Risk Management

Risk is the possibility that a loss or injury will occur.

 Classification of Risk:
• Pure risk: Pure risk is a type of risk that cannot be controlled
and has two outcomes: complete loss or no loss at all. There
are no opportunities for gain or profit when pure risk is
involved. The possibility of damage due to hurricane, fire, or
automobile accident is a pure risk.

• Speculative risk: A speculative risk refers to something that

cannot be predicted to yield a profit or a loss. It is, however,
taken on by someone who is aware of the future unknown.
Most business decisions, such as the decision to market a new
product, involve speculative risks. If the new product succeeds
in the marketplace, there are profits; if it fails, there are
losses.
• Fundamental risks affect the entire economy or large
numbers of people or groups within the economy. Examples
of fundamental risks are high inflation, unemployment, war,
and natural disasters such as earthquakes, hurricanes,
tornadoes, and floods.

• Particular risks are risks that affect only individuals and not
the entire community. Examples of particular risks are
burglary, theft, auto accident, dwelling fires. With particular
risks, only individuals experience losses and the rest of the
community are left unaffected.

• Enterprise risk is a term that includes all major risks faced by

a business firm. Such risks include pure risk, speculative risk,
strategic risk, operational risk, and financial risk.
• Strategic risk refers to uncertainty regarding the firm’s
financial goals and objectives; for example, if a firm enters a
new line of business, the line may be unprofitable.

• Operational risk results from the firm’s business operations.

For example, a bank that offers online banking services may
incur losses if “hackers” break into the bank’s computer.

• Enterprise risk also includes financial risk, which is becoming

more important in a commercial risk management program.
Financial risk refers to the uncertainty of loss because of
adverse changes in commodity prices, interest rates, foreign
exchange rates, and the value of money. For example, a
company that agrees to deliver grain at a fixed price to a
supermarket chain in six months may lose money if grain
prices rise.
 Techniques for Managing Risks:
Techniques for managing risk can be classified broadly as either
risk control or risk financing. Risk control refers to techniques
that reduce the frequency or severity of losses . Risk financing
refers to techniques that provide for the funding of losses .
Risk managers typically use a combination of techniques for
treating each loss exposure.
1. Risk Control:
As noted above, risk control is a generic term to describe
techniques for reducing the frequency or severity of losses.
Major risk-control techniques include the following:
■ Avoidance
■ Loss prevention
■ Loss reduction
• Avoidance: is one technique for managing risk. For example,
one can avoid the risk of divorce by not marrying; and a
business firm can avoid the risk of defective product by not
producing the product.

• Loss Prevention: aims at reducing the probability of loss so

that the frequency of losses is reduced. Several examples of
personal loss prevention can be given. Auto accidents can be
reduced if motorists take a safe-driving course and drive
defensively. The number of heart attacks can be reduced if
individuals control their weight, stop smoking, and eat healthy
diets.
• Loss Reduction: Strict loss prevention efforts can reduce the
frequency of losses; however, some losses are unavoidable.
Thus, the second objective of loss control is to reduce the
severity of a loss after it occurs. For example, a department
store can install a sprinkler system so that a fire will be
promptly extinguished, thereby reducing the severity of loss.

Risk Financing: As stated earlier, risk financing refers to

techniques that provide for the payment of losses after they
occur.
Major risk-financing techniques include the following:
■ Retention
■ Noninsurance transfers
■ Insurance
• Retention: Risk retention is an individual or organization’s
decision to take responsibility for a particular risk it faces, as
opposed to transferring the risk over to an insurance company
by purchasing insurance. That means the individual or
organization has chosen to pay for any losses out of pocket
rather than purchasing insurance as a means of transferring
the financial burden of a loss to a third party.
For example, in an individual case, a person decides to bear all
the losses caused to his property by himself and never cares
to get his property insured means all the risk shall be
retrained by that particular individual and in case of any loss
he shall only be paying from his own pocket for the losses
caused to his property.
• Noninsurance Transfers are another technique for managing
risk. The risk is transferred to a party other than an insurance
company.
A risk can be transferred by several methods, including:
■ Transfer of risk by contracts
■ Hedging price risks

• Transfer of Risk by Contracts: Undesirable risks can be

transferred by contracts. For example, the risk of a defective
television set can be transferred to the retailer by purchasing
a service contract, which makes the retailer responsible for all
repairs.
• Hedging Price Risks: Hedging price risks is another example of
risk transfer. Hedging is a technique for transferring the risk of
unfavorable price fluctuations to a speculator by purchasing
and selling futures contracts on an organized exchange.

Insurance for most people, insurance is the most practical

method for handling major risks.
 Risk management is a process that identifies loss exposures
faced by an organization and selects the most appropriate
techniques for treating such exposures.

 Steps in Risk Management Process

There are four steps in the risk management process:
■ Identify loss exposures
■ Measure and analyze the loss exposures
■ Select the appropriate combination of techniques for treating
the loss exposures
■ Implement and monitor the risk management program
A. Identify Loss Exposures
The first step in the risk management process is to identify all
major and minor loss exposures. This step involves a careful
review of all potential losses. Important loss exposures
include such as building, company car, boats and death or
disability of key employees structures.
A risk manager can use several sources of information to identify
the preceding loss exposures. They include the following:
■ Risk analysis questionnaires and checklists: Questionnaires and
checklists require the risk manager to answer numerous
questions that identify major and minor loss exposures.
■ Physical inspection: . A physical inspection of company plants
and operations can identify major loss exposures.
■ Flowcharts: Flowcharts that show the flow of production and
delivery can reveal production and other bottlenecks as well
as other areas where a loss can have severe financial
consequences for the firm.
■ Financial statements: Analysis of financial statements can
identify the major assets that must be protected, loss of
income exposures, and key customers and suppliers.
■ Historical loss data: Historical loss data can be valuable in
identifying major loss exposures.
B. Measure and Analyze the Loss Exposures:
The second step is to measure and analyze the loss exposures. It is
important to measure and quantify the loss exposures in order to
manage them properly This step requires an estimation of the
frequency and severity of loss. 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 occur.

C. Select the Appropriate Combination of Techniques for Treating the

Loss Exposures: The third step in the risk management process is to
select the appropriate combination of techniques for treating the
loss exposures. These techniques can be classified broadly as either
risk control or risk financing. Risk control refers to techniques that
reduce the frequency or severity of losses . Risk financing refers to
techniques that provide for the funding of losses . Risk managers
typically use a combination of techniques for treating each loss
exposure.
Risk Control As noted above, risk control is a generic term to
describe techniques for reducing the frequency or severity of
losses. Major risk-control techniques include the following:
■ Avoidance
■ Loss prevention
■ Loss reduction

Risk Financing as stated earlier, risk financing refers to

techniques that provide for the payment of losses after they
occur. Major risk-financing techniques include the following:
■ Retention
■ Noninsurance transfers
■ Commercial insurance
D. Implement and Monitor the Risk Management Program:
This step begins with a policy statement.

A risk management policy statement is necessary to have an

effective risk management program. This statement outlines
the risk management objectives of the firm, as well as
company policy with respect to treatment of loss exposures. It
also educates top-level executives in regard to the risk
management process; establishes the importance, role, and
authority of the risk manager; and provides standards for
judging the risk manager’s performance.
Secondly it involves with periodic review and evaluation: To be
effective, the risk management program must be periodically
reviewed and evaluated to determine whether the objectives
are being attained or if corrective actions are needed.