chapter 3

Chapter 3: Introduction to Risk Management* Monday, September 01, 2008 10:07 PM   Meaning of Risk Management Definition: a process that identifies loss exposures faced by an organization and selects the most appropriate techniques for treating such exposures Loss exposure Definition: any situation or circumstance in which a loss is possible, regardless of whether a loss occurs Objective of Risk Management Pre-loss objectives The firm should prepare for potential losses in the most economical way The reduction of anxiety Meet any legal obligations Post-loss objectives Survival of the firm. Survival means that after a loss occurs, the firm can resume at least partial operations within some reasonable time period Continue operating. The ability to operate after a loss is extremely important Stability of earnings Continued growth of the firm. A company can grow by developing new products and markets or by acquiring or merging with other companies Social responsibility is to minimize the effects that a loss will have on other persons and on society. A severe loss can adversely affect employees, suppliers, creditors, and the community in general Steps in the Risk Management Process Identify loss exposures Property loss exposures Liability loss exposures Business income loss exposures Human resources loss exposures Crime loss exposures Employee benefit loss exposures Foreign loss exposures Market reputation and public image of the company Failure to comply with government laws and regulations Sources of information use to identify the preceding loss exposures Risk analysis questionnaires Physical inspection Flowcharts Financial statements Historical loss data Analyze the loss exposures Loss frequency refers to the probable number of losses that may occur during some given time period Loss severity refers to the probable size of the losses that may occur Maximum possible loss is the worst loss that could happen to the firm during its lifetime Maximum probable loss is the worst loss that is likely to happen Select appropriate techniques for treating the loss exposures Risk control Definition: refers to techniques that reduce the frequency and severity of losses Avoidance Definition: a certain loss exposure is never acquired, or an existing loss exposure is abandoned Advantage The chance of loss is reduced to zero if the loss exposure is never acquired Disadvantage The firm may not be able to avoid all losses It may not be feasible or practical to avoid the exposure Loss prevention Definition: measures that reduce the frequency of a particular loss Loss reduction Definition: measures that reduce the severity of a loss after it occurs Risk financing Definition: refers to techniques that provide for the funding of losses Retention Definition: the firm retains part or all of the losses that can result from a given loss Retentions can be effectively used in a risk management program under the following conditions No other method of treatment is available The worst possible loss is not serious Losses are highly predictable Determining retention levels Definition: which is the dollar amount of losses that the firm will retain Methods used to determine the retention level A corporation can determine the maximum uninsured loss it can absorb without adversely affecting the company's earnings A company can determine the maximum retention as a percentage of the firm's net working capital Paying losses If retention is used, the risk manager must have some method for paying losses Current net income. The firm can pay losses out of its current net income and treat losses as expenses for that year Unfunded reserve. An unfunded reserve is a bookkeeping account that is charged with actual or expected losses from a given exposure Funded reserve. A funded reserve is the setting aside of liquid funds to pay losses Credit line. A credit line can be established with a bank, and borrowed funds may be used to pay losses as they occur Captive insurer Definition: an insurer owned by a parent firm for the purpose of insuring the parent firm's loss exposures Single parent captive is an insurer owned by only one parent, such as a corporation Association or group captive is an insurer owned by several parents Captive insurers are formed for several reasons Difficulty in obtaining insurance Lower costs Easier access to a reinsurer Formation of a profit center Self-insurance Definition: a special form of planned retention by which part or all of a given loss exposure is retained by the firm Risk retention groups Definition: a group captive that can write any type of liability coverage except employer liability, workers comp., and personal lines Risk retention groups are exempt from many state insurance laws that apply to other insurers Advantages and disadvantages of retention Advantages Save money Lower expenses Encourage loss prevention Increase cash flow Disadvantages Possible higher losses Possible higher expenses Possible higher taxes Noninsurance transfers Definition: methods other than insurance by which a pure risk and its potential financial consequences are transferred to another party Advantages The risk manager can transfer some potential losses that are not commercially insurable Noninsurance transfers often cost less than insurance The potential loss may be shifted to someone who is in a better position to exercise loss control Disadvantages The transfer of potential loss may fail because the contract language is ambiguous If the party to whom the potential loss is transferred is unable to pay the loss, the firm is still responsible for the claim An insurer may not give credit for the transfers, and insurance costs may not always by reduced Commercial insurance Selection of insurance coverage Selection of an insurer Negotiation of terms Dissemination of information concerning insurance coverage Periodic review of the program Advantages The firm will be indemnified after a loss occurs Uncertainty is reduced, which permits the firm to lengthen its planning horizon Insurers can provide valuable risk management services, such as loss-control services, loss exposure analysis, and claims adjusting Insurance premiums are income-tax deductible as a business expense Disadvantages The payment of premiums is a major cost, because the premium consists of a component to pay losses, an amount for expenses, and an allowance for profit and contingencies Considerable time and effort must be spent in negotiating the insurance coverage The risk manager may have less incentive to follow a loss-control program, because the insurer will pay the claim if a loss occurs Implement and Monitor the Risk Management Risk management policy statement Is necessary to have an effective risk management program. This statement outlines the risk management objectives of the firm, as well as company policy with respect to treatment of loss exposures Risk management manual may be developed and used in the program. The manual describes in some detail the risk management program of the firm and can be a very useful tool for training new employees who will be participating in the program. Writing the manual also forces the risk manager to state precisely his or her responsibilities, objectives, and available techniques Cooperation with other departments Other functional departments within the firm are extremely important in identifying pure loss exposures and methods for treating these exposures Departments Accounting Finance Marketing Production Human resources Periodic review and evaluation To be effective, the risk management program must be periodically reviewed and evaluated to determine whether the objectives are being attained Benefits of Risk Management The pre-loss and post-loss risk management objectives are more easily attainable The cost of risk is reduced, which may increase the company's profits Because the adverse financial impact of pure loss exposures is reduced, a firm may be able to enact an enterprise risk management program that treats both pure and speculative loss exposures Society also benefits since both direct and indirect losses are reduced Personal Risk Management Definition: the identification of pure risks faced by an individual or family, and to the selection of the most appropriate technique for treating such risks Steps in personal risk management Identify loss exposures Analyze the loss exposures Select appropriate techniques for treating the loss exposures Implement and review the program periodically Analyze the loss exposures The frequency and severity of potential losses should be estimated so that the most appropriate technique can be used to deal with the exposure Select appropriate techniques for treating the loss exposures Avoidance Risk control Retention Noninsurance transfers insurance