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RI SK MANAGEMENT
Meaning of risk

Although business and small businesses are desirable in an economy, they often face a
lot of risks. Risk is defined in the context of the probability of an event and its
consequences. It is the chance of something happening that will impact negatively upon
objectives. The objectives of a small business might be: to provide the best quality
service; to maximize revenue and decrease expenses; to have quality employees; to
increase productivity and product quality; and to increase market share. Anything
which threatens the overall achievement of the objectives is classified as a business risk.
i
Risks however differ in their severity and the business can live with some risks. It is
however worth noting that the whole idea of investment entails risk. Moreover business
asks for a risk taking culture. Therefore, risk cannot be totally eliminated.

Risk taking has long been a central theme of the business

literature. While business
managers are known to constantly take risk, there is no much empirical data on the risk
propensity of business managers
ii
. As outlined in other sections, risk is part of business.
It is from risky that opportunity arises. Therefore from a risk there is the probability
that good or bad things may happen that will impact your objectives. Risk
management is the process of identifying potential negative outcomes and managing
them while realizing potential opportunities.

However, risk taking culture does not mean that business managers have to
become gamblers. Business managers are different from gamblers. Gamblers maybe
motivated by dissatisfaction with their present position, hence they look for a "magic
pot of gold" for quick riches. They are motivated by the size of the potential reward
offered. They pay little regard to the probability of success, and do not give much
thought to the degree of effort required on their part. These people find it difficult to
accept their own responsibility in case of failure, and their often attributes events in
their life to luck or to forces beyond their control. Attracted by hopes of high return
with little effort, they are thus pure gamblers.
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Business managers on the other hand are risk takers, but carefully evaluate every step
they are taking, vis--vis the benefits. They may be influenced by factors like the
attractiveness of each alternative the level of loss you are able to accept; the probability
of success or failure of a particular business venture; the degree to which your efforts
could minimize the probability of failure or maximize the probability of success among
others.
Risks can either be pure or speculative. The occurrence of perils like earthquakes,
terrorist attacks, floods etc., generally causes losses only. Their occurrence never results
into gains. Because their occurrence is uncertain and unpredictable, they are usually
termed as pure risks. There occurrence causes losses only and not any gains to the
business. A machine operator in a factory faces a risk of injury to himself which may
again cause damage to the machinery. If an accident occurs, the driver may suffer
physical and financial losses. If the injury and damage does not occur, there would not
be any gain. Thus, in the case of a pure risk, there is loss when it occurs; otherwise,
there is no loss or gain. On the other hand speculative risks involve events which may
produce either gains or losses. For instance, expansion of operations in a new market or
geographical area may lead to higher profits or loss of invested funds. Most business
decisions relating marketing, production, finance, etc., are taken with the idea of making
gains, but there are possibilities of incurring losses also. Thus, all business enterprises
face both pure risks as well as speculative risks. Many pure risks can be handled
through insurance, while most of the speculative risks are not generally handled
through insurance. So business enterprises must find their own ways of handling
speculative risks.

Risks can also be classified as dynamic risks and static risks. Dynamic risks are related
to uncertainties caused by ever-changing business environmental factors such as
consumer wants, technology, competition, governmental policies, firms internal
organisation, etc. On the other hand static risks are those which occur even if there are
no changes in the business environment. Normally static risks are closely related to
pure risks such as fire, flood, windstorm, etc., where as dynamic risks are more closely
associated with speculative risks. Therefore, as discussed in the case of pure and
speculative risks, most of the static risks can be handled through insurance while most
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of the dynamic risks may not be handled by insurance. However, it is increasingly
becoming difficult to separate or distinguish clearly between the losses caused by
dynamic risks and static risks. For instance, fire which is a static risk may be caused by
an irate crowd during a demonstration which is a dynamic risk.

