Risk MGT CH 1 and 2

Select Business and Technology College
Faculty of Business
A teaching material on:

Risk Management and Insurance
December,2020 Risk Mgt & insurance

RISK MANAGEMENT AND
INSSURANCE:
ALL IN ONE
BY: TSEGAYE A.
 Bachelor of Art International Trade and Investment
Management ,(BSC)
 Masters of Art in Project Management,(MSC)
 Masters of Business Administration,(MBA)

Chapter One
An overview of Risk
Definition of Risk
 Risk is uncertainty concerning the occurrence of
undesired result such as loss, damage, theft etc.
 It refers uncertainty weather the demanded or
unpleasant result will occur.
 Practically all people are risk managers; because we
all are facing risks and handling them throughout
our actions.

Risk vs. Uncertainty
 Risk :- “the possibility of meeting danger or

suffering harm or loss”.
 Uncertainty:- “the state of being in doubt about
occurrence of some result”.
 uncertainty of meeting with a undesired outcome is
known as risk.
 The less the uncertainty/the more the predictability
the less the level of the risk would be.

Chance of loss Vs. Risk
Chance of loss is the probability that an

event(loss) will occur.
The chance of loss may be same for two
different groups, but objective risk may be
different.
Eg. OIC- insured 10,000 houses both in A.A and
Adama; the chance of loss is 1%(100). If the annual
variation ranges from 80 to 120 in A.A and from 90
to 110 in Adama, the objective risk is greater in A.A.

Distinction of Risk from Peril & Hazard
 Peril:- the cause/sources of loss.
 If a house burns because of fire, the peril is the fire.
The following are major sources of risk:
 Companies operation and structure: company’s own
policy and strategy, manpower, process and structure are
main source of uncertainty.
 Physical Environment-earthquakes, drought, flooding or
excessive rainfall can all lead to loss.
 Social Environment. Changing traditions, tastes and
values, human behavior, social structures, and institutions
are another source of risk.

Cont’d…
 Political-Legal Environment one country or
international political and legal conditions such as business
regulations, monetary/fiscal policy, political instability and
formulation of new policy may emanate risk exposure.
 Technological environment: technological
developments, technology life cycle and imitation of new
technology brings uncertainty to organizations.
 Economic environment: Inflation, recession and financial
crisis are now elements of interdependent economic systems of
the world. On a local level, interest rates, economic
competition and credit policies can impose significant risk on
an organization.

Hazard
 Hazard is a condition that creates or increases the
chance of loss/damage.
 Flood is the peril and the proximity of the house to the river
is the hazard.
 Hence, hazards would facilitate the occurrence of perils.
 Types of hazards;
Physical hazard
Moral hazard
Morale hazard
Legal hazard

i. Physical Hazard:-a physical condition that
increases the chance of loss.
 Nature of the building
 Nature of the road (icy road, rough road, mud
road)
 Proximity to river
ii. Moral Hazard:- dishonesty or character defects
in an individual that increase the frequency or
severity of loss.
 the dishonest persons may fake an accident to
collect the indemnity.
 deliberately burning unsold
merchandise/insured house.
Cont’d…
iii. Morale Hazard:- carelessness to a loss
because of the existence of insurance.
 Forgetting a door/car unlocked.
iv. Legal Hazard: refers to characteristics of
the legal system or regulatory environment
that increase the frequency or severity of
losses.
 Risk increases during chaos, strikes, civil war
and loose regulatory system.

Classifications of risks
 Risks can be classified as:-

1. Subjective and objective risk
2. Pure risks and Speculative risks
4. Fundamental risks and Particular risks

1. Subjective versus objective risk
1. Objective Risk:-relative variation of actual loss

from the expected loss.
 The actual amount of loss may be deviates from
the expected one.
2. Subjective Risk-uncertainty based on a person’s
mental condition or state of mind.
 Individuals perceive same risk/risk exposure
differently.

Cont’d…
The impact of subjective risk varies depending on
the individual.
Two persons in the same situation may have a d/t
perception of risk, and their behavior may be altered
accordingly.
High subjective risk often results in conservative
and prudent behavior; low subjective risk results in
less conservative behavior.

2. Pure Risk and speculative Risk
A. Pure risk:- situation in which there are only the

possibilities of loss or no loss.
The only possible outcomes are loss and no loss.
Eg. Job related accident, medical expenses, damages
of properties from fire, flood, earthquake, etc.

