CHAPTER ONE

The Nature of Risk

Chapter objectives
Dear learners, after completing this chapter you are expected to;
 Understand the meaning of risk

 Differentiate and relate between risk, uncertainty, and probability

 Understand Risk Distinguished from Peril and Hazard

 Identify the different types of risks

1.1. INTRODUCTION
It has been aptly stated that "man is the only case in a nature where life becomes aware of itself."
However, man makes numerous choices and decisions on uncertain conditions. He is not aware of all that
threatens him and eventually the ultimate reality and certainty that is, death. Thus, we live in an uncertain
world in which decisions must be make and risks taken.
When a person gets married, goes into business, decides to attend college, buys a house or does
innumerable other things that affect his life in any important way, he is naturally somewhat apprehensive
over the outcome. He is uncertain as to how this particular action will turn out, but he always hopes for the
best. He usually considers the various alternatives and make up his mind only after weighing the
advantages and disadvantages of each course of action. We say that this individual is facing the
uncertainties of the future, that is, the different kinds of risks. Usually he is happier for making decision
that he is almost certain is correct. He likes the soft-heard advice, "be sure you are right, then go ahead."
Conversely, he usually dislikes decisions that he has to make "in the dark," those with more risks attached.
As an illustration, consider the various uncertainties that enter into the purchase of a home by taking a
loan from a bank to repay within 20 years. The family breadwinner must make the decision whether or not
to buy a certain home in the environment of uncertainties such as:
 Is the level of my income high enough and certain enough to enable me make the payments for 20
years?

 How can I protect the investment for my families benefit in case I should die before the loan is
repaid?
 Will my health permit me to continue to work for 20 years?
 Would it be better to rent rather than to buy and use my funds for other purposes? if so, what risks
characterize the alternative uses of my fund?
  How can a person protect my investment in case of fire, flood, wind-storm, or other peril?
 It is possible that may investment will lose value because of a job
 Transfer and consequent forced sale of property?
In order to have exactly the type of house want, should the person take the risk of building a home rather
than buying.
If the potential home buyer cannot find satisfactory answers to those and other questions, he may decide
that "the risks are too great" and fail to purchase a home. Indeed, the subject of risk is of great importance
to an "economic man"; risk has an element of distastefulness (economists would call it disutility) that
make him want to eliminate it. The more completely he can avoid risk, the better. Because people usually
try to avoid all the uncertainties they can, the subject of risk and its wise management has received
important consideration by social scientists for many years. They have tried to identify what type of risks
there are and how to avoid or to handle risk in some satisfactory manner.
In general, risk exists whenever the future is unknown. Because the adverse effects of risk have plagued
mankind since the beginning of time individuals, groups, and societies have developed various methods
for managing risk. Since no one knows the future exactly, everyone is a risk manager not by choice, but by
sheer necessity.
Dear learners, this chapter discuss risks, uncertainties and related concepts and introduce you with the
various types of risks.
1.2. Definition of Risk
The word risk is used in many different ways. It can refer to general uncertainty, doubt, an insured object,
or chance of loss.

Williams and Heinz define risk as the variation in the outcomes that could occur over a specified period in
a given situation. If only one outcome is possible, the variation and hence the risk is 0. If many outcomes
are possible, the risk is not 0. The greater the variation is the greater the risk.
For the purpose of this course we will define risk as the possibility of an adverse deviation from a desired
outcome that is expected or hoped for. If you own a house, you hope it will not catch fire. When you make
a wager, you hope the outcome will be favorable. The fact that the outcome in either event may be
something other than what you hope for constitutes a possibility of loss or risk.
Note that the above definition is not subjective. Risk is a state of the external environment. This possibility
of loss must exist, even though the individual exposed to that possibility may not be aware of it. If the
individual believes that there is a possibility of loss where none is present, there is only imagined risk, and
not risk in the sense of the real world. Finally, there is not requirement that the possibility of loss must be
measurable, only that it must exist.
Risk is uncertainty as to loss. If a cost or a loss is certain to occur, it may be planned for in advance and
treated as a definite, known expense. It is when there is uncertainty about the occurrence of a cost or loss
that risk becomes an important problem.
When risk is said to exist there must always be at least two possible outcomes. If we know in advance
what the outcome will be, there is no risk. For example, investment in a capital asset involves a realization
that the asset is subject to physical depreciation and that its value will decline. Here the outcome is certain
so there is no risk.
The degree of risk is inversely related to the ability to predict which outcome will actually occur. If the
risk is 0, the future is perfectly predictable. If the risk in a given situation can be reduced, the future
becomes more predictable and more manageable.
In a two - outcome situation for which the probability of one outcome is 1 and the probability of the
second outcome is 0, the risk is 0 because the actual outcome is known.

1.3. Risk versus Uncertainty

Uncertainty is the doubt a person has concerning his or her ability to predict which of the many possible
outcomes will occur. Uncertainty is a person's conscious awareness of the risk in a given situation. It
depends upon the person's estimated risk-what that person believes to be the state of the world-and the
confidence he or she has in this belief. A person may be extremely uncertain about the future in a situation
where in reality the risk is small; on the other hand, this person may have great confidence in his or her
ability to predict the future when in fact the future is highly uncertain. Unlike probability and risk,
uncertainty cannot be measured by any commonly accepted yardstick.
1.4. Risk versus Probability
It is necessary to distinguish carefully between risk and probability. Probability refers to the long-run
chance of occurrence, or relative frequency of some event.Insurers are particularly interested in the
probability or chance of loss, or more accurately, the probability that a loss will occur to one of a group of
insured objects.
Risk as differentiated from probability, is a concept in relative variation. We are referring here particularly
to objective risk, which is the relative variation of actual from probable or expected loss. Objective risk
can be measured meaningfully only in terms of a group large enough to analyze statistically. If the number
of objects is too small, the range of probable variation is so large that is virtually infinite as far as the
insurer is concerned.
1.5. Risk Distinguished from Peril and Hazard
Many persons commonly employ the terms "risky," "hazardous," and "perilous" synonymously. For
clarity in thinking, however, the meanings of these words should be carefully distinguished
A peril is a contingency, which may cause a loss. We speak of the peril of "fire" or "windstorm," for "hail"
or "theft". Each of these is the cause of a loss that may occur.

A hazard, on the other hand, is that condition which creates or increases the probability of loss from a
peril. For example, one of the perils that can cause loss to an auto is collision. A condition that makes the
occurrence of collisions more likely is an icy street. The icy street is the hazard and collision is the peril.
In winter the probability of collision is higher owing to the existence of icy streets. In such a situation, the
risk of loss is not necessarily any higher or lower, since we have defined risk as the uncertainty that
underlying probability will work out in practice.
It is possible for something to be both a peril and hazard. For instance sickness is a peril causing economic
loss, but it is also a hazard that increases the chance of loss from the peril of premature death.
There are three basic types of hazards: physical, moral, and morale.
1. Physical Hazard

A physical hazard is a condition stemming from the physical characteristics of an object that increases the
probability and severity of loss from given perils. Physical hazards include such phenomena as the
existence of dry forests (hazard for fire), earth faults (hazard for earthquakes), and icebergs (hazard to
ocean shipping). Such hazards may or may not be within human control. For example, some hazards for
fire can be controlled by placing restrictions on building camp fires in forests during the dry season. Some
hazards, however, cannot be controlled. For example, little can be done to prevent or to control air masses
that produce ocean storms.
2. Moral Hazard

A moral hazard stems from the mental attitude of the insured. A moral hazard is a condition that increases
the chance that some person will intentionally (1) cause a loss or (2) increase its severity.Some
unscrupulous persons can make, or believe that they can make, a profit by bringing about a loss. For
example, arson, inspired by the possibility of an insurance recovery, is a major cause of fires. A dishonest
person, in the hope of collecting money from the insurance company, may intentionally cause a loss.

3. Morale Hazard

The moral hazard includes the mental attitude that characterizes an accident-prone person. A moral hazard
is condition that causes persons to be less careful than they would otherwise be. Some persons do not
consciously seek be bring about a loss, but the fact that they have insurance causes them to take more
chances than they would if they had no insurance. The purchase of insurance may create a morale hazard,
since the realization that the insurance company will bear the loss may lead the insured to exercise less
care than if forced to bear the loss alone. Morale hazard results from a careless attitude on the part of
insured persons toward the occurrence of losses.

1.6. Classifications of Risk

Risks may be classified in several ways according to their cause, their economic effect, or some other
dimension. However, there are certain distinctions that are particularly important for our purpose stated
hereunder.
1.6.1. Financial Versus Non-Financial Risks
In its broadest context, the term risk includes all situations in which there is an exposure to adversity. In
some cases this adversity involves financial loss, while in others it does not. There is some element of risk
in every aspect of human endeavor and many of these risks have no (or only incidental) financial
consequences. In this course we are concerned with those risks which involve a financial loss.
1.6.2. Static Risk versus Dynamic Risks
A second important distinction is between static and dynamic risks.
Dynamic risks are those resulting from change the economy. They are risks associated with changes,
especially changes in human wants and improvements in machinery and organization.

For example, changes in the price level, consumer tastes, income and output, and technology may cause
financial loss to members of the economy.
Static risks involve those losses, which would occur even if there are no changes in the economy. These
are risks connected with losses caused by the irregular action of the forces of nature or the mistakes and
misdeeds of human beings.
Static risks are risks stemming from a level, unchanging society that is in stable equilibrium. Examples
include the uncertainties due to random events such as fire, windstorm, or death. They would be present in
an unchanging economy. If we could hold consumer taste, output, and income, and the level of technology
constant, some individuals would still suffer financial loss. These losses arise from causes other than the
changes in the economy, such as the perils of nature and the dishonesty of other individuals.
Dynamic risks normally benefit society over the long-run since they are the result of adjustments to
misallocation of resources. They usually affect a large number of individuals and are generally considered
less predictable, since they occur with no precise degree of regularity. Static risks, unlike dynamic risks
usually result in a loss to society, affect directly few individuals at most, exhibit more regularity over a
specified period of time and, as a result, are generally predictable.
1.6.3. Pure Risks versus Speculative Risks
A distinction has been made between pure risk and speculative risk, which further clarifies the nature of
risk. A pure risk exists when there is a chance of loss but no chance of gain. For example, the owner of an
automobile faces the risk associated with a potential collision loss. If a collision occurs, the owner will
suffer a financial loss. If there is no collision, the owner's position remains unchanged.
A speculative risk exists when there is a chance of gains as well as a chance of loss. For instance,
expansion of an existing plant involves a chance of loss and chance of gain. Pure risks are always
distasteful, but speculative risks possess some attractive features. In the above example, i.e., expansion of
existing plant, the investment made may be lost if the product s not accepted by the market at a price
sufficient to cover costs but this risk is born in return for the possibility of profit. Gambling is also a good
example of speculative risk. In a gambling situation risk is deliberately created in the hope of gain.
Pure risks also differ from speculative risks in that they generally are repeatable under essentially the same
condition and thus are more amenable to the law of large numbers (a basic law of mathematics, which
states that as the number of exposure units increases, the more certain it is that actual loss experience will
equal probable loss experience).
This means that one can more successfully predict the proportion of units that will be loss if they are
exposed to a pure risk than if they are subject to a speculative risk. One notable exception to this statement
is the speculative risks associated with games of chance, which are highly amenable to this law.
In a situation involving a speculative risk, society may benefit even though the individual is hurt. For
example, the introduction of socially beneficial product may cause a firm manufacturing the product it
replaces to go bankrupt. In a pure-risk situation society almost always suffers if any individual experiences
a loss.
The distinction between pure and speculative risk is an important one, because normally pure risks are
insurable. Insurance is not concerned with the protection of individuals against those losses arising out of
speculative risks. Speculative risk is voluntarily accepted because of its two dimensional nature, which
includes the possibility of gain and loss.
Both pure and speculative risks commonly exist at the same time. For example, the ownership of a
building exposes the owner to both pure risks (for example, accidental damage to the property) and
speculative risk (for example, rise or fall in property values caused by general economic conditions).

Classification of Pure Risks

While it would be impossible to list all the risks confronting an individual or business organization, we
can briefly outline the nature of the various pure risks that we face. For the most part, these are also static
risks. Pure risks that exist for individuals and business firms can be classified under one of the following:
a) Personal Risks. These consist of the possibility of the loss of income or assets as a result of loss the
ability to earn income. In general earning power is subject to four basic perils:

1. Premature death

2. Dependent old age

3. Sickness or disability

4. Unemployment

b) Property risks. Anyone who owns property faces risks simply because such possession can be
destroyed or stolen. Property risks embrace two distinct types of loss: direct loss and indirect or
consequential loss. Direct loss is the simplest to understand. If a house is destroyed by fire, the property
owner loses the value of the house. This is a direct loss. However, in addition to losing the value of the
building itself the property owner no longer has a place to live, and during the time required to rebuild the
house, it is likely that the owner will incur additional expenses living somewhere else. This loss of use of
the destroyed asset is an indirect or consequential loss.

