risk and insurance

29
Defining Risk • Risk Used to describe any situation where the actual outcome of a decision, event or action is different from the expected outcome. The deviation from expected outcome may be desirable or undesirable. E.g., a fall in profits or a rise in profits. Risk is mostly used to denote the undesirable outcome; but includes desirable outcome also. Risk is defined as ‘a variation in the possible outcome’ and also as ‘the degree of uncertainty associated with a possible loss’ The degree is risk is estimated based on certainty level with which the outcome of an activity can be forecast. The greater the accuracy with which the outcome can be predicted, the lower is the risk. Apart from uncertainty, certainty, risk other words such as ‘peril’ and ‘hazard’ are also used in the field of risk.

Upload: raj-ganjoo

Post on 29-Aug-2014

40 views

Category:

Documents


3 download

TRANSCRIPT

Page 1: Risk and Insurance

Defining Risk• Risk

– Used to describe any situation where the actual outcome of a decision, event or action is different from the expected outcome.

– The deviation from expected outcome may be desirable or undesirable. E.g., a fall in profits or a rise in profits.

– Risk is mostly used to denote the undesirable outcome; but includes desirable outcome also.

– Risk is defined as ‘a variation in the possible outcome’ and also as ‘the degree of uncertainty associated with a possible loss’

– The degree is risk is estimated based on certainty level with which the outcome of an activity can be forecast.

– The greater the accuracy with which the outcome can be predicted, the lower is the risk.

– Apart from uncertainty, certainty, risk other words such as ‘peril’ and ‘hazard’ are also used in the field of risk.

Page 2: Risk and Insurance

• Peril:– Is a cause of risk. Fire, earthquake, flood, criminal activities, etc.,

are examples of perils.– Thus perils are losses.– Individuals and organisations buy insurance policies and use other

methods to save assets from peril. • Hazard:

– Is a condition that increases the severity or frequency of a loss.– E.g., chances of theft are more in case of no fencing or security.

Using spurious lubricants in a machine, leading to damage.– There are hazards related to human behaviour, social values and

ethics. A house owner may set his house on fire with an objective of claiming damage from the insurance company. A busniessman may put his godown on fire for claiming damages. These are known as ‘moral hazards’.

– In some cases an individual is indifferent to the damages, thereby aggravating degree of damages. A businessman may not take adequate steps to control a fire because his stocks are insured. This causes greater loss to the stock resulting in an increase in the severity of loss. This type of hazard is termed as ‘Morale hazard’.

Page 3: Risk and Insurance

Risk Measurement• Risk Measurement

– The risk measurement follows risk identification and risk classification.– Plays an important role in handling risks effectively.– As soon as the source of risk has been identified, the next step is to measure the

degree of risk. However, measurement is not possible in subjective risks, and is possible only with that of objective risks, where the possible outcomes associated with risks are easily observed.

– Two concepts used for measuring risk• Chance of loss, and• Degree of risk

– Chance of loss• Refers to the probability of occurrence of a loss• Chance of loss is said to be an outcome of two factors, viz., peril and hazard. Peril is

potential danger that can cause a loss whereas hazard is a condition which holds a potential to increase the chances of occurrence as well as has the innate tendency to amplify the degree of risk.

• Hazards are classified as Physical Hazards, Moral, Morale

Page 4: Risk and Insurance

• Degree of risk– Refers to the intensity of objective risk which

is assessed by finding the difference between the expected loss with that of the actual losses

• Degree of risk= difference between the expected and the actual loss/expected loss.

Page 5: Risk and Insurance

Classification of risk• Pure vs. speculative risk

– Pure risk refers to those events whose effects cause either loss or no loss to the enterprise in all circumstances but no gain. Chances of making any profit from such risk occurrences is low. Examples: fire, theft, earthquake, death, accident etc

– Speculative risk refers to the events the outcomes of which may result in profit or loss. E.g., reduction in SP of products, increasing distribution outlets, mergers etc.

– Classification of pure risk• Property risk• Personal risk• Liability risk• Loss of income risk

• Dynamic vs. Static risk– Static risk remains constant over an observed period of time. Risks remain static

becoz of environment in which they exist are static. Resembles pure risk– Dynamic risks arise from changes that occur in an environment, which may be

economical, social, technological and political. Change in environment creates risk and uncertainty about the future. Resembles speculative risk.

Page 6: Risk and Insurance

• Fundamental vs. particular risks– Fundamental risks are those which affect larger group such as society

or an industry or a particular segment of an industry– E.g., natural calamities such as flood, earthquake, drought, epidemics

etc. political and economic changes are also fundamental risks– In particular risks the individual or the particular enterprise has to bear

loss

Page 7: Risk and Insurance

Risk Management• The process of risk management involves identification, analysis and

economic control of risks, which exposes the assets (men and material) or economic capacity of an enterprise.

