CHAPTER III

Risk management
Risk management

We define Risk Management as the logical
development and execution of a plan to deal
with potential losses.
 Risk Management benefits all types of
organizations facing potential losses, including
business firms, non-profit organizations,
individuals, and families.


 Simply put then, Risk management is a

three-step process. First, identify and measure
potential losses; second, develop and execute a
plan to manage this loss potential; and third,
continuously review the plan after it has been
Risk management


 Risk management is a dynamic process.

Large corporations change frequently: They
introduce new products or services, merge
divisions, acquire or sell operations, and capital
costs increase or decrease. Each time an
organization changes significantly, its risk
management plan must be reviewed and
updated as necessary.
THE RISK MANAGEMENT FUNCTION



In one survey of risk managers, 5 percent
reported having a law degree, about 30 percent
reported having a master’s degree, and about
half held a bachelor’s degree.
 Risk management staff

 Wide variety of expensive potential losses, a

large risk management staff would be headed
by a manager with overall responsibility. The
staff would include one or more of the following
positions: insurance expert, financial risk
manager, claims manager, loss control
engineer, employee benefits specialist, and
financial analyst.
 RIMS


 The Risk and Insurance Management

Society, Inc. (RIMS), a professional organization
for risk managers.
 Statement of Objectives and Principles

 Survival, Growth, and Responsibility

 The first objective for the risk manager is to
make sure the organization can survive losses.
Moreover , the risk management program
should allow the firm to continue to grow after a
loss as if the loss has not occurred.


 Efficiency and Compliance

 Another essential objective is to operate
efficiently in a risky environment. Balance
between loss prevention, insurance, and other
risk management tools.

 Statement of Objectives and Principles

 Risk Management Manual

 In practice, each organization should develop
a written manual with objectives and
procedures related to their particular exposures.
For example, a bank’s risk management manual
might emphasize security issues. A hospital’s
manual might have much attention devoted to
hygiene. While the risk management
department often develops a statement of
objectives, principles, and procedures, the
organization’s chief executive officer and the
directors should approve this statement.

 Statement of Objectives and Principles
One large manufacturing company’s risk
management
manual includes the following general guidelines:

 1.Engage in loss prevention activities as if

all chance of loss remained with the
company.


 2. Assume all risks that are not significant in

relation to the company’s financial strength.


 3. Insure all risks not assumed.


 Statement of Objectives and Principles
 Company’s Risk Management manual, which makes
the following
 points under the heading “Protecting the Company’s
Property
 against Fire and Associated Perils.”
 1. Good Housekeeping: Good housekeeping is a key
component in the loss prevention and control program. Good
housekeeping includes prompt waste disposal and proper
material handing, especially in storage areas. Special care
should be taken to avoid build up of combustible wastes.
 2. Sprinklers: The Company will install automatic fire
sprinkler systems wherever needed.
 3. Adequate Water Supply: The Company will maintain
an adequate water supply to preserve the efficiency on the fire
sprinkler system, and fight all fires.
 4. Emergency Organizations: The Company will train
employees to respond to all emergencies ranging from natural
Risk management process
Risk management activities occur before, during,
and after
losses. Most planning is done before losses occur.

After the
loss, the risk manager must file insurance claims

and
analyze loss patterns.

The risk management process requires the

following steps:
STEP1: Identify and measure potential loss
exposures.


 STEP2: Choose the most efficient methods of

STEP1: INDENTIFICATION AND MEASUREMENT OF
EXPOSURES
Logically thinking about loss begins with
categorizing the
Possibilities into four distinct classes:

 Direct property losses.

 Losses of income and extra expenses following
a property loss.
 Losses arising from lawsuits called liability
losses.
 Losses caused by the death, disability, or
unplanned retirement of key people.


It is well to remember that before a loss occurs,


 Direct Property Losses


Risk managers can identify potential direct

property losses
in different ways. A walking tour of a factory,

store, or
hospital can reveal many of the property loss
exposures.



 Checklists
 Many insurance organizations provide a property checklist
that may be
 used to identify and value potential property losses.



P ro p e rty In su ra n ce C h e ck list

 Identify and value: Identify special perils

§Owned buildings, equipment, and land to which property is
 §Property leased from others exposed:
§Property leased to others

§Stationery inventory (average cost) §Radiation
 §Inventory being transported §Explosion
(average cost) §Flood
§Property under construction §Earth movement
§Owned or leased vehicles §Theft
§
§
 Flow Charts

A flow chart graphically represents the production

or
distribution process. Flow chart analysis displays

the firm’s
relations with suppliers, customers, utilities and

modes of
transportation. Risk managers analyze flow charts

to spot
production bottlenecks, sole-source suppliers, or

concentrations of valuable property.

