CHAPTER TWO

RISK MANAGEMENT
Introduction:
In the previous sections we have identified several types of pure risks that affect individuals and
businesses. After sources of risks are identified and measured, a decision can be made as to how
the risk should be handled. The process used to systematically manage pure risk exposures is
known as risk management.
In this chapter we discuss the meaning of risk management, objectives of risk management, steps
in the risk management process, and the various techniques for treating loss exposures.
Definition of Risk Management:
“Risk Management is defined as a systematic process for the identification and evaluation of
pure loss exposures faced by an organization or individuals and for the selection and
implementation of the most appropriate techniques for treating such exposures”. Many risk
managers use the term “loss exposure” to identify potential losses.
Because the term risk is ambiguous and has different meanings many authors and corporate risk
managers use the term “loss exposure” to identify potential losses. Loss exposure is a situation
or circumstance in which a loss is possible, regardless of a loss occurs. For example defective
products that may result in lawsuits against the company.
As a general rule, the risk manager is concerned only with management of pure risks, not
speculative risks.
Objectives of Risk Management:
The objectives of risk management can be broadly classified into two;
1) Pre-loss Objectives
2) Post-loss Objectives
(1) Pre-loss Objectives:
An organization has many risk management objectives prior to the occurrence of a loss. The
most important of such objectives are as follows;
(a) The first objective is that the firm should prepare for potential losses in the most
economical way possible. This involves as analysis of safety program expenses, insurance
premiums and the costs associated with the different techniques of handling losses.
(b) The second objective is the reduction of anxiety. It is more complicated. In a firm, certain
loss exposures can cause greater worry and fear for the risk manager, key executives and
unexpected stockholders of that firm. For example, a threat of a lawsuit from a defective

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 product can cause greater anxiety than a possible small loss from a minor fire. However, the
risk manager wants to minimize the anxiety and fear associated with such loss exposures.
(c) The third pre-loss objective is to meet any externally imposed obligations. This means that
the firm must meet certain obligations imposed on it by the outsiders. For example,
government regulations may require a firm to install safety devices to protect workers from
harm. Similarly, a firm’s creditors may require that property pledged as collateral for a loan
must be insured. Thus, the risk manager is expected to see that these externally imposed
obligations are met properly.
(2) Post-loss Objectives:
Post-loss objectives are those which operate after the occurrence of a loss. They are as follows;
(a) The first post-loss objective is survival of the firm. It means that after a loss occurs, the firm
can at least resume partial operation within some reasonable time period.
(b) The second post-loss objective is to continue operating. For some firms, the ability to
operate after a severe loss is an extremely important objective. Especially, for public utility
firms such as banks, dairies, etc, they must continue to provide service. Otherwise, they may
lose their customers to competitors.
(c) Stability of earnings is the third post-loss objective. The firm wants to maintain its earnings
per share after a loss occurs. This objective is closely related to the objective of continued
operations. Because, earnings per share can be maintained only if the firm continues to
operate. However, there may be substantial costs involved in achieving this goal, and perfect
stability of earnings may not be attained.
(d) Another important post-loss objective is continued growth of the firm. A firm may grow by
developing new products and markets or by acquiring or merging with other companies.
Here, the risk manager must consider the impact that a loss will have on the firm’s ability to
grow.
(e) The fifth and the final post-loss objective is the social responsibility to minimize the impact
that a loss has on other persons and on society. A severe loss can adversely affect the
employees, customers, suppliers, creditors and the community in general. Thus, the risk
manager’s role is to minimize the impact of loss on other persons.
Thus, there are the pre-loss and post-loss objectives of risk management. A prudent risk
manager must keep these objectives in mind while handling and managing the risk.
Steps in Risk Management Process:
Whether the concern is with a business or an individual situation, the same general steps can be
used to analyze systematically and deal with risk. This is known as risk management process.
The Risk Management Process has five steps to be implemented by the risk manager. They are
shown in the following chart;

