Risk Management Concepts: January 1998
Risk Management Concepts: January 1998
Risk Management Concepts: January 1998
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Objective
This chapter explains the objective of risk management and describes the
framework in which financing decisions including insurance are taken and
evaluated. Many of these concepts important in business risk management are
also applicable to individual economic agents.
The risk manager evolved from the insurance manager because risk
management is broader than insurance in that it deals with the choice of the
appropriate techniques for dealing with pure risks including insurance. Felix
Kloman argued recently that "organizations have been challenged by newer and
more dynamic risks, risks that have not been addressed effectively by the risk
management that is tied to the insurance industry." 4 His argument is that risks in
an organization are closely interrelated and that the risk management function
should address all risks in a comprehensive approach.
Despite its potential and scope, risk management is not yet recognized as a
major element of corporate organizations. The approach of analyzing specific
industry uncertainties in isolation from general environmental uncertainties has
come more often under criticism. It is also arguable that to confine risk
management only to handling pure risks is too restrictive a view of its function
since pure risks are inevitably intermingled with decisions bearing on business
risks. An integrated managerial approach should analyze all the sources of
uncertainties that affect the total risk of a firm.
Property losses are often not the only losses that occur when property is
damaged or destroyed. Until that property is replaced or restored to its initial
condition, the business may suffer a reduction in its net income either because
revenues are decreased or because expenses are increased or both. Any action
taken by a firm that decreases risks, improves its prospects for survival and
provides greater assurance to potential customers that the company will be around
in the future to service and upgrade its products. 5
Obviously, the relative importance of risk management activities will vary
according to the corporation ownership. The existence of other claims, such as
those of employees and suppliers, creates incentive for risk management.6 In the
following discussion, the management is willing to take any action to reduce the
preloss fire hazard and the postloss consequences.
3
DISCUSSION:
Suppose that 3 toys manufacturers, YOTOYS, B.S.TOY and
ZODI are sharing the same closed market and that a fire
destroys the total inventories of toys of ZODI on November
20th. Because of delays in the production, ZODI will be unable
to supply the market for Christmas and the two competitors will
mainly benefit from this situation.
At the end of the year, ZODI will report losses
whereas YOTOYS and B.S.TOY will enjoy unexpected higher
profits. An investor holding a diversified portfolio of stocks of
the three companies will be almost unaffected by the event (
assuming there is no tax effect ).
On the other hand the lenders and bondholders may
become concern about the future of the firm because they have
prior claim to shareholders on the firm's revenues. They may
expect a relative stability of revenues. Statistics show a number
of firms going bankrupt after a major fire. Similarly there is in
this case a conflict of interest between the owners of the firm
and the managers and workers, because the later want to ensure
their own survival.
managers and are directed toward specific goals and objectives, for example, a
"quiet night's sleep" may be one of the managerial objectives.
Because the management of a firm is often directly concerned with problems
of injury or damage to employees and to the public in general, social
responsibility or "good citizenship" is important. Mehr and Hedges argued "If
results after a loss are a matter of indifference, no reason remains to consider the
loss before it happens." 7 On the other hand, a firm may not be prepared to take
a chance of polluting a river even though it may be able to accept the risk and its
financial consequences. Similarly, any airline company places great emphasis on
its safety record and prefer to avoid adverse publicity.
Risk management is a specialized aspect of the overall financial management
of an enterprise. The objectives must be consistent with the financial objectives
and as in other financial management problems, alternatives are evaluated by
considering their potential financial advantages and risks.
While the objective of management in general is the conservation of assets
and the maximization of the wealth of the shareholders, the objective of risk
management is to make sure that losses that arise because of existing risks do not
prevent management from meting its goal. Although risk management principles
and procedures are applicable to a wide variety of problems, they are generally
limited to the problems that arise from the existence of pure and static risks.
Since risk management does not generate revenues, in the traditional sense
of the term, the evaluation of alternative programs will be made on comparative
costs. The objective of risk management has frequently been stated as the
"minimization of costs".
Risk Measurement
Once the risks have been identified, the risk manager must evaluate them. The
process of creating data is known as measurement. This means measuring the
potential size of the loss and the probability that it is likely to occur. Information
is needed concerning two dimensions of each risk exposure:
6
Risk Assessment
Loss-frequency and loss-severity data do more than identify the important losses.
