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Risk Management Concepts

Chapter · January 1998
DOI: 10.1007/978-1-4615-6187-3_4

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 RISK MANAGEMENT 4
CONCEPTS

Objective
This chapter explains the objective of risk management and describes the
framework in which financing decisions including insurance are taken and
evaluated. Many of these concepts important in business risk management are
also applicable to individual economic agents.

The Evolution of Risk Management

In an originally french published book in 1916, Henry Fayol identified risk
management as a security function among the six basic functions of a business
firm.1 In 1931, the American Management Association established its Insurance
Division for exchanging information among members. In 1950 the National
Insurance Buyers Association was created which became in 1955 the American
Society of Insurance Management (ASIM). In 1969 the name of the society's
magazine was changed from the National Insurance Buyers to Risk Management
and in 1975 the name of the Society was changed to the Risk and Insurance
Management Society (RIMS).2
Risk management has been re-discovered by multinational firms in the
United States after World War II. The general trend in the current usage of risk
management probably began in the early 1950s. One of the earliest reference to
the concept of risk management in the literature appeared in an article by Russel
Callagher in the Harvard Business Review in 1956.3
In October 1988 the first world congress on risk management was sponsored
by the International Federation of Risk and Insurance Management Associations
(IFRIMA). Today, the Association has 22 members around the world. The latest
national association were created at the end of the 1980s in Singapore, Malaysia
and the Philippines.
 2

The risk manager evolved from the insurance manager because risk
management is broader than insurance in that it deals with the choice of the
appropriate techniques for dealing with pure risks including insurance. Felix
Kloman argued recently that "organizations have been challenged by newer and
more dynamic risks, risks that have not been addressed effectively by the risk
management that is tied to the insurance industry." 4 His argument is that risks in
an organization are closely interrelated and that the risk management function
should address all risks in a comprehensive approach.
Despite its potential and scope, risk management is not yet recognized as a
major element of corporate organizations. The approach of analyzing specific
industry uncertainties in isolation from general environmental uncertainties has
come more often under criticism. It is also arguable that to confine risk
management only to handling pure risks is too restrictive a view of its function
since pure risks are inevitably intermingled with decisions bearing on business
risks. An integrated managerial approach should analyze all the sources of
uncertainties that affect the total risk of a firm.

The Objective of Risk Management

According to asset pricing models in Finance, the risks specific to a firm are
diversifiable and therefore irrelevant except as it affects the firm's systematic risk.
However, corporations are majors purchasers of insurance and financial futures
and forward contracts, sign long-term purchase and sales contracts, and engage
in a variety of activities to avoid or reduce risks. One explanation of this behavior
is that asset pricing models are concerned only with the effect of risk on market
discount rates and for the most part ignore its effect on expected cash-flows.
Value of firm = ∑[ Cash Flows at period t / ( 1+k) t ]
where k is the market discount rate.

Property losses are often not the only losses that occur when property is
damaged or destroyed. Until that property is replaced or restored to its initial
condition, the business may suffer a reduction in its net income either because
revenues are decreased or because expenses are increased or both. Any action
taken by a firm that decreases risks, improves its prospects for survival and
provides greater assurance to potential customers that the company will be around
in the future to service and upgrade its products. 5
Obviously, the relative importance of risk management activities will vary
according to the corporation ownership. The existence of other claims, such as
those of employees and suppliers, creates incentive for risk management.6 In the
following discussion, the management is willing to take any action to reduce the
preloss fire hazard and the postloss consequences.
 3

DISCUSSION:
Suppose that 3 toys manufacturers, YOTOYS, B.S.TOY and
ZODI are sharing the same closed market and that a fire
destroys the total inventories of toys of ZODI on November
20th. Because of delays in the production, ZODI will be unable
to supply the market for Christmas and the two competitors will
mainly benefit from this situation.
At the end of the year, ZODI will report losses
whereas YOTOYS and B.S.TOY will enjoy unexpected higher
profits. An investor holding a diversified portfolio of stocks of
the three companies will be almost unaffected by the event (
assuming there is no tax effect ).
On the other hand the lenders and bondholders may
become concern about the future of the firm because they have
prior claim to shareholders on the firm's revenues. They may
expect a relative stability of revenues. Statistics show a number
of firms going bankrupt after a major fire. Similarly there is in
this case a conflict of interest between the owners of the firm
and the managers and workers, because the later want to ensure
their own survival.

The Survival Objective

After the disaster at the Union Carbide plant in Bhopal, India that occurred in
December 1984 and killed or injured thousands of individuals, the price of the
stock on the market dropped by 40% overnight. The company's reputation came
under intense attack by the news media worldwide and the accident threatened
Union Carbide's survival. Institutional ownership of the company stock dropped
from 60 percent to 35 percent. In the second half of 1985, to avoid takeover by
GAF corporation, Union Carbide was forced to take a series of cost-cutting
measures. Some plants were closed and Carbide had to sell its profitable
consumer products division.
Professors Robert Mehr and Bob Hedges in their risk management text have
classified the objectives in risk management as postloss and preloss. Survival is
often considered as the most important objective of a firm. The other possible
objectives include (1) the continuity of operations, (2) the stability of earnings
and preservation of growth, and (3) a good public image. They also explained
how risk management activities inevitably reflect the anxiety level of the
 4

managers and are directed toward specific goals and objectives, for example, a
"quiet night's sleep" may be one of the managerial objectives.
Because the management of a firm is often directly concerned with problems
of injury or damage to employees and to the public in general, social
responsibility or "good citizenship" is important. Mehr and Hedges argued "If
results after a loss are a matter of indifference, no reason remains to consider the
loss before it happens." 7 On the other hand, a firm may not be prepared to take
a chance of polluting a river even though it may be able to accept the risk and its
financial consequences. Similarly, any airline company places great emphasis on
its safety record and prefer to avoid adverse publicity.
Risk management is a specialized aspect of the overall financial management
of an enterprise. The objectives must be consistent with the financial objectives
and as in other financial management problems, alternatives are evaluated by
considering their potential financial advantages and risks.
While the objective of management in general is the conservation of assets
and the maximization of the wealth of the shareholders, the objective of risk
management is to make sure that losses that arise because of existing risks do not
prevent management from meting its goal. Although risk management principles
and procedures are applicable to a wide variety of problems, they are generally
limited to the problems that arise from the existence of pure and static risks.
Since risk management does not generate revenues, in the traditional sense
of the term, the evaluation of alternative programs will be made on comparative
costs. The objective of risk management has frequently been stated as the
"minimization of costs".

