LECTURE TWO: RISK MANAGEMENT.

After identifying and evaluating exposures to risk, systematic consideration can be given to alternative methods of managing each exposure. The four basic methods of handling risk are:

METHODS OF HANDLING RISK

1. Risk avoidance 2. Loss control 3. Risk retention 4. Risk transfer The first three are called noninsurance methods of risk management and the last one is an insurance method of risk management.

NON-INSURANCE METHODS OF RISK MANAGEMENT a). RISK AVOIDANCE

Risk avoidance is about conscious decisions which do not expose oneself or one firm to a particular risk of loss. Risk avoidance can be said to decrease ones chance of loss to zero. For example one, can avoid death by an air crash by avoiding traveling by air. A good example was the decision of South Korean automobile makers to delay entry into the American car industry until their products could meet safety standards due to the litigious nature of the American society.

 Risk avoidance is common especially to those who are risk averse. However, risk avoidance is not always feasible and may not be desirable even when it is possible. Managers must weigh the benefit against the costs of risk avoidance. When a risk is avoided the potential benefits and the cost are given up. If a business is to operate at all, certain risks are nearly impossible to avoid.

 LOSS CONTROL When a risk cannot be avoided, measures are taken to reduce the losses associated with them. This method of dealing with risks is called loss control. It is different from risk avoidance because the individual or the business still engages in operations that give rise to particular risks. The risk manager makes conscious decisions to reduce losses that arise from the activities conducted.

 Types of Loss Control. Effective loss control sometimes requires technical knowledge of the exposure itself e.g. in safety engineering in many manufacturing processes, two methods of classifying loss control involve focus and timing.

1. Focus of Loss Control Frequency reduction: This focuses on reducing the possible frequency of loss e.g. maintaining airplanes regularly or regular safety drills in a factory. Severity reduction: This is attempting to reduce the severity of loss once the peril has occurred. For example, airbags in vehicles do not prevent accidents but reduce the extent of injury when an accident occurs. Severity reduction can be done in two common ways:

i). separation i.e. the risk management policy may separate activities e.g. Bralirwa having a factory in Gisenyi and in Kigali so that in case of a serious fire accident its operations will not be completely curtailed. In case of accident, the loss will have been reduced. ii). Duplication. The other severity reduction is duplication e.g. where spare parts are bought in pairs so that in case of a break down, replacement can be done immediately without serious loss of business. This will also reduce the severity of loss.

2. Timing of Loss Control

Some loss control methods are implemented before losses occur. These are called pre-loss activities e.g. employee safety education programs, which are aimed both at reducing the frequency and severity of injuries to workers. The second timing classification for loss control measures is that of activities that take place concurrently with losses. The activation of building sprinkler systems illustrates the concept of concurrent loss control.

 The third timing category is that of post loss activities. They tend to reduce the severity of the loss when it occurs e.g. attempting to salvage property instead of discarding it when the loss occurs e.g. repair of an automobile after an accident and selling it before buying another.

Potential Benefits of Loss Control Many of the benefits associated with loss control are either readily quantifiable or can be reasonably estimated. 1.These may include the reduction or elimination of expenses associated with the following: Repair or replacement of damaged property. Income losses due to loss of property Extra costs to maintain operations after a loss. Adverse liability judgments Medical costs to treat injuries Income loses due to deaths or disabilities.

 Another potential quantifiable benefit of loss control is a reduction in the cost of other risk management techniques used in conjunction with loss control. An example is the decrease in insurance premiums that accompanies a loss control investment. Other benefits cannot be quantified in monetary terms such as a good reputation of a company as a safe working environment and ability to attract talented workers.

 Potential Costs of Loss Control These are easier to estimate than the benefits. Two obvious cost components are installation and maintenance e.g. a sprinkler system will have an initial cost and maintenance cost. The challenge in estimating loss control costs is to identify all the costs associated with the loss control technique some of which are not easy to identify e.g. Hiring a night guard may have hidden costs apart from the salary e.g. medical benefits, house allowance etc. An electric fences expenses are not only the cost of installation but the increase in electricity cost.

