Chapter 3

Chapter 3
Risk Management 1:
Risk Management
• It is defined as the logical development and
execution of a plan to deal with potential losses.
• The focus of RM program is to manage an
organisation’s exposure to accident losses, and
to protect assets.
• RM benefits all types of organizations facing
potential losses, including business firms,
nonprofit organizations, individuals and firms.
The Risk Management Function
• It is carried out by trained specialists:
- Loss Control Engineer, Attorneys, Accountants
 Risk MAnagement Staff:
 Insurance Experts: to work with insurance brokers in purchasing
and renewing the organisation’s commercial insurance and
 Claim Managers: track and process claims from the time of loss
until the insurer responds with payment
 Loss Control Engineer: manage losses arasing from employee
injuries, environmental pollution, defective products
 Financial Analyst: Risk Financing to control organisation’s
• The Risk and Insurance Soceity, Inc, a
professional organisation for risk managers,
recently reported 4500 different profit and
nonprofit organisations including 90% of the
nation’s 1500 largest corporation as member.
• RIMS helps risk managers stay alert to new
problems and possible solutions through
educational classes, publications such as montly
journals and computer networks.
Statement of Objective and Principles
• A statement of principles and procedures designed to achieve the
following objectives:
– Survival: The risk manager is to make sure that the organization can
– Grow: The firm should continue to grow even after a loss.
– Responsibility: Even in the event of serious loss, the risk management
plan should allow the organization to continue to behave responsible
toward the environment, employees, suppliers, customers, and the
communities in which it operates.
– Efficiency and Compliance: An other essential objective is to operate
efficiently in a risk environment. This objective requires the firm to
choose the appropriate balance between loss prevention, insurance and
other risk management tools.
• Risk Management Manual: objectives, principles and procedures
Bank’s Risk Mgmt security issues
Hospital’s --- Hygiene
The Risk Management Process
• RM activities occur before, during and after
• Most planning is done before losses occur.
• The RM process requires the following steps:
– Step One: Identify and measure potential loss
– Step Two: Choose the most efficient methods of
controlling and financing loss.
– Step Three: Monitor outcomes
Step One: Identification and
Measurement of Exposures
• Four District Classes:
– Direct property losses;
– Losses of income and extra expenses following a
property loss.
– Losses arising from lawsuit called liability losses.
– Losses caused by the death, disability, or unplanned
retirement of key people.
Measurement is merely an estimate. Not all preloss
estimates will reflect accurately the actual amount of
damages or the actual exposure to loss.
Direct Property Losses
• Risk Managers can identify potential direct property losses in
different ways.
Checklist may be used to identify and value potential property losses:
Identify and value:
 owned buildings, equipment and land
 Property leased from others
 Stationary inventory
 Property under construction
 Owned and leased vehicles
Identify special perils to which property is exposed:
 Radiation
 Explosion
 Flood
 Earth movement
 theft
Flow Charts
• Graphically represents the production or
distribution process.
• Flow Charts analysis displays the firm’s relations
with suppliers, customers, utilities, and modes of
• Flow Charts also help reveal the consequential
impact of losses. (e.g. Loss of raw material
inventory in a storage may lead to stopping the
entire production
(Insert Figure 3-1)
Valuing Property
• Risk Managers must know the property’s replacement value to
estimate potential property losses.
• Replacement cost often is unrelated to accounting book value (
acquisition-depreciation), 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.
International Operations
• Firms with international operations may have property and
employees in several countries. These firms must devote special
attention to identifying all their property, including that being
transported between location.
• Indirect Losses are more difficult to identify than
direct losses. e.g machine and lost profit. Risk
Managers must make careful estimates and
judgements about the potential size of indirect
• The process begins with a forecast of expected
income under normal circumtences. A second
estimate of postloss income follows. The
difference is the potential income loss following
a direct loss.
• These losses arise from three sources:
– 1. Legal damages: an organization responsible for negligently
injuring, someone should pay legal damages awarded by a court
to the insured party.
– 2. Cost of a legal defense: A defense can be expensive even in
cases where a court finds the “victims” claim groundless, false or
– 3. Cost of loss prevention: In some cases, the legal defense
costs more than the damages awarded to parties claiming injury.
Risk managers spend considerable time trying to identify potential
liability problems so they may be handled in an appropriate way.
e.g. Workers compensation claims arise from injury to firm’s
employees while at work
Product liability occurs when a firms product’s allegedly injure
the public.
Loss of Key Personnel
• Business losing a key personnel by unplanned
retirement, resignation, death or disability, the
effect may be felt in a lost income. (research
scientist, president, etc.)
• Trained subordinates. Life and disability
insurance on key employee may be a part of the
risk management program.
• Estimating the cost of a key employee losses is
difficult because finding and training a
replacement is a function of the job market.