• Thus RM performs three functions.– Identifies the various risks to which enterprise is exposed.– Analyzes the degree to which the enterprise is vulnerable to various sources of

risks– Assigns the economic value of these exposures

• Risk management strategies– Risk is all pervasive and there is no escape. Hence human beings must always

find different ways in dealing with risks. – Methods used in dealing with both pure and speculative risks are;

• Risk avoidance: (results in total elimination of exposure to loss due to a specific risk. Involves abandoning some activity and so losing the benefits associated with it. Proactive avoidance and abandonment avoidance are the two ways of risk avoidance)

• Risk reduction: (aims at decreasing the number of losses by reducing the occurrence of loss through various measures. Loss prevention and loss control are two ways of risk reduction. Prevention involves safety programs like medical care, security guard, fire sprinkler system, burgler alarm etc. loss control involves purchase of insurance policy

• Risk retention: (risks faced by individuals which cannot be avoided, reduced or transferred. Risk may be retained knowingly or unknowingly. When known and no attempts are made to transfer or reduce a risk, it is known retention. When risk is not perceived at all, then it is retained unknowingly. There can be voluntary or involuntary retention of risk also.)

Page 8: Risk and Insurance

• Risk combination : (it is a strategy in which two or more risks are retained in a proportion, so that overall risk of portfolio/combination is reduced to the minimum desired level.)

• Risk transfer: (if risk is borne by a party other than the one who is primarily exposed to risk, it may be risk transfer.

• Risk sharing: (it is an arrangement to share losses. Corporation, where investments are pooled for common adventure and insurance are examples of risk sharing.)

• Risk hedging: (hedging is resorted to to reduce the risk evolved in holding an investment. Corporate investments are prone to fluctuations in all kinds of financial prices like foreign exchange rate, interest rates, commodity prices and equity prices.)

Page 9: Risk and Insurance

Loss reduction

• The aim is to reduce the degree of loss incurred by occurrence of a particular event.

• Does not reduce the chances of occurrence of the event, it reduces the impact of loss caused by the event

• E.g., seat belt in car/helmet/fire extinguishers etc does not reduce the chances of accident but reduces the severity of the damage caused by an accident.

• Risk chain of events leading to loss are – The hazard– The environment– The interaction– The outcome– The consequences

• Major emphasis of loss reduction is on ‘interaction’ as also the ‘outcome’ and ‘consequences’. The outcome and consequences come into existence after the incident and the loss. These aim to reduce the severity.

Page 10: Risk and Insurance

Nature of RM• Increased competition, more demanding customers, increasing pace of

technological developments and other changes, increasing complexities and novelty of business opportunities demand the need for more structured, systematic and effective approach to managing uncertainty and business risk. This led to development of the concept of RM.

• RM refers to the process by which a company attempts to manage its exposure to risks at an acceptable level. It is a scientific approach and deals with various kinds of risks faced by a corporate.

• The aim of RM is maintain overall and specific risks at the desired level with minimum possible costs.

• It aims at controlling risk exposure of a firm.• Is a rational approach towards controlling pure risk .• Can be grouped with other management functions such as financial

management , human resource management etc.• Risks in day to day activity are : fire, theft, loss of customers, delay in

delivery of raw material, breakdown of machinery, accidents, bad debts, changes in industrial policy, changes in financial market, changes in taxation

Page 11: Risk and Insurance

Risk Management and Insurance management• Risk management includes both risks; pure and speculatie, which

are insurable and uninsurable in nature• Scope of insurance management is limited to those activities which

can be insured• Insurance management uses methods which may differ from risk

management such as preventing occurrence of loss or retaining the loss.

• Insurance manager of a company underwrites policies to cover the underlying risk whereas the risk manager preceives insurance as one of the methods to protect his business

• Emphasis of risk manager is to identify those risks which are to be insured whereas the insurance manager aims at identifying those risks which can be retained.

• Due to high costs, risk manager takes insurance only when all other options are exhausted.

