CHAPTER TWO: THE RISK MANAGEMENT

2.1 What is Risk Management?

• Risk management is a systematic process for the identification and evaluation of
pure loss exposures.
• A loss exposure is any situation or circumstance in which a loss is possible,
regardless of whether a loss occurs.
• It is a scientific approach to deal with pure 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 do occur.
• Risk management focuses on a part of the total bundle of risks, those that are
classified as “pure risk”.
• As a general rule, the risk manager is concerned only with the management of
pure risks, not speculative risks.
• Hence, risk management is the identification, measurement and treatment of
property, liability and personnel pure risk exposures.
2.2 Why the study of Risk Management is important?

• The future is uncertain for everyone, exposed to many risks, and risks
are inevitable part of everyday life.
• Business firms face risks, unforeseen circumstances that can impair
their operational capability or financial integrity, arising from different
perils.
• Accidental losses happen each day threaten the survival of the
organizations
• It causes their earnings to dip below acceptable levels, interrupt their
operations, or slow their growth or in a worst-case scenario, cause the
organization to close.
• Risk management is a process of thinking systematically about all
possible risks, problems or disasters before they happen
 Cont…
• Proper risk management enables a business firm to handle its exposure to accidental
losses in the economic and effective way.
• It enables companies to react in early stage of change in environment and avoiding
possible crises.

• It protects and adds value to the organization and its stakeholders through
supporting the organization’s objectives.
• It also enables a business firm to handle better its ordinary business risk and
• It contributes to the survival and profitability of a business.
• It is setting up procedures that will avoid the risk, minimize or cope/deal with its
impact.
Therefore, Understanding risk and application of risk management techniques is a
very important aspect to effectively deal with uncertainty and associated risk.
 Objectives of Risk Management

• The first step in the risk management process is the determination of the objectives of the
risk management

• This step is often overlooked, with the result that the risk management program is less
effective than it could be.

• In the absence of coherent objectives, there is a tendency to view the risk management
process as a series of individual isolated problem.

• Risk management has several important objectives that can be classified into two categories:

1. Pre-loss objectives

2. Post-loss objectives
 1. Pre-loss objectives

• A firm or organization has several risk management objectives prior to the

occurrence of a loss. The most important includes:
A. Economy means that the firm should prepare for potential losses in the most
economical possible way.
B. Reduction in anxiety
• Certain loss exposures can cause greater worry and fear for the risk manager, key
executives and stockholders than other exposures.
C. Meeting external obligations
• This objective is to meet any externally imposed obligations.
• This means the firm must meet certain obligations imposed on it by outsiders.
• For example, a firm’s creditors may require that property pledged as collateral
for a loan must be insured. The risk manager must see that these externally
imposed obligations are met.
 2. Post-loss objectives

• The most important post-loss objectives of the firm are:

A. Survival &Continuity of operations
• The first and most important post-loss objective is survival of the firm. For some firms, the ability
to operate after a sever loss is an extremely important objective.
• E.g. a public utility firm must continue to provide services. Banks and other competitive firms
must continue to operate after a loss. Otherwise, business will be lost to competitors.
B. Earnings stability
• The firms Earnings per share can be maintained if the firm continues to operate after loss.
C. Continued growth
• A firm may grow by developing new products and markets or by acquisitions and mergers. The
risk manager must consider the impact that a loss will have on the firm’s ability to grow.
D. Social responsibility: The goal of social responsibility is to minimize the impact that a loss has
on other persons and on society.
• For example, a severe loss requires shutting down a plant in a small community for an extended
period can lead to depressed business conditions and substantial unemployment.
 Risk Management Process