An even better example is the case of a business firm. When a firm's facilities are destroyed, it loses not
only the value of these facilities but also the income that would have been earned through their use.
Property risks, then, can involve three types of losses.
i) the loss of the property

ii) loss of use of the property or its income and

iii) Additional expenses occasioned by the loss of the property.

c) Liability Risk. The basic peril in the liability risk is the unintentional injury of property of others
through negligence or carelessness. However, liability may also result from intentional injuries or damage.
Under our legal system, the laws provide that one who has injured another or damaged another man's
property through negligence or otherwise, can be held responsible for the harm cause. Liability risks
therefore, involve the possibility of loss of present assets or future income as a result of damages assessed
or legal liability arising out of either intentional or unintentional torts or invasion of the rights ofcontractor
to complete a construction project as scheduled or failure of to make payments as expected.
1.6.4. Fundamental Risk versus Particular Risks
The distinction between fundamental and particular risks is based on the differences in origin and
consequences of the losses. Fundamental risks involve losses that are impersonal in origin and
consequence. They are group risks caused by economic, social, and political phenomena, although they
may also result from physical occurrences. They affect large segments or even all of the population. Since
these are group risks, impersonal in origin and effect they are, at least for the individual, unpreventable.
Particular risks involve losses that arise out of individual events and that are felt by individuals rather than
by the entire group. They are risks personal in origin and effect and more readily controlled. Examples of
fundamental risks are those associated with extraordinary natural disturbances such as drought, earthquake
and floods. Examples of particular risks are the risk of death or disability from non-occupational causes,
the risk of property losses by such perils as fire, explosion, theft, and vandalism, and the risk of legal
liability for personal injury or property damage to others.
Since fundamental risks are caused by conditions more or less beyond the control of the individuals who
suffer the losses and since they are not the fault of anyone in particular, it is held that society rather than
the individual has a responsibility to deal with them. Although some fundamental risks are dealt with
through private insurance (for example, earthquake insurance is available from private insurers in many
countries, and flood insurance is frequently include in all risk contracts covering movable personal
property) it is an inappropriate tool for dealing with most fundamental risks, and some form of social
insurance or other transfer program may be necessary.
Particular risks are considered to be the individual's own responsibility, inappropriate subjects for action
by society as a whole. The individual through the use of insurance, loss prevention or some other
technique deals them with.
1.6.5. Objective Risks versus Subjective Risks
Objective risks, or statistical risk, applicable mainly to groups of objects exposed to loss, refer to the
variation that occurs when actual losses differ from expected losses. It may be measured statistically by
some concept in variation, such as the standard deviation. Subjective risk on the other hand, refers to the
mental state of individual who experiences doubt or worry as to the outcome of a given event. It is a
psychological uncertainty that stems from the individual's mental attitude or state of mind.
Subjective risk has been measured by means of different psychological tests, but no widely accepted or
uniform tests of proven reliability have been developed. Thus, although we recognize different degrees of
risk-taking willingness in persons, it is difficult to measure these attitudes scientifically and 5to predict
risk-taking behavior, such as insurance-buying behavior, from tests of risk-taking attitudes.
Subjective risk may affect a decision when the decision-maker is interpreting objective risk. One risk
manager may determine that some given level of risk is "high" while another may interpret this same level
as "low". These different interpretations depend on the subjective attitudes of the decision-makers toward
risk. Thus it is not enough to know only the degree of objective risk; the risk attitude of the decision maker
who will act on the basis of this knowledge must also be know. A person who knows that there is only one
chance in a million that a loss will occur may still experience worry and doubt, and thus would by
insurance, while another would not. For example, Business A insures the plant against fire even though
the premium may be very high, while Business B, a neighbor operating under similar conditions, refuses
the insurance. In this example 12
A can be described as apparently perceiving a higher degree of risk in the given situation and behaving
more conservatively than B. A tends to be a risk averted and B, a risk taker.

Chapter Summary
The word risk is used in many different ways. It can refer to general uncertainty, doubt, an insured object,
or chance of loss. Uncertainty is the doubt a person has concerning his or her ability to predict which of
the many possible outcomes will occur. Uncertainty is a person's conscious awareness of the risk in a
given situation. Risk as differentiated from probability, is a concept in relative variation. Probability refers
to the long-run chance of occurrence, or relative frequency of some event. A peril is a contingency, which
may cause a loss. A hazard, on the other hand, is that condition which creates or increases the probability
of loss from a peril.
There are three basic types of hazards: physical, moral, and morale. A physical hazard is a condition
stemming from the physical characteristics of an object that increases the probability and severity of loss
from given perils. A moral hazard stems from the mental attitude of the insured. A moral hazard is a
condition that increases the chance that some person will intentionally (1) cause a loss or (2) increase its
severity. The moral hazard includes the mental attitude that characterizes an accident-prone person. A
moral hazard is condition that causes persons to be less careful than they would otherwise be.
Risks may be classified in several ways according to their cause, their economic effect, or some other
dimension. A risk that involves financial loss are called financial risk while in others it does not which are
known as non-financial risks. Dynamic risks are those resulting from change the economy whereas, static
risks involve those losses, which would occur even if there are no changes in the economy. A pure risk
exists when there is a chance of loss but no chance of gain.
Further pure risks can be classified as personal risk, property risk and liability risks. Fundamental risks
involve losses that are impersonal in origin and consequence. Particular risks involve losses that arise out
of individual events and that are felt by individuals rather than by the entire group. Objective risks, or
statistical risk, applicable mainly to groups of objects exposed to loss, refer to the variation that occurs
when actual losses differ from expected losses. Subjective risk has been measured by means of different
psychological tests, but no widely accepted or uniform tests of proven reliability have been developed.
 CHAPTER TWO
RISK MANAGEMENT

Chapter objectives
Dear learners, at the completion of this chapter, you should be able to:
 Describe what risk management means
 Understand the objectives of risk management
 Explain the functions of risk management
 Identify the steps in the risk management process

2.1. Introduction
The future is uncertain for everyone, exposed to many risks, and risks are inevitable part of everyday life.
Business firms face risks, unforeseen circumstances that can damage their operational capability or
financial integrity, arising from different perils. Accidental losses happen each day threaten the survival of
the organizations; causes their earnings to dip below acceptable levels, interrupt their operations, or slow
their growth or in a worst-case scenario, cause the organization to close. Worry about these possibilities
does more than make life less pleasant; it may stop a business firm from engaging in certain activities and
otherwise alter how it conducts its operations.
In addition, the environment of modern business, particularly the large industrial unit, is becoming
increasingly complex. Several factors have contributed to the increased complexity of modern enterprise
and have greatly enlarged the risks faced by business. Among these factors are inflation, the growth of
international operations, more complex technology, and increasing government regulation. This increased
complexity creates greater need for special attention to the risks facing the enterprise. Most large
corporations and many smaller ones employ specialized managers to grapple with the problems of
increased risk. Even if a separate risk manager is not employed, someone in the firm performs risk
management functions such as insurance buying or loss control.
2.2. Meaning of risk management
Risk management is a systematic process for the identification, evaluation of pure loss exposures faced by
an organization or individual and for the, selection, and implementation of the most appropriate techniques
for treating such exposure.
It is a scientific approach to deal with pure risks by anticipating possible accidental losses and designing
and implementing procedures that minimize the occurrence of loss or the financial impact of the losses
that do occur. Risk management focuses on a part of the total bundle of risks, those that are classified as
“pure risk”. As a general rule, the risk manager is concerned only with the management of pure risks, not
speculative risks. All pure risks are considered, including those that are uninsurable. Hence, risk
management is the identification, measurement and treatment of property, liability and personnel pure risk
exposures.
Understanding risk and application of risk management techniques is a very important aspect to
effectively deal with uncertainty and associated risk. And
 Proper risk management enables a business firm to handle its exposure to accidental losses in the
economic and effective way.
 It enables companies to react in early stage of change in environment and avoiding possible crises.
 It also enables a business firm to handle better its ordinary business risk, and
 It contributes to the survival and profitability of a business.