Methods of Handling Risks

It must be recognized that risk management is still in a development state. Willett
considered that the ways of meeting risk for "a man in isolation" or a business
firm, could be classified into avoidance, prevention and assumption. Then, he
explained that "a man living in society" had the same opportunities but that he
could also consider other courses of action such as distribution, transfer and
combination of risks.
Risk management like other areas of management, is concerned with
establishing or identifying objectives, gathering relevant information regarding
the nature of the problem and the environment, evaluating the costs and benefits
of alternatives using modern analytical techniques, and choosing the alternative
that is most consistent with the goals and objectives.
Doherty (1982) suggests that the risk management process can be represented
in terms of the responses to the following questions:
1. What is the problem? (identification)
2. What is the magnitude of the problem? (measurement)
3. What can be done about the problem? (decision)
 5

The Risk Management Process

Hazard (or Risk) Identification

One of the most critical functions of risk management is probably the
identification process. A failure to recognize the existence of one or more
potential events can result in financial disaster. The importance of being able to
anticipate the existence of the problem before it materializes is recognized by
everyone but unfortunately there is no scientific method or systemic approach to
the identification process. In the extreme case, the very existence of the risk may
be unknown. In the past, exposure identification has largely been exercised in
terms of those exposures that are insurable and in terms of the company past
experience. The most difficult part of the identification process is that it requires
that the manager be clairvoyant and continually asks "what if" questions.
Williams and Heins (1989) define risk identification as "the process by which
a business systematically and continuously identifies property, liability and
personnel exposures as soon as or before they emerge." 8
Several approaches to the identification process have been suggested and
most of them consist of an evaluation of all the operational characteristics of the
firm. Checklists of potential risks have been developed by risk management
associations, risk management consulting firms or insurance companies and they
are mainly based on a questionnaire approach. On-site inspections are usually an
indispensable complement to a questionnaire.
Other approaches have been suggested based on flow-chart methods,
financial-statement methods or contracts analysis.9 Professor John O'Connell has
identified four components in a systematic approach to identifying the exposures
of a particular firm: (1) customers, (2) suppliers, (3) competitors and (4)
regulators.10 The greatest difficulties for the identification function have
probably occurred in the recent past in the area of legal liabilities.
Job or position analysis is another area for risk identification. In dealing with
job description, manpower management enumerates the duties of an employee,
analyzes how the functions are performed and should also identify potential
dangers to the employee or the organization. The Taylorism focused attention on
the man and machine relations. Frederick Taylor's emphasis upon the physical
environment of the job points out a natural area of interest to risk identification.11

Risk Measurement
Once the risks have been identified, the risk manager must evaluate them. The
process of creating data is known as measurement. This means measuring the
potential size of the loss and the probability that it is likely to occur. Information
is needed concerning two dimensions of each risk exposure:
 6

(1) the frequency of occurrence and

(2) the severity of the losses that will occur.

Information is collected for the purpose of description of a phenomena,

evaluation and prediction. It is usually desirable to summarize the data by
preparing frequency distributions. The presentation of data can bring a very useful
information on the causes or consequences of a phenomena. Table 4.1 gives an
example of the causes of accidental deaths in India.
One difficulty that is encountered in the measurement process is that an event
may give rise to both direct and indirect costs. Direct losses involve the direct
costs associated with (1) property exposures, i.e. replacing or repairing damaged
or destroyed property, (2) liability exposures and (3) personnel exposures,
expenses resulting from death, injury or sickness. Indirect losses are those that
arise as a consequence of direct losses.

Risk Assessment
Loss-frequency and loss-severity data do more than identify the important losses.
They are also extremely useful in determining the way to handle the situation.
Risk assessment aims to determine how serious a hazard is and whether
individuals or the society should be exposed to it. One aspect to the idea of risk
measurement relates to the basic premise that the ability to predict the outcome
of a risk is critically dependent upon the quantity and reliability of information
relating to the phenomenon that is being investigated. In some cases, however,
the uniqueness of the situation is such that it is difficult to measure and hence to
assess the risk.
In all risky situations, there are three important determinants which are
information, control and time. Crisis management often refers to the lack of
time to assess the risk and take a decision. Lack of control and/or lack of
information about the risk in a crisis management situation are also usually the
rule.
Despite an appearance of objectivity, risk assessment is inherently
subjective. The motion picture "Jaws", has increased the availability (and
perceived likelihood) of sharks attacks. Some nuclear power proponents feel that
the risk of that technology are exaggerated in the public' eye because of excessive
medium coverage. Fischhoff et al.(1981) consider that the acceptability of a risk
is a relative concept rather than an absolute one and therefore, there can be no
single, all-purpose number that expresses the acceptable risk for a group or a
society.
 7

Table 4.1
Incidence of Accidental Deaths in India
Classified According to Causes During 1982
Causes of Number Percentage to
Accidental Deaths total Number

A. Natural Causes

Lighting 1,754 1.4

Heat Strokes 492 0.4
Floods 699 0.6
Land Slides 596 0.5
Cold and Exposure 391 0.3
Cyclone 505 0.4

