risk management

RISK AND INSURANCE

RISK MANAGEMENT

DEFINITION• As a systematic approach to

identifying, measuring and controlling risks that can threaten assets and earnings of oneself, a business or the organization.

• The purpose of risk management is to enable an organization to progress toward its goal and objectives (mission) in the most direct, efficient, and effective path

OBJECTIVES OF RISK MANAGEMENT

• Objectives prior to a loss

• Objectives after a loss occurs

OBJECTIVES PRIOR TO A LOSS

• Reduce impact of loss

• Reduce fear and worry

• Required by law

OBJECTIVES AFTER A LOSS OCCURS

• Survival of organization – organization still able to continue operations

• Stability of earnings – business operations do not have to stop and the organizations can concentrate on their business activities as usual.

• Reduce impact of losses to organization and society – when a loss occurs not only will the organization suffer but the loss has to be burdened by society as well. Employees may have to be retrenched and some departments may have to be closed down.

RISK MANAGEMENT PROCESS

1. Identifying potential losses

2. Evaluating potential losses

3. Examining alternative risk management techniques

4. Implementing the risk management program

5. Controlling/monitoring the program

IDENTIFYING POTENTIAL LOSSES

• Risk identification is the process by which an organization is able to learn of the areas in which it is exposed to risk.

• Identification techniques are designed to develop information on sources of risk, hazards, risk factors, perils and exposures to loss.

• It is everybody’s task to identify the loss exposures in one organization.


• Losses can be classify as:– Direct damage (damage to building)– Indirect damage (loss of profits due to

business interruption)– Liability (court award to 3rd party since fire

was caused by negligence of the owner of building)

– Loss of Key Employees (key employees such as general manager/CEO/Researcher)


• How to identify risk?– Questionnaires

– Interviews

– Financial Statements

– Flow Charts

– Personal inspection / Observation

EVALUATING POTENTIAL LOSSES

– Risk measurement evaluates the likelihood of loss and the value of loss in terms of frequency and severity.

– The measurement process may take the form of a qualitative assessment (using %)

– This step involves two important aspects of loss exposures

• Frequency• Severity


– Identifying and determining the loss exposures alone is not sufficient

– In evaluating the potential losses:• Estimating the frequency and severity for each

type of loss exposure and ranked it according to their relative importance. High loss exposure will be given priority.

• Estimating relative frequency and severity of each loss exposure as the selection of appropriate technique will depend on this.


• How can you determine and estimate the impact of losses– Frequency

• Referring to the number of times the loss occurs

– Severity• Referring to the maximum size of loss exposures

EXAMINING THE METHODS OF HANDLING THE LOSS EXPOSURES

• Two main ways to classify the risk management techniques– Risk Control

• Risk avoidance• Loss control

– Loss prevention– Loss reduction

• Separation • Contractual Transfer

• Risk Financing– Retention/Assumption

– Captive insurer

– Insurance

RISK CONTROL

• Methods seek to alter an organization’s exposure to risk.

• Risk control efforts help organization avoid a risk, prevent loss, lessen the amount of damage if a loss occurs or reduce undesirable effects of risk on an organization.

Risk Avoidance

• Risk is proactively avoided or abandoned after rational consideration.

• If someone is afraid of risks, the best way to deal with it is to avoid it completely.

• Example; a manufacturer may stop production of a defective products to avoid a lawsuit.

• However, some risks are unavoidable although risk avoidance may be chosen as an option in handling certain risks, the exposures of losses cannot be eliminated entirely.

Loss Control

• Loss control is designed to reduce both the frequency and severity of losses by changing the characteristics of the exposure so that it is more acceptable to the firm. Divided into:– Loss prevention– Loss reduction

Loss Control

• Loss Prevention– Seek to reduce the number

of losses (frequency) of losses

– Is used when the benefits outweigh the costs involved.

– Either imposed by law or imposed by companies and factories to fence dangerous machinery to reduce the chances of employees being injured.

• Loss Reduction– Designed to reduce or lower

the severity of losses, should it occur.

– Since some risks are unavoidable, the other alternative is to reduce its impact.

– Can be used in two circumstances: before a loss, e.g. installation of fire alarm or after a loss e.g. salvage efforts in the restoration of a building burnt down by fire.

Separation

• Involves the dispersal of the firm’s assets in several locations instead of confining it to one major area.

• This measure will reduce the impact of losses should a major disaster occurs.

• Example, separation of head quarters and assembly plant in automobile industry.

Contractual Transfer

• Risk transfer mechanism.

• Refers to the various methods other than insurance by which a pure risk and its potential financial consequences can be transferred to other party.

Contractual Transfer• Types of contractual transfer

– Incorporation• The owner of the company transfers the risks to corporation

by registering the company.

– Leasing contracts• An agreement where the owner or landlord transfers the risks

to the tenants

– Hedging• An agreement to buy or sell a commodity at a certain price to

avoid losses due to price increase or decrease.

– Hold-harmless agreements• An agreement between a retailer and a manufacturer whereby

the later agrees to bear losses due to the manufacturer of defective products thus relieving the retailer of any liability.

Contractual Transfer

• Advantages– Can transfer potential

losses that are commercially uninsurable

– Often cost less than insurance

– Potential loss shifted to a party who is in a better position to exercise control

• Disadvantages– If the party to whom the

loss is transferred is unable to pay the loss the firm is still responsible

– Not necessarily cheaper than insurance if discounts are taken into consideration

– Ambiguity in contracts drafted may not hold in court.

RISK FINANCING

• Methods involving generating funds to pay for these losses– Retention– Self insurance and captive insurer– Insurance

Retention

• Retention – the company will bear the consequences of the loss

• Risk or loss exposed are normally assumed or retained when their impact and consequences are not too great or in cases when or other methods seem feasible.

• In an organization, the ability to assume a risk depends on one’s financial ability.

Self insurance & Captive Insurer

• Self insurance implies tat the organization sets up a pool of fund to retain its loss exposures.

• Adequate financial agreement has to be made in advance of the occurrence of losses.

• The number of loss exposures must be large enough to ensure the mechanism of insurance to be operative.


• A captive insurance company is an entity to write insurance arrangement for its parent company.

• The captive’s parent may be one company, several companies or an entire industry.


• Advantages– Cash flow advantages

– Safe money

– Lower expenses

– Encourage loss prevention

• Disadvantages– Possible higher losses

– Possible higher expenses

Insurance

• Risk financing method of transferring the financial consequences of potential accidental losses from an insured firm or family to an insurer

• Transferring the risks to another party involves a contractual agreement whereby the other party assumes the risks and is liable for the loss in the event of loss.

Insurance

• In an insurance contract, the party exposed to the risks (the proposer/insured) pays the premium to the insurance company.

• In return, the insurance company agrees to pay a stated sum on the happening of certain risks specified in the contract.

TO DRAW UP AND IMPLEMENT THE RISK MANAGEMENT PROGRAM

• Once a decision has been in the selection, the management must select the best and most cost effective risk management program

• The selection may based of two factors– Financial criteria – whether it will affects the

organization’s profitability or rate of return.

– Non financial criteria – whether it affects the growth of the organization, humanitarian aspects and legal requirements.

risk management

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