Transcript Chapter_3.ppt

Chapter 3
Risk Management 1:
Essentials
Risk Management
• It is defined as the logical development and
execution of a plan to deal with potential losses.
• The focus of RM program is to manage an
organisation’s exposure to accident losses, and
to protect assets.
• RM benefits all types of organizations facing
potential losses, including business firms,
nonprofit organizations, individuals and firms.
The Risk Management Function

It is carried out by trained specialists:
- Loss Control Engineer, Attorneys, Accountants
Risk Management Staff:
 Insurance Experts: to work with insurance brokers in
purchasing and renewing the organisation’s commercial
insurance and reinsurance.
 Claim Managers: track and process claims from the
time of loss until the insurer responds with payment
 Loss Control Engineer: manage losses arasing from
employee injuries, environmental pollution, defective
products
 Financial Analyst: Risk Financing to control
organisation’s profitability.
RIMS
• The Risk and Insurance Soceity, Inc, a
professional organisation for risk managers,
recently reported 4500 different profit and
nonprofit organisations including 90% of the
nation’s 1500 largest corporation as member.
• RIMS helps risk managers stay alert to new
problems and possible solutions through
educational classes, publications such as
montly journals and computer networks.
Statement of Objectives and Principles
 A statement of principles and procedures designed to achieve
the following objectives:
• Survival: The risk manager is to make sure that the organization
can survive.
• Growth: The firm should continue to grow even after a loss.
• Responsibility: Even in the event of serious loss, the risk
management plan should allow the organization to continue to
behave responsible toward the environment, employees,
suppliers, customers, and the communities in which it operates.
• Efficiency and Compliance: An other essential objective is to
operate efficiently in a risk environment. This objective requires
the firm to choose the appropriate balance between loss
prevention, insurance and other risk management tools.
• Risk Management Manual: objectives, principles and
procedures
Bank’s Risk Mgmt security issues
Hospital’s --- Hygiene
The Risk Management Process
• RM activities occur before, during and after
losses.
• Most planning is done before losses occur.
• The RM process requires the following steps:
– Step One: Identify and measure potential loss
exposures
– Step Two: Choose the most efficient methods of
controlling and financing loss.
– Step Three: Monitor outcomes
Step One:
Identification and Measurement of
Exposures

