Download TOPIC 3

TOPIC 3
Risk Management 1:
Essentials
Risk Management
• It is defined as the logical
development and execution of a plan
to deal with potential losses.
• The focus of RM program is to
manage an organisation’s exposure to
accidental losses, and to protect
assets.
• RM benefits all types of organizations
facing potential losses, including
business firms, nonprofit
organizations, individuals and firms.
The Risk Management Function
• It is carried out by trained specialists:
 Loss Control Engineer, Attorneys, Accountants and
Risk Management Staff.
• Risk Management Staff:
 Insurance Experts: to work with insurance brokers in
purchasing and renewing the organisation’s commercial
insurance and reinsurance.
 Claim Managers: track and process claims from the
time of loss until the insurer responds with payment
 Loss Control Engineer: manage losses arasing from
employee injuries, environmental pollution, defective
products
 Financial Analyst: Risk Financing to control
organisation’s profitability.
RIMS
• The Risk and Insurance Soceity RIMS, is a professional
organisation for risk managers.
• RIMS recently reported 4500 different profit and
nonprofit organisations including 90% of the nation’s
1500 largest corporation as member.
• RIMS helps risk managers stay alert to new problems
and possible solutions through educational classes,
publications such as monthly journals and computer
networks.
Objectives of Risk Management
• Risk management has objectives before and after a loss
occurs
• Pre-loss objectives:
– Prepare for potential losses in the most economical
way
– Reduce anxiety
– Meet any legal obligations
Objectives of Risk Management contn’d...
• Post-loss objectives:
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Ensure survival of the firm
Continue operations
Stabilize earnings
Maintain growth
Minimize the effects that a loss will have on other
persons and on society
Statement of Objectives and Principles
 A statement of principles and procedures designed to achieve the
following objectives:
• Survival: The risk manager is to make sure that the organization can
survive.
• Growth: The firm should continue to grow even after a loss.
• Responsibility: Even in the event of serious loss, the risk management
plan should allow the organization to continue to behave responsible
toward the environment, employees, suppliers, customers, and the
communities in which it operates.
• Efficiency and Compliance: An other essential objective is to operate
efficiently in a risk environment. This objective requires the firm to
choose the appropriate balance between loss prevention, insurance
and other risk management tools.
• Risk Management Manual: objectives, principles and procedures
Bank’s Risk Mgmt security issues
Hospital’s --- Hygiene
The Risk Management Process
• RM activities occur before, during and after losses.
• Most planning is done before losses occur.
• The RM process requires the following steps:
 Step One: Identify and measure potential loss
exposures
 Step Two: Choose the most efficient methods of
controlling and financing loss.
 Step Three: Monitor outcomes.
STEP ONE
Identification and Measurement of Exposures
 Four District Classes of Identifying:
• Direct property losses.
• Losses of income and extra expenses following a
property loss.
• Losses arising from lawsuit, called liability losses.
• Losses caused by the death, disability, or unplanned
retirement of key people. (Human Resoruce Losses)
 Measurement is merely an estimate. Not all pre loss
estimates will reflect accurately the actual amount of
damages or the actual exposure to loss.
Direct Property Losses
 Risk Managers can identify potential direct property losses in
different ways.
 Checklist may be used to identify and value potential property losses:
Identify and value:
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owned buildings, equipment and land
Property leased from others
Stationary inventory
Property under construction
Owned and leased vehicles
 Identify special perils to which property is exposed:
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Radiation
Explosion
Flood
Earth movement
theft
Flow Charts
• Graphically represents the production or distribution
process.
• Flow Charts analysis displays the firm’s relations with
suppliers, customers, utilities, and modes of
transportation.
• Flow Charts also help reveal the consequential impact of
losses. (e.g. Loss of raw material inventory in a storage
may lead to stopping the entire production
Valuing Property
• Risk Managers must know the property’s replacement value to
estimate potential property losses.
• Replacement cost often is unrelated to accounting book value (
acquisition-depreciation), risk managers should keep a current price
and source list for their property.
• In an inflationary economy, the replacement cost of physical
equipment is likely to be higher than its historical cost and the risk
manager should attempt to protect this greater value.
International Operations
Firms with international
operations may have property
and employees in several
countries. These firms must
devote special attention to
identifying all their property,
including that being transported
between location.
Loss of Income
• Indirect Losses are more difficult to identify than direct
losses. e.g machine and lost profit. Risk Managers must
make careful estimates and judgements about the
potential size of indirect losses.
• The process begins with a forecast of expected income
under normal circumtences. A second estimate of
postloss income follows. The difference is the potential
income loss following a direct loss.
Liability Lossess
• These losses arise from three sources:
 1. Legal damages: an organization responsible for negligently
injuring, someone should pay legal damages awarded by a court to
the insured party.
 2. Cost of a legal defense: A defense can be expensive even in
cases where a court finds the “victims” claim groundless, false or
fraudulent.
 3. Cost of loss prevention: In some cases, the legal defense costs
more than the damages awarded to parties claiming injury.
• Risk managers spend considerable time trying to identify potential
liability problems so they may be handled in an appropriate way.
e.g. Workers compensation claims arise from injury to firm’s
employees while at work.
Product liability occurs when a firms product’s allegedly injure
the public.
Loss of Key Personnel
(Human Resource Losses)
• Business losing a key personnel by unplanned
retirement, resignation, death or disability, the effect may
be felt in a lost income. (research scientist, president,
etc.)
• Trained subordinates. Life and disability insurance on
key employee may be a part of the risk management
program.
