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Unformatted text preview: Dr Mariusz Dybał Institute of Economic Sciences [email protected] Insurance market Introduction to risk management (Based upon: George E. Rejda, PRINCIPLES OF RISK MANAGEMENT AND INSURANCE (10TH EDITION), Addison Wesley, 2007) 1 Mariusz Dybał – Introduction to risk management Scheme of the Lecture 1. 2. 3. 4. 5. 6. Meaning of Risk Management Objectives of Risk Management Steps in the Risk Management Process Benefits of Risk Management Personal Risk Management Case application no. 3 2 Mariusz Dybał – Introduction to risk management 1. Meaning of 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; exposures; Becase the term „risk” is unclear many risk managers use the term „loss exposure” to identify potential losses; A loss exposure is any situation or circumstance in which a loss is possible, regardless of whether a loss occurs: occurs:   E.g., a plant that may be damaged by an earthquake, or an automobile that may be damaged in a collision; collision; New forms of risk management consider both pure and speculative loss exposures. exposures. 3 1 Mariusz Dybał – Introduction to risk management 2. Objectives of Risk Management   Risk management has important objectives objectives;; These objectives can be classified as follows:   PrePre-loss objectives; PostPost-loss objectives. 4 Mariusz Dybał – Introduction to risk management 2. Objectives of Risk Management  PrePre-loss objectives:  Prepare for potential losses in the most economical way: way:   Reduce anxiety: anxiety:   This preparation involves an analysis of the costs associated with the different techniques for handling losses; Certain loss exposures can cause greater worry and fear for the risk manager and key executives; Meet any legal obligations: obligations:  For example, government regulations may require a firm to install safety devices to protect workers from harm. 5 Mariusz Dybał – Introduction to risk management 2. Objectives of Risk Management  Post Post--loss objectives:  Ensure survival of the firm – it means that after the loss  occurs the firm can resume at least partial operations within some resonable time period; Continue operations – it means that firms must continue to operate after the loss. Otherwise, business will be lost to competitors;   Stabilize earnings; earnings; Maintain growth – The risk manager must consider the effect that loss will have on the firm’s ability to grow;  Minimize the effects that a loss will have on other persons and on society – A severe loss can adversely affect employees, supliers, creditors, and the community in general. 6 2 Mariusz Dybał – Introduction to risk management 3. Steps in the Risk Management Process  There are four steps in the risk management process:  Identify loss exposures;  Analyze the loss exposures;  Select the appropriate technique echniquess for treating the loss exposures;  Implement and monitor the risk management program.. program 7 Mariusz Dybał – Introduction to risk management 3. Steps in the Risk Management Process Exhibit 1 Steps in the Risk Management Process: Process:  8 Mariusz Dybał – Introduction to risk management 3. Steps in the Risk Management Process  Identify loss exposures:  Property loss exposures – buildings, plants, other structures, furniture, equipment, supplies, computers, computer software and data, inventory, accounts receivable, valuable papers and records, company vehicles, boats, mobile equipment;  Liability loss exposures – defective products, enviromental pollution, sexual harrasment of employees, discrimination against employees, wrongful termination, premises and general liability loss exposures, liability arising from company vehicles, misues of the internet and ee-mails transmissions, directors’ and officers’ liability suits;  Business income loss exposures – loss of income from a covered loss, continuing expenses after a loss, extra expenses, contingent business income losses;  Human resources loss exposures – death or disability of key employees, retirement or unemployment, jobjob-related injuries or disease experienced by workers; 9 3 Mariusz Dybał – Introduction to risk management 3. Steps in the Risk Management Process  Identify loss exposures, cont.: cont.:  Crime loss exposures – holdups, robberies, burglaries, employee theft and dishonesty, fraud and embezzlement, internet and computer crime exposures, theft of intellectual property;  Employee benefit loss exposures – failure to comply with government regulations, violation of fiduciary responsibilities, group life and health and retirement plan exposures, failure to pay promised benefits;  Foreign loss exposures – acts of terrorism, plants, business property, inventory, foreign currency risks, kidnapping of key personnel, political risks;  Market reputation and public image of company; company;  Failure to comply with government rules and regulations.. regulations 10 Mariusz Dybał – Introduction to risk management 3. Steps in the Risk Management Process  Identify loss exposures:  Risk Managers have several sources of information to identify loss exposures:   Questionnaires – that identify major and minor loss exposures; Physical inspection – of company plant and operations can identify major loss exposures;  Flowcharts – that show the flow of production and delivery can reveal production bottlenecks where loss can have severe financial consequences for the firm;  Financial statements – It’s analisys can identify the major assets that must be protected, loss if income exposures, and key customers and suppliers;  Historical loss data – can be invaluaable in identifying major loss exposures. 