CH 1 Intro to Risk Management

Elements of Loss Exposures

1. An asset exposed to loss: anything of value an individual or organization has that is exposed to loss. Property, investments, accounts receivable, patents, human resources, skill sets. 2. Cause of loss (peril). Fire, wind, theft. Hazards. 3. Financial consequences of that loss. Depend on the type of loss exposure, the cause of loss, frequency and severity. Property easier to determine than liability. Used for property, liability, personnel, and net income loss exposures. Necessary to completely describe a loss exposure.

Risk Management Program

A system for planning, organizing, leading, and controlling the resources and activities that an org needs to protect itself from the adverse effects of accidental losses.

Physical Hazard

A tangible characteristic of property, persons, or operations that tends to increase the frequency or severity of a loss. Icy sidewalk, defective wiring, inadequate ventilation.

Loss Exposure

Any condition or situation that presents a possibility of loss, whether or not an actual loss occurs.

Components of Financial Consequences of Risk

Expected cost of losses or gains Expenditures on risk management Cost of residual uncertainty Even if difficult to precisely calculate, these components help determine where to focus risk mgmt efforts.

Quadrants of Risk

Hazard: Property, liability, personnel loss exposures. Generally the subject of insurance. Pure risk. Operational: Arise from people or a failure in processes, systems or controls. Pure risk. Financial: Arise from effect of market forces on financial assets or liabilities. Market risk, credit risk, liquidity risk, price risk. Speculative risk. Strategic: Arise from trends in economy and society. Speculative risk. Focus on risk source and who traditionally manages it.

Expected Cost of Losses or Gains

Herbert W Heinrich worked on calculating expected cost of losses or gains specifically for industrial accidents. Include cost of compensation paid to employee and these hidden costs: Time lost by injured employee, time lost by employees who stop work, time lost by foremen/supervisors, time spent on case by first-aid attendants and hospital staff, damage to machinery, interference to production, employee wages if they cannot perform entire job function, loss of profit on productivity due to idle machines and weakened morale, overhead per injured employee. Hidden costs difficult to measure and are indirect costs. More difficult to calculate for speculative risks than pure risks.

Tolerable Uncertainty

Involves keeping managers' uncertainty about losses at tolerable levels. Managers should be able to make decision without being affected by uncertainty. The risk mgmt program should provide assurance through risk control and risk financing that loss exposures are being managed well.

Step 6: Monitoring Results

May lead to identification of new or additional loss exposures. Risk mgmt program must be monitored and revised as necessary. 1. Establishing standards of acceptable performance for results and activities. 2. Comparing actual results with these standards 3. Correcting substandard performance or revising standards that prove to be unrealistic 4. Evaluating standards that have been substantially exceeded

Continuity of Operations

No loss can be allowed to interrupt the org's operations for any appreciable time. More costly than the goal of survival. Essential goal for all public entities because they must maintain police, fire protection and clean water etc. Steps to Forestall an Intolerable Shutdown: -Identify activities whose interruptions cannot be tolerated -Identify the types of events that could interrupt such activities -Determine the standby resources that must be immediately available to counter the effects of these losses -Ensure the availability of the standby resources at even the most unlikely and difficult times (will add to org's expenses)

Economy of Operations

Organization should not incur substantial costs in exchange for slight benefits. Measured by benchmarking like with a RIMS survey.

Types of Loss Exposures

Property Liability Personnel Net Income The three elements of loss exposures apply to these but each type is distinguished in relation to how it affects the first element of a loss exposure - asset exposed to loss.

Tangible Property

Property that has a physical form. Can be real property or personal property.

Intangible Property

Property that has no physical form.

Risk Classifications

Pure and Speculative Subjective and Objective Diversifiable and Nondiversifiable Quadrants of Risk Helps an organization understand, asses and manage risk because risks in the same classification have same attributes and can be managed with similar techniques and risks are less likely to be overlooked.

Earnings Stability

Rather than strive for the highest possible level of income, some orgs emphasize earning stability over time. Requires precision in forecasting risk mgmt costs, lower retention levels and a willingness to spend more on risk transfer mechanisms. Strive for consistency rather than fluctuations.

Indirect Loss

Results from, but is not directly caused by, a particular cause of loss. ie revenue loss because of a fire that damages a building

Survival

Resuming operations to some extent after an adverse event. The most basic goal after a severe loss. Does not necessarily mean returning to the condition that existed before loss. An org survives a loss when that loss does not permanently halt its production and the incomes of those who work for or own it.

