IRM UNIT 2 NOTES

Risk Management: Objectives

● Risk management is a process that identifies loss exposures faced by

an organization and selects the most appropriate techniques for
treating such exposures.

Loss Exposure:
Loss exposure refers to any situation or circumstance in which a loss is
possible, irrespective of whether the loss actually occurs.

Risk Management Objectives:

1. Pre-Loss Objectives:
● a. Economic Preparation: The organization should prepare for potential
losses in the most economical way. This involves analyzing the costs
associated with safety programs, insurance premiums, and various
techniques for handling losses.
● b. Reduction of Anxiety: Addressing loss exposures that can cause
significant worry and fear for risk managers and executives. Prioritizing
and managing high-impact risks is essential.
● c. Legal Obligations: Ensuring compliance with legal requirements,
such as installing safety devices, proper disposal of hazardous
materials, and adherence to labeling regulations. Meeting these
obligations is essential for legal and ethical reasons.

2. Post-Loss Objectives:
● a. Survival of the Firm: The primary post-loss objective is the survival
of the organization. This means the firm can resume at least partial
operations within a reasonable time frame after a loss occurs.
● b. Continuation of Operations: Certain industries, like public utilities,
banking, and competitive firms, must continue operating after a loss.
Maintaining operational capabilities is crucial.
● c. Stability of Earnings: Managing post-loss expenses to maintain
stability in earnings per share. This objective may involve additional
expenses, such as operating at an alternative location, to ensure
financial stability.
● d. Continued Growth: Assessing the impact of a loss on the
organization's ability to grow. This involves considering factors like
developing new products, entering new markets, or engaging in
mergers and acquisitions.
● e. Social Responsibility: Minimizing the effects of a loss on
stakeholders and society at large. A severe loss can have widespread
consequences on employees, suppliers, customers, creditors, and the
community. Social responsibility involves mitigating these impacts.
Components of Risk Management:
● Risk Identification: Identifying potential risks and loss exposures
faced by the organization.
● Risk Assessment: Evaluating the likelihood and potential impact of
identified risks to prioritize and focus on high-impact areas.
● Risk Mitigation: Implementing strategies to reduce or manage the
impact of identified risks, including risk avoidance, loss prevention,
risk retention, and risk transfer (insurance).
● Monitoring and Review: Continuously monitoring the effectiveness of
risk management strategies and adapting them to changing
circumstances.

Risk Management Process:

The risk management process involves four key steps, each contributing to the
systematic identification, assessment, and treatment of potential risks.

1. Identify Loss Exposures:

● Definition: The initial step is to identify all major and minor loss
exposures that an organization may face. This involves a thorough
examination of potential risks and vulnerabilities.
○ Examples of Loss Exposures:
○ Property Loss Exposures: Buildings, plants, structures, inventory,

vehicles, and valuable records.

○ Liability Loss Exposures: Defective products, environmental

pollution, sexual harassment, premises liability, and directors' and

officers' liability.
○ Business Income Loss Exposures: Loss of income, continuing

expenses, extra expenses, and contingent business income losses.

○ Human Resources Loss Exposures: Death or disability of key

employees, retirement or unemployment risks, and job-related

injuries.
○ Crime Loss Exposures: Holdups, employee theft, fraud,

embezzlement, and theft of intellectual property.

○ Employee Benefit Loss Exposures: Non-compliance with

regulations, violation of fiduciary responsibilities, and issues

related to group life, health, and retirement plans.
○ Foreign Loss Exposures: Acts of terrorism, currency and exchange

rate risks, kidnapping of key personnel, and political risks.

○ Intangible Property Loss Exposures: Damage to the company's

public image, loss of goodwill, intellectual property loss, and failure

to comply with government laws.

Risk manager can use several sources of information to identify the preceding
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, and
key customers and suppliers.
● Historical loss data. Historical loss data can be invaluable in
identifying major loss exposures.

