Risk Management and Insurance

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Trieschmann, Hoyt & Sommer

Risk Management Techniques: Noninsurance Methods

Unit 5

Source Material

• Trieschmann J., Sommer, D. & Hoyt, R. E. (2004). Risk

Management and Insurance 12th Edition. KY: South-

Western College

Risk Management Techniques:

Noninsurance Methods • After identifying and evaluating exposures to risk,

systematic consideration can be given to alternative

methods for managing each exposure.

• The four basic methods available for handling risks are:

– Risk Avoidance

– Loss of Control

– Risk Retention

– Risk Transfer

Risk Avoidance

• Risk Avoidance is a conscious decision not to expose oneself or one’s firm to a particular risk.

– It can be said to decrease one’s chance of loss to zero.

• For example, a doctor may decide to leave the practice of medicine rather than contend with the risk of malpractice liability losses

– Another e.g. is having a seller assumes responsibility for goods until arrival at the buyer’s warehouse. In this case the buyer avoids the risk until the goods are delivered.

• Risk avoidance is common, particularly among those with a strong aversion to risk.

• However, avoidance is not always feasible

– Or may not even be desirable even when it is possible

Risk Avoidance

• When risk is avoided, the potential benefits, as well as

costs, are given up

– For example, the doctor who quits practicing medicine avoids

future liability risks but also forfeits the income and other forms

of satisfaction that may be associated with a career in

medicine.

Loss Control

• When particular risks cannot be avoided

– Actions may often be taken to reduce the losses associated with them.

• This method is known as Loss Control.

• In this instance, the firm or individual is still engaging in operations that give rise to particular risks.

• Rather than abandoning specific activities, loss of control involves making conscious decisions regarding the manner in which those activities will be conducted.

– Common goals are either to reduce the probability of losses or to decrease the cost of losses that do occur.

– For e.g. holding inventory and setting up a security camera

Focus of Loss Control

• Some loss control measures are designed primarily to

reduce loss frequency

– Called frequency reduction

• Some firms spend considerable funds in an effort to

reduce the frequency of injuries to its workers

– Safety gears/equipment, training workshops

• In this regard, it is useful to consider the classic domino

theory originally stated by H. W. Heinrich.

Domino Theory

• Employee accidents can be viewed in light of the following steps

– Heredity and social environment, which cause persons to act a particular way

– Personal fault, which is the failure of individuals to respond appropriately in a given situation

– An unsafe act or the existence of a physical hazard

– Accident

– Injury

• Each step can be thought of as a domino that falls, which in turn causes the next domino to fall

Figure 5-1: Heinrich’s Domino Theory

• If any of the dominos prior to the final one are removed the injury will not occur.

• It is often argued that the emphasis of loss control should be on the third domino or step.

• Thus by removing physical hazard and eliminating unsafe actions by employees the frequency of injuries to workers can be reduced.

Types of Loss Control

• Severity Reduction – For example, an auto manufacturer having airbags installed in the

company fleet of automobiles • The air bags will not prevent accidents from occurring, but they will reduce the

probable injuries that employees will suffer if an accident does happen

• Two types of severity reduction: – Separation

• Involves the reduction of the maximum probable loss associated with some kinds of risks e.g. work dispersion so that in the event of a catastrophe, only a limited number of injuries

– Duplication • Spare parts or supplies are maintained to replace immediately damaged

equipment and/or inventories

Timing of Loss Control

• Pre-Loss Activities

– Implemented before any losses occur

• e.g. employee safety education programs

• Concurrent Loss Control

– Activities that take place concurrently with losses

• E.g building fire sprinklers (the actual sprinkler activity at the time of a fire

• Post-Loss Activities

– Always have a severity-reduction focus

• One example is trying to salvage damaged property rather than discard it; like

a wrecked car

Decisions Regarding Loss Control

• A major issue for risk managers

– The decision about how much money to spend on the various forms of

loss control

• In some cases it may be possible to significantly reduce the exposure

to some types of risk

– But if the cost of doing so is very high relative to the firm’s financial

situation

» The loss control investment may not be money well spent.

– The general rule is that to justify the expenditure

• The expected gains from an investment in loss control should be at

least equal to the expected costs

Potential Benefits of Loss Control

• Many of the benefits are either readily quantifiable or can be

reasonably estimated

• These may include the reduction or elimination of expenses

associated with the following

– Repair or replacement of damaged property

– Income losses due to destruction of property

– Extra costs to maintain operations following a loss

– Adverse liability judgments

– Medical costs to treat injuries

– Income losses due to death or disabilities

Potential Benefits of Loss Control

• Another potential quantifiable benefit of loss control

– A reduction in the cost of other risk management techniques used in conjunction with the loss control

• An example is the decrease in insurance premiums that often accompanies a loss control investment

• There may be loss control benefits for which a dollar value cannot be easily estimated

