2. Introduction to Risk Management Bus 200 Introduction to Risk Management and Insurance Fall 2008 Prof. Jin Park

Overview Definition & Objectives Process Risk Management Technique Control vs. Finance More on Risk Finance Retention, Captive, Insurance, Transfer

Definition and Objectives Risk Management A systematic process for managing (pure) risks faced by an individual or organization. Pre-loss vs. Post-loss risk management Loss Exposure Ay situation or circumstance in which a loss is possible regardless of whether a loss occurs. Objectives Why? Management’s job Reduce earnings volatility Maximize shareholder’s value Promote job and financial security

Risk and Relative Return Risk- Adjusted Return Zone 1 Insufficient Risk Taking Zone 2 Optimal Risk Taking Zone 3 Excessive Risk Taking Risk

Risk Management Process

The Process Step 1 - Identification Loss exposures Methods Step 2 – Evaluation Frequency Severity Step 3 – Risk Management Selection Control vs. Finance Prevention vs. Reduction Step 4 – Implementation and Monitor

Evaluation Tools Risk mapping A graphical presentation of potential frequencies and severities of identified loss exposures faced by individual/organization Critical issue tolerance boundary or risk- tolerance boundary Prioritize risks Risk management matrix

Risk Mapping Frequency Severity Fire on warehouse Flood on warehouse EE’s petty theft Job related injuries System failure Owner’s disability Vandalism Tornado Robbery Auto liability Default on payment

Risk Management Matrix High Low Frequency Severity Prevention Retention Reduction Insurance Avoidance

Risk Management Techniques Risk Control Goals Risk control options Avoidance Loss control Prevention Reduction Pre-loss risk control Post-loss risk control Risk Financing Goals Risk financing options Retention How? Transfer Insurance Non-insurance

Risk Financing - Retention A method of funding losses using internal money No purchase of insurance Retention with insurance What determines the retention decision? Frequency & severity of expected losses No other effective method available Costs and availability of insurance MMP, Health care insurance Highly predictable losses Self-confidence or degree of risk aversion Failure to identify

Risk Financing - Retention What determines the retention level? Degree of risk aversion Financial condition Ability to diversify the retained risk Potential cost/benefit Costs and availability of insurance Ability to administer a retention program in a cost effective manner

Risk Financing - Retention Self-Insurance, Captive, RRG Self-Insurance Captive A form of self-insurance through a wholly owned subsidiary (insurance company) created to provide insurance to the parent companies Pure captive, Group captive, Risk Retention Group Which one? UPS vs. IRS

Transfer - Insurance Advantages Less uncertainty Loss control services. Eligible expenses Non-taxable insurance proceeds. Disadvantages High insurance premium. Moral and morale hazards. Time and effort. Insurance may not be available. Dependable No benefit of loss control

Non-Insurance Transfer Methods of transferring risk to another party other than by insurance Contracts Hold harmless agreements Leases

Non-Insurance Transfer Advantages May be able to transfer losses that are otherwise not commercially insurable. Noninsurance transfers may cost less than insurance. May be able to shift loss to someone who is in a better position to exercise loss control. Disadvantages Transfer may fail for legal reasons Transferee may be unable to pay the loss May not reduce insurance costs if insurer does not give credit for the transferred risk