CHAPTER TWO

THE RISK MANAGEMENT

2.1 Risk Management definition:
•Risk management is a process that identifies,
analyzing, and takes steps to reduce or eliminate
loss exposures faced by an organization and
selects the most appropriate techniques for
treating such exposures.
•Past:-- risk managers generally considered only pure
loss exposures faced by the firm.
•Newer:- forms of risk management consider certain
speculative risks as well. 1
2.2 Why is the study of risk management important

1st It affects our personal life

2nd Your activities will affect

3rd Risk management and insurance touch our lives in

other highly significant ways.

4th Finally, the importance of the insurance business

2
2.3 Objectives of Risk Management
Risk
Management
Objectives

Pre-Loss Post-Loss
Objective Objective

Economy Reduction Meeting Legal

of Anxiety Requirement

Continued Stability of Contin Social

Survival ued Respons
Operation Earning
ibility
Growth

3
2.3 Objectives of Risk Management…to be continued

Risk management objectives can be classified as either :

(1) Pre-loss Objectives
(2) Post -loss Objectives.
(1) Pre-loss Objectives:
Important objectives before a loss occurs include
economy, reduction of anxiety, and meeting legal
obligations (externally imposed obligations ).

a) Economy objective: means that the firm should prepare

for potential losses in the most economical way.
4
• It involves an analysis of the cost of safety
programs, insurance premiums paid, and
the costs associate with 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. 5
 This risk manager, however, wants 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. 6
(2) Post loss Objectives:
•Important objectives after a loss occurs include survival,
continued operation, stability of earnings, continued
growth, and social responsibility.
a) Survival: Survival means that after a loss occurs,
the firm can resume at least partial operations within
some reasonable time period.

b) Continued Operation: For some, forms, the

ability to operate after a loss is extremely important
7
Continued Operation cont’
• Banks, post offices, dairies, and other competitive
forms must continue to operate after a loss.
• Otherwise, business will be lost to competitors.
c) Stability: 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.
8
d) Continued Growth:
•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: The objective of social
responsibility is to minimize the effects that a loss will
have on other persons and on society.
•A sever loss can adversely affect employees, suppliers, creditors
and the community in general. 9
 Functions of Risk Management
• To recognize exposures to loss;
• To estimate the frequency and size of loss
• To decide the best and most economical method of
handling the risk of loss
• To administer the programs of risk management

10
2.4 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.
2.4.1 Risk Identification:
• It is first step in risk management process
• Step involves a painstaking/Careful 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. 11
•A loss exposure is a potential loss that may be associated
with a specific type of risk.
• Loss exposures typically classified as (Sources of Risks)
For example:
1. Property Loss Exposures:
•Buildings, Plants, Other Structures
•Furniture, Equipments, Supplies
•Electronic data processing equipments; Computer
Software
•Inventory
•Accounts receivables, Valuable papers and records
•Company planes, boats, mobile equipments.
12
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
13
4. Crime Loss Exposures: •Group life and health
Holdups, robberies and retirement plan
Employees theft and exposures.
dishonesty 6. Foreign Loss Exposures:
Fraud and •Acts of terrorism
Embezzlement •Plants, business property,
Interest and computer inventory
crime exposures. •Foreign currency risks
5. Employee Benefit Loss •Kidnapping of key
Exposures: persons
•Failure to comply with •Political risks
government regulation
•Failure to pay promised
benefits 14
7. Liability Risks:
•Defective Products
•Sexual harassment of employees, discrimination
against employees, wrongful termination
•Misuse of internet and e-mail transactions

Techniques for Identifying Risks:

They include the following:
A. Loss Exposure Checklists (The risk Analysis
questionnaire)
B. The Financial Statement Method
C. The Flow Chart Method
15
 D. Contract Analysis
E. Interactions with other Departments
F. Statistical Records of Losses
Others techniques:-
• Analysis of the Environment: (Customers, Suppliers,
Competitors, Regulators )
• Use of outsiders to identify loss exposures: consultants
• Organizational Charts: intended to highlight broad areas of risk
rather than specific
• The Best Method …no single method
A. Loss Exposure Checklists (The risk Analysis questionnaire):
•Specifies numerous potential sources of loss from destruction of
assets and from legal liability.
• Can be used both by business and by individuals

16
• For each item of checklist, the user asks the question,
“is this a potential source of the loss to me or my
firm?”
• 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.
• They attempt to cover all the exposures that various
entities are likely to face.
17
B. The Financial Statement Method:

Which
Organizat
ions use
it?

