CHAPTER TWO

THE RISK MANAGEMENT

Introduction
This unit focuses on the methods, procedures and techniques used by the risk manager so as to minimize
the risk occur in a firm. Once we understand that risk always exist with a firm or human being activities,
managers should take different measure to avoid or reduce these losses or undesired events.
2.1 Risk management
Risk Management refers to the identification; measurement and treatment of exposure to potential
accidental losses almost always in situations where the only possible outcomes are losses or no
change in the status.
Risk Management is a general management function that seeks to assess and address the causes and
effects of uncertainty and risk on an organization. The purpose of risk management is to enable an
organization to progress towards its goals and objectives in the most direct, efficient, and effective path. It
is concerned with all risks.
Risk Management is the executive function of dealing with specified risks facing the business enterprise.
In general, the risk manager deals with pure, not speculative risk.
The risk manager has certain specific duties. These include:
1. To recognize exposures to loss; the risk manager must, first of all, be aware of the possibility of
each type of loss. This is a fundamental duty that must precede all other functions.
2. To estimate the frequency and size of loss; to estimate the probability of loss from various
sources.
3. To decide the best and most economical method of handling the risk of loss, whether it be by
assumption, avoidance, self-insurance, reduction of hazards, transfer, commercial insurance, or
some combination of these methods.
4. To administer the programs of risk management, including the tracks of constant revaluation of
the programs, record keeping and the like.
2.2 Objectives of risk management
Risk management has several important objectives that can be classified into two categories: pre-loss
objectives and post-loss objectives.
1. Pre-loss objectives. A firm or organization has several risk management objectives prior to the
occurrence of a loss.
The first goal is economy. It means that the firm should prepare for potential losses in the most
economical way possible. This involves an analysis of safety program expenses, insurance premiums, and
the costs associated with the different techniques for handling losses.
The second objective is the reduction of anxiety. It is more complicated. Certain loss exposures can
cause greater worry and fear for the risk manager, key executives, and stockholders than other exposures.
For example, the threat of a catastrophic lawsuit from a defective product can cause greater anxiety and
concern than a possible small loss from a minor fire. However, the risk manager wants to minimize the
anxiety and fear associated with all loss exposures.
The third objective is to meet any externally imposed obligations. This means the firm must meet certain
obligations imposed on it by outsiders. For example, government regulations may require a firm to install
safety devices to protect workers from harm. Similarly, 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. A firm or organization has several risk management objectives after the
occurrence of a loss.
The first and most important post-loss objective is survival of the firm. Survival means that after a loss
occurs, the firm can at least resume (begin again) partial operation within some reasonable time period if
it chooses to do so.
The second post-loss objective is to continue operating. For some firms, the ability to operate after a
severe loss is an extremely important objective. This is particularly true of certain firms, such as public

