What Is Risk Management?
What Is Risk Management?. A good place to start is to understand the types of risk's that businesses face. Modern insurance is still based on the concept of risk sharing.
Each member of a group exposed to a particular hazard contributes a comparatively small amount of his funds, known as the premium, into a pool of funds from which those who sustain loss from a specific peril or cause of loss receive indemnification for the damages to their covered property or injury to another party.
What is risk management? Risks of loss differ from one another and not all can be insured. As a general rule, risks fall into one or the other of two different classes - pure and speculative.
What is risk management? Risk management helps to identify potential risks a business may face, then analyzing and taking precautionary steps to reduce, eliminate or transfer the risk.
Below are some answers to commonly asked risk management questions:
- What Are The Major Types Of Risk?
- What Are The Steps In Risk Management?
- How Does Insurance Fit Into The Risk Management Process?
What Are The Major Types Of Risk?
Speculative risks, also referred to as dynamic risks, are inherent in the nature of all businesses and day-to-day living. Every business and individual faces daily decisions that entail elements of risk. Business decisions must be made concerning issues such as expansion, new equipment purchases, venturing into new domestic or foreign markets, diversifying product lines, borrowing additional capital or spending more money on advertising.
In addition, consideration must be given to changes in customer preferences, fashion or attitudes. If decisions are made based on unfounded expectations, the business will likely suffer losses.
On the other hand, if developments in the business’s marketplace occur as expected or predicted, the business will be enhanced. Individuals must also make significant financial and investment decisions such as the purchase of home, vehicles, works of art and stock. All of these personal financial decisions may increase or decrease the individual’s net worth.
The possibility of loss or gain is the distinguishing feature of speculative or dynamic risk. For the most part, this type of decision or risk is not insurable.
This is the other type of risk. The real property, machinery and stock of the enterprise, or the home or vehicle of the individual may be damaged or destroyed by fire, lightning, windstorm, explosion, riot, water damage, theft or robbery. Loss due to employee dishonesty, liability claims from members of the public or from automobile accidents may occur.
Insurance is available for risks of this type.
What Are The Steps In Risk Management?
Several steps must be taken to minimize risk before the insurance policy is brought into play.
Insurance is actually only one phase or element of a broader area of protection against loss and is often the last step in the overall process of risk management.
The process as described in this section is based on business exposures, but most will also work with personal exposures.
In the nature of a broad and simplified outline, the usual steps in risk management are:
- RISK IDENTIFICATION AND ANALYSIS
- ANALYSIS OF RISK MANAGEMENT TECHNIQUES
- LOSS PREVENTION
- RISK AVOIDANCE
- RETENTION OF RISK
RISK IDENTIFICATION AND ANALYSIS
A careful survey of the operations of the business, its assets and exposures, plus the probability of a loss occurring and the potential severity of a loss highlight the potential losses. The analysis addresses the physical assets that may be threatened by damage or destruction, such as buildings, equipment and materials.
It also considers crime losses, both the internal kind caused by employees and the external ones from sources outside the business; suits by government agencies, customers, members of the public, employees and contractors; and various types of interruption of business operations, among others.
ANALYSIS OF RISK MANAGEMENT TECHNIQUES
After the risks of loss are identified, the possible methods of eliminating or controlling them must be examined. Internal control systems, such as inventory and material flow checks, record keeping and similar or related systems must be evaluated with the single intent of minimizing any possible loss.
In addition, existing risk management techniques and operations must be reviewed periodically to assure their continued effectiveness in the face of changing conditions.
Techniques to prevent or reduce potential losses must be evaluated and steps taken to assure the reasonable utilization of all such measures.
Improved internal controls to reduce pilferage and opportunities for employee theft; installation of automatic sprinkler systems and fire-detection devices to control the spread of fire; burglar alarms and related theft-protection measures are examples of some of the more familiar methods for reducing or minimizing losses.
After identifying all potential hazards, certain risks may be eliminated completely by simply changing company practices and procedures. One example could be the active decision of an electrical component manufacturer to not sell its products to a highly volatile product manufacturer.
The active decision is made because the electrical component manufacturer can foresee the possibility of being named in a lawsuit along with that other manufacturer. If its product is not part of that volatile product, it has avoided a potential lawsuit.
RETENTION OF RISK
Even the most advanced techniques for avoiding or minimizing risk cannot completely eliminate risk. Therefore, it is necessary to distinguish risks that threaten the financial stability of the enterprise from those which can be met with minimal financial strain.
