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Risk Management & Insurance Chapter -2- Risk Management

CHAPTER TWO

RISK MANAGEMENT

2.1. Risk management defined

Risk management is a process that identifies loss exposures faced by an organization and selects

the most appropriate techniques for treating such exposures. Because the term risk is

ambiguous and has different meanings, risk managers typically use the term loss exposure to

identify potential losses.

• A loss exposure is any situation or circumstance in which a loss is possible, regardless of

whether a loss occurs

2.2. Objectives of risk management

Risk management has two important objectives:

1) Pre-loss objectives and 2) Post-loss objectives


Pre-Loss Objectives

Important objectives before a loss occurs include economy, reduction of anxiety, and meeting

legal obligations.

The first objective means that the firm should prepare for potential losses in the most economical

way. This preparation involves an analysis of the cost of safety programs, insurance premiums

paid, and the costs associated with the different techniques for handling losses.

The second objective is the reduction of anxiety. Certain loss exposures can cause greater worry

and fear for the risk manager and key executives. For example, the threat of a catastrophic lawsuit

because of a defective product can cause greater anxiety than a small loss from a minor fire.

The final objective is to meet any legal obligations. For example, government regulations may

require a firm to install safety devices to protect workers from harm, to dispose of hazardous

waste materials properly, and to label consumer products appropriately.

Workers compensation benefits must also be paid to injured workers. The firm must see that these

legal obligations are met.

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Post-Loss Objectives:

Risk management also has certain objectives after a loss occurs. These objectives include survival

of the firm, continued operations, stability of earnings, continued growth, and social

responsibility.
 The most important post-loss objective is survival of the firm. Survival means that after a loss

occurs, the firm can resume at least partial operations within some reasonable time period.

 The second post-loss objective is to continue operating. For some firms, the ability to operate

after a loss is extremely important. For example, a public utility firm must continue to provide

service. Banks, bakeries, and other competitive firms must continue to operate after a loss.

Otherwise, business will be lost to competitors.

 The third post-loss objective is stability of earnings. Earnings per share can be maintained if

the firm continues to operate. However, a firm may incur substantial additional expenses to

achieve this goal (such as operating at another location), and perfect stability of earnings may

be difficult to attain.

 The fourth post-loss objective is continued growth of the firm. A company can grow by

developing new products and markets or by acquiring or merging with other companies. The

risk manager must therefore consider the effect that a loss will have on the firm’s ability to

grow.

 Finally, the objective of social responsibility is to minimize the effects that a loss will have on

other persons & on society. A severe loss can adversely affect employees, suppliers, customers,

creditors, and the community in general. For example, a severe loss that shuts down a plant in a

small town for an extended period can cause considerable economic distress in the town

2.3. Steps in the Risk Management Process

There are four steps in the risk management process

1) Risk Identification

2) Risk Measurement

3) Selecting Appropriate risk Management techniques and

4) Risk Administration

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2.3.1. Risk Identification

It is the first step in the risk management process. Here, the risk manager tries to locate the areas

where losses could happen due to a wide range of perils. It would be very difficult to deal with

the risks faced by a firm unless they are properly identified.

In the identification process, the risk manager places more emphasis on pure risks. The following

three types of loss exposures (risks) are mainly considered by the risk manager.

(1) Property Losses (2) Third Party Liability Losses and (3) Personal Losses

1. PROPERTY LOSSES

Ownership of property puts a person or a firm to property exposure, i.e., the property will be

exposed to a wide range of perils.

In small organizations, the risk manager can identify the property owned and the exposed value

of such property with less difficulty. In large organizations this may become cumbersome,

especially where the internal information system is weak.

On the other hand, if the international information system is efficient and is backed by electronics

data processing equipment, then the risk manager can obtain the required information in a more

accurate and suitable form from the data processing unit. Thus, in the identification process he

will find it helpful to prepare a checklist of the property exposed to various types of risks.