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utility firm, which must continue to provide service. The ability to operate is also important for firms that
may loss customers to competitors if they cannot operate after a loss occurs. This would include banks,
bakeries, dairy farms, and other competitive firms.
Stability of earnings is the third post-loss objective. The firm wants to maintain its earnings per share
after a loss occurs. This objective is closely related to the objective of continued operations. Earnings per
share can be maintained if the firm continues to operate. However, here may be substantial costs involved
in achieving this goal (such as operating at another location), and perfect stability of earnings may not be
attained.
The fourth post-loss objective is continued growth of the firm. 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.
Finally, the goal of social responsibility is to minimize the impact that a loss has on other persons and on
society. A sever loss can adversely affect employees, customers, suppliers, creditors, taxpayers, and the
community in general. For example, a severe loss that requires shutting down a plant in a small
community for an extended period can lead to depressed business conditions and substantial
unemployment in the community.
2.3 Steps in risk management process
The process involves five steps. These are:
i. Identifying loss exposures. The loss exposures of the business or family must be identified. Risk
identification is the first and perhaps the most difficult function that the risk manager or
administrator must perform. Failure to identify all the exposures of the firm or family means that
the risk manager will have no opportunity to deal with these unknown exposures intelligently.
ii. Measuring the losses. After risk identification, the next important step is the proper measurement
of the losses associated with these exposures. This measurement includes a determination of (a)
the probability or chance that the losses will occur, (b) the impact the losses would have upon the
financial affairs of the firm or family, should they occur, and (c) the ability to predict the losses
that will actually occur during the budget period. The measurement process is important because
it indicates the exposures that are most serious and consequently most in need of urgent attention.
It also yields information needed in step 3.
iii. Selection of the risk management tools. Once the exposure has been identified and measured, the
various tools of risk management should be considered and a decision made with respect to the
best combination of tools to be used in attacking the problem. These tools include primarily (a)
avoiding the risk, (b) reducing the chance that the loss will occur or reducing its magnitude if it
does occur, (c) transferring the risk to some other party, and (d) retaining or bearing the risk
internally. The final alternative includes, but is not limited to, the purchase of insurance.
Selecting the proper tool or combination of tools requires considering the present financial
position of the firm or family, its overall policy with reference to risk management, and its
specific objectives.
iv. Implementing the decision made. After deciding among the alternative tools of risk treatment, the
risk manager must implement the decision made. If insurance is to be purchased, for example,
establishing proper coverage, obtaining reasonable rates, and selecting the insurer are part of the
implementation process.
v. Evaluating the result. The results of the decisions made and implemented in the first four steps
must be monitored to evaluate the wisdom of those decisions and to determine whether changing
conditions suggest different solutions.
2.3.1 Risk identification
Risk identification is the process by which an organization is able to learn areas in which it is exposed to
risk. Identification techniques are designed to develop information on sources of risk, hazards, risk
factors, perils, and exposures to loss. It seems quite logical to inquire in to the sources of organizational
risks at this particular moment. A discussion of the sources is presented below.
2.3.1.1 Sources of Risk

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Sources of risk are the sources of factors or hazards that may contribute to positive or negative outcomes.
Sources of risk can be classified in several ways. For instance, the following sources of risk represent one
listing:
i. Physical Environment. Clearly, the physical environment is a fundamental source of risk.
Earthquakes, drought, or excessive rainfall can all lead to loss. The ability to fully understand
our environment and the effects we have on it - as well as those it has on us - is a central
aspect of this source of risk. The physical environment may be the source of opportunity as
well, for example, real estate as an investment, agribusiness, and weather as a contributing
factor to tourism.
ii. Social Environment. Changing traditions and values, human behavior, social structures, and
institutions are a second source of risk.
iii. Political Environment. Within a single country, the political environment can be an
important source of risk. A new party can move the nation into a policy direction that might
have dramatic effects on particular organizations (new stringent regulations on toxic waste
disposal). In the international realm, the political environment is even more complex. Not all
nations are democratic in their form of government, and some have very undemocratic atti-
tudes and policies toward business. Foreign assets might be confiscated by a host government
or tax policies might change dramatically. The political environment also can promote
positive opportunities through fiscal and monetary policy, enforcement of laws, and the
education of the population.
iv. Legal Environment. The expected laws and directives may be issued by the government
which may render risky environment to the businesses operating in the country. In the
international domain, complexity increases because legal standards can vary dramatically
from country to country. The legal environment also produces positive outcomes in the sense
that rights are protected and that the legal system provides a stabilizing influence on society.
v. Operational Environment. Processes and procedures of an organization generate risk and
uncertainty. A formal procedure for promoting, hiring, or firing employees may generate a
legal liability. The manufacturing process may put employees at risk of physical harm.
Activities of an organization may result in harm to the environment. International businesses
may suffer from risk or uncertainty due to unreliable transportation systems. The operational
environment also provides gains, as it is the ultimate source of the goods and services by
which an organization succeeds or fails.
vi. Economic Environment. Although the economic environment often flows directly from the
political realm, the dramatic expansion of the global marketplace has created an environment
that is greater than any single government. Although a particular government’s actions may
affect international capital markets, control of capital markets is beyond the reach of a single
nation. Inflation, recession, and depression are now elements of interdependent economic
systems. On a local level, interest rates and credit policies can impose significant risk on an
organization.
vii. Cognitive Environment. A risk manager’s ability to understand, see, measure, and assess is
far from perfect. An important source of risk for organizations is the difference between the
perception of the risk manager and reality. The cognitive environment is a challenging source
of risk to identify and analyze. The analyst must contemplate such questions as “How do we
understand the effect of uncertainty on the organization? And “How do we know whether a
perceived risk is real?”
2.3.1.2 Identification of Exposures
A given peril or hazard can originate in any one of several environments. Fire, for example, could arise
from the physical environment (a lightning strike) or the social environment (arson, civil unrest). Sources
of risk are essentially of no concern to an organization unless that organization is exposed or vulnerable to
the perils that arise from those environments. Therefore, an important aspect of risk identification is
exposure identification. Although in the broadest sense an entire organization is at exposure to risk, it is