11 Mariusz Dybał – Introduction to risk management 3. Steps in the Risk Management Process  Analyze the loss exposures:  This step involves estimat estimation ion of the frequency and severity of loss for each type of loss exposure: exposure:    Loss frequency refers to the probable number of losses that may occur during some given time period; period; Loss severity refers to the probable size of the losses that may occur; occur; Once loss exposures are analyzed, they can be ranked according to their relative importance. importance. 12 4 Mariusz Dybał – Introduction to risk management 3. Steps in the Risk Management Process  Analyze the loss exposures:  Loss severity is more important than loss frequency:  Both the maximum possible loss and maximum probable loss must be estimated:    The maximum possible loss is the worst loss that could happen to the firm during its lifetime; lifetime; The maximum probable loss is the worst loss that is likely to happen happen;; For example:    If a plant is totally destroyed in a flood, the risk manager estimates cost will total $10 million (maximum possible loss); The risk manager also estimates that a flood causing more than $8 million of damage to the plant would not occur more than once in 50 years, therefore he may choose to ignore events that occure infrequently; Thus, the maximum probable loss is $8 million. 13 Mariusz Dybał – Introduction to risk management 3. Steps in the Risk Management Process  Select the appropriate technique echniquess for treating the loss exposures:  These techniques can be classified broadly as either:  Risk control - refers to techniques that reduce the frequency and severity of losses: losses:     Avoidance; Avoidance; Loss prevention; prevention; Loss reduction; reduction; Risk financing - refers to techniques that provide for the funding of losses: losses:    Retention;; Retention NonNon-insurance Transfers Transfers;; Commercial Insurance. Insurance. 14 Mariusz Dybał – Introduction to risk management 3. Steps in the Risk Management Process  Select the appropriate technique echniquess for treating the loss exposures:  Avoidance means a certain loss exposure is never acquired, or an existing loss exposure is abandoned; abandoned;  For example:    Flood losses can be avoided by not building a new plant in a floodplaint; The chance of loss is reduced to zero; zero; It is not always possible, or practical, to avoid all losses. losses. 15 5 Mariusz Dybał – Introduction to risk management 3. Steps in the Risk Management Process  Select the appropriate technique echniquess for treating the loss exposures:  Loss prevention refers to measures that reduce the frequency of a particular loss: loss:   e.g., installing safety features on hazardous products; products; Loss reduction refers to measures that reduce the severity of a loss after is occurs: occurs:  e.g., installing an automatic sprinkler system. system. 16 Mariusz Dybał – Introduction to risk management 3. Steps in the Risk Management Process  Select the appropriate technique echniquess for treating the loss exposures:  Retention means that the firm retains part or all of the losses that can result from a given loss; loss;  Retention is effectively used when:    No other method of treatment is available; available; The worst possible loss is not serious; serious; Losses are highly predictable. predictable. 17 Mariusz Dybał – Introduction to risk management 3. Steps in the Risk Management Process  Select the appropriate technique echniquess for treating the loss exposures:  If retention is used, the risk manager must determine the firm’s retention level:  The retention level is the dollar amount of losses that the firm will retain: retain:  A financially strong firm can have a higher retention level than a financially weak firm. firm. 18 6 Mariusz Dybał – Introduction to risk management 3. Steps in the Risk Management Process  Select the appropriate technique echniquess for treating the loss exposures:  If retention is used, the risk manager must have some method for for paying retained losses:   Current net income: losses are treated as current expenses; expenses; Unfunded reserve: losses are deducted from a bookkeeping account; account;   Funded reserve: losses are deducted from a liquid fund; fund; Credit line: funds are borrowed to pay losses as they occur. occur. 