2.3. Objectives of Risk Management

The first step in the risk management process is the determination of the objectives of the risk
management program, which is, deciding precisely what it is that the organization expects its risk
management program to do. This step is often overlooked, with the result that the risk management
program is less effective than it could be. In the absence of coherent objectives, there is a tendency to view
the risk management process as a series of individual isolated problem, rather than as one single problem
and there are no guidelines to provide for a logical consistency in dealing with the risks that the
organization face. Risk management objectives serve as a prime source of guidance for those charged with
responsibility for the program and also serve as a means of evaluating performance.
Risk management has several important objectives that can be classified into two categories:
I. Pre-loss objectives

II. Post-loss objectives

I. Pre-loss objectives
A firm or an organization has several risk management objectives prior to the occurrence of a loss. The
most important includes:
A. Economy

B. Reduction in anxiety

C. Meeting external obligations

A. Economy
Economy means that the firm should prepare for potential losses in the most economical possible way.
This involves an analysis of safety program expenses, insurance premiums and the costs associated with
the different techniques for handling losses.
B. Reduction in anxiety
Certain loss exposures can cause greater worry and fear for the risk manager, key executives and
stockholders than other exposures. For example, the threat of a catastrophic lawsuit from a defective
product can cause greater anxiety and concern than a possible small loss from a minor fire. However, the
risk manager wants to minimize the anxiety and fear associated with all loss exposures.
C. Meeting external obligations
This objective is to meet any externally imposed obligations. This means the firm must meet certain
obligations imposed on it by outsiders. For example, government regulations may require a firm to install
safety device to protect workers from harm. Similarly, a firm’s creditors may require that property pledged
as collateral for a loan must be insured. The risk manager must see that these externally imposed
obligations are met.
II. Post-loss objectives
The most important post-loss objectives of the firm are:
A. Survival

B. Continuity of operations

C. Earnings stability

D. Continued growth

E. Social responsibility
A. Survival
The first and most important post-loss objective is survival of the firm. Survival means that after a loss
occurs, the firm can at least restart partial operation within some reasonable time period if it chooses to do
so.
B. Continuity of operations
For some firms, the ability to operate after a sever loss is an extremely important objective. This is
particularly true for certain firms, such as a public service firm, which must continue to provide service.
The ability to operate is also important for firms that may lose customers if they cannot operate after a loss
occurs.
C. Earnings stability
The firms want to maintain its earnings per share after a loss occurs. Earnings per share can be maintained
if the firm continues to operate. However, there may be substantial costs involved in achieving this goal
(such as operating at another location), and perfect stability of earnings may not be attained.
D. Continued growth
A firm may grow by developing new products and markets or by acquisitions and mergers. The risk
manager must consider the impact that a loss will have on the firm’s ability to grow.
E. Social responsibility
The goal of social responsibility is to minimize the impact that a loss has on other persons and on society.
A severe loss can adversely affect employees, customers, suppliers, creditors and the community in
general. For example, a severe loss requires shutting down a plant in a small community for an extended
period can lead to depressed business conditions and substantial unemployment in the community.

2.4. Functions of Risk Management

At one-time business enterprises paid little attention to the problem of handling risk. Insurance policies
were purchased on a haphazard basis, with considerable over lapping coverage on hand, and wide gaps in
coverage of important exposures on the other.
Little control over the cost of losses and insurance premium was exercised. Many risks were assumed
when they should have been insured and vice versa. It was gradually realized that greater attention to this
aspect of business management would yield great dividends. Instead of having insurance decision handled
by a busy executive whose primary responsibility lay in another area, management began to assign this
responsibility first as a part-time job to an officer, perhaps the treasurer, and later as a full time position.
As the full scope of responsibility for risk management was realized, an insurance department was
established, with several people employed. At first the department manager was usually known as the
insurance buyer. Later the title was changed to insurance manager or risk manager.
Many different titles, including insurance buyer, are still used, but the tendency is to reflect the broader
nature of the manager's duties and responsibilities. Assistants to the insurance manager often include
specialists in various branches of insurance, law, statistics, and personal relations.
In general, the functions of the risk manager include the following:
1. To recognize exposures to loss, the risk manager must first of all be aware of the possibility of each
type of loss. This is a fundamental duty that must precede all other functions. Before other functions
potential loss exposures must be identified.

2. To estimate the frequency and size of loss; that is, to estimate the probability of loss from various
sources.

3. To decide the best and most economical method of handling the risk of loss, whether it be by
assumption, avoidance, self-insurance, reduction of hazards, transfer, commercial insurance, or some
combination of these methods.

4. To decide the best and most economical method of handling the risk of loss, including the tasks of
constant re-evaluation of the programs, record keeping, and the like.

It is the responsibility of the risk manager to see that the concern's profits are not lost because of the
occurrence of a peril which could have been insured against or otherwise adequately handled.
2.5. Risk Management Process
In order to have an effective risk management program, there are certain steps that must be followed. The
following four procedures are significant in the risk management process.

