Risk Management

Prof Mahesh Kumar

Amity Business School
profmaheshkumar@rediffmail.com
 Introduction- Business Risk
 The major business risks that give riser to
variation in cash flows and business value are:
a) Price Risk
b) Credit Risk
c) Pure Risk
Introduction- Business Risk
 Price risk refers to uncertainty over magnitude of cash
flows due to possible changes in input and output prices.
The specific types of price risk are commodity price,
exchange rate risk & interest rate risk.
 Credit risk refers to uncertainty that a firm’s customers
and the parties to which it has lent money fail to make
promised payments.
 Pure Risk is associated with Direct losses and Indirect
losses.
Direct losses include damage to assets, injury or illness to
employees & liability claims and defense costs
Indirect losses include loss of normal profit (net cash
flow), continuing and extra operating expense, higher
cost of funds and foregone investment and bankruptcy
cost (legal fees).
What is Risk Management?
 Good management practice
 Process steps that enable improvement
in decision making
 A logical and systematic approach
 Identifying opportunities
 Avoiding or minimizing losses
Risk Management- Defined
 Risk Management is a management process for
preserving the operating effectiveness of the
organization.
 Risk Management may be defined as ‘the identification,
analysis and economic control of those risks which can
threaten the assets or earning capacity of an enterprise.’
 Risk Management evaluates risks identified in the risk
assessment process which require management and
selects and implements the plans or actions that are
required to ensure that those risks are controlled.
 Risk Management is now an integral part of business
planning and is a methodology that helps managers make
best use of their available resources.
Importance of Risk Management
 Risk Management is essential not only for
prevention of risk but also for reduction of risks.
 Risk Management leads to maximum social
advantages and plays a significant role in
bringing about social, political and economic
development in a country.
 The process of risk management helps focus on
priorities and in decisions on deploying limited
resources to deal with the highest risks.
Importance of Risk Management
Risk Management helps:
a) To create the right corporate policies and strategies.
b) To manage men and machine (processes) effectively.
c) To evaluate the risk confronted by a business.
d) To effectively handle, spread, monitor and insure the risks.
e) To introduce various plans and techniques to minimize the
risk.
f) To give advices and suggestions for handling the risks.
g) To create awareness among the people.
h) To avoid cost, disruption and unhappiness relating to risk.
i) To decide which risks are worth taking/ pursuing and which
should be shunned.
j) To fix the sum assured under the policy and to decide
whether to insure or not.
k) To select the appropriate technique or method to manage
the risks.
 Objectives of Risk Management
 Pre loss Objectives:
a) Firms should prepare for potential loss in most
economical manner. It involves an analysis of the
cost of safety programs, insurance premiums paid
and the costs associated with different techniques
for handling losses.
b) Reduction of anxiety by covering or minimizing
large loss exposures.
c) To meet any legal obligation like government
regulations to install safety devices to protect
workers from harm, to dispose of hazardous
waste materials properly and to label consumer
products appropriately.
 Objectives of Risk Management
 Post Loss Objectives:
a) Survival of the firm. Survival implies that after loss occurs,
the firm can resume at least partial operations within
reasonable time period.
b) Continuity in operation.
c) Stability of earnings. Earnings per share can be maintained if
the firm continues to operate.
d) Continued growth of the firm. A company can grow by
developing new products and markets or by acquiring or
merging with other companies. The risk manager must
therefore consider the effect that a loss will have on the firm’s
ability to grow.
e) Corporate social responsibility of minimizing the effects that a
loss will have on other persons or society. For example, a
severe loss that shuts down a plant in a small town for an
extended period can cause considerable economic distress in
the town.
Steps in Risk Management Process
Following are five steps in risk management process:
1) Identify all significant risks that can reduce
business value (cause loss).
2) Evaluate the potential frequency and severity of
losses.
3) Develop and select methods for managing risk in
order to increase business value to shareholder.
4) Implement risk management methods chosen.
5) Monitor the performance and suitability of the
firm’s risk management methods and strategies in
an ongoing basis.
Risk Management Process-Identity Potential losses

Risk identification is the foundation of risk management.

