RISK

MANAGEME
NT
Definition of Risk Management
 “a systematic process for the identification

and evaluation of pure loss exposures

faced by an organization or individual and
for the selection and implementation of
the most appropriate techniques for
treating such exposures”.
Objectives Of Risk Management:
(1) Pre-loss Objectives:
a. To prepare for potential losses in the most
economical way possible.

This involves :
 as analysis of safety program expenses,

 insurance premiums and

 the costs associated with the different

techniques of handling losses.

b. reduction of anxiety
In a firm, certain loss exposures can cause greater
worry and fear for the risk manager, key executives
and unexpected stockholders of that firm.
E.g. a threat of an lawsuit from a defective product
can cause greater anxiety than a possible small loss
from a minor fire.
However, the risk manager wants to minimize the
anxiety and fear associated with such loss
exposures.
c. to meet any externally imposed
obligations

This means that the firm must meet certain

obligations imposed on it by the outsiders.

E.g. government regulations may require a firm to

install safety devices to protect workers from harm.

Similarly, a firm’s creditors may require that

property pledged as collateral for a loan must be

insured.

Thus, the risk manager is expected to see that these

externally imposed obligations are met properly.

(2) Post-loss Objectives:
a. Survival of the firm

It means that after a loss occurs, the firm can

at least resume partial operation within some
reasonable time period.
b. to continue operating
For some firms, the ability to operate after a

severe loss is an extremely important

objective.
Especially, for public utility firms such as

banks, dairies, etc, they must continue to

provide service. Otherwise, they may lose
their customers to competitors.
c. Stability of earnings
The firm wants to maintain its earnings per

share after a loss occurs.

This objective is closely related to the

objective of continued operations.

Because, earnings per share can be

maintained only if the firm continues to

operate.
d. continued growth of the firm
A firm may grow by developing

 new products and markets or

 by acquisitions and mergers.

Here, the risk manager must consider the

impact that a loss will have on the firm’s

ability to grow.
e. social responsibility
is the social responsibility to minimize the impact
that a loss has on other persons and on society.
 A severe loss can adversely affects
 the employees,
customers,
suppliers,
creditors and
 the community in general.
Thus, the risk manager’s role is to minimize the
impact of loss on other persons.
Steps in Risk Management Process
1. RISK IDENTIFICATION

2. RISK MEASUREMENT

3. TOOLS OF RISK MANAGEMENT

Avoidance
Loss control
Retention
NIT
Insurance

4. SELECTION OF RISK MANAGEMENT TOOLS

5. RISK ADMINISTRATION
 1. Risk Identification
it is the responsibility of the risk manager to

identify several types of potential losses such as

 Property losses

 Business income losses

 Liability losses
 Death or inability of key people

 Job-related injuries or disease

 Fraud, criminal acts and dishonesty of

employees

 Employee benefits loss exposures

sources of information
 Physical inspection of company plant &

machineries can identify major loss exposures.

 Extensive risk analysis questionnaire can be

used to discover hidden loss exposures that

are common to many firms.

 Flow charts that show production and delivery

processes can reveal production bottlenecks where a

loss can have severe financial consequences to the firm.

 Financial statements can be used to identify the major

assets that must be protected.

 Departmental & historical claims data can be invaluable

in identifying major loss exposures.

2. Risk Measurement
This 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 period of time.

Loss severity: refers to the probable size of

the losses that may occur.

various loss exposures can be ranked

according to their relative importance.

E.g. a loss exposure with the potential for

bankrupting the firm is much more

important than a exposure with a small loss
potential.
o Although the risk manager must consider both

loss frequency and loss severity, severity is more

important

 Both the maximum possible loss and maximum

probable loss must be estimated.

The maximum possible loss : is the worst loss that

could possibly happen to the firm during its

lifetime.

 E.g. if a plant is totally destroyed in a flood, the

risk manager may estimate that replacement cost,

demolition costs and other costs will total Birr 10

million.

 Thus, the maximum possible loss is 10million Birr.

 The maximum probable loss : is the worst loss

that is likely to happen.

