Segment C

Assignment 7
Risk Management

Assignment 8
Loss Exposures

Assignment 9
Insurance Policies
Direct Your Learning

Risk Management

Educational Objectives Outline

After learning the content of this assignment, you should be able to: Basic Purpose
and Scope of Risk
Describe the basic purpose and scope of risk management i n terms of the Management
following: Identifying and
• How risk management is practiced by individuals and organizations Analyzing Loss
Exposures
• T h e basic distinction between traditional risk management and enter-
prise-wide risk management Examining the
Feasibility of Risk
Explain how to identify and analyze loss exposures. Management
Techniques
Describe the risk management techniques for risk control and risk
financing. Selecting,
Implementing,
Explain how to select the appropriate risk management techniques,
and Monitoring
implement the selected techniques, and monitor a risk management Risk Management
program. Techniques
Explain how risk management benefits businesses, individuals, families, Benefits of Risk
society, and insurers. Management
Applying the risk management process, recommend appropriate tisk man- Applying the Risk
agement techniques for handling loss exposures of an individual, a family, Management
or a business. Process

Summary

• 7.1
Risk Management

BASIC PURPOSE AND SCOPE OF RISK

MANAGEMENT
Risk management involves the efforts of individuals or organizations to effi-
ciently and effectively assess, control, and finance risk in order to minimize
the adverse effects of losses or missed opportunities.

Individuals practice risk management to protect their limited assets from

losses and to help meet personal goals. For an organization, sound risk man-
agement adds value and helps to ensure that losses or missed opportunities
do not prevent it from meeting its goals. W h i l e many organizations have
traditionally focused their risk management efforts on pure risk, the emerging Pure risk
discipline of enterprise-wide risk management is focused on managing all of A chance of loss or no loss,
an organization's pure and speculative risks. but no chance of gain.
Speculative risk
A chance of loss, no loss,
Risk Management for Individuals and or gain.

Organizations
In its simplest form, risk management includes any effort to economically
deal w i t h uncertainty of outcomes (risk). For individuals, risk management
is usually an informal series of efforts, not a formalized process. Individual or
personal risk management may be viewed as part of the financial planning
process that encompasses broader matters such as capital accumulation, retire-
ment planning, and estate planning.

Individuals and families often practice risk management informally without

explicitly following a risk management process. For example, individuals
purchase insurance policies to cover accidental or unexpected losses, or they
contribute to savings plans so that they have money available to covet unfore-
seen events.

I n smaller organizations, risk management is not usually a dedicated function,

but one of many tasks carried out by the owner or senior manager. I n many
larger organizations, the risk management function is conducted as part of a
formalized risk management program. A risk management program is a system
for planning, otganizing, leading, and controlling the resources and activities
that an otganization needs to protect itself from the advetse effects of acciden-
tal losses.

7.3
7.4 Property and Liability Insurance Principles

Most risk management programs arc built around the risk management
process. The risk management process is the method of making, implement-
ing, and monitoring decisions that minimize the adverse effects of risk on an
organization. A l t h o u g h the exact steps in an organization's risk management
process may differ from the process discussed in this section, all risk manage-
ment processes are designed to assess, control, and finance risk.

Traditional Risk Management and Enterprise-Wide

Risk Management
Traditionally, the risk management professional's role has been associated w i t h
loss exposures related mainly to pure, as opposed to speculative, risks. This
view excludes from the scope of risk management all loss exposures that arise
from speculative risk, also referred to as business risk. Therefore, organiza-
tional risk management has focused on managing safety, purchasing insurance,
and controlling financial recovery from losses generated by hazard risk.

Enterprise-wide risk management (ERM) is the term commonly used to

describe the broader view of risk management that encompasses all types of
risk. E R M is an approach to managing all of an organization's key risks and
opportunities with the intent of maximizing the organization's value.

A n ERM approach allows an organization to integrate all of its risk manage-

ment activities so that the risk management process occurs at the enterprise
level, rather than at the departmental or business unit level. H o w ERM is
implemented in practice varies significantly among organizations, depending
on their size, nature, and complexity.

IDENTIFYING AND ANALYZING LOSS

EXPOSURES
The risk management process, which enables businesses and individuals to
effectively manage the risk of accidental loss, begins w i t h an examination of
loss exposures.

To help ensure the success of a business or a household, a risk manager must

analyze any loss exposures. The risk management process helps risk managers
deal w i t h loss exposutes efficiently and effectively. As used in this discussion,
the term "risk manager" refers to anyone who is tcsponsible for risk manage-
ment w i t h i n an organization ot a family.

Insurance professionals benefit from understanding the risk management pro-

cess because it provides a framework for understanding why individuals and
entities purchase insurance products. It also enables insurance professionals to
help prospective policyholders identify risks that can be effectively managed
using insurance products. The risk management process has six steps. The

•
first two steps i n the process are identifying loss exposures and analyzing loss
exposures. See the exhibit "Risk Management Process."

Risk Management Process

Step 1
Identifying loss
exposures

Step 6 Step 2
Monitoring results and revising Analyzing loss
the risk management program exposures

Step 5 Step 3
Implementing selected risk Examining feasibility of risk
management techniques management techniques

Step 4
Selecting the
appropriate risk
management
techniques

[DA07143]

Identifying Loss Exposures

Identifying loss exposures involves developing a thorough list of accidental
losses that could affect a particular household or organization. To identify loss
exposures, the risk manager must understand how the household or organiza-
tion operates. A physical inspection of the premises is a starting point, and
then the risk manager can use other techniques, such as financial statement
analysis, flowcharts, and interviews. The more common techniques, i n addi-
tion to physical inspection, ate loss exposure surveys and loss history analysis.
See the exhibit "Step 1: Risk Management Process."

Physical Inspection
A tisk manager generally cannot gain a cleat picture of possible loss exposures
by sitting at a desk away from the source of risk. T h e most straightforward
method of identifying loss exposures is to physically inspect all locations,
operations, maintenance routines, safety practices, work processes, and other
7.6 Property and Liability Insurance Principles

Step 1: Risk Management Process

Step 1
Identifying loss
exposures

[DA07143]

activities i n which his or her household or organization is involved. For

example, a risk manager for an industrial operation may observe that the
safety guards have been removed from machines or that boxes of parts are
stacked high on a storage shelf, creating an exposure for injury should the
parts fall. Physical inspection alone may not be enough, however, because the
risk manager may not have sufficient knowledge of the household or opera-
tions to identify all exposures or to ask the right questions to uncover all loss
exposures.

