Chapter 3
Introduction to
Risk Management
12/22/20 © Abas M. Hassan 2017 1
Agenda
Meaning of Risk Management
Objectives of Risk Management
Steps in the Risk Management Process
Benefits of Risk Management
Personal Risk Management
12/22/20 © Abas M. Hassan 2017 2
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
A loss exposure is any situation or circumstance in
which a loss is possible, regardless of whether a
loss occurs
E.g., a plant that may be damaged by an earthquake, or
an automobile that may be damaged in a collision
12/22/20 © Abas M. Hassan 2017 3
Objectives of Risk Management
Risk management has objectives before and
after a loss occurs
Pre-loss objectives:
Prepare for potential losses in the most
economical way
Reduce anxiety
Meet any legal obligations
12/22/20 © Abas M. Hassan 2017 4
Continued…
Post-loss objectives:
Survival of the firm
Continue operating
Stability of earnings
Continued growth of the firm
Minimize the effects that a loss will have on
other persons and on society
12/22/20 © Abas M. Hassan 2017 5
Risk Management Process
Identify potential losses
Measure and analyze the loss exposures
Select the appropriate combination of
techniques for treating the loss exposures
Implement and monitor the risk management
program
12/22/20 © Abas M. Hassan 2017 6
Exhibit 3.1 Steps in the Risk Management Process
12/22/20 © Abas M. Hassan 2017 7
Identify Loss Exposures
Property loss exposures
Liability loss exposures
Business income loss exposures
Human resources loss exposures
Crime loss exposures
Employee benefit loss exposures
Foreign loss exposures
Intangible property loss exposures
Failure to comply with government rules and regulations
12/22/20 © Abas M. Hassan 2017 8
Continued…
Risk Managers have several sources of information
to identify loss exposures:
Risk analysis questionnaires and checklists
Physical inspection
Flowcharts
Financial statements
Historical loss data
Industry trends and market changes can create new
loss exposures.
e.g., exposure to acts of terrorism
12/22/20 © Abas M. Hassan 2017 9
Measure and Analyze Loss Exposures
Estimate for each type of loss exposure:
Loss frequency refers to the probable number of losses
that may occur during some time period
Loss severity refers to the probable size of the losses
that may occur
Rank exposures by importance
Loss severity is more important than loss frequency:
The maximum possible loss is the worst loss that could
happen to the firm during its lifetime
The probable maximum loss is the worst loss that is
likely to happen
12/22/20 © Abas M. Hassan 2017 10
Select the Appropriate Combination of Techniques
for Treating the Loss Exposures
Risk control refers to techniques that reduce
the frequency and severity of losses
Methods of risk control include:
Avoidance
Loss prevention
Loss reduction
12/22/20 © Abas M. Hassan 2017 11
Continued…
Avoidance means a certain loss exposure is
never acquired or undertaken, or an existing
loss exposure is abandoned
The chance of loss is reduced to zero
It is not always possible, or practical, to avoid all
losses
12/22/20 © Abas M. Hassan 2017 12
Continued…
Loss prevention refers to measures that
reduce the frequency of a particular loss
e.g., installing safety features on hazardous
products
Loss reduction refers to measures that reduce
the severity of a loss after it occurs
e.g., installing an automatic sprinkler system
12/22/20 © Abas M. Hassan 2017 13
Continued…
Risk financing refers to techniques that
provide for the payment of losses after they
occur
Methods of risk financing include:
Retention
Non-insurance Transfers
Commercial Insurance
12/22/20 © Abas M. Hassan 2017 14
Continued…
Retention means that the firm retains part or
all of the losses that can result from a given
loss
Retention is effectively used when:
No other method of treatment is available
The worst possible loss is not serious
Losses are highly predictable
The retention level is the dollar amount of losses
that the firm will retain
12/22/20 © Abas M. Hassan 2017 15
Continued…
A risk manager has several methods for paying
retained losses:
Current net income: losses are treated as current
expenses
Unfunded reserve: losses are deducted from a
bookkeeping account
Funded reserve: losses are deducted from a liquid
fund
Credit line: funds are borrowed to pay losses as they
occur
12/22/20 © Abas M. Hassan 2017 16
Continued…
A captive insurer is an insurer owned by a
parent firm for the purpose of insuring the
parent firm’s loss exposures
A single-parent captive is owned by only one
parent
An association or group captive is an insurer
owned by several parents
12/22/20 © Abas M. Hassan 2017 17
Continued…
Reasons for forming a captive include:
The parent firm may have difficulty obtaining
insurance
To take advantage of a favorable regulatory
environment
Costs may be lower than purchasing commercial
insurance
A captive insurer has easier access to a reinsurer
A captive insurer can become a source of profit
12/22/20 © Abas M. Hassan 2017 18
Continued…
Premiums paid to a single parent (pure) captive are
generally not income-tax deductible.
