Risk Management and Insurance

CHAPTER TWO
RISK MANAGEMENT
2.1. Definition of Risk Management
Several factors have contributed to the increased complexity of modern enterprise and have
greatly enlarged the risks faced by business. Among these factors are inflation, the growth of
international operations, more complex technology, and increasing government regulation

 Risk management is defined as a systematic process for the identification and evaluation of
pure loss exposures faced by an organization or individual, and for the selection and
implementation of the most appropriate techniques for treating such exposures
 What loss of exposure? it is any situation or circumstances in which a loss is possible,
regardless of whether a loss occur
Example:
 Manufacturing plants that may be damaged in an earth quake or flood
 Defective products that may result in lawsuits against the company
 The possible theft of company property because of inadequate security
2.2. Objective of Risk Management
Risk management has several important objectives that can be classified in to two categories
1. Pre-loss Objectives
 The first goal means that the firm should prepare for potential losses in the most
economical way possible.
 The second objectives, the reduction of anxiety, is more complicated certain loss exposures
can cause greater worry and fear for the risk manager.
 The final objective is to meet any legal obligations
2. Post-loss Objectives

Risk management also has certain objectives after a loss occurs

 The most important post-loss objective is survival of the firm. Survival means that after the
loss occur; the firm can resume at least partial operations within some reasonable time
period.

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 Risk Management and Insurance

 The second post-loss objective is to continue operating. For some firms, the ability to
operate after a loss is extremely important.
 The third post-loss objective is stability of earnings. Earnings per share can be maintained if
the firm continues to operate
 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.
 Finally, the objective of social responsibility is to minimize the effects that a loss will have
on other persons and on society.
2.3. Steps in the Risk Management Process
In order to have an effective risk management program, the risk manager must take certain steps.
There are four steps in the risk management process.
Step1. Identifying Loss Exposure
Risk identification is the process by which a business systematically and continuously identifies
property, liability, and personal exposures as soon as or before they emerge.

A risk manager has several sources of information that he/she can use to identify the preceding
loss exposures. Includes:

 Risk analysis questionnaires- it aims at identifying the risk faced by an organization.

 Physical inspection: a physical inspection of company plants and operations can identify
major loss exposures
 Flow charts: which shows the flow of production and delivery can reveal production
bottlenecks where a loss can have severe financial consequences for the firm.
 Financial statement method: analysis of financial statements can identify the major assets
that must be protected, loss of income exposures, and key customers and suppliers.
 Historical loss data: historical and departmental loss data over time can be invaluable in
identifying major loss exposures.
 The choice of the above method is a function of:
Nature of the business
The size of the business
The availability of in house expertise
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 Risk Management and Insurance

Step2. Evaluating Loss Exposures (Risk Management)

This steps involves an estimation of the frequency and severity of loss

 Loss frequency: refers to the probable member of losses that may occur during some given
time period.
 Loss severity: refers to the probable size of the losses that may occurs

Prouty Measure of Severity

The two measures suggested by prouty (name of person) to measure loss severity are the
maximum possible loss to one unit per occurrence and the maximum probable loss to one unit
per occurrence.
 The maximum possible loss is the worst loss that could possibly happen to the firm
 The maximum probable loss is the worst loss that is likely to happen

The maximum probable loss, therefore, is usually less than the maximum possible loss.

Severity of risk
The more severe the losses due to a risk the higher the rank.
 Critical risk: include those exposures to loss where the magnitude of losses could lead to
bankruptcy
 Important risk: include those exposures in which the possible losses would not lead to
bankruptcy, but would require the individual or firm to borrow in order to continue
operations
 Unimportant risk: include those exposures in which the possible losses could be met out of
the existing assets or current income without imposing undue financial strain
Step 3. Selecting the Appropriate Technique for Treating Loss Exposures

1) Risk Control Techniques: Risk control techniques attempt to reduce the frequency and
severity of accidental losses to the firm.
A) Avoidance: means that a certain loss exposure is never acquired, or an existing loss
exposure is abandoned
B) Loss control
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 Risk Management and Insurance

 Loss prevention: refers measures that reduce the frequency of a particular loss
 Loss reduction: refers to measures that reduce the severity of a loss after it occurs.
C) Separation/Diversification; another risk control tool is 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.
D) Combination: Combination or pooling makes loss experience more predictable by
increasing the number of exposure units.

In conclusion, an effective risk control techniques can reduce significantly the frequency
and severity of claims. A study by one insurer shows that for every $ 1 invested in workplace
safety, savings of $ 3 or more are possible.

2) Risk Financing Techniques

Risk financing refers to techniques that provide for the funding of losses after they occur. Major
risk financing techniques include the following:
A) Retention: means that the firm retains part or all of the losses that can result from a
given loss. Retention can be either active or passive.
B) Self-insurance: is a special form of planned retention by which part or all of a given loss
exposure is retained by the firm. A better name of self-insurance is self-funding, which
expresses more clearly the idea that losses are founded and paid by the firm.
C) Noninsurance Transfers
Non insurance transfers are methods other than insurance by which a pure risk and its potential
financial consequences are transferred to another party. Examples of noninsurance transfers
include neutralization or hedging and hold-harmless agreements.
D) Insurance
Commercial insurance is also used in a risk management program. From the risk manager’s
viewpoint, insurance represents a contractual transfer of risk. Insurance is appropriate for loss
exposures that have a low probability of loss, but the severity of loss is high. 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

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 Risk Management and Insurance

 Selection of an insurer
 Negotiation of terms
 Dissemination of information concerning insurance coverage
 Periodic review of the insurance program
Method of calculating severity of loss
Risk Management Matrix

Frequency of loss

Low High
Severity of loss

Low Retention Loss control and retention

High Insurance Avoidance

Step 4. Implementing and Administrating the Risk Management Program.

a. Risk Management Policy Statement
This statement outlines the risk management objectives of the firm, as well as company policy
with respect to treatment of loss exposures.
b. Cooperation with other Departments
The risk manger does not work alone. Other functional departments within the firm are
extremely important in identifying pure loss exposures and methods for treating these exposures.
c. Periodic Review and Evaluation
 To be effective, the risk management program must be periodically reviewed and
evaluated to determine if the objectives are being attained
 In addition, new departments that affect the original decision on handling a loss exposure
must be examined.
 Finally the risk manager must determine if the firm’s overall risk management policies
are being carried out, and if the risk manager is receiving the total cooperation of the othe
 r departments in carrying out the risk management functions.

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