Four District Classes:
– Direct property losses;
– Losses of income and extra expenses following a
property loss.
– Losses arising from lawsuit called liability losses.
– Losses caused by the death, disability, or unplanned
retirement of key people.
 Measurement is merely an estimate. Not all pre loss
estimates will reflect accurately the actual amount of
damages or the actual exposure to loss.
Direct Property Losses
• Risk Managers can identify potential direct property losses in
different ways.
Checklist may be used to identify and value potential
property losses:
Identify and value:
 owned buildings, equipment and land
 Property leased from others
 Stationary inventory
 Property under construction
 Owned and leased vehicles
Identify special perils to which property is exposed:
 Radiation
 Explosion
 Flood
 Earth movement
 theft
Flow Charts
• Graphically represents the production or
distribution process.
• Flow Charts analysis displays the firm’s
relations with suppliers, customers, utilities,
and modes of transportation.
• Flow Charts also help reveal the
consequential impact of losses. (e.g. Loss of
raw material inventory in a storage may lead
to stopping the entire production
(Insert Figure 3-1)
Valuing Property
• Risk Managers must know the property’s replacement
value to estimate potential property losses.
• Replacement cost often is unrelated to accounting book
value ( acquisition-depreciation), risk managers should
keep a current price and source list for their property.
• In an inflationary economy, the replacement cost of
physical equipment is likely to be higher than its
historical cost and the risk manager should attempt to
protect this greater value.
International Operations
• Firms with international operations may have property
and employees in several countries. These firms must
devote special attention to identifying all their property,
including that being transported between location.
Loss of Income
• Indirect Losses are more difficult to identify than
direct losses. e.g machine and lost profit. Risk
Managers must make careful estimates and
judgements about the potential size of indirect
losses.
• The process begins with a forecast of expected
income under normal circumtences. A second
estimate of postloss income follows. The
difference is the potential income loss following
a direct loss.
Liability Lossess
•
These losses arise from three sources:
– 1. Legal damages: an organization responsible for negligently
injuring, someone should pay legal damages awarded by a
court to the insured party.
– 2. Cost of a legal defense: A defense can be expensive even
in cases where a court finds the “victims” claim groundless,
false or fraudulent.
– 3. Cost of loss prevention: In some cases, the legal defense
costs more than the damages awarded to parties claiming
injury.
Risk managers spend considerable time trying to identify
potential liability problems so they may be handled in an
appropriate way.
e.g. Workers compensation claims arise from injury to firm’s
employees while at work
Product liability occurs when a firms product’s allegedly
injure the public.
Loss of Key Personnel
• Business losing a key personnel by unplanned
retirement, resignation, death or disability, the
effect may be felt in a lost income. (research
scientist, president, etc.)
• Trained subordinates. Life and disability
insurance on key employee may be a part of the
risk management program.
• Estimating the cost of a key employee losses is
difficult because finding and training a
replacement is a function of the job market.
Estimation of Maximum Loss
• Maximum possible Loss: refers to the total
amount of financial harm a given loss
could cause under the worst circumtances.
• Maximum probable loss: is the most likely
maximum amount of damage a peril might
cause under average circumtances.
Step Two: Loss Control And Risk
Financing
• All organizations incur cost because they are
exposed to unexpected losses.
• Paying Insurance premiums, paying for uninsured
losses, paying for driver training programs or paying
for installing a fire sprinkler system, each represents
a cost of being exposed to loss.
• The risk managers has some ability to control the
amount and timing of these costs. Successful lost
control efforts reduce the amount of loss costs.
Given that some losses occur even when loss
control efforts are effective.
Loss Control: Activities designed to reduce loss
cost and include the following risk management
tools:
-Risk avoidance, loss prevention, loss reduction.
Risk Management Tools for Loss
Control
• Risk Avoidance: eliminating the chance of loss.
- Basic Rule: When the chance of loss is high and loss
severity is also high, avoidance is often the best and
sometimes the only practical alternative e.g. Not doing a
business in dangerous places (earthquake zones).
• Loss Prevention: It activates lower frequency of losses.
As long as benefits exceeds the costs, loss prevention
should be used to treat all exposures, whether assumed
or transferred to commercial insurer.
- Risk managers first goal in risk prevention program is
to reduce or eliminate the chance of death or injury to
people. (employing loss control engineers to identify
sources of loss to institute corrective actions.
e.g. Poor lighting or ventilation, poor layout of machines,
insufficient fire fighting equipment.
Loss Prevention (cont.)
 Other losses are more directly related to human
shortcomings and errors such as bad judgment,
inadequate training or supervision or lack of attention to
safety requirements. Example of activities:
 temper resistant packing, security guards in banks,
driver training safety education programs, warning
printed on drugs and dangerous chemicals.
 As a rule, when the frequency of loss is high, loss
prevention activities should be considered as one
alternative for dealing with the problem. They are
feasible only as far as benefits realized from fewer
occurrences of losses are greater than the cost of the
loss prevention measures.
Loss Reduction
• Loss reduction activities aim at minimizing the impact of
losses. It refers to the severity of a loss after it occurs.
Successful loss reduction activities reduce loss severity.
e.g. automatic fire-sprinkler system.( a system design
not to prevent fires but to prevent the spread of fires.
• When the severity of loss is great, and when the loss
cannot be avoided, loss reduction activities are
appropriate.
-Fire walls and doors, training replacement personnel
-Loss reduction can be justified as long as the savings
they produce exceed the cost of the effort
Risk Financing
• Refers to the techniques that provide for
the funding of losses after they occur.
• Determination of time and by whom the
costs are borne. The alternatives are:
– Risk assumptions
– Self-insurance and financial risk retention
– Risk transfer other than insurance
– Insurance
Risk Assumption
Means the consequences of loss will be borne by the
party exposed to the chances of loss.
– It is often a deliberate risk management decision.
They are assumed by firms when:
- Loss costs are small and are funded from current cash flow
- Loss exposures are retained and funded with a cash
reserve
- Loss exposures are retained and recognized in an
unfunded reserve account
- A self-insurance or finite risk program is operated.
- Self-insurance
-It 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. For a true selfinsurance system to operate, payments to the selfinsurance funds are needed to be calculated and regularly
paid.
The Captive Insurance Company
• One approach to self-insurance involves the use of a company
formed to write insurance for a parent. (One company, several
companies, or an entire industry)
• Motivations for forming a captive:
– To save overheads and profits earned by commercial insurers.
– To earn investment income available on advanced funding.
– To recognize insurance premiums as a current business
expense to parent while the captive insurer reports insurance
income, to capture the favorable tax differential between regular
corp and insurance comp
Potential Advantages observed by Captive insurance companies
appealing to some other organizations:
- Improved Loss Prevention Incentives. Offer a chance to reap
directly the benefits of successful loss control.
- Improved Claims Settlements. Includes the ability to cover
claims or exclude claims with more flexibility than an commercial
insurer.
- Improved Profitability . Includes the investment potential from
investing cash flow or avoiding premium taxes.
Risk Transfer
• The original party exposed to a loss is able to
obtain a substitute party to bear the risk.
- uncertainty of who will pay the loss is
transferred from the individual to the insurance
pool. (insurance noninsurance)
-Hedging: To take two or more simultaneous
position that offset each other so that no matter
what the outcome is of some event based on
chance, the hedger neither wins or losses.
Insurance
• Represents a contractual transfer of risk. It is an
expensive risk mgmt tool and used when the
chance of loss is low and the severity of a
potential loss is high.
- From a risk manager’s viewpoint: its a
contractual transfer of risk.
- From society’s viewpoint: it is risk reduction
because of the pooling of numerous risk allows
better loss predictability.
-For small and medium sized businesses,
insurance is their foundation of the risk mgmt
program.
Step Three:
Regular Review of the Risk
Management Program
• After all potential sourses of loss have been
identified and plans to deal with them
implemented, the risk managers must review the
program regularly to be sure that it meets
current needs.
• New assests are needed, old assets lose
their value, new production processes are
used.