Paul Hopkin. Fundamentals of Risk Management

Подождите немного. Документ загружается.

274 Risk response

a speciﬁ c control is introduced. Whether the speciﬁ c control is actually introduced may

depend on the judgement of the organization. If it is considered that the risk has a low likeli-

hood of materializing, then the cost of the control may be greater than the anticipated beneﬁ t

at low likelihood.

This ﬁ gure also illustrates that the cost of control needs to be taken into account when evalu-

ating the reduced exposure to loss. Another important consideration is that attention should

be paid to the need to achieve continuous improvement in the effectiveness and efﬁ ciency of

the controls that are employed.

Controls should be reviewed on a continuing basis and Figure 29.3 provides a means of under-

taking the continuous review that should be part of learning from controls. The phases

involved in learning from business activities are often referred to as the ‘plan, do, measure and

learn’ approach. This approach is also used in Appendix B, which considers the overall steps

in the successful implementation of an enterprise risk management initiative.

This constant evaluation of controls will result in a number of beneﬁ ts. It will ensure that the

controls are effective in producing the result that is required and controlling the risk to the

standard that is set out in the risk management policy. Also, the efﬁ ciency of the existing con-

trols can be evaluated, so that it can be decided whether the current level of control is achieved

in a cost-effective manner.

Another important advantage of seeking to learn from controls is that unnecessary and inap-

propriately complex controls will be identiﬁ ed and steps can be taken to remove the control,

Cost of

control

Impact or

potential loss

Likelihood of loss

After

control

Before

control

Figure 29.2 Cost–beneﬁ t analysis

Control of selected hazard risks 275

4. Learning

(continuous improvement)

• Management oversight

• Post-implementation review

• Decide adequacy of control

1. Planning

(strategic and business objectives)

• Investment appraisal

• Design of control

• Feasibility study

3. Measuring

(key performance indicators)

• Value added by control

• Monitor effectiveness

• Evaluate risk performance

2. Implementing

(core processes and functions)

• Project risk management

• Plan implementation

• Implementation of control

Figure 29.3 Learning from controls

modify it or replace it with a more cost-effective option. Risk assessment activities should take

account of the continuing review of controls that is taking place, because the level of risk will

be affected by the nature and quality of the controls. The role of monitoring controls is an area

of expertise that is well established for internal audit.

Learning from controls may be mainly concerned with increasing their efﬁ ciency. However, it

is also necessary to ensure that they are effective and they are the correct controls. Internal

audit will assist with the evaluation of the effectiveness and efﬁ ciency of existing controls and

this will assist with the process of learning from controls. The evaluation of controls should

also pay regard to the level of reward that is being sought. Therefore, there is a need to evaluate

strategy and tactics, as well as evaluating the effectiveness and efﬁ ciency of hazard controls.

Throughout this chapter, the emphasis has been on hazard controls, with details presented on

some of the more common hazards that will be faced by many organizations. The ideas and

principles explained in this chapter are also appropriate to opportunity management, and

Figure 29.4 illustrates how the relationship between risk exposure and anticipated reward

affects business decisions.

Initially, as risk exposure increases, a higher reward will be expected and the increase in reward

is greater than the increase in risk exposure. Ultimately, there will be increasing exposure, but

no increase in expected reward, so there is no beneﬁ t in taking that extra risk. In between these

two situations, increasing risk exposure will produce a marginal increase in anticipated

award.

It is in this intermediate area that the judgement of management is required as to whether the

increase in risk exposure is within the appetite of the organization. Although it may not seem

appropriate to increase risk exposure for a marginal increase in anticipated reward, this may

be necessary to satisfy existing customer requirements or to help fulﬁ l a longer-term business

objective.

276 Risk response

Increasing

reward with

increasing

risk exposure

Level of

reward

Risk exposure

Marginal

benet, so

judgement

required

Increasing

risk with little

additional

reward

Figure 29.4 Risk and reward decisions

Insurance and risk transfer

Importance of insurance

Risk transfer is one of the main risk responses available in relation to hazard risks. This trans-

fer normally takes place by way of insurance and it is often described as risk ﬁ nancing. The

fundamental principle of insurance is that the insurance company is contracted to pay a certain

sum of money in the event of deﬁ ned circumstances arising or deﬁ ned events occurring.

