Chapter 2: The risk

management function

Lecturer : Amadeus GABRIEL

BBA4

La Rochelle Business School

Agend
a
• Meaning of Risk Management
• Objectives of Risk Management
• Steps in the Risk Management Process
• Benefits of Risk Management
• Personal Risk Management
• Insurance
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
• A loss exposure is any situation or circumstance in which a
loss is possible, regardless of whether a loss occurs
– E.g., a plant that may be damaged by an earthquake,
or an automobile that may be damaged in a collision
Objectives of Risk Management
• Risk management has objectives before and after a loss
occurs

• Pre-loss objectives: • Post-loss objectives:

– Prepare for potential – Survival of the firm
losses in the most – Continue operating
economical way – Stability of earnings
– Reduce anxiety
– Continued growth of the firm
– Meet any legal
– Minimize the effects that a loss
obligations
will have on other persons and
on society
Risk Management Process
1. Identify potential losses
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

1. ID POTENTIAL LOSSES
2. MEASURE AND ANALYZE LOSS EXPOSURES use past data, own subjective estimations, vertical
and horizontal analysis
3. SELECT classes losses according to frequency & damaga (how often it happens and how it
affects…)
Ex: Low probability of happening and low damage  risk retention (self-insurance insurance is not
worth it (too expensive))
 Steps in the Risk Management Process
Avoidance= eliminate the risk
Loss prevention=____ ex: Security
tools
Loss reduction = when the loss has
already happened (fire extintor (fire
has already started))
Loss duplication= ex: back up in your
data (if you loose your data
Loss separation = ex separate
geographically
Diversification is a technique that
reduces risk by allocating
investments across various financial
instruments, industries, and other
categories. 
If they move in the same direction
Risk retention is an individual
or organization’s decision to
take responsibility for a
particular risk it faces, as
opposed to transferring the
risk over to an insurance
company by purchasing
insurance.
Important Loss Exposures
• Property loss exposures liability

• Liability loss exposures

• Business income loss exposures
• Human resources loss exposures
• Crime loss exposures
• Employee benefit loss exposures
• Foreign loss exposures
• Intangible property loss exposures
• Failure to comply with government rules and regulations
Identifying Loss Exposures
• Risk Managers have several sources of information to
identify loss exposures:
– Risk analysis questionnaires and checklists
Ex for factories (loss exposure of a broken machine)
– Physical inspection
– Flowcharts
– Financial statements Whether there are a potetial loss exposures (financial
statement analysis ratios (quick ratio  ability to meet short
– Historical loss data term liabilities (ex: business cant respond to financial stress)

• Industry trends and market changes can create new loss

exposures.
– e.g., exposure to acts of terrorism
Measure and Analyze Loss
•Exposures
Estimate for each type of loss exposure:
– Loss frequency refers to the probable number of
losses that may occur during some time period
– Loss severity refers to the probable size of the losses
that may occur

• Rank exposures by importance

**Why? Bc it would tell us the worst case
scenario ad we could see if our company ca
deal with this situation or not (stress test)
• Loss severity is more important than loss frequency:
– 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
Kind of more realistic??
Select the Appropriate Combination of
Techniques for Treating the Loss Exposures (1 of 5)

• Risk control refers to techniques that reduce the

frequency and severity of losses
• Methods of risk control include:
– Avoidance
– Loss prevention
– Loss reduction
– Duplication
– Separation
– Diversification
Select the Appropriate Combination of
Techniques for Treating the Loss Exposures (2 of 5)

• Avoidance means a certain loss exposure is never

acquired or undertaken, or an existing loss exposure is
abandoned
– The chance of loss is reduced to zero
– It is not always possible, or practical, to avoid all losses

Chance of loss is 0?
Select the Appropriate Combination of
Techniques for Treating the Loss Exposures (3 of 5)

• Loss prevention refers to measures that reduce the

frequency of a particular loss
– e.g., installing safety features on hazardous products
• Loss reduction refers to measures that reduce the
severity of a loss after it occurs
– e.g., installing an automatic sprinkler system
Select the Appropriate Combination of
Techniques for Treating the Loss Exposures (4 of 5)

