(RIMS). RIMS is the leading risk management organization in the United
States. Risk management contributes to the continued existence of economic
entities, both for-profit and not-for-profit, by allowing those entities to
maintain their productive resources, to meet their business objectives, and
to provide their critical services. Peter Drucker, the renowned management
scholar, notes that the practice of risk management is a hallmark of a
developed economy.
RELATIONSHIP OF RISK MANAGEMENT TO
FINANCIAL MANAGEMENT
Financial theory holds that the value today of the future earnings of an
economic enterprise will be maximized if periodic fluctuations in those
earnings are minimized. One of the purposes of risk management is to
eliminate, or to minimize, those periodic fluctuations in earnings. In other
words, the planning and budgeting processes are optimized if risk manage-
ment strategies are in place to either prevent or offset the negative effects of
random events. The availability of financial products (e.g., insurance) to
offset those negative effects makes entrepreneurs more willing to accept risk
in areas that they understand—and in which they possess a comparative
advantage. Thus risk management promotes financial soundness and the
market economy.
THE RISK MANAGEMENT PROCESS
The risk management process is a series of ordere d steps leading to the
accomplishment of risk management objectives . Those risk management ob-
jectives support the overall objectives of the economic entity. It is important
to focus on the notion that risk management is a process, an ongoing
activity. It is not workable to have an annual ‘‘Risk Management Day’’ or
‘‘Risk Management Week.’’ Risk management must be part of the continu-
ing operations of the economic entity for the optimum results to occur. The
steps in the risk management process are outlined below.
STEP 1—DETERMINATION OF RISK MANAGEMENT OBJECTIVES
The initial step in the risk management process is determination of the
risk management objectives. Those risk managem ent objectives are stated in
two time frames, pre-loss and post-loss. Pre-loss objectives are those things
that are to be accomplished in risk management before any losses occur.
Typical pre-loss objectives include cost effectiveness in risk manage ment
practices and minimization of losses or loss-producing ‘‘incidents.’’ Typical
Essentials of Risk Management 333
post-loss risk management objectives include survival of the firm, minimiza-
tion of the impact of the loss, and maintenance of reputation. Risk manage-
ment objectives should be reviewed periodically to ensure that they are in
concert with the evolving overall objectives of the company.
STEP 2—IDENTIFICATION OF EXPOSURES TO LOSS
The second step in the risk management process is to identify exposures to
loss. Exposure identification is the critical component of successful risk man-
agement. This is the part of the process that must be ongoing and systematic.
There are many strategies for exposure identification, including periodic
inspections, the use of checklists and exposure surveys, consultations with
employees, analysis of financial statements, and the use of outside consult-
ants. A later section of the chapter will detail many of the most common
exposures to loss.
STEP 3—ANALYSIS OF EXPOSURES TO LOSS
The third step in the risk management process is to analyze the exposures
to loss that have been identified. The key issue in this analysis is the potential
significance of the exposure to the economic entity. A helpful notion in this
regard is the following designations for exposures.
. A critical exposure is one that would bankrupt the firm.
. An important exposure is one that would cause serious disruption to the
firm (e.g., the need to borrow money).
. A bearable exposure is one that could be treated as a current expense
with no material impact on financial results.
At this step in the risk management process, most entities will try to
determine two significant measures of their risk management exp osure, the
maximum possible loss an d the probable maximum loss. The maximum
possible loss is the worst-case scenario, (e.g., the fire that destroys the manu-
facturer’s sole factory). The probable maximum loss is the worst loss that has
any reasonable likelihood of occurrence. Discussion of both of these is im-
portant to selection of the correct risk treatment methods.
A FUNDAMENTAL RULE OF RISK MANAGEMENT: DO NOT RISK
MORE THAN YOU CAN AFFORD TO LOSE. SIMPLY PUT, YOU
WILL NOT RETAIN LOSS EXPOSURES THAT YOU JUDGE TO BE
CRITICAL.
334 Essentials of Risk Management

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