School of Mechanical And

Industrial Engineering
Entrepreneurship for engineers
(IEng5242)

Lecture 6
Risk And Insurance In Business
Enterprises
Prepared by: Fekadu B.
1 February: 2023
 Part six:
Risk And Insurance In Business Enterprises
6.1 Definition of Risk

6.2 Classification of Risk

6.3 Classifying risks by type of Asset

6.4 Risk Management

6.5 Tools of Risk Management

6.6 Insurance of Small Business

2
 Definition of Risk
 The term risk used in different ways.
 The following definitions given by different scholars and
practitioners in the field:
 Risk is the channel of loss
 Risk is the possibility of loss
 Risk is uncertainly
 Risk is the dispersion of actual from expected result
 Risk is the probability of any outcome different from the one
expected
 Generally, it has bad/negative connotation

3
 Definition of Risk
 Risk may exists whenever the future is unknown.
 Since no one knows the future exactly, everyone is a risk
manager for himself.
i.e., not by choice, but by sheer necessity.
 Example: In buying a tire, we may have a choice.
There is no sheer necessity
 Risk by itself has an adverse effect
 For managing risk;
individuals,
groups and
societies have developed various methods.
4
 Classification of Risk
 Business risks can be classified into two broad
categories:
1. Market risk
 Market risk is the risk of loss due to the factors that affect an
entire market or asset class.
 Market risk is also known as undiversifiable risk because it
affects all asset classes and is unpredictable.
 Market risk is the uncertainty associated with an investment
decision.
 Market Risk is the possibility of a specific business incurring
losses due to factors affecting the market or the industry that
the business belongs to.
5
 Classification of Risk
An entrepreneur who invests in a new business hopes for a gain
but realizes that the eventual outcome may be a loss.
Market risk: exists when there is a only chance of loss exists
from the business.
Some known causes of market risk include economic
recessions, shifts in interest rates and political unrest.
2. Pure risk
Pure risk is a category of risk that cannot be controlled and has
two outcomes: complete loss or no loss at all.
 There are no opportunities for gain or profit when pure risk is
involved.
 Pure risk is generally prevalent in situations such as natural
6
disasters, fires, or death.
 Classification of Risk
Pure risk is used to describe a situation where only loss or no
loss can occur-but there is no potential gain.
A pure risk exists when there is a chance of loss but no chance
of gain/profit.
Example: Owner of an automobile faces the risk of a collusion
loss.
If collusion occurs, he will suffer a financial loss.
 If there is no collusion, the owner will not gain
 Speculative risk: exists when there is a chance of gain as well
as a chance of loss.
i.e. there is a possibility of loss and gain.
7
Example: Gambling, Smuggling, keeping dollar etc..
 Classifying Risk By Type of Asset
Risk may be grouped according to the type of asset.
Specifically, there are:

