Chapter 1

INTRODUCTION TO RISK
MANAGEMENT
"The essence of risk management lies in maximizing the areas where we
have some control over the outcome while minimizing the areas where
we have absolutely no control over the outcome . .."
Contemporary Homes is a large construction company that builds homes and apartment buildings in three states. In
recent months, several employees have been injured on the job, and the theft of material and supplies from job sites
has increased. The company s accountant recommended that the firm establish a risk management program to deal
with these problems. Risk management is process that identifies the loss exposures faced by a firm and uses a
number of methods, including insurance, to treat the loss exposures. After implementing the program,
Contemporary Homes saw dramatic results. Job-related injuries declined; thefts of materials and supplies declined;
and workers compensation premiums were reduced. The firms profitability also increased.

Clearly, Contemporary Homes benefited from its risk management program. Other organizations have also
recognized the merits of a formal risk management program. Today, risk management is widely used by
corporations, small employers, nonprofit organizations, and state and local governments. Students can also benefit
from a personal risk management program.
RISK MANAGEMENT
a process that identifies loss exposures faced by an organization and
selects the most appropriate techniques for treating such exposures.

LOSS EXPOSURE
any situation or circumstance in which a loss is possible, regardless
of whether a loss occurs
OBJECTIVES OF RISK
MANAGEMENT
• Pre-loss objectives

• Post-loss objectives
 PRE-LOSS
1 OBJECTIVES
Prepare for potential losses in the most economical
way

2 The reduction of anxiety

3 Meet any legal obligations

 POST-LOSS
1 3
OBJECTIVES
Survival of the Firm Stability of Earnings

2 Continuation of Operation 4 Continued Growth of

Firm

5 minimize effects that a loss will have on other persons

and on society
 STEPS IN THE RISK
MANAGEMENT PROCESS
Identify loss exposures Analyze the loss exposures

Select the appropriate technique for treating the

Implement and monitor the risk
loss exposures:
management program
1.Risk Control (Avoidance, Loss Prevention, Loss
Reduction)

2. Risk Financing (Retention, Noninsurance

Transfers, Commercial Insurance)
 1
IDENTIFYING LOSS
EXPOSURES
 IDENTIFYING LOSS EXPOSURE
1. Property loss exposures
• Building, plants, other structures
• Furniture, equipment, supplies
• Computers, computer software, and data
• Inventory
• Accounts receivable, valuable papers and
records
• Company vehicles, planes, boats, mobile
equipment
1 Identify the loss exposures
2. Liability loss exposures
• Defective Products
• Environmental pollution (land, water, air,
noise)
• Sexual harassment of employees,
discrimination against employees,
wrongful termination
• Premises and general liability loss
exposures
• Liability arising from company vehicles
• Misuse of the Internet and e-mail
transmissions
 IDENTIFYING LOSS EXPOSURE
3. Business income loss exposures 5. Crime loss exposures

• Loss of income from a covered loss • Holdups, robberies, burglaries

• Continuing expenses after a loss • Employee theft and dishonesty

• Extra expenses • Fraud and embezzlement

• Contingent business income losses • Internet and computer crime exposures

4. Human resources loss exposures • Theft of intellectual property

• Death or disability of key employees

• Retirement or unemployment
• Job-related injuries or disease experienced
by workers

1 Identify the loss exposures

 IDENTIFYING LOSS EXPOSURE
7. Foreign loss exposures
6. Employee benefit loss exposures
• Plants, business property, inventory
• a Failure to comply with government
• Foreign currency risks
• regulations
• Kidnapping of key personnel
• Violation of fiduciary responsibilities
• Political risks
• Group life and health and retirement plan
exposures
8. Market reputation and public image
• Failure to pay promised benefits
of the company

1 Identify the loss exposures

 IDENTIFYING LOSS EXPOSURE
9. Failure to comply with government laws and regulations

A risk manager has several sources of • Flowcharts

information that he or she can use to
• Financial statements
identify the preceding loss exposures. They
include the following: • Historical loss data

• Risk analysis questionnaires

• Physical inspection

1 Identify the loss exposures

 2
ANALYZE THE LOSS
EXPOSURES
 ANALYZE THE LOSS EXPOSURES
Loss Frequency refers to the probable
number of losses that may occur during
some given time period.