Loss Exposure Surveys

Loss exposure surveys, or checklists, are documents listing potential loss
exposures that a household or an organization may face. Such surveys are
often designed to be comprehensive enough to apply to almost any household
or organization, even though a given household or organization is unlikely to
face all of the loss exposures detailed.

A sample of questions frequently asked on loss exposure surveys for organiza-

tions demonstrates the scope of questions that would be appropriate. Such
surveys usually group similat exposutes togethet, such as exposures from manu-
facturing operations, from the sale of products, from the use of vehicles, and
so fotth. Similat but less extensive surveys ate available from insurers to help
individual households identify the loss exposutes they face. See the exhibit
"Sample of Questions Ftequcntly Asked on Loss Exposure Sutveys."

The risk manager usually discusses the items on the business sutvey with man-
agers, supervisors, and othet employees who are familiar w i t h an organization's
exposures. In some cases, the sutvey can also help familiarize the risk manager
w i t h the organization's operations. Because sutveys may omit an important
exposute, especially if the organization has unique operations not included on
a standard survey form, risk managers cannot depend solely on them. Rather,
risk managers should use the survey as a guide i n developing a comprehensive
pictute of the otganization's opetations and loss exposures.

•
 Risk Management 7.7

Sample of Questions Frequently Asked on Loss Exposure

Surveys
Yes No

• • 1. Do you have a brochure or other written material that describes your

business operations or products?

• • 2. Is your business confined to one industry?

• J 3. Is your business confined to one product?

• LI 4. Do you own buildings?

• LI 5. Do you lease buildings from others?

• J 6. Do you lease buildings to others?

• • 7. Do you plan any new construction?

• • 8. Are your fixed asset values established by certified property

appraisers?

• J 9. Do you own any vacant land?

• • 10. Are any properties located in potential riot or civil disturbance areas?

• • 11. Are any properties located in potential flood or earthquake areas?

• • 12. Do your properties have security alarm systems? (Fire-sprinkler

discharge, burglary, smoke detection, and so forth)

• 13. Are there any unusual fire or explosion hazards in your business
operation? (Welding, painting, woodworking, steam boilers or
pressurized machinery, and so forth)

• • 14. Do you take a physical count of inventory at least once a year?

• J 15. Do you lease machinery or equipment other than automotive?

• • 16. Do you stockpile inventory, either raw or finished?

• • 17. Could you conveniently report inventory values on a monthly basis?

• J 18, Do you buy, sell, or have custody of goods or equipment of extremely

high value? (Radium, gold, and so forth)

• • 19. Do you use any raw stock, inventory, or equipment that requires
substantial lead time to reproduce?

• • 20. Do you export or import?

[DA02673]

Loss History Analysis

Loss history analyses deal w i t h an organization's past losses and can assist a
risk manager i n identifying that organization's exposures to future acciden-
tal losses. A high-quality loss history is complete, organized, consistent, and
relevant. Past events or conditions that were not recorded, were inaccurately

•
7.8 Property and Liability Insurance Principles

recorded, or were made irrelevant by changing environments have little, if

any, value for fotecasting futute events. Fot example, data quality is reduced
when a loss is omitted, any item of information normally collected about
losses (such as where or when they occur) is omitted, the conditions under
which an organization operates change ot those operations themselves change
in some fundamental way, or a new cause of loss emerges.

Analyzing Loss Exposures

Analyzing a loss exposure requires estimating how large a possible loss could
be and how often it might occur. Such an analysis helps to detetmine how
losses may interfere w i t h the activities and objectives of the household ot
organization and what their financial effect may be. A n analysis of the prob-
able frequency and severity of the possible losses enables the risk manager to
give priority to the most significant loss exposures. See the exhibit "Step 2:
Risk Management Process."

Step 2: Risk Management Process

Step 2
Analyzing loss
exposures

[DA07143]

Loss Frequency
Loss frequency indicates the number of losses that occur w i t h i n a specified
period. Examples of frequent losses include employees' abrasions and minor
lacerations at a manufacturing plant, minor accidents involving autos from
an organization's fleet, and spoilage of produce at a supermarket. Other losses,
such as those caused by earthquakes, tornadoes, and hurricanes, occur much
less frequently.

Accurate measutement of loss frequency is important because the proper

treatment of the loss exposure often depends on how frequently the loss is
expected to occur. If a particular type of loss occurs frequently, or if its fre-
quency has been increasing i n recent years, the risk manager may decide that
procedures for controlling the risk are necessary. Alternatively, if the loss
occurs rarely or its frequency has dropped in recent years, corrective proce-
dures may not be cost-effective.

•
Loss Severity
Loss severity is the amount of loss, typically measured monetatily, fot a loss
that has occurred. I t is much easiet to gauge the potential severity of prop-
erty losses than of liability losses. Most property losses have a finite value.
Whether the property is partially or completely destroyed, the severity of the
loss is usually calculable. Conversely, the severity of liability exposutes can be
almost impossible to calculate. For example, if a paint manufacturer sells paint
that produces toxic fumes when applied, the severity of this potential liability
loss is almost unlimited.

As another example, the seventy of the property loss from an airplane crash
may equal several m i l l i o n dollars, but it is still a calculable amount. However,
if a commercial passenger aircraft crashed i n a densely populated metropolitan
area, the potential severity of the liability loss would be difficult, if not impos-
sible, to estimate accurately.

Properly estimating loss severity is essential in treating the loss exposure,

as the potential severity of losses is a major consideration i n determining
whether the household or organization should insure a particular exposure or
retain all or part of the financial consequences of the loss.

EXAMINING THE FEASIBILITY OF RISK

MANAGEMENT TECHNIQUES
Understanding the various techniques fot managing risk is essential fot any
individual, family, or organization that uses the risk management process.

Once loss exposures have been identified and analyzed, the next step i n the
risk management process is to examine all possible techniques for handling
the exposures. These techniques are grouped into two broad categoties—risk
control and risk financing. A n overview of some of the mote common risk
management techniques w i l l help insurance professionals understand options
to control and finance risk. See the exhibit "Step 3: Risk Management
Process."

