CHAPTER TWO

THE RISK MANAGEMENT PROCESS

MEANING OF RISK MANAGEMENT
 Risk management is a systematic process that identifies
loss exposures faced by an organization and selects the
most appropriate techniques for treating such exposures.
 It is a scientific approach to deal with risks by anticipating

possible accidental losses and designing and implementing

procedures that minimize the occurrence of loss or the
financial impact of the losses that occur.
 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.

OBJECTIVES OF RISK MANAGEMENT
 It deals with deciding precisely what the
organization expects its risk management program
to do.
 Objectives serve as a prime source of guidance for

those charged with responsibility for the program,

and also means of evaluating performance.
 Risk management objectives can be classified as

either
(1) Pre loss Objectives
(2) Post loss Objectives
PRE LOSS OBJECTIVES
 A firm may have several risk management
objectives prior to the occurrence of the loss.
 These important objectives before a loss occurs

include;
 Economy,
 Reduction of anxiety, and
 Meeting legal obligations.
 THE FIRST GOAL IS ECONOMY.

It means that the firm should prepare for
potential losses in the most economical way
possible.
 This involves an analysis of safety program

expenses, insurance premiums, and the costs

associated with the different techniques for
handling losses.
THE SECOND OBJECTIVE IS THE REDUCTION
OF ANXIETY
 Certain loss exposures can cause greater worry and fear
for the risk manager, key executives, and stockholders
than other exposures.
 For example, the threat of a catastrophic lawsuit from a

defective product can cause greater anxiety and concern

than a possible small loss from a minor fire.
 However, the risk manager wants to minimize the

anxiety and fear associated with all loss exposures

 THE THIRD OBJECTIVE IS TO MEET
ANY EXTERNALLY IMPOSED
OBLIGATIONS
 This means the firm must meet certain obligations
imposed on it by outsiders.
 For example, government regulations may require a firm

to install safety devices to protect workers from harm.

 Similarly, a firm’s creditors may require that property

pledged as collateral for a loan must be insured.

 The risk manager must see that these externally imposed

obligations are met.

POST LOSS OBJECTIVES
 Important objectives after a loss occurs include;
 Survival,
 Continued operation,
 Stability of earnings,
 Continued growth, and
 Social responsibility.
SURVIVAL OF THE FIRM.
 The first and most important post-loss objective
is survival of the firm.
 Survival means that after a loss occurs, the firm

can at least resume (begin again) partial

operation within some reasonable time period
if it chooses to do so.
 THE SECOND POST-LOSS OBJECTIVE IS TO
CONTINUE OPERATING
 The second post-loss objective is to continue
operating.
 The ability to operate after a severe loss is an extremely

important objective.
 The ability to operate is also important for firms that

may loss customers to competitors if they cannot

operate after a loss occurs.
 This would include banks, bakeries, dairy farms, and

other competitive firms.

STABILITY OF EARNINGS
 Stability of earnings is the third post-loss objective. The
firm wants to maintain its earnings per share after a loss
occurs.
 This objective is closely related to the objective of

continued operations.
 Earnings per share can be maintained if the firm

continues to operate.
 However, here may be substantial costs involved in

achieving this goal (such as operating at another

location), and perfect stability of earnings may not be
attained.
THE FOURTH POST-LOSS OBJECTIVE IS
CONTINUED GROWTH OF THE FIRM.
 A firm may grow by developing new products and
markets or by acquisitions and mergers.
 The risk manager must consider the impact that a

loss will have on the firm’s ability to grow.

 Finally, the goal of social responsibility is to

minimize the impact that a loss has on other

persons and on society.
 A sever loss can adversely affect employees,

customers, suppliers, creditors, taxpayers, and the

community in general.
STEPS IN THE RISK MANAGEMENT PROCESS

 The whole process of RM involves the following

four steps:
 Identifying potential losses (Risk Identification)
 Evaluate Potential losses (Risk Measurement)
 Select the appropriate techniques for treating loss

exposure, and
 Implement and administer the program .
RISK IDENTIFICATION
 Its the first step in the risk management process.
 Its to identify all major and minor loss exposures.
 It involves a thorough analysis of all potential losses.
 It is a phase where a firm systematically and

continually identifies property, liability, and personal

exposures as soon as or before they emerge.
 Unless the sources of possible losses are recognized,

its impossible to select 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.

 LOSS EXPOSURES/SOURCES OF RISKS
 Are classified as follows:
1. Property Loss Exposures
 Buildings, Plants, Furniture, Equip’s, Supplies, Electronic

data processing equip’s; Computer Software, Inventory,

A/R, boats, mobile equip’s.
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
4. CRIME LOSS EXPOSURES
Robberies, Employees theft and dishonesty, Fraud and
Embezzlement, Interest and computer crime exposures.
5. Employee Benefit Loss Exposures
Failure to comply with government regulation , Failure to
pay promised benefits, Group life and health and retirement
plan exposures.
6. Foreign Loss Exposures
Acts of terrorism, Foreign currency risks, Kidnapping of
key persons, Political risks
7. Liability Risks
Defective Products, Sexual harassment of employees,
discrimination against employees, wrongful termination,
Misuse of internet and e-mail transactions
RISKS
 A risk manager has several techniques for identify
the preceding loss exposures.
 But no single method or procedure of risk

identification method is free of weakness.

 The strategy of a management must employ

method or a combination of methods that best fit(s)

the situation on hand.
 The choice is a function of the following factors;
The nature of the business;

 The size of the business and

The availability of skill man power.

 THE RISK IDENTIFICATION METHODS
 Loss exposure checklists;
 The financial statement method;
 The flow chart method;
 Contract analysis;
 Interactions with other departments;
 Interactions-with-outside-suppliers-and

professional organizations;
 Statistical Records of Losses and
 On Site Inspection
RISK MEASUREMENT (RISK EVALUATION)
 The risk management process is to evaluate and measure
the impact of potential losses on the firm.
 The exposures are to be measured in order to determine

their relative importance and to obtain information for the

risk manager to decide up on the most desirable
combination of risk management tools.
 It involves in estimation of the potential frequency and

severity of loss.
 Loss frequency refers to the probable number of losses

that may occur during the same given period of time.

CONT’D
 Loss severity refers to the probable magnitude/scale 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.
 In addition, the relative frequency and severity of each

loss exposure must be estimated in order the risk

manager to select the most appropriate technique or
combination of techniques for handling each exposure.
CONT’D
Loss frequency and loss severity data do more
than identify the important losses.
 They are also extremely useful in

determining the best way of handle an

exposure to loss.
The actual estimation of the frequency and

severity of loses may be done in various ways.

CONT’D
 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.
SELECT THE APPROPRIATE TECHNIQUES FOR TREATING
LOSS EXPOSURE
 Afteridentifying and evaluating exposures to risk,
systematic consideration can be given to
alternative methods for managing each
exposure.
 The third step in the risk management process is to

select the most appropriate technique/tool or

combination of techniques/tools for treating each
loss exposure.
RISK MEASUREMENT AND PROBABILITY DISTRIBUTION
MEANING OF PROBABILITY
 Probability theory is the body of knowledge concerned
with measuring the likelihood that something will happen
and making predictions on the basis of this likelihood.
 The likelihood of an event is assigned a numerical value

between 0 and 1.
 Zero is assigned for impossible and one for definitely

possible events.
 In general 0 ≤ P(A) ≤1; where P designates the probability

of an event and P(A) for probability of an event A to occur

in a single observation.
DETERMINING THE PROBABILITY OF AN EVENT
 There are two common methods to obtain an estimate of the
probability of an event.
 Prior probabilities: these probabilities are determined before an

experiment.
 A number of equally likely outcomes must exist, some of which

represent the particular outcome whose probability is being

determined.
 For example the probability of obtaining a head when a coin is

tossed is ½ because there are two equally likely outcomes; a tail or a

head, and one of these outcomes is a head.
 The probability of drawing the king from a full playing card is 4/52

or 1/13 as there are 52 cards and of which 4 are kings.

