Unit 2
Risk management
2.1 INTRODUCTION
This unit focuses on the methods, procedures and techniques used by the risk manager so as
to minimize the risk occur in a firm.
Once we understand that risk always exist with a firm or human being activities, managers
should take different measure to avoid or reduce these losses or undesired events.
2.2 Definition of Risk Management
Risk management is the identification, measurement, and treatment of property, liability, and
personnel pure-risk exposures. It involves the application of general management concepts to
a specialized area.
It requires the drawing up of plans, the organizing of material and individuals for the
undertaking, the maintaining of activity among personnel for the objectives involved, the
unifying and coordinating all the activities and efforts, and finally the controlling these activities.
2.3 Risk Management Process
The process of Risk management includes the following five steps.
1. Risk identification
The loss exposures of the business or family must be identified. Risk identification is the first
and perhaps the most difficult function that the risk manager or administrator must perform.
Failure to identify all the exposures of the firm or family means that the risk manager will have
no opportunity to deal with these unknown exposures intelligently.
2. Risk Measurement: -
After risk identification, the next important step is the proper measurement of the losses
associated with these exposures. This measurement includes a determination of:
a) The probability or chance that the losses will occur
b) The impact the losses would have upon the financial affairs of the firm or family, should
they occur.
c) The ability to predict the losses that will actually occur during the budget period.
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The measurement process is important because it indicates the exposures that are most serious
and consequently most in need of urgent attention. It also yields information needed in risk
treatment.
3. Tools of Risk Management
Once the exposures has been identified and measured the various tools of risk management
should be considered and a decision made with respect to the best combination of tools to
be used in attacking the problem. These tools include:
a) avoiding the risk
b) reducing the chance that the loss will occur or reducing its magnitude if it does
occur
c) transferring risk to some other party, and
d) retaining or bearing the risk internally
The third alternative includes, but not limited to the purchase of insurance. In selecting the
proper tool or combination of tools the risk manager must establish the cost and other
consequences of using each tool or combination of tools. He/she must also consider the present
financial condition /position/ of the firm or family, its over all policy with reference to risk
management and its specific objectives.
4. Implementation:
After deciding among the alternative tools of risk treatment the risk manager must implement
the decisions made. If insurance is to be purchased for example, establishing proper
coverage, obtaining reasonable rates, and selecting the insurer are part of the implementation
process.
5. Controlling/monitoring:
The results of the decisions made and implemented in the first four steps must be monitored
to evaluate the wisdom of those decisions and to determine whether changing conditions
suggest different solutions.
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2.4 Objectives of Risk Management
1. Mere survival: - to exist as a business enterprise as a going concern
2. Peace of mind: - to avoid mental and physical strain of uncertainty of a person
3. Lower risk management costs and thus higher profits
4. Fairly stable earnings: - to eliminate the fluctuating nature of earnings due to fluctuating
losses.
5. Little or no interruptions of operations
6. Continued growth
7. Satisfaction of the firm’s sense of social responsibility or desire for a good image/
creating good will on society/value maximization/
8. Satisfaction of externally imposed obligations.
2.5 RISK IDENTIFICATION
Risk identification is the process by which a business systematically and continually
identifies property, liability, and personnel exposures as soon as or before they emerge.
The risk manager tries to locate the areas where losses could happen due to a wide range of
perils.
Unless the risk manager identifies all the potential losses confronting the firm, he or she will
not have any opportunity to determine the best way to handle the undiscovered risks.
To identify all the potential losses the risk manager needs
first a checklist of all the losses that could occur to any business.
Second, he or she needs a systematic approach to discover which of the potential
losses included in the checklist are faced by his/her business.
The risk manager may personally conduct this two-step procedure or may rely upon
the services of an insurance agent, broker, or consultant.
Discover and describe the types of losses faced by a particular business. Because
most business are complex, diversified, dynamic operations, a more systematic
method of exploring all facets of the specific firm is highly desirable.
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Seven methods that have been suggested are:
1. the risk analysis questionnaire
2. the financial statement method
3. the flow-chart method
4. on-size inspection
5. planned interactions with other departments
6. statistical records of past losses
7. analysis of the environment
No single method or procedure of risk identification is free of weaknesses or can be
called foolproof. The choice depends on:
- the nature of the business
- the size of the business
- the availability of in house expertise, etc
1. The risk analysis questionnaire: - It does more than provide a checklist of potential losses. It
directs the risk manager to secure in a systematic fashion specific information concerning the
firm’s properties and operations.
Eg. If a building is leased from some one else, does the lease make the firm responsible for repair
or restoration of damage not resulting from its own negligence?
2. Financial statement method: - A second systematic method for determining which of the
potential losses in the checklist apply to a particular firm and in which way is the financial
statement method. By analyzing the balance sheet, operating statements and supporting records,
the risk manager can identify all the existing property, liability and personal exposures of the
firm. By coupling these statements with financial forecasts and budgets, the risk manager can
discover future exposures.
3. Flow-chart method: - Is the 3rd systematic procedure for identifying the potential losses facing
a particular firm. First, a flow chart or series of flow charts is constructed, which shows all the
operations of the firm, starting with raw materials, electricity, and other inputs at supplies
locations and ending with finished products in the hands of customers. Second the checklist of
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potential property, liability, and personal losses is applied to each property and operation shown
in the flow chart to determine which losses the firm faces.
4. On-site inspections: - are a must for the risk manager. By observing first hand the firm’s
facilities and the operations conducted thereon the risk manager can learn much about the
exposures faced by the firm.
5. Interactions with other departments:- Through systematic and continuous interactions with
other departments in the business, the risk manager attempts to obtain a complete understanding
of their activities and potential losses created by these activities.
6. Statistical Records of losses: - Another approach that will probably suggest fewer exposures
than the others but which may identify some exposures not other wise discovered is to consult
statistical records of losses or near losses that may be repeated in the future.
7. Analysis of the environment: By analyzing the internal and external environment such as
customers, competitors, suppliers and government, the risk manager can identify the potential
losses.
In identification process the risk manager gives more emphasis on pure risks: property losses,
personal and liability losses.
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2.6 LIABILITY LOSSES
Firms might get exposed to liability risks which refer to injuries caused to other people or
damages caused to their property, because of their operating activities.
The following are some of the factors leading to liability losses.
i) Product Liability: is associated with the manufacture and sell of a particular product. For
example, if a pharmaceutical company sells a drug or medicine that causes serious health
problems, the victim might file a law suit demanding compensation. This then may lead to
a potential loss to the firm producing the product. Quality problems, breach of warranty,
misleading advertisement, etc are some of the factors that lead to liability losses.
ii) Motor Vehicles: this is the most frequent factor a firm should expect liability losses as use
of various kinds of motor vehicles. Operation of motor vehicles could lead to killing of
people or injuries and damages of property of other people due to accidents such as
collisions, fire, crash, etc.
iii) Industrial Accidents: factory employees are likely to suffer physical injuries at work sites.
In some types of activities they may be exposed to job related diseases. This is common in
the case of laundries, chemical industries, cement factories, and others where employees
are exposed to dust inhalation and pungent chemical smell that can cause occupational
diseases. Liability loss arises then as the firm has to compensate employees for their
injuries and job related diseases faced during the course of employment.
iv) Industrial Waste: industrial wastes released into air or thrown into rivers and lakes are
major sources of environmental pollution. Following the development of environmental
economics, environmentalists are giving hard time to industries. There is then a potential
liability loss if the firm's activities pollute the environment and a law suit is filed against its
activities.
v) Professional Activities: in the filed of consultancy, medicine, construction, and other
professional activities, liability losses are likely to emerge because of the deficiencies
inherent in the services rendered due to negligence, errors, intentional concealment and the
like.
vi) Ownership of immovable: this refers to building, land and machinery owned. The use of
such immovable by people may bring liability losses for injuries might be caused by
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accidents. For example, faulty electrical, connections, old building faulty elevators and
escalators may cause injury to people while they are using these facilities.
2.7 Risk Measurement
After the risk manager has identified the various types of potential losses faced by his or her
firm, these exposures must be measured in order to determine their relative importance and to
obtain information that will help the risk manager to decide upon most desirable combination of
risk management tools.
2.7.1 Dimensions to be measured
Information is needed concerning two dimensions of each exposure
1. The loss frequency or the number of losses that will occur and
2. The loss severity
Both loss frequency and loss severity data are needed to evaluate the relative importance of an
exposure to potential loss. However, the importance of an exposure depends mostly upon the
potential loss severity not the potential frequency. A potential loss with catastrophic possibilities
although infrequent, is far more serious than one expected to produce frequent small losses and
no large losses. On the other hand loss frequency cannot be ignored.