Step 3: Risk Management Process

Step 3
Examining feasibility of risk
management techniques

[DA07143]
7.10 Property and Liability Insurance Principles

Risk Control
Risk control is a risk management technique that attempts to decrease the
frequency and/or severity of losses or make them more predictable. These are
some common risk conttol techniques:

• Avoidance
• Loss prevention
• Loss reduction
• Separation
• Duplication

Avoidance
Avoidance Avoidance eliminates a loss exposure and reduces the chance of loss to zero.
A risk control technique that For example, a manufacturer of sports equipment may decide not to sell
involves ceasing or never football helmets to avoid the possibility of large lawsuits from head injuries.
undertaking an activity Likewise, a family may decide not to purchase a motor boat to avoid the
so that the possibility of a
potential property and liability exposutes that accompany boat ownership.
future loss occurring from
that activity is eliminated. The advantage of avoidance as a risk control technique is that the probability
of loss equals zero—there is no doubt or uncertainty about the loss exposute
because a loss is not possible. Avoidance has the disadvantage of sometimes
being impractical and is often difficult, if not impossible, to accomplish.

For example, suppose Priya is contemplating the purchase of het first automo-
bile, but she is worried about the exposures inherent in automobile ownetship.
She may believe the chance of damage to the car is too great. Further, Priya
may be unwilling to assume the chance of liability imposed by law, or perhaps
she cannot afford automobile insurance.

In Priya's case, however, avoidance of these exposures may pose additional

problems for Priya. Does she need a car for commuting to work or for other
activities? If so, she will have to exchange the exposutes of automobile owner-
ship for the exposures inherent i n some othet type of transportation. Renting
or leasing a cat may be mote expensive than auto ownership, and Priya would
still be liable for any accidents she may cause. Forgoing a car would mean
traveling by public transportation, by bicycle, by motorcycle, or on foot; any
of these alternatives could prove more hazardous to Ptiya than riding i n her
own car. Priya may decide that avoidance is not a feasible technique and
would thus choose to purchase a cat and buy automobile insurance to cover
her automobile loss exposures.

Loss Prevention
Loss prevention seeks to lower the frequency of losses from a particular loss
exposure. Some common examples of loss prevention ate keeping doors and
windows locked to prevent burglaries, and maintaining a regular program of
vehicle maintenance to prevent accidents caused by faulty equipment.

•
Loss Reduction
Loss reduction seeks to lower the severity of losses from a particular loss
exposure. Some common loss reduction measures include installing a sprin-
kler system, which does not usually prevent fires, but can limit damage
should a fire occur, and installing a restrictive money safe that a store clerk
cannot open.

Many insurers have a risk control department that includes risk manage-
ment professionals who attempt to reduce an insured's frequency and severity
of losses. Insureds often use risk control measures because the insurer has
recommended them. Insurers direct much risk control effort to commercial
insurance accounts. The risk control programs recommended by insurers are
generally based on inspection reports prepared by the insurers' risk control
representatives. A n inspection report is one of the best sources of underwrit-
ing information and it supplements the application.

W h e n an underwriter receives an application fot a commercial account, one

of the underwriter's first tasks is often to tequest an inspection teport from the
insuter's risk control department. A risk control engineer or representative
visits the applicant's location or locations to inspect the premises and opera-
tions and submits an inspection report.

A n inspection report usually has these two main objectives:

• To provide a thorough description of the applicant's operation so that the

underwriter can make an accurate assessment when deciding whether to
accept the application for insurance
• To provide an evaluation of the applicant's current risk control measures
and recommend improvements i n risk control efforts. The underwriter
may requite that the applicant implement the risk control recommenda-
tions for the application to be accepted

Separation
Sepatation is a risk control technique that isolates loss exposutes from one
another to minimize the adverse effect of a single loss. Fot example, an organi-
zation may stote inventory in several warehouses for valid business teasons, as
well as fot risk conttol. Another example of separation is using several suppli-
ers for raw matetial purchases, which might also provide competitive pricing.

Duplication
Duplication is a risk control technique that uses backups, spares, or copies of
critical property, information, or capabilities and keeps them i n reserve. For
example, an organization may store copies of key documents or information
at another location and may maintain an inventory of spare parts for critical
equipment. Risk control techniques are rarely used alone and are most often
effective when used in conjunction w i t h risk financing techniques.
7.12 Property and Liability Insurance Principles

Risk Financing
Risk financing is an effective risk management technique that includes steps
to pay for or transfer the cost of losses. The most common risk financing
techniques include retention and transfer (noninsurance risk transfer and
insurance).

Retention
The financial consequences of any loss exposure that has not been avoided or
Retention transferred are retained. Retention involves acceptance of the costs associated
A risk financing technique w i t h all or part of a particular loss exposure. Retention can be intentional or
by which losses are retained unintentional. After thoroughly analyzing the alternatives, a risk manager
by generating funds within may decide that retention is the best way to handle a given exposure, perhaps
the organization to pay for
because insurance is not available or is too expensive. For example, a risk
the losses.
manager may decide that putchasing collision coverage o n a fleet of older
vehicles is not worth the premium and may thus decide to retain the organiza-
tion's exposure by paying for any collision losses from the company's operating
funds.

Unintentional retention may result from inadequate exposute identification

and analysis ot from incomplete evaluation of risk management techniques.
Fot example, a restaurant may not identify its liability exposure for serving too
much alcohol to a customer and thetefote may fail to putchase liquor liability
insurance to cover this exposure.

Retention can be partial or total. Fot example, a $10,000 per building deduct-
ible on a commercial property insurance policy is a partial retention. A n
example of total retention would be a husband and wife choosing not to
purchase flood insurance on their lakeside home because they believe it is too
expensive—they are effectively retaining their entire exposure to flood losses.

In the long run, retention is less expensive than insurance. W h i l e retention

involves absorbing the cost of losses, insurance premiums are used to cover
losses plus the insurer's overhead, taxes, expenses, and other costs of policy
and claim handling. I n the short run, however, many people and organizations
do not have the financial means to retain more than a small amount of their
losses.

Retention is usually used in combination w i t h other risk management tech-

niques, particularly risk control and insurance. A deductible in a business auto
policy is an example of the combination of retention and insurance. If the
risk manager also implements a driver safety program to lower the frequency
of corporate auto accidents, the combination of risk control, retention, and
insurance can handle the exposure economically.

