Chapter 3Introduction to Risk ManagementCopyright © 201.docx

Chapter 3
Introduction
to Risk Management
Copyright © 2017 Pearson Education, Inc. All rights reserved.
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Agenda
Meaning of Risk Management
Objectives of Risk Management
Steps in the Risk Management Process
Benefits of Risk Management
Personal Risk Management
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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
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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
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Objectives of Risk Management (Continued)
Post-loss objectives:
Survival of the firm
Continue operating
Stability of earnings

Continued growth of the firm
Minimize the effects that a loss will have on other persons and
on society
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Risk Management Process
Identify potential losses
Measure and analyze the loss exposures
Select the appropriate combination of techniques for treating
the loss exposures
Implement and monitor the risk management program
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Transparency Master 1.2
Exhibit 3.1 Steps in the Risk Management Process

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Important Loss Exposures
Property loss exposures
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
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Identifying Loss Exposures
Risk Managers have several sources of information to identify
loss exposures:
Risk analysis questionnaires and checklists
Physical inspection
Flowcharts
Financial statements
Historical loss data

Industry trends and market changes can create new loss
exposures.
e.g., exposure to acts of terrorism
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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
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
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Select the Appropriate Combination of Techniques for Treating

the Loss Exposures
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
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the Loss Exposures (Continued)
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
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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
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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
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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
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Risk Financing Methods: Retention
Retention means that the firm retains part or all of the losses
that can result from a given loss
Retention is effectively used when:
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
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Risk Financing Methods: Retention (Continued)
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
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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
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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
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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.
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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
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Advantages
Save on loss costs
Save on expenses
Encourage loss prevention
Increase cash flow
Disadvantages
Possible higher losses
Possible higher expenses
Possible higher taxes
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Risk Financing Methods:
Non-insurance Transfers
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
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Risk Financing Methods:
Non-insurance Transfers (Continued)
Advantages
Can transfer some losses that are not insurable
Less expensive
Can transfer loss to someone who is in a better position to
control losses
Disadvantages
Contract language may be ambiguous, so transfer may fail
If the other party fails to pay, firm is still responsible for the
loss
Insurers may not give credit for transfers

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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
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Risk Financing Methods: Insurance
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
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Risk Financing Methods: Insurance (Continued)
Advantages
Firm is indemnified for losses; can continue to operate
Uncertainty is reduced
Firm may receive valuable risk management services
Premiums are income-tax deductible
Disadvantages
Premiums may be costly
Negotiation of contracts takes time and effort
The risk manager may become lax in exercising loss control
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Exhibit 3.2 Risk Management Matrix
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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 insurance is
hard to obtain
In a “soft” market, profitability is improving, standards are
loosened, premiums decline, and insurance become easier to
obtain
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Implement and Monitor the Risk Management Program
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
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Implement and Monitor the Risk Management Program
(Continued)
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
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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
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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
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