The various methods of identification are:
1. Preparing checklist of risks of various losses which may
arise due to risks.
2. Onsite inspections and risk assessment.
3. Financial statement analysis.
4. Flowchart preparation and identification of risky activities.
5. Interaction with employees for their views about risk
exposures of business based on their knowledge and
experience.
6. Statistical record of occurrence of losses related to
various categories of risks.
Risk Management Process-Identity Potential losses

1. Property loss exposure.

2. Liability loss exposure.
3. Business income loss exposure.
4. Human resource loss exposure.
5. Crime loss exposure.
6. Employee benefit loss exposure.
7. Foreign loss exposure.
 Risk Management Process-Evaluating Potential
loss
After identifying and analyzing the risks, you can evaluate.
What is the likelihood of the risk event occurring? (Potential
Loss Frequency)
• Almost certain
• Likely
• Moderate
• Unlikely
• Rare?
What is the consequence if the risk event occurs? (Severity
of loss)
• Extreme
• Very high
• Moderate
• Low
• Negligible?
 Risk Management Process-Evaluating Potential
loss
 You need to describe or to quantify exactly what
the ‘Likelihood’ and ‘Consequence’ terms means
to you.
 This helps in ensuring a consistent approach in
future risk assessment and review and
monitoring.
 It promotes a common understanding within the
Administration.
Risk Management Process-Evaluating Potential
loss
• After establishing ‘Likelihood’ and ‘Consequence’ you
can use a table like this to set a level of risk.

Extreme Very high Moderate Low Negligible

Almost certain Severe Severe High Major Moderate

Likely Severe High Major Significant Moderate

Moderate High Major Significant Moderate Low

Unlikely Major Significant Moderate Low Very low

Rare Significant Moderate Low Very low Very Low

You must define what these risk levels mean to you.

Implementation and Administration
Loss Frequency Loss severity Application of
Risk Mgt. Tech.
Low Low Retention

