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The importance of objectives in risk management.

The Importance of Objectives In Risk Management

Despite a nearly universal acceptance of the crucial role of risk management objectives, a significant number, or perhaps even a majority, of organizations which never made their objectives explicit. For those organizations which have, these objectives are usually found in policy statements which have been adopted over the years.

The importance of clearly defined objectives to risk management is suggested by the definition of risk management found in the introductory text used in preparing students for their professional (ARM) examinations, and further emphasized by a leading college text. Indeed, most authors and practitioners throughout the world have implicitly or explicitly accepted the range of objectives.

There are two primary methods of how policy statements are created. First, the initiative may come from the risk manager who carefully prepares such a policy statement and informally sends it up through the organizational structure until it reaches the appropriate level for adoption. It is then formally sent down through the organization until it reaches the risk manager, where it serves as an appropriate guide.

A second approach is for a management consultant to develop the policy statement, usually with the advice of the risk manager. It is then sent to senior management for approval and adoption. It is rare for senior management to prepare or establish a formal policy of risk management on its own initiative, since it seldom has substantive understanding of the function. Thus, formal statements of risk management objectives are primarily recognized and outlined by the risk manager. It is their own bailiwick.

These policy statements must be generalized. They provide little substance to guide a risk manager in the decision-making process, because there is an inherent conflict between pre-loss and post-loss objectives. Listed objectives can best be described in the words of a professor of insurance, "As for God, Motherhood and Country, who can be against them?" Their practical value often is limited to the success of educating senior management on risk management.

Structure Influences Objectives

In practice, the primary determinant of objectives is where a risk management department is located within an organizational structure. The reason for this is that the management objectives of a superior will determine, and strongly influence, the objectives of a subordinate. In this country, the superior to whom a risk manager reports is frequently someone associated with the area of finance. This is natural since risk management evolved from insurance buying, which is a loss financing device. The effect of this, however, has been to stress considerations of loss financing to the detriment of other techniques for risk treatment. In 1980, Waller Smith characterized the decade of the 1960s as one of growing sophistication in insurance buying, the decade of the 1970s as one of growing sophistication in risk retention, and predicted that the 1980s would stress loss prevention. Unfortunately, he was wrong; it has been a decade of growing sophistication in the financing of losses through the expansion of the liability system.

Further, the objectives of senior financial officers in recent years seems to be increasingly directed toward short-term financial gains rather than the long-term. Such emphasis has influenced the goals of risk managers. For example, during the early 1980s, some risk managers were forced to buy insurance rather than to retain risks to make costs certain, even when it was evident that retaining some risk would reduce total cost. This was done to permit senior financial management to direct its attention to maximizing short-term investment income, without consideration of variations in expenditures for losses. Thus, a common risk management goal of minimizing loss cost was subordinated to other financial goals.

Questions are also raised regarding a related impact on risk management because of reporting structure. Has growth in the importance of risk management consulting by organizations associated with accounting firms increased because of the location of risk management within the organizational structure? As reported in Business Insurance, three of the top 10 risk management consulting firms are associated with accounting firms. Would these firms have grown so rapidly in recent years if the risk manager had not reported to finance? Do consulting firms have a bias toward the immediate goals of senior finance management, thereby perpetuating the emphasis? For example, do they provide expertise in loss prevention comparable to other large risk management consulting organizations? The report in Business Insurance states that the largest of the three never performs a loss prevention audit. The other two report they only occasionally perform such audits.

This analysis suggests that, technically, the risk management process in the United States is meeting the objectives established for it by the great majority of organizations. Risk management in the United States has stressed the treatment of risk by loss financing because it was originally--and is currently--the primary concern of those to whom most risk managers report. But is that enough? Many practitioners and students of risk management believe that much more could be done. They believe that the objectives of financial management are too limited and put too much emphasis on short-run considerations. They believe that the importance of the risk management process in discovering and evaluating dynamic risks has not been properly recognized by many organizations. They believe that the importance of loss control and prevention is frequently ignored. They believe that the centralization of authority for the management of risk is rarely achieved, and as a consequence, there are too many failures.

Alternatives and Solutions

If these criticisms are, in fact, veracious, what can be done to achieve the benefits of risk management? One of two approaches would be to educate senior financial management about employing a broad-based risk management approach beyond insurance buying. Few financial officers have studied the field of risk management and their knowledge of the field is often superficial. Also, their knowledge is often acquired either on the job from the risk manager, or from financial consultants. It would be helpful if senior management would learn the basic principles and integrate them into general business theory and practice. Two decades ago, I stated that the impediments for the expansion of risk management were two-fold; one was the lack of competent risk managers, the other was the failure of senior management to recognize and demand competency. Today, the first impediment has largely been overcome (although there is always a need for greater competence). The second hurdle has scarcely been addressed. Two decades ago, risk management enjoyed the advantage of being a buzzword, and many senior managers attempted to learn about it. Today, the only time they make an effort to learn about risk management is when there is a capacity crisis, particularly for directors' and officers' liability coverage.

The second approach to the betterment of the field is to move risk management away from the area of finance. Much attention in risk management literature has been directed to the work of the French management scholar, Henri Fayol, who suggested in 1916 that security was one of the six basic functions of management. Whether or not this is totally accurate, it is apparent that after more than seven decades his thinking has not been incorporated into the organizational structure of American firms. One must conclude, therefore, that if the current restraints will be overcome, serious consideration must be given to shifting risk management to another part of the organization: one that is oriented more toward long-range thinking and where there is emphasis on loss prevention activities.

H. Wayne Snider is professor of risk management and insurance at Temple University.
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Author:Snider, H. Wayne
Publication:Risk Management
Article Type:column
Date:Jan 1, 1990
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