• Estimating the cost of a key employee losses is difficult
because finding and training a replacement is a function
of the job market.
Estimation of Maximum Loss
• Maximum possible Loss:
refers to the total amount of financial harm a given
loss could cause under the worst circumtances.
• Maximum probable loss:
is the most likely maximum amount of damage a
peril might cause under average circumtances.
STEP TWO
Loss Control and Risk Financing
• All organizations incur cost because they are exposed to
unexpected losses.
• Paying Insurance premiums, paying for uninsured losses,
paying for driver training programs or paying for installing a
fire sprinkler system, each represents a cost of being exposed
to loss.
• The risk managers has some ability to control the amount and
timing of these costs. Successful lost control efforts reduce
the amount of loss costs. Given that some losses occur even
when loss control efforts are effective.
Loss Control: Activities designed to reduce loss cost and
include the following risk management tools:
 Risk avoidance, loss prevention, loss reduction.
Risk Management Tools for Loss Control
• Risk Avoidance:
Eliminating the chance of loss.
Basic Rule: When the chance of loss is high and loss severity is also
high, avoidance is often the best and sometimes the only practical
alternative e.g. Not doing a business in dangerous places
(earthquake zones).
• Loss Prevention:
 Refers to measures that reduce the frequency of a particular loss
(e.g., installing safety features on hazardous products).
 As long as benefits exceeds the costs, loss prevention should be
used to treat all exposures, whether assumed or transferred to
commercial insurer.
 Risk managers first goal in risk prevention program is to reduce or
eliminate the chance of death or injury to people. (employing loss
control engineers to identify sources of loss to institute corrective
actions. (e.g. Poor lighting or ventilation, poor layout of machines,
insufficient fire fighting equipment).
Loss Prevention contn’d..
 Other losses are more directly related to human shortcomings and
errors such as bad judgment, inadequate training or supervision or
lack of attention to safety requirements. Example of activities:
 temper resistant packing, security guards in banks, driver training
safety education programs, warning printed on drugs and dangerous
chemicals.
 As a rule, when the frequency of loss is high, loss prevention
activities should be considered as one alternative for dealing with
the problem. They are feasible only as far as benefits realized from
fewer occurrences of losses are greater than the cost of the loss
prevention measures.
• Loss Reduction
 Loss reduction activities aim at minimizing the impact of losses.
 It refers to the severity of a loss after it occurs.
 Successful loss reduction activities reduce loss severity. e.g.
automatic fire-sprinkler system.( a system design not to prevent
fires but to prevent the spread of fires.
 When the severity of loss is great, and when the loss cannot be
avoided, loss reduction activities are appropriate.
• Fire walls and doors, training replacement personnel
• Loss reduction can be justified as long as the savings they
produce exceed the cost of the effort
Risk Financing
• Refers to the techniques that provide for the funding of
losses after they occur.
• Determination of time and by whom the costs are borne.
• The alternatives are:
 Risk assumptions
 Self-insurance and financial risk retention
 Risk transfer other than insurance
 Insurance
Risk Assumption
• Means the consequences of loss will be borne by the party
exposed to the chances of loss.
• It is often a deliberate risk management decision.
• They are assumed by firms when:
 Loss costs are small and are funded from current cash flow
 Loss exposures are retained and funded with a cash
reserve
 Loss exposures are retained and recognized in an
unfunded reserve account
 A self-insurance or finite risk program is operated.
Self Insurance
• It requires risk retention.
• It implies an attempt by a business to combine a
sufficient number of its own similar exposures to
predict the losses accurately.
• For a true self-insurance system to operate, payments
to the self-insurance funds are needed to be
calculated and regularly paid.
The Captive Insurance Company
• One approach to self-insurance involves the use of a company
formed to write insurance for a parent. (One company, several
companies, or an entire industry)
• Motivations for forming a captive:
 To save overheads and profits earned by commercial insurers.
 To earn investment income available on advanced funding.
 To recognize insurance premiums as a current business
expense to parent while the captive insurer reports insurance
income, to capture the favorable tax differential between regular
corp and insurance company.
• Potential Advantages observed by Captive insurance companies
appealing to some other organizations:
 Improved Loss Prevention Incentives. Offer a chance to reap
directly the benefits of successful loss control.
 Improved Claims Settlements. Includes the ability to cover
claims or exclude claims with more flexibility than an commercial
insurer.
 Improved Profitability . Includes the investment potential from
investing cash flow or avoiding premium taxes.
Risk Transfer
• The original party exposed to a loss is able to obtain a
substitute party to bear the risk.
 uncertainty of who will pay the loss is transferred from
the individual to the insurance pool. (insurance
noninsurance)
 Hedging: To take two or more simultaneous position that
offset each other so that no matter what the outcome is
of some event based on chance, the hedger neither wins
or losses.
Insurance
• Represents a contractual transfer of risk.
•
It is an expensive risk management tool and used when
the chance of loss is low and the severity of a potential
loss is high.
•
From a risk manager’s viewpoint: its a contractual
transfer of risk.
• From society’s viewpoint: it is risk reduction because of
the pooling of numerous risk allows better loss
predictability.
• For small and medium sized businesses, insurance is
their foundation of the risk mgmt program.
THE RISK MANAGEMENT MATRIX
STEP THREE
Regular Review of the Risk Management Program
• After all potential sourses of loss have been identified and
plans to deal with them implemented, the risk managers must
review the program regularly to be sure that it meets current
needs.
• New assests are needed, old assets lose their value, new
production processes are used.
Steps in the Risk Management Process