19 Mariusz Dybał – Introduction to risk management 3. Steps in the Risk Management Process  Select the appropriate technique echniquess for treating the loss exposures:  The retention technique has both advantages and disadvantages:: disadvantages  Advantages:  Save money – if its actual losses are less than the loss component in a private insurer’s premium;  Lower expenses – some expenses may be reduced, including commisions and brokerage fees, insurer’s profit, etc.;  Encourage loss prevention – because the exposure is retained, there may be a greater incentive for loss prevention;  Increase cash flow – because the firm can use the funds that normally would be paid to the insurer. 20 Mariusz Dybał – Introduction to risk management 3. Steps in the Risk Management Process  Select the appropriate technique echniquess for treating the loss exposures:  The retention technique has both advantages and disadvantages:: disadvantages  Disadvantages:  Possible higher losses – the losses retained by the firm may be greater than the loss allowance in the insurance premium that is saved by not purchasing insurance;  Possible higher expenses – outside experts such as safety engineers may have to be hired;  Possible higher taxes - because premiums paid to the insurer were income--tax deductible. income 21 7 Mariusz Dybał – Introduction to risk management 3. Steps in the Risk Management Process  Select the appropriate technique echniquess for treating the loss exposures:  A nonnon-insurance transfer is a method other than insurance by which a pure risk and its potential financial consequences are transferred to another party; party;  Examples include:  Contracts, leases, holdhold-harmless agreements. agreements. 22 Mariusz Dybał – Introduction to risk management 3. Steps in the Risk Management Process  Select the appropriate technique echniquess for treating the loss exposures:  The noninsurance transfers have both advantages and disadvantages: disadvantages:  Advantages:: Advantages    Can transfer some losses that are not insurable; insurable; Save money; money; Can transfer loss to someone who is in a better position to control losses losses.. 23 Mariusz Dybał – Introduction to risk management 3. Steps in the Risk Management Process  Select the appropriate technique echniquess for treating the loss exposures:  The noninsurance transfers have both advantages and disadvantages: disadvantages:  Disadvantages:: Disadvantages    Contract language may be ambiguous, so transfer may fail; fail; If the other party fails to pay, firm is still responsible for the loss; loss; Insurers may not give credit for transfers. transfers. 24 8 Mariusz Dybał – Introduction to risk management 3. Steps in the Risk Management Process  Select the appropriate technique echniquess for treating the loss exposures:  Insurance is appropriate for loss exposures that have a low probability of loss but for which the severity of loss is high high;;  Five key areas of insurance:  The risk manager selects the coverages needed, and policy provisions:   A deductible is a provision by which a specified amount is subtracted from the loss payment otherwise payable to the insured insured;; An excess insurance policy is one in which the insurer does not participate in the loss until the actual loss exceeds the amount a firm has decided to retain. retain. 25 Mariusz Dybał – Introduction to risk management 3. Steps in the Risk Management Process  Select the appropriate technique echniquess for treating the loss exposures:  Five key areas of insurance, cont.: cont.:   The risk manager selects the insurer, or insurers, to provide the coverages; coverages; The risk manager negotiates the terms of the insurance contract:: contract   Language in the policy must be clear to both parties; parties; The parties must agree on the contract provisions, endorsements, forms, and premiums. premiums. 26 Mariusz Dybał – Introduction to risk management 3. Steps in the Risk Management Process  Select the appropriate technique echniquess for treating the loss exposures:  Five key areas of insurance, cont.: cont.:   In addition, information concerning insurance coverages must be disseminated to others in the firm; The risk manager must periodically review the insurance program.. program 27 9 Mariusz Dybał – Introduction to risk management 3. Steps in the Risk Management Process  Select the appropriate technique echniquess for treating the loss exposures: The insurance have both advantages and disadvantages:: disadvantages   Advantages:: Advantages      Firm is indemnified for losses; losses; Uncertainty is reduced; reduced; Insurers may provide other risk management services; services; Premiums are taxtax-deductible deductible;; Disadvantages:: Disadvantages    Premiums may be costly; costly; Negotiation of contracts takes time and effort; effort; The risk manager may become lax in exercising loss control. control. 