The risk management process chapter two

CHAPTER TWO
THE RISK MANAGEMENT
2.1 Meaning of Risk Management:
Risk management is a process that identifies loss exposures faced
by an organization and selects the most appropriate techniques for
treating such exposures. Risk management is the process of identifying,
measuring, and handling losses associated with property, liability and
persons.
In the past, risk managers generally considered only pure loss exposures
faced by the firm. However, newer forms of risk management are emerging
that consider certain speculative risks as well. This chapter discusses only
the treatment of pure risks or pure loss exposures.
2.2 Objectives of Risk Management:
Risk management has important objectives. These objectives can be
classified as either (1) Pre loss Objectives
(2) Post loss Objectives
Pre loss Objectives:
Important objectives before a loss occurs include economy, reduction of
anxiety, and meeting legal obligations.
Economy: The economy objective means that the firm should
prepare for potential losses in the most economical way. This
preparation involves an analysis of the cost of safety programs, insurance
premiums paid, and the costs associate with different techniques for
handling losses.
Reduction of Anxiety: Certain loss exposures can cause greater worry
and fear for the risk manager and key executives. For example, the threat of
a terrible court case from a defective product can cause greater anxiety than
a small loss from a minor fire. This risk manager, however, wants minimize
the anxiety and fear associated with all loss exposures.
Meeting legal obligations: The final objective is to meet any legal
obligations. For example, government regulations may require a firm to
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install safety devices to protect workers from harm, to dispose of harmful

waste material properly and to label consumer products appropriately. The
risk manager must see that these legal obligations are met.
Post loss Objectives:
Important objectives after a loss occurs include survival, continued
operation, stability of earnings, continued growth, and social
responsibility.
Survival: The most important post loss objective is survival of the firm.
Survival means that after a loss occurs, the firm can resume at least partial
operations within some reasonable time period.
Continued Operation: The second post loss objective is to continue
operating. For some, firms, the ability to operate after a loss is
extremely important. For example, a public utility firm most continues to
provide service. Banks, post offices, dairies, and other competitive forms
must continue to operate after a loss. Otherwise, business will be lost to
competitors.
Stability: The third post loss objective is stability of earnings. Earnings per
share can be maintained if the firm continues to operate. However, a firm
may incur substantial additional expenses to achieve this goal (such as
operating at another location), and perfect stability of earnings may not be
attained.
Continued Growth: The fourth post loss objective is continued growth of
the firm. A company can grow by developing new products and
markets or by acquiring or merging with other companies. The risk
manager must therefore consider the effect that a loss will have on the firm’s
ability to grow.
Social Responsibility: Finally, the objective of social responsibility is
to minimize the effects that a loss will have on other persons and on society.
A sever loss can adversely affect employees, suppliers, creditors and the
community in general.
2.3 Steps in the Risk Management Process:
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The risk management process involves four steps:

Step 1: Identifying potential losses (Risk Identification)
Step 2: Evaluate Potential losses (Risk Measurement)
Step 3: Select the appropriate techniques for treating loss exposure, and
Step 4: Implement and administer the program.
Step 1:- RISK IDENTIFICATION:
The first step in the risk management process is to identify all major and
minor loss exposures. This step involves a painstaking analysis of all
potential losses. Unless the sources of possible losses are recognized, it is
impossible to consciously choose appropriate, efficient methods for dealing
with those losses should they occur.
A loss exposure is a potential loss that may be associated with a specific
type of risk. Loss exposures typically classified as (Sources of Risks)
Loss Exposures (Sources of Risks):
 Property Loss Exposures:
 Business Income Loss Exposures:
 Human Resources Exposures:
 Crime Loss Exposures:
 Employee Benefit Loss Exposures:
 Failure to comply with government regulation
 Failure to pay promised benefits
 Group life and health and retirement plan exposures.
 Foreign Loss Exposures:
 Acts of terrorism
 Plants, business property, inventory
 Foreign currency risks
 Kidnapping of key persons
 Political risks
 Liability Risks:
 Defective Products

