RMIN 4000 Chapter 3

Introduction to Risk Management

• Course: RMIN 4000

• Chapter: 3

• Instructor: Daniel Brown

• Institution: Terry College of Business, University of Georgia

Risk Management Process

• Definition: Identifies loss exposures faced by an organization and selects the most appropriate techniques for treating such exposures.

Loss Exposure

• Definition: A situation or circumstance where a loss is possible, irrespective of whether the loss actually occurs.

Steps in the Risk Management Process

1. Identify loss exposures.

2. Measure and analyze the loss exposures.

3. Consider and select the appropriate risk management techniques.

4. Implement and monitor the chosen techniques.

Step 1: Identify Loss Exposures

• Key Questions:

  • What assets need protection?

  • What perils are those assets exposed to?

• Importance: This is the most crucial step in the risk management process.

Sources for Identifying Loss Exposures

• Loss history

• Financial statements

• Other firms/competitors

• Risk management consultants

• Surveys/questionnaires

• Inspections

• Contract analysis

• Flowcharts

Step 2: Measure and Analyze the Loss Exposures

Measure

• Estimate both frequency and severity of loss exposures:

  • Frequency (probability): How often loss occurs?

  • Severity (outcome): Cost when a loss does occur.

Analyze

• Rank loss exposures based on relative importance:

  • Severity is prioritized over frequency.

• Key Metrics:

  • Maximum Possible Loss: Worst-case scenario for the firm’s lifetime.

  • Probable Maximum Loss (PML): Most likely worst loss.

Step 3: Consider and Select Risk Management Techniques

Risk Control Techniques

• Aim: To reduce the frequency or severity of losses.

Risk Financing Techniques

• Aim: To fund losses when they occur.

Risk Control Techniques

1. Avoidance

2. Loss Prevention

3. Loss Reduction

4. Duplication

5. Separation

6. Diversification

Risk Control - Avoidance

• Definition: Avoiding or abandoning a certain loss exposure.

• Advantages:

  • Frequency is reduced to 0.

• Disadvantages:

  • May not be feasible.

  • Opportunity costs and potential for creating new exposures.

Risk Control - Loss Prevention

• Purpose: Measures that lower the frequency of specific losses without eliminating risk.

Risk Control - Loss Reduction

• Purpose: Measures that lessen the severity of a loss with no effect on frequency.

Risk Control - Duplication

• Definition: Keeping backups or copies of essential documents or properties to mitigate loss.

Risk Control - Separation

• Definition: Dividing assets to minimize the impact of a single event.

• Examples include firewalls and multiple warehouse strategies.

Risk Control - Diversification

• Purpose: Spreading loss exposure among various parties, securities, or transactions to reduce the chance of loss.

Risk Financing Techniques

1. Retention

2. Noninsurance Transfer

3. Insurance

Risk Financing - Retention

• Definition: Maintaining part or all of the potential losses.

• Retention Levels: Amount of losses to retain.

• Types:

  • Active Retention: Deliberate decision to retain risk.

  • Passive Retention: Unintentional retention of risk.

• When to Retain:

  • Difficult to insure risks.

  • Low severity losses.

  • Predictable losses with high frequency.

Risk Financing – Retention (Types)

• Unfunded Retention

• Funded Reserve

• Deductible

• Captive Insurer

• Self-Insurance

• Risk Retention Groups

Risk Financing – Captive Insurer

• Definition: An insurer owned by a parent firm to cover its loss exposures.

• Types:

  • Single-parent captive: Owned by one parent.

  • Association/group captive: Owned by multiple parents.

Advantages of Captive Insurers

• Cost-effective when traditional insurance is expensive/difficult to obtain.

• Lower costs due to reduced commissions and interest on premiums.

• Easier access to the reinsurance market.

• Possibility of lower tax rates and favorable regulations.

Risk Financing – Self-Insurance

• Special form of planned retention by which losses are retained by the firm.

• Risk retention group: A group captive writing liability coverage excluding certain forms (workers compensation, personal lines).

Risk Financing - Retention

• Summary: Risk Managers must evaluate potential costs before choosing retention.

• Advantages: Save on loss costs, expenses, encourage loss prevention.

• Disadvantages: Possible higher losses, expenses, and taxes.

Risk Financing – Noninsurance Transfer

• Definition: Transfer of pure risk and financial consequences without insurance.

• Example Methods: Contracts, leases, hold-harmless agreements.

Noninsurance Transfer: Advantages & Disadvantages

• Advantages: Potentially less expensive, can transfer non-insurable losses.

• Disadvantages: Ambiguous contract language may lead to failure; responsibility remains if the other party cannot cover losses.

Risk Financing – Insurance

• Best suited for low-frequency, high-severity loss exposures.

• Emphasis on:

  1. Insurance coverage selection

  2. Insurer selection

  3. Negotiation of terms

  4. Dissemination of coverage information

  5. Periodic program reviews

Risk Financing – Insurance (Key Terms)

• Deductible: Amount deducted from loss payment to the insured.

• Excess Insurance: Coverage that kicks in after a predetermined loss limit.

• Manuscript Policy: Tailored insurance policy for specific needs.

Insurance Advantages & Disadvantages

• Advantages:

  • Indemnification for losses, business continuity, reduced uncertainty, tax-deductible premiums.

• Disadvantages:

  • Premium costs, negotiation efforts, potential laxity in loss control due to coverage.

Decision-Making in Risk Management Techniques

• Considerations:

  • Avoidance

  • Captive or Risk Retention Groups

  • Loss Prevention/Reduction

  • Funded and Unfunded Retention Strategies based on frequency and severity.

Underwriting Cycles

• Hard Market: Insurer profitability declines, tougher standards, and increased premiums.

• Soft Market: Improved profitability, looser standards, and reduced premiums.

Step 4: Implement and Monitor the Chosen Techniques

• Risk Management Policy Statement: Defines the objectives and policy for managing loss exposures.

• Importance of Collaboration: Active cooperation from other departments is crucial.

• Ongoing Evaluation: Risk management programs need periodic reviews to assess achievement of objectives and cost-benefit analyses.

Benefits of Risk Management

• Achieves pre-loss and post-loss objectives effectively.

• Reduces both direct and indirect losses to society.

• Can lower a firm's cost of risk.