1. INTRODUCTION TO RISK
MANAGEMENT
Lectured by:
Zulfiqar Shams
Adjunct Faculty

2. OUTLINE: LECTURE 01
 Risk: Definitions
 Introduction to Risk Management
 Objectives of Risk Management
 Risk Management Process
 Benefits of Risk Management Program
 Classification of Risk
 Enterprise Risk Categories
 Value of Risk Management

3. RISK: DEFINITIONS
• There is no single definition of risk. Economists, behavioral scientists, risk theorists, statisticians, actuaries, and
historians each have their own concept of risk.
• Traditional Definition of Risk:
• Risk traditionally has been defined in terms of uncertainty. Based on this concept, risk is defined as:
“uncertainty concerning the occurrence of a loss.”
• Risk Distinguished from Uncertainty
• In the economics and finance literature, authors and actuaries often make a distinction between risk and
uncertainty.
• According to the American Academy of Actuaries, the term
“risk is used in situations where the probabilities of possible outcomes are known or can be estimated with some degree of
accuracy, whereas uncertainty is used in situations where such probabilities cannot be estimated.”

4. INTRODUCTION TO RISK
MANAGEMENT
 Risk management is a process that identifies loss exposures faced by an
organization and selects the most appropriate techniques for treating such exposures.
 A loss exposure is any situation or circumstance in which a loss is possible,
regardless of whether a loss actually occurs.
 Financial risk is distinguished into the following classifications:
“The essence of risk management lies in
maximizing the
areas where we have some control over the
outcome while
minimizing the areas where we have absolutely no
control
over the outcome.”
Peter L. Bernstein
Against the Gods: The Remarkable Story of Risk
Basic risk; Liquidity risk;
Capital risk; Operations risk;
Country risk; Payment framework risk;
Default risk; Political risk;
Delivery risk; Refinancing risk;
Economic risk; Reinvestment risk;
Exchange rate risk; Settlement risk;
Interest rate risk; Sovereign risk; and
Underwriting risk.

5. OBJECTIVES OF RISK
MANAGEMENT
 Risk management has important objectives. These objectives can be classified as
follows:
■■ Pre-loss objectives
■■ Post-loss objectives
Pre-Loss Objectives:
First The first objective means that the firm should prepare for
potential losses in the most economical way.
Second The second objective is the reduction of anxiety.
Third The final objective is to meet any legal obligations.

6. OBJECTIVES OF RISK
MANAGEMENT
 Risk management has important objectives. These objectives can be classified as
follows:
■■ Pre-loss objectives
■■ Post-loss objectives
Post-Loss Objectives:
First The most important post-loss objective is survival of the
firm.
Second The second post-loss objective is to continue operating.
Third The third post-loss objective is stability of earnings.
Fourth The fourth post-loss objective is continued growth of the
firm.
Fifth Finally, the objective of social responsibility is to
minimize the effects that a loss will have on other

7. RISK MANAGEMENT PROCESS

8. TECHNIQUES FOR TREATING LOSS
EXPOSURE
 Techniques can be classified broadly as either risk control or risk financing:
 Risk control refers to techniques that reduce the frequency or severity of losses.
 Risk financing refers to techniques that provide for the funding of losses.
 Risk managers typically use a combination of techniques for treating each loss exposure.
 Risk Control Strategies:
 Avoidance means a certain loss exposure is never acquired or undertaken, or an existing loss exposure is
abandoned.

9. TECHNIQUES FOR TREATING LOSS
EXPOSURE
 Risk Control Strategies:
 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.
Duplication refers to having back-ups or copies of important documents or property
available in case a loss occurs.
Separation means dividing the assets exposed to loss to minimize the harm from a single
event.
Diversification refers to reducing the chance of loss by spreading the loss exposure across
different parties (e.g., customers and suppliers), securities (e.g., stocks and bonds), or
transactions.

