Chapter One: The Nature of Risk

CHAPTER ONE
THE NATURE OF RISK

In the present day context, individuals have a strong desire for financial security and protection
against those events that threaten their financial security. Financial security can be threatened by
numerous factors such as;

 If the family head is killed in an accident

 Destruction of property by fire, floods, earth quakes and other natural factors.
 If a family head infected by serious diseases such as HIV/AIDS, Cancer, Heart disease,
etc.
Thus, it is apparent that certain factors can threaten the financial security of individuals and their
families.

MEANING OF RISK

There is no single definition of risk. Economists, behavioral scientists, risk theorists, statisticians,
and actuaries each have their own concept of risk. There are common elements in all the
definitions: indeterminacy and loss.

 The notion of an indeterminate outcome is implicit in all definitions of risk: the outcome
must be in question. When risk is said to exist, there must always be at least two possible
outcomes. If we know for certain that a loss will occur, there is no risk.
 At least one of the possible outcomes is undesirable. This may be a loss in the generally
accepted sense, in which something the individual possesses is lost, or it may be a gain
smaller than the gain that was possible.

Risk is a condition in which there is a possibility of an adverse deviation from a desired outcome
that is expected or hoped for. Risk is uncertainty regarding loss. The individual hopes that
adversity will not occur, and it is the possibility that this hope will not be met that constitutes
risk. If you own a house, you hope that it will not catch fire.

RISK VS. UNCERTAINTY

Uncertainty refers to a state of mind characterized by doubt, based on a lack of knowledge about
what will or will not happen in the future. Uncertainty is simply a psychological reaction to the
absence of knowledge about the future. The existence of risk creates uncertainty on the part of
individuals when that risk is recognized.

Uncertainty is the doubt a person has concerning his or her ability to predict which of the many
possible outcomes will occur. Uncertainty is a person’s conscious awareness of the risk in a
given situation.

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RISK VS. PROBABILITY

Probability refers to the long-run chance of occurrence, or relative frequency of some event.
Insurers are particularly interested in the probability or chance of loss, or accurately, the
probability that a loss will occur to one of insured objects. Actually, probability has little
meaning if applied to the chance of occurrence of a single event. It has meaning only when
applied to the chance of occurrence among a large number of events.

Risk, as differentiated from probability, is a concept in relative variation. We are referring here
particularly to objective risk, which is the relative variation of actual from probable or expected
one. Objective risk can be measured meaningfully only in terms of a group large enough to
analyze statistically.

Probability has both objective and subjective aspects.

Objective Probability

Refers to the long-run relative frequency of an event based on the assumptions of an infinite
number of observations and of no change in the underlying conditions. Objective probabilities
can be determined in two ways. First, they can be determined by deductive reasoning. These
probabilities are called a priori probabilities. For example, the probability of getting a head from
the toss of a perfectly balanced coin is ½ because there are two sides, and only one is a head.
Second, objective probability can be determined by inductive reasoning. For example, the
probability that a person age 21 will die before age 26 cannot be logically deductive. However,
by a careful analysis of past mortality experience, life insurers can estimates the probability of
death and sell a five year term insurance policy issued at age 21.

Subjective Probability

It is the individual’s personal estimate of the chance of loss. For example, people who buy a
lottery ticket on their birthday may believe it is their lucky day and overestimate the small
chance of winning.

RISK DISTINGUISHED FROM PERIL AND HAZARD

Peril

Peril is defined as a cause of loss. It is a contingency that may cause a loss. Example, if your
house is burns because of a fire, the peril, or cause of loss, is the fire. If your car is damaged in a
collision with another car, collision is the peril, or the cause of the loss.

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Hazard
A hazard is a condition that may create or increase the chance of a loss arising from a giver peril.
A hazard is a condition that introduces or increases the probability of loss from a peril. For
example, one of the perils that can cause loss to an auto is collision. A condition that makes the
occurrence of collisions more likely is an icy street. The icy street is the hazard and the collision
is the peril.

There are basic types of hazards

Physical hazard

A physical hazard is a condition stemming from the physical characteristics of an object that
increases the probability and severity of loss from given perils. For example, the existence of dry
forests (hazard for fire), earth faults (hazard for earthquakes), icy road (hazard for auto accident).

Moral hazard

Moral hazard is dishonesty or character defects in an individual that increase the frequency or
severity of loss. Moral hazard refers to the increase in the probability of loss that result from
dishonest tendencies in the character of the insured person. Example of moral hazard includes
intentionally burning unsold merchandise that is insured.

Morale hazard

Morale hazard is carelessness or indifference to a loss because of the existence of insurance.

Some insured are careless or indifferent to a loss because they have insurance. Examples of
morale hazard include leaving car keys in the ignition of an unlocked car and thus increasing the
chance of theft, leaving a door unlocked that allows a burglar, etc.

CLASSIFICATION OF RISK

1. Static and Dynamic Risks

Dynamic risks are those resulting from changes in the economy. Changes in the price level,
consumer tastes, income and output, and technology may cause financial loss to members of the
economy. These dynamic risks normally benefit society over the long run, since they are the
result of adjustments to misallocation of resources. Although these dynamic risks may affect a
large number of individuals, they are generally considered less predictable than static risks, since
they do not occur with any precise degree of regularity.