 Risk Identification
 Risk Measurement
 Selecting the Appropriate Technique for Handling Losses
 Implementing and Administrating the Risk Management Program
2.5.1. Risk Identification
The first step in business risk management is to identify the various types of potential losses confronting
the firm; the second step is to measure these potential losses with respect to such matters as their
likelihood of occurrence and their probable severity.
Risk identification is the process by which a business systematically and continuously identifies property,
liability, and personnel exposures as soon as or before they emerge. Unless the risk manager identifies all
the potential losses confronting the firm, he will not have any opportunity to determine the best way to
handle the undiscovered risks. The business will unconsciously retain these risks, and this may not be the
best or even a good thing to do.
In one way or another, the risk manager must dig into the operations of the concern and discover the risks
to which the organization is exposed. To identify all potential losses the risk manager needs first a
checklist of all the losses that could occur to any business. To reduce the possibility of overlooking
important risks, most risk managers use some systematic approach to the problem of risks identification.
These tools include:
A. Insurance Policy Checklists

B. Loss Exposure Checklists

C. Risk Analysis Questionnaires

D. Flow Charts

E. Analysis of Financial Statements and

F. Inspections of the Firm’s Operation

G. Interactions with other Departments

A. Insurance Policy Checklists

Insurance Policy Checklists provide a listing of all the various policies or types of insurance that may be
needed by a business. Since only insurable risks are listed in insurance policy checklists, they are not
effective in identifying uninsurable pure risks
Insurance policy checklists can be sourced from insurance companies and other publishers.
B. Loss Exposure Checklists
Loss Exposure Checklists provide a listing of common risk exposures of a firm. An exposure checklist is a
very simple but effective tool for risk identification. In fact, it is one of the most common tools used for
identifying and analyzing risk. Loss exposure checklists are available from various sources, such as
insurer, agencies and risk management associations. These checklists are containing possible source of
loss to the business firm from the damage of physical and intangible assets. Sources of loss are organized
according to whether the loss is predictable or unpredictable, controllable or uncontrollable, direct or
indirect or from different types of legal liability. Then, the risk manger needs a systematic approach to
discover which of the potential losses included in the checklist are faced by his/ her business. This is done
by ask the question “is this a potential source of loss in our firm?” after each item. Use of such a list
reduces the likelihood of overlooking important sources of loss.
C. Risk Analysis Questionnaires
Risk Analysis Questionnaires aim at identifying the risks faced by an organization. A series of well-
developed and well-formulated questions are put forth to respondents. The answers indicate risk areas and
specific risks.
Example: are company-owned vehicles provided to directors, executives or employees for business and
personal use? if so, to what extent?
D. Flow Charts
Flow Charts are graphic representations of a sequential process. A flow chart depicting the operations of a
firm can guide a risk manager to risks associated with those operations.
First, a flow chart or series of flow charts is constructed, which shows all the operations of the firm,
starting with raw materials, electricity and other inputs at suppliers’ locations and ending with finished
products in the hands of customers. For example, the following flow chart shows the major operations of a
hypothetical firm.

Second, the checklist of potential property, liability and personnel losses is applied to each property and
operation shown in the flow chart to determine which losses the firm faces. For example, Figure 2.1
suggests, among others, the following potential losses:
Property losses:
Replacement or repair of trucks, manufacturing plant, machinery, raw materials, goods in process, or
finished goods, subject to physical and human perils on the manufacturing premises or in transit.

Shutdown or slowdown of manufacturing operations, because of direct property losses

Liability losses:
Liability for bodily injury or property damage to customers because of defective products, to visitors
because of defects in the premises and to other because of negligent operation of the firm’s trucks

Legal responsibility under the workers’ compensation law for bodily injuries to employees
Personnel losses:
Losses to firm because of death or disability of key employees

Losses to families of employees because of death, poor health, retirement or unemployment of employees
E. Analysis of Financial Statements
By analyzing the balance sheet, operating statements and supporting documents; the risk manager can
identify property, liability and human asset loss exposures of the organization. By coupling these
statements with financial forecasts and budget, the risk manager can discover future exposures. Financial
statements reveal this information because every organizational transaction ultimately involves either
money or property.
F. On-site Inspections
On-site Inspections are necessary for the risk manager. By observing firsthand the organization’s facilities
and the operations conducted thereon, the risk manager can learn much about the risk exposures faced by
the firm.
G. Interactions with other Departments
Interactions with other departments provide another source of information on exposures to risk. These
interactions may include oral or written reports from other departments on their own initiative or in
response to a regular reporting system that keeps the risk manager informed of development. The
importance of such a communications network should not be underestimated. These departments are
constantly creating or becoming aware of exposures that might otherwise get away the risk manager’s
attention. Indeed the risk manager’s success in risk identification is heavily dependent upon the
cooperation he/she secure from other departments.
The Best Method
No single method or procedure of risk identification is free of weakness or can be called perfect. The
strategy of management must be to employ that method or combination of methods that best fits the
situation at hand. The choice is a function of
(1) The nature of the business

(2) The size of the business and

(3) The availability of in house expertise

For example, smaller firms that cannot afford to have the task done by specialists in their own
management structure use published checklists and outsiders more frequently. Larger firms with a more
sophisticated risk management department may show more originality in identifications procedure.
The preferred approach to risk identifications is a combination approach, in which all available tools listed
are brought to bear on the problem. In a sense, tools such as insurance policy checklists and risk analysis
questionnaires, flow charts, and the analysis of financial statements can provide a part to the puzzle and
together they can be of considerable assistance to the risk manager. However, no individual method or
combination of methods can replace the diligence and imagination of the risk manager in discovering the
risk to which the firm is exposed. Because risks may lurk in many sources, the risk manager needs a wide-
reaching information system, designed to provide a continual flow of information about changes in
operations, the acquisition of new assets, and changing relationships with outside entities.
2.5.2. Risk Measurement

After the risk manager has identified the various types of potential losses faced by his firm, these
exposures must be measured. Risk measurement is required by the risk manager for two purposes: i) to
determine the relative importance of potential losses and ii) To obtain information that will help him to
decide upon the most desirable combination of risk management tools.
Dimensions to be measured
Information is needed concerning two dimension of each exposure:
i) The loss frequency or the number of losses that will occur and

