Chapter 11

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Risk and Insurance

nsurance is the most common method used for transferring risks. It transfers the risk from an individual to a group. It also provides a means for paying for losses. Insurance provides an important means of preventing risk from interfering with a clients achieving financial objectives.

How Insurance works?

To understand the concept of insurance, let us imagine a small town with 100 houses. The town is located in an area where storms of great severity occur frequently. Each family in the town faces the risk that a storm will destroy their house completely. If the house is destroyed, the family will have to spend Rs. 50,000 to reconstruct the house. However, at the same time, it is unlikely that a storm will destroy all the 100 houses simultaneously. Lets suppose all the citizens of the town agree to share the losses (if and when they occur) equally, so that no single family will be forced to bear the entire loss of Rs. 50,000. This means that whenever any house is destroyed, every family will pay a sum of Rs. 500 to the affected family to rebuild their house. While the cost of Rs. 50,000 would have been crippling for a single family, the expense of Rs. 500 is easily affordable. Thus, the risk is transferred from a single family to the entire village and the loss (when it occurs) is shared. In our example, the risk sharing and risk transfer is dependent upon the town people successfully agreeