CHAPTER 2

FUNDAMENTALS OF RISK
MANAGEMENT

Mahdzan & Boey 2015

Learning Outcomes
 Explain the meaning of risk management
 Discuss the objectives of risk management.
 Review the steps in the risk management
process.
 Provide examples of how risk management
benefits businesses and individuals.

Mahdzan & Boey 2015

1.0 What is Risk management?
The process of identifying, assessing and
prioritizing potential losses faced by individuals and
businesses, and determining the most suitable
methods in dealing with those loss exposures.

Mahdzan & Boey 2015

2.0 Objectives of risk management
a) Minimizing the cost of risk
• Risk: the variability of outcomes from expected return.
• Management of risk- involves cost.
• The greater the risk, the greater the risk management costs.
• Components of cost of risks:
(i) Expected losses
(ii) Loss control
(iii) Loss financing
(iv) Internal risk reduction
(v) Cost of residual uncertainty

Mahdzan & Boey 2015

2.0 Objectives of risk management
b) Maximizing the firm’s value
Managers must understand the magnitude of risk, the costs in
dealing with risk and their impact on the value of the firm.
Value of a firm
without risk a : Value without risk
a b : Value with risk
c : Cost of risk
c

Value of a firm with

risk
b

Figure 1: Conceptual illustration of the value of a firm with and without risk

Mahdzan & Boey 2015

2.0 Objectives of risk management
c) Pre-loss objective
Considered by individuals or firms before a loss occurs.
Include:
1. Cost-benefit advantages: The cost of a risk management
program should commensurate the benefits derived
from it
2. Peace of mind: To minimize fear, stress and anxiety
3. Fulfillment of legal obligations: Aware of and abide to
mandatory legal requirements in relation to risk
management set by the government.
◦ E.g. : SOCSO

Mahdzan & Boey 2015

2.0 Objectives of risk management
d) Post-loss objective
Need to be met after a loss occurs.
Objectives :-
1. Survival of the firm
2. Continuous operations
3. Regular income
4. Steady growth
5. Social accountability

Mahdzan & Boey 2015

3.0 The Risk Management Process
1. Identify
potential losses

5. Monitor the risk

2. Evaluate the
management
potential losses
program

4. Implement the 3. Select a risk

risk management management
methods technique

Figure 2: Risk management process

Mahdzan & Boey 2015

3.0 The Risk Management Process

1. Identify potential losses

• Process begins with identification of all potential losses.
• E.g.: losses to physical assets, intangible assets, business
income, human resources and liability losses.

2. Evaluate the potential losses

To estimate :-
• Severity of losses - the magnitude of the losses.
• Frequency of the losses - the number of potential occurrence
of loss within a certain period of time.

Mahdzan & Boey 2015

3.0 The Risk Management Process
3. Determine a suitable risk management technique
The most appropriate risk management technique can be chosen
for each of the risk.
Methods: risk control, risk financing & internal risk reduction
• Risk avoidance
Risk control • Risk prevention
• Risk reduction

• Risk retention
Risk Financing • Insurance
• Non-insurance transfers

Internal Risk • Diversification

reduction • Research on risk

Figure 3: Risk management methods

Mahdzan & Boey 2015
3.0 The Risk Management Process
I. Risk control
Limit the frequency or severity of losses.
Types:
1. Risk Avoidance: people try to evade the exposure to loss
and/or totally abandon existing loss exposures.
2. Risk Prevention: actions that affect the frequency of
losses.
3. Risk Reduction: actions that aim to reduce the severity of
losses.

Mahdzan & Boey 2015

 3.0 The Risk Management Process
II. Risk financing

Require certain amount of funds to finance the risk management

method.
Types:
i) Risk retention: firms or individuals retain some or all of the
losses incurred, and can either be passive or active.
◦ Passive risk retention: the firm had failed to identify all risk
exposures.
◦ Active risk retention: firms consciously know about risks but
has decided to retain it entirely or partially.
Mahdzan & Boey 2015
3.0 The Risk Management Process
ii) Insurance
• Contractual transfer of risk from one party to another
(insurance company/insurer) for the exchange of a certain
sum of money (premiums).
• Insurance policy: state the terms and conditions under which
the compensation will be payable.
iii) Noninsurance transfers
Ways to transfer risk apart from insurance policies.
E.g. : warranty extensions

Mahdzan & Boey 2015

 3.0 The Risk Management Process
III. Internal Risk Reduction
Diversification
Varying the types of activities and investments in a portfolio

 Research
• Conduct its own research or engage in the services of a risk
management consultant to produce better forecasts of risk
probabilities.
• E.g.: a firm could internally conduct research or even engage in
services of risk management consultant

Mahdzan & Boey 2015

3.0 The Risk Management Process
4. Determining a suitable risk management method
Recommended technique:
• Risk management matrix - determine which risks have
high or low frequencies, and which have high or low
severity.
• Risk rating matrix - categorizes the severity and
frequency of loss in a more detailed manner.

Mahdzan & Boey 2015

3.0 The Risk Management Process

Risk prevention & Risk avoidance

High
retention
(4)
(2)
Frequency

Risk retention Risk transfer

Low

(1) (3)

Low High
Severity

Figure 4: Risk management matrix

Mahdzan & Boey 2015

3.0 The Risk Management Process
Likelihood of the loss (Frequency)

Impact of Almost
Rare Unlikely Possible Likely
the loss Certain
(Severity)
Catastrophic
Moderate Moderate High Critical Critical
Major
Low Moderate Moderate High Critical
Moderate
Low Moderate Moderate Moderate High
Minor
Very low Low Moderate Moderate Moderate
Insignificant
Very low Very low Low Low Moderate

Table 1: Risk rating matrix

Mahdzan & Boey 2015

3.0 The Risk Management Process

4. Implement the risk management methods

Develop a documentation to provide a policy statement on
the risk management objectives of the firm, identify the
potential risks and severity of losses, map out each of the
risks with the appropriate risk management methods, and
the costs involved.
Shared with top-level management:
 awareness on the potential risks

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 3.0 The Risk Management Process

5. Monitor the risk management program

Regular monitoring of the program.
Must assess the losses that have occurred in terms of its actual
frequency and financial impact, and to determine the
appropriateness of the risk management techniques already
implemented.

Mahdzan & Boey 2015

4.0 Benefits of Risk Management
Increase profits
Reduces the probabilities of losses- maximize profits.
Reduce uncertainties
Increases the firm’s ability to respond effectively to various
circumstances.
Strengthen relationship between departments
Common focus and objective to be achieved.

Mahdzan & Boey 2015

 4.0 Benefits of Risk Management
Improves stakeholder’s confidence
Promotes continuous improvements in regards to safeguarding
the firm’s assets and implementation of best practices.
Aligned with long term business plans
Supports the strategic and business planning of a firm.
Protects the organization’s reputation and public image
Prepared to face potential risks, increasing its reputation and
public image.

Mahdzan & Boey 2015

4.0 Benefits of Risk Management
Enhances compliance with relevant requirements
 Promotes efficient and effective activities
Protects people from danger
 Includes activities that control loss.
Happy working environment
 Employees will feel secure knowing that their
workplace is safe with appropriate risk management
plan enforced.

Mahdzan & Boey 2015