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CHAPTER TWO

THE RISK MANAGEMENT PROCESS

2.1: Risk Management Defined

The following definitions of risk management have been forwarded for convenience.

Risk Management refers to the identification; measurement and treatment of exposure

to potential accidental losses almost always in situations where the only possible
outcomes are losses or no change in the status.

* Risk Management and Insurance Management

Risk management should not be confused with insurance management. Risk
management is a much broader concept and differs from insurance management in
several aspects. Risk management places greater emphasis on the identification and
analysis of pure loss exposures. Insurance is only one of the several methods that can be
used to treat a particular loss exposure; as you will see latter in this course, the
techniques of avoidance, loss control, non-insurance transfers, and retention are also
widely used in a modern risk management program. Risk management also provides
for the periodic evaluation of all techniques for meeting losses, not just insurance. And a
successful risk management program requires the cooperation of a large number of
individuals and departments throughout the firm. Risk management decisions have a
greater impact on the firm than insurance management decisions. Insurance
management affects a smaller number of persons.

2. 2: Objectives of Risk Management

Risk management has several important objectives that can be classified into two
categories; pre - loss objectives and post - loss objectives.

1. Pre - loss objectives. A firm or organization has several risk management

objectives prior to the occurrence of a loss. The most important include economy, the
reduction of anxiety, and meeting externally imposed obligations.

a. Economy
The first goal 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.

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b. The reduction of anxiety

The second objective, the reduction of anxiety, is more complicated. Certain loss
exposures can cause greater worry and fear for the risk manager, key executives, and
stockholder 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 accident. However, the risk manager wants to minimize the
anxiety and fear associated with all loss exposures.

c. Meeting externally imposed obligations

The third objective is to meet any externally imposed obligations. This means that 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.

2. Post – loss obligations. 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 partial operation within some reasonable period of time if it chooses to do so.

The second post-loss objective is to continue operating. For some firms, the ability to
operate after a severe loss is an extremely important objective. This is particularly true
of certain firms, such as public utility firm, which must continue to provide service. The
ability to operate is also important for firms that may lose 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 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, there 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. For example, a severe
loss that requires shutting down a plant in a small community for an extended period

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can lead to depressed business conditions and substantial unemployment in the

community.

2. 3: Possible Contributions of Risk Management

Because risk management, as defined in this reading material, is concerned with pure
risks, it may be regarded by some as the true ‘dismal science.” Pure risks have severe
consequences. They hurt those affected by it without resulting in any gain. They can
only hurt a firm or family, and the purpose of risk management is to minimize the hurt
at minimum cost. Upon closer investigation, however, one discovers that the possible
contributions of risk management to businesses, families, and society are highly
significant.

a. Possible Contributions of Risk Management to a Business

The possible contributions of risk management to a business can be divided into five
major categories. The contributions that the risk manager will make in a particular case
depend upon the objectives set for this function and the extent to which these
objectives are achieved.

First, risk management may make the difference between survival and failure. Some
losses, such as large liability suits or the destruction of a firm’s manufacturing facilities,
may so cripple a firm that without proper advance preparation for such event the firm
must close its doors. Hence, this contribution of risk management is critical as those
organizations that do not undertake proper risk management may not even survive in
their businesses.

Second, because profits can be improved by reducing expenses as well as increasing

income, risk management can contribute directly to business profits (or, in the case of
nonprofit organizations or public agencies risk management improves the operating
efficiency). For example, risk management may lower expenses through preventing or
reducing accidental losses as the result of certain low-cost measures, through
transferring potential serious losses to others at the lowest transfer fee possible,
through electing to take a chance on small losses unless the transfer fee is a bargain,
and through preparing the firm to meet most economically those losses that it has
decided to retain. Hence, risk management can make direct contribution to business
profit.

Third, risk management can contribute indirectly to business profits in at least six ways.

i. If a business has successfully managed its pure risks, the peace of mind and
confidence it creates permits its managers to investigate and assume attractive
speculative risks that they might otherwise seek to avoid. For example, if a firm
had to worry about windstorm damage to its plants and industrial injuries to

