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Risk Identification: Logical Classifications

Learning Objectives 1. Describe the exposures, perils, hazards and losses associated with

each of the four logical classifications of exposures. (p. 4) 2. Explain and apply property valuation methods. (p. 14) 3. Explain and apply tort, contract and statutory liability concepts.

(p. 20) 4. Discuss and apply factors affecting net income losses. (p. 26)

I. Introduction

Using the four logical classifications of exposures is a systematic method of identifying and categorizing exposures and the perils, hazards, and losses arising from the exposures so the risks can be effectively analyzed, controlled, and financed.

I. Property – Owned, Rented, Controlled

A. Exposures (real, personal property, intellectual property, intangible property, legal interest for property)

B. Perils (windstorm, theft by employees or outsiders, infringement of intellectual property, loss of reputation, obsolescence)

C. Hazards (faulty wiring, lack of security, neglect in protection, poor public relations practices) D. Losses (accidents and occurrences)

II. Human Resources A. Exposures

1. Owners, partners, shareholders 2. Board members and officers 3. Employees, management and 4. Outside employees (leased, temporary and non-management borrowed employees and volunteers) 5. Independent contractors 6. Others (primary clients, suppliers, vendors

B. Perils 1. Employment practices 2. Death 3. Disability, on and off job, 4. Illness, on and off job, family members

family members 5. Resignation, termination, 6. Strikes and labor unrest retirement C. Hazards 1. Unclear personnel practices 2. Non-adherence to safety practices 3. Poor morale, poor performance, 4. Terrorist acts or natural aging process 5. Management attitudes D. Losses 1. Damages awarded to employees 2. Cost to replace deceased key employees 3. Cost to replace retired employees 4. Extortion payment 5. Loss of productivity III. Liability

A. Exposures 1. Types (premises and operations, personal injury, products, statutory) 2. Basis (tort law, contract law, statutory law)

B. Perils (slip and fall on premises, product malfunction, work-related injury to employees) C. Hazards (poor housekeeping, poor quality control, lack of safety training and equipment) D. Losses (legal damages, statutory damages)

IV. Net Income (including speculative risks)

A. Exposures (loss of use of property, loss of productivity, reduction of income/assets, speculative risk) B. Perils (property, human resources, liability, loss of primary supplier/customer, weather, market,

fluctuations in financial markets, governmental action, fluctuations in economy) C. Hazards (poor product positioning, overextension of credit or excessive borrowing, inadequate

investment in research and development) D. Losses (decreased revenues, increased expenses)

Logical Classifications

Learning Objective #1: Describe the exposures, perils, hazards, and losses associated with each of the four logical classifications of exposures.

II. Logical Classifications of Exposures

A. Property

1. Exposures

a. Real property

1) Buildings and structures

a) Office building, plant, warehouse

b) Store silos or bins

c) Concrete mixing plants

d) Tenant improvements and betterments (owner’s interest)

e) Retaining walls, piers, docks

Logical Classifications 1. Property 2. Human Resources 3. Liability 4. Net Income

2) Land

a) Golf course tee boxes and greens

b) Landscaping

c) Trees and shrubs

b. Personal property

1) Cash and securities

2) Records and documents

3) Inventory

4) Mobile equipment

5) Equipment, furnishings, and supplies

6) Tenant improvements and betterments (tenant’s interest)

7) Computer systems, hardware, software, databases

c. Intellectual property

1) Copyrights and patents

2) Trademarks, service marks, and trade names

3) Trade secrets

4) Licenses and franchises

5) Leases and leasehold interests

d. Intangible property

1) Branding

2) Reputation

e. Legal interest (tangible and intangible)

1) Ownership

2) Control and use (rented or leased property)

3) Bailment

4) Secured creditors

2. Perils (short list of examples)

a. Windstorm

b. Theft by employees or outsiders

c. Infringement of intellectual property such as patent or trademark

d. Loss of reputation

e. Obsolescence

3. Hazards

a. “COPE”

