RISK MANAGEMENTRISK AND INSURANCE

IntroductionUnknown future risk and uncertainty

Risk and uncertainty cause losses that cause people has to find ways to control and try to minimize losses.

DEFINITIONAs a systematic approach to identifying, measuring and controlling risks that can threaten assets and earnings of oneself, a business or the organization.

PURPOSE OF RISK MANAGEMENTThe purpose of risk management is to enable an organization to progress toward its goal and objectives (mission) in the most direct, efficient, and effective path

RISK MANAGEMENT OBJECTIVES

OBJECTIVES OF RISK MANAGEMENTCan be divided into two major categories:Before loss

(pre-loss)After loss

(post-loss)

OBJECTIVES PRIOR TO A LOSSObjectives before loss (pre-loss)Risk management is necessary before loss happens as:to reduce or minimized the impact of the loss if it should occurto reduce fear and worry (peace of mind)required by law and regulators

OBJECTIVES AFTER A LOSS OCCURSSurvival of organization organization still able to continue operationsStability of earnings business operations do not have to stop and the organizations can concentrate on their business activities as usual.Reduce impact of losses to organization and society when a loss occurs not only will the organization suffer but the loss has to be burdened by society as well. Employees may have to be retrenched and some departments may have to be closed down.

RISK MANAGEMENT PROCESS

RISK MANAGEMENT PROCESSIdentifying potential lossesEvaluating potential lossesExamining alternative risk management techniquesImplementing the risk management programControlling/monitoring the program

IDENTIFYING POTENTIAL LOSSESMost important processTo develop information on sources of risks, hazards, risk factors, perils and exposures to lossSince it is not easy to identify risks, everyone in the organization is responsible to identify loss exposuresIt must be a concerted effort from every level in the organization.

IDENTIFYING POTENTIAL LOSSESLosses can be classify as:Direct damage (damage to building)Indirect damage (loss of profits due to business interruption)Liability (court award to 3rd party since fire was caused by negligence of the owner of building)Loss of Key Employees (key employees such as general manager/CEO/Researcher)

IDENTIFYING POTENTIAL LOSSESRisk Identification techniques:

Distribution of questionnaires and interviews with relevant partiesAnalyzing financial statements (balance sheet, profit and loss accountAnalyzing the flow chart Observation and personal inspection

EVALUATING POTENTIAL LOSSESSecond step involve evaluation of likelihood of loss and the impact in terms of frequency and severityFrequency referring to the number of times the loss occursSeverity referring to the size of loss exposureImportant to evaluate risks so that they can be categorized based on the degree of risksRisks can be classified into such as Extremely High, High, Medium or Low risks.Different level of risks required different risk management techniques to be applied

EVALUATING POTENTIAL LOSSESIdentifying and determining the loss exposures alone is not sufficientIn evaluating the potential losses:Estimating the frequency and severity for each type of loss exposure and ranked it according to their relative importance. High loss exposure will be given priority.Estimating relative frequency and severity of each loss exposure as the selection of appropriate technique will depend on this.

EVALUATING POTENTIAL LOSSES

EXAMINING THE METHODS OF HANDLING THE LOSS EXPOSURESRisk management techniques can be classified into two:Risk controlRisk financing

RISK CONTROLMethods seek to alter an organizations exposure to risk.Risk control efforts help organization avoid a risk, prevent loss, lessen the amount of damage if a loss occurs or reduce undesirable effects of risk on an organization.Risk AvoidanceLoss controlLoss preventionLoss reductionSeparationContractual transfer

Risk AvoidanceRisk is proactively avoided or abandoned after rational consideration.If someone is afraid of risks, the best way to deal with it is to avoid it completely.Example; a manufacturer may stop production of a defective products to avoid a lawsuit. However, some risks are unavoidable although risk avoidance may be chosen as an option in handling certain risks, the exposures of losses cannot be eliminated entirely.

Loss ControlLoss control is designed to reduce both the frequency and severity of losses by changing the characteristics of the exposure so that it is more acceptable to the firm. Divided into:Loss preventionLoss reduction

Loss ControlLoss PreventionSeek to reduce the number of losses (frequency) of lossesIs used when the benefits outweigh the costs involved.Either imposed by law or imposed by companies and factories to fence dangerous machinery to reduce the chances of employees being injured.

