A risk management program
The scientific method of planning to deal with losses is called risk management.
A risk management program usually involves three steps:
1.Identifying and measuring exposures to loss
2.Developing and implementing plans to deal with potential losses after they have been identified
3.Regularly reevaluating and updating the risk management program
Identifying and measuring exposures
The recognition that a problem exists is always the first step in solving the problem.
Recognizing one's exposure to loss requires organized thinking about the subject.
One starting point is to categorize the sources of loss into speculative or pure risk exposures.
Speculative risks are exposures that can result in gains or losses and usually are not the subject of risk management.
Losses or gains that result from bad or good management decisions,from a competitor's actions,
or from government intervention in the economy are examples of speculative risks,
and these are usually outside the scope of the risk manager's responsibility.
Price fluctuation in commodities or foreign currencies,however,can result in gain or loss,
and this speculative risk can be managed with a hedging program.
On the other hand,pure risks can result only in losses and usually arise from the following sources:
1.Direct losses of property
2.Indirect losses of income because normal business activity has been interrupted by a direct loss
3.Liability losses
4.Losses due to death or disability of key personnel
These pure risks usually can be managed once they have been identified and measured.
Regarding measurement,it is well to remember that,before a loss occurs,measurement is merely an estimate.
Not all preloss estimates will necessarily reflect with accuracy the actual amount of damages or even the actual amount of exposure to loss.
Developing and implementing a risk management program
After all potential sources of loss have been identified and measured,
it is the job of the risk manager to develop and implement plans to deal with the potential losses before they occur.
Accomplishing this task demands a knowledge of the alternative methods of dealing with risk,the uncertainty about loss.
In addition to insurance,six other methods of dealing with potential losses are:
1.Risk avoidance
2.Risk assumption
3.Self-insurance
4.Loss prevention
5.Loss reduction
6.Risk transfer other than insurance
A thorough risk management program is the result of the consideration of all these alternatives,
rather than the reliance on just one method of dealing with an exposure to loss.
In every case the risk manager with carefully weigh the ratio of the costs of a particular risk management approach withthe potential benefits to be produced.
Since unlimited budgets for risk management are not the rule,spending priorities must be established.
Also determining the choice of an appropriate tool are an estimate of the chance of loss and an estimate of the severity of a potential loss.
Once a decision has been made to treat an exposure to loss with a given risk management tool,the decision must be implemented.
For example,if it has been decided to purchase insurance,
arrangements must be made to acquire the proper amount of insurance at the best possible price accompanied by all the service needed or desired.
Equally important,once the insurance is in force,
the risk manager must be familiar with the terms of the contract so that none of the firm's actions cause the coverage to be suspended
or the conditions of the contract to be breached in any way either before or after a loss occurs.
If a loss prevention program is decided upon,the risk manager must see to it that all affected employees,
know what the plan's aims are and what part they are expected to play in the program.
The risk manager must remain alert to any advances in safety engineering that may make a given operation or plant or store a safer place in which to work.
The insurance mechanism
One of the chief problems that risk management has had to overcome has been to differentiate itself from insurance,
partly because of the insurance background of many of the pioneers in risk management thinking,
and partly because risk-at least those varieties of it with which risk management is chiefly concerned-
has for so long been considered the preserve of insurance alone.
The confusion has been perpetuated because insurance retains such an important role as the main method of risk financing in a risk management programme.
Risk management does not supersede insurance,but puts it in its proper perspective,
as fulfilling a useful function determined after critical assessment of what it has to offer compared with other financing possibilities.
To get the best out of any risk management programme,therefore,requires a knowledge of how the insurance mechanism works,
and an appreciation of ways in which the insurance industry treats the risk passed on to it in return for the premium paid.
For the purchaser,insurance provides a method of smoothing loss experience over a period of time,
by exchanging the static risk which is insured for the smaller risk of the failure of the insurer to settle a claim when it is made,
either through lack of funds or by some breach of the conditions of the insurance contract by the insured himself.
Except for the small insured,or the catastrophic loss,it is unlikely that the cost of loss will be permanently transferred from the insured to the insurer;
for the latter will seek to recover what he has paid out by increased premiums in subsequent years,
or he may already have recovered it in previous years when the premiums paid have been greater than the amount needed to pay claims and meet the insurer's expenses.
Where the market for a particular type of risk is not governed by rating agreements between insurers,
it may be possible to defer or avoid repayment of the cost of loss by changing insurers,
but in most cases this will be only a short-term solution,
unless there has been some substantial improvement in loss control to improve the probable future cost of loss.
A new insurer may offer a lower premium,taking the chance that the loss experience will improve,
but if it does not,then the premium cost is likely to rise to,and perhaps beyond,its old level.
The service of chronological loss spreading is,however,what the insured really needs,
even if the total cost is not thereby reduced,for it enables him to reduce the annual cost of large losses to a size at which they can be borne in a single accounting year.
From the insurer's point of view,the risk that is transferred to him has a different aspect.
What was a static risk for the insured becomes a dynamic risk for the insurer,
for in his hands it presents possibilities either of profit or of loss.
The fact that a reinsurance market exists as a method of treating this risk is,
however,a reminder that static risk and insurable risk are not synonymous terms.
The methods the insurer uses to treat the risk he carries are themselves a good example of risk management in action.
He seeks first of all to diminish his risk by ensuring that it is well spread.
This is achieved in a number of ways.
First,a good spread of risk is sought by endeavouring to ensure that the portfolio he is insuring consists of a large number of similar items.
This will give the greatest play to the operation of the law of large numbers,and thus improve the predictability of the loss experience.
Next,the insurer will wish these insurances to come from many different locations to provide the necessary geographical spread
to minimise the chance of an abnormal loss experience due to a localised catastrophe