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Chapter 3

Introduction to Risk Management

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Agenda

Meaning of Risk Management

Objectives of Risk Management

Steps in the Risk Management Process

Benefits of Risk Management

Personal Risk Management

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Meaning of Risk Management

Risk Management is a process that identifies loss exposures faced by an organization and selects the most appropriate techniques for treating such exposures

A loss exposure is any situation or circumstance in which a loss is possible, regardless of whether a loss occurs

E.g., a plant that may be damaged by an earthquake, or an automobile that may be damaged in a collision

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Objectives of Risk Management

Risk management has objectives before and after a loss occurs

Pre-loss objectives:

Prepare for potential losses in the most economical way

Reduce anxiety

Meet any legal obligations

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Objectives of Risk Management (Continued)

Post-loss objectives:

Survival of the firm

Continue operating

Stability of earnings

Continued growth of the firm

Minimize the effects that a loss will have on other persons and on society

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Risk Management Process

Identify potential losses

Measure and analyze the loss exposures

Select the appropriate combination of techniques for treating the loss exposures

Implement and monitor the risk management program

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Transparency Master 1.2

Exhibit 3.1 Steps in the Risk Management Process

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Important 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

Intangible property loss exposures

Failure to comply with government rules and regulations

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Identifying Loss Exposures

Risk Managers have several sources of information to identify loss exposures:

Risk analysis questionnaires and checklists

Physical inspection

Flowcharts

Financial statements

Historical loss data

Industry trends and market changes can create new loss exposures.

e.g., exposure to acts of terrorism

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Measure and Analyze Loss Exposures

Estimate for each type of loss exposure:

Loss frequency refers to the probable number of losses that may occur during some time period

Loss severity refers to the probable size of the losses that may occur

Rank exposures by importance

Loss severity is more important than loss frequency:

The maximum possible loss is the worst loss that could happen to the firm during its lifetime

The probable maximum loss is the worst loss that is likely to happen

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Select the Appropriate Combination of Techniques for Treating the Loss Exposures

Risk control refers to techniques that reduce the frequency and severity of losses

Methods of risk control include:

Avoidance

Loss prevention

Loss reduction

Duplication

Separation

Diversification

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Select the Appropriate Combination of Techniques for Treating the Loss Exposures (Continued)

Avoidance means a certain loss exposure is never acquired or undertaken, or an existing loss exposure is abandoned

The chance of loss is reduced to zero

It is not always possible, or practical, to avoid all losses

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Select the Appropriate Combination of Techniques for Treating the Loss Exposures (Continued)

Loss prevention refers to measures that reduce the frequency of a particular loss

e.g., installing safety features on hazardous products

Loss reduction refers to measures that reduce the severity of a loss after it occurs

e.g., installing an automatic sprinkler system

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Select the Appropriate Combination of Techniques for Treating the Loss Exposures (Continued)

Duplication refers to having back-ups or copies of important documents or property available in case a loss occurs

Separation means dividing the assets exposed to loss to minimize the harm from a single event

Diversification means spreading the loss exposure across different parties, securities, or transactions, to reduce the chance of loss

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Select the Appropriate Combination of Techniques for Treating the Loss Exposures (Continued)

Risk financing refers to techniques that provide for the payment of losses after they occur

Methods of risk financing include:

Retention

Non-insurance Transfers

Commercial Insurance

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Risk Financing Methods: Retention

Retention means that the firm retains part or all of the losses that can result from a given loss

Retention is effectively used when:

No other method of treatment is available

The worst possible loss is not serious

Losses are highly predictable

The retention level is the dollar amount of losses that the firm will retain

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Risk Financing Methods: Retention (Continued)

A risk manager has several methods for paying retained losses:

Current net income: losses are treated as current expenses

Unfunded reserve: losses are deducted from a bookkeeping account

Funded reserve: losses are deducted from a liquid fund

Credit line: funds are borrowed to pay losses as they occur

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Risk Financing Methods: Retention (Continued)

A captive insurer is an insurer owned by a parent firm for the purpose of insuring the parent firm’s loss exposures

A single-parent captive is owned by only one parent

An association or group captive is an insurer owned by several parents

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Risk Financing Methods: Retention (Continued)

Reasons for forming a captive include:

The parent firm may have difficulty obtaining insurance

To take advantage of a favorable regulatory environment

Costs may be lower than purchasing commercial insurance

A captive insurer has easier access to a reinsurer

A captive insurer can become a source of profit

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Risk Financing Methods: Retention (Continued)

Premiums paid to a single parent (pure) captive are generally not income-tax deductible, unless:

The transaction is a bona fide insurance transaction

A brother-sister relationship exists

The captive insurer writes a substantial amount of unrelated business

The insureds are not the same as the shareholders of the captive

Premiums paid to a group captive are usually income-tax deductible.

