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Risk managmet chapter2

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Risk managmet chapter2

  2. 2. INTRODUCTION Does risk have any beneficial function at all? Yes. Risk enables wea lth to be created; it does this in a number of ways: i. It creates the hope for profit. Entrepreneurs are encouraged to take risks of all kinds, in the hop e that the reward will be higher than they could achieve by choosi ng a safer option.  Often, this risk taking will be wealth creating in the form of emplo yment, goods services, and investment. 2
  3. 3. ii. Risk is a barrier to entry into the market place for ventures, whic h are unsound, or likely to be short-lived. The cost of risk will be viewed as too high and potential players i n the risk market place will look elsewhere for a return. The result should be a more competitive market place, which is to the benefit of the consumer and the national economy. iii. Risk encourages a safety culture. This means safety in its widest sense and includes employees, con sumers, the public and the environment. 3
  4. 4. 2.1: RISK MANAGEMENT DEFINED Definition 1 Risk Management refers to the identification; measurement and trea tment of exposure to potential accidental losses almost always in situa tions where the only possible outcomes are losses or no change in the status. Definition 2 Risk Management is a general management function that seeks to as sess and address the causes and effects of uncertainty and risk on an o rganization. 4
  5. 5. Definition 3 Risk Management is the executive function of dealing with specified risks facing the business enterprise. In general, the risk manager deals with pure, not speculative, risk. Definition 4 Risk Management is the identification, analysis and economic contro l of those risks which can threaten the assets or earning capacity of an enterprise. Definition 5 “Risk Management deals with the systematic identification of a comp any’s exposure to the risk of loss.” 5
  6. 6. Definition 6 RISK MANAGEMENT: is defined as a systematic process for the identification & evaluation of pure loss exposures and for the selection and implementation of the most appropriate techniques for treating such exposures. It is a scientific approach to dealing with pure risks. 6
  7. 7. RISK Mgt. Vs. INSURANCE Mgt. Risk management is a much broader concept than insurance management. Risk Mgt.: places greater emphasis on the identification and analysis of pure loss exposures and techniques for dealing with these exposures. Insurance Mgt.: however, is only one of the several methods that can be used to treat a particular loss exposure. Risk Mgt. : requires the cooperation of a large number of individuals and departments Insurance Mgt. : involves a smaller number of persons. 7
  8. 8. 2.2. OBJECTIVES OF RISK MANAGEMENT  Risk Mgt. has several important objectives that can be classified into two categories; 1. pre-loss objectives: Includes:-  Economy, Reduction of anxiety, and Meeting externally imposed obligations 2. post-loss objectives. Includes:-  Survival, Continue operating, Stability of earnings, Continu ed growth of the firm, and Social responsibility 8
  9. 9. 1. PRE-LOSS OBJECTIVES: a) ECONOMY:  The firm should prepare for the potential losses (risks) in the most economical way possible.  This involves an analysis of safety program expenses, insurance premiums, and the costs of different techniques for handling losses. b) THE REDUCTION OF ANXIETY:  Certain loss exposures can cause greater worry and fear. However, the risk manager wants to minimize the anxiety and fear associated with all loss exposures.  For example, the threat of a catastrophic lawsuit (court case) fro m a defective product can cause greater anxiety and concern 9
  10. 10. c) MEETING EXTERNALLY IMPOSED OBLIGATIONS: This means that the firm must meet certain obligations imposed on it by 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.  Therefore, The risk manager must see that these externally imposed obligations are met. 10
  11. 11. 2. POST–LOSS OBJECTIVES: a) SURVIVAL:  Means that after a loss occurs, the firm can at least resume (restart) partial operation within some reasonable period of time. b) CONTINUE OPERATING: For some firms, the ability to operate after a severe loss is an extremely important objective.  This is particularly true of certain firms, such as public utility firm, which must continue to provide service; and also include banks, bakeries, dairy farms, and other competitive firms etc…. 11
  12. 12. c) STABILITY OF EARNINGS: The firm wants to maintain its earnings per share after a loss occurs. This objective is closely related to the objective of continued operations  There may be substantial costs involved in achieving this goal and perfect stability of earnings may not be attained. d) CONTINUED GROWTH OF THE FIRM: 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. 12
  13. 13. e) SOCIAL RESPONSIBILITY: The final goal of social responsibility is, to minimize the impact that a loss has on other persons and on society. A sever loss can adversely affect employees, customers, suppliers, creditors, etc... and the community in general. 13
  14. 14. 2.3. THE RISK MANAGEMENT PROCESS Step 1) Identifying potential loss. Step 2) Measuring (Evaluating) potential loss. Step 3) Selecting appropriate techniques for handling losses. Risk control techniques: includes Avoidance, Loss control , Separation/ Diversification, Combination Risk financing techniques: includes Retention/ Assumption, Self-insurance, Non-insurance transfer, and Insurance Step 4) Implementing and administering the program.
