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CHAPTER TWO
RISK MANAGEMENT
Risk management is a process that identifies loss exposures faced by an organization and selects
the most appropriate techniques for treating such exposures. Because the term risk is
ambiguous and has different meanings, risk managers typically use the term loss exposure to
Important objectives before a loss occurs include economy, reduction of anxiety, and meeting
legal obligations.
The first objective means that the firm should prepare for potential losses in the most economical
way. This preparation involves an analysis of the cost of safety programs, insurance premiums
paid, and the costs associated with the different techniques for handling losses.
The second objective is the reduction of anxiety. Certain loss exposures can cause greater worry
and fear for the risk manager and key executives. For example, the threat of a catastrophic lawsuit
because of a defective product can cause greater anxiety than a small loss from a minor fire.
The final objective is to meet any legal obligations. For example, government regulations may
require a firm to install safety devices to protect workers from harm, to dispose of hazardous
Workers compensation benefits must also be paid to injured workers. The firm must see that these
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Post-Loss Objectives:
Risk management also has certain objectives after a loss occurs. These objectives include survival
of the firm, continued operations, stability of earnings, continued growth, and social
responsibility.
The most important post-loss objective is survival of the firm. Survival means that after a loss
occurs, the firm can resume at least partial operations within some reasonable time period.
The second post-loss objective is to continue operating. For some firms, the ability to operate
after a loss is extremely important. For example, a public utility firm must continue to provide
service. Banks, bakeries, and other competitive firms must continue to operate after a loss.
The third post-loss objective is stability of earnings. Earnings per share can be maintained if
the firm continues to operate. However, a firm may incur substantial additional expenses to
achieve this goal (such as operating at another location), and perfect stability of earnings may
be difficult to attain.
The fourth post-loss objective is continued growth of the firm. A company can grow by
developing new products and markets or by acquiring or merging with other companies. The
risk manager must therefore consider the effect that a loss will have on the firm’s ability to
grow.
Finally, the objective of social responsibility is to minimize the effects that a loss will have on
other persons & on society. A severe loss can adversely affect employees, suppliers, customers,
creditors, and the community in general. For example, a severe loss that shuts down a plant in a
small town for an extended period can cause considerable economic distress in the town
1) Risk Identification
2) Risk Measurement
4) Risk Administration
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It is the first step in the risk management process. Here, the risk manager tries to locate the areas
where losses could happen due to a wide range of perils. It would be very difficult to deal with
In the identification process, the risk manager places more emphasis on pure risks. The following
three types of loss exposures (risks) are mainly considered by the risk manager.
(1) Property Losses (2) Third Party Liability Losses and (3) Personal Losses
1. PROPERTY LOSSES
Ownership of property puts a person or a firm to property exposure, i.e., the property will be
In small organizations, the risk manager can identify the property owned and the exposed value
of such property with less difficulty. In large organizations this may become cumbersome,
On the other hand, if the international information system is efficient and is backed by electronics
data processing equipment, then the risk manager can obtain the required information in a more
accurate and suitable form from the data processing unit. Thus, in the identification process he
will find it helpful to prepare a checklist of the property exposed to various types of risks.
Property Checklist
Property checklist can facilitate the risk identification process. Accordingly, the risk manager
prepared a listing of the various assets owned by the firm in major categories that are exposed to
risk. He can as well identify the perils that can possibly cause property losses. The exposed value
of each property will also be entered in the checklist to have a clear picture as to the severity of a
Analysis of insurance policy forms can also help in identifying various types of insurable pure
risks. Here, the risk manager initially collects a specimen of insurance policy forms from various
insurers. He, then, proceeds to prepare a checklist of various types of pure risks that can be dealt
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with insurance. An example of this type of checklist is presented on the next page. The
disadvantage of this procedure, however, is that it ignores non-insurable pure risks. Nevertheless,
through close examination of the policy forms the risk manager can identify the non-insurable
2. LIABILITY LOSSES
Third party liability losses refer to injuries caused to other people and/or damages caused to their
property. Firms are exposed to liability risks by virtue of their operating activities.
Consequently, it becomes an essential responsibility of the risk manager to identify the possible
liability losses that the firm may be exposed to. Liability losses originate in various ways. Some of
Product Liability
It is associated with the manufacture and sell of a particular product. A good example is
pharmaceutical products. Pharmaceutical companies are very much exposed to this risk.