Property Checklist

Property checklist can facilitate the risk identification process. Accordingly, the risk manager

prepared a listing of the various assets owned by the firm in major categories that are exposed to

risk. He can as well identify the perils that can possibly cause property losses. The exposed value

of each property will also be entered in the checklist to have a clear picture as to the severity of a

loss in case the property is damaged or destroyed by a particular peril.

Insurance Policy Checklists

Analysis of insurance policy forms can also help in identifying various types of insurable pure

risks. Here, the risk manager initially collects a specimen of insurance policy forms from various

insurers. He, then, proceeds to prepare a checklist of various types of pure risks that can be dealt

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with insurance. An example of this type of checklist is presented on the next page. The

disadvantage of this procedure, however, is that it ignores non-insurable pure risks. Nevertheless,

through close examination of the policy forms the risk manager can identify the non-insurable

risks and accordingly will consider other risk handling tools.

2. LIABILITY LOSSES

Third party liability losses refer to injuries caused to other people and/or damages caused to their

property. Firms are exposed to liability risks by virtue of their operating activities.

Consequently, it becomes an essential responsibility of the risk manager to identify the possible

liability losses that the firm may be exposed to. Liability losses originate in various ways. Some of

the factors leading to liability losses are discussed below.

Product Liability

It is associated with the manufacture and sell of a particular product. A good example is

pharmaceutical products. Pharmaceutical companies are very much exposed to this risk.

Consumption of a particular drug or medicine may cause serious health damages to the

consuming public. The victim in most case files a lawsuit demanding a considerable amount of

compensation for the damages he/she suffered as a result of consuming the product. Quality

problems, breach of warranty, misleading advertisement, etc… are some of the other factors that

lead to liability losses.

Motor Vehicles

This is the most frequent factor a firm should expect concerning liability losses. Use of various

kinds of motor vehicles (buses, trucks, small cars, motor cycles, special vehicles, aircraft, etc…)

exposes the firm to third party liability losses. Operation of motor vehicles could lead to killing of

people, injuries and damages caused to the property of other people due to accidents such as: fire,

collision, overturning, crash, explosion, etc….

Industrial Accidents

Factory employees are likely to suffer physical injuries at worksites. In some types of activities

they may develop job related diseases. This is particularly the case in foundries, chemical

industries, cement factories etc… Where factory employees are exposed to dust inhalation and

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pungent chemical smell that can cause occupational diseases. The firm will have to compensate

the employees for the injuries they sustained during the course of employment.

Industrial Waste
This refers to industrial garbage’s thrown into rivers and lakes thereby polluting the environment.

Environmentalists are likely to file a lawsuit against the activities polluting firms, especially

concerning the firms waste disposal practices.

Professional Activities

In the field of public accounting, medicine, construction and other professional activities, liability

risks are likely to emerge because of the deficiencies inherent in the services rendered due to

negligence, errors, international concealment and the like.

Ownership of Immovables

This refers to buildings; land and machinery owned the use of such immovables by people may

bring liability losses for injuries caused by accidents. For example, faulty electrical connection, old

building, faulty elevators and escalators may cause injury to people while they are using these

facilities.

3. PERSONNEL LOSSES

These are losses to a firm regarding its employees and their families. The risks include death and

bodily injury due to accidents while off duty, industrial accident, occupational disease,

kidnapping, retirement, sickness, etc…

Employees represent the human asset (capital) of the firm. Their good health, motivation, moral,

dedication and loyalty greatly increase the value of the firm. Employees put relentless effort, for

the achievement of the sales of the firm when they realize that the firm has a strong interest in the

wellbeing of its employees and, hence, expend resources to safeguard their safety.

In some situation, the reputation and success of a particular firm is attributed to the exceptional

caliber of a particular management executive. Loss of this key executive (death or disability) can

bring severe operating disturbances: declining profits, disintegration of the moral of employees,

business interruption and the like.

