CHAPTER 2

RISK MANAGEMENT
LEARNING OBJECTIVES
Upon completion of the chapter, you should be able to:
Define some common terminology
Explain the importance of risk management to individuals and
organization
Define the risk management from Islamic perspective
Describe the objectives of risk management
Explain the risk management process
Identify the best risk management techniques to be used for different
category of risk
Overview

Definition & Evolution of Risk Management

Risk Management from Islamic Perspectives
Objectives of Risk Management
Risk Management Process
DEFINITION AND EVOLUTION OF RISK MANAGEMENT

Risk management is now considered crucial for survival of the

organization
Climate changes, political uncertainties, economic forces are among
external factors of emerging needs of risk management in an
organization.
As a systematic approach to identifying, measuring and controlling risks
that can threaten assets and earnings of oneself, a business or the
organization.
The purpose of risk management is to enable an organization to
progress toward its goal and objectives (mission) in the most direct,
efficient, and effective path
RISK MANAGEMENT IN ISLAMIC PERSPECTIVE

Every human being who is the caliph (vicegerent) of Allah

SWT must accept all His divine stipulations and give way to
His qada’ and qadar (actions and reactions). In fact, efforts
and prayers should precede this kind of belief. Muslims are
asked to work hard in order to be able to change their
conditions as God says:
"… Verily never will God change the condition of a people until they
change it themselves (with their own souls)…" (Qur'an 13:11).
The ummah should anticipate the risks that will hinder
the ultimate goal of them which is to attain success in the
world and here after.
Risk management in Islamic perspective should be aimed
to reduce the utilization of resources (financial and non-
financial) and to minimize the negative effects of risks or
maximize the opportunities and goals.
The goals must be aligned with the Shariah.
OBJECTIVES OF RISK MANAGEMENT

Objectives of
Risk
Management

Pre loss
objectives Post loss occurs
Pre Loss Objectives

Reduce impact of loss

Reduce fear and worry
Required by law
 Post Loss Objectives

Survival of organization – organization still able to continue

operations
Stability of earnings – business operations do not have to stop and
the organizations can concentrate on their business activities as
usual.
Reduce impact of losses to organization and society – when a loss
occurs not only will the organization suffer but the loss has to be
burdened by society as well. Employees may have to be
retrenched and some departments may have to be closed down.
RISK MANAGEMENT PROCESS
 RISK MANAGEMENT PROCESS

1) Identifying existing and potential risks

2) Evaluating potential risks
3) Examining alternative risk management techniques
4) Selecting and Implementing risk management
program
5) Evaluating, reviewing and controlling the program
1. IDENTIFYING EXISTING AND POTENTIAL
LOSSES

Risk identification is the process by which an

organization is able to learn of the areas in which it is
exposed to risk.
Identification techniques are designed to develop
information on sources of risk, hazards, risk factors, perils
and exposures to loss.
It is everybody’s task to identify the loss exposures in one
organization.
Losses can be classify as:
• Direct damage (damage to building)
• Indirect damage (loss of profits due to business
interruption)
• Liability (court award to 3rd party since fire was caused
by negligence of the owner of building)
• Loss of Key Employees (key employees such as general
manager/CEO/Researcher)
Risk Identification Tools;
• Orientation
• Risk Analysis Questionnaires
• Exposure checklists
• Insurance Policy checklist
• Flowchart
• Financial Statements
• Inspections
• Interviews
• Combination approach
2. EVALUATING POTENTIAL LOSSES

Risk measurement evaluates the likelihood of loss and

the value of loss in terms of frequency and severity.
The measurement process may take the form of a
qualitative assessment (using %)
This step involves two important aspects of loss
exposures
• Frequency
• Severity
Risk measurement evaluates the likelihood of loss and
the value of loss in terms of frequency and severity.
The measurement process may take the form of a
qualitative assessment (using %)
This step involves two important aspects of loss
exposures
• Frequency
• Severity
Identifying and determining the loss exposures alone is
not sufficient
In evaluating the potential losses:
• Estimating the frequency and severity for each type of
loss exposure and ranked it according to their relative
importance. High loss exposure will be given priority.
• Estimating relative frequency and severity of each loss
exposure as the selection of appropriate technique will
depend on this.
How can you determine and estimate the impact of losses

• Frequency
• Referring to the number of times the loss occurs

• Severity
• Referring to the maximum size of loss exposures
3. EXAMINING ALTERNATIVE RISK MANAGEMENT
TECHNIQUES
Two main ways to classify the risk management
techniques

1.Risk Control
Risk avoidance 2. Risk Financing
Loss control Retention/Assumption
•Loss prevention Captive insurer
•Loss reduction
Insurance
Separation
Contractual Transfer
1. Risk Control

Methods seek to alter an organization’s exposure to risk.

