CHAPTER -6

Risk Management and Insurance of Business Enterprises

OUTLINES
 5.1 Strategic planning
 5.2 Definition of Risk,
 5.3 Classifying risks,
 5.4 The process of Risk Management
 5.5 Insurance of the Small Business

By: Asnakew S. Dec. 2013 E.C

 Strategic planning
Planning is the process of setting objectives for the future
and developing courses of action to accomplish them.
Its purpose is to facilitate programs and improve
performance. It allows integrated, consistent, and
purposeful action.
Planning must be based on prudent /careful, discreet,
practical/ forecasts and reasonable premise.
It is the process by which managers set objectives, assess
the future and develop courses of action to accomplish
these objectives.

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The concept of business risk
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
for himself. i.e., not by choice, but by absolute necessity.

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The term risk used in different ways. The following definitions
given by different scholars and practitioners in the field:
 Risk is the channel of loss
 Risk is the possibility of loss

 Risk is uncertainty

 Risk is the dispersion of actual from expected result

 Risk is the probability of any outcome different from

the one expected.

Generally, risk is an uncertain event or condition that, if it
occurs, has a positive or a negative effect on a business
objective.
Qn. In what condition do you think risk has positive effect?
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 Definition of Risk

Is a condition in which there is a possibility of an adverse

deviation from desired out come that is expected or
hoped .
Applied to a business, risk is the possibility of losses
associated with the assets & earnings potential of the firm.
 CLASSIFYING RISK

Generally, Business risks can be classified into two broad categories:

1.Market risk:- is the uncertainty associated with an investment
decision. An entrepreneur who invests in a new business hopes for a
gain but realizes that the eventual outcome may be a loss.
2.Pure risk:- is used to describe a situation where only loss or no loss
can occur-there is no potential gain.
A pure risk exists when there is a chance of loss but no chance of
gain/profit. Example: Owner of an automobile faces the risk of a
collusion loss. If collusion occurs, he will suffer a financial loss. If
there is no collusion, the owner will not gain loss.

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Owning property, for instance, creates the possibility of
loss due to fire or severe weather, the only out comes are
loss or no loss.
As a general rule, only pure risk is insurable, i.e.,
insurance is not intended to protect investors from a
market risk where the chance of both gain & loss exists
 CLASSIFYING RISK BY TYPE OF ASSET
Risk may be grouped according to the type of asset-Physical or
human-needing protection.
1.Property risks
Property-oriented risks involve tangible and highly visible assets.
 Many property-oriented risks are insurable (The loss must not be
catastrophic)
Risks may include:
 Fire , Natural disasters, robbery,

2.Personnel risks
Personnel-oriented losses occur through the actions of employees.
The three primary types of Personnel-oriented risks are:
 Employee dishonesty, Competition from former employees,

Loss of key executives

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3. Customer risks
 Customers are the source of profit for small business, but they are also
the source of an ever-increasing amount of business risk. Much of these
risks are: On-premises injuries and Product liability
On-premises injuries:
 Customers may initiate legal claims as a result of on-premises

injuries.
e.g. When a customer breaks an arm by slipping on icy steps while
entering or leaving a store;
 Inadequate security, which may result in robbery, physical attack,

or other violent crimes; Customers who are victims often look to

the business to recover their losses.
Product liability:
 A product liability suit may be filed when a customer becomes ill

or sustains physical or property damage from using a product made

or sold by a firm.
How we are going to manage risks?
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 RISK MANAGEMENT

The complexity of the business environment calls for or

demand for a special attention to a risk:
Some of the factors, which increase the complexity of
environment are:
 Inflation
 Growth of internal operation
 More complex technology
 Increasing government regulation

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What is risk management?
 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.
OR
 Risk management is the identification, measurement and treatment
of liability, property and personal pure risks that the business
organization is facing in order to reduce and prevent the
unfavorable effects of risk at minimum cost.
OR
 It is the science that deals with the techniques of forecasting future
losses so as to plan, organize, direct and control the adverse effect
of risk. i.e., Risk management is defined on the base of managerial
functions. 14
Risk management and Insurance management
What is the difference in b/n?
Risk management is broader than insurance management.
 Risk management deals with both insurable and
uninsurable risks.
 Insurance management for most part it is restricted to
the area of those risks that are considered to be insurable.
Naturally only pure risks are insurable. Speculative or
market risks are not. Even all pure risks are not insurable
The emphasis in the risk management concept is on
reducing the cost of safeguarding against risk by whatever
means.
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 The process (Steps) of Business risk management
In general, the basic functions of the risk management in carrying out
of the responsibilities assigned are:
1. To recognize exposure to loss
 Is also called as risk identification

 Is the 1st step of risk managers’ function.

 Is the most vital task

What types of possible losses are there?