Static risks involve those losses that would occur even if there were no changes in the economy.
If we could hold consumer tastes, output and income, and the level of technology constant, some

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individuals would still suffer financial loss. These losses arise from causes other than the
changes in the economy, such as the perils of nature and the dishonesty of other individuals.
Unlike dynamic risk, static risks are not a source of gain to society. Examples of static risks
include the uncertainties due to random events such as fire, windstorm, or death. Static losses
involve either the destruction of the asset or a change in its possession as a result dishonesty or
human failure. Static losses tend to occur with a degree of regularity overtime and, as a result,
are generally predictable. Because they are predictable, static risks are more suited to treatment
by insurance than are dynamic risks.

2. Fundamental and Particular Risks

The distinction between fundamental and particular risks is based on the difference in the origin
and consequences of the losses.

A fundamental risk is a risk that affects the entire economy or large numbers of persons or
groups within the economy. Fundamental risks involve losses that are impersonal in origin and
consequence. They are group risks, caused for the most part by economic, social and political
phenomena, although they may also result from physical occurrences. They affect large segments
or even all of the population. Examples of fundamental risks include high inflation, war, drought,
earthquakes, floods and other natural disasters.

A particular risk is a risk that affects only individuals and not the entire community. Particular
risks involve losses that arise out of individual events and are felt by individuals rather than by
the entire group. They may be static or dynamic. Examples of particular risks are the burning of
a house, the robbery of a bank, and the damage of a car.

3. Objective and Subjective Risks

Objective risk is defined as the relative variation of actual from expected loss. Objective risk, or
statistical risk, applicable mainly to groups of objects exposed to loss, refers to the variation that
occurs when actual losses differ from expected losses. For example assume that a property
insurer has 10.000 houses insured over a long period and, on average, 1 percent, or 100 houses,
burn each year. However, it would be rare for exactly 100 houses to burn each year. In some
years, as few as 90 houses may burn, while in other years, as many as 110 house my burn. Thus,
there is a variation of 10 houses from the expected number of 100, or a variation of 10 percent.
This relative variation of actual loss from expected loss is known as objective risk.

Subjective risk is defined as uncertainty based on a person’s mental condition or state of mind.
A subjective risk is a psychological uncertainty that stems from the individual’s mental attitude
or state of mind. Some writers have used the word “uncertainty” to be synonymous with
subjective risk as defined here. Subjective risk has been measured by means of different
psychological tests, but no widely accepted or uniform tests of proven reliability have been
developed. Thus, although we recognize different degrees of risk-taking willingness in persons,

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it is difficult to measure these attitudes scientifically and to predict risk-taking behavior, such as
insurance-buying behavior, from test of risk-taking attitudes.

Degree of Risk

Degree of risk is the range of variability around the expected losses, which are calculated using
the chance of loss concept by means of the following formula:

Objective risk =

Consider the possibility of fire losses to buildings in towns A and B. There are 100,000 buildings
in each town and, on average; each town has 100 fire losses per year. By looking at historical
data from the towns, statisticians are able to estimate that in town A the actual number of fire
losses during the next year will very likely range from 95 to 105. In town B, however, the range
probably will be greater, with at least 80 fire losses expected and possibly as many as 120. The
degree of risk for each town is computed as follows

As shown, the degree of risk for town B is four times that for town A, even though the chances
of loss are the same. Chance of loss is expressed as the ratio of the number of losses that are
likely to occur compared to the larger number of possible losses in a given group.

4. Pure and Speculative Risks

Pure risk is defined a situation in which there are only the possibilities of loss or no loss. The
only possible outcomes are adverse (loss) and neutral (no loss). A pure risk exists when there is a
chance of loss but not chance of gain. For example, the owner of an automobile faces the risk
associated with a potential collision loss. If a collision occurs, the owner will suffer a financial
loss. If there is no collision, the owner does not gain. The owner’s position remains unchanged.
Other examples of pure risks include premature death, job-related accidents, and damage to
property from fire, lighting, flood, or earthquake.

Speculative Risk is defined as a situation in which either profit or loss is possible. A speculative
risk exists when there is a chance of gain as well as a chance of loss. For instance, investment in
a capital project might be profitable or it might prove to be a failure. If you purchase 100 shares
of common stock, you would profit if the price of the stock increases but would lose if the price
declines. Other examples of speculative risks are betting on a football match, investing in real
estate, and going into business for yourself. In these situations, both profit and loss are possible.

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Classifications of Pure Risk

The major types of pure risk that can create great financial insecurity include personal risks,
property risks, liability risks, and risks arising from failure of others.

A. Personal Risks

Personal risks are risks that consist of the possibility of loss of income or assets as a result of
the loss of the ability to earn income. Personal risks are risks that directly affect an individual;
they involve the possibility of the complete loss or reduction of earned income, extra expenses,
and the depletion of financial asset. There are four major personal risks:

 Risk of premature death

 Risk of insufficient income during retirement
 Risk of poor health
 Risk of unemployment

Risk of premature death

Premature death is defined as the death of a household head with unfulfilled financial
obligations. These obligations can include dependents to support, a mortgage to be paid off, or
children to educate. If the surviving family members receive an insufficient amount of
replacement income from other sources, or have insufficient financial assets to replace the lost
income, they may be financially insecure.

Premature death can cause financial problems only if the deceased has dependents to support or
dies with unsatisfied financial obligations. Thus, the death of a child age 10 is not “premature” in
the economic sense.

There are at least four costs that result from the premature death of a household head. First, the
human life value of the family head is lost forever. The human life value is defined as the present
value of the family’s share of the deceased breadwinner’s future earnings. Second, additional
expenses may be incurred because of funeral expenses, uninsured medical bills and others. Third
because of insufficient income, some families will experience a reduction in their standard of
living. Finally, certain non-economic costs are also incurred, including emotional grief, loss of a
role model, and counseling and guidance for the children.

Risk of insufficient income during retirement

Risk of insufficient income during the retirement is another major risk associated with old age.
The majority of workers in America retire before age 65. When they retire, they lose their earned

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income. Unless they have sufficient financial assets, or have access to other sources of
retirement, they will be exposed to financial insecurity during retirement

Risk of Poor Health

The risk of poor health includes both the payment of catastrophic medical bills and the loss of
earned income. Unless a person has adequate health insurance, private saving and financial
assets, or other sources of income to meet medical expenditures, he or she will be financially
insecure.

The loss of earned income is another major cause of financial insecurity if the disability is
severe. In cases of long-term disability, there is a substantial loss of earned income, medical bills
are incurred, employee benefits may be lost, or reduced, savings are often depleted, and someone
must take care of the disabled person. The loss of earned income during an extended disability
can be financially very painful.

Risk of Unemployment

The risk of unemployment is another major threat to financial security. Unemployment can cause
financial insecurity in at least three ways. First, the worker loses his or her earned income.
Unless there is adequate replacement income or past savings on which to draw, the unemployed
worker will be financially insecure. Second, because of economic conditions, the worker may be
able to work only part-time. The reduced income may be insufficient in terms of the worker’s
needs. Finally, if the duration of unemployment is extended over a long period, past savings may
be exhausted.

B. Property Risks

Anyone who owns property faces property risks simply because such possessions can be
destroyed or stolen. There are two major types of loss associated with the destruction or theft of
property: direct loss and indirect or consequential loss.

Direct Loss

A direct loss is defined as a financial loss that results from the physical damage, destruction, or
theft of the property. Direct loss is the simplest to understand; if a house is destroyed by fire, the
owner loses the value of the house. This is a direct loss.

Indirect Loss

However, in addition to losing the value of the building itself, the property owner no longer has a
place to live, and during the time required to rebuild the house, it is likely that the owner will
incur additional expenses living somewhere else. This loss of use of the destroyed asset is an

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“indirect,” or “consequential,” loss. An indirect loss is a financial loss that results indirectly
from the occurrence of a direct physical damage or theft loss.

An even better example is the case of a business firm. When a firm’s facilities are destroyed, it
losses not only the value of those facilities but also the income that would have been earned
through their use. Property risks, then, can involve two types of losses:(a) the loss of the property
and (b) loss of use of the property resulting in lost income or additional expenses.

C. Liability Risks

The basic peril in the liability risk is the unintentional injury of other persons or damage to their
property through negligence or carelessness; however, liability may also result from intentional
injuries or damage. Under our legal system, you can be held legally liable if you do something
that result in bodily injury or property damage to someone else. Liability risks therefore involve
the possibility of loss of present assets or future income as a result of damages assessed or legal
liability arising out of either intentional or unintentional torts, or invasion of the rights of others.

Liability risks are of great importance for several reasons. First, there is no maximum upper limit
with respect to the amount of the loss. You can be sued for any amount. In contrast, if you own
property, there is a maximum limit on the loss. Second, a lien can be placed on your income and
financial assets to satisfy a legal judgment. For example, assume that you injure someone, and a
court of law orders you to pay substantial damages to the injured party. If you cannot pay the
judgment, a lien may be placed on your income and financial assets to satisfy the judgment.
Finally, legal defense costs can be enormous. If you have no liability insurance, the cost of hiring
an attorney to defend you can be staggering.

D. Risks Arising from Failure of Others

When another person agrees to perform a service for you, he or she undertakes an obligation that
you hope will be met. When the person’s failure to meet this obligation would result in your
financial loss, risk exists. Examples of risks in this category would include failure of a contractor
to complete a construction project as scheduled, or failure of debtors to make payments as
expected.

BURDEN OF RISK ON SOCIETY

Regardless of the manner in which risk is defined, the greatest burden in connection with risk is
that some losses will actually occur. When a house is destroyed by fire, or money is stolen, or a
wage earner dies, there is a financial loss. These losses are the primary burden of risk and the
primary reason that individuals attempt to avoid risk or alleviate its impact.

In addition to the losses themselves, there are other detrimental aspects of risk, Risk entails two
major burdens on society.