Transfer
Businesses often treat loss exposures by noninsurance risk transfer, a risk
financing technique in which one party transfers the potential financial con-
sequences of a particular loss exposure to another party that is not an insurer.
For example, the landlord of a commercial building may wish to transfer the
financial consequences of a liability exposure arising out of activities of a
tenant. The landlord accomplishes this transfer by having the tenant sign a
hold-harmless agreement. T h e agreement can be a separate contract, but it
is usually a provision included i n the lease. I n this case, the hold-hatmless
agreement might state that the tenant agrees to indemnify the landlord for
any damages the landlord becomes legally obligated to pay because of injury
or damage occurring on the premises occupied by the tenant.

In addition to other techniques for handling loss exposures, households and

small businesses depend heavily on insurance—another transfer technique—
which transfers the potential financial consequences of certain specified loss
exposures from the insured to the insurer. Most medium-sized and large busi-
nesses also rely o n insurance as a major component of their risk management
programs, but they may be less dependent o n insurance and employ other
risk management techniques more systematically than households and small
businesses.

Even large businesses face loss exposures that they can handle most eco-
nomically by purchasing insurance. N o viable alternative exists for highly
unpredictable loss exposures that could result in catastrophic financial con-
sequences. Such businesses may use large retention amounts (deductibles or
self-insurance) and purchase insurance policies to provide coverage above
these amounts to protect them against large losses.

By working closely w i t h the organization's insurance producer, a risk man-

ager can develop an insurance program tailoted to the company's needs and
coordinate an insurance program w i t h risk control and other risk financ-
ing to develop a complete risk management program. See the exhibit "Risk
Management Techniques."

Apply Your Knowledge

Dorian has followed the auto manufacturers' scheduled maintenance recom-
mendations o n her new Kia and five-year-old Honda to avoid any accidents
caused by mechanical malfunctions. Her sixteen-year-old son, M a r v i n , has
just received his driver's license. Dorian decides that M a r v i n will drive the
Honda, which has dual front and side airbags installed. Dorian adds M a r v i n to
her auto insurance policy and asks her insurer to increase the comprehensive
and collision deductibles for the Honda to $1,000 to reduce the cost of the
insurance coverage. A t Dotian's insistence, M a r v i n completed a safe-driver
education program, which included thirty hours of driving time w i t h a certi-
fied driver education instructor, before obtaining his driver's license.

Identify the risk management techniques that Dorian has used to manage her
auto loss exposures.
7.14 Property and Liability Insurance Principles

Risk Management Techniques

Risk Control Techniques

Technique What the Technique Does Example
Avoidance Eliminates the chance of a particular type A family decides not to purchase a boat
of loss by either disposing of an existing and therefore avoids the loss exposures
loss exposure or by not assuming a new associated with boat ownership.
exposure.
Loss Lowers loss frequency (number of losses). A business installs bars on windows and
prevention door deadbolts to prevent burglaries.
Loss reduction Lowers loss severity (dollar amount of A business installs a sprinkler system to
losses). reduce the amount of fire damage from
potential fires.
Separation Lowers loss severity. A business buys multiple small warehouses
to contain the effects of a single loss.
Duplication Lowers loss frequency. A taxi firm maintains a few spare vehicles
to keep all drivers on the road even if one
vehicle needs repair.
Risk Financing Techniques
Retention Retains all or part of a loss exposure A business decides not to purchase
(intentionally or unintentionally), which collision coverage for its fleet of vehicles
means that losses must be paid for with and sets aside its own funds to pay for
available funds or other assets. possible collision losses.
Noninsurance Transfers potential financial In a lease, a landlord transfers the liability
transfer consequences of a loss exposure from exposures of a rented building to the
one party to another party that is not an tenant.
insurer.
Insurance Transfers financial consequences of A family purchases homeowners and
specified losses from one party (the personal auto policies from an insurer.
insured) to another party (the insurer) in
exchange for a specified fee (premium).

[DA02674]

Feedback: Dorian used these techniques to manage her auto loss exposures:

• Dorian's auto maintenance practice is a loss prevention technique.

• Dorian's decision for M a r v i n to drive the older auto w i t h dual airbags is a
loss reduction technique because the value of the older Honda is less than
that of the newer Kia, and the airbags could minimize or prevent injury to
M a r v i n and his passenger i n an accident.
• A d d i n g M a r v i n to her insurance policy is an insurance risk transfer
technique.

•
• Increasing the auto deductibles on the Honda is a retention technique.
• T h e safe-driver education program that M a r v i n completed is both a loss
reduction technique and a loss prevention technique because Marvin's
knowledge of safe-driving practices can help prevent accidents (losses)
and his knowledge of how to react i n an accident might help h i m reduce
the amount of damage incurred if he has an accident.

SELECTING, IMPLEMENTING, AND

MONITORING RISK MANAGEMENT
TECHNIQUES
After identifying and analyzing loss exposures and considering the feasibility
of the available risk management techniques, the risk manager must complete
steps 4, 5, and 6 of the risk management process. The last three steps in the
risk management process guide businesses and individuals in selecting appro-
priate risk management techniques, implementing the selected techniques,
and monitoring results of the techniques selected and revising their risk man-
agement programs.

The fourth step i n the risk management process is to select the most appropri-
ate risk management technique(s) based on financial criteria and guidelines.
The fifth step is implementation of the selected techniques. The final step
involves monitoring the results and revising the program as needed. A n
understanding of these steps helps insurance professionals guide customers
through the tisk management process and provides a deeper understanding
of the issues a customer might face in developing and implementing a risk
management program.

Selecting the Appropriate Risk Management

Techniques
Organizations and households select risk management techniques based on
financial criteria or informal guidelines. For example, organizations that are
accustomed to reaching decisions based o n expected profits or other financial
criteria will probably use these same financial standards to select the most
promising risk management techniques. I n contrast, organizations that are
less financially oriented are more likely to apply informal guidelines in choos-
ing risk management techniques. See the exhibit "Step 4: Risk Management
Process."
7.16 Property and Liability Insurance Principles

Step 4: Risk Management Process

f% A
Jm
Step 4
Selecting the appropriate risk
03 management techniques

[DA07143]

Selection Based on Financial Criteria

Financial management decisions are typically made w i t h the objective of
increasing profits and/or operating efficiency. Selection of risk management
techniques can be based on the same objectives. W h e n an organization under-
takes an activity to achieve profit goals or other objectives, it also assumes
the exposures to accidental loss that are inherent i n that activity. How the
organization deals with those loss exposutes affects the profits or output from
the activity. By forecasting how selection of a particular risk management
technique will affect profits or output, an organization can choose the risk
management technique that is likely to be the most financially beneficial.