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As a result, the risks associated with personnel losses should also be carefully examined by the

risk manager. The need to avoid personnel risks (enhancing the safety of employees) is justified

for a number of reasons. They include:

1. To boost the morale of employees that leads to higher productivity.

2. To attract and retain highly qualified employees.

3. To instill a confidence in the minds of the employees that the firm is really caring for the

safety of its employees.

Most firms are taking certain preventive measures to avert personnel losses. For example.

- Employees in some firms have 24-hour insurance protection against any accident –

on or off duty.

- Employees working in foundries, cement factors, soap factories, etc...are provided

with free milk to minimize occupational diseases.

- Key management executives are protected by bodyguards to prevent assault,

kidnapping, etc…

- Special work-clothes, appropriate tools and safety measures are employed to


prevent industrial accidents.

2.3.2. RISK MEASURMENT

Once the risk manager has identified the risk 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.

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The following example is considered for illustrative purpose. The data presented below represents
the number of cars operated (similar in type of use) by a firm in each year, the corresponding
number of accidents occurred and the total monetary losses incurred in connection with the
accidents.
Year Number of Cars Number of Accident Amount of Loss
1 10 1 Birr 2,500
2 12 2 4,200
3 14 3 4,500
4 15 3 6,000
5 20 2 6,500
6 20 3 6,600
7 25 4 6,000
8 25 5 8,000
9 28 3 7,500
10 30 4 10,000
SUM 200 30 61,800
Mean 20 3 6,180
S.D 1.15 2,115

Probability of Accident =

Loss per accident over 10 years =


Suppose in year 11 the number of cars owned by the firm increased to 40. The risk manager wants
to construct a probability distribution of accidents on the basis of the data collected above.
POISSON DISTRIBUTION
The Poisson probability distribution can be used for the analysis. The only information that is
crucial in constricting 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 using the following formula:

( ) Where: e = 2.71828
r = number of occurrences
M =Expected number of Accidents = (pn)
STD = Standard Deviation = √ (M)
n = Number of Exposed Units = 40
Accordingly, M = pn = 0.15 * 40 = 6 accidents and STD = √ (M) = 2.45

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The Poisson probability distribution allows for unlimited number of accidents occurring to the

object under consideration, (car). This means that a particular car can possibly experience more

than one accident. This is normally the case in real life situation.

Using the Poisson process, the following probability distribution is constructed.

No of Amount Probability Expected Expected


Accidents of Loss* No. of Accidents Amount of Loss**
0 0 0.0025 0 0
1 2,060 0.0149 0.0149 30.69
2 4,120 0.0446 0.0892 183.75
3 6,180 0.0892 0.2676 551.26
4 8,240 0.1339 0.5356 1103.34
5 10,300 0.1606 0.8030 1654.18
6 12,360 0.1606 0.9636 1985.02
7 14,420 0.1377 0.9639 1985.63
8 16,480 0.1033 0.8264 1702.38
9 18,540 0.0688 0.6192 1275.55
10 20,600 0.0413 0.4130 850.78
11 22,660 0.0225 0.2475 509.85
12 24,720 0.0113 0.1356 279.34
13 26,780 0.0052 0.0676 139.26
14 28,840 0.0022 0.0308 63.45
15 30,900 0.0009 0.0135 27.81
16 32,960 0.0003 0.0048 9.89
17 35,020 0.0001 0.0017 3.50
18 37,080 0.0001 0.0018 3.71
SUM 1.0000 5.9997 12,359.39
* Number of accidents multiplied by the loss per accident

** Amount of loss multiplied by the probability.

Once the probability distribution is developed, it would not be difficult to determine the

probability of any number of Let x represent the number of accidents,

P(r ≥ 3) = 1- (.0025 + .0149 + .0446)

= 0.938

This is the probability that there would be at least three accidents in the year.

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Similarly, the probability that the number of accidents equal or exceed 13 is given by:

P(r ≥ 13) = .0052 + .0022 + .0009 +.0003 +.0001 +. 0001

= 0.0088

Accordingly, P (3 ≤ r < 13) = 0.938 –0.0088

= 0.9292

This indicates that, the risk manager’s expectation of accidents is heavily concentrated between 3

and 13 accidents.

