CHAPTER TWO

THE RISK MANAGEMENT PROCESS

2.1. MEANING OF RISK MANAGEMENT

Risk management is a systematic process that identifies loss exposures faced by an organization
and selects the most appropriate techniques for treating such exposures. It is a scientific approach
to deal with risks by anticipating possible accidental losses and designing and implementing
procedures that minimize the occurrence of loss or the financial impact of the losses that occur.
In the past, risk managers generally considered only pure loss exposures faced by the firm.
However, newer forms of risk management are emerging that consider certain speculative risks
as well. This chapter discusses only the treatment of pure risks or pure loss exposures.

2.2. OBJECTIVES OF RISK MANAGEMENT

Objectives of risk management deals with deciding precisely what the organization expects its
risk management program to do. Objectives serve as a prime source of guidance for those
charged with responsibility for the program, and also means of evaluating performance. Risk
management has many important objectives which can be classified as either

(1) Pre loss Objectives

(2) Post loss Objectives

Pre loss Objectives

A firm may have several risk management objectives prior to the occurrence of the loss. These
important objectives before a loss occurs include economy, reduction of anxiety, and meeting
legal obligations.

Economy: The economy objective means that the firm should prepare for potential losses in the
most economical way. This preparation involves an analysis of the cost of safety programs,
insurance premiums paid, and the costs associated with different techniques for handling losses.

Reduction of Anxiety: Certain loss exposures can cause greater worry and fear for the risk
manager and key executives. For example, the threat of a terrible court case from a defective
product can cause greater anxiety than a small loss from a minor fire. The risk manager,
however, wants to minimize the anxiety and fear associated with all loss exposures.

Meeting legal obligations: The final objective is to meet any legal obligations. For example,
government regulations may require a firm to install safety devices to protect workers from
harm, to dispose of harmful waste material properly and to label consumer products
appropriately. The risk manager must see that these legal obligations are met.

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Post loss Objectives

Likewise, a firm may have many risk management objectives subsequent to the occurrence of the
loss. Important objectives after a loss occurs include survival, continued operation, stability of
earnings, continued growth, and social responsibility.

Survival: The most important post loss objective is survival of the firm. Survival means that
after a loss occurs, the firm can resume at least partial operations within some reasonable time
period.

Continued Operation: The second post loss objective is to continue operating. For some, firms,
the ability to operate after a loss is extremely important. For example, a public utility firm must
continue to provide service, Banks, post offices, dairies, and other competitive firms must
continue to operate after a loss. Otherwise, business will be lost to competitors.

Stability: The third post loss objective is stability of earnings. Earnings per share can be
maintained if the firm continues to operate. However, a firm may incur substantial additional
expenses to achieve this goal (such as operating at another location), and perfect stability of
earnings may not be attained.

Continued Growth: The fourth post loss objective is continued growth of the firm. A company
can grow by developing new products and markets or by acquiring or merging with other
companies. The risk manager must therefore consider the effect that a loss will have on the
firm’s ability to grow.

Social Responsibility: Finally, the objective of social responsibility is to minimize the effects
that a loss will have on other persons and on society. A sever loss can adversely affect
employees, suppliers, creditors and the community in general.

2.3. STEPS IN THE RISK MANAGEMENT PROCESS

The whole process of risk management involves the following four steps:

Step 1: Identifying potential losses (Risk Identification)

Step 2: Evaluate Potential losses (Risk Measurement)

Step 3: Select the appropriate techniques for treating loss exposure, and

Step 4: Implement and administer the program.

2.3.1. RISK IDENTIFICATION

The first step in the risk management process is to identify all major and minor loss exposures.
This step involves a thorough analysis of all potential losses. In other words it is a phase where a

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firm systematically and continually identifies property, liability, and personal exposures as soon
as or before they emerge. Unless the sources of possible losses are recognized, it is impossible to
consciously choose appropriate, efficient methods for dealing with those losses should they
occur.

A loss exposure is a potential loss that may be associated with a specific type of risk. Loss
exposures (so called sources of risks) typically classified as follows:

1. Property Loss Exposures

 Buildings, Plants, Other Structures

 Furniture, Equipment, Supplies
 Electronic data processing equipment;
 Computer Software
 Inventory
 Accounts receivables, Valuable papers and records
 Company planes, boats, mobile equipment.

2. Business Income Loss Exposures

 Loss of income from a covered loss

 Continuing exposures after a loss
 Extra expenses
 Contingent Business income losses.

3. Human Resources Exposures

 Death of key employees/disability of key employees

 Retirement or unemployment
 Job-related injuries or disease experienced by workers

4. Crime Loss Exposures

 Holdups, robberies
 Employees theft and dishonesty
 Fraud and Embezzlement
 Interest and computer crime exposures.

5. Employee Benefit Loss Exposures

 Failure to comply with government regulation

 Failure to pay promised benefits
 Group life and health and retirement plan exposures.

6. Foreign Loss Exposures

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  Acts of terrorism
 Plants, business property, inventory
 Foreign currency risks
 Kidnapping of key persons
 Political risks

7. Liability Risks

 Defective Products
 Sexual harassment of employees, discrimination against employees, wrongful termination
 Misuse of internet and e-mail transactions

Techniques for Identifying Risks

A risk manager has several techniques that he or she can use to identify the preceding loss
exposures. But no single method or procedure of risk identification method is free of weakness.
The strategy of a management must employ method or a combination of methods that best fit(s)
the situation on hand. The choice is a function of the following factors

i. The nature of the business

ii. The size of the business
iii. The availability of skill man power.

Below some of the risk identification methods are described:

Loss Exposure Checklists

A risk identification tool that can be used both by business and by individuals is a loss exposure
checklist, which specifies numerous common potential sources of loss from destruction of assets
and from legal liability. Loss exposure checklists are available from various sources, such as
insurers, agencies etc. the checklists contain possible source of loss to the business firm from the
destruction of physical and intangible assets. Sources of loss are categorized according to their
being predictable or unpredictable, controllable or uncontrollable, direct or indirect, etc. For each
item of checklist, the user asks the question, “is this a potential source of the loss to me or my
firm?” In this way, the systematic use of loss exposure checklists reduces the likelihood of
overlooking important sources of risks.

Some loss exposure checklists are designed for specific industries, such as manufacturers, retail
stores, educational institutions, or religious organizations. Such lists tend to be quite lengthy, as
they attempt to cover all the exposures that various entities are likely to face.

In contrary, some type of checklists focus on a specific category of exposures. The questions
included in the checklists usually address specific exposures in considerable detail. Thus, these

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checklists can be helpful net only in risk identification but also in compiling information
necessary for an in depth evaluation of risks that are identified.

The Financial Statement Method

The financial statement method was proposed by A.H. Criddle (1962). Although it was intended
for private originations, the concepts of this financial statements approach can be generalized in
public sector organizations as well. By analyzing the balance sheet, operating statements and
supporting documents, the risk manager can identify property, liability and human exposures
(losses) of the organizations.

By combining these statements with financial forecast and budgets, the risk manager can
discover future exposures. Financial statements reveal this information because every
organizational transaction ultimately involves either money or property.

The Flow Chart Method

An organization’s exposure to risk also can be identified by studying flow chart of organization’s
activities and operations. Flow charts are schematic representations of a sequential process.
Flow charts depicting the operations of a firm can guide a risk manager to associate risks with
those operations. Flow charts are studies alongside the checklists of possible exposures to
determine which items apply.

Contract Analysis

Many of an organization’s exposures to risk arise from contractual relationships with other
persons and organizations. An examination of these contracts may reveal areas of exposures that
are not evident from the organization’s operations and activities. In some cases, contracts may
shift responsibility to other parties.

Interactions with other Departments

Frequent interactions with other departments provide another source of information on exposures
of risk. These interactions may include oral or written reports from other departments on their
own initiative or in response to regular reporting system that keep the risk manager informed of
the different developments. The importance of such a communications network should not be
underestimated. These departments are consistently creating or becoming aware of exposures
that might otherwise escape the risk manger’s attention. Indeed, the risk manager’s success in
risk identification is heavily dependent on the co-operation of other departments.

Interactions with Outside Suppliers and Professional Organizations

In addition to communicating with other departments the risk manager normally interacts with
outsiders who provide services to the organizations. These outsiders may be, for example,

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accountants, lawyers, risk management consultants, actuaries, or loss control specialists. The
objective would be to determine or assess whether the outsiders have identified exposures that
otherwise would be missed. Possibly, the outsiders themselves may create new exposures.

Statistical Records of Losses

When available, statistical records of losses can be used to identify sources of risk. These records
may be available from risk management information systems developed by consultants or in
some cases, the risk manager. These systems allow losses to be analyzed according to cause,
location amount and other issues to interest.

Statistical records allow the risk manager to asses‟ trends in the organization’s loss experience
and to compare the organization’s loss experience with the experience of others. In additions,
these records enable the risk manager to analyze issues such as the cause, time and location of
the accidents, identify of the insured individual and the supervisions, and any hazards or other
special factors affecting the nature of the accident.

On Site Inspection

Onsite inspections are must for a risk manager. By observing the firm’s facilities and the
operations conducted thereon the risk manager can learn much about the exposures faced by
firm.

2.3.2. RISK MEASUREMENT (RISK EVALUATION)

The second step in the risk management process is to evaluate and measure the impact of
potential losses on the firm. The exposures are to be measured in order to determine their relative
importance and to obtain information that will help the risk manager to decide up on the most
desirable combination of risk management tools. This step involves in estimation of the potential
frequency and severity of loss.

Loss frequency refers to the probable number of losses that may occur during the same given
period of time. Loss severity refers to the probable magnitude of the losses that may occur.

Once the risk manager estimates the frequency and severity of loss for each type of loss
exposure, the various loss exposures can be ranked according to their relative importance. For
example, a loss exposure with the potential for bankrupting the firm is much more important in a
risk management program than an exposure with a small loss potential.

In addition, the relative frequency and severity of each loss exposure must be estimated in order
the risk manager to select the most appropriate technique or combination of techniques for
handling each exposure. For example, if certain losses occur regularly and are fairly predictable,
they can be budgeted out of a firm income and treated as normal operating expenses. If the
certain type of exposure fluctuates widely, however, an entirely different approach is required.
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Although the risk manager must consider both loss frequency and loss severity, more attention
should be given to severity as a single catastrophic loss could wipe out the firm. Therefore, the
risk manager must also consider all losses that can result from a single event. Both the
maximum possible loss and maximum probable loss must be estimated. This is suggested by
Richard Prouty and is called prouty measures of severity. The maximum possible loss is the
worst loss that could possibly happen to the firm during its lifetime.

In determining loss severity the risk manager must be careful to include all the type of losses that
might occur as a result of a given event as well as their ultimate financial impact upon the firm.
In estimating loss severity, it is important to recognize the timing of any losses as well as their
total birr amount.

Loss frequency and loss severity data do more than identify the important losses. They are also
extremely useful in determining the best way or ways to handle an exposure to loss. For
example, the average loss frequency times the average loss severity equals the average total birr
losses expected in a year. These average losses are to be compared with the premium the firm
would have to pay an insurer for complete or partial protection.

The actual estimation of the frequency and severity of loses may be done in various ways. Some
risk mangers consider these concepts informally in evaluation of identified risks. They may
broadly classify the frequency of various losses into categories such as “Slight”, “Moderate”, and
“Certain” and many have similarly broad estimates for loss severity. Even this type of informal
evaluation is better than none at all. But as risk management becomes increasingly sophisticated,
most large firms, attempts to be more precise in evaluation of risk. It is now common to use
probability distributions and statistical techniques in estimating both loss frequency and severity.

