – insurance on attractive alternative because of expense savings. Few, if any,
contracts (policies) will be dropped from the essential – category. Contracts covering potential
catastrophic losses will be purchased unless they satisfy one of the three conditions

Conditions stated above or if the premium for the insurance seems unreasonably high relative to
the frequency and severity of the exposure.
Quantitative Approaches
The application of the quantitative approach is limited because.

Application of these modern techniques to insurance and particularly to risk management

problems is of still more recent in origin.
Their data requirement is difficult to meet.
Most risk managers are not well trained in the quantitative
application.

But these techniques are likely to be more widely applied in the future and it is important to
consider these quantitative methods in selecting the "proper" tools of risk management.
Therefore this section discusses some quantitative approaches that may be used in selecting risk
management tools.