Introduction to Risk

Management and
Insurance
Principles of Risk Management and Insurance
George E. Redja
Objective of Risk Management
Risk management has two important objectives. These objectives can be classified as follows:

Pre-loss Post-loss
objective objective
Pre-loss objective
The first objective means that the firm should prepare for potential losses in the most
economical way. This preparation involves an analysis of the cost of safety programs, insurance
premiums paid, and the costs associated with the different techniques for handling losses.

The second objective is the reduction of anxiety. Certain loss exposures can cause greater worry
and fear for the risk manager and key executives. For example, the threat of a catastrophic
lawsuit from a defective product can cause greater anxiety than a small loss from a minor fire.

The final objective is to meet any legal obligations. For example. government regulations
may require a firm to install safety devices to protect workers from harm, to dispose of
hazardous waste materials properly, and to label consumer products appropriately. The risk
manager must see that these legal obligations are met.
 Post-Loss Objectives
The most important post-loss objective is survival of the firm. Survival means that after a loss occurs, the firm can
resume at least partial operations within some reasonable time period.
The second post-loss objective is to continue operating. For some firms, the ability to operate operating. For some
firms, the ability to operate after a loss is extremely important. For example, a public utility firm must continue to
provide service. Banks, bakeries, dairies, and other competitive firms must continue to operate after a loss. Otherwise,
business will be lost to competitors.
The third post-loss objective is stability of earnings. Earnings per share can be maintained if the firm continues to
operate. However, a firm may incur substantial additional expenses to achieve this goal (such as operating at another
location), and perfect stability of earnings may not be attained.
The fourth post-loss objective is continued growth of the firm. A company can grow by developing new products and
markets or by acquiring or merging with other companies. The risk manager must therefore consider the effect that a
loss will have on the firm’s ability to grow.
Finally, the objective of social responsibility is to minimize the effects that a loss will have on other persons and on
society. A severe loss can adversely affect employees, suppliers, creditors, and the community in general. For example,
a severe loss that shuts down a plant in a small town for an extended period can cause considerable economic distress
in the town.
Benefits of risk management
The pre-loss and post-loss risk management objectives are more easily attainable.
The cost of risk is reduced, which may increase the company’s profits. The cost of risk is a risk
management tool that measures certain costs. These costs include premiums paid, retained
losses, loss control expenditures, outside risk management services, financial guarantees,
internal administrative costs, and taxes, fees, and certain other expenses.
Because the adverse financial impact of pure loss exposures is reduced, a firm may be able to
enact an enterprise risk management program that treats both pure and speculative loss
exposures.
Society also benefits since both direct and indirect (consequential) losses are reduced. As a
result, pain and suffering are reduced.
Captive Insurer
Captive Insurer Losses can also be paid by a captive insurer. A captive insurer is an insurer owned
by a parent firm for the purpose of insuring the parent firm’s loss exposures.
There are different types of captive insurers. A single parent captive (also called a pure captive) is
an insurer owned by only one parent, such as a corporation. An association or group captive is
an insurer owned by several parents. For example, corporations that belong to a trade
association may own a captive insurer. Many captive insurers are located in the Caribbean
because of a favorable regulatory climate, relatively low capital requirements, and low taxes.
Captive insurers are formed for several reasons including the following:
Difficulty in obtaining insurance. The parent firm may have difficulty obtaining certain types of
insurance from commercial insurers, so it forms a captive insurer to obtain the coverage. This pattern is
especially true for global firms that often cannot purchase certain coverages at reasonable rates from
commercial insurers, including liability insurance, political risk insurance, and insurance against terrorist
attacks.
Lower costs. Forming a captive may reduce insurance costs because of lower operating expenses,
avoidance of an agent’s or broker’s commission, and retention of interest earned on invested premiums
and reserves that commercial insurers would otherwise receive. Also, the problem of wide fluctuations
in commercial insurance premiums is avoided.
Easier access to a reinsurer. A captive insurer has easier access to reinsurance, because reinsurer
generally deal only with Insurance companies, not with insureds.
Formation of a profit center. A captive insurer can become a source of profit if it insures other parties
as well as the patch firm and its subsidiaries.
Advantages of Retention
Save money. The firm can save money in the long run if its actual losses are less than the loss
component in a private insurer’s premium.
Lower expenses. The services provided by the insurer may be provided by the firm at a lower
cost. Some expenses may be reduced, including loss-adjustment expenses, general
administrative expenses, commissions and brokerage fees, loss control expenses, taxes and fees,
and the insurer profit.
Encourage loss prevention. Because the exposure is retained, there may be a greater incentive
for loss prevention.
Increase cash flow. Cash flow may be increased, because the firm can use the funds that
normally would be paid to the Insurer at the beginning of the policy period.
Disadvantages of retention
Possible higher losses. The losses retained by the firm may be greater than the loss allowance
in the insurance premium that is saved by not purchasing insurance. Also, in the short run, there
may be great volatility in the firm’s loss experience.
Possible higher expenses. Expenses may actually be higher. Outside experts such as safety
engineers may have to be hired. Insurers may be able to provide loss control and claim services
less expensively.
Possible higher taxes. Income taxes may also be higher. The premiums paid to an insurer are
immediately income-tax deductible. However if retention is used, only the amounts paid out for
losses are deductible, and the deduction cannot be taken until the losses are actually paid.
Contributions to a funded reserve are not income-tax.
Advantages of commercial Insurance
The firm will be indemnified after a lone occurs. The firm can continue to operate and may
experience little or no fluctuation in earnings.
Uncertainty is reduced, which permits the firm to lengthen its planning horizon. Worry and fear
a are reduced for managers and employees, which should improve performance and
productivity.
Insurers can provide valuable risk management services, such as loss-control services, loss
exposure analysis, and claims adjusting.
Insurance premiums are income-tax deductible as a business expense.
Disadvantages of commercial Insurance
The payment of premiums is a major cost, because the premium consists of a component to
pay losses, an amount for expenses, and an allowance for profit and contingencies. These in also
an opportunity cost. If insurance is used, premium must be paid in advance, and the opportunity
to use the funds is forgone.
Considerable time and effort must be spent in negotiating the insurance savages. An insurer or
insurers must be selected, policy terms and premiums must be negotiated, and the firm must
cooperate with the loss control activity.
The risk manager may have less incentive to follow a loss control program, because the Insurer
will pay the claim if a loss occurs. Such a lax attitude toward loss control could increase the
number of noninsured losses as well.