2.The second step is to measure and analyze the loss exposures

● 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.
● The maximum possible loss is the worst loss that could happen to
the firm during its lifetime. The probable maximum loss is the worst
loss that is likely to happen. For example, if a plant is totally destroyed
by a flood, the risk manager estimates that replacement cost, debris
removal, demolition costs, and other costs will total $25 million. Thus,
the maximum possible loss is $25 million. The risk manager also
estimates that a flood causing more than $20 million of damage to the
plant is so unlikely that such a flood would not occur more than once
in 100 years. The risk manager may choose to ignore events that occur
so infrequently. Thus, for this risk manager, the probable maximum
loss is $20 million.

3.Select the Appropriate Combination of Techniques for Treating the Loss

Exposures

● The third step in the risk management process is to select the

appropriate combination of techniques for treating the loss exposures.
– Risk control refers to techniques that reduce the frequency or
severity of losses.
– Risk financing refers to techniques that provide for the funding of
losses

● Risk control
– Avoidance
– Loss prevention
– Loss reduction

. Avoidance

– Avoidance means a certain loss exposure is never acquired or

undertaken, or an existing loss exposure is abandoned.
– Eg- 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 withdraw the drug
from the market to avoid possible legal liability

– Advantages
– 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.

– Disadvantage
– The firm may not be able to avoid all losses. For example, 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. For
example, a paint factory can avoid losses arising from the production
of paint. Without paint production, however, the firm will not be in
business.

. Loss Prevention

– Loss prevention refers to measures that reduce the frequency of a

particular loss.
– Examples-Measures that reduce truck accidents include driver
training, zero tolerance for alcohol or drug abuse, and strict
enforcement of safety rules. Measures that reduce lawsuits from
defective products include installation of safety features on hazardous
products, placement of warning labels on dangerous products, and
use of quality-control checks.
 . Loss Reduction

– 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; segregation of exposure units so that a
single loss cannot simultaneously damage all exposure units, such as
having warehouses with inventories at different locations;
rehabilitation of workers with job-related injuries; and limiting the
amount of cash on the premises.

● Risk Financing

– Retention
– Non insurance transfers
– Commercial insurance

. Retention

● Retention means that the firm retains part or all of the losses that can
result from a given loss.
● It is of two types

– Active- Active risk retention means that the firm is aware of the loss
exposure and consciously decides to retain part or all of it, such as
collision losses to a fleet of company cars
– Passive-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

– Advantages
– Save on loss costs. 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.
– Save on 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 administrative expenses,
commissions and brokerage fees, risk-control expenses, taxes and
fees, and the insurer’s profit.
– Encourage loss prevention. Because the exposure is retained, there
may be a greater incentive for loss prevention.
– Increase cash flow. Cash flow may be increased because the firm can
use some of the funds that normally would be paid to the insurer at the
–

beginning of the policy period.

– Disadvantage
– 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 risk control and claim services at a lower cost.
– 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.

. Non Insurance transfers

– Noninsurance 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.
– 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 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

. Insurance

– Insurance is appropriate for loss exposures that have a low probability

of loss but the severity of loss is high.

● There are five points

– the risk manager must select the insurance coverage needed

– the risk manager must select an insurer or several insurers
– A number of important factors come into play here, including the
financial strength of the insurer, risk management services provided
by the insurer, and the cost and terms of protection. The insurer’s
financial strength is determined by the size of the policyholders’
surplus, underwriting and investment results, adequacy of reserves for
outstanding liabilities, types of insurance written, and the quality of
management.
– After the insurer or insurers are selected, the terms of the insurance
 –
contract must be negotiated.
– Finally, the insurance program must be periodically reviewed. This
review is especially important when the firm has a change in business
operations or is involved in a merger or acquisition of another firm. The
review includes an analysis of agent and broker relationships,
coverages needed, quality of risk control services provided, whether
claims are paid promptly, and numerous other factors

4.Self Insurance

– Self-insurance is a special form of planned retention by which part or

all of a given loss exposure is retained by the firm. Another name for
self-insurance is self-funding.
– Self-insurance is also used by employers to provide group health,
dental, vision, and prescription drug benefits to employees. Firms
often self-insure their group health insurance benefits because they
can save money and control health-care costs. There are other
benefits of self-insurance as well