B. Other Causes

By Fire Arms 1,874 1.5

By Explosion 356 0.3
By House Collapse 1,157 0.9
On Road 22,199 17.6
In Factories 735 0.6
In Mines/Quarry Disaster 624 0.5
In Railways 12,789 10.1
In Air Crashes 102 0.1
By Boat Capsize 161 0.1
By Fire 14,555 11.6
By Drowning 22,632 18.0
By Poisoning 6,864 5.4
By Snake Biting 3,299 2.6
By Animal Killing/Biting 1,437 1.1
Miscellaneous Causes 32,790 26.0

TOTAL 125,993 100.0

Source: Accidental Deaths and Suicides in India, Bureau of Police Research

and Development, Ministry of Home Affairs, 1982.
 8

DISCUSSION:
In 1982 in the Chicago area, several bottles of Tylenol capsules,
a pain remedy, contained cyanide that caused the death of seven
people. There was little information about what was happening
and what was causing it? Was the problem a local problem
only?
Johnson and Johnson, the pharmaceutical company,
had inadequate control of the situation and action had to be
taken immediately. J&J decided to recall and test all Tylenol
capsules in Chicago and to test samples from other marketing
areas (a total of 31 million bottles).
Three months after the tragedy had begun, J&J
announced to the public that Tylenol products were being
distributed in a new "tamper-resistant" package that had three
safety features: 1) A cellophane wrap on the box, 2) The cap is
sealed with a plastic ring and, 3) The bottle is foil sealed.
Despite losing most of its very large 35% share of the market
of pain remedy (an estimated $100 millions in losses), within
one year the product had bounced back to over 25%.

Risk perception differs greatly according to personal experience, but also

psychological anxieties of a subjective nature. For example Cohen (1964) found
that English football players tended to overestimate their abilities to score a goal
from a long distance but underestimate their abilities to score from a short
distance. Usually the level of perceived risk drops when the event has become
"acceptable" in society. Furthermore, risk perception is linked to the
appropriateness of a technical solution. 12
Availability bias is illustrated in numerous studies in which subjects are
asked to judge potential hazards or risky situations. Contemporary issues in risk
analysis have look at public perceptions, determinants of "perceived risks" and
what makes a risk "acceptable".13 An interesting series of studies on perceived
risks have been done by Professors Fischoff, Lichtenstein and Slovic, at the
University of Oregon, USA. For example, to determine perceived risk, subjects
were ask to judge the annual frequencies of death from each of 41 causes,
including diseases, accidents, homicide, suicide and natural hazards. Table 4.2
lists the causes whose frequencies were most seriously misjudged. Overestimated
death rates are the well-publicized causes of death such as botulism, tornadoes
and flood. People underestimate chronic causes that are unspectacular,
undramatic or events that are common in non-fatal form.
 9

Table 4.2
Bias in Judged Frequency of Death

Most Overestimated Most Underestimated

Motor vehicle accidents Diabetes

Pregnancy, Childbirth, Abortion Stomach cancer
Tornadoes Lightning
Flood Stroke
Botulism Tuberculosis
Homicide Asthma

Source: Lichtenstein S., Slovic , P., Fischhoff, B., Layman , M. and Combs, B.,
"Judged Frequency of Lethal Events," Journal of Experimental Psychology:
Human Learning and Memory, vol. 4, 1978, pp. 551- 578.
See also Slovic, P., Fischhoff, B. and S. Lichtenstein, "Facts and Fears:
Understanding Perceived Risks," in R.C. Schwing and W.A. Albers (Eds.)
(1980) for an extended analysis.

Risk may be avoided: Risk is avoided when an individual economic agent

refuses to take an action that gives rise to the risk. This is not possible in many
situations and very unsatisfactory at the level of the society.
Avoidance through abandonment is much less common but it does occur
when a loss provides a suitable opportunity for abandoning the investment. Once
an investment has been made, incurred costs become sunk costs and are no longer
relevant to a financial management decision. The role of financial management
in the strategic planning process is to translate future operating scenarios into
meaningful financial statements. This provides the means for measuring and
controlling key performance areas such as profitability, market position, and
costs. A reinvestment decision to replace losses of assets, on the other hand, will
have to consider the present value of expected cash-flows before the reinvestment
decision is taken.
In his financial approach to risk management, Professor Doherty (1985)
discussed whether abandonment should arise before or after the loss. The
reinvestment decision after a loss is ignored in most risk management texts
because the assumption is that the objective of the firm is to resume its operations
as soon as possible. Assuming that preloss investment was optimal, reinvestment
following a loss is not necessarily so: "Given a differential between disposal
values and replacement costs, the value-maximizing criterion may well indicate
that reinvestment is not appropriate following loss and the activity should
therefore be abandoned." 14
 10

Risk may be transferred: The property or activity responsible for the risk may
be transferred to some other economic agent. Transfer is different from avoidance
in the sense that the source of the risk is not discontinued. A transfer is possible
whenever the firm enters into a contractual arrangement with an outside entity for
either the sale or purchase of goods or services. A lease contract is the typical
example of the transfer of the risks associated with ownership.

DISCUSSION:
By selling and distributing products, the marketing department
typically exposes the firm to some important potential losses.
In transporting the products to retailers or customers, typical
examples of exposures are the packaging of the products, the
loading and unloading accidents and the risks generated by the
mean of transportation.
The decision to own a fleet of vehicles or to rent the
services of a specialized company must be made by
incorporating all types of losses that might occur as a result of
a given event as well as their ultimate financial impact upon the
firm.

