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Insurance & Risk

Management
Basic Queries
• What will be the contribution of this paper
in my carrier as finance professional?
• Why do we need to study Insurance?
• What are insurance services?
WHAT IS RISK?
• Risk is defined as uncertainty concerning the
occurrence of a loss.
• Objective Risk: the relative variation of actual
loss from expected loss. Objective risk declines
as the number of exposures increases. More
specifically, objective risk varies inversely with
the square root of the number of cases under
observation.
• Subjective Risk :uncertainty based on a
person’s mental condition or state of mind.
Categories of Risk
• Pure and Speculative risks
• Types of Pure Risk
– Personal risk
• Risk of premature death or disability
• Risk of insufficient income on retirement
• Risk of unemployment
– Property risk
• Direct Loss
• Indirect or consequential loss
– Liability risk
• Fundamental and Particular Risks
Chance of loss
• Chance of loss is defined as the probability that an event will
occur.
• Objective Probability
– deductive reasoning
– inductive reasoning
• Subjective Probability
• Chance of Loss distinguished from Risk: For example,
assume that a fire insurer has 10,000 homes insured in
Mumbai and 10,000 houses insured in Delhi. Also assume
that the chance of loss in each city is 1 percent. Thus, on an
average, 100 homes should burn annually in each city.
However, if the annual variation in losses ranges from 75 to
125 in Mumbai, but only from 90 to 110 in Delhi, objective risk
is greater in Mumbai even though the chance of loss in both
cities is the same.
Insurance and society
• Risk to society
– Larger emergency fund
– Loss of certain goods and services
– Worry and fear
• Costs to society
– Cost of doing business
– Fraudulent claims
– Inflated claims
• Benefits to society
– Indemnification for loss
– Less worry and fear
– Source of investment funds
– Loss prevention
– Enhancement of credit
METHODS OF HANDLING RISK
• Risk avoidance;
• Risk retention;
– Active retention
– Passive retention
• Risk transfer;
– Transfer of risk by contracts
– Hedging
– Incorporation of a business firm
• Loss control;
– Loss prevention
– Loss reduction
• Insurance
• Choice of methods depends on the frequency and severity of loss.
Peril and Hazard
• Peril is the cause of loss.
• Hazard is a condition that creates or
increases the chance of loss.
– Physical Hazard
– Moral Hazard
– Morale Hazard
Definition of Insurance
• “Insurance is the pooling of fortuitous
losses by transfer of such risks to insurers,
who agree to indemnify insured for such
losses, to provide other pecuniary benefits
on their occurrence or to render services
connected with the risk”
Commission on Insurance Terminology
of the American Risk and Insurance
Association
Basic Characteristics of Insurance
• Pooling of losses
– Spreading losses incurred by the few over the entire group
– Risk reduction based on the Law of Large Numbers
• Payment of fortuitous losses
– Insurance pays for losses that are unforeseen, unexpected, and
occur as a result of chance
• Risk transfer
– A pure risk is transferred from the insured to the insurer, who
typically is in a stronger financial position
• Indemnification
– The insured is restored to his or her approximate financial
position prior to the occurrence of the loss
Requirements of an Insurable Risk
• Large number of exposure units
– to predict average loss
• Accidental and unintentional loss
– to control moral hazard
– to assure randomness
• Determinable and measurable loss
– to facilitate loss adjustment
• insurer must be able to determine if the loss
is covered and if so, how much should be
paid.
Requirements of an Insurable Risk

• No catastrophic loss
– to allow the pooling technique to work
– exposures to catastrophic loss can be managed
by:
• dispersing coverage over a large geographic area
• using reinsurance
• catastrophe bonds

• Calculable chance of loss


– to establish an adequate premium
Requirements of an Insurable Risk
• Economically feasible premium
– so people can afford to buy
– Premium must be substantially less than the
face value of the policy

• Based on these requirements:


– Most personal, property and liability risks can be
insured
– Market risks, financial risks, production risks and
political risks are difficult to insure
– Compare Fire and Unemployment
Risk of Fire as an Insurable
Risk
Risk of Unemployment as an
Insurable Risk
Adverse Selection
• The tendency of persons with higher than
average chance of loss to seek insurance at
standard rates which if not controlled by
underwriting results in higher than expected loss
levels.
• Underwriting refers to the process of selecting
and classifying applicants for insurance.
• Policy provisions are also used to control
adverse selection.
Insurance vs. Gambling
Insurance Gambling

• Insurance is a technique • Gambling creates a


for handing an already new speculative risk
existing pure risk

• Insurance is socially • Gambling is not socially


productive: productive
– both parties have a – The winner’s gain comes
common interest in the at the expense of the
prevention of a loss loser
Insurance vs. Hedging
Insurance Hedging