Cont.....
 There are three types of pure risk;
1. Personal Risks:-risks that directly affect an
individual.
 There are four major personal risks:-
 Risk of premature death:-possibility of death of a person to
die before attaining the average age of living.
- Death of a child is not included in premature death.
 Risk of insufficient income during retirement
 Risk of poor health:- includes the payment of
medical bills.
 Risk of unemployment

Cont.....
2. Property Risks:- the risk of property damage or lost
due to different reasons.
i. Direct loss:- a financial loss that results from the
physical damage, destruction, or theft of the
property.
ii. Indirect loss:- a financial loss that results
indirectly from the occurrence of a direct physical
damage or theft loss.
3. Liability Risks:- One can be made legally liable, if
he or she do something that result in bodily injury or
property damage to someone else.

Liability risk cont’d…

B. Speculative Risk:- a situation in which either profit
or loss is possible.
Investing money in shares
Setting up own business
Invention of new product

Pure risk Speculative risk
1. Private insurers mostly 1. Majority of Speculative risks
insure pure risks. are not commercially insurable.
2. Insurers can predict loss 2. Insurers cannot predict loss in
in advance with same advance in speculative risks.
accuracy. 3. Society may benefit from a
3. It is harmful to the speculative risk even though a
society. loss occurs.
E.g. Earthquake, fire, flood, E.g. Decrease in share price.
etc.
3. Fundamental Risks and Particular Risks:
a. Fundamental risks:- connected with losses caused

by the irregular action of nature or by the mistakes
and misdeeds of human beings and it affects the
overall society/large number of people.
 Mainly pure risk in nature
Example:- lose caused by earthquake, flood,
premature death, economic recession etc.

Cont.....
b. Particular risks:- caused by specific perils which
affect particular entity.
 Are mainly speculative risks car theft, product
liability risk etc.

Risk Related with Business activities:
 Operation Risk – Related with physical operation of a

company such as machine breakdown, destruction of
plant, less quality output etc.
 Financial Risk – Related with funds such as adverse price
fluctuation, change in interest rate, financial theft,
insolvency, bankruptcy etc.
 The opposite is non financial risk which includes
psychological risk, emotional risk etc.
 Purchasing Power Risk –due to inflationary situations, the
purchasing power of money would fall.
 Human resource risk: risk of losing key employee.
 Product liability risk: risk of selling a product which may
hurt healthy condition of user.
Chapter Two
Risk Management
Dfn:- It is a process that identifies loss
exposures faced by a particular entity and
select suitable technique(s) for handling
such exposures.
Risk Management is a field of activity
seeking to eliminate or reduce risks.

Objectives of Risk Management
 Objectives of risk management can be broadly
classified into two:
Pre-loss Objectives
Post-loss Objectives
I. Pre-loss Objectives:-objectives to be
achieved prior to the occurrence of a loss.
II. Post-loss Objectives- include objectives to
be attained after the occurrence of a loss.

End of the chapter
one!!

Objectives of Risk Management includes:
Pre-loss Post-loss
Objective Objective
SURVIVAL OF
ECONOMY
THE FIRM
REDUCTION OF STABILITY OF
ANXIETY EARNINGS
MEETING
LEGAL CONTINUED
OBLIGATION GROWTH
SOCIAL
RESPONSIBILIT
Y

Pre-loss objectives of risk mgt:
1. A firm should prepare for potential losses in the
most economical possible way.
This involves as analysis of costs associated with the
different techniques of handling risks.
Cost efficient risk mitigation tool is selected, cetirus
peribus.
2. Reduction of anxiety: certain loss exposures can
cause greater worry and fear in managers and
employees.
For example, a threat of a lawsuit from a defective
product can cause greater anxiety than a possible small
loss from small financial loss.
Cont’d…
3. To meet any externally imposed
obligations. This means that the firm must
meet certain obligations imposed on it by
the outsiders.
◦ For example, government regulations may
require a firm to install safety devices to protect
workers from harm.
◦ Employers are legally required to have health
insurance for the employees.
◦ Pension fund is saved to deal with lack of
income during disability.
Post loss objectives of risk mgt include:
1. survival of the firm: It means that after a

loss occur, the firms can at least resume
partial operation within some reasonable time
period.
2. Stability of earnings: a firm wants to
maintain its earnings after a loss occurs.
◦ The risk manager may take different actions to
stabilize the earning of the firm after loss.

Cont’d…
3. Continued growth: A firm may grow by developing
new products and markets. Here, the risk manager
must consider the impact of the loss on the firm’s
ability to grow.
4. Social responsibility objectives to minimize the
impact that a loss has on other persons and on
society. A severe loss can adversely affect the
employees, customers, suppliers, creditors and the
community in general.