  15. 15. STEP 1. IDENTIFYING POTENTIAL LOSSES Risk identification: is the process by which an organization is able to learn areas in which it is exposed to risk. It is the process by which a business systematically and continuously identifies loss exposures as soon as or before they emerge. Therefore, an important aspect of risk identification is exposure identification. THERE ARE FOUR CATEGORIES OF RISK EXPOSURES: (i) physical asset exposures, (ii) financial asset exposures, (iii) liability exposures, and (iv) human exposures. 15
  16. 16. i. PHYSICALASSET EXPOSURES:  Property may be damaged, destroyed, lost, or diminished in value in a number of ways. ii. FINANCIALASSET EXPOSURES:  Ownership of securities such as common stock and mortgages creates this type of exposure.  Financial assets may decline in value, b/c of various market forces. 16
  17. 17. iii. LIABILITY EXPOSURES: Obligations imposed by the legal system create this type of exposure. Civil and criminal law detail obligations carried by citizens: state and federal legislatures impose statutory limitations on activities; governmental agencies promulgate administrative rules and directives that establish standards of care. iv. HUMAN ASSET EXPOSURES: Possible injury or death of managers, employees, or other significant stakeholders (customers, secured creditors, stockholders, suppliers) exemplifies this type of exposure. 17
  18. 18. STEP 2. MEASUREMENT OF POTENTIAL LOSS Risk measurement refers to the measurement of potential loss as to its size and the probability of occurrence. Evaluation and measurement of potential losses involves an estimation of the (i) The potential frequency of losses, and (ii) The potential severity of losses. 18
  19. 19. i. Loss frequency: refers to the probable number of losses that may occur during some given time period. ii. Loss severity: refers to the probable size of the losses that may occur. The average loss frequency times the average loss severity equals the total Birr losses expected in an average year. LF X LS = Total birr loss 19
  20. 20. PROUTY MEASURE OF SEVERITY One of the systems used to measure the severity of risks is the Prouty measure of severity, suggested by a risk manager called R. Prouty. The two measures suggested by prouty are: i. The maximum possible loss: w/c is the worst loss to one unit per occurrence, that could possibly happen to the firm. ii. The maximum probable loss: w/c is the worst loss to one unit per occurrence, that is likely to happen. The maximum probable loss, therefore is usually less than the maximum possible loss. 20
  21. 21. PRIORITY RANKING BASED ON SEVERITY The more severe the losses due to a risk is, the higher the rank. Under such circumstances, classification of risks are made into three heads:- i. Critical risks - Where the magnitude of losses could lead to bankruptcy. ii. Important risks - Where the possible losses would not lead to bankruptcy, but would require to borrow in order to continue operations. iii. Unimportant risks - Where the possible losses could be met out of the existing assets or out of current income, without imposing  21
  22. 22. THE CONCEPT OF PROBABILITY Probability is the body of knowledge concerned with measuring the likelihood that something will happen; and making predictions on the basis of this likelihood. The likelihood of an event is assigned a numerical value between 0 and 1; with those that are impossible assigned a value of 0 and those that are inevitable assigned a value of 1. Thus, in general: 0 ≤ P(A) ≤ 1, where P(A) denotes the probability that event A will occur in a single observation or experiment. 22
  23. 23. THE LAW OF LARGE NUMBERS  States that, as the number of exposure units increase, the more closely the actual loss experience will approach the expected loss experience. Hence, as the number of loss exposure units increases, objective risk decreases. Objective risk is defined as the probable variation of actual from expected losses. Degree of Objective risk = Actual losses - Expected losses (i.e. Range) Expected losses 23
  24. 24. Example 1:- Assume that ABC company and XYZ company own 100 and 900 automobiles, respectively. These cars are used by the sales personnel of each firm and are driven in the same general geographical territory. The probability of the loss in a given year due to collision is 20 percent. Suppose further that statisticians have computed that the likely range in the number of losses in one year is 8 for ABC and 24 for XYZ. Compute the degree of risk? 24
  25. 25. Solution : The expected number of losses is computed as follows; For ABC = 0.20 × 100 = 20 For XYZ = 0.20 × 900 = 180 Degree of Objective risk= Probablevariationof actuallossesfromexpectedlosses(i.e. Range) Expectedlosses DOR for ABC = 8/20 = 40 percent DOR for XYZ = 24/180 = 13.3 percent In general, the degree of objective risk (loss) decreases on a relative basis as the number of exposure units increases. 25