Consumption of a particular drug or medicine may cause serious health damages to the
consuming public. The victim in most case files a lawsuit demanding a considerable amount of
compensation for the damages he/she suffered as a result of consuming the product. Quality
problems, breach of warranty, misleading advertisement, etc… are some of the other factors that
Motor Vehicles
This is the most frequent factor a firm should expect concerning liability losses. Use of various
kinds of motor vehicles (buses, trucks, small cars, motor cycles, special vehicles, aircraft, etc…)
exposes the firm to third party liability losses. Operation of motor vehicles could lead to killing of
people, injuries and damages caused to the property of other people due to accidents such as: fire,
Industrial Accidents
Factory employees are likely to suffer physical injuries at worksites. In some types of activities
they may develop job related diseases. This is particularly the case in foundries, chemical
industries, cement factories etc… Where factory employees are exposed to dust inhalation and
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pungent chemical smell that can cause occupational diseases. The firm will have to compensate
the employees for the injuries they sustained during the course of employment.
Industrial Waste
This refers to industrial garbage’s thrown into rivers and lakes thereby polluting the environment.
Environmentalists are likely to file a lawsuit against the activities polluting firms, especially
Professional Activities
In the field of public accounting, medicine, construction and other professional activities, liability
risks are likely to emerge because of the deficiencies inherent in the services rendered due to
Ownership of Immovables
This refers to buildings; land and machinery owned the use of such immovables by people may
bring liability losses for injuries caused by accidents. For example, faulty electrical connection, old
building, faulty elevators and escalators may cause injury to people while they are using these
facilities.
3. PERSONNEL LOSSES
These are losses to a firm regarding its employees and their families. The risks include death and
bodily injury due to accidents while off duty, industrial accident, occupational disease,
Employees represent the human asset (capital) of the firm. Their good health, motivation, moral,
dedication and loyalty greatly increase the value of the firm. Employees put relentless effort, for
the achievement of the sales of the firm when they realize that the firm has a strong interest in the
wellbeing of its employees and, hence, expend resources to safeguard their safety.
In some situation, the reputation and success of a particular firm is attributed to the exceptional
caliber of a particular management executive. Loss of this key executive (death or disability) can
bring severe operating disturbances: declining profits, disintegration of the moral of employees,
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As a result, the risks associated with personnel losses should also be carefully examined by the
risk manager. The need to avoid personnel risks (enhancing the safety of employees) is justified
3. To instill a confidence in the minds of the employees that the firm is really caring for the
Most firms are taking certain preventive measures to avert personnel losses. For example.
- Employees in some firms have 24-hour insurance protection against any accident –
on or off duty.
kidnapping, etc…
Once the risk manager has identified the risk that the firm is facing, his next step would be the
evaluation and measurement of the risks. Risk measurement refers to the measurement of the
The risk manager, by using available data from past experience, tries to construct a probability
distribution of the number of events and /or the probability distribution of total monetary losses.
This would, indeed, require knowledge of certain statistical techniques and concepts. The
probability distribution of number of events and /or total monetary losses would enable the risk
manager to estimate among other things the size of possible monetary losses and the
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The following example is considered for illustrative purpose. The data presented below represents
the number of cars operated (similar in type of use) by a firm in each year, the corresponding
number of accidents occurred and the total monetary losses incurred in connection with the
accidents.
Year Number of Cars Number of Accident Amount of Loss
1 10 1 Birr 2,500
2 12 2 4,200
3 14 3 4,500
4 15 3 6,000
5 20 2 6,500
6 20 3 6,600
7 25 4 6,000
8 25 5 8,000
9 28 3 7,500
10 30 4 10,000
SUM 200 30 61,800
Mean 20 3 6,180
S.D 1.15 2,115
Probability of Accident =
( ) Where: e = 2.71828
r = number of occurrences
M =Expected number of Accidents = (pn)
STD = Standard Deviation = √ (M)
n = Number of Exposed Units = 40
Accordingly, M = pn = 0.15 * 40 = 6 accidents and STD = √ (M) = 2.45
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The Poisson probability distribution allows for unlimited number of accidents occurring to the
object under consideration, (car). This means that a particular car can possibly experience more
than one accident. This is normally the case in real life situation.