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its employees, it might elect to limit itself to its present markets. Freed of this
worry, might expand to new markets.
ii. By alerting business managers to the pure-risk aspects of speculative ventures,
risk management improves the pure-risk aspects of speculative ventures, risk
management improves the quality of the decisions regarding such ventures.
For example, a firm that was deciding whether to lease or purchase a building
might reach the wrong decision if it ignored the differing economic impacts of
accidental physical damage to the building.
iii. Once a decision is made to assume a speculative venture, proper handling of
the pure-risk aspects permits the business to handle the speculative risk more
wisely and more efficiently. For example, a business may develop its product
lines more aggressively if it knows that it is adequately protected against suits
by persons who may be harmed accidentally by defective products.
iv. Risk management can reduce the fluctuation is in annual profits and cash
flows. Keeping these fluctuations within bounds aids planning and is a
desirable goal in itself. Investors regard more favorably a stable earnings
record than an unstable one.
v. Through advance preparations, risk management can in many cases make it
possible to continue operations following a loss, thus retaining customers or
suppliers who might otherwise turn to competitors.
vi. Creditors, customers, and suppliers, all of whom contribute to company profits,
prefer to do business with a firm that has sound protection against pure risks.
Employees also prefer to work for such firms.

Fourth, the peace of mind made possible by sound management of pure risks may by
itself is a valuable non-economic asset because it improves the physical and mental
health of the management and owners.

Fifth, because the risk management plan may also help others, such as employees, who
would be affected by losses to the firm, risk management can also help satisfy the firm’s
sense of social responsibility or desire for a good public image.

b. Possible Contributions of Risk Management to a family

Risk management can provide families with the same five major classes of benefits. For
example, by protecting the family against catastrophic losses, risk management may
enable a family to continue a lifestyle that might otherwise be severely threatened or
disrupted. Indeed the continued existence of the family unit might be at stake. Second,
sound risk management may enable the family to reduce its expenditures for insurance
without reducing its protection. Because a family cannot deduct insurance premiums
from its taxable income, a birr reduction in insurance premiums may be worth more
than an additional birr of income. Third, if a family has adequate protection against the
death or poor health of the breadwinner, damage to or disappearance of their property,
or a liability suit they may be willing to assume greater risks in equity investments or

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career commitments would undoubtedly increase. Fourth, family members are relieved
of some physical and mental strain. Fifth, families may also gain some satisfaction from
a risk management program that helps others as well as themselves in improving their
image.

c. Possible Contributions of Risk Management to the Society

To the extent that individual businesses and families benefit from risk management, so
does the society of which they are members. Society also benefits from the more
efficient use of risk management from the reduction in social costs associated with
business and family resources and from the reduction in social costs associated with
business and family financial reserves.

2.4: The Risk Management process

As we have observed in the previous few definitions forwarded to describe risk
management, risk management is the identification, measurement and treatment of
property, liability, and personnel pure-risk exposures. What does the process
specifically involve? What are the sequences of activities to be performed in the risk
management process? Such and other related questions will be replied in the forth-
coming discussions.

The Risk Management process involves five steps. These are:

i. Identifying loss exposures: The loss exposures of a business or family must

be identified. Risk identification is the first and perhaps the most difficult
function that the risk manager or administrator must perform. Failure to
identify all the exposures of the firm or family means that the risk manager will
have no opportunity to deal with these unknown exposures intelligently.
ii. Measuring the losses: After risk identification, the next important step is the
proper measurement of the losses associated with these exposures. This
measurement includes a determination of (a) the probability or chance that
the losses will occur, (b) the impact the losses would have upon the financial
affairs of the firm or family, and (c) the ability to predict the losses that will
actually occur during the budget period. The measurement process is
important because it indicates the exposures that are most serious and
consequently most in need of urgent attention. It also yields information
needed in step iii here under.
iii. Selection of the risk management tools: Once the exposure has been
identified and measured, the various tools of risk management should be
considered and a decision must be made with respect to the best combination
of tools to be used in attacking the problem. These tools include primarily (a)
avoiding the risk, (b) reducing the chance that the loss will occur or reducing
its magnitude if it does occur, (c) transferring the risk to some other party, and
(d) retaining or bearing the risk internally. Selecting the proper tool or

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combination of tools requires considering the present financial position of the

firm or family, its overall policy with reference to risk management, and its
specific objectives.
iv. Implementing the decision made: After deciding among the alternative tools
of risk treatment, the risk manager must implement the decision mad. If
insurance is to be purchased, for example, establishing proper coverage,
obtaining reasonable rates, and selecting the insurer are part of the
implementation process.
v. Evaluating the result: The results of the decisions made and implemented in
the first four steps must be monitored to evaluate the wisdom of those
decisions and to determine whether changing conditions suggest different
solutions.