As many businesses focus on value creation as a key goal, they may forget that the
environment in which they operate is uncertain. It is the normal tendency for the
managers to over emphasize the profit aspect of enterprise and forget the risk factors.
There are several factors that may operate to hinder it from achieving its objectives.
But without adequate procedures in place to manage both the upside and downside of
risk, many of them have been unable to create real sustainable value. Opportunities and
risks just have to be well-balanced against each other, and risks threatening the very
existence of a company have to be identified early and eliminated. For this reason there
is the need for a systematic process in order to identify and evaluated risks as soon as
possible. Risk management is now a core business process and should be planned
accordingly and on a continuing basis so as to reduce risk and volatility and improve
returns. If a risk has both opportunities and threats, then any risk management system
must be tailored to maximizing from the opportunities and minimizing the threats.
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Areas of Risks
Risks whether pure or speculative, dynamic or static pervade all kinds of business
activities and processes. Such areas of risk include:-
o Property and Personnel Risks: Every business firm is confronted by potential
loss to its property and personnel through common perils such as fire, explosion,
wind storm, flood, theft, business liability damage suits, earth quake and death or
disability of its personnel. These perils may cause direct loss by damaging
property or killing personnel. Losses may occur to business from the occurrence
of some of these perils.
o Marketing Risks: Marketing activity includes all those business activities
necessary to move goods from producers to consumers. The major functions
include buying, selling, transportation and storage. There is an element of risk
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in all these activities. For instance, you may not be able to sell your products at
the prices you want. Due to market conditions, you may be forced to sell at
lower prices and incur losses. Similarly, due to sudden spurt in the raw material
prices, your cost of production may go up and you may incur losses. Goods may
be stolen, damaged or destroyed in transit from perils for which the transporter
is not- liable. Similarly, improper facilities for storage may cause unexpected
losses.
o Normal perils such as fire, floods, storm, explosion, theft, etc., can cause
extensive damage to goods in the storage. For instance, the fire due to electric
short circuit may cause extensive damage to the goods in the storage.
o Financial Risks: All business firms borrow money and also extend credit to
customers. There is always scope for loss from both credit received as well as
credit extended. Bad debts due to insolvency of customers are a continuous
problem in business. Similarly, creditors like banks and financial institutions
may fail or cancel the loans due to bad business conditions. This can cause
financial loss to the firm due to curtailed operations. Similarly, unexpected rise
in interest rates on bank loans may reduce profits. Business firms' investments in
stocks and bonds always face risk.
o Production Risks: Manufacturing enterprises face the problems such as
production losses due to breakdown of machinery, defective products due to
faulty machinery or poor quality of raw material, under utilization of installed
capacity, inventory build up to levels much higher than current demand,
improper plant layout, uneconomical plant capacity, etc. Such production risks
may be minimized by careful planning.
I
o strategic: - Strategic risks arise from being in a particular industry and
geographical area, for example a radical competitor moves on to the market, new
disruptive technologies, changes in customer demand, industry changes etc. for
example the ICT industry is highly dynamic and the changes come very fast.
New and better technologies are a real business risk that the organization needs
to be prepared for.
o Risks of the Grey Economy: - Rules imposed on business managers by
Government, such as tax laws, safety regulations, environmental regulations,
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establishment requirements, land-use planning rules, permits, etc. are all burden
for small firms, bringing up their costs. This may give rise to the unofficial
economy, called the grey economy in economics, e.g. smuggling and avoiding
the legal requirements. Because the players in this economy do not comply with
the government rules, they are at an advantageous position and they may end up
pushing the abiding business managers out of business.
o Financial risk is normally any risk associated with any form of financing.
Financial risks arise from the financial structure of the business, from
transactions with third parties and from the financial systems in place. Also
includes risks like non-payment by a customer or increased interest charges on a
business loan. Exchange rate fluctuations affect especially when transactions are
invoiced at a currency of a different country.
o Compliance: - Compliance risks derive from the necessity to ensure compliance
with laws, regulations and other less formal societal expectations which, if
infringed, can damage a company. Other examples include the introduction of
new health and safety legislation
o Environmental Risks: Business environment is a crucial factor for every
enterprise. Environmental factors such as competition, changing tastes and
preferences of consumers, technological developments, governmental policies,
ecological issues, political developments, etc., have lot of impact on each and
every business firm. All these environmental problems pose risks to business
firms.
o Political and economic risks- Political risk relates to the preferences of political
leaders, parties, and factions, as well as their capacity to execute their stated
policies when confronted with internal and external challenges. Changes in the
regulatory environment, local attitudes to corporate governance, reaction to
international competition, labour laws, and withholding and other taxes, to name
but a few, may all be influenced by hard to discern shifts in the political
landscape.

