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CHAPTER 9 - 14 – Part 2:RISK TREATMENT

MFS 4023 – RISK MANAGEMENTBy : Salman Bin Lambak

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Risk Reduction

Types of Risk Reductions:-

1. Loss Prevention

2. Loss Control

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Loss Prevention

Loss prevention efforts are aimed at preventing the occurrence or loss.

Example: Vehicle’s anti-theft device is installed to prevent the vehicle being stolen

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Loss Control

Loss control efforts can be directed toward reducing the severity of those losses that do occur.

Example: Water sprinkler is aimed to reduce the fire damage to the building or content

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Risk Reduction

Basic Principles of Risk Reductions:-

1. Timing

2. Measure

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Risk Reduction : Timing

Risk control can be applied to act:-1. Before the occurrence, to reduce the likelihood of

happening2. During the occurrence, to reduce the severity3. After the occurrence, to reduce severity and

further consequential impact i.e. contingency plan, first aid provision

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Risk Reduction : Measures / Mechanics

Measure can be hard or soft:-1. Hard (physical) measures that alter the risk by

physical means, e.g. water sprinkler, theft alarm, locks and bolts.

2. Soft (organizational and procedural) measures that are aimed to ensure the people act in the appropriate way to reduce the risk, e.g. risk committee, security patrol and non-smoking room.

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Risk Finance

Risk finance is a form of risk treatment involving contingent arrangements for the provision of funds to meet or modify the financial consequences should they occur. Risk financing is not generally considered to be the

provision of funds to meet the cost of implementing risk treatment.

as defined by ISO/IEC Guide 73; see page 11 @ 17

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Risk Finance : Transfer / Sharing

Risk transfer / sharing is form of risk treatment involving the agreed distribution of risk with other parties.

It can be carried out through insurance or other forms of contract.

The extent to which risk is distributed can depend on the reliability and clarity of the sharing arrangements.

Types of Transfer

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Non Insurance Transfer

Insurance Transfer

Alternative Risk Transfer

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Non Insurance Transfer

It may be possible to transfer a risk to another party in a contract.

For example, a landlord might make a condition of a lease that the tenant be responsible for any damage to the premises.

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Insurance Transfer

Insurance is the most widely used of all risk transfer method.

It is a mechanism by which an organization can exchange its uncertainty for greater certainty.

The details of insurance will be elaborated in next chapter.

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Insurance Transfer

Like any other risk treatment method, insurance is not perfect.

A residual risk will usually remain for the customer, whereby:-1. Some events may be excluded by policy conditions2. A proportion of loss will be carried by the insured in

the form of deductible3. The insurance company itself may become insolvent

and fail to pay the claim

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ART (Alternatives Risk Transfers)

ART is a name given to a range of instruments that enable an organization to transfer financial risk to a professional risk carrier other than by way of a conventional insurance contract.

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ART (Alternatives Risk Transfers)

Instruments of ART:-1. Derivatives:

It is a forward contract that will enable someone to buy or sell a specified asset at a specified date in the future and at a specified price.

Example is an earthquake. One such contract could be triggered by an earthquake of a magnitude in excess of, say 7.1 on the Richter scale occurring within the defined latitude and longitude, and within a defined period.

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ART (Alternatives Risk Transfers)

Instruments of ART:-2. Catastrophe bonds:

It is an investment bonds that provide a return to investors that is based on insurance type events rather than financial market development.

3. Catastrophe Risk Exchange (CATEX): It is an electronic system for trading insurance risk.

Licensed risk bearers exchange or swap catastrophe exposures offered by other subscribers.

For example, insurers and reinsurers may exchange a Japanese earthquake risk for a Florida hurricane risk.

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ART (Alternatives Risk Transfers)

Instruments of ART:-4. Loans:

Borrow funds after a catastrophe has occurred to help it meet the extra costs that emerged.

5. Put Options: It is sold by a financial institution to the organization. The

effect is that the option, or a contracted right to act, will become effective following certain specified events. The damaged organization then could use the contracted right to sell a pre-agreed level and type of equity to the financial organization that provided the option.

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ART (Alternatives Risk Transfers)

Instruments of ART:-6. Mutual:

Some industries find value in avoiding the insurance market by creating a mutual company that can be used to share risks across the sector. Examples include pools for the oil industry, marine risks and others.

7. Combination of ART 1 - 6

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Risk Finance : Risk Retention

It means an acceptance of the potential benefit of gain, or burden of loss, from a particular risk

Risk retention includes the acceptance of residual risks1

The level of risk retained can depend on risk criteria2

1 – Residual risk is the remaining after risk treatment. It can contain unidentified risk. The residual risk can also be known as “retained risk.

2 – Risk criteria are based on organizational objectives, and external and internal context

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Risk Retention : Types

1. Self Insure2. Captive

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Self Insure

Self Insure was previously related to risks which are not covered by insurance.

But now, the scope becomes wider which that the individual or organization retains the risk on their owns for many reasons.

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Self Insure

Reasons for self-insurance:-1. Cost of insurance, be it short term or long run, exceed

average losses.2. The organizational may also believe that the loss

experience is better than the average loss experience of other same nature.

3. The amount spent for insurance may more worth to be invested.

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Self Insure :- Types

1. Handles as an expense In this approach, the organization decides that no

separate funding is necessary. The losses, such as collision damage to their motor vehicle, are handled as part of the running expenses.

2. Loans The organization may choose to rely on a loan if a loss

occurs. This saves of insurance premiums, but it has its drawbacks i.e. the organization may be weakened by the loss.

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Self Insure :- Types

3. Contingency Fund A special fund may be set up to pay for the loss, using

all or part of the money that would have been paid out as an insurance premium. This has the attraction that the organization will benefit from any investment income if the contingency never occurs.

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Captive

A captive is an insurance company that has been set up by the organization to insure its own risk, although some may actually accept risk for profit from other organizations.

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Captive

Captive perform a number of roles:-1. They are a formalized method of self-insurance for

high frequency risk that can be carried by the company itself in a tax efficient way.

2. They are also used as a financing instrument for very specific low frequency / high severity risk.