Risk Control
Whether or not the firm has decided to assume the risks, it must also examines
the possibilities (1) to reduce the frequency of occurrence and (2) to reduce the
severity of losses that will occur. The potential gains from any risk-control
activity must be weighted against the costs involved. Unless the expected gains
equal or exceed the costs, the firm would be better off not to engage in that
activity. If the reduction of direct and indirect costs may be estimated, long-term
expected gains such as the reduction of uncertainty, improved public or customers
perception, and increased employees morale and efficiency, are not necessarily
measurable.
It is important to notice that the marginal cost of risk reduction increases with
a decline of risk. Commonly used criteria for decision-taking are relative to the
level of "acceptable" risk which should be "as low as best practicable technology"
or "as low as best available technology." "Zero tolerance" indicates that risk is to
be reduced independent of the cost.15
A detailed study of loss control activities requires a background of technical
and scientific skills. The risk manager will often make use of the technical
expertise of the production staff to decide on physical devices and procedures to
be implemented.
 11

Table 4.3
Examples of Loss-Control Measures

PHYSICAL DEVICES PROCEDURES

Separation of potential hazards Maintenance and repair system

Safety devices and protective Housekeeping
equipment Proper procedures and training
Proper advertising of risk for use of tools, and
hazards equipment, facilities
Security locks, boxes, etc. Enforcement of safety rules
Alarms Guards, Patrols routine
Sprinklers and other Inspection and audit
risk reduction devices Fire brigade procedures

Risk control or loss control measures have been classified in various ways
according (1) to whether they are loss-prevention or loss reduction measures, (2)
to the cause or the location of the risk and (3) to the timing of the event.
Loss-prevention programs seek to reduce or eliminate the chance of loss, i.e.
the frequency of the risk. The possibility of a loss is never completely eliminated
but it is an important approach to reduce the consequences of a risk. Loss
prevention activities, safety programs, fire departments, police and army forces
are few examples of actions being taken to prevent the risk.
Loss-reduction programs seek to reduce the potential severity of the loss.
According to the timing of the event, the loss-prevention phase take place before
any accident has occur while the loss-reduction is applied during the accident
phase or after the accident has occur. Emergency planning often refers to the
development of procedures so that prompt post-loss action can be taken that will
reduce further chances of injury to persons, loss of life, and damage to property.

Risk control programs are mainly designed to tackle the following areas:

(1) Property conservation: the protection of all of the physical assets of a

corporation,
(2) Personnel safety and health: the prevention of injury and maintenance of
health of all the employees,
(3) Product safety: the design, manufacture, and distribution of products that are
safe for the public consumption,
(4) Environmental protection: the elimination or reduction of air, water, and
solid-waste pollution.
 12

The cause of an accident may be mechanical or physical or may be due to

human action. The engineering approach to risk control emphasizes on the
technical aspects whereas the human relation approach emphasizes on safety
education. The information on the nature and causes of losses will be very useful
to determine the actions to be taken and provides information that can be used to
motivate workers and managers to pay more attention to loss control.
(see Appendix on the causes of fire )
According to Heinrich's domino theory, an accident is one factor in a
sequence (a series of dominos) that may result in an injury. An accident occurs
as the result of a personal or mechanical hazard. Personal and mechanical hazards
exist only because of the fault of persons. Faults of persons are inherited or
acquired as a result of their environment (Heinrich, 1980, p. 17). After a study of
75,000 industrial accidents, Heinrich concluded that for about 98 percent of these
accidents, the consequences could have been reduced with some form of loss
control.

DISCUSSION:
Around midnight on Saturday, 10 November 1979, the
Canadian Pacific freight train carrying 106 cars derailed. A
number of cars collided causing a vapor explosion near the city
of Mississauga, Ontario. Thirty-eight cars were carrying cargo
designated as hazardous, including chlorine and liquid
petroleum products (butane, propane).
On learning that a chlorine tanker was probably in the
derailed and burning section of the train, local official decided
the evacuation (on Sunday morning between 1:45 am and 8:30
am) of a quarter of a million residents of the city of
Mississauga, probably the largest peacetime evacuation ever
conducted in North America. Residents were permitted to
return home only six days after the first departures.
The post-accident analysis revealed that the cars
containing butane and propane collided and probably caused
the initial vapor explosion. If they had been separated from
each other by other cars the derailment would probably not
have caused any fear for the population.
 13

Safety Management
Given society's increasing demands for personnel safety and health programs and
product safety programs, it is apparent that risk control will certainly be the major
function of risk management and the area where the greatest growth is likely to
take place. Some of these approaches are principally geared to educating the
public, the customers or the employees regarding their exposure to risks. It is
interesting to note that, in many countries, the decision to implement a loss-
control program is frequently imposed to the firm because the benefits that are
realized extend beyond the enterprise itself and tend to benefit the whole society.
Legal requirements do not themselves optimize safety, but they create a climate
for the development of reliable means.
Organized safety developed at the end of last century under the pressures
created by the new worker's compensation laws in Germany (1885) and in Great
Britain (1897). In the United States, the first law passed in the State of Maryland
in 1902, but it was so restrictive that it had no practical value until the 1930s.
Work injuries were a focal point of the developing safety specialty. It was
believed by the proponents of worker's compensation legislations that the
indemnification costs imposed on the employer would motivate the development
of occupational safety programs ( Grimaldi and Simonds, 1989, Chap. 2).
The concept of safety management (Grimaldi and Simonds, 1989) is an
integral part of management responsibilities. The objective of "safety first" is
similar to the risk control objective, i.e., the elimination of hazards, or their
control to levels of acceptable tolerance. In industrialized societies, the question
"How safe is safe enough?, has emerged as a major policy issues of the 1980's
and many hazards or risks are still poorly known or understood by society. 16
Beyond the particular studies reported here, a growing interest has developed
for political and policy studies on risk assessment. Baram (1982) has discussed
a wide variety of alternatives to regulation of managing risks to health, safety,
and the environment. These include private voluntary self-regulation, taxation as
an alternative to rules, insurance, and other compensatory plans.

