Chapter 3 Introduction to Risk Management PDF

Fall 2024 Chapter 3 Introduction to Risk Management Dr. Dina Qamar 1. Definition of Risk Management. 2. Objectives of Risk Management. Pre-Loss Objectives. Post- Loss Objectives. 3. Steps in the Risk Management Process. Identify lo...

Fall 2024 Chapter 3 Introduction to Risk Management Dr. Dina Qamar 1. Definition of Risk Management. 2. Objectives of Risk Management. Pre-Loss Objectives. Post- Loss Objectives. 3. Steps in the Risk Management Process. Identify loss exposure. Measure and analysis the loss exposure. Select the appropriate combination of techniques for treating the loss exposure. Implement and monitor the risk management program. 4. Benefits of Risk Management. 1 Definition 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. Risk managers typically use the term loss exposure to identify potential losses. As stated in Chapter 1, a loss exposure is any situation or circumstance in which a loss is possible, regardless of whether a loss actually occurs. In the past, risk managers generally considered only pure loss exposures faced by the firm. This chapter discusses only the traditional treatment of pure loss exposures. Objectives of Risk Management: Risk management has important objectives. These objectives can be classified as follows: Pre-loss objectives, and Post-loss objectives. Pre-Loss Objectives: 1. The Firm Should Prepare for the Potential Losses in the Most Economical Way: This preparation involves an analysis of the cost of safety programs, insurance premiums paid, and the costs associated with the different techniques for handling losses. 2. The Reduction of Anxiety: Certain loss exposures can cause greater worry and fear for the risk manager and key executives. For example, the threat of a catastrophic lawsuit because of a defective product can cause greater anxiety than a small loss from a minor fire. 3. To Meet Legal Obligation: For example, government regulations may require a firm to install safety devices to protect workers from harm, to dispose of hazardous waste materials 2 properly, and to label consumer products appropriately. Workers compensation benefits must also be paid to injured workers. The firm must see that these legal obligations are met. Post-Loss Objectives: 1. Survival of the Firm: Survival means that after a loss occurs, the firm can resume at least partial operations within some reasonable time period. 2. Continue Operation: For some firms, the ability to operate after a loss is extremely important. For example, a public utility firm must continue to provide service. Banks, dairies, bakeries, and other competitive firms must continue to operate after a loss. Otherwise, business will be lost to competitors. 3. Stability of Earning: Earnings per share can be maintained if the firm continues to operate. However, a firm may incur substantial additional expenses to achieve this goal (such as operating at another location), and perfect earnings stability may be difficult to attain. 4. Continued Growth of The Firm: A company can grow by developing new products and markets or by acquiring or merging with other companies. The risk manager must therefore consider the effect that a loss will have on the firm’s ability to grow. 5. Social Responsibility: The objective of social responsibility is to minimize the effects that a loss will have on other persons and on society. A severe loss can adversely affect employees, suppliers, customers, investors, creditors, and the community in 3 general. For example, a severe loss that shuts down a factory in a small town for an extended period can cause considerable economic distress in the local area. Steps in the Risk Management Process: 1. Identify loss exposure. 2. Measure and analyze the loss exposure. 3. Select the appropriate combination of techniques for treating the loss exposure. 4. Implement and monitor the risk management program. Step 1: Identify Loss Exposure: The first step in the risk management process is to identify all major and minor loss exposures. This step involves an exhaustive review of all potential losses. Important loss exposures include the following: 1. Property loss exposures: buildings, plants, furniture, equipment, inventory, valuable paper, computer software, data, Inventory Accounts receivable, valuable papers, records Company vehicles, planes, boats, and mobile equipment. 2. Liability loss exposures: defective productive, environmental pollution (land, water, air, noise), Sexual harassment of employees, employment discrimination, wrongful termination, and failure to promote. 3. Business income loss exposures: loss of income from a covered loss, continuing expenses after a loss, and extra expenses. 4. Human recourses loss exposures: death of key employees, retirement and unemployment, job-related injuries and disease experienced by workers. 5. Crime loss exposure: employee theft and dishonesty, internet and computer crime exposure, burglaries, and theft of intellectual property. 