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 The size of an emergency fund must be increased

 Worry and fear are present.

Larger Emergency Fund

It is prudent to set aside funds for an emergency. However, in the absence of insurance,
individuals and business firms would have to increase the size of their emergency fund in order
to pay for unexpected losses (one great danger of this approach is the possibility that a loss may
occur before a sufficient fund has been accumulate). Accumulation of such a reserve fund carries
an opportunity cost, for funds must be available at the time of the loss and must therefore be held
in a highly liquid state. The return on such funds will presumably be less than if they were put to
alternative uses.

Worry and Fear

The uncertainty connected with risk usually produces a feeling of frustration and mental unrest.
This is particularly true in the case of pure risk. Speculative risk is attractive to many individuals.
The gambler obviously enjoys the uncertainty connected with wagering more than the certainty
of not gambling-otherwise he or she would not gamble. But here it is the possibility of gain or
profit, which exists only in the speculative risk category that is attractive. In the cases of pure
risk, where there is no compensating chance of gain, risk is distasteful. Some examples can
illustrate the mental unrest and fear caused by risk. Parents may be fearful if a teenage son or
daughter departs on a hiking trip. Some passengers in a commercial jet may become extremely
nervous and fearful if the jet encounters severe turbulence during the flight. A college student
who needs a grade of C in a course in order to graduate may enter the final examination room
with a feeling of apprehension and fear.

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CHAPTER TWO
RISK MANAGEMENT

MEANING OF RISK MANAGEMENT

Risk Management is defined as a systematic process for the identification and evaluation of pure
loss exposures faced by an organization or individual, and for the selection and implementation
of the most appropriate techniques for treating such exposures. It is a scientific approach to
dealing with pure risks by anticipating possible accidental losses and designing and
implementing procedures that minimize the occurrence of loss or the financial impact of the
losses that do occur. Risk management focuses on a part of the total bundle of risks, those that
are classified as “pure risk.” As a general rule, the risk manager is concerned only with the
management of pure risks, not speculative risks. All pure risks are considered, including those
that are uninsurable. Hence, risk management is the identification, measurement, and treatment
of property, liability, and personnel pure-risk exposures.

OBJECTIVES OF RISK MANAGEMENT

Risk management has several important objectives that can be classified into two categories: pre-
loss objectives and post-loss objectives.

Pre-loss Objectives Post-loss Objectives

Economy Survival

Reduction in anxiety Continuity of operation

Meeting external obligations Earnings stability

Continued growth

Social responsibility

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 imposed
obligations.

The first objective means that the firm should prepare for potential losses in the most economical
way. This involves an analysis of safety program expenses, insurance premiums, and the costs
associated with the different techniques for handling losses.

The second objective, the reduction of anxiety, is more complicated. Certain loss exposures can
cause greater worry and fear for the risk manager, key executives, and stockholders than other

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exposures. For example, the threat of a catastrophic lawsuit from a defective product can cause
greater anxiety and concern than a possible small loss form a minor fire. However, the risk
manager wants to minimize the anxiety and fear associated with all loss exposures.

The third objective is to meet any externally imposed obligations. This means the firm must meet
certain obligations imposed on it by outsiders. For example, government regulations may require
a firm to install safety devices to protect workers from harm. Similarly, a firm’s creditors may
require that property pledged as collateral for a loan must be insured. The risk manager must see
that these externally imposed obligations are met.

Post loss Objectives

The first and most important post loss objective is survival of the firm. Survival means that after
a loss occurs, the firm can at least resume partial operation within some reasonable time period if
it chooses to do so.

The second post loss objective is to continue operating. For some firms, the ability to operate
after a sever loss is an extremely important objective. This is particularly true of the certain
firms, such as a public utility firm, which must continue to provide service. The ability to operate
is also important for firms that may lose customers to competitors if they cannot operate after a
loss occurs. This would include banks, bakeries, dairies, and other competitive firms.

Stability of earnings is the third post loss objective. The firm wants to maintain its earnings per
share after a loss occurs. This objective is closely related to the objective of continued
operations. Earnings per share can be maintained if the firm continues to operate. However, there
may be substantial costs involved in achieving this goal (such as operating at another location),
and perfect stability of earnings may not be attained.

The fourth post loss objective is continued growth of the firm. A firm may grow by developing
new products and markets or by acquisitions and mergers. The risk manager must consider the
impact that a loss will have on the firm’s ability to grow.

Finally, the goal of social responsibility is to minimize the impact that a loss has on other persons
on society. A server loss can adversely affect employees, customers, suppliers, creditors,
taxpayers, and the community in general. For example, a severe loss requires shutting down a
plant in a small community for an extended period can lead to depressed business conditions and
substantial unemployment in the community.

