UNIT- 2

RISK MANAGEMENT

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 2.1 Introduction

This unit focuses on the methods,

procedures and techniques used by the risk
manager so as to minimize the risk occur in
a firm.
Once we understand that risk always exist
with a firm or human being activities,
managers should take different measure to
avoid or reduce these losses or undesired
events.

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 2.2 Definition of Risk Management
Risk Management is the identification,
measurement, and treatment of property,
liability, and personnel pure-risk exposures. It
involves the application of general
management concepts to a specialized area.
In requires the drawing up of plans, the
organizing of material and individual for the
undertaking, the maintaining of activity among
personnel for the objectives, involved, the
unifying and coordinating all the activities and
efforts, and finally the controlling these
activities.
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 2.3 Risk Management Process

1: Risk identification
The loss exposures of the business or
family must be identified. Risk identification
is the first and perhaps the most difficult
function that the risk manager or
administrator must perform.
Failure to identify all the exposures of the
firm or family means that the risk manager
will have no opportunity to deal with these
unknown exposures intelligently.

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 2.3 Risk Management Process (Cont….)
2: Risk Measurement:-
After risk identification, the next important step is
the proper measurement of the losses associated
with these exposures. This measurement includes a
determination of:
 the probability or chance that the losses will occur
 The impact the losses would have upon the financial
affairs of the firm or family should they occur.
 The ability to predict the losses that will actually occur
during the budget period.
The measurement process is important because it
indicates the exposures that are most serious and
consequently most in need of urgent attention. It also
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yields information needed in risk treatment.
 2.3 Risk Management Process (Cont….)

3: Tools of Risk Management

Once the exposures has been identified and
measured the various tools of risk
management should be considered and a
decision made with respect to the best
combination of tools to be used in attacking
the problems. These tools include.
 avoiding the risk
 reducing the chance that the loss will occur or
reducing its magnitude if it does occur
 transferring risk to some other party, and
 retaining or bearing the risk internally
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 2.3 Risk Management Process
(Cont….)
The third alternative includes, but not limited to the
purchase of insurance. In selecting the proper tool or
combination of tools the risk manager must establish
the cost and other consequences of using each tool
or combination of tools. He/she must also consider
the present financial condition/position/ of the firm or
family, it’s over all policy with reference to risk
management and its specific objectives.

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 2.3 Risk Management Process (Cont….)

4: Implementation:
After deciding among the alternative tools of
risk treatment the risk manager must
implement the decisions made. If insurance is
to be purchased for example, establishing
proper coverage, obtaining reasonable rates,
and selecting the insurer are part of the
implementation process.

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 2.3 Risk Management Process (Cont….)

5: Controlling/monitoring:
The results of the decisions made and
implemented in the first four steps must be
monitored to evaluate the wisdom of those
decisions and to determine whether
changing conditions suggest different
solutions.

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 2.4 Objectives of Risk Management
Mere survival:- to exist as a business enterprise as a
going concern
Peace of mind:- to avoid mental and physical strain of
uncertainty of a person
Lower risk management costs and thus higher profits
Fairly stable earnings:-to eliminate the fluctuating
nature of earnings due to fluctuating losses.
Little or no interruptions of operations
Continued growth
Satisfaction of the firm’s sense of social responsibility
or desire for a good image/creating good will on
society/value maximization
Satisfaction of externally imposed obligations.
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 2.5 Risk Identification
Risk identification is the process by which a
business systematically and continually identifies
property, liability, and personnel exposures as soon
as or before they emerge. The risk manager tries to
locate the areas where losses could happen due to
a wide range of perils. Unless the risk manager
identifies all the potential losses confronting the
firm, he or she will not have any opportunity to
determine the best way to handle the undiscovered
risks.

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 2.5 Risk Identification (Cont…)
To identify all the potential losses the risk manager needs first
a checklist of all the losses that could occur to any business.
Second, he or she needs a systematic approach to discover
which of the potential losses included in the checklist are
faced by his/her business. The risk manager may personally
conduct this two-step procedure or may rely upon the
services of an insurance agent, broker, or consultant.