•By analyzing the balance sheet, operating statements

and supporting documents, the risk manager can identify
property, liability and human exposures (losses) of the
organizations.
18
•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.
C. 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.
19
D. Contract Analysis:
•Risk arise from contractual relationships with other
persons and organizations.
•An examination of these contracts may reveal exposures
that are not evident from the organization’s operations and
activities.
• In some cases, contracts may shift responsibility to other
parties.
E. Interactions with other Departments:
•These interactions may include oral or written reports
form other departments on their own initiative or in
response to regular reporting system that keep the risk
manager informed of developments
20
G. Statistical Records of Losses:
•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 analyses according to
cause, location amount and other issues to interest.
• Statistical records allow the risk manager to asses’ trends
in the organization’s loss experience compare with the
experience of others .
21
G. Statistical Records of Losses cont’
•In additions, these records enable the risk manager to
analyze issues such as the cause, time and location of the
accidents, identify of the injured individual and the
supervisions, and any hazards or other special factors
affecting the nature of the accident.

22
2.3.2 Risk Measurement (risk evaluation)
• This step involves on estimation of the potential
frequency and severity of loss.
• Loss frequency: the probable number of losses that may
occur during the some given period of time.
•Loss severity: 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.

23
2.3.2 Risk Measurement (risk evaluation)… continued
Statistical terms used in measuring risk
1. Probability distribution,
2. Measures of central tendency:-
a) The arithmetic mean,
b) Standard deviation and
c) Coefficient of variation.
3. Binomial Distribution
4. Normal Probability Distribution
Probability: The probability of an event refers to the frequency of
occurrence of an event
• All events have a probability between zero and one (0-1).

24
Example: Assume that a company has 2000 houses and determined
that 400 of these houses are expected to be destroyed by fire
accident.
Then probability of an accident = 400 = 0.2 or 20%
2,000
1) Probability Distribution (relative frequency distribution)…
next class
• It is a mutually exclusive and collectively exhaustive list of all
events associated with its loss.
• It is a more sophisticated way to measure potential losses
• It is difficult to explain and the data are commonly not
available.
25
1) Probability Distribution (relative frequency
distribution)…continued
• It make possible more comprehensive risk
measurements than other techniques.
• It is used to estimate numerically the potential loss
from a risk.
It is possible to measure the various aspects of a risk; such
as:-
 The number of occurrences per year,
 The monetary losses per occurrence, and
 The total monetary losses per year (fiscal period).

26
2) Measures of Central Tendency
A) Arithmetic mean
The arithmetic mean (X) can be defined as a sum of set of n
measurements X1, X2, X3-- -Xn divide by n:

Where, = arithmetic means

x= Measurement
n= Total number of measurements
In calculating the mean, equal weight is given for each observation
(measurement).
Example: The mean of the five numbers 0, 3, 5, 4 and 6 is
0 + 3 + 5 + 4 + 6 = 3.6
5
27
Arithmetic mean ….to be continue

Expected value-is a special case of the arithmetic mean

and similar to it.
• It is obtained by multiplying each item or event by the
probability of its occurrences.
=

Example: The following data relate to ABC Company for

the monetary loss of its automobiles because of accidents
and related probabilities.

28
 Expected Value
Event Amount of loss if Probability of loss Actual loss in money
event occurs (x) (p)
A Br 20,000 0.20 Br 4,000

B 15,000 0.30 4500

C 25,000 0.10 2500

D 20,000 0.40 8000

TOTAL 19,000.00

So, expected value=19,000

Note that expected value of loss = the summation of each loss

amount x its probability of loss
= x (p(x)) 29
B) Standard deviation
• Sd(): a number that measures how close/ far a group
of individual measurements /losses/ is to its average
value (mean).
• Sd (): is obtained by subtracting the average value
from each possible value of the variable, squaring the
difference, multiplying each squared difference by
probability that the variable will assume the value
involved, summing the resulting products, and taking
the square root of the sum. 30
B) Standard Deviation …continued
The Standard Deviation is a measure of how spread out numbers are
• The symbol for Standard Deviation is σ (the Greek letter sigma).