Once the probability distribution is developed, it would not be difficult to determine the
= 0.938
This is the probability that there would be at least three accidents in the year.
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Similarly, the probability that the number of accidents equal or exceed 13 is given by:
= 0.0088
= 0.9292
This indicates that, the risk manager’s expectation of accidents is heavily concentrated between 3
and 13 accidents.
The expected annual total monetary loss is Birr 12,359. 39 as determined on the table above. The
expected dollar loss per accident is obtained by dividing the expected annual total monetary loss
by the expected annual total monetary loss by the expected number of accidents.
Expected Monetary
The calculation of standard deviation of total monetary loss is presented on the next page. The
standard deviation is 5,046.46. From earlier analysis the following measures were obtained:
P = .15
n = 40
RM 0.408 indicates the variability of total annual monetary losses from the expected value, (the
mean).
The higher the Coefficient of Variation (RM), the higher, the risk, meaning variability increases.
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In this example total annual monetary losses could deviate 40.8% from the mean in either
direction. For example the range for 1 standard deviation is Birr 7,314 to Birr 17,406. On the table
above, this range is approximated by Birr 6,180 to Birr 18,540. The probability that total annual
monetary loss falls in this range is 0.8542, which is obtained by adding all the probabilities in the
range. In terms of number of accidents, the risk manager expects to observe 3 to 9 accidents about
SUM 25,466,692.320
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RISK MEASURES:
The standard deviation of total annual monetary loss can also be determined as follows:
SD of Accidents x Expected Monetary Loss per Accident
2.44949 x 2,060 = 5,046
Rn indicates the deviation from the expected outcome as a percentage of the total number of
exposure units. Accordingly, given one standard deviation, the actual accidents could vary from
the expected accidents by about 6.1% of the total number of exposure units. The higher the
percentage, the higher the variability (higher variance), and consequently, the higher the risk.
POSSIBLE DECISIONS
Self-Insurance
1. To keep reserve fund equal to the expected total annual monetary loss.
Reserved Fund = Birr 12,360
2. To keep reserve fund equal to the expected value of the loss plus an amount to cover for
one standard deviation of the expected value.
Reserved Fund = 12,360 + 5,046 = Birr 17406
3. To keep reserve fund equal to the maximum probable loss (ignoring losses with a
probability of occurrence less than 1%).
Reserved Fund = Birr 24,720
RISK AND LAW OF LARGE NUMBER
Suppose the exposure units are to be increased to 50, (n = 50).
Mean Number of Accidents = M = .15*50 = 7.5
SD of Accidents = SD = √ (7.5) = 2.7386
Rm = = 0.365
Rn = = 0.054772
It is possible to simulate this process to see how risk decrease as the number of exposure units
increase. Here is the summary.
N M Sd Rm Rn
40 6 2.4495 0.408 0.06124
50 7.5 2.7386 0.365 0.05478
100 15 3.8730 0.258 0.03873
The mean (M) increases proportionately while Rm and Rn decrease less than proportionately.
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The Risk Manager may also use the Binomial probability distribution to measure risk. To use the
Binomial distribution the Risk Manager must be familiar with the basic assumptions of the
distribution to avoid misleading results. The first assumption is that the objects are independently
exposed to loss. The other assumption is that each exposed unit suffers only one loss in a year.
With this assumption in mind, the following illustrative example is considered. A fleet of 5
delivery trucks are operated by a business. If an accident happens to a particular truck it becomes
a total loss. New trucks are purchased at the beginning of every year to make up the lost ones so
that the firm always starts the new fiscal period with a fleet of 5 delivery trucks.
First it is assumed that monetary loss per accident is constant at Birr 5000.
1 5 2 Birr 10,000
2 5 2 10,000
3 5 3 15,000
4 5 2 10,000
5 5 1 5,000
SUM 25 10 50,000
Mean 5 2 10,000
SD 0.6324 3,162.27
P= = 0.40
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Under the Binomial probability distribution the probability of observing exactly r occurrences is
given by:
( ) ( )
( )
0 0.07776 0
1 0.25920 0.2592
2 0.34560 0.6912
3 0.23040 0.6912
4 0.07680 0.3072
5 0.01024 0.0512
The expected number of accidents is 2. The standard deviation can be determined as usual
√ √ √
The probability that the firm will face some accident is 0.92224, (1-0.07776). This probability is so
high that the risk manager should take appropriate measures to handle the risk.
