Risk Management Definition and Objective

Avoidance and Loss control are called risk control techniques, because they attempt to reduce the frequency and severity of accidental losses to the firm. On the other hand, retention, non-insurance transfers and insurance are called risk financing techniques, because they provide for the funding of accidental losses after they occur.

I) Avoidance:

Avoidance means that a certain loss exposure is never acquired (refusal), or an existing loss exposure is abandoned. For example, a firm can avoid earthquake loss by not building a plant in an earthquake prone area. An existing loss exposure may also be abandoned. For example, a pharmaceutical firm that produces a drug with dangerous side effects may stop manufacturing that drug.The major advantage of avoidance is that the 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.

However, avoidance has two disadvantages. First, it may not be possible to avoid all losses. For example, a company cannot avoid the pre-mature death of a key executive. Second, it may not be practical or feasible to avoid the loss exposure. In the above said example, 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.

(II) Loss Control:

It is another method of handling loss in a risk management program. Loss control measures attack risk by lowering the chance a loss will occur (loss frequencies) or by reducing the amount of damage when the loss does occur (loss severity). Loss control tools can be classified as: loss prevention and loss reduction measures.

The following are the examples that illustrate how loss control measures reduce the frequency and severity of losses.           

Measures that prevent loss frequency are quality control checks, driver examination, strict enforcement of safety rules and improvement in product design.

Measures that reduce loss severity are the installation of an automatic sprinkler or burglar alarm system, employing fire extinguishers, early treatment of injuries and rehabilitation of injured workers.

(III) Retention:

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.

First, no other method of treatment is available. Insurers may be unwilling to write certain type of coverage. Non-insurance transfers may not be available. In addition, although loss control can reduce the frequency of loss, all losses cannot be eliminated. In these cases, retention is a residual method. If the loss exposure cannot be insured or transferred, then it must be retained.

Second, the worst possible loss is not serious. For example, physical damage losses to automobiles in a large firm’s fleet will not bankrupt the firm.

Finally, losses are highly predictable. Retention can be effectively used for workers compensation claims, physical damage losses to automobiles, etc. Based on past experience, the risk manager can estimate a probable range of frequency and severity of actual losses.

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.

Though there are many methods of determining retention level, the following two methods are very important.

First, a Corporation can determine the maximum uninsured loss it can absorb without adversely affecting the company’s earnings can dividend policy. One rough rule is that the maximum retention can be set at 5% of the company’s annual earnings before taxes from current operations.

Second approach is to determine the maximum retention as a percentage of the firm’s net working capital, such as between 1% and 5%. Although this method does not reflect the firm’s overall financial position for absorbing a loss, it measures the firm’s ability to fund a loss.

Paying losses:

If retention is used, the risk manager must have some method for paying losses. Normally, a firm can pay losses by one of the following three methods:

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. Another method is to 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. Another method for paying losses is an unfunded or funded reserve. An unfounded 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 does 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:

1. The firm can save money in the long run if its actual losses are less than the loss allowance in the insurer’s premium.
2. 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.
3. Since the risk exposure is retained, there may be greater care for loss prevention.
4. Cash flow may be increased since the firm can use the funds that normally would be held by the insurer.

Disadvantages of Retention:

1. 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.
2. 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.
3. 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.

(IV) Non-Insurance Transfers:

Non-insurance Transfers is another method of handling losses. Non-insurance transfers 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. For example, 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.

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. Otherwise, a firm may insert a hold-harmless clause in a contract, by which one party assumes legal liability on behalf of another party. Thus, 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:

1. The transfer of potential loss would become impossible, if the contract language is ambiguous.
2. If the party to whom the potential loss is transferred is unable to pay the loss, the firm is still responsible for the claim.
3. Non-Insurance Transfers may not always reduce insurance costs since an insurer may not give credit for the transfers.

(V) Insurance:

Insurance is also used in a risk management program. 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;

1. Selection of insurance coverages
2. Selection of an insurer
3. Negotiation of terms
4. Dissemination of information concerning insurance coverages
5. Periodic review of the insurance program

   (i) Selection of insurance coverages:

The risk manager must select the insurance coverages needed. Since there may not be enough money in the risk management budget to insure all possible losses, the need for insurance can be divided into three categories;

1. Essential Insurance
2. Desirable Insurance
3. Available Insurance

Essential Insurance includes those coverages required by law or by contract, such as workers compensation insurance. It also includes those coverages that will protect the firm against a loss that threatens the firm’s survival. Desirable insurance is protection against losses that may cause the firm financial difficulty, but not bankruptcy. Available insurance is coverage for slight losses that would merely inconvenience the firm.