σ: Standard deviation of sample

N= Number of value in the data set
Each value in the data set
µ = Mean of all value in the data set

31
Standard deviation…continued
To calculate the standard deviation the following steps are required as
mentioned on slide no.30:-
1. Work out the Mean (the simple average of the numbers)
2. Then for each number: subtract the Mean and square the result
3. Then work out the mean of those squared differences.
4. Take the square root of that and we are done!
Example: Sam has 20 Rose Bushes.
The number of flowers on each bush is 9, 2, 5, 4, 12, 7, 8, 11, 9, 3, 7,
4, 12, 5, 4, 10, 9, 6, 9, 4
Work out the Standard Deviation.
32
Step 1. Work out the mean
In the formula above μ (the Greek letter "mu") is the mean of all our
values ..
Example: 9, 2, 5, 4, 12, 7, 8, 11, 9, 3, 7, 4, 12, 5, 4, 10, 9, 6, 9, 4
The mean is:
9+2+5+4+12+7+8+11+9+3+7+4+12+5+4+10+9+6+9+4
20
= 140/20 = 7
Step 2. Then for each number: subtract the Mean and square the
result
This is the part of the formula that says:

So what is xi ? They are the individual x values 9, 2, 5, 4, 12, 7, 8, 11,

9, 3, 7, 4, 12, 5, 4, 10, 9, 6, 9, 4 33
In other words x1 = 9, x2 = 2, x3 = 5, etc.
So it says "for each value, subtract the mean and square the result",
like this.
Example (continued):
(9 - 7)2 = (2)2 = 4
(2 - 7)2 = (-5)2 = 25
(5 - 7)2 = (-2)2 = 4
(4 - 7)2 = (-3)2 = 9
(12 - 7)2 = (5)2 = 25
(7 - 7)2 = (0)2 = 0
(8 - 7)2 = (1)2 = 1... etc...
And we get these results:
4, 25, 4, 9, 25, 0, 1, 16, 4, 16, 0, 9, 25, 4, 9, 9, 4, 1, 4, 9

34
Step 3. Then work out the mean of those squared differences.
• To work out the mean, add up all the values then divide by how
many.
• First add up all the values from the previous step.
• But how do we say "add them all up" in mathematics? We use
"Sigma": Σ
• We want to add up all the values from 1 to N, where N=20 in our
case because there are 20 values:

• Which means: Sum all values from (x1-7)2 to (xN-7)2

=4+25+4+9+25+0+1+16+4+16+0+9+25+4+9+9+4+1+4+9
= 178
35
Step 3. Then work out the mean of those squared differences cont’

• But that isn't the mean yet, we need to divide by how

many, which is done by multiplying by 1/N (the same
as dividing by N):
• Mean of squared differences = (1/20) × 178 = 8.9
• (Note: this value is called the "Variance")

Step 4. Take the square root of that:

σ = √(8.9) = 2.983...
36
C) Variance
• Variance is the mean of the squared deviation or the mean
of the squared deviation multiplied by probability of each
occurrence.
• That is, Standard deviation ( ) =variance.
Example:
• Mean of squared differences = (1/20) × 178 = 8.9
(Variance)
• σ = √(8.9) = 2.983... (Standard deviation)
• Taking the square root of the sum makes it standard
deviation, i.e. Standard deviation () is the square root of
variance.
37
• Coefficient of variation:
• When the standard deviation is expressed as a percent of the
mean, the result is termed the coefficient of variation, which is
one way to characterize the concept of mathematical risk to the
insurer.
• If losses from a group of exposure units have a low coefficient of
variation, there is less risk (less variation) associated with this
group of exposures than with another group with high coefficient
of variation.
• Coefficient of Variance = σ/µ
• σ= standard deviation
• µ= mean of the value
38
3) The binomial distribution
This is a two parameter distribution:-
 The number of exposure units (n), and
 The probability that a randomly selected unit be
damaged (p)
Assumptions of the binomial distribution:
• 1st the objects are independently exposed to loss.
• 2nd each exposed unit suffered (experience) at most one
accident in a year (or the budget period).
Thus, the binomial formula for probability of r accidents from n
exposure units is calculated using the formula:
39
The binomial distribution cont’
P (r) =(1-p)
Where: n = number of exposures
r = number of accidents (occurrences)
P (r) = Probability of r accidents
n!=n factorial, computed by successive multiplication of
the numbers n (n-1) (n-2), - - - (n-k)!
Example: 3! = 3(3-1) (3-2)! = 6
o! is conventionally defined to be 1
p= probability that the event will occur and
q= probability that the event will not occur and
q can be computed by the equation q = 1-p.
40
The binomial distribution…continued ’
Example: 1
Assume that a company has 100 automobiles and past experience
shows that the probability of loss of any one automobile by an
accident each year is 0.01, what is the probability that:
A. No accident will occur?
B. 1 accident will occur?
C. 2 accidents will occur?
D. 3 accidents will occur?
E. 4 accidents will occur?
F. 1 or more accidents will occur?
G. At least 5 accidents will occur?
H. At most 5 accidents will occur?
I. Exactly 5 accidents will occur?
41
The binomial distribution cont’
Solution
A. P (0) = 100! (0.01)0 (0.99)100-0 = 0.366032341
0! (100-0)!
B. P (1) = 100! (0.01)1 (0.99)100-1= 0.3697296376
1! (100-1)!
C. P (2) = 100! (0.01)2 (0.99)100-2 =0.184864818
2! (100-2)!
D. P (3) = 100! (0.01)3 (0.99)100-3 = 0.060999165
3! (100-3)!
E. P (4) = 100! (0.01) 4 (0.99) 100-4= 0.0149417
4! (100-4)!
F. P(1) = 1 – cumulative p (1-1)  1 – cumulative P (0) = 1-0.37 =
0.63
G. P (5)=1- cumulative p (5-1)=1– cumulative P (4) = 1-
0.0149417 =0.9850583
42
The binomial distribution cont’
Solution
H. p(5) = cumulative p(5) = p(0) + p(1)+p(2) + p(3) +p(4)+ p(5) =
0.995768167
I. P (5) = 100! / 5! (100-5)! * (0.01)5 (0.99) 100-5 = 0.002897787
Example-2: Suppose we have a firm which operates with
six (6) delivery trucks. Assume that if an accident happens
to a particular truck, it becomes a total loss and no repair.
And assume further that new trucks are purchased at the
beginning of every year to makeup the loss once so that the
firm always starts the new period with 6 trucks and no two
trucks are at the same time involving accident. Assume
each truck is working Br 25,000.

43
Year No. of trucks No. of accidents Monetary
loss
1 6 3 75,000
2 6 2 50,000
3 6 4 100,000
4 6 1 25,000
5 6 2 50,000
Total 30 12 300,000

44
4) The Normal Probability Distribution
• The normal distribution is important to compute the value of the
variables with in some given intervals.
• When one knows its mean and standard deviation, the distribution
is said to be completely defined.
• Mean and standard deviation (variance) are the only information
required to know the entire distribution.
• The risk manager may assume that the number of accidents or
total annual monetary losses as approximately normally
distributed.
• Normal distribution can be well explained by identifying only
two parameters the mean and the standard deviation,
45
4) The Normal Probability Distribution

Example-1: Assume the following

Year No. of accidents Total monetary loss
1 2 10,000
2 2 10,000
3 3 15,000
4 2 10,000
5 2 10,000
11 Sum… 55,000
Mean... 11,000
SD… 2,000

• The value of Z for any normal distribution is computed from the

equation:-
Z = x-m
 46
Where; x-is the value of the variable we want to measure
m- is mean of the distribution
 (Sigma) - is the standard deviation of the distribution
Z - is the standard deviation that the value of the variable x is
from its mean (m)
Example 2: If the mean (m) =100, standard deviation ( ) =15, what is
the probability that the value of the loss is less than 130 i.e. P(x < 130).
Solution
At x = 130 we have:
Z= x-m

Z= 130 – 100 = 30 = 2 = 0.4772 (from the table)
15 15
P (0 to 2) = 0.4772
P (Z2) = P (0 to 2) + P (0 to -)= 0.4772 + 0.5 = 0.9772 (i.e.
47
97.72%)
The above computation tells us that:
97.72% of the losses are less than 130.
Z = 2 means 130 is 2 standard deviation from the mean (100)
1 = 1(15) = 15 = 100 + 15 = 115
2 = 2 (15) = 30 =100 + 30 = 130, so 130 is 2 from the mean.
Example 3: Given the above example what is the probability of the
loss is to be
Between 70 and 130?

Between 55 and 145?