4  6. Employee benefit loss exposure: failure to pay promised benefit, retirement plan exposure, and failure to comply with government regulations. 7. Foreign loss exposure: foreign currency and interest rate risks, political risks, acts of terrorism. 8. Intangible property loss exposures: damage to the company’s public image, loss of goodwill and market reputation, and loss or damage to intellectual property. 9. Failure to comply with government rules and regulations. Risk Managers have several sources of information to identify loss exposures: Risk Analysis Questionnaires and Checklists: Questionnaires and checklists require the risk manager to answer numerous questions that identify major and minor loss exposures. Physical Inspection. A physical inspection of company plants and operations can identify major loss exposures. Flowcharts. Flowcharts that show the flow of production and delivery can reveal production and other bottlenecks as well as other areas where a loss can have severe financial consequences for the firm. Financial Statements. Analysis of financial statements can identify the major assets that must be protected, loss of income exposures, key customers and suppliers, and other important exposures. Historical loss data. Historical loss data can be invaluable in identifying major loss exposures. In addition, risk managers must keep abreast of industry trends and market changes that can create new loss exposures and cause concern. 5 Step 2: Measure and Analyze the Loss Exposure: It is important to measure and quantify the loss exposures in order to manage them properly. This step requires an estimation of the frequency and severity of loss. Loss frequency refers to the probable number of losses that may occur during some given time period. Loss severity refers to the probable size of the losses that may occur. Once the risk manager estimates the frequency and severity of loss for each type of loss exposure, the various loss exposures can be ranked according to their relative importance. For example, a loss exposure with the potential for bankrupting the firm is much more important in a risk management program than an exposure with a small loss potential. If certain losses occur regularly and are fairly predictable, they can be budgeted out of a firm’s income and treated as a normal operating expense. Severity is more important because a single catastrophic loss could destroy the firm. Step 3: Select the Appropriate Combination of Techniques for Treating the Loss Exposure: These techniques can be classified broadly as either risk control or risk financing. Risk control refers to techniques that reduce the frequency or severity of losses. Major risk-control techniques include: Avoidance, Loss prevention, Loss reduction, Duplication, Separation, and Diversification. 1. Avoidance: means a certain loss exposure is never acquired or undertaken, or an existing loss exposure is abandoned. For example, flood losses can be avoided by building a new plant on high ground, well above a floodplain. A pharmaceutical firm that markets a drug with dangerous side effects can remove the drug from the market to avoid possible legal liability. The 6  major advantage of avoidance is that the chance of loss is reduced to zero if the loss exposure is never acquired. 2. Loss Prevention refers to measures that reduce the frequency of a particular loss. For example, measures that reduce truck accidents include driver training, zero tolerance for alcohol or drug abuse, and strict enforcement of safety rules. 3. Loss Reduction refers to measures that reduce the severity of a loss after it occurs. Examples include installation of an automatic sprinkler system that promptly extinguishes a fire; first-aid boxes in production areas; and rehabilitation of workers with job-related injuries; and limiting the amount of cash on the premises. 4. Duplication refers to having back-ups or copies of important documents or property available in case a loss occurs. Examples include back-up copies of key business records (e.g., accounts receivable) in case the original records are lost or destroyed. 5. Separation means dividing the assets exposed to loss to minimize the harm from a single event. A manufacturing company, for example, may divide the production area of a plant into four quadrants by using 6-foot-thick concrete walls. Similarly, a manufacturer may store finished goods in two warehouses in different cities. If one of the warehouses is damaged or destroyed, the finished goods in the other warehouse are unharmed. 6. Diversification refers to reducing the chance of loss by spreading the loss exposure across different parties (e.g., customers and suppliers), securities (e.g., stocks and bonds), or transactions. Having different customers and suppliers reduces risk. For example, if the entire customer base consists of 7  four domestic purchasers, sales will be impacted adversely by a domestic recession. If there are foreign and domestic customers, the risk is reduced. Risk financing refers to techniques that provide for the funding of losses after they occur. Major risk-financing techniques include: Retention, Noninsurance transfers, Commercial insurance. 