The less serious risk does not need to be shifted to a risk-bearing institution, such as an insurance company, but should be retained by the business. A common example of a retained risk is the breakage of outdoor wooden signage because, while a loss could occur, the repair and/or replacement cost would be minimal.
Even if a particular hazard presents potentially large losses, small losses from it may be retained by the business enterprise without jeopardizing its financial stability. Insurance coverage can be written in a manner where it pays only amounts above a specified sum, usually referred to as the deductible.
This should result in premium reductions that exceed the amount of uninsured losses paid for by the business for two reasons:
- An insurance company is a business. In addition to paying losses out of premiums collected, it must pay operating costs such as company overhead, commission, salaries, rent and stockholder dividends.
- Any loss that is presented costs more than just the amount paid to settle the loss. Loss adjustment expenses such as loss verification, loss adjusting, value verification and settlement significantly increase the cost of a single loss. The reduction of premium for the insured and the reduction in loss and claims handling expenses make significant deductibles mutually beneficial and an important component of the risk management process.
The size of the loss that can be safely retained depends on the nature of the business and the extent of its assets. Businesses with multiple locations that are widely dispersed geographically may safely retain, or self-insure, relatively substantial dollar amounts at a given location.
This is because damage or loss at any single location will not halt operations nor will it result in a total loss of assets.
How Does Insurance Fit Into The Risk Management Process?
After taking all the steps outlined above, the remaining exposures must be shifted to an insurance company. However, as stated earlier, not all risks are insurable. In broad and general terms, there are three basic areas of exposure:
1st Area Of Risk Exposure
The first consists of the inevitable wear and tear, depreciation, spoilage and obsolescence types of losses. All property faces one or more of these hazards, simply as an inevitable result of the passage of time. These risks are generally not insurable under even the broadest coverage forms.
2nd Area Of Risk Exposure
The second is represented by those risks so potentially catastrophic in nature that no insurance company would, or could be expected to, assume liability or provide coverage for them. The risk of destruction in modern warfare is a prime example of such an exposure to loss.
Economic crises and unemployment are other examples of exposures only a government could contemplate insuring because of its vast taxing and assessment powers. Sometimes the hazard itself does not present disastrous consequences on a national scale, but is one that affects only a certain part of the total population and cannot be spread over the total population or a large enough segment of the population.
As an example, flood was once considered uninsurable because only those exposed to it were interested in obtaining insurance against it, but the federal government stepped in to provide a mechanism as it has also done with unemployment insurance and other exposures.
3rd Area Of Risk Exposure
The third falls between these two extremes. These losses are neither inevitable nor catastrophic. This is the area where private insurance operates.
Private insurance can be divided into two categories. One is characterized as private (voluntary) insurance and the other as social (compulsory) insurance. These two categories tend to overlap and the distinctions between them blur.
Workers compensation insurance is compulsory and is classified as social insurance by some, but as private insurance by others, because private insurers write it in most states. Even this classification is incomplete. In some jurisdictions, state-operated insurance funds offer workers’ compensation insurance and compete with private insurance carriers.
In others, this form of compulsory insurance is available only from a monopolistic state insurance fund. Auto insurance is another example of state-mandated compulsory insurance coverage while homeowners and commercial property coverages are often mandated because mortgages and other loans cannot be obtained unless the coverage is purchased.
What is risk management? Insurance companies offer other services to their customers that go beyond the providing of insurance coverage. As was pointed out earlier, loss prevention techniques are an important component in the risk management process.
Insureds and businesses are usually subject to inspections by insurance companies, and recommendations for eliminating or reducing hazards are a required condition for writing or continuing to write coverage. The rating organizations that provide services to fire insurance companies in establishing loss costs or similar rating factors also offer the insuring public advice on reducing hazards in order to reduce their fire premiums.
Insurance companies that cover boiler explosion have highly professional and specialized inspection services designed to detect hazardous conditions in the equipment they insure. In other cases, groups of companies fund research in fire prevention, pollution control and the elimination of dangerous products.
They also identify situations that could lead to employee injuries and liability claims from the public.
As a result, there is no sharp line of distinction between the role of insurance and the overall concept of risk management. All phases of risk identification, risk avoidance, prevention, self-insurance and insurance join together to minimize risk and spread the impact of disasters over large numbers of insureds.
What Is Risk Management? - The Bottom Line
So what is risk management? It is the process of identifying possible risks, problems or disasters before they happen to avoid or minimize the impact of that risk on a business.
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