CHAPTER TWO
RISK MANAGEMENT
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.
a scientific approach to dealing with pure risks
by anticipating possible accidental losses and
designing and implementing procedures that
minimize the occurrence of loss
• A loss exposure is any situation or circumstances
in which a loss is possible, regardless of whether
a loss occur. E.g.
• Manufacturing plants that may be damaged in an
earth quake or flood.
• The possible theft of company property because
of inadequate security
Objective of Risk Management
Pre Loss Objectives
• Economy: firm should prepare for potential
losses in the most economical way possible.
Involves analysis of safety program expenses,
insurance premiums, and the costs associated
• Reduction in anxiety: certain loss exposures can
cause greater worry and fear for the risk manager,
• Meeting any legal obligations For example,
government regulations may require a firm to
install safety devices to protect workers from
harm
Post Loss Objectives
Survival after the loss occur; the firm can resume at
least partial operations within some reasonable
time period.
Continuity of operations For some firms, the ability
to operate after a loss is extremely important E.g.
Banks, bakeries, dairies, and other competitive
firms must continue to operate after a loss
Earnings stability Earnings per share can be
maintained if the firm continues to operate.
Continued growth
Social responsibility
Steps in the Risk Management Process
1. Identifying Loss Exposure
Risk identification is the process by which a business
systematically and continuously identifies
exposures as soon as or before they emerge. we can
identify risks by using
Risk analysis questionnaires, Physical inspection,
Flow charts (flow of production and delivery),
Financial statement method, Historical loss data
• 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
2. Evaluating Loss Exposures (Risk Management)
• 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 occurs
• Prouty Measure of Severity
• 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
Priority Ranking Based on Severity
• 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
3. Selecting the Appropriate Technique for Treating Loss Exposures
• Risk Control Techniques
Avoidance: means that a certain loss exposure is
never acquired, E.g. Flood loss can be avoided by
not building a new plant in a floodplain
Loss control: are designed to reduce both the
severity and frequency of losses. Unlike the
avoidance techniques, loss control deals with an
exposure that the firm does not wish to abandon.
the firm wishes to keep the exposure but wants to
reduce the frequency and severity of losses.
Separation/Diversification
Instead of placing its entire inventory in one
warehouse a firm may elect to separate this exposure
by placing equal parts of the inventory in ten widely
separated warehouses.
Combination: makes loss experience more
predictable by increasing the number of exposure
units under the control of the firm.
• 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.
Risk Financing Techniques
Retention: means that the firm retains part or all
of the losses that can result from a given loss.
Active risk retention: means that the firm is
aware of the loss exposure and plans to retain
part or all of it
Passive retention, however, is the failure to
identify a loss exposure, failure to act, or
forgetting to act.
Self-insurance: is a special form of planned
retention by which part or all of a given loss
exposure is retained by the firm itself.
Captive insure is an example of self insurance.
A captive insurer is an insurer that owned by a
parent firm for the purpose of insuring the parent
firm’s loss exposures.
Noninsurance Transfers: are methods other than
insurance by which a pure risk and its potential
financial consequences are transferred to another
party.
Neutralization or hedging: the process of
balancing a chance of loss against a chance of
gain. E.g. betting in a football game.
Hold-harmless agreements.
Insurance: Commercial insurance is also used in
a risk management program. From the risk
manager’s viewpoint, insurance represents a
contractual transfer of risk.
Which Method should be used?
Frequency of loss
Severity Low High
of loss
Low Retention Loss control and
retention
High Insurance Avoidance
Implementing and Administrating the Risk Management
Program.
• 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.
Cooperation with other Departments
• Accounting: internal accounting control can
reduce employee fraud and theft of cash.
• Marketing: accurate packaging can prevent
liability lawsuits. Safe distribution procedures
can prevent accidents.
• Production: quality control can prevent the
production of defective goods and liability
lawsuits. Effective safety programs in the plant
can reduce injuries and accidents.
• Personnel: this department may be responsible
for employee benefit programs, pension
programs, and safety programs
• 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.
Thank you!!!