1) Construction

2) Occupancy

3) Protection

4) Exposure

b. Examples of common hazards

1) Faulty wiring

2) Lack of security

3) Neglect in protection

4) Poor public relations practices

4. Losses

a. Accidents

b. Occurrences

B. Human Resources

1. Exposures

a. Owners, partners, shareholders

b. Board members and officers

c. Employees, management and non-management

d. Outside employees, e.g., leased, temporary and borrowed employees and volunteers

e. Independent contractors

f. Others, e.g., primary clients, suppliers, vendors

2. Perils

a. Employment practices

b. Death

c. Disability

1) On the job

2) Off the job

3) Family members

d. Illness

1) On the job

2) Off the job

3) Family members

e. Resignation, termination and retirement

f. Strikes and labor unrest

3. Hazards (short list of examples)

a. Unclear personnel practices

b. Non-adherence to safety practices

c. Poor morale, poor performance, or natural aging process

d. Terrorist acts

e. Management attitudes

4. Losses

a. Damages awarded to employees

b. Costs to replace deceased key employees

c. Costs to replace retired employees

d. Extortion payment

e. Loss of productivity

5. Auxiliary concerns

a. International exposures b. Benefit programs c. Non-compete contracts and restrictive covenants d. Trade secrets e. Incentive programs f. The risk manager may not have authority over

Human Resources, but will likely have responsibility and involvement

C. Liability

1. Exposures

a. Types

1) Premises and operations

2) Personal injury, libel, slander, and defamation

3) Products and completed operations

4) Statutory

b. Basis

1) Law of torts or negligence (common law)

2) Law of contracts

3) Statutory law

2. Perils

a. Slip and fall on premises

b. Product malfunction

c. Work-related injury to employee

3. Hazards

a. Poor housekeeping

b. Poor quality control

c. Lack of safety equipment

4. Losses

a. Legal damages

b. Statutory damages

D. Net Income

1. Exposures

a. Loss of use of property (property)

b. Loss of productivity from human resources (human resources)

c. Reduction of income or assets (liability)

d. Speculative risk (enterprise risk management)

2. Perils

a. Property, human resource, or liability

1) Damage or destruction of owned or controlled property

2) Legal liability and related expenses

3) Personnel losses

b. Loss of primary supplier, primary customer, or “magnet” business

c. Weather (no property damage) d. Market (operational, business risk) e. Fluctuations in financial markets

f. Governmental action

g. Fluctuations in economy, e.g., inflation, recession, downturns

3. Hazards

a. Most hazards affecting net income are the same as those affecting property, human resources, and liability exposures

b. Examples of hazards affecting economic perils

1) Poor product positioning

2) Overextension of credit or excessive borrowing

3) Inadequate investment in research and development

4. Losses

a. Reduction in revenues

b. Increase in expenses

Skills Application Scenario #5 – Logical Classifications

Using the 20 risks you identified in Skills Application Scenario #1, classify them using the four logical classifications of exposures.

Learning Objective #2: Explain and apply property valuation methods.

III. Basis for Property Valuation

A. Property exposures – valuations are estimated before the loss and measured after the loss to the extent of the financial consequences suffered

B. Property valuations are estimated and measured by the same

methodologies

Property Valuation Methods

1. Historical cost 2. Book value 3. Market value 4. Replacement cost 5. Actual cash value (ACV) 6. Economic value 7. Functional replacement cost 8. Other

1. Historical cost – the original purchase price

This value is of primary use to accountants, as tax-driven depreciation and the calculation of gain or loss from a disposal of the asset. These values are used by financial and accounting personnel in the creation of balance sheets, both internal and those prepared under Generally Accepted Accounting Practices for reporting to the general public and regulators. Risk managers must be alert to the use of this value as a substitute for an insurable value.

2. Book value – the historical cost less accumulated depreciation as recorded on the organization’s accounting records

This is an accounting concept, as explained above, and shows the net book value as of the end of the accounting period.

