CHAPTER -5

OUTLINES Risk and Insurance of Business Enterprises

 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
 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. Planning is deciding in advance
i. What to do it,
ii. How to do it,
iii. When to do it and
iv. Who is to do it
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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
sheer necessity.

Before we define risk for our purpose it would be

advisable to consider the various definitions given by
different scholars and practitioners to comprehend the
basic concept of risk
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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; they include:
 Fire , Natural disasters, Burglary, Business swindles (or
fraudulent transactions) and, Shoplifting.

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, assault, 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.
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Risk management and Insurance management
What is the difference in b/n?
Risk management is broader than insurance
management in that it 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 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 and/or likelihood.
• 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
for the risks that have been decided to be transferred to an
insurer, 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 tacit agreement to assume the 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
misfortune 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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READING ASSIGNMENT

TYPES OF BUSINESS INSURANCE???

END OF THE COURSE
WISH U A BRIGHT FUTURE!!!