The Nature of Risk Management

1. Scientific approach to dealing with pure

risks
2. Broader than insurance management
3. Differs from insurance management in
philosophy

3-1

Development of Risk Management

Risk management evolved from corporate
insurance buying
1929 Corporate insurance buyers met in Boston
to discuss mutual problems.
1931 American Management Association
established its Insurance Division.
1932 Insurance Buyers of New York formed.
1950 National Association of Insurance Buyers
formed; (later became American Society of
Insurance Management and then became
the Risk and Insurance Management
Society (RIMS)).
3-2

The Risk Management Process

1.

Determination of objectives

2.

Identification of risks

3.

Evaluation of risks

4.

Consideration of alternatives selection of the tool

5.

Implementing the decision

6.

Evaluation and review

3-3

Primary Objective
To preserve the operating effectiveness of
the organization.

3-4

Risk Management Objectives

Post-Loss Objectives

Pre-Loss Objectives

Survival

Economy

Continuity of Operations

Reduction in Anxiety

Earnings Stability

Meeting Externally
Imposed Obligations

Continued Growth

Social Responsibility

Social Responsibility

3-5

Formal Risk Management Policy

1.

States the objectives of risk management

program and describes measures by which
they are to be reached.

2.

Objectives and risk management policy

should be determined by board of directors
(or other highest policy-making body in the
organization).

3.

Risk manager acts as staff advisor to board

in formulating risk management policy.
3-6

Risk Identification
1.
2.
3.
4.
5.
6.
7.
8.
9.

Orientation
Risk analysis questionnaires
Exposure checklists
Insurance policy checklists
Flow process charts
Analysis of financial statements
Other internal records
Inspections
Interviews

The preferred approach is a combination

approach.
3-7

Evaluation of Risks

Critical

Severe financial impact (e.g.,

losses that could result in
bankruptcy)

Important

Moderate financial impact

(e.g., losses that would require
resort to credit)

Unimportant

Modest financial impact (e.g.,

losses that could be met from
existing assets or cash flow)
3-8

Consideration of Alternatives
Risk Control

Avoidance

Reduction

Risk Financing

Retention

Transfer
3-9

Choosing the Technique

1.

Primarily a problem in decision-making.

2.

Sometimes organizations risk management

policy establishes criteria.

3.

In selecting the technique for a given risk,

the risk manager considers

the size of potential loss,

its probability, and

the resources that would be available

to meet the loss.
3-10

Implementing the Decision

Once the decision is made on how to deal with
a given risk, the decision must be implemented
for retained risks, it may be necessary to
establish a fund

loss prevention and control measures must

be designed and implemented

decision to transfer a risk must be followed

by selection of the insurer, negotiations,
and placement of the insurance
3-11

Rules of Risk Management

1.

Dont risk more than you can afford to lose

2.

Consider the odds

3.

Dont risk a lot for a little

3-12

Risk Characteristics as Determinants of Tool

High
Frequency

Low
Frequency

High
Severity
Low
Severity

3-13

Risk Characteristics as Determinants of Tool

High
Frequency
High
Severity

Low
Frequency

Avoid
Reduce

Low
Severity

3-14

Risk Characteristics as Determinants of Tool

High
Severity

High
Frequency

Low
Frequency

Avoid
Reduce

Transfer

Low
Severity

3-15

Risk Characteristics as Determinants of Tool

High
Frequency

Low
Frequency

High
Severity

Avoid
Reduce

Transfer

Low
Severity

Retain
Reduce

3-16

Risk Characteristics as Determinants of Tool

High
Frequency

Low
Frequency

High
Severity

Avoid
Reduce

Transfer

Low
Severity

Retain
Reduce

Retain

3-17

The Special Case of Risk Reduction

1. A technique should be used when it is the
lowest cost approach for the particular risk.
2. Humanitarian considerations and legal
requirements sometimes dictate that risk
control be used when it is not the lowest cost
approach.
3. OSHA requires employers to incur expenses
that might not be justified based on a
marginal-revenue/marginal cost analysis.
4. Building codes impose similar mandates.
3-18

The Nonprofessional Risk Manager

1.

In giant corporations, risk managers devote

full attention to the problem of pure risks.

2.

In smaller firms, the risk manager may have

other responsibilities competing for his or
her attention.

3.

