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Unit 1 Risk—An Introduction

Structure

1.1 Introduction

Objectives

1.2 Meaning of RiskTypes of Risks Facing Businesses and IndividualsComparison of Pure Risk with Other Types of Risk

1.3 Risk ManagementRisk Management ProcessRisk Management MethodsBusiness Risk Management Organization

1.4 Summary

1.5 Glossary

1.6 Terminal Questions

1.7 Answers

1.8 Case Study

Caselet

IRDA’s Draft Proposal for Insurance Cover to BPL Families

Insurance Regulatory and Development Authority (IRDA) has put up a draft

proposal for expanding the reach of insurance cover to Below Poverty Line

(BPL) families during the next five years. In its draft, the IRDA states, ‘The

target group shall be the BPL population. Each insurer shall prescribe the

target in proportion to their market share. IRDA shall prescribe annual target

so as to cover entire BPL population in the next five years.’

The standard insurance product will be in addition to the governmental

schemes that provide insurance cover at concessional rates. The draft

further says, ‘This product would facilitate supplementing or topping up of

any existing social security benefit and would not overlap with such benefits.

The IRDA suggests that leading life insurers should collaborate with non-

life insurers or vice-versa to ensure that maximum benefits reach the

masses.

These standard products should include minimum sum assured of ̀ 40,000

for life term cover and up to ̀ 2,00,000. The products might be extended to

the family members and the cover period shall be in the range of 5–25

years. The report maintains that during the period 2012–18, all the insurers

shall cover a minimum of 50 per cent of the targeted group through the

Insurance and Risk Management Unit 1

Sikkim Manipal University Page No. 2

standard product sales and the rest 50 per cent might be covered by any

other approved social sector and rural products. The prospectus and policy

conditions must be clear and simple. Further, transparent language must

be used without ambiguous and vague statements keeping in mind the target

market.

In its report titled ‘Composite Package of Standard Insurance Product for

Rural and Social Sector’ IRDA states that‘ weaker sections should be

provided cover to meet the exigencies cast by natural catastrophes,

accidental death, protection means for the family as well as to promote

some savings to bolster their financial security’. According to IRDA, it has

made the standard product more flexible and simple with an objective to

provide widespread package of insurance covers to these deprived sections

of India. The policy document states, ‘The product will have defined options

and levels to provide choice and flexibility to customers in order to cater to

individual circumstances.’

The IRDA has also invited stakeholders’ comment and views about the

proposed draft.

Source: Adapted from a news item in Business Standard, available at http:/

/business-standard.com/india/news/irdas-draft-proposal-for-insurance-

cover-to-bpl-families/188047/on (Retrieved on 1 October 2012)

1.1 Introduction

Risk is generally perceived as an uncertainty relating to the occurrence of a

loss, such as risk of death in an accident, risk of loss due to fire or a natural

calamity, among others. Risk, however, has a different meaning. It represents a

condition in which there is a possibility that the actual outcome deviates adversely

from the expected outcome. In other words, risk is present when the actual loss

is likely to be more than the expected loss or when the actual returns from an

investment are likely to be less than the expected returns. For instance, suppose

a firm expects that it could suffer a loss from bad debts to the extent of 5 per

cent of its outstanding accounts and has adequately provided for such loss.

The firm does not face any risk if the actual loss on account of bad debts does

not exceed 5 per cent.

This unit discusses the concept of risk from various perspectives in relation

to business. It also focuses on risk management strategies employed to ensure

successful business, thus reducing personal risk in addition to the risk associated



with business. Situations of uncertainty, with possible negative evolution, have

an important bearing on the long-term decisions of the corporate sector. Every

business or investment comprises a certain amount of risk. However, it is the

responsibility of the firm to ensure adequate strategies for the minimization or

removal of such risks that may be foreseen or unforeseen, for successful running

and expansion of its business. From experiences with regard to undergoing

damage or losses in earlier times, the corporate sector has now come up with

advanced methods and procedures of risk management to ensure cost-

effectiveness and resource optimization.

Objectives

After studying this unit, you should be able to:

• list different meanings of the term ‘risk’

• describe major types of business and personal risks

• compare pure risk with other types of risks

• assess the significance of risk management function within business

organizations

1.2 Meaning of Risk

The expression ‘risk’ can be interpreted from different perspectives. At its most

general level, risk is used to describe any situation involving an uncertainty about

the outcome. Life is obviously very risky. Even the short-term future is often

highly uncertain. In probability and statistics, financial management and

investment management, risk is often used in a more particular sense to indicate

the possible variability in the outcomes around some expected value. For

instance, an entrepreneur may undergo profits or losses in business, and it is

the losses and the extent of the same that are determined by the risks associated

in his deals.