• In order to have an effective risk management program, there are certain

steps that must be followed. These are four steps in the risk management
process. These are:
I. Identifying Potential Losses
• The first step in the risk management process is to identify all pure loss
exposures.
• Risk identification is the process by which a business systematically and
continuously identifies property, liability and personnel exposures.
• Unless the risk manager identifies all the potential losses facing the firm,
s/he will not have any opportunity to determine the best way to handle the
undiscovered risks.
• Risk identification is a very difficult process because the risk manager has to look
into all operations of the company, so as to identify where exactly risks emanate
from.
 Cont…
• Risk identification is a continuous job for him or her since risk
environment is dynamic.
• Both obvious and hidden risks need to be identified. hidden risks pose a
more serious.
• Therefore, it becomes necessary to have a proper system that identifies all
kinds of risks on a continuous basis.
• Some risks are relatively obvious while there are many risks that can be
and often are, overlooked.
• To identify all potential losses the risk manager needs first a checklist of
all the losses that could occur to any business.
• To reduce the possibility of overlooking important risks, most risk
managers use some systematic approach to the problem of risks
identification.
 Cont…
• These tools include:
1. Insurance Policy Checklists
2. Loss Exposure Checklists
3. Risk Analysis Questionnaires
4. Flow Charts
5. Analysis of Financial Statements and
6. Inspections of the Firm’s Operation
1. Insurance Policy Checklists
• Insurance Policy Checklists provide a listing of all the various policies or
types of insurance that may be needed by a business.
• Insurance policy checklists can be sourced from insurance companies and
other publishers.
 Cont…
2. Loss Exposure Checklists
• Loss Exposure Checklists provide a listing of common risk exposures of a firm.
• An exposure checklist is a very simple but effective tool for risk identification.
• Loss exposure checklists are available from various sources, such as insurer,
agencies and risk management associations.
• These checklists are containing possible source of loss to the business firm
from destruction of physical and intangible assets.
• Then, the risk manger needs a systematic approach to discover which of the
potential losses included in the checklist are faced by his/ her business.
• This is done by ask the question “is this a potential source of loss in our firm?”,
after each item. Use of such a list reduces the likelihood of overlooking
important sources of loss.
Cont…
3. Risk Analysis Questionnaires
• Risk Analysis Questionnaires aim at identifying the risks faced by an
organization. A series of well-developed and well-formulated
questions are put forth to respondents. The answers indicate risk areas
and specific risks.
• Example: are company-owned vehicles provided to directors,
executives or employees for business and personal use? If so, to what
extent?
4. Flow Charts
• Flow Charts are schematic representations of a sequential process. A
flow chart depicting the operations of a firm can guide a risk manager
to risks associated with those operations.
 Cont…
5. Analysis of Financial Statements
• By analyzing the balance sheet, operating statements and supporting documents the risk
manager can identify property, liability and human asset exposures of the organization.
• By coupling these statements with financial forecasts and budget, the risk manager can
discover future exposures.
6. Interactions with other Departments
• Interactions with other Departments provide another source of information on
exposures to risk.
• These interactions may include oral or written reports from other departments on their
own initiative or in response to a regular reporting system that keeps the risk manager
informed of development.
No single method or procedure of risk identification is free of weakness or can be
called foolproof.
The preferred approach to risk identifications is a combination approach, in which all
available tools listed are brought to bear on the problem.
 II. Evaluating or Measuring Potential Losses
• After various types of potential losses faced by the firm has been identified, these
exposures must be measured in order to
(i) determine their relative importance and

(ii) obtain information that will help the risk manager to decide up on the most
desirable combination of risk management tools.
Dimensions to Measured
• Evaluating and measuring the impact of losses on the firm involves an estimation
of the potential 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 sizes of the losses that may occur.
Cont…
Why we need each dimension

• Both loss frequency and loss severity data are needed to evaluate the
relative importance of an exposure to potential loss.
The importance of an exposure to loss depends mostly upon the
potential loss severity, not the potential frequency.
• If two exposures are characterized by the same loss severity, the
exposure whose frequency is greater should be ranked more important.
• 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 loss equals the total birr losses expected in average year to
pay an insurer for complete or partial protection.
Prouty measure of severity