 E.g. The risk manager may estimates that

another flood causing more than 8 million

Birr of damage to the plant.

 Thus, for this risk manager, the maximum

probable loss is 8 million Birr.

3. Tools of Risk Management:
 identify the available tools of risk
management such as

a)Avoidance

b)Loss control

c)Retention

d)Non-insurance transfers

e)Insurance
 a) voidance:
means that a certain loss exposure is never

acquired, or an existing loss exposure is

abandoned.
 E.g. a firm can avoid earthquake loss by not

building a plant in an earthquake prone area.

An existing loss exposure may also be abandoned.

 E.g. a pharmaceutical firm that produces a drug

with dangerous side effects may stop

manufacturing that drug.
advantage of avoidance
chance of loss is reduced to zero, if the loss

exposure is not acquired.

In addition, if an existing loss exposure is

abandoned, the possibility of loss is either

eliminated or reduced because the activity

that could produce a loss has been abandoned.

Disadvantages of avoidance
it may not be possible to avoid all losses.

 E.g. a company cannot avoid the pre-mature death of

a key executive.
it may not be practical or feasible to avoid the loss

exposure.
 E.g. the pharmaceutical company can avoid losses

arising from the production of a particular drug.

However, without any drug production, the firm will
not be in business.
 b. Loss Control
designed to reduce both the frequency and
severity of losses.
It deals with an exposure that the firm does not
with to abandon.
The purpose of loss control activities is to change
the characteristics of the exposure so that it is
more acceptable to the firm.
Thus, the firm wishes to keep the exposure but
wants to reduce the frequency and severity of
losses.
Measures that reduce loss frequency

quality control checks,

driver examination,

strict enforcement of safety rules and

improvement in product design.

Measures that reduce loss severity
installation of an automatic sprinkler or

burglar alarm system,

early treatment of injuries and

rehabilitation of injured workers.

 c. Retention

means that the firm retains part or all of the

losses that result from a given loss exposure.

It can be effectively used when three

conditions exist.
 no other method of treatment is available

 the worst possible loss is not serious.

 E.g. physical damage losses to automobiles in

a large firm’s fleet will not bankrupt the firm.

 losses are highly predictable.

Determining Retention Levels

If retention is used, the risk manager must

determine the firm’s retention level, which is the

Dollar / Birr amount of losses that the firm will retain.

A financially strong firm can have a higher retention

level than one whose financial position is weak.

methods of determining retention level

i. a Corporation can determine the maximum retention

level at 5 % the company’s annual earnings before

taxes from current operation

ii. determine the maximum retention as a percentage of

the firm’s net working capital, such as between 1% and

5%.
Methods of Paying losses

1. The firm can pay losses out of its current net

income, with the losses treated as expenses

for that year. However, a large number of

losses could exceed current net income.

 Then, other assets may have to be

liquidated to pay losses.

2.borrow the necessary funds from a bank.

A line of credit is established and used to pay

losses as they occur.

However, interest must be paid on the loan

and loan repayments can aggravate cash flow

problems the firm may have.

3. unfunded or funded reserve.
 An unfunded reserve is a book keeping account that is

charged with the actual or expected losses from a given

risk exposure.

 A funded reserve is the setting aside of liquid funds to pay

losses.

 Private employers do not use funded reserve, in their risk

management programs, because the funds may yield higher

return if it is used in the business.

Advantages of Retention
a. The firm can save money in the long run if its

actual losses are less than the loss allowance

in the insurer’s premium.

b. The services provided by the insurer may be

provided by the firm at a lower cost.

Some expenses may be reduced, including

 loss-adjustment expenses,

 general administrative expenses,

 commissions and

 brokerage, etc.
c. Since the risk exposure is retained, there

may be greater care for loss prevention.

d. Cash flow may be increased since the firm

can use the funds that normally would be

held by the insurer.

Disadvantages of Retention

a. The losses retained by the firm may be

greater than the loss allowance in the

insurance premium that is saved by not

purchasing the insurance.

b. Actually, expenses may be higher as the firm

may have to hire outside experts such as

safety engineers. Thus, insurers may be able

to provide loss control services less

expensively.
c. Income taxes may also be higher.