Loss ReductionDesigned to reduce or lower the severity of losses, should it occur.Since some risks are unavoidable, the other alternative is to reduce its impact.Can be used in two circumstances: before a loss, e.g. installation of fire alarm or after a loss e.g. salvage efforts in the restoration of a building burnt down by fire.

SeparationInvolves the dispersal of the firms assets in several locations instead of confining it to one major area.This measure will reduce the impact of losses should a major disaster occurs.Example, separation of head quarters and assembly plant in automobile industry.

Contractual TransferRisk transfer mechanism.Refers to the various methods other than insurance by which a pure risk and its potential financial consequences can be transferred to other party.

Contractual TransferTypes of contractual transferIncorporationThe owner of the company transfers the risks to corporation by registering the company.Leasing contractsAn agreement where the owner or landlord transfers the risks to the tenantsHedgingAn agreement to buy or sell a commodity at a certain price to avoid losses due to price increase or decrease.Hold-harmless agreementsAn agreement between a retailer and a manufacturer whereby the later agrees to bear losses due to the manufacturer of defective products thus relieving the retailer of any liability.

Contractual TransferAdvantagesCan transfer potential losses that are commercially uninsurableOften cost less than insurancePotential loss shifted to a party who is in a better position to exercise control

DisadvantagesIf the party to whom the loss is transferred is unable to pay the loss the firm is still responsibleNot necessarily cheaper than insurance if discounts are taken into considerationAmbiguity in contracts drafted may not hold in court.

RISK FINANCINGMethods involving generating funds to pay for these losses:RetentionSelf insurance and captive insurerInsurance

RetentionRetention the company will bear the consequences of the lossRisk or loss exposed are normally assumed or retained when their impact and consequences are not too great or in cases when or other methods seem feasible.In an organization, the ability to assume a risk depends on ones financial ability.

Self insurance & Captive InsurerSelf insurance implies that the organization sets up a pool of fund to retain its loss exposures.Adequate financial agreement has to be made in advance of the occurrence of losses.The number of loss exposures must be large enough to ensure the mechanism of insurance to be operative.

Self insurance & Captive InsurerA captive insurance company is an entity to write insurance arrangement for its parent company.The captives parent may be one company, several companies or an entire industry.

Self insurance & Captive InsurerAdvantagesCash flow advantagesSafe moneyLower expensesEncourage loss preventionDisadvantagesPossible higher lossesPossible higher expenses

InsuranceRisk financing method of transferring the financial consequences of potential accidental losses from an insured firm or family to an insurerTransferring the risks to another party involves a contractual agreement whereby the other party assumes the risks and is liable for the loss in the event of loss.

InsuranceIn an insurance contract, the party exposed to the risks (the proposer/insured) pays the premium to the insurance company. In return, the insurance company agrees to pay a stated sum on the happening of certain risks specified in the contract.

Selection of Risk Management Techniques

LOW HIGHFREQUENCYRisk Assumption/retention Loss PreventionAlso: Also:Loss prevention and loss Loss reduction if cost can bereduction if the cost justified.justifies the benefits.

Insurance Risk Avoidance:Also: Also:Risk transfer, loss reduction, Loss prevention and loss loss prevention. loss reduction is possibleSEVERITYLOWHIGH

TO DRAW UP AND IMPLEMENT THE RISK MANAGEMENT PROGRAMOnce a decision has been in the selection, the management must select the best and most cost effective risk management programThe selection may based of two factorsFinancial criteria whether it will affects the organizations profitability or rate of return.Non financial criteria whether it affects the growth of the organization, humanitarian aspects and legal requirements.

Monitor and control the risk management program Evaluation and review are important to the riskmanagement process for two reasons.Things change. Mistakes are sometimes made. THINGS CHANGE Solutions that were appropriate in the past may no longer be appropriate. New risks emerge and old risks disappear. MISTAKES ARE MADE Exposures may be overlooked. Measures selected to address risks may not have been the most appropriate