Process of Risk Management
Management of risk can be formal with standardized processes and informal with no defined processes or methods. The process of risk management should be formal with specific processes, standards, and reports. This would help in identifying and mitigating the risks easily.
Table of Content
- 1 Process of Risk Management
- 1.1 Identifying Loss Exposures
- 1.2 Analyzing the Loss Exposures
- 1.3 Selecting the Right Techniques
- 1.4 Implementing and Monitoring the Risk Management Programme
The process of risk management is discussed below:
- Identifying Loss Exposures
- Analyzing the Loss Exposures
- Selecting the Right Techniques
- Implementing and Monitoring the Risk Management Programme
Identifying Loss Exposures
This is the first step in risk management. It categorizes all the major and minor risk exposures implying it identifies the property that is vulnerable to risk.
Types of Loss Exposures
- Liability loss exposures
- Business income loss exposure
- Human resource loss exposures
- Crime loss exposure
- Employee-benefit loss exposure
Property loss exposures
Any condition or situation that creates some kind of damage or loss to property. Property loss exposures include the following:
- Building, plants, and other structures
- Furniture, equipment, supplies
- Computers, data inventory
- Accounts receivable and records
- Company vehicles, planes, mobile equipment
Property is exposed to losses because of accidents or catastrophes, such as floods or hurricanes. There are two types of loss in property loss exposure:
- Direct loss: It is the upfront damage caused to the asset.
- Indirect loss: It is a complete loss of revenue or an increase in expenses, which is commonly known as net income loss. Insurers also offer cover for net income loss.
Example: In a fire accident, a shop gets destroyed. In such a case, the direct loss is the money spent by the owner on re-establishing the building. The indirect loss in this case is the expense for an alternative place that is used for continuing the business.
Net income loss = Amount used to restore the building + Amount spent on alternative shop during renovation + Business income loss.
Property owners face the possibility of both direct and indirect losses. Indirect losses are intangible losses, such as loss of business.
Liability loss exposures
Liability loss exposures relate to the following:
- Defective products
- Environmental pollution
- Liability arising from company vehicles
- Discrimination against employees
Liability loss exposure is an event that creates the possibility of a claim by a person or business for injury or damage suffered by another person or party. This claim is generally made for financial damages because of injury to another party or damage to another party’s property.
For example, a five-star hotel property located in City X catches fire. If the hotel business is covered against liability loss, then the losses incurred by employees, guests, visitors, etc., would be borne by the insurer. Losses include medical expenses, rehabilitation costs, etc.
Business income loss exposure
Organisations that depend on specific types of buildings or specialized equipment are typically subject to income loss exposure. In the event of a disaster, such organizations would probably have to shut down their operations until the buildings/equipment get repaired. Such a shutdown would cause a further loss of income.
Manufacturers of a product are the classic example of businesses in this category because of their dependence on specialized production equipment and factory. The insurance that addresses loss of exposure is called business income coverage. This plan promises to replace the income that would otherwise have been earned by the business when repairs are being made.
The business income loss exposures relate to:
- Loss of income from a covered loss
- Extra expenses
- Continuing expenses after loss
Human resource loss exposures
These include losses related to worker injuries, disabilities, death, retirement, employee turnover, etc. These include the losses related to:
- Death of employees
- Retirement of employees
- Job-related injuries
Organizations mostly take insurance to compensate the employees or beneficiaries in this case.
Crime loss exposure
This loss exposure results from criminal acts. It is related to the following:
- Robberies and employee theft
- Internet crimes
- Intellectual property theft
Organizations purchase crime insurance that helps in filing claims for employee theft or other offenses.
Employee-benefit loss exposure
This involves the loss of an employee when the employer mistakenly or deliberately makes an error or omission in the administration of an employee benefit program. These include failure to advise employees of benefit programs.
This relates to the following:
- Failure to comply with government regulations
- Violation of fiduciary responsibilities
- Failure to pay the promised benefits
Coverage of this exposure is usually provided by a fiduciary liability insurance policy.
All these exposures can be identified with the help of questionnaires, inspection, financial statements, historical data, etc.
Analyzing the Loss Exposures
This step involves analyzing the loss exposures. The frequency of exposures and loss from that exposure is analyzed. Frequency implies the probable number of losses that occurred during a specific period. Loss refers to the size of the losses that may occur. After analysis, the risk manager ranks the type of loss exposure according to its importance.
For example, the loss exposure that leads to a major financial loss to the organization would be much more severe than the loss exposure of employee turnover. The relative frequency of each loss exposure should also be estimated so that an appropriate technique can be selected for handling the exposure.
The analysis should include the maximum possible loss and maximum probable loss for estimation. Maximum possible loss is defined as the worst loss that could happen to the firm during its lifetime. Maximum probable loss can be defined as the worst loss that is likely to happen. The result of the analysis is the primary input to risk management where it is analyzed whether to accept, reduce, share, or avoid risks. Thus, a strategy is formulated along with a response plan.
Selecting the Right Techniques
This step involves selecting the most appropriate method for treating the loss exposures. There are generally two techniques for selecting the appropriate method, namely, risk control techniques and risk financing techniques.
Risk control techniques are divided into risk avoidance, risk reduction, risk transfer, and risk retention. These techniques have already been covered in Section of the chapter. Thus, let us study another technique of treating loss exposure, i.e., the risk financing technique.
Risk financing techniques help in providing funds for the losses incurred by individuals/organizations.
The important risk financing techniques are non-insurance transfers and commercial insurance.
- Non-insurance transfers: These are those transfers in which the pure risk is transferred to another party. For example, a contract of construction in which the construction company that is building the plant specifies that it is responsible for any damage to the plant. The following are the advantages of non-insurance transfers:
- Costs less than the insurance
- Shifts the non-commercial loss that is not insurable
- Costs less than the insurance
The disadvantage of non-insurance transfers is that the firm will be responsible for the claim if the party is unable to pay the loss.
- Insurance: It is an important technique for risk exposure. It involves a low probability of loss, but the effect of loss is more.
When insurance is taken, the following areas need to be emphasized:
- Selection of the insurer
- Selection of insurance coverage
- Negotiation of terms
- Periodic review of the program
- Selection of the insurer
The advantages of the insurance program are as follows:
- The organization is indemnified after the loss occurs
- Insurers can provide valuable risk management services, such as loss exposure analysis
Implementing and Monitoring the Risk Management Programme
This is the last step in the risk management process. In this, a risk management policy statement is necessary for the risk management program to be effective. This involves devising plans and taking action for communicating and implementing the risk management decision.
The implementation of risk management techniques should include:
- How and when the risk management strategy will be carried out
- Roles and responsibilities of individuals and organizations
- Plans for communication
- Requirement for training, staffing, and financing
A risk management policy statement involves the objective of risk management related to lose exposures. This policy helps top-level executives in judging the performance of a risk manager. A risk management manual is also maintained that involves details of the risk management program.
Risk monitoring involves a periodic review and evaluation that determine whether the objectives have been attained or not. This review is essential for correction and changes in risk priorities and management plans if required.
Monitoring of the following takes place:
- Risk management costs
- Safety programs
- Loss prevention programs
The advantages of monitoring in risk management include:
- Identifying changes like risk
- Gathering proof for supporting assumptions and results of analysis
- Developing an accurate picture of the risks
- Controlling costs associated with incorrect or redundant risk control measures