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Risk Financing Methods: Retention (Continued)

Self-insurance, or self-funding is a special form of planned retention by which part or all of a given loss exposure is retained by the firm

A risk retention group (RRG) is a group captive that can write any type of liability coverage except employers’ liability, workers compensation, and personal lines

They are exempt from many state insurance laws

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Risk Financing Methods: Retention (Continued)

Advantages

Save on loss costs

Save on expenses

Encourage loss prevention

Increase cash flow

Disadvantages

Possible higher losses

Possible higher expenses

Possible higher taxes

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Risk Financing Methods: Non-insurance Transfers

A non-insurance transfer is a method other than insurance by which a pure risk and its potential financial consequences are transferred to another party

Examples include: contracts, leases, hold-harmless agreements

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Risk Financing Methods: Non-insurance Transfers (Continued)

Advantages

Can transfer some losses that are not insurable

Less expensive

Can transfer loss to someone who is in a better position to control losses

Disadvantages

Contract language may be ambiguous, so transfer may fail

If the other party fails to pay, firm is still responsible for the loss

Insurers may not give credit for transfers

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Risk Financing Methods: Commercial Insurance

Insurance is appropriate for low-probability, high-severity loss exposures

The risk manager selects the coverages needed, and policy provisions

A deductible is a specified amount subtracted from the loss payment otherwise payable to the insured

In an excess insurance policy, the insurer pays only if the actual loss exceeds the amount a firm has decided to retain

The risk manager selects the insurer, or insurers, to provide the coverages

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Risk Financing Methods: Insurance

The risk manager negotiates the terms of the insurance contract

A manuscript policy is a policy specially tailored for the firm

The parties must agree on the contract provisions, endorsements, forms, and premiums

Information concerning insurance coverages must be disseminated to others in the firm

The risk manager must periodically review the insurance program

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Risk Financing Methods: Insurance (Continued)

Advantages

Firm is indemnified for losses; can continue to operate

Uncertainty is reduced

Firm may receive valuable risk management services

Premiums are income-tax deductible

Disadvantages

Premiums may be costly

Negotiation of contracts takes time and effort

The risk manager may become lax in exercising loss control

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Exhibit 3.2 Risk Management Matrix

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Market Conditions and the Selection of Risk Management Techniques

Risk managers may have to modify their choice of techniques depending on market conditions in the insurance markets

The insurance market experiences an underwriting cycle

In a “hard” market, profitability is declining, underwriting standards are tightened, premiums increase, and insurance is hard to obtain

In a “soft” market, profitability is improving, standards are loosened, premiums decline, and insurance become easier to obtain

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Implement and Monitor the Risk Management Program

Implementation of a risk management program begins with a risk management policy statement that:

Outlines the firm’s objectives and policies

Educates top-level executives

Gives the risk manager greater authority

Provides standards for judging the risk manager’s performance

A risk management manual may be used to:

Describe the risk management program

Train new employees

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Implement and Monitor the Risk Management Program (Continued)

A successful risk management program requires active cooperation from other departments in the firm

The risk management program should be periodically reviewed and evaluated to determine whether the objectives are being attained

The risk manager should compare the costs and benefits of all risk management activities

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Benefits of Risk Management

Enables firm to attain its pre-loss and post-loss objectives more easily

A risk management program can reduce a firm’s cost of risk

Reduction in pure loss exposures allows a firm to enact an enterprise risk management program to treat both pure and speculative loss exposures

Society benefits because both direct and indirect losses are reduced

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Personal Risk Management

Personal risk management refers to the identification and analysis of pure risks faced by an individual or family, and to the selection of the most appropriate technique(s) for treating such risks

The same principles applied to corporate risk management apply to personal risk management

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