 Flow Charts
Ai
rF
Supplier r
A tr e ig
(Chemical uc h t
k
s, paint) W a re h o u se Manufacture
Finished Chicago
(computeriz books Three
Assembly
Supplier B train e d in ve n to ry regional
(Lumber) co n tro l) warehouses L.A
truck Quality
Control (leased)
10,000,000$ Packing
Average
value of New York
Truck
Supplier k goods in (common
C,D r uc hand carrier)
(metal, t
fasteners) 10 employees 230 employees
$ 1,750,000 $ 42,000,000 book
Book value Value equipment
2,200,000 $ 28,000,000
Replacement cost Replacement cost
24-hour security 24-hour operation
 Valuing Property

 Risk managers must know the property’s

replacement value to estimate property
losses. Because replacement cost often is
unrelated to accounting book value, risk
managers should keep a current price and
source list for their property.


 In an inflationary economy, the replacement

cost of physical equipment is likely to be
higher than its historical cost and the risk
manager should attempt to protect this
greater value.
 Loss of Income

Indirect losses are more difficult to identify than

direct
property losses. We can see a machine and
measure its
value, but we cannot see the lost profits if the

machine is
unavailable for three months.

Despite these difficulties risk managers must

make careful
estimates and judgments about the potential size

of
 Loss of Income

The risk manager should ask informed people how

long it
would take to resume physical operations if a
total or partial
loss occurs. The accountant should estimate how

much
income would be lost in addition to how much

fixed and
continuing expenses would occur before normal

operations
resume. The risk manager usually considers the

fact that
 Liability Losses
 Liability losses arise from three sources. First, an
organization
 responsible for negligently injuring somebody must pay
legal damages
 awarded by a court to the injured party. Second is the cost of
a legal
 defense. A defense can be expensive even in cases where a
court finds
 the “victim’s” claims groundless, false, or fraudulent. In
some cases, the
 legal defense costs more than the damages awarded to
partied claiming
 injury. The cost of loss prevention is a third source of cost
arising from
 potential legal liability.

 Loss of key personnel

 If a business looses a key person by unplanned

retirement, resignation, death, or disability the
effect may be felt in lost income. If several key
employees are killed, disabled or leave
simultaneously, the results could devastate a
firm. Key employees may occupy almost any
position: research scientists, president, sales
person, or treasurer.


 Part of identifying a key employee exposure is

developing an estimate of where, at what cost,
and how quickly a replacement may be hired
and trained.
 Loss of key personnel

 Key personnel may be identified using an

organizational chart or a flow chart. Estimating
the cost of key employee losses is difficult
because finding and training a replacement is
a function of the job market. In some cases,
trained substitutes can be found easily. In
other cases, especially those involving sales
people who have built relationships with
clients over long periods, resumption of the
same level of performance may take years.

 Estimation of maximum loss
When developing a risk management program the
risk
manager should have a good notion of the
maximum
possible loss and the maximum probable loss. The

maximum possible loss refers to the total amount

of
financial harm a given loss could cause under the

worst
circumstances. The maximum probable loss is the

most
likely maximum amount of damage a parent might

cause under average circumstances.


 Emergency planning-disaster recovery


Emergency planning is an integral part of a



thorough risk management program. Some

disasters require quick actions plans should be in
place in advance to be with such things as
extortion plots, kidnapping of executives,
explosions, natural disasters, chemical leaks, or
any disaster where the amount of damage can be
reduced by the action of an emergency response
team.



STEP2: L O S S C O N T R O L A N D R IS K F IN A N C IN G
All organizations incur costs because they are
exposed to unexpected losses. Paying insurance
premiums, paving for uninsured losses, or paying
for installing a fire sprinkler system each
represents a cost of being exposed to loss.
 

The risk manager has some ability to control the

amount and timing of these costs. Successful loss

control efforts reduce the amount of loss costs.
 Loss Control


Loss control activities are designed to reduce loss



cost and include the following risk management

tools: risk avoidance, loss prevention, and loss
reduction.







 Loss Control
 Risk Avoidance
Sometimes the best method of dealing with an


exposure to loss is to avoid all possibility of the loss

occurring. Risk avoidance means the chance of loss
has been eliminated.
For example, there are foreign countries in which


American business firms will not make investments.

The firms prefer to avoid the risks, such as confiscation
of property or having employees held hostage, rather
than attempt to make a profit. Individuals practice risk
avoidance in their choice of careers when they avoid
occupations that involve a significant chance of death
or disabling injuries.
Some risks are unavoidable. For example, the risk of


bankruptcy, the risk of a liability suit, or the risk of

premature
 Loss Control
 Loss Prevention


Successful loss prevention activities lower the



frequency of losses. As long as the benefits exceed the

costs, loss prevention should be used to treat all
exposures, whether assumed or transferred to
commercial insurers. The foremost purpose of loss
prevention is to preserve human life. That is, a risk
manager's first goal in a loss prevention program is to
reduce or eliminate the chance of death or injury to
people.