If two exposures are characterized by the same loss severity, the exposure whose frequency is
greater should be ranked more important. There is no formula for ranking the losses in order of
importance, and different persons may develop different rankings. The rational approach,
however, is to place more emphasis on loss severity.
Loss-frequency Measures
One measure of loss frequency is the probability that a single unit will suffer one type of loss
from a single peril. Instead of estimating the probability that a single unit suffer one type of loss
from a single peril during the coming year, the risk manager can, in the same way estimate the
probability that the unit will suffer that type of loss from many perils. This probability will be
higher because of the additional possible causes of loss.
Loss-severity Measures
Two measures commonly used to measure loss severity are:
1. the maximum possible loss, and
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2. the maximum probable loss
The maximum possible loss is the worst loss that could possibly happen and the maximum
probable loss is the worst loss that is likely to happen. The maximum possible loss, therefore, is
usually greater than the maximum probable loss. Of these two measures, the maximum probable
loss is the most difficult to estimate but also the most useful.
In estimating the maximum possible loss and the maximum possible loss and the maximum
probable loss the risk manager, ideally, would consider all types of losses that might result from
a given peril.
In determining loss severity the risk manager must be careful to include all the types of losses
that might occur as a result of a given event as well as their ultimate financial impact upon the
firm: direct, indirect and net income losses.
The potential direct property losses are rather generally appreciated in advance of any loss, but
potential indirect and net income losses that may result from the same event are commonly
ignored until the loss occurs. This same event may also cause liability and personnel losses.
2.8 RISK MEASUREMENT METHODS/TOOLS
This section takes our attention away from the risks themselves towards the methods, resources,
techniques, and strategies for managing risks and the principles governing the management of
the risk.
After the risks facing the firm are identified and measured, the risk manager must decided how to
handle/manage them. Risk can be handled in several ways. However, we can classify them into
two broad measures / approaches. They are risk control tools and risk financing tools.
2.8.1 Risk Control Tools
Risk control approaches are designed to reduce the firm’s expected losses and to make the
annual loss experience more predictable. More specifically, risk control efforts help individuals
and organizations avoid a risk, prevent loss, lessen the amount of damage if a loss occurs, or
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reduce undesirable effects of risk on an organization. The application of risk control techniques
to achieve these ends may range from simple and low cost to complex and costly approaches.
The activities that constitute one organization’s risk control efforts may vary from those of a
similar organization in another part of the world. Although risk control programs vary from
organization to organization as a consequence of creativity and innovation, a typology of risk
control tools and methods still exist. Risk control tools and techniques can be categorized as:
Avoidance
Avoidance of risk exists when the individual or the firm frees itself from the exposure through
(1) abandonment, or (2) refusal to accept the risk from the very beginning (proactive avoidance).
To avoid the risk the individual or the firm need to avoid the property, person or activity with
which the exposure is associated.
Avoidance through abandonment is not quite as common as proactive avoidance, but it does
occur. For example, suppose a firm finds out that one of its product has a serious health problem
on customers. Therefore, to avoid liability risk that could arise, the firm can abandon the
production and sale of that specific product.
Proactive avoidance or refusal to accept the risk from the very beginning can be explained by the
following example; ABC has planned to build a 50 story building around Arada area but while
consultants finds out that the area cannot support more than a 20 story building. Thus the
company can refuse to under take construction.
Avoidance is an effective approach to the handling of risk. By avoiding a risk, the company can
avoid the uncertainty that the company experiences. However, the company loss the benefit that
might have been derived from that risk.
In general, it would be impossible to use avoidance in the following situations.
1) The production of some products and the provision of some service may provide rewards
whose expected value far exceeds potential loss pr costs at the margin.
2) It is impossible to avoid all the properties such as vehicles, buildings, machinery,
inventory etc. Without them operations of business would become impossible.
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3) The context of the decision also may make avoidance impossible. A risk does not exist in
a vacum, and a decision to avoid a risk might actually create a new risk else ware or
enhance some existing risk. For example, if the Addis Ababa city Administration learned
that Ras Tefere Bridge is in a state of serious disrepair, in response the administration
decided to close the bridge and divert all traffic to the other alternative bridge. The traffic
load will made failure of the second alternative bridge more likely to occur, and within a
year the second bridge will collapse. That means the measure taken to avoid risk in the
first bridge bring another risk in the second road.