• Duplication refers to having back-ups or copies of

important documents or property available in case a loss
occurs
• Separation means dividing the assets exposed to loss to
minimize the harm from a single event
• Diversification means spreading the loss exposure
across different parties, securities, or transactions, to
reduce the chance of loss
 RISK CONTROL
refers to techniques that reduce the frequency and severity of losse
Avoidance means a certain loss exposure is never acquired or
undertaken, or an existing loss exposure is abandoned
• The chance of loss is reduced to zero
• It is not always possible, or practical, to avoid all losses
Loss prevention measures that reduce the frequency of a particular loss
Loss reduction measures that reduce the severity of a loss after it occurs
Duplication having back-ups or copies of important documents or
property available in case a loss occur
Separation dividing the assets exposed to loss to minimize the harm
from a single event
Diversification spreading the loss exposure across different parties,
securities, or transactions, to reduce the chance of loss
 Select the Appropriate Combination of
Techniques for Treating the Loss Exposures (5 of 5)
• Risk financing refers to techniques that provide for the
payment of losses after they occur
• Methods of risk financing include:
– Retention
– Non-insurance Transfers
– Commercial Insurance
RISK FINANCING
Retention firm retains part or all of the losses that can result from a given
loss (Captive insurer, self insurance, RRG)
Non-insurance Transfers method other than insurance by which a pure risk and its
potential financial consequences are transferred to another
party (Contract, leases, hold harmless agreements..)
Commercial Insurance appropriate for low-probability, high-severity
loss exposures
Risk Financing Methods: Retention (1 of 7)
• Retention means that the firm retains part or all of the
losses that can result from a given loss
• Retention is effectively used when:
NORMALLY THE LAST CHOICE
– No other method of treatment is available
– The worst possible loss is not serious
– Losses are highly predictable
• The retention level is the dollar amount of losses that the
firm will retain

Risk Retention — planned acceptance of losses by deductibles, deliberate noninsurance, and loss-sensitive plans
where some, but not all, risk is consciously retained rather than transferred.
 Risk Financing Methods: Retention (2 of 7)
• A risk manager has several methods for paying retained
losses:
– Current net income: losses are treated as current
expenses*
– Unfunded reserve: losses are deducted from a
bookkeeping account
– Funded reserve: losses are deducted from a liquid
fund
– Credit line: funds are borrowed to pay losses as they
occur
*REDUCTION IN PROFIT WHY NOT UNHAPPY TO REDUCE CURRENT NET INCOME? BC YOU PAY LESS TAXES (its treated
as current expenses and the fact that the current income decreases makes you pay less taxes  some companies benefit
from this

≠unfunded and funded???

Credit line you don’t have aything to cover it so you have to open a credit line
Risk Financing Methods: Retention (3 of 7)
• A captive insurer is an insurer owned by a parent firm for
the purpose of insuring the parent firm’s loss exposures
– A single-parent captive is owned by only one parent
– An association or group captive is an insurer owned
by several parents

A "captive insurer" is generally defined as an insurance company that is wholly owned

and controlled by its insureds; its primary purpose is to insure the risks of its owners, and
its insureds benefit from the captive insurer's underwriting profits.

Not easy to find insurance insurance are not willing to cover such a huge damage that’s
why big companies decide to create these.

Ex oil Tank that’s spils

Risk Financing Methods: Retention (4 of 7)
• Reasons for forming a captive include:
– The parent firm may have difficulty obtaining insurance
– To take advantage of a favorable regulatory
environment
– Costs may be lower than purchasing commercial
insurance
– A captive insurer has easier access to a reinsurer
– A captive insurer can become a source of profit

Reinsurance insurance of an insurance (in case of insolvency, big damages,

catastrophic disasters…)
Risk Financing Methods: Retention (5 of 7)
• Premiums paid to a single parent (pure) captive are
generally not income-tax deductible, unless:
– The transaction is a bona fide insurance transaction
– A brother-sister relationship exists
– The captive insurer writes a substantial amount of
unrelated business
– The insureds are not the same as the shareholders of
the captive
• Premiums paid to a group captive are usually income-tax
deductible.
Risk Financing Methods: Retention (6 of 7)
• Self-insurance, or self-funding is a special form of
planned retention by which part or all of a given loss
exposure is retained by the firm
• A risk retention group (RRG) is a group captive that can
write any type of liability coverage except employers’ liability,
workers compensation, and personal lines
– They are exempt from many state insurance laws
Risk Financing Methods: Retention (7 of 7)
Advantages Disadvantages
• Save on loss costs • Possible higher losses
• Save on expenses • Possible higher expenses
• Encourage loss prevention* • Possible higher taxes
• Increase cash flow

