INTRODUCTION TO RISK MANAGEMENT

MEANING OF RISK MANAGEMENT

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 actually
occurs. In the past, risk managers generally considered only pure loss exposures faced by the firm.
However, new forms of risk management are emerging that consider both pure and speculative loss
exposures. This chapter discusses only the traditional treatment of pure loss exposures.

OBJECTIVES OF RISK MANAGEMENT

Risk management has important objectives. These objectives can be classified as follows:
1 ■ Pre-loss objectives ■ 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 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
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.

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. 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. Finally,
the objective of social responsibility is to minimize the effects that a loss will have on other persons and
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.
 STEPS IN THE RISK MANAGEMENT PROCESS
There are four steps in the risk management process.
■ Identify loss exposures
■ Measure and analyze the loss exposures
■ Select the appropriate combination of techniques for treating the loss exposures
■ Implement and monitor the risk management program
Each of these steps is discussed in some detail in the sections that follow.
Steps in the Risk Management Process

Identify Loss Exposures

The first step in the risk management process is to identify all major and minor loss exposures. This step
involves a painstaking review of all potential losses.
Important loss exposures include the following:
1. Property loss exposures
■ Building, plants, other structures
■ Furniture, equipment, supplies
■ Computers, computer software, and data
■ Inventory
■ Accounts receivable, valuable papers, and
records
■ Company vehicles, planes, boats, and mobile
Equipment

2. Liability loss exposures

■ Defective products
■ Environmental pollution (land, water, air, noise)
■ Harassment of employees, employment discrimination, wrongful termination, and
failure to promote
■ Premises and general liability loss exposures
■ Liability arising from company vehicles
■ Misuse of the Internet and e-mail transmissions
■ Directors’ and officers’ liability suits

3. Business income loss exposures

■ Loss of income from a covered loss
■ Continuing expenses after a loss
■ Extra expenses

4. Human resources loss exposures

■ Death or disability of key employees
■ Retirement or unemployment exposures
■ Job-related injuries or disease experienced by workers

5. Crime loss exposures

■ Holdups, robberies, and burglaries
■ Employee theft and dishonesty
■ Fraud and embezzlement
■ Internet and computer crime exposures
■ Theft of intellectual property

6. Employee benefit loss exposures

■ Failure to comply with government regulations
■ Violation of fiduciary responsibilities
■ Failure to pay promised benefits
 7. Foreign loss exposures
■ Acts of terrorism
■ Plants, business property, inventory
■ Foreign currency and exchange rate risks
■ Kidnapping of key personnel
■ Political risks

8. Intangible property loss exposures

■ Damage to the company’s public image
■ Loss of goodwill and market reputation
■ Loss or damage to intellectual property
9. Failure to comply with government laws and Regulations
A risk manager can use several sources of information to identify the preceding loss exposures.
They include the following:
■ Risk analysis questionnaires and checklists
Questionnaires and checklists require the risk manager to answer numerous questions that identify major
and minor loss exposures.
■ Physical inspection
A physical inspection of company plants and operations can identify major loss exposures.
■ Flowcharts
Flowcharts that show the flow of production and delivery can reveal production and other areas where a
loss can have severe financial consequences for the firm.
■ Financial statements
Analysis of financial statements can identify the major assets that must be protected, loss of income
exposures, and key customers and suppliers.
■ Historical loss data.
Historical loss data can be invaluable in identifying major loss exposures. In addition, risk managers must
keep abreast of industry trends and market changes that can create new loss exposures and cause concern.
Protection of company assets and personnel against acts of terrorism is another important issue.

Measure and Analyze the Loss Exposures

The second step is to measure and analyze the loss exposures. It is important to measure and
quantify the loss exposures in order to manage them properly.
 This step requires an estimation of the frequency and severity of loss. Loss frequency refers to the
probable number of losses that may occur during some given time period. Loss severity refers to the
probable size of the losses that may occur.
Once the risk manager estimates the frequency and severity of loss for each type of loss
exposure, the various loss exposures can be ranked according to their relative importance.
In addition, the relative frequency and severity of each loss exposure must be estimated so that
the risk manager can select the most appropriate technique, or combination of techniques, for handling
each exposure.
Although the risk manager must consider both loss frequency and loss severity, severity is more
important because a single catastrophic loss could destroy the firm. Therefore, the risk manager must also
consider all losses that can result from a single event. Both the maximum possible loss and probable
maximum loss must be estimated. The maximum possible loss is the worst loss that could happen to the
firm during its lifetime. The probable maximum loss is the worst loss that is likely to happen.
Catastrophic losses are difficult to predict because they occur infrequently. However, their
potential impact on the firm must be given high priority. In contrast, certain losses, such as physical
damage losses to vehicles, occur with greater frequency, are usually relatively small, and can be predicted
with greater accuracy.

Select the Appropriate Combination of Techniques for Treating the Loss Exposures
The third step in the risk management process is to select the appropriate combination of
techniques for treating the loss exposures. These techniques can be classified broadly as either risk control
or risk financing. Risk control refers to techniques that reduce the frequency or severity of losses. Risk
financing refers to techniques that provide for the funding of losses. Risk managers typically use a
combination of techniques for treating each loss exposure.

Risk Control
As noted above, risk control is a term to describe techniques for reducing the frequency or severity of
losses. Major risk-control techniques include the following:
■ Avoidance ■ Loss prevention ■ Loss reduction

Avoidance
Avoidance means a certain loss exposure is never acquired or undertaken, or an existing loss exposure is
abandoned. For example, flood losses can be avoided by building a new plant on high ground, well above
a floodplain. A pharmaceutical firm that markets a drug with dangerous side effects can withdraw the
drug from the market to avoid possible legal liability.
The major advantage of avoidance is that the chance of loss is reduced to zero if the loss exposure is
never acquired. In addition, if an existing loss exposure is abandoned, the chance of loss is reduced or
eliminated because the activity or product that could produce a loss has been abandoned.
Avoidance has two major disadvantages. First, the firm may not be able to avoid all losses. For example,
a company may not be able to avoid the premature death of a key executive. Second, it may not be
feasible or practical to avoid the exposure. For example, a paint factory can avoid losses arising from the
production of paint. Without paint production, however, the firm will not be in business.
Loss Prevention
Loss prevention refers to measures that reduce the frequency of a particular loss. For example, measures
that reduce truck accidents include driver trainingand strict enforcement of safety rules. Measures that
reduce lawsuits from defective products include installation of safety features on hazardous products and
placement of warning labels on dangerous products.

Loss Reduction
Loss reduction refers to measures that reduce the severity of a loss after it occurs. Examples include
installation of an automatic sprinkler system that promptly extinguishes a fire; segregation of exposure
units so that a single loss cannot simultaneously damage all exposure units, such as having warehouses
with inventories at different locations; rehabilitation of workers with job-related injuries; and limiting the
amount of cash on the premises.
Risk Financing
As stated earlier, risk financing refers to techniques that provide for the payment of losses after they
occur. Major risk-financing techniques include the following:
■ Retention ■ Noninsurance transfers ■ Commercial insurance

Retention
Retention means that the firm retains part or all of the losses that can result from a given loss. Retention
can be either active or passive. Active risk retention means that the firm is aware of the loss exposure and
consciously decides to retain part or all of it, such as collision losses to a fleet of company cars. Passive
retention, however, is the failure to identify a loss exposure, failure to act, or forgetting to act. For
example, a risk manager may fail to identify all company assets that could be damaged in an earthquake.
Retention can be effectively used in a risk management program under the following conditions.
■ No other method of treatment is available. Insurers may be unwilling to write a certain type of
coverage, or the coverage may be too expensive. Also, noninsurance transfers may not be available. In
addition, although loss prevention can reduce the frequency of loss, all losses cannot be eliminated. If the
exposure cannot be insured or transferred, then it must be retained.
■ The worst possible loss is not serious.
■ Losses are fairly predictable. Retention can be effectively used for workers compensation claims and
physical damage losses to cars. Based on past experience, the risk manager can estimate a probable range
of frequency and severity of actual losses. If most losses fall within that range, they can be paid out of the
firm’s income.
Determining Retention Levels
If retention is used, the risk manager must determine the firm’s retention level, which is the dollar
amount of losses that the firm will retain. A financially strong firm can have a higher retention level than
one whose financial position is weak.
Although a number of methods can be used to determine the retention level, only two methods are
summarized here. First, a corporation can determine the maximum uninsured loss it can absorb without
adversely affecting the company’s earnings. One rough rule is that the maximum retention can be set at 5
percent of the company’s annual earnings before taxes from current operations.
Second, a company can determine the maximum retention as a percentage of the firm’s net working
capital—for example, between 1 and 5 percent. Net working capital is the difference between a
company’s current assets and current liabilities

Paying Losses
If retention is used, the risk manager must have some method for paying losses. The following methods
are typically used;

■ Current net income

The firm can pay losses out of its current net income and treat losses as expenses for that year. A large
number of losses could exceed current income, however, and other assets may have to be liquidated to
pay losses.

■ Unfunded reserve
An unfunded reserve is a bookkeeping account that is charged with actual or expected losses from a given
exposure.

■ Funded reserve. A funded reserve is the setting aside of funds to pay losses. A self- insurance
program that is funded is an example of a funded reserve. However, if not required to do so, many
businesses do not establish funded reserves because the funds may yield a higher return by being used
elsewhere in the business.

■ Credit line. A credit line can be established with a bank, and borrowed funds may be used to pay
losses as they occur.