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 Sexual harassment of employees, discrimination against

employees, wrongful termination
 Misuse of internet and e-mail transactions

Techniques for Identifying Risks:

A risk manager has several techniques that he or she can use to identify the
preceding loss exposures. They include the following:
Loss Exposure Checklists:
One risk identification tool that can be used both by business and by
individuals is a loss exposure checklist, which specifies numerous potential
sources of loss from destruction of assets and from legal liability. For each
item of checklist, the user asks the question, “is this a potential source of the
loss to me or my firm?” In this way, the systematic use of loss exposure
checklists reduces the likelihood of overlooking important sources of risks.
Some loss exposure checklists are designed for specific industries, such as
manufacturers, retail stores, educational institutions, or religious
organizations. Such list tend to the quite lengthy, as they attempt to cover
all the exposures that various entities are likely to face.
A second type of checklists focuses on a specific category of exposure. The
questions included in the checklists usually address specific exposures in
considerable detail. Thus, these checklists can be helpful net only in risk
identification but also in compiling information necessary for an in depth
evaluation of risks that are identified.
The Financial Statement Method:
The financial statement method was proposed by A.H. Criddle (1962).
Although this approach was intended for private originations, the concepts,
of this financial statements approach can be generalized in public sector
organizations as well. By analyzing the balance sheet, operating statements
and supporting documents, criddle maintains, the risk manager can identify
property, liability and human exposures (losses) of the organizations.
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By coupling these statements with financial forecast and budgets, the risk
manager can discover future exposures. Financial statements reveal this
information because every organizational transaction ultimately involves
either money or property.

The Flow Chart Method:

An organization’s exposure to risk also can be identified by studying flow
chart of organization’s activities and operations. These flow charts are
studies alongside the checklists of possible exposures to determine which
items apply.
Contract Analysis:
Many of an organization’s to risk arise from contractual relationships with
other persons and organizations. An examination of these contracts may
reveal are of exposures that are not evident from the organization’s
operations and activities. In some cases, contracts may shift responsibility
to other parties.
Interactions with other Departments:
Frequent interactions with other departments provide another source of
information on exposures of risk. These interactions may include oral or
written reports from other departments on their own initiative or in response
to regular reporting system that keep the risk manager informed of
developments. The importance of such a communications network should
not be underestimated. These departments are consistently creating or
becoming aware of exposures that might otherwise escape the risk manger’s
attention. Indeed, the risk manager’s success in risk identification is heavily
dependent on the co-operation of other departments.
Interactions with Outside Suppliers and Professional Organizations:
In addition to communicating with other departments the risk manager
normally interacts with outsiders who provide services to the organizations.
These, outsiders, for example, accountants, lawyers, risk management
consultants, actuaries, or loss control specialists. The objective would be to
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determine whether the outsiders have identified exposures that otherwise

would be missed. Possibly, the outsiders themselves may create new
exposures.
Statistical Records of Losses:
Where available, statistical records of losses can be used to identify sources
of risk. These records may be available from risk management information
systems developed by consultants or in some cases, the risk manager.
These systems allow losses to be analyses according to cause, location
amount and other issues to interest.
Statistical records allow the risk manager to asses’ trends in the
organization’s loss experience and to compare the organization’s loss
experience with the experience of others. In additions, these records enable
the risk manager to analyze issues such as the cause, time and location of
the accidents, identify of the inured individual and the supervisions, and any
hazards or other special factors affecting the nature of the accident.
Step two: RISK MEASUREMENT (RISK EVALUATION)
The second step in the risk management process is to evaluate and measure
the impact of losses on the firm. This step involves on estimation of the
potential frequency and severity of loss.
Loss frequency refers to the probable number of losses that may occur
during the some given period of time. Loss severity refers to the probable
size of the losses that may occur.
Once the risk manager estimates the frequency and severity of loss for each
type of loss exposure, the various loss exposures can be ranked according to
their relative importance. For example, a loss exposure with the potential for
bankrupting the firm is much more important in a risk management program
than an exposure with a small loss potential.
In addition, the relative frequency and severity of each loss exposure must
be estimate so that the risk manager can select the most appropriate
technique or combination of techniques for handling each exposure. For
example, if certain losses occur regularly and are fairly predictable, they can
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be budgeted out of a firm income and treated as normal operating expenses.