The expected annual total monetary loss is Birr 12,359. 39 as determined on the table above. The

expected dollar loss per accident is obtained by dividing the expected annual total monetary loss

by the expected annual total monetary loss by the expected number of accidents.

Expected Monetary

Loss per Accident =

The calculation of standard deviation of total monetary loss is presented on the next page. The

standard deviation is 5,046.46. From earlier analysis the following measures were obtained:

P = .15

n = 40

Expected Number of Accidents = M = np = .15 x 40 = 6

SD of Accidents = SD = √ (M) = √ (6) = 2.4495

Expected Annual Total Monetary Loss = 12,359.9

Standard Deviation of Annual Monetary Loss = 5,046.4

Risk Relative to the Mean (Coefficient of Variation)

Rm = = 0.408 or, = 0.408

RM 0.408 indicates the variability of total annual monetary losses from the expected value, (the

mean).

The higher the Coefficient of Variation (RM), the higher, the risk, meaning variability increases.

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In this example total annual monetary losses could deviate 40.8% from the mean in either

direction. For example the range for 1 standard deviation is Birr 7,314 to Birr 17,406. On the table

above, this range is approximated by Birr 6,180 to Birr 18,540. The probability that total annual

monetary loss falls in this range is 0.8542, which is obtained by adding all the probabilities in the

range. In terms of number of accidents, the risk manager expects to observe 3 to 9 accidents about

85.42 percent of the time.


No. of Monetary Mean Deviation Deviation Probability DS times

Accidents Loss From Mean Squared probability

0 0 12,360 -12360 152,769,600.000 0.0025 3,81,924.000

1 2,060 12,360 -10300 106,090,000.000 0.0149 1,580,741.000

2 4,120 12,360 -8240 67,897,600.000 0.0446 3,028,232.960

3 6,180 12,360 -6180 38,192,400.000 0.0893 3,410,581.320

4 8,240 12,360 -4,120 16,974,400.000 0.1339 2,272,872.160

5 10,300 12,360 -2,060 4,243,600.000 0.1606 681,522.160

6 12,360 12,360 0 0.000 0.1606 0.000

7 14,420 12,360 2,060 4,243,600.000 0.1377 584,343.720

8 16,480 12,360 4,120 16,974,400.000 0.1033 1,753,455.520

9 18,540 12,360 6,180 38,192,400.000 0.0688 2,627,637.120

10 20,600 12,360 8,240 67,897,600.000 0.0413 2,804,170.880

11 22,660 12,360 10,300 106,090,000.000 0.0225 2,387,025.000

12 24,720 12,360 12,360 152,769,600.000 0.0113 1,726,296.480

13 26,780 12,360 14,,420 207,936,400.000 0.0052 1,081,269.280

14 28,840 12,360 16,480 271,590,400.000 0.0022 597,498.880

15 30,900 12,360 18,540 343,731,600.000 0.0009 309,358.440

16 32,960 12,360 20,600 424,360,000.000 0.0003 127,308.440

17 35,020 12,360 22,660 513,475,600.000 0.0001 51,347.560

18 37,080 12,360 24,720 611,078,000.000 0.0001 61,107.840

SUM 25,466,692.320

STANDARD DEVIATION = √ (25,466,692.32) = 5,046.4

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RISK MEASURES:

Risk relative to Mean = Rm = 0.408

The standard deviation of total annual monetary loss can also be determined as follows:
SD of Accidents x Expected Monetary Loss per Accident
2.44949 x 2,060 = 5,046