Net Income

Revenues - (Expenses + Income Taxes) A reduction of revenue, an increase in expenses, or a combination of both.

Post-loss Goals

Risk management program goals that should be in place in the event of a significant loss. Broadly describe the degree of recovery an org will strive to reach following a loss. Based on the operating and financial conditions that the org's senior mgmt would consider acceptable after a significant foreseeable loss. Survival Continuity of Operations Profitability Earning Stability Social Responsibility Growth

Step 1: Identifying Loss Exposures

Systematic approach to identifying loss exposures that could interfere with the achievement of the org's goals or missed opportunities. Document analysis (contracts, policies, flow charts,) Compliance Reviews Inspections Expertise within and beyond org

Real Property (Realty)

Tangible property consisting of land, all structures permanently attached to the land, and whatever is growing on the land.

Step 4: Selecting the Appropriate Risk Management Techniques

Techniques are selected that best prevent or reduce losses and that will adequately finance losses that occur despite prevention and reduction efforts. Financial Considerations: Techniques with the greatest positive or least negative affect on the org's value. Effective to help achieve desired goals and economical if it is the least expensive. Cost/benefit analysis is used. Nonfinancial Considerations: Maintaining operations. Peace of mind. Nonfinancial goals and constrain financial goals.

Objective Risk

The measurable variation in uncertain outcomes based on facts and data. Based on facts.

Risk Management Process

The method of making, implementing, and monitoring decisions that minimize the adverse effects of risk on an org. Initiated by insurance renewal, serious claim, merger, new law but it is continuous so it may not need one of these to be initiated. Step 1: Identifying Loss Exposures Step 2: Analyzing Loss Exposures Step 3: Examining the Feasibility of Risk Management Techniques Step 4: Selecting the Appropriate Risk Management Techniques Step 5: Implementing Selected Risk Management Techniques Step 6: Monitoring Results

Systemic Risk

The potential for a major disruption in the function of an entire market or financial system. Non diversifiable. ie Global interconnections of finance and industry.

Risk Management

The process of making and implementing decisions that will minimize the adverse effects of accidental losses on an organization.

Interest Rate Risk

The risk associated with a security's future value because of changes in interest rates.

Liquidity Risk

The risk associated with being able to liquidate an investment easily and at a reasonable price.

Enterprise-Wide Risk Management ERM

A broader view of risk management that encompasses all types of risk. An approach to managing all of an org's key risks and opportunities with the intent of maximizing the org's value. Risk mgmt process occurs at the enterprise level.

Pure Risk

A chance of loss or no loss, but no chance of gain. Because there is no opportunity for financial gain, pure risks are always undesirable.

Speculative Risk

A change of loss, no loss, or gain. Desirable because there is a chance of gain. Involved in every business venture. Price risk, credit risk, inflation risk, market risk, interest rate risk, liquidity risk.

Morale Hazard

A condition of carelessness or indifference that increases the frequency or severity of loss. Driving carelessly, not locking a building.

Legal Hazard

A condition of the legal environment that increases loss frequency or severity. Courts in some geographic areas may award large damages or are more likely to find in favor of the plaintiff than in other areas. Increasing number of decisions against tobacco mfg present legal hazard for companies also in the industry.

Hazard

A condition that increases the frequency or severity of a loss. Four classifications are moral, morale, physical, and legal. Can have a compounding effect if multiple hazards are present which can increase frequency.

Moral Hazard

A condition that increases the likelihood that a person will intentionally cause or exaggerate a loss. Intentionally causing, fabricating, or exaggerating a loss. A deliberate act. Incentives include financial difficulty and purchasing insurance.

Personnel Loss Exposure

A condition that presents the possibility of loss caused b a person's death, disability, retirement, or resignation that deprives an org of the person's special skill or knowledge that the org cannot readily replace. For organizations.

Net Income Loss Exposures

A condition that presents the possibility of loss caused by a reduction in net income. The result of a property, liability, or personnel loss, which are direct losses. Net income losses are therefore an indirect loss. Can also be caused by: Loss of goodwill: Poor service, mismangaing ops, poor products. Especially important for NFP. Failure to perform: Product failure, contractor failure to complete a project, debtor's failure to make payments. Missed opportunities: Delayed decisions marketing or product changes.

Property Loss Exposure

A condition that presents the possibility that a person or org with sustain a loss resulting from damage to property in which that person or org has financial interest. Damage to property can cause a reduction in value, loss of use, or loss of income. Tangible or intangible.