Risk is a part of everyday life. There are many types of risk that will be encountered in
business. Some will have a minimal impact and can be managed easily; others may
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threaten the longevity of a business. Understanding the principles and processes for
effective risk management will help a business owner make the decisions necessary to
ensure the best possible outcome for the business.
Risk Management involves measuring, or assessing risk and developing strategies to
manage it. Strategies include transferring the risk to another party, avoiding the risk,
reducing the negative effect of the risk, and accepting some or all of the consequences of
a particular risk.
The risk management process
Risk management focuses on identifying what could go wrong, evaluating which
risks should be dealt with and implementing strategies to deal with those risks.
Businesses that have identified the risks will be better prepared and have a more cost-
effective way of dealing with them.
Risk management becomes even more important if your business decides to try
something new, for example launch a new product or enter new markets. Competitors
following you into these markets, or breakthroughs in technology which make your
product redundant, are two risks you may want to consider in cases such as these.
Risk management affords a business the following benefits:-
o improves decision-making, planning and prioritization
o helps you allocate capital and resources more efficiently
o allows you to anticipate what may go wrong, minimizing the amount
of fire-fighting you have to do or, in a worst-case scenario, preventing
a disaster or serious financial loss
o significantly improves the probability that you will deliver your
business plan on time and to budget
The risk management process involves:
Identifying analyzing and ranking the risks
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Risk cannot be managed unless it is first identified. Risk identification and analysis helps
you determine the significance of each risk. It also enables you to decide whether to
accept, mitigate or take action to prevent it. Failure to identify all the loss exposers of
the firm means you will not be in a position to deal with those risks. Risks that have
occurred before are the easiest to identify and analyze. Information on these risks may
be available from sources like hazard or incident logs or registers, audit reports,
customer complaints, accreditation documents and report, past staff or client surveys
newspapers or professional media, such as journals or websites etc.

On the other hand, risks that have never occurred but have reasonable chance of
occurring are the most difficult to analyze. However, they may be analyzed through:-

o Market surveys
o R & D
o SWOT - Analysis of Strengths, Weakness, Opportunities, Threats
o PEST - Political, Economic, Social and Technology analysis
o Scenario Analysis
o Auditing and Inspection
o Industry benchmarking
o Business process analysis
o Risk map
o Brainstorming
After identifying the risks, you should assess the intensity of financial loss associated
with each of those risks. At this stage you have to determine two aspects: (a) probability
of the occurrence of each of the perils or risk identified in the first stage, and (b) extent
of financial loss to the firm, if that peril occur. With this assessment, you can identify
the relatively more serious risks and can pay more attention to them.

Impact can be measured in many ways ultimately there will be a financial effect but as
this is often extremely difficult to calculate with any certainty, businesses often use a
series of levels (measuring the overall effect on the business or selected business unit in
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a larger organisation). Whatever method is chosen it must be clear and easily
understood by everyone in the organisation.

Measuring likelihood is a similar exercise. Usually a series of categories is chosen, for
example linking each one to a frequency such as every day, every month, or every 10
years. Once each risk is plotted, the chart can be divided into categories of risk, usually
high (top right corner), medium and low (bottom left corner). The concentration should
then be on reducing the higher risk items lying in the top right corner of the chart.

Defining and implementing appropriate actions for managing these
risks
After risk identification and analysis, you should consider various tools of risk
management and decide upon the best combination of the tools to be used for attacking
the problem. There are basically six tools of risk management viz,
o assumption (or retention)
o loss prevention,
o avoidance,
o transfer (insurance),
o separation, and
o Business firms may adopt any one of these six methods or a combination of
them.

Risk Assumption or Retention: This is a common way of handling risks. Business
enterprises assume or retain risks consciously (intentionally) or unconsciously
(unintentionally). Under conscious assumption, one is aware of the risk to which his/ her
business is exposed, but essentially does nothing to avoid it. A manager of a business
who consciously assumes risk is doing something about it by the very act of being aware
of those perils and hazards which may cause loss. Being aware of risk, he may
knowingly or unknowingly make adjustments in operations which will help to alleviate
the impact of that risk. Awareness of risk itself is a significant achievement in better
management. In the case of unconscious assumption, risk is not recognized. As you are
not even aware of the existence of some risk, losses stemming from it can cause
disastrous surprises to your business.
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Loss Prevention: Another method of handling risk is to take appropriate measures to
prevent the occurrence of a peril, or minimize its financial impact on business. 11is
approach is known as loss prevention. For instance, by using fire resistant building
material, you can prevent the occurrence of fire in the building. However, in most cases
loss prevention measures may not totally eliminate the risk, but can reduce its
probability in terms of frequency as well as severity.