The anticipated value is the outcome that would occur on average if a

person or business were frequently exposed to the same type of risk. If you

have not yet encountered these concepts in statistics or finance classes, the

following example from the sports world might help. Allen Iverson has averaged

about 30 points per game in his career in the National Basketball Association.

As we write this, he shows little sign of slowing down. It is, therefore, reasonable

to assume that the expected value of his total points in any given game is about

30 points. Risk, in the sense of variability around the expected value, is clearly



present. He might score 50 points or even higher in a particular game, or he

might score as few as 10 points.

In other situations, the term ‘risk’ may imply the anticipated losses in relation

to a situation. In insurance markets, for instance, high-risk policy-holders are

commonly referred to as those people whose expected value of losses to be

paid by the insurer (the expected loss) is high. As another example, described

as having a high risk of earthquake. While this statement might encompass the

notion of variability around the expected value, it simply means that California’s

expected loss from earthquakes is high relative to other states.

Uncertainty refers to the absence of complete certainty, that is, the

existence of more than one possibility. The actual outcome is not known. A set

of probabilities assigned to a set of possibilities is used to measure uncertainty.

For instance: ‘There is a 70% chance that this market will double in five years.’

Risk, on the other hand, is a state of uncertainty where some of the possibilities

involve a loss, catastrophe, or other unfavourable outcome. A set of possibilities,

each with quantified probabilities and quantified losses, is used to measure risk.

For instance: ‘There is a 30 per cent chance that the proposed oil well will be dry

with a loss of `12 crores in exploratory drilling costs’.

1.2.1 Types of Risks Facing Businesses and Individuals

Broadly defined, business risk management concerns the possible decrease in

business value from any source. Business value to shareholders, as reflected

in the value of a firm’s common stock, depends fundamentally on the expected

size, timing and risk (variability) associated with the firm’s future net cash flows

(cash inflows less cash outflows). Unforeseen changes in the expected future

net cash flows happen to majorly influence fluctuations in business value.

Following are broad categories of risk: financial and non-financial and quantifiable

and non-quanitifiable.

In particular, unexpected reductions in cash inflows or increases in cash

outflows can significantly reduce business value. The major business risks that

give rise to variation in cash flows and business value are price risk, credit risk

and pure risk.

Price risk

Price risk represents the uncertainty about the magnitude of cash flows because

of the probable changes in the input and output prices. Output price risk stands

for the risk of changes in the prices which an organization may ask for its goods



and services. Input price risk means the risk of changes in the prices which a

company has to pay for materials, labour and other inputs in the production

process. In strategic management, the analysis of price risk related to the sale

and production of the prevailing and future products and services plays a

significant role.

Tthere are three basic types of price risk:

• commodity price risk

• exchange rate risk and

• interest rate risk

Commodity price risk is born of the fluctuations in the prices of commodities,

like copper, coal, oil, gas and electricity. These constitute the inputs for some

companies and outputs for others. With economic globalization, output and input

prices for various organizations are being influenced by the foreign exchange

rate fluctuations. The input and output prices can also fluctuate because of the

changes in interest rates. For instance, increases in interest rates might change

a company’s revenues by affecting both the credit terms and the speed with

which customers make payments for the products bought on credit. Further,

fluctuations in interest rates also affect the organization’s cost of borrowing funds

for financing its operations.

Credit risk

Credit risk means the risk which an organization’s customers and the parties to

which it has lent money will delay or fail to make the promised payments. Usually,

most of the firms are under some kind of credit risk for account receivables.

The credit risk exposure is specifically substantial for the financial institutions,

such as commercial banks, which regularly provide loans that are subject to the

risk of default by the borrower. When organizations borrow money, the lenders

are exposed to credit risk (i.e., the risk that the firm may default on the promised

payments). Consequently, borrowing exposes the owners of the firm to the risk

that it may not be able to pay its debts and hence be forced into bankruptcy. As

the credit risk increases, generally the firm has to pay more for borrowing money.

Pure risk

In medium-to-large corporations, the risk management function (and the

expression risk management) has generally aimed at the management of what

is referred as ‘pure risk’. The basic types of pure risk which affect businesses

include:



1. The risk of value reduction in business assets because of physical

damage, theft and expropriation (for instance, seizure of assets by foreign

governments).