The premiums paid to an insurer are income-tax

deductible. However, if retention is used, only the

amounts actually paid out for losses are deductible.

Contributions to a funded reserve are not income-tax

deductible.
d. Non-Insurance Transfers (NIT)
are methods other than insurance by which a

pure risk and its potential financial consequences

are transferred to another party.

Examples of non-insurance transfers include

 contracts,

 leases and

 hold-harmless agreements.
E.g.1. a company’s contract with a

construction firm to build a new plant can

specify that the construction firm is

responsible for any damage to the plant

which it is being built.

E.g.2. A firm’s computer lease can specify that

maintenance, repairs and any physical

damage loss to the computer are the

responsibility of the computer firm.

E.g.3. a publishing firm may insert a hold-

harmless clause in a contract, by which the

author and not the publisher is held legally

liable if anybody sued the publisher.

Advantages of Non-Insurance Transfers

1. The risk manager can transfer some potential

losses that are not commercially insurable.

2. Non-Insurance transfers often cost less than

insurance.

3. The potential loss may be shifted to someone

who is in a better position to exercise loss

control.
Disadvantages of Non-Insurance Transfers

a. The transfer of potential loss would become impossible, if

the contract language is ambiguous.

b. If the party to whom the potential loss is transferred is

unable to pay the loss, the firm is still responsible for the

claim.

c. Non-Insurance Transfers may not always reduce insurance

costs since an insurer may not give credit for the transfers.
 e. Insurance

Insurance is appropriate for loss exposures that have a

low probability of loss but the severity of loss is high.

If the risk manager uses insurance to treat certain loss

exposures, five key areas must be emphasized.

They are as follows;

Selection of insurance coverage

Selection of an insurer

Negotiation of terms

Dissemination of information concerning

insurance coverage

Periodic review of the insurance program

Advantages of Insurance

a. The firm will be indemnified after a loss occurs.

Thus, the firm can continue to operate.

b. Uncertainty is reduced. Thus, worry and fear are

reduced for the managers and employees, which

should improve their productivity.

c. Insurers can provide valuable risk management

services, such as

 loss-control services,

 claims adjusting, etc.

d. Insurance premiums are income-tax deductible

as a business expense.
Disadvantages of Insurance:

a. The payment of premiums are a major cost.

Under the retention technique, the premiums

could be invested in the business until needed

to pay claims, but if insurance is used,

premiums must be paid in advance.

c. Considerable time and effort must be spent in

negotiating the insurance coverage.

d. The risk manager may take less care to loss-

control program since he has insured. But, such a

lax attitude toward loss control could increase

the number of non-insured losses as well.

 4. Selection of Risk Management Tools
Types of Loss Loss Appropriat Examples
Loss Frequency Severity e risk
manageme
nt tools
1. Low Low Retention Theft of
secretary’s
notepad

2 High Low Loss control Damage for

& Retention automobile
Shoplifting
Food
spoilage
3. Low High Insurance Fire
Explosion
Flood etc
4. High High Avoidance If a person
drunk &
drive a car
 5. Risk Administration

is implementation and administration of the

risk management program.

It involves three important components;

1. Risk management policy statement

2. Co-operation with other departments

3. Periodic review and evaluation

Risk management policy statement
 is necessary in order to have an effective risk

management program.

 outlines the risk management objectives of the firm, as

well as company policy with respect to the treatment of

loss exposures.

 It also educates top level executives in regard to the risk

management process and gives the risk manager greater

authority in the firm.

Co-operation with other departments

The Accounting Department can adopt

Internal Accounting Controls to reduce

employees fraud and theft of cash.

The Finance Department can provide

information showing how losses can disrupt

profits and cash flow.

The Marketing Department can prevent

liability suits by ensuring accurate packaging.

The Production Department has to ensure

quality control and effective safety programs

in the plant can reduce injuries and accidents.

Periodic review & evaluation
The risk management program must be
periodically reviewed and evaluated to see
whether the objectives are being attained or
not. Especially,
 risk management costs,
 safety programs and
 loss preventive programs must be carefully
monitored.