They are also extremely useful in determining the way to handle the situation.
Risk assessment aims to determine how serious a hazard is and whether
individuals or the society should be exposed to it. One aspect to the idea of risk
measurement relates to the basic premise that the ability to predict the outcome
of a risk is critically dependent upon the quantity and reliability of information
relating to the phenomenon that is being investigated. In some cases, however,
the uniqueness of the situation is such that it is difficult to measure and hence to
assess the risk.
In all risky situations, there are three important determinants which are
information, control and time. Crisis management often refers to the lack of
time to assess the risk and take a decision. Lack of control and/or lack of
information about the risk in a crisis management situation are also usually the
rule.
Despite an appearance of objectivity, risk assessment is inherently
subjective. The motion picture "Jaws", has increased the availability (and
perceived likelihood) of sharks attacks. Some nuclear power proponents feel that
the risk of that technology are exaggerated in the public' eye because of excessive
medium coverage. Fischhoff et al.(1981) consider that the acceptability of a risk
is a relative concept rather than an absolute one and therefore, there can be no
single, all-purpose number that expresses the acceptable risk for a group or a
society.
7
Table 4.1
Incidence of Accidental Deaths in India
Classified According to Causes During 1982
Causes of Number Percentage to
Accidental Deaths total Number
A. Natural Causes
B. Other Causes
DISCUSSION:
In 1982 in the Chicago area, several bottles of Tylenol capsules,
a pain remedy, contained cyanide that caused the death of seven
people. There was little information about what was happening
and what was causing it? Was the problem a local problem
only?
Johnson and Johnson, the pharmaceutical company,
had inadequate control of the situation and action had to be
taken immediately. J&J decided to recall and test all Tylenol
capsules in Chicago and to test samples from other marketing
areas (a total of 31 million bottles).
Three months after the tragedy had begun, J&J
announced to the public that Tylenol products were being
distributed in a new "tamper-resistant" package that had three
safety features: 1) A cellophane wrap on the box, 2) The cap is
sealed with a plastic ring and, 3) The bottle is foil sealed.
Despite losing most of its very large 35% share of the market
of pain remedy (an estimated $100 millions in losses), within
one year the product had bounced back to over 25%.
Table 4.2
Bias in Judged Frequency of Death
Source: Lichtenstein S., Slovic , P., Fischhoff, B., Layman , M. and Combs, B.,
"Judged Frequency of Lethal Events," Journal of Experimental Psychology:
Human Learning and Memory, vol. 4, 1978, pp. 551- 578.
See also Slovic, P., Fischhoff, B. and S. Lichtenstein, "Facts and Fears:
Understanding Perceived Risks," in R.C. Schwing and W.A. Albers (Eds.)
(1980) for an extended analysis.
Risk may be transferred: The property or activity responsible for the risk may
be transferred to some other economic agent. Transfer is different from avoidance
in the sense that the source of the risk is not discontinued. A transfer is possible
whenever the firm enters into a contractual arrangement with an outside entity for
either the sale or purchase of goods or services. A lease contract is the typical
example of the transfer of the risks associated with ownership.
DISCUSSION:
By selling and distributing products, the marketing department
typically exposes the firm to some important potential losses.
In transporting the products to retailers or customers, typical
examples of exposures are the packaging of the products, the
loading and unloading accidents and the risks generated by the
mean of transportation.
The decision to own a fleet of vehicles or to rent the
services of a specialized company must be made by
incorporating all types of losses that might occur as a result of
a given event as well as their ultimate financial impact upon the
firm.
Risk Control
Whether or not the firm has decided to assume the risks, it must also examines
the possibilities (1) to reduce the frequency of occurrence and (2) to reduce the
severity of losses that will occur. The potential gains from any risk-control
activity must be weighted against the costs involved. Unless the expected gains
equal or exceed the costs, the firm would be better off not to engage in that
activity. If the reduction of direct and indirect costs may be estimated, long-term
expected gains such as the reduction of uncertainty, improved public or customers
perception, and increased employees morale and efficiency, are not necessarily
measurable.
