CHAPTER 2

THE RISK MANAGEMENT

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 2.1: RISK MANAGEMENT DEFINED
Definition 1
Risk Management refers to the identification;
measurement and treatment of exposure to potential
accidental losses almost always in situations where the
only possible outcomes are losses or no change in the
status.
Definition 2
Risk Management is a general management function that
seeks to assess and address the causes and effects of
uncertainty and risk on an organization.
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Definition 3
Risk Management is the executive function of dealing with
specified risks facing the business enterprise.
In general, the risk manager deals with pure, not speculative, risk.
Definition 4
Risk Management is the identification, analysis and economic
control of those risks which can threaten the assets or earning
capacity of an enterprise.
Definition 5
“Risk Management deals with the systematic identification of a
company’s exposure to the risk of loss.”

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Definition 6
RISK MANAGEMENT: is defined as a systematic

process for the identification & evaluation of pure

loss exposures and for the selection and
implementation of the most appropriate techniques
for treating such exposures.
It is a scientific approach to dealing with pure risks.
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 RISK Mgt. Vs. INSURANCE Mgt.
Risk management is a much broader concept than insurance
management.
Risk Mgt.: places greater emphasis on the identification and
analysis of pure loss exposures and techniques for dealing with
these exposures.
Insurance Mgt.: however, is only one of the several methods
that can be used to treat a particular loss exposure.
Risk Mgt. : requires the cooperation of a large number of
individuals and departments
Insurance Mgt. : involves a smaller number of persons.

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 2.2. OBJECTIVES OF RISK MANAGEMENT
 Risk Mgt. has several important objectives that
can be classified into two categories;
1. pre-loss objectives: Includes:-
 Economy, Reduction of anxiety, and Meeting
externally imposed obligations
2. post-loss objectives. Includes:-
Survival, Continue operating, Stability of
earnings, Continued growth of the firm, and
Social responsibility 8
 1. PRE-LOSS OBJECTIVES:
a) ECONOMY:
 The firm should prepare for the potential losses (risks) in
the most economical way possible.
Þ This involves an analysis of safety program expenses, insurance
premiums, and the costs of different techniques for handling losses.
b) THE REDUCTION OF ANXIETY:
 Certain loss exposures can cause greater worry and fear.
However, the risk manager wants to minimize the anxiety
and fear associated with all loss exposures.
 For example, the threat of a catastrophic lawsuit (court case)
from a defective product can cause greater anxiety and concern
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c) MEETING EXTERNALLY IMPOSED
OBLIGATIONS:
This means that the firm must meet certain obligations
imposed on it by outsiders.
 For example, government regulations may require a firm to
install safety devices to protect workers from harm.
 Similarly, a firm’s creditors may require that property
pledged as collateral for a loan must be insured.
Therefore, The risk manager must see that these externally
imposed obligations are met. 10
 2. POST–LOSS OBJECTIVES:
a) SURVIVAL:
 Means that after a loss occurs, the firm can at least
resume (restart) partial operation within some
reasonable period of time.
b) CONTINUE OPERATING:
 For some firms, the ability to operate after a severe
loss is an extremely important objective.
 This is particularly true of certain firms, such as public
utility firm, which must continue to provide service; and also
include banks, bakeries, dairy farms, and other competitive
firms etc…. 11
c) STABILITY OF EARNINGS:
 The firm wants to maintain its earnings per share after
a loss occurs. This objective is closely related to the
objective of continued operations
 There may be substantial costs involved in achieving

this goal and perfect stability of earnings may not be

attained.
d) CONTINUED GROWTH OF THE FIRM:
 A firm may grow by developing new products and
markets or by acquisitions and mergers.
 The risk manager must consider the impact that a loss
will have on the firm’s ability to grow.
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e) SOCIAL RESPONSIBILITY:
The final goal of social responsibility is, to minimize
the impact that a loss has on other persons and on
society.
A sever loss can adversely affect employees, customers,
suppliers, creditors, etc... and the community in general.