28 Mariusz Dybał – Introduction to risk management 3. Steps in the Risk Management Process Select the appropriate technique echniquess for treating the loss exposures:   Exhibit 2 Risk Management Matrix: Matrix: 29 Mariusz Dybał – Introduction to risk management 3. Steps in the Risk Management Process  Implement and monitor the risk management program:: program  Implementation of a risk management program begins with a risk management policy statement that:      Outlines the firm’s risk management objectives; objectives; Outlines the firm’s policy on loss control; control; Educates toptop-level executives in regard to the risk management process; process; Gives the risk manager greater authority; authority; Provides standards for judging the risk manager’s performance.. performance 30 10 Mariusz Dybał – Introduction to risk management 3. Steps in the Risk Management Process  Implement and monitor the risk management program:: program  In addition, a risk management manual may be developed and used in the program:   Describes the risk management program; Describes program; Train Trainss new employees participating in the program. 31 Mariusz Dybał – Introduction to risk management 3. Steps in the Risk Management Process  Implement and monitor the risk management program: program:  A successful risk management program requires active cooperation from other departments in the firm: firm:      Accounting – Internal accounting controls can reduce employee fraud and theft of cash; Finance - Information can be provided showing the effect that losses will have on the firm’s balance sheet and profit and loss statement; Marketing – Accurate packaging and productproduct-use information can prevent liability lawsuits. Effective safety programs in the plant can reduce injuries and accidents; Production – Quality control can prevent the production of defective goods and liability lawsuits. Effective safety programs in the plant can reduce injuries and accidents; Human resources – This department is responsible for employee benefit programs, retirement programs, safety programs, and the company’s hiring, promotion, and dismissal policies. 32 Mariusz Dybał – Introduction to risk management 3. Steps in the Risk Management Process  Implement and monitor the risk management program:: program  To be effective, the the risk management program must be periodically reviewed and evaluated to determine whether the objectives are being attained: attained:  The risk manager should compare the costs and benefits of all risk management activities. activities. 33 11 Mariusz Dybał – Introduction to risk management 4. Benefits of Risk Management Major benefits include the following:    PrePre-loss and post post--loss objectives are aachived; chived; A risk management program can reduce a firm’s cost of risk: risk:    The cost of risk includes premiums paid, retained losses, outside risk management services, financial guarantees, internal administrative costs, taxes, fees, and other expenses; expenses; Reduction in pure loss exposures allows a firm to start an enterprise risk management program to treat both pure and speculative loss exposures; exposures; Society benefits because both direct and indirect losses are reduced. reduced. 34 Mariusz Dybał – Introduction to risk management 5. Personal Risk Management Personal risk management refers to the identification of pure risks faced by an individual or family, and to the selection of the most appropriate technique for treating such risks; risks; The same principles applied to corporate risk management apply to personal risk management. management.   35 Mariusz Dybał – Introduction to risk management 6. Case application no. 3 City Bus Corporation provides school bus transportation to private and public schools in Lancaster County. City Bus owns 50 buses that are garaged in three different cities within the county. The firm faces competition from two larger bus companies that operate in the same area. Public school boards and private schools generally award contracts to the lowest bidder, but the level of service and overall performance are also consideraded:  1. 2. 3. 4. 5. Briefly describe the steps in the risk management process that should be followed by the risk manager of City Bus; Identify the major loss exposures faced by City Bus; For each of the loss exposures identified in (2), identify a risk management technique or combination of techniques that could be used to handle the exposure; Describe several sources of funds for paying losses if retention is used in the risk management program; Identify other departments in City Bus that would also be involved in the risk management program. 36 12 Mariusz Dybał – Introduction to risk management Thank You ;) 37 1...
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