For example, a corporation may analyze its financial position and decide that
it does not want any retained loss exposures to affect annual corporate earn-
ings by more than five cents pet share of stock. If the corporation has 100
million shares outstanding, the risk management department can tetain up to
$5 million for all exposures in a fiscal year. The risk management depattment
makes its tetention decisions fot the coming year based o n this strategy of
protecting corporate earnings.

Selection Based on Informal Guidelines

Most households and small organizations follow informal guidelines i n select-
ing risk management techniques. Four guidelines might be used to select
techniques.

The fitst guideline is do not retain more than you can afford to lose. Setting
an upper limit on the proper retention level is an important guideline. The
amount that a household or an organization can afford to lose depends on
its financial situation. For example, if a family has only $500 i n its savings
account and has little remaining from each paycheck after paying expenses,
it may not be feasible for the family to carry a $1,000 deductible o n either its
homeowners or personal automobile policies. Unless the family has resources
to borrow money to bear the portion of a loss atttibuted to a high deductible,
the family may choose to carry whichever m i n i m u m deductibles the insutet
offets, despite the fact that the family could save premium dollars by choosing
a higher deductible.

•
The second guideline is do not retain large exposures to save a little pre-
mium. A risk manager should not retain a loss exposure w i t h high potential
severity, such as auto liability, to save a small amount of insurance premium.
Depending on market conditions, certain types of liability insurance cover-
age, such as some umbrella policies (designed to cover large liability losses),
can cost telatively little because the potential frequency of large liability losses
is low. However, such coverage can be priced much higher given different
matkct conditions.

Exposures w i t h the potential of low frequency but high severity should

generally be insured because they are highly unpredictable. For example, the
probability of a building's suffering a total fire loss is low because total fire
losses happen infrequently; however, if a family's residence does burn to the
ground, the seventy of the loss would be great. One such loss would cost the
family many times an annual insurance premium, so the family should fully
insure the residence but use an appropriate deductible to decrease the policy
premium.

The third guideline is do not spend a lot of money for a little protection. Risk
managers should spend insurance dollars where they will do the most good.
If the exposure is almost certain to lead to a loss during the policy period,
the insurer must charge a premium close to the expected cost of the loss plus
a portion of the insurer's overhead, premium taxes, and profit. I t is better to
retain exposures of this type because the household or organization could
absorb the cost of a loss almost as easily as the cost of the insurance. For loss
exposures w i t h high frequency and low severity, retention and risk control
are usually the best alternatives. For example, a family may choose a higher
deductible on auto physical damage coverage and use that savings to buy
umbrella insurance to provide coverage for the infrequent but severe liability
losses exceeding theit homeowners or auto policy liability limits.

The fourth guideline is do not consider insurance a substitute for risk con-
trol. A company's risk manager may evaluate a particular exposure, such as
automobile collisions, and discover that the frequency of accidents has been
increasing i n recent years. If the company has a $1,000 collision deductible
for each accident, the risk manager may consider reducing the company's
total annual retention for auto accidents. However, lowering the deductible
to $500 so that the company retains less of the loss exposure o n each accident
would not solve the real problem, which is the increase i n loss frequency. The
insurance cost increases w i t h the lower deductible, and the loss frequency is
likely to remain high. In this case, the risk manager would be using the pur-
chase of insurance in lieu of risk control.

A better option would be for the company to implement a tisk control pro-
gram to prevent accidents from occurring. This program could include more
careful screening of company drivers, periodically reviewing drivers' motor
vehicle records, training employees in safe driving practices, ensuting vehicle
safety through regular vehicle maintenance, and implementing othet risk
control activities to teduce the frequency of collisions. If the program works
7.18 Property and Liability Insurance Principles

and fewer accidents occur, the company's overall retention from absorbing
deductibles decreases, although the cost of the risk control program must also
be considered. Future insurance premiums may be lower as well, because the
insurer may offer a lower premium for the improved accident record.

W h e n insurance takes the place of risk control, the insuted simply passes the
cost of absorbing additional losses to the insuter. It may be more economical
to spend dollars o n a risk conttol program that will prevent and reduce losses
and lower the long-tetm cost of insurance and the risk management program.

0 Reality Check
Construction Company Reduces Workers Compensation Claims Through Risk
Management Techniques
CF Jordan LP, a construction general contractor, implemented a risk control program
that included construction superintendents' use of a device to report safety concerns
on job sites and increase safety on all of its jobs. After implementation of its risk
management program, CF Jordan reported a direct cost savings of $2.5 million for
workers compensation over a four-year period and an 85 percent drop in severity of its
workers compensation claims. The contractor based its selection of risk management
techniques on a cost/benefit analysis comparing the cost of workers compensation
claims with the cost to administer the safety process.
1

[DA07678]

Implementing the Selected Risk Management

Techniques
Implementing the risk management techniques that an organization has
selected requires the risk managet to make these decisions:

• W h a t should be done
• W h o should be responsible
• H o w to communicate the risk management information
• How to allocate the costs of the tisk management program

Once these decisions have been made, the risk management program w i l l be
effectively implemented. See the exhibit "Step 5: Risk Management Process."

Deciding What Should Be Done

Once the tisk managet has decided which risk management techniques to
use, he ot she must implement them. For example, Helen, the risk manager of
a supermarket, has decided that the store needs a sprinkier system. She must
now decide how much the supermarket can afford to spend o n the system,

•
 Step 5: Risk Management Process

®
Step 5
Implementing selected risk
management techniques P 9 0

W o
[DA07143]

what kind of system should be installed, and which contractor should install
it. She might also need to check on the local water supply and building per-
mits and decide what is necessary to comply w i t h local ordinances. Because
the store executives w i l l want to minimize customer disruption, Helen must
decide how to accomplish this objective. She must also consult w i t h the
store's insutance agent to make sute that appropriate property and liability
coverages are i n place during and after the installation and that the insurer
gives an insurance credit for the sprinkler system. Helen must take into
account these considerations and many others before deciding exactly how to
implement the risk control technique she has selected.

