RISK MANAGEMENT METHODS

Chapter Objectives
By the end of this chapter the student should
 Appreciate the many options available to manage risks
 Be able to fit different treatment strategies to different situations
 Understand factors influencing the choice of a response strategy

Methods of Handling Risks

The existence of risk causes discontent to individuals and the uncertainty accompanying
it causes anxiety and worry. The following are the main five ways of handling risks.
i) Risk avoidance Risk is avoided when an individual refuses to accept the risk.

This is accomplished by merely not engaging in actions that would give rise to
risk. For instance if a firm wants to avoids risks associated with property
ownership, it will not purchase but lease it. The avoidance of risk is one way of
dealing with risk but it is a negative rather than a positive technique. Risk
avoidance if extensively utilized by both individuals and the society will lead to
lack of development.
ii) Risk Retention When an organization does not take the step of avoiding,
reducing or transferring the risk, then the possibility of risk involved will be
retained. The act of retention may be voluntary or involuntary. Voluntary risk
retention is characterized by the recognition that the risk exists and the
organization has decided to retain it. Involuntary retention occurs when and
individual exposed to risk does not recognize it existence until the risk occurs.
Risk retention is a legitimate way of dealing with risk and in most cases it’s the
best method of handling risk. Each organization must decide which risk it should
retain, avoid or transfer on the basis its ability to bear the loss. As a general rule
risks that should be retained are those that lead to relatively small certain loss.
iii) Risk Transfer Risks may be transferred from one firm to another that is more
willing and is capable of bearing the risk. Additionally risk may be transferred
through insurance contracts. Insurance is a mean of shifting or transferring risk,
in consideration of specific payments (premiums). The insurance company
undertakes to indemnify the party taking insurance up to a certain limit for a
specified loss that might occur.
iv) Risk Sharing The distribution of risk is accomplished in many ways in the
society. One way through which risk is shared is through co-operatives. These
organizations funds are pooled together each bearing only a portion of risk that the
enterprise will fail. Insurance is another device designed to deal with risk through sharing.
v) Risk/Loss Reduction This is achieved through risk control (risk prevention) or
the law of large numbers. Risk control is achieved through safety and loss
prevention programs e.g. medical cover, fire sprinklers, guards, burglary alarms
are measures of dealing with risk by reducing its impact. Through the law of
 large numbers of exposure units, a reasonable estimate of the cost of losses can
be made. On the basis of these estimates it is possible for an organization such as
an insurance company to assume responsibility of loss of each exposure unit.

Risk Control and Risk Financing

Risk control includes techniques, tools, strategies and processes that seek to avoid,
prevent, reduce or otherwise control the frequency and/ or magnitude of loss and other
undesirable effects of risks. Risk control also includes methods that seek to improve
understanding or awareness within an organization of activities affecting exposure to risk.

Risk control has a strong relationship to risk financing because the control of risks can
have a significant effect on the frequency and severity of losses that must be financed.
The positive effects of risk control on an organization’s risk financing usually occur
irrespective of the particular risk financing methods used: if losses do not occur, loss
financing is not needed. Therefore any efforts to control a risk will usually have a
positive effect on the cost of financing.

Contingency or Catastrophe Planning

This is an integrated approach to loss reduction. It is an organization wide effort to

identify possible crisis or catastrophes and develop plans for responding to such events.
Catastrophe planning usually involves a fairly lengthy process of research and evaluation
that ultimately yields a contingency plan for possible use in the event of catastrophe.
A catastrophe plan involves the following activities:

Backup, off-site storage computerized records.

Updating fire suppressant system.

Training employees on emergency safety procedures

Disaster training/ planning with government agencies such as the fire department.

Creation of an emergency response team or committee e.t.c.

Catastrophe plans are much less likely to succeed if imposed on an organization that has
no existing risk management culture in place at the time of a disaster. Duplication offers a
special case of loss reduction. Backing up of computers files and storing the files off-site
is a good example of duplication while storing of critical spare parts fall under the
concept of duplication too.
Separation is the other case of loss reduction. This technique isolates loss exposures
 from each other instead of leaving them vulnerable to a single event e.g. a rule that
requires employees in a supermarket to move cash accumulations over stated
amount from cash registers to a secure location such as bank vault. The logic behind
separation is to reduce the likelihood that a single event could affect all organization’s
exposure to loss Separation does not necessarily reduce the chance of loss to a single
exposure unit, but it tends to reduce the chance of a catastrophic loss.

