Risk: uncertainty about loss or injury.
Risks can be divided into:
o Speculative Risk
Gives the firm or individual the chance of profit or a loss (i.e.
business expanding to new market can succeed or fail).
o Pure Risk
Involves only the chance of loss (i.e. motorists always face the
risk of an accident and an accident can result in financial and
physical losses but no accident does not provide profit).
Risk management: calculations and actions a firm takes to recognize and deal
with real or potential risks to its survival.
Executives must consider many factors when evaluating risks, such as:
o A nation’s economic stability
o Social and cultural factors (i.e. language)
o Available technologies
o Distribution systems
o Government regulations
Businesses have four alternatives in handling risk:
o Avoid It
I.e. a manufacturer can locate a new production facility away
from an area that is at risk of hurricanes or tornadoes.
o Minimize It
Managers can minimize risk by removing hazards or by taking
Many companies develop safety programs to educate
employees about potential hazards and the proper methods of
performing dangerous tasks.
Accidents cost companies time and money.
Most major insurers offer the services of loss-prevention
experts who evaluate customers’ work environments and
recommend procedures and equipment to help firms minimize
worker injuries and property losses.
o Assume It
Some companies accumulate special funds that are created by
periodically setting aside cash reserves that the firm can draw
on in the event of a financial loss resulting from a pure risk.
o Transfer It
Insurance: a contract in which the insurer, for a fee, agrees to
reimburse an insured firm or individual a sum of money if a
loss occurs. Premium: the insured party’s fee to the insurance company for
coverage against losses.
Insurance substitutes a small, known loss for a larger,
Insurer must understand the customer’s business, risk
exposure, and insurance needs.
Multinational firms do business with insurance companies that
maintain global networks of offices.
Insurance Return on Investments
Claims Operating Reserves
Steps in the operation of an insurance company:
o Insurance company collects premiums from policyholders in
exchange for insurance coverage.
o Some of these funds are used to pay current claims and operating
o The remaining funds are held in the form of reserves, which are
o Returns from the reserves may allow the insurer to reduce premiums,
generate profits, or both.
By investing in reserves, the insurance industry represents a major source of
long-term financing for other businesses.
The basic principles that underlie insurance are:
o The concept of insurable interest
To purchase insurance, the policyholder must stand to suffer a
loss, financial or otherwise, due to fire, storm damage, accident,
theft, illness, death, or lawsuit (insurance interest). Firm’s can purchase property and liability insurance on
physical assets to cover losses due to fire and theft because the
company has an obvious insurance interest.
A business often purchases key-person life insurance, which
compensates the business should an important individual die.
o The concept of insurable risk
Insurable risk: the requirements that a risk must meet for the
insurer to provide protection.
Only some pure risks are insurable; no speculative risks are.
A pure risk must meet four requirements to be considered an
The likelihood of loss should be reasonably predictable.
If an insurance company cannot reasonably predict
losses, it has no basis for setting affordable premiums.
The loss should be financially meas