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Risk Management

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• KEY TRENDS IN RISK MANAGEMENT


• FURTHER READING:

Risk management is the identification, appraisal, and prevention or minimization of


exposures to accidental loss for an organization or individual. Since risk offers not
only the opportunity for growth but also for harm, risk managers must predict and
prevent or control any potential harm. Risk management is essential for companies
to avoid costly mistakes and business losses. The practice of risk management
utilizes many tools and techniques, including insurance, to manage a wide variety
of risks facing any entity, from the largest corporation to the individual. The term
"risk management" has usually referred to property and casualty exposures to loss
but recently has come to include financial risk management, e.g., interest rates,
foreign exchange rates, derivatives, etc.

The term "risk management" is a relatively recent evolution of the term "insurance
management," and originated in the mid-1970s. The reason for this evolution is
that the concept of risk management encompasses a much broader scope of
activities and responsibilities than does insurance management. Risk management
is now a widely accepted description of a discipline within most large companies as
well as a growing number of smaller ones. The myriad risks faced by most
businesses today necessitate a department solely devoted to managing these risks.
Basic risks such as fire, windstorm, flood, employee injuries, and automobile
accidents, as well as more complex exposures such as product liability,
environmental impairment, and employment practices, are the province of the risk
management department in a typical corporation.

These risks stem from various aspects of doing business and they generally fit into
the following categories, according to Kevin Dowd in Beyond Value at Risk:

1. Business risks: risks associated with a company's particular market or


industry.
2. Market risks: risks stemming from changes in market conditions, such as
changes in prices, interest rates, and exchange rates.
3. Credit risks: risks arising from the possibility of not receiving payments
promised by debtors.
4. Operational risks: risks resulting from internal system failures because of
mechanical problems (e.g., machines breaking down) or human errors (e.g.,
poor management of funds).
5. Legal risks: risks stemming from the potential for other parties not to fulfill
their contractual obligations.

Generally, risk managers are insurance brokers who advise clients on insurance and
risk, independent consultants on risk who work for a fee, or salaried employees—
frequently treasurers and chief financial officers (CFOs)—who manage risk for their
companies. Because risk management has become an increasing part of insurance
brokers' responsibilities, many work for fees instead of for commissions.

According to C. Arthur Williams Jr. and Richard M. Heins, authors of Risk


Management and Insurance, the risk management process includes six steps. These
steps are: (1) determining the objective of the organization, (2) identifying
exposures to loss, (3) measuring those same exposures, (4) selecting from
alternative methods of risk management, (5) implementing a method or set of
methods as a solution, and (6) monitoring the results. The objective of an
organization—growth, for example—will determine the strategy for managing
various risks. Identification and measurement are relatively straightforward. The
possibility of an earthquake, for instance, may be identified as a potential exposure
to loss, but if the exposed facility is in New York the probability of an earthquake is
very low and will have a low priority as a risk to be managed.
There are many alternative methods available for the management of risk,
including loss prevention, loss reduction, risk avoidance, and risk financing. Loss
prevention involves preventing a loss from occurring, via such methods as
employee safety training. Loss reduction is concerned with reducing the severity of
a loss, through, for example, the installation of fire sprinklers. While sprinklers will
not prevent fire from occurring, they will reduce the damage it may cause. Risk
avoidance is another available tool for managing risk. An example of this method is
a drug company deciding not to market a drug because of potential liability claims.

Risk managers also may opt to use risk financing, which refers to paying for losses
by retention or transfer. Retention of risk—sometimes referred to as self-insurance
—is the last resort for managing risk. If there is no other way to manage a
particular risk, a company bears the losses resulting from its risks, or retains its
losses. For example, the deductible of an insurance policy is a retained loss. In
addition, companies may establish special funds to cover any losses.

Transferring risk is when the risk is shared by a party other than the company
ultimately responsible for the risk, such as a contractor or a consultant who may
contribute to a company's risk, or by an insurance provider. Companies can transfer
their losses through insurance by obtaining insurance policies that cover various
kinds of risk that are insurable; insurance constitutes the leading method of risk
management. Insurance typically covers property risks such as fire, natural
disasters, and vandalism, liability risks such as employer's liability and workers'
compensation, and transportation risks covering air, land, and sea travel as well as
transported property and transportation liability.