If the certain type of exposure fluctuates widely, however, an entirely
different approach is required.
Although the risk manager must consider both loss frequency and loss
severity, severity is more important, because a singly catastrophic loss could
wipe out the firm. Therefore, the risk manager must also consider all losses
that can result from a singly events. Both the maximum possible loss and
maximum probable loss must be estimated. The maximum possible loss is
the worst loss that could possibly happen to the firm during its lifetime.
The maximum probable loss is the worst loss that is likely to happen to the
firm during its lifetime.
The actual estimation of the frequency and severity of loses may be done in
various ways. Some risk manger considers these concepts informally in
evaluation identified risks. They may broadly classify the frequency of
various losses into categories such as “Slight”, “moderate”, and “certain”
and many have similarly broad estimates for loss severity. Even this type of
informal evaluation is better than none at all. But as risk management
becomes increasingly sophisticated, most large firms, attempts to be more
precise in evaluation risk. It is now common to use probability distributions
and statistical techniques in estimating both loss frequency and severity.
Step 3 Select the appropriate techniques for treating loss
exposure (risk control
Risk control approaches are designed to reduce the firm’s expected losses and to make the
annual loss experience more predictable. After identifying and evaluating exposures
to risk, systematic consideration can be given to alternative methods for
managing each exposure.
The major techniques to handling risks are:
1. Risk control
 Risk avoidance
 Loss control

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 Diversification(separation)
 Combination
2. Risk financing technics
 Risk retention
 Insurance
 Non insurance transfer

1) Risk control technics

 Risk avoidance: - Avoidance means a certain loss exposure is never
acquired, or an existing loss exposure is abandoned. Risk avoidance is
conscious decision net to expose oneself or one’s firm to a particular risk
of loss. In this way, risk avoidance can be said to decrease one’s chance
of loss to zero. Example: if one doesn’t want to face car collusion, he/she
decide not have car at all.
Advantage of risk avoidance
 Chance of loss is reduced to zero if the loss exposure is never
acquired.
 If it is abandoned, the chance of loss is reduced because the
activity or product that could produce a loss has been
abandoned.
Disadvantage of risk avoidance
 The firm may not avoid all the losses e.g. The Company may not
be able to avoid the death of key executives.
 May not be feasible or practical to avoid the exposure. OR even
avoid one risk may create another risk. E.g. A paint factory can
avoid losses arising from the production of paint. Without paint
production, however, the firm will not be business.
 Loss control:-When particular losses/ risks cannot be avoided, actions
may be taken to reduce the losses associated with them. This is
method of dealing with risk is known as “Loss Control”. It is different
than the risk avoidance, because the firm or individual is still engaging
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in operations that gives rise to particular risks. Rather than

abandoning specific activities, loss control involves making conscious
decisions regarding the manner in which those activities will be
conducted. Common goals are either to reduce the probability of
losses or to decrease the cost of losses that do occur.

Types of Loss Control: Two methods of classifying loss control involve

focus and timing.
Focus of Loss Control:
Some loss control measures are designed primarily to reduce loss
frequency. This form of loss control is referred to as “frequency
reduction” (Loss Prevention). For example, measurers that reduce truck
accidents include driver examinations, zero tolerance for alcohol or drug
abuse and strict enforcement of safety rules. Measures that reduce
lawsuits from defective products include installation of safety features on
hazardous products, placement of warning labels on dangerous products,
and institution of quality control checks.
In contrast to frequency reduction, consider an auto manufacturer having
airbags installed in the company fleet off automobiles. This form is
engaging in “severity reduction” (Loss Reduction). It refers to measure
that reduce the severity of a loss. The air bags will not prevent accidents
from occurring, but they will reduce the probable injuries that employees
will suffer if an accident does happen.
Timing of Loss Control:
First Timing Categories – Pre-Loss Activities
 Loss Prevention
 Loss Reduction
Second Timing Categories – Concurrent Activities
Post – Loss Activities.
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Concurrent Activities: In second timing classification for loss control