– Examples include

• The reduction in subjective risk that may accompany lower expected loss frequency and severity

• Improved public and employee relations associated with fewer and less severe losses

Potential Costs of Loss Control

• It is usually easier to estimate the potential costs

• Two obvious cost components are installation and maintenance

expenses

– For example, a sprinkler system will have an initial cost to install and

also will have ongoing expenses necessary to maintain it in proper

working order

• The challenge in cost estimation is often identifying all of the

ongoing expenses

– Also, some of the ongoing cost may merely be increases in other

expenses, for example, increase in utility bills

Risk Retention

• Risk retention involves the assumption (acceptance or

taking responsibility) of risk

– If a loss occurs, an individual or firm will pay for it out of

whatever funds are available at the time

• Retention can be planned or unplanned and losses that

occur can either be funded or unfunded in advance.

Planned Versus Unplanned Retention

• Planned Retention

– Involves a conscious and deliberate assumption of recognized risk.

– Sometimes it occurs because it is the most convenient risk treatment technique

• Or because there are simply no alternatives available short of ceasing operations

• Or after analysis of alternatives, it might be the most appropriate technique.

• Unplanned Retention

– This is when a firm or individual does not recognize that a risk exists and unwittingly believes that no loss could occur

– Sometimes it occurs even when the existence of a risk is acknowledged

• This can result if the maximum possible loss associated with a recognized risk is significantly underestimated

Planned Versus Unplanned Retention

• For example, a manufacturer of kitchen appliances may

recognize the potential for product liability suits. But, the

potential size of the adverse liability judgements may be

much greater than the manufacturer anticipates.

• Thus, even though the exposure is recognized and the

firm elects to purchase insurance based on its estimate of

the maximum possible loss, it is still engaging in

unplanned retention of loss – the amount that exceeds

that estimate.

Funded Versus Unfunded Retention

• Many risk retention strategies involve the intention to pay for

losses as they occur

– W ithout making any funding arrangements in advance of a loss

and any loss that occur is paid from current revenue.

• This is known as Unfunded Retention - e.g. absorbing shoplifting

expense or broken windows expenses.

• This strategy must be used with caution because financial difficulties

can arise if actual losses are greater than expected.

• Funded Retention

– Pre-loss arrangements are made to ensure that money is readily

available to pay for losses that occur.

Funded Retention: Strategies

• Credit

– The use of credit may provide some limited opportunities to fund losses that result from retained risks.

– It is usually not a viable source of funds for the payment of large losses.

• Unless, however, the risk manager has already established a line of credit prior to the loss, the very fact that the loss has occurred may make it impossible to obtain credit when needed.

• Reserve Funds

– Sometimes a reserve fund is established to pay for losses arising out of risks a firm has decided to retain.

• It can be appropriate when the maximum possible loss is small.

– W hen the maximum possible loss is quite large a reserve fund may not be appropriate.

Funded Retention

• Self-Insurance

– If the firm has a group of exposure units large enough to reduce risk and thereby predict losses

• the establishment of a fund to pay for those losses is a special form of planned, funded retention known as self-insurance

– Self insurance is not the intent to transfer risk.

– Necessary elements of self-insurance:

• Existence of a group of exposure units that is sufficiently large to enable accurate loss prediction

• Prefunding of expected losses through a fund specifically designed for that purpose

• Captive Insurers

– Combines the techniques of risk retention and risk transfer.

– It is a type of insurer that is general formed and owned by potential insureds to meet their own risk financing needs.

Decisions Regarding Retention: Financial

Resources • A large business can often use risk retention to a greater extent than can a

small firm

– In part because of the large firm’s greater financial resources. Thus, losses due to many risks may merely be absorbed as losses occur, without much advance planning

• Examples may include stealing of office supplies, breakage of windows, burglary of vending machines

• The following elements from a firm’s financial statements should be considered when choosing possible retention levels

– Total assets, total revenues, asset liquidity, cash flows, working capital, ratio of revenues to net worth, retained earnings, ratio of total debt to net worth

– For all except the last one, the greater the number, the greater the firm’s ability to retain risk. Lower ratios are preferred for the exception.

Decisions Regarding Retention

• Ability to Predict Losses

– Although a firm may be able to retain the maximum probable loss associated with a particular risk

• Problems may result if there is considerable variability in the range of possible losses

– There must be a large enough group of items exposed to the same risk to be able to accurately predict loss experience.

• Feasibility of the Retention Program

– If the decision to retain losses involves advance funding

• Administrative issues may need to be considered

– If the risk is likely to result in several losses over time

• There will be administrative expenses associated with investigating and paying for those losses.

– Administrative issues are of particular concern when a firm decides to set up a self - insurance or captive insurer arrangement.

Risk Transfer

• Risk transfer involves payment by one party (the transferor) to another

(the transferee, or risk bearer)

– The transferee agrees to assume a risk that the transferor desires to

escape.