Risk Relative to the Number of Exposure Units = Rn = = 0.061

Rn indicates the deviation from the expected outcome as a percentage of the total number of

exposure units. Accordingly, given one standard deviation, the actual accidents could vary from

the expected accidents by about 6.1% of the total number of exposure units. The higher the

percentage, the higher the variability (higher variance), and consequently, the higher the risk.
POSSIBLE DECISIONS
Self-Insurance
1. To keep reserve fund equal to the expected total annual monetary loss.
Reserved Fund = Birr 12,360
2. To keep reserve fund equal to the expected value of the loss plus an amount to cover for
one standard deviation of the expected value.
Reserved Fund = 12,360 + 5,046 = Birr 17406
3. To keep reserve fund equal to the maximum probable loss (ignoring losses with a
probability of occurrence less than 1%).
Reserved Fund = Birr 24,720
RISK AND LAW OF LARGE NUMBER
Suppose the exposure units are to be increased to 50, (n = 50).
Mean Number of Accidents = M = .15*50 = 7.5
SD of Accidents = SD = √ (7.5) = 2.7386

Rm = = 0.365

Rn = = 0.054772
It is possible to simulate this process to see how risk decrease as the number of exposure units
increase. Here is the summary.
N M Sd Rm Rn
40 6 2.4495 0.408 0.06124
50 7.5 2.7386 0.365 0.05478
100 15 3.8730 0.258 0.03873
The mean (M) increases proportionately while Rm and Rn decrease less than proportionately.

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BINOMIAL PROBABILITY DISTRIBUTION

The Risk Manager may also use the Binomial probability distribution to measure risk. To use the

Binomial distribution the Risk Manager must be familiar with the basic assumptions of the

distribution to avoid misleading results. The first assumption is that the objects are independently

exposed to loss. The other assumption is that each exposed unit suffers only one loss in a year.

With this assumption in mind, the following illustrative example is considered. A fleet of 5

delivery trucks are operated by a business. If an accident happens to a particular truck it becomes

a total loss. New trucks are purchased at the beginning of every year to make up the lost ones so

that the firm always starts the new fiscal period with a fleet of 5 delivery trucks.

First it is assumed that monetary loss per accident is constant at Birr 5000.

Year Number of Trucks Number of Accidents Total Monetary Loss

1 5 2 Birr 10,000

2 5 2 10,000

3 5 3 15,000

4 5 2 10,000

5 5 1 5,000

SUM 25 10 50,000

Mean 5 2 10,000

SD 0.6324 3,162.27

Monetary Loss per Accident = = 5,000

The probability of an accident can be estimated as:

P= = 0.40

With this information as a point of departure it would be possible to construct a Binomial

probability distribution for the following variables of interest:

1. Probability Distribution of Number of Accidents

2. Probability Distribution of Total Monetary Losses

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1. PROBABILITY DISTRIBUTION OF NUMBER OF ACCIDENT

Given: n=5 p = 0.4 q = 0.6

Under the Binomial probability distribution the probability of observing exactly r occurrences is

given by:

( ) ( )
( )

Using this formula the following probability distribution is constructed.

Number of Accidents Probability Expected No. of Accidents

0 0.07776 0

1 0.25920 0.2592

2 0.34560 0.6912

3 0.23040 0.6912

4 0.07680 0.3072

5 0.01024 0.0512

SUM 1.00000 2.0000

The expected number of accidents is 2. The standard deviation can be determined as usual

manner, which turns out to be 1.095.

√ √ √
The probability that the firm will face some accident is 0.92224, (1-0.07776). This probability is so

high that the risk manager should take appropriate measures to handle the risk.
FORMULA FOR MEAN AND SD OF A BINOMIAL DISTRIBUTION

The mean and the standard deviation of a Binomial probability distribution can also be

determined using the following formula:

Mean = M = =

SD = √ =√

RISK MEASURES
Risk Relative to Mean, (Coefficient of Variation) =

Risk Relative to the Number of Exposure units =

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RISK Vs LAW OF LARGE NUMBERS


Risk Relative to the Mean
( ) √


( ) ( )

( ) ( )
( )
( )
( )

Rm decreases as n increases.
Risk Relative to the Number of Exposure units
( ) √


( ) ( )

( ) ( )


Rn decreases as n increases
To illustrate the situation suppose the exposure units are to be increased to 20, (n = 20)

√ √

Increasing the number of exposure units to 100 will give the values for Rm & Rn as shown below.
n M SD RM Rn
5 2 1.095 0.54750 0.21900
20 8 2.190 0.27375 0.10950
25 10 2.449 0.2449 0.09796
50 20 3.464 0.1732 0.06928
100 40 4.899 0.12247 0.04899
The risk does not decrease in proportion to the increase in the number of exposure units.