2.3.3. SELECT THE APPROPRIATE TECHNIQUES FOR TREATING LOSS EXPOSURE

After identifying and evaluating exposures to risk, systematic consideration can be given to
alternative methods for managing each exposure. The third step in the risk management process
is to select the most appropriate technique/tool or combination of techniques/tools for treating
each loss exposure. The different tools of risk management will be discussed later in this
material.

2.4. RISK MEASUREMENT AND PROBABILITY DISTRIBUTION

2.4.1. MEANING OF PROBABILITY

Probability theory is the body of knowledge concerned with measuring the likelihood that
something will happen and making predictions on the basis of this likelihood. The likelihood of
an event is assigned a numerical value between 0 and 1. Zero is assigned for impossible and one
for definitely possible events. In general 0 ≤ P(A) ≤1; where P designates the probability of an
event and P(A) for probability of an event A to occur in a single observation.

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Determining the Probability of an Event

There are two common methods to obtain an estimate of the probability of an event.

1. Prior probabilities: these probabilities are determined before an experiment. A number of

equally likely outcomes must exist, some of which represent the particular outcome whose
probability is being determined. For example the probability of obtaining a head when a coin is
tossed is ½ because there are two equally likely outcomes; a tail or a head, and one of these
outcomes is a head. The probability of drawing the king from a full playing card is 4/52 or 1/13
as there are 52 cards and of which 4 are kings. But the probability of drawing a king of hearts is
1/52; a king of hearts or a king of shovels is 1/26.

2. Posterior or Empirical probabilities: these probabilities are computed after a study of past
experience. When we do not know the underlying probability of an event and cannot deduce it
from the nature of the event, we can estimate it on the basis of past experience. For example,
Assume that we are told that the probability of a student will fail in English course is 0.01. This
indicates that someone has gone through the records and discovered that in the past 1 man of
every 100 men failed the English course. It can also imply that unless some corrective actions are
taken, we can expect the same proportion of students to fail each year in the future.

In situations where it is not possible to use either prior or empirical methods, subjective
probability estimates may be used.

Law of Large Numbers

The law of large numbers is a basic principle of mathematics which states that as the number of
the exposure units increases (for our case, persons or objects exposed to risk), the more certain it
becomes that actual loss experience will equal probable loss experience. It states that the greater
the numbers of exposures, the more closely will the actual results approach the probable results
that are expected from an infinite number of exposures. Therefore, the degree of objective risk
diminishes as the number of exposure units increases. For example suppose that a given
insurance company expected 1% of its insurers to experience a loss in a certain given year. The
law of large numbers states that the greater the number of the exposures under its policy, the
more likely is the 1% loss figure to be realized. By applying the law of large numbers, the
insurance company can predict accurately the birr amount of losses it will experience in a given
period. The relative accuracy of the company’s prediction increases as the number of exposures
in the insurance policy increases. If the loss amounts are predicted in advance, the company
could take its own arrangements for safe operation.

For precise illustration, assume that Avon and Saxon companies own 100 and 900 cars
respectively. These cars are used by the salesperson of each firm and are driven in the same
geographical location, assume Addis Ababa. The probability of loss in a given year due to
collusion is 20% for both. Hence, the expected losses of Avon company is 20 (100*20%) and
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180 (900*20%) for Saxon. Assume further that statisticians revealed that the likely range in the
number of losses in one year is 8 and 24 for Avon and Saxon respectively. As shown below the
degree of risk for Saxon is 1/3 of the Avon’s.

Objective risk Avon = Range/Expected = 8/20 = 40%

Objective risk Saxon = Range/Expected = 24/180 = 13.3%

One thing we should have to bear in mind is that the law of large numbers only allows accurate
predictions of group results, but not particular exposures of individuals in the group.

