Unit 1 RiskAn Introduction

Structure
1.1 Introduction
Objectives
1.2 Meaning of Risk
Types of Risks Facing Businesses and Individuals
Comparison of Pure Risk with Other Types of Risk
1.3 Risk Management
Risk Management Process
Risk Management Methods
Business Risk Management Organization
1.4 Summary
1.5 Glossary
1.6 Terminal Questions
1.7 Answers
1.8 Case Study
Caselet
IRDAs Draft Proposal for Insurance Cover to BPL Families
Insurance Regulatory and Development Authority (IRDA) has put up a draft
proposal for expanding the reach of insurance cover to Below Poverty Line
(BPL) families during the next five years. In its draft, the IRDA states, The
target group shall be the BPL population. Each insurer shall prescribe the
target in proportion to their market share. IRDA shall prescribe annual target
so as to cover entire BPL population in the next five years.
The standard insurance product will be in addition to the governmental
schemes that provide insurance cover at concessional rates. The draft
further says, This product would facilitate supplementing or topping up of
any existing social security benefit and would not overlap with such benefits.
The IRDA suggests that leading life insurers should collaborate with non-
life insurers or vice-versa to ensure that maximum benefits reach the
masses.
These standard products should include minimum sum assured of `40,000
for life term cover and up to `2,00,000. The products might be extended to
the family members and the cover period shall be in the range of 525
years. The report maintains that during the period 201218, all the insurers
shall cover a minimum of 50 per cent of the targeted group through the
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standard product sales and the rest 50 per cent might be covered by any
other approved social sector and rural products. The prospectus and policy
conditions must be clear and simple. Further, transparent language must
be used without ambiguous and vague statements keeping in mind the target
market.
In its report titled Composite Package of Standard Insurance Product for
Rural and Social Sector IRDA states that weaker sections should be
provided cover to meet the exigencies cast by natural catastrophes,
accidental death, protection means for the family as well as to promote
some savings to bolster their financial security. According to IRDA, it has
made the standard product more flexible and simple with an objective to
provide widespread package of insurance covers to these deprived sections
of India. The policy document states, The product will have defined options
and levels to provide choice and flexibility to customers in order to cater to
individual circumstances.
The IRDA has also invited stakeholders comment and views about the
proposed draft.
Source: Adapted from a news item in Business Standard, available at http:/
/business-standard.com/india/news/irdas-draft-proposal-for-insurance-
cover-to-bpl-families/188047/on (Retrieved on 1 October 2012)
1.1 Introduction
Risk is generally perceived as an uncertainty relating to the occurrence of a
loss, such as risk of death in an accident, risk of loss due to fire or a natural
calamity, among others. Risk, however, has a different meaning. It represents a
condition in which there is a possibility that the actual outcome deviates adversely
from the expected outcome. In other words, risk is present when the actual loss
is likely to be more than the expected loss or when the actual returns from an
investment are likely to be less than the expected returns. For instance, suppose
a firm expects that it could suffer a loss from bad debts to the extent of 5 per
cent of its outstanding accounts and has adequately provided for such loss.
The firm does not face any risk if the actual loss on account of bad debts does
not exceed 5 per cent.
This unit discusses the concept of risk from various perspectives in relation
to business. It also focuses on risk management strategies employed to ensure
successful business, thus reducing personal risk in addition to the risk associated
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with business. Situations of uncertainty, with possible negative evolution, have
an important bearing on the long-term decisions of the corporate sector. Every
business or investment comprises a certain amount of risk. However, it is the
responsibility of the firm to ensure adequate strategies for the minimization or
removal of such risks that may be foreseen or unforeseen, for successful running
and expansion of its business. From experiences with regard to undergoing
damage or losses in earlier times, the corporate sector has now come up with
advanced methods and procedures of risk management to ensure cost-
effectiveness and resource optimization.
Objectives
After studying this unit, you should be able to:
list different meanings of the term risk
describe major types of business and personal risks
compare pure risk with other types of risks
assess the significance of risk management function within business
organizations
1.2 Meaning of Risk
The expression risk can be interpreted from different perspectives. At its most
general level, risk is used to describe any situation involving an uncertainty about
the outcome. Life is obviously very risky. Even the short-term future is often
highly uncertain. In probability and statistics, financial management and
investment management, risk is often used in a more particular sense to indicate
the possible variability in the outcomes around some expected value. For
instance, an entrepreneur may undergo profits or losses in business, and it is
the losses and the extent of the same that are determined by the risks associated
in his deals.