Risk avoidance means avoiding situations which have the potential to cause loss, is
another approach. For instance, a firm can avoid the risk of loss due to bad debts by
simply stopping credit sales. Similarly, a firm may avoid operations in certain areas
which are known for some perils like terrorism.

Transferring the risk to another party is a very widely followed approach to handle
risks. Insurance is the most common method of transferring' pure risks such as fire,
windstorm, flood, riot, theft, etc. Business enterprises normally transfer the pure risks
to the insurance company and devote their full efforts to their normal business.

Separation: Fifth method of risk control is separation of the firm's exposers to loss
instead of concentrating them at one location where all of them might be involved in the
same loss. For example, when a firm keeps its entire raw material one warehouse, the
entire raw material may be damaged if fire occurs in that warehouse. Therefore, the firm
may decide to store the raw material in ten separate warehouses. If fire occurs in one
warehouse, materials stored in that warehouse are damaged and the remaining nine
warehouses are safe. Here through separation the firm increases the number of
independent exposers units under its control. This method is also a kind of loss
prevention.

A combination of strategies like diversification of products, law of large numbers,
formation of more companies with unrelated lines of business, etc., comes under this
method. For example, if a firm is engaged in more products, the losses incurred in one
product may be upset by the gains in another product. Similarly, if there are more
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companies, the losses incurred by one company may be upset by the, gains by the other
companies. Insurance companies work on this combination principle where a sufficiently
large number of similar objects are combined to make the loss predictable within
narrow limits.
Deciding and implementing control measures to prevent or control the level of the
risks. Appropriate responses must then be prepared to all the risks that would
significantly affect the strategy or returns of the company if they were to occur.
Complete elimination of a risk or reduction to an acceptable level may not always be
possible and sometimes the risks may be so high in a particular business or process that
it is not sensible to proceed.
Ideally, risk management in a small business should not be a stand-alone program.
There are relationships between risk management and many of the management
processes and functions that may be employed to ensure the successful operation of a
business.
In other businesses there may be risks (e.g. volatility or economic or weather) that are
inherent to the business but which, so long as they are explained, investors are willing
to accept if the likely return is also commensurately high.
Various methods are used to deal with risks ranging from: -
o Diversification
o Hedging
o Avoid or reduce risk - reduce probability of risk
o Reduce or limit the consequences
o Share or deflect the risk e.g. by insurance
o Make contingency plans - prepare for it
o Adapt in order to maintain performance
o Treat it as an opportunity- if it affects competitors, then flexibility leads
to competitive advantage
o Move to another environment
Monitoring and reviewing the effectiveness of the control measures.
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Risk management is not a one-off exercise. Risks need to be monitored on a regular
basis the business environment changes rapidly, as do the ways of managing risks. It
is particularly important to be alert to new risks that a business may face and to have
early warning systems in place to monitor for changing risk levels.
Minimizing political risks
Always do extensive market research and try to about the politics, economy, culture and
business environment of the place where you want to do business. Sometimes you may
incorporate the local opinion and political leaders in your business, though this may be
risky in the long run because the political players may change over time.
The language of the place should also be well understood. It may be of help to
incorporate people who speak the local language. In export business, a clear agreement
is very important to get rid of confusion and to reduce risk. If you find that doing
business with a company in a foreign land is very risky, don't get involved in long term
business deals. Sometimes the business may have to lobby the political leaders so that
they do not make decisions that have adverse consequences to the business. For
example laws to do with taxation.
Minimizing Financial risks:
Some financial risks can be reduced by hedging and forward exchange contracts. In
finance, a hedge is an investment that is taken out specifically to reduce or cancel out
the risk in another investment. Hedging is a strategy designed to minimize exposure to
an unwanted business risk, while still allowing the business to profit from an
investment activity. It is the process of protecting oneself against unfavorable changes
in prices. Thus one may enter into an offsetting purchase or sale agreement for the
express purpose of balancing out any unfavorable changes in an already consummated
agreement due to price fluctuations. Hedge transactions are commonly used to protect
positions in
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A forward exchange is where you agree to purchase (or sell) a fixed amount of foreign
currency at a fixed exchange rate on an agreed future date. The date aligns with a
scheduled payment you need to make to a supplier or expect to receive from one.
By taking out a forward exchange contract, you will know how many Australian dollars
you will need to pay for a fixed amount of foreign currency on that future date, or
conversely how many Australian dollars you will receive in exchange for a fixed amount
of foreign currency.
Risks to do with customers can be reduced by:-
o Understand the creditworthiness of your customers before extending credit
facilities to them.
o Always use reliable payment methods for transactions
o Incase of foreign currency transactions, be aware of foreign exchange rate
fluctuations exchange could change, and therefore, you may consider hedging
your transactions
o Do not provide financial account information of your company unless there is a
good reason to do so.
o Get all the terms and conditions, modes of payment, sales conditions, quality
inspection, etc. in writing.
Minimizing strategic risks
Strategic risks are more industry wide and are well managed by keeping a loyal
customer base, and investing in continues research and development. Research and
development ensures the business is producing items that the market needs, hence can
cope with the competitor. A loyal customer base can actually help defend the business
even when a radical new competitor comes into the market. The business should also
engage in constant market and industry research so as to anticipate any changing
customer needs and industry requirements. Existing businesses may choose to go into
mergers and acquisitions to consolidate their market share when they are facing the risk
of new competitors.
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Strategic risks can also be reduced by diversification which may take any of the
following forms
o new, related products or services to existing customers
o new markets for existing products
o new products for new markets
Diversification helps reduce any risk of over-reliance on one market or too few products.
Incase the demand in one market or for one of the products reduces, the business can
still rely on the other markets as it explores other options. After the outbreak of post-
election violence in Kenya, Ukwala Super Market, one of the leading retail outlets
Kisumu branch was extensively looted. It may have had disastrous consequences for the
business if it only had branches in Kisumu. However, because there were others all over
the countrys major towns, the retailer was able to survive the crisis.
Minimizing compliance risks
Compliance is key to the success of the business in a particular location. Not only have
the laws of the country be obeyed but the expectations of the society. The business must
always strive to gain acceptance from a particular locality. Laws of the country can be
obeyed by seeking the relevant legal expertise. Compliance with the local expectations
is also critical and needs a careful evaluation.