• Measurement of the severity of risk is essential for ranking risks based on

severity.
One of the systems used to measure the severity of risk is the prouty
measure of severity.
• It was suggested by Richard prouty, a risk manager. The two measures
suggested by prouty to measure loss severity are the maximum possible
loss to one unit per occurrence and the maximum probable loss to one unit
per occurrence.
• The maximum possible loss is the worst loss that could possibly happen to
the firm during its lifetime.
• It is the maximum absolute dollar amount of damages
• The maximum probable loss is the worst loss that is likely to happen.
• The maximum probable loss, therefore, is usually less than the maximum
possible loss.
Cont…
• A conservative estimate of what is likely to occur in a worst case loss
• "Possibility" means something may happen, but we don't know how
likely.
• "Probability" means something may happen, but we believe it is more
likely (i.e., more "probable") than not.
• e.g. there is a possibility of rain next week; but I think there is a
probability of rain tonight, because I can see dark clouds and detect a
change in the barometric pressure.
• The term possibility may refer to something with a small chance of
happening.
• probability may refer to something with a great chance of happening
or occurring.
Priority Ranking Based on Severity

• The process of risk evaluation ranks risks as per the severity

(importance) of losses.
• The more severe the losses due to risk the higher the rank, as the relative
severity of losses differs, not all losses warrant equal attention.
• Some are to be given priority over others. Under such circumstances,
risks can be classified into three head.
• Critical risks include those loss exposures to loss where the magnitude
of losses could lead to bankruptcy.
• Important risks include those exposures in which the possible losses
would not lead to bankruptcy, but would require the individual or firm to
borrow in order to continue operations.
• Unimportant risks include those exposures in which the possible losses
could be met out of the existing assets or current income without
imposing excessive financial strain.
III. Selecting the Appropriate Technique for Handling Losses

• Once potential exposure facing the firm has identified and measured, the
next step is deciding how to handle them. There are two basic approaches:
Risk Control techniques and risk financing.
I. Risk Control techniques: the firm can use risk control measures to alter
the exposures in such away as:
(i)To reduce the firm’s expected losses or
(ii)To make the annual loss experience more predictable.
• Risk control techniques attempt to reduce the frequency and severity of
accident to the firm.
1. Avoidance
• Avoidance means a certain loss exposure is never acquired, or an existing
loss exposure is abandoned/uncontrolled.
 Cont…
• E.g. flood losses can be avoided by not building a new plant in a flood plain. A
pharmaceutical firm that markets a drug with dangerous side effects can
withdraw the drug from the market to avoid possible legal liability.
• The major advantage of 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 two major disadvantages.
• First, the firm may not be able to avoid all losses. e.g. 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. e.g. a bank
cannot avoid giving loans to avoid default risk, without the banks granting loans,
the bank will not be in the business of banking.
 2. Loss Control

• Loss control activities are intended to reduce both the frequency and
severity of losses.
• Loss control measures attack risk by lowering the chance that a loss will
occur or by reducing its severity if it does occur.
• Loss control has the unique ability to prevent or reduce losses for the
individual, firm and society while permitting the firm to commence or
continue the activity creating the risk.
• Loss control deals with an exposure that the firm does not wish to
abandon.
• The purpose of loss control activities is to change the characteristics of
the exposure so that it is more acceptable to the firm; the firm wishes to
keep the exposure but want to reduce the frequency and severity of
losses.
Loss prevention and loss reduction methods
• Loss prevention programs seek to reduce or eliminate the chance of loss.
Loss reduction programs seek to reduce the potential severity of the loss.
• The variety of loss prevention programs are illustrated below:
The chance of fire can be reduced by fire-resistive construction, building
in an area where there are few external dangers
The chance of a product liability suit can be reduced by tightening the
quality control limits and choosing distributors more carefully and
Other examples of loss prevention programs include Periodic physical
examinations for employees, Internal accounting control and speed limit
for vehicles etc.
• Loss reduction program include:
• Loss reduction refers to measures that reduce the severity (the size) of a
loss after it occurs.
 Cont…
• E.g. For banks, the use of collateral as a guarantee for the collection of a
bank loan, this serves as a backup, the bank can sell the collateral to gain
their money back although they might not realise the same amount.
Automatic sprinklers to minimize a fire loss by spraying water or some
other substance upon a fire soon after it starts in order to confine the
damage to a limited area
Immediate first aid for persons injured on the premises
Medical care and rehabilitation programs for injured workers
Fire alarms
Speed limits for motor vehicles etc.
3. Separation/ Diversification/
• Another risk control tool is 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.
• For example instead of placing its entire inventory in one warehouse a
firm may elect to separate this exposure by placing equal parts of the
inventory in ten widely separated warehouses.
• If the fire destroys one warehouse, the firm will have others from
which to draw needed supplies.
• To the extent that this separation of exposures reduces the maximum
probable loss to one event, it may be regarded as a form of loss
reduction.
4. Combination