   (ii) Selection of an Insurer:

The next step is that the risk manager must select an insurer or several insurers. Here, several important factors are to be considered by the risk manager. These include the financial strength of the insurer, risk management services provided by the insurer and the cost and terms of protection. The insurers financial strength is determined by the size of policy owner’s surplus, underwriting & investment results, adequacy of reserves for outstanding liabilities, etc. The risk manager can identify the financial strength of the insurer by referring the rating given to that insurance company. For example in America, A.M.Best Company is one of the famous rating company that publishes the rating of insurers based on their relative financial strength. Besides, the financial strength, the risk manager must also consider the risk management services by the insurer and the cost & terms of protection.

   (iii) Negotiation of terms:

After the insurer is selected, the terms of the insurance contract must be negotiated. If printed policies, endorsements and forms all used, the risk manager and insurer must agree on the documents that will form the basis of the contract. If a specially tailored manuscript policy is written for the firm, the language and meaning of the contractual provisions must be clear to both parties. If the firm is large, the premiums are negotiable between the firm and insurer.

   (iv) Dissemination of information concerning insurance coverages:

Information concerning insurance coverages must be given to others in the firm. The firm’s employees must be informed about the insurance coverages, the records that must be kept, the risk management services that the insurer will provide, etc.

   (v) Periodic review of the insurance program:

The entire process of obtaining insurance must be evaluated periodically. This involves an analysis of agent and broker relationships, coverages needed, cost of insurance, quality of loss-control services provided, whether claims are paid promptly, etc.

Advantages of Insurance:

1. The firm will be indemnified after a loss occurs. Thus, the firm can continue to operate.
2. Uncertainty is reduced. Thus, worry and fear are reduced for the managers and employees, which should improve their productivity.
3. Insurers can provide valuable risk management services, such as loss-control services, claims adjusting,etc.
4. Insurance premiums are income-tax deductible as a business expense.

Disadvantages of Insurance:

1. The payment pf premiums is 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.
2. Considerable time and effort must be spent in negotiating the insurance coverages.
3. 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 th number of non-insured losses as well.

 

   4. Selection of Risk Management Tools:

Risk Management Matrix

Type of Loss	Loss Frequency	Loss Severity	Appropriate Risk Management Technique
1	Low	Low	Retention
2	High	Low	Loss Control & Retention
3	Low	High	Insurance
4	High	High	Avoidance

In determining the appropriate method or methods of handling losses, the above matrix can be used. It classifies the various loss exposures according to frequency and severity.

The first loss exposure is characterized by both low frequency and low severity of loss. One example of this type of exposure would be the potential theft of a secretary’s Note pad. This type of exposure can be best handled by retention, since the loss occurs infrequently and when it occurs it does not cause financial harm.

The second type of exposure is more serious. Losses occur frequently, but severity is relatively low. Examples of this type of exposure include physical damage losses to automobiles, shoplifting and food spoilage. Loss control should be used here to reduce the frequency of losses. In addition, since losses occur regularly and are predictable, the retention technique can also be used.

The third type of exposure can be met by insurance. Insurance is best suited for low frequency, high severity losses. High severity means that a catastrophic potential is present, while a low probability of loss indicates that the purchase of insurance is economically feasible. Examples include fires, explosion and other natural disasters. Here, the risk manager could also use a combination of retention and insurance to eal with these exposures.

The fourth and most serious type of exposure is characterized by both high frequency and high severity. This type of risk exposure is best handled by avoidance. For example, if a person has drunken and if he attempts to drive home in that drunken stage, the chance of meeting with an accident is more. This loss exposure can be avoided by not driving at the drunken  stage or by having a driver to drive his car.

 

   5. Risk Administration:

The next and the final step in the risk management process 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

(i) Risk management policy statement:

A risk management policy statement is necessary in order 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 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. In addition, a risk management manual may be developed and used in the program. The manual describes 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.

(ii) Co-operation with other departments:

The risk manager has to work in co-operation with other functional departments in the firm. It will facilitate to identify pure loss exposures and methods of treating these exposures. 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. Besides, safe distribution procedures can prevent accidents. The Production Department has to ensure quality control and effective safety programs in the plant can reduce injuries and accidents. The Personnel Department may be responsible for employee benefit program, pension program and safety program.

(iii) 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. Loss records must also be examined to detect any changes in frequency and severity. Finally, the risk manager must determine whether the firm’s overall risk management policies are being carried out, and whether the risk manager is receiving the total co-operation of the other departments in carrying out the risk management functions.