2. 5: Risk identification
Risk identification is the process by which an organization is able to learn areas in
which it is exposed to risk. Identification techniques are designed to develop
information on sources of risk, hazards, risk factors, perils, and exposures to loss. It
seems quite logical to inquire in to the sources of organizational risks at this particular
moment.

2.6: Risk Measurement

Once the risk manager has identified the risks that the firm is facing, his next step
would be the evaluation and measurement of the risks. Risk measurement refers to the
measurement of the potential loss as to its size and the probability of occurrence.

The risk manager, by using available data from past experience, tries to construct a
probability distribution of the number of events and/or the probability distribution of
total monetary losses. The probability distribution of number of events and/or total
monetary losses would enable the risk manager to estimate, among other things, the
size of possible monetary losses and the corresponding probabilities of occurrence.

Probability distributions: - are used to measure the severity and frequency of loss to a
firm or individuals on the basis of past data. Different types of probability distribution
can be used to measure and evaluate loss exposures. But the selection of each depends
on the nature of the risk exposure and the available parameter to be used.

a) Poisson probability distribution

Is a discrete probability distribution that could be applied to a very large number of

units exposed to risk each facing very small chance of accidents. This approach allows
the possibility of multiple accidents to the same risk exposure unit, which the binomial
probability distribution doesn't allow.

It is applicable truly for larger number of exposures which brings limitation to

binomials. It is a discrete probability distribution making it useful for describing the

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possible number of accidents. Poisson distribution depends on a single parameter - the

expected value - M. The probability that an event (accident) happens r times is given
by:-

P (x) = probability of x = M x e -M

accidents X! , where e = 2.71828

x! = x*(x-1)*(x-2)*…….*1

M = Expected number of
Accidents = pn
P =probability of accident

n = No. of exposed units

Illustration:-

A firm wants to estimate what may happen in the sixth year based on the five years
experience regarding losses on cars. Following are data of the past recent five years.

Amount of
No. of No. of monetary
Year cars accidents loss (in Br.)

1 10 0 0

2 12 1 1200

3 14 3 4500

4 15 1 1000

5 19 2 6500

Total 70 7 13200

Mean 14 1.4 2640

The above data expresses the following:

a- the number of cars operated in each year,

b- the corresponding number of accidents occurred
c- the total monetary losses incurred in connection with the accidents.
d- probability of accident-using counting probability method probability of accident
is given by:
Probability of accident = Mean No. of accidents

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Mean No. of cars owned

= 1.4/14 = 0.1

e- Monetary loss per accident over the period of time is given by:
Monetary loss per accident = Mean monetary loss

over the five years Mean No. of accidents

= 2640/1.4 = 1885.7 (approximately = 1886)

Assume in the 6th year the firm will increase the number of cars to 25. Based on the
past data and the currently available truth the risk manager can construct probability
distribution by the use of Poisson probability methods.

This is an easy tool of measuring and evaluating risk and it only depends on mean or
expected value of occurrence to drive the remaining probability distribution.
The average number of accidents in the sixth year =pn

= 0.1 * 25 =2.5

Standard deviation for the number of accidents =√ M= √pn = √2.5 = 1.58

Poisson probability distribution allows for unlimited number of events to occur on the
object under consideration which in our case accidents over cars. This implies that one
car can experience more than once in a period which is realistic in real life situation.
Hence, this probability distribution is a better tool of measuring and evaluating risk
involving realistic assumption.

Based on the above facts and the Poisson process the following probability distribution
is developed as follows.

 P(x) = Mx e -M
x!

 P(0) = 2.50 * e -2.5

0!

=0.0821

 P(1) = 2.51 * e -2.5

1!

= 0.2052

 P(2) = 2.52 * e-2.5

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2!

= 0.2565

 P(3) = 2.53 * e -2.5

3!

=0.2138

 P(4) =2.54 * e-2.5

4!

= 0.1336

 P(11)= 2.511* e -2.5

11!

