Risk cha 2 ppt-3
Risk cha 2 ppt-3
Risk Management
What is Risk Management?
• Risk management is a systematic process for the identification,
evaluation of pure loss exposures faced by an organization or
individual and for the, selection of suitable loss control and handling
techniques, and implementation of the most appropriate techniques
for treating such exposure.
• It is a scientific approach to deal with pure risks by anticipating
possible accidental losses and designing and implementing procedures
that minimize the occurrence of loss or the financial impact of the
losses that do occur.
• Risk management is a process of thinking systematically about all
possible risks, problems or disasters before they happen and setting up
procedures that will avoid the risk, minimize or handle its impact.
Why the Study of Risk Management is Important?
Following are reasons why study of risk management is important:
• Proper risk management enables a business firm to handle its
exposure to accidental losses in the economic and effective way.
• It enables companies to react in early stage of change in
environment and avoiding possible crises.
• It also enables a business firm to handle better its ordinary
business risk, and
• It contributes to the survival and profitability of a business
Objectives of Risk Management
Risk management has several important objectives that can be
classified into two categories:
• Pre-loss objectives
• Post-loss objectives
Pre-loss objectives: A firm or an organization has several risk management
objectives prior to the occurrence of a loss. The most important includes:
• Economy: treating potential losses economically or with moderate cost
• Reduction in anxiety: the risk manager wants to minimize the anxiety and
fear associated with all loss exposures
• Meeting external obligations : For example, government regulations may
require a firm to install safety device to protect workers from harm.
Similarly, a firm’s creditors may require that property pledged as collateral
for a loan must be insured.
Post-loss objectives: The following are the post-loss objectives of risk
management:
• Survival : after a loss occurs, the firm can at least restart partial operation
within some reasonable time period if it chooses to do so.
• Continuity of operations
• Earnings stability
• Continued growth
• Social responsibility: a severe loss can adversely affect employees,
customers, suppliers, creditors and the community in general.
Risk Management Process
• The following four procedures are significant in the risk
management process:
First : Identifying potential losses
Second: Evaluating potential losses
Third: selecting the Appropriate technique or
combination of techniques for treating loss exposures
Fourth: Implementing and administering the program
1) Identifying potential losses
• Risk identification is the process by which a business systematically and
continuously identifies property, liability and personnel exposures before or
as soon as they appear
• It is a very difficult process because the risk manager has to look into all
operations of the company, so as to identify where exactly risks originate from
Most risk managers use some systematic approach to the problem of risks
identification. These tools include:
• Insurance Policy Checklists: Insurance policy checklists can be sourced from
insurance companies and other publishers only for insurable risks
• This risk identification approach doe not useful to identify non insurable
losses.
• Loss Exposure Checklists : Loss exposure checklists are available from
various sources, such as insurer, agencies and risk management associations
• Risk Analysis Questionnaires: a series of well-developed and well-
formulated questions are put forth to respondents
• Flow Charts : a flow chart depicting the operations of a firm can guide a risk
• Analysis of Financial Statements : By analyzing the balance sheet,
profit or loss statements and supporting documents; the risk manager
can identify property, liability and human asset loss exposures of the
organization
• On site-Inspections :by observing the organization’s facilities and the
operations conducted thereon, the risk manager can learn much about
the risk exposures faced by the firm.
• Interactions with other Departments: Interactions with other
departments provide another source of information on exposures to
risk
The Best Method
No single method or procedure of risk identification is free of
weakness or can be called perfect. The strategy of management must
be to employ that method or combination of methods that best fits the
situation at hand. The choice is a function of
The nature of the business
The size of the business and
2) Evaluating or Measuring Potential Losses
• After various types of potential losses faced by the firm has been identified,
these exposures must be measured
• Evaluating and measuring the impact of losses on the firm involves an
estimation of the potential frequency and severity of loss
• Loss frequency refers to the probable number of losses that may occur
during some given time period.