property-oriented risks,
personnel-oriented risks, and
customer-oriented risks.
1. Property risks
Property-oriented risks; involve tangible and highly visible
assets.
Many property-oriented risks are insurable.
They include:
8 Fire , Natural disasters, Burglary, Business swindles and, Shoplifting.
 Classifying Risk By Type of Asset
[Link] risks
Personnel-oriented losses occur through the actions of
employees.
The three primary types of Personnel-oriented risks are:
Employee dishonesty, Competition from former employees,
Loss of key executives
[Link] risks
Customers are the source of profit for business, but they are
also the source of an increasing amount of business risk.
 Much of these risks are:
 On-premises injuries and
 Product liability
9
 Classifying Risk By Type of Asset
On-premises injuries:
Customers may initiate legal claims as a result of on-premises
injuries.
Customers who are victims often look to the business to recover
their losses.
Inadequate security, which may result in robbery, assault, or other
violent crimes.
When a customer breaks an arm by slipping on icy steps while
entering or leaving a store.
Product liability:
A product liability suit may be filed when a customer becomes ill or
sustains physical or property damage from using a product made or
10 sold by a firm.
 Risk Management
Risk management: Risk management is a systematic way of
protecting business resources and income against losses.
 Risk management: is the
identification,
measurement and
treatment, of risks that faces from business organization.
 Risk management: It is the reduction and prevention of the
unfavorable effects of risk at minimum cost.
 To reduce risk, an organization needs to apply resources to
minimize, monitor and control the impact of negative events
while maximizing positive events.
11
 Risk Management
A consistent, systemic and integrated approach to risk
management can help to identify, manage and mitigate
significant risks.
Risk management: is the special task to identify, analyze,
and combat the operating risks.
 The complexity of the business environment results a special
attention to a risk:
 Some of the factors, which increase the complexity of
environment, are:
 Inflation
 Growth of internal operation
 More complex technology
12
 Increasing government regulation
 The process of risk management
The basic functions of the risk manager in carrying out of the
responsibilities assigned are:
1. Recognize exposure to loss
 Is also called as risk identification
 Is the 1st step of risk managers’ function.
 It is a fundamental duty that proceed all other functions.
 Is the most vital task:
What types of possible losses are there?
Identify exposure to loss
i.e. the risk manager will not have any chance of handling
13
the loss that identify the risk.
 The Process of Risk Management
2. Estimate the frequency and size of loss:
 Estimate the probability of loss from various sources.
 Is also called as risk measurement.
 Risk measurement; The ability to predict the losses that will actually
occur during the budget year.
i. Determination of the chance of an occurrence or relative frequency.
ii. Determination of the impact of losses upon financial affairs.
3. Decide the best and most economical method of handling
the risk if loss:
i.e. Selection of the proper tool for handling risk
4. Implementing the decision: Try to handle the risk if loss
145. Revaluating the decision: Checking Process
 Tools of Risk Management
 Once the risk manager has identified and measured the risks

facing the firm, the next task is to seek for appropriate tools and
decide how best to handle them.
 Risk can be handled through the following tools.
1. Avoidance
2. Retention
3. Loss prevention and reduction
4. Combination or increasing the No of units exposed to the loss
5. Separation / Diversification
6. Neutralization
15
7. Transfer
 Tools of Risk Management
1. Avoidance
 One way to handle a particular pure risk is to avoid the property,
person or activity with which the risk is associated.
 Two approaches of risk avoidance:
i. Refusing (assume an activity )
e.g. For instance, a firm can avoid a flood loss by not building a
plant in a place where flood is frequently affecting.
 In case of refusing, we are discontinuing the activity
ii. Abandonment (previously assumed activities)
e.g. A firm that produces a highly toxic product may stop
manufacturing that product.
 In case of abandonment, we may continue after some time.
16
 Tools of Risk Management
2. Retention
 It is the most common method of handling risk by the individual
or the firm itself.
 Bearing all the risk by that person/organization.
Types of retention:
i. Planned/conscious/ active risk retention
 It is characterized by the recognition that the risk exists,
and make agreement to assume the losses involved.
 The decision to retain a risk actively is made because there
are no alternatives more attractive.
 Self-insurance is a special case of active retention.
i.e. self-insurance is not insurance.
E.g. A firm may keep some money to retain the risk.
17
 Tools of Risk Management
ii. Unplanned/Unconscious( Passive Retention)
When a company unexpectedly retains risk leading to losses.
This usually occurs when they are not properly managing their
reserves or self insurance.
Passive risk retention takes place when the individual
exposed to the risk does not recognize its existence.
In this case, the person so exposed retains the financial
consequence of the possible loss without realizing that he does
so.
For example, smoking cigarettes can be considered a form of
passive risk retention,
Since many people smoke without knowing the many risks of
18
disease.
 Tools of Risk Management
3. Loss Prevention and Reduction Measures
Prevention is defined as a measure taken before the misfortune
occurs.
Generally speaking, loss prevention programs intend to reduce
the chance of occurrence.
Example:
Constructing a building with a fire resistance material
e.g. fireproofing.
Constructing a building in a place where there is little danger.
Regularly inspecting the machine / area
The existence of automatic loss detection programs.
Fire alarms
19 Warning posters: NO SMOKING!! , DANGER ZONE!!
 Tools of Risk Management
 Loss reduction: measures try to minimize the severity of the
loss once happened /after the event occurs.
For Example:
Automatic sprinkler
An immediate first aid
Medical care and rehabilitation service
Guards
Cover
Fire extinguisher
Fire alarms
20
 Tools of Risk Management
 Loss reduced in any of the following ways:
i. Engineering Risks
 This approach of reducing loss/risk emphasizes by focusing on the
mechanical causes of accidents such as:
 defective wiring,
 improper disposal of waste products,
 poorly designed high ways, etc.
ii. Training of Personnel
 The machines or equipment need to be operated by qualified
personnel to reduce the loss due to human failures.
 Workers should be integrated with the machines they are to
operate through an adequate training to reduce losses.
21
 Tools of Risk Management
iii. Diversification
 Losses may be reduced by distributing the loss to various types of
exposure units possessed.
E.g. Farmers have learnt from experience the need for having more type
of crops to reduce the loss emanating from focusing in any single crop.
4. Separation /Diversification
 Separation of the firm’s exposures to loss instead of concentrating them
at one location where they might all be involved in the same loss.
 Separation =>Dispersion/Scattering the exposure in different places.
 “Don’t put all your eggs in one basket”
Example: Instead of placing its entire inventory in one warehouse,
the firm may elect to separate this exposure by placing equal parts of
22 the inventory in ten widely separated warehouses.
 Tools of Risk Management
5. Combination
 It is a pooling or combination process.
Combination results in the pooling of resources of two or more
firms.
 The new firm has,
more building,
more automobiles, and
more employees than either of the original companies.