2. Legal liability risk related to the damages including harm to suppliers,

shareholders, customers and other parties.

3. The risk in giving benefits to the injured workers under the workers’

compensation laws and the risk of legal liability regarding injuries or other

harm to the employees not covered under the workers’ compensation

laws.

4. The risk of illness, disability and death of employees (sometimes family

members) on the grounds of which businesses agree to make payments

under employee benefit schemes, including the commitments to

employees under pension and other retirement savings schemes.

Personal risk

The risks faced by individuals and families can be classified in a variety of ways.

We classify personal risk into six categories: earnings risk, medical expense

risk, liability risk, physical asset risk, financial asset risk and longevity risk.

Earnings risk refers to the potential fluctuation in a family’s earnings, which can

occur as a result of a decline in the value of an income earner’s productivity due

to death, disability, aging or a change in technology. A family’s expenses also

are uncertain. Healthcare costs and liability suits, in particular, can cause large

unexpected expenses. A family also faces the risk of a loss in the value of the

physical assets that it owns. Automobiles, homes, boats and computers can be

lost, stolen or damaged.

The values of financial assets are also subject to fluctuation due to the

changes in inflation and the changes in the real values of stocks and bonds.

Finally, longevity risk refers to the possibility that the retired people will outlive

their financial resources. Often individuals obtain advice about personal risk

management from professionals, such as insurance agents, accountants,

lawyers and financial planners.

1.2.2 Comparison of Pure Risk with Other Types of Risk

Common (but, not essentially distinct) characteristics of pure risk comprise the

following:

1. Losses from destruction of property, legal liability and employee injuries

or illness often have the potential to become enormous relative to a



business’s resources. Whereas there can be an increase in business

value if the losses from pure risk are lower than anticipated, the maximum

possible gain in such cases is usually comparatively less. On the contrary,

an effective decrease in business value caused as a result of the losses

exceeding the anticipated value can be huge to the extent of threatening

the viability of the firm.

2. The causes underlying losses in relation to pure risk, such as a plant

being destroyed by the explosion of a steam boiler or product liability suits

from consumers injured by a certain product, are often highly firm-specific

and are dependent on the actions undertaken by a firm. Thus, the causes

underlying these losses are often significantly regulated by businesses;

in other words, firms can lower the occurrence and intensity of losses by

the means of actions that change the underlying causes (e.g., by initiating

steps for reducing the probability of fire or lawsuit). In comparison, while

firms can take a variety of steps to reduce their exposure or vulnerability

to price risk, the underlying causes of some important types of price

changes are largely beyond the control of individual firms (e.g., economic

factors that cause changes in foreign exchange rates, market wide

changes in interest rates, or aggregate consumer demand).

3. Businesses frequently decrease uncertainty and finance losses related

to pure risk by entering into contracts with insurance companies

specializing in the evaluation of and bearing pure risk. The prevalence of

insurance partially highlights the firm-specific nature of losses resulting

from pure risk. The events causing huge losses to a certain firm usually

have little impact on the losses experienced by other firms, which enables

the reduction of risk through diversification accomplished by the means

of insurance contracts. Insurance contracts are usually not used to

decrease uncertainty and finance losses in relation to price risk (and many

types of credit risk). Price risks that can simultaneously produce gains for

many firms and losses for many others are commonly reduced with

financial derivatives, such as forward and futures contracts, option

contracts and swaps. With these contracts, much of the risk of loss is

often shifted to parties that have an opposite exposure to the particular

risk.

4. Losses resulting from pure risk are usually not related to balancing gains

for other parties. Instead, losses to businesses arising from other kinds of

risk are often related to the gains to other parties. For instance, a rise in

input prices is detrimental to the one who purchases the inputs but is



beneficial to the seller. Similarly, a decrease in the value of the dollar value

relative to foreign currencies can be detrimental to domestic importers

but may be beneficial to domestic exporters and foreign importers dealing

in U.S. goods. An indication of this demarcation between pure risk and

price risk is that the losses resulting from pure risk lower the cumulative

wealth in society, whereas fluctuations in out-put and input prices need

not lower the total wealth. In addition, and as we hinted above, the fact that

price changes often produce losses for some firms and gains for others

in many cases allows these firms to reduce risk by taking opposite

positions in derivative contracts.

