The Risk Management Decision—Return to the Example

Dana, the risk manager of Energy Fitness Centers, also uses a risk management matrix to decide whether or not to recommend any additional loss-control devices. Using the data in Table 4.3 "Net Present Value (NPV) of Workers’ Compensation Premiums Savings for Energy Fitness Centers When Purchasing Innovative Safety Belts for $50,000" and Figure 4.3 "Workers’ Compensation Frequency and Severity of Energy Fitness Centers—Actual and Trended", Dana compared the forecasted frequency and severity of the worker’s compensation results to the data of her peer group that she obtained from the Risk and Insurance Management Society (RIMS) and her broker. In comparison, her loss frequency is higher than the median for similarly sized fitness centers. Yet, to her surprise, EFC’s risk severity is lower than the median. Based on the risk management matrix she should suggest to management that they retain some risks and use loss control as she already had been doing. Her cost-benefit analysis from above helps reinforce her decision. Therefore, with both cost-benefits analysis and the method of managing the risk suggested by the matrix, she has enough ammunition to convince management to agree to buy the additional belts as a method to reduce the losses.

To understand the risk management matrix alternatives, we now concentrate on each of the cells in the matrix.

Risk Transfer—Insurance

The lower-left corner of the risk management matrix represents situations involving low frequency and high severity. Here we find transfer of riskDisplacement of risk to a third, unrelated party.—that is, displacement of risk to a third, unrelated party—to an insurance company. We discuss insurance—both its nature and its operations—at length in Chapter 6 "The Insurance Solution and Institutions" and Chapter 7 "Insurance Operations". In essence, risk transference involves paying someone else to bear some or all of the risk of certain financial losses that cannot be avoided, assumed, or reduced to acceptable levels. Some risks may be transferred through the formation of a corporation with limited liability for its stockholders. Others may be transferred by contractual arrangements, including insurance.

Corporations—A Firm

The owner or owners of a firm face serious potential losses. They are responsible to pay debts and other financial obligations when such liabilities exceed the firm’s assets. If the firm is organized as a sole proprietorship, the proprietor faces this risk. His or her personal assets are not separable from those of the firm because the firm is not a separate legal entity. The proprietor has unlimited liability for the firm’s obligations. General partners in a partnership occupy a similar situation, each partner being liable without limit for the debts of the firm.

Because a corporation is a separate legal entity, investors who wish to limit possible losses connected with a particular venture may create a corporation and transfer such risks to it. This does not prevent losses from occurring, but the burden is transferred to the corporation. The owners suffer indirectly, of course, but their loss is limited to their investment in the corporation. A huge liability claim for damages may take all the assets of the corporation, but the stockholders’ personal assets beyond their stock in this particular corporation are not exposed to loss. Such a method of risk transfer sometimes is used to compartmentalize the risks of a large venture by incorporating separate firms to handle various segments of the total operation. In this way, a large firm may transfer parts of its risks to separate smaller subsidiaries, thus placing limits on possible losses to the parent company owners. Courts, however, may not approve of this method of transferring the liability associated with dangerous business activities. For example, a large firm may be held legally liable for damages caused by a small subsidiary formed to manufacture a substance that proves dangerous to employees and/or the environment.

Contractual Arrangements

Some risks are transferred by a guarantee included in the contract of sale. A noteworthy example is the warranty provided a car buyer. When automobiles were first manufactured, the purchaser bore the burden of all defects that developed during use. Somewhat later, automobile manufacturers agreed to replace defective parts at no cost, but the buyer was required to pay for any labor involved. Currently, manufacturers typically not only replace defective parts but also pay for labor, within certain constraints. The owner has, in effect, transferred a large part of the risk of purchasing a new automobile back to the manufacturer. The buyer, of course, is still subject to the inconvenience of having repairs made, but he or she does not have to pay for them.

Other types of contractual arrangements that transfer risk include leases and rental agreements, hold-harmless clauses“A Hold Harmless Agreement is usually used where the Promisor’s actions could lead to a claim or liability to the Promisee. For example, the buyer of land wants to inspect the property prior to close of escrow, and needs to conduct tests and studies on the property. In this case, the buyer would promise to indemnify the current property owner from any claims resulting from the buyer’s inspection (i.e., injury to a third party because the buyer is drilling a hole; to pay for a mechanic’s lien because the buyer hired a termite inspector, etc.). Another example is where a property owner allows a caterer to use its property to cater an event. In this example, the Catering Company (the “Promisor”) agrees to indemnify the property owner for any claims arising from the Catering Company’s use of the property.” From Legaldocs, a division of U.S.A. Law Publications, Inc., http://www.legaldocs.com/docs/holdha_1.mv. and surety bonds.A surety bond is a three-party instrument between a surety, the contractor, and the project owner. The agreement binds the contractor to comply with the terms and conditions of a contract. If the contractor is unable to successfully perform the contract, the surety assumes the contractor’s responsibilities and ensures that the project is completed. Perhaps the most important arrangement for the transfer of risk important to our study is insurance.