The two most important application of the law of large numbers in relation to objective risk are
as follows:

1. as the number of exposure units increase, the degree of risk decreases

2. Given constant number of exposure units, as the probability of loss increases, the degree of
risk decreases.

2.5. TOOLS OF RISK MANAGEMENT

The major techniques to handling risks are shown below under two categories

Risk control techniques

1. Risk Avoidance
2. Loss Control
3. Diversification (separation)
4. Combination

Risk financing techniques

 Risk- Retention
 Self- insurance
 Non insurance risk Transfer
 Insurance

2.5.1. Risk Control Techniques

RISK AVOIDANCE

One way to control a particular risk is to avoid the property, person or activity giving rise to
possible by either refusing to assume it even temporarily (called proactive avoidance) or by
abandoning an exposure to a loss assumed earlier (abandonment). Avoidance stands to mean that
a certain loss exposure is never acquired, or an existing loss exposure is abandoned. Risk
avoidance is conscious decision not to expose oneself or one’s firm to a particular risk of loss. In
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this way, risk avoidance can be said to decrease one’s chance of loss to zero. Example: If one
doesn’t want to face car collusion, he/she may decide not to have car at all. Similarly, a
pharmaceutical firm that markets a drug with dangerous side effects can withdraw the drug from
the market.

The major advantage of risk avoidance is that the chance of loss is reduced to zero if the loss
exposure is never acquired. In addition, if an existing loss exposure is abandoned, the chance of
loss is reduced or eliminated because the activity or product that could produce a loss has been
abandoned.

Avoidance, however, has also some disadvantages. First, the firm may not be able to avoid all
losses. Example, a company may not be able to avoid the premature death of a key executive.
Second, it may not be feasible or practical to avoid the exposure. Or even avoiding one risk may
create another risk. For example, a paint factory can avoid losses arising from the production of
paint. Without paint production, however, the firm will not be in business.

LOSS CONTROL

When particular losses/ risks cannot be avoided, actions may be taken to reduce the losses
associated with them. This method of dealing with risk is known as “Loss Control”. Loss control
activities are designed to reduce both the frequency and severity of losses. Loss control measures
do counteract risks by lowering the chance the loss will occur or by reducing its severity if the
loss is to occur. This method deals with an exposure that the firm doesn’t want to abandon.

Loss control is different from risk avoidance, because loss exposures that give rise to particular
risks are still used in operations, but the firm will conduct its operations in the safest possible
manner. Rather than abandoning specific activities, loss control involves making conscious
decisions regarding the manner in which those activities will be conducted. Common goals are
either to reduce the probability of losses or to decrease the cost of losses that do occur.

Types of Loss Control

Loss control can be classified based on two factors called focus and timing.

Based on Focus, Loss Control can be classified as

 Loss Prevention
 Loss Reduction

Some loss control measures are designed primarily to reduce loss frequency. This form of loss
control is referred to as “frequency reduction” (Loss Prevention). For example, measures that
reduce truck accidents include driver examinations, zero tolerance for alcohol or drug abuse and
strict enforcement of safety rules. Measures that reduce lawsuits from defective products include

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installation of safety features on hazardous products, placement of warning labels on dangerous
products, and institution of quality control checks.

In contrast to frequency reduction, consider an auto manufacturer having airbags installed in the
company fleet off automobiles. This form is engaging in “severity reduction” (Loss Reduction).
It refers to measure that reduce the severity of a loss. The air bags will not prevent accidents
from occurring, but they will reduce the probable injuries that employees will suffer if an
accident does happen.

Based on Timing, Loss Control can be classified as

 Pre-Loss Activities
 Concurrent Activities
 Post – Loss Activities.

Pre-Loss Activities are measures to be taken to reduce the frequency or magnitude of the risk
prior to its occurrence. These activities deal with risk prevention or reduction mechanisms.

Concurrent Activities denotes for activities that take place concurrently with losses. The
activities of building sprinkler systems illustrate this concept of concurrent loss control.

Post – Loss Activities are measures to be taken after the loss is occurred. Similar to concurrent
loss control, Post-Loss activities always have a severity-reduction focus. For example, one is
trying to salvage damaged property rather than discard it. Thus, the partial restoration of an
automobile and subsequent sale of the car to an automobile wholesaler can reduce the overall
severity of a loss due to an automobile accident.