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useful to develop categories of exposures for analytical purposes. This reading material considers four
categories of risk exposures: physical asset exposures, financial asset exposures, liability exposures, and
human exposures.
i Physical Asset Exposures. Ownership of property gives rise to possible gains or losses to
physical assets and to intangible assets (goodwill, political support, intellectual property), that
arise from these exposures. Property may be damaged, destroyed, lost, or diminished in value in a
number of ways. The inability to use property for a period of time, the so-called time element
loss, is often overlooked by individuals and organizations. Conversely, property exposures to risk
may result in gain or enhancement.
ii Financial Asset Exposures. Ownership of securities such as common stock and mortgages
creates this type of exposure. This exposure can occur either from ownership of the security or
when the organization issues a security held by others. A financial asset conveys rights that are
enumerated in financial terms, such as the right to receive income or the right to purchase an asset
at a specified price. Unlike physical property, loss or gain to a financial asset can occur without
any physical change in the asset itself. Often these gains and losses occur as a consequence of
changing market conditions or changes in the value of the rights conveyed by the security as
perceived by investors.
iii Liability Exposures. Obligations imposed by the legal system create this type of exposure. Civil
and criminal law detail obligations carried by citizens; state and federal legislatures impose
statutory limitations on activities; governmental agencies promulgate administrative rules and
directives that establish standards of care. Legal obligations that differ from country to country
are an increasingly important aspect of this area.
Unlike property exposures to risk, liability exposures do not have an upside. That is, liability
exposures generally can be considered pure risks. It is true that the law establishes rights as well
as obligations, and the enforcement of a right can result in a gain.
iv Human Asset Exposures. Part of the wealth of an organization arises from its investment in
humans: the human resources of the organization. Possible injury or death of managers,
employees, or other significant stakeholders (customers, Secured creditors, stockholders, and
suppliers) exemplifies this type of exposure. Human asset exposures also can lead to gains, as
exemplified by improvements in productivity. One might, for example, view a highly technical
piece of machinery as source of loss (worker injury) and gain (increased productivity). In such a
case, the risk management strategy is likely to incorporate elements that will reduce the potential
for loss while maximizing the likelihood of gain (employee training, for instance). As a final
note, loss of human assets does not always imply physical harm. Economic insecurity is a
common type of loss, unemployment and retirement being excellent examples. Both the physical
and economic welfare of human beings are components of this type of exposure to risk.
2.3.2 Risk Measurement
Once the risk manager has identified the risks that the firm is facing, his next step would be the evaluation
and measurement of the risks. Risk measurement refers to the measurement of the potential loss as to its
size and the probability of occurrence.
The risk manager, by using available data from past experience, tries to construct a probability
distribution of the number of events and/or the probability distribution of total monetary losses. This
would, indeed, require knowledge of certain statistical techniques and concepts. The probability
distribution of number of events and/or total monetary losses would enable the risk manager to estimate,
among other things, the size of possible monetary losses and the corresponding probabilities of
occurrence.
2.3.3 Tools of risk management
After the risk manager has identified and measured the risks facing the firm, he or she must decide to
handle them. There are two basic approaches. First, the risk manger can use risk control measures to alter
the exposures in such a way as (1) to reduce the firm’s expected property, liability, and personnel losses,

