RMIN 4000 Chapter 3 PDF

RMIN 4000 Chapter 3 Introduction to Risk Management Risk Management Process that identifies loss exposures faced by an organization and selects the most appropriate techniques for treating such exposures. 2 Objectives Pre-Loss Ef...

RMIN 4000 Chapter 3 Introduction to Risk Management Risk Management Process that identifies loss exposures faced by an organization and selects the most appropriate techniques for treating such exposures. 2 Objectives Pre-Loss Efficient cost of risk Permits better decision making Meet legal obligations Post-Loss Survival of firm Business continuity, earnings, growth Societal 3 Steps in the Risk Management Process 1. Identify loss exposures. 2. Measure and analyze the loss exposures. 3. Consider and select the appropriate risk management techniques. 4. Implement and monitor the chosen techniques. 4 Step 1: Identify Loss Exposures What assets need to be protected? What perils are those assets exposed? 5 Important Exposures Property Liability Business Income Human Resources Crime Employee Benefits Foreign Intangible Regulatory 6 Sources for Identifying Loss Exposures Meeting with management including the Risk Manager Financial statements Loss history Other firms/competitors Risk management consultants Surveys/questionnaires Site Inspections Review sales and purchase agreements Flowcharts 7 Step 2: Measure and Analyze the Loss Exposures Measure Estimate the frequency and severity of loss exposures. Frequency (probability) – How often does the loss occur? Severity (outcome) – How much does it cost when a loss does occur? 8 Step 2: Measure and Analyze the Loss Exposures (Continued) Analyze Rank loss exposures according to relative importance. Severity is more important. Maximum Possible Loss (MPL) – the worst loss that could happen to the firm during its lifetime. Probable Maximum Loss (PML) – the worst loss that is likely to happen. 9 Step 3: Consider and Select the Appropriate Risk Management Techniques Risk Control Techniques that reduce the frequency or severity of losses. Risk Financing Techniques that provide for the funding of losses. 10 Risk Control - Avoidance A certain loss exposure is never acquired (proactive), or an existing loss exposure is abandoned (reactive). Advantage – Frequency is reduced to 0! Disadvantages May not be possible. Usually has an opportunity cost. Avoiding one loss exposure may create another. 11 Risk Control – Loss Prevention Measures that reduce the frequency of a particular loss. Does NOT completely eliminate the risk. 12 Risk Control – Loss Reduction Measures that reduce the severity of a loss. No effect on the frequency of a loss. 13 Risk Control - Duplication Having back-ups or copies of important documents or property available in case a loss occurs. 14 Risk Control - Separation Dividing the assets exposed to loss to minimize the harm from a single event. Examples: Firewalls in buildings Have multiple data centers or warehouses 15 Risk Control - Diversification Reducing the chance of loss by spreading the loss exposure across different parties (customers, suppliers), securities (stocks, bonds), or transactions. Examples: Expanding customer base Using multiple suppliers 16 Risk Financing - Retention A firm or individual retains part or all of losses that can occur from a given risk. Retention level – the dollar amount of losses that the individual/firm will retain. Active – Deliberately retaining risk Passive – Unknowingly retaining risk When should risk be retained? No other option more attractive or available. Worst possible losses are not serious (low severity). Losses are predictable (high frequency; not catastrophic). 17 Risk Financing – Retention (Types) Unfunded; cash flow Funded Reserve Deductible Captive Insurer Self-Insurance Plan Risk Retention Group / Group Captive 18 Risk Financing – Retention (Captive Insurance Company) A captive insurer is an insurer owned by a parent firm for the purpose of insuring the parent firm’s loss exposures. Single-parent captive is owned by only one parent. Association or group captive is an insurer owned by several parents. 19 Advantages of a Captive Insurance Company Can help a firm when insurance is too expensive or difficult to obtain. Lower Costs o No agent or broker commissions. o Interest earned on invested premium. Easier access to reinsurance market. Possibility tax advantages. Possibility of favorable regulatory environment. 