Risk Management: A Comprehensive Guide to Identifying and Treating Loss Exposures

Posted on Sep 1, 2024 in Economy

Risk Management

is a process that identifies loss exposures faced by an organization and selects the most appropriate techniques for treating such exposures.

What is a Loss Exposure?

A loss exposure is any situation or circumstance in which a loss is possible, regardless of whether a loss occurs.

Objectives of Risk Management

Risk management has objectives before and after a loss occurs.

Pre-loss Objectives:

• Prepare for potential losses in the most economical way.
• Reduce anxiety.
• Meet any legal obligations.

Post-loss Objectives:

• Survival of the firm.
• Continue operating.
• Stability of earnings.
• Continued growth of the firm.
• Minimize the effects that a loss will have on other persons and on society.

Risk Management Process

1. Identify potential losses.
2. Measure and analyze the loss exposures.
3. Select the appropriate combination of techniques for treating the loss exposures.
4. Implement and monitor the risk management program.

Identify Loss Exposures

• Property loss exposures.
• Liability loss exposures.
• Business income loss exposures.
• Human resources loss exposures.

Measure and Analyze Loss Exposures

Estimate for each type of loss exposure:

• Loss frequency refers to the probable number of losses that may occur during some time period.
• Loss severity refers to the probable size of the losses that may occur.

Rank exposures by importance. Loss severity is more important than loss frequency.

• The maximum possible loss is the worst loss that could happen to the firm during its lifetime.
• The probable maximum loss is the worst loss that is likely to happen.

Select the Appropriate Combination of Techniques for Treating the Loss Exposures

Risk control refers to techniques that reduce the frequency and severity of losses.

Methods of risk control include:

• Avoidance.
• Loss prevention.
• Loss reduction.

Avoidance means a certain loss exposure is never acquired or undertaken, or an existing loss exposure is abandoned.

Loss prevention refers to measures that reduce the frequency of a particular loss.

Loss reduction refers to measures that reduce the severity of a loss after it occurs.

Risk Financing Methods: Retention

Retention means that the firm retains part or all of the losses that can result from a given loss.

Advantages:

• Save on loss costs.
• Save on expenses.
• Encourage loss prevention.
• Increase cash flow.

Disadvantages:

• Possible higher losses.
• Possible higher expenses.
• Possible higher taxes.

A captive insurer is an insurer owned by a parent firm for insuring the parent firm’s loss exposures.

A non-insurance transfer is a method other than insurance by which a pure risk and its potential financial consequences are transferred to another party.

Insurance is appropriate for low-probability, high-severity loss exposures.

Claim Settlement

The objectives of claims settlement include:

• Verification of a covered loss.
• Fair and prompt payment of claims.
• Personal assistance to the insured.

Some laws prohibit unfair claims practices, such as:

• Refusing to pay claims without conducting a reasonable investigation.
• Not attempting to provide prompt, fair, and equitable settlements.

Major Types of Claims Adjustors:

• An insurance agent often has authority to settle small first-party claims up to some limit.
• A company adjustor is usually a salaried employee who will investigate a claim, determine the amount of loss, and arrange for payment.
• An independent adjustor is an organization or individual that adjusts claims for a fee.

Steps in Claim Settlement

The claim process begins with a notice of loss, typically immediately or as soon as possible after a loss has occurred. Next, the claim is investigated. An adjustor must determine that a covered loss has occurred and determine the amount of the loss. The adjustor may require a proof of loss before the claim is paid.

Reinsurance

Reinsurance is an arrangement by which the primary insurer that initially writes the insurance transfers to another insurer part or all of the potential losses associated with such insurance.

Why Use Reinsurance?

• Increase underwriting capacity.
• Stabilize profits.
• Provide protection against a catastrophic loss.
• Retire from business or from a line of insurance or territory.

Two Principal Forms of Reinsurance

• Facultative reinsurance is an optional, case-by-case method that is used when the ceding company receives an application for insurance that exceeds its retention limit.
• Treaty reinsurance means the primary insurer has agreed to cede insurance to the reinsurer, and the reinsurer has agreed to accept the business.

Two Basic Methods for Sharing Losses

• Under the pro rata method, the ceding company and reinsurer agree to share losses and premiums based on some proportion.
• Under the excess method, the reinsurer pays only when covered losses exceed a certain level.

Types of Reinsurance Treaties:

• Quota-share treaty: the ceding insurer and the reinsurer agree to share premiums and losses based on some proportion.
• Surplus-share treaty: the reinsurer agrees to accept insurance in excess of the ceding insurer’s retention limit, up to some maximum amount.
• Excess-of-loss treaty: designed for protection against a catastrophic loss.

Key Insurance Terms

• Unearned premium reserve: a liability item that represents the unearned portion of gross premiums on all outstanding policies at the time of valuation.
• Policyholders’ surplus: the difference between an insurance company’s assets and liabilities.
• Income and expense statement: summarizes revenues and expenses paid over a specified period of time.

Life Insurance

A life insurer’s assets have a longer duration, on average, than those of property and casualty insurers.

Because many life insurance policies have a savings element, life insurers keep an interest-bearing asset called “contract loans” or “policy loans”.

Policy reserves are a liability item on the balance sheet that must be offset by assets equal to that amount.

Ratemaking in Property and Casualty Insurance

State Laws Require:

• Rates should be adequate for paying all losses and expenses.
• Rates should not be excessive, such that policyholders are paying more than the actual value of their protection.

Business Rate-Making Objectives Include:

• Rates should be easy to understand.
• Rates should be stable over short periods of time.

Social Insurance

Reasons for Social Insurance:

• To help solve complex social problems.
• To provide coverage for perils that are difficult to insure privately.
• To provide a base of economic security to the population.

Basic Characteristics of Social Insurance:

• Most programs are compulsory.
• Programs are designed to provide a floor of income.
• Programs pay benefits based on social adequacy rather than individual equity.