TOPIC 1: INTRODUCTION TO

RISK MANAGEMENT:
ESSENTIALS
Chapter 3: Introduction to Risk
Management

Copyright © 2020, 2017, 2014 Pearson Education, Inc. All Rights Reserved 3-1
Agenda

• Meaning of Risk Management

• Objectives of Risk Management
• Steps in the Risk Management Process
• Benefits of Risk Management

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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
• New forms of risk management consider both pure and
speculative loss exposures

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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

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Objectives of Risk Management

• Post-loss objectives:
– Ensure survival of the firm
– Continue operations
– Stabilize earnings
– Maintain growth
– Minimize the effects that a loss will have on
other persons and on society

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Example

• All of the following are post-loss risk

management objectives EXCEPT:
• (a) survival of the firm
• (b) reduction of anxiety
• (c) continued operations
• (d) stability of earnings

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Risk Management Process

1. Identify potential losses

2. Measure and analyze potential losses
3. Select the appropriate risk management
technique
4. Implement and monitor the risk
management program

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Exhibit 3.1 Steps in the Risk
Management Process

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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
• Market reputation and public image of company
• Failure to comply with government rules and regulations

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Identify Loss Exposures
• Risk Managers have several sources of
information to identify loss exposures:
– Questionnaires
– 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

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Measure and Analyze Loss
Exposures
• Estimate the frequency and severity of loss for each type of
loss exposure
– Loss frequency refers to the probable number of losses that may
occur during some given time period
– Loss severity refers to the probable size of the losses that may
occur
• Once loss exposures are analyzed, they can be ranked
according to their relative 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
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Example
If one company has three warehouses, one in Cheras, one in
Semenyih, and one in Shah Alam. The inventory of each warehouse
is valued at RM 1 million. The risk manager is concerned about the
damage which could be caused by a single flood. The risk manager
believes there is an extremely low probability that a single flood could
destroy two or all three warehouses because they are located so far
apart.
What is the probable maximum loss associated with a single flood?
(a) RM 0 mil
(b) RM 1 mil
(c) RM 2 mil
(d) RM 3 mil

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Example
If one company has three warehouses, one in Cheras, one in
Semenyih, and one in Shah Alam. The inventory of each warehouse
is valued at RM 1 million. The risk manager is concerned about the
damage which could be caused by a single flood. The risk manager
believes there is an extremely low probability that a single flood
could destroy two or all three warehouses because they are located
so far apart.
What is the maximum possible loss associated with a single flood?
(a) RM 0 mil
(b) RM 1 mil
(c) RM 2 mil
(d) RM 3 mil

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Select the Appropriate Risk
Management Technique
• Risk control refers to techniques that reduce the
frequency and severity of losses
• Methods of risk control include:
– Avoidance
– Loss prevention
– Loss reduction
– Duplication
– Separation
– Diversification
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Risk Control Methods

– Avoidance means a certain loss exposure is

never acquired, 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

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Risk Control Methods

– 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 is occurs
• e.g., installing an automatic sprinkler system

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Risk Control Methods
– Duplication refers to having back-ups or copies of
important documents or property available in case a loss
occurs.
• E.g., back-up copies of key business records
– Separation means dividing the assets exposed to loss to
minimize the harm from a single event.
• E.g., A manufacturer store finished goods in two warehouses in different
cities
– Diversification refers to reducing the chance of loss by
spreading the loss exposure across different parties
• E.g., holding different assets

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Select the Appropriate Risk
Management Technique
• Risk financing refers to techniques that
provide for the funding of losses
• Methods of risk financing include:
– Retention
– Non-insurance Transfers
– Commercial Insurance

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Risk Financing Methods: Retention

• 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
• A financially strong firm can have a higher retention level than a
financially weak firm
• The maximum retention may be calculated as a percentage of
the firm’s net working capital

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Risk Financing Methods: Retention

– 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

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Risk Financing Methods: Retention

• 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

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Risk Financing Methods: Retention

• 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

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Risk Financing Methods: Retention

• Premiums paid to a single parent (pure) captive are

generally not income-tax deductible, unless:
– 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.
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Risk Financing Methods: Retention