FORMULA FOR MEAN AND SD OF A BINOMIAL DISTRIBUTION
The mean and the standard deviation of a Binomial probability distribution can also be
Mean = M = =
SD = √ =√
RISK MEASURES
Risk Relative to Mean, (Coefficient of Variation) =
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√
( ) ( )
( ) ( )
( )
( )
( )
Rm decreases as n increases.
Risk Relative to the Number of Exposure units
( ) √
√
( ) ( )
( ) ( )
√
Rn decreases as n increases
To illustrate the situation suppose the exposure units are to be increased to 20, (n = 20)
√ √
Increasing the number of exposure units to 100 will give the values for Rm & Rn as shown below.
n M SD RM Rn
5 2 1.095 0.54750 0.21900
20 8 2.190 0.27375 0.10950
25 10 2.449 0.2449 0.09796
50 20 3.464 0.1732 0.06928
100 40 4.899 0.12247 0.04899
The risk does not decrease in proportion to the increase in the number of exposure units.
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1.095
Risk relative to the Maximum Possible Loss is:
NORMAL DISTRIBUTION
The Risk Manager may assume that the numbers of accidents or total annual monetary losses are
approximately normally distributed. Under such circumstances, he/she may use the Normal
distribution in measuring the number of accidents or the total annual monetary losses. If
observations are normally distributed, the Risk Manager will have a good insight of the size of
possible losses at much greater ease. This is because the normal distribution can be well explained
by identifying only two parameters, the mean and the standard deviation. For illustrative purpose
let us consider the example under Binomial distribution with slight changes
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68.27 % of the observations fall within the range of one standard deviation of the mean.
95.45 % of the observations fall within the range of two standard deviation of the mean.
99.73 % of the observations fall within the range of three standard deviations of the mean.
The implication of this for the Risk Manager, in the case of monetary losses, is that he/she would
construct the following interval estimation about the true mean monetary loss.
The true mean monetary loss is expected to fall in the range of Birr 9,000 and Birr 13,000 with a
probability of 0.6827.
The true mean monetary loss is expected to fall in the rage of Birr 7,000and Birr 15,000 with a
probability of 0.9545.
The true mean monetary loss is expected to fall in the range of Birr 5,000 and Birr 17,000 with a
probability of 0.9973.
Risk is handled in several ways. Most authors cite the following risk handling tools:
These tools are classified as Risk Control Tools and Risk Financing Tools.
1. Avoidance
Avoidance of risk exists when the individual or the organization frees itself from the exposure
through abandonment or refusal to accept the risk. An individual can avoid third person liability
by not owning a car. Product liability can be avoided by dropping the product leasing avoids the
Avoidance, however, may not be a sound risk handling tool. For example, a business has to own
vehicles building, machinery, inventory, etc.. Without them operations would become impossible.
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In other situations, avoidance could be a viable alternative. For example, it may be better to avoid
the construction of a company near river banks, volcanic areas, valleys, etc because the risk is so
great Moreover, a research laboratory may abandon a highly dangerous experiment similarly, and
dangerous sport activities like skiing, mountain climbing, and motor racing could be avoided to
These measures refer to the safety actions taken by the firm to prevent the occurrence of loss or
reduce its severity if the loss has already occurred. Prevention measures in some cases eliminate
the loss totally although their major effect is to reduce the probability of loss substantially. Loss
reduction measures try to minimize the severity of the loss once the peril happened. For example,
auto accidents can be prevented or reduced by having good roads, better lights and sound traffic
regulation and control, fast first-aid service and the like. LP & R measures must be considered
before the Risk Manager considers the application of any risk financing measures.
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society as well. For example, a destruction of inventory of a firm could be a fatal loss to the firm in
particular. The society also faces a real economic loss because those goods are no more available
to people.
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Thus the importance of LP&R measures should not be underestimated by a firm. To design
Some of the causes of accidents and the possible LP & R measures are indicated below.