Risk Financing
The objective of risk financing, the third element in the risk management process,
is to have the necessary financial resources available following the occurrence of
a loss so that the continuity of the operations of the firm or organization can be
preserved. Basically, the finance alternatives include internal funds available to
the firm and external funding or compensation that can be obtained from other
economic agents.
Michael Smith in Williams and Heins (1989, Chap. 14 ) argued that restoring
a damaged asset is rational when its restoration increases the market value of the
firm. He explained that both the restoration and the commitment to restoration
 14

contribute to the value of the firm. The emphasis on restoration or on replacement

may explain the importance of insurance to finance contingent losses.
According to Doherty (1985, p.30) when the loss financing arrangement is
set in place in anticipation of a possible loss, the procedure can be defined as
preloss-financing. The commitment to restoration is usually made before any
loss has occur, but the decision to secure funds can also be set in place after the
loss. This arrangement is called postloss-financing.
The strategy that is adopted for dealing with assumed risks may give rise to
either greater or lesser costs, and hence will offset expected profits. If a firm
decides to absorb the costs of losses within its own financial resources, the
strategy may be speculative in nature. The decision to finance the expected losses
should be made on the same basis as any financial decision such as the investment
in plant or equipment, whether to buy or lease and so forth. In most cases, the
optimal strategy will combined both the retention of part the costs by the firm and
external funding arrangements or compensation.
Retention can be used successfully when losses are predictable and within
the funding capacity of the firm. However, this involves a close examination of
the financial strength of the organization to ensure that retained losses do not act
contrary to the other objectives of the firm. The rationale for retention is that self-
funding of losses that are within the financial capacity of a firm is generally more
economical than seeking external funds or transferring the risk through an
insurance mechanism to obtain compensation for losses. However, the insurance
mechanism is certainly the most important preloss-financing tool and it is
critically important for high severity of losses.

Administration and Risk Management

Administration involves the effective implementation, monitoring, and control of
the overall risk management plan. An organized system to provide the feedback
and analyze and compare the effective results with the expectations of the plan is
essential.
The objective is to ensure compliance with the overall management
objectives of the firm. Since the risk resulting from any alternative solution is an
integral part of the total risk faced by a firm, it is not possible to devise a solution
in isolation to other management decisions. The decision must be made in light
of the risk and return relationship existing for alternatives of systematic risks that
the enterprise is assuming.
Risk management is also a dynamic process. Social, political, economic and
other technological changes usually exert some influence on the frequency and
severity of risk occurrence. As a result, there is continuous requirement for
evaluation, information and analysis of the impact of changes. Such changes may
also affect the costs of various alternative solutions. However, as more
information is gained through experience, familiarity and knowledge of the
 15

problem, uncertainty is reduced and other alternatives may become more

attractive.

Risk Management and the Purchase of Insurance

A survey undertaken by Blinn and Brown (1982) and published by the Risk and
Insurance Management Society attempted to estimate the aggregate size of
corporate risk-management costs.17 The survey of society members of RIMS
estimated that in 1980 insurance premiums comprises about 52% of the total risk
management costs and that risk control activities represented an additional 25%.
Naturally it is expected that costs vary considerably across industries.
One approach to an understanding of the importance of risk management and
insurance is to determine the extent to which principles of risk management are
applied and what are the risk managers' areas of responsibility. According to the
seventh annual survey conducted by Logic Associates, Inc., a New York based
recruiting firm that specializes in the risk management profession, there is a trend
toward broadening risk management duties. However, risk managers are more
likely to be involved in the management of property and liability exposures than
of personnel exposures.
Whereas the principles of risk management are the same regardless of the
size of the business, many important differences exist in the applications of these
principles and in the areas of responsibilities of the risk managers. In small firms
the risk financing aspect and the negotiation of the risk coverage placement is
more likely to be the sole responsibility of the risk manager.

The Promotion of Risk management

in Developing Countries
On December 3, 1984 the most recent tragic industrial accident occurred in
Bhopal, India. Forty-five tons of methyl isocyanate gas leaked from a storage
tank, killing about 2,600 people and injuring thousands. Just two weeks before
Bhopal accident, about 450 people died when a liquified gas storage plant
exploded in San Juan, Mexico. In both cases the accident was caused by
interdependent human, organizational and technological factors. It was against
the consequences of these kind of disasters that the UNCTAD Committee on
Invisibles and Financing related to Trade decided in February 1985 to undertake
a study on the applicability of risk management techniques to commercial and
industrial enterprises located in developing countries.18
As industrialization has proceeded, concentration and specialization have
increased with size. Developing countries like other countries have witnessed a
trend toward large-scale projects with associated high values at risk as a
proportion of the country's total exposures to loss. Developed countries are
 16

probably more successful in transferring technology than providing the know-

how and education to cope with the risks associated with these technologies.
Bhopal is a textbook example of a rapidly developing city that sought and
obtained a sophisticated industrial plant without placing industrial safety and
pollution burden on the industry for fear of losing the opportunity. 19
There is also a recent increased interest in the economic consequences of
natural calamities such as flood, hurricanes, typhoons, earthquakes, that seem
regularly to hinder the efforts of development of some countries. Uncontrolled
risks certainly reduce the incentive for investment and sound risk management
practices can certainly help minimize the effect of such damage or destruction.
Risk management practices should be compatible with a country's cultural,
economical and physical environment, its level of development and its financial
and human resources. In many developing countries, industrialization is
undertaken without making a commensurate investment in physical and social
infrastructure. A large number of people are living around industrial plants and
other employment centers, creating slums and shanty towns. 20
However, industrialized countries are not immune to crises. The Three Mile
Island (March 1979) and Chernobyl (April 1986) nuclear disasters occurred under
the direction of technologically sophisticated organizations. It is interesting to
notice that in both cases the government acted self-defensively by trying to
minimize the event to the public.
An important conclusion of the UNCTAD's study is that governments in
most developing countries must assume a major responsibility for promoting risk
management:
" In most developed market-economy countries, the impetus for risk
management has emanated primarily from the commercial and industrial
enterprises of these countries, with governments enacting laws requiring
loss control, safety and environmental protection activities where
managers have not been sufficiently responsive to the well-being of
people and the environment. In developing countries, however,
governments often assume a more prominent role and can wield more
influence over the economic activities within the country."21

