CHAPTER 4
TECHNIQUES FOR DEALING WITH RISK
Prepared by : Kashif Abbass

RM TOOLS (Techniques)
• A.Risk Control
 1. Avoidance
 2. Reduction
• B. Risk Financing
 1. Retention
 2. Transfer

A. Risk Control
• Broadly defined, risk control encompasses all techniques
aimed at reducing the number of risks facing the
organization or the amount of loss that can arise from these
exposures.
• Risk control includes risk avoidance and risk reduction.

1. Risk Avoidance
 Risk avoidance simply means that an individual can evade
certain risks merely by staying away from the risk that one
chooses not to incur. Technically, avoidance takes place
when decisions are made that prevent a risk from even
coming into existence.
 Risks are avoided when one refuses to accept the risk even
for an instant.

Risk Avoidance
For example:
• a firm that considers manufacturing some product
but, because of the hazards involved, elects not to
do so
• An individual will not die in a plane crash if the
individual chooses not to fly.
• An individual will not be arrested for drunk driving, if
the individual does not drink and drive

Risk Avoidance
 it is a negative rather than a positive approach.
If avoidance is used extensively, the firm may not be
able to achieve its primary objectives.
Risk avoidance should be used in those instances in
which the exposure has catastrophic potential and
cannot be reduced or transferred.
 Generally, these conditions will exist in the case of risks for
which both the frequency and the severity are high.

Risk Avoidance
• Appropriate when there is potential for catastrophic loss
Adv
 Do not face loss at all
Disadv
 Not practical
 Not all losses can be avoided

2. Risk Reduction
• The term risk reduction is used to define a broad set of efforts aimed at
minimizing risk.
Other terms that were formerly used, and which have been
displaced by the more generic term "risk reduction" include "loss
prevention" and "loss control.”
The term "risk reduction" is considered to include both loss
prevention and loss control efforts.
Common examples of risk reduction would include the installation
of dead bolt locks, or the use of smoke detectors in a home.

Risk Reduction
• Broadly speaking, "loss prevention" efforts are
aimed at preventing the occurrence of loss.
In addition, "loss control" efforts can be directed toward
reducing the severity of those losses that do occur.
In other words, some risk control efforts aim at reducing
frequency, others seek to reduce the severity of the
losses that do occur.

• Risk Prevention (Loss prevention)
– Efforts to reduce the frequency of loss
– Pre-Loss objective
– Ex: Frequent inspection, training (safe
procedures)
• Risk Reduction (loss control)
– Efforts to reduce the severity of loss
– Post-loss objective
– Ex: Fire drill, Sprinkler System, Smoke
Detector, First-Aid kit

B. Risk Financing
• Risk financing consists of those techniques designed to guarantee the
availability of funds to meet those losses that do occur.
 Risk financing takes the form of retention or transfer.
 All risks that cannot be avoided or reduced must, by definition, be
transferred or retained.
 Transfer and retention are used in combination for a particular risk,
with a portion of the risk retained and a part transferred.

1. Risk Retention
• Risk retention is the "residual" or "default" risk management
technique, exposures that are not avoided, reduced, or transferred
are retained.
• The retention of risk means that an individual chooses to self-fund
any losses that may be incurred
• When nothing is done about a particular exposure, the risk is
retained.
• Applied when
• Risk can’t be avoided
• Low severity and frequency can be estimated

Risk Retention
• For example, an individual may chose a deductible of $1,000 on their
automobile insurance coverage. This indicates that the individual is
prepared to personally pay the first $1,000 of damage incurred in an
auto accident.
• Risk Retention Techniques Classified
- Active retention
- Passive retention

Retention
• Advantages
 Save on premium loading
 Investment income
 Encourage risk control
 Flexibility
• Disadvantages
 Possibility of higher losses
 Risk management expenses

2. Risk Transfer
• The transfer of risk simply means that individuals who are
unable, or unwilling, to bear a particular loss may transfer this
uncertainty to a third party, who is prepared to accept the risk
• Risk transfer is accomplished in a variety of ways
1. Insurance transfer
Purchase of insurance is a primary means of risk transfer.
2. Non – Insurance transfer

Non-Insurance Risk Transfer
• Methods other than insurance by which a pure risk and its potential
financial consequences are transferred to another party
 Hedging
 Hold harmless agreements
 Contract
 Subcontracting certain activities
 Leases

Risk Sharing
• Risk sharing is sometimes cited as an additional
way of dealing with risk.
Risk sharing may be viewed as a special case of risk
transfer and risk retention.
The risk of the individual is transferred to the group.
The risks of a number of individuals are retained
collectively.

Insurance
• Definition 1
Insurance may be defined as a contract in which one
person pays money, which is called a premium, to a
second party, known as the insurer, who promises to
reimburse the individual for specified losses, should
these losses occur. Insurance is a way to distribute
losses and eliminate uncertainty. Insurance can be
thought of as the reverse of gambling.

Definition 2
The pooling of fortuitous losses by transfer of such
risks to insurers in exchange of a premium. The
insurer agrees to indemnify insured for covered
losses, to provide other pecuniary benefits on their
occurrence, or to render services connected with the
risk.

Insurance
• The concept of insurance is relatively simple. People who
face potential losses band together to establish a fund with
which to compensate those who actually experience
disaster. The principle of risk sharing is applied when large
numbers of people pay a regular fee, which is known and
therefore certain, in exchange for protection against a
hazard that is uncertain.

Insurance
• The premium paid by individuals is composed of the pure
cost of insurance plus a loading charge, with the loading
charge representing the insurer's costs including a profit.
• The pure cost of insurance is dependent upon three
factors:
 the probability of the event occurring,
 the cost of the compensation, and
 the number of individuals sharing the risk.

Insurance
• Advantages
– Reduce uncertainty
– Compensation is confirmed
– Risk management services
– Premium is tax deductible
• Disadvantages
– Premium is high
– Not all risk is insurable
– Less incentive for loss control
– Difficult to get coverage

Noninsurance Risk Transfer
• Adv
– Risk is transferred
– Low cost
• Disadv
– Ambiguous contract
– Inability to pay

Other techniques
– Duplication
– Separation
– Diversification

Non Traditional Risk Financing
• Also known as Alternative Risk Transfer (ART)
• Characteristics:
- Involves a high level of retention
- covers multiple years
- provides coverage for multiple sources of risk
- provides sources of risk that are not offered by
traditional insurance

ART Methods
• Loss sensitive contract
• Finite risk contract
• Captive insurer

Loss Sensitive Contract
• Insurer assumes less risks but policyholder assumes
large portion of risk
• An experience rated policy vs retro policy

Finite Risk Contract
• Multiple year loss sensitive contract
• A finite risk contract spreads risks across time
Adv
• Protection against the timing of loss exposure.
• Systematic cash accumulation to finance loss.
• Premium payment is tax deductible item.
• Cash flow stabilisation

Captive Insurer
A captive insurer is a wholly owned insurance company
subsidiary formed by a parent company for the main
purpose of providing insurance protection to finance the
losses retained by the parent company in a formal
structure.

Types of Captive Insurer
• Pure captive insurer vs group captive insurer
• Onshore vs offshore

Motivations of establishing a captive
• Tax advantage of insurance
• Parent company can purchase excess policy directly
from its captive
• Retain a large portion of its risk
• Reduce the risk exposure
• Profit center
• Provide coverage that is not available in the market.