The anticipated value is the outcome that would occur on average if a
person or business were frequently exposed to the same type of risk. If you
have not yet encountered these concepts in statistics or finance classes, the
following example from the sports world might help. Allen Iverson has averaged
about 30 points per game in his career in the National Basketball Association.
As we write this, he shows little sign of slowing down. It is, therefore, reasonable
to assume that the expected value of his total points in any given game is about
30 points. Risk, in the sense of variability around the expected value, is clearly
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present. He might score 50 points or even higher in a particular game, or he
might score as few as 10 points.
In other situations, the term risk may imply the anticipated losses in relation
to a situation. In insurance markets, for instance, high-risk policy-holders are
commonly referred to as those people whose expected value of losses to be
paid by the insurer (the expected loss) is high. As another example, described
as having a high risk of earthquake. While this statement might encompass the
notion of variability around the expected value, it simply means that Californias
expected loss from earthquakes is high relative to other states.
Uncertainty refers to the absence of complete certainty, that is, the
existence of more than one possibility. The actual outcome is not known. A set
of probabilities assigned to a set of possibilities is used to measure uncertainty.
For instance: There is a 70% chance that this market will double in five years.
Risk, on the other hand, is a state of uncertainty where some of the possibilities
involve a loss, catastrophe, or other unfavourable outcome. A set of possibilities,
each with quantified probabilities and quantified losses, is used to measure risk.
For instance: There is a 30 per cent chance that the proposed oil well will be dry
with a loss of `12 crores in exploratory drilling costs.
1.2.1 Types of Risks Facing Businesses and Individuals
Broadly defined, business risk management concerns the possible decrease in
business value from any source. Business value to shareholders, as reflected
in the value of a firms common stock, depends fundamentally on the expected
size, timing and risk (variability) associated with the firms future net cash flows
(cash inflows less cash outflows). Unforeseen changes in the expected future
net cash flows happen to majorly influence fluctuations in business value.
Following are broad categories of risk: financial and non-financial and quantifiable
and non-quanitifiable.
In particular, unexpected reductions in cash inflows or increases in cash
outflows can significantly reduce business value. The major business risks that
give rise to variation in cash flows and business value are price risk, credit risk
and pure risk.
Price risk
Price risk represents the uncertainty about the magnitude of cash flows because
of the probable changes in the input and output prices. Output price risk stands
for the risk of changes in the prices which an organization may ask for its goods
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and services. Input price risk means the risk of changes in the prices which a
company has to pay for materials, labour and other inputs in the production
process. In strategic management, the analysis of price risk related to the sale
and production of the prevailing and future products and services plays a
significant role.
Tthere are three basic types of price risk:
commodity price risk
exchange rate risk and
interest rate risk
Commodity price risk is born of the fluctuations in the prices of commodities,
like copper, coal, oil, gas and electricity. These constitute the inputs for some
companies and outputs for others. With economic globalization, output and input
prices for various organizations are being influenced by the foreign exchange
rate fluctuations. The input and output prices can also fluctuate because of the
changes in interest rates. For instance, increases in interest rates might change
a companys revenues by affecting both the credit terms and the speed with
which customers make payments for the products bought on credit. Further,
fluctuations in interest rates also affect the organizations cost of borrowing funds
for financing its operations.
Credit risk
Credit risk means the risk which an organizations customers and the parties to
which it has lent money will delay or fail to make the promised payments. Usually,
most of the firms are under some kind of credit risk for account receivables.
The credit risk exposure is specifically substantial for the financial institutions,
such as commercial banks, which regularly provide loans that are subject to the
risk of default by the borrower. When organizations borrow money, the lenders
are exposed to credit risk (i.e., the risk that the firm may default on the promised
payments). Consequently, borrowing exposes the owners of the firm to the risk
that it may not be able to pay its debts and hence be forced into bankruptcy. As
the credit risk increases, generally the firm has to pay more for borrowing money.
Pure risk
In medium-to-large corporations, the risk management function (and the
expression risk management) has generally aimed at the management of what
is referred as pure risk. The basic types of pure risk which affect businesses
include:
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1. The risk of value reduction in business assets because of physical
damage, theft and expropriation (for instance, seizure of assets by foreign
governments).
2. Legal liability risk related to the damages including harm to suppliers,
shareholders, customers and other parties.
3. The risk in giving benefits to the injured workers under the workers
compensation laws and the risk of legal liability regarding injuries or other
harm to the employees not covered under the workers compensation
laws.
4. The risk of illness, disability and death of employees (sometimes family
members) on the grounds of which businesses agree to make payments
under employee benefit schemes, including the commitments to
employees under pension and other retirement savings schemes.
Personal risk
The risks faced by individuals and families can be classified in a variety of ways.
We classify personal risk into six categories: earnings risk, medical expense
risk, liability risk, physical asset risk, financial asset risk and longevity risk.
Earnings risk refers to the potential fluctuation in a familys earnings, which can
occur as a result of a decline in the value of an income earners productivity due
to death, disability, aging or a change in technology. A familys expenses also
are uncertain. Healthcare costs and liability suits, in particular, can cause large
unexpected expenses. A family also faces the risk of a loss in the value of the
physical assets that it owns. Automobiles, homes, boats and computers can be
lost, stolen or damaged.
The values of financial assets are also subject to fluctuation due to the
changes in inflation and the changes in the real values of stocks and bonds.
Finally, longevity risk refers to the possibility that the retired people will outlive
their financial resources. Often individuals obtain advice about personal risk
management from professionals, such as insurance agents, accountants,
lawyers and financial planners.
1.2.2 Comparison of Pure Risk with Other Types of Risk
Common (but, not essentially distinct) characteristics of pure risk comprise the
following:
1. Losses from destruction of property, legal liability and employee injuries
or illness often have the potential to become enormous relative to a
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businesss resources. Whereas there can be an increase in business
value if the losses from pure risk are lower than anticipated, the maximum
possible gain in such cases is usually comparatively less. On the contrary,
an effective decrease in business value caused as a result of the losses
exceeding the anticipated value can be huge to the extent of threatening
the viability of the firm.
2. The causes underlying losses in relation to pure risk, such as a plant
being destroyed by the explosion of a steam boiler or product liability suits
from consumers injured by a certain product, are often highly firm-specific
and are dependent on the actions undertaken by a firm. Thus, the causes
underlying these losses are often significantly regulated by businesses;
in other words, firms can lower the occurrence and intensity of losses by
the means of actions that change the underlying causes (e.g., by initiating
steps for reducing the probability of fire or lawsuit). In comparison, while
firms can take a variety of steps to reduce their exposure or vulnerability
to price risk, the underlying causes of some important types of price
changes are largely beyond the control of individual firms (e.g., economic
factors that cause changes in foreign exchange rates, market wide
changes in interest rates, or aggregate consumer demand).
3. Businesses frequently decrease uncertainty and finance losses related
to pure risk by entering into contracts with insurance companies
specializing in the evaluation of and bearing pure risk. The prevalence of
insurance partially highlights the firm-specific nature of losses resulting
from pure risk. The events causing huge losses to a certain firm usually
have little impact on the losses experienced by other firms, which enables
the reduction of risk through diversification accomplished by the means
of insurance contracts. Insurance contracts are usually not used to
decrease uncertainty and finance losses in relation to price risk (and many
types of credit risk). Price risks that can simultaneously produce gains for
many firms and losses for many others are commonly reduced with
financial derivatives, such as forward and futures contracts, option
contracts and swaps. With these contracts, much of the risk of loss is
often shifted to parties that have an opposite exposure to the particular
risk.
4. Losses resulting from pure risk are usually not related to balancing gains
for other parties. Instead, losses to businesses arising from other kinds of
risk are often related to the gains to other parties. For instance, a rise in
input prices is detrimental to the one who purchases the inputs but is
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beneficial to the seller. Similarly, a decrease in the value of the dollar value
relative to foreign currencies can be detrimental to domestic importers
but may be beneficial to domestic exporters and foreign importers dealing
in U.S. goods. An indication of this demarcation between pure risk and
price risk is that the losses resulting from pure risk lower the cumulative
wealth in society, whereas fluctuations in out-put and input prices need
not lower the total wealth. In addition, and as we hinted above, the fact that
price changes often produce losses for some firms and gains for others
in many cases allows these firms to reduce risk by taking opposite
positions in derivative contracts.
While many of the details concerning pure risk and its management differ
from other types of risk, it is nonetheless important for you to understand that
pure risk and its management are conceptually similar, if not identical, to other
types of risk and their management. To make this concrete, consider the case
of a manufacturer that uses oil in the production of consumer products. Such a
firm not just faces the risk of large losses from product liability lawsuits if its
products harm consumers, but it also faces the risk of potentially large losses
from oil price increases. The business can manage the expected cost of product
liability settlements or judgments by making the products design safer or by
providing safety instructions and warnings. While the business might not be
able to do anything to reduce the likelihood or size of increases in oil prices, it
might be able to reduce its exposure to losses from oil price increases by adopting
a flexible technology that allows low cost conversion to other sources of energy.
The business might purchase product liability insurance to reduce its liability
risk; it might hedge its risk of loss from oil price increases using oil futures
contracts.
While the concepts and broad risk management strategies are the same
for pure risk and other types of business risk, the specific characteristics of
pure risk and the significant reliance on insurance contracts as a method of
managing these risks generally lead to their management by personnel with
specialized expertise. Major areas of expertise needed for pure risk management
include risk analysis, safety management, insurance contracts and other
methods of reducing pure risk, as well as broad financial and managerial skills.
The insurance business, with its principal function of reducing pure risk for
businesses and individuals, employs millions of people and is one of the largest
industries in the United States (and other developed countries). In addition, pure
risk management and insurance have a major effect on many other sectors of
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the economy, such as the legal sector, medical care, real estate lending and
consumer credit.
Increases in business risk of all types and dramatic growth in the use of
financial derivatives for hedging price risks in recent years have stimulated
substantial growth in the scope and efforts devoted to overall business risk
management. It has become increasingly important for managers that they focus
on pure risk to understand the management of other types of business risk.
Similarly, general managers and managers need to understand how pure risk
affects specific areas of activity and the business as a whole.
Self Assessment Questions
1. Three specific types of price risk are commodity price risk, exchange
rate risk and interest rate risk.(True/False)
2. Physical asset risk, financial asset risk and longevity risk are personal
risks. (True/False)
3. The risk of legal liability associated with damages inducing harm to
customers, suppliers, shareholders and other parties is classified as pure
risk.(True/False)
4. The risk of death, illness and disability to employees (and at times family
members) is classified as __________ risk.
Activity 1
Visit different types of businesses in your area. Hold discussions with
management personnel about the various types of risks faced by their
enterprises. Prepare a report on the categories of risks faced by these firms,
the remedial measures undertaken by them to handle such situations and
the loopholes in the existing risk management strategies.
Hint:
1. Risk is generally perceived as an uncertainty relating to the occurrence
of a loss such as risk of death in an accident, risk of loss due to fire, etc.
To learn more on the subject visit the link http://business.gov.in/
growing_business/types_business.php (Retrieved on 3 September
2012)
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1.3 Risk Management
The process of identification, analysis and either acceptance or mitigation of
uncertainty in investment decision-making refers to risk management in business.
It is a two-step process that can be represented as follows in Figure 1.1.
Determining the risks existing in
an investment
Dealing with those
risks in a way most
appropriate to one's
investment objectives
Figure 1.1 Risk Management Process
Risk management involves essential features such as reliable resources,
financial strategies and foresight. It prevents or reduces the possibility of external
as well as internal risks in business by employing intelligent strategies, and thus
forms an integral part of business or investment.
1.3.1 Risk Management Process
Regardless of the type of risk being considered, the risk management process
involves several key steps:
1. Categorize all significant risks.
2. Estimate the potential frequency and severity of losses.
3. Improve and choose methods for managing risk.
4. Execute the risk management methods selected.
5. Keep track of the performance and suitability of the risk management
methods and strategies on a continuous basis.
Figure 1.2 gives a flow chart of the risk management process.
1.3.2 Risk Management Methods
These methods are not mutually exclusive and may be largely categorized as:
loss control
loss financing
internal risk reduction
Usually, loss control and internal risk reduction include the decisions to
invest (or forgo investing) resources to cut down the expected losses. These
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are theoretically similar to other investment decisions, such as a companys
decision to purchase a new plant or an individual deciding to buy a computer.
Loss financing decisions are the decisions concerned about the manner of
paying for the losses if they do occur.
Figure 1.2 Risk Management Flow Chart
Source: http://www.scu.edu.au/risk_management/index.php/2/ (Retrieved on 3 September
2012)
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Loss control
The activities which decrease the expected cost of losses by lowering the
occurrence of losses and/or their extent are referred as loss control. Sometimes
loss control is also termed as risk control. Usually, the actions basically affecting
the frequency of losses are referred as loss prevention methods. Actions primarily
influencing the severity of losses that do occur are often called loss reduction
methods. An example of loss prevention would be routine inspection of aircraft
for mechanical problems. These inspections help reduce the frequency of
crashes; they have little impact on the magnitude of losses for crashes that
occur. An example of loss reduction is the installation of heat- or smoke-activated
sprinkler systems that are designed to minimize fire damage in the event of a
fire.
Many types of loss control influence both the frequency and severity of
losses and cannot be readily classified as either loss prevention or loss reduction.
For example, thorough safety testing of consumer products reduces the number
of injuries, but it may also affect the severity of injuries. Similarly, equipping
automobiles with airbags in most cases should reduce the severity of injuries,
but airbags also might influence the frequency of injuries. The increase or
decrease in the injuries is dependent upon whether the number of injuries that
are completely prevented for the accidents that occur exceeds the number of
injuries that might be caused by airbags inflating at the wrong time or too forcefully,
as well as any increase in accidents and injuries that may occur if protection by
airbags causes some drivers to drive less safely.
Viewed from another perspective, there are two general approaches to
loss control:
(i) reduction of the risky activity level, and
(ii) increasing precautions against loss for the activities undertaken.
First, exposure to loss can be reduced by reducing the level of risky
activities, for example, by cutting back the production of risky products or shifting
attention to less risky product lines. Limiting the level of risky activity primarily
affects the frequency of losses. The main cost of this strategy is that it forgoes
any benefits of the risky activity that would have been achieved apart from the
risk involved. In the limit, exposure to losses can be completely eliminated by
reducing the level of activity to zero; that is, by not engaging in the activity at all.
This strategy is called risk avoidance.
As a specific example of limiting the level of risky activity, consider a trucking
firm that hauls toxic chemicals that might harm people or the environment in the
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case of an accident and thereby produce claims for damages. This firm could
reduce the frequency of liability claims by cutting back on the number of shipments
that it hauls. Alternatively, it could avoid the risk completely by not hauling toxic
chemicals and instead hauling non-toxic substances (such as clothing or
cholesterol and cheese). An example from personal risk management would be
a person who flies less frequently to reduce the probability of dying in a plane
crash. This risk could be completely avoided by never flying. Of course, alternative
transportation methods might be much riskier (e.g., driving down Agra from New
Delhi the day before a festival, along with many long-haul trucks, including those
transporting heavy machines).
The second major approach to loss control is to increase the amount of
precautions (level of care) for a given level of risky activity. The goal here is to
make the activity safer and thus reduce the frequency and/or severity of losses.
Thorough testing for safety and installation of safety equipment are the examples
of increased precautions. The trucking firm in the above example could give its
drivers extensive training in safety, limit the number of hours driven by a driver in
a day, and reinforce containers to reduce the likelihood of leakage. Increased
precautions usually involve direct expenditures or other costs (e.g., the increased
time and attention required to drive an automobile more safely).
Loss financing
Methods applied to obtain funds for paying for or offsetting losses that occur are
termed as loss financing (sometimes called risk financing). There are four broad
methods of financing losses:
(1) Retention,
(2) Insurance,
(3) Hedging, and
(4) Other contractual risk transfers.
These approaches are not mutually exclusive; that is, they are often used
in combination. With retention, a business or individual retains the obligation to
pay for a part or the entire loss incurred. For example, a trucking company
might decide to retain the risk that cash flows will drop due to oil price increases.
When coupled with a formal plan to fund losses for medium-to-large businesses,
retention is generally called self-insurance.
Firms can pay retained losses using either internal or external funds.
Internal funds include cash flows from ongoing activities and investments in
liquid assets that are dedicated to financing losses. External sources of funds
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include borrowing and issuing new stock, but these approaches may be very
expensive following large losses. Note that these approaches still involve retention
even though they employ external sources of funds. For example, the firm must
pay back any funds borrowed to finance losses. When new stock is issued, the
firm must share future profits with new stockholders.
The second major method of financing losses is the purchase of insurance
contracts. As you most likely already know, the typical insurance contract requires
the insurer to provide funds to pay for the specified losses (thus financing these
losses) in exchange for receiving a premium from the purchaser at the inception
of the contract. Insurance contracts reduce risk for the buyer by transferring
some of the risk of loss to the insurer. Insurers in turn reduce risk through
diversification. For example, they sell large numbers of contracts that provide
coverage for a variety of different losses.
The third broad method of loss financing is hedging. As noted above,
financial derivatives, such as forwards, futures, options and swaps, are used
extensively to manage various types of risk, most notably price risk. These
contracts can be used to hedge risk; that is, they may be used to offset losses
that can occur from changes in interest rates, commodity prices, foreign
exchange rates and the like. Some derivatives have begun to be used in the
management of pure risk, and it is possible that their use in pure risk management
will expand in the future.
