An expense loading is the amount needed to pay all expenses including commissions general administrative expenses state premium taxes acquisition expenses and an allowance for contingencies and profit A loss exposure is any situation or circumstance in which a loss is possible regardless of whether a loss occurs RMI 3011 Notes Chapter 3 What is Risk Management Risk Management Objectives Pre loss Objectives o Prepare for potential losses in the most economical way o Reduce anxiety o Meet legal obligations Post loss Objectives o Business survival o Continue operations o Continue growing the business o Minimize the effects of a loss on others and society Operational Risks Financial Risks Strategic Risks Loss of earnings Assets damaged destroyed or stolen Assets become obsolete Employee related risks Legal liability Political risks Various risks including input price output price interest rate credit counterparty risk currency or foreign exchange rate risk Loss of Market Share Compeition Decisions Regarding Products o Products Don t Meet Sales Productions o Technology Issues Products Become Obsolete o Economic Risks that Impact Sales and or Costs Merger Acquisition doesn t pay off Identify Loss Exposures Property loss exposures Liability loss exposures Business income loss exposures Human resources loss exposures Crime loss exposures Employee benefit loss exposures Foreign loss exposures Intangible property loss exposures Failure to comply with government rules and regulations Measure and Analyze Loss Exposures Estimate for each type of loss exposure o Loss frequency time period o Loss severity refers to the probable number of losses that may occur during some refers to the probable size of the losses that may occur Rank exposures by importance Loss severity is more important than loss frequency o The maximum possible loss is the worst loss that could happen to the firm during its lifetime o The probable maximum loss is the worst loss that is likely to happen Select Techniques for Treating the Loss Exposures Methods of Risk Control Avoidance Loss Control Loss Reduction o Loss prevention refers to measures that reduce the frequency of a particular loss e g installing safety features on hazardous products o Loss reduction refers to measures that reduce the severity of a loss after it occurs e g installing an automatic sprinkler system Risk Financing Methods Retention a risk manager has several methods for paying retained losses Current net income losses are treated as current expenses Unfunded reserve losses are deducted from a bookkeeping account Funded reserve losses are deducted from a liquid fund Credit line funds are borrowed to pay losses as they occur A captive insurer is an insurer owned by a parent firm for the purpose of insuring the parent firm s loss exposures o A single parent captive is owned by only one parent o An association or group captive is an insurer owned by several parents Why would someone want to have their own insurance o The parent firm may have difficulty obtaining insurance o To take advantage of a favorable regulatory environment o Costs may be lower than purchasing commercial insurance o A captive insurer has easier access to a reinsurer Insurance for insurance companies o A captive insurer can become a source of profit o Advantages Save on loss costs Save on expenses Encourage loss prevention Increase cash flow o Disadvantages Possible higher losses Possible higher expenses Have to bring in outside experts Possible higher taxes Risk Financing Methods Non Insurance Transfers Advantages Disadvantages o Can transfer some losses that are not insurable o Less expensive o Can transfer loss to someone who is in a better position to control losses o Contract language may be ambiguous so transfer may fail In cases when this happens usually the individual will win and the insurance company will lose o If the other party fails to pay firm is still responsible for the loss o Insurers may not give credit for transfers Risk Financing Methods Insurance The risk manager negotiates the terms of the insurance contract A manuscript policy is a policy specially tailored for the firm The parties must agree on the contract provisions endorsements forms and premiums Information concerning insurance coverages must be disseminated to others in the firm The risk manager must periodically review the insurance program Advantages o Firm is indemnified for losses o Uncertainty is reduced o Insurers can provide valuable risk management services o Premiums are income tax deductible Disadvantages o Premiums may be costly o Negotiation of contracts takes time and effort o The risk manager may become lax in exercising loss control Excess Insurance insurance will cover o People buy private insurance to cover amounts that exceed what the normal Sometimes flood insurance will only cover up to 250 000 people who have really expensive houses right on the water should get the additional coverage ex Hurricane Katrina losses Risk Management Matrix Low frequency Low severity Retain the loss High frequency Low severity Loss prevention or retention Low frequency High severity Transfer risk High frequency High severity Avoidance Market Conditions and the Selection of Risk Management Techniques Risk managers may have to modify their choice of techniques depending on market conditions in the insurance markets The insurance market experiences an underwriting cycle In a hard market profitability is declining underwriting standards are tightened premiums increase and insurance is hard to obtain o Hard market HARD for CONSUMERS In a soft market profitability is improving standards are loosened premiums decline and insurance become easier to obtain o Soft market GOOD for CONSUMERS Benefits of Risk Management Enables firm to attain its pre loss and post loss objectives more easily A risk management program can reduce a firm s cost of risk Reduction in pure loss exposures allows a firm to enact an enterprise risk management program to treat both pure and speculative loss exposures Society benefits because both direct and indirect losses are reduced Personal Risk Management refers to the identification of pure risks faced by an individual or Personal risk management family and to the selection of the most appropriate technique for treating such risks The same principles applied to corporate risk management apply to personal risk management
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