After the checklist is developed, the second step

is to discover and describe the types of losses
faced by a particular business. Because most
business is complex, diversified, dynamic
operations, a more systematic method of
exploring all facets of the specific firm is highly
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desirable.
 2.5 Risk Identification (Cont…)

Seven methods that have been

suggested are:
1. the risk analysis questionnaire
2. the financial statement method
3. the flow-chart method
4. on-site inspection
5. planned interactions with other
departments
6. statistical records of past losses
7. analysis of the environment

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 2.5 Risk Identification (Cont…)
No single method or procedure of risk identification is
free of
weaknesses or can be called foolproof. The strategy of
management
must be to employ that method or combination of
method that best fits
the situation at the hand.

The choice depends on:

 The nature of the business
 The size of the business
 The availability of in house expertise, etc.

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 2.5 Risk Identification (Cont…)
1. The risk analysis questionnaire:-
It does more than provide a checklist of potential losses. It
directs the risk manager to secure in a systematic fashion
specific information concerning the firm’s properties and
operation.
E.g. If a building is leased from some one else, does the
lease make the firm responsible for repair or restoration of
damage not resulting from its own negligence?
2. Financial statement method:
A second systematic method for determining which of the
potential losses in the checklist apply to a particular firm
and in which way is the financial statement method. By
coupling these statements with financial forecasts and
budgets, the risk manager can discover future exposures.
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 2.5 Risk Identification (Cont…)
3. Flow-chart method:- Is the 3rd systematic
procedure for identifying the potential losses facing a
particular firm. First, a flow chart or series of flow
charts I constructed, which shows all the operations
of the firm, starting with raw materials, electricity,
and other inputs at supplies locations and ending
with finished products in the hands of customers.
Second the checklist of potential property, liability,
[Link] personal
On-site- losses is applied
inspections: - aretoa each
mustproperty
for the and
risk
operation
manager. shown in the flow
By observing first chart
hand to determine
the which
firm’s facilities
losses the firm
and the faces. conducted thereon the risk
operations
manager can learn much about the exposures faced
by the firm.
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 2.5 Risk Identification (Cont…)
[Link] with other departments: Through
systematic & continuous interaction with other
departments in the business, the risk manager
attempts to obtain a complete understanding of their
activities and potential losses created by these
activities.
6. Statistical Records of lasses:- Another approach
that will probably suggest fewer exposures that the others
but which may identify some exposures not other wise
discovered is to consult statistical records of losses or
near losses that may be repeated in the future.

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 2.5 Risk Identification (Cont…)

7. Analysis of the environment: By analyzing the

internal and external environment such as customers,
competitors, suppliers and government, the risk
manager can identify the potential losses.

In identification process the risk manager gives more

emphasis on pure risks: property losses, personal and
liability losses.

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 2.6 Liability losses
Firms might get exposed to liability risks which refer to
injuries caused to other people or damages caused to their
property, because of their operating activities.

The following are some of the factors leading to liability

losses

1: Product liability: is associated with the manufacture

and sell of a particular product. For example, if a
pharmaceutical company sell a drug or medicine that
causes serious health problems, the victim might file a law
suit demanding compensation. This then may lead to a
potential loss to the firm producing the product. Quality
problems, breach of warranty, misleading advertisement,
etc are some of the factors that lead to liability losses.
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 2.6 Liability losses (Cont…)

2: Motor Vehicles: this is the most frequent factor

a firm should expect liability losses as use of
various kinds of motor vehicles. Operation of
motor vehicles could lead to killing of people or
injuries and damages of property of other people
due to accidents such as collisions, fire, crash, etc.

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2.6 Liability losses (Cont…)

3: Industrial accidents: factory employees are likely

to suffer physical injuries at work sites. In some types
of activities they may be exposed to job related
diseases. This is common in the case of laundries,
chemical industries, cement factories, and other where
employees are exposed to dust inhalation and pungent
chemical smell that can cause occupational diseases.
Liability loss arises then as the firm has to compensate
employees for their injuries and job related diseases
faced during the course of employment.

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 2.6 Liability losses (Cont…)

4: Industrial Waste: industrial wastes released into

air or thrown into rivers and lakes are major sources
of environmental pollution. Following the development
of environmental economics, environmentalists are
giving hard time to industries. There is then a
potential liability loss if the firm’s activities pollute the
environment and a law suit is filed against its
activities.
5: Professional activities: in the filed of consultancy,
medicine, construction, and other professional
activities, liability losses are likely to emerge because
of the deficiencies inherent in the services rendered
due to negligence, errors, intentional concealment
and the like.
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 2.6 Liability losses (Cont…)

6: Ownership of immovable: this refers to building,

land and machinery owned. The use of such
immovable by people may bring liability losses for
injuries might be because by accidents. For
example, faulty electrical, connections, old building
faulty elevators and escalators may cause injury to
people while they are using these facilities.

