Risk Management and Insurance

Chapter Two

Risk Management
 Contents/Chapter Agenda
2

Chapter-Two
Risk Management
2.1. Definitions of Risk Management
2.2. Functions of Risk Managers
2.3. Tools of Risk Management
2.4. Process of Risk Management
2.5. Risk Measurement
2.6. Methods of Risk Measurement
 After studying this chapter you should be able
to:
3
Learning Objectives

1. Describe the meaning and nature of risk management.

2. Describe the difference b/n risk mgt and insurance mgt.

3. List and describe pre and post-loss objectives.

4. Describe the process/steps of risk management.

5. List the source of risk exposures identifications.

6. Describe the risk financing and risk control techniques.

7. List the steps of applying insurance.

 2.1. Definition of Risk Management
4

 The term risk management can be defined as “A systematic

process for Identification and Evaluation of Pure risk
exposures exposed to an organization or individual and
for the Selection and Implementation of most appropriate
techniques for treating such exposures.

 Risk management is a scientific approach to the problem

of risk that has its objective the reduction and elimination
of risks facing the business firm.

 R.M is a systematic process and Deals with only pure risks

 Risk Management Vs Insurance
Management

Risk Management (RM) Insurance Mgt.

 It is a broader concept & deals with all
 It is a narrower concept & deals
pure risks exposures.
with only those risks having high
 In addition to insurance, R.M uses
severity and low frequency.
avoidance, loss prevention, loss control,
 It uses only insurance as a tool to
retention, non-insurance transfer,
handle risk.
separation. etc. as a tool to handle risk.
 Has lesser impact on the organs.
 R.M has a greater impact on the organs.
 Needs a few number of
 R.M. needs the coordination and help of
employees in the organization.
all employees and departments in an
organization.
 2.2 Functions of Risk Management

 The risk manager has certain specific duties.

These include the following;
1. To recognize exposures to loss
2. To estimate the frequency and size of loss
3. To decide the best and most economical method
of handling the risk of loss
4. To administer the programs of risk management
 2.3 Risk Management Tools
 The techniques for dealing with risk are grouped
into two broad approaches:

1. Risk Control: It refers to techniques that reduce

the frequency or severity of losses.

2. Risk Financing: It refers to techniques that

provide for the funding of losses.
 2.4 Objectives of Risk Management
8

 Risk management has objectives both before and after a loss occurs
 Risk management objectives serves as a:
 Prime source of guideline
 Bench mark to evaluate the performance.

Pre-loss objectives Post-loss objectives

1. The objective of economy. 1. Insure Survival of the firm
2. Continued operation
Stabilize earning
1. Reduction of anxiety. 3.

4. Maintain growth (using

different strategies)
1. Discharging externally 5. Social responsibility
imposed obligations. (Minimize the effects on the
society or stake holders).
 2.4 The Risk Management Process

 The six steps in the risk management process are:

1. Identification of risks
2. Evaluation of risks
3. Identifying of risk management techniques/tools
4. Selection of the appropriate risk treatment device/tools
5. Implementation of the decision
6. Evaluation and review
 2.4.1. Identification of Potential Risk
10 Exposures

This is the most difficult step in risk
management process.

 Identification is a process by which a business

systematically and continuously identifies
property, liability and personal risk exposures.

 Both hidden and oblivious( not aware of)

risk exposures should be identified.

 If we fails to identify a given risk we will

not have any opportunity to determine the
best way.
 2.4.1. Identification of Potential Risk
Exposures (Cont…)
11

Sources of Identifying Loss Exposures

 Risk Managers have several sources of
information to identify loss exposures both
hidden and oblivious:
1. Risk analysis Questionnaires

2. Physical observation and inspection

3. Analyzing production and delivery flowcharts

4. Analyzing Financial statements

5. Through Historical and departmental loss

claim data
 2.4.2. Evaluation of Potential Risk Exposures
12

 It is about the measurement of the impact of a

given risk on the organization.

 Done through estimate of Frequency and Severity.