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2. PROBABILITY DISTRIBUTION OF TOTAL MONETARY LOSSES

The Binomial probability distribution of total monetary losses is constructed as follows:

Number of Accidents Monetary Loss Probability Expected Monetary Loss


0 0 0.07776 0
1 5,000 0.25920 1,296
2 10,000 0.34560 3,456
3 15,000 0.23040 3,456
4 20,000 0.07680 1,536
5 25,000 0.01024 256
SUM 1.00000 10,000
The Expected Total Annual Monetary Loss is Birr 10000. The standard deviation of total annual

monetary loss is calculated as follows:

1.095
Risk relative to the Maximum Possible Loss is:

NORMAL DISTRIBUTION
The Risk Manager may assume that the numbers of accidents or total annual monetary losses are

approximately normally distributed. Under such circumstances, he/she may use the Normal

distribution in measuring the number of accidents or the total annual monetary losses. If

observations are normally distributed, the Risk Manager will have a good insight of the size of

possible losses at much greater ease. This is because the normal distribution can be well explained

by identifying only two parameters, the mean and the standard deviation. For illustrative purpose

let us consider the example under Binomial distribution with slight changes

Year Number of Accidents Total Monetary Loss


1 2 Birr 10,000
2 2 10,000
3 3 15,000
4 2 10,000
5 2 10,000
SUM 55,000
MEAN 11,000
SD 2,000

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The Normal distribution has the following properties:

68.27 % of the observations fall within the range of one standard deviation of the mean.

95.45 % of the observations fall within the range of two standard deviation of the mean.

99.73 % of the observations fall within the range of three standard deviations of the mean.

The implication of this for the Risk Manager, in the case of monetary losses, is that he/she would

construct the following interval estimation about the true mean monetary loss.

The true mean monetary loss is expected to fall in the range of Birr 9,000 and Birr 13,000 with a

probability of 0.6827.

The true mean monetary loss is expected to fall in the rage of Birr 7,000and Birr 15,000 with a

probability of 0.9545.

The true mean monetary loss is expected to fall in the range of Birr 5,000 and Birr 17,000 with a

probability of 0.9973.

2.3.3. TOOLS OF RISK HANDLING

Risk is handled in several ways. Most authors cite the following risk handling tools:

(1) Avoidance (2) Loss Prevention & Reduction (3) Separation/Diversification

(4) Combination (5) Transfer (6) Retention and (7) Insurance.

These tools are classified as Risk Control Tools and Risk Financing Tools.

A. RISK CONTROL TOOLS

1. Avoidance

Avoidance of risk exists when the individual or the organization frees itself from the exposure

through abandonment or refusal to accept the risk. An individual can avoid third person liability

by not owning a car. Product liability can be avoided by dropping the product leasing avoids the

risk originating from property ownership.

Avoidance, however, may not be a sound risk handling tool. For example, a business has to own

vehicles building, machinery, inventory, etc.. Without them operations would become impossible.

Under such circumstances avoidance is impossible.

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In other situations, avoidance could be a viable alternative. For example, it may be better to avoid

the construction of a company near river banks, volcanic areas, valleys, etc because the risk is so

great Moreover, a research laboratory may abandon a highly dangerous experiment similarly, and

dangerous sport activities like skiing, mountain climbing, and motor racing could be avoided to

escape the risk of injury or death.