While many of the details concerning pure risk and its management differ

from other types of risk, it is nonetheless important for you to understand that

pure risk and its management are conceptually similar, if not identical, to other

types of risk and their management. To make this concrete, consider the case

of a manufacturer that uses oil in the production of consumer products. Such a

firm not just faces the risk of large losses from product liability lawsuits if its

products harm consumers, but it also faces the risk of potentially large losses

from oil price increases. The business can manage the expected cost of product

liability settlements or judgments by making the product’s design safer or by

providing safety instructions and warnings. While the business might not be

able to do anything to reduce the likelihood or size of increases in oil prices, it

might be able to reduce its exposure to losses from oil price increases by adopting

a flexible technology that allows low cost conversion to other sources of energy.

The business might purchase product liability insurance to reduce its liability

risk; it might hedge its risk of loss from oil price increases using oil futures

contracts.

While the concepts and broad risk management strategies are the same

for pure risk and other types of business risk, the specific characteristics of

pure risk and the significant reliance on insurance contracts as a method of

managing these risks generally lead to their management by personnel with

specialized expertise. Major areas of expertise needed for pure risk management

include risk analysis, safety management, insurance contracts and other

methods of reducing pure risk, as well as broad financial and managerial skills.

The insurance business, with its principal function of reducing pure risk for

businesses and individuals, employs millions of people and is one of the largest

industries in the United States (and other developed countries). In addition, pure

risk management and insurance have a major effect on many other sectors of



the economy, such as the legal sector, medical care, real estate lending and

consumer credit.

Increases in business risk of all types and dramatic growth in the use of

financial derivatives for hedging price risks in recent years have stimulated

substantial growth in the scope and efforts devoted to overall business risk

management. It has become increasingly important for managers that they focus

on pure risk to understand the management of other types of business risk.

Similarly, general managers and managers need to understand how pure risk

affects specific areas of activity and the business as a whole.

Self Assessment Questions

1. Three specific types of price risk are commodity price risk, exchange

rate risk and interest rate risk.(True/False)

2. Physical asset risk, financial asset risk and longevity risk are personal

risks. (True/False)

3. The risk of legal liability associated with damages inducing harm to

customers, suppliers, shareholders and other parties is classified as pure

risk.(True/False)

4. The risk of death, illness and disability to employees (and at times family

members) is classified as __________ risk.

Activity 1

Visit different types of businesses in your area. Hold discussions with

management personnel about the various types of risks faced by their

enterprises. Prepare a report on the categories of risks faced by these firms,

the remedial measures undertaken by them to handle such situations and

the loopholes in the existing risk management strategies.

Hint:

1. Risk is generally perceived as an uncertainty relating to the occurrence

of a loss such as risk of death in an accident, risk of loss due to fire, etc.

To learn more on the subject visit the link http://business.gov.in/

growing_business/types_business.php (Retrieved on 3 September

2012)



1.3 Risk Management

The process of identification, analysis and either acceptance or mitigation of

uncertainty in investment decision-making refers to risk management in business.

It is a two-step process that can be represented as follows in Figure 1.1.

Determining the risks existing inan investment

Dealing with thoserisks in a way mostappropriate to one's

investment objectives

Figure 1.1 Risk Management Process

Risk management involves essential features such as reliable resources,

financial strategies and foresight. It prevents or reduces the possibility of external

as well as internal risks in business by employing intelligent strategies, and thus

forms an integral part of business or investment.

1.3.1 Risk Management Process

Regardless of the type of risk being considered, the risk management process

involves several key steps:

1. Categorize all significant risks.

2. Estimate the potential frequency and severity of losses.

3. Improve and choose methods for managing risk.

4. Execute the risk management methods selected.

5. Keep track of the performance and suitability of the risk management

methods and strategies on a continuous basis.

Figure 1.2 gives a flow chart of the risk management process.

1.3.2 Risk Management Methods

These methods are not mutually exclusive and may be largely categorized as:

• loss control

• loss financing

• internal risk reduction

Usually, loss control and internal risk reduction include the decisions to

invest (or forgo investing) resources to cut down the expected losses. These



are theoretically similar to other investment decisions, such as a company’s

decision to purchase a new plant or an individual deciding to buy a computer.

Loss financing decisions are the decisions concerned about the manner of

paying for the losses if they do occur.

Figure 1.2 Risk Management Flow Chart

Source: http://www.scu.edu.au/risk_management/index.php/2/ (Retrieved on 3 September2012)



Loss control

The activities which decrease the expected cost of losses by lowering the

occurrence of losses and/or their extent are referred as loss control. Sometimes

loss control is also termed as risk control. Usually, the actions basically affecting

the frequency of losses are referred as loss prevention methods. Actions primarily

influencing the severity of losses that do occur are often called loss reduction

methods. An example of loss prevention would be routine inspection of aircraft

for mechanical problems. These inspections help reduce the frequency of

crashes; they have little impact on the magnitude of losses for crashes that

occur. An example of loss reduction is the installation of heat- or smoke-activated

sprinkler systems that are designed to minimize fire damage in the event of a

fire.