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 2.7 Risk Measurement
After the risk manager has identified the various
types of potential losses faced by his or her firm,
these exposures must be measured in order to
determine their relative importance and to obtain
information that will help the risk manager to decide
upon most desirable combination of risk management
tools.

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 2.7.1 Dimensions to be Measured
Information is needed concerning two dimensions
of each exposure
 The loss frequency or the number of losses that will occur
and
 The loss severity
Both loss frequency and loss severity data are needed
to evaluate the relative importance of an exposure to
potential loss. However, the importance of an
exposure depends mostly upon the potential loss
severity not the potential frequency. A potential loss
with catastrophic Possibilities although infrequent, is
far more serious than one expected to produce
frequent small losses and no large losses. On the other
hand loss frequency cannot be ignored.
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 2.7.1 Dimensions to be Measured (Cont…)
If two exposures are characterized by the same loss
severity, the exposure whose frequency is greater should
be ranked more important. There is no formula for ranking
the losses in order of importance, and different persons
may develop different rankings. The rational approach,
however, is to place more emphasis on loss severity.

Loss- frequency Measures

One measure of loss frequency is the probability that a single
Unit ill suffer one type of loss from a single peril. Instead of
estimated the probability that a single unit suffer one type of
loss from a single peril during the coming year, the risk manger
can, in the same way estimate the probability that the unit will
suffer that type of loss from many perils. This probability will be
higher because of the additional possible causes of loss.

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 2.7.1 Dimensions to be Measured (Cont…)
Loss-severity Measures
Two measures commonly used to measure loss
severity are:
 The maximum possible loss, and
 The maximum probable loss

The maximum possible loss is the worst loss that

could possibly happen and the maximum probable
loss is the worst loss that is likely to happen. The
maximum possible loss, therefore, is usually
greater than the maximum probable loss. Of these
two measures, the maximum probable loss is the
most difficult to estimate but also the most useful.

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 2.7.2 Risk Management and Probability
Distribution
 A more sophisticated way to measure potential losses
involves probability distributions. However, this
method is more difficult to explain and the data
needed to construct the required probability
distribution are commonly not available. Nevertheless,
probability distributions make possible more
comprehensive risk measurements than other
techniques; and also, they are becoming a more
common tool of modern management, and data
sources are improving. Furthermore, probability
distributions improve one’s understanding of the more
popular risk measurement and are extremely useful in
determining which risk management devices would be
best in a given situation.
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 2.7.2 Risk Management and Probability
Distribution
A probability distribution shows for each possible
outcome, its probability of occurrence. It is used to
estimate numerically the potential loss from a risk.
Using the probability distribution, it is possible to
measure the various aspects of a risk; such as

1. The total dollar losses per year (physical period)

2. The number of occurrences per year
3. The dollar losses per occurrence

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 1. Total Dollar Losses Per Year
 The probability distribution of the total dollar losses per
year shows each of the total dollar losses that the
business may experience in the coming year and the
probability that each of these totals might occur. For
example, assume that:
• A business has five cars, each of which is valued at
10,000 Birr
• Each car may be involved in more that one collision a
year; and
• The physical damage may be partial or total .
 Also assume prompt replacement of any car that goes out
of service, thus reducing net income losses to a minimal
level. A hypothetical probability distribution that might
apply in this situation is shown below.
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Total Dollar losses per year
Probability
Birr 0 0.606
500 0.273
1000 0.100
2000 0.015
5000 (If this Loss is considered as severe)
0.003
10,000 0.002
20,000 0.001
1.000
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 If the risk manager can estimate accurately the
probability distribution of the total dollar losses per
year, s/he can obtain useful information concerning:
a) The probability that the business will incur some
dollar loss,
b) The probability that “severe” losses will occur,
c) The average loss per year, and
d) The risk or variation in the possible results

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1. Total Dollar Losses Per Year

a) The probability that the business will incur some

dollar loss
 Given the above distribution, the probability that the
business will suffer no dollar loss is almost 0.61 (0.606).
 Because the business must suffer either no loss or some
loss.
 The sum of the probabilities of no loss and some loss
must equal 1. Consequently, the probability of some loss
is equal to about 1-0.61=0.39.
 An alternative way to determine the probability of some
loss is to sum the probability for each of the possible total
dollar losses:
 i.e., 0.273+0.100+0.015+0.003+0.001=0.3941(1-
0.606=0.394)
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1. Total Dollar Losses Per Year (Cont…)
b). The probability that “severe” losses will occur
• The potential severity of the total dollar losses can be
measured by stating the probability that the total
losses will exceed various values. For example, the
risk manager may be interested in the probability that
the dollar losses will equal or exceed 5,000 Birr. These
probabilities can be calculated for each of the values
in which the risk manager is interested and for all
higher values. For example, the probability that the
dollar losses will equal or exceed birr 5000 is equal to
0.003+00.002+0.001=0.006.

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1. Total Dollar Losses Per Year (Cont…)
C) The average loss per year
 Another extremely useful measure that reflects both loss
frequency and loss severity is the expected total dollar
loss or the average annual dollar loss in the long run.
Because the probability above represent the proportion
of times each dollar loss is expected to occur in the long
run, the expected loss can be obtained by summing the
products formed by multiplying each possible outcome
by the probability of its occurrence; i.e.,
0(0.606)+500(0.273)+1000(0.100)+2000(0.015)+5000(
0.003)+10,00(0.002)+20,000(0.001)=321.5 Birr. This
measure indicates the average annual dollar loss the
business will sustain in the long run if it retains this
exposure.
 136.5+ 100+ 30+ 15+20+20= 321.5
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1. Total Dollar Losses Per Year (Cont…)

d) The risk or variation in the possible results

 Up to this point, no yardstick has been suggested for
measuring risk but its relationship to the variation in
the probability distribution has been noted.
Statisticians measure this variation in several ways.
One of the most popular yardsticks for
measuring the dispersion around the expected
values is the standard deviation. The standard
deviation is obtained by subtracting the average value
from each possible value of the variable, squaring the
difference, multiplying each squared difference by
probability that the variable will assume the value
involved, summing the resulting products, and taking
the square root of the sum.
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 Standard Deviation= (Value- Average Value)2 x
 The Standard deviation for the example given above is calculated as follows:

(1) (2) (3)= (1-2)2 (4) (5)=3x4

Value Value-average (Value-average)2 Probability

$0 0-321 $(-321)2 0.606 62,443

500 500-321 (179) 2 0.273 8,747
1000 1000-321 (679) 2 0.100 46,104
2000 2000-321 (1679)2 0.015 42,286
5000 5000-321 (4679)2 0.003 65,679
10,000 10,000-321 (9679)2 0.002 187,366
20,000 20,000-321 (19679)2 0.001 387,263
799,888

Then, the standard deviation is

799,888 =#894
When there is much doubt what will happen because there are many
outcomes with some reasonable chance of occurrence, the standard
deviation will be large; when there is little doubt about what will happen
because one of the few possible outcomes is almost certain to occur, the
standard deviation will be small.
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2. Number of Occurrences per Year
This refers to the number of accidents expected to occur per
year.
 If each occurrence produces the same dollar loss, the
distribution of the number of occurrences per year can be
transformed in to a distribution of the total dollar losses per
year by multiplying each possible number of occurrences by
the uniform loss per occurrence.
 If the dollar loss per occurrence varies within a small
range, the distribution of the total dollar losses per year can
be approximated by multiplying each possible number of
occurrences by the average dollar losses per occurrence.
 If the dollar losses per occurrence vary widely, one needs
the probability distributions of the dollar losses per
occurrence and the number of occurrences per year to
develop information about the total dollar losses per year.

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3. Dollar Losses per Occurrence
Research have also has some success describing
the probability distribution of the dollar losses
per occurrence. This distribution would state the
probabilities that the dollar losses in an
occurrence would assume various value.
Generally, dollar loss per occurrence refers
to the average monetary loss expected per
accident (occurrence).

