Chapter 3 Introduction to Risk Management

Answers to Review Questions

1. Risk management is defined as a systematic process for the identification and evaluation of pure
loss exposures faced by an organization or individual and for the selection and administration of the
most appropriate technique for treating such exposures.

2. Risk management is broad and covers all potential risks to an organization including non insurable
ones. It involves the employment of a number of management techniques, acquiring insurance being
one of them.
Insurance management, on the other hand, only manages insurable risks, where insurance is the
fundamental technique used to manage these risks.

3. (a) There are four steps in the risk management process:

1. Identify loss exposures
2. Measure and analyze the loss exposures
3. Select the appropriate combination of techniques for treating the loss exposures
4. Implement and monitor the risk management program
(b) Risk identification is considered the most critical step in risk management. Firms need to be careful
in identifying the key risks faced by them. Failure or error in identifying these risks can affect the
entire risk management process and harm the company.

4. The major loss exposure categories are:

(a) Property loss exposures: this includes damage to the company’s public image; loss of goodwill and
market reputation; and loss or damage to intellectual property.
(b) Liability loss exposures: includes defective products and environmental pollution (land, water, air,
noise).
(c) Business income loss exposures: includes loss of income from a covered loss; extra expenses; and
contingent business income losses.
(d) Human resources loss exposures: this includes death or disability of key employees; retirement and
unemployment exposures; and job-related injuries or disease experienced by workers.
(e) Crime loss exposures: includes fraud and embezzlement and Internet and computer crime
exposures.
(f) Employee benefits loss exposures: this includes violation of fiduciary responsibilities and group
life, health, and retirement plan exposures.
(g) Foreign loss exposures: includes acts of terrorism; plants, business property, inventory; foreign
currency and exchange rate risks; and kidnapping of key personnel.
(h) Intangible property loss exposures: includes damage to the company’s public image.
(i) Failure to comply with government laws and regulations.

5. (a) Risk control refers to techniques that reduce the frequency and severity of accidental losses.
Specific techniques are avoidance, loss prevention, and loss reduction.
(b) (1) Avoidance means that a loss exposure is never acquired, or an existing loss exposure is
abandoned. The major advantage of avoidance is that the chance of loss is zero if the loss exposure is
never acquired. However, abandonment may still leave the firm with a residual liability exposure from
the sale of previous products.
(2) Loss prevention refers to measures that reduce the frequency of a particular loss. For
example, measures that reduce lawsuits from defective products include installation of safety features
on hazardous products, warning labels on dangerous products, and quality control checks.
(3) Loss reduction refers to measures that reduce the severity of a loss after it occurs.
Examples include installation of an automatic sprinkler system, rehabilitation of injured
workers with job-related injuries, and limiting the amount of cash on the premises.
Chapter 3 Introduction to Risk Management

(4) Duplication refers to having back-ups or copies of important documents or property

available in case a loss occurs. Examples include back-up copies of key business records (e.g.,
accounts receivable) in case the original records are lost or destroyed.
(5) Separation means dividing the assets exposed to loss to minimize the harm from a single
event. For example, .a manufacturer may store finished goods in two warehouses in different
cities.
(6) Diversification refers to reducing the chance of loss by spreading the loss exposure
across different parties (e.g., customers and suppliers), securities (e.g., stocks and bonds),or
transactions. For example, having different customers and suppliers reduces risk.

6. (a) Risk financing refers to techniques that provide for the funding of losses after they occur.
Specific risk financing techniques include retention, noninsurance transfers, and insurance.
(b) (1) Retention means that the firm retains part or all of the loss that can result from a given loss
exposure. Retention can be active or passive. Active risk retention means that the firm is aware of the
loss exposure and plans to retain part or all of it. Passive risk retention, however, is the failure to
identify a loss exposure, failure to act, or forgetting to act.
(2) Noninsurance transfers are methods other than insurance by which a pure risk and its
potential financial consequences are transferred to another party. Examples include contracts, leases,
and hold-harmless agreements.
(3) Commercial insurance can also be used to fund losses. Insurance is appropriate for loss
exposures that have a low probability of loss but the severity of loss is high.

7. The advantages of the retention technique of risk financing are:

(a) Saving on loss costs.
(b) Saving on expenses.
(c) Encouraging loss prevention.
(d) Increase in cash flow. Cash flow may be increased because the firm can use some of the
funds that would normally be paid by the insurer at the beginning of the policy period.
The disadvantages of retention technique include:
(a) 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 the insurance, and there
may be greater volatility of the firm’s losses in the short run.
(b) Possible higher expenses. Experts such as safety engineers and claims administrators may
have to be hired separately.
(c) Possible higher taxes. Contributions to a funded reserve under a retention program are not
usually income tax-deductible.

8. (a) Uncertainty regarding the ongoing existence of the insurer; commercial insurers unwillingness to
fund claims; and commercial insurers' extensive policy exclusions are some reasons why captive
insurance companies are formed.
(b) A single parent captive is an insurance subsidiary that provides insurance to cover the loss
exposures of its parent company and a group captive is one that is owned by a number of different
parent companies, who are normally from the same industry.

