Mgmt.101 ~ Introduction to Business

Risk Management & Insurance

Risk

• Uncertainty about future events.

• The chance of financial loss due to a peril.

• The probability of an event occurring times the consequence or out come from that event.

Insurance

• A system that makes financial loss more affordable by transferring it from individuals to large groups.

• The transfer of risk to another individual or company who will, for a fee (premium), pay a specified amount in the event of certain losses.

Risk

Businesses constantly face two basic types of risk:

Pure Risk ~ The possibility only of loss or no loss (i.e. no possibility of gain). For example, an accidental fire that destroys business premises and their contents.

Speculative Risk ~ The chance of either a loss or a gain. For example, designing and distributing a new product, buying stock in the hope of making a profit.

Risk Management

• The process of conserving the firm’s earning power and assets by reducing the threat of losses due to uncontrollable events.

• This involves analyzing the firm’s operations, evaluating potential risks, measuring the frequency and severity of losses, and figuring out how to minimize losses in a cost-effective manner.

Steps for Risk Management1) Identify possible risks; recognize what can go wrong2) Analyze each risk to estimate the probability that it will

occur and the impact (i.e., damage) that it will do if it does occur

3) Rank the risks by probability and impact - Impact may be negligible, marginal, critical, and catastrophic

4) Develop a contingency plan to manage those risks having high probability and high impact

Managing Risk

Risk Avoidance: Stay away from situations that can lead to loss. Risk Control: When risk avoidance is not practical or desirable, the probability of risk can be lessened or minimized by requiring certain work practices, e.g. by requiring people to wear safety equipment and informing, educating, and training employees in safe working practices.

Managing Risk

Risk Transfer: When the potential for risks cannot be avoided or controlled, the risk can be transferred to another firm – namely, an insurance company.

For a fee (called a premium), the insurance company issues a formal agreement (a policy) to pay the firm (the policy holder) a specified amount in the event of certain losses.

Where premiums are affordable, the risk can be transferred to an insurance company.

Managing Risk

Risk Assumption or Retention (aka Self Insurance)Where premiums become too expensive, or where the risk is uninsurable, a firm can carry the risk itself. That is, cover any losses with its own funds.

Insurable & Uninsurable Risk

Insurance companies divide risk into Insurable Risk: property, legal liability, personal risk. Uninsurable Risk: speculative, business, political.

They will offer coverage only on the former.

Criteria for Insurable RiskThe things being insured must be sufficiently numerous and similar to allow a calculation of the probability of loss to be made. The insured items could not all be insured by one broker. Loss must be accidental and unintentional. Loss must be determinable and measurable. The loss must not be catastrophic. That is, a terrible event that results in a lot of destruction and causes the insurance company to suffer very large losses.

The premium must be economically feasible.

Insurance Companies• Non-depository financial institutions which sell financial

coverage of risk for premiums.

• The monies collected from premiums are invested in stocks, bonds, real estate and other interest-earning operations.

• Earnings pay for insured losses such as death benefits, vehicle accidents, business liability, etc.

Mutual Insurance CompaniesAn insurance company owned entirely by its policyholders. Any profits earned by a mutual insurance company are rebated to policyholders in the form of dividend distributions or reduced future premiums. • Examples in the U.S.• Liberty Mutual• Mutual of Omaha• Nationwide Mutual Insurance Company• New York Life• State Farm Insurance

Public and Private Insurance CompaniesPublic• Unemployment Insurance• Workers’ Compensation

Insurance• Social Security

Private• Stock Companies & mutual

Companies• Property & Liability Insurance• Health Insurance • Life Insurance

The "Law Of Large Numbers"

The theory upon which all insurance exists.

The concept that seemingly random events will follow predictable patterns if enough events are observed.

See “actuarial tables”.

Actuaries

A professional who analyzes the financial consequences of risk.

Uses mathematics, statistics and financial theory to study uncertain future events, especially those of concern to insurance companies.

What Insurance Do Companies Need?Liability Insurance Covers losses resulting from damage to people or when the insured is judged responsible.

Property Insurance Covers losses resulting from physical damage to or loss of the insured’s real estate or personal property.

What Insurance Do Companies Need?

Business Interruption InsuranceCovers income lost during times when a company is unable to conduct business.

Employee Health Care InsurancePart of the benefits package for employees in larger firms. Losses resulting from medical expenses as well as income lost from injury or disease. It is expensive.

What Insurance Do Companies Need?

Workers Compensation InsuranceCoverage provided by a firm to employees for medical expenses, loss of wages, and rehabilitation costs resulting from job-related injuries or disease.

What Insurance Do Companies Need?Directors and OfficersMalpracticeFidelity BondSurety BondMotor VehicleLifePower PlantCreditHazardous WasteSurplus Lines