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 2.7.3. Risk Measurement Methods

There are various methods used to

measure the different aspects of a risk.
Some of these methods are:
1. Poisson distribution method
2. Binomial distribution method, and
3. Normal distribution method

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1. Poisson Distribution
The Poisson probability distribution can be used
for the analysis of risk measurement. The
Poisson distribution works well when:
1. There are at least 50 unit exposed
independently to loss, and
2. The probability that any particular unit will
suffer a loss is the same for all units’ less than
0.1(1/10).
These conditions can be satisfied in two ways.
First, the business can have at least 50 persons,
properties, or activities each of which can suffer
at most one occurrence per year, and the
probability being less than 0.1 (1/10) that any
41 particular unit will have an occurrence. Second,
 1. Poisson Distribution (Cont…)

 The only information that is crucial in constructing a Poisson

probability distribution is the expected number of accidents (the
mean). Once the mean is determined, the probability of any number
of accidents will be easily calculated using the following formula:

 re  
P(r )  r!

where ;   Expected number of accidents

r  Number of occurrences

e  2.71828

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 1. Poisson Distribution (Cont…)

To illustrate the application of this formula, assume that

there are 5 cars and each has experiencing about one
collision every two years. The mean therefore is ½ or 0.5
collision per year. Then the probability distribution is
developed as follows.
( 0.5 ) 0e  0.5 )
P ( 0)  0!  (1)( 0.6065
1 0.6065

( 0.5 )1e  0.5

P (1)  1!  ( 0.5)( 01.6065) 0.3033

( 0.5 ) 2e  0.5
P (2)  2!  ( 0.25)(2 0x1.6065) 0.0785

( 0.5 ) 3e  0.5 ( 0.125)( 0.6065)

P(3)  3!  3 x 2 x1 0.0126

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1. Poisson Distribution (Cont…)
We continue like the above until we found that the sum of
probability
of all accidents equal to 1. Thus the probability distribution is:
No of Collisions Probability
0 0.6065
1 0.3033
2 0.0785
3 0.0126

 Once the probability distribution is developed, it would not

be difficult to determine the probability of any number of
accidents that are likely to occur.
For example, the probability of no collisions is almost
0.61 or 61%;
The probability of more than two collision is 1-0.9883=
0.0117. i.e, 1- (0.6065+0.3033+0.0785)= 0.0117; and
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The probability of more than one collision is 1-
(0.6065+0.3033) = 0.0902 or 9.02%. Etc.
 2. Binomial Distribution
Another method used by the risk manager to measure risk is binomial
probability distribution. To use the binomial distribution the risk manager
must be familiar with the basic assumption of the distribution.

The first assumption is that the objects are

independently exposed to loss. The other assumption
is that each exposed until suffered (experience) only
one loss in a year (or other budget period). Thus the
probability that the n ! firmr will suffer
n r occurrences during
r )  r!( n  r )! pusing
the year isP (calculated (1  pthe
) formula:

When: n= Number of exposures

r = Number of accidents
(occurrences)
p = Probability of occurrence

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 2. Binomial Distribution (Cont…)

 To illustrate, assume that there are 5 trucks which are

operated by a business and if an accident happens to
a particular trucks, it be comes a total loss. New
trucks are purchased at the beginning of every year
to make up the lost ones so that the firm always
starts the new physical period with 5 trucks.
 First it is assumed that monetary loss per accident is
constant
Year and itNois Birr 5000. No of accidents
of trucks Total monetary loss

1 5 2 Br 10,000

2 5 2 10,000

3 5 3 15,000

4 5 2 10,000

5 5 1 5,000

Sum 25 10 50,000

Mean 5 2 10,000
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 2. Binomial Distribution (Cont…)

10 , 000
 Thus, the average monetary loss per accident
2 =
= 5,000, and the probability of an2 accident
5 can be
estimated as p= = 0.4
 With this information as a point of departure it would
be possible to construct a binomial probability
distribution for the following variables of interest:
1. number of accidents, and
2. total monetary losses
Given: n =5 n! p=r 0.4 q=
p q (n r )
0.6(1-p) r!( n  r )!

Using the formula [p(r)= ]

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 2. Binomial Distribution (Cont…)

Solution:
# of Expected # of Accidents Expected Monetary Loss
Monetary Loss Probability
Accidents (# of Accidents x Probability) (Monetary Loss x Expected # of Accidents)
(5,000x # of Accidents) (i.e, 5,000 x 0.2592= 1296)
0 0 0.07776 0 5000 x 0 = Birr 0

1 5000 x 1 = 5,000 0.25920 0.2592 5000 x 0.2592 = 1296

2 5000 x 2 = 10,000 0.34560 0.6912 5000 x 0.6912 = 3456

3 5000 x 3 = 15,000 0.23040 0.6912 5000 x 0.6912 = 3456

4 5000 x 4 = 20,000 0.07680 0.3072 5000 x 0.3072 = 1536

5 5000 x 5 = 25,000 0.010024 0.0512 5000 x 0.0512 = 256

sum 1.00 2.00 10,000

 From the above probability distribution we can

determine the following:
1. the expected number of accidents or the average
accidents to occur is 2
48 2. the expected total monetary loss is birr 10,000.
3. Normal Distribution
The risk manager may also use a normal distribution
method to measure risks. The assumption here is the
number of accidents or total annual monetary losses
are approximately normally distributed. The normal
distribution can be well explained by identifying only
two parameters: the mean and the standard
deviation.
1. 68.27% of the observations fall with in the range of
one standard deviation of the mean (+1).
2. 95.45% of the observations fall with in the range of
two standard deviation of the mean (+2).
3. 99.73% of the observations fall with in the range of
three standard deviations of the mean (+3).
For this movement it is not important to go to the
49 detail of normal distribution.
 Risk and Law of Large Number
Law of large number states that as the number of
exposure units increases, risk decreases. That means risk
and number of exposure units are inversely related but
not proportional.
Law of large number states that as the number of
exposure units (persons or objects exposed to risk)
increases, the more certain it becomes that actual loss
experience will equal probable loss experience. For
example, if you flip a balanced coin in to the air, the
probability of getting a head is 0.5. if you flip the coin only
ten times, you may get a head eight times. Although the
observed probability of getting a head is 0.8, the true
probability is still 0.5. If the coin were flipped one million
times, however, the actual number of heads would be
approximately 500,000. Thus, as the number of random
tosses increases, the actual results approach the
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expected results.
2.8 Risk Measurement Methods/ Tools
This section takes our attention away from the
risks themselves towards the methods, resources,
techniques, and strategies for managing risks and
the principles governing the management of the
risk.
After the risks facing the firm are identified and
measured, the risk manager must decided how to
handle/manage them. Risk can be handled in
several ways. However, we can classify them into
two broad measures/ approaches. They are;
 Risk Control Tools, and
 Risk Financing Tools.

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2.8.1 Risk Control Tools
 Risk Control approaches are designed to reduce the firm’s
expected losses and to make the annual loss experience
more predictable. More specifically, risk control efforts help
individuals and organizations avoid a risk, prevent loss,
lessen the amount of damage if a loss occurs, or reduce
undesirable effects of risk on an organization. The application
of risk control techniques to achieve these ends may range
from simple and low cost to complex and costly approaches.
 Risk Control Techniques – attempt to reduce the
frequency and severity of accidental losses to the
firm. Some of the techniques are listed as follows:
A. Avoidance,
B. Loss Control,
C. Separation, /Diversification/
D. Combination
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A. Avoidance
 Avoidance means that a certain loss exposure is never acquired,
or an existing loss exposure is abandoned.
 Avoidance of risk exists when the individual or the firm frees itself
from the exposure through (1) abandonment, or (2) refusal to
accept the risk from the very beginning (proactive avoidance). To
avoid the risk the individual or the firm need to avoid the
property, person or activity with which the exposure is associated.
 Avoidance through abandonment is not quite as common as
proactive avoidance, but it does occur. For example, suppose a
firm finds out that one of its product has a serious health problem
on customers. Therefore, to avoid liability risk that could arise,
the firm can abandon the production and sale of that specific
product.
 Proactive avoidance or refusal to accept the risk from the very
beginning can be explained by the following example;
 ABC has planned to build a 50 stair building around Hawelti area
but while consultants finds out that the area cannot support more
than a 20 stair building. Thus the company can refuse to under-take
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construction.
A. Avoidance (cont…)

Avoidance is an effective approach to the

handling of risk. By avoiding a risk, the company
can avoid the uncertainty that the company
experiences. However, the company loss the
benefit that might have been derived from that
risk.
In general, it would be impossible to use
avoidance in the following situations.
1. The production of some products and the provision
of some service may provide rewards whose
expected value far exceeds potential loss per costs
at the margin.
2. It is impossible to avoid all the properties such as
54 vehicles, buildings, machinery, inventory etc.
A. Avoidance (cont…)
3. The context of the decision also may make avoidance
impossible. A risk does not exist in a vacuum, and a
decision to avoid a risk might actually create a new risk
elsewhere or enhance some existing risk. For example, if
the Addis Ababa city Administration learned that Ras Tefere
Bridge is in a state of serious disrepair, in response the
administration decided to close the bridge and divert all
traffic to the other alternative bridge. The traffic load will
made failure of the second alternative bridge more likely to
occur, and within a year the second bridge will collapse.
That means the measure taken to avoid risk in the first
bridge bring another risk in the second road.
4. The risk may be so fundamental to the organization’s
reason for being that avoidance cannot be contemplated. A
mining concern may not avoid the risk of tunnel collapse,
but true avoidance would mean leaving the mining
55 business, which is the reason for existence.
B. Loss Control
 Loss Control measures attack risk by lowering the
chance a loss will occur (loss frequencies) or by reducing
the amount of damage when the loss does occur (loss
severity). Loss Control tools can be classified as: loss
prevention and loss reduction measures.
a) Loss Prevention (LP)
 Loss prevention programs seek to reduce the number of
losses or to eliminate them entirely.
 Loss prevention activities are focused on:
1. Altering or modifying the hazard
2. Altering or modifying the environment in which
the hazard exists
3. Intervening in the process where by hazard and
environment interacts.
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B. Loss Control (cont… )

Hazard Loss Prevention Activities

1. Careless house keeping * Training and monitoring
program
2. Flood * Construction of dams
3. Smoking and Drunk driving * Prohibition, enforcement of
law, prison sentence
4. Improperly trained worker * Training (on the job and
off the job)
5. Building susceptible to fire * Fire resistive construction
6. Dangerous working environment * Regular inspection &
internal control

Tight quality control can avoid a product liability risk that

might arise due to product’s quality.
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B. Loss Control (cont… )

b) Loss Reduction Measure

 Loss reduction activities on the other hand are
designed to reduce the potential severity of a loss
once the peril happened. Such a system does not
reduce the probability of loss; instead, they reduce
the amount of damage if a peril occurs. Loss
reduction activities are post loss measures.
 The best examples of loss Reduction measures are:
Employing fire extinguishers
Using active and trained guards
Installing automatic sprinkler
 A sprinkler system is a classic example of loss
reduction effort; because fire is required to activate
58 the sprinklers
B. Loss Control (cont… )
A firm that employs an effective risk prevention and risk
reduction programs is benefiting not only itself but the society
as well. For instance, the firm that makes strict quality control
to prevent liability losses is safeguarding the society from
possible harms. A destruction of inventory of a firm may
affect society because those goods are no more available to
the society.
Therefore, effective loss prevention and reduction measures
should be designed to benefit both the firm and the society.
However, these measure involve costs which include
expenditures for the acquisition of safety equipments and
devices, operating expenses such as salary payments to
guards, inspectors, and other employees engaged in safety
work and training and seminar costs. The risk manager will
have to design the most efficient measures in order to
minimize such costs without reducing the desired safety level.
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C. Separation/ Diversification
 Separation refers to scattering the firm’s property exposed to risk
to different places. The principle is “do not put all your eggs in one
basket.” For example, instead of placing its entire inventories in
one warehouse, a firm may put them in different warehouses and
separate exposure. Another example, a firm can store files
depending on their respective importance. Top secret files, say, can
be put in fire proof cabinets, others in locked cabinets and the less
important one can be left on tables.
 Diversification is another risk control tool used to handle most
speculative risks, For example, businesses can diversify their
product line so that a decline in profit of one product could be
compensated by profits from other product lines. Here we can take
our country as an example. Ethiopia can minimize international
trade risk by producing and selling different types of products in
addition to coffee export which accounts the lion share in our
export trade. This can be noticed from the current situation. The
country has lost thousands of foreign exchange from coffee export
because of the decline in the world price of coffee.
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D. Combination
This is some how similar to separation as it involves increasing
the number of exposure units to make loss exposure more
predictable. Their difference lies on the fact that unlike
separation, which simply spreads a specified number of
exposure units, combination (pooling) increases the number of
exposure units under the control of the firm. Combination
follows the law of large numbers, which states that when the
exposure units increase, the loss will be more predictable with
high degree of accuracy and then reduces risk.
Example:
 A taxi owner increasing the number of fleets
 Merger with other firms (the merger of Lion Insurance and Hibret
Insurance). In this case combination results in the pooling of
resources of the two companies. This leads to financial strength,
there by reducing the adverse effect of the potential loss.
 Use of spare parts and reserve machines

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2.8.2 Risk Financing Tools
In most risk management programs, some losses
occur in spite of the best risk control efforts.
Risk financing techniques provide for the funding of
accidental losses after they occur.
This means some measures must be used to finance
losses that do occur. Risk control measures by
altering the loss itself, either reduce the potential
losses or make those losses more predictable. The
risk financing tools, on the other hand, are ways of
financing the losses that do occur. Some of the
techniques are listed as follows:
A. Retention/ Self-insurance,
B. Non-insurance Transfers,
C. Insurance
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A. Retention/ Self-insurance
 The most common and easiest method of risk handling tools
used by firm is retention. It is an arrangement under which the
firm or an individual experiencing the loss bears the direct
financial consequences. In other words, the person or the firm
consciously or unconsciously, decides to assume the risk and
pays for the loss without any attempt to transfer it to somebody
else. The sources of the funds are the firm itself. Retention may
be passive or active, unconscious or conscious, unplanned or
planned.
 The retention is passive or unplanned when the risk manager is
not aware that exposure exists and consequently does not
attempt to handle it. By default, therefore, the firm has elected
to retain the risk associated with that exposure. Retention is
active or planned when the risk manager considers other
methods of handling the risk and consciously decides not to
transfer the potential losses. For this, the firm may set aside a
fund for the contingencies (self insurance- it is a special case of
63 active/planned retention).
A. Retention/ Self-insurance (cont….)

Retention can be effectively used in a risk

management program when three conditions
exist:
1. When no other method of treatment is
available.
2. When the worst possible loss is not serious.
The risk may be too remote.
3. When losses are highly predictable.

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A. Retention/ Self-insurance (cont….)

 In most cases retention is not the only possible tool. The

choice is between retention and insurance. The major factors
to be considered in making the choice are:
a. The maximum probable cost relative to the firm’s capacity
for bearing the risk, Expected loss and risk
b. Restrictions or legal limitations applying to risk transfers.
In such types of situation the only option may be
retention.
c. Opportunity costs related to investment of funds that is
going to be paid as a premium if the risk is transferred to
the insurance companies.
d. Quality of service provided by the insurance companies.
 The risk may be remote: If the risk manager knows that the
risk is so remote that cannot exist in the near future, then
he/she may prefer to retain the loss.
65
B. Non-insurance Transfers
 Non-insurance transfers are methods other than insurance by which a
pure risk and its potential financial consequences are transferred to
another party. Neutralization or hedging and hold harmless agreements
are examples of non-insurance transfer of risk.
a. Neutralization or Hedging: as a generic terms, Neutralization and
hedging describe actions whereby a possible gain is balanced against a
possible loss. Neutralization is the process of balancing a chance
of loss against a chance of gain. For example, a person who has bet
that a certain team will win the national cup series may neutralize the
risk involved by also placing a bet on the opposing team. The risk is
transferred to the person who accepts the second bet.
b. Hold-Harmless Agreements: Hold-harmless Agreements are contract
entered in to prior to a loss, in which one party agrees to assume a
second party’s responsibility should a loss occur. For example,
contractors may require subcontractors to provide the contractor with
liability protection if they are sued because of the subcontractor’s
activities. Likewise, vendors request hold harmless agreements before
selling a manufacturer’s goods.
c. Information Management: Information emanating from an
organization’s risk management department can have important effects
in reducing uncertainty in an organization’s stakeholders such as,
66 suppliers, customers, creditors, employees etc.
C. Insurance
 Commercial insurance is also used in a risk management
program. From the risk manager’s point of view, insurance
represents a contractual transfer of risk. Insurance is appropriate
for loss exposures that have a low probability of loss but the
severity of loss is high. If the risk manager uses insurance to
treat certain loss exposures, five key areas must be emphasized.
They are listed as follows:
1. Selection of insurance coverage's ( Essential, Desirable, &
Available insurance),
2. Selection of an insurer (Financial strength of the insurer,
costs & terms of protection),
3. Negotiation of terms (on policies, forms, endorsements,
premiums etc),
4. Dissemination of information concerning insurance
coverage’s, and
5. Periodic review of the insurance program.
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Which Method Should be Used?
In determining the appropriate method/s for
handling losses, a matrix can be used that
classifies the various loss exposures according to
frequency and severity.
Loss
Frequency Retention Loss Control &
Retention
Low
High
Insurance Avoidance
Low

loss Severity
High
Fig. Risk Management Matrix

 A risk manager should be knowledgeable enough to

68 make analysis and select the “best” risk handling
tool(s). Cost-benefit analysis is important in selecting
 The End
Thank you …..!!!

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