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or (2) to make the annual loss experience more predictable. Risk control measures includes avoidance,
loss prevention and reduction measures, separation, combination, & some transfers.
Second, the risk manager can use risk-financing measures to finance the losses that do occur. Funds may
be required to repair or restore damaged property, to settle liability claims, or to replace the services of
disabled or deceased employees or owners. In some, the firm will decide not to restore the damaged
property or replace the disabled or decreased person. Nevertheless, it may also have suffered a financial
loss through a reduction in its assets or its future earning power. The tools in this second category include
those transfers, including the purchase of insurance, that are not considered under risk control devices and
retention, which includes, “self-insurance”.
2.3.1 Risk Control Tools
i. Avoidance
One way to control a particular pure risk is to avoid the property, person, or activity with which the
exposure is associated by (1) refusing to assume it even momentarily or (2) an exposure assumed earlier.
The first of these avoidance activities is proactive avoidance; the second is abandonment. Most examples
of risk avoidance fall in the first category.
To illustrate a firm can avoid a flood loss by not building a plant in a flood plain. An existing loss
exposure may also be abandoned. For example, a firm that produces a highly toxic product may stop
manufacturing that product. Similarly, an individual can avoid third party liability by not owning a car.
Product liability can be avoided by dropping the product. Leasing avoids the risk originating from
property ownership.
The major advantage of avoidance is that the chance of loss is reduced to zero if the loss exposure is not
acquired. In addition, if an existing loss exposure is abandoned, the possibility of loss is either eliminated
or reduced because the activity or product that could produce a loss has been abandoned.
Avoidance, however, has two disadvantages. First, it may not be possible to avoid all losses. For example,
a company cannot avoid the premature death of a key executive. Similarly, a business has to own
vehicles, building, machinery, inventory, etc… Without them operations would become impossible.
Under such circumstances avoidance is impossible. In fact there are circumstances where avoidance is a
viable alternative. For example, it may be better to avoid the construction of a company near river bank,
volcano-prone areas, valleys, etc. because the risk is so great.
The second disadvantage of avoidance is that it may not be practical or feasible to avoid the exposure. For
example, a paint factory can avoid losses arising from the production of paint. However, without any
paint production, the firm will not be in business.
ii. Loss Prevention and Reduction Measures
These measures refer to the safety actions taken by the firm to prevent the occurrence of a loss or reduce
its severity if the loss has already occurred. Prevention measures, in some cases, eliminate the loss totally
although their major effect is to reduce the probability of loss substantially. Loss reduction measures try
to minimize the severity of the loss once the peril happened. For example, auto accidents can be
prevented or reduced by having good roads, better lights and sound traffic regulation and control, fast
first-aid service, and the like.
Following are some examples of loss prevention and reduction plans.
Loss Prevention Measures:
 Research on fire protection equipment and appliances.
 Construction using fire insensitive materials.
 Automatic smoke detectors, fire alarms.
 Burglar alarms in costly business situation, jewelry, diamonds.
 Locational choice, avoiding construction near petrol stations, chemical reservoirs, waste disposal
areas, etc.
 Tight quality control to prevent risk of product liability.
 Educational programs to the public using available media.
 Multiple suppliers, buffer stocks.