Some companies choose to finance their risk by acquiring insurance companies to


cover all or part of their risks. Such insurance companies are known as "captive
insurers." Awareness of, and familiarity with, various types of insurance policies is
necessary for the risk management process.

Furthermore, risk financing is commonly classified as preloss or postloss financing.


Preloss financing refers to financing secured in anticipation of loss, such as an
insurance policy. Here, companies pay insurance premiums prior to suffering losses.
In contrast, postloss financing is securing funds after losses when companies obtain
financing in response to losses. For example, taking out a loan and
issuing stocks are forms of postloss financing.

In the implementation step, combinations of the above tools may be used. Indeed,
the basic risk management techniques—retention, reduction or avoidance, and
transfer—are complementary and risk managers often must use a variety of
methods to adequately manage a company's risks. The final step, called
monitoring, is necessary to determine if the solution employed actually obtained the
desired result or if that solution requires modification.

KEY TRENDS IN RISK MANAGEMENT

The Risk and Insurance Management Society (RIMS), the primary trade group for
risk managers, predicts that the key areas for risk management in the 21st century
will be operations management, environmental risks, and ethics. RIMS also believes
more small- and medium-size companies will focus on risk management and will
hire risk managers or assign risk management tasks to treasurers or CFOs.

As RIMS predicted, corporate risk managers began concentrating more on ensuring


their companies' compliance with federal environmental regulations during the
1990s. According toRisk Management, risk managers started to assess
environmental risks such as those associated with pollution, waste management,
and environmental liability in order to help companies bolster profitability and
competitiveness. In addition, stricter environmental regulations also prompted
companies to have risk managers review their compliance with environmental
policies to avoid any penalties for failing to comply.

Furthermore, Risk Management indicated that there were five times as many
natural disasters in the 1990s as the 1960s and that insurers paid 15 times what
they paid in the 1960s. For instance, there were a record 600 catastrophes
worldwide in 1996, which caused 12,000 deaths and $9 billion in losses from
insurance. Some experts attribute the increase in natural disasters to global
warming, which they believe will lead to more and fiercer crop damage, droughts,
floods, and windstorms in the future.

The trend towards mergers in the 1990s also affected risk management. More and
more companies called on risk managers to assess the risks involved in these
mergers and to join their merger and acquisition teams. Buyers and sellers both
use risk managers to identify and control risks. Risk managers on the buying side,
for instance, review a selling company's expenditures, insurance policies, loss
experience, and other aspects that could result in losses. After that, they develop a
plan for preventing or controlling the risks they identify.

A final trend in risk management has been the advent of nontraditional insurance
policies, providing risk managers with a new tool for preventing and controlling
risks. These insurance policies cover financial risks such as corporate profits and
currency fluctuation. Consequently, such policies ensure a level of profit even if a
company experiences unexpected losses from circumstances beyond its control,
such as natural disasters or economic problems in other parts of the world. In
addition, they guarantee profits for companies operating in international markets,
preventing losses if a currency appreciates or depreciates.

[Louis J. Drapeau,

updated by Karl Heil]

FURTHER READING:

Dowd, Kevin. Beyond Value at Risk: The New Science of Risk Management. New
York: John Wiley & Sons, Inc., 1998.

Feldman, Paul. "Risk Managers' 'Global' Concerns." Risk Management, June 1998,
64.

Head, George L., and Stephen Horn 11. Essentials of Risk Management. Vols. 1-11.
Insurance Institute of America, 1991.

Katz, David M. "Cost Managers About to Become Asset Managers." National


Underwriter Property and Casualty—Risk and Benefits Management, 2 December
1996.

"New RIMS President Delillo Sees RM Future in Operations, Not Finance." National
Underwriter Property and Casualty—Risk and Benefits Management, 27 April 1998,
3.
Kroll, Karen M. "Covering Non-traditional Risks." Industry Week, I February 1999,
63.

Mills, Evan. "The Coming Storm: Global Warming and Risk Management." Risk
Management, May 1998, 20.

Risk and Insurance Management Society, Inc. "Risk and Insurance Management
Society, Inc. (RIMS) Website." Risk and Insurance Management Society, Inc., 1999.
Available fromwww.rims.org.

Williams, C. Arthur, Jr., and Richard M. Heins. Risk Management and


Insurance. New York: McGraw-Hill, 1989.

Wojcik, Joanne. "Gaining a Higher Profile." Business Insurance, 5 October 1998, 2.