Which technique should be used

● 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 office supplies. This type of exposure can be
handled by retention because the loss occurs infrequently and, when it
does occur, it seldom causes 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, workers
compensation claims, shoplifting, and food spoilage. Loss prevention
should be used here to reduce the frequency of losses. In addition,
because losses occur regularly and are predictable, the retention
technique can also be used. However, because small losses in the
aggregate can reach sizable levels over a one-year period, excess
insurance could also be purchased
● The third type of exposure can be met by transfer, including
insurance. As stated earlier, 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 of this type of exposure
include fires, explosions, natural disasters, and liability lawsuits. The
risk manager could also use a combination of retention and
commercial insurance to deal with these exposures.
● The fourth and most serious type of exposure is one characterized
by both high frequency and high severity. This type of exposure is best
 ●

handled by avoidance. For example, a pharmaceutical company might

be concerned about the harmful side effects of a new drug that it is
developing. The exposure to liability arising from this drug can be
avoided if the drug is not produced and sold.

Type of Loss Loss Loss Severity Appropriate

Frequency Risk
Management
Technique
1 Low Low Retention
2 High Low Loss Prevention
and Retention
3 Low High Transfer
4 High High Avoidance

4.Implement and Monitor the Program Periodically

● The final step is to implement the personal risk management program

and review the program periodically. At least every two or three years,
you should determine whether all major loss exposures are adequately
covered. You should also review your program at major events in your
life, such as a divorce, birth of a child, purchase of a home, change of
jobs, or death of a spouse or family member.

Risk Management by Individuals and Corporations:

Individuals:
● Insurance:
○ Individuals manage risks through various insurance policies, such

as health, life, auto, and property insurance.

○ Insurance provides financial protection against unexpected events,

reducing personal financial vulnerabilities.

● Emergency Fund:
○ Individuals create emergency funds to cover unexpected expenses

or loss of income.
○ Having savings ensures financial stability during unforeseen

circumstances, mitigating the impact of unexpected events.

● Diversification of Investments:
○ Individuals diversify their investment portfolios to spread risk.
○ Investing in different asset classes reduces the impact of a poor-

performing investment on the overall portfolio.

 ● Health and Wellness Practices:
○ Individuals adopt healthy lifestyles to minimize health risks.
○ Regular exercise, balanced nutrition, and preventive healthcare

contribute to overall well-being.

Corporations:
● Insurance Coverage:
○ Corporations use various insurance coverages, including property,

liability, and business interruption insurance.

○ Insurance transfers financial risks associated with operations and

assets.
● Risk Assessment and Mitigation:
○ Corporations conduct risk assessments to identify and analyze

potential risks.
○ Mitigation strategies, such as implementing safety measures and

quality controls, are employed to reduce the likelihood and impact

of risks.
● Financial Risk Management:
○ Corporations manage financial risks, including market fluctuations,

interest rate changes, and currency risks.

○ Hedging strategies, financial derivatives, and diversification are

used to protect against financial uncertainties.

● Supply Chain Management:
○ Corporations assess and manage risks within their supply chains.
○ Diversifying suppliers, implementing risk-sharing agreements, and

ensuring supply chain resilience are common strategies.

● Compliance and Regulatory Risk Management:
○ Corporations navigate legal and regulatory risks by ensuring

compliance with laws and regulations.

○ Legal teams and compliance officers work to mitigate the impact of

regulatory changes on business operations.

● Crisis Management and Business Continuity Planning:
○ Corporations develop crisis management and business continuity

plans.
○ These plans outline strategies to respond to crises, ensuring

minimal disruption to operations and protecting the organization's

reputation.
● Employee Training and Safety Measures:
○ Corporations invest in employee training programs and safety

measures to prevent workplace accidents.

○ Ensuring a safe and healthy work environment reduces the

likelihood of human resources-related risks.

● Strategic Planning:
○ Corporations integrate risk considerations into strategic planning.
○ Anticipating potential risks allows organizations to proactively
 ○

address challenges and capitalize on opportunities.

Understanding the Cost of Risk:

Definition:
The cost of risk refers to the total financial impact an organization incurs due to
the occurrence of various risks and uncertainties.

Components:
● Direct Costs:
○ Insurance Premiums: The amount paid for insurance coverage.
○ Losses Incurred: Direct financial losses resulting from events

covered by insurance.

● Indirect Costs:
○ Risk Management Expenses: Costs associated with implementing

risk management strategies, including hiring risk professionals and

implementing safety measures.
○ Operational Disruptions: Financial impact due to interruptions in

business operations caused by unforeseen events.

○ Reputation Damage: Costs related to a tarnished reputation

following a crisis or negative event.

Hidden Costs:
● Opportunity Costs: Potential revenue or growth opportunities
foregone due to risk-related disruptions.
● Legal and Regulatory Penalties: Fines and legal expenses incurred
for non-compliance with laws and regulations.

Risk Financing Costs:

● Premiums for Transferred Risks: Costs associated with purchasing
insurance or engaging in risk-sharing agreements.
● Cost of Capital: The expense of maintaining financial reserves to
cover potential losses when using retention strategies.

Risk Control Costs:

● Investments in Prevention: Expenditures on safety measures, quality
control, and training programs to reduce the likelihood of losses.

Risk Management and Societal Welfare:

Definition:
Risk management involves the systematic identification, assessment, and
mitigation of uncertainties to protect assets, ensure resilience, and promote
stability.

Impact on Societal Welfare:

● Safety and Security:
○ Effective risk management enhances safety measures, reducing
the likelihood of accidents and disasters.
○ Improved security measures contribute to public well-being,
ensuring a safer environment.
● Economic Stability:
○ By addressing financial risks, risk management supports economic
stability.
○ Minimizing business disruptions and financial losses contributes to
overall economic well-being.
● Public Health:
○ Risk management in healthcare helps prevent and control the
spread of diseases, ensuring public health.
○ Safety protocols and crisis management strategies contribute to
societal well-being.
● Environmental Protection:
○ Risk management addresses environmental risks, promoting
sustainable practices.
○ Mitigating environmental threats contributes to the well-being of
ecosystems and future generations.
● Infrastructure Resilience:
○ Effective risk management in infrastructure development enhances
resilience to natural disasters and other hazards.
○ Robust infrastructure contributes to societal welfare by ensuring
reliable services and reducing vulnerabilities.
● Social Equity:
○ Risk management practices consider the impact of uncertainties
on diverse communities.
○ Promoting social equity involves addressing risks that
disproportionately affect vulnerable populations.
● Crisis Response:
○ Well-prepared risk management plans contribute to efficient crisis
response.
○ Quick and coordinated responses during emergencies enhance
societal welfare by minimizing the impact of disasters.
● Resource Allocation:
○ Prioritizing risks and allocating resources efficiently enhances
societal welfare.
○ Addressing critical risks ensures the optimal use of resources for
the benefit of the community.
Advanced Issues in Risk Management: The Changing Scope of Risk
Management:

Overview:
The landscape of risk management is evolving, driven by dynamic global
challenges, technological advancements, and shifts in organizational priorities.
Several advanced issues characterize the changing scope of risk management.

1. Technological Risks:
● Cybersecurity: The increasing reliance on technology brings forth
cybersecurity challenges. Risk management now extends to
safeguarding digital assets, sensitive data, and protecting against
cyber threats.
2. Climate Change and Environmental Risks:
● Climate-Related Risks: Organizations must address the impact of
climate change on operations, supply chains, and sustainability. This
includes assessing physical risks, regulatory changes, and reputational
consequences.
3. Supply Chain Complexity:
● Globalization: With intricate and interconnected supply chains, risk
management expands to navigate geopolitical uncertainties, trade
tensions, and disruptions in the supply and demand dynamics.
4. Social and Cultural Risks:
● Social Responsibility: Organizations are increasingly addressing
social and cultural risks. This involves considering diversity, equity,
and inclusion, as well as understanding the societal and cultural
implications of business operations.
5. Pandemic Preparedness:
● Global Health Crises: The COVID-19 pandemic has highlighted the
need for robust pandemic preparedness. Risk management now
includes strategies for mitigating the impact of health crises on
business continuity.
6. Regulatory Complexity:
● Compliance Challenges: Organisations face evolving and complex
regulatory landscapes. Risk management encompasses staying
compliant with changing laws, regulations, and industry standards.
7. Data Privacy and Ethics:
● Data Governance: The increasing focus on data privacy and ethical
considerations requires organizations to manage risks associated with
data collection, storage, and usage in alignment with regulatory
requirements.
8. Geopolitical Risks:
● Global Dynamics: Organizations operating internationally must
navigate geopolitical risks, including political instability, trade conflicts,
 ●