ii) The severity of losses. The total impact of these losses if they should be retained, not only their dollar
values, should be included in the analysis.
Why we need Each Dimension
Both loss-frequency and loss-severity data re needed to evaluate the relative importance of an exposure to
potential loss. Contrary to the views of most persons, however, the importance of an exposure to loss
depends mostly upon the potential loss severity, not the potential frequency. A potential loss with
catastrophic possibilities, although infrequent, is far more serious than one expected to produce frequent
small losses and no large losses.
On the other hand, loss frequency cannot be ignored. If two exposures are characterized by the same loss
severity, the exposure whose frequency is greater should be ranked more important. An exposure with a
certain potential loss severity may be ranked above a loss with a slightly higher severity because the
frequency of the first loss is much greater than that of the second. There is no formula for ranking losses in
order of importance, and different persons may develop different rankings. The rational approach,
however, is to place more emphasis on loss severity.
An example may clarify the point. The chance of an automobile collision loss may be greater than the
chance of being sued as a result of the collision, but the potential severity of the liability loss s so much
greater than the damage to the owned automobile that there should be no hesitation in ranking a liability
loss over the property loss.
Why we need Each Dimension
Both loss-frequency and loss-severity data re needed to evaluate the relative importance of an exposure to
potential loss. Contrary to the views of most persons, however, the importance of an exposure to loss
depends mostly upon the potential loss severity, not the potential frequency. A potential loss with
catastrophic possibilities, although infrequent, is far more serious than one expected to produce frequent
small losses and no large losses.
On the other hand, loss frequency cannot be ignored. If two exposures are characterized by the same loss
severity, the exposure whose frequency is greater should be ranked more important. An exposure with a
certain potential loss severity may be ranked above a loss with a slightly higher severity because the
frequency of the first loss is much greater than that of the second. There is no formula for ranking losses in
order of importance, and different persons may develop different rankings. The rational approach,
however, is to place more emphasis on loss severity.
An example may clarify the point. The chance of an automobile collision loss may be greater than the
chance of being sued as a result of the collision, but the potential severity of the liability loss s so much
greater than the damage to the owned automobile that there should be no hesitation in ranking a liability
loss over the property loss.
A particular type of loss may also be subdivided into two or more kinds of losses depending upon whether
the loss exceeds a specified dollar amount. For example, consider the collision loss cited in the preceding
paragraph. This loss may be subdivided into two kinds of losses: i) collision losses of $100 (for some
other figure) or less and ii) losses over $100. Losses in the second category are the more important,
although they are less frequent. Another illustration would be the losses associated with relatively small
medical expenses as contrasted with extremely large bills. Such a breakdown by size of loss shows clearly
the desirability of assigning more weight to loss severity than to loss frequency.
In determining loss severity the risk manager must be careful to include all the types of losses that might
occur as a result of a given event as well as their ultimate financial impact upon the firm. Often, while the
less important types of losses are obvious to the risk manager, the more important types are much more
difficult to identify. The potential direct property losses are rather generally appreciated in advance of any
loss, but the potential indirect and net income losses (such as the interruption of business while the
property is being repaired) they may result from the same event are commonly ignored until the loss
occurs.
The ultimate financial impact of the loss is even more likely to be ignored in evaluating the dollar value of
any loss. Relatively small losses, if retained, cause only minor problems because the firm can meet these
losses fairly easily out of liquid assets. Somewhat larger losses may cause liquidity problems which in turn
may make it more difficult or more costly for the firm to borrow funds required for various purposes.
Finally, very large losses may have serious adverse affects upon the firm's financial planning, and their
dollar impact may be much greater than it would be for a firm that could more easily absorb these losses.
Ultimately the loss could be the ruin of the business as a going concern.
To illustrate, a fire could destroy a building and its contents valued at $300,000; the ensuing shutdown of
the firm for six months might cause another $360,000 loss. This $660,000 loss of the difference between
the going-concern values of the business, say $2,400,000, and the value for which the remaining assets
could be sold, say $1,500,000, causing a $900,000 loss. 28
Finally, in estimating loss severity, it is important to recognize the timing of any losses as well as their
total dollar amount. For example, a loss of $5,000 a year for 20 years is not as severe as immediate loss for
$100,000 because of:
i) The time value of money, which can be recognized by discounting future dollar losses at some assumed
interest rate, and

ii) The ability of the firm to spread the cash outlay over a longer period.

Loss-frequency and loss-severity data do more than identify the important losses. They are also extremely
useful in determining the best way or ways to handle an exposure to loss. For example, the average loss
frequency times the average loss severity equals the total dollar losses expected in an average year. These
average losses can be compared with the premium the firm would have to pay an insurer for complete or
partial protection.
Proudly Measure of Severity
Measurement of the severity of risk is essential for ranking risks based on severity. One of the systems
used to measure the severity of risk is the Prouty measure of severity. It was suggested by Richard
Proudly, a risk manager. The two measures suggested by Prouty to measure loss severity are the maximum
possible loss to one unit per occurrence and the maximum probable loss to one unit per occurrence. The
maximum possible loss is the worst loss that could possibly happen to a firm. The maximum probable loss
is the worst loss that is likely to happen. The maximum probable loss, therefore, is usually less than the
maximum possible loss.
Priority Ranking Based on Severity
The process of risk evaluation ranks risks as per the severity (importance) of losses. The more severe the
losses due to risk the higher the rank, as the relative severity of losses differs, not all losses warrant equal
attention. Some are to be given priority over others. Under such circumstances, risks can be classified into
three head.
 Critical risks
 Important risks
 Unimportant risks

Critical risks include those loss exposures to loss where the magnitude of losses could lead to
bankruptcy.

Important risks include those exposures in which the possible losses would not lead to bankruptcy, but
would require the individual or firm to borrow in order to continue operations.
Unimportant risks include those exposures in which the possible losses could be met out of the existing
assets or current income without imposing too much financial damage.

2.5.3. Selecting the Appropriate Technique for Handling Losses (Risk control & risk financing
techniques)
Once potential exposure facing the firm has identified and measured, the next step is deciding how to
handle them. There are two basic approaches: risk control and risk financing measures.
First, the firm can use risk control measures to alter the exposures in such away as:
(i) To reduce the firm’s expected losses or
(ii) To make the annual loss experience more predictable.
These measures include:
a. Avoidance

b. Loss control

c. Separation/diversification/ and

d. Combination (pooling)

Second, the firm can use financing measures to finance the losses that do occur. These risk-financing
tools include:
a. Retention/assumption/

b. Self-insurance

c. Non-insurance transfer and

d. Insurance
I. Risk Control techniques
Risk control techniquesattempt to reduce the frequency and severity of accident to the firm.
A. Avoidance (discarding risky activities or properties)

Avoidance means that a certain loss exposure is never acquired, or an existing loss exposure is
abandoned. One way to control a particular risk is to avoid the property, person or activity-giving rise to
possible loss by either refusing to assume it even for a short time or by abandoning an exposure to loss
assumed earlier. The first of these avoidance activities is proactive avoidance, while the second is
abandonment. If a business does not want to be concerned about potential property losses to a building or
to cars, it can avoid these risks by never acquiring any interest in a building or cars. An existing loss
exposure may also be abandoned. For example, a pharmaceutical firm that produces a drug with
dangerous side effects may stop manufacturing that drug. Avoidance should be distinguished from loss-
control measure. Loss control measures assume that the firm will retain the property, person or activity
creating the risk but that firm will conduct its operation in the safest possible manner.
Avoidance is a useful, fairly common approach to the handling of risk. By avoiding a risk exposure, the
firm knows that it will not experience the potential losses or uncertainties that exposure may generate. On
the other hand, it also loses the benefits that may have been derived from that exposure.
Some characteristics of avoidance (it may be sometimes impossible, impractical, &creates another risk)
i. Avoidance may be impossible

The broadly the risk is defined; the more likely this is to be so. For example, the only way to avoid all
liability exposures is to cease to exist.
ii. The potential benefits to be gained from employing certain persons, owing a piece of property or
engaging in some activity may so far outweigh the potential losses and uncertainties involved that the risk
manager will give due consideration to avoiding the exposure. For instance, most businesses would find it
almost impossible to operate without owning or renting automobiles/cars. Therefore, they consider
avoidance to be impractical approach.