20 Risk Financing – Other Forms of Retention Self-insurance A special form of planned retention by which part or all of a given loss exposure is retained by the firm. Risk Retention Group Group captive that can write any type of liability coverage except employers’ liability, workers compensation, and personal lines. Exempt from many state insurance laws. 21 Risk Retention Group (RRG) An insurance company formed pursuant to the federal Risk Retention Act of 1981, which was amended in 1986 to allow insurers underwriting all types of liability risks except workers compensation / employer’s liability to avoid cumbersome multistate licensing laws. An RRG must be owned by its insureds. Most RRGs are formed as captives and must be domiciled onshore, except for those grand fathered under the 1981 Act. Other than the laws of the state in which it is based, RRGs are exempt from all laws, rules, regulations, or orders that would control their activities. Owners of RRGs must provide sufficient funds to cover losses and are required to provide its home state with written evidence of financial history, insurance coverages, and underwriting processes, among other information, in order to get a license. 22 Risk Financing - Retention Advantages Disadvantages Save on loss costs Possible higher losses. Save on expenses Possible higher expenses. Encourage loss prevention Possible higher taxes. Increase cash flow Moral of the story is that a Risk Manager needs to evaluate all potential costs before choosing retention as a risk management technique. 23 Risk Financing – Noninsurance Transfer Methods other than insurance by which a pure risk and its potential financial consequences are transferred to another party. Examples Contracts Leases Hold-harmless agreements 24 Sample Holdharmless Wording Each Party shall indemnify, defend and save the other Party, its officers, directors, employees and affiliates harmless from any loss, cost or expense claimed by third parties, for property damage and/or bodily injury, including death, to the proportionate extent such loss, cost or expense arises from the negligence or willful misconduct of the indemnifying Party, its employees or affiliates in connection with the Services. 25 Risk Financing – Noninsurance Transfer Advantages Disadvantages Can transfer some losses that Contract language may be are not insurable ambiguous, so transfer may fail Less expensive If the other party fails to pay, firm is still responsible for the loss Can transfer loss to someone Insurers may not give credit for who is in a better position to transfers control losses 26 Risk Financing – Commercial Insurance Appropriate for low-frequency, high-severity loss exposures. These areas must be emphasized: 1. Selection of insurance coverages. 2. Selection of an insurer. 3. Negotiation of terms and services (risk control, claims, et al) 4. Dissemination of information concerning insurance coverages. 5. Periodic review of the insurance program. 27 Risk Financing – Commercial Insurance (Other Terms) Deductible A specified amount subtracted from the loss payment otherwise payable to the insured. Excess insurance A plan in which the insurer pays only if the actual loss exceeds the amount a firm has decided to retain. Manuscript policy A policy specially tailored for the firm. 28 Risk Financing – Commercial Insurance Advantages Disadvantages Firm is indemnified for Premiums may be more losses; can continue to costly operate Negotiation of policies Uncertainty is reduced takes time and effort Firm may receive valuable risk management services Most policies are annual Premiums are income-tax The risk manager may deductible become lax in exercising loss control 29 Which Technique Should be Used? High Funded Reserve Avoidance (Retain) Captive or Risk Retention Frequency Loss Prevention Group Loss Prevention/Reduction Low Unfunded Retention Insurance Loss Reduction Low High Severity 30 Underwriting Cycles Hard Insurance Market Insurer profitability is declining, underwriting standards are tightened, premiums increase, and insurance is hard to obtain. Soft Insurance Market profitability is improving, standards are loosened, premiums decline, and insurance become easier to obtain. How might the underwriting cycle affect the decision of a Risk Manager? 31 Step 4: Implement and Monitor the Chosen Techniques Risk Management Policy Statement Outlines o The risk management objectives of the firm. o The company policy with respect to treatment of loss exposures. Provides standards for judging the risk manager’s performance. 32 Step 4: Implement and Monitor the Chosen Techniques Successful risk management program requires active cooperation from many other disciplines within 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. 33 Benefits of Risk Management Enables a firm to attain its pre-loss and post-loss objectives more easily. Society benefits because both direct and indirect losses are reduced. Can reduce a firm’s total cost of risk. 34