measures is that of activities that take place concurrently with losses.
The activities of building sprinkler systems illustrate this concept of
concurrent loss control.
Post – Loss Activities: The third category is that of post loss activities.
As with concurrent loss control, post-loss activities always have a
severity-reduction focus. For example, one is trying to salvage damaged
property rather than discard it. Thus, the partial restoration of an
automobile and subsequent sale of the car to an automobile wholesaler
can reduce the overall severity of a loss due to an automobile accident.
Potential Benefits of Loss Control:
Many of the benefits association with loss control are either readily
quantifiable or can be reasonably estimated. These may include the
reduction or elimination of expense associated with the following:
 Repair or replacement of damaged property
 Income losses due to destruction of property
 Extra costs to maintain operations following a loss
 Adverse liability of judgments
 Medical costs to threat injuries
 Income losses due to deaths or disabilities.
Another quantifiable benefit of loss control is a reduction in the cost of other
risk management techniques used in conjunction with the loss control.
Two special forms of loss control are “Separation” and “Duplication”.
 Separation: - involves the reduction of maximum probable loss
associated with some kinds of risks. Example, a firm may disperse
work operations in such a way that on explosion or other terrible will
not injure more than a limited number of persons. (Through such
separation, the firm is reducing the likely severity of overall firm losses
by reducing the size of the exposure in any one location.)
 Combination:-this method makes loss experience more predictable
by increasing the number of exposure units. Unlike separation which
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spreads a specific number of exposure units, combination increases

the number of exposure units under the control of the firm.
2. Risk financing technics
 Risk retention: - Retention means that the firm’s retains part or all
activities exposed to a loss. Retention can be Actives (Planned) or
Passive (Unplanned). Active risk retention means that the firm is aware of
the loss exposure and plans to retain part or all of it, such as automobile
crash losses to a fleet of company cars. Passive risk retention, however,
is the failure to identify a loss exposure, failure to act or forgetting to act.
For example, a risk manager may fail to identify all company assets that
could be damaged in an earthquake.
 Retention can be effectively used in a risk management program under
the following conditions:
 No other method of treatment is available
 The worst possible loss is not serious
 Loss are highly predictable
If retention is used, the risk manager must have some method for paying
losses. The following methods are typically used:
 Current Net Income: The firm can pay losses out of its current net
income and treat losses as exposure for that year. A large number of
losses could exceed current income, however, and other assets may
then have to be liquidated to pay losses.
 Unfunded Reserve: An unfunded reserve is a bookkeeping account
that is charged with actual or expected losses form a given exposure.
 Funded Reserve: A funded reserve is the setting aside of liquid funds to
pay losses. Funded reserves are net widely used by private employers,
because the funds many yield a much higher rate of return by being
used in the business. Also, contributions to funded reserves are net
income tax deductible losses, however, are tax deductible when paid.
 Credit Line: A credit line can be established with a bank, and
borrowed funds may be used to pay losses as they occur. Interest
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must be paid on the loan, however, and loan repayments can

aggregate any cash flow problems a firm may here.
Advantage of risk retention
 Save Money: The firm can save money in the long run if its actual loses
are less than the loss component in the insurance’s premium.
 Lower Expenses: The services provide by the insurer may be provided
by the firm at a lower cost. Some expenses may be reduced, including
loss adjustment expenses, general administrative expenses,
commissions and brokerage fees, loss control expenses, taxes and fees
and the insurer’s profit.
 Encourage Loss Prevention: Because the exposure is retained, there
may be a greater incentive for loss prevention.
 Increase Cash Flow: Cash flow may be increased because the firm can
use the funds that normally would be paid to the insurer at the
beginning of the policy period.
Disadvantage of risk retention
 Possible higher losses: The losses retained by the firm may be greater
than the loss allowance in the insurance premium that is saved by net
purchasing the insurance.
 Possible higher expenses: Expenses may actually be higher outside
experts such as safety engineers may have to be hired. Insurers may
be able to provide loss control and claim services less expensively.
 Possible higher taxes: Income taxes may also be higher.
 Insurance: - this is the most widely used risk transfer is insurance. It
is a contractual transfer of risk. If the risk manager uses insurance to
treat certain loss exposures, five key areas must be emphasized. They
are the following;
 Selection of insurance coverage
 Selection of an insurer
 Negotiation of terms
 Dissemination of information concerning insurance coverage
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 Periodic review of the insurance program