Nonprofessional risk manager must know

enough about risk management and
insurance to know when help is needed,
and also be able to judge if he or she is
getting the right kind of advice.
3-19

Common Errors in Buying Insurance

1.

Buying too much.

2.

Buying too little.

3.

Buying too much and too little at the same

time.

3-20

Priority Ranking for Insurance Coverages

Essential

insures against losses that

could cause bankruptcy.

Important

insures against losses that

would require resort to credit.

Optional

insures against losses that

could be met from assets or
cash flow.

3-21

Large Loss Principle

1. Probability that a loss may or may not occur
is less important than potential severity of
the loss.
2. Important question is not can I afford the
insurance? but can I afford to be without
it?
3. When available dollars cannot provide all the
essential and important coverages required,
a part of the loss may be assumed through
deductibles.
3-22

Insurance as a Last Resort

1.

Insurance always costs more than the

expected value of the loss.

2.

People who purchase coverage against

small loss exposures are trying to beat the
insurance company at its own game.

3.

Insurance should be used as a last resort.

3-23

Tax Considerations and Risk Retention

1.

Business firms may deduct uninsured

losses as an expense of operation.

2.

For the individual, casualty losses are

deductible only to the extent that each loss
exceeds $100 and the aggregate for all
losses exceeds 10% of adjusted gross
income.

3.

Medical expenses are deductible to the

extent they exceed 7.5% of adjusted gross
income.
3-24

Selecting the Agent

1.

Most important service provided by the

agent is probably advice.

2.

Primary consideration in selecting an agent

should be knowledge of the insurance field
and interest in the needs of the client.

3.

One indicator of a knowledgeable and

professional agent is a professional
designation.

3-25

Professional Designations
1.

CPCU: Chartered Property &

Casualty Underwriter

2.

CLU: Chartered Life Underwriter

3-26

Selecting the Insurer

1.

Major consideration should be financial

stability

2.

Cost

3.

Other considerations include attitude

toward claims and cancellation

3-27

A.M. Best Policyholders Ratings

A++, A+
A, AB++, B+
B, BC++, C+
C, CD
E
F

Superior
Excellent
Very Good
Good
Fair
Marginal
Below Minimum Standards
Under State Supervision
In Liquidation
3-28

Alternatives to Commercial Insurance

Self-Insurance
Captive Insurance Companies
Risk Retention Groups
Purchasing Groups

3-29

Self-Insurance
1. Despite theoretical defects, the term selfinsurance, it is a convenient way of
distinguishing retention programs that use
insurance techniques from those that do not.
2. Self-insurance is distinguished from other
retention programs primarily by the formality of
the arrangement.
3. In some instances, this means approval from a
state regulatory agency.
4. In other instances, it means funding measures
based on actuarial calculations and contractual
definitions of insured exposures.
3-30

Reasons for Self-Insurance

1.

Avoid insurer overhead and profits

2.

Organizations experience may be better

than average

3.

Gain cash-flow benefits by retaining

reserves

4.

Avoid social load that insurers are

obligated to bear

3-31

Disadvantages of Self-Insurance
1.

Possible exposure to catastrophe loss

2.

Greater variation in losses from year to year

3.

Possible adverse employee- and publicrelations by handling own liability claims

4.

Loss of ancillary insurer services

Some potential disadvantages can be avoided.

3-32

Captive Insurance Companies

An entity created and controlled by a parent
whose main purpose is to provide insurance to
the parent.
1.

Pure captives

2.

Association group captives

3-33

Tax Treatment of Captives

Deductibility of premiums
1. IRS position is that a captive is an insurer in
form but not substance; premiums paid by a
parent to a captive are not deductible.
2. Exceptions exist for premiums paid to
association captives, where risks are pooled
with those of other organizations.
3. Exception also exists if the captive assumes
outside risks.
3-34

Tax Treatment of Captives

Taxation of Income
1.

Deductibility of premiums to association

captives and rules on controlled foreign
corporations created a loophole in tax laws.

2.

TRA-86 makes income to captives taxable

as income to parents.

3.

This effectively eliminated favorable tax

treatment of off-shore captives.
3-35

Risk Retention Act of 1986

1. Carved out federal preemption over state
regulation.
2. Authorized two mechanisms: Risk retention
groups and insurance purchasing groups.
3. Risk retention groups are group captives,
regulated principally by the state in which
organized.
4. Insurance purchasing groups do not retain
risk, but purchase insurance on behalf of
their members.
3-36