3. Market value – the amount a willing buyer will give to a willing seller

This value is of interest to finance and operations personnel when there is a discussion of a purchase or sale of an asset. In an acquisition or merger, market value may be used in part to set an offer or counteroffer price. In some instances, the risk manager must use this to set insurance values (such as fine arts or inventory values).

4. Replacement cost – the amount to replace a damaged or destroyed piece of property with new property of like kind and quality

This is an insurance term that is very important to the risk manager when negotiating insurance coverages and settling claims.

5. Actual cash value – the replacement cost less an allowance for insurance depreciation or obsolescence

6. Economic value – a future stream of income assigned to the property

Finance, operations, and risk management personnel use this term. Finance and operations are interested because this value may be a measure of the success of an operation or financing decision. Risk managers may use this to determine the value of net income exposures.

7. Functional replacement cost – the cost to repair or replace damaged or destroyed property with materials that are functionally the equivalent of the damaged or destroyed property

Risk managers use this value when the property is unusual, either because of historic value or outdated construction or décor techniques, such as ornate plaster work in a theater or marble work on the exterior of a building.

8. Other – reproduction costs, assessed value, etc.

Risk managers will use other valuation methods to negotiate insurance coverage when none of the traditional valuation methods produce reasonable or workable results.

Commentary Sometimes a risk manager must result to creative valuation methods. For example, the risk manager must provide a value for Oriental art at a museum – the proverbial “priceless” asset. Insurance on the art is inadequate as it is irreplaceable, so payment for the object is pointless even if the underwriter agrees to the limit of coverage. The only advantage to insuring it for its appraised value is to recover the acquisition cost, but there is no similar piece with which to replace it. Instead of insuring the art at some artificial value that is meaningless, the funds allocated for premium might be better spent at protecting the property from loss (security, fire suppression, etc) with a smaller amount of coverage to provide for restoration, if possible, or for clean- up. Another example of a creative valuation is of rare books and manuscripts that cannot be replaced but can be recovered or restored if damaged. A coverage limit based on the linear foot of material to be cleaned times the cost per linear foot would provide for restoration funds. (Thanks to Vince Morris, CRM Faculty Member.)

Skills Application Scenario #6 – Property Valuations Diamond Creek Naples just suffered a windstorm loss to the hotel building from a recent tropical storm system and is preparing its insurance proof of loss. The risk management department and accounting department have prepared the following exhibit: Cost to build ten years ago $ 37,000,000 Current construction cost 52,000,000 Accumulated depreciation as per the accounting records 6,000,000 Current comparable value appraisal for refinancing effort (30% of value was land) 80,000,000 Net present value of future income for the next 40 years 75,000,000 The insurance adjustor’s calculated depreciation 12,000,000 Calculate the following property valuations: Historical cost ___________________ Market value ___________________ Book value ___________________ Replacement cost ___________________ Actual cash value ___________________ Economic value ___________________

Learning Objective #3: Explain and apply tort, contract and statutory liability concepts.

IV. Basis for Liability

A. Civil law versus criminal law – the interests of society are protected by criminal law while the interests of individuals are protected by civil law. Civil law includes the following:

1. Torts 2. Contract law 3. Statutes

B. Tort – a private or civil wrong, other than a breach of

contract, for which the courts will provide a remedy in the form of an action for damages

1. Strict liability – liability directed by law (statute OR

common law) without regard to the intention of the offender’s actions. Strict liability shifts the burden of proof; it creates a rebuttable presumption that the defendant must overcome. Strict liability is also called no-fault liability or absolute liability.

Examples of strict liability:

a. Selling alcohol to minors because a person can be convicted even if s/he believed the minors were old enough to buy alcohol

b. Traffic offenses are usually strict liability crimes. For example, a speeding ticket is still issued even if the driver reasonably believed they were driving within the speed limit

c. Inherently dangerous activities (construction, blasting, excavation) – strict liability imposed by common law

2. Intentional act – when an individual commits an act with the intent of causing injury, damages, or a private violation of another person’s rights

Examples of an intentional act:

a. Libel/slander

b. Battery

c. Wrongful detention

d. False arrest

e. Discrimination

3. Negligence – failure to exercise a degree of care which a reasonably prudent person would exercise under the same circumstances. Elements of negligence are:

a. A duty owed b. A breach of that duty c. Causation – breach of duty must be the proximate

cause of the injury meaning no intervening action contributed to the injury, e.g., the unbroken chain of events.

d. Damages resulting from the injury

All four elements must be proven to establish negligence.

