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PBBF 303: FIN. RISK MANAGEMENT AND INSURANCE

LECTURE THREE

INTRODUCTION TO RISK MANAGEMENT

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Meaning of Risk Management

Objectives of Risk Management

Steps in the Risk Management Process

Benefits of Risk Management

OUTLINE

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Rejda (2008) defines Risk management as the process that identifies loss exposures faced by an organization and selects the most appropriate techniques for treating such exposures.

Risk management is also defined as the logical development and implementation of a plan to deal with potential losses.

The purpose of a risk management program is to manage an organization’s exposure to loss and to protect its assets.

Risk management benefits all types of organizations facing potential loses, including businesses, non-profit organizations, individuals and families.

Meaning of Risk Management

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Risk management has important objectives. These objectives can be classified as follows:

Pre-loss objectives

Post-loss objectives

Objectives of Risk Management

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Important objectives before a loss occurs include economy (cost-cutting measure), reduction of anxiety and meeting legal obligations.

The first objective means that the firm should prepare for 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.

Pre-loss Objectives

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The second objective is the reduction of anxiety. Certain loss exposures can cause greater worry and fear for the risk manager and key executives. E.g. the threat of a catastrophic lawsuit from a defective product can cause greater anxiety than a small loss from a minor fire.

The final objective is to meet any legal obligations. E.g

government regulations may require a firm to install safety devices to protect workers from harm, to dispose of hazardous waste materials properly, and to label consumer products appropriately. The risk manager must see that these legal obligations are met.

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Risk management also has certain objectives after a loss occurs. These objectives include, survival, continued operation, stability of earnings, continued growth and social responsibility.

The most important post-loss objective is survival of the firm. Survival means that after a loss occurs, the firm can resume at least partial operations within some reasonable time period.

Post-loss Objectives

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The second post-loss objective is to continue operating. For some firms, the ability to operate after a loss is extremely important.

E.g. a public utility firm must continue to provide services. Banks and other competitive firms must continue to operate after a loss. Otherwise, business will be lost to competitors.

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The third post-loss objective is stability of earnings. 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 stability of earnings may not be attained.

The fourth post-loss objective is 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.

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Finally, the objective of social responsibility is to minimize the effects that a loss will have on other persons and on society.

A sever loss can adversely affect employees, suppliers, creditors and the community in general. For example, a severe loss that shuts down a plant in a small town for an extended period can cause considerable economic distress in the town.

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The risk management process begins when somebody asks, “What kinds of events can damage my business, how much damage can be done, and what should I do about it?

After evaluating the answers to these questions and making decisions to solve the problems, the risk manger will ask, “Did I make the right decisions? Were my choices too expensive? Have circumstances changed sufficiently so that past decisions no longer apply?

Risk Management Process

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According to Dorfman (2008) Risk management is considered to be a three-step process.

1. Identify and measure potential losses 2. Develop and execute a plan to manage this loss

potential and 3. Review the plan continuously after it has been put in

operations

Harrington and Niehans (2003) posits that regardless of the type of risk being considered, the risk management process involves several key steps:

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1. Identify all significant risks

2. Evaluate the potential frequency and severity of losses

3. Develop and select methods for managing risk

4. Implement the risk management method chosen

5. Monitor the performance and suitability of the risk management method and strategies on an ongoing basis.

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The first step in the risk management process is to identify all major and minor loss exposures. This step involves a painstaking analysis of all potential losses.

A risk manager has several sources of information that he or she can use to identify the preceding loss exposures. They include the following:

a) Risk analysis questionnaires: Questionnaires require the risk manager to answer numerous questions that identify major and minor loss exposures.

Step One: Identify All Significant Risks

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b) Physical inspection: A physical inspection of company plants and operations can identify major loss exposures.

c) Flowcharts: Flowcharts that show the flow of production and delivery can reveal production bottlenecks where a loss can have severe financial consequences for the firm.

d) Financial statements: Analysis of financial statements can identify the major assets that must be protected, loss of income exposures, and key customers and suppliers.

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e) Historical loss data. Historical and departmental loss data over time 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.

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Major risk management issues include rising workers compensation costs, effects of mergers and consolidations by financing risk through the capital markets.

Protection of company assets and personnel against acts of terrorism is another important issue.

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The second step in the risk management process is to analyze the loss exposures. This step involves an estimation of the frequency and severity of loss.

The frequency refers to the probable number of losses that may occur during some given period.

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

Step Two: Evaluate the Potential Frequency and Severity of Losses

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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.

In addition, the relative frequency and severity of each loss exposure must be estimated so that the risk manager can select the most appropriate technique, or combination of techniques, for handling each exposure.

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E.g. 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.

If the annual loss experience of certain type of exposures fluctuates widely, however, an entirely different approach is required.

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Although, the risk manager must consider both the loss frequency and loss severity, severity is more important, because a single catastrophic loss could wipe out the firm.

Therefore, the risk manager must also consider all losses that can result from a single event.

Both the maximum possible loss and the maximum probable loss must be estimated. (Students should check this concept from text book)

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

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

E,g if a plant is totally destroyed in a flood, the risk manager estimates that the replacement cost, debris removal, demolition costs and other costs will total GHc10 million.

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Thus, the maximum possible loss is GHc 10 million.

The risk manager also estimates that a flood causing more than GHc 8 million of damage to the plant is so unlikely that such a flood would not occur more than once in 50 years.

The risk manager may choose to ignore events that occur so infrequently. Thus, for this risk manager, the maximum probable loss is GHc 8 million.

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Catastrophic losses are difficult to predict because they occur infrequently. However, their potential impact on the firm must be given high priority.

In contrast, certain losses, such as physical damage losses to cars and trucks, occur with greater frequency, are usually relatively small, and can be predicted with greater accuracy.

