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Chapter 3

Introduction to Risk Management

Answers to Review Questions

Risk management is defined as a systematic process for the

identification and evaluation of pure loss exposures faced by an
organization or individual and for the selection and administration of
the most appropriate technique for treating such exposures.


Risk management is broad, it includes non insurable risk. It utilizes all techniques and
insurance is one of the techniques.
Insurance management only manages insurable risk and insurance is the main
technique to manage the insurable risk.


(a) There are four steps in the risk management process

Identify loss exposures
Measure and analyze the loss exposures
Select the appropriate combination of techniques for treating the loss
Implement and monitor the risk management program
(b) Risk identification. Firms need to be careful in identifying the key risks faced by
them. Failure or error in identifying risk can affect the entire risk management
process and harm the company.


(a) Several sources of information can be used to identify potential

losses. They are as follows:
Risk analysis questionnaire
Physical inspection
Flow charts
Financial statements
Historical loss data
(b) The risk manager must consider the maximum possible loss and
probable maximum loss for each loss exposure. The maximum
possible loss is the worst loss that could possibly happen to the firm
during its lifetime. The probable maximum loss is the worst loss that
is likely to happen.


(a) Risk control refers to techniques that reduce the frequency and
severity of accidental losses. Specific techniques are avoidance,
loss prevention, and loss reduction.
(1) Avoidance means that a loss exposure is never acquired,
or an existing loss exposure is abandoned. The major
advantage of avoidance is that the chance of loss is zero if
the loss exposure is never acquired. However, abandonment
may still leave the firm with a residual liability exposure from
the sale of previous products.
(2) Loss prevention refers to measures that reduce the
frequency of a particular loss. For example, measures that
reduce lawsuits from defective products include installation of
safety features on hazardous products, warning labels on
dangerous products, and quality control checks.

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(3) Loss reduction refers to measures that reduce the severity

of a loss after it occurs. Examples include installation of an
automatic sprinkler system, rehabilitation of injured workers
with job-related injuries, and limiting the amount of cash on
the premises.

(a) Risk financing refers to techniques that provide for the funding
of losses after they occur. Specific risk financing techniques include
retention, noninsurance transfers, and insurance.
(1) Retention means that the firm retains part or all of the
loss that can result from a given loss exposure. Retention can
be 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. Passive risk retention, however, is the failure to identify a
loss exposure, failure to act, or forgetting to act.
(2) Noninsurance transfers are methods other than insurance
by which a pure risk and its potential financial consequences
are transferred to another party. Examples include contracts,
leases, and hold-harmless agreements.
(3) Commercial insurance can also be used to fund losses.
Insurance is appropriate for loss exposures that have a low
probability of loss but the severity of loss is high.


Retention can be used if no other method of treatment is available,

the worst possible loss is not serious, and losses are highly


(a) Captive insurers are form for several reasons:

Difficulty in obtaining insurance
Favorable regulatory environment
Lower cost
Easier access to reinsurer
Formation of a profit center
(b) Single parent captive is also called a pure captive is an insurer owned by
only one parent, such as a corporation. An association or group captive is an
insurer owned by several parents.


(a) Self-insurance is a special form of planned retention by which

part or all of a given loss exposure is retained by the firm.
(b) A risk retention group is a group captive that can write any type
of liability coverage except employer liability, workers
compensation, and personal lines. For example, a group of
physicians may form a risk retention group to obtain malpractice
insurance because professional liability insurance is difficult to
obtain or too expensive to purchase.

(a) Insurance has several advantages in a risk management
The firm will be indemnified after a loss occurs.
Uncertainty is reduced, which permits the firm to lengthen
its planning horizon.
Insurers can provide valuable risk management services,
such as loss control, identification of loss exposures, and
claims adjusting.

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Premiums are deductible for income tax purposes.

(b) Insurance has several disadvantages in a risk management
The payment of premiums is a major cost.
Considerable time and effort must be spent in negotiating
the insurance coverages.
The risk manager may have less incentive to follow a risk
control program, because the insurer will pay the claim if a
loss occurs.

Answers to Application Questions


(a) See answer to Review Question 3.

(1) Avoidance. The firm could discontinue manufacturing
certain ladders and scaffolds that could result in a products
liability lawsuit.
(2) Loss prevention. The firm could issue detailed instructions
on how the ladders and scaffolds can be safely used.
(3) Loss reduction. Claims involving injured persons should be
promptly investigated. Procedures for providing immediate
medical attention to injured persons should be established.
Such measures can reduce the severity of a loss.
(4) Noninsurance transfers. A hold-harmless agreement could
be used by which retailers agree to hold Scaffold Equipment
harmless if someone is injured while using a ladder or
scaffold manufactured by Scaffold Equipment.