and regional tensions. Risk management extends to geopolitical

intelligence and scenario planning.
9. Remote Work and Digital Transformation:
● Changing Work Environments: The shift towards remote work and
digital transformation introduces new risks related to cybersecurity,
employee well-being, and the need for flexible risk management
strategies.
10. Reputation Management:
● Social Media Impact: The influence of social media on reputation is a
critical consideration. Risk management now includes monitoring
online sentiment and addressing reputational risks in real-time.

Insurance Market Dynamics: Factors Influencing Risk Management

Decisions

In the realm of risk management, decisions regarding risk retention or transfer

are significantly influenced by conditions in the insurance marketplace. Three
key factors shape the dynamics of the insurance market:

● The Underwriting Cycle:

○ Definition: The underwriting cycle refers to the cyclical pattern of

insurance market conditions, impacting pricing, availability, and

terms of insurance coverage.
◆ Influence on Decision-Making:
◆ During a soft market (low premiums, broad coverage),

organizations may find it cost-effective to transfer more risks

through insurance.
◆ In a hard market (high premiums, limited coverage), retaining

risks might be a more attractive option.

○ Example: In a soft market, a company might choose to purchase

additional insurance coverage due to favorable pricing and broad

availability.

● Consolidation in the Insurance Industry:

○ Definition: Consolidation involves mergers and acquisitions within

the insurance industry, leading to the formation of larger and

potentially more stable insurance entities.
◆ Influence on Decision-Making:
◆ Consolidation may impact the number and competitiveness of

insurers in the market.

◆ Larger insurers may offer stability but could also result in

reduced choices for insurance buyers.

○ Example: A company might assess the financial strength and

market presence of potential insurers when deciding to transfer

 ○

risks, considering the impact of industry consolidation.

● Capital Market Risk Financing Alternatives:

○ Definition: Capital market risk financing involves using financial

instruments beyond traditional insurance to manage risks, such as

catastrophe bonds, securitization, or other capital market
solutions.
◆ Influence on Decision-Making:
◆ Organizations explore alternatives beyond traditional insurance

to diversify risk financing strategies.

◆ Capital market solutions can provide customized risk transfer

options.
○ Example: A company exposed to natural disasters may consider

issuing catastrophe bonds as an alternative to traditional

insurance, gaining access to capital markets for risk financing.

Loss Forecasting:

Definition:
Loss forecasting is the process of predicting potential financial losses that an
organization may incur due to various risks and uncertainties. It involves
estimating the magnitude and frequency of potential adverse events.

Key Components:
● Risk Identification:
○ Identifying and categorizing potential risks that could impact the
organization.
○ Recognizing both internal and external factors contributing to
potential losses.
● Data Analysis:
○ Analyzing historical data, incident reports, and relevant information
to understand past occurrences of similar risks.
○ Utilizing statistical methods and modeling techniques to extract
meaningful insights.
● Scenario Analysis:
○ Creating hypothetical scenarios to assess the impact of specific
events on the organization.
○ Considering various factors such as severity, frequency, and
interconnected risks.
● Quantitative Modeling:
○ Employing mathematical models to quantify potential financial
losses.
○ Utilizing actuarial techniques, statistical models, or simulations to
project future outcomes.
● Trend Analysis:
 ○ Examining trends in relevant risk factors, industry developments,
and external influences.
○ Considering economic, regulatory, or technological trends that may
affect the likelihood and severity of losses.
● Sensitivity Analysis:
○ Evaluating the sensitivity of loss forecasts to changes in key
assumptions or variables.
○ Understanding how variations in inputs impact the accuracy of
predictions.