Topic 2:Risk Management Process

• Meaning of Risk Management

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

• Risk Management is a process that identifies

loss exposures faced by an organization and
selects the most appropriate techniques for
treating such exposures
• A loss exposure is any situation or circumstance
in which a loss is possible, regardless of
whether a loss occurs
–E.g., a plant that may be damaged by an earthquake,
or an automobile that may be damaged in a collision
 Objectives of Risk Management

• Risk management has objectives before and

after a loss occurs
• Pre-loss objectives: before the loss
–Prepare for potential losses in the most economical
way(cost implications of the safety programs, cost of
premiums paid)
–Reduce anxiety
–Meet any legal obligations (e.g. disposal of
hazardous products safely)
 Objectives of Risk Management

• Post-loss objectives: after the loss

–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
 Risk Management Process

1. Identify potential losses

2. Measure and analyze the loss exposures
3. Select the appropriate combination of
techniques for treating the loss exposures
4. Implement and monitor the risk
management program
Exhibit 3.1 Steps in the Risk Management
Process

Process
 1.Identify Loss Exposures
• Property loss exposures(buildings,plants,equipment, inventory..etc)
• Liability loss exposures (defective products,sexual harassment,
environmental pollution,etc)
• Business income loss exposures(extra expenses, loss of income from
a covered loss, contingent claims)
• Human resources loss exposures (death, disability,retirement,job
related injuries)
• Crime loss exposures (money laundering, highjackings, theft by
employees, heists, ATM bombings e.t.c)
• Employee benefit loss exposures (workers compensation,medical aid,
death benefits etc.)
• Foreign loss exposures (political disputes, war, price risk)
• Intangible property loss exposures(patents, trade secrets, etc)
• Failure to comply with government rules and regulations (qoutas,
 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.
–e.g., exposure to acts of terrorism
 2. Measure and Analyze Loss
Exposures
• Estimate for each type of loss exposure:
–Loss frequency refers to the probable number of losses
that may occur during some time period
–Loss severity refers to the probable size of the losses that
may occur
• Rank exposures by importance (severity vs.
frequency)
• Loss severity is more important than loss frequency:
–The maximum possible loss is the worst loss that could
happen to the firm during its lifetime
–The probable maximum loss is the worst loss that is likely
to happen
 3.Select the Appropriate Combination of Techniques for
Treating the Loss Exposures

• 1. Risk control refers to techniques that reduce

the frequency and severity of losses
• Methods of risk control include:
–Avoidance
–Loss prevention
–Loss reduction
 Select the Appropriate Combination of Techniques for
Treating the Loss Exposures

• Avoidance means a 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 (e.g. flying as a means of transport)
 Select the Appropriate Combination of Techniques for
Treating the Loss Exposures

• Loss prevention refers to measures that

reduce the frequency of a particular loss
–e.g., installing safety features on hazardous
products, defensive driving, alcohol testing before
driving/flying,
• Loss reduction refers to measures that reduce
the severity of a loss after it occurs
–e.g., installing an automatic sprinkler system, fire
extinguisher, fire walls, etc
 Select the Appropriate Combination of Techniques for
Treating the Loss Exposures

• Risk financing refers to techniques that

provide for the payment of losses after they
occur
• Methods of risk financing include:
–Retention
–Non-insurance Transfers
–Commercial Insurance
 Risk Financing Methods: Retention

• Retention means that the firm retains part or all of

the losses that can result from a given loss
–Retention is effectively used when:
•No other method of treatment is available (e.g. no insurance
coverage, insurance cover is too expensive, other non-insurance
techniques are not there)
•The worst possible loss is not serious (the loss is manageable)
•Losses are highly predictable (e.g. workers compensation,
shoplifting in supermarkets)
•Active Retention (aware and deliberately retain the risk) Vs.
Passive Retension(unknowingly retained due to ignorance,
carelessness, indifference, laziness)-lack of disability cover
–The retention level is the dollar(or pula) amount of losses
that the firm will retain (large firms might require large
retention level.. % of networking capital)
 Risk Financing Methods: Retention

• A risk manager has several methods for paying

retained losses:
–Current net income: losses are treated as current
expenses
–Unfunded reserve: losses are deducted from a
bookkeeping account
–Funded reserve: losses are deducted from a liquid fund
–Credit line: funds are borrowed to pay losses as they
occur
 Risk Financing Methods: Retention

• A captive insurer is an insurer owned by a

parent firm for the purpose of insuring the
parent firm’s loss exposures
–A single-parent captive is owned by only one
parent
–An association or group captive is an insurer
owned by several parents
 Risk Financing Methods: Retention

• Reasons for forming a captive include:

–The parent firm may have difficulty obtaining insurance
–To take advantage of a favorable regulatory environment
–Costs may be lower than purchasing commercial
insurance
–A captive insurer has easier access to a reinsurer
–A captive insurer can become a source of profit
 Risk Financing Methods: Retention

• Self-insurance, or self-funding is a special form

of planned retention by which part or all of a
given loss exposure is retained by the firm

• A risk retention group (RRG) is 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
 Risk Financing Methods: Retention

Advantages Disadvantages

–Save on loss costs –Possible higher losses

–Save on expenses –Possible higher expenses
–Encourage loss –Possible higher taxes
prevention
–Increase cash flow
 Risk Financing Methods:
Non-insurance Transfers
• A non-insurance transfer is a method other
than insurance by which a pure risk and its
potential financial consequences are
transferred to another party
–Examples include: contracts, leases, hold-harmless
agreements, company incorporation
 Risk Financing Methods:
Non-insurance Transfers
Advantages Disadvantages

–Can transfer some losses –Contract language may be

that are not insurable ambiguous, so transfer
–Less expensive may fail
–Can transfer loss to –If the other party fails to
someone who is in a better pay, firm is still responsible
position to control losses for the loss
–Insurers may not give
credit for transfers
 Risk Financing Methods: Insurance

• Insurance is appropriate for low-probability, high-severity loss

exposures
–The risk manager selects the coverages needed(coverage is
appropriate), and policy provisions (exclusions, riders,
deductible etc)
–A deductible is a 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
 Risk Financing Methods: Insurance

–The risk manager negotiates the terms of the

insurance contract
–A manuscript policy is a policy specially tailored for
the firm
–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
 Risk Financing Methods: Insurance

Disadvantages Advantages

–Premiums may be costly –Firm is indemnified for

–Negotiation of contracts losses
takes time and effort
–Uncertainty is reduced
–The risk manager may
become lax in exercising loss –Insurers can provide
control valuable risk management
services
–Premiums are income-tax
deductible
Exhibit 3.2 Risk Management Matrix
 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 easier to obtain
 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 program
–Train new employees
 Implement and Monitor the Risk
Management Program
• A successful risk management program requires
active cooperation from other departments in the
firm
• The risk management program should be
periodically reviewed and evaluated to determine
whether the objectives are being attained
–The risk manager should compare the costs and benefits
of all risk management activities
 Benefits of Risk Management

• Enables firm to attain its pre-loss and post-loss

objectives more easily
• A risk management program can reduce a fir
m’s cost of risk
• Reduction in pure loss exposures allows a firm
to enact an enterprise risk management
program to treat both pure and speculative
loss exposures
• Society benefits because both direct and
indirect losses are reduced
 Personal Risk Management

• Personal risk management refers to the

identification of pure risks faced by an
individual or family, and to the selection of the
most appropriate technique for treating such
risks
• The same principles applied to corporate risk
management apply to personal risk
management