Many types of loss control influence both the frequency and severity of

losses and cannot be readily classified as either loss prevention or loss reduction.

For example, thorough safety testing of consumer products reduces the number

of injuries, but it may also affect the severity of injuries. Similarly, equipping

automobiles with airbags in most cases should reduce the severity of injuries,

but airbags also might influence the frequency of injuries. The increase or

decrease in the injuries is dependent upon whether the number of injuries that

are completely prevented for the accidents that occur exceeds the number of

injuries that might be caused by airbags inflating at the wrong time or too forcefully,

as well as any increase in accidents and injuries that may occur if protection by

airbags causes some drivers to drive less safely.

Viewed from another perspective, there are two general approaches to

loss control:

(i) reduction of the risky activity level, and

(ii) increasing precautions against loss for the activities undertaken.

First, exposure to loss can be reduced by reducing the level of risky

activities, for example, by cutting back the production of risky products or shifting

attention to less risky product lines. Limiting the level of risky activity primarily

affects the frequency of losses. The main cost of this strategy is that it forgoes

any benefits of the risky activity that would have been achieved apart from the

risk involved. In the limit, exposure to losses can be completely eliminated by

reducing the level of activity to zero; that is, by not engaging in the activity at all.

This strategy is called risk avoidance.

As a specific example of limiting the level of risky activity, consider a trucking

firm that hauls toxic chemicals that might harm people or the environment in the



case of an accident and thereby produce claims for damages. This firm could

reduce the frequency of liability claims by cutting back on the number of shipments

that it hauls. Alternatively, it could avoid the risk completely by not hauling toxic

chemicals and instead hauling non-toxic substances (such as clothing or

cholesterol and cheese). An example from personal risk management would be

a person who flies less frequently to reduce the probability of dying in a plane

crash. This risk could be completely avoided by never flying. Of course, alternative

transportation methods might be much riskier (e.g., driving down Agra from New

Delhi the day before a festival, along with many long-haul trucks, including those

transporting heavy machines).

The second major approach to loss control is to increase the amount of

precautions (level of care) for a given level of risky activity. The goal here is to

make the activity safer and thus reduce the frequency and/or severity of losses.

Thorough testing for safety and installation of safety equipment are the examples

of increased precautions. The trucking firm in the above example could give its

drivers extensive training in safety, limit the number of hours driven by a driver in

a day, and reinforce containers to reduce the likelihood of leakage. Increased

precautions usually involve direct expenditures or other costs (e.g., the increased

time and attention required to drive an automobile more safely).

Loss financing

Methods applied to obtain funds for paying for or offsetting losses that occur are

termed as loss financing (sometimes called risk financing). There are four broad

methods of financing losses:

(1) Retention,

(2) Insurance,

(3) Hedging, and

(4) Other contractual risk transfers.

These approaches are not mutually exclusive; that is, they are often used

in combination. With retention, a business or individual retains the obligation to

pay for a part or the entire loss incurred. For example, a trucking company

might decide to retain the risk that cash flows will drop due to oil price increases.

When coupled with a formal plan to fund losses for medium-to-large businesses,

retention is generally called self-insurance.

Firms can pay retained losses using either internal or external funds.

Internal funds include cash flows from ongoing activities and investments in

liquid assets that are dedicated to financing losses. External sources of funds



include borrowing and issuing new stock, but these approaches may be very

expensive following large losses. Note that these approaches still involve retention

even though they employ external sources of funds. For example, the firm must

pay back any funds borrowed to finance losses. When new stock is issued, the

firm must share future profits with new stockholders.

The second major method of financing losses is the purchase of insurance

contracts. As you most likely already know, the typical insurance contract requires

the insurer to provide funds to pay for the specified losses (thus financing these

losses) in exchange for receiving a premium from the purchaser at the inception

of the contract. Insurance contracts reduce risk for the buyer by transferring

some of the risk of loss to the insurer. Insurers in turn reduce risk through

diversification. For example, they sell large numbers of contracts that provide

coverage for a variety of different losses.