* You try the situation not to happen bc you re the one paying in case the risk happens
Risk Financing Methods:
Non-Insurance Transfers (1 of 2)
• A non-insurance transfer is a method other than
insurance by which a pure risk and its potential financial
consequences are transferred to another party
– Examples include: contracts, leases, hold-harmless
agreements

A noninsurance transfer is the transfer of risk from one person or entity to

another by way of something other than a policy of insurance.
Risk Financing Methods:
Non-Insurance Transfers (2 of 2)
Advantages Disadvantages
• Can transfer some • Contract language may be
losses that are not ambiguous, so transfer may
insurable fail
• Less expensive
• If the other party fails to pay,
• Can transfer loss to
firm is still responsible for the
someone who is in a
loss
better position to control
losses • Insurers may not give credit
Plagiarism transfer de risk from the for transfers
publisher to the author
Retailer – producer: if problem with a
product normally the person liable for the
problem
Risk Financing Methods: Commercial
Insurance
• Insurance is appropriate for low-probability, high-severity
loss exposures
– The risk manager selects the coverages needed, and
policy provisions
– A deductible is a specified amount subtracted from the
loss payment otherwise payable to the insured
– In an excess insurance policy, the insurer pays only if
the actual loss exceeds the amount a firm has decided to
retain
– The risk manager selects the insurer, or insurers, to
provide the coverages
Risk Financing Methods:
Insurance (1 of 2)
• The risk manager negotiates the terms of the insurance
contract
• A manuscript policy is a policy specially tailored for the
firm
• The parties must agree on the contract provisions,
endorsements, forms, and premiums
• Information concerning insurance coverages must be
disseminated to others in the firm
• The risk manager must periodically review the insurance
program
Risk Financing Methods:
Insurance (2 of 2)
Advantages Disadvantages
• Firm is indemnified for • Premiums may be costly
losses; can continue to
• Negotiation of contracts
operate
takes time and effort
• Uncertainty is reduced
• The risk manager may
• Firm may receive valuable become lax in exercising
risk management services loss control
• Premiums are income-tax
deductible
Exhibit 3.2 Risk Management Matrix
Market Conditions and the Selection
of Risk Management Techniques
• Risk managers may have to modify their choice of
techniques depending on market conditions in the
insurance markets
• The insurance market experiences an underwriting
cycle
– In a “hard” market, profitability is declining, underwriting
standards are tightened, premiums increase, and toinsurance
Requirements get insured is
hard to obtain
– In a “soft” market, profitability is improving, standards
are loosened, premiums decline, and insurance become
easier to obtain
RIGHT NOW Relative hard mkt: not as easy to get a credit, Interest rates low…
Implement and Monitor the Risk
Management Program (1 of 2)
• Implementation of a risk management program begins with
a risk management policy statement that:
– Outlines the firm’s objectives and policies
– Educates top-level executives
– Gives the risk manager greater authority
– Provides standards for judging the risk manager’s
performance
• A risk management manual may be used to:
– Describe the risk management program
– Train new employees
Implement and Monitor the Risk
Management Program (2 of 2)
• A successful risk management program requires active
cooperation from other departments in the firm
• The risk management program should be periodically
reviewed and evaluated to determine whether the
objectives are being attained
– The risk manager should compare the costs and
benefits of all risk management activities
Benefits of Risk Management
• Enables firm to attain its pre-loss and post-loss objectives
more easily
• A risk management program can reduce a firm’s cost of
risk
• Reduction in pure loss exposures allows a firm to enact an
enterprise risk management program to treat both pure and
speculative loss exposures
• Society benefits because both direct and indirect losses are
reduced
Personal Risk Management
• Personal risk management refers to the identification and
analysis of pure risks faced by an individual or family, and to
the selection of the most appropriate technique(s) for treating
such risks
• The same principles applied to corporate risk management
apply to personal risk management
Scaffold Equipment manufactures and sells scaffolds and ladders that are used by construction
firms. The products are sold directly to independent retailers in the United States. The
company's risk manager knows that the company could be sued if a scaffold or ladder is
defective, and someone is injured. Because the cost of products liability insurance has
increased, the risk manager is considering other techniques to treat the company's loss
exposures. 
a. Describe the steps in the risk management process.
There are four steps in the risk management process: (1) identify major and minor loss
exposures; (2) measure and analyze the loss exposures in terms of loss frequency and loss
severity; (3) select the appropriate technique or combination of techniques for treating the loss
exposures; and (4) implement and monitor the program.