Information Management

To realize maximum benefits from a loss control program. The program objectives and
benefits should be communicated to stakeholders such as employees insurers, regulators
among others.
Lack of information can cause stakeholders to become uncertain about the nature of the
organizations actions with respect to matters affecting their interests. Communication
also increases awareness of the loss causing process, this allows better forecasts of the
consequences. One possibility for enhancing awareness is a reporting method and system
of rewards for employees who make suggestions leading to safer practices.

Funding Arrangements

Funding arrangements for retention of risk range from not making any provisions out of
profits to sophisticated techniques such as captive insurance. These are discussed below

(i) No Advance Funding

Many decisions to retain property and liability losses do not involve any formal advance
funding. The organization simply bears the losses when they occur. However, if losses
fluctuate widely year to year the organization may experience distress when large losses
occur. Major losses are rarely financed through borrowing partly because creditors
consider retention of such losses to be financial mismanagement.

(ii) Earmarked liability

Account

This account is created to absorb fluctuation in uncovered losses. Each year a provision
for loss is added to this account with profit or other financial gain being reduced by this
amount. When an uninsured loss occurs it is then deducted from this account rather than
from profits thereby smoothing the effects of uninsured loses.

(iii) Earmarked Asset

Accounts

Organization may hold cash or investments which can be easily turned into cash for the
purpose of paying uninsured losses. This approach could be used when uninsured loss
could possibly exceed cash available for emergencies.
 iv) Captive Insurers

A captive insurer is an insurer that is owned by the insured. The parent organization
establishes a captive insurance subsidiary that writes insurance against the parents
insured risks. The captive insurers may write insurance for other parties not affiliated
with the parent. Since the captive insurers are part of the same organization with the
parent transfer of risk would not appear to be motive. The reasons for firms forming
captive are;
i) Lack of specialized firm which can offer the kind of insurance required.

ii) When there are no statistics about chance of loss so that accurate premiums can be
calculated.
iii) When the chance of loss is so rare that the parent company does not require re-
insurance.

Non insurance Transfers

Risk financing transfers in contrast to risk control transfers provide external funds that
will pay for the losses should an adversity strike. Non insurance transfers differ from
insurance in that the transferees are not legally insurers.
(i) Instruments of trade
credit

Drafts: - are used in international trade. The seller draws up a draft and ships it to the
customer’s bank along with the shipping documents. The customer either pays or
acknowledges debt prior to being gives the shipping documents. The customer’s bank
then forwards the payment or the acknowledgement in the form of a trade acceptance.
Bank acceptance: - If there is uncertainty about a customers ability to pay the seller may
ask the customer’s bank for a guaranty of payment in the form of a bank acceptance.
Letter of Credit: - When an even stronger guaranty of payments is required the seller may
ask the customer to arrange a letter of credit with an established in a bank in the seller’s
country. The letter of credit signifies the customer credit worthiness and should the
customer default the bank will pay for the goods.
Stand by Letter of Credit: Serves the same purpose as letter of credit but in domestic
transactions and may apply to a category of transactions.
In theory, a letter of credit would satisfy financial security requirements for self
insurance. However the holder of a letter of credit faces default risk, hence the letter of
credit should be confirmed by a bank in the letter of credit or a very reputable bank
outside the customer’s country.

(ii) Other Non-Insurance Transfers

Many of such transfers occur as a result of provisions in contracts dealing primarily with
other matters but in some cases the transfers occur through contracts specifically
designed to shift financial responsibility.
The transfers differ as to the extent of responsibility at one extreme the transferor shifts
only the financial responsibility for negligent act of the transferee (vicarious liability)
and at the other end is to be identified for losses covered under the contract no matter
who
caused the loss e.g.
a) Lease contract where the landlord transfer responsibility for damage to the
rented property
b) A courier service contract obligating the bailee to pay for losses in excess of

its statutory or common law liability.

(iii) Hedging

A hedge is employed to offset a risk associated with holding an asset or arising from a
transaction hedging contracts such as options, forwards and futures, swaps have been
employed to offset such risks as price fluctuation of assets e.g. oil, currencies, interests
rates etc. A hedge could also employ assets whose rations are negatively correlated e.g. a
holder of stock in a corporation with oil reserves might hedge the stock to invest in an
electrical utility that uses oil to produce electricity efficient diversification.

Agreements and Combination

A pooling agreement may take the form of an agreement to store losses that occur among
pool participants e.g. municipalities may agree to share liability exposures arising from
fire protection activities through a pooling agreement. A pooling of risk exposures also is
called combination which refers to the combining or pooling of loses arising from a large
number of exposures. This results in the loss per unit becoming more predictable risk
control. The number of units in the pool serves as a proxy for the pools risk bearing
capacity which is in the form of financial resources.