Minimizing operational risks
Some operational risks can be reduced through risk transfer, e.g. through insurance.
Insurance is a form of risk management primarily used to protect against the risk of a
contingent loss. Insurance is defined as the equitable transfer of the risk of a loss, from
one entity to another, in exchange for a premium. An insurer is a company selling the
insurance. A contract of insurance is one of indemnity, i.e. the insurer will compensate
the insured for the loss suffered. Even if the risk which was insured happens, no
compensation is received if no actual loss is suffered. Examples of risks that can be
insured include:-
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o Destruction of premises and stock by fire
o Theft by employees
o Theft by outsiders
o Injury of employees in the work place
o Destruction of motor vehicles by accidents
o Injury caused by the business on third parties
o Goods on transit against theft. Etc
WHAT IS INSURANCE
Risk is born out of uncertainty and it is inseparable from business. Business risks can
not be eliminated, but they can be controlled to some extent by adopting appropriate
measures. One of such risk control measure is risk transfer by means of insurance.

Insurance is a device by which a loss likely to be caused by uncertain event is spread
over a large number of persons who are exposed to it and who voluntarily join to insure
themselves against such an event,
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For example in the risk of fire, every year a certain
number of houses are destroyed by fire, but no body can predict which particular house
will be destroyed. Thus, all house owners run the risk of loss through fire. If all of them
pay a small sum into a find every year, anyone who does lose his house can claim money
from such fund to build a new house. In the absence of such a fund, the owner of the
house has to bear the whole loss by himself.

In the case of insurance, in the similar way, loss is being shared by a large number of
persons instead of being borne by one. People are willing to lose a small sum in order to
be certain that they will not lose a much bigger sum. In the above illustration the
persons who got their houses insured are known as 'Insured'. The agency which helped
them in entering into this arrangement is known as 'Insurer' or the Insurance Company.
The agreement or contract between the insurer and insured is known as 'Policy'.
The amount paid by the insured in return of which the insurer undertakes to make good
the loss is known as 'Premium'.

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Insurance therefore is a form of contract between two parties (insurer and insured)
whereby one party (insurer) undertakes in exchange for a fixed amount of money
(premium) to pay the other party (insured), a fixed amount of money on the happening
of actual loss when it takes place through the risk insured (in case of property).

Insurance and Assurance
Sometimes these two terms are used synonymously but they do not mean the same
thing. In fact insurance is now commonly used in a general sense to include assurance,
though it is customary to speak of assurance in connection with life policies. The term
'assurance' is used in those contracts which guarantee the payment of a certain sum on
the happening of a specified event which is bound to happen sooner or later. For
example, human beings certainly attain a certain age or death. Thus, all life policies
come under assurance.

On the other hand 'insurance' contemplates the granting of agreed compensation on the
happening of certain events stipulated in the contract which are not expected, but which
may happen. Thus, insurance refers to risks such as fire, accident, theft, etc., which are
contingent in nature.

Insurable Risks and Non-Insurable
You should know that all risks can not be transferred to the insurer. Mostly, pure risks
can be transferred to the insurer.

The characteristics of the insurable risks are as follows:
1. The risk should be accidental and random or contingent in nature. The loss
causing factor should not be within the control of the insured. Thus, the loss
which has occurred already or which is very likely to occur can not be insured.
For instance, a building which is on fire or which is already destroyed by fire can
not be insured against fire.
2. The amount of loss should be measurable and possible to estimate. This
condition is necessary to set the premium at appropriate levels.
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3. There should be a sufficiently large number of units exposed to the same risk. In
other words, there must be a large number of people interested to insure against
the same risk. This requirement follows from the law of large numbers, since an
insurance operation is safe only when the insurer is able to predict fairly
accurately its expected losses.
4. The units facing the same risk must be spread over large geographical area. In
other words, the risk must be spread over a wide geographical area so that the
happening of a single event in a small region may not cause heavy burden to the
insurer. For instance, if an insurance company had accepted against fire for the
buildings located in one area only, an incidence of fire in that area can destroy all
those builds. The insurance company may become bankrupt with that single
incidence as it has to pay to all the insured. Therefore, it is necessary that the
values exposed to loss should not be concentrated in one area.
Normally, pure risks fulfill all the above four features and they are insurable.
There are certain risks which do not fulfill these four requirements explained above, and
cannot be insured against. They are called non-insurable risks. These non-insurable
risks include:
o Risks due to war
o Risks incapable of measurement such as unforeseen changes in fashion,
marketing of new products, etc.
o Risks too small and recurring too frequently, or risks so large and recurring
so infrequently. For instance, a hotel can not insure the crockery against
breakages.

INSURANCE CONTRACT
When a person buys insurance from an insurance company (insurer), it is essentially a
contract between the insured and insurer. An insurance contract is a vehicle used for
transferring risk from an individual or business firm to the insurer. Insurance contract,
constitutes the agreement between the insured and insurer, and details the conditions
under which the risk transfer takes place. Before we discuss the components of an
insurance contract, you should understand the meaning and importance of the following
three aspects.
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o The Proposal: A person wishing to enter into insurance contract is required to
submit a proposal to the insurer. This proposal may be made either orally or in
writing. Proposal form consists of a number of questions to which the person
must give true answers. The insurer can reject the proposal if the proposal is
incomplete or incorrect.

o The Cover Notes: Insurance contract comes into existence only when the
proposal is accepted by the insurer. While the proposal is under consideration by
the insurer, sometimes the person making the proposal may wish to have
immediate cover. In such case, on request, the insurer may issue a cover note
which grants temporary protection. Thus, the main purpose of cover note is to
confirm the risk cover prior to the issue of policy by the insurer,

o The Policy: Insurance policy contains all the terms of the contract. Having
accepted a proposal, insurer must issue the after receiving the first premium.
Most policies are for fixed periods, usually a year.