= 0.001

The Poisson distribution represents the probability that a rarely occurring outcome will
actually occur particular times (x) when there is a large number of opportunities for it
to occur. The probability distribution of expected number of accidents and the expected
amount of monetary losses for x year is presented as follows:

Amount of
Expected
No of
Amount of
accidents loss
Exp. No of Monetary
(given) (given) Probability accidents loss

0 0 0.0821 0 0

1 1886 0.2052 0.2052 387.01

2 3772 0.2565 0.0513 967.52

3 5658 0.2138 0.6414 1209.68

4 7544 0.1336 0.5344 1007.88

5 9430 0.0668 0.334 629.92

6 11316 0.0278 0.1668 314.58

7 13202 0.0099 0.0693 130.7

8 15088 0.0031 0.248 46.78

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9 16974 0.0009 0.0081 15.28

10 18860 0.0002 0.002 3.77

11 20746 0.0001 0.0011 20.7

Total 1.0000 2.5001 4,715.00

Expected monetary = Expected amount of total monetary loss

loss per accident Expected number of accidents

= 4715 / 2.5 = 1886

Based on the above probability distribution, risk managers and analysts can determine
the probability of exposures that are likely to occur, which in this case the probability of
accidents that are likely to happen.

e.g. - P (No. accident) = P(0) = 1 - P(r > 1)

- P(accident) = P(r > 0) = 1 - P(0)

- P(at least 1 and at most 4 accidents = P(1 < r < 4)= P(1) + p(2) + p(3) + p(4)

= 0.2052 + 0.2565 + 0.2138 + 0.1336

= 0.8091
There is almost 81% chance of facing between 1 and 4 accidents.

Exercise 1
Consider the following historical data available for a firm regarding fleet of trucks and
accidental losses.
Year Numberof Numberof Monetar
trucks accident y loss

1 5 2 12,000

2 5 3 14,600

3 6 2 12,004

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4 8 3 15,000

5 8 2 13,000

For the coming year the firm is intending to operate a fleet of 10 trucks. Assume, a truck
will experience only a single accident within a particular year.
Required:

1. Construct the appropriate probability distribution.

2. What is the probability that the firm experience an accident next year?
3. Calculate the amount of expected loss
4. Determine the range by which the actual monetary loss may exceed the expected
loss.
5. Calculate the risk related to the mean
Exercises 2
Given the following historical data answer the questions that follow.

Year Number Number

Monetary loss
of cars of
accident

1 10 2 4,600

2 12 2 4,800

3 14 3 5,396

4 16 3 5,600

5 20 3 5,500

Suppose the firm plans to have 25 cars for the next year.

Required:

1. Construct the appropriate probability distribution

2. What is the probability that the firm will suffer some monetary loss next year?
3. What is the probability that the firm will suffer losses totaling Birr 10,000 or
more?

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4. Determine the standard deviation of loss.

5. What is the expected number of accident?
6. What is the expected monetary loss?

2.7: Tools of Risk Management - Overview

After the risk manager has identified and measured the risks facing the firm, he or she
must decide to handle them. There are two basic approaches. First, the risk manager
can use risk control measures, which are

(1) Avoidance, (2) loss prevention and reduction measures (3) separation, (4)
combination / diversification, (5) Non - insurance transfers

Second, the risk manager can use risk financing measures to finance the losses that do
occur. Funds may be required to repair or restore damaged property, to settle liability
claims, or to replace the services of disabled or deceased employees or owners. In some
instances however, the firm will decide not to restore the damaged property or replace
the disabled or deceased person. Nevertheless, the firm may also have suffered a
financial loss through a reduction in its assets or its future learning power. The tools in
this second category include

(1) Retention, which includes, “self insurance” and

(2) Risk Financing Transfer Methods

2.7.1 Risk control measures

Risk control refers to techniques, tools, strategies and processes that organizations
employ to reduce an exposure to risk. Put in different way, risk control includes
techniques, tools, strategies, and processes that seek to avoid, prevent, reduce, or
otherwise control the frequency and/or magnitude of loss and other undesirable effects
of risk. Moreover, it includes methods that seek to improve understanding or
awareness within an organization of activities affecting exposure to risk.

1) Risk Avoidance

Risk avoidance is one particular risk control tool and it involves avoiding the property
person, or activity giving rise to possible loss by either refusing to assume it even
momentarily or by abandoning an exposure to loss assumed earlier.

What this implies is that risk avoidance involves two activities; a proactive avoidance
that is reflected by refusal to even momentarily assumes the risk and abandonment of
an already assumed exposure.

We can mention various examples of proactive avoidance. Addis pharmaceutical, say, is

engaged in an intensive research to produce a certain type of drug. While the research

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is going on, however, the researchers found out that the drug to be produced might
cause serious health problems to its users. The management of Addis pharmaceuticals
may decide now to altogether stop the planned production of that drug and hence use a
proactive avoidance tool to control risk.