 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

 Once loss exposures are analyzed, they can be

ranked according to their relative importance

 Loss severity is more important than loss frequency:

 2.4.2. Evaluation of potential risk
13 exposures(cont’d…)
Ranking potential risks based on severity:
 Critical Risks
 Losses which may lead the firm to bankruptcy

 Important Risks
 Losses which may lead the firm to external
assistance like borrowing

 Unimportant Risks
 Losses which may have negligible financial
impact on the firms financial wellbeing
2.4.3. Identifying the Risk Management Technique

 It is about identifying the appropriate tool (s) of risk management

to treat the risk that already identified and evaluated.
 Roughly classified in to two:
1. Risk Control Techniques:
 Refers to techniques that reduce frequency and severity of
losses
 The following are the common tools of risk control:
1. Risk Avoidance
2. Loss prevention
3. Loss reduction
2. Risk Financing Techniques:
 Refers to techniques that provide for the funding of losses
 The following are the common tools of risk financing:
4. Retention
5. Non-Insurance Transfers
6. Commercial Insurance
 A/ Risk Control Methods or Techniques:
15

1. AVOIDANCE
 Avoidance means a certain loss
exposure is never acquired or an
existing loss exposure is abandoned.

Examples: flood losses can be avoided by

building a new plant on high ground, well above a
floodplain.
 Advantages and Disadvantages of
Avoidance

Advantages of Avoidance Disadvantages of Avoidance

 The chance of  The firm may not

loss is reduced to be able to avoid all
zero, if the loss losses. Example,
exposure is not premature death.
acquired.  It may not be
feasible or
practical to avoid
the exposure.
 Risk Control Techniques: (Cont’d)
17

2. LOSS PREVENTION
 It refers to measures that reduce the “frequency” of a
particular loss.
 Example: measures that reduce truck accidents include; driver training, zero tolerance
for alcohol or drug abuse, and strict enforcement of safety rules.

3. LOSS REDUCTION
 It refers to measures that reduce the severity of loss after it
occurs.
 Examples:
 Installation of an automatic sprinkler system that promptly extinguishes a fire.

 Having warehouses with inventories at different locations (diversification).

 B/ Risk Financing Methods or Techniques:
18

1. Retention Means that the firm retains part or all of the losses that result from
a given loss exposure.

 It is the most commonly and frequently used tools of risk

management.
 The source of finance for retention is both internal and external
sources.

 There are two types of Retention.

I. Passive Retention
1. When we don’t know the risk exposure at all

 When we poorly/wrongly measure the potential risk

exposure

 Active Retention
 When we properly and actively identify and evaluate a risk
exposure and decide retention as a best tools of risk
management.
 Retention(cont’d…)
19

 Conditions to use Retention:

There are Three conditions:
1. When there is no other tools or risk management techniques
2. When the worst possible loss is negligible.
3. When the risk is easily predictable and we have an advantage
over retaining the risk

 Determination or Retention Level

1. As a maximum level of 5% of the annual net income.
2. As a maximum level of 1%-5% of the working capital of the
firm.

 Methods for Paying Losses

 Out of the firms current capital (Internal source of
finance )
 Out of the funded or unfunded reserves (Internal source
finance)
 Out of borrowing (external source of finance)
 Retention(cont’d…)

Advantages of Retention
Disadvantages of Retention

1. May Save money 1. Possible higher losses

2. May have lower expenses 2. Possible higher expenses
3. Encourage loss 3. Possible higher taxes
prevention
4. Increase cash flow
21

2. Non-Insurance Transfer:
 Is a method other than insurance by which a pure risk and
its potential financial consequences are transferred to
another party usually who is in a better position to exercise
loss control and or other tools.
 Typical Examples: of non insurance transfer include:
Transferring risks through CONTRACTS
Example: DBU and XYZ construction PLC
 Transferring risks through LEASES
Example: Renting of real property, such as land, car, building,
etc.
Transferring risks through HOLDING -HARMLESS
AGREEMENTS
Example: An Author and Publisher of a Book , Music e.t.c
 Non-Insurance Transfer(cont’d…)

Advantages of NIT Disadvantages of NIT

1. Can transfer some 1. Contract language may be

losses that are not ambiguous, so transfer may

insurable fail

2. If the other party fails to pay,

2. May Save money
firm is still responsible for
3. Can transfer loss to
loss
someone who is in a
3. Insurers may not give credit
better position to
for transfers
control losses
23

3. Commercial Insurance
Insurance is appropriate for loss exposures that happens infrequently and have
a bigger magnitude of loss

If we decide to apply insurance we have the following steps:

1. Selection of insurance coverage

2. Selection of an insurer (S)

3. Negotiation of terms and conditions.

4. Dissemination of information concerning the coverage

5. Periodic review of the insurance program

 Insurance(cont’d…)

Advantages of Insurance Disadvantages of Insurance

1. Firm is indemnified for 1. Premiums may be costly;

losses Opportunity cost should be
2. Uncertainty is reduced considered
3. Insurers may additionally 2. Negotiation of contracts takes
provide other risk time and effort
management services
3. The risk manager may
4. Premiums are tax-deductible
become lacks in exercising
loss control
2.4.4. Select the Appropriate Risk Management Technique

 It is about selecting or looking for appropriate tool (s) of risk

management to treat the risk already identified and evaluated.