High Low Loss prevention

and retention
Low High Insurance

High High Avoidance

Techniques of Risk Management
 Risk control-reduces the frequency and the
severity of the loss. Avoidance, Loss prevention
and loss reduction.
 Risk financing-provides for the funding of the
losses. Retention, Non Insurance transfers,
Insurance.
Techniques of Risk Management
There are, thus, six major methods of
handling risk:
1. Avoidance of Risk
2. Prevention/Reduction of Risk
3. Retention or Accepting Risks
4. Non Insurance Transfers or Shifting of Risk
5. Insurance
6. Spreading Of Risk
Techniques of Risk Management
Avoidance of Risk
 Certain loss exposure is never acquired or
existing loss exposure is abandoned
Illustrative examples of risk avoidance are:
1. A business firm can avoid the risk of being
sued for a defective product by not producing
the product.
2. You can avoid the risk of divorce by not
marrying.
3. You can avoid the risk of being mugged in a
high crime rate area by staying out of the
area.
Techniques of Risk Management
Prevention of Risk
 ‘Prevention is better than cure’
 The objective of loss prevention is to reduce the
frequency of loss.
 Risks can be eliminated or at least minimized by taking
preventive steps.
Illustrative examples of risk avoidance are:
1. Losses from theft, shop lifting etc. can be minimized by
giving effective training to the employees of the firm.
Apart from this, burglars alarm, watchmen, safety vaults
etc help a lot in preventing or avoiding the risk.
2. If creditworthiness of the party is known before granting
credit, losses from bad debts can be prevented.
Techniques of Risk Management
Prevention of Risk
3) Loss from fire, weather change etc can be completely
avoided by conducting fire proof building for storing
products.
4) To avoid the non availability of raw materials, it is
advisable to adopt vertical integration, in which full
control over supply of raw materials to the distribution
of final goods can be exercised.
5) Loss from overstocking or under stocking should be
avoided by producing the product to meet the orders.
Over stocking will block the working capital and under
stocking will result in lost sales and thus loss of profit.
6) Demand of products can be regulated by effective sales
efforts through trademarks and brands. This will
overcome the loss through bogus sales.
Techniques of Risk Management
Reduction of Risk
 Many risks are neither transferable nor avoidable.
 The objective of risk reduction is to reduce the severity
of loss.
 Risk reduction does not affects cost of capital.
 Risk reduction does not affect the expected cash flow.
 In modern times, it is expected business conditions will
change frequently and illustrative risk reduction
measures are:
a) Loss of sale due to change in fashion, improved
products, substitutes can be overcome by stock
clearance sales at discount.
b) Loss on account of market change may be minimized by
market research and then making changes in business
policies accordingly.
Techniques of Risk Management
Reduction of Risk
c) Innovations invite risk and at the same time changes
may lead to progress as well. Business cannot progress
without innovations.
d) Re-organization of firms- mergers & acquisitions,
conversion from one form of organization into another
e.g. shifting from a partnership business into a
company form may greatly help in improving the
managerial ability, financial strength etc. of the
business.
e) A department store can install a sprinkler system so
that fire can be promptly extinguished, thereby
reducing the loss.
f) A plant can be constructed with fire resistant materials
to minimize fire damages.
g) A community warning system can reduce the number of
injuries & deaths from an approaching tornado.
Advantages of Loss Control Strategies
 Loss control strategies are desirable for two reasons:
1) The indirect cost of losses may be large, and in some
instances can easily exceed the direct costs.
Ex: A worker may be injured on the job. In addition
being responsible for the worker’s medical expense
and a certain percentage of earnings (direct costs)
the firm may incur sizeable indirect costs: a machine
may be damaged and must be repaired; the
assembly line may have to be shut down; costs are
incurred in training a new worker to replace the
injured worker and a contract may be cancelled
because goods are not shipped on time. By
preventing the loss from occurring, both indirect
costs and direct costs are reduced.
Advantages of Loss Control Strategies
2) The social costs of losses are reduced.
Ex: Assume that the worker in the preceding
example dies from accident. Society is deprived
forever of the goods and services the deceased
worker could have produced. The family losses its
share of the worker’s earnings and may experience
considerable grief and financial insecurity. And the
worker may personally experience great pain and
suffering before dying. In short, the social costs can
be reduced through an effective loss control
program.
Retention or Acceptance of Risk
 The element of risk is incidental to life and cannot always
be avoided or transferred.
 In Retention or Acceptance of Risk an individual or a
business firm retains all or part of a given risk.
 Risk may be retained/ accepted in the following ways:
a) Certain risks are retained because of ignorance,
indifference or laziness (Passive retention).
retention) This type of
risk retention is very dangerous if the risk retained has the
potential for destroying you financially.
Ex: Many workers with earned income are not insured
against the risk of total and permanent disability under
either an individual or group disability income plan.
However, the adverse financial consequences of total and
permanent disability generally are more severe than
financial consequences of premature death.
Retention or Acceptance of Risk
b) Some risks are accepted inadvertently.
Ex: A Family Head fails to make adequate provision for his
family and in the event of premature death or disability
through accident, his family has to suffer. He might not
have been callous or indifferent but merely
neglectful/unmindful.
c) Some risks are accepted intentionally. Where the degree
of risk is less or the probable loss is small, a man may be
willing to bear it without any exception. (Active retention).
retention)
Ex: A business firm may deliberately retain the risk of
petty thefts by employees, shoplifting or the spoilage of
perishable goods.
 In these cases, a conscious decision is made to retain part
or all of a given risk.
Retention or Acceptance of Risk
Retention technique is used:
a) No other method of treatment is available.
b) The worst possible loss is not serious.
c) Losses are highly predictable.