2. Loss Control (Loss Prevention and Reduction)

These measures refer to the safety actions taken by the firm to prevent the occurrence of 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. LP & R measures must be considered

before the Risk Manager considers the application of any risk financing measures.

Following are some examples of loss prevention and reduction plans

Loss Control Function


 Occupational health
 Environmental protection
 Fire control & property conservation
 Public safety (general liability)
 Insurance
 Claims
Loss control measures (prevention and reduction) are taken at three stages:
Prior to the happening of loss
 Eliminate possibility of occurrence (e.g. Avoidance)
 Reduce probability of occurrence
Up on a loss happening
 Detect occurrence and raise alarm
 Minimize severity
Following the happening of a loss
 Minimize severity
 Maximize salvage
 Quick and effective rehabilitation

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Loss Prevention Measures:


 Research on fire protection equipment and appliances.
 Construction using fire insensitive materials.
 Automatics smoke detectors, fire alarms
 Burglar alarms in costly business situation, jewels, diamonds
 Location 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.
 Safety measures adequate lighting, ventilation, special work clothes to prevent industrial
accidents.
 Regular inspection of machinery to prevent explosions, 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 of train and motor vehicles.
 Warning posters. These are posted at strategic places within the organization (notice board
mess hall, shop floor, etc.) Consider the following messages:
- NO SMOKING DANGER ZONE!!
- “A Fire on the job can send your job, income, health, and life up in smoke”
- “Let’s step up our safety effort”
- “Don’t learn safety by ACCIDENTS”
- “The price of an accident is always high”
Loss Reduction Measures:
They are intended to reduce the extent of loss once the adverse incident happened, i.e. to reduce
the severity of the loss.
 Installing automatic sprinklers.
 First aid kit
 Evaluation of people
 Immediate clean-up operations
 Fire extinguishers, guards.
Appropriate measures taken to prevent accidents bring benefits not only to the firm but to the

society as well. For example, a destruction of inventory of a firm could be a fatal loss to the firm in

particular. The society also faces a real economic loss because those goods are no more available

to people.

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Thus the importance of LP&R measures should not be underestimated by a firm. To design

effective LP&R measures, it may be helpful to identify the causes of accidents.

Some of the causes of accidents and the possible LP & R measures are indicated below.

Causes of Accidents Loss Prevention measures


Working on dangerous equipment with less care Safety seminar, Inspection at regular time
Improper use of equipment Training, Safety seminar
Violating Safety Procedures and Regulations Safety Seminar, Warning, dismissal
Human error, Negligence Training, safety seminar
Use of inappropriate tools Provide appropriate tools
Lack of protective clothing Provide necessary protective clothing
Use of defective equipment Regular inspection and maintenance
Inadequate Knowledge about the job Training
Working while physically ill Sick-leave, don’t allow to work until recovery
Mental Disturbance of employee Date-off to the employee

Data should be kept regarding accidents occurred. The causes of these accidents must be

investigated. Pre-designed forms may be employed to report on accidents and their causes. This

would allow for the design of a much better LP &R measures.

Loss control measures entail costs. These costs include expenditures for the acquisition of safety

equipment’s and devices, 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 &R

measures in the most efficient way in order to minimize such costs without reducing the desired

safety level.

3. Separation/Diversification
The exposed property is scattered to different places. The principle is “don’t put all your eggs in

one basket”. This could be regarded as a loss reduction measure. For example, a firm’s inventories

could be kept in warehouses located in different areas. In another case, the inventories could be

grouped according to their value or importance and be kept in separate places with differing

safety measures ABC analysis of inventories is a clear example.

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4. Combination

Combination is a basic principle of insurance that follows the law of large numbers. Combination

increases the number of exposure units since it is a pooling process. It reduces risk by making

losses more predictable with a higher degree of accuracy.

In the case of firms, combination results in the pooling of resources of two or more firms. 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.