 The risk manager must select the insurance coverage needed. Since there
may not be enough money in the risk management budget to insure all
possible losses, the need for insurance can be divided into several
categories depending on importance.
 Essential insurance includes that coverage required by law or by
contract, such as workers compensation insurance. It also includes
that coverage that will protect the firm against a catastrophic loss or
a loss that threatens the firm’s survival; commercial general liability
insurance would fall into that category.
 Desirable or important insurance is protection against losses
that may cause the firm financial difficulty, but not bankruptcy.
Desirable insurance coverage’s include those that protect against
loss exposure that would force the firm to borrow or resort to credit.
 Available or optional insurance is coverage for slight losses that
would merely inconvenience the firm. Optional insurance coverage
includes those that protect against losses that could be met out of
existing assets or current income.
 The risk manager must select an insurer or several insurers. Several
important factors come in play here. These include the financial
strength of the insurer, risk management services provided by the
insurer, and the cost and terms of protection.
 After the insurer or insurers are selected, the terms of the insurance
contract must be negotiated. If printed policies, endorsements, and
forms are used, the risk manger and the insurer must agree on the
documents that will form the basis of the contract. If specially tailored
manuscript policy is written for the firm, the language and meaning
of the contractual provisions must be clear to both parties. In any
case, the various risk management services the insurer will provide
must be clearly stated in the contract. Finally, if the firm is large, the
premiums may be negotiable between the firm and insurer
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 Information concerning insurance coverage must be disseminated to

others in the firm. The firm’s employees and mangers must be
informed about the insurance coverage, the various records that
must be kept, the risk management services that the insurer will
provide, and the changes in hazards that could result in a suspension
of insurance.
 The insurance program must be periodically reviewed. The entire
process of obtaining insurance must be evaluated periodically. This
involves analysis of agents and broker relationships, coverage
needed, cost of insurance, quality of loss-control services provided,
whether claims are paid properly, and numerous other factors. Even
the basis decision –whether to purchase-insurance must be reviewed
periodically.

 Non insurance transfer:-Transfer,

Transfer, the final tools to be discussed, may
be accomplished in three 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 is 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

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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 manufacture 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.
 Hedging:
Hedging involves the transfer of speculative risk. It is a business
transaction in which the risk of price fluctuations is transferred to a
third party known as a speculator.
In this section, we have discussed large number of risk management tools.
These tools may not be appropriate in all situations to all firms or individuals
at all times. As a result, a risk manager should be knowledgeable enough to
make analysis and select the “best” risk handling tool(s). Cost-benefit
analysis is important in selecting an appropriate risk management tool(s)
Risk Management Matrix
Type of Loss Loss Loss Appropriate Risk
Frequency Severity Risk Management Technique
1 Low Low Retention (Treat)
2 High Low Loss Prevention (Tolerate)
3 Low High Insurance (Transfer)
4 High High Avoidance (Terminate)
Step 4 Implement and administer the program
Once we select the appropriate techniques for treating loss exposure
executing is the basic [Link] achieve this activity the following are the
most important tools.
1. Risk management policy statement

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2. Risk management manual

3. Cooperate with other department
4. Periodic review and evaluating

Benefits of risk management

 Attain its pre-loss and post loss objective easily
 Cost of risk is reduced, increase companies profit
 Enact an enterprise risk management program that treats both pure
and

 pain and suffering reduce--> society benefits

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