RISK RETENTION A third technique of managing risk is known as risk retention. This involves the assumption of risk. That is incase the loss occurs the individual or business will cover the loss from whatever resources that are available. Retention can be planned or unplanned and the losses that occur may be funded or unfunded in advance.

Planned versus Unplanned Retention Planned retention involves a conscious and deliberate assumption of recognized risk. Sometimes planned retention occurs because it is the most convenient risk treatment technique or because there are no alternatives other than ceasing operations. Others times it is because the risk manager has considered all other alternatives and decided that risk retention is the most appropriate loss control method.

 When an individual or organization does not recognize that a risk exists and unwillingly believes that no loss could occur, this is risk retention that is unplanned. This occurs also when a risk has been recognized but the potential loss is significantly underestimated.

 Funded versus Unfunded Retention Many risk retention strategies involve the intention to pay for losses when they occur without making any funding arrangement in advance of a loss. This is called unfunded retention and is paid out of current revenues e.g. a shop may replace shoplifted items out of current revenue. In contrast a firm or individual may decide on a funded retention by making various pre-loss arrangements to ensure that funds are available for losses if they occur. Funding for retained losses can be through: Credit or borrowing. Reserve funds

Decisions Regarding Retention There are several factors to consider in assessing retention as risk management technique. These factors include the following: 1. Financial resources: A large company with more financial resources may retain loses more than a small company with limited resources.

The following factors about an organizations financial position should be taken into account. Total assets Total revenues Asset liquidity Cash flows Working capital (current assets- current liabilities Retained earnings.

2. Ability to predict losses: The Company may face financial ruin if it underestimates a particular loss. Thus loss retention depends on an organization to fairly estimate the amount of potential loss that it is likely to incur. 3.Feasibility of the retention program: if the decision to retain loses involves advance funding, administrative issues may need to be considered and the expenses associated with risk retention and management e.g. investigation and paying for the losses.

 RISK TRANSFER This is the final risk management tool. It involves payment by one party (the transferor) to another (the transferee or risk bearer). The transferee agrees to assume the risk that the transferor desires to escape. There are five types of risk transfer: Hold harmless Agreements Incorporation Diversification Hedging Insurance

Hold Harmless Agreements These are provisions that are added to contractual agreements that transfer risk from one party to another. Sometimes they are called indemnity agreements. The aim of the provisions is to specify the party that will bear the loss if it occurs e.g. a landlord may include in a lease agreement that the tenant will be responsible for injuries that guests may suffer while in the leased premises or a hotel may indicate that vehicles parked in its premises are parked at owners risk.

 Incorporation This is registering a business as a limited company. The most that an incorporated firm can lose is the total amount of its assets. Personal assets of the owners cannot be used to help pay for the losses of the business as is the case with sole proprietors and partnerships. Through incorporation a firm transfers to its creditors the risk that may not have sufficient assets to pay for loses and other debts.

 Diversification Sometimes although not a risk management technique, the production decisions that a firm makes may serve to transfer risk. Diversification across various businesses or geographical regions results in the transfer of risk across business units.

 Hedging Hedging involves the transfer of a speculative risk. It is a business transaction where the risk of price fluctuations is transferred to a third party. For example an airline faces significant price risk from fluctuation in the price of jet fuel that it buys. The airline sells airline tickets well in advance of the date in which it intends to transport its passengers. The price of fuel it buys on the day it transports its passengers may increase or decrease relative to the price on the date it set its ticket prices causing either profit or loss. To avoid such a possibility of loss the airline buys oil in the oil futures market at a price determined now.

 Insurance This is the most common method of risk transfer. This is discussed in lecture number 3 on Insurance as a risk transfer mechanism.