Individuals and small businesses do relatively little hedging with derivatives.
At this point, it is useful to illustrate hedging with a very simple example. Firms
that use oil in the production process are subject to loss from unexpected
increases in oil prices; oil producers are subject to loss from unexpected
decreases in oil prices. Both types of firms can hedge their risk by entering into
a forward contract that requires the oil producer to provide the oil user with a
specified amount of oil on a specified future delivery date at a predetermined
price (known as the forward price), regardless of the market price of oil on that
date. Because the forward price is agreed upon when the contract is written,
the oil user and the oil producer both reduce their price risk.
The fourth major method of loss financing is to use one or more of a
variety of other contractual risk transfers that allow businesses to transfer
risk to another party. Like insurance contracts and derivatives, the use of these
contracts also is pervasive in risk management.
For example, businesses that engage independent contractors to perform
some task routinely enter into contracts, commonly known as hold harmless
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and indemnity agreements, which require the contractor to protect the business
from losing money from lawsuits that might arise if persons are injured by the
contractor.
Internal risk reduction
In addition to loss financing methods that allow businesses and individuals to
reduce risk by transferring it to another entity, businesses can reduce risk
internally. There are two major forms of internal risk reduction:
(i) Diversification, and
(ii) Investment in information.
Regarding the first of these, firms can reduce risk internally by diversifying
their activities (i.e., not putting all of their eggs in one basket). Individuals also
routinely diversify risk by investing their savings in many different stocks. The
ability of shareholders to reduce risk through portfolio diversification is an important
factor affecting insurance and hedging decisions of firms.
The second major method of reducing risk internally is to invest in
information to obtain superior forecasts of expected losses. Investing in
information can produce more accurate estimates or forecasts of future cash
flows, thus reducing variability of cash flows around the predicted value.
Examples include:
estimates of the frequency and severity of losses from pure risk
marketing research on the potential demand for different products to reduce
output price risk
forecasting future commodity prices or interest rates
One way that insurance companies reduce risk is by specializing in the
analysis of data to obtain accurate forecasts of losses. Medium-to-large
businesses often find it advantageous to reduce pure risk in this manner as
well. Given the large demand for accurate forecasts of key variables that affect
business value and determine the price of contracts that can be used to reduce
risk (such as insurance and derivatives), many firms specialize in providing
information and forecasts to other firms and parties.
1.3.3 Business Risk Management Organization
Where does the risk management function fit within the overall organizational
structure of businesses? In general, the views of senior management concerning
the need for, scope, and importance of risk management and possible
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administrative efficiencies determine how the risk management function is
structured and the exact responsibilities of units devoted to risk management.
Most large companies have a specific department responsible for managing
pure risk that is headed by the risk manager (or director of risk management).
However, given that losses can arise from numerous sources, the overall risk
management process ideally reflects a coordinated effort between all of the
corporations major departments and business units, including production,
marketing, finance and human resources.
Depending on a companys size, a typical risk management department
includes various staff specializing in areas such as propertyliability insurance,
workers compensation, safety and environmental hazards, claims management,
and, in many cases, employee benefits. Given the complexity of modem risk
management, most firms with significant exposure to price risk related to the
cost of raw materials, interest rate changes, or changes in foreign exchange
rates have separate departments or staff members that deal with these risks.
Whether there will be more movement in the future towards combining the
management of these risks with pure risk management within a unified risk
management department is uncertain.
In most firms, the risk management function is subordinate to and thus
reports to the finance (treasury) department. This is because of the close
relationships between protecting assets from loss, financing losses and the
finance function. However, some firms with substantial liability exposures have
the risk management department report to the legal department. In some firms,
the risk management unit reports to the human resources department.
Firms also vary in the extent to which the risk management function is
centralized, as opposed to having responsibility spread among the operating
units. Centralization may achieve possible economies of scale in arranging loss
financing. Moreover, many risk management decisions are strategic in nature,
and centralization facilitates effective interaction between the risk manager and
senior management.
A possible limitation of a centralized risk management function is that it
can reduce concern for risk management among the managers and employees
of a firms various operating units. However, allocating the cost of risk or losses
to particular units often can improve incentives for unit managers to control
costs even if the overall risk management function is centralized. On the other
hand, there are advantages to decentralizing certain risk management activities,
such as routine safety and environmental issues. In these cases, operating
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managers are close to the risk and can deal effectively and directly with many
issues. Figure 1.3 shows the organizational structure of risk categories.