 Tools of Risk Management (Risk Management Matrix)

 2.4.5. Implement & Administer the R. M Program
26

 This step of risk management process involves

three major issues:
1. Preparation of Risk Management Policy Statement
 Implementation of a risk management program
begins with a risk management policy statement that:
 Outlines the firm’s risk management objectives
 Outlines the firm’s policy on loss control and other
mechanisms

 A risk management manual may be used to:

 Describe the risk management program
 Train new employees
27
-------------------Cont’d

2. Cooperative work with all other departments

A successful risk management program requires active
cooperation from other departments in the firm.
3. Periodic review and evaluation of the entire program
 The risk management program should be periodically
reviewed and evaluated:
 To determine whether the objectives are being attained
or not.

 Toupdate the R.M program with the changing

environment.

 The risk manager should compare the costs and benefits

of all risk management activities.
 It is also known as cost-benefit analysis
 2.4.6 Evaluation and Review
 Evaluation and review must be included in the program for
two reasons.

 First: The risk management process does not take place in

a vacuum.

 Things change; new risks arise and old risks disappear.

 The techniques that were appropriate last year may not be

the most advisable this year.
 Second: Mistakes are sometimes made. Evaluation and review
permits to review decisions and discover mistakes, ideally before
they become costly.
 The evaluation and review is the managerial control phase of the
risk management process.
 Thus, Controlling requires;
1. Setting standards or objectives to be achieved;
2. Measuring performance against those standards; and
3. Taking corrective action when results differ from the
intended results.
 2.5 Risk Measurement
 This 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. how often losses will occur
 Loss Severity: Refers to the probable size of the
losses that may occur during some given time
period.
 The two measures commonly used to measure loss severity are:
1. The Maximum Possible Loss: It is the worst loss that could
possibly happen.
2. The Maximum Probable Loss: It is the worst loss that is
likely to happen.
 Note: The maximum possible loss, is usually greater than the
maximum probable loss.
 Of these two measures, the maximum probable loss is the most
difficult to estimate but also the most useful.
 If there is a 10% chance of rain today, it is possible
that it will rain. It could rain, but there is a 90%
chance that it will not rain. If something is
probable, there is a good chance that it will
happen, but it is not certain. If there is a 90%
chance of rain today, it is probable [=it is likely]
that it will rain.
 2.6. Risk Measurement Methods

 There are various methods used to measure the

different aspects of a risk.. Some of these methods
include:
1. Poisson distribution method
2. Binomial distribution method, and
3. Normal distribution method
 2.6.1. Poisson Distribution Method

 It can be used for the analysis of risk

measurement. It is commonly used to model the number
of events occurring within a fixed interval of time or
space, given the average rate of occurrence of those
events
You can use a Poisson distribution to predict or explain
the number of events occurring within a given interval
of time or space.
 The only information that is crucial in
constructing a Poisson probability distribution is
the expected number of accidents (the mean).

 Once the mean is determined, the probability of

any number of accidents will be easily calculated.
 2.6.2 Binomial Distribution Method

 To use the binomial distribution, the risk manager

must be familiar with the basic assumption of the
distribution: if we toss a coin, there could be only two
possible outcomes: heads or tails, and if any test is taken,
then there could be only two results: pass or fail.
1. The objects are independently exposed to loss.
2. Each exposed unit suffered (experience) only one loss in a
year
 2.6.3 Normal Distribution Method
 The number of accidents or total annual monetary
losses is approximately normally distributed.
Half the data will be above the mean and half will be below
the mean. Examples of normal distributions include
standardized test scores, people's heights, IQ scores,
incomes, and shoe size.
 Thus, this method measures (1) the number of
accidents or (2) the total annual monetary losses.
 It can be well explained by identifying only two

parameters, (1) the mean and (2) the standard

deviation.
38

End of the Chapter!

 Quiz-1 (5%) 5’
1. Implementation and administration is the one step in risk
management process. What are the three important components of
this step?
2. Retention is one of the risk financing technique. What conditions
should be fulfill in order to use retention effectively in risk
management?
3. Retention is one of the risk financing technique. What are the
major advantages and disadvantages of retention technique?
4. The evaluation and review is the managerial control phase of the
risk management process.. What requires are involved in this
controlling phase?