CHAPTER TWO

THE RISK MANAGEMENT

By: Lencho M. 12/20/2023

 Meaning of Risk management
2
❖ Risk management refers to the identification;
measurement and treatment of exposure to potential
accidental losses
❖ It is a general management function that seeks to assess
and address the causes and effects of uncertainty and
risk on an organization.
❖ It is a systematic process that identifies and evaluates
loss exposures faced by an organizations or individuals and
selects the most appropriate techniques for treating such
exposures.
❖ The purpose of risk management is to enable an
organization to progress towards its goals and objectives
in the most direct, efficient, and effective path. It is
concerned with all risks.
By: Lencho M. 12/20/2023
 Objectives of Risk Management
3
1. Pre loss Objectives
2. Post loss Objectives
1) Pre-loss objectives: A firm or organization has several
risk management objectives prior to the occurrence of a
loss.
❖ The most important include economy, the reduction of
anxiety, and meeting externally/legally imposed
obligations.
❖ Economy objectives: the firm should prepare for potential
losses in the most economical way.
❖ This preparation involves an analysis of the cost of safety
programs, insurance premiums paid, and the costs
associated with different techniques for handling losses.

By: Lencho M. 12/20/2023

 Objectives of Risk Management
4
❖ Reduction of Anxiety: Certain loss exposures can
cause greater worry and fear for the risk manager
and key executives.
❖ For example, the threat of a terrible court case
from a defective product can cause greater anxiety
than a small loss from a minor fire.
❖ The risk manager, however, wants to minimize the
anxiety and fear associated with all loss exposures.
❖ Meeting any legal obligations: government regulations
may require a firm to install safety devices to
protect workers from harm

By: Lencho M. 12/20/2023

 Objectives of Risk Management
5

2. Post- loss objectives: Likewise, a firm may have

many risk management objectives subsequent to the
occurrence of the loss.
a) Survival: Survival means that after a loss occurs,
the firm can resume at least partial operations
within some reasonable time period.
b) Continued Operation:For some, firms, the ability to
operate after a loss is extremely important.
❖ For example, a public utility firm must continues to
provide service.
❖ Banks, post offices, dairies, and other competitive
firms must continue to operate after a loss.
Otherwise, business will be lost to competitors.
By: Lencho M. 12/20/2023
 Objectives of Risk Management
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 Stability of earnings: Earnings per share can be

maintained if the firm continues to operate.
 Continued Growth: A company can grow by
developing new products and markets or by
acquiring or merging with other companies.
 Social Responsibility: is to minimize the effects
that a loss will have on other persons and on
society.

By: Lencho M. 12/20/2023

 2.3. The Risk Management Process
7

 The risk management process involves

the following five steps:-
Step 1: Risk Identification
Step 2: Risk Measurement
Step 3: Select the appropriate techniques for
treating loss exposure, and
Step 4: Implementing and administering the
program

By: Lencho M. 12/20/2023

 The Risk Management Process
8

1. 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 pure
risk (property, personal and liability risk)
exposures as soon as or before they occur.
 It is a very difficult process and it is a continuous
job for the risk manager because the risk
environment is dynamic.

By: Lencho M. 12/20/2023

 Risk identification techniques
9

 The commonly used methods of risk identification can

be described as follows:
1. Loss Exposure Checklists: It specifies numerous
common potential sources of loss from destruction of
assets and from legal liability.
2. The Financial Statement Method: By analyzing the
balance sheet, operating statements and supporting
documents.
3. Contract Analysis: Many of an organization’s exposures
to risk arise from contractual relationships with other
persons and organizations.

By: Lencho M. 12/20/2023

 Risk identification techniques
10

4. The Flow Chart Method: by studying flow chart of

organization’s activities and operations.
5. Interactions with other Departments:
 These interactions may include oral or written reports
from other departments on their own initiative or in
response to regular reporting system that keep the
risk manager informed of developments.
6. Interactions with Outside Suppliers and
Professional Organizations: These outsiders may
be, for example, accountants, lawyers, risk
management consultants, actuaries, or loss
control specialists.
By: Lencho M. 12/20/2023
 Risk identification techniques
11

7. Statistical Records of Losses: allow losses to be

analyzed according to cause, location amount and other
issues to accident.
8. On Site Inspection: By observing the firm’s facilities
and the operations conducted thereon the risk
manager can learn much about the exposures faced by
firm.
Which method is the best?
✓ There is a range of techniques available and no one
technique can be used in all situations.
❖ No single method of risk identification is free of
weakness , the preferred is combination.
❖ The choice of risk identification method based on
nature & size of the business
By: Lencho M. 12/20/2023
 2.Measuring /Evaluating potential loss
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 Evaluating and measuring the impact of losses on the

firm involves an estimation of the potential frequency
and severity of loss.
 Loss frequency – it refers to the probable number of
losses that may occur during some given time period.
 Loss severity – it refers to the probable size of the
losses that may occur during some given time period.