Steps of risk management
 There are Four steps in risk management:-
RISK IDENTIFICATION
(Identify Potential Losses)
RISK MEASUREMENT
(To Evaluate Potential Losses)
SELECTION OF APPROPRIATE RISK

MANAGEMENT TOOLS
(For Handling Losses)
RISK ADMINISTRATION
(Implement, follow up & Administer the Program)

1. Identifying the potential losses (Risk Identification)
 Itis the responsibility of the risk manager to identify
several types of potential losses.
 These potential losses may include the following;
Health risk
Employment practice risk
Property Loss Exposures (house, car, ship, cargo etc)
Business Income Loss Exposures
Liability Loss Exposures
Human Resource Loss Exposures
Crime Loss Exposures
Employee Benefits Loss Exposures

Cont...
Sources of information to identify potential
losses:
Physical inspection
Risk analysis questionnaire
Flow charts
Financial Statements
Historical Loss Data
Check lists
Contract analysis

1. Physical Inspection
The physical inspection of premises, plant or

processes takes a different approach. Everyone
understands what is meant by physical
inspection, it is possibly the most common and
best understood of all the techniques available.
2. Questionnaire
A number of questions are prepared to be filled
by relevant respondents and analyzed to
identify and prioritize loss exposures.

3. Flowchart
Analysis of production, service, financial and
other activities flow to identify where there is
the bottleneck which brings loss exposures.
4. Financial Statements
Analysis of company’s income statement,
balance sheet, cash flow statement and
financial ratio analysis to identify potential
fund related risks.

5. Historical Loss Data
Analysis of time series loss data which mainly
consists about frequency of loss, amount of
loss, causes of the loss and risk management
techniques applied.
From past data it is possible to predict
probability of loss and amount of loss along
with its related perils.

6. Check list method
The basic idea of the checklist is that a pro-forma is
sent to the site for completion by someone there.
This dispenses with the need for a physical inspec
tion and hence cuts the time and cost of identifi
cation.
7. Contract Analysis
Many of an organization’s exposures to risk arise
from contractual relationships with other persons
and organizations. An examination of these
contracts may reveal areas of exposures that are not
evident from the organization’s operations and
activities.
2. Evaluating Potential Losses (Risk Measurement)
 is to evaluate and measure the impact of
losses on the firm.
 involves an estimation of the potential
frequency and severity of loss.
 Once the risk manager estimates the
frequency and severity of loss, the various
loss exposures can be ranked according to
their relative importance

Cont...
 Although both loss frequency and loss
severity are considered, severity is more
important.
 Both the maximum possible loss (expressed
in monetary terms) and maximum probable
loss (expressed in percentage) must be
estimated.
 maximum possible loss :-is the worst loss
that could possibly happen
 maximum probable loss :-is the worst loss
that is likely to happen.
3. Selection of risk management tools
 The third step is to identify the available tools of risk
management.
Risk Financing tools
Insurance
Retention
Non-Insurance Transfer
Risk controlling tools
Avoidance
Loss Prevention
Loss Reduction
Diversification
I. RISK CONTROLLING TOOLS
 riskcontrolling techniques attempt to reduce
frequency and severity of accidental losses to the
firm.
 1. Avoidance:- means that a certain loss exposure is
never acquired or an existing loss exposure is
abandoned.
Advantages:-
 chance of loss is reduced to zero.
Disadvantages:-
 not possible to avoid all losses.
 not practical or feasible to avoid the loss exposure
Cont...
2. Loss Prevention:- includes actions which

reduces the frequency of losses.
 Here different strategies which reduces the
happening of loss are carried out.
It include:
 Quality control checks
 Driver examination
 Strict enforcement of safety rules
 Improvement in product design
. December,2020 Risk Mgt & insurance

3. Loss Reduction:-are designed to reduce
severity of losses.
 It includes all efforts made to minimize the
adverse effect of loss.
It include:
 Installation of an automatic sprinkler
 Installation of Burglar alarm system
 Early treatment of injuries
 Rehabilitation of injured workers

4. Diversification:
applying either geographical or activity
diversification so the amount of loss would
be minimized.
Insurance companies, commercial banks,
agribusiness operators are major users of
diversification strategy.

II. RISK FINANCING TOOLS:
5. Retention (self insurance):-

 the firm retains part or all of the losses that
result from a given loss exposure.
 It can be effectively used when :-
No other method of treatment is available
(residual method)
The worst possible loss is not serious
Losses are highly predictable

Cont...
 Methods for paying losses
 pay losses out of its current net income.
 borrow the necessary funds from a bank
 From unfunded or funded reserve
 Advantages:-
firm can save money
services provided by the insurer may be
provided by the firm at a lower cost.
Cash flow may be increased
Cont...
Disadvantages:-
 The losses retained by the firm may be greater
than the loss allowance .
 expenses may be higher .
 Income taxes may also be higher
6. Non-Insurance Transfers:-
 methods other than insurance by which a pure
risk and its potential financial consequences are
transferred to another party.
 e.g:- sub-contracting, leases, hedging,
forwarding and hold-harmless agreements.
Non insurable Transfer
Advantages:-
Firm can transfer some potential losses that are
not commercially insurable.
cost less than insurance.
potential loss may be shifted to someone who is
in a better position to exercise loss control
Disadvantages:-
 transfer of potential loss would become impossible, if the
contract language is ambiguous.
 If the party is unable to pay the loss, the firm is still
responsible for the claim.