It is important to notice that the marginal cost of risk reduction increases with
a decline of risk. Commonly used criteria for decision-taking are relative to the
level of "acceptable" risk which should be "as low as best practicable technology"
or "as low as best available technology." "Zero tolerance" indicates that risk is to
be reduced independent of the cost.15
A detailed study of loss control activities requires a background of technical
and scientific skills. The risk manager will often make use of the technical
expertise of the production staff to decide on physical devices and procedures to
be implemented.
11
Table 4.3
Examples of Loss-Control Measures
Risk control or loss control measures have been classified in various ways
according (1) to whether they are loss-prevention or loss reduction measures, (2)
to the cause or the location of the risk and (3) to the timing of the event.
Loss-prevention programs seek to reduce or eliminate the chance of loss, i.e.
the frequency of the risk. The possibility of a loss is never completely eliminated
but it is an important approach to reduce the consequences of a risk. Loss
prevention activities, safety programs, fire departments, police and army forces
are few examples of actions being taken to prevent the risk.
Loss-reduction programs seek to reduce the potential severity of the loss.
According to the timing of the event, the loss-prevention phase take place before
any accident has occur while the loss-reduction is applied during the accident
phase or after the accident has occur. Emergency planning often refers to the
development of procedures so that prompt post-loss action can be taken that will
reduce further chances of injury to persons, loss of life, and damage to property.
Risk control programs are mainly designed to tackle the following areas:
DISCUSSION:
Around midnight on Saturday, 10 November 1979, the
Canadian Pacific freight train carrying 106 cars derailed. A
number of cars collided causing a vapor explosion near the city
of Mississauga, Ontario. Thirty-eight cars were carrying cargo
designated as hazardous, including chlorine and liquid
petroleum products (butane, propane).
On learning that a chlorine tanker was probably in the
derailed and burning section of the train, local official decided
the evacuation (on Sunday morning between 1:45 am and 8:30
am) of a quarter of a million residents of the city of
Mississauga, probably the largest peacetime evacuation ever
conducted in North America. Residents were permitted to
return home only six days after the first departures.
The post-accident analysis revealed that the cars
containing butane and propane collided and probably caused
the initial vapor explosion. If they had been separated from
each other by other cars the derailment would probably not
have caused any fear for the population.
13
Safety Management
Given society's increasing demands for personnel safety and health programs and
product safety programs, it is apparent that risk control will certainly be the major
function of risk management and the area where the greatest growth is likely to
take place. Some of these approaches are principally geared to educating the
public, the customers or the employees regarding their exposure to risks. It is
interesting to note that, in many countries, the decision to implement a loss-
control program is frequently imposed to the firm because the benefits that are
realized extend beyond the enterprise itself and tend to benefit the whole society.
Legal requirements do not themselves optimize safety, but they create a climate
for the development of reliable means.
Organized safety developed at the end of last century under the pressures
created by the new worker's compensation laws in Germany (1885) and in Great
Britain (1897). In the United States, the first law passed in the State of Maryland
in 1902, but it was so restrictive that it had no practical value until the 1930s.
Work injuries were a focal point of the developing safety specialty. It was
believed by the proponents of worker's compensation legislations that the
indemnification costs imposed on the employer would motivate the development
of occupational safety programs ( Grimaldi and Simonds, 1989, Chap. 2).
The concept of safety management (Grimaldi and Simonds, 1989) is an
integral part of management responsibilities. The objective of "safety first" is
similar to the risk control objective, i.e., the elimination of hazards, or their
control to levels of acceptable tolerance. In industrialized societies, the question
"How safe is safe enough?, has emerged as a major policy issues of the 1980's
and many hazards or risks are still poorly known or understood by society. 16
Beyond the particular studies reported here, a growing interest has developed
for political and policy studies on risk assessment. Baram (1982) has discussed
a wide variety of alternatives to regulation of managing risks to health, safety,
and the environment. These include private voluntary self-regulation, taxation as
an alternative to rules, insurance, and other compensatory plans.
Risk Financing
The objective of risk financing, the third element in the risk management process,
is to have the necessary financial resources available following the occurrence of
a loss so that the continuity of the operations of the firm or organization can be
preserved. Basically, the finance alternatives include internal funds available to
the firm and external funding or compensation that can be obtained from other
economic agents.