By: Lencho M. 12/20/2023

3. Selecting appropriate techniques for treating loss
exposures
13

The major techniques for treating loss exposures are the

following:
A. Risk control techniques – attempt to reduce the frequency
and severity of accidental losses. It includes:
▪ Avoidance
▪ Loss control
▪ Separation/ diversification
▪ Combination
B. Risk financing techniques – provides for funding of
accidental losses after they occur. It includes:
 Retention/Self - insurance
 Non-insurance transfers
 Insurance
By: Lencho M. 12/20/2023
 A. Risk control techniques
14

1. Avoidance – it means that certain loss exposure is

never acquired or existing loss exposures is abandoned.
➢ It avoids property, person or activity that could be a
source of risk.
➢ One way to control a particular risk is to avoid the
property, person or activity giving rise to possible loss.
➢ Risk avoidance discontinues the source of risk.
There are some characteristics of avoidance. These are:
✓ Avoidance may be impossible
✓ It is an impractical approach
✓ Avoiding a risk may create another risk
By: Lencho M. 12/20/2023
 Cont.…
15

2.Loss control – it assumes that the firm will

retain the property, person or activity creating
the risk but the firm will conduct its operation
in the safest ways.
➢ It is designed to reduce both the frequency
and severity of loss.
➢ Loss control deals with an exposure that the
firm doesn’t wish to abandon.
➢ It uses both loss prevention and reduction
program.

By: Lencho M. 12/20/2023

 Cont.…
16

Loss prevention program – seeks to reduce

or eliminate the chance of loss.
❖Loss Prevention are designed primarily to
reduce loss frequency.
❖For example, measures that reduce car
accidents include driver examinations,
zero tolerance for alcohol or drug abuse
and strict enforcement of safety rules.

By: Lencho M. 12/20/2023

 Cont.….
17

 Loss reduction program – seeks to reduce the

potential severity of the loss.
 Eg. Consider an auto manufacturer having
airbags installed in the company fleet off
automobiles.
 This form is engaging in “severity reduction”
(Loss Reduction).
 The air bags will not prevent accidents from
occurring, but they will reduce the probable
injuries that employees will suffer if an
accident does happen.
By: Lencho M. 12/20/2023
 Risk control techniques - Loss Control
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By: Lencho M. 12/20/2023

 CONT……
19
3.Separation/diversification
 involves the reduction of maximum probable loss
associated with some kinds of risks.
 “Do not put all your eggs in one basket”
 Separation of the firm’s exposures to loss instead
of concentrating them at one location.
 Example, a firm may disperse its inventory in to
different warehouses than keeping it in one store.
 If fire destroys one of the warehouses, the firm
will save some of its inventories placed in the other
warehouses.
By: Lencho M. 12/20/2023
 Cont…
20

4. Combination
 It increases the number of exposure units since
it is a pooling process.
 It reduces losses by making losses more
predictable with higher degree of accuracy.
 Unlike separation which spreads a specified
number of exposure units, combination
increases the number of exposure units under
the control of the firm.
➢ Eg. Expand through internal growth, merger and
acquisition
By: Lencho M. 12/20/2023
 B. Risk financing techniques
21
1.Retention/ Self – insurance
 It is a method of handling risks by the organization and
the source of the fund is the organization itself.
Self – insurance:
 It is a special form of planned retention by which part
or all a given loss exposure is retained by the firm.
 It requires risk retention and there should be adequate
financial arrangement in advance to provide funds to pay
for losses should they occur.

By: Lencho M. 12/20/2023

 CONT….
22

2.Non-insurance transfers
 Risk transfer involves in payments by one party to
another when the transferee agrees to assume a risk
that the transferor desires to escape.
 It is a method other than insurance by which Pure risk
and its potential financial consequences are transferred
to another party.
 The most common forms of non insurance risk transfers
are hedging, hold-harmless agreements and
incorporation.
3. Insurance
 It represents a contractual transfer of risks.
 It is appropriate for loss exposures that have low
frequency and high severity.
By: Lencho M. 12/20/2023
 Risk Management Matrix
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❖ Which method should be used?

 In determining the appropriate method or methods of
for handling losses, a matrix can be used that
classifies loss exposures according to frequency and
severity.
Loss frequency
Low High
low Retention Loss prevention
Loss severity

high Insurance Avoidance

By: Lencho M. 12/20/2023

 4. Implementing and administering the risk
management program
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 It is the last step in the risk management process.

 To be effective, the risk management must be
periodically reviewed and evaluated to determine if
the objectives are being attained.
 After deciding among the alternative tools of risk
treatment the risk manager must implement the
decisions made.
 If insurance is to be purchased for example,
establishing proper coverage, obtaining reasonable
rates, and selecting the insurer are part of the
implementation process.

By: Lencho M. 12/20/2023

 End of chapter two

By: Lencho M. 25 12/20/2023