Loss Control

CHAPTER 6

Chapter 6 BU 353 1
 Students will be able to explain the
Explain difference between and provide examples
of loss prevention and loss reduction.

Learning Students can list the costs and benefits of

List
Objectives a loss control program.

Using discounted cash flow analysis,

students will calculate the financial
Calculate impact of implementing a loss control
program.

Chapter 6 BU353 2
 Loss control is expenditures of
time, money, or effort to reduce
expected losses.
Types of Loss ◦ Loss prevention:
Control ◦ Reduce probability of loss.
◦ Loss reduction:
◦ Reduce severity of loss.
◦ Can be before or after a loss occurs.

Chapter 6 BU 353 3
Importance of Indirect Losses

Recall, largeContinuing
lossesandcan cause significant indirect losses:
Foregone
Costs of raising Bankruptcy
Lost profits. extra operating investment
capital. costs.
expenses. opportunities

Thus, reducing probability of large losses can reduce

indirect losses.

Chapter 6 BU 353 4
 Characteristics of Every ERM Process
within Larger ERM Framework

Identify risks:
Analyze risks:
find,
understand Evaluate
recognize,
the risks and risks: determine Treat risks:
Understand in and describe
its drivers and whether Avoid, retain, Monitor and
the business the risks that
you examine specified level of mitigate and communicate.
context. could affect
the controls risk is acceptable transfer.
the
that currently or tolerable.
achievement
exist.
of objectives.

BU 353 5
 Benefits and Costs of Loss Control
Basic cost-benefit trade-off:
Cost of increased precautions
versus benefit of reduced
expected losses.
OR
Reduction in the level of
revenue due to a reduced
level of risky activity.
Some costs and benefits may
be difficult to quantify.

Chapter 6 BU 353 6
 • Equipment and installation.
• Maintenance.
• Water damage if sprinklers go off when they should not.
Costs:

• Reduce property insurance premiums (and perhaps other premiums such as

CGL or workers comp).
• Reduced expected losses retained by the firm:
/
• Per occurrence deductibles.

Benefits: • Business interruption losses (i.e. indirect losses).

• Maybe lower wages, better terms with contractors?

Benefits and Costs of Loss Control –

Installation of automatic sprinkler system

Chapter 6 BU 353 7
Benefits and Costs of Loss Control –
Installation of equipment guards

Chapter 6 BU 353 8
 Look at present value of expected cash
flows rising from a risk management
decision.
1. Setting up a captive.
Use of 2. Choosing between loss financing
Discounted alternatives.
3. Looking at effectiveness of loss control.
Cash Flow
Analysis Use net present value (NPV) criterion.
Remember to look at incremental cash
flows.
Undertake loss control if the NPV > 0.

Chapter 6 BU 353 9
 There may be other
beginning of the year
Insurance is paid at the
expenses or revenues as well
beginning of the year.
(will be stated in the
problem).

Key
Assumptions All tax effects associated
(that differ with beginning of the year
expenses or revenues accrue
Retained losses are paid at
the end of the year.
from at the end of the year.

BU393):

* For teaching purposes, we

will use a pre-developed
Depreciation is on a straight-
template in class. There will
line basis.
be no template provided in
an examination setting.

Chapter 6 BU 353 10
 Wood’s has property insurance on a replacement cost basis
with a $5000 per occurrence deductible. It can install
sprinklers, which have a lifetime of 5 years, for a cost of
$10,000. Annual upkeep is $1000 / year, payable at year end
for the first 4 years of installation.
Depreciation for tax purposes is on a straight-line basis.

Example 1 Wood’s cost of capital is 10% and its tax rate is 34%.

– Sprinkler Without the sprinklers expected cash flow for losses is

expected to be $1000 / year & insurance is $10,000 / year.
With the sprinklers, expected cash flow for losses is expected
Installation to be $500 / year & insurance is $7000 / year.
Retained losses are tax deductible and paid at the end of the
year. Insurance is payable at the beginning of the year and
tax is deducted at the end of the year.
Should Wood install the sprinklers?

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 Kanvas Milliners is a small textile mill employing 50
employees. Currently the firm pays $11,000 a year in
fire insurance with a $1000 per occurrence
deductible. Historically the mill averages 1 fire loss
every 2 years.
Recently Kanvas Milliners contracted a local
consulting firm to undertake a risk management
study. The cost of the study was $2500, and the
Example 2 - comprehensive 5 year loss control plan proposed
follows.
Comprehensive Improvements should be made in fabric storage. The
Loss Control cost would be $5500. 80% is for capital purchases
that can be depreciated using straight-line
depreciation over 5 years. The remaining 20% of
costs can be expensed at the beginning of the first
year.
This improvement is expected to reduce the
frequency of fires from 1 loss every 2 years to 1 loss
every 4 years.

Chapter 6 BU 353 12
 Kanvas Milliners should purchase direct fire reporting
for a cost of $2000 per year, payable at the beginning
of the year. It is estimated that the presence of direct
fire reporting will cause 1 false alarm per year.
However, there is a user fee of $250 every time the fire
2nd Capital engines visit the mill, whether for false alarms or
legitimate fire calls.
Budgeting If Kanvas Milliners undertakes both these measures,
Question they are eligible for a reduced insurance premium of
$7500 a year with a $1000 per occurrence deductible.
con’t Insurance is paid at the beginning of the year, and
deductibles are paid at year end.
If Kanvas Milliner’s tax rate is 34% and their cost of
capital is 8%, should they undertake the loss control
program?

Chapter 6 BU 353 13
 Government Safety
Regulation
Loss control can be enforced by government
mandates.
◦ Business might not have enough incentive
to undertake the optimal level of loss
control to maximize societal wellbeing.
◦ But regulation is expensive and it may be
difficult / impossible / expensive to
monitor for compliance
◦ Regulation might reduce loss control costs
since it centralizes the information
gathering and research costs and reduces
duplication

Chapter 6 BU 353 14
 Should companies (or regulators) enforce safety standards so that lives are
never at risk?

Individuals are willing to accept ‘riskier’ situations for a higher premium (i.e.
wage) or lower cost (i.e. cheaper car).
/

Consider residential fire risk.

Installing smoke detectors in unprotected houses costs about $200 Installing sprinklers costs $9000 per home and
per house, and results in more than 7 lives out of 100,000 being
saved. saves about 1 life out of 100,000

Valuing Loss of Life & Cost-Benefit Analysis

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 To calculate the “benefit”
the number of lives saved is
multiplied by the “value of a
Benefit Per life”
Life Saved –
Safety Regulation that protects
Regulation highly skilled workers will
use an implicit higher value
of life than regulation that
protects the “average
person”
Chapter 6 BU 353 16
Regulation Year Agency Cost Per Life
Passed Saved
$Million
Unvented space 1980 Consumer $0.10

Cost per
heaters Product Safety
Commission

life saved
Seatbelts / 1984 NHTSA $0.10
airbags

– safety
Grain dust 1987 Occupational $4.00
explosion Safety and
prevention Health
standards

Asbestos ban 1989

Administration

Environmental $329.20
regulation
Protection
Agency in the U.S.
Formaldehyde 1987 Occupational $256,372.70
Occupational Safety and
Exposure Limit Health
Administration

Chapter 6 BU 353 17