The successful promotion of risk management in all countries will require

not only the endorsement and active support of governments but also a concerted
effort of the commercial and industrial enterprises as well as the financial
intermediaries providing the funding for the risks. The international implications
of this argument are that disclosure of the actual danger or potential harm in the
use of a technology or a product ought to be obligatory.
The insurance sector has an even greater role to play in developing countries.
Insurance laws and regulations of a country should be compatible with the
principles of risk management.
 17

Summary
Risk management involves the application of general management concepts to a
specialized area. It is a process that uses human, financial and physical resources
to identify, evaluate, control and finance most of the pure loss exposures of a firm.
However, the management of risks cannot be undertaken in isolation from the rest
of the organization. The risk manager is part of a management team with a
responsibility for achieving the objectives set for the organization.
Concepts: Value of a firm, Risk assessment, Risk control, Risk financing.
 18

Suggestions for Additional Reading

Doherty, Neil, A., Corporate Risk Management: A Financial Exposition, New
York: McGraw-Hill Book Co., 1985, Chap. 1 & 2.
Williams C. Arthur and R.M. Heins, Risk Management and Insurance , New
York: McGraw-Hill Book Co., 6th ed., 1989, Chap 1, 2 & 3.

References
Baram, M.S., Alternatives to Regulation , Lexington, MA: Lexington Books,
1982.
Bird, F.E and G.L. Germain, Practical Loss Control Leadership , Loganville,
GA: International Loss Control Institute, 1986.
Carter, R.L. and N.A. Doherty, Handbook of Risk Management London:
Kluwer-Harrap Handbooks, 1974, Part 1.
Charbonnier, Jacques, Le Risk Management Europeen / European Risk
Management, Paris: Editions de l'Argus, 1985.
Cohen, J., Behavior in Uncertainty , New York: Basic Books, 1964.
Covello, V.T., Menkes, J. and J. Mumpower, (Eds.), Risk Evaluation and
Management , New York: Plenum Press, 1986.
Covello, V.T., Lave, L.B., Moghissi, A. and V.R. Uppuluri, (Eds.), Uncertainty
in Risk Assessment, Risk Management and Decision Making , New York:
Plenum Press, 1987.
Fischhoff, B., Lichtenstein, S., Slovic, P., Derby S.L., and R.L. Keeney,
Acceptable Risk , Cambridge,UK: Cambridge University Press, 1981.
Greene, M. and O. Serbein, Risk Management: Text and Cases , Reston,
Virginia: Reston Publishing Co., 2nd ed., 1983.
Grimaldi , J.V. and R.H. Simonds, Safety Management , Homewood, Il.: R.D.
Irwin, 5th ed., 1989.
Heinrich, H. W., Industrial Accident Prevention , New York: McGraw Hill
Book Co., 5th ed., 1980.
Kleindorfer, P.R. and H.C. Kunreuther, Insuring and Managing Hazardous
Risks: From Seveso to Bhopal and Beyond, Laxenburg, Austria: International
Institute for Applied Systems Analysis, 1987.
Lagadec, P., Le risque technologique majeur, Paris: Collection Futuribles, 1981.
Translated in English: An Assessment of Industrial Disasters, Oxford:
Pergamon Press, 1982.
Lave, L.B., (Ed.), Risk Assessment and Management , New York: Plenum
Press, 1987.
Mehr, R.I. and E. Cammack, Principles of Insurance , Homewood, Illinois:
Richard D. Irwin, 7th ed., 1980.
 19

Mehr, R.I. and B.A. Hedges, Risk Management in Business Enterprise ,

Homewood, Illinois: Richard D. Irwin, 1963.
Mehr, R.I. and B.A. Hedges, Risk Management: Concepts and Applications,
Homewood, Illinois: Richard D. Irwin, 1974.
Muckleston, R.A., Risk Management for the Smaller Company London:
Association of Insurance and Risk Managers (AIRMIC), 1977.
Paterson, Dan, Techniques of Safety Management , New York: McGraw Hill
Book Co., 2nd ed., 1978.
Rescher, Nicholas, Risk, a Philosophical Introduction to the Theory of Risk
Evaluation and Measurement, Wahington, D.C.: University Press of America,
1983.
Rowe,William, An Anatomy of Risk , New York: J. Wiley & Sons, 1977.
Schwing, R. C. and W.A. Albers, Jr. (Eds.), Societal Risk Assessment: How Safe
is Safe Enough?, New York: Plenum Press, 1980.
Snider, Wayne H., Risk Management , Homewood, Illinois: Richard D. Irwin,
1964.
UNCTAD, The Promotion of Risk Management in Developing Countries ,
Geneva: United Nations, TD/B/C.3/218, 1987.
Williams, C.A., Head, G.L., Horn, R.C. and G.W. Glendenning, Principles of
Risk Management and Insurance , Malvern, Pennsylvania: American Institute
for Property and Liability Underwriters, 2nd ed., 1981.
Whipple, C. and V.T. Covello, (Eds.), Risk Analysis in the Private Sector, New
York: Plenum Press, 1985.
 20