Other examples of proactive avoidance include:

Imagine a leading chemical firm that has planned to conduct a series of experiments in
rural areas containing a single small town. While the firm is on the verge of conducting
the experiment, researchers discovered that the experiment would cause extensive
property damage to the community that cannot even be covered by insurance
companies. In this situation, the firm may decide to altogether quit the idea of
conducting the experiment.

Sometimes proactive avoidance may involve avoiding the hazards rather than totally
avoiding the possible source of risk. For example, suppose The Awassa city parks
Administration wants to open a new park around Amora Gedel area. While in the
process of negotiation with the Awassa city Administration is going on to take over the
place, the managers of the parks administration found out that there are a number of
snakes in the park that might be hazardous to people visiting the park. Rather than
avoiding the place as a possible park site for this reason, the management of the Park
Administration may decide to find ways of getting rid of the snakes. In this case, what is
avoided is not the source of risk but the hazard involved. Hence, one possible risk
avoidance activity is to proactively avoid the source of risk altogether or the hazard
involved with it.

Avoidance through abandonment is the other way of risk avoidance. However, it is not
commonly used as the proactive avoidance. As has been pointed out before, this
technique is employed to an already assumed risk.

The following may be examples of risk avoidance through abandonment.

 A pharmaceutical firm may choose to discontinue the production of some particular

product when reports of serious side effects that were not known before begin to
surface.
 A pastry may decide not to purchase again a particular type of flour after
discovering that the flour is not of good quality having negative effect on the quality of
cakes it produces.
 An apartment manager firm may decide to remove a swimming pool from its
premise after learning that a majority of the renters have small children.
Avoidance is an effective approach to the handling of risk. By avoiding a risk, the
organization knows that it will not experience the potential losses or the uncertainty
that the risk may generate. But remember that risk avoidance is not without costs.

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When we decide to avoid a given risk, we also lose the benefits that may have been
derived from that risk.

This is what makes risk avoidance an unacceptable option. It is not always easy to avoid
a given risk. A particular activity such as the production of some product or the
provision of some services may provide economic rewards whose expected value by far
exceeds potential loss costs at the margin. Consider an owner of a taxi - though this
person is exposed to a risk of car accidents, deciding to avoid the provision of taxi
service is not an acceptable option, as it would entail loss of income.

There are other circumstances when avoidance simply is not possible. This is the case
when risk is defined more broadly.

Thinking of risk avoidance, the only way for an organization to avoid property damage,
is to sell all its physical assets. However, this seems non-sense thing to do, as it is not
possible to sell all your assets just because you want to avoid risk.

Consider another example where avoiding risk is an unacceptable option. As a college

student, you take exams on periodic basis and when you take exams, there is risk of
failure. However, you cannot avoid taking exams because of this as doing so would
result in more serious problems and greater complications.

Sometimes, avoidance becomes impossible due to legal expectations imposed by the

government. For example, an employer cannot avoid the cost of financing the risk of
unemployment because participation in the unemployment insurance program is
mandatory.

In other instances, the context of the decision to avoid also may make avoidance
impossible. A risk does not exist in a vacuum, and a decision to avoid a risk might
actually create a new risk elsewhere or enhance some existing risk. For instance,
Ethiopian Roads Authority gets reports that one of the two bridges crossing Akaki River
is in a state of serious disrepair. Thus, the authority closed this bridge and opened only
the other bridge for traffic. This would increase the traffic load on the second bridge
and may ultimately lead to the collapse of the other bridge. The thing is risks that most
organizations encounter often are interrelated in some way, and the avoidance of one
can adversely affect the risk remaining in the risk portfolio.

To put it in a nutshell, risk avoidance though a very effective risk control tool, is not
always a feasible option.

2 ) Loss Prevention and Loss Reduction

The other risk control technique relates to loss prevention and loss reduction. These
tools work by reducing loss frequency and loss severity. Loss prevention measures

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attack risk by reducing the number of losses that occur. In other words they reduce loss
frequency. Loss reduction method, on the other hand, deal with mitigating the amount
of damage when a loss does occur i.e. by reducing loss severity.

These tools have a distinct advantage of preventing or reducing losses for both the
individual organization and society while permitting the organization to commence or
continue the activity creating the risk.

a) Loss prevention
Loss prevention programs seek to reduce the number of losses or to eliminate them
entirely. Loss prevention activities seek to intervene in the first three links in the risk
chain. In other words, loss prevention activities focuses on altering or modifying the
hazard, altering or modifying the environment in which the hazard exists, and
intervening in the processes whereby hazard and environment interact. Some examples
for each of the three links are given below.