 But the probability of drawing a king of hearts is 1/52.
CONT’D
 Empirical probabilities: these probabilities are computed after a
study of past experience.
 When we do not know the underlying probability of an event and

cannot deduce it from the nature of the event, we can estimate it on

the basis of past experience.
 For example, Assume that we are told that the probability of a

student will fail in English course is 0.01.

 This indicates that someone has gone through the records and

discovered that in the past 1 man of every 100 men failed the English
course.
 In situations where it is not possible to use either prior or empirical

methods, subjective probability estimates may be used.

LAW OF LARGE NUMBERS
 The law of large numbers is a basic principle of
mathematics which states that as the number of the
exposure units increases, the more certain it becomes that
actual loss experience will equal probable loss experience.
 It states that the greater the numbers of exposures, the more

closely will the actual results approach the probable results

that are expected from an infinite number of exposures.
CONT’D
 By applying the law of large numbers, the insurance
company can predict accurately the birr amount of
losses it will experience in a given period.
 The relative accuracy of the company’s prediction

increases as the number of exposures in the insurance

policy increases.
 If the loss amounts are predicted in advance, the company

could take its own arrangements for safe operation.

ILLUSTRATION
 Assume that Avon and Saxon companies own 100 and 900
cars respectively. These cars are used by the salesperson of
each firm and are driven in the same geographical location,
assume Addis Ababa.
 The probability of loss in a given year due to collusion is

20% for both.

 Hence, the expected losses of Avon company is 20

(100*20%) and 180 (900*20%) for Saxon.

 Assume further that statisticians revealed that the likely

range in the number of losses in one year is 8 and 24 for

Avon and Saxon respectively.
CONT’D
 As shown below the degree of risk for Saxon is 1/3
of the Avon’s.
 Objective risk Avon = Range/Expected = 8/20 =

40%
 Objective risk Saxon = Range/Expected = 24/180 =

13.3%
 One thing we should have to bear in mind is that the

law of large numbers only allows accurate

predictions of group results, but not particular
exposures of individuals in the group.
TOOLS OF RISK MANAGEMENT
 The major techniques for handling risks are categories in
to two;
 Risk control techniques
Risk Avoidance

Loss Control

Diversification(Separation)

Combination

 Risk financing techniques

Risk- Retention

Self- insurance

Non insurance risk Transfer

Insurance
RISK CONTROL TECHNIQUES
 RISK AVOIDANCE
 One way to control a particular risk is to avoid the
property, person or activity giving rise to possible by either
refusing to assume it even temporarily (called proactive
avoidance) or by abandoning an exposure to a loss
assumed earlier (abandonment).
 Avoidance stands to mean that a 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.

LOSS CONTROL
 When particular losses/ risks cannot be avoided,
actions may be taken to reduce the losses associated
with them.
 This method of dealing with risk is known as “Loss

Control”.
 Loss control activities are designed to reduce both the

frequency and severity of losses.

 Loss control measures do counteract risks by

lowering the chance the loss will occur or by

reducing its severity if the loss is to occur.
CONT’D
 Loss control can be classified based on two factors called
focus and timing.
 Based on Focus, Loss Control can be classified as
Loss Prevention

Loss Reduction

 Based on Timing, Loss Control can be classified as

Pre-Loss Activities

Concurrent Activities

Post – Loss Activities.

BENEFITS OF LOSS CONTROL
 These may include the reduction or elimination of
expense 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 of judgments;
 Medical costs to threat injuries and
 Income losses due to deaths or disabilities.
SEPARATION AND DUPLICATION
 Separation involves the reduction of maximum probable
loss associated with some kinds of risks.
 This method deals with 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.
 Example, a firm may disperse its inventory in to different

warehouses than keeping it in one store.