Insurance contracts can require the insurance company to pay for losses suffered directly by

the insured. This is ﬁ rst-party insurance and includes property damage insurance. Other types

of insurance contract the insurance company to pay compensation to other parties if they have

been injured or suffer loss because of the activities of the insured. This is third-party insurance

and includes motor third-party and public/general liability.

Insurance contracts are contracts of utmost good faith. This means that the insured party is

required to disclose all information relevant to the insurance contract. If this information has

not been disclosed, the insurance company or underwriter has the right to refuse to continue

to provide insurance cover and may refuse to pay any claims that have arisen.

There are advantages and disadvantages associated with the use of insurance as a risk transfer

mechanism. The advantages of insurance are that it provides indemnity against an expected

loss. Insurance can reduce uncertainty regarding hazard events that may occur. It can provide

economic beneﬁ ts to the insured, because the loss may be greater than the insurance premium.

Finally, insurance can provide access to specialist services as part of the insurance premium.

These services may include advice on loss control.

The disadvantages of insurance include the delays often experienced in obtaining settlement

of an insurance claim and the difﬁ culties that can arise in quantifying the ﬁ nancial costs asso-

ciated with the loss. There may be disputes regarding the extent of the cover that has been pur-

chased and the exact terms and conditions of the insurance contract. Finally, the insured may

277

278 Risk response

have difﬁ culty in deciding the limit of indemnity that is appropriate for liability exposures.

This may result in under-insurance and the subsequent failure to have claims paid in full.

There are alternatives to insurance when an organization wishes to transfer the ﬁ nancial con-

sequences of a hazard event. Alternatives to insurance are sometimes referred to as alternative

risk transfer or alternative risk ﬁ nancing techniques. The risk ﬁ nancing options available to an

organization include:

conventional insurance; •

contractual transfer of risk; •

captive insurance companies; •

pooling of risks in mutual insurance companies; •

derivatives and other ﬁ nancial

instruments. •

Organizations may decide to retain a certain amount of the ﬁ nancial consequences

associated

with the losses. Risk retention may be achieved by accepting a large excess or deductible on an

insurance policy, deciding not to insure a certain risk exposure (self-insurance) or setting up

a captive insurance company. A number of organizations with similar risk exposures may

decide to set up a joint captive insurance company. This is often referred to as risk pooling or

the establishment of a mutual insurance company.

History of insurance

Insurance has a very long history that can be traced back to Chinese and Babylonian traders.

There is evidence that marine insurance had become universal among the maritime nations of

Europe by the mid-1300s. In more recent times, the great Fire of London in 1666 gave rise to

the modern insurance industry. In the 1680s, a coffee shop (Lloyd’s) opened in London, which

became the meeting place for parties wishing to insure cargoes and ships and those willing to

underwrite such ventures.

Insurance developed rapidly during the 18th and 19th centuries. Prior to the formation of

incorporated organizations, insurance policies were signed by individuals whose names and

the amount of risk they were prepared to assume were written underneath the insurance pro-

posal. This gave rise to the term ‘underwriter’.

Modern insurance companies in the United States developed between the mid-1730s and

mid-1750s. The development of insurance was frequently in response to major disasters, typi-

cally large ﬁ res. There was a signiﬁ cant ﬁ re in New York in 1835, and the great Chicago Fire of

1871 illustrated the costly nature of ﬁ res in urban areas and the need for insurance. The

Chicago Fire of 1871 is considered in more detail in the box below.

Insurance and risk transfer 279

Some insurance arrangements were also associated with protection for dependents following

the death of the money-earning member of the household. These arrangements became more

formalized with the establishment of friendly or beneﬁ t societies during the 19th century.

The development of liability insurance has a more recent history, spreading back perhaps only

100 years. Compulsory liability insurance is a requirement in many countries and it has an

even more recent history of perhaps only 50 years. Compulsory liability insurance is normally

restricted in most countries to employers’ liability (or workers’ compensation) and motor

third party.

Chicago Fire of 1871

At about 9 o’clock on the night of 8 October 1871, a ﬁ re started in a cowshed behind a

Chicago home. It had been an unusually dry summer and the ﬂ ames jumped quickly

from house to house, then from street to street. The blaze raced along from the

southwest to the northeast, enveloping the business district. Then the lumber capital of

the world, Chicago was a city built primarily of wood.