Deciding Who Should Be Responsible

The risk manager usually does not have complete authority to implement
risk management techniques and must depend on others to implement the
program based o n the risk manager's advice. Larger organizations may have a
written risk management statement and a risk management manual outlin-
ing guidelines, procedures, and authority fot implementing risk management
techniques. I n smaller organizations and i n households, the person making
risk management decisions is often the person implementing the program
because that person is the organization's owner or the household's primary
wage earner.

Communicating Risk Management Information

A risk management program must include a communications plan. Risk
management departments of large organizations generally rely on a manual
to inform others of how to identify new exposures, which risk management
techniques are currently i n place, how to report insurance claims, and othet
important information. Management and othet employees must communicate
information to the risk manager so that the program can be modified for new
exposures and evaluated for effectiveness.

Allocating Costs of the Risk Management Program

Allocating the costs of the risk management program also requires consider-
ation. I n latge organizations, the costs of risk control, tetention, noninsutance
7.20 Property and Liability Insurance Principles

risk transfers, and insurance, as well as the expenses of the risk manage-
ment department, must be spread appropriately across all departments and
locations.

In smaller organizations or w i t h i n households, allocating costs is also feasible.

For example, an employee of a small business may be required to pay the
deductible arising from damage she caused to a company cat, or a teenager
may have to pay to fix a neighbor's window that he accidentally btoke.

Monitoring Results and Revising the Risk

Management Program
Monitoring the tesults of the tisk management program is an ongoing activ-
ity that a tisk managet must carefully perform. Because the needs of all
households and otganizations change over time, a risk management program
should not be allowed to become outdated. M o n i t o t i n g the program ranges
from handling routine matters, such as updating fleets of vehicles by replacing
those less roadworthy, to making complex decisions concerning new activities
to initiate ot avoid. See the exhibit "Risk Management Process."

Risk Management Process

Step 6
Monitoring results and revising
the risk management program

[DA07143]

A household or an organization should review its insurance program w i t h its

agent or btoket each year. Because decisions regarding insurance are usually
associated w i t h othet tisk management techniques, any change i n insutance
will affect the other areas.

The last step in the tisk management process is actually a teturn to the fitst.
To monitot and modify the risk management program, the risk manager must
petiodically identify and analyze new and existing loss exposutes and then
teexamine, select, and implement appropriate tisk management techniques.
Thus, the process of monitoring and modifying the risk management program
begins the tisk management process once again.

•
 Risk Management 7.21

Reality Check
Construction Company Uses Electronic Tracking Equipment to Recover Stolen
Property
Zachry Construction earned an award for Innovative Construction Project Planning
Process at an International Risk Management Institute, Inc., conference. Zachry
2

implemented use of a global tracking system as part of its risk management program
and later found that it met that need even more completely than it originally expected.
Mike Monnot, a director for Zachry, commented, "Even though our main purpose was
to increase equipment productivity and streamline our maintenance program.. .we
were pleased to learn first hand about its security features." When an unauthorized
3

move of a thirty-ton crane was noted, Zachry's equipment superintendent was able
to quickly confirm that the crane, a truck, and a trailer were all missing; he used a
tracking device to pinpoint the geographic location of the equipment. He notified police,
who recovered the unit and released it back to Zachry. Zachry noted cost benefits of
using the tracking device in this manner. The company avoided filing an insurance
claim, losing time and paying rental fees to temporarily replace the equipment, and
paying storage and retrieval fees to the police department because the police could
immediately and definitively confirm that the equipment belonged to the construction
firm.

[DA07679]

BENEFITS OF RISK MANAGEMENT

A sound risk management program benefits businesses, individuals, and fami-
lies, enabling them to better manage their loss exposures. Additionally, risk
management can benefit society and insurers.

Risk management's benefits to businesses, individuals, and families can

include peace-of-mind, improved access to affordable insurance, cost-effective
achievement of goals, and the ability to take o n more risk and explore greater
opportunities. Society and insurers also benefit when businesses and individu-
als practice risk management.

Benefits of Risk Management to Businesses

Making insurance part of an overall risk management program rather than
relying solely on insurance improves access to affordable coverage. Insurers
are more receptive to organizations that practice good tisk management than
those that rely solely on insurance for protection against the financial conse-
quences of accidental losses. A n insured that combines insurance w i t h the risk
management techniques of avoidance, tisk control, retention, and noninsur-
ance tisk ttansfer usually has fewer and smaller losses than do other insureds.
Therefore, insurers are likely to generate better loss ratios and underwriting
results by insuring policyholders having sound risk management programs.

•
7.22 Property and Liability Insurance Principles

Consequently, such insureds are often able to obtain broader coverage at

lower premiums than insureds who do not practice risk management.

By diminishing uncertainty of future losses from new business activities, risk

management increases opportunities for the insuted. The possibility of futute
losses tends to make many business owners and executives reluctant to under-
take activities they consider to be risky. This reluctance deprives the business
of the benefits that undertaking such activities could bring. A business that
has an effective risk management program is better prepared to seek opportu-
nities that could increase its profits. For example, if a business is confident it
has appropriately managed its present property and liability loss exposures, it
may consider proposals to manufacture a new product or expand its present
sales territory that it otherwise would not.

Risk management also leads to achievement of business goals through better

management of large loss exposures, and it helps organizations achieve thcit
business and financial goals i n a cost-effective manner. Risk management
techniques help minimize the chance that a business would face a disruption
or would have to absorb a large loss caused by a loss exposure. As a result,
profits could be increased because of the reduced expenses. For example, a
firm may reduce its insurance costs because the risk manager chooses to retain
a loss exposure instead of insuting it.

Benefits of Risk Management to Individuals and

Families
Like businesses, individuals and families benefit from effective risk
management.

Risk management helps individuals and families cope mote effectively

w i t h financial disasters that may otherwise cause a greatly reduced stan-
dard of living, personal bankruptcy, or family discord. Additionally, it helps
them continue their activities following an accident or other loss, reducing
inconvenience.