4) The risk may be so fundamental to the organization’s reason for being that avoidance
cannot be contemplated. A mining concern may not avoid the risk of tunnel collapse, but
true avoidance would mean leaving the mining business, which is the reason for
existence.
Loss Control Measures
Loss control measures attack risk by lowering the chance a loss will occur (loss frequencies) or
by reducing the amount of damage when the loss does occur (loss severity). Loss control tools
can be classified as: loss prevention and loss reduction measures.
a) Loss Prevention (LP)
Loss prevention programs seek to reduce the number of losses or to eliminate them entirely. Loss
prevention activities are focused on:
i) Altering or modifying the hazard
ii) Altering or the modifying the environment in which the hazard exists
iii) Intervening in the process whereby hazard and environment interacts.
The following are examples of low prevention activities.
Hazard Loss prevention activities
1. Careless house keeping * Training and monitoring program
2. Flood * Construction of dams
3. Smoking and * Prohibition, enforcement of law, prison
Drunk driving sentence
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ENVIRONMENT
4. Improperly trained worker * Training (on the job and off the job)
5. Building susceptible to fire * Fire resistive construction
6. Slippery shop floor * Installation of absorbent mats
7. Dangerous working environment * Regular inspection and Internal control
warning poster.
Tight quality control can avoid a product liability risk that might arise due to product’s quality.
b) Loss Reduction Measures
Loss reduction activities on the other hand are designed to reduce the potential severity of a loss
once the peril happened. Such a system does not reduce the probability of loss, instead, they
reduce the amount of damage if a peril occurs. Loss reduction activities are post loss measures.
The best examples of loss Reduction measures are:
employing fire extinguishers
using active and trained guards
installing automatic sprinkler
A sprinkler system is a classic example of loss reduction effort; because fire is required to
activate the sprinklers.
A firm that employees an effective risk prevention and risk reduction programs is benefiting not
only itself but the society as well. For instance, the firm that makes strict quality control to
prevent liability losses is safeguarding the society from possible harms. A destruction of
inventory of a firm may affect society because those goods are no more available to the society.
Therefore, effective loss prevention and reduction measures should be designed to benefit both
the firm and the society. However, these measures involve costs which include expenditures for
the acquisition of safety equipments and devices, operating expenses such as salary payments to
guards, inspectors, and other employees engaged in safety work and training and seminar costs.
The risk manager will have to design the most efficient measures in order to minimize such costs
without reducing the desired safety level.
Neutralization
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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 national cup series may neutralize the risk
involved by also placing a bet on the opposing team. The risk is transferred to the person who
accepts the second bet.
Information Management
Information emanating from an organization’s risk management department can have important
effects in reducing uncertainty in an organization’s stakeholders such as, suppliers, customers,
creditors, employees etc.
Risk transfer
Transfer as a risk control tool refers to transferring the loss that causes a loss to some entity other
than the one experiencing it to bear the burden of the loss. Transfer may be accomplished in two
ways:
1. The activity or property responsible for the risk can be transferred to some other person or
groups of persons.
For example, an organization that sells one of its buildings can transfer the risk associated with
ownership of the building to the new owner. The main contractor can transfer some of the risks.
By hiring sub-contractor who can handle some part of the project.
One may ask a question “what makes transfer different from avoidance?” Risk transfer measure
attempt to transfer risk that results in an exposure to a particular peril for some other person or
organization, whereas in the case of avoidance through abandonment the risk is passed to no one.
2. The risk, but not the property or activity, may be transferred. For example, a manufacturer
may be able to force a retailer to assume responsibility for any damage to products that occur
after the products leave the manufacturer’s premises.
Separation
This refers to scattering the firm’s property exposed to risk to different places. The principle is
“do not put all your eggs in one basket.” For example, instead of placing its entire inventories in
one warehouse, a firm may put them in different warehouses and separate exposure. An other
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example, a firm can store files depending on their respective importance. Top secret files, say,
can be put in fire proof cabinets, others in locked cabinets and the less importance once can be
left on tables.