4. Remedies

a. Compensatory damages b. Punitive or exemplary damages c. Injunctive relief

C. Contract law – governs the performance of a promise

1. Four characteristics of an enforceable contract

a. Competent parties b. Agreement or assent c. Legal consideration (exchange of values) d. Legal purpose

2. Remedies for breach of contract or failure to perform

a. Damages – compensatory, punitive, or liquidated b. Reformation – change the contract to reflect true

intentions c. Injunction – requirement to refrain from doing an

act d. Performance – compliance with contractual

promises

D. Statutory law – enactments of legislative and administrative bodies

E. Other “bodies of law”

1. Common law – the body of law consisting of prior precedents or rulings by judges and juries as to the facts of a case. These rulings form codes of conduct that apply to situations involving tort or contract law. Sometimes, common law is referred to as stare decisis, “let the decision stand” or res judicata, “the matter has been decided”

2. Voluntary regulations – the rules created by

professional, trade, and other organizations to internally govern their members

F. The prominent characteristic of liability exposures is that

these exposures cannot be accurately measured in advance of a loss. The amount of the loss depends upon the following:

1. Circumstances of the event 2. Nature and severity of the damage or injury 3. Degree of negligence by one or more parties 4. Applicable law 5. Judge’s or jury’s decision

Skills Application Scenario #7 – Negligence and Contract Law A. Analyze the following losses using the elements of negligence.

At the Lake Tahoe resort, a maintenance staff member forgot to clean the snow and ice from a sidewalk. Two guests slipped on the ice. Their incident reports are as follows:

1. Picabo Rhodes suffered a broken leg when she fell after

stepping on the ice. The medical bills are $4,000, and her lost wages are $1,000. Is DCRI negligent, and if so, what are the damages?

2. Jerry Forde landed in a snow bank after slipping on the ice.

He brushed off his ski clothes and continued to the chair lifts. Is DCRI negligent, and if so, what are the damages?

B. Analyze the following situation using elements of contract law.

The French Lick resort has made use of its natural surroundings nestled in the midst of an old growth hickory and oak forest. In the fall and winter, the leaves often collect on the wooden walkways. Rain and light snow make the walkways very slippery and hazardous. Management hires local students to rake and brush the wooden walkways once a week. To protect themselves, the facility entered into a written contract with the boys that contains a provision that the boys will hold the resort harmless should anyone be injured from a slip or fall caused by the wet leaves on the wooden walkways. Is DCRI protected adequately by this contract?

Learning Objective #4: Discuss and apply factors affecting net income losses.

V. Basis for Net Income Losses

A. Factors affecting property-driven net income losses

1. Property managed or owned by the organization, e.g., shutdown of a facility

a. Severity of shutdown (partial or total) b. Frequency of shutdown c. Timing of shutdown (low or high season) d. Length of shutdown

2. Property managed or owned by others

a. Key suppliers b. Key customers c. Magnet or anchor locations d. Utilities or other governmental organizations

B. Factors affecting human resource-driven net income losses

1. Loss of key employee services, e.g., death, disability, termination, resignation

a. Length

b. Severity – partial or total loss of services

c. Frequency, e.g., how often key employee is ill

d. Timing

2. Workers compensation losses

C. Factors affecting liability-driven net income losses

1. Legal fees, e.g. litigation, civil fines

2. Compliance requirements

3. Product recall

D. Types of net income losses

1. Decreased revenues

a. Business interruption (direct or contingent)