  26. 26. Example 2:- Assume that employers A and B, each with 10,000 employees, are concerned about occupational injuries to workers. Employer A is in a “safe” industry, with the probability of loss of a disabling injury in its plant being equal to 0.01. Employer B is in a more dangerous industry, with its probability of loss equal to 0.25. It has been determined that the probable variation in injuries in employer A’s plant will be not more than 20, whereas in employer B’s plant the probable variation will not exceed 87. Compute the degree of objective risk for both A&B. 26
  27. 27. DOR for A = 20/(0.01×10,000) = 20/100 = 20 % DOR for B = 87/(0.25×10,000) = 87/2,500 =3.5% Although B’s probability of loss is much greater than A’s, its degree of risk is only 17.5% of A’s risk (3.5 ÷ 20 = 0.175). In general, the degree of objective risk will vary inversely with the probability of loss for any constant number of exposure units. 27
  28. 28. In summary, the two most important applications of the law of large numbers in relation to objective risk are as follows; 1. As the number of exposure units increases, the degree of risk decreases 2. Given a constant number of exposure units, as the probability of loss increases, the degree of risk decreases. 28
  29. 29. STEP 3. TECHNIQUES OF RISK MANAGEMENT  There are two basic approaches. First, the risk manager can use risk control measures, which are; Avoidance, loss control, separation, & combination Second, the risk manager can use risk financing measures to finance the losses that do occur. It includes :- retention/ assumption, self-insurance, non insurance transfers and Insurance 29
  30. 30. Risk Control Techniques/Measures Risk control refers to techniques, tools, strategies and processes that organizations employ to reduce an exposure to risk. Hence, risk control refers to those methods employed to avoid, prevent, reduce or otherwise control the frequency and / or magnitude of loss or other undesirable effects of risk.  These risk control methods are exemplified by security systems to prevent unauthorized entry or access to data; by sprinklers and other fire control systems; by training programs to educate employees on techniques to reduce the likelihood of injury, by the development and enforcement of codes regulating construction with the purpose of decreasing the vulnerability of structures to forces of nature, etc. 30
  31. 31. 1 ) Risk Avoidance  Risk avoidance involves avoiding the property, person, or activity gi ving rise to possible loss; by either refusing to assume it even momentarily or by abandoning an exposure to loss assumed ea rlier.  Risk avoidance involves two activities; a proactive avoidance that is reflected by refusal to even momentarily assume the risk and avoidance through abandonment of an already assumed exposure. 31
  32. 32.  E.g. i).Proactive avoidance - Addis pharmaceutical is engaged in an intensive research to produce a certain type of drug. While the research is going on, however, the researchers found out that the drug to be produced might cause serious health problems to its users. The management of Addis pharmaceuticals may decide now to altogether stop the planned production of that drug.  ii) Avoidance through abandonment is the other way of risk avoidance. But it is not commonly used as the proactive avoidance. As has been pointed out before, this technique is employed to an already assumed risk.  E.g. a pharmaceutical firm that produces a drug with a dangerous side effects may stop manufacturing that drug.  N.B: Risk avoidance is not always an acceptable option. 32
  33. 33. 2. Loss prevention andreduction Are designed to reduce both loss frequency and loss severity. Unlike the avoidance technique, loss prevention and reduction deals with an exposure that the firm does not wish to abandon. The firm wishes to keep the exposure but wants to reduce the frequency and severity of losses. 33
  34. 34. Loss prevention: Loss prevention programs seek to reduce the number of losses or to eliminate them entirely. E.g. Lossprevention activities that focus on hazard: hazard Loss prevention activity Careless house keeping => Training and monitoring programs Flooding => dams and water resource management Smoking => ban on smoking except in restricted areas Etc…… 34
  35. 35.  Loss prevention activities that focus on the environment Environment Loss prevention activity The Addis Ababa ring road -Barrier construction, lighting signs and road markings Improperly trained work force - Training Structures susceptible to fire - Fire-resistive construction Etc……………. 35
  36. 36. Loss reduction: Loss reduction programs are designed to reduce the potential severity of a loss. E.g. the usage of fire extinguishers and sprinklers. Unlike loss prevention activities that attempt to reduce the probability of loss, loss reduction activities are post loss measures or while it is occurring.  One illustration of a loss reduction technique is catastrophe or contingency planning.  Another possible technique is asset duplication. It reduces the probability of an indirect lo ss. 36
  37. 37. 3. Separation- Involves isolating exposures to loss from each other instead of leaving them vulnerable to a single event. A common saying that goes, “donotputallyoureggsinonebasket”may possibly illustrate this technique, A firm might store its inventory in different warehouses than putting them all in a single ware house. 37