They may be tax deductible if:
The transaction is a bona fide insurance transaction
A brother-sister relationship exists
The captive insurer writes a substantial amount of
unrelated business
The insureds are not the same as the shareholders
of the captive
Premiums paid to a group captive are usually income-
tax deductible.
12/22/20 © Abas M. Hassan 2017 19
Continued…
Self-insurance, or self-funding is a special form of
planned retention by which part or all of a given
loss exposure is retained by the firm
A risk retention group (RRG) is a group captive
that can write any type of liability coverage except
employers’ liability, workers compensation, and
personal lines
They are exempt from many state insurance laws
12/22/20 © Abas M. Hassan 2017 20
Continued…
Advantages Disadvantages
Save on loss costs Possible higher losses
Save on expenses Possible higher
Encourage loss expenses
prevention Possible higher taxes
Increase cash flow
12/22/20 © Abas M. Hassan 2017 21
Continued…
A non-insurance transfer is a method other
than insurance by which a pure risk and its
potential financial consequences are
transferred to another party
Examples include: contracts, leases, hold-
harmless agreements
12/22/20 © Abas M. Hassan 2017 22
Continued…
Advantages Disadvantages
Can transfer some Contract language may
losses that are not be ambiguous, so
insurable transfer may fail
Less expensive If the other party fails
Can transfer loss to to pay, firm is still
someone who is in a responsible for the loss
better position to Insurers may not give
control losses credit for transfers
12/22/20 © Abas M. Hassan 2017 23
Continued…
Insurance is appropriate for low-probability, high-
severity loss exposures
The risk manager selects the coverages needed, and
policy provisions
A deductible is a specified amount subtracted from the
loss payment otherwise payable to the insured
In an excess insurance policy, the insurer pays only if the
actual loss exceeds the amount a firm has decided to
retain
The risk manager selects the insurer, or insurers, to
provide the coverages
12/22/20 © Abas M. Hassan 2017 24
Continued…
The risk manager negotiates the terms of the insurance
contract
A manuscript policy is a policy specially tailored for
the firm
The parties must agree on the contract provisions,
endorsements, forms, and premiums
Information concerning insurance coverages must be
disseminated to others in the firm
The risk manager must periodically review the
insurance program
12/22/20 © Abas M. Hassan 2017 25
Continued…
Disadvantages Advantages
Premiums may be costly Firm is indemnified for
Negotiation of contracts losses
takes time and effort
Uncertainty is reduced
The risk manager may
become lax in exercising Insurers can provide
loss control valuable risk
management services
Premiums are income-
tax deductible
12/22/20 © Abas M. Hassan 2017 26
Exhibit 3.2 Risk Management Matrix
12/22/20 © Abas M. Hassan 2017 27
Market Conditions and the Selection of Risk
Management Techniques
Risk managers may have to modify their choice of
techniques depending on market conditions in the
insurance markets
The insurance market experiences an underwriting cycle
In a “ hard” market, profitability is declining,
underwriting standards are tightened, premiums
increase, and insurance is hard to obtain
In a “ soft” market, profitability is improving,
standards are loosened, premiums decline, and
insurance become easier to obtain
12/22/20 © Abas M. Hassan 2017 28
Implement and Monitor the Risk
Management Program
Implementation of a risk management program
begins with a risk management policy statement
that:
Outlines the firm’s objectives and policies
Educates top-level executives
Gives the risk manager greater authority
Provides standards for judging the risk manager’s
performance
A risk management manual may be used to:
Describe the risk management program
Train new employees
12/22/20 © Abas M. Hassan 2017 29
Continued…
A successful risk management program requires
active cooperation from other departments in the
firm
The risk management program should be
periodically reviewed and evaluated to determine
whether the objectives are being attained
The risk manager should compare the costs and
benefits of all risk management activities
12/22/20 © Abas M. Hassan 2017 30
Benefits of Risk Management
Enables firm to attain its pre-loss and post-loss
objectives more easily
A risk management program can reduce a firm’s
cost of risk
Reduction in pure loss exposures allows a firm to
enact an enterprise risk management program to
treat both pure and speculative loss exposures
Society benefits because both direct and indirect
losses are reduced
12/22/20 © Abas M. Hassan 2017 31
Personal Risk Management
Personal risk management refers to the
identification of pure risks faced by an
individual or family, and to the selection of
the most appropriate technique for treating
such risks
The same principles applied to corporate risk
management apply to personal risk
management
12/22/20 © Abas M. Hassan 2017 32