Captive Insurer
Losses can also be paid by a captive insurer. A captive insurer is an insurer owned by a parent firm for the
purpose of insuring the parent firm’s loss exposures. There are different types of captive insurers. A
single parent captive (also called a pure captive) is an insurer owned by only one parent, such as a
corporation. An association or group captive is an insurer owned by several parents. For example,
corporations that belong to a trade association may jointly own a captive insurer.
Captive insurers are formed for several reasons, including the following:

■ Difficulty in obtaining insurance

The parent firm may have difficulty obtaining certain types of insurance from commercial
insurers, so it forms a captive insurer to obtain the coverage

■ Lower costs
Forming a captive may reduce insurance costs because of lower operating expenses, avoidance of
an agent’s or broker’s commission, and retention of interest earned on invested premiums and
reserves that commercial insurers would otherwise receive.
 ■ Easier access to a reinsurer
A captive insurer has easier access to reinsurance because reinsurers generally deal only with
insurance companies, not with insureds. A parent company can place its coverage with the
captive, and the captive can pass the risk to a reinsurer.

■ Formation of a profit center

A captive insurer can become a source of profit if it insures other parties as well as the parent
firm and its subsidiaries. It should be noted that there are costs involved in forming a captive
insurance company and that this option is not feasible for many organizations. A firm is putting
its capital at risk when it insures through its captive.

Self-Insurance
Self-insurance is widely used in risk management programs. Self-insurance is a special form of
planned retention by which part or all of a given loss exposure is retained by the firm. Another
name for self-insurance is self-funding. For example, self-insurance is widely used in workers
compensation insurance.
Finally, self-insured plans are typically protected by some type of stop-loss limit that caps the
employer’s out-of-pocket costs once losses exceed certain limits. For example, an employer may
self-insure workers compensation claims up to $1 million and purchase excess insurance for the
amount exceeding $1 million.

Advantages and Disadvantages of Retention

The risk retention technique has both advantages and disadvantages in a risk management program. The
major advantages are as follows:
■ Save on loss costs The firm can save money in the long run if its actual losses are less than the
loss component in a private insurer’s premium.
■ Save on expenses The services provided by the insurer may be provided by the firm at a lower
cost.
■ Encourage loss prevention Because the exposure is retained, there may be a greater incentive
for loss prevention.
■ Increase cash flow Cash flow may be increased because the firm can use some of the funds
that normally would be paid to the insurer at the beginning of the policy period.
The retention technique, however, has several disadvantages:
■ Possible higher losses The losses retained by the firm may be greater than the loss allowance
in the insurance premium that is saved by not purchasing insurance.
■ Possible higher expenses Expenses may actually be higher. Outside experts such as safety
engineers may have to be hired. Insurers may be able to provide risk control and claim services at
a lower cost.
 ■ Possible higher taxes Income taxes may also be higher. The premiums paid to an insurer are
immediately income-tax deductible. However, if retention is used, only the amounts paid out for
losses are deductible, and the deduction cannot be taken until the losses are actually paid.

Noninsurance Transfers
Noninsurance transfers are another risk-financing technique. Noninsurance transfers are methods other
than insurance by which a pure risk and its potential financial consequences are transferred to another
party. Examples of noninsurance transfers include contracts and hold-harmless agreements. For example,
a company’s contract with a construction firm to build a new plant can specify that the construction firm
is responsible for any damage to the plant while it is being built. For example, a publishing firm may
insert a hold-harmless clause in a contract, by which the author, not the publisher, is held legally liable if
the publisher is sued for plagiarism.
In a risk management program, noninsurance transfers have several advantages:
■ The risk manager can transfer some potential losses that are not commercially insurable.
■ Noninsurance transfers often cost less than insurance.
■ The potential loss may be shifted to someone who is in a better position to exercise loss control.

Insurance
Commercial insurance is also used in a risk management program. Insurance is appropriate for loss
exposures that have a low probability of loss but the severity of loss is high. If the risk manager uses
insurance to treat certain loss exposures, five key areas must be emphasized:

Advantages of Insurance
The use of commercial insurance in a risk management program has certain advantages.
■ The firm will be indemnified after a loss occurs.
■ Uncertainty is reduced, which permits the firm to lengthen its planning horizon. Worry and fear
are reduced for managers and employees, which should improve performance and productivity.
■ Insurers can provide valuable risk management services

Disadvantages of Insurance
The use of insurance also entails certain disadvantages and costs
■ The payment of premiums is a major cost
■ Considerable time and effort must be spent in negotiating the insurance coverages.
■ The risk manager may have less incentive to implement loss-control measures because the
insurer will pay the claim if a loss occurs. Such a lax attitude toward risk control could increase
the number of noninsured losses as well.
Which Technique Should Be Used?
In determining the appropriate technique or techniques for handling loss exposures, a matrix can
be used that classifies the various loss exposures according to frequency and severity. This matrix
can be useful in determining which risk management.

Risk Management Matrix

Type Loss Loss Risk Management

of Frequency Severity Technique
Loss Appropriate
1. Low Low Retention
2. High Low Loss prevention and
retention
3. Low High Transfer

4. High High Avoidance