The Nature of Risk Management

1. The Nature of Risk Management • 1. Scientific approach to dealing with pure risks • 2. Broader than insurance management • 3. Differs from insurance management in philosophy

2. Development of Risk Management • Risk management evolved from corporate insurance buying • 1929 Corporate insurance buyers met in Boston to discuss mutual problems. • 1931 American Management Association established its Insurance Division. • 1932 Insurance Buyers of New York formed. • 1950 National Association of Insurance Buyers formed; (later became American Society of Insurance Management and then became the Risk and Insurance Management Society (RIMS)).

3. The Risk Management Process • 1. Determination of objectives • 2. Identification of risks • 3. Evaluation of risks • 4. Consideration of alternatives - selection of the tool • 5. Implementing the decision • 6. Evaluation and review

4. Primary Objective • To preserve the operating effectiveness of the organization.

5. Risk Management Objectives Post-Loss Objectives Pre-Loss Objectives Survival Economy Continuity of Operations Reduction in Anxiety Earnings Stability Meeting Externally Imposed Obligations Continued Growth Social Responsibility Social Responsibility

6. Formal Risk Management Policy • 1. States the objectives of risk management program and describes measures by which they are to be reached. • 2. Objectives and risk management policy should be determined by board of directors (or other highest policy-making body in the organization). • 3. Risk manager acts as staff advisor to board in formulating risk management policy.

7. Risk Identification • 1. Orientation • 2. Risk analysis questionnaires • 3. Exposure checklists • 4. Insurance policy checklists • 5. Flow process charts • 6. Analysis of financial statements • 7. Other internal records • 8. Inspections • 9. Interviews • The preferred approach is a combination approach.

8. Evaluation of Risks • Critical Severe financial impact (e.g., losses that could result in bankruptcy) • Important Moderate financial impact (e.g., losses that would require resort to credit) • Unimportant Modest financial impact (e.g., losses that could be met from existing assets or cash flow)

9. Consideration of Alternatives • Risk Control • Avoidance • Reduction • Risk Financing • Retention • Transfer

10. Choosing the Technique • 1. Primarily a problem in decision-making. • 2. Sometimes organization’s risk management policy establishes criteria. • 3. In selecting the technique for a given risk, the risk manager considers • the size of potential loss, • its probability, and • the resources that would be available to meet the loss.

11. Implementing the Decision • Once the decision is made on how to deal with a given risk, the decision must be implemented • for retained risks, it may be necessary to establish a fund • loss prevention and control measures must be designed and implemented • decision to transfer a risk must be followed by selection of the insurer, negotiations, and placement of the insurance

12. Rules of Risk Management • 1. Don’t risk more than you can afford to lose • 2. Consider the odds • 3. Don’t risk a lot for a little

13. Risk Characteristics as Determinants of Tool Low Frequency High Frequency High Severity Low Severity

14. Risk Characteristics as Determinants of Tool Low Frequency High Frequency Avoid Reduce High Severity Low Severity

15. Risk Characteristics as Determinants of Tool Low Frequency High Frequency Avoid Reduce High Severity Transfer Low Severity

16. Risk Characteristics as Determinants of Tool Low Frequency High Frequency Avoid Reduce High Severity Transfer Low Severity Retain Reduce

17. Risk Characteristics as Determinants of Tool Low Frequency High Frequency Avoid Reduce High Severity Transfer Low Severity Retain Reduce Retain

18. The Special Case of Risk Reduction • 1. A technique should be used when it is the lowest cost approach for the particular risk. • 2. Humanitarian considerations and legal requirements sometimes dictate that risk control be used when it is not the lowest cost approach. • 3. OSHA requires employers to incur expenses that might not be justified based on a marginal-revenue/marginal cost analysis. • 4. Building codes impose similar mandates.

19. The Nonprofessional Risk Manager • 1. In giant corporations, risk managers devote full attention to the problem of pure risks. • 2. In smaller firms, the risk manager may have other responsibilities competing for his or her attention. • 3. Nonprofessional risk manager must know enough about risk management and insurance to know when help is needed, and also be able to judge if he or she is getting the right kind of advice.

20. Common Errors in Buying Insurance • 1. Buying too much. • 2. Buying too little. • 3. Buying too much and too little at the same time.

21. Priority Ranking for Insurance Coverages • Essential insures against losses that could cause bankruptcy. • Important insures against losses that would require resort to credit. • Optional insures against losses that could be met from assets or cash flow.

22. Large Loss Principle • 1. Probability that a loss may or may not occur is less important than potential severity of the loss. • 2. Important question is not “can I afford the insurance?” but “can I afford to be without it?” • 3. When available dollars cannot provide all the essential and important coverages required, a part of the loss may be assumed through deductibles.

23. Insurance as a Last Resort • 1. Insurance always costs more than the expected value of the loss. • 2. People who purchase coverage against small loss exposures are trying to beat the insurance company at its own game. • 3. Insurance should be used as a last resort.

24. Tax Considerations and Risk Retention • 1. Business firms may deduct uninsured losses as an expense of operation. • 2. For the individual, casualty losses are deductible only to the extent that each loss exceeds $100 and the aggregate for all losses exceeds 10% of adjusted gross income. • 3. Medical expenses are deductible to the extent they exceed 7.5% of adjusted gross income.

25. Selecting the Agent • 1. Most important service provided by the agent is probably advice. • 2. Primary consideration in selecting an agent should be knowledge of the insurance field and interest in the needs of the client. • 3. One indicator of a knowledgeable and professional agent is a professional designation.

26. Professional Designations • 1. CPCU: Chartered Property & Casualty Underwriter • 2. CLU: Chartered Life Underwriter

27. Selecting the Insurer • 1. Major consideration should be financial stability • 2. Cost • 3. Other considerations include attitude toward claims and cancellation

28. A.M. Best Policyholders Ratings • A++, A+ Superior • A, A- Excellent • B++, B+ Very Good • B, B- Good • C++, C+ Fair • C, C- Marginal • D Below Minimum Standards • E Under State Supervision • F In Liquidation

29. Alternatives to Commercial Insurance • Self-Insurance • Captive Insurance Companies • Risk Retention Groups • Purchasing Groups

30. Self-Insurance • 1. Despite theoretical defects, the term self-insurance, it is a convenient way of distinguishing retention programs that use insurance techniques from those that do not. • 2. Self-insurance is distinguished from other retention programs primarily by the formality of the arrangement. • 3. In some instances, this means approval from a state regulatory agency. • 4. In other instances, it means funding measures based on actuarial calculations and contractual definitions of insured exposures.

31. Reasons for Self-Insurance • 1. Avoid insurer overhead and profits • 2. Organization’s experience may be better than average • 3. Gain cash-flow benefits by retaining reserves • 4. Avoid “social load” that insurers are obligated to bear

32. Disadvantages of Self-Insurance • 1. Possible exposure to catastrophe loss • 2. Greater variation in losses from year to year • 3. Possible adverse employee- and public-relations by handling own liability claims • 4. Loss of ancillary insurer services • Some potential disadvantages can be avoided.

33. Captive Insurance Companies • An entity created and controlled by a parent whose main purpose is to provide insurance to the parent. • 1. Pure captives • 2. Association group captives

34. Tax Treatment of Captives • Deductibility of premiums • 1. IRS position is that a captive is an insurer in form but not substance; premiums paid by a parent to a captive are not deductible. • 2. Exceptions exist for premiums paid to association captives, where risks are pooled with those of other organizations. • 3. Exception also exists if the captive assumes outside risks.

35. Tax Treatment of Captives • Taxation of Income • 1. Deductibility of premiums to association captives and rules on controlled foreign corporations created a loophole in tax laws. • 2. TRA-86 makes income to captives taxable as income to parents. • 3. This effectively eliminated favorable tax treatment of off-shore captives.

36. Risk Retention Act of 1986 • 1. Carved out federal preemption over state regulation. • 2. Authorized two mechanisms: Risk retention groups and insurance purchasing groups. • 3. Risk retention groups are group captives, regulated principally by the state in which organized. • 4. Insurance purchasing groups do not retain risk, but purchase insurance on behalf of their members.