• Sometimes the degree of risk is reduced through transfer process because the

transferee may be in a better position to predict losses.

• Other times, it remain the same but transferred at a price.

– Risk transfer types include:

• Hold harmless agreements

• Incorporation

• Diversification

• Hedging

• Insurance

Forms of Risk Transfers - Hold-Harmless

Agreements • The provisions of hold harmless agreements are inserted into

many different kinds of contracts – It can transfer responsibility for some types of losses to a party different

from the one that would otherwise bear it.

• These are also known as indemnity agreements - e.g. clause in leases

• The intent of these contractual clauses is:

– To specify the party that will be responsible for paying for various losses

– Usually, no dollar limit is stated – the transferee must pay for all losses covered by the agreement, regardless of size.

Hold-Harmless Agreements

• Types of hold-harmless agreements

– Limited Form • Clarifies that all parties are responsible for liabilities arising from their

own actions.

– Intermediate Form • Transferee agrees to pay for any losses in which both the transferee

and transferor are jointly liable.

– Broad Form • Requires the transferee to be responsible for all losses arising out of a

particular situation – Regardless of fault

Hold-Harmless Agreements

• Enforcement of hold harmless agreements:

– They are not always legally enforceable.

– If the transferor is in a superior position to the transferee with

respect to either bargaining power or knowledge of the factual

situation

• Attempt to transfer risk through a hold-harmless agreement may not be

upheld by the courts

– Particularly true of broad-form hold-harmless agreements

– For example, a manufacturer transferring all losses from problems associated

with candies to its distributors. But what is the distributors are kids selling candies

to raise funds for a field trip?

Forms of Risk Transfers - Incorporation

• The most that an incorporated firm can ever lose is the total

amount of its assets

• Personal assets of the owners cannot be attached to help

pay for business losses

– As can be the case with sole proprietorships and partnerships

• Through incorporation, the firm transfers to its creditors the

risk that it might not have sufficient assets to pay for losses

and other debts.

Forms of Risk Transfers – Diversification and

Hedging • Diversification

– Diversification across various businesses or geographic locations while frequently justified by business synergies or economies of scale results in the transfer of risk across business units.

– The combining into one firm can even result in a reduction in total risk through the portfolio effect of pooling individual risks that have different correlations - e.g the same wind storm is unlikely to damage a plant in Nebraska and Georgia

• Hedging

– Involves the transfer of a speculative risk.

– Hedging is a business transaction in which the risk of price fluctuations is transferred to a third party

• Which can be either a speculator (transferee) or another hedger

• Hedging tools include: futures contracts, forwards, swaps and options

Forms of Risk Transfers - Insurance

• The most widely used form of risk transfer

• Implemented through legal contracts, or policies

– The insurer (transferee) promises to reimburse the insured (transferor) for losses suffered during the term of the agreement

• It is assumed that the insurer will indeed be able to pay whatever losses may occur.

• Many risk managers consider insurance as a last resort – to be used only when other risk management techniques are not

sufficient by themselves.

The Value of Risk Management

• Some elements of risk management such as loss control decisions can be viewed as positive net present value projects. – If the expected gains from an investment in loss control measures

exceed the expected costs associated with that investment

– The project should increase the value of the firm

• However, shareholders in a publicly traded corporation can eliminate firm-specific risk by holding a diversified portfolio of different company stocks – Therefore, the shareholder would appear to care little about the

management of non-systematic or firm-specific risk • This would appear to make many risk management activities negative net

present value projects

– However, many corporations engage in a number of activities directed at managing firm-specific risk

The Value of Risk Management

• Risk management activities such as risk transfer – add value to a publicly traded firm by efficiently allocating risk

among the firm’s claimholders

– reducing bankruptcy costs

– increasing the likelihood that obligations to debtholders are met

– providing access to real services of insurers

– reducing expected tax liabilities

The Value of Risk Management

• A broader view of risk underpins the movement toward enterprise risk management

• It reflects the realization that appropriate risk management must consider the fact that the corporation faces a portfolio of risks

• Diversification within the portfolio of risks facing the corporation can alter the firm’s risk profile

• Ignoring these diversification effects by managing the firm’s many risks independently – Can lead to an inefficient use of the corporation’s resources

Integrated Risk Management

• The enterprise view of risk management

– Encompasses building a structure and a systematic process for managing all the corporation’s risks

– Considers financial, commodity, credit, legal, environmental, reputation, and other intangible exposures that could adversely impact the value of the corporation

• The formation by some firms of the new position of chief risk officer (CRO)

– Reflects a realization of the importance of identifying all risks that could negatively impact the firm

– Suggested responsibilities of the CRO include:

• Implementation of a consistent risk management framework across the organization’s business areas

• Implementation and management of an integrated risk management program

– With particular emphasis on operational risk

• Communication of risk and the integrated risk management program to stakeholders

• Mitigation and financing of risks