iii. Avoiding a risk may create another risk. For example, a firm may avoid the risks associated with air
shipments by substituting train and truck shipments. In the process, however, it has created some new
risks.
B. Loss Control

Loss control activities are intended to reduce both the frequency and severity of losses. Loss control
measures attack risk by lowering the chance that a loss will occur or by reducing its severity if it
does occur. Loss control has the unique ability to prevent or reduce losses for the individual, firm and
society while permitting the firm to commence or continue the activity creating the risk. Loss control deals
with an exposure that the firm does not wish to abandon. The purpose of loss control activities is to change
the characteristics of the exposure so that it is more acceptable to the firm; the firm wishes to keep the
exposure but want to reduce the frequency and severity of losses.
Loss prevention and loss reduction methods
Loss prevention programs seek to reduce or eliminate the chance of loss. Loss reduction programs
seek to reduce the potential severity of the loss.
The variety of loss prevention programs are illustrated below:
o The chance of fire can be reduced by fire-resistive construction, building in an area where there are
few external dangers
o The chance of a product liability suit can be reduced by tightening the quality control limits and
choosing distributors more carefully and
o Other examples of loss prevention programs include Periodic physical examinations for
employees, Internal accounting control and speed limit for vehicles etc.

Loss reduction program include:

Automatic sprinklers to minimize a fire loss by spraying water or some other substance upon a fire soon
after it starts in order to confine the damage to a limited area

Alternative facilities to reduce the net income losses arising out of direct losses to the original facilities

Immediate first aid for persons injured on the premises

Medical care and rehabilitation programs for injured workers

Fire alarms

Speed limits for motor vehicles etc

C. Separation/ Diversification/
Another risk control tool is separation of the firm’s exposures to loss instead of concentrating them at one
location where they might all be involved in the same loss. For example instead of placing
its entire inventory in one warehouse, a firm may elect to separate this exposure by placing equal parts of
the inventory in ten widely separated warehouses. If the fire destroys one warehouse, the firm will have
others from which to draw needed supplies.
To the extent that this separation of exposures reduces the maximum probable loss to one event, it may be
regarded as a form of loss reduction. The probability of some loss actually increases. The probability that
at least one of several units will suffer a loss is greater than the probability that any particular unit will
suffer a loss. Emphasis is placed here, however, on the fact that through this separation the firm increases
the number of independent exposure units under its control.

D. Combination
Combination or pooling makes loss experience more predictable by increasing the number of exposure
units. The difference is that unlike separation, which spreads a specified number of exposure units,
combination increases the number of exposure units under the control of the firm.
One way a firm can combine risk is to expand through internal growth. Combination also occurs when two
firms merge or one acquires another. The new, firm has more buildings, more automobiles and more
employees than either of the original companies.
II. Risk financing techniques
Risk financing techniques designed for the funding of accidental losses after they occur.
A. Retention/ assumption/
The most common method of handling risk is retention by the organization. The source of the funds is the
organization itself including borrowed funds that the organization must repay. Retention may be passive
or active, unconscious or conscious, planned or unplanned.
 Retention is passive or unplanned when the risk manager is not aware that the exposure exists and
consequently does not attempt to handle it. By default, therefore, the organization has elected to retain the
risk associated with that exposure. Few organizations have identified all their exposures to property,
liability and human resource losses. Consequently, some unplanned retention is common and perhaps
inevitable. If the risk identification has been poorly performed, too much risk is passively retained. A
related form of unplanned retention occurs when the risk manager has properly recognized the exposures
but has underestimated the magnitude of the potential losses.
 Retention is active or planned when the risk manager considers other methods of handling the risk and
consciously decides not to transfer the potential losses. Self-insurance is a special case of active or
planned retention. Self-insurance is not insurance, because there is no transfer of the risk to an outsider.

Retention can be effectively used in risk management program when the following three conditions
exist.
I) when no other method of treatment is available

Insurers may be unwilling to write a certain type of coverage, the coverage may be too expensive, or
noninsurance transfers may not be available. In addition, although loss control can reduce the frequency of
loss, not all losses can be eliminated. In these cases, retention is a residual method.
ii) When the worst possible loss is not serious
For example, physical damage losses to automobiles in a large firm’s fleet will not bankrupt the firm if the
automobile are separated by wide distances and are not likely to be simultaneously damaged.
iii) When losses are highly predictable
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.
B. 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. A better name for self-insurance is self-funding, which expresses more clearly the
idea that losses are funded and paid by the firm.
A self-insurance plan implies that adequate financial arrangement have been made in advance to provide
funds to pay for losses if they occur.
Captive (locked up) insurers
One approach to self-insurance involves the use of a company formed to write insurance for a parent,
called captive insurance company. A captive insurer is an insurer that is owned by the insured. A captive
insurer is established and owned by a parent firm for the purpose of insuring the parent firm’s loss
exposures. The parent organization establishes a captive insurance subsidiary that writes insurance against
the parents’ insured risks.
Captive insurers are formed for several reasons, including the following:
 Difficulty in obtaining insurance
The parent firm may have difficulty in obtaining certain types of insurance from commercial insurers, so it
forms its own captive insurer to write the coverage. Establishing a captive may also reduce insurance costs
because of lower operating expenses, avoidance of an agent’s or broker’s commission and interest earned
on invested premiums and reserves that otherwise would be received by commercial insurers.
 Easier access to a reinsurer

A captive insurer has easier access to reinsurance, since many reinsurers will deal only with insurance
companies and not insured.
 Profit center

A captive insurer can be a source of profit by insuring other parties as well as providing insurance to the
parent firm and subsidiaries.
C. Noninsurance transfers
Noninsurance transfers are a methods other than insurance by which a pure risk and its potential
financial consequences are transferred to another party. Neutralization or hedging and hold-harmless
agreements are examples of noninsurance transfer of risk.
Neutralization or Hedging
As generic terms, neutralization and hedging describe actions whereby a possible gain is balanced against
a possible loss. Neutralization is the process of balancing a chance of loss against a chance of gain. For
example, a person who has bet that a certain team will win the World Cup may neutralize the risk involved
by also placing a bet on the opposing team. In other words, he or she transfers the risk to the person who
accepts the second bet.
The nature of hedging is to take two simultaneous positions that offset each other. So that no matter what
the outcome is of some event based on chance, the hedger neither wins nor loses. Because there is no
chance of gain associated with pure risks, neutralization or hedging is not a tool of pure risk management.
Hold-harmless agreements are contract entered into prior to a loss, in which one party agrees to assume
a second party’s responsibility if a loss occurs. For example, contractors may require subcontractors to
provide the contractor with liability protection if they are sued because of the subcontractor’s activities. 35
D. Insurance
Commercial insurance is also used in a risk management program. From the risk manager’s viewpoint,
insurance represents a contractual transfer of risk. 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. These are:
 Selection of insurance coverage
  Selection of an insurer
 Negotiation of terms
 Dissemination of information concerning insurance coverage
 Periodic review of the insurance program