b. Reduced profit margin

c. Reduced sales

d. Reduced investments

2. Increased expenses

a. Costs to repair or replace

b. Costs to hire and train employees

c. Expedited costs

d. Incremental costs

Skills Application Scenario #8 – Net Income Exposures Last year, DCRI reported revenues of $350,000,000, by location as follows: Diamond Creek Coastside 60,000,000 Hotel 30,000,000 Restaurant 8,000,000 Convention services including banquet 10,000,000 Golf 7,000,000 Spa 3,000,000 Shopping 2,000,000 Diamond Creek Lake Tahoe 80,000,000 Hotel 35,000,000 Restaurant 12,000,000 Golf 2,000,000 Entertainment venue 6,000,000 Casino 24,000,000 Spa 3,000,000 Ski 8,000,000 Diamond Creek Naples 70,000,000 Hotel 32,000,000 Restaurant 11,000,000 Golf 6,000,000 Spa 4,000,000 Shopping 9,000,000 Tours 8,000,000

Diamond Creek Atlantic City 60,000,000 Hotel 15,000,000 Restaurant 4,000,000 Convention center including banquets 7,000,000 Entertainment venue 5,000,000 Casino 18,000,000 Spa 2,000,000 Shopping 3,000,000

Tours 6,000,000 Diamond Creek French Lick 30,000,000 Hotel 8,000,000 Restaurant 5,000,000 Golf 6,000,000 Convention center including banquets 6,000,000 Spa 1,000,000 Tours 4,000,000 Diamond Creek Cancun 50,000,000 Hotel 27,000,000 Restaurants 6,000,000 Golf 7,000,000 Spa 2,000,000 Tours 8,000,000 To facilitate reservations, DCRI operates a reservation center in Phoenix, AZ. All reservations are made via toll-free telephone and the website is maintained on a computer at the reservation center. At the annual meeting of facility managers, the general manager at each location was asked to identify “what keeps you up at night” with respect to the net income risks the facilities face. The managers listed the following “scary scenarios”:

o Coastside: destruction of the scenic seaside 15th, 16th, and 17th fairways and greens on the golf course due to wave- induced erosion of the cliffs. Reconfiguring the golf course on nearby undeveloped land would require five years of environmental studies and occupancy and usage permit hearings and construction.

o Lake Tahoe: too little snow on the signature black-diamond

run, the Perilous Precipice, and too much snow on the ever- popular, family-friendly, intermediate run, the Slippery Slope. He estimates 30% of their guests are expert skiers seeking excitement on the challenging run and 40% are families enjoying the intermediate run.

o French Lick: since marketing surveys indicate a significant

number (50%) of their guests visit the facility because of the near-by casino operated by a resort competitor, the manager is concerned about the possible shut-down of the casino by the state gaming authorities because of the lack of projected gaming taxes.

o Atlantic City: after investing a substantial amount of

money in creating a state-of-the art, multi-media entertainment center and entering into a five-year contract with Celine Dijon, a French chanteuse and pop diva, management is worried Ms. Dijon will perish in a trans- Atlantic crash of her personal jet. She performs 150 nights a year and the house has sold out for every performance for the last two years.

o Naples: although the hotel facility has been built to resist a direct hurricane strike, the shopping complex is not, and management would anticipate complete destruction, with an 18-month rebuilding process.

o Cancun: since the only access is by air or cruise ship, the

manager is worried about the loss of use of the state-owned airport serving Cancun. Ninety percent of the guests arrive by air. Reopening the airport to handle full-sized jets would take at least two years.

A. Identify the key exposure(s) for each location that are likely to

keep Mary, the risk manager, awake and worrying at night. Include a dollar estimate of the exposure(s).

B. Identify the likely net income loss exposure(s) and the possible

maximum value faced by DCRI.

Review of Learning Objectives

1. Describe the exposures, perils, hazards and losses associated with each of the four logical classifications of exposures. (p. 4)

2. Explain and apply property valuation methods. (p. 14)

3. Explain and apply tort, contract and statutory liability concepts. (p. 20)

4. Discuss and apply factors affecting net income losses. (p. 26)

Notes