Figure 1.3 Organizational Structure of Risk Categories
Source: http://www.google.co.in
Self Assessment Questions
5. When coupled with a formal plan to fund losses for medium-to-large
businesses, retention often is called _________.
6. _________, _________, and _______ are the three types of loss financing.
7. The basic risk management methods are: _________, ________, and
_________.
8. Most large companies have a specific department responsible for
managing pure risk that is headed by the risk manager. (True/False)
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Activity 2
Prepare a report on the generally accepted norms of responding to risks by
the business organizations.
Hint:
1. A risk can be avoided if the organization refuses to accept risk by not
taking up the action which may create a risk (elimination of the peril). To
get the details of the risk response process visit the link http://
www.investopedia.com/exam-guide/cfp/principles-of -risk-and-
insurance/cfp3.asp#axzz28DdZFHfc (Retrieved on 3 September 2012)
1.4 Summary
Let us recapitulate the important concepts discussed in this unit:
The term risk broadly refers to the situations where outcomes are
uncertain. Risk often refers specifically to variability in outcomes around
the expected value. In other cases, it refers to the expected value (e.g.,
the expected value of losses).
Major types of business risk that produce fluctuations in business value
include price risk, credit risk and pure risk.
Pure risk encompasses risk of loss from (i) damage, theft or expropriation
of business assets, (ii) legal liability for injuries to customers and other
parties, (iii) workplace injuries to employees, and (iv) obligations assumed
by businesses under employee benefit plans.
Risk management involves (i) identifying potential direct and indirect losses,
(ii) evaluating their potential frequency and severity, (iii) developing and
selecting methods for management of risk for maximizing business value,
(iv) implementing these methods and (v) ongoing monitoring.
Major risk management methods include loss control, loss financing and
internal risk reduction.
Loss control reduces expected losses by lowering the level of risky activity
and/or increasing precautions against loss for any given level of risky
activity.
Loss financing methods include retention (self-insurance), insurance,
hedging and other contractual risk transfers.
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Many businesses achieve internal risk reduction through diversification
and through investments in information to improve forecasts of expected
cash flows.
1.5 Glossary
Price risk: Uncertainty over the magnitude of cash flow due to possible
changes in output and input prices
Credit risk: The risk that a firms customers and the parties to which it
has lent money will delay or fail to make promised payments
Pure risk: Includes risks of reduction in value of business assets, risk of
legal liability, risk involved in providing benefits to injured workers, risk of
death, illness and disability to employees
Personal risk: Risk faced by individuals and families such as earning
risk, medical expense risk, liability risk, physical assets risk, financial risk
and longevity risk
1.6 Terminal Questions
1. What do you understand by the term risk?
2. Explain different types of business risk.
3. What do you understand by risk management? List the steps involved in
the risk management process.
4. Discuss the different methods of risk management.
5. Describe the four basic methods of financing losses.
6. Where does the risk management function fit within the overall
organizational structure of businesses?
1.7 Answers
Self Assessment Questions
1. True
2. True
3. True
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4. Pure
5. Self-insurance
6. Retention, insurance, hedging
7. Loss control, loss financing, internal risk reduction
8. True
Terminal Questions
1. The term risk has various meanings in business and everyday life.
Generally, risk is used to describe a situation characterized by uncertainty
with regard to the occurrence of outcome. For more details, refer
section1.2.
2. The major business risks that give rise to variation in cash flows and
business value are price risk, credit risk, and pure risk. For more details,
refer section 1.2.1.
3. The process of identification, analysis and either acceptance or mitigation
of uncertainty in investment decision-making refers to risk management
in business. For more details, refer section 1.3.
4. The risk management methods, which are not mutually exclusive, can be
broadly classified as (a) loss control, (b) loss financing, and (c) internal
risk reduction. For more details, refer section 1.3.2.
5. There are four broad methods of financing losses: retention, insurance,
hedging and other contractual risk transfers. For more details, refer section
1.3.2.
6. Most of the large companies have a specific department responsible for
managing pure risk that is headed by the risk manager (or director of risk
management). For more details, refer section 1.3.3.
1.8 Case Study
Demand for Risk Mitigation Professionals on the Rise
The role of risk managers begins right from the strategy and planning stage
till the completion of the transaction, all along the way highlighting and
explaining various risks as well as putting up recommendations and solutions
at all the stages. They hold expertise in managing complex situations in
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difficult, dangerous or unknown markets and advise the client companies
regarding the potential risks if any to its business(es), profitability or existence
after assessing and identifying the threats posed by uncertain environments
and elements. On the basis of their findings, they plan for their client to the
means and mechanisms of avoiding, reducing or transferring risks.