48
Between 85 and 115?
Solution
A. At x = 70 we have, Z =70 – 100 = -30 = -2 = 0.4772 (from the
table)
15
At x= 130, we have Z= 130 – 100 = 30 = 2 = 0.4772 (from the table)
15 15
P (0 to - 2) + p (0 to 2) = p (-2  Z  0) + p (0  Z 2)
= 0.4772 + 0.4772 = 0.9544 = 95.44%
From the above computation, it can be noted that, 0.9544 or 95.44% of
the loss is between 70 and 130 or  2 standard deviation from the
mean. /we have 95% confidence that the loss will be between 70 and
130.

49
Solution...CONTINUED
B. At x = 55, Z = 55 – 100 = -45 = -3 = 0.49865 (from the table)
15 15
At x = 145, Z 145 – 100= 45 = 3 = 0.49865 (from the table)
P (0 to -3) + p(0 to 3) = p(-3  Z 0) + p(0  Z 3)
= 0.49865 + 0.49865 = 0.99730 = 99.73%
From the above computation, it can be noted that, 0.99730 or 95.73%
of the loss in between 55 and 145 or 3 standard deviation from the
mean.
C. At x = 85, Z = 85 – 100 = -15 = -1 = 0.3413
15 15
At x = 115, Z =115 – 100 = 15 = 1 = 0.3413
15 15
P (0 to -1) + p (0 to 1) = p (-1  Z 0) + p (0  Z  1
= 0.3413 + 0.3413 = 0.6826 = 68.26%
50
2.8 Tools of Risk Management ……Reading
• After the risk manager has identified and measured, he or she must
decide how to handle them.
• There are two basic approaches:-
1st, The risk manager can use risk-control measures:-
 To reduce the firm’s expected property, liability, and personnel
losses, or
 To make the annual loss experience more predictable.
Risk control measures includes:
 Avoidance
 Loss prevention and reduction measures
 Separation
 Combination
 Some transfers.
51
2nd, the risk manger can use risk-financing measures to
finance the losses that do occur.
• Funds may be required to repair or restore damaged
property, to settle liability claims, or to replace the
services of disabled or deceased employees or owners.
• It includes the purchase of insurance
• Retention
OR
1. Risk Avoidance
2. Loss Control
3. Risk Retention and
4. Risk Transfer.
52
 1. Risk Control Tools
A. Avoidance: One way to control a particular pure risk is to avoid
the property, person, or activity with which the exposure is
associated by:
• Refusing to assume it even momentarily or an exposure assumed
earlier,
• Chance of loss is reduced to zero if the loss exposure is not
acquired.
Example: Leasing avoids the risk originating from property
ownership.
Disadvantage of avoidance:-
1st It may not be possible to avoid all losses.
Example: a company cannot avoid the premature death of a key
executive
Similarly, a business has to own vehicles, building, machinery,
inventory, etc… Without them operations would become impossible.53
For example, it may be better to avoid the construction of a
company near river bank, volcanic areas, valleys, etc. because the
risk is so great.
2nd it may not be practical or feasible to avoid the exposure
For example: a paint factory can avoid losses arising from the
production of paint. However, without any paint production, the firm
will not be in business.
Considerations Affecting use of Avoidance
 Avoidance may be impossible
 The potential benefits to be gained from employing certain
persons, owning a piece of property, or engaging in some
activity may so far out weight the potential losses and
uncertainties involved that the risk manager will give little
consideration to avoiding the exposure.
 The more narrowly the avoided risk is defined, the more likely it
becomes that avoiding that risk will create another risk.
54
B) Loss control measures
• Attack risk by lowering the chance that the loss will occur or by
reducing its severity if it does occur.
Loss control measures may be classified as follows:
 Loss prevention and reduction methods: Loss preventions are
programs that seek to reduce or eliminate the chance of loss. Loss
reduction programs seek to reduce the potential severity of the
loss.
Example:
The chance of fire loss can be reduced by:
• Fire resistive construction,
• Building in area where there are few external dangers, and
• Having many suppliers in order that a fire loss suffered by one
supplier will not halt the firm’s operations
55
Types of Loss Control
1. Focus of Loss Control:
• Loss control measures designed primarily to reduce
loss frequency
• Is referred to as frequency reduction or loss prevention
measures.
2. Timing of loss control:
• Some loss control methods are implemented before any
loss occurs
1stpre-loss activities = Frequency reduction + severity
reduction
2nd Concurrent loss control=severity reduction focus
3rd Post-loss activities=severity reduction focus
56
Decisions Regarding Loss Control
• Comparison of costs and benefits in the decision rule of the loss
control
a) Potential Benefits of Loss Control
These may include the reduction or elimination of expenses
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 judgments;
 Medical costs to treat injuries;
 Income losses due to deaths or disabilities;
 Cost of other risk management techniques used in conjunction with
loss control;