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 2.3. THE RISK MANAGEMENT PROCESS
Step 1) Identifying potential loss.
Step 2) Measuring (Evaluating) potential loss.
Step 3) Selecting appropriate techniques for handling
losses.
Risk control techniques: includes
Avoidance, Loss control , Separation/ Diversification,
Combination
Risk financing techniques: includes
Retention/ Assumption, Self-insurance, Non-insurance
transfer, and Insurance
Step 4) Implementing and administering the program.
 STEP 1. IDENTIFYING POTENTIAL LOSSES
Risk identification: is the process by which an organization
is able to learn areas in which it is exposed to risk.
 It is the process by which a business systematically and
continuously identifies loss exposures as soon as or before they
emerge.
Therefore, an important aspect of risk identification is
exposure identification.
THERE ARE FOUR CATEGORIES OF RISK EXPOSURES:
(i) physical asset exposures, (ii) financial asset exposures, (iii)
liability exposures, and (iv) human exposures.
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i. PHYSICAL ASSET EXPOSURES:

 Property may be damaged, destroyed, lost, or

diminished in value in a number of ways.
ii. FINANCIAL ASSET EXPOSURES:

 Ownership of securities such as common stock and

mortgages creates this type of exposure.

 Financial assets may decline in value, b/c of various

market forces.
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 iii. LIABILITY EXPOSURES:
Obligations imposed by the legal system create this type
of exposure.
Civil and criminal law detail obligations carried by
citizens: state and federal legislatures impose statutory
limitations on activities; governmental agencies
promulgate administrative rules and directives that
establish standards of care.
iv. HUMAN ASSET EXPOSURES:
Possible injury or death of managers, employees, or other
significant stakeholders (customers, secured creditors,
stockholders, suppliers) exemplifies this type of exposure. 17
 STEP 2. MEASUREMENT OF POTENTIAL LOSS
Risk measurement refers to the measurement of
potential loss as to its size and the probability of
occurrence.
Evaluation and measurement of potential losses involves
an estimation of the (i) The potential frequency of losses,
and (ii) The potential severity of losses.

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 i. Loss frequency: refers to the probable number of
losses that may occur during some given time
period.
ii. Loss severity: refers to the probable size of the
losses that may occur.
The average loss frequency times the average loss
severity equals the total Birr losses expected in an
average year.

LF X LS = Total birr loss

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 PROUTY MEASURE OF SEVERITY
One of the systems used to measure the severity of risks is
the Prouty measure of severity, suggested by a risk manager
called R. Prouty.
The two measures suggested by prouty are:
i. The maximum possible loss: w/c is the worst loss to
one unit per occurrence, that could possibly happen to
the firm.
ii. The maximum probable loss: w/c is the worst loss to
one unit per occurrence, that is likely to happen.
The maximum probable loss, therefore is usually less than the maximum
possible loss. 20
 PRIORITY RANKING BASED ON SEVERITY
The more severe the losses due to a risk is, the higher the rank.
Under such circumstances, classification of risks are made into
three heads:-
i. Critical risks - Where the magnitude of losses could lead to
bankruptcy.
ii. Important risks - Where the possible losses would not lead to
bankruptcy, but would require to borrow in order to continue
operations.
iii. Unimportant risks - Where the possible losses could be met out of
the existing assets or out of current income, without imposing too
much financial strain.
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 THE CONCEPT OF PROBABILITY
Probability is the body of knowledge concerned with
measuring the likelihood that something will happen; and
making predictions on the basis of this likelihood.
The likelihood of an event is assigned a numerical value
between 0 and 1; with those that are impossible assigned a
value of 0 and those that are inevitable assigned a value of
1.
Thus, in general: 0 ≤ P(A) ≤ 1, where P(A) denotes the
probability that event A will occur in a single observation
or experiment.
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 THE LAW OF LARGE NUMBERS
 States that, as the number of exposure units increase, the
more closely the actual loss experience will approach the
expected loss experience.
Hence, as the number of loss exposure units increases,
objective risk decreases.
Objective risk is defined as the probable variation of
actual from expected losses.
Degree of Objective risk = Actual losses - Expected losses (i.e. Range)
Expected losses

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Example 1:- Assume that ABC company and XYZ company
own 100 and 900 automobiles, respectively. These cars are used by
the sales personnel of each firm and are driven in the same general
geographical territory.
The probability of the loss in a given year due to collision is 20
percent.
Suppose further that statisticians have computed that the likely
range in the number of losses in one year is 8 for ABC and 24 for
XYZ.
Compute the degree of risk?