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STEPS IN RISK MANAGEMENT PROCESS
(1) Identifying the potential losses: (Risk Identification)
The first and foremost step in the risk management process is to identify all pure (risk) loss
exposures. Here, it is the responsibility of the risk manager to identify several types of potential
losses. These potential losses include the following;
- Property losses
- Business income losses
- Liability losses
- Death or inability of key people
- Job-related injuries or disease
- Fraud, criminal acts and dishonesty of employees
- Employee benefits loss exposures
A risk manager has several sources of information that can be used to identify major and minor
loss exposures. They are as follows;
(a) Physical inspection of company plant & machineries can identify major loss exposures.
(b) Extensive risk analysis questionnaire can be used to discover hidden loss exposures that are
common to many firms.
(c) Flow charts that show production and delivery processes can reveal production bottlenecks
where a loss can have severe financial consequences to the firm.
(d) Financial statements can be used to identify the major assets that must be protected.
(e) Departmental & historical claims data can be invaluable in identifying major loss exposures.
Risk managers must also be aware of new loss exposures that may be emerging. More recently
misuse of the internet and e-mail transmissions by employees have exposed employers to
potential legal liability because of transmission of pornographic material and theft of confidential
information.
(2) Evaluating Potential Losses (Risk Measurement):
The second step in the risk management process is to evaluate and measure the impact of losses
on the firm. This involves an estimation of the potential frequency and severity of loss.
Loss frequency refers to the probable number of losses that may occur during some given
period of time. 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

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exposure with the potential for bankrupting the firm is much more important than an exposure
with a small loss potential.
Although the risk manager must consider both loss frequency and loss severity, severity is more
important. Therefore, the risk manager must also consider all losses that can result from a single
event. Both the maximum possible loss and maximum probable loss must also be estimated.
The maximum possible loss is the worst loss that could possibly happen to the firm during its
lifetime. The maximum probable loss is the worst loss that is likely to happen. For example, if a
plant is totally destroyed in a flood, the risk manager may estimate that replacement cost,
demolition costs and other costs will total Birr10 million. Thus, the maximum possible loss is
10million Birr. The risk manager also estimates that another flood causing more than 8 million
Birr of damage to the plant. Thus, for this risk manager, the maximum probable loss is 8 million
Birr.
Catastrophic losses are difficult to predict because they occur infrequently. However, their
potential impact on the firm must be given high priority. In contrast, certain losses such as
physical damage losses to automobiles and trucks, occur with greater frequency, but are usually
relatively small. This can be predicted with greater accuracy.
(3) Tools of Risk Management:
The third step is to identify the available tools of risk management. The major tools of risk
management are the following:
I) Avoidance
II) Loss control
III) Retention
IV) Non-insurance transfers
V) Insurance
Avoidance and Loss control are called risk control techniques, because they attempt to reduce
the frequency and severity of accidental losses to the firm.
Retention, non-insurance transfers and insurance are called risk financing techniques, because
they provide for the funding of accidental losses after they occur.
I) Avoidance:
Avoidance means that a certain loss exposure is never acquired, or an existing loss exposure is
abandoned. For example, a firm can avoid earthquake loss by not building a plant in an
earthquake prone area. 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.

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The major advantage of avoidance is that the chance of loss is reduced to zero, if the loss
exposure is not acquired. In addition, if an existing loss exposure is abandoned, the possibility of
loss is either eliminated or reduced because the activity that could produce a loss has been
abandoned.
However, avoidance has two disadvantages. First, it may not be possible to avoid all losses. For
example, a company cannot avoid the pre-mature death of a key executive. Second, it may not be
practical or feasible to avoid the loss exposure. In the above said example, the pharmaceutical
company can avoid losses arising from the production of a particular drug. However, without any
drug production, the firm will not be in business.
(II) Loss Control:
It is another method of handling loss in a risk management program. Loss control activities are
designed to reduce both the frequency and severity of losses. 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. Thus, the firm wishes to
keep the exposure but wants to reduce the frequency and severity of losses.
The following are the examples that illustrate how loss control measures reduce the frequency
and severity of losses.
Measures that reduce loss frequency are quality control checks, driver examination, strict
enforcement of safety rules and improvement in product design.
Measures that reduce loss severity are the installation of an automatic sprinkler or burglar alarm
system, early treatment of injuries and rehabilitation of injured workers.
(III) Retention:
Retention means that the firm retains part or all of the losses that result from a given loss
exposure. It can be effectively used when three conditions exist.
First, no other method of treatment is available. Insurers may be unwilling to write certain type
of coverage. Non-insurance transfers may not be available. In addition, although loss control can
reduce the frequency of loss, all losses cannot be eliminated. In these cases, retention is a
residual method. If the loss exposure cannot be insured or transferred, then it must be retained.
Second, 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.
Finally, losses are highly predictable. Retention can be effectively used for workers
compensation claims, physical damage losses to automobiles, etc. Based on past experience, the
risk manager can estimate a probable range of frequency and severity of actual losses.