9. (a) Self-insurance is a special form of planned retention by which part or all of a given loss exposure
is retained by the firm.
(b) A risk retention group is a group captive that can write any type of liability coverage except
employer liability, workers compensation, and personal lines. For example, a group of physicians may
form a risk retention group to obtain malpractice insurance because professional liability insurance is
difficult to obtain or too expensive to purchase.
Chapter 3 Introduction to Risk Management

10. For example, as discussed in the chapter, one matrix classification used to determine the
appropriate technique or techniques for handling loss exposures is attributed to Prouty. The matrix is
illustrated as follows:

Loss Frequency
Almost Nil Slight Moderate Definite
Severe Transfer Reduce/Prevent Reduce/Prevent Avoid
Loss Severity Significant Retain Transfer Reduce/Prevent Avoid
Slight Retain Transfer Prevent Prevent

Application Questions

1. Kind Sicherheit can apply the risk control techniques listed below to manage his company’s loss
exposure:
(a) Avoidance. Avoidance implies that a certain loss exposure is never acquired or undertaken, or an
existing loss exposure is abandoned. The firm could discontinue manufacturing certain car seats and
strollers which could then result in a product liability lawsuit.
(b) Loss prevention. Loss prevention refers to applying measures that reduce the frequency of a
particular loss. For example, Kind Sicherheit could install extra safety locking mechanisms on their
strollers, conduct additional quality-control checks, issue detailed instruction manuals on how the car
seats and strollers can be used safely, and place warning labels that remind customers to install their
car seats and strollers properly.
(c) Loss reduction. Loss reduction refers to applying measures that reduce the severity of a loss after it
occurs. Shock absorption mechanism could be applied to products and claims involving injured
persons be promptly investigated. Such measures can reduce the severity of a loss.

2. (a) The following factors should be considered while partially retaining collision loss exposures:
(1) Whether other methods of treatment are available. If the exposure cannot be insured or
transferred, only then it must be retained.
(2) If the worst possible loss is serious. Retention would be more effective if the worst
possible loss were not serious.
(3) Whether the losses are fairly predictable. Risk managers can estimate a probable range of
frequency and severity of actual losses based on past experience. If most losses fall within that
range, they can be paid out of the company’s income.
(b) Losses can be paid out of the company’s current net income, earmarked assets, funds borrowed
from commercial lenders, or payment from a captive insurer if a captive insurer has been established.
Losses in excess of the retention levels can be paid by commercial insurance.
(c) Risk control refers to the measures that reduce the frequency and severity of losses. The company
could avoid renting cars to drivers with poor driving records. It could also reduce losses by requiring
drivers to take a defensive driving course.

3. (a) The major advantage of avoidance is that the chance of loss is reduced to zero if the loss
exposure is never acquired. Also, 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.
(b) It is not feasible or practical for a firm to avoid all potential losses. Some losses will occur in the
normal operations of the firm’s business. For example, a paint factory can avoid fire and explosion
losses arising from the production of paint by not manufacturing paint. Without paint production,
however, the firm will not be in business.

4. (a) A risk management policy statement offers several advantages to a firm. The policy statement is
necessary to have effective administration of the risk management program. The policy statement
states the risk management objectives of the firm and the company’s policy with respect to treatment
of loss exposures. Also, the risk management policy statement has the advantage of educating top-
Chapter 3 Introduction to Risk Management

level executives about the risk management process. In addition, the written policy statement enables
the risk manager to have greater authority throughout the firm. Finally, the policy statement provides a
standard for judging the risk manager’s performance.
(b) Other departments that are important in a risk management program are accounting, finance,
marketing, production, and human resources.

5. (a) A personal risk management program has the following steps:

• Identify loss exposures
• Analyze the loss exposures
• Select appropriate techniques for treating the loss exposures
• Implement and review the program periodically
(b) (1) Major personal loss exposures include the following:
• The premature death of James or Emily and the subsequent loss of financial support to the
surviving family members
• Insufficient income and financial assets once James or Emily retire
• Loss of income earned if James or Emily are unemployed
• Loss of income earned during an extended period of disability of James or Emily
• Catastrophic medical bills incurred by any family member
• Identity theft

(2) Major property loss exposures include the following:

• Direct physical damage to their home and personal property because of fire, lightning,
windstorm, flood, earthquake, or other causes
• Indirect losses resulting from direct physical damages, including extra expenses, moving to
another apartment during a period of renovation, and loss of ownership of the property
• Theft of valuable personal property, including their furniture, cars, computers, and other
valuables
• Residing in an area where the crime rate is rising, which increases the probability of theft or
robbery

(3) Major liability loss exposures include the following:

• Legal liability arising out of the operation of a family car by family members
• Legal liability arising out of the use of a rental car by Emily when she is traveling
• Legal liability arising out of other activities by the family members that can result in bodily
injury or property damage to others
• Payment of attorney fees and other legal defense costs
(d) The risk management techniques listed below should be considered:
(1) Avoidance. For example, the family members could avoid legal liabilities that might result
from operating cars by not owning or renting cars at all.
(2) Risk control. For personal loss exposures, risk control could be exercised by practicing
healthy lifestyle habits. For property loss exposures, the family could reduce the chance of
legal liabilities arising out of operating cars by driving within the speed limit, taking a safe
driving course, or driving defensively. Car and other property thefts could be prevented by
locking the car, removing the keys from the ignition, installing anti-theft devices on their cars
and at their apartment, and not leaving laptops and other computers unattended while
traveling. The severity of such losses can also be reduced by wearing a seat belt while driving
and having a fire extinguisher on the premises.
(3) Insurance. James and Emily should purchase adequate life insurance and disability income
insurance to deal with the risk of premature death and total disability. Health insurance will
help them deal with the risk of catastrophic medical bills. They should have homeowner’s
insurance and auto insurance to cover the physical damage and theft of household property and
Chapter 3 Introduction to Risk Management

cars. Their auto legal liability insurance should insure the legal liability arising out of the
negligent operation of a family car by the family members.