CHAPTER -6

OUTLINES Risk and Insurance of Business Enterprises

 Definition of Risk,
 Classifying risks,
 The process of Risk Management
 Insurance of the Small Business
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 uncertainty
Risk is the dispersion of actual from expected
result
Risk is the probability of any outcome different
from the one expected

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 CLASSIFYING RISK

Generally, Business risks can be classified into two broad

categories:

[Link] risk is the uncertainty associated with an investment

decision. An entrepreneur who invests in a new business hopes
for a gain but realizes that the eventual outcome may be a loss.

[Link] risk is used to describe a situation where only loss or no

loss can occur-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
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 CLASSIFYING RISK BY TYPE OF ASSET
Risk may be grouped according to the type of asset-Physical
or human-needing protection.
[Link] risks
 Property-oriented risks involve tangible and highly visible assets.
Many property-oriented risks are insurable; they include:
Fire , Natural disasters, Burglary, Business swindles (or
fraudulent transactions) and, Shoplifting.
[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

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[Link] risks
 Customers are the source of profit for small business, but they are
also the source of an ever-increasing amount of business risk.
Much of these risks are: On-premises injuries and Product liability
 On-premises injuries:
Customers may initiate legal claims as a result of on-premises
injuries.
e.g. When a customer breaks an arm by slipping on icy steps while
entering or leaving a store;
Inadequate security, which may result in robbery, assault, or other
violent crimes; Customers who are victims often look to the
business to recover their losses.
 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
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sold by a firm.
 RISK MANAGEMENT
The complexity of the business environment calls for or
demand for 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
 Increasing government regulation

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What is risk management? Many definitions…
 Risk management is a systematic way of protecting
business resources and income against losses so that the
organization’s aims are reached without interruption,
creating stability and contributing to profit.
OR

 Risk management is the identification, measurement and

treatment of liability, property and personal pure risks
that the business organization is facing in order to
reduce and prevent the unfavorable effects of risk at
minimum cost.
OR
 It is the science that deals with the techniques of
forecasting future losses so as to plan, organize, direct
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and control the adverse effect of risk. i.e., Risk
 Risk management and Insurance management
What is the difference in b/n?
Risk management is broader than insurance management in
that it deals with both insurable and uninsurable risks.
Insurance management for most part it is restricted to the
area of those risks that are considered to be insurable.
Naturally only pure risks are insurable . Speculative or
market risks are not. Even all pure risks are not insurable

The emphasis in the risk management concept is on

reducing the cost of safeguarding against risk by whatever
means.

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 The process of Business risk management
In general, the basic functions of the risk management in carrying
out of the responsibilities assigned are:

1. To recognize exposure to loss

Is also called as risk identification
Is the 1st step of risk managers’ function.
Is the most vital task
• What types of possible losses are there?
• Failure to identify exposure to loss ==> the risk
manager will not have any chance of handling the
loss that identify the risk.
Some techniques for identifying risk are:
 Brainstorming
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 Event inventories and loss event data
  Interviews and self-assessment  Facilitated workshops
 SWOT analysis  Risk questionnaires and risk surveys
 Scenario analysis  Using technology
 Other techniques
[Link] estimate the frequency and size of loss, i.e., to
estimate the probability of loss from various sources. It
is also called as risk measurement.
Risk measurement means
i. Determination of the chance of an occurrence or relative
frequency.
ii. Determination of the impact of losses upon financial affairs.
[Link] ability to predict the losses that will actually occur
during the budget year.

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 [Link] decide the best and most economical method of
handling the risk if loss. (risk response development)
i.e. Selection of the proper tool for handling risk
• Identifies and evaluates possible responses to risk.
• Evaluates options in relation to entity‘s risk appetite, cost
vs. benefit of
potential risk responses, and degree to which a response will
reduce
impact and/or likelihood.
• Selects and executes response based on evaluation of the
portfolio of
risks and responses
4. Implementing the decision (risk response control)
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Implementation follows all of the planned methods for
mitigating the effect of the risks. Purchase insurance
 [Link] the decision
Initial risk management plans will never be perfect. Practice,
experie nce, and actual loss results will necessitate changes
in the plan and contribute information to allow possible
different decisions to be made in dealing with the risks
being faced.
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:

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 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/acceptance
3. Loss prevention and reduction
4. Separation / Diversification
5. Transfer

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 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 to 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 of previously assumed activities:

e.g. A firm that produces a highly toxic product may stop
manufacturing that product.

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 2. Retention/Acceptance
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 tacit agreement to assume the losses involved.
The decision to retain a risk actively is made because
there are no alternatives more attractive.

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 Prerequisites of Active Retention
Active/planned retention should be considered only when at
least one of the following conditions exists:
 It is impossible to transfer the risk to someone else or to
prevent the loss from occurring
 When the maximum possible loss is so small
 When the chance of loss is so extremely low
Self-insurance is a special case of active retention. Self-
insurance is not insurance, because there is no transfer of
the risk to an outsider.
 E.g. A firm may keep some money to retain the risk.

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 ii. Unplanned/Unconscious/ Passive Retention
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.

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 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:
Constricting a building with a fire resistance material /
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
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• Warning posters /NO SMOKING!! , DANGER
 Loss reduction measures try to minimize the severity of
the loss once the peril happened/ after the event occurs.

For Example:
• Automatic sprinkler
• An immediate first aid
• Medical care and rehabilitation service
• Guards
• Cover
• Fire extinguisher

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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 the inventory in ten widely separated warehouses.

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 

5. 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.

The following matrix can determine which risk management

be used.

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INSURANCE FOR BUSINESS
 Insurance' may be defined as a contract in writing
under which one party agrees to indemnify the other
party against a loss or damage suffered by it on
account of an uncertain future, in return for a
consideration called 'premium'.
 The person/business who gets its life/property insured
is called 'Insured/Assured'.
 The agency which helps in entering into an insurance
arrangement is called 'Insurer' or 'Insurance Company'.
 The agreement or contract which is put in writing is
called a 'policy'.
 INSURANCE FOR BUSINESS…

1. 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

[Link] for obtaining insurance

1. There must be a sufficiently large number of homogenous

exposure units to make the losses reasonably predictable.
o Insurance is based on the operation of the law of large
numbers.
o There must be a large number of exposures and those
exposures must be homogenous.
23 o Unless we are able to calculate the probability of loss, we
cannot have a financially sound program.
 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 fortuitous or accidental.

 the loss must be the result of a contingency, i.e., 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.
We should not be certain as to the occurrence of a loss
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 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 loss.

The risk to be insured against must be capable of producing a large
loss, which the insured could not pay without economic distress.
Incase the loss occurs, it must be severe that must be transferred to
the insurer. Those recurring and minor types of losses are not
transferred to the insurance company.
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 6. Reasonable cost of transfer
i.e: 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.

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END OF THE COURSE
WISH U A BRIGHT FUTURE!!!