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Risk Management 1: Essentials


Chapter 3 Risk Management 1: Essentials Risk Management It is defined as the logical development and execution of a plan to deal with potential losses. – PowerPoint PPT presentation

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Title: Risk Management 1: Essentials

Chapter 3
  • Risk Management 1Essentials

Risk Management
  • It is defined as the logical development and
    execution of a plan to deal with potential
  • The focus of RM program is to manage an
    organisations exposure to accident 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
  • Risk MAnagement Staff
  • Insurance Experts to work with insurance brokers
    in purchasing and renewing the organisations
    commercial insurance and reinsurance.
  • Claim Managers track and process claims from the
    time of loss until the insurer responds with
  • Loss Control Engineer manage losses arasing from
    employee injuries, environmental pollution,
    defective products
  • Financial Analyst Risk Financing to control
    organisations profitability.

  • The Risk and Insurance Soceity, Inc, a
    professional organisation for risk managers,
    recently reported 4500 different profit and
    nonprofit organisations including 90 of the
    nations 1500 largest corporation as member.
  • RIMS helps risk managers stay alert to new
    problems and possible solutions through
    educational classes, publications such as montly
    journals and computer networks.

Statement of Objective 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.
  • Grow 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
  • 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
  • Risk Management Manual objectives, principles
    and procedures
  • Banks Risk Mgmt? security issues
  • Hospitals ---? Hygiene

The Risk Management Process
  • RM activities occur before, during and after
  • Most planning is done before losses occur.
  • The RM process requires the following steps
  • Step One Identify and measure potential loss
  • Step Two Choose the most efficient methods of
    controlling and financing loss.
  • Step Three Monitor outcomes

Step One Identification and Measurement of
  • Four District Classes
  • Direct property losses
  • Losses of income and extra expenses following a
    property loss.
  • Losses arising from lawsuit called liability
  • Losses caused by the death, disability, or
    unplanned retirement of key people.
  • Measurement is merely an estimate. Not all
    preloss 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
  • 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
  • Radiation
  • Explosion
  • Flood
  • Earth movement
  • theft
  • -

Flow Charts
  • Graphically represents the production or
    distribution process.
  • Flow Charts analysis displays the firms
    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
  • (Insert Figure 3-1)

Valuing Property
  • Risk Managers must know the propertys
    replacement value to estimate potential property
  • 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.

  • 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
  • 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.

  • 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 firms employees while at work
  • Product liability occurs when a firms products
    allegedly injure the public.

Loss of Key Personnel
  • 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.

  • 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
  • - risk avoidance, loss prevention, loss

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 It activates lower frequency of
    losses. 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 (cont.)
  • - 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
  • 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

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
  • 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
  • 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
  • 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

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
  • 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 comp
  • Potential Advantages observed by Captive
    insurance companies appealing to some other
  • 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.

  • Represents a contractual transfer of risk. It is
    an expensive risk mgmt tool and used when the
    chance of loss is low and the severity of a
    potential loss is high.
  • - From a risk managers viewpoint its a
    contractual transfer of risk.
  • - From societys 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

Step Three Regular Review of the Risk Management
  • 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.
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