Loss prevention activities that focus on the hazard

1. Hazard: careless house keeping
Loss prevention activity: Training and monitoring programs
2. Hazard: flooding
Loss prevention activity: dams and water resource management
3. Hazard: smoking
Loss prevention activity: ban on smoking except in restricted areas
4. Hazard: pollution
Loss prevention activity: handling protocols for use and disposal of polluting
substances
5. Hazard: muddy and slippery roads
Loss prevention activity: graveling or asphalting the road.
6 Hazard: Drunk driving
Loss prevention activity: prohibition: enforcement of ban, prison sentence, etc.
7. Hazard: Lack of information on side effects of a pharmaceutical product
Loss prevention activity: rigorous research and development on the field

Loss prevention activity that focuses on the Environment

Here again, some examples are presented in the following table.

Environment Loss prevention activity

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1 A shop floor that could become Installation of absorbent

slippery from oil spillage

2 The Addis Ababa ring road Barrier construction lighting signs and
road markings

3 Improperly trained work force Training

4 Consuming public property Adequate product instructions and

warnings

5 The drug-addicted population Counseling treatment, detection.

6 Structures susceptible to fire Fire-resistive construction

7 Unlighted central city parking Lighting, escort and security services

facility

8 Employees driving a fleet of Driver’s education training

delivery vehicles

The illustrations made above are on loss prevention activities that focus on the hazard
and on the environment. As the purpose of these illustrations is not so much to identify
the full scope of activities that constitute loss prevention, what we did is to just give you
a general sense of the variety of loss prevention activities. To finalize the illustration, I
am going to give you some examples of loss prevention activities that focus on the
interaction of hazard and the environment. This is presented in the table below.

Interaction Loss prevention activity

1 A heating process that may overheat surrounding A water-cooling system.

equipment.

2 Telephone line repair person working during Proper clothing raincoat

‘keremet’. and warm sweaters.

3 Consumer use of a hazard product. Safety features customer

assistance.

4 An underground storage tank leaking fuel. Double- seal tanks

5 Vehicle skidding on a slippery road. Antilock brakes

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b) Loss Reduction
As has been mentioned before, loss reduction programs are designed to reduce the
potential severity of a loss. A good example of loss reduction effort is the usage of fire
extinguishers and sprinklers. When you buy a fire sprinkler, you are not doing so to
reduce the probability of loss. Rather you want to use it to reduce the amount of
damage in case a fire occident occurs.

Unlike loss prevention activities that attempt to reduce the probability of loss, loss
reduction activities are post loss measures. Loss reduction measures might be planned
prior to any loss, and their function or purpose is to minimize the impact of losses that
occur. Thus, when a risk manager plans on loss reduction measures, he/she is tacitly
admitting that some losses are going to occur despite effort made by the organization to
reduce the probability of its occurrence. This being the case, loss reduction measures
attempt to control the loss and reduce its potential severity.

In the previous part, you’ve seen how loss prevention activities can be undertaken by
focusing on the first three links of the risk chain. Though loss reduction, too,
occasionally focuses on the third chain, it more commonly focuses on the fourth and
fifth links that deal with the outcome of the interaction and the consequences of the
outcome.

An example may clarify this point. A worker suffers serious burn on his arms and legs.
There is nothing to prevent here as the worker is already suffering. However, a loss
reduction measure such as promptly sending the worker to a burn treatment center
with the appropriate expertise can help reduce the risk.

One illustration of a loss reduction technique is catastrophe or contingency planning. I

hope you very well know that what loss reduction tries to do is to reduce the impact of
loss either through controlling the event as it occurs and controlling the immediate
outcome of the event or controlling the longer-term consequences of the event. To do
so, firms usually undertake catastrophe or contingency planning in their loss reduction
efforts. A catastrophe plan is an organization’s wide effort to identify possible crises or
catastrophes and develop plans for responding to such events.

Catastrophe planning usually involves a fairly lengthy process of research and

evaluation that ultimately yields a contingency plan for possible use in the event of a
catastrophe.

Among the activities that might become part of a catastrophe plan are:

 Cross training employees.

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 Back up off-site storage of computerized records.