• Combination or pooling makes loss experience more predictable by

increasing the number of exposure units.
• The difference is that unlike separation, which spreads a specified
number of exposure units, combination increases the number of
exposure units under the control of the firm.
• One way a firm can combine risk is to expand through internal growth.
• Combination also occurs when two firms merge or one acquires
another.
• The new, firm has more buildings, more automobiles and more
employees than either of the original companies.
 II. Risk financing techniques
• Risk financing techniques designed for the funding of accidental losses
after they occur.
A. Retention/ assumption/
• The most common method of handling risk is retention by the organization.
• The source of the funds is the organization itself including borrowed funds
that the organization must repay.
• Retention may be passive or active, unconscious or conscious, planned or
unplanned.
• Retention is passive or unplanned when the risk manager is not aware
that the exposure exists and consequently does not attempt to handle it.
• By default, therefore, the organization has elected to retain the risk
associated with that exposure.
Cont…
• Few organizations have identified all their exposures to property, liability
and human resource losses.
• Consequently, some unplanned retention is common and perhaps inevitable.
• If the risk identification has been poorly performed, too much risk is
passively retained.
• A related form of unplanned retention occurs when the risk manager has
properly recognized the exposures but has underestimated the magnitude
of the potential losses.
• Retention is active or planned when the risk manager considers other
methods of handling the risk and consciously decides not to transfer the
potential losses.
• Self-insurance is a special case of active or planned retention. Self-
insurance is not insurance, because there is no transfer of the risk to an
outsider.
Cont…
• Retention can be effectively used in risk management program when the
following three conditions exist.
1. When no other method of treatment is available
• Insurers may be unwilling to write a certain type of coverage, the coverage may
be too expensive, or noninsurance transfers may not be available. In addition,
although loss can reduce the frequency of loss, not all losses can be eliminated.
In these cases, retention is a residual method.
2. When the worst possible loss is not serious
• For example, physical damage losses to automobiles in a large firm’s fleet will
not bankruptcy the firm if the automobile are separated by wide distances and
are not likely to be simultaneously damaged.
3. When losses are highly predictable
• Based on past experience, the risk manager can estimate a probable range of
frequency and severity of actual losses. If most losses fall within that range,
they can be budgeted out of the firm’s income.
B. Self-insurance

• Self-insurance is a special form of planned retention by which part or all of a

given loss exposure is retained by the firm. A better name for self-insurance is
self-funding, which expresses more clearly the idea that losses are funded and
paid by the firm.
• A self-insurance plan implies that adequate financial arrangement have been
made in advance to provide funds to pay for losses if they occur.
Captive insurers
• One approach to self-insurance involves the use of a company formed to write
insurance for a parent, called captive insurance company.
• A captive insurer is an insurer that is owned by the insured.
• A captive insurer is established and owned by a parent firm for the purpose of
insuring the parent firm’s loss exposures.
• The parent organization establishes a captive insurance subsidiary that writes
insurance against the parents’ insured risks.
C. Noninsurance transfers

• Noninsurance transfers are a methods other than insurance by which

a pure risk and its potential financial consequences are transferred to
another party.
• Neutralization or hedging and hold-harmless agreements are examples
of noninsurance transfer of risk.
Neutralization or Hedging
• As generic terms, neutralization and hedging describe actions whereby
a possible gain is balanced against a possible loss.
• For example, a person who has bet that a certain team will win the
World Cup may neutralize the risk involved by also placing a bet on
the opposing team.
• In other words, he or she transfers the risk to the person who accepts
the second bet.
 Cont…
• The nature of hedging is to take two simultaneous positions that offset each
other.
• So that no matter what the outcome is of some event based on chance, the
hedger neither wins nor loses.
• Because there is no chance of gain associated with pure risks, neutralization
or hedging is not a tool of pure risk management.
• Hold-harmless agreements are contract entered into prior to a loss, in
which one party agrees to assume a second party’s responsibility if a loss
occurs.
• For example, contractors may require subcontractors to provide the
contractor with liability protection if they are sued because of the
subcontractor’s activities.
D. Insurance

• Commercial insurance is also used in a risk management program.