Risk management provides individuals and families greater peace of mind

because they know that their loss exposures are under control. It also reduces
expenses by handling loss exposures in the most economical fashion.

Risk management enables individuals and families to take more chances and
make more aggressive decisions on ventures with the potential for profit,
such as investing in the stock market, changing careers, or starting a part-
time business. Though this may seem inconsistent w i t h the purpose of risk
management, such decisions can have long-term value when made w i t h a full
knowledge of costs and potential benefits.

•
Benefits of Risk Management to Society
By helping themselves through effective risk management, businesses, indi-
viduals, and families also benefit society.

Risk management can help reduce the number of persons dependent on

society for support, because businesses and families plan for financial crises.
For example, families who buy flood insurance need less help from charitable
agencies or the government for federal flood relief after a flood event.

Risk management also results in fewer disruptions i n the economic and social
environment. Organizations and families that practice risk management are
not subject to the big and sudden expense of bearing the cost of a loss.

In addition, economic growth can be stimulated by effective risk manage-

ment. Because fewer and less costly losses result, funds are available for other
uses, such as investment.

Gf Reality Check
City Fire Department Benefits From Risk Management
Individuals, households, and all types of organizations, including city fire departments,
benefit from risk management. Kansas City Fire Chief Smokey Dyer acknowledges the
danger of the fire fighting profession, as well as the responsibility of the department
to work diligently to protect its staff. According to Dyer, his department has made
considerable improvements in safety, equipment, and training their professionals.
Dyer cites these benefits that the department has gained through improved risk
management as "an increase in fixed fire protection in buildings, better training
methods, better procedures to follow and a cultural shift to worry more about our own
lives."

Goforth, Alan, "Danger? These People Don't Mind it at Work," Kansas City Star, April 4, 2011, www.kansascity.
com/2011/04/04/2776332/danger-these-people-dont-mind.html (accessed on May 17, 2011). [DA07695]

Benefits of Risk Management to Insurers

From an insurer's point of view, risk management is beneficial in many ways.
Risk management creates a positive effect o n an insurer's underwriting results,
loss tatio, and ovetall profitability because insureds who practice sound tisk
management tend to experience fewer or less severe insured losses than those
who do not.

Consumers of insurance who practice risk management are generally more

knowledgeable about handling loss exposures than consumers who don't
practice risk management. They are likely to combine insurance w i t h othet
7.24 Property and Liability Insurance Principles

techniques for handling loss exposures, and thetefore may incut and submit
fewer claims.

Risk management also stimulates insutets to cteate innovative insurance

products and maintain competitive prices and services. Professional risk
managers seek to get the most fot theit insurance dollars and ate often willing
to pay highet ptemiums in exchange for greater insurance value. As a result,
these tisk managers may encourage insurers to be more innovative and com-
petitive i n the products and services they provide.

APPLYING THE RISK MANAGEMENT PROCESS

By applying the risk management process, insurance professionals can recom-
mend the most appropriate risk management techniques for theit customers
to use.

Risk management programs for organizations can be quite sophisticated.

These programs become more complex as organizations increase i n size and
their loss exposures become more extensive and complicated. However, even
typical households face many loss exposures, such as various property and
liability exposutes from home and automobile ownership. A family scenario,
including the loss exposures to be tteated, facilitates an uncomplicated appli-
cation of the risk management process.

Tony and Maria

Tony and Maria both work outside theit home, and they have three school-
aged children. They own two automobiles and a home w i t h a pool, have a
modest savings account, and have invested i n the stock market. Aftet attend-
ing a seminar at his company on risk management, Tony decided that the
family should initiate a risk management program of its own. To do so, Tony
knew that the family must follow these steps i n the risk management process:

• Identify the family's loss exposures

• Analyze the loss exposures
• Examine the feasibility of tisk management techniques
• Select tisk management techniques that are apptoptiate for the family
• Implement the selected techniques
• M o n i t o r and revise the family's risk management program

Identifying and Analyzing Loss Exposures

Tony and Maria identified loss exposures by listing the exposutes they could
think of and then inspecting their home, looking for othet exposures they had
not yet considered. For example, when Tony spotted his son's hockey stick, he
realized that they have a liability exposure arising from the childten's vari-

•
ous athletic activities. His daughter's saxophone in her bedroom reminded
Tony that the saxophone was not specifically insured and that they did not
have the funds readily available to replace it if it were stolen or damaged. As
Tony viewed their swimming pool full of neighborhood children, he realized
that they needed higher liability limits than theit current homeowners policy
provided.

Aftet physically inspecting theit home and property, Maria called their
insurance agent and obtained a household inventory form that they used to
inventoty theit household contents and other possessions to determine their
property loss exposures. The agent also sent them a survey to complete, which
they used to list potential liability exposures for the family.

Mafia and Tony then analyzed all the loss exposutes they had identified and
attempted to determine which ones could cause the most frequent or most
severe losses.

Examining, Selecting, and Implementing Risk

Management Techniques
Aftet identifying and analyzing theit property and liability exposures, Tony
and Maria's third step was to examine risk management techniques. Tony
knew from the seminar that the possible techniques include avoidance, tisk
control, noninsurance risk transfer, and retention, as well as insurance.

In an attempt to practice sound risk control, Tony and Maria installed

deadbolt locks on all theit doors and locks on all their windows. They also
installed smoke detectots in several places in theit home, and they ate con-
templating installing a burglar alarm system if they can find one that is both
effective and affordable.

Tony and Maria explored noninsurance risk transfer by considering leasing a

car, but they found that they would still be tesponsible fot all liability con-
nected w i t h the use of the auto and would therefore still have to purchase
insurance. They decided noninsutance risk transfer was not a good tisk man-
agement technique.

Because Tony and Maria do not have much disposable income after they pay
their mortgage, car payments, and other household bills each month, they
know that they must rely heavily on insurance to cover theit loss exposures.
A l t h o u g h they cannot afford to retain a large amount of their loss exposure,
they did raise the deductibles on both theit homeownets and personal auto
policies from $250 to $500, thereby reducing their premiums.

They decided not to specifically insure theit daughter's saxophone because

theit homeowners policy already covered it fot fire, theft, lightning, and othet
causes of loss. They also decided to apply the retention technique if theit
daughtet simply lost ot damaged the saxophone; in othet words, they would
7.26 Property and Liability Insurance Principles

replace the saxophone from their personal funds, make their daughter earn
money to replace it, or choose not to buy a new one.