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Determining Retention Levels:
If retention is used, the risk manager must determine the firm’s retention level, which is the
Dollar / Birr amount of losses that the firm will retain. A financially strong firm can have a
higher retention level than one whose financial position is weak.
Though there are many methods of determining retention level, the following two methods are
very important.
First, a Corporation can determine the maximum uninsured loss it can absorb without adversely
affecting the company’s earnings dividend policy. One rough rule is that the maximum retention
can be set at 5% of the company’s annual earnings before taxes from current operations.
Second approach is to determine the maximum retention as a percentage of the firm’s net
working capital, such as between 1% and 5%. Although this method does not reflect the firm’s
overall financial position for absorbing a loss, it measures the firm’s ability to fund a loss.
Paying losses:
If retention is used, the risk manager must have some method for paying losses. Normally, a firm
can pay losses by one of the following three methods:
(a) The firm can pay losses out of its current net income, with the losses treated as expenses for
that year. However, a large number of losses could exceed current net income. Then, other
assets may have to be liquidated to pay losses.
(b) Another method is to borrow the necessary funds from a bank. A line of credit is established
and used to pay losses as they occur. However, interest must be paid on the loan and loan
repayments can aggravate cash flow problems the firm may have.
(c) Another method for paying losses is an unfunded or funded reserve. An unfounded reserve is
a book keeping account that is charged with the actual or expected losses from a given risk
exposure. A funded reserve is the setting aside of liquid funds to pay losses. Private
employers do not use funded reserve, in their risk management programs, because the funds
may yield higher return if it is used in the business.
Advantages of Retention:
The advantages are as follows;
(a) The firm can save money in the long run if its actual losses are less than the loss allowance
in the insurer’s premium.
(b) 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, etc.
(c) Since the risk exposure is retained, there may be greater care for loss prevention.

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(d) Cash flow may be increased since the firm can use the funds that normally would be held
by the insurer.
Disadvantages of Retention:
(a) The losses retained by the firm may be greater than the loss allowance in the insurance
premium that is saved by not purchasing the insurance.
(b) Actually, expenses may be higher as the firm may have to hire outside experts such as safety
engineers. Thus, insurers may be able to provide loss control services less expensively.
(c) Income taxes may also be higher. The premiums paid to an insurer are income-tax
deductible. However, if retention is used, only the amounts actually paid out for losses are
deductible. Contributions to a funded reserve are not income-tax deductible.
(IV) Non-Insurance Transfers:
Non-insurance Transfers is another method of handling losses. Non-insurance 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 and
hold-harmless agreements.
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. Otherwise, a firm may insert a hold-
harmless clause in a contract, by which one party assumes legal liability on behalf of another
party. Thus, a publishing firm may insert a hold-harmless clause in a contract, by which the
author and not the publisher is held legally liable if anybody sued the publisher.
Advantages of Non-Insurance Transfers:
(a) The risk manager can transfer some potential losses that are not commercially insurable.
(b) Non-Insurance transfers often cost less than insurance.
(c) The potential loss may be shifted to someone who is in a better position to exercise loss
control.
Disadvantages of Non-Insurance Transfers:
(a) The transfer of potential loss would become impossible, if the contract language is
ambiguous.
(b) If the party to whom the potential loss is transferred is unable to pay the loss, the firm is still
responsible for the claim.
(c) Non-Insurance Transfers may not always reduce insurance costs since an insurer may not
give credit for the transfers.

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(V) Insurance:
Insurance is also used in a risk management program. 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. They are as follows;
(i) Selection of insurance coverages
(ii) Selection of an insurer
(iii) Negotiation of terms
(iv) Dissemination of information concerning insurance coverages
(v) Periodic review of the insurance program
(i) Selection of insurance coverages:
The risk manager must select the insurance coverages 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 three categories;
(a) Essential Insurance
(b) Desirable Insurance
(c) Available Insurance
Essential Insurance includes those coverages required by law or by contract, such as workers
compensation insurance. It also includes those coverages that will protect the firm against a loss
that threatens the firm’s survival.
Desirable insurance is protection against losses that may cause the firm financial difficulty, but
not bankruptcy.
Available insurance is coverage for slight losses that would merely inconvenience the firm.
(ii) Selection of an Insurer:
The next step is that the risk manager must select an insurer or several insurers. Here, several
important factors are to be considered by the risk manager. These include 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 policy owner’s surplus, underwriting
& investment results, adequacy of reserves for outstanding liabilities, etc. The risk manager can
identify the financial strength of the insurer by referring the rating given to that insurance
company. For example in America, A.M.Best Company is one of the famous rating companies
that publish the rating of insurers based on their relative financial strength.
Besides the financial strength, the risk manager must also consider the risk management services
by the insurer and the cost & terms of protection.