The third broad method of loss financing is hedging. As noted above,

financial derivatives, such as forwards, futures, options and swaps, are used

extensively to manage various types of risk, most notably price risk. These

contracts can be used to hedge risk; that is, they may be used to offset losses

that can occur from changes in interest rates, commodity prices, foreign

exchange rates and the like. Some derivatives have begun to be used in the

management of pure risk, and it is possible that their use in pure risk management

will expand in the future.

Individuals and small businesses do relatively little hedging with derivatives.

At this point, it is useful to illustrate hedging with a very simple example. Firms

that use oil in the production process are subject to loss from unexpected

increases in oil prices; oil producers are subject to loss from unexpected

decreases in oil prices. Both types of firms can hedge their risk by entering into

a forward contract that requires the oil producer to provide the oil user with a

specified amount of oil on a specified future delivery date at a predetermined

price (known as the forward price), regardless of the market price of oil on that

date. Because the forward price is agreed upon when the contract is written,

the oil user and the oil producer both reduce their price risk.

The fourth major method of loss financing is to use one or more of a

variety of other contractual risk transfers that allow businesses to transfer

risk to another party. Like insurance contracts and derivatives, the use of these

contracts also is pervasive in risk management.

For example, businesses that engage independent contractors to perform

some task routinely enter into contracts, commonly known as hold harmless



and indemnity agreements, which require the contractor to protect the business

from losing money from lawsuits that might arise if persons are injured by the

contractor.

Internal risk reduction

In addition to loss financing methods that allow businesses and individuals to

reduce risk by transferring it to another entity, businesses can reduce risk

internally. There are two major forms of internal risk reduction:

(i) Diversification, and

(ii) Investment in information.

Regarding the first of these, firms can reduce risk internally by diversifying

their activities (i.e., not putting all of their eggs in one basket). Individuals also

routinely diversify risk by investing their savings in many different stocks. The

ability of shareholders to reduce risk through portfolio diversification is an important

factor affecting insurance and hedging decisions of firms.

The second major method of reducing risk internally is to invest in

information to obtain superior forecasts of expected losses. Investing in

information can produce more accurate estimates or forecasts of future cash

flows, thus reducing variability of cash flows around the predicted value.

Examples include:

• estimates of the frequency and severity of losses from pure risk

• marketing research on the potential demand for different products to reduce

output price risk

• forecasting future commodity prices or interest rates

One way that insurance companies reduce risk is by specializing in the

analysis of data to obtain accurate forecasts of losses. Medium-to-large

businesses often find it advantageous to reduce pure risk in this manner as

well. Given the large demand for accurate forecasts of key variables that affect

business value and determine the price of contracts that can be used to reduce

risk (such as insurance and derivatives), many firms specialize in providing

information and forecasts to other firms and parties.

1.3.3 Business Risk Management Organization

Where does the risk management function fit within the overall organizational

structure of businesses? In general, the views of senior management concerning

the need for, scope, and importance of risk management and possible



administrative efficiencies determine how the risk management function is

structured and the exact responsibilities of units devoted to risk management.

Most large companies have a specific department responsible for managing

pure risk that is headed by the risk manager (or director of risk management).

However, given that losses can arise from numerous sources, the overall risk

management process ideally reflects a coordinated effort between all of the

corporation’s major departments and business units, including production,

marketing, finance and human resources.

Depending on a company’s size, a typical risk management department

includes various staff specializing in areas such as property–liability insurance,

workers’ compensation, safety and environmental hazards, claims management,

and, in many cases, employee benefits. Given the complexity of modem risk

management, most firms with significant exposure to price risk related to the

cost of raw materials, interest rate changes, or changes in foreign exchange

rates have separate departments or staff members that deal with these risks.

Whether there will be more movement in the future towards combining the

management of these risks with pure risk management within a unified risk

management department is uncertain.

In most firms, the risk management function is subordinate to and thus

reports to the finance (treasury) department. This is because of the close

relationships between protecting assets from loss, financing losses and the

finance function. However, some firms with substantial liability exposures have

the risk management department report to the legal department. In some firms,

the risk management unit reports to the human resources department.

Firms also vary in the extent to which the risk management function is

centralized, as opposed to having responsibility spread among the operating

units. Centralization may achieve possible economies of scale in arranging loss

financing. Moreover, many risk management decisions are strategic in nature,

and centralization facilitates effective interaction between the risk manager and

senior management.

A possible limitation of a centralized risk management function is that it

can reduce concern for risk management among the managers and employees

of a firm’s various operating units. However, allocating the cost of risk or losses

to particular units often can improve incentives for unit managers to control

costs even if the overall risk management function is centralized. On the other

hand, there are advantages to decentralizing certain risk management activities,

such as routine safety and environmental issues. In these cases, operating



managers are close to the risk and can deal effectively and directly with many

issues. Figure 1.3 shows the organizational structure of risk categories.