Direct Loss

A loss that occurs immediately as the result of a particular cause of loss. ie a fire that damages a building

Diversifiable Risk

A risk that affects only some individuals, businesses, or small groups.

Profitability

Ability to generate income (FP) or operate within a budget (NFP) after a loss.

Social Responsibility

Acting ethically and fulfilling obligations to the community and society as a whole. Both pre-loss and post-loss goal. Enhances reputation. The overriding pre-loss goal for NFP and public entities.

Expenditures on Risk Management

Activities for risk control and risk financing. The most widely known risk management technique used by individuals is risk financing by purchasing insurance.

Personal Property

All tangible or intangible property that is not real property.

Possibility

An element within the definition of risk. An outcome or event may or may not occur. Risk exists because of the possibility of a negative outcome. Identifies risk. Does not quantify risk; it only verifies that risk is present.

Uncertainty

An element within the definition of risk. What will happen, when will it happen, or both. Results from the inability to predict the future.

Liability Loss Exposure

Any condition or situation that presents the possibility of a claim alleging legal responsibility of a person or business for injury or damage suffered by another party. Results from the claim itself, not the payment of damages.

Personal Loss Exposure

Any condition or situation that presents the possibility of a financial loss to an individual or a family by such causes as death, sickness, injury, or unemployment. For individuals.

Elements of a Liability Loss Exposure

Asset Exposed to Loss: Money. Payments made for damages, settlement costs, legal fees, court costs. Cause of Loss: The making or threat of making a claim or suit against the insured by another party seeking damages or legal remedy. Financial Consequences of Loss: Theoretically limitless. Practically limited to total wealth of insured. Can affect reputation, assets, and future income.

Elements of a Property Loss Exposure

Asset Exposed to Loss: Tangible, intangible, real and personal property. Cause of Loss: Hail, wind, water, theft, fire, mold. Financial Consequences of Loss: Max financial consequence is limited to the value of the property, but can result in loss of income if property is unusable.

Elements of Net Income Loss Exposures

Asset Exposed to Loss: The future stream of net income cash flows of the individual or org. Cause of Loss: Property, liability, personnel loss exposures and business risks such as poor strategic planning. Financial Consequence of Loss: Varies based on the cause of loss. Decreased revenues or increased expenses.

Elements of a Personnel Loss Exposure

Asset Exposed to Loss: The value the key person adds to the org. Cause of Loss: Death, disability, retirement, resignation, layoff or firing. Financial Consequences of Loss: Can be partial or total, temporary or permanent. ie Death is a total, permanent loss. Disability is a partial loss. Injury may be temporary loss.

Step 2: Analyzing Loss Exposures

Completed by estimating the likely significance of possible losses identified in step one. Step 1 and 2 are the process of assessing loss exposures are therefore the most important steps because only properly assess loss exposure can be appropriately managed. Analyzed based on frequency, severity, total dollar losses, and timing.

Cost of Residual Uncertainty

Cost of Worry. The level of risk that remains after individuals or orgs implement their risk mgmt plans. Influenced by subjective view of the risks to which they are exposed. Minimizing cost of residual uncertainty is costly because more has to be spent to control on finance risk involved. Difficult to measure and is largely ignored in cost of risk studies. Includes consumers, investors and suppliers that consider reputation, product quality, financial stability.

Diversifiable vs Nondiversifiable Risk

Diversifiable risk is not highly correlated and can be managed through diversification (spread of risk). ie fire Nondiversifiable risk are correlated; their gains and losses tend to occur simultaneously rather than randomly. ie interest rates

Basic Purpose and Scope of Risk Management

Effectively assess, control, and finance risk in order to minimize the adverse effects of losses or missed opportunities. Protect assets and meet goals. Individuals: Series of efforts. Informal. Part of financial planning. Organizations: More informal for smaller orgs, but part of a formal program for larger orgs.

Risk Source (ISO 31000)

Element which alone or in combination has the intrinsic potential to give rise to risk.

Growth

Emphasizing growth might have two opposing effects on risk mgmt program. If org is willing to accept greater uncertainty in exchange for minimizing risk mgmt costs, costs for risk mgmt would be low. If the goal if risk mgmt is to protect expanding resources, risk mgmt costs would be high. ie increasing market share, size/scope of activities or assets

Legality

Ensuring the org's legal obligations are satisfied. Legal obligations are based on -Standard of care that is owed to others -Contractors entered into by the org -Federal, state, and local laws and regulations

Reducing the Financial Consequences of Risk

Evaluate cost of risk and compare to benchmarks. Overall financial consequence of risk is the sum of three costs: cost of the value lost because of actual events that cause a loss, cost of the resources devoted to risk mgmt, cost of residual uncertainty. These are broken down to cost of losses not reimbursed by insurance, cost of insurance premiums, cost of external sources of funds, cost of measures to prevent or reduce size of potential losses, cost of implementing and administering risk mgmt. Benchmarking completed by Risk and Insurance Management Society RIMS.