5. Non-Insurance Transfer

Risk is transferred to another party through insurance or non-insurance means. Non-insurance

transfer may take two forms.

i. Transfer of the hazardous activity

ii. Transfer of the probable loss.

Transfer of the Activity or the Property

 Operating a staff lounge in an organization may be given to outside contractor.

 Certain activities may be given to subcontractors to avoid the probable increase in costs.

 Factoring of accounts receivable without recourse. Some premiums are paid but

collection expenses are saved. Default risk is transferred.

 Delivery of goods at the warehouse rather than at the buyer’s premises. Transit risk is

transferred to the buyer.

 Purchase of goods at terms f.o.b. Destination.

Transfer of the Probable Loss

 Leasing rather than buying

 Consignment shipments rather than purchase. If the goods remain unsold or expired, they

will be returned to the consignor.

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B. RISK FINANCING TOOLS

1. Retention

This is the easiest method of handling risk. The person or the firm, consciously or unconsciously,

decides to assume the risk. The loss is to be borne by the person or the firm, and no specific

measures are taken to transfer the risk to others.

A person or a firm decides to retain the risk for a number of reasons. It is probability impossible to

transfer the risk, as in the case of gambling. Besides, the attitude of the individual or the firm

towards risk than do risk will influence risk assumption. Risk lovers prefer to assume

considerable risk than do risk-avoiders. The value of goods to be insured compared to insurance

cost is another factor that may force businesses to assume risk, cost-benefit analysis. One also may

think that the risk is so remote that retention is a better alternative. In other situations, some risks

are minor as compared to the size of the business that the business can absorb the loss.

It is important to be aware of the underlying risk if retention is to be adopted (active retention).

This is because the person or the firm, being aware of the risk may take necessary precautions to

finance the probable loss. For example, finds may be set aside for contingencies (self- insurance),

or some form of financial planning would be made to finance the loss. Retention can also happen

because the person is unaware of the risk. Thus, he will take no action (passive retention is

inevitable since it is difficult to identify all the firm’s exposures.

2. Insurance

Here the risk is transferred to an insurance company for a consideration. The insurer normally has

a better knowledge regarding loss prediction and a sound financial resource to accept the risk. He

is also in a better position to get the advantage of the law of large numbers.

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TECHNIQUES OF MANAGING SPECULATIVE RISKS

Speculative risks are handled with information and planning; i.e., careful study and planning. The

following common approaches are used:

Diversification

Diversification is another risk handling tool. Most speculative risks in business can be dealt with

diversification. Businesses diversity 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. It goes with the saying “Don’t put all your eggs in one basket”. Thus a shareholder

can diversify his/her investment by acquiring shares if different companies. A closer look shall

made to determine the kind of diversification and the degree of diversification needed.

Diversification may be achieved in a number of ways:

 Enter new industries through acquisition of an existing business, or create a new

company under the existing corporate umbrella, or enter in to a joint venture for a

venture that is risky to do alone>

 Diversify products within the company’s core business (e.g. baby care products,

disposable diapers, wound care products, feminine hygiene products, surgical and

hospital products, dental products)

 Diversification into any industry where top management spots a good profit opportunity

Hedging

Sensitivity (What If) Analysis

GENERAL GUIDELINE FOR SELECTION OF TOOLS

Type of loss Loss Frequency Loss Severity Appropriate Risk Management Technique

1. Low Low Retention

2. High Low Loss Prevention & Retention

3. Low High Transfer

4. High High Avoidance

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2.3.4. Implementing & Administering the Risk Management Program

At this point, three of the four steps in the risk management process have been discussed. 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. Thus, risk managers are an important part of the management team.

Generally, risk implementation includes

Monitor Triggers, Cues, and Handling

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. Loss records must also be

examined to detect any changes in frequency and severity. In addition, new developments that

affect the original decision on handling a loss exposure must be examined. Finally the risk

manager must determine if the firm’s overall risk management policies are being carried out, and

if the risk manager is receiving the total cooperation of the other departments in carrying out the

risk management function.

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