Examples of loss prevention activities include the use



of tamper-resistant packaging, security guards in

banks, driver training and safety education programs,
and warnings printed on drugs and dangerous
 Loss Control
 Loss Reduction


Successful loss reduction activities reduce loss

severity. Despite the best loss prevention efforts, some
losses occur- Loss reduction activities aim at
minimizing the impact of losses. An excellent example
of a loss reduction device is the automatic fire-
sprinkler system. This system is not designed to
prevent fires, but to prevent the spread of Fires.
Obviously it introduces a new peril to the environment-
water damage.


Other examples of loss reduction devices include fire



walls and doors, labeling instructions for treating

people who have swallowed poisonous substances

 Federal Loss Control Regulation


Loss control engineering became increasingly

important in the United States with the passage of
the Occupational Safety and Health Act of 7970
(OSHA). This federal law is designed to promote a
safe working environment for workers. In some
cases, the state. provide enforcement of OSHA
rules. OSHA creates two duties For employer. One
is to remove all recognized hazards from the work
environment. The second is to comply with the
standards for a safe working environment as
published in bulletins from the department of
Labor.



 Risk Financing


Risk financing determines when and by whom

loss costs are borne. Risk financing includes the
following alternatives:
 

• Risk assumption

• Risk transfer other than insurance

• Self-insurance and financed risk retention

• Insurance



 Risk financing
 Risk Assumption


Risk assumption means that the consequences of a

loss will be borne by the party exposed to the chance
of loss.


Sometimes, however, risk is assumed because the



potential loss was not identified before it occurred.

 Business firms assume risks when :
 • Loss costs are small and are funded from current
cash flow
 • Loss exposures are retained and funded with a cash
reserve.
 • Loss exposures are retained and recognized in an
unfunded reserve account.
 Risk financing
 Self insurance


Self-insurance requires risk retention, it implies an

attempt by a business to combine a sufficient
number of its own similar exposures to predict the
losses accurately.







 Risk financing
 The Captive Insurance Company
one approach to self-insurance involves the use of a
company formed to write insurance for a parent, called a
captive insurance company. The captive's parent may be
one company; several companies, or an entire industry.
One motive in Forming a captive is to save the overhead
and profits earned by commercial insurers. A second
incentive is to earn the investment income available on
advanced funding. A third, and controversial, motive is to
recognize insurance premium payments as a current
business expense to parents while the captive insurer
reports insurance income, thus allowing firms to capture
the favorable tax differential between regular
corporations and insurance companies.


Under federal income tax procedures, self-insurance



funding cannot be deducted until losses occur, while

 Risk financing
 Risk Transfer


Risk transfer Risk transfer means the original

party exposed to a loss is able to obtain a
substitute party to bear the risk. Risk transfer is a
feature of all insurance transactions because the
uncertainty of who twill pay for the loss is
transferred from the individual to the insurance
pool.
 

- Hedging is an example of a non-insurance

transfer of risk.



 Risk financing
 Insurance


From the risk manager's viewpoint, insurance



represents a contractual transfer of risk. From

society's viewpoint, insurance is more than mere
risk transfer; it is risk reduction because the
pooling of numerous risks allows better loss
predictability. insurance is an especially
appropriate risk management tool when the
chance of loss is low and the severity of a
potential loss is high.



 RISK MANAGEMENT TOOLS
FR E Q U E N C Y O F
LO S S
LO W H IG H
Risk Loss
Assumption prevention
Also: Also: loss
LO W loss reduction if
cost can be
S E V E R IT Y O F LO S S

prevention and justified.

loss reduction Assume risk if
if the cost cost of
justifies the prevention or
benefits reduction
cannot be
justified.
Insurance Risk
Also: Avoidance
risk transfer, Also:
HIGH loss loss
reduction, prevention and
loss loss
prevention. reduction, if
possible.
STEP THREE:REGULAR REVIEW OF THE RISK MANAGEMENT
PROGRAM
After all potential sources of loss have been identified

and plans to deal with them implemented, the risk

manager must review the program regularly to be sure
that it meets current needs.


Over time, conditions change in every business. New

assets are acquired, old assets lose their value,
inventories increase or decrease, new production
processes are used, new products are marketed, new
personnel are hired, and laws are changed. Each
change in the business might represent a new
exposure to loss or might alter an existing source of
loss. The risk manager must also be aware of all
significant changes in the firm's legal environment and
must be able to assess correctly their impact on the
firm's risk management program.