I. Selection of insurance coverage

The risk manager must select the insurance coverage needed. Since there may not be enough money in the
risk management budget to insure all possible losses, the need for insurance can be divided into several
categories depending on importance. One useful approach is to classify the need for insurance into three
categories:
a. Essential insurance includes those coverage required by law or by contract, such as workers
compensation insurance. Essential insurance also includes those coverage that will protect the firm against
a catastrophic loss or a loss that threatens the firm’s survival.

b. Desirable or important insurance is protection against losses that may cause the firm financial
difficulty, but not bankruptcy. Desirable insurance coverages include those that protect against loss
exposures that would force the firm to borrow or resort to credit.

c. Available or optional insurance is coverage for slight losses that would merely inconvenience for the
firm. Optional insurance coverages include those that protect against losses that could be met out of
existing assets or current income.

II. Selection of an insurer

The risk manager must select an insurer or several insurers. Several important factors should have to be
considered. These include the financial strength of the insurer, risk management services provided by the
insurer, and the cost and terms of protection.
III. Negotiation of terms
After the insurer or insurers are selected, the terms of the insurance contract must be negotiated. If printed
polices, endorsements, and forms are used, the risk manager and insurer must agree on the Document that
will form the basis of the contract.
If a specially tailored manuscript policy is written for the firm, the language and meaning of the
contractual provisions must be clear to both parties. In any case, the various risk management services the
insurer will provide must be clearly stated in the contract. Finally, if the firm is large, the premiums may
be negotiable between the firm and insurer.
IV. Dissemination of information concerning insurance coverage
Information concerning insurance coverage must be disseminated to others in the firm. The firm’s
employees and managers must be informed about the insurance coverages, the various records that must
be kept, the risk management services that the insurer will provide and the changes in hazards that could
result in a suspension of insurance. Those persons responsible for reporting a loss must also be informed.
The firm must comply with policy provisions concerning how notice of a claim is to be given and how the
necessary proofs of loss are to be presented.
V. Periodic review of the insurance program
The insurance program must be periodically reviewed. The entire process of obtaining insurance must be
evaluated periodically. This involves an analysis of agent and broker relationships, coverages needed, cost
of insurance, quality of loss-control services provided, whether claims are paid promptly and numerous
other factors. Even the basic decision-whether to purchase- insurance must be reviewed periodically.
Which method should be used?
In determining the appropriate method or methods for handling losses, a matrix can be used that classifies
the various loss exposures according to frequency and severity. The matrix can be useful in determining
which risk management method should be used.
The first loss exposure is characterized by both low frequency and low severity of loss. This type of
exposure can be best handled be retention, since the loss occurs infrequently and when it does occur, it
seldom causes financial harm.
The second type of exposure which is characterized by high frequency and low severity of losses is more
serious. Loss control should be used here to reduce the frequency of losses. In addition, since losses occur
regularly and are predictable, the retention technique can also be used.
The third type of exposure can be met by insurance. 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 these types of exposure
include fires, explosions and liability lawsuits.
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.
2.5.4. Implementing and Administrating the Risk Management Program
The fourth step is implementation and administration of the risk management program. Typical activities
of a risk manager include identifying and evaluating loss exposures, establishing procedures for handling
insurance claims, designing and installing employee benefit plans, participating in loss control and safety
programs, and administering group insurance and self-insurance programs. Thus, risk managers are an
important part of the management team.
Periodic Review and Evaluation
To be effective, the risk management program must be periodically reviewed and evaluated to determine if
the objectives are being attained. In particular, risk management costs, safety programs, and loss
prevention programs must be carefully monitored. Loss records must be examined to detect any changes
in frequency and severity. In addition, new developments that affect the original decision on handling a
loss exposure must be examined. Finally, the risk manager must determine if the firm’s overall risk
management policies are being carried out and if the manager is receiving the total cooperation of the
other deportments in carrying out the risk management functions.

Chapter summary
Risk management is a systematic process for the identification, evaluation of pure loss exposures faced by
an organization or individual and for the, selection, and implementation of the most appropriate techniques
for treating such exposure. Understanding risk and application of risk management techniques is a very
important aspect to effectively deal with uncertainty and associated risk. Risk management has several
important objectives that can be classified into two categories (1) pre-loss objectives (2) post-loss
objectives. The pre-loss objectives include economy, reduction in anxiety and meeting external
obligations. The post –loss objectives consists of survival, continuity of operations, earnings stability,
continued growth and social responsibility.
The functions of the risk manager include recognizing exposures to loss, estimating the frequency and size
of loss, deciding the best and most economical method of handling the risk of loss, decide the best and
most economical method of handling the risk of loss. The risk management process includes (a) risk
identification (b) risk Measurement (c) selecting the appropriate technique for handling losses (d)
implementing and administrating the risk Management Program.
Most risk managers use some systematic approach to the problem of risks identification. These tools
include: insurance policy checklists, loss exposure checklists, risk analysis questionnaires, flow charts,
analysis of financial statements and, inspections of the firm’s operation, interactions with other
departments.
After the risk manager has identified the various types of potential losses faced by his firm, these
exposures must be measured. Risk measurement is required by the risk manager for two purposes: i) to
determine the relative importance of potential losses and ii) To obtain information that will help him to
decide upon the most desirable combination of risk management tools. In measuring possible risk
exposures Information is needed concerning two dimension of each exposure: (1) The loss frequency or
the number of losses that will occur and (2) The severity of losses. The total impact of these losses if they
should be retained, not only their dollar values, should be included in the analysis. Measurement of the
severity of risk is essential for ranking risks based on severity. The more severe the losses due to risk the
higher the rank, as the relative severity of losses differs, not all losses warrant equal attention. Some are to
be given priority over others. such circumstances, risks can be classified into three as critical risks ,
important risks ,unimportant risks.
Once potential exposure facing the firm has identified and measured, the next step is deciding how to
handle them. There are two basic approaches: risk control and risk financing measures.
Risk control techniques attempt to reduce the frequency and severity of accident to the firm. Risk
financing techniques designed for the funding of accidental losses after they occur.
Risk control techniques includes avoidance, loss control, separation/diversification/ and combination
(pooling). Risk financing techniques consists of retention/assumption/, self-insurance, non-insurance
transfer and insurance.
The fourth step is implementation and administration of the risk management program. Typical activities
of a risk manager include identifying and evaluating loss exposures, establishing procedures for handling
insurance claims, designing and installing employee benefit plans, participating in loss control and safety
programs, and administering group insurance and self-insurance programs.