Michael Smith in Williams and Heins (1989, Chap. 14 ) argued that restoring
a damaged asset is rational when its restoration increases the market value of the
firm. He explained that both the restoration and the commitment to restoration
14
Summary
Risk management involves the application of general management concepts to a
specialized area. It is a process that uses human, financial and physical resources
to identify, evaluate, control and finance most of the pure loss exposures of a firm.
However, the management of risks cannot be undertaken in isolation from the rest
of the organization. The risk manager is part of a management team with a
responsibility for achieving the objectives set for the organization.
Concepts: Value of a firm, Risk assessment, Risk control, Risk financing.
18
References
Baram, M.S., Alternatives to Regulation , Lexington, MA: Lexington Books,
1982.
Bird, F.E and G.L. Germain, Practical Loss Control Leadership , Loganville,
GA: International Loss Control Institute, 1986.
Carter, R.L. and N.A. Doherty, Handbook of Risk Management London:
Kluwer-Harrap Handbooks, 1974, Part 1.
Charbonnier, Jacques, Le Risk Management Europeen / European Risk
Management, Paris: Editions de l'Argus, 1985.
Cohen, J., Behavior in Uncertainty , New York: Basic Books, 1964.
Covello, V.T., Menkes, J. and J. Mumpower, (Eds.), Risk Evaluation and
Management , New York: Plenum Press, 1986.
Covello, V.T., Lave, L.B., Moghissi, A. and V.R. Uppuluri, (Eds.), Uncertainty
in Risk Assessment, Risk Management and Decision Making , New York:
Plenum Press, 1987.
Fischhoff, B., Lichtenstein, S., Slovic, P., Derby S.L., and R.L. Keeney,
Acceptable Risk , Cambridge,UK: Cambridge University Press, 1981.
Greene, M. and O. Serbein, Risk Management: Text and Cases , Reston,
Virginia: Reston Publishing Co., 2nd ed., 1983.
Grimaldi , J.V. and R.H. Simonds, Safety Management , Homewood, Il.: R.D.
Irwin, 5th ed., 1989.
Heinrich, H. W., Industrial Accident Prevention , New York: McGraw Hill
Book Co., 5th ed., 1980.
Kleindorfer, P.R. and H.C. Kunreuther, Insuring and Managing Hazardous
Risks: From Seveso to Bhopal and Beyond, Laxenburg, Austria: International
Institute for Applied Systems Analysis, 1987.
Lagadec, P., Le risque technologique majeur, Paris: Collection Futuribles, 1981.
Translated in English: An Assessment of Industrial Disasters, Oxford:
Pergamon Press, 1982.
Lave, L.B., (Ed.), Risk Assessment and Management , New York: Plenum
Press, 1987.
Mehr, R.I. and E. Cammack, Principles of Insurance , Homewood, Illinois:
Richard D. Irwin, 7th ed., 1980.
19
Appendix 4.1
Examples of Major Industrial Accidents
and Consequences
Appendix 4.2
Summary of Natural Catastrophes and Major Accidents
Number of Victims from 1986 to 1990
Natural catastrophes
Floods 4,534 1,420 8,429 4,481 2,101
Storms 4,553 5,828 6,271 3,332 1,545
Earthquakes 52,100 523 26,782 1,042 2,784
Appendix 4.3
Causes of Fire
( 10 years average )
Heating
Stoves, furnaces, boilers,
and smoke pipes
Solid Fuel 1,030 2,657,456
Oil Fired 1,742 6,219,364
Gas Fired 587 2,692,155
Unclassified 1,665 6,403,581
Defective and overheated
chimneys and flues 886 1,949,042
Hot ashes, coals, open fires 2,546 13,037,137
Smoking
Matches 2,152 4,586,097
Smokers' carelessness 18,468 15,484,791
Miscellaneous
Lightning 2,862 3,324,055
Lights, other than electric 857 2,045,985
Sparks on roof 146 442,053
Spontaneous ignition 465 3,797,763
Other known ( fireworks,
friction, explosion etc.) 10,529 30,809,007
Notes
1 Henri Fayol, General and Industrial Management, New York: Pitman Publishing Co., 1949.
2
For an history of Risk Management see R.I. Mehr and E. Cammack, Principles of Insurance, 7th ed., Homewood, Illinois: R.D.