b. For each of the following risk management techniques, describe a specific action using that
technique that may be helpful in dealing with the company's products liability exposure. 
 (1) Avoidance. The firm could discontinue manufacturing certain ladders and scaffolds that
could result in a products liability lawsuit.
(2) Loss prevention. The firm could issue detailed instructions on how the ladders and scaffolds
can be safely used.
(3) Loss reduction. Claims involving injured persons should be promptly investigated.
Procedures for providing immediate medical attention to injured persons should be established.
Such measures can reduce the severity of a loss.
(4) Noninsurance transfers. A hold-harmless agreement could be used by which retailers agree
to hold Scaffold Equipment harmless if someone is injured while using a ladder or scaffold
manufactured by Scaffold Equipment.
 EXERCISE 5
The LR Corporation has 5000 sales representatives and employees France who drive company
cars. The company's risk manager has recommended to the firm's management that the
company should implement a partial retention program for physical damage losses to company
cars. 
a. Explain the advantages of a partial retention program to the Swift Corporation.
b. Identify the factors that the Swift Corporation should consider before it adopts a partial
retention program for physical damage losses to company cars.
c. If a partial retention program is adopted, what are the various methods the Swift
Corporation 
can use to pay for physical damage losses to company cars?
d. d. Identify two risk-control measures that could be used in the company's partial retention
program for physical damage losses.
 5.a) Explain the advantages of a partial retention program to the Swift Corporation.

The following advantages may result from the retention program:

Advantages
• Save on loss costs (insurance): The Corporation can save money if its
actual losses are less than the loss allowance in the insurer's • Save on loss costs
premium.
• Save on expenses
• Save on expenses: There may also be sizable expense savings. • Encourage loss
prevention*
• Encourage loss prevention: Loss prevention is encouraged.
• Increase cash flow
• Cash flow may be increased since the firm can use the funds that
normally would be held by the insured.

• Tax reasons (IS: decreases the current net income because it is

considered as administrative expenses?)

Disadvantages Disadvantages
• Possible higher losses
• Possible higher losses
• Possible higher expenses
• Possible higher expenses  money expent for the loss prevention

• Possible higher taxes • Possible higher taxes

5.b) Identify the factors that the Swift Corporation should consider before it adopts a partial
retention program for physical damage losses to company cars.
FACTORS TO CONSIDER BEFORE ADOPTING PARTIAL RETENTION PROGRAM FOR PHYSHICAL DAMAGES

1. Average frequency and severity of losses

2. Company's past loss experience

3. Dollar amount of losses the firm will retain

4. Added costs of retention (administrative problems)

5. Elements of the premium that could be saved (potential premium savings)

6. Predictability of losses

7. Maximum possible loss and maximum probable loss

8. Tax aspects

9. Availability of excess of loss coverage

10. Availability of other alternatives Check that no other method treatment is available?

11. Whether management is risk adverse

12. Full comparison with expenses insurance etc

5.c) If a partial retention program is adopted, what are the various methods the Swift
Corporation can use to pay for physical damage losses to company cars?

Losses can be paid out of current net income (funded reserve and un funded reserve),
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. Credit line

5.d) Identify two risk-control measures that could be used in the company's partial
retention program for physical damage losses.
Risk control refers to measures that reduce the frequency and severity of losses.
• The company could avoid hiring drivers with poor driving records.  check. Its
background
• The company could also reduce losses by requiring drivers to take a defensive driving
course.
• Increase quality control and inspection of cars

https://quizlet.com/280141028/rmi-370-hw-study-guide-flash-cards/
• Avoidance means a certain loss exposure is never acquired or
undertaken, or an existing loss exposure is abandoned
– The chance of loss is reduced to zero
– It is not always possible, or practical, to avoid all losses

b) Practical or possible? It depends