10. TECHNIQUES FOR TREATING LOSS
EXPOSURE
 Risk Financing Strategies:
 Retention means that the firm retains part or all of the losses that can result from a given
loss.
 Can be active or passive; Active retention means Active risk retention means that the firm is aware of the loss exposure
and consciously decides to retain part or all of it. For example, a risk manager may decide to retain physical damage
losses to a fleet of company cars.
 Passive retention, however, is the failure to identify a loss exposure, failure to act, or forgetting to act. For example, a
risk manager may fail to identify all company assets that could be damaged in an earthquake.
 Mostly used when:
 No other method of treatment is available.
 The worst possible loss is not serious.
 Losses are fairly predictable

11. TECHNIQUES FOR TREATING LOSS
EXPOSURE
 Risk Financing Strategies:
 Advantages of Retention:
■■ Save on loss costs. 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.
■■ Save on 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, risk control expenses, taxes and
fees, and the insurer’s 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 some of the
funds that normally would be paid to the insurer at the beginning of the policy period.

12. TECHNIQUES FOR TREATING LOSS
EXPOSURE
 Risk Financing Strategies:
 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 and claims administrators may have to be hired. Insurers may be able to
provide risk control and claim services at a lower cost.
■■ 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 deductible.

13. TECHNIQUES FOR TREATING LOSS
EXPOSURE
 Risk Financing Strategies:
 Noninsurance transfers are methods other than insurance by which a pure risk and
its potential financial consequences are transferred to another party. Examples of
noninsurance transfers include contracts, leases, hold-harmless agreements, and
incorporation of a business.
 Noninsurance transfers have several advantages:
■■ The risk manager can transfer some potential losses that are not commercially insurable.
■■ Noninsurance transfers often cost less than insurance.
■■ The potential loss may be shifted to someone who is in a better position to exercise loss control.

14. TECHNIQUES FOR TREATING LOSS
EXPOSURE
 Risk Financing Strategies:
 However, noninsurance transfers have several disadvantages:
■■ The transfer of potential loss may fail because the contract language is ambiguous. Also,
there may be no court precedents for the interpretation of a contract tailor-made to fit the
situation.
■■ If the party to whom the potential loss is transferred is unable to pay the loss, the firm is
still responsible for the claim.
■■ An insurer may not give credit for the transfers, and insurance costs may not be reduced.

15. TECHNIQUES FOR TREATING LOSS
EXPOSURE
 Risk Financing Strategies:
 Commercial insurance is also used in a risk management program. Insurance is
appropriate for loss exposures that have a low probability of loss but the severity of loss is
high.
If the risk manager uses insurance to treat certain loss exposures, five key areas must be
emphasized:
■■ Selection of insurance coverages
■■ Selection of an insurer
■■ Negotiation of terms
■■ Dissemination of information concerning insurance coverages
■■ Periodic review of the insurance program

16. BENEFITS OF RISK MANAGEMENT
PROGRAM
 Businesses may have following benefits if they have effective risk
management program:
■■ A formal risk management program enables a firm to attain its pre-loss and post-loss
objectives more easily.
■■ The cost of risk is reduced, which may increase the company’s profits. The cost of risk is
a risk management tool that measures the costs associated with treating the organization’s
loss exposures. These costs include insurance premiums paid, retained losses, loss control
expenditures, outside risk management services, financial guarantees, internal administrative
costs, and taxes, fees, and other relevant expenses.
■■ Because the adverse financial impact of pure loss exposures is reduced, a firm may be
able to implement 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.

17. CLASSIFICATION OF RISK
 Classification of Risk
Risk can be classified into several distinct classes. The most important include the following:
■■ Pure and speculative risk
■■ Diversifiable risk and non-diversifiable risk
■■ Enterprise risk
■■ Systemic risk

18. ENTERPRISE RISK CATEGORIES

19. VALUE OF RISK MANAGEMENT
 Risk management improves the management system of a company, and a value is
added through financial risk management.