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(iii) Negotiation of terms:
After the insurer is selected, the terms of the insurance contract must be negotiated. If printed
policies, endorsements and forms all used, the risk manager and insurer must agree on the
documents 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. If the firm is large, the premiums are negotiable between the firm and insurer.
(iv) Dissemination of information concerning insurance coverages:
Information concerning insurance coverages must be given to others in the firm. The firm’s
employees must be informed about the insurance coverages, the records that must be kept, the
risk management services that the insurer will provide, etc.
(v) Periodic review of the insurance program:
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, etc.
Advantages of Insurance:
(a) The firm will be indemnified after a loss occurs. Thus, the firm can continue to operate.
(b) Uncertainty is reduced. Thus, worry and fear are reduced for the managers and employees,
which should improve their productivity.
(c) Insurers can provide valuable risk management services, such as loss-control services, claims
adjusting, etc.
(d) Insurance premiums are income-tax deductible as a business expense.
Disadvantages of Insurance:
(a) The payment of premium is a major cost. Under the retention technique, the premiums could
be invested in the business until needed to pay claims, but if insurance is used, premiums
must be paid in advance.
(b) Considerable time and effort must be spent in negotiating the insurance coverages.
(c) The risk manager may take less care to loss-control program since he has insured. But, such a
lax attitude toward loss control could increase the number of non-insured losses as well.
In addition to the above tools there are some other suggested techniques:
a. Separation(diversification) and
b.Combination
Both of them are risk control techniques.

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i. Separation (diversification) it is the separation of the firms exposure’s 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.
ii. Combination it is also known as pooling makes loss experience more predictable by increasing
a number of exposure units.
(4) Selection of Risk Management Tools:
Risk Management Matrix

Type of Loss Loss Frequency Loss Severity Appropriate Risk Management Technique

1 Low Low Retention

2 High Low Loss Control & Retention

3 Low High Insurance

4 High High Avoidance

In determining the appropriate method or methods of handling losses, the above matrix can be
used. It classifies the various loss exposures according to frequency and severity.
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 a secretary’s Note pad. This type
of exposure can be best handled by retention, since the loss occurs infrequently and when it
occurs it does not cause 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,
shoplifting and food spoilage. 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
include fires, explosion and other natural disasters. Here, the risk manager could also use a
combination of retention and insurance to deal with these exposures.
The fourth and most serious type of exposure is characterized by both high frequency and high
severity. This type of risk exposure is best handled by avoidance. For example, if a person has
drunken and if he attempts to drive home in that drunken stage, the chance of meeting with an

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accident is more. This loss exposure can be avoided by not driving at the drunken stage or by
having a driver to drive his car.
(5) Risk Administration:
The next and the final step in the risk management process are implementation and
administration of the risk management program. It involves three important components;
(i) Risk management policy statement
(ii) Co-operation with other departments
(iii) Periodic review and evaluation
(i) Risk management policy statement:
A risk management policy statement is necessary in order to have an effective risk management
program. This statement outlines the risk management objectives of the firm, as well as company
policy with respect to the treatment of loss exposures. It also educates top level executives in
regard to the risk management process and gives the risk manager greater authority in the firm.
In addition, a risk management manual may be developed and used in the program. The manual
describes the risk management program of the firm and can be a very useful tool for training new
employees who will be participating in the program.
(ii) Co-operation with other departments:
The risk manager has to work in co-operation with other functional departments in the firm. It
will facilitate to identify pure loss exposures and methods of treating these exposures.
The Accounting Department can adopt Internal Accounting Controls to reduce employees’ fraud
and theft of cash.
The Finance Department can provide information showing how losses can disrupt profits and
cash flow.
The Marketing Department can prevent liability suits by ensuring accurate packaging. Besides,
safe distribution procedures can prevent accidents.
The Production Department has to ensure quality control and effective safety programs in the
plant can reduce injuries and accidents.
The Personnel Department may be responsible for employee benefit program, pension program
and safety program.
(iii) Periodic review & evaluation:
The risk management program must be periodically reviewed and evaluated to see whether the
objectives are being attained or not. Especially, risk management costs, safety programs and loss
preventive programs must be carefully monitored. Loss records must also be examined to detect
any changes in frequency and severity. Finally, the risk manager must determine whether the
firm’s overall risk management policies are being carried out, and whether the risk manager is
receiving the total co-operation of the other departments.

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