Benefits of Loss Control

Many of the benefits association with loss control are either readily quantifiable or can be
reasonably estimated. These may include the reduction or elimination of expense associated with
the following:

 Repair or replacement of damaged property

 Income losses due to destruction of property
 Extra costs to maintain operations following a loss
 Adverse liability of judgments
 Medical costs to threat injuries
 Income losses due to deaths or disabilities.

Another quantifiable benefit of loss control is a reduction in the cost of other risk management
techniques used in conjunction with the loss control.

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SEPARATION AND DUPLICATION

Separation involves the reduction of maximum probable loss associated with some kinds of risks.
This method deals with separation of the firm’s exposures to loss instead of concentrating them
at one location where they might all be involved in the same loss. Example, a firm may disperse
its inventory in to different warehouses than keeping it in one store. If fire destroys one of the
warehouses, the firm will save some of its inventories placed in the other warehouses. Through
such separation, the firm is reducing the likely severity of overall firm losses by reducing the size
of the exposure in any one location.

Duplication is a very similar technique, in which spare parts or supplies are maintained to replace
immediately damaged equipment and or inventories. This type of loss control also helps to
reduce the severity of losses that would occur.

COMBINATION

This method makes loss experiences more predictable by increasing the number of exposure
units. Unlike separation which spreads a specified number of exposure units, combination
increases the number of exposure units under the control of the firm.

2.5.2. Risk Financing Techniques

RISK RETENTION

Retention means that the firm’s retains part or all of the losses that can result from a given loss.
Retention can be Active (Planned) or Passive (Unplanned). Active risk retention means that the
firm is aware of the loss exposure and plans to retain part or all of it, such as automobile crash
losses to a fleet of company cars. Passive risk retention, however, is the failure to identify a loss
exposure, failure to act or forgetting to act. For example, a risk manager may fail to identify all
company assets that could be damaged in an earthquake.

Retention can be effectively used in a risk management program under the following conditions:

 No other method of treatment is available

 The worst possible loss is not serious
 Losses are highly predictable.

Funding Losses

If retention is used, the risk manager must have some method for paying losses. The following
methods are typically used:

1. Current Net Income

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The firm can pay losses out of its current net income and treat losses as exposure for that year. A
large number of losses could exceed current income, however, and other assets may then have to
be liquidated to pay losses.

2. Unfunded Reserve

An unfunded reserve is a bookkeeping account that is charged with actual or expected losses
from a given exposure.

3. Funded Reserve

A funded reserve is the setting aside of liquid funds to pay losses. Funded reserves are net
widely used by private employers, because the funds may yield a much higher rate of return by
being used in the business. Also, contributions to funded reserves are net income tax deductible
losses, however, are tax deductible when paid.

4. Credit Line

A credit line can be established with a bank, and borrowed funds may be used to pay losses as
they occur. Interest must be paid on the loan, however, and loan repayments can aggregate any
cash flow problems a firm may here.

Advantages of Retention

Save Money: the firm can save money in the long run if its actual loses are less than the loss
component in the insurance’s premium.

Lower Expenses: the services provided by the insurer may be provided by the firm at a lower
cost. Some expenses may be reduced, including loss adjustment expenses, general administrative
expenses, commissions and brokerage fees, loss control expenses, taxes and fees and the
insurer’s profit.

Encourage Loss Prevention: because the exposure is retained, there may be a greater incentive
for loss prevention.

Increase Cash Flow: cash flow may be increased because the firm can use the funds that
normally would be paid to the insurer at the beginning of the policy period.

Disadvantages of Retention

Possible higher losses: the losses retained by the firm may be greater than the loss allowance in
the insurance premium that is saved by net purchasing the insurance.

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Possible higher expenses: expenses may actually be higher outside experts such as safety
engineers may have to be hired. Insurers may be able to provide loss control and claim services
less expensively.

Possible higher taxes: income taxes may also be higher.