Page 12: Risk and Insurance

Risk Management Process• Six different steps in RMP

– Determination of objectives (Post-loss objectives: like survival of organisation, perpetuity of the organisation’s operations, steady flow of income/earnings, social obligation—Pre-loss objectives : like economy, fulfillment of external obligations, reduction in anxiety, social obligation --- depends upon type of organisation. Guiding principle is save the organisation from perceived threats)

– Identification of risks : (techniques used are - Risk analysis questionnaire, checklist of exposure, insurance policy checklist, flow charts, analysis of financial statements, other records like minutes of meetings, inspection, discussion, combination approahc)

– Evaluation of risk exposure: Categorization into (i) critical, (ii) important and (iii) unimportant categories

– Consideration and selection of risk management techniques: (Risk avoidance, risk reduction, risk retention, risk transfer)

– Implementation of decisions: – Evaluation and review

Page 13: Risk and Insurance

Measurement of risk• Risk is all pervasive and there is nothing with zero risk. • Best way to reduce risk is to make balanced activity choices that

keep unnecessary risk to a minimum• IDENTIFICATION OF RISK

– Sources of risk : (Physical environment, technological envint, social envirt, political envirnt, economic envirent, legal envi, operational env, cognitive envirt, )

• EXPOSURE TO RISK– Property exposure (Real and personal), Liability exposure, Human resource

expo)

• RISK EVALUATION– Helps to fin out the possible consequences of risk in monetary terms. – Suggests the quantum of funds to be allocated towards managing and controlling

risks– Goals are (i) to develop a benchmark based on importance of the risk to the

organisation and (ii) to apply this yardstick to all the risks identified– Direct and indirect costs– Hidden costs (people/Machinery material equipment)

Page 14: Risk and Insurance

• RISK PROFILING (RISK MAPPING)– A method used for managing all types of risks viz., pure, speculative, life, nonlife,

single period or muti period in an integrated manner.– It is enterprise wide risk management.– It aims at classifying the numerous types of risk faced by a company into

manageable classes.– It involves measuring risks in terms of a matrix of two dimensions; one dimension

measures the frequency of events of losses or gain while the other measures the severity of these losses or gains.

– Dimensions of exposure risk ;– Loss of frequency (almost nil, slight, moderate, definite)– Loss severity : (Normal loss expected, probable maximum loss, maximum

foreseeable loss, maximum possible loss)

• OBJECTIVE OF RISK ASSESSMENT– Budget setting– Estimation of future effects.

Page 15: Risk and Insurance

Loss exposure and control• PERSONAL LOSS EXPOSURES

– Exposure due to premature death• Income needs of survivors : (children, spouse, parents, others)• Loss Assessment :

– Exposure due to loss of Health• Medical care expenses loss of income

– Exposure due to unemployment– Exposure due to retirement– Exposure due to excessive longevity– Direct exposure to an organisation

• Key-man losses• Credit losses• Business discontinuation losses

Page 16: Risk and Insurance

Risk control tools and techniques

• Risk avoidance : – Proactive avoidance: (refusal to accept a risk even for a moment)– Reactive/abandonment avoidance: (to give up or abandon an exposure to loss

that has been assumed early)

• Loss control– Loss prevention: (attempt to reduce frequency of losses)– Loss reduction: (Post loss measures : Salvage, subrogation, catastrophe or

contingency plan, duplication, separation are some of the techniques/mechanisms adopted for loss reduction)

• Information management• Risk transfer

Page 17: Risk and Insurance

Risk financing techniques• Risk financing methods:

– Contemporaneous risk financing : (organizations having sufficient operating revenues absorb the financial burdens of a loss as a current expense. Calls for no advance planning)

– Prospective Risk financing: (Orgn anticipating a future loss, accumulate funds in advance. Calls for advance planning. Purchase of an insurance policy)

– Retrospective risk financing : (loss payments are spread across two or three years following occurrence of the loss claim.

• Risk financing is attempted in two ways– Risk retention : (orgn experiencing risk simply bears its financial consequences

by itself)• Passive or unplanned retention : (orgn is not aware about the risk and does

not attempt to control it)• Active or planned retention (

Page 18: Risk and Insurance

• Risk transfer : (loss experienced is borne by a third party)– Insurance transfer– Pooling agreements and combinations– Non-insurance risk financing transfers– Hold harmless agreements– Hedging or neutralization– Risk transfer through incorporation– Risk transfer through diversification– Business and firm-specific risks– Diversifiable and non-diversifiable risks

Page 19: Risk and Insurance

INSURANCE• Definition:

– an arrangement by which the losses of a few are shared by many. – A group exposed to similar kind of risk come together and contribute small amounts called

premiums to a common fund.– As and when a member suffers a loss, his loss is made good through the pool.