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The third step in the risk management process is to select the most appropriate technique, or combination of techniques, for treating the loss exposures.

These techniques can be classified broadly as either Risk control or Risk financing.

Step Three: Develop and select methods for managing risk

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

Risk financing refers to techniques that provide for the funding of losses. Many risk managers use a combination of techniques for treating each loss exposure.

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Major risk control techniques include

Avoidance

Loss prevention

Loss reduction

Risk Control

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

E.g. flood losses can be avoided by not building a new plant in a flood plain. A pharmaceutical firm that markets a drug with dangerous side effects can withdraw the drug from the market to avoid possible legal liability.

Avoidance

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The major advantage of avoidance is that the chance of loss is reduced to zero if the loss exposure is never acquired.

In addition, if an existing loss exposure is abandoned, the chance of loss is reduced or eliminated because the activity or product that could produce a loss has been abandoned.

Advantages of avoidance

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Avoidance, however, has two major disadvantages.

First, the firm may not be able to avoid all losses. e.g. a company may not be able to avoid the premature death of a key executive.

Second, it may not be feasible or practical to avoid the exposure. e.g. a bank cannot avoid giving loans to avoid default risk, without the banks granting loans, the bank will not be in the business of banking.

Disadvantages of Avoidance

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Loss prevention refers to measures that reduce the frequency (number of times) of a particular loss.

E.g. measures that reduce bank credit risk include, checking the persons credit worthiness and the ability of the person to pay a loan before granting the loan.

Measures that reduce lawsuits from defective products include installation of safety features on hazardous products, placement of warning labels on dangerous products and institution of quality-control checks.

Loss Prevention

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Loss reduction refers to measures that reduce the severity (the size) of a loss after it occurs.

E.g. For banks, the use of collateral as a guarantee for the collection of a bank loan, this serves as a backup, the bank can sell the collateral to gain their money back although they might not realise the same amount.

Or banks given loans to a variety of sectors (diversifying their loan portfolio)

Loss Reduction

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Also, the installation of an automatic sprinkler system that promptly extinguishes a fire.

In conclusion, effective risk control techniques can significantly reduce the frequency and severity of claims, especially in workplace safety. A study by one insurer found that for every $1 invested in workplace safety by employers, savings of $3 or more are possible.

Effective safety programs reduce direct costs (payments to injured workers and health care providers) and indirect costs (such as overtime and lost productivity)

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Major risk financing techniques include the

Retention

Noninsurance transfers

Commercial insurance

Risk Financing

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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 risk retention means that the firm is aware of the loss exposure and plans to retain part or all of it.

Passive retention, however, is the failure to identify a loss exposure, failure to act, or forgetting to act.

Retention can be effectively used in a risk management program under the following conditions.

Retention

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1. No other method of treatment is available. Insurers may be unwilling to write a certain type of coverage, or the coverage may be too expensive. Also, noninsurance transfers may not be available.

In addition, although loss prevention can reduce the frequency of loss, all losses cannot be eliminated. In these cases, retention is a residual method.

If the exposure cannot be insured or transferred, then it must be retained.

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2. The worst possible loss is not serious.

E.g. physical damage losses to car in a large firm’s fleet will not bankrupt the firm if the cars are separated by wide distances and are not likely to be simultaneously damaged.

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3. Losses are highly predictable. Retention can be effectively used for workers

compensation claims, physical damage losses to cars.

Based on past experience, the risk manager can estimate a probable range of frequency and severity of actual losses. if most losses fall within that range, they can be budgeted out of the firm’s income.

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The term self-insurance is commonly used by risk managers to describe aspects of their risk management programs.

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

A better name for self-insurance is self-funding, which expresses more clearly the idea that losses are funded and paid for by the firm.

Self-Insurance

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The retention techniques has both advantages and disadvantages in a risk management program. The major advantages are as follow:

Save money- The firm can save money in the long run if its actual losses are less than the loss component in a private insurer’s premium.

Lower expenses- 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

Advantages and Disadvantages of Retention

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administrative expenses, commissions and brokerage fees, loss control expenses.

Encourage loss prevention- Because the exposure is retained, there may be a greater incentive for loss prevention. (There will be less morale hazard).

Increase cash flow- Cash flow may be increased, because the firm can use the funds that normally would be paid to the insurer at the beginning of the policy period.

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Possible higher losses- The losses retained by the firm may be greater than the loss allowance in the insurance premium that is saved by not purchasing insurance. Also, in the short run, there may be great volatility in the firm’s loss experience.

Possible higher expenses- Expenses may actually be higher. Outside experts such as safety engineers may have to be hired. Insurers may be able to provide loss control and claim services less expensively (because they do that on a large scale, thus they have the expertise).

Disadvantages associated with the retention technique

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Possible higher taxes- Income taxes may also be higher. The premiums paid to an insurer are immediately income-tax deductible.

However, if retention is used, only the amounts paid out for losses are deductible, and the deduction cannot be taken until the losses are actually paid. Contributions to a funded reserve are not income-tax deductible.

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Although a number of methods can be used to determine the retention level, only two methods will be discussed.

First a corporation can determine the maximum uninsured loss it can absorb without adversely affecting the company’s earnings.

One rough rule is that the maximum retention can be set at 5% of the company’s annual earnings before taxes form current operations.

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Second a company can determine the maximum retention as a percentage of the firm’s net working capital.

E.g between 1 and 5%. Net working capital is the difference between a company’s current assets and current liabilities.

Although this method does not reflect the firm’s overall financial position for absorbing a loss, it does measure the firm’s ability to fund a loss.

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Determining Retention Levels- If retention is use the risk manager must determine the

firm’s retention level, which is the Ghana Cedi (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.

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