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Solution :
The expected number of losses is computed as follows;
For ABC = 0.20 × 100 = 20
For XYZ = 0.20 × 900 = 180

Degree of Objective risk=

Probable variation of actual losses from expected losses (i.e. Range)

Expected losses

DOR for ABC = 8/20 = 40 percent

DOR for XYZ = 24/180 = 13.3 percent

In general, the degree of objective risk (loss) decreases on a

relative basis as the number of exposure units increases. 25
Example 2:- Assume that employers A and B, each with 10,000
employees, are concerned about occupational injuries to workers.
Employer A is in a “safe” industry, with the probability of loss of a
disabling injury in its plant being equal to 0.01.
Employer B is in a more dangerous industry, with its probability of
loss equal to 0.25.
It has been determined that the probable variation in injuries in
employer A’s plant will be not more than 20, whereas in employer
B’s plant the probable variation will not exceed 87.
Compute the degree of objective risk for both A&B.

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 DOR for A = 20/(0.01×10,000) = 20/100 = 20 %
DOR for B = 87/(0.25×10,000) = 87/2,500 =3.5%
Although B’s probability of loss is much greater than
A’s, its degree of risk is only 17.5% of A’s risk (3.5 ÷
20 = 0.175).
In general, the degree of objective risk will vary
inversely with the probability of loss for any
constant number of exposure units.

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In summary, the two most important applications of
the law of large numbers in relation to objective risk
are as follows;

1.As the number of exposure units increases, the degree

of risk decreases
2.Given a constant number of exposure units, as the
probability of loss increases, the degree of risk
decreases.

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 STEP 3. TECHNIQUES OF RISK MANAGEMENT
There are two basic approaches.
First, the risk manager can use risk control
measures, which are; Avoidance, loss control,
separation, & combination
Second, the risk manager can use risk financing
measures to finance the losses that do occur. It
includes :- retention/ assumption, self-insurance, non
insurance transfers and Insurance

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 Risk Control Techniques/Measures
Risk control refers to techniques, tools, strategies and
processes that organizations employ to reduce an exposure to
risk.
 Hence, risk control refers to those methods employed to avoid, prevent,
reduce or otherwise control the frequency and / or magnitude of loss or
other undesirable effects of risk.
 These risk control methods are exemplified by security systems to
prevent unauthorized entry or access to data; by sprinklers and
other fire control systems; by training programs to educate
employees on techniques to reduce the likelihood of injury, by the
development and enforcement of codes regulating construction
with the purpose of decreasing the vulnerability of structures to
forces of nature, etc.
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1 ) Risk Avoidance
Risk avoidance involves avoiding the property,
person, or activity giving rise to possible loss; by
either refusing to assume it even momentarily or by
abandoning an exposure to loss assumed earlier.
Risk avoidance involves two activities; a proactive
avoidance that is reflected by refusal to even
momentarily assume the risk and avoidance through
abandonment of an already assumed exposure.

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2. Loss prevention and reduction
Are designed to reduce both loss frequency and
loss severity.
Unlike the avoidance technique, loss prevention
and reduction deals with an exposure that the firm
does not wish to abandon. The firm wishes to
keep the exposure but wants to reduce the
frequency and severity of losses.

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 Loss prevention:
Loss prevention programs seek to reduce the number of
losses or to eliminate them entirely.
E.g. Loss prevention activities that focus on hazard:
hazard Loss prevention activity

Careless house keeping => Training and monitoring

programs
Flooding => dams and water resource management
Smoking => ban on smoking except in restricted areas
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Loss prevention activities that focus on the
environment
Environment Loss prevention
activity
The Addis Ababa ring road -Barrier
construction, lighting
signs and road
markings
Improperly trained work force - Training
Structures susceptible to fire - Fire-resistive
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 Loss reduction:
Loss reduction programs are designed to reduce the potential
severity of a loss.
E.g. the usage of fire extinguishers and sprinklers.
Unlike loss prevention activities that attempt to reduce the
probability of loss, loss reduction activities are post loss
measures or while it is occurring.
One illustration of a loss reduction technique is catastrophe
or contingency planning.
Another possible technique is asset duplication. It reduces
the probability of an indirect loss.

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3. Separation-
Involves isolating exposures to loss from each
other instead of leaving them vulnerable to a
single event.
A common saying that goes, “do not put all
your eggs in one basket” may possibly illustrate
this technique, A firm might store its inventory in
different warehouses than putting them all in a
single ware house.