 Updating of fire suppressant system.
 Securing of credit from lending institutions to be used in crisis situation.
 Training of employees on emergency safety procedures.
 Construction modification, such as installation of firewalls.
 Creation of an emergency response team or committee.
Another possible loss reduction technique is asset duplication. This involves
duplication of an existing asset that is not used unless something happens to the
original asset. For example, consider a factory that uses certain strategic machinery in
its production activity. If this machinery breaks down for some reason, the factory
would come to a stand still. However, if duplicate machinery is already made available,
the potential loss that occurs due to disruption of operation in the factory will be
avoided.

Duplication reduces the probability of an indirect loss because the duplicate may be
available for use if the original asset cannot be used.

Another example of the use of duplication could be backing up computer files and
storing the backup records off-site. Since the loss of employee records, accounts
receivable, transaction documentation, or other financial information could be a serious
problem for an organization, the importance of making duplicate file is crystal clear.

3) Separation

The other loss reduction technique that we will discuss now is separation. A common
saying that goes, “do not put all your eggs in one basket” may possibly illustrate this
technique, which involves isolating exposures to loss from each other instead of leaving
them vulnerable to a single event.

Several examples can be cited to clarify this point. A firm might store its inventory in
different warehouses than putting them all in a single ware house. This would possibly
reduce the risk that may happen due to any peril such as fire accident.

Another example of separation is a rule requiring employees in a retail establishment to

move cash accumulation over a stated amount from cash registers to a more secure
location such as a bank vault.

Separation is a loss reduction technique that isolates exposures to loss from each other
instead of leaving them vulnerable to one single event.

Another risk Control technique relates to proper management and use of information.
Information emanating from an organization’s risk management department can have
important effects in reducing uncertainty in an organization’s stakeholders. For
example, the firm that has put in place an effective risk control programmes realizes the

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maximum benefit from these programmes only if the programmes’ objectives and their
favorable effects are properly communicated to stakeholders ( such as customers,
employees insurance, government agencies, etc.) that have an interest in the outcome.

The information provided may describe the effectiveness of loss control measures and
the intent of the department’s future actions. Failure to furnish proper information may
put stakeholders in an uncertainty as to the nature of the organizations actions with
respect to matters affecting their interests.

For example, many countries in the middle east, import cattle and meat from Ethiopia.
If a local firm that engages in this business fails to properly communicate the strict
safety procedures it undertakes to supply quality meat and cattle, - these countries may
impose restrictions on this product or may even ban it altogether. Thus, we consider
information management by itself as an important risk control technique.

Proper information on the loss causing process is also another area in which the
importance of information management can be seen. In other words, knowledge of the
process by which hazards evolve in to injuries can reduce uncertainty in affected
parties, as the awareness allows better forecasts of the consequences of actions.

For example, employees can become alert to situations requiring preventive action if
they are aware of circumstances leading to possible injury.

4) Combination / Diversification
Combination is a basic principle of insurance that follows the law of large numbers.
Combination increases the number of exposure units since it is a pooling process. It
reduces risk by making loses more predictable with a higher degree of accuracy. The
difference is that unlike separation, which spreads a specified number of exposure
units, combination increases the number of exposure units under the firm.

In the case of firms, combination results in the pooling of resources of two or more
firms. One way a firm can combine risks is to expand through internal growth. For
example, a taxicab company may increase its fleet of automobiles. Combination also
occurs when two firms merge or one acquires another. The new firm has more
buildings, more automobiles, and more employees than either of the original
companies. This leads to financial strength, thereby minimizing the adverse effect of the
potential loss. For example, a merger in the same or different lines of business increases
the available resources to meet the probable loss.

Diversification is another risk-handling tool; most speculative risk in business can be

dealt with diversification. Businesses diversify their product lines so that a decline in
profit of one product could be compensated by profits from others. For example

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farmers diversify their products by growing different crops on their land.

Diversification however, has limited use in dealing with pure losses.

5) Non - insurance transfers

Transfer, the final tool to be discussed, may be accomplished in two ways. These are:
 Transfer of the activity or the property. The property or activity responsible for
the risks may be transferred to some other person or group of persons. For example, a
firm that sells one of its buildings transfers the risks associated with ownership of the
building to the new owner. A contractor who is concerned about possible increase in
the cost of labor and materials needed for the electrical work on a job to which he/she
is already committed can transfer the risk by hiring a subcontractor for this portion of
the project.
This type of transfer, which in closely related to avoidance through abandonment, is a
risk control measure because it eliminates a potential loss that may strike the firm. It
differs from avoidance through abandonment in that to transfer a risk the firm must
pass it to someone else.

