NATURE OF RISK MANAGEMENT

Chapter outline:
Meaning and definition Scope and objectives of risks management Role of the risk manager Evaluation

 Although the term risk management is of recent vintage, the actual practice of risk management is as old as civilization itself. In the Broad sense, Risk management is the process of protecting ones person and assets. In the Narrower sense, It is a managerial function of business use a scientific approach to deal with risks. In this Chapter, we examine the distinguishing features of risk management.

 Risk management is a scientific approach to the problem of dealing with the pure risks facing individuals and organization

It evolved from corporate insurance management, which focused on the risk of accidental loss to assets and income of the organization

 The general trend in use of the term risk management began in the early 1950s One of the early references to risk management in literature appeared a 1956 article in Havard Business Review by Russel Gallagher.

Gallagher proposed that someone within the organization should be

responsible for managing the organizations pure risks.

Evolution from corporate insurance buying

1929

Corporate insurance buyers met informally in Boston to discuss mutual problems American Management Association established its Insurance Division Insurance Buyers of New York formed-RRI National Association of Insurance Buyers Formed

1931 1932 1950

 Emergence of risk management was a revolution that signaled a dramatic shift in philosophy. It occurred when the attitude toward insurance changed and insurance lost its traditional status as the standard approach for dealing with risk.

The question is why the change occurred when it did?

 What cause the change in attitude toward insurance and shift to a risk management philosophy?

The shift to a risk management philosophy coincided with a reappraisal of curriculum in business colleges in the U.S in 1950 and 60s. The most significant changes in business curriculum were the introduction of operation research and management science.

 Management sciences emphasis on cost-benefit analysis value, and a scientific approach to decisionmaking under uncertainty led to a shift from descriptive courses to normative decision theory.

 Not surprisingly, insurance faculty were among the first to embrace decision theory.
Many were trained in actuarial science Most had an inventory of interesting questions relating to decision making under uncertainty. They not only questioned the central role that had been granted to insurance, but developed the theoretical justification for the challenge.

 Some insurance buyers intuitively (and independently) reached the same conclusions about the supremacy of insurance in dealing with risk as academics who applied the new decision models.
Many concepts of modern risk management that originated in academics halls were taken over and applied in the corporate world.

 Risk management grew out of a merger of engineering applications in military and aerospace programs, financial theory and insurance.

Risk management is a scientific approach to dealing with pure risks by anticipating possible accidental losses and designing and implementing procedures that minimize the occurrence of loss or the financial impact of the losses that do occur.

1. Scientific approach to dealing with pure risks. 2. Broader than insurance management 3. Differs from insurance management in philosophy

 Risk management depends on rules (laws) derived from the general knowledge of experience, through deduction, and from percepts drawn from other disciplines, especially decision theory.
Although risk management is not a science in the same sense as the physical sciences, this does not preclude its use of scientific method.

 A fundamental part of the risk management function is designing and implementing procedures that minimize the occurrence of loss or the financial impact of the losses that do occur.
Two broad techniques used in risk management dealing with risk: Risk control Risk financing

Risk Control
Design to minimize at least possible costs exposed by organization. Methods used are risk avoidance and risk reduction. Risk Avoidance (loss prevention) The individual or organization refuses to accept any exposure to loss arising from particular activity. Risk Reduction (loss control) Consists of all techniques that are designed to reduce the likelihood of loss or the potential severity of those losses that do occur. However, these techniques constitute the application of risk control to the exposure involved.

Risk Financing
Focuses on guaranteeing the availability of funds to meet those losses that do occur. Methods used are retention or transfer.
Retention (maintenance) Accompanied by specific budgetary allocations to meet uninsured losses and may involve the accumulation of a fund to meet deviations from expected losses. Transfer Take the form of contractual arrangements (such as hold-harmless agreement), the subcontracting of certain activities or surety bonds. For example, transfer of risk through the purchase of insurance contracts is primary approach to risk financing.

 Risk Management vs General Management

Differs from its scope even both deals with risks. General management is responsible to all risk facing the organization: speculative and pure. Responsibility for pure risk is delegated to the risk manager.

 Risk Management vs Insurance Management

Because it evolved from insurance management, risk management is concerned primarily with insurable risk. The risk managers responsibility is broader however, and includes both insurable and uninsurable pure risks.

 Henri Fayol (1916) , famous French management authority divided all industries activities into six broad functions: Technical activities (production, manufacture and adaption) Commercial activities (marketing) Financial activities Security activities Accounting activities Managerial activities

Determination of objectives

Identification of risks

Evaluation of risks

Consideration of alternativesselection of the tool

Implementin g the decision

Evaluation and review

STEP 1: Determining objectives

Decide precisely what the organization would like its risk management program to do. Variety of possible objectives for the risk management include maintaining the organization survival, minimizing the costs association with pure risk, and protecting employees from accidents

STEP 2: Identifying Risks

Be aware to the risks because risk management process is often delegated to an outside party, such as an insurance agent or a risk management consultant. Tools of risk identification are internal records of the organization, insurance policy checklist, risk analysis questionnaires, flow process charts, analysis of financial statement, inspections of the firm operations and interviews.

STEP 3: Evaluating The Risk

Involves measuring the potential size of the loss and the probability that the loss is likely to occur and then providing some ranking in into general classifications such as critical, important, and unimportant. One set of criteria may be used to establish priority ranking:
Critical risk: all exposure to loss which possible losses are of a magnitude that will result in bankruptcy. Important risks: those exposure in which possible losses will not result in bankruptcy but will require the firm to borrow to continue operations. Unimportant risks: possible losses can be met out of the firms existing assets or current income.

STEP 4: Considering Alternatives and Selecting the Risk Treatment Device.

Consider the techniques that should be used to deal with each risk. Include risk avoidance, retention, sharing, transfer and reduction. This stage primarily to decide which of the techniques available should be used in dealing with each risk. To determine which techniques are compatible, risk managers considers size of the potential loss, its probability and the resource that would be available to meet the loss if it should occur.

STEP 5: Implementing the Decision

Decision to hold a risk may be accomplished with or without a reserve and with or without fund. If the decision made to include accumulation of a fund, the administrative procedure must be launch. If the decision is made to loss prevention to deal with a particular risk, the proper loss prevention program must be designed and implemented.

STEP 6: Evaluating and Reviewing

valuation and review must be included in the program for two reasons:
The risk management process does not take place in vacuum (things change: new risks arise and old risk disappear) Mistakes are sometime made. Thus, this step permits the risk manager to review decisions and discover mistakes.

Responsibilities and duties of the Risk Manager:

1.

Assist in developing risk management policy helps management objectives and prepares a statement of policy for consideration and approval by top management. 2. Engages in risk identification and measurement 3. Selects risk financing alternatives risk manager recommends the techniques to be used or in some cases makes the choice. 4. Negotiates insurance coverage determine what insurance is needed. 5. Manages claims see the reporting procedures are adequate, that claims adjusters best available, reserves frequently checked etc. 6. Supervise internal administration 7. Communicates with other managers. 8. Handles accounting. 9. Administers risk functions. 10. Manages employees benefits.

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