7. Insurance
 Insurance is a contract between insured and
insurer where the insured agrees to pay regular
interest payment to get indemnity up on
occurrence of covered damage/loss.
 Here the insurance company uses the law of
large number to distribute each loss for insured.
 is appropriate for loss exposures with low
probability but high severity.

Cont...
Advantages of Insurance:-
being indemnified after a loss occurs.
Uncertainty is reduced.
Insurers can provide valuable risk management
services
premiums are income-tax deductible
Disadvantages:-
 premiums is a major cost
 Considerable time and effort must be spent in
negotiation.
 Risk manager may take less care to loss-control
program December,2020 Risk Mgt & insurance
Selecting an appropriate tool
 Risk Management Matrix

Type of Loss Loss Appropriate Risk
Loss Frequency Severity Management Technique
1 Low Low Retention

2 High Low Loss prevention &
Retention
3 Low High Insurance, non
insurance transfer &
diversification
4 High High Avoidance
4. Risk administration
 It involves three important components:-
a. Design of risk management policy
b.Co-operation with other departments
c.Periodic review and evaluation of the result.
a. Risk management policy statement:-
 outlines the risk management objectives of the firm.
Outline company policy with respect to the treatment
of loss exposures
educates top level executives in regard to the risk
management process

Cont...
b. Co-operation with other departments:-
 It will facilitate identification of loss exposures and
methods of treating these exposures.
eg. Accounting, adopt Internal Accounting Controls to
reduce employees' fraud and theft of cash.
Finance provide information how losses can
disrupt profits and cash flow.
 Marketing prevent liability suits by ensuring
accurate packaging
, Production ensure quality control and effective
safety programs .

End of the chapter
two!!

Risk MGT CH 1 and 2

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Select Business and Technology College

A teaching material on:

December,2020 Risk Mgt & insurance

December,2020 Risk Mgt & insurance

December,2020 Risk Mgt & insurance

 Risk :- “the possibility of meeting danger or

December,2020 Risk Mgt & insurance

Chance of loss is the probability that an

December,2020 Risk Mgt & insurance

December,2020 Risk Mgt & insurance

December,2020 Risk Mgt & insurance

December,2020 Risk Mgt & insurance

December,2020 Risk Mgt & insurance

 Risks can be classified as:-

December,2020 Risk Mgt & insurance

1. Objective Risk:-relative variation of actual loss

December,2020 Risk Mgt & insurance

December,2020 Risk Mgt & insurance

A. Pure risk:- situation in which there are only the

December,2020 Risk Mgt & insurance

December,2020 Risk Mgt & insurance

December,2020 Risk Mgt & insurance

December,2020 Risk Mgt & insurance

December,2020 Risk Mgt & insurance

a. Fundamental risks:- connected with losses caused

December,2020 Risk Mgt & insurance

December,2020 Risk Mgt & insurance

 Operation Risk – Related with physical operation of a

December,2020 Risk Mgt & insurance

December,2020 Risk Mgt & insurance

December,2020 Risk Mgt & insurance

December,2020 Risk Mgt & insurance

1. survival of the firm: It means that after a

December,2020 Risk Mgt & insurance

December,2020 Risk Mgt & insurance

SELECTION OF APPROPRIATE RISK

December,2020 Risk Mgt & insurance

December,2020 Risk Mgt & insurance

December,2020 Risk Mgt & insurance

The physical inspection of premises, plant or

December,2020 Risk Mgt & insurance

December,2020 Risk Mgt & insurance

December,2020 Risk Mgt & insurance

December,2020 Risk Mgt & insurance

2. Loss Prevention:- includes actions which

. December,2020 Risk Mgt & insurance

December,2020 Risk Mgt & insurance

December,2020 Risk Mgt & insurance

5. Retention (self insurance):-

December,2020 Risk Mgt & insurance

December,2020 Risk Mgt & insurance

December,2020 Risk Mgt & insurance

 Risk Management Matrix

1 Low Low Retention

December,2020 Risk Mgt & insurance

December,2020 Risk Mgt & insurance

December,2020 Risk Mgt & insurance

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