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4. Combination / Diversification
Combination is increasing the number of exposure units since it is
a pooling process. It reduces risk by making loses more
predictable with a higher degree of accuracy.
In the case of firms, combination results in the pooling of
resources of two or more firms.
For example, a taxicab company may increase its fleet of
automobiles. Combination also occurs when two firms merge or
one acquires another.
Diversification: Businesses diversify their product lines so that a
decline in profit of one product could be compensated by profits
from others
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5. Non-insurance transfers:-
Transfers can be accomplished in two ways:
i. Transfer of the activity or the property. The
property or activity responsible for the risks may be
transferred to some other person or group of persons.
ii. Transfer of the probable loss. The risk, but not the
property or activity, may be transferred.
 E.g. under a lease, the tenant may be able to shift to the
landlord any responsibility the tenant may have for damage
to the landlord’s premises caused by the tenant’s
negligence.
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 RISK FINANCING TECHNIQUES
1. Retention:-
Retention is an arrangement under which the direct
financial consequences of the loss are born by the entity
experiencing the loss itself.
Retention is active (planned), when the risk manager
considers other methods of handing the risk and
consciously decides not to transfer the potential losses.
Retention is passive (unplanned) when the risk
manager unconsciously assume the loss.

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 Payment of losses
i. Out of current income.
ii. Unfunded or funded reserve:
 An unfunded reserve is a bookkeeping account that is charged
with the actual or expected losses from a given exposure. A
funded reserve is the setting aside of liquid funds to pay losses.
iii. Borrow from bank.
iv. Captive insurer: A captive insurer is an insurer established and
owned by a parent firm for the purpose of insuring the parent
firm’s loss exposures.
v. Self-insurance/Self funding - is a special form of planned
retention by which part or all of a given loss exposure is retained
by the firm.
vi. Insurance
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If the risk manager decides to use insurance to treat certain loss
exposures, five key areas must be emphasized.
Selection of insurance coverage
 Essential insurance includes those coverage required by law or by
contract, such as workers compensation insurance.
 Desirable insurance is protection against losses that may cause the

firm financial difficulty, but not bankruptcy.

 Available insurance is coverage for slight losses that would merely

creates inconvenience the firm.

 Selection of an insurer, Negotiation of terms,
 Dissemination of information concerning insurance coverage
 Periodic review of the insurance programs

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 WHICH METHOD SHOULD BE USED?
In determining the appropriate method or methods for
handling losses, a matrix can be used that classifies loss
exposures according to frequency and severity. The
following matrix can be determine which risk
management should be used.
Loss frequency Loss severity Appropriate risk management
technique

Low Low Retention

High Low Loss control and retention
Low High Insurance
High High Avoidance
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4. Implementing and administering the program

A risk management policy statement is necessary in order

to have an effective risk management program.
 This statement outlines the risk management objectives of
the firm, as well as company policy with respect to
treatment of loss exposures.
In addition, a risk management manual may be developed
and used in the program.

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 Cooperation with Other Departments
The risk manager does not work in isolation.
Other functional departments within the firm are
extremely important in identifying pure loss
exposures and method for treating these exposures.
These departments can cooperate in the risk
management process in the following ways

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Accounting: Internal accounting controls can reduce
employee fraud and theft of cash.
Finance: Information can be provided showing how
losses can disrupt profits and cash flow and the impact
that losses will have on the firm’s balance sheet and
profit and loss statement.
Marketing: Accurate packaging can prevent liability
lawsuits. Safe distribution procedures can prevent
accidents.

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Production : Quality control can prevent production of

defective goods and so prevent liability lawsuits.

Adequate safety in the plant can reduce accidents.

Personnel : This department may be responsible for

employee benefit programs, pension programs, and

safety programs

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 PERIODIC REVIEW AND EVALUATION
To be effective, the risk management program must

be periodically reviewed and evaluated to determine if

the risk management objectives are being attained.
In particular, those activities relating to risk

management costs, safety programs, and loss

prevention must be carefully monitored.
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Loss records must also be examined to detect any changes in

frequency and severity.

Moreover, new developments that affect the original decision

on handling a loss exposure must also be examined.

Finally, the risk manager must determine if the firm’s overall

risk management policies are being carried out and if he or she

is receiving the total cooperation of the other departments in
carrying out the risk management functions

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END OF CHAPTER TWO

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