Appendix 4.1
Examples of Major Industrial Accidents
and Consequences

1921 Oppau, Germany Fertilizer factory explosion (ammonium

nitrate),561 people killed and severe
damage to the city.
1942 Tessenderloo, Belgium Explosion in a chemical
plant (ammonium nitrate), 200 people
killed and about 1000 casualties.
1944 Cleveland, Ohio, USA Explosion of 4,300 m3 of liquefied
natural gas, 136 people killed,
350 casualties, 79 houses, 2 factories
and 79 cars destroyed ($6.8 million).
1947 Galveston, Texas, USA The worst industrial accident in
U.S. history.The explosion of a freighter
loaded with ammonium nitrate destroyed
the entire plant and killed 576 people.
1948 Ludwigshafen, Germany Explosion a tanker of dimethyl ether.
245 people killed and 3,800 casualties.
heavy damage to the neighborhood.
1956 Minamata, Japan Mercury discharge into river,
250 people killed and over 100,000
mercury poisoning casualties.
1974 Flixborough, England The explosion involved the evacuation of
3,000 residents and destroyed 100 houses.
The US$ 50 million loss also stopped
almost one-third of the world's output of
caprolactum, an essential ingredient for the
manufacture of nylon.
1976 Seveso, Italy On 10 July 1976, the blowout of a valve at
the ICMESA chemical plant caused a
dispersion in the air of glycol vapor and
dioxin. 950 people were evacuated and
about 220,000 people living in 11
municipalities affected by the accident were
probably contaminated. Uncertainty about
the effect of the contamination still exist
today.
 21

1978 Portsall, France The accident of the tanker Amoco Cadix

spilled 220,000 t of oil off the Brittany cost.
The most expensive accident estimated at
FF 800 million ($ 120 M.) in 1983.
1982 Tacon, Venezuela Explosion of oil tanker. 145 people killed
and 1,000 casualties.
1984 Cubatao, Brazil Explosion following a pipeline fracture on
Petrobras plant. About 500 people killed.
Fire and evacuation of a shanty town
(3,000) built illegally on the plant lands.
1984 San Juan , Ixhuatepec, Explosion of liquid natural gas reservoirs.
Mexico 452 people killed, 4,300 casualties,
300 houses destroyed, 31,000 homeless and
300,000 evacuated.
1984 Bhopal, India On December 3, methyl isocyanate gas
leaked from a storage tank at the Union
Carbide plant. Within a week, about 2,600
people had died and probably 300,000
others had been affected by exposure to
the deadly poison. More than 2,000
animals were killed, and environmental
damage was considerable.
1988 North Sea The explosion and fire on the British oil and
gas platform "Piper Alpha" . The loss was
estimated at US$ 1,200 million.
1989 Alaska In March, the oil tanker "Exxon Valdez"
liters of crude oil. The first estimation
reported a direct loss of nearly US$ 425 m.
1989 Pasadena, Texas, USA Gas cloud explosion in a petrochemical
plant. The loss was estimated at US$ 1,100
million.

Source: Lagadec (1981); Sigma, Zurich: Swiss Reinsurance Company, several

issues.
See also Smets, H., "Compensation for Exceptional Environmental
Damage Caused by Industrial Activities," in Kleindorfer and Kunreuther,
(1987).
 22

Appendix 4.2
Summary of Natural Catastrophes and Major Accidents
Number of Victims from 1986 to 1990

1990 1989 1988 1987 1986

Natural catastrophes
Floods 4,534 1,420 8,429 4,481 2,101
Storms 4,553 5,828 6,271 3,332 1,545
Earthquakes 52,100 523 26,782 1,042 2,784

Major Fires 405 938 458 333 235

Aviation 890 1,783 1,625 1,267 888

Waterborne traffic 1,562 1,821 2,603 3,533 2,281

Traffic (Bus, Railways, etc.) 1,995 2,392 2,128 2,314 1,266

Mine disasters 440 438 311 244 223

Miscellaneous 2,900 345 1,791 967 679

Examples of Major Recent Natural Catastrophes:

1992 August Florida, USA Hurricane Andrew hit The Bahamas
and Florida. The costliest natural
disaster in US history with losses
estimated at 15.5 billion dollars.
1991 October California, USA Oakland fires have cost an estimated
1.7 billion dollars.
1990 June Iran Earthquake (7.4 Richter scale)
at least 50,000 victims.
1990 June Bogra, Bangladesh Heavy monsoon rain, floods at
least 1,000 victims.
1990 July Luzon, Philippines Earthquake (7.7 Richter scale)
at least 1,600 victims.
1989 October California, USA Earthquake hit Loma Prieta
(7.5 Richter scale) and losses
 23

estimated at US$ 960 million.

1989 April Bangladesh Cyclone, at least 1,100 victims.
1989 September The Caribbean Hurricane "Hugo" hit Martinique,
Dominica, Guadeloupe, Bahamas and
the South-Eastern cost of the USA.
Losses estimated at US$ 4,1 billion.
1988 September The Caribbean Hurricane "Gilbert" hit
The Dominican Republic, Haiti,
Jamaica, Mexico and the Southern
cost of The USA.
Losses estimated at US$ 800 million.
1988 August Bangladesh Monsoon rains, floods
at least 3,000 victims.
1988 December Armenia Earthquake (7.5 Richter scale)
at least 25,000 victims.
1986 October El Salvador Earthquake (7.5 Richter scale)
982 dead, 200,000 homeless and
losses estimated at US$ 1,500 m.
1985 March Chile Earthquake, 145 dead, 500,000
homeless insured damage US$
90 million.
1985 May Bangladesh Typhoon, more than 11,000 dead.
1985 September Mexico City Earthquake, over 5,000 dead,
insured damage US$ 220 million.
1985 November Armeco, Colombia Eruption of volcano
Nevado del Ruiz over 23,000 dead.