Failure to identify exposure to loss ==> the risk
manager will not have any chance of handling the loss
that identify the risk.
Some techniques for identifying risk are:
 Brainstorming
 Event inventories and loss event data
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 Interviews and self-assessment  Facilitated workshops
 SWOT analysis  Risk questionnaires and risk surveys
 Scenario analysis  Using technology
 Other techniques
2.To estimate the frequency and size of loss, i.e., to estimate
the probability of loss from various sources. It is also
called as risk measurement.
Risk measurement means
i. Determination of the chance of an occurrence or relative
frequency.
ii. Determination of the impact of losses upon financial affairs.
iii.The ability to predict the losses that will actually occur during
the budget year.
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3.To decide the best and most economical method of handling the
risk if loss. (risk response development)
i.e. Selection of the proper tool for handling risk
• Identifies and evaluates possible responses to risk.
• Evaluates options in relation to entity‘s risk appetite, cost vs. benefit
of potential risk responses, and degree to which a response will
reduce impact.
• Selects and executes response based on evaluation of the portfolio of
risks and responses
4. Implementing the decision (risk response control)
Implementation follows all of the planned methods for mitigating the
effect of the risks.
Purchase insurance policies, avoid all risks that can be avoided without
sacrificing the entity's goals, reduce others, and retain the rest.
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5. Revaluating the decision
Initial risk management plans will never be perfect. Practice,
experience, and actual loss results will necessitate changes
in the plan and contribute information to allow possible
different decisions to be made in dealing with the risks
being faced.
Once the risk manager has identified and measured the risks
facing the firm, the next task is to seek for appropriate
tools and decide how best to handle them. Risk can be
handled through the following tools:

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Tools of Risk Management
1. Avoidance
One way to handle a particular pure risk is to avoid the
property, person or activity with which the risk is associated.
Two approaches of risk avoidance:
i. Refusing to assume an activity
e.g. For instance, a firm can avoid a flood loss by not
building a plant in a place where flood is frequently
affecting. In case of refusing, we are discontinuing the
activity
ii. Abandonment of previously assumed activities:
e.g. A firm that produces a highly toxic product may stop
manufacturing that product.
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2. Retention/Acceptance
It is he most common method of handling risk by the individual or
the firm itself.
Bearing all the risk by that person/organization.
Types of retention
i. Planned/conscious/ active risk retention
It is characterized by the recognition that the risk exists, and at
w/c losses involved.
The decision to retain a risk actively is made because there are
no alternatives more attractive.
Self-insurance is a special case of active retention. Self-insurance
is not insurance, because there is no transfer of the risk to an
outsider.
 E.g. A firm may keep some money to retain the risk.
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ii. Unplanned/Unconscious/ Passive Retention

Passive risk retention takes place when the individual

exposed to the risk does not recognize its existence.

In this case, the person so exposed retains the financial

consequence of the possible loss without realizing that he
does so.

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3. Loss Prevention and Reduction Measures
Prevention is defined as a measure taken before the bad luck
occurs.
 Generally speaking, loss prevention programs intend to

reduce the chance of occurrence.

Example:
 Constricting a building with a fire resistance material /

fireproofing.
 Constructing a building in a place where there is little danger.

 Regularly inspecting the machine / area

 The existence of automatic loss detection programs.

 Fire alarms
 Warning posters /NO SMOKING!! , DANGER ZONE!!/
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Loss reduction measures try to minimize the severity of
the loss once the peril happened/ after the event occurs.
For Example:
Automatic sprinkler
An immediate first aid
Medical care and rehabilitation service
Guards
Cover
Fire extinguisher
Fire alarms

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4. Separation /Diversification
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.
Separation==>Dispersion/Scattering the exposure in
different places.
“Don’t put all your eggs in one basket”
Example: Instead of placing its entire inventory in one
warehouse, the firm may elect to separate this exposure by
placing equal parts of the inventory in ten widely
separated warehouses.
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  

5. Transfer
It is also called as shifting method.
When a business organization cannot afford to cover the loss by
itself, it may look for/transfer institutions.
Insurance is a means of shifting or transferring risk.

The following matrix can determine which risk

management be used.

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5.INSURANCE FOR BUSINESS
Insurance is defined as protection against risks. And
there are many risks associated with starting a business.
To protect your business and yourself, consider the
following insurance options.
Insurers are professional risk takers. They know the
probability of different types of risk happening.

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 INSURANCE FOR BUSINESS…
1. Basic principles for a sound insurance program
Basic principles in evaluating an insurance program include:
Identifying insurable business risks
Limiting coverage to major potential losses and
Relating premium costs to probability of loss

2.Requierments for obtaining insurance

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1. There must be a sufficiently large number of homogenous
exposure units to make the losses reasonably
predictable.
 Insurance is based on the operation of the law of large
numbers.
 There must be a large number of exposures and those

exposures must be homogenous.

 Unless we are able to calculate the probability of loss, we

cannot have a financially sound program.

2. The loss produced by the risk must be definite and measurable.
 The loss must have financial measurement or financial implication.
 The risk must be calculated
 Example: For instance a person may purchase disability insurance.
How do we know that the person is unable to do? Thus, the risk
must be definite and measurable.

3. The loss must be fortuitous or accidental.

 i.e. the loss must be the result of a contingency, i.e., it must be
something that may or may not happen. It must not be something
that is certain to happen. 
 Wear and tear or depreciation, which is a certainty, should not be
insured. No protection is given by insurance.
 We should not be certain as to the occurrence of a loss
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4. The loss must not be catastrophic

 All or most of the objects in the group should not suffer loss at the
same time because the insurance principle is based on a notion of
sharing losses.

 Example: Damage which results from war, flood, windstorm and so

on would be catastrophic in nature and hence do not have insurance.
5. The loss must be large loss.
 The risk to be insured against must be capable of producing a large loss,
which the insured could not pay without economic distress.

 Incase the loss occurs, it must be severe that must be transferred to the
insurer. Those recurring and minor types of losses are not transferred to the
insurance company.

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6. Reasonable cost of transfer
i.e. the probability of loss must not be too high because the
cost of transfer tends to be excessive.

To be insurable, the chance of loss must be small. The more

probable the loss, the more certain it is to occur.
The more certain it is, the greater the premium will be. But to
make insurance attractive, the premium has to be for less than
the face of the policy.

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