Insurance is a common form of planned risk transfer as a financing technique for individuals and most organizations. The insurance industry has grown tremendously in industrialized countries, developing sophisticated products, employing millions of people, and investing billions of dollars. Because of its core importance in risk management, insurance is the centerpiece in most risk management activities.

Risk Assumption

The upper-left corner of the matrix in Table 4.4 "The Traditional Risk Management Matrix (for One Risk)", representing both low frequency and low severity, shows retention of risk. When an organization uses a highly formalized method of retention of a risk, it is said the organization has self-insured the risk. The company bears the risk and is willing to withstand the financial losses from claims, if any. It is important to note that the extent to which risk retention is feasible depends upon the accuracy of loss predictions and the arrangements made for loss payment. Retention is especially attractive to large organizations. Many large corporations use captives, which are a form of self-insurance. When a business creates a subsidiary to handle the risk exposures, the business creates a captive. As noted above, broadly defined, a captive insurance company is one that provides risk management protection to its parent company and other affiliated organizations. The captive is controlled by its parent company. We will provide a more detailed explanation of captives in Chapter 6 "The Insurance Solution and Institutions". If the parent can use funds more productively (that is, can earn a higher after-tax return on investment), the formation of a captive may be wise. The risk manager must assess the importance of the insurer’s claims adjusting and other services (including underwriting) when evaluating whether to create or rent a captive.

Risk managers of smaller businesses can become part of a risk retention groupA group that provides risk management and retention to a few players in the same industry who are too small to act on their own..President Reagan signed into law the Liability Risk Retention Act in October 1986 (an amendment to the Product Liability Risk Retention Act of 1981). The act permits formation of retention groups (a special form of captive) with fewer restrictions than existed before. The retention groups are similar to association captives. The act permits formation of such groups in the U.S. under more favorable conditions than have existed generally for association captives. The act may be particularly helpful to small businesses that could not feasibly self-insure on their own but can do so within a designated group. How extensive will be the use of risk retention groups is yet to be seen. As of the writing of this text there are efforts to amend the act. A risk retention group provides risk management and retention to a few players in the same industry who are too small to act on their own. In this way, risk retention groups are similar to group self-insurance. We discuss them further in Chapter 6 "The Insurance Solution and Institutions".

Risk Reduction

Moving over to the upper-right corner of the risk management matrix in Table 4.4 "The Traditional Risk Management Matrix (for One Risk)", the quadrant characterized by high frequency and low severity, we find retention with loss control. If frequency is significant, risk managers may find efforts to prevent losses useful. If losses are of low value, they may be easily paid out of the organization’s or individual’s own funds. Risk retention usually finances highly frequent, predictable losses more cost effectively. An example might be losses due to wear and tear on equipment. Such losses are predictable and of a manageable, low-annual value. We described loss control in the case of the fitness center above.

Loss preventionEfforts that seek to reduce the probability of a loss occurring. efforts seek to reduce the probability of a loss occurring. Managers use loss reductionEfforts to lessen loss severity. efforts to lessen loss severity. If you want to ski in spite of the hazards involved, you may take instruction to improve your skills and reduce the likelihood of you falling down a hill or crashing into a tree. At the same time, you may engage in a physical fitness program to toughen your body to withstand spills without serious injury. Using both loss prevention and reduction techniques, you attempt to lower both the probability and severity of loss.

Loss prevention’s goal seeks to reduce losses to the minimum compatible with a reasonable level of human activity and expense. At any given time, economic constraints place limits on what may be done, although what is considered too costly at one time may be readily accepted at a later date. Thus, during one era, little effort may have been made to prevent injury to employees, because employees were regarded as expendable. The general notion today, however, is that such injuries are prevented because they have become too expensive. Change was made to adapt to the prevailing ideals concerning the value of human life and the social responsibility of business.

Risk Avoidance

In the lower-right corner of the matrix in Table 4.4 "The Traditional Risk Management Matrix (for One Risk)", at the intersection of high frequency and high severity, we find avoidance. Managers seek to avoid any situation falling in this category if possible. An example might be a firm that is considering construction of a building on the east coast of Florida in Key West. Flooding and hurricane risk would be high, with significant damage possibilities.

Of course, we cannot always avoid risks. When Texas school districts were faced with high severity and frequency of losses in workers’ compensation, schools could not close their doors to avoid the problem. Instead, the school districts opted to self-insure, that is, retain the risk up to a certain loss limit.Etti G. Baranoff, “Determinants in Risk-Financing Choices: The Case of Workers’ Compensation for Public School Districts,” Journal of Risk and Insurance, June 2000.

Not all avoidance necessarily results in “no loss.” While seeking to avoid one loss potential, many efforts may create another. Some people choose to travel by car instead of plane because of their fear of flying. While they have successfully avoided the possibility of being a passenger in an airplane accident, they have increased their probability of being in an automobile accident. Per mile traveled, automobile deaths are far more frequent than aircraft fatalities. By choosing cars over planes, these people actually raise their probability of injury.