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  Safety measures, adequate lighting, ventilation, special work clothes to prevent industrial
accidents.
 Regular inspection of machinery to preventexplosions, breakdowns, etc..
 Accounting controls (Internal Control).
 Electronic metal detectors to check passengers for arms and explosives in the airline business.
 Automatic gates at crossing lines to prevent collisions train and motor vehicles.
 Warning posters (NO SMOKING!! DANGER ZONE!!)
Loss Reduction Measures:
 Installing automatic sprinklers.
 First aid equipment
 Evacuation of people, CHERNOBYL
 Immediate clean-up operations, EXXON – VALDEZ, Alaska oil spill
 Fire extinguishers, guards.
Appropriate measures take to prevent accidents bring benefits not only to the firm, but also to the society
as well. For example, a destruction of inventory of a firm, could be a total loss to the firm in particular.
The society also faces a real economic loss because those goods are no more available to people. Thus,
the importance of Loss Prevention and Reduction measures should not be underestimated by a firm.
Costs of Loss Prevention and Reduction measures These costs include expenditures for the acquisition
of safety equipment and services, operating expenses such as salary payments to guards, inspectors, safety
engineers and other employees engaged in safety work. Other costs are also incurred in connection with
safety training and seminars. The risk manager will have to design the LP and R measures in the most
efficient way in order to minimize such costs without reducing the desired safety level.
iii. Separation
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 is the third risk control tool. For example, instead of placing its entire
inventory in one warehouse the firm may elect to separate this exposure by placing equal parts of the
inventory in ten widely separated warehouse. 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. Emphasis is placed
here, however, on the fact that through this separation the firm increases the number of independent
exposure units under its control. Other things being equal, because of the law of large number, this
increase reduces the risk, thus improving the firm’s ability to predict what its loss experience will be.
iv. Combination
Combination is a basic principle of insurance that follows the low of large numbers. Combination
increases the number of exposure units since it is a pooling process. It reduces risk by making loses more
predictable with a higher degree of accuracy. 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.
In the case of firms, combination results in the pooling of resources of two or more firms. One way a firm
can combine risks is to expand through internal growth. For example, a taxi-cab company may increase
its fleet of automobiles. 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.
This leads to financial strength, thereby minimizing the adverse effect of the potential loss. For example,
a merger in the same or different lines of business increases the available resources to meet the probable
loss.
v. Diversification
Diversification is another risk handling tool. Most speculative risk in business can be dealt with
diversification. Businesses diversify their product lines so that a decline in profit of one product could be
compensated by profits from others. For example farmers diversify their products by growing different
crops on their land. Diversification however, has limited use in dealing with pure losses.
vi. Non-insurance Transfer
Transfer, the final tools to be discussed, may be accomplished in two ways. These are:

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  Transfer of the activity or the property. The property or activity responsible for the risks may
be transferred to some other person or group of persons. For example, a firm that sells one of its
buildings transfers the risks associated with ownership of the building to the new owner. A
contractor who is concerned about possible increase in the cost of labor and materials needed for
the electrical work on a job to which he/she is already committed can transfer the risk by hiring a
subcontractor for this portion of the project.
This type of transfer, which is closely related to avoidance through abandonment, is a risk control
measure because it eliminates a potential loss that may strike the firm. It differs from avoidance
through abandonment in that to transfer a risk the firm must pass it to someone else.
 Transfer of the probable loss. The risk, but not the property or activity, may be transferred. For
example, under a lease, the tenant may be able to shift to the landlord any responsibility the
tenant may have for damage to the landlord’s premises caused by the tenant’s negligence. A
manufacture may be able to force a retailer to assume responsibility for any damage to products
that occurs after the products leave the manufacturer’s premises even if the manufacturer would
otherwise be responsible. A business may be able to convince a customer to give up any rights
the customers might have to give the business for bodily injuries and property damage sustained
because of defects in a product or a service.
2.6.2 Risk Financing Tools
i. Retention
Retention means that the firm retains part or all of the losses that result from a given loss exposure.
Retention can be effectively used in a risk management program when certain conditions exist. First, no
other method of treatment is available. Insurers may be unwilling to write a certain type of coverage, or
the coverage may be too expensive. Noninsurance transfers may not be available. Loss control can reduce
the frequency of loss, but not all losses can be eliminated. In these cases, retention is a residual method. If
the exposure cannot be insured or transferred, then it must be retained.
Second, the worst possible loss is not serious. For example, physical damage losses to automobiles in a
large firm's fleet will not bankrupt the firm if the automobiles are separated by wide distances and are not
likely to be simultaneously damaged.
Finally, losses are highly predictable. Retention can be effectively used for workers' compensation claims,
physical damage losses to automobiles, and shoplifting losses. 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.
ii. Insurance
Commercial insurance can also be used in a risk management program. Insurance can be advantageously
used for the treatment of loss exposures that have a low probability of loss but the severity of a potential
loss is high.
If the risk manager decides to use insurance to treat certain loss exposures, five key areas must be
emphasized.
- Selection of insurance coverage’s
- Selection of an insurer
- Negotiation of terms
- Dissemination of information concerning insurance coverage
- Periodic review of the insurance programs

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