Figure 1.3 Organizational Structure of Risk Categories

Source: http://www.google.co.in


5. When coupled with a formal plan to fund losses for medium-to-large

businesses, retention often is called _________.

6. _________, _________, and _______ are the three types of loss financing.

7. The basic risk management methods are: _________, ________, and

_________.

8. Most large companies have a specific department responsible for

managing pure risk that is headed by the risk manager. (True/False)



Activity 2

Prepare a report on the generally accepted norms of responding to risks by

the business organizations.

Hint:

1. A risk can be avoided if the organization refuses to accept risk by not

taking up the action which may create a risk (elimination of the peril). To

get the details of the risk response process visit the link http://

www.investopedia.com/exam-guide/cfp/principles-of-risk-and-

insurance/cfp3.asp#axzz28DdZFHfc (Retrieved on 3 September 2012)

1.4 Summary

Let us recapitulate the important concepts discussed in this unit:

• The term risk broadly refers to the situations where outcomes are

uncertain. Risk often refers specifically to variability in outcomes around

the expected value. In other cases, it refers to the expected value (e.g.,

the expected value of losses).

• Major types of business risk that produce fluctuations in business value

include price risk, credit risk and pure risk.

• Pure risk encompasses risk of loss from (i) damage, theft or expropriation

of business assets, (ii) legal liability for injuries to customers and other

parties, (iii) workplace injuries to employees, and (iv) obligations assumed

by businesses under employee benefit plans.

• Risk management involves (i) identifying potential direct and indirect losses,

(ii) evaluating their potential frequency and severity, (iii) developing and

selecting methods for management of risk for maximizing business value,

(iv) implementing these methods and (v) ongoing monitoring.

• Major risk management methods include loss control, loss financing and

internal risk reduction.

• Loss control reduces expected losses by lowering the level of risky activity

and/or increasing precautions against loss for any given level of risky

activity.

• Loss financing methods include retention (self-insurance), insurance,

hedging and other contractual risk transfers.



• Many businesses achieve internal risk reduction through diversification

and through investments in information to improve forecasts of expected

cash flows.

1.5 Glossary

• Price risk: Uncertainty over the magnitude of cash flow due to possible

changes in output and input prices

• Credit risk: The risk that a firm’s customers and the parties to which it

has lent money will delay or fail to make promised payments

• Pure risk: Includes risks of reduction in value of business assets, risk of

legal liability, risk involved in providing benefits to injured workers, risk of

death, illness and disability to employees

• Personal risk: Risk faced by individuals and families such as earning

risk, medical expense risk, liability risk, physical assets risk, financial risk

and longevity risk

1.6 Terminal Questions

1. What do you understand by the term ‘risk’?

2. Explain different types of business risk.

3. What do you understand by risk management? List the steps involved in

the risk management process.

4. Discuss the different methods of risk management.

5. Describe the four basic methods of financing losses.

6. Where does the risk management function fit within the overall

organizational structure of businesses?

1.7 Answers


1. True

2. True

3. True



4. Pure

5. Self-insurance

6. Retention, insurance, hedging

7. Loss control, loss financing, internal risk reduction

8. True

Terminal Questions

1. The term risk has various meanings in business and everyday life.

Generally, risk is used to describe a situation characterized by uncertainty

with regard to the occurrence of outcome. For more details, refer

section1.2.

2. The major business risks that give rise to variation in cash flows and

business value are price risk, credit risk, and pure risk. For more details,

refer section 1.2.1.

3. The process of identification, analysis and either acceptance or mitigation

of uncertainty in investment decision-making refers to risk management

in business. For more details, refer section 1.3.

4. The risk management methods, which are not mutually exclusive, can be

broadly classified as (a) loss control, (b) loss financing, and (c) internal

risk reduction. For more details, refer section 1.3.2.

5. There are four broad methods of financing losses: retention, insurance,

hedging and other contractual risk transfers. For more details, refer section

1.3.2.

6. Most of the large companies have a specific department responsible for

managing pure risk that is headed by the risk manager (or director of risk

management). For more details, refer section 1.3.3.