1. Retention means that the firm retains part or all of the losses that can result from a given loss. Retention can be either active or passive. Active retention means that the firm is aware of the loss exposure and consciously decides to retain part or all of it. For example, a risk manager may decide to retain physical damage losses to a fleet of company cars. Passive retention, however, is the failure to identify a loss exposure, failure to act, or forgetting to act. For example, a risk manager may fail to identify all company assets that could be damaged in an earthquake. Retention can be effectively used in a risk management program under the following conditions: A) No other method of treatment is available, B) The worst possible loss is not serious, and C) Losses are fairly predictable. Determining Retention Levels: if retention is used, the risk manager must determine the firm’s retention level, which is the dollar 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. 2. Noninsurance Transfers are methods other than insurance by which a pure risk and its potential financial consequences are transferred to another party. Examples of noninsurance transfers include contracts, leases, hold- harmless agreements, and incorporation of a business. 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 8  plant while 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. 3. Commercial 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: 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. Step 4: Implement and Monitor the Risk Management Program. This step begins with a policy statement. 1. A risk Management Policy Statement is necessary 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 treatment of loss exposures. It also educates top-level executives in regard to the risk management process. It establishes the importance, role, and authority of the risk manager It provides standards for judging the risk manager’s performance. 2. Risk Management Manual The manual describes in some detail the risk management program of the firm. It can be a very useful tool for training managers, supervisors, and new employees who will be participating in the program. 9  It forces the risk manager to state precisely his or her responsibilities, objectives, and available techniques. A risk management manual often includes a list of insurance policies, agent and broker contact information, who to contact when a loss occurs, emergency contact numbers, and other relevant information. 3. Cooperation with Other Departments The risk manager does not work alone. Other functional departments within the firm are extremely important in identifying loss exposures. Accounting: Internal accounting controls can reduce employee fraud and theft of cash. Finance: Information can be provided showing the effect that losses will have on the firm’s balance sheet and profit and loss statement. Operations: Quality control can prevent the production of defective goods and lawsuits. Effective safety programs in the plant can reduce injuries and accidents. Marketing: Accurate packaging and product-use information can prevent lawsuits. Safe distribution procedures can prevent accidents. Human resources. This department is responsible for employee benefit programs, retirement programs, safety programs, and the company’s hiring, promotion, and dismissal policies. 4. Periodic Review and Evaluation: The risk management program must be periodically reviewed and evaluated to determine whether the objectives are being attained or if corrective actions are needed. In particular, risk management costs, safety programs, and loss- prevention programs must be carefully monitored. 10  Loss records must also be examined to detect any changes in frequency and severity. Retention and transfer decisions must also be reviewed to determine if these techniques are being properly used. 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 cooperation from other departments. Benefits of Risk Management: 1. Enables firm to attain its pre-loss and post-loss objectives more easily. 2. Reduce a firm’s cost of risk, which may increase the company’s profit. The cost of risk is a risk management tool that measures the costs associated with treating the organization’s loss exposures. These costs include insurance premiums paid, retained losses, loss control expenditures, outside risk management services, financial guarantees, internal administrative costs, and taxes, fees, and other relevant expenses 3. Because the adverse financial impact of pure loss exposures is reduced, the firm may be able to implement an enterprise risk management program to treat both pure and speculative loss exposures. 4. Society benefits because both direct and indirect (consequential) losses are reduced Questions for Practice: 1. Compare between diversification and duplication. 2. Explain in details step number two in risk management program. 3. Explain in details the pre loss objectives of risk management program. 11