Reasons Subjective and Objective Risk Can Differ

Familiarity and Control: people may feel safer doing something they are more familiar with and have more control over, even though the risk of severe injury is greater. ie driving vs flying Consequences Over Likelihood: Low likelihood, high consequence events. People have two misconceptions about these types of events: it can't happen to me, or overstating the event. Risk Awareness: Different levels of risk awareness cause org's to view risk differently.

Pre-loss Goals

Goals to be accomplished before a loss, involving social responsibility, externally imposed goals, reduction of anxiety, and economy. Operational goals. Economy of Operations Tolerable Uncertainty Legality Social Responsibility

Pure vs Speculative Risk

Insurance primarily deals with pure risk (risks of loss, not gain). Many risks have both pure and speculative aspects. Must be managed differently. Pure risk is managed with insurance. Speculative risk is managed with choices and planning ie maintaining property and obtaining a favorable mortgage.

Step 5: Implementing the Selected Risk Management Techniques

Involves: Purchasing loss reduction devices Contracting for loss prevention services Funding prevention programs Implementing and continually reinforcing loss control programs Selecting agents, brokers, insurers, TPAs and other insurance program providers Requesting insurance policies and paying premiums

Step 3: Examining the Feasibility of Risk Management Techniques

Loss exposures can be addressed through the risk control techniques and risk financing techniques. Risk Control Techniques minimize the frequency or severity of a loss and make the loss more predictable. Risk Financing Techniques generate funds to finance losses that risk control techniques can not entirely prevent or reduce.

Traditional Risk Management RM

Main focus is managing safety, purchasing insurance, and controlling financial recovery from losses generated by hazard risk. Associated with pure risk. Risk mgmt process occurs at business unit level.

Risk Management Program Goals

Pre-loss and post-loss goals. Tailored to support the organization's goals.

Risk Management Benefits

Properly managing risk reduces its negative financial consequences and thereby benefits individuals, organizations, and society. Lower expected losses, meaning less frequency or severity. This preserves financial resources. Less residual uncertainty reduces anxiety, deterrence effect and improves allocation of productive resources. Individuals: Preserve financial resources by reducing expected losses. Reduces residual uncertainty and anxiety. Organizations: Preservation of financial resources adds value to the org and makes it safer and more attractive to investors, confidence capital is protected against future loss which is attractive to suppliers and customers. Reduce deterrence of risk effect which allows org to plan for possible outcomes. Society: Lower expected losses and reduce uncertainty. Resources can be lost. Risk mgmt improves allocation of resources. Ability for orgs to take on risky activities to maximize profits, investments and wages. This increases productivity within an economy and improve the overall standard of living.

Probability

The likelihood that an outcome or event will occur. Quantifies risk. Measurable and has a value between 0 (no chance of an event occurring) and 1 (the event will definitely occur). If event is possible but not certain, its probability is between 0 and 1. Helps focus risk management on risks that can be appropriately managed and which activities to undertake and which risk management techniques to use.

Conflicts Between Goals

The more ambitious and costly the post-loss goal, the greater the conflict with economy of operations. Expending risk mgmt resources conflicts with pre-loss goal of economy of operations. Economy of operations may conflict with tolerable uncertainty. Legality and social responsibility goals may conflict with economy of operations goal.

Subjective Risk

The perceived amount of risk based on an individuals's or organization's opinion. Based on opinions. Can exist where object risk does not. The closer and org's subjective interpretation is to the objective risk, the more effective its risk mgmt plan will be.

Market Risk

The risk associated with fluctuations in prices of financial securities, such as stocks and bonds.

Inflation Risk

The risk associated with the loss of purchasing power because of an overall increase in the economy's price level.

Credit Risk

The risk that customers or other creditors will fail to make promised payments as they come due.

Risk

The subject matter of insurance. The insurance applicant/insured. The possibility of bodily injury or property damage. A cause of loss (peril). The variability associated with a future outcome.

Price Risk

Uncertainty over the size of cash flows resulting from possible changes in the cost of raw materials and other inputs, as well as cost-related changes in the market for completed products and other outputs.