Furthetmore, they decided to purchase an umbrella policy to covet large

liability losses such as those that might arise from use of autos, the children's
sporting activities, ot the pool exposure. The increased deductibles and
retention of the property loss exposures for the saxophone were about all
the retention Tony and Matia thought they could handle. Thus, as in most
households, insurance will play a dominant role in treating loss exposures fot
the Garcia family.

By installing locks and smoke detectots, purchasing umbrella insutance, and

deciding to retain some loss exposures, the Garcias effectively completed the
foutth and fifth steps in the risk management process: selecting and imple-
menting their tisk management techniques.

Monitoring Results and Revising the Risk

Management Program
The last step in Tony and Maria's risk management process is to petiodi-
cally monitor and modify theit program. For a family, an annual review of
the program is probably sufficient unless the family's circumstances change
significantly.

A n ideal time fot Tony and Matia to do another physical inspection and
inventoty would be at the renewal of theit homeownets policy or if either
Tony or Maria changes jobs, receives a large bonus, receives a salary increase,
or purchases any type of high-value property.

W h e n Tony fitst began to monitor theit tisk management program, he real-

ized that they had neglected to considet theit net income loss exposutes, such
as death, illness, injury, or unemployment. Tony and Maria immediately rook
steps to modify theit tisk management program to include theit net income
loss exposures and thus began the tisk management process w i t h exposure
identification and analysis all over again.

Apply Your Knowledge

Six months aftet implementing theit tisk management program, Tony and
Maria considered building a new house in a neighborhood that is next to a
tiver Mafia's elderly mother lives in that neighborhood, and moving there
would allow them to help her more readily should an emergency or another
need arise. However, Tony and Maria are concerned because this new neigh-
borhood has a history of flooding in the spring and late summer

•
Evaluate each of these risk management techniques, and explain how each
technique could apply to Tony and Maria's potential flood loss exposure:

• Avoidance
• Loss prevention or loss reduction
• Insurance
• Retention

Feedback: These answers provide examples of how these techniques could

apply, but other answers may be acceptable as well:

Avoidance—Tony and Maria could decide not to build a house in that

location. Instead, they might build in a neighborhood that is not subject to
flooding but is still reasonably near Maria's mother's home.

Loss prevention or reduction—Tony and Maria might consider building the

house on a built-up lot ot building it according to a plan w i t h an elevated first
floor and no basement to prevent or reduce flood damage.

Insurance—Tony and Maria could buy federal flood insurance and accept the
possibility that their property may flood, knowing that the insurance would
pay most of their loss.

Retention—Choosing to retain the entire flood risk would be a poor risk man-
agement decision, as Tony and Maria could lose the entite value of their home
and personal property. However, Tony and Maria could buy flood insurance
subject to a larger deductible (compared w i t h their deductible for other perils)
to enable them to save money o n the cost of insurance. To improve their risk
management program, Tony and Maria could create a special savings account
and have money deducted from their paychecks until they have sufficient sav-
ings to fund the uninsured portion of theit flood loss exposure.

SUMMARY
Risk management can differ markedly for individuals, small organizations,
and large organizations. A t whatever level it is practiced, risk management
is aimed at dealing economically w i t h tisk, whether through an individual's
informal efforts or through an organizations^ formalized risk management pro-
gram. Traditionally, risk management has been concerned almost exclusively
w i t h pure risk. A new approach, called enterprise-wide risk management, is
concerned w i t h all risks, pure and speculative, that an organization faces.

The risk management process can be used to help organizations and families
deal w i t h loss exposures efficiently and effectively. Physical inspections, loss
exposure surveys, and loss history analyses can be used to identify loss expo-
sutes, the first step in the risk management process. To analyze loss exposures,
the second step in the process, an organization or a family must determine the
7.28 Property and Liability Insurance Principles

probable frequency and severity of the losses and the effect on the activities,
objectives, and finances of the organization or household.

The thitd step in the tisk management process is examining the feasibility of
tisk management techniques. These techniques ate categorized as risk con-
trol and tisk financing. Risk control includes avoidance, loss prevention, loss
teduction, separation, and duplication. Risk financing includes retention and
transfer (both insutance and noninsurance).

The fourth step in the risk management process is to select the most appropri-
ate risk management technique(s) based on financial criteria and guidelines.
The fifth step is implementation of the selected techniques and includes the
decisions to be made and by whom, communication of the information, and
cost allocation of the program. The final step involves monitoring the tesults
and revising the program as needed by testatting the entite process.

Risk management's numerous benefits to businesses, individuals, and families

include peace-of-mind, improved access to affordable insurance, cost-effective
achievement of goals, and the ability to take mote tisk and explore greatet
opportunities. W h e n individuals, families, and organizations practice risk
management, society benefits from the reduced need for social services
aftet losses, improved social/economic environment, and encouragement of
economic growth. Insurers benefit from improved profitability, more knowl-
edgeable insurance consumers, and being stimulated to innovate and create
competitive products and services.

A l t h o u g h businesses are the primary users of formal risk management

programs, individuals and families can also benefit from applying risk manage-
ment to their loss exposures. A risk management program for a large business
can be complex, but one fot a family can be simple and is well worth the time
and effort to implement.

ASSIGNMENT NOTES
1. CF Jordan LP, "Integrating Technology to Improve and Measure Risk
Management Initiatives and Track Leading Indicators to Prevent Incidents,
Improve Quality and Overall Employee H e a l t h , " I R M I . c o m , 2007, www.irmi.
com/conferences/crc/awards/handouts/gebha2007winnersubmission.pdf (accessed
May 16, 2011).
2. International Risk Management Institute, Inc., " T h e Zachty Construction
Corporation Risk Management Team Receives Award for Innovative
Consttuction Project Planning Process," I R M I . c o m , Novembet 9, 2005, www.
itmi.com/about/pressteleases/2005/1109a.aspx (accessed May 16, 2011).
3. Qualcomm, "Zachry Construction Wrenches Crane from the Grasp of Thieves,"
Qualcomm Solutions, Decembet 2004, www.qualcomm.com/common/
documents/case_studies/QUALCOMM-Zachry-Testimonial.pdf (accessed May
16, 2011).