Irwin, 1980, pp. 35-37 and Crockford, G.N. , "The Bibliography and History of Risk Management: Some Preliminary
Observations," The Geneva Papers on Risk and
Insurance, vol. 7, no. 23, 1982, pp. 169-179.
Also V.C. Covello and J. Mumpower, "Risk Analysis and Risk Management: A Historical Perspective," Risk Analysis, vol. 5,
no. 2, 1985.
3
Russel B. Callagher , "Risk Management: A New Phase of Cost Control," Harvard Business Review, Sept-Oct. 1956, pp. 75-86.
4
Felix H. Kloman , Risk Management Report, January/February 1991, pp. 5-6.
5
The effect of risks on sales and costs for a corporation are explained in details in Alan C. Shapiro and Sheridan Titman, "An
Integrated Approach to Corporate Risk Management," Midland Corporate Finance Journal, Summer 1985, pp. 41- 56; reprinted in
The Revolution in Corporate Finance, J.M. Stern and D.H. Chew, (Eds.), New York: Basil Blackwell Inc., 1986.
6
Jensen and Meckling provide a positive analysis of the impact of agency relationships on the investment and financing
decisions of a firm. Jensen, M.C. and W.H. Meckling, "Theory of the Firm: Managerial Behavior, Agency Costs and Ownership
Structure," Journal of Financial Economics, vol. 3, 1976.
See also Mayers David and Clifford W. Smith, "On the Corporate Demand for Insurance," Journal of Business, vol. 55, no. 2,
1982, pp. 281-296.
7
Robert I. Mehr and Bob A. Hedges, (1974), p. 28.
8
C.A. Williams and R. M. Heins (1989), p. 53.
9
See for example A.H. Criddle, "Evaluation of Risk," in H. Wayne Snider (1964).
10
John J. O'Connell, "Systematic Risk Identification,"
Risk Management, vol. 23, no. 3, March 1976, pp. 34-36.
11
Frederick W. Taylor, Principles of Scientific Management, New York: Harper & Brothers, 1911.
In relation to safety engineering, specific methods of searching out and identifying risks in the physical work setting have been
suggested by Brereton Philip R. and Daniel C. Peterson, "Safety Management for the Risk Manager," Risk Management, February
1971, p. 31.
12
See Orio Giarini and Walter R. Stahel, The Limits to Certainty: Facing Risks in the New Service Economy, London: Kluwer
Academic Press, 1989.
13
For a survey, see P. Slovic , B. Fischhoff, and S. Lichtenstein, "The Psychometric Study of Risk Perception," in V.T. Covello,
J. Menkes, and J. Mumpower, (Eds.) (1986).
14
Neil A.Doherty (1985), pp. 187- 214.
15
See William Rowe, An Anatomy of Risk, New York: J. Wiley & Sons, 1977.
16
The Society for Risk Analysis has organized and sponsored a number of international workshops on risk assessment. The
following publications are a valuable source of opinions and researches on the subject:
C. Whipple,and V.T. Covello, (Eds.), Risk Analysis in the Private Sector, (1985)
V.T. Covello, J. Menkes, and J. Mumpower, (Eds.), Risk Evaluation and
Management, (1986)
V.T. Covello, L.B. Lave, A. Moghissi, and V.R. Uppuluri, (Eds.), Uncertainty
in Risk Assessment, Risk Management and Decision Making, (1987).
L.B.Lave (Ed.), Risk Assessment and Management, (1987).
17
J.D. Blinn and B.M. Brown , "The Cost of Risk: A Summary of the 1981 Survey," Risk Management, November 1982.
For a similar survey in Europe see J. Charbonnier (1985)
18
UNCTAD, The Promotion of Risk Management in Developing Countries, Geneva: United Nations, TD/B/C.3/218, 1987.
19
See Paul Shrivastava, Bhopal, An Anatomy of a Crisis, Cambridge, MA: Ballinger Pub., 1987.
20
Cubatao is a town of nearly 100,000 people located on the southern coast of Brazil. It has the world's record of air pollution
level. In 1984, a petrol explosion killed about 500 people in a shanty town built on Petrobras plant lands.
21
UNCTAD (1987), p. 12.