(a) The following advantages may result from the retention
(1) The Swift Corporation can save money if its actual losses
are less than the loss allowance in the insurers premium.
(2) There may also be sizable expense savings.
(3) Loss prevention is encouraged.
(4) Cash flow may be increased since the firm can use the
funds that normally would be held by the insured.
The major disadvantages include:
(1) The losses retained by the firm may be greater than the
loss allowance in the insurance premium that is saved by not
purchasing the insurance, and there may be greater volatility
in the firms loss experience in the short run.
(2) Expenses may actually be higher, since loss-prevention
programs should be established, which may be provided by
insurers more cheaply.
(3) Contributions to a funded reserve under a retention
program are not usually income tax-deductible.
(b) The following factors should be considered in the decision to
partially retain the collision loss exposure:
(1) Average frequency and severity of losses
(2) Companys past loss experience
(3) Dollar amount of losses the firm will retain
(4) Added costs of retention (administrative problems)
(5) Elements of the premium that could be saved (potential
premium savings)
(6) Predictability of losses
(7) Maximum possible loss and maximum probable loss

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(8) Tax aspects

(9) Availability of excess of loss coverage
(10) Availability of other alternatives
(11) Whether management is risk adverse
(c) Losses can be paid out of current net income, earmarked assets,
funds borrowed from commercial lenders, or payment from a
captive insurer if a captive insurer has been established.
Losses in excess of the retention levels can be paid by commercial
(d) Risk control refers to measures that reduce the frequency and
severity of losses. The company could avoid hiring drivers with poor
driving records. The company could also reduce losses by requiring
drivers to take a defensive driving course.

(a) The major advantage of avoidance is that the chance of loss is

reduced to zero if the loss exposure is never acquired. Also, if an
existing loss exposure is abandoned, the chance of loss is reduced
or eliminated because the activity or product that could produce a
loss has been abandoned.
(b) It is not feasible or practical for a firm to avoid all potential
losses. Some losses will occur in the normal operations of the firms
business. For example, a paint factory can avoid fire and explosion
losses arising from the production of paint by not manufacturing
paint. Without paint production, however, the firm will not be in


(a) A risk management policy statement offers several advantages

to a firm. The policy statement is necessary to have effective
administration of the risk management program. The policy
statement states the risk management objectives of the firm and
the companys policy with respect to treatment of loss exposures.
Also, the risk management policy statement has the advantage of
educating top-level executives about the risk management process.
In addition, the written policy statement enables the risk manager
to have greater authority throughout the firm. Finally, the policy
statement provides a standard for judging the risk managers
(b) Other departments that are important in a risk management
program are accounting, finance, marketing, production, and human


(a) A personal risk management program has the following steps:

Identify loss exposures
Analyze the loss exposures
Select appropriate techniques for treating the loss
Implement and review the program periodically
(1) Major personal loss exposures include the following:
Premature death of Chris or Karen and the
subsequent loss of financial support to surviving family
Catastrophic medical bills incurred by Chris or Karen
Catastrophic medical bills incurred by Christian or

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Total disability of Chris or Karen and the subsequent

loss of financial support to the surviving family
(2) Major property loss exposures include the following:
Physical damage or theft of household personal
Physical damage or theft of family cars
Theft of the laptop computer used by Karen while
Damage or theft of the business computer used by
Residing in a high crime-rate area, which increases
the probability of theft or robbery
(3) Major liability loss exposures include the following:
Legal liability arising out of the operation of a family
car by family members
Legal liability arising out of the use of a rental car by
Karen when she is traveling
Legal liability arising out of other activities of family
members that can result in bodily injury or property
damage to others
(c) Chris and Karen should purchase adequate life insurance and
disability income insurance to deal with the risk of premature death
and total disability. Chris and Karen and the children should be
insured under a group or individual major medical expense policy to
deal with the risk of catastrophic medical bills. Loss control could
also be used by practicing healthy lifestyle habits. A homeowners
policy would cover the physical damage and theft of household
property. Collision and comprehensive auto insurance would cover
the possible physical damage or theft of a family car; retention
could also be used by having a deductible for collision and
comprehensive losses. Chris and Karen should also check with their
insurance agent to see if their homeowners policy provides
adequate insurance on the business computer and laptop computer.
Karen could also use risk control when she is traveling by not
leaving the laptop computer unattended. The legal liability loss
exposures can be handled by a homeowners policy, which provides
personal liability insurance. Auto legal liability insurance could
insure the legal liability arising out of the negligent operation of a
family car by family members.

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