Chicago’s business district was indeed impressive. With the development of the

railroad and the economic boom that followed the American Civil War (1861–65), the

city thrived. But the ﬁ re raged through four square miles of the metropolis; it

demolished factories, stores, railroad depots, hotels, theatres and banks. Flames burned

ships in the Chicago River and consumed nearly all the city’s publishing and printing.

In the end property damage totalled $192 million. Nearly 300 people died in the blaze

and 100,000 were made homeless.

The rebuilding of Chicago was a tremendous endeavour. Insurance companies in the

United States and Europe rose to the occasion, producing the sums they were obliged

to pay for the damages. Cities in the United States and abroad sent $5 million in relief

funds and thousands of donated books replenished Chicago’s libraries. Before long

Chicago began to attract entrepreneurs, businessmen and well-known architects, who

found ways to proﬁ t from the reconstruction efforts.

Types of insurance cover

The different types of insurance cover that may be required by an organization are set out in

Table 30.1. Generally speaking, there are three reasons why an organization will wish to pur-

chase insurance cover. In summary, the reasons for buying insurance are as follows:

legal and contractual obligations; •

280 Risk response

balance sheet/proﬁ t and loss protection; •

employee beneﬁ t/protection of employee assets. •

Table 30.1 provides more information on the different types of insurance that are available and

the circumstances in which insurance should be purchased. In most cases, the purchase of insur-

ance is not compulsory. However, most countries require that the purchase of insurance is com-

pulsory in certain circumstances. Typically, these are the liability classes including insurance

cover to compensate injured employees and for the parties involved in road accidents.

Table 30.1 Different types of insurance

Legal and Contractual Obligations

Employers’ Liability – compensation to employees injured at work

•

Public Liability – compensation to public or customers •

Product Liability – compensation for damage or injury •

Professional Indemnity – compensation to client for negligent advice •

Balance Sheet/Proﬁ t and Loss Protection

Business Premises – damage to premises by adverse events

•

Business Interruption – loss of proﬁ t and increase in cost of working •

Asset Protection – losses, such as: •

Loss of cash •

Goods in transit •

Credit risk •

Fidelity guarantee (staff dishonesty) •

Machinery Breakdown (including computers) •

Motor Insurance – compensation following motor accident •

Terrorism – compensation for damage caused by terrorism •

Loss of a Key Person – compensation on loss of key staff member •

Employee Beneﬁ t/Protection of Employee Assets

Life and Health – beneﬁ ts to employees that can include:

•

Life cover •

Critical Illness cover •

Income Protection •

Private Medical costs •

Permanent Health •

Personal Accident •

Travel injury/losses •

Directors’ and Ofﬁ cers’ Liability – legal and compensation costs •

Insurance and risk transfer 281

Apart from the compulsory classes, organizations can decide whether to purchase insurance.

This decision will be based on the assessment of the risk and whether the nature and level of

risk is within the hazard tolerance of the organization. The cost of insurance (premium) and

the extent of insurance coverage are also important considerations when deciding whether to

buy insurance. Typically, insurance is purchased for low-likelihood, but high-magnitude risks,

such as ﬂ ooding, hurricane damage and major ﬁ res.

Consider the example of the insurance needs of a publisher. In relation to legal obligations, the

company realizes that it has to buy employers’ liability insurance and motor third-party insur-

ance. Also, it is a requirement placed on magazine distributors by the wholesalers that the

company purchases libel and slander insurance. In order to protect the balance sheet and

proﬁ t and loss account, the company needs to purchase property damage and business inter-

ruption insurance, together with credit risk insurance and goods in transit insurance.

The publisher may also decide to provide beneﬁ ts to staff by way of life, critical illness and

private medical insurance, as well as personal accident and travel insurance. For the beneﬁ t of

directors of the company, directors’ & ofﬁ cers’ liability (D&O) insurance will be purchased.

By undertaking this evaluation, in consultation with insurance brokers, the company has

ensured that it has put in place an insurance programme that provides cover only where it is

necessary, appropriate and cost-effective.

Evaluation of insurance needs

Table 30.2 provides a checklist for organizations to decide which types of insurance are

required. There is a wide range of different types of insurance available and the speciﬁ c activi-

ties and features of the organization will assist in deciding the scope of insurance that needs to

be purchased. Sometimes, there is a shortage of insurance capacity and although the organiza-

tion has decided that it wishes to purchase that type of insurance, it may not be available at an

affordable cost.

