Introduction to Risk Management

1
Introduction to Risk Management

• Lecture 4

2
Risk Management

• Process to
• Identify exposures faced by an organization or
  individual
• Select the most appropriate techniques for
  treating such exposures
• Insurance management is a subset of risk
  management

3
Objectives

• Preloss
• Choose economical method (cost/benefit)
• Reduce anxiety
• Meet all legal (govt. regs) regulations
• Postloss
• Survival and continued operation of firm (family)
• Firm can resume at least partial operations
  within a reasonable period of time loss to
  competitors

4
Objectives

• Postloss
• Stability of earnings (family income)
• Continue growth of earnings
• Minimize impact of losses on others and on
  society

5
Steps in the Risk Management Process
6
Types of Exposures

• Property loss exposure
• Liability loss exposure
• Business Income loss exposure
• Human resources loss exposures
• Crime loss exposures
• Employee Benefit loss exposures
• International loss exposures

7
Tools for Identifying Exposure

• Risk analysis questionnaires
• Physical inspection
• Flow charts
• Financial statements
• Historical loss data

8
Evaluation of Potential Losses

• Evaluation of potential loss frequency and
  severity
• Frequency probable number of losses that may
  occur over a period of time
• Severity probably size of the losses that may
  occur

9
Loss Severity

• Maximum possible loss worst loss that could
  possibly happen to firm over its lifetime (worst
  case scenario)
• Maximum probable loss worst loss that is most
  likely to happen

10
Appropriate Techniques

• Risk Control techniques that reduce the
  frequency and severity of losses
• Risk Financing techniques that provide for the
  funding of losses once they occur

11
Risk Control

• Avoidance not acquiring a certain loss
  exposure, or abandoning an existing exposure
• Ex asbestos, childrens toys, alcohol at BOD
  meetings, riding motorcycles
• Disadvantages
• Cannot avoid all losses (premature death)
• Have to give up activities

12
Loss Control

• Loss prevention methods to reduce the frequency
  of loss
• Drivers education DWI laws locking doors
• Loss reduction methods to reduce the severity
  of loss
• Sprinkler systems floor lighting in planes,
  segregation of exposure units (inventories)
• Very effective for Workers Comp

13
Risk Financing Retention / Transfer

• Retention retaining all or part of the loss
• Noninsurance risk transfers contractually
  transferring risk to others
• Commercial Insurance transfer through insurance

14
Retention

• Active intentionally retain losses
• Passive unintentionally retain losses
• Necessary conditions for retention
• No other effective method available
• Worst possible loss is not serious
• Losses are highly predictable frequency and
  severity can be reasonably estimated

15
Retention

• Retention level dollar amount of losses firm is
  willing to retain
• What is maximum possible loss that can be
  absorbed without adversely affecting earnings
• What is maximum percentage of NWC, or capital

16
Retention Methods for Paying

• Current income effectively treats losses as
  expenses during the year
• Unfunded reserve a bookkeeping reserve, similar
  to allowance for bad debts
• Funded reserve setting aside funds (not widely
  used)
• Credit line using credit line from a bank to
  fund losses

17
Captive Insurer

• Captive Insurer an insurer owned and
  established by a parent firm for the purpose of
  insuring the parent firms loss exposure
• Pure captive owned only by one parent
• Group captive owned by several parents (ex
  trade associations)

18
Reasons for Captive Insurers

• Difficulty in obtaining insurance
• Global firms liability or political risk
• Lower operating costs No commissions Interest
  on invested premiums
• Greater stability of earnings
• Easier access to a reinsurer
• Potential profit center
• Tax treatment of captives (?)

19
Examples of Third-Party Captive Businesses
20
Self-insurance

• Special form of planned retention where part or
  all of a loss exposure is retained
• Not insurance no risk transfer
• Really self-funding
• Examples
• Workers compensation
• Group health, dental, drugs
• Protected with stop loss
• Risk retention groups (taxicab drivers)

21
Advantages

• Save money if actual losses less than what is
  priced in premium
• Lower costs
• no commissions may be able to lower
  administrative expenses no insurer profits
• Increase cash flow firm can use funds that
  would be paid out at beginning of period (timing
  only)

22
Disadvantages

• Possibly higher losses losses may be higher
  than the allowance in the insurance premium
  that is saved by not purchasing
• Possible higher expenses insurers may be able
  to provide loss control and claim services less
  expensively
• Possible higher taxes premiums deductible
  payments to a funded reserve not

23
Non-Insurance Transfers

• Methods of transferring pure risk to another
  party other than by insurance
• Contracts
• Hold harmless agreements
• Leases (lessor responsible for maintenance)

24
Noninsurance Transfers

• Advantages
• May be able to transfer losses that are otherwise
  not commercially insurable
• Noninsurance transfers may cost less than
  insurance
• May be able to shift loss to someone who is in a
  better position to exercise loss control

25
Noninsurance Transfers

• Disadvantages
• Transfer may fail for legal reasons
• Transferee may be unable to pay the loss
• May not reduce insurance costs if insurer does
  not give credit for the transferred risk

26
Insurance

• Low probability (frequency) of loss but high
  severity
• Issues
• Selection of coverages
• Selection of insurer
• Negotiation of terms
• Dissemination of information
• Periodic review

27
Insurance

• Coverage how much insurance and size of
  deductible
• Deductible amount paid by firm Portion
  retained by firm Used to
• Eliminate small claims admin. Expense of
  adjusting these claims
• Help solve the moral hazard problem
• Excess insurance insurer participates after
  loss exceeds planned retention amount

28
Insurance

• Selecting an insurer
• Financial strength Ability to pay off claims
• A.M. Best company
• Loss control services
• Claim adjustment services
• Costs and terms

29
Insurance

• Advantages
• Firm indemnified after loss.
• Uncertainty reduced (sleep factor).
• Risk management services Loss control, etc.
• Insurance premiums are tax deductible.
• Disadvantages
• Premium cost Time and effort (pre post loss).
• Moral hazard.

30
Risk Management Matrix
31
Implement Administer

• Risk management policy statement outlines
  objectives and company policy with respect to
  loss exposures
• Coordination with other depts acctg, finc,
  production, marketing, personnel
• Review