Retention losses are paid by current net

income, unfunded reserves, funded reserves,
credit line.
Retention or Acceptance of Risk
Advantages :
a) Saving on money.
b) Lower expenses like risk adj exp, general
administrative expenses, comm. and
brokerage fees, loss control exp, taxes & fees
and insurance profit.
c) Encourage loss prevention
d) Increase cash flow.
Disadvantage:
a) Possible higher losses.
 Non Insurance Transfers
Methods other than insurance by which a pure risk
& its potential financial consequences are
transferred to another party.
They can be done in three ways.
a) By transfer of risk by contract.
b) Hedging the price risk.
c) Incorporation of a business firm.
 Non Insurance Transfers
Transfer of Risk by Contracts
 Unwanted risk can be transferred by contracts. Illustrative
examples are:
a) The risk of defective television or stereo set can be transferred
to the retailer by purchasing a service contract which makes the
retailer responsible for all repair after the warranty expires.
b) The risk of rent increase can be transferred to the landlord by a
long term lease.
c) The risk of a price increase in construction costs can be
transferred to the builder by having a fixed price in the contract.
d) Risk can be transferred by hold-harmless clause. Ex: If a
manufacturer inserts a hold harmless clause in a contract with a
retailer, the retailer agrees to hold manufacturer harmless in
case of loss suffered by retailer on account of supply of goods by
the manufacturer.
 Non Insurance Transfers
Hedging Price Risks
 Hedging price risks is another example of risk
transfer.
 Hedging is the technique for transferring the risk
of unfavorable price fluctuation to a speculator by
purchasing and selling futures contract on an
organized exchange.
 Non Insurance Transfers
Incorporation of a Business Firm
 By incorporation, the liability of the stock holders
is limited, and the risk of the firm having
insufficient assets to pay business debts is shifted
to the creditors.
Non Insurance Transfers
Advantages :
a) Transfer potential risk which are otherwise not
commercially insurable.
b) Insurance cost is less.
c) Potential loss may be shifted to someone who
is in better position to excise loss control.
Disadvantages:
a) Contract language is ambiguous.
b) If the party to whom the potential loss is trfd
is unable to pay for the loss.
Insurance
 Insurance is the most practical method for
handling a major risk.
 Insurance is a contract by which the insurer
(insurance company) in consideration of the
payment of a sum (premium) agrees to pay a
specified sum to the insured (the person or
party insuring against the risk) in the event of
some untoward happening taking place.
 The insurer undertakes to indemnify the
assured for the loss on the happening of the
event.
 Insurance
 There are three major characteristics of
insurance:
1. Risk transfer is used because pure risk is
transferred to the insurer.
2. Pooling technique is used to spread the losses of
the few over the entire group so that average
loss is substituted for actual loss.
3. The risk may be reduced by application of the
Law of large numbers by which an insurer can
predict future loss experience with greater
accuracy.
Insurance & Expected Cash Flows

 Negative effects: Decrease expected cash flow

 Loading on insurance premium
 Positive effects: Increase expected cash flow
 By decreasing cost of services from insurers
 Usually bundled in insurance contract
 By decreasing likelihood of having to raise new
funds
 By decreasing likelihood of financial distress
 By decreasing expected tax payments
 Insurance
1. Select the insurance coverage.
2. Select an insurer or several insurers.
3. Term of insurance contract to be negotiated
Advantages:
1. Firm is indemnified from potential loss. Continuity and
earnings are unaffected.
2. Uncertainty is reduced which permits meticulous planning
of business.
3. Tax advantage as premium is deductible as business exp.
Disadvantages:
1. The payment of premium is a major cost.
2. Considerable time is utilized in negotiating the insurance
coverage.
 Spreading Of Risks
 Spreading of Risks is also termed as ‘Averaging of Risks’.
 It does not reduce the aggregate amount of potential
loss but it helps to achieve reduction of uncertainty and
thus spreads the burden of those who have collaborated
against the risk. Illustrative examples are:
1. Operating nationally and multinationally i.e. entering
business in different geographical states within a country
or different countries.
2. Incorporating as a public company so that with larger
capital resources, it is in position to enter large volumes
of business in order to achieve a large spread of risks
i.e. have economies of scale.
 Spreading Of Risks
3) Entering into reinsurance business with other
companies and also accepting re-insurances for
other companies. (way of spreading risk by an
insurance company).
4) Entering into pools of certain risks particularly of
difficult or more hazardous nature such as
Tsumani.
 Risks can thus be spread over a large capital, a
wide geographic area and a large period of
time.
 Summary: Scope of Risk Management
Scope of Risk Management

Control of Loss Financing Of loss Internal Risk Control

Extra Precautions Risk Retention & Diversification

Self Insurance

Reduced level of Buy Insurance Investment in

Risky Activities Policies Contracts Risk Information

Non Insurance Risk

Transfers