Factors Affecting Choice between Retention and Transfer

a) Legal Economic and Public Policy Limitations

Significant limitations apply to transfer of risk especially non insurance

transfers.

i) A contract may transfer only part of the risk that the organization though it had
shifted to someone else.
ii) The language is often so complicated that legal action may be required for the
meaning to become apparent.
iii) Courts interpret transfer provisions narrowly due to their being that broad shifts
of responsibilities are often declared invalid by being out of tune with public
policy or being grossly unfair to the transferee.
iv) Since contracts vary widely there are few precedents for courts to follow.

v) If the transferee is unable to pay the transferor must bear the loss.

vi) The transferee who has the major incentive for loss control may lack the
expertise or authority for effective control
 b) Degree of control

When an organization has little or no control over the outcome, transfer becomes
attraction. The larger the degree of control the more attractive retention becomes over
transfer. Insurance weakens incentives to prevent or reduce loss because losses are
compensated moral hazard. As a consequence, the premium for insurance coverage is
higher than what it would be if some mechanisms for manifesting the loss prevention
incentives were present. The results are increase in the cost of insurance relative to
retaining the loss. Retention therefore increases the incentives of the organization to
establish the loss-prevention and loss mitigating activities. From a public policy
perspective, society benefits when the burden of loss falls on the party best equipped to
control the loss producing events.

c) Loading Commission, financial services fees and other transactions costs

Loading fees and transaction costs represent the amount by which the cost of transfer
exceeds the expected value of the benefit payments from the transferee. Holding other
factors constant higher loading fees increase the attractiveness of retention. Loading
commissions are fees charged for providing the insurance service. Fees charged by banks
other financial institutions for services such as providing letters of credit or other
financial commitments are other examples. Securities transactions also entail transaction
costs, when options are used to hedge risk the transaction cost are incurred in buying and
selling securities to maintain the hedge.

d) Value of services provided by insurers and other financial institutions

Loading fees and transaction costs are not necessarily wasted money. In many cases
loading fees are compensation for providing services that the transferee would provide
itself in the absence of the transfer. A bank may provide valuable advice to a client in
arranging a letter of credit and the bank’s compensation may come from arranging the
required letter of credit. Insurers have the advantage that they can spread overhead costs
over many insureds’. They offset to some exert the services would have been provided by
the risk manager. These would otherwise spare the risk manager time in selecting the
insurer, negotiating terms of the insurance contract and the price to be charged and filling
a proof loss with the insurer incase of a loss.

e) Opportunity Costs

Evaluation of insuring a risk versus retention should consider the investment income that
should be earned during the time between payment of the insurance premium and the
ultimate payment of the claim. Investment income reduces the cost of a given
claim. This is often evaluated by comparing the present value of retention costs to the
present value of insuring the risk. In the absence of market restrictions or institutional
constraints, one would not expect the opportunity set of investments to differ between
insurers and organizations that retain risks. Similarly one would expect insurance
premiums to reflect anticipated investment
income.

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 f) Tax Considerations

Generally insurance companies tend to receive favorable tax treatment relative to consumers
of insurance. Insurance companies are allowed to deduct from current taxable income their
provision for future claim payment. A firm paying claims using its own funds in
contrast cannot deduct payments from taxable income until economic performance
occurs (claim payments). Holding other factors constant the tax-induced effects place
insurers at the greatest advantage relative to heavily taxed organizations, but this advantage
declines with lowly taxed forms or non taxed firms. When tax related
effects are believed to be important, experts in tax accounting and tax law may be
consulted to evaluate appropriate methods for risk financing.

g) Retention may be the only possible method

In some case, retention is the only possible, or at least the only feasible tool. The
organization cannot prevent the loss, avoidance is impossible or clearly undesirable, and no
transfer possibilities (including insurance) exist, consequently the organization has no choice
but to retain the risk. A firm with a plant in a river valley or an earthquake prove area may
find that no other method handling the flood) earthquake risk if feasible. Abandonment and
loss control would be to expensive and no insurance cover available
.In other passes, part but not all of the potential can be controlled or financed internally.
Sometimes insurance is not available unless the insured agrees to absorb the first part of
say Ksh. 5M of any loss. These uninsured losses cannot be completely controlled or
transferred elsewhere; the organization will be forced to retain them.

Commercial Insurance

Insurance is a risk financing transfer under which an insurer agrees to accept financial
burdens arising from loss. The insurer agrees as reimburse the insured the loss (as
defined, in the insurance contract) in return for premium payments. Insurance as a device of
handling risk is covered comprehensively in the next topic.