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THE RISK MANAGEMENT PROCESS

In order to have an effective risk management program, the risk manager must take certain steps.
There are four steps in the risk management process:

1. Identifying potential losses

2. Evaluating potential losses
3. Selecting the appropriate technique, or combination of techniques for treating loss exposures
4. Implementing and administering the program

Identifying potential losses

Evaluating potential losses

Selecting the appropriate technique for handling losses

Risk control techniques

 Avoidance
 Loss control
 Separation/Diversification
 Combination

Risk financing techniques

 Retention/Assumption
 Self - insurance
 Non- insurance
 Insurance

Implement and administer the program

1. Identifying Potential Losses

The first step in the risk management process is to identify all pure loss exposures. Risk
identification is the process by which a business systematically and continuously identifies
property, liability, and personnel exposures as soon as or before they emerge. Unless the risk
manager identifies all the potential losses confronting the firm, he or she will not have any

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opportunity to determine the best way to handle the undiscovered risks. The business will
unconsciously retain these risks, and this may not be the best or even a good thing to do.

Risk identification is a very difficult process because the risk manager has to look into all
operations of the company, so as to identify where exactly risks emanate from. Risk
identification is a continuous job for him or her since risk environment is dynamic. Both obvious
and hidden risks need to be identified. As compared to obvious risks, hidden risks pose a more
serious threat because the organization is least prepared for them. Therefore, it becomes
necessary to have a proper system that identifies all kinds of risks on a continuous basis. The risk
manager has to recognize exposures to loss, i.e., he or she must first of all be aware of the
possibility of each type of loss. This is a fundamental duty that must precede all other functions.

Obviously, before anything can be done about the risks an organization faces, someone must be
aware of them. In one way or another, the risk manager must dig into the operations of the
organization and discover the risks to which it is exposed. It is difficult to generalize about the
risks that a given organization is likely to face, because differences in operations and conditions
give risk to differing risks. Some risks are relatively obvious, while there are many that can be,
and often are, overlooked. To reduce the possibility of overlooking important risks, most risk
managers use some systematic approach to the problem of risk identification. A few of their
more important tools include insurance policy checklists, risk analysis questionnaires, flow
process charts, analysis of financial statements, and inspections of the firm’s operations.

2. Evaluating Potential Losses

The second step in the risk management process is to evaluate and measure the impact of losses
on the firm. This involves an estimation of the potential frequency and severity of loss.

Loss frequency refers to the probable number of losses that may occur during some given
period of time. Loss severity refers to the probable size of the losses that may occur. Once the
risk manager estimates the frequency and severity of loss for each type of loss exposure, the
various loss exposures can be ranked according to their relative importance. For example, a loss
exposure with the potential for bankrupting the firm is much more important than an exposure
with a small loss potential.

Although the risk manager must consider both loss frequency and loss severity, severity is more
important. Therefore, the risk manager must also consider all losses that can result from a single
event. Both the maximum possible loss and maximum probable loss must also be estimated.

The maximum possible loss is the worst loss that could possibly happen to the firm during its
lifetime. The maximum probable loss is the worst loss that is likely to happen. For example, if a
plant is totally destroyed in a flood, the risk manager may estimate that replacement cost,
demolition costs and other costs will total Birr10 million. Thus, the maximum possible loss is

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10million Birr. The risk manager also estimates that another flood causing more than 8 million
Birr of damage to the plant. Thus, for this risk manager, the maximum probable loss is 8 million
Birr.
Catastrophic losses are difficult to predict because they occur infrequently. However, their
potential impact on the firm must be given high priority. In contrast, certain losses such as
physical damage losses to automobiles and trucks, occur with greater frequency, but are usually
relatively small. This can be predicted with greater accuracy.

3. Selecting the Appropriate Technique for Treating Loss Exposures

The third step in the risk management process is to select the most appropriate technique, or
combination of techniques, for treating each loss exposure. The major techniques for treating
loss exposures are the following:

Risk control techniques Risk financing techniques

 Avoidance  Retention /Assumption/

 Loss control  Self-insurance
 Separation, /Diversification/  Noninsurance transfers
 Combination  Insurance

A. Risk Control Techniques

Risk control techniques attempt to reduce the frequency and severity of accidental losses to the
firm.

Avoidance

Avoidance means that a certain loss exposure is never acquired, or an existing loss exposure is
abandoned. One way to control a particular risk is to avoid the property, person, or activity
giving rise to possible loss by either refusing to assume it even momentarily or by abandoning an
exposure to loss assumed earlier. The first of these avoidance activities is proactive avoidance,
while the second is abandonment. If a business does not want to be concerned about potential
property losses to a building or to a fleet of cars, it can avoid these risks by never acquiring any
interest in a building or fleet of cars. An existing loss exposure may also be abandoned. For
example, a pharmaceutical firm that produces a drug with dangerous side effects may stop
manufacturing that drug.

Avoidance, whether it be implemented by abandonment or by refusal to accept the risk, should

also be distinguished from loss-control measure. Loss-control measures assume that the firm will
retain the property, person, or activity creating the risk but that the firm will conduct its
operations in the safest possible manner.
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Avoidance is a useful, fairly common approach to the handling of risk. By avoiding a risk
exposure the firm knows that it will not experience the potential losses or uncertainties that
exposure may generate. On the other hand, it also loses the benefits that may have been derived
from that exposure.