Source: Sigma, Zurich: Swiss Reinsurance Company, several issues.

 24

Appendix 4.3
Causes of Fire
( 10 years average )

CAUSE OF FIRES NUMBER LOSS IN $

Heating
Stoves, furnaces, boilers,
and smoke pipes
Solid Fuel 1,030 2,657,456
Oil Fired 1,742 6,219,364
Gas Fired 587 2,692,155
Unclassified 1,665 6,403,581
Defective and overheated
chimneys and flues 886 1,949,042
Hot ashes, coals, open fires 2,546 13,037,137

Electrical wiring and appliances 11,031 42,944,718

Smoking
Matches 2,152 4,586,097
Smokers' carelessness 18,468 15,484,791

Petroleum and its products 2,221 9,606,706

Exposure 1,131 7,216,464

Incendiarism 2,899 23,655,598

Miscellaneous
Lightning 2,862 3,324,055
Lights, other than electric 857 2,045,985
Sparks on roof 146 442,053
Spontaneous ignition 465 3,797,763
Other known ( fireworks,
friction, explosion etc.) 10,529 30,809,007

Undetermined 8,932 84,552,629

TOTAL 70,144 261,424,601

Source: Report of the Dominion Fire Commissioner on Fire Losses in Canada,

(Year unknown).
 25

Notes
1 Henri Fayol, General and Industrial Management, New York: Pitman Publishing Co., 1949.
2
For an history of Risk Management see R.I. Mehr and E. Cammack, Principles of Insurance, 7th ed., Homewood, Illinois: R.D.
Irwin, 1980, pp. 35-37 and Crockford, G.N. , "The Bibliography and History of Risk Management: Some Preliminary
Observations," The Geneva Papers on Risk and
Insurance, vol. 7, no. 23, 1982, pp. 169-179.
Also V.C. Covello and J. Mumpower, "Risk Analysis and Risk Management: A Historical Perspective," Risk Analysis, vol. 5,
no. 2, 1985.
3
Russel B. Callagher , "Risk Management: A New Phase of Cost Control," Harvard Business Review, Sept-Oct. 1956, pp. 75-86.
4
Felix H. Kloman , Risk Management Report, January/February 1991, pp. 5-6.
5
The effect of risks on sales and costs for a corporation are explained in details in Alan C. Shapiro and Sheridan Titman, "An
Integrated Approach to Corporate Risk Management," Midland Corporate Finance Journal, Summer 1985, pp. 41- 56; reprinted in
The Revolution in Corporate Finance, J.M. Stern and D.H. Chew, (Eds.), New York: Basil Blackwell Inc., 1986.
6
Jensen and Meckling provide a positive analysis of the impact of agency relationships on the investment and financing
decisions of a firm. Jensen, M.C. and W.H. Meckling, "Theory of the Firm: Managerial Behavior, Agency Costs and Ownership
Structure," Journal of Financial Economics, vol. 3, 1976.
See also Mayers David and Clifford W. Smith, "On the Corporate Demand for Insurance," Journal of Business, vol. 55, no. 2,
1982, pp. 281-296.
7
Robert I. Mehr and Bob A. Hedges, (1974), p. 28.
8
C.A. Williams and R. M. Heins (1989), p. 53.
9
See for example A.H. Criddle, "Evaluation of Risk," in H. Wayne Snider (1964).
10
John J. O'Connell, "Systematic Risk Identification,"
Risk Management, vol. 23, no. 3, March 1976, pp. 34-36.
11
Frederick W. Taylor, Principles of Scientific Management, New York: Harper & Brothers, 1911.
In relation to safety engineering, specific methods of searching out and identifying risks in the physical work setting have been
suggested by Brereton Philip R. and Daniel C. Peterson, "Safety Management for the Risk Manager," Risk Management, February
1971, p. 31.
12
See Orio Giarini and Walter R. Stahel, The Limits to Certainty: Facing Risks in the New Service Economy, London: Kluwer
Academic Press, 1989.
13
For a survey, see P. Slovic , B. Fischhoff, and S. Lichtenstein, "The Psychometric Study of Risk Perception," in V.T. Covello,
J. Menkes, and J. Mumpower, (Eds.) (1986).
14
Neil A.Doherty (1985), pp. 187- 214.
15
See William Rowe, An Anatomy of Risk, New York: J. Wiley & Sons, 1977.
16
The Society for Risk Analysis has organized and sponsored a number of international workshops on risk assessment. The
following publications are a valuable source of opinions and researches on the subject:
C. Whipple,and V.T. Covello, (Eds.), Risk Analysis in the Private Sector, (1985)
V.T. Covello, J. Menkes, and J. Mumpower, (Eds.), Risk Evaluation and
Management, (1986)
V.T. Covello, L.B. Lave, A. Moghissi, and V.R. Uppuluri, (Eds.), Uncertainty
in Risk Assessment, Risk Management and Decision Making, (1987).
L.B.Lave (Ed.), Risk Assessment and Management, (1987).
17
J.D. Blinn and B.M. Brown , "The Cost of Risk: A Summary of the 1981 Survey," Risk Management, November 1982.
For a similar survey in Europe see J. Charbonnier (1985)
18
UNCTAD, The Promotion of Risk Management in Developing Countries, Geneva: United Nations, TD/B/C.3/218, 1987.
19
See Paul Shrivastava, Bhopal, An Anatomy of a Crisis, Cambridge, MA: Ballinger Pub., 1987.
20
Cubatao is a town of nearly 100,000 people located on the southern coast of Brazil. It has the world's record of air pollution
level. In 1984, a petrol explosion killed about 500 people in a shanty town built on Petrobras plant lands.
21
UNCTAD (1987), p. 12.

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