Risk control efforts help organization avoid a risk,
prevent loss, lessen the amount of damage if a loss occurs
or reduce undesirable effects of risk on an organization.
Risk Avoidance

Risk is proactively avoided or abandoned after rational

consideration.
If someone is afraid of risks, the best way to deal with it is
to avoid it completely.
Example; a manufacturer may stop production of a
defective products to avoid a lawsuit.
However, some risks are unavoidable although risk
avoidance may be chosen as an option in handling certain
risks, the exposures of losses cannot be eliminated
entirely.
Loss Control

Loss control is designed to reduce both the frequency and

severity of losses by changing the characteristics of the
exposure so that it is more acceptable to the firm. Divided
into:
• Loss prevention
• Loss reduction
 Loss Control
Loss Prevention
• Seek to reduce the number of
losses (frequency) of losses
• Is used when the benefits
outweigh the costs involved.
• Either imposed by law or
imposed by companies and
factories to fence dangerous
machinery to reduce the chances
of employees being injured.
Loss Reduction
• Designed to reduce or lower the
severity of losses, should it occur.
• Since some risks are unavoidable,
the other alternative is to reduce its
impact.
• Can be used in two circumstances:
before a loss, e.g. installation of fire
alarm or after a loss e.g. salvage
efforts in the restoration of a
building burnt down by fire.
Separation

Involves the dispersal of the firm’s assets in several

locations instead of confining it to one major area.
This measure will reduce the impact of losses should a
major disaster occurs.
Example, separation of head quarters and assembly plant
in automobile industry.
Contractual Transfer

Risk transfer mechanism.

Refers to the various methods other than insurance by
which a pure risk and its potential financial consequences
can be transferred to other party.
 Contractual Transfer
Types of contractual transfer
• Incorporation
• The owner of the company transfers the risks to corporation by registering the
company.
• Leasing contracts
• An agreement where the owner or landlord transfers the risks to the tenants
• Hedging
• An agreement to buy or sell a commodity at a certain price to avoid losses due
to price increase or decrease.
• Hold-harmless agreements
• An agreement between a retailer and a manufacturer whereby the later agrees
to bear losses due to the manufacturer of defective products thus relieving the
retailer of any liability.
Contractual Transfer
Advantages
• Can transfer potential losses
that are commercially
uninsurable
• Often cost less than insurance
• Potential loss shifted to a party
who is in a better position to
exercise control
Disadvantages
• If the party to whom the loss
is transferred is unable to
pay the loss the firm is still
responsible
• Not necessarily cheaper than
insurance if discounts are
taken into consideration
• Ambiguity in contracts
drafted may not hold in court.
2. Risk Financing

Methods involving generating funds to pay for these

losses

• Retention

• Self insurance and captive insurer

• Insurance
Retention

Retention – the company will bear the consequences of

the loss
Risk or loss exposed are normally assumed or retained
when their impact and consequences are not too great or
in cases when or other methods seem feasible.
In an organization, the ability to assume a risk depends
on one’s financial ability.
Self insurance & Captive Insurer

Self insurance implies tat the organization sets up a pool

of fund to retain its loss exposures.
Adequate financial agreement has to be made in advance
of the occurrence of losses.
The number of loss exposures must be large enough to
ensure the mechanism of insurance to be operative.
Self insurance & Captive Insurer

A captive insurance company is an entity to write

insurance arrangement for its parent company.
The captive’s parent may be one company, several
companies or an entire industry.
Example; Sime Darby Group is the parent company of
Sime AXA Assurance Sdn Bhd
Self insurance & Captive Insurer

Advantages Disadvantages
• Cash flow advantages • Possible higher losses
• Safe money • Possible higher expenses
• Lower expenses
• Encourage loss
prevention
 Insurance

Risk financing method of transferring the financial

consequences of potential accidental losses from an insured
firm or family to an insurer
Transferring the risks to another party involves a contractual
agreement whereby the other party assumes the risks and is
liable for the loss in the event of loss.
In an insurance contract, the party exposed to the risks (the
proposer/insured) pays the premium to the insurance
company.
In return, the insurance company agrees to pay a stated sum on
the happening of certain risks specified in the contract.
4. SELECTION AND IMPLEMENTATION OF THE RISK
MANAGEMENT PROCESS

The selection of a risk management programme may be based

on two (2) factors, i.e. financial or non-financial criteria.
•Financial criteria – whether it will affect the organisation’s
profitability or rate of return.
•Non-financial criteria – whether it affects the growth of the
organisation, humanitarian aspects and legal requirements.
Type of risk High Frequency Low Frequency

High Severity Risk avoidance, loss Risk transfer

prevention and loss (e.g.Insurance etc)
reduction is possible
Loss reduction and loss
prevention
Low Severity Loss prevention Risk retention
Also: Loss reduction if cost Loss prevention and loss
can be justified reduction if the cost
Assume risk if cost of justifies the benefits
prevention or reduction
can’t be justified
5. EVALUATION, REVIEW AND CONTROL

The risk management program must be monitored and

controlled systematically. It must be periodically
reviewed
The techniques that were appropriate last year many not
be the most advisable this year, and constant attention is
required
Evaluation and review of the risk management program
permits the manager to review decisions and discover
mistakes, it is hoped, before they become costly.