Some characteristics of avoidance should be noted:

i) Avoidance may be impossible. The more broadly the risk is defined, the more likely this
is to be so. For example, the only way to avoid all liability exposures is to cease to exist.
ii) The potential benefits to be gained from employing certain persons, owning a piece of
property, or engaging in some activity may so far outweigh the potential losses and
uncertainties involved that the risk manager will give little consideration to avoiding the
exposure. For example, most businesses would find it almost impossible to operate
without owning or renting a fleet of cars. Consequently they consider avoidance to be an
impractical approach.
iii) Avoiding a risk may create another risk. For example, a firm may avoid the risks
associated with air shipments by substituting train and truck shipments. In the process,
however, it has created some new risks.

Loss Control

Loss control is another method for handling loss in a risk management program. Loss-control
activities are designed to reduce both the frequency and severity of losses. Loss-control measures
attack risk by lowering the chance that a loss will occur or by reducing its severity if it does
occur. Loss control has the unique ability to prevent or reduce losses for both the individual firm
and society while permitting the firm to commence or continue the activity creating the risk.

Unlike the avoidance technique, loss control deals with an exposure that the firm does not wish
to abandon. The purpose of loss-control activities is to change the characteristics of the exposure
so that it is more acceptable to the firm; the firm wishes to keep the exposure but wants to reduce
the frequency and severity of losses.

Loss-Prevention and Reduction Methods

Loss-prevention programs seek to reduce or eliminate the chance of loss. Loss-reduction

programs seek to reduce the potential severity of the loss.

The variety of loss-prevention programs is illustrated by the following examples:

 The chance of a fire loss can be reduced by fire-resistive construction, building in an area
where there are few external dangers, and having many suppliers in order that a fire loss
suffered by one supplier will not halt the firm’s operations.

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 The chance of a product liability suit can be reduced by tightening the quality control limits
and choosing distributors more carefully.

Loss-reduction programs can be sub classified as minimization or salvage programs. Both try to
limit the amount of the loss, the distinction between the two beings that minimization programs
take effect in advance of the loss or while it is occurring, whereas salvage programs become
effective after the loss is over. Automatic sprinklers, for example, are designed to minimize a fire
loss by spraying water or some other substance upon a fire soon after it starts in order to confine
the damage to a limited area. The restoration of the damaged property to the highest possible
degree of usefulness would constitute a salvage operation.

Other examples of loss-reduction programs include alternate facilities to reduce the net income
losses arising out of direct losses to the original facilities, periodic physical examinations for
employees, immediate first aid for persons injured on the premises, medical care and
rehabilitation programs for injured workers, fire alarms, internal accounting controls, actions
against persons responsible for losses suffered by the firm, and speed limits for motor vehicles.

Many risk managers are in direct charge of their companies’ accident-prevention programs.
Among their varied duties are:

i) Keeping accurate records of all accidents by number, type, cause, and total damage incurred.
ii) Maintaining plant safety-inspection programs,
iii) Devising ways and means to prevent recurrence of accidents
iv) Keeping top management accident conscious.
v) Seeing that proper credits are obtained in the insurance premium for loss prevention measures.
vi) Minimizing losses by proper salvage techniques and other action at the time of a loss.
vii) Working with company engineers and architects in planning new construction to provide for
maximum safety.

Separation /Diversification/

Another risk control tool is separation of the firm’s exposures to loss instead of concentrating
them at one location where they might all be involved in the same loss. For example, instead of
placing its entire inventory in one warehouse a firm may elect to separate this exposure by
placing equal parts of the inventory in ten widely separated warehouses. If fire destroys one
warehouse, the firm will have others from which to draw needed supplies. Another example is to
disperse work operations in such a way that explosion or other catastrophe would not injure more
than a limited number of persons.

To the extent that this separation of exposures reduces the maximum probable loss to one event,
it may be regarded as a form of loss reduction. The probability of some loss actually increases.
The probability that at least one of several units will suffer a loss is greater than the probability
that any particular unit will suffer a loss. Emphasis is placed here, however, on the fact that
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through this separation the firm increases the number of independent exposure units under its
control. Other things being equal, because of the law of large numbers, this increase reduces the
risk, thus improving the firm’s ability to predict what its loss experience will be.

Combination

Combination or pooling makes loss experience more predictable by increasing the number of
exposure units. The difference is that unlike separation, which spreads a specified number of
exposure units, combination increases the number of exposure units under the control of the firm.

One way a firm can combine risk is to expand through internal growth. For example, a taxicab
company may increase its fleet of automobiles. Combination also occurs when two firms merge
or one acquires another. The new firm has more buildings, more automobiles, and more
employees than either of the original companies.

Combination of pure risks is seldom the major reason why a firm expands its operations, but this
combination may be an important by-product of merger or growth. (An example of pooling with
respect to speculative risks, which may be a primary objective of merger or expansion, is the
diversification of products by a business). Insurers, on the other hand, combine pure risks
purposefully; they insure a large number of persons in order to improve their ability to predict
their losses.

B. Risk Financing Techniques

Risk financing techniques provide for the funding of accidental losses after they occur.