NON INSURANCE RISK TRANSFER

Risk transfer involves in payments by one party (the transferor) to another (the transferee or risk
bearer) when the transferee agrees to assume a risk that the transferor desires to escape.
Sometimes the degree of risk is reduced through the transfer process, because the transferee may
be in a better position to use the law of large numbers to predict losses. In other cases the degree
of risk remains the same and is merely shifted from transferor to the transferee for a price.

Non insurance transfers are methods other than insurance by which a pure risk and its potential
financial consequences are transferred to another party. The most common forms of non-
insurance risk transfers are hedging, hold-harmless agreements and incorporation.

Hedging

Hedging involves the transfer of speculative risk. It is a business transaction in which the risk of
price fluctuations is transferred to a third party known as a speculator. This is the process of
balancing a chance of loss against the chance of gain.

Hold-Harmless Agreements

Provisions inserted into many different kinds of contracts can transfer responsibility for some
types of losses to a party different than the one that would otherwise bear it. These are contracts
entered into prior to a loss, in which one party agrees to assume a second party’s responsibility
should loss occur. Such provisions are called hold-harmless agreements or sometimes indemnity
agreements. The following are three different forms of hold-harmless agreements.

(a) Limited Form

The limited form merely clarifies that all parties are responsible for liabilities arising from their
own activities/actions. For example, YZ general trading engages in agreement with DEF
Company for electrical wiring of its office building. The limited form hold-harmless agreement
between YZ and DEF hold YZ general trading responsible for any liabilities losses arising from
faulty wiring.

(b) Intermediate Form

A second type of hold-harmless agreement is the intermediate form, in which the transferee
agrees to pay for any losses in which both the transferee and transferor are jointly liable.
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(c) Broad Form

The broad form is the third type of hold-harmless agreements. It requires the transferee to be
responsible for all losses arising out of particular situations regardless of fault.

(d) Incorporation

Another way for a business to transfer risk is to incorporate. In this way, the most that an
incorporated firm can ever loss is the total amount of its assets. Personal assets of the owners
cannot be attached to help pay for business losses, as can be the case with sole proprietorships
and partnerships. Through this act of incorporation, a firm transfers to its creditors the risk that it
might net has sufficient assets to pay for losses and other debts.

INSURANCE

The most widely used form of risk transfer is insurance. Insurance represents a contractual
transfer of risk. Insurance is appropriate for loss exposures that have a low probability of loss but
the severity of loss is high. If insurance is used to treat certain loss exposures, five key areas
must be emphasized.

They are:

 Selection of insurance coverage

The need for insurance can be divided in to several categories depending on importance. One
useful approach is to classify the need for insurance in to three categories: essential, desirable,
and available Essential insurance includes those coverages required by law or by contract, such
as the works compensation insurance. It also includes coverages that will protect the firm against
a catastrophic loss or a loss that threatens the firm’s survival; commercial general liability
insurance would fall in to that category.

Desirable insurance is protection against losses that may cause the firm financial difficulty, but
not bankruptcy. It includes those that protect against loss exposures that would force the firm to
borrow or restore to credit.

Available insurance is coverage for slight losses that would merely inconvenience the firm.
Optional insurance coverage includes those that protect against losses that could be met out of
existing assets or current income.

 Selection of an insurer

In selecting the insurer a risk manager should pay due attention to several factors such as the
financial strength of the firm, service provided by the insurer, and cost and terms of protection.

 Negotiation of terms
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The risk manager and the insurer must agree on the documents and the terms should be clear to
both parties.

 Dissemination of information concerning insurance coverage

The firm’s managers and employees must be informed about the insurance coverage, the various
records to be kept, the services of the insurer etc.

 Periodic review of insurance program

The entire process of obtaining insurance must be evaluated periodically. This involves an
analysis of agent and broker relationship, coverage needed, cost of insurance, pace of claim
payment and etc.

2.6. RISK MANAGEMENT MATRIX

Which method should be used for a particular exposure depends on the frequency and severity of
the loss. The following matrix may help in determining which risk management tool is to be
used, considering the nature of the loss:

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