There has been a tendency in recent times for organizations to look at the whole portfolio of

risks that it faces. This enterprise risk management approach to risk has resulted in a careful

review of how much insurance an organization wishes to purchase. For example, if there are

signiﬁ cant risks within a project, but insurance is only available for limited risk exposures,

purchase of insurance for only those limited risks may not be appropriate. The enterprise

approach to risk management has reduced the use of insurance as a risk control mechanism

for some organizations.

One of the features of the insurance market is that the cost of insurance varies signiﬁ cantly

during different cycles of the insurance market. The market will cycle between soft market

conditions (low premium) and hard market conditions (high premium) over perhaps a 6–10

year period. When the premium rates are high, organizations will tend to buy less insurance

282 Risk response

Table 30.2 Identifying the necessary insurance

Feature of the Business Insurance Requirement

1. Business has employees Employers’ Liability

2. Employees travel outside the country Business Travel

3. Members of the public could be affected Public Liability

4. Business supplies products or components Product Liability/Recall

5. Business provides professional advice Professional Indemnity

6. Theft or dishonesty by employees could occur

Fidelity Guarantee

7. Business occupies business premises Premises Insurance

8. Premises has machinery or other stock Contents Cover

9. Business depends on machinery or computers Engineering Insurance

10. Business could be disrupted by ﬁ re, ﬂ ood etc Business Interruption

11. Business is involved in transporting goods Goods in Transit

12. Business has motor vehicles on public roads Motor

13. Business provides life beneﬁ ts to employees Life and Health

14. Certain staff are key to operation of business Key Person

15. Business would suffer in event of a bad debt Trade Credit

16. Business has directors and/or ofﬁ cers (D&O) D&O Liability

and make greater use of a captive insurance company – as described below. When premium

rates are low, organizations will purchase more insurance because the insurance becomes a

more cost-effective control measure.

Purchase of insurance

When looking at the purchase of insurance cover, the organization will need to consider the

following six aspects:

cost; •

coverage; •

capacity; •

Insurance and risk transfer 283

capability; •

claims; •

compliance. •

The cost of insurance is deﬁ

ned by the insurance premium that is required from the organiza-

tion. A second component of the cost is the level of self-insurance (including excess or deduct-

ible) that is imposed by the policy. This means that if a claim occurs, the organization will have

to pay the ﬁ

rst part of the claim before receiving any money from the insurance company.

Insurance policies usually have limitations, warranties and exclusions. These will state that

claims will be refused in certain circumstances. These coverage issues need to be explored in

detail by the organization purchasing the insurance to ensure that adequate coverage is avail-

able. The only reason for buying insurance is that claims will be paid when one of the identi-

ﬁ ed events occurs. The history of the particular insurance company in relation to the payment

of claims and the reputation of that insurance company will be important factors when decid-

ing which insurance company to appoint.

For very large organizations with considerable assets, one insurance company on its own may

not be willing to offer coverage up to the full value of those assets. When buying insurance, the

organization will need to think about the capacity that the insurance company is willing to

offer in relation to the value of the assets/exposure that need to be insured.

Many insurance companies offer services in addition to insurance. These may include loss

control services and assistance with business continuity planning. The capabilities of the insur-

ance company in these areas may be an important part of deciding which insurance company

to choose.

An increasingly important issue for buyers of insurance is the ﬁ nancial security, status and

capabilities of the insurance company. The nature of the business model operated by insur-

ance companies means that they receive premiums at the beginning of the policy, but do not

have to pay claims until some time later. This results in a positive cash-ﬂ ow position for insur-

ance companies and the associated opportunity to earn investment income.

However, diversiﬁ cation of insurance companies into higher-risk ﬁ nancial activities has

resulted in signiﬁ cant losses for some insurance companies and a downgrading of their ﬁ nan-

cial status. Also, low interest rates and poor performance of stock markets has resulted in a

reduction in investment income. Accordingly, buyers of insurance need to pay greater atten-

tion to the ﬁ nancial status or credit rating awarded to individual insurance companies when

making decisions about which company to use.

Reference has already been made to insurance claims and the vital importance of insurance

claims in relation to insurance. The only reasons an organization buys insurance are to cover

the increased cost of operation, recover the cost of repairing the damage and restoring the

business following a loss. In respect of third-party insurance, it is the third-party injured

person who will make the insurance claim.