From the risk manager’s viewpoint, 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 the risk manager uses insurance to treat certain loss exposures, five
key areas must be emphasized. These are:
Selection of insurance coverages
Selection of an insurer
Negotiation of terms
Dissemination of information concerning insurance coverages
Periodic review of the insurance program
 1. Selection of insurance coverage

• The risk manager must select the insurance coverages needed. Since there may
not be enough money in the risk management budget to insure all possible
losses, the need for insurance can be divided into several categories depending
on importance.
• Essential insurance includes those coverages required by law or by contract.
• Essential insurance also includes those coverages that will protect the firm
against a catastrophic loss or a loss that threatens the firm’s survival.
• Desirable or important insurance is protection against losses that may cause
the firm financial difficulty, but not bankruptcy.
• Available or optional insurance is coverage for slight losses that would
merely inconvenience for the firm.
• Optional insurance coverages include those that protect against losses that
could be met out of existing assets or current income.
 2. Selection of an insurer

• The risk manager must select an insurer or several insurers.

• Several important factors should have to be considered.
• These include the financial strength of the insurer, risk management services
provided by the insurer, and the cost and terms of protection.
3. Negotiation of terms
• After the insurer or insurers are selected, the terms of the insurance contract
must be negotiated.
• If printed polices, endorsements, and forms are used, the risk manager and
insurer must agree on the document that will form the basis of the contract.
• If the firm is large, the premiums may be negotiable between the firm and
insurer.
4. Dissemination of information concerning insurance coverages

• The firm’s employees and managers must be informed about the

insurance coverages, the various records that must be kept,
5. Periodic review of the insurance program
• The insurance program must be periodically reviewed.
• The entire process of obtaining insurance must be evaluated
periodically.
• This involves an analysis of agent and broker relationships, coverages
needed, cost of insurance, quality of loss-control services provided,
whether claims are paid promptly and numerous other factors.
• Even the basic decision-whether to purchase- insurance must be
reviewed periodically.
 Which method should be used?

• In determining the appropriate method or methods for handling losses, a matrix can be
used that classifies the various loss exposures according to frequency and severity.
• The first loss exposure is characterized by both low frequency and low severity of
loss.
• This type of exposure can be best handled be retention, since the loss occurs
infrequently and when it does occur, it seldom causes financial harm.
• The second type of exposure which is characterized by high frequency and low
severity of losses is more serious.
• Loss control should be used here to reduce the frequency of losses. In addition, since
losses occur regularly and are predictable, the retention technique can also be used.
• The third type of exposure can be met by insurance. Insurance is best suited for low
frequency, high-severity losses.
• The fourth and most serious type of exposure is one characterized by both high
frequency and high severity. This type of exposure is best handled by avoidance.
Figure 2.2 Risk Management Matrix
 IV. Implementing and Administrating the Risk Management Program

• The fourth step is implementation and administration of the risk management

program.
• Typical activities of a risk manager include identifying and evaluating loss
exposures, establishing procedures for handling insurance claims, designing and
installing employee benefit plans, participating in loss control and safety programs,
and administering group insurance and self-insurance programs.
Periodic Review and Evaluation
• To be effective, the risk management program must be periodically reviewed and
evaluated to determine if the objectives are being attained.
• In particular, risk management costs, safety programs, and loss prevention
programs must be carefully monitored.
• Finally, the risk manager must determine if the firm’s overall risk management
policies are being carried out and if the manager is receiving the total cooperation of
the other deportments in carrying out the risk management functions.