Course: RMIN 4000
Chapter: 3
Instructor: Daniel Brown
Institution: Terry College of Business, University of Georgia
Definition: Identifies loss exposures faced by an organization and selects the most appropriate techniques for treating such exposures.
Definition: A situation or circumstance where a loss is possible, irrespective of whether the loss actually occurs.
Identify loss exposures.
Measure and analyze the loss exposures.
Consider and select the appropriate risk management techniques.
Implement and monitor the chosen techniques.
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.
Loss history
Financial statements
Other firms/competitors
Risk management consultants
Surveys/questionnaires
Inspections
Contract analysis
Flowcharts
Estimate both frequency and severity of loss exposures:
Frequency (probability): How often loss occurs?
Severity (outcome): Cost when a loss does occur.
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.
Aim: To reduce the frequency or severity of losses.
Aim: To fund losses when they occur.
Avoidance
Loss Prevention
Loss Reduction
Duplication
Separation
Diversification
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.
Purpose: Measures that lower the frequency of specific losses without eliminating risk.
Purpose: Measures that lessen the severity of a loss with no effect on frequency.
Definition: Keeping backups or copies of essential documents or properties to mitigate loss.
Definition: Dividing assets to minimize the impact of a single event.
Examples include firewalls and multiple warehouse strategies.
Purpose: Spreading loss exposure among various parties, securities, or transactions to reduce the chance of loss.
Retention
Noninsurance Transfer
Insurance
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.
Unfunded Retention
Funded Reserve
Deductible
Captive Insurer
Self-Insurance
Risk Retention Groups
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.
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.
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).
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.
Definition: Transfer of pure risk and financial consequences without insurance.
Example Methods: Contracts, leases, hold-harmless agreements.
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.
Best suited for low-frequency, high-severity loss exposures.
Emphasis on:
Insurance coverage selection
Insurer selection
Negotiation of terms
Dissemination of coverage information
Periodic program reviews
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.
Advantages:
Indemnification for losses, business continuity, reduced uncertainty, tax-deductible premiums.
Disadvantages:
Premium costs, negotiation efforts, potential laxity in loss control due to coverage.
Considerations:
Avoidance
Captive or Risk Retention Groups
Loss Prevention/Reduction
Funded and Unfunded Retention Strategies based on frequency and severity.
Hard Market: Insurer profitability declines, tougher standards, and increased premiums.
Soft Market: Improved profitability, looser standards, and reduced premiums.
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.
Achieves pre-loss and post-loss objectives effectively.
Reduces both direct and indirect losses to society.
Can lower a firm's cost of risk.