• Financial Definition:– Insurance involves two elements (1) transfer or sghifting of risk from one individual to a

group and (2) sharing of losses on an equitable basis by all members of the group.– Insurance (1) primarily creates counter part of the risk which is security– Does not reduce risk– Does not alter the probability of risk– Only spreads and reduces the financial losses

• Legal definition– Insurance is a contractual agreement whereby one party agrees, for a consideration called

premium, to compensate another party for losses. Such transaction involves the following terms like insurer, Insured, Premium, Policy, Exposure to loss

Page 20: Risk and Insurance

Requirements of an insurance contract• Insurance policies are legal agreements representing a set of

promises enforceable by law. Hence must comply with all elements of a valid contract.

• Four general requirements– Agreement must be for legal purpose– Parties must have legal capacity for contract– There must be a valid offer and acceptance– There must be exchange of consideration

• Characteristics of insurance contract– Aleatory contract– Conditional contract– Contract of adhesion– Unilateral contract

Page 21: Risk and Insurance

• Rights and liabilities of the insurer– Right to collect premium from the insured– Right to specify the rules and conditions that govern the promise made under the

policy– Obligation to pay for the losses occurred and claimed by the insured

• Rights and responsibilities of insured– Right to collect payment from the insurer if a covered loss occures– Obligation to pay the premium to the insurer– Duty of disclosure (utmostgood faith)– Obligation to comply with the terms and conditions prescribed by the insurer

• General terms in insurance– Loss

• Direct loss• Indirect loss• Chnaces of loss

– Peril– Hazrad : Moral, morale – Proximate cause– Risk

Page 22: Risk and Insurance

• Nature of Insurance– Pooling– Insurance and gambling– Insurance and bonding

• Insurable loss exposure: – A risk to be ideal for insurance coverage must satisfy following criteria

• Should be a pure risk (personal/property/liability risk/loss of income risk).• There should be a large group of similar items exposed to the same peril• Losses out of risk must be accidental• Definite losses capable of causing economic hardships• Extremely low probability of a catastrophic loss to the insurance pool

Page 23: Risk and Insurance

• Benefits and costs of insurance– Social benefits

• Reduced reserve requirement• Capital freed for investment• Indemnification• reduction of uncertainty• Reduced cost of capital• Reduced credit risk• Loss control activities• Business and social stability

– Social Costs of Insurance• Operating expenses• Moral hazard• Exaggerated losses• Benefit-cost tradeoff

Page 24: Risk and Insurance

– Social Insurance– Meant for those who are socially weak and whose income flows are

likely to be disturbed by any social or economic upheavals. It is most offered through some form of Govt intervention.

– Difference between a social insurance plan and private insurance plan.• Compulsions• Set level of benefits• Floor of protection• Subsidy• Unpredictability of losses• Conditional benefits• Contributions Required• Attachment to the labor force• Minimal advance funding

Page 25: Risk and Insurance

Principles of insurance• Five principles on which the concept and practice of insurance is

based are;– Principle of indemnity

• Methods of indemnification (Claim payment, repair, replacement, reinstatement)

– Principle of insurable interest (Life insurance, property insurance, liability insurance)

– Principle of subrogation (Trot, statute)– Principle of contribution – Principle of utmost good faith– Principle of proximate cause

Page 26: Risk and Insurance

Property Risk

• In this case there is a lose of property because of some unforeseen events. There is always chances of loss of house because of earthquake, heavy storm and other natural calamites. The value of the property destroyed due to a given peril is a direct loss and the additional expenses incurred due to the destruction of the property is the indirect loss. In the other words, indirect loss occurs because of direct loss.

Page 27: Risk and Insurance

Personal Risk

• Personal risk refers to the possibility of loss of income or assets as a result of the loss of the ability to earn income. This may result from untimely DEATH of the earning member, dependent old age, prolonged illness, disability or unemplyment.

Page 28: Risk and Insurance

Insurance Policy• Insurance is risk transfer method. It is a contract under which the insurer

agrees to reimburse the losses suffered by the insured in return for a premium.

• Elements of Insurance– Contractual agreement btwen insurer and insured– Payment of premium by the insured– Benefit payment by the insured based upon a contingent event and– Pool of resources held by the insurer to reimburse the losses

• INSURANCE POLICY– A formal document, provides evidence of the insurance contract– Stamped according to provisions of Indian Stamps Act 1899.– Some insurance contracts like fire are goverened by Tariff– Insurance policy divided into following sections

• (The heading, the preamble, proposal and declaration, the insuring clause, the exclusions, the conditions, endorsements, the schedule, the signature clause, definitions)

Page 29: Risk and Insurance

Administering a risk management Program

• Effective RM prog call for performance of following duties;– Identification of Loss exposure– Identification of key person– Selection of broker– Information system– Settlement of claims– Develop information systems