• Risk is transferred by a • Risk is transferred by a


contract contract
• Insurance involves the • Hedging involves risks
transfer of insurable risks that are typically
• Insurance can reduce the uninsurable
objective risk of an • Hedging does not result
insurer through the Law in reduced risk
of Large Numbers
Types of Insurance
Types of Insurance
• Private Insurance
– Life and Health
– Property and Liability
• Government Insurance
– Social Insurance
– Other Government Insurance
Private Insurance
• Life and Health
– Life insurance pays death benefits to beneficiaries when
the insured dies
– Health insurance covers medical expenses because of
sickness or injury
– Disability plans pay income benefits
• Property and Liability
– Property insurance indemnifies property owners against
the loss or damage of real or personal property
– Liability insurance covers the insured’s legal liability
arising out of property damage or bodily injury to others
– Casualty insurance refers to insurance that covers
whatever is not covered by fire, marine, and life insurance
Private Insurance
• Private insurance coverages can be grouped
into two major categories
– Personal lines
• coverages that insure the real estate and personal property
of individuals and families or provide protection against legal
liability
– Commercial lines
• coverages for business firms, nonprofit organizations, and
government agencies
Government Insurance
• Social Insurance Programs
– Financed entirely or in large part by contributions from
employers and/or employees
– Benefits are heavily weighted in favor of low-income
groups
– Eligibility and benefits are prescribed by statute
– Examples:
• Social Security, Unemployment, Workers Comp
• Other Government Insurance Programs
– Found at both the federal and state level
– Examples:
• Federal flood insurance, state health insurance pools
Basic Statistics and law of Large
Numbers
• EV = X1P1+X2P2+X3P3…………
• SD= P1(X1-EV)2+P2(X2-EV)2+……….
• Law of large numbers
• Central Limit Theorum : If you draw random samples of n
observations from any population and n is sufficiently large, the
distribution of sample means will be approximately normal, with the
mean of the distribution equal to the mean of the population. And
the standard error of the sample mean equal to the standard
deviation of the population divided by the square root of n. this
approximation becomes increasingly accurate as the sample size
increases.
• Standard error of the sample mean loss distribution is equal to the
S.D of the population divided by the square root of the sample size.
Risk management
Meaning of Risk Management
• Risk Management is a process that identifies loss
exposures faced by an organization and selects the most
appropriate techniques for treating such exposures
• A loss exposure is any situation or circumstance in which
a loss is possible, regardless of whether a loss occurs
– E.g., a plant that may be damaged by an earthquake, or an
automobile that may be damaged in a collision
• New forms of risk management consider both pure and
speculative loss exposures
Objectives of Risk Management
• Risk management has objectives before
and after a loss occurs
• Pre-loss objectives:
– Prepare for potential losses in the most
economical way
– Reduce anxiety
– Meet any legal obligations
Objectives of Risk Management
• Post-loss objectives:
– Ensure survival of the firm
– Continue operations
– Stabilize earnings
– Maintain growth
– Minimize the effects that a loss will have on
other persons and on society
Risk Management Process
• Identify potential losses
• Evaluate potential losses
• Select the appropriate risk management
technique
• Implement and monitor the risk
management program
Steps in the Risk Management
Process
Identifying Loss Exposures
• Property loss exposures
• Liability loss exposures
• Business income loss exposures
• Human resources loss exposures
• Crime loss exposures
• Employee benefit loss exposures
• Foreign loss exposures
• Market reputation and public image of company
• Failure to comply with government rules and regulations
Identifying Loss Exposures
• Risk Managers have several sources of
information to identify loss exposures:
– Questionnaires
– Physical inspection
– Flowcharts
– Financial statements
– Historical loss data
• Industry trends and market changes can create
new loss exposures.
– e.g., exposure to acts of terrorism
Analyzing Loss Exposures
• Estimate the frequency and severity of loss for each type of
loss exposure
– Loss frequency refers to the probable number of losses that may
occur during some given time period
– Loss severity refers to the probable size of the losses that may
occur
• Once loss exposures are analyzed, they can be ranked
according to their relative importance
• Loss severity is more important than loss frequency:
– The maximum possible loss is the worst loss that could happen to
the firm during its lifetime
– The maximum probable loss is the worst loss that is likely to happen
Select the Appropriate Risk
Management Technique
• Risk control refers to techniques that reduce
the frequency and severity of losses
• Methods of risk control include:
– Avoidance
– Loss prevention
– Loss reduction
Risk Control Methods
– Avoidance means a certain loss exposure is
never acquired, or an existing loss exposure
is abandoned
• The chance of loss is reduced to zero
• It is not always possible, or practical, to avoid all
losses
Risk Control Methods
– Loss prevention refers to measures that
reduce the frequency of a particular loss
• e.g., installing safety features on hazardous
products
– Loss reduction refers to measures that reduce
the severity of a loss after is occurs
• e.g., installing an automatic sprinkler system
Select the Appropriate Risk
Management Technique
• Risk financing refers to techniques that
provide for the funding of losses
• Methods of risk financing include:
– Retention
– Non-insurance Transfers
– Commercial Insurance
Risk Financing Methods: Retention
• Retention means that the firm retains part or all of
the losses that can result from a given loss
– Retention is effectively used when:
• No other method of treatment is available
• The worst possible loss is not serious
• Losses are highly predictable
– The retention level is the dollar amount of losses that the
firm will retain
• A financially strong firm can have a higher retention level than a
financially weak firm
• The maximum retention may be calculated as a percentage of
the firm’s net working capital
Risk Financing Methods: Retention
– A risk manager has several methods for
paying retained losses:
• Current net income: losses are treated as current
expenses
• Unfunded reserve: losses are deducted from a
bookkeeping account
• Funded reserve: losses are deducted from a liquid
fund
• Credit line: funds are borrowed to pay losses as
they occur
Risk Financing Methods: Retention
• A captive insurer is an insurer owned by a parent firm for the
purpose of insuring the parent firm’s loss exposures
– A single-parent captive is owned by only one parent
– An association or group captive is an insurer owned by several
parents
– Captives are formed for several reasons, including:
• The parent firm may have difficulty obtaining insurance
• Costs may be lower than purchasing commercial insurance
• A captive insurer has easier access to a reinsurer
• A captive insurer can become a source of profit
– Premiums paid to a captive may be tax-deductible under certain
conditions
Risk Financing Methods: Retention
• Self-insurance is a special form of planned retention
– Part or all of a given loss exposure is retained by the firm
– A more accurate term would be self-funding
– Widely used for workers compensation and group health
benefits
• A risk retention group is a group captive that can write
any type of liability coverage except employer liability,
workers compensation, and personal lines
Risk Financing Methods: Retention
Advantages Disadvantages