Retention/Assumption/

The most common method of handling risk is retention by the organization. The source of the
funds is the organization itself, including borrowed funds that the organization must repay.
Retention may be passive or active, unconscious or conscious, unplanned or planned.

Retention is passive or unplanned when the risk manager is not aware that the exposure exists
and consequently does not attempt to handle it. By default, therefore, the organization has
elected to retain the risk associated with that exposure. Few, if any, organizations have identified
all their exposures to property, liability, and human resource losses. Consequently, some
unplanned retention is common-place and perhaps inevitable. If the risk identification has been
poorly performed too much risk is passively retained. A related form of unplanned retention
occurs when the risk manager has properly recognized the exposures but has underestimated the
magnitude of the potential losses. Liability exposures exemplify the type of potential loss that is
often underestimated.

Retention is active or planned when the risk manager considers other methods of handling the
risk and consciously decides not to transfer the potential losses.

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Self-insurance is a special case of active or planned retention. It is distinguished from the other
type of retention usually referred to as noninsurance in that the organization has a large number
of exposure units. Self-insurance is not insurance, because there is no transfer of the risk to an
outsider. Self-insures and insurers, however, share the ability, though in different degrees, to
predict their future loss experience.

Retention can be effectively used in a risk management program when three conditions exist.

i) When no other method of treatment is available. Insurers may be unwilling to write a

certain type of coverage, or the coverage may be too expensive. Non-insurance transfers
may not be available. In addition, although loss control can reduce the frequency of loss,
all losses cannot be eliminated. In these cases, retention is a residual method. If the
exposure cannot be insured or transferred, then it must be retained.
ii) When the worst possible loss is not bankrupt the firm if the automobiles are separated by
wide distances and are not likely to be simultaneously damaged.
iii) When losses are highly predictable. Based on past experience, the risk manager can
estimate a probable range of frequency and severity of actual losses. If most losses fall
within that range, they can be budgeted out of the firm’s income.

Self-insurance

Self-insurance is a special form of planned retention by which part or all of a given loss
exposure is retained by the firm. A better name for self-insurance is self-funding, which
expresses more clearly the idea that losses are funded and paid by the firm.

Risk retention, planned or unplanned, should not be confused with the concept of self-insurance.
Although self-insurance 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. Furthermore, a
self-insurance plan implies that adequate financial arrangements have been made in advance to
provide funds to pay for losses should they occur. Unless payments to the self-insurance fun are
calculated scientifically and paid regularly, a true self-insurance system does not exist.

Self-insurance plans are distinguished from other insurance operations by having the pooling of
exposures and funding of the cost of losses takes place within one business entity.

Self-insurance is widely used in workers compensation insurance. Self-insurance is also used by

employers to provide group health, dental, vision, and prescription drug benefits to employees.
Firms often self-insure their group health-insurance benefits because they can save money and
control health-care costs.

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Non insurance Transfers

Non insurance transfers are methods other than insurance by which a pure risk and its potential
financial consequences are transferred to another party. Neutralization or hedging and hold-
harmless agreements are examples of noninsurance transfer of risk.

Non insurance or hedging As generic terms, neutralization and hedging describe actions
whereby a possible gain is balanced against a possible loss. Neutralization is the process of
balancing a chance of loss against a chance of gain. For example, a person who has bet that a
certain team will win the World Cup may neutralize the risk involved by also placing a bet on the
opposing team. In other words, he or she transfers the risk to the person who accepts the second
bet.

A commercial example of neutralization is hedging in raw material prices or by exporters who

would be affected by changes in foreign exchange rates. The nature of hedging is no chance of
gain associated with pure risks, neutralization or hedging is not a tool of pure risk management.

Hold-harmless agreements are contract entered into prior to a loss, in which one party agrees to
assume a second party’s responsibility should a loss occur. For example, contractors may require
subcontractors to provide the contractor with liability protection if they are sued because of the
subcontractor’s activities. Likewise, vendors request hold harmless agreements before selling a
manufacturer’s goods.

Insurance

Commercial insurance is also used in a risk management program. From the risk manger’s
viewpoint, insurance represents a contractual transfer of risk. Insurance is appropriate for loss
exposures that have a low probability of loss but the severity of loss is high. If the risk manager
uses insurance to treat certain loss exposures, five key areas must be emphasized. They are as
follows:

 Selection of insurance coverage

 Selection of an insurer
 Negotiation of terms
 Dissemination of information concerning insurance coverage
 Periodic review of the insurance program
i) The risk manager must select the insurance coverage needed. Since there may not be
enough money in the risk management budget to insure all possible losses, the need for
insurance can be divided into several categories depending on importance. One useful
approach is to classify the need for insurance into three categories: (1) essential, (2)
desirable, and (3) available.
 Essential insurance includes that coverage required by law or by contract, such as workers
compensation insurance. Essential insurance also includes that coverage that will protect the