  38. 38. 4. Combination / Diversification  Combination is increasing the number of exposure units since it is a pooling process. It reduces risk by making loses more predictable with a higher degree of accuracy.  In the case of firms, combination results in the pooling of resources of two or more firms.  For example, a taxicab company may increase its fleet of automobiles. Combination also occurs when two firms merge or one acquires another.  Diversification: Businesses diversify their product lines so that a decline in profit of on e product could be compensated by profits from others 38
  39. 39. 5. Non-insurance transfers:- Transfers can be accomplishedin two ways: i. Transfer of the activity or the property. The property or activity responsible for the risks may be transferred to some other person or group of persons. ii. Transfer of the probableloss. The risk, but not the property or activity, may be transferred.  E.g. under a lease, the tenant may be able to shift to the landlord any responsibility the tenant may have for damage to the landlord’s premises caused by the tenant’s negligence. 39
  40. 40. RISKFINANCINGTECHNIQUES 1. Retention:- Retention is an arrangement under which the direct financial consequences of the loss are born by the entity experiencing the loss itself. Retention is active (planned), when the risk manager considers other methods of handing the risk and consciously decides not to transfer the potential losses. Retention is passive (unplanned) when the risk manager unconsciously assume the loss. 40
  41. 41. Payment of losses i.Out of current income. ii.Unfundedor funded reserve:  An unfunded reserve is a bookkeeping account that is charged with the actual or expected losses from a given exposure. A funded reserve is the setting aside of liquid funds to pay losses. iii.Borrowfrombank. iv.Captive insurer: A captive insurer is an insurer established and owned by a parent firm for the purpose of insuring the parent firm’s loss exposures. 2. Self-insurance/Self funding - is a special form of planned retention by which part or all of a given loss exposure is retained by the firm. 3.Insurance 41
  42. 42.  If the risk manager decides to use insurance to treat certain loss exposures, five key areas must be emphasized.  Selection of insurance coverage  Essential insurance includes those coverage required by law or by contract, such as workers compensation insurance.  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 creates inconvenience the firm.  Selection of an insurer, Negotiation of terms,  Dissemination of information concerning insurance coverage  Periodic review of the insurance programs 42
  43. 43. WHICHMETHODSHOULDBE USED?  In determining the appropriate method or methods for handling losses, a matrix can be used that classifies loss exposures according to frequency and severity. The following matrix can be determine which risk management should be used. 43 Loss frequency Loss severity Appropriate risk management technique Low Low Retention High Low Loss control and retention Low High Insurance High High Avoidance
  44. 44. 4. Implementing and administering the program  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 treatment of loss exposures.  In addition, a risk management manual may be developed and used in the program. 44
  45. 45. Cooperation withOther Departments  The risk manager does not work in isolation.  Other functional departments within the firm are extremely important in identifying pure loss exposures and method for treating these exposures.  These departments can cooperate in the risk management process in the following ways 45
  46. 46.  Accounting: Internal accounting controls can reduce employee fraud and theft of cash.  Finance: Information can be provided showing how losses can disrupt profits and cash flow and the impact that losses will have on the firm’s balance sheet and profit and loss statement.  Marketing: Accurate packaging can prevent liability lawsuits. Safe distribution procedures can prevent accidents. 46
  47. 47.  Production: Quality control can prevent production of defective goods and so prevent liability lawsuits.  Adequate safety in the plant can reduce accidents.  Personnel: This department may be responsible for employee benefit programs, pension programs, and safety programs 47
  48. 48. PERIODIC REVIEWAND EVALUATION  To be effective, the risk management program must be periodically reviewed and evaluated to determine if the risk management objectives are being attained.  In particular, those activities relating to risk management costs, safety programs, and loss prevention must be carefully monitored. 48
  49. 49.  Loss records must also be examined to detect any changes in frequency and severity.  Moreover, new developments that affect the original decision on handling a loss exposure must also be examined.  Finally, the risk manager must determine if the firm’s overall risk management policies are being carried out and if he or she is receiving the total cooperation of the other departments in carrying out the risk management functions 49
  50. 50. END OF CHAPTER TWO 50