– Save money – Possible higher losses


– Lower expenses – Possible higher
– Encourage loss expenses
prevention – Possible higher taxes
– Increase cash flow
Risk Financing Methods: Non-
insurance Transfers
• A non-insurance transfer is a method
other than insurance by which a pure risk
and its potential financial consequences
are transferred to another party
– Examples include:
• Contracts, leases, hold-harmless agreements
Risk Financing Methods: Non-
insurance Transfers
Advantages Disadvantages

– Can transfer some – Contract language


losses that are not may be ambiguous,
insurable so transfer may fail
– Save money – If the other party
– Can transfer loss to fails to pay, firm is
someone who is in still responsible for
a better position to the loss
control losses – Insurers may not
give credit for
transfers
Risk Financing Methods: Insurance
• Insurance is appropriate for loss exposures that
have a low probability of loss but for which the
severity of loss is high
– The risk manager selects the coverages needed, and
policy provisions:
• A deductible is a provision by which a specified amount is
subtracted from the loss payment otherwise payable to the
insured
• An excess insurance policy is one in which the insurer does not
participate in the loss until the actual loss exceeds the amount
a firm has decided to retain
– The risk manager selects the insurer, or insurers, to
provide the coverages
Risk Financing Methods: Insurance
– The risk manager negotiates the terms of the
insurance contract
• A manuscript policy is a policy specially tailored for
the firm
– Language in the policy must be clear to both parties
• The parties must agree on the contract provisions,
endorsements, forms, and premiums
– The risk manager must periodically review the
insurance program
Risk Financing Methods: Insurance

Advantages Disadvantages

– Firm is indemnified for – Premiums may be costly


losses • Opportunity cost
– Uncertainty is reduced should be considered
– Insurers may provide – Negotiation of contracts
other risk management takes time and effort
services – The risk manager may
– Premiums are tax- become lax in
deductible exercising loss control
Risk Management Matrix
Implement and Monitor the Risk
Management Program
• Implementation of a risk management program begins with
a risk management policy statement that:
– Outlines the firm’s risk management objectives
– Outlines the firm’s policy on loss control
– Educates top-level executives in regard to the risk management
process
– Gives the risk manager greater authority
– Provides standards for judging the risk manager’s performance
• A risk management manual may be used to:
– Describe the risk management program
– Train new employees
Implement and Monitor the Risk
Management Program
• A successful risk management program
requires active cooperation from other
departments in the firm
• The risk management program should be
periodically reviewed and evaluated to
determine whether the objectives are being
attained
– The risk manager should compare the costs and
benefits of all risk management activities
Benefits of Risk Management
• Pre-loss and post-loss objectives are attainable
• A risk management program can reduce a firm’s cost of risk
– The cost of risk includes premiums paid, retained losses, outside risk
management services, financial guarantees, internal administrative
costs, taxes, fees, and other expenses
• Reduction in pure loss exposures allows a firm to enact an
enterprise risk management program to treat both pure and
speculative loss exposures
• Society benefits because both direct and indirect losses are
reduced
Personal Risk Management
• Personal risk management refers to the
identification of pure risks faced by an individual
or family, and to the selection of the most
appropriate technique for treating such risks
• The same principles applied to corporate risk
management apply to personal risk
management

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