• Self-insurance is a special form of planned retention

– Part or all of a given loss exposure is retained by the firm
– A more accurate term would be self-funding
– Widely used for workers compensation and group health benefits
• A risk retention group is a group captive that can write any
type of liability coverage except employer liability, workers
compensation, and personal lines
– Federal regulation allows employers, trade groups, governmental
units, and other parties to form risk retention groups
– They are exempt from many state insurance laws

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Example
All of the following are reasons to form a captive
insurance company EXCEPT:
(a) the parent firm may have difficulty in obtaining
some types of insurance
(b) premiums paid to a captive, under certain
circumstances, may be tax deductible
(c) the captive can serve as another profit center
(d) parent firms are allowed to take tax credits for
losses paid by the captive

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Risk Financing Methods: Retention

Advantages Disadvantages

– Save money – Possible higher losses

– Lower expenses – Possible higher
– Encourage loss expenses
prevention – Possible higher taxes
– Increase cash flow

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Risk Financing Methods: Non-
insurance Transfers
• 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,
incorporation

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Risk Financing Methods: Non-
insurance Transfers
Advantages Disadvantages

– Can transfer some – Contract language

losses that are not may be ambiguous,
insurable so transfer may fail
– Less expensive – If the other party
– Can transfer loss to fails to pay, firm is
someone who is in still responsible for
a better position to the loss
control losses – Insurers may not
give credit for
transfers
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Risk Financing Methods:
Insurance
• Insurance is appropriate for loss exposures that
have a low probability of loss but for which the
severity of loss is high
– The risk manager selects the coverages needed, and
policy provisions:
• A deductible is a provision by which a specified amount is
subtracted from the loss payment otherwise payable to the
insured
• An excess insurance policy is one in which the insurer does
not participate in the loss until the actual loss exceeds the
amount a firm has decided to retain
– The risk manager selects the insurer, or insurers, to
provide the coverages
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Risk Financing Methods:
Insurance
– The risk manager negotiates the terms of the
insurance contract
• A manuscript policy is a policy specially tailored for
the firm
– Language in the policy must be clear to both parties
• The parties must agree on the contract provisions,
endorsements, forms, and premiums
– The risk manager must periodically review the
insurance program

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Risk Financing Methods:
Insurance
Advantages Disadvantages

– Firm is indemnified for – Premiums may be

losses costly
– Uncertainty is reduced • Opportunity cost
should be considered
– Firm may receive
valuable risk – Negotiation of contracts
management services takes time and effort
– Premiums are tax- – The risk manager may
deductible become lax in
exercising loss control

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Exhibit 3.2 Risk Management
Matrix

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Risk Financing Methods:
Insurance
• 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

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Example

All of the following are disadvantages of using

insurance in a corporate risk management
program EXCEPT:
(a) premium payments are not tax deductible
(b) insurance coverage may be expensive
(c) it may be time consuming to negotiate the
coverages and terms
(d) the presence of insurance may lead to reduced
incentives to engage in loss control
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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 risk management objectives
– Outlines the firm’s policy on loss control
– Educates top-level executives in regard to the risk management
process
– 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

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Implement and Monitor the Risk
Management Program
• 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

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Benefits of Risk Management
• Pre-loss and post-loss objectives are attainable
• A risk management program can reduce a firm’s cost of risk
– The cost of risk includes premiums paid, retained losses, outside risk
management services, financial guarantees, internal administrative
costs, taxes, fees, and other expenses
• 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

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Case Application

The Bus4School Company provides school bus

transportation to public schools in London. The company
owns 50 buses that are garaged in four different boroughs,
and it provides school bus services to over 20 public
schools. The firm faces competition from two larger bus
companies that operate in the same area. Public school
boards generally award contracts to the lowest bidder, but
the level of service and overall performance are also
considered.

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Case Application

a) Briefly describe the steps in the risk management process that

should be followed by the risk manager of Bus4School.
b) Identify the major loss exposures faced by Bus4School.
c) For each of the loss exposures identified in (b), identify a risk
management technique or combination of techniques that could
be used to handle the exposure.
d) Describe several sources of funds for paying losses if retention is
used in the risk management program.
e) Identify other departments in Bus4School that would also be
involved in the risk management program.

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