 Transfer of the probable loss. The risk, but not the property or activity, may be
transferred. For example, under a lease, the tenant may be able to shift to the landlord
any responsibility the tenant may have for damage to the landlord’s premises caused by
the tenant’s negligence. A manufacturer may be able to force a retailer to assume
responsibility for any damage to products that occurs after the products leave the
manufacturer’s premises even if the manufacturer would otherwise be responsible. A
business may be able to convince a customer to give up any rights the customers might
have to give the business for bodily injuries and property damage sustained because of
defects in a product or a service. The contracts that implement such transfers are called
exculpatory contracts.
In each of the above examples, the transfer excuses the transferor from firm
responsibility for property or personal losses to the transferee. The exposure itself is
eliminated. Some risk control transfers limit but do not eliminate the exposure. For
example, the transfer may limit, but not eliminate the transfer’s birr responsibility.
Under a risk financing transfer, the transferor makes the transferee pay for losses that
would otherwise have to be assumed by the transferor. For example, under a lease, a
landlord may make a tenant pay for fire loses to rented premises even if the tenant is
not negligent. Under purchase agreement, a retailer may obtain a promise from a
manufacturer that the manufacturer will reimburse the retailer for any payments the
retailer might have to make to others because of defects in the manufacturers products.
As part of a bailment relationship, a laundry may accept responsibility for damage to
customers’ property even if the business, except for the contract, would not be liable.

2.7.2. Risk financing tools

1) Retention

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Retention means that the firm retains part or all of the losses that result from a given
loss exposure. Retention can be effectively used in a risk management program when
certain conditions exist.

First, no other method of treatment is available. Insurers may be unwilling to write a

certain type of coverage, or the coverage may be too expensive. Non - insurance
transfers may not be available. Loss control can reduce the frequency of loss, but not all
losses can be eliminated. In these cases, retention is a residual method. If the exposure
cannot be insured or transferred, then it must be retained.

Second, the worst possible loss is not serious. For example, physical damage losses to
automobiles in a large firm’s fleet will not bankrupt the firm if the automobiles are
separated by wide distances and are not likely to be simultaneously damaged.

Finally, losses are highly predictable. Retention can be effectively used for workers’
compensation claims, physical damage losses to automobiles, and shoplifting losses.
Based on experience, the risk manager can estimate a probable range of frequency and
severity of actual losses. If most losses fall within that range, they can be budgeted out
of the firm’s income.

2) Insurance
Commercial insurance can also be used in a risk management program. Insurance can
be advantageously used for the treatment of loss exposures that have a low probability
of loss but the severity of a potential loss is high.

If the risk manager decides to use insurance to treat certain loss exposures, five key
areas must be emphasized.
1. Selection of insurance coverages
2. Selection of an insurer
3. Negotiation of terms
4. Dissemination of information concerning insurance coverage
5. Periodic review of the insurance programs

2.8: Implementing the risk management program

At this point, three of the four steps in the risk management process have been
discussed. The fourth step is implementation and administration of the risk
management program. Common activities of a risk manager include identifying and
evaluating loss exposures, establishing procedures for handling insurance claims,
designing and installing employee benefit plans, participating in loss-control and safety
programs, and administrating group insurance and self-insurance programs. It is
apparent from these activities that the risk manager is an important part of the
management team.

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A risk management policy statement is necessary in order to have an effective risk

management program. This statement outlines the risk management objectives of the
firm, as well as company policy with respect to treatment of loss exposures. It also
educates top-level executives in regard to the risk management process, gives the risk
manger greater authority in the firm, and provides standards for judging the risk
manager’s performance.

In addition, a risk management manual may be developed and used in the program. The
manual describes in some detail the risk management program of the firm and can be a
very useful tool for training new employees who will be participating in the program.
Writing such a manual also forces the risk manger to state precisely his or her
responsibilities, objectives, and available techniques.

2.9: Periodic Review and Evaluation

To be effective, the risk management program must be periodically reviewed and
evaluated to determine if the risk management objectives are being attained. In
particular, those activities relating to risk management costs, safety programs, and loss
prevention must be carefully monitored. Loss records must also be examined to detect
any changes in frequency and severity. Moreover, new developments that affect the
original decision on handling a loss exposure must also be examined. Finally, the risk
manager must determine if the firm’s overall risk management policies are being
carried out and if he or she is receiving the total cooperation of the other departments
in carrying out the risk management functions.

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