Risk managers are also given the task of managing and mitigating the risks
of customers, employees, reputation, assets and stakeholders interests.
These professionals work in various sectors and specialize in different
domains comprising corporate governance, enterprise risk, operational and
regulatory risk, business continuity, security and information risk, technology
risk, and market and credit risk. The introduction of UK Bribery Act in 2011
serves as a good example. We, sometimes, commit the mistake of
presuming that risk comprises financial risks only. Physical risks caused
by crime and terrorist acts, law and order problems, epidemics, social
disputes, natural hazards, etc., may also affect business operations. Such
situations necessitate deep understanding and strategizing to handle such
risks.
Indian economy is making a mark at the world level and the country is opening
up for more and more foreign direct investment in different sectors. As
professionals, risk managers enter the domain when these investors seek
their help for comprehensive risk assessments and frequently guide them
in this regard. Risk managers may either be a generalist possessing a
chartered accountant degree or a specialist in the field of sales and
marketing, law, management or even a research and development expert.
Although organizations hire risk managers for assessing the overall risk,
some organizations might have such managers for particular areas like
supply chains.
Lately, firms in the Banking Financial Services and Insurance (BFSI) sector
are taking stringent measures for risk management because of the strict
compliance norms put up by the regulatory authorities and institutions. The
customer needs of these firms have also gone up, thus boosting the
requirement for such risk managers by 40 per cent, approximately.
For the CEOs risk management has become really important and has come
to acquire a corporate imperative status. It is proved by the fact that even
non-financial firms have started to incorporate the concept of recruiting Chief
Risk Officers (CROs). The CROs are expected to thoroughly put to test the
assumptions underlying the business strategy and authenticate the same
with the help of competitive data, benchmarking data and sector analysis.
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These risk managers enable the CROs to develop, deploy and maintain a
practical and composite risk management approach to handle the situations
related to immediate, long-term and evolving risks.
Discussion Questions
1. What are the reasons that have increased the demand for risk mitigation
professionals?
2. What are the challenges faced by the risk managers in tackling various
types of risks faced by businesses?
Source: Adapted from http://articles.economictimes.indiatimes.com/2012-
09-22/news/34022136_1_operational-risk-risk-mitigation-enterprise-risk
(Retrieved on 1 October 2012)
References
George E Rejda (2009). Risk Management and Insurance, Dorling
Kindersley, New Delhi, India.
Gupta P K. Insurance and Risk Management, Himalaya Publishing House,
India.
Neil.A.Doherty (2000). Integrated Risk Management, First edition, McGraw
Hill Companies, USA.
Skipper, Harold D. and W. Jean Kwon. 2007. Risk Management and
Insurance: Perspectives in a Global Economy. Malden, MA: John Wiley &
Sons.
Trieschmann, James S. and Sandra G. Gustavson. 1998. Risk
Management and Insurance. Cincinnati, OH: South-Western College
Publishing.
Rejda, George E. 2005. Principles of Risk Management and Insurance.
New Delhi: Pearson Education India.
Pritchett, S. Travis, Joan Schmit and James L. Athearn. 1996. Risk
Management and Insurance. St. Paul, MN: West Publishing Company.
Greene, Mark Richard and James S. Trieschmann. 1981. Risk and
Insurance. Cincinnati, Ohio: South-Western Publishing Company.
E-References
www.assocham.org/events/recent/event.../insurance_risk_mgmnt.ppt
(Retrieved on 1 October 2012)
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www.cholarisk.com/files/RiskManagementandInsurancePlanning.doc
(Retrieved on 1 October 2012)
http://www.ey.com/IN/en/Industries/Financial-Services/Insurance
(Retrieved on 1 October 2012)
http://www.irmi.com/forms/online/insurance-glossary/terms.aspx
(Retrieved on 1 October 2012)
http://business-standard.com/india/news/irdas-draft-proposal-for-
insurance-cover-to-bpl-families/188047/on (Retrieved on 1 October 2012)
http://www.scu.edu.au/risk_management/index.php/2/ (Retrieved on 3
September 2012)
http://articles.economictimes.indiatimes.com/2012-09-22/news/
34022136_1_operational-risk-risk-mitigation-enterprise-risk (Retrieved on
1 October 2012)