Loss severity refers to the probable size

of the losses that may occur.

2 Analyze the loss exposures

 ANALYZE THE LOSS EXPOSURES
• Various Loss Exposures are ranked The maximum possible loss is the worst loss
according to their relative importance that could happen to the firm during its

• The most appropriate technique is selected lifetime. The maximum probable loss is the

for handling each exposure worst loss that is likely to happen.

• The risk manager must consider both loss

frequency and loss severity, severity is
• Catastrophic losses are difficult to
more important.
predict because they occur
infrequently.

2 Analyze the loss exposures

 3
SELECT THE APPROPRIATE
TECHNIQUES FOR TREATING
THE LOSS EXPOSURES
 techniques that reduce the frequency and
Risk Control severity of losses

MAJOR RISK-CONTROL TECHNIQUES INCLUDE THE

FOLLOWING:
Avoidance means a certain loss exposure is never acquired, or an existing loss
exposure is abandoned.

Loss prevention refers to measures that reduce the frequency of a particular

loss.

Loss Reduction refers to measures that reduce the severity of a loss after it
occurs.

3 Selecting the Appropriate Techniques for Treating the Loss Exposures

 Risk Financing techniques that provide for the funding
of losses after they occur

Major risk-financing techniques include the

following:
▪ Retention

▪ Noninsurance transfers

▪ Commercial insurance

3 Selecting the Appropriate Techniques for Treating the Loss Exposures

 Retention
Retention can be effectively used in a risk
the firm retains part or all of the management program under the following
losses that can result from a given conditions:
loss.
▪ No other method of treatment is available.

▪ Active Retention ▪ The worst possible loss is not serious.

▪ Losses are highly predictable.

▪ Passive Retention

3 Selecting the Appropriate Techniques for Treating the Loss Exposures

 Non- Insurance Transfers
are methods other than insurance by which a pure risk and its potential
financial consequences are transferred to another party

3 Selecting the Appropriate Techniques for Treating the Loss Exposures

 Advantages:
▪ The risk manager can transfer some potential losses that are not commercially
insurable.

▪ Noninsurance transfers often cost less than insurance.

▪ The potential loss may be shifted to someone who is in a better position to

exercise loss control.

3 Selecting the Appropriate Techniques for Treating the Loss Exposures

 Disadvantages:
▪ The transfer of potential loss may fail because the contract language is
ambiguous.

▪ If the party to whom the potential loss is transferred is unable to pay the loss,
the firm is still responsible for the claim.

▪ An insurer may not give credit for the transfers, and insurance costs may
not always be reduced.

3 Selecting The Appropriate Techniques For Treating The Loss Exposures

 Insurance
If the risk manager uses insurance to treat certain loss exposures, five key areas must
be emphasized:

▪ Selection of insurance coverages

▪ Selection of an insurer

▪ Negotiation of terms

▪ Dissemination of information concerning insurance coverages

▪ Periodic review of the program

3 Selecting The Appropriate Techniques For Treating The Loss Exposures

 Advantages of Insurance:
▪ Indemnification after a loss occurs

▪ Reduction in uncertainty

▪ Availability of valuable risk management services

▪ The income-tax deductibility of the premiums

3 Selecting The Appropriate Techniques For Treating The Loss Exposures

 Disadvantages of Insurance:
▪ Cost of insurance, time and effort that must be spent in negoti
ating for insurance

▪ A possible lax attitude toward loss control because of the

existence of insurance.

3 Selecting The Appropriate Techniques For Treating The Loss Exposures

 4
IMPLEMENT AND MONITOR THE
RISK MANAGEMENT PROGRAM
 Risk Management Policy
Statement
This statement outlines the risk management objectives of the firm, as well as
company policy with respect to treatment of loss exposures.

4 Implement And Monitor The Risk Management Program

 Periodic Review and Evaluation
Major benefits of this includes:

▪ The pre-loss and post-loss risk management objectives are more easily
attainable.

▪ The cost of risk is reduced, which may increase the company's profits.

▪ The adverse financial impact of pure loss exposures is reduced.

▪ Society also benefits.

4 Implement And Monitor The Risk Management Program

 Personal Risk Management
refers to the identification of pure risks faced by an individual or family, and
to the selection of the most appropriate technique for treating such risks.