Combination
This is some how similar to separation as it involves increasing the number of exposure units to
make loss exposures more predictable. Their difference lies on the fact that unlike separation,
which simply spreads a specified number of exposure units, combination (pooling) increases the
number of exposure units under the control of the firm. Combination follows the law of large
numbers, which states that when the exposure units increase, the loss will be more predictable
with high degree of accuracy and then reduces risk.
Examples:
- A taxi owner increasing the number of fleets
- Merger with other firms (the merger of Lion Insurance and Hibret Insurance). In this case
combination results in the pooling of resources of the two companies. This leads to
financial strength, thereby reducing the adverse effect of the potential loss.
- Use of spare parts and reserve machines
Diversification
Diversification is another risk control tool used to handle most speculative risks. For example,
businesses can diversify their product line so that a decline in profit of one product could be
compensated by profits form other product lines. Here we can take our country as an example.
Ethiopia can minimize international trade risk by producing and selling different types of
products in addition to coffee export which accounts the lion share in our export trade. This can
be noticed from the current situation. The country has lost thousands of foreign exchange from
coffee export because of the decline in the world price of coffee.
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2.8.2 Risk Financing Tools
In most risk management programs, some losses occur in spite of the best risk control efforts.
This means some measures must be used to finance losses that do occur. Risk control measures
by altering the loss itself, either reduce the potential losses or make those losses more
predictable. The risk financing tools, on the other hand, are ways of financing the losses that do
occur. It includes:
Retention (Self-Insurance)
The most common and easiest method of risk handling tools used by firm is retention. It is an
arrangement under which the firm or an individual experiencing the loss bears the direct
financial consequences. In other words, the person or the firm consciously or unconsciously,
decides to assume the risk and pays for the loss without any attempt to transfer it to somebody
else. The sources of the funds is the firm itself. Retention may be passive or active, unconscious
or conscious, unplanned or planned.
The retention is passive or unplanned when the risk manager is not aware that exposure exists
and consequently does not attempt to handle it. By default, therefore, the firm has elected to
retain the risk associated with that exposure. Retention is active or planned when the risk
manager considers other methods of handling the risk and consciously decides not to transfer the
potential losses. For this, the firm may set aside a fund for the contingencies (self Insurance).
Why person or a firm decides to retain the risk? Planned retention exist for a number
of reasons. Some of these are:
1. It is probability impossible to transfer the risk, as in the case of speculative and dynamic
risks: In some cases retention is the only possible tool. The firm cannot prevent the loss,
avoidance is impossible or undesirable, and no transfer possibilities (including insurance)
exist. Consequently, the firm has no choice other than retaining the risk. Example, a
factory located in a river valley may find no other method of handling the flood risk is
feasible. Abandonment and loss control would be too costly, and flood insurance for such
situation may not be available.
2. Attitudes of individuals or firms towards risk: Usually risk lovers prefer to assume
(retain) considerable risk than do risk avoiders.
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3. The value of the goods to be insured and insurance costs: If the value of the property
insured is less than the cost of insurance the firm may prefer to retain the risk.
In most cases retention is not the only possible tool. The choice is between retention and
insurance. The major factors to be considered in making the choice are:
a) The maximum probable cost relative to the firm’s capacity for bearing the risk.
b) Expected loss and risk
If the business believes that its expected losses are less than those assumed by the insurer
in calculating its premium, it may reason that in the long run it can save the difference
between the two expected losses estimated by retaining the loss
c) Restrictions or legal limitations applying to risk transfers. In such types of situation the
only option may be retention.
d) Opportunity costs related to investment of funds that is going to be paid as a premium if
the risk is transferred to the insurance companies.
e) Quality of service provided by the insurance companies.
4. The risk may be remote: If the risk manager knows that the risk is so remote that cannot
exist in the near future, then he/she may prefer to retain the loss.
Transfer
Transfer as a risk-financing tool is an arrangement under which some entity other than the one
experiencing the loss bears the direct financial consequences. Under "risk financing transfer”, the
transferor seeks external funds that will pay for the losses that do occur. In this arrangement,
unlike the risk "control transfer”, the risk itself is not shifted rather it is assumed by somebody
else.
The most common form of risk transfer is by way of insurance. Insurance is so important in the
management of pure risks. We will explore insurance as a risk transfer mechanism in more detail
in the next three units.
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