 This leads to financial strength, there by minimizing the

adverse effect of the potential loss.
23
 Tools of Risk Management
6. Neutralization
 It is the process of balancing a chance of loss against a chance
of gain.
 Neutralization, which is very closely related to transfer.
E.g. An excellent example is the process of making commitments
on both sides of transaction in such a way the risks compensate each
other
7. Transfer
 It is also called as shifting method.
 When a business organization cannot afford to cover the loss by
itself, it may look for/transfer institutions.
 Insurance is a means of shifting or transferring risk.
24
 Tools of Risk Management
 In determining the appropriate method or methods for handling
losses, a matrix can be used that classifies loss exposure
according to frequency and severity.
Loss Frequency Loss Severity Appropriate risk Management technique

Low Low Retention

High Low Retention & Reduction

Low High Insurance

High High Avoidance

 Severity: is the most likely consequence of a particular risk

25 occurrence upon financial affairs.
 Insurance for Small Business
Basic principles for a sound insurance program
 Basic principles in evaluating an insurance program include:
Identifying insurable business risks
Limiting coverage to major potential losses and
Relating premium costs to probability of loss
Requirements for obtaining insurance
1. There must be a sufficiently large number of homogenous
exposure units to make the losses reasonably predictable.
Insurance is based on the operation of the law of large numbers.
There must be a large number of exposures and those exposures
must be homogenous.
Unless we are able to calculate the probability of loss, we cannot
26 have a financially sound program.
 Insurance for Small Business
2. The loss produced by the risk must be definite and measurable.
 The loss must have financial measurement or financial
implication.
 The risk must be calculated
Example: For instance a person may purchase disability insurance. How
do we know that the person is unable to do? Thus, the risk must be definite
and measurable.
3. The loss must be accidental
The loss must be the result of a contingency,
 It must be something that may or may not happen.
It must not be something that is certain to happen.
Wear and tear or depreciation, which is a certainty, should not be
insured. No protection is given by insurance.
27
We should not be certain as to the occurrence of a loss
 Insurance for Small Business
4. The loss must not be catastrophic
All or most of the objects in the group should not suffer loss at the
same time because the insurance principle is based on a notion of
sharing losses.
Example: Damage which results from war, flood, windstorm
and so on would be catastrophic in nature and hence do not have
insurance.
5. The loss must be large enough.
Capable of producing a large loss, which the insured could not pay
without economic distress.
it must be severe and transferred to the insurer.
i.e. those recurring and minor types of losses are not
transferred to the insurance company.
28
 Insurance for Small Business
6. Reasonable cost of transfer
The probability of loss must not be too high because the cost
of transfer tends to be excessive.
To be insurable, the chance of loss must be small.
 The more probable the loss, the more certain it is to occur.
The more certain it is, the greater the premium will be.
But to make insurance attractive, the premium has to be for
less than the face of the policy.
For instance, a life insurance company to issue a birr 1000
policy on a man aged 99. The net premium would be about
birr 980.
29
30