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THE RISK MANAGEMENT
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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.
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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.
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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.
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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.”
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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.
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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.
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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
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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
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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.
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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….
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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.
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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.
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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.

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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.
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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.
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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.
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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.
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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
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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.
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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
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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.
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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
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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?
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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

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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.
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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.
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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.
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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
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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

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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.
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 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.
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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.
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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

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 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…………….
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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.
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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.
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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
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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.
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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.
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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
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 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

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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.
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Loss frequency Loss severity Appropriate risk management
technique
Low Low Retention
High Low Loss control and retention
Low High Insurance
High High Avoidance

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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.
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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
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 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.
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 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
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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.
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 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
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END OF CHAPTER TWO
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