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firm against a catastrophic loss or a loss that threatens the firm’s survival; commercial
general liability insurance would fall into that category.
 Desirable or important insurance is protection against losses that may cause the firm
financial difficulty, but not bankruptcy. Desirable insurance coverage includes those that
protect against loss exposures that would force the firm to borrow or resort to credit.
 Available or optional insurance is coverage for slight losses that would merely
inconvenience the firm. Optional insurance coverage includes those that protect against
losses that could be met out of existing assets or current income.
ii) The risk management must select an insurer or several insurers. Several important factors
come into play here. These include the financial strength of the insurer, risk management
services provided by the insurer, and the cost and terms of protection.
iii) After the insurer or insurers are selected, the terms of the insurance contract must be
negotiated. If printed polices, endorsements, and forms are used, the risk manager and
insurer must agree on the documents that will form the basis of the contract. If a specially
tailored manuscript policy is written for the firm, the language and meaning of the
contractual provisions must be clear to both parties. In any case, the various risk
management services the insurer will provide must be clearly stated in the contract.
Finally, if the firm is large, the premiums may be negotiable between the firm and
insurer.
iv) Information concerning insurance coverage must be disseminated to others in the firm.
The firm’s employees and managers must be informed about the insurance coverage, the
various records that must be kept, the risk management services that the insurer will
provide, and the changes in hazards that could result in a suspension of insurance. Those
persons responsible for reporting a loss must also be informed. The firm must comply
with policy provision concerning how notice of a claim is to be given and how the
necessary proofs of loss are to be presented.
v) The insurance program must be periodically reviewed. The entire process of obtaining
insurance must be evaluated periodically. This involves an analysis of agent and broker
relationships, coverage needed, cost of insurance, quality of loss-control services
provided, whether claims are paid promptly, and numerous other factors. Even the basic
decision- whether to purchase-insurance must be reviewed periodically.

Which Method should be used?

In determining the appropriate method or methods for handling losses, a matrix can be used that
classifies the various loss exposures according to frequency and severity. The matrix can be
useful in determining which risk management method should be used.

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FREQUENCY OF LOSS

SEVERITY OF LOSS LOW HIGH

Loss Control and

LOW Retention Retention

HIGH Insurance Avoidance

Risk Management Matrix

The first loss exposure is characterized by both low frequency and low severity of loss. One
example of this type of exposure would be the potential theft of a secretary’s dictionary. This
type of exposure can be best handled by retention, since the loss occurs infrequently and, when it
does occur, it seldom causes financial harm.

The second type of exposure which is characterized by high frequency and low severity of losses
is more serious. Examples of this type of exposure include physical damage losses to
automobiles, workers compensation claims, and food spoilage. Loss control should be used here
to reduce the frequency of losses. In addition, since losses occur regularly and are predictable,
the retention technique can also be used.

The third type of exposure can be met by insurance. Insurance is best suited for low frequency,
high-severity losses. High severity means that a catastrophic potential is present, while a low
probability of loss indicates that the purchase of insurance is economically feasible. Examples of
this type of exposure include fires, explosions, and liability lawsuits. The risk manager could
also use a combination of retention and commercial insurance to deal with these exposures.

The fourth and most serious type of exposure is one characterized by both high frequency and
high severity. This type of exposure is best handled by avoidance.

4. Implementing and Administering the Risk Management Program

At this point, three of the four steps in the risk management process have been discussed. The
fourth step is implementation and administration of the risk management program.

Typical activities of a risk manager include identifying and evaluating loss exposures,
establishing procedures for handling insurance claims, designing and installing employee benefit
plans, participating in loss-control and safety programs, and administering group insurance and
self-insurance programs. Thus, risk managers are an important part of the management team.

Risk Management Policy Statement

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A risk management policy statement is necessary in order to have an effective risk management
program. This statement outlines the risk management objectives of the firm.

In addition, a risk management manual may be developed and used in the program. The manual
describes in some detail the risk management program of the firm and can be a very useful tool
for training new employees who will be participating in the program. Writing the manual also
forces the risk manager to state precisely his or her responsibilities, objectives, and available
techniques.

Cooperation with Other Departments

The risk manger does not work alone. Other functional departments within the firms are
extremely important in identifying pure loss exposures and methods for treating these exposures.
These departments can cooperate in the risk management process in the following ways:

 Accounting: - Internal accounting controls can reduce employee fraud and theft of cash.
 Marketing: - Accurate packaging can prevent liability lawsuits. Safe distribution procedures
can prevent accidents.
 Production: - Quality control can prevent the production of defective goods and liability
lawsuits. Effective safety programs in the plant can reduce injuries and accidents.
 Personnel: - This department may be responsible for employee benefit programs, pension
programs, and safety programs.

This list indicates how the risk management process involves the entire firm. Indeed, without the
active cooperation of the other departments, the risk management program will be a failure.

Periodic Review and Evaluation

To be effective, the risk management program must be periodically reviewed and evaluated to
determine if the objectives are being attained. In particular, risk management costs, safety
programs, and loss prevention programs must be carefully monitored. Loss records must also be
examined to detect any changes in frequency and severity. In addition, new developments that
affect the original decision on handling a loss exposure must be examined. Finally the risk
manager must determine if the firm’s overall risk management policies are being carried out, and
if the risk manager is receiving the total cooperation of the other departments in carrying out the
risk management functions.

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