 If fire destroys one of the warehouses, the firm will save

some of its inventories placed in the other warehouses.

 The likely severity of overall firm losses by reducing the

size of the exposure in any one location.

CONT’D
 Duplication is a very similar technique, in which

spare parts or supplies are maintained to replace

immediately damaged equipment and or inventories.
 This type of loss control also helps to reduce the

severity of losses that would occur.

COMBINATION
 This method makes loss experiences 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.
RISK FINANCING TECHNIQUES
RISK RETENTION
 Itmeans that the firm’s retains part or all of the
losses that can result from a given loss.
 Retention can be Active (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.
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.
 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.
NON INSURANCE RISK TRANSFER
 Risk transfer involves in payments by one party (the
transferor) to another (the transferee or risk bearer) when
the transferee agrees to assume a risk that the transferor
desires to escape.
 Non insurance transfers are methods other than insurance

by which a pure risk and its potential financial

consequences are transferred to another party.
 The most common forms of non- insurance risk transfers

are hedging, hold-harmless agreements and

incorporation.
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.
 This is the process of balancing a chance of loss

against the chance of gain.

HOLD-HARMLESS AGREEMENTS
 Provisions inserted into many different kinds of contracts
can transfer responsibility.
 These are contracts entered into prior to a loss, in which

one party agrees to assume a second party’s responsibility.

 Such provisions are called hold-harmless agreements or

sometimes indemnity agreements.

 Forms of hold-harmless agreements are;

(a) Limited Form

 The limited form merely clarifies that all parties are

responsible for liabilities arising from their own

activities/actions.
(B) INTERMEDIATE FORM
 Its 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
 It requires the transferee to be responsible for all losses

arising out of particular situations regardless of fault.

(d) Incorporation
 For a business to transfer risk is to incorporate.

 An incorporated firm can ever loss is the amount of its

assets.
 Personal assets of the owners cannot be attached to help

pay for business losses, ( as s/proprietorships and p/ships).

INSURANCE
 The most widely used form of risk transfer is
insurance.
 Insurance represents a contractual transfer of risk.
 Insurance is appropriate for loss exposures that

have a low probability of loss but the severity of

loss is high.
 If insurance is used to treat certain loss exposures,

five key areas must be emphasized.

 They are;
1. SELECTION OF INSURANCE COVERAGE
 The need for insurance can be divided in to several
categories depending on importance.
 Approach used to classify the need for insurance in

to three categories: essential, desirable, and

available.
 Essential insurance includes those coverages

required by law or by contract, such as the works

compensation insurance.
 It includes coverages that will protect the firm

against a catastrophic loss or a loss that threatens

the firm’s survival; commercial general liability
insurance would fall in to that category.
CONT’D
 Desirable insurance is protection against losses that may
cause the firm financial difficulty, but not bankruptcy.
 It includes those that protect against loss exposures that

would force the firm to borrow or restore to credit.

 Available insurance is coverage for slight losses that

would merely inconvenience the firm.

 Optional insurance coverage includes those that protect

against losses that could be met out of existing assets or

current income.
2. SELECTION OF AN INSURER
 In selecting the insurer a risk manager should pay due attention to
several factors such as the financial strength of the firm, service
provided by the insurer, and cost and terms of protection.
3. Negotiation of terms
 The risk manager and the insurer must agree on the documents and

the terms should be clear to both parties.

4. Dissemination of information concerning insurance coverage
 The firm’s managers and employees must be informed about the

insurance coverage, the various records to be kept, the services of

the insurer etc.
5. Periodic review of insurance program
 The entire process of obtaining insurance must be evaluated

periodically. This involves an analysis of agent and broker

relationship, coverage needed, cost of insurance, pace of claim
payment and etc.
RISK MANAGEMENT MATRIX

 Which method should be used for a particular exposure

depends on the frequency and severity of the loss.
 The following matrix may help in determining which risk

management tool is to be used, considering the nature of

the loss:
 N D
E