Chapter 3 Risk Management 1: Essentials 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 reinsurance. 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 profitability. RIMS • 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 survive. – 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 losses. • Most planning is done before losses occur. • The RM process requires the following steps: – Step One: Identify and measure potential loss exposures – 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 transportation. • 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. LOSS OF INCOME • 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 losses. • 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. LIABILITY LOSSES • 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 fraudulent. – 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. STEP TWO: LOSS CONTROL AND RISK FINANCING • 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 Control • 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 insurer. - 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 actions. 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 appropriate. – 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 account - A self-insurance or finite risk program is operated. Self-insurance -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. Insurance • 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 program. 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.