ASC172 – PRINCIPLES OF RISK

MANAGEMENT AND INSURANCE

Chapter 2:
Introduction To Risk Management
Week 3

Nur Haidar Binti Hanafi

Siti Nurasyikin Binti Shamsuddin
 TABLE OF CONTENTS

Learning Objectives
2.1 Meaning of risk management
2.2 Objectives of risk management
2.3 Steps in the risk management
Conclusions
Quiz
References
 LEARNING OBJECTIVES
At the end of this lesson, students should
be able to:
• Define the meaning of risk management
• Discuss the objectives of risk
management
• Explain steps in risk management
 2.1 Meaning of Risk Management
• Risk managementa process that identifies
loss exposures faced by an organization
and selects the most appropriate
techniques for treating such exposures
Loss exposure: any situation in which a
loss is possible
Eg: A plant that may be damaged by an
earthquake
 2.2 Objectives of Risk
Management
• Risk management has objectives before
and after a loss occurs
a) Pre-loss objectives:
Prepare for potential losses in the most
economical way
Reduce anxiety
Meet any legal obligations
 Cont. Objectives of Risk
Management
b) 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
2.3 Steps in the Risk
Management Process
 1. 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
 Cont. Identify Loss Exposures
• 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.
• Eg: Exposure to acts of terrorism
 2. Measure and Analyze Loss
Exposures
i. Estimate for each type of loss exposure:
• Loss frequency probable number of
losses that may occur during some time
period
• Loss severity probable size of the
losses that may occur
ii. Rank exposures by importance
• Loss severity is more important than loss
frequency:
The maximum possible loss the worst
loss that could happen to the firm during
its lifetime
The probable maximum loss the worst
 3. Select the Appropriate
Combination of Techniques for
Treating the Loss Exposures
a) Risk control techniques that reduce
the frequency and severity of losses
• Methods of risk control include:
i. Avoidance
ii. Loss prevention
iii. Loss reduction
Cont. Select the Appropriate
Combination of Techniques for
Treating the Loss Exposures
i. Avoidance 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
Cont. Select the Appropriate
Combination of Techniques for Treating
the Loss Exposures
ii. Loss prevention measures that reduce
the frequency of a particular loss
• Eg: Installing safety features on
hazardous products
iii. Loss reduction measures that reduce
the severity of a loss after it occurs
• Eg: Installing an automatic sprinkler
system
Cont. Select the Appropriate
Combination of Techniques for
Treating the Loss Exposures
b) Risk financing techniques that provide
for the payment of losses after they occur
• Methods of risk financing include:
i. Retention
ii. Non-insurance transfers
iii. Commercial insurance
Cont. Select the Appropriate Combination of
Techniques for Treating the Loss Exposures

i. Retention 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
 Cont. Select the Appropriate
Combination of Techniques for
Treating the Loss Exposures
• 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
Cont. Select the Appropriate Combination of
Techniques for Treating the Loss Exposures
• A captive insurer insurer owned by a
parent firm for the purpose of insuring
the parent firm’s loss exposures
• Single-parent captive insurer owned
by only one parent
• Association or group captive insurer
owned by several parents
 Cont. select the Appropriate
Combination of Techniques for
Treating the Loss Exposures
• 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
Cont. select the Appropriate Combination of
Techniques for Treating the Loss Exposures
• 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.
 Cont. select the Appropriate
Combination of Techniques for
Treating the Loss Exposures
• Self-insurance, or self-funding special
form of planned retention by which part
or all of a given loss exposure is retained
by the firm

• Risk retention group (rrg) 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
Cont. select the Appropriate Combination of
Techniques for Treating the Loss Exposures

Advantages Disadvantages
• Save on loss • Possible higher
costs losses
• Save on • Possible higher
expenses expenses
• Encourage loss • Possible higher
prevention taxes
• Increase cash
flow
 Cont. select the Appropriate
Combination of Techniques for
Treating the Loss Exposures
ii. Non-insurance transfer method other
than insurance  a pure risk and its
potential financial consequences are
transferred to another party
• Eg: contracts, leases, hold-harmless
agreements
Cont. select the Appropriate Combination of
Techniques for Treating the Loss Exposures

Advantages Disadvantages
• Can transfer • Contract language may
some losses that be ambiguous, so
transfer may fail
are not insurable
• If the other party fails to
• Less expensive pay, firm is still
• Can transfer loss responsible for the loss
to someone who • Insurers may not give
is in a better credit for transfers
position to
control losses
 Cont. select the Appropriate Combination of
Techniques for Treating the Loss Exposures

iii. Insurance appropriate for low-

probability, high-severity loss exposures
• The risk manager selects the coverages
needed, and policy provisions
• A deductible 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
 Cont. select the Appropriate
Combination of Techniques for
Treating the Loss Exposures
• 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
Cont. select the Appropriate Combination of
Techniques for Treating the Loss Exposures

Disadvantages Advantages
• Premiums may • Firm is indemnified
be costly for losses
• Negotiation of • Uncertainty is
contracts takes reduced
time and effort • Insurers can
provide valuable
• The risk manager risk management
may become lax services
in exercising loss • Premiums are
control income-tax
deductible
 Cont. select the Appropriate
Combination of Techniques for
Treating the Loss Exposures
Risk Management Matrix
 Cont. select the Appropriate Combination
of Techniques for Treating the Loss
Exposures
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
 4. 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
 Cont. Implement and Monitor the
Risk Management Program
• A successful risk management program
requires active cooperation from other
departments in the firm
• To determine whether the objectives are
being attained, the risk management
program should be periodically reviewed
and evaluated
• The risk manager should compare the
costs and benefits of all risk
management activities
 Benefits of Risk Management
• Enables firm to achieve its pre-loss and
post-loss objectives more easily
• A risk management program can
decrease a firm’s cost of risk
• Reduction in pure loss exposures allows a
firm to endorse an enterprise risk
management program to treat both pure
and speculative loss exposures
• Society benefits because both direct and
indirect losses are reduced
 CONCLUSIONS

Now, students are able to:

• Give the definition of the risk
management
• Discuss the objectives of risk
management
• Explain steps in risk management
 QUIZ
1) What is meant by risk management?
Answer: Risk management is a process that
identifies loss exposures faced by an
organization and selects the most
appropriate techniques for treating such
exposures
2) When is the best time to use retention
method?
Answer:
i) No other method of treatment is
available
ii) The worst possible loss is not
serious
 QUIZ
3) Which of the following is least likely to occur during a "hard" insurance
market period?
A) higher insurer profits
D) increasing premiums
C) difficulty in obtaining insurance
D) tightening underwriting standards
Answer: A

4) All of the following are disadvantages of using insurance in a risk

management program EXCEPT
A) It results in considerable fluctuations in earnings after losses occur.
D) Attitudes toward loss control may become lax when losses are insured.
C) There is an opportunity cost because premiums must be paid in advance.
D) Considerable time and effort must be spent selecting and negotiating
coverages.
C) Answer: A
 QUIZ
5) Which of the following types of loss
exposures may be appropriately handled
through the purchase of insurance?
I. High-frequency, low-severity
II. Low-frequency, high-severity
A) I only
B) II only
C) both I and II
D) neither I nor II
Answer: B
REFERENCE
• Redja, G.E. (2008). Principles of Risk Management
and Insurance, tenth edition, Addison-Aesley

• Redja, G.E. (2014). Principles of Risk Management

and Insurance, twelth edition, Pearson Education
Limited