57
b) Potential Costs of Loss Control
• Compared to estimating the benefits of a proposed investment in
loss control, it is usually easier to estimate the potential costs.
• Two obvious cost components are installation and maintenance
expenses.
• The challenge in cost estimation is often identifying all the
ongoing expenses.
• To further complicate the process, some of the ongoing costs of
loss control may merely be increases in other expenses.

58
C) Separation
• Separation of the firm’s exposures to loss instead of
concentrating them at one location
D) Combination/Diversification
• Combination: increases the number of exposure units
since it is a pooling process.
• It follows the low of large numbers
• Combination increases the number of exposure units under
the control of the firm.
• Diversification: most speculative risks in business can be
dealt with through diversification.
Example: Businesses diversify their product lines so that a
decline in profit of one product could be compensated by
profits from others. 59
E) Non-insurance Transfer: non-insurance risk transfer involves
payment by one party (the transferor) to another (the transferee, or risk
bearer).
• The transferee agrees to assume a risk that the transferor desires to
escape.
Non-insurance transfers may be accomplished in two ways. These are:
1. Transfer of the activity or the property: Sells of property
2. Transfer of the probable loss
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.
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Four specific forms of risk transfer are:
a) 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, exculpatory
contracts or sometimes indemnity agreements.
b) Incorporation: Personal assets of the owners cannot be attached
to help pay for business losses, as can be the case with sole
proprietorships and partnerships.
• A firm transfers to its creditors the risk that it might not has
sufficient assets to pay for losses and other debts.
c) Insurance:
• The most widely used form of risk transfer is insurance.

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d) 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.
2. Risk Financing Tools
• Ways of financing the losses that do occur.
• It includes: Retention and insurance.
Retention: The most common and easiest method of risk handling
tools used by firm.
• The firm or an individual experiencing the loss bears the direct
financial consequences without any attempt to transfer.
• Retention can be effectively used in a risk management program
when certain conditions exist. These are:
• First, no other method of treatment is available
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Second, the worst possible loss is not serious.
Finally, losses are highly predictable.
Example: physical damage losses to automobiles, and shoplifting
losses
The source of the funds is the firm itself.
The following are some of the types of retention that firms use.
• Planned (Active) versus Unplanned (Passive) Retention
 Planned retention involves a conscious and deliberate assumption
of recognized risk
 When a firm or individual does not recognize that a risk exists and
unwittingly believes that no loss could occur, risk retention also is
underway – albeit unplanned retention.
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Funded Vs Unfunded Retention
• Many risk retention strategies involve the intention to pay for losses
as they occur, without making any funding arrangements in advance
of a loss.
• Unfunded retention should be used with caution, because financial
difficulties may arise if actual total losses are considerably greater
than what was expected.
• Credit – one method is to borrow the necessary funds from a bank
• Reserve funds - a funded reserve is the setting aside of liquid funds
to pay losses.
 If the maximum possible loss due to a particular risk is relatively
small, the existence of a reserve fund may be an efficient means of
managing risk.
• Self-insurance - Our discussion of retention would not be complete
without a brief discussion of self-insurance.
 The term self-insurance is commonly used by risk managers in their
risk management programs. 64
There are two necessary elements of self-insurance:
(1) existence of a group of exposure units that is sufficiently large to
enable accurate loss prediction and
(2) prefunding of expected losses through a fund specifically
designed for that purpose.
 A captive insurer - A captive insurer is an insurer established
and owned by a parent firm for the purpose of insuring the parent
firm's loss exposures.
 If the captive is owned by only one parent, such as a corporation,
it is known as a pure captive
 If the captive is owned by a sponsoring organization, such as a
trade association, it is called an association or group captive
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Disadvantage of retention
• Possible higher losses
• Possible higher expenses
• Possible higher taxes

End of the chapter

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 END
THANK YOU

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