Estimation of Maximum Loss
• Maximum possible Loss: refers to the total
amount of financial harm a given loss
could cause under the worst circumtances.
• Maximum probable loss: is the most likely
maximum amount of damage a peril might
cause under average circumtances.
• All organizations incur cost because they are exposed to
unexpected losses.
• Paying Insurance premiums, paying for uninsured
losses, paying for driver training programs or paying for
installing a fire sprinkler system, each represents a cost
of being exposed to loss.
• The risk managers has some ability to control the
amount and timing of these costs. Successful lost control
efforts reduce the amount of loss costs. Given that some
losses occur even when loss control efforts are effective.
Loss Control: Activities designed to reduce loss cost and
include the following risk management tools:
- risk avoidance, loss prevention, loss reduction
Risk Management Tools for Loss
• Risk Avoidance: eliminating the chance of loss.
- Basic Rule: When the chance of loss is high and loss severity is
also high, avoidance is often the best and sometimes the only
practical alternative e.g. Not doing a business in dangerous places
(earthquake zones)
• Loss Prevention: It activates lower frequency of losses. As long as
benefits exceeds the costs, loss prevention should be used to treat
all exposures, whether assumed or transferred to commercial
- Risk managers first goal in risk prevention program is to reduce or
eliminate the chance of death or injury to people. (employing loss
control engineers to identify sources of loss to institute corrective
e.g. Poor lighting or ventilation, poor layout of machines, insufficient
fire fighting equipment
Loss Prevention (cont.)
- Other losses are more directly related to human
shortcomings and errors such as bad judgment,
inadequate training or supervision or lack of attention to
safety requirements. Example of activities:
- temper resistant packing, security guards in banks,
driver training safety education programs, warning
printed on drugs and dangerous chemicals.
• As a rule, when the frequency of loss is high, loss
prevention activities should be considered as one
alternative for dealing with the problem. They are
feasible only as far as benefits realized from fewer
occurrences of losses are greater than the cost of the
loss prevention measures.
Loss Reduction
• Loss reduction activities aim at minimizing the impact of
losses. It refers to the severity of a loss after it occurs.
Successful loss reduction activities reduce loss severity.
e.g. automatic fire-sprinkler system.( a system design
not to prevent fires but to prevent the spread of fires.
• When the severity of loss is great, and when the loss
cannot be avoided, loss reduction activities are
– Fire walls and doors, training replacement personnel
Loss reduction can be justified as long as the savings they produce
exceed the cost of the effort
Risk Financing
• Refers to the techniques that provide for
the funding of losses after they occur.
• Determination of time and by whom the
costs are borne. The alternatives are:
– Risk assumptions
– Self-insurance and financial risk retention
– Risk transfer other than insurance
– Insurance
Risk Assumption
• Means the consequences of loss will be borne by the party exposed
to the chances of loss.
– It is often a deliberate risk management decision.
They are assumed by firms 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
- A self-insurance or finite risk program is operated.
-It 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. For a true self-insurance system to operate, payments to the
self-insurance funds are needed to be calculated and regularly paid.
The Captive Insurance Company
• One approach to self-insurance involves the use of a company
formed to write insurance for a parent. (One company, several
companies, or an entire industry)
• Motivations for forming a captive:
– To save overheads and profits earned by commercial insurers.
– To earn investment income available on advanced funding.
– To recognize insurance premiums as a current business expense to
parent while the captive insurer reports insurance income, to capture
the favorable tax differential between regular corp and insurance comp
Potential Advantages observed by Captive insurance companies appealing
to some other organizations:
- Improved Loss Prevention Incentives. Offer a chance to reap directly
the benefits of successful loss control.
- Improved Claims Settlements. Includes the ability to cover claims or
exclude claims with more flexibility than an commercial insurer.
- Improved Profitability . Includes the investment potential from investing
cash flow or avoiding premium taxes
Risk Transfer
• The original party exposed to a loss is able to
obtain a substitute party to bear the risk.
- uncertainty of who will pay the loss is
transferred from the individual to the insurance
pool. (insurance noninsurance)
-Hedging: To take two or more simultaneous
position that offset each other so that no matter
what the outcome is of some event based on
chance, the hedger neither wins or losses.
• Represents a contractual transfer of risk. It is an
expensive risk mgmt tool and used when the
chance of loss is low and the severity of a
potential loss is high.
- From a risk manager’s viewpoint: its a
contractual transfer of risk.
- From society’s viewpoint: it is risk reduction
because of the pooling of numerous risk allows
better loss predictability.
-For small and medium sized businesses,
insurance is their foundation of the risk mgmt
Step Three: Regular Review of the
Risk Management Program.
• After all potential sourses of loss have
been identified and plans to deal with them
implemented, the risk managers must
review the program regularly to be sure
that it meets current needs.
– New assests are needed, old assets lose their
value, new production processes are used.

similar documents