Data should be kept regarding accidents occurred. The causes of these accidents must be
investigated. Pre-designed forms may be employed to report on accidents and their causes. This
Loss control measures entail costs. These costs include expenditures for the acquisition of safety
equipment’s and devices, operating expenses such as salary payments to guards, inspectors,
safety engineers and other employees engaged in safety work. Other costs are also incurred in
connection with safety training and seminars. The Risk manager will have to design the LP &R
measures in the most efficient way in order to minimize such costs without reducing the desired
safety level.
3. Separation/Diversification
The exposed property is scattered to different places. The principle is “don’t put all your eggs in
one basket”. This could be regarded as a loss reduction measure. For example, a firm’s inventories
could be kept in warehouses located in different areas. In another case, the inventories could be
grouped according to their value or importance and be kept in separate places with differing
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4. Combination
Combination is a basic principle of insurance that follows the law of large numbers. Combination
increases the number of exposure units since it is a pooling process. It reduces risk by making
In the case of firms, combination results in the pooling of resources of two or more firms. This
leads to financial strength thereby minimizing the adverse effect of the potential loss. For
example, a merger in the same or different lines of business increases the available resources to
5. Non-Insurance Transfer
Certain activities may be given to subcontractors to avoid the probable increase in costs.
Factoring of accounts receivable without recourse. Some premiums are paid but
Delivery of goods at the warehouse rather than at the buyer’s premises. Transit risk is
Consignment shipments rather than purchase. If the goods remain unsold or expired, they
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1. Retention
This is the easiest method of handling risk. The person or the firm, consciously or unconsciously,
decides to assume the risk. The loss is to be borne by the person or the firm, and no specific
A person or a firm decides to retain the risk for a number of reasons. It is probability impossible to
transfer the risk, as in the case of gambling. Besides, the attitude of the individual or the firm
towards risk than do risk will influence risk assumption. Risk lovers prefer to assume
considerable risk than do risk-avoiders. The value of goods to be insured compared to insurance
cost is another factor that may force businesses to assume risk, cost-benefit analysis. One also may
think that the risk is so remote that retention is a better alternative. In other situations, some risks
are minor as compared to the size of the business that the business can absorb the loss.
This is because the person or the firm, being aware of the risk may take necessary precautions to
finance the probable loss. For example, finds may be set aside for contingencies (self- insurance),
or some form of financial planning would be made to finance the loss. Retention can also happen
because the person is unaware of the risk. Thus, he will take no action (passive retention is
2. Insurance
Here the risk is transferred to an insurance company for a consideration. The insurer normally has
a better knowledge regarding loss prediction and a sound financial resource to accept the risk. He
is also in a better position to get the advantage of the law of large numbers.
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Speculative risks are handled with information and planning; i.e., careful study and planning. The
Diversification
Diversification is another risk handling tool. Most speculative risks in business can be dealt with
diversification. Businesses diversity their product lines so that a decline in profit of one product
could be compensated by profits from others. For example, farmers diversify their products by
growing different crops on their land. Diversification, however, has limited use in dealing with
pure losses. It goes with the saying “Don’t put all your eggs in one basket”. Thus a shareholder
can diversify his/her investment by acquiring shares if different companies. A closer look shall
made to determine the kind of diversification and the degree of diversification needed.
company under the existing corporate umbrella, or enter in to a joint venture for a
Diversify products within the company’s core business (e.g. baby care products,
disposable diapers, wound care products, feminine hygiene products, surgical and
Diversification into any industry where top management spots a good profit opportunity
Hedging
Type of loss Loss Frequency Loss Severity Appropriate Risk Management Technique
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At this point, three of the four steps in the risk management process have been discussed. The
Typical activities of a risk manager include identifying and evaluating loss exposures, establishing
procedures for handling insurance claims, designing and installing employee benefit plans,
participating in loss-control and safety programs, and administering group insurance and self-
insurance programs. Thus, risk managers are an important part of the management team.
To be effective, the risk management program must be periodically reviewed and evaluated to
determine if the objectives are being attained. In particular, risk management costs, safety
programs, and loss prevention programs must be carefully monitored. Loss records must also be
examined to detect any changes in frequency and severity. In addition, new developments that
affect the original decision on handling a loss exposure must be examined. Finally the risk
manager must determine if the firm’s overall risk management policies are being carried out, and
if the risk manager is receiving the total cooperation of the other departments in carrying out the
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