• Loss severity refers to the probable sizes of the losses that may occur
Under the severity of loss, risks can be classified into three head:
Critical risks, Important risks and Unimportant risks.
• Critical risks: include those loss exposures to loss where the magnitude of
losses could lead to bankruptcy.
• Important risks : include those exposures in which the possible losses
would not lead to bankruptcy, but would require the individual or firm to
borrow in order to continue operations.
• Unimportant risks: include those exposures in which the possible losses
could be met out of the existing assets or current income without imposing
too much financial damage.
3) Selecting the Appropriate Technique for Handling Losses
• Once potential exposure facing the firm has identified and measured,
the next step is deciding how to handle them.
• There are two basic approaches: risk control and risk financing
measures.
• Risk control is useful to reduce the firm’s expected losses or to
make the annual loss experience more predictable.
• The risk control measures include:
Avoidance
Loss control
Separation/diversification/ and
Combination (pooling)
Avoidance: means discarding risky activities or properties from a firm.
• Some characteristics of avoidance:
Avoidance may be impossible
Avoidance may be impractical
Avoidance creates another risk
Loss control Measures: LP &LR
Means activities intended to reduce both the frequency and severity of losses
• Loss Prevention: used to reduce/eliminate the chance of loss. Example:
Construction using fire insensitive materials, fire alarms, Burglar alarms,
Location choice, Educational programs to the public, inspection, Safety
measures, Warning posters, etc.
• Loss reduction measures try to minimize the severity of the loss once the
peril happened. Examples: Installing automatic sprinklers, First aid kit,
Evacuation of people, Fire extinguishers, etc.
• LP and LR measures must be considered before the Risk manager considers
the application of any risk financing measures.
• To design effective LP and R measures, it may be helpful to identify the
causes of accidents.
Separation/ Diversification/: investing assets on different
investment area instead of in one investment
Combination or pooling :makes loss experience more
predictable by increasing the number of exposure units.
One way a firm can combine risk is to expand through internal
growth.
Combination also occurs when two firms merge or one
acquires another
Risk financing techniques
Risk financing techniques designed for the funding of accidental
losses after they occur.
There are different risk financing techniques:
Retention/self-financing/
Self-insurance
Noninsurance transfers
Insurance
Retention/self-financing/: means treating losses by own self
• Self-financing is not insurance, because there is no transfer of the risk
to an outsider
• Retention can be effectively used in risk management program when
the following three conditions exist:
When no other method of treatment is available
When the worst possible loss is not serious
When losses are highly predictable
Self-insurance: is a special form of planned retention by which part or
all of a given loss exposure is retained by the firm.
• A better name for self-insurance is self-funding, which expresses
more clearly the idea that losses are funded and paid by the firm
• Here ,firms may put or reserve a certain money by thinking that there
may be some losses in the future
Non-insurance transfers: are a methods other than insurance by which
a pure risk and its potential financial consequences are transferred to
another party.
• Neutralization or hedging and hold-harmless agreements are examples
of noninsurance transfer of risk
• Neutralization is the process of balancing a chance of loss against a
chance of gain
• For example, a person who has bet that a certain team will win the
World Cup may neutralize the risk involved by also placing a bet on
the opposing team.
Insurance: from the risk manager’s viewpoint, insurance represents a
contractual transfer of risk to insurance companies.
• Which method of risk financing technique should be used?
• In determining the appropriate method or methods for handling
losses, a matrix can be used that classifies the various loss exposures
according to frequency and severity.
• If there is low severity and low frequency of loss, such type of loss
exposure can be best handled by retention.
• If there is low severity and high frequency of loss, such type of loss
exposure can be best handled by both loss control and retention.
• If there is high severity and low frequency of loss, such type of loss
exposure can be best handled by insurance.
• If there is high severity and high frequency of loss, such type of loss
exposure can be best handled by avoidance.
4) Implementing & Administrating the Risk Management Program
• The fourth step in risk management is implementation and
administration of the risk management program
• Taking actions to control and finance potential loss exposures of the
firm by the risk managers.