Q.1 Explain the steps involved in risk management process?
Steps in Risk Management Process
1 Identifying Potential Losses
(a) Property loss exposures
• Building, plants, other structures
• Furniture, equipment, supplies
• Electronic Data Processing (EDP) equipment; computer software
(b) Liability loss exposures
• Defective products
• Environmental pollution (land, water, air, noise)
• Sexual harassment of employees, discrimination against employees, wrongful termination
(c) Business income loss exposures
• Loss of income from a covered loss
• Continuing expenses after a loss
• Extra expenses
(d) Human resources loss exposures
• Death or disability of key employees
• Retirement or unemployment
• Job-related injuries or disease experienced by workers
(e) Crime loss exposures
• Hold-ups, robberies, burglaries
• Employee theft and dishonesty
• Fraud and embezzlement
(f) Employee benefit loss exposures
· Fairly to comply with Government regulations
· Violation of fiduciary responsibilities
· Group life and health and retirement plan exposures
(g) Foreign loss exposure
• Plants, business property, inventory
• Foreign currency risks
• Kidnapping of key personnel
2 Evaluating Potential Losses:
The second step in the risk management process is to evaluate and measure the impact of losses on the firm. This step 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 time period. 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 exposure with the potential for bankrupting the firm is much more important in a risk management programme than an exposure with a small loss potential.
In addition, the relative frequency and severity of each loss exposure must be estimated so that the Risk Manager can select the most appropriate technique, or combination of techniques, for handling each exposure. For example, if certain losses occur regularly and are fairly predictable they can be budgeted out of a firm’s income and treated as a normal operating expense. If the annual loss experience of a certain type of exposure fluctuates widely, however, an entirely different approach is required.
Although the Risk Manager must consider both loss frequency and loss severity, severity is more important, because a single catastrophic loss could wipe out the firm. 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 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 estimates that replacement cost, debris removal, demolition costs, and other costs will total Rs.10 million. Thus, the maximum possible loss is Rs.10 million. The Risk Manager also estimates that a flood causing more than Rs.8 million of damage to the plant is so unlikely that such a flood would not occur more than once in 50 years. The Risk Manager may choose to ignore events that occur so infrequently. Thus, for this Risk Manager, the maximum probable loss is Rs.8 million.
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 cars and trucks, occur with greater frequency, are usually relatively small, and can be predicted with greater accuracy.
3 Selecting the Appropriate Techniques for Treating Loss Exposures:
The third step in the risk management process is to select the most appropriate techniques for treating loss exposures. These techniques can be classified broadly as either risk control or risk financing. Risk control refers to techniques that reduce the frequency and severity of accidental losses. Risk financing refers to techniques that provide for the funding of accidental losses after they control. Many Risk Managers use a combination of techniques for treating each loss exposure.
(a) Risk Control: Risk control encompasses techniques that prevent losses from occurring or reduce the severity of a loss after it occurs. Major risk control techniques include avoidance and loss control.
i) Avoidance: Avoidance means a certain loss exposure is never acquired, or an existing loss exposure is abandoned. For example, flood losses can be avoided by not building a new plant in a flood plain. A pharmaceutical firm that markets a drug with dangerous side effects can withdraw the drug from the market.
ii) Loss Control: Loss control has two dimensions – Loss prevention and loss reduction. Loss prevention refers to measures that reduce the frequency of a particular loss. For example, measures that reduce truck accidents include driver examinations, zero tolerance for alcohol or drug abuse, and strict enforcement of safety rules. Measures that reduce lawsuits by the consumer of a defective product include installation of safety features on hazardous products, placement of warning labels on dangerous products, and institution of quality control checks.
(b) Risk Financing:Risk financing refers to techniques that provide for the funding of losses after they occur. Major risk-financing techniques include retention, non-insurance transfers and commercial insurance.
(i) Retention: Retention means that the firm retains part or all of the losses that can result from a given loss. Retention can be either active or passive. Active risk retention means that the firm is aware of the loss exposure and plans to retain part or all of it, such as automobile collision losses to a fleet of company cars. Passive retention, however, is the failure to identify a loss exposure, failure to act. For example, a Risk Manager may fail to identify all company assets that could be damaged in an earthquake.
(ii) Non-insurance Transfers: Non-insurance transfers are another type of risk financing technique. 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 responsibilities of the computer firm. Or 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 the publisher is sued for plagiarism.
(c) Insurance: Commercial insurance is also used in a risk management programme. Insurance is appropriate for loss exposures that have a low probability of loss but for which 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:
. Selection of insurance coverages
. Selection of an insurer
. Negotiation of terms
. Dissemination of information concerning insurance coverages
. Periodic review of the programme
4 Implementing and administering the Risk Management Programme:
At this point, we have discussed three of the four steps in the risk management process. The fourth step is implementation and administration of the risk management programme. This step begins with a policy statement.
(a) Risk Management Policy Statement:A risk management policy statement is necessary to have an effective risk management programme. This statement outlines the risk management objectives of the firm, as well as company policy with respect to treatment of loss exposures. It also educates top-level executives with regard to the risk management process, gives the Risk Manager greater authority in the firm, and provides standards for judging the Risk Manager’s performance.
(b) Co-operative with other Departments:The Risk Manager does not work alone. Other functional departments within the firm are extremely important in identifying pure loss exposures and methods for treating these exposures. These departments can co-operate in the risk management process in the following ways:
• 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 effect 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.
• Production. Quality control can prevent the production of defective goods and liability lawsuits. Effective safety programmes in the plant can reduce injuries and accidents.
• Human resources. This department may be responsible for employee benefit programmes, pension programmes, safety programmes, and the company’s hiring, promotion, and dismissal policies.
This list indicates how the risk management process involves the entire firm. Indeed, without the active co-operation of the other department, the risk management programme will be failure.
(c) Periodic Review and Evaluation: To be effective, the risk management programme must be periodically reviewed and evaluated to determine whether the objectives are being attained. In particular, risk management costs, safety programmes, and loss-prevention programmes 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 in carrying out the risk management functions.
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