1.8 Case Study

Demand for Risk Mitigation Professionals on the Rise

The role of risk managers begins right from the strategy and planning stage

till the completion of the transaction, all along the way highlighting and

explaining various risks as well as putting up recommendations and solutions

at all the stages. They hold expertise in managing complex situations in



difficult, dangerous or unknown markets and advise the client companies

regarding the potential risks if any to its business(es), profitability or existence

after assessing and identifying the threats posed by uncertain environments

and elements. On the basis of their findings, they plan for their client to the

means and mechanisms of avoiding, reducing or transferring risks.

Risk managers are also given the task of managing and mitigating the risks

of customers, employees, reputation, assets and stakeholders’ interests.

These professionals work in various sectors and specialize in different

domains comprising corporate governance, enterprise risk, operational and

regulatory risk, business continuity, security and information risk, technology

risk, and market and credit risk. The introduction of UK Bribery Act in 2011

serves as a good example. We, sometimes, commit the mistake of

presuming that ‘risk’ comprises ‘financial risks’ only. Physical risks caused

by crime and terrorist acts, law and order problems, epidemics, social

disputes, natural hazards, etc., may also affect business operations. Such

situations necessitate deep understanding and strategizing to handle such

risks.

Indian economy is making a mark at the world level and the country is opening

up for more and more foreign direct investment in different sectors. As

professionals, risk managers enter the domain when these investors seek

their help for comprehensive risk assessments and frequently guide them

in this regard. Risk managers may either be a generalist possessing a

chartered accountant degree or a specialist in the field of sales and

marketing, law, management or even a research and development expert.

Although organizations hire risk managers for assessing the overall risk,

some organizations might have such managers for particular areas like

supply chains.

Lately, firms in the Banking Financial Services and Insurance (BFSI) sector

are taking stringent measures for risk management because of the strict

compliance norms put up by the regulatory authorities and institutions. The

customer needs of these firms have also gone up, thus boosting the

requirement for such risk managers by 40 per cent, approximately.

For the CEOs risk management has become really important and has come

to acquire a ‘corporate imperative’ status. It is proved by the fact that even

non-financial firms have started to incorporate the concept of recruiting Chief

Risk Officers (CROs). The CROs are expected to thoroughly put to test the

assumptions underlying the business strategy and authenticate the same

with the help of competitive data, benchmarking data and sector analysis.



These risk managers enable the CROs to develop, deploy and maintain a

practical and composite risk management approach to handle the situations

related to immediate, long-term and evolving risks.

Discussion Questions

1. What are the reasons that have increased the demand for risk mitigation

professionals?

2. What are the challenges faced by the risk managers in tackling various

types of risks faced by businesses?

Source: Adapted from http://articles.economictimes.indiatimes.com/2012-

09-22/news/34022136_1_operational-risk-risk-mitigation-enterprise-risk

(Retrieved on 1 October 2012)

References

• George E Rejda (2009). Risk Management and Insurance, Dorling

Kindersley, New Delhi, India.

• Gupta P K. Insurance and Risk Management, Himalaya Publishing House,

India.

• Neil.A.Doherty (2000). Integrated Risk Management, First edition, McGraw

Hill Companies, USA.

• Skipper, Harold D. and W. Jean Kwon. 2007. Risk Management and

Insurance: Perspectives in a Global Economy. Malden, MA: John Wiley &

Sons.

• Trieschmann, James S. and Sandra G. Gustavson. 1998. Risk

Management and Insurance. Cincinnati, OH: South-Western College

Publishing.

• Rejda, George E. 2005. Principles of Risk Management and Insurance.

New Delhi: Pearson Education India.

• Pritchett, S. Travis, Joan Schmit and James L. Athearn. 1996. Risk

Management and Insurance. St. Paul, MN: West Publishing Company.

• Greene, Mark Richard and James S. Trieschmann. 1981. Risk and

Insurance. Cincinnati, Ohio: South-Western Publishing Company.

E-References

• www.assocham.org/events/recent/event.../insurance_risk_mgmnt.ppt




• www.cholarisk.com/files/RiskManagementandInsurancePlanning.doc


• http://www.ey.com/IN/en/Industries/Financial-Services/Insurance


• http://www.irmi.com/forms/online/insurance-glossary/terms.aspx


• http://business-standard.com/india/news/irdas-draft-proposal-for-

insurance-cover-to-bpl-families/188047/on (Retrieved on 1 October 2012)

• http://www.scu.edu.au/risk_management/index.php/2/ (Retrieved on 3

September 2012)

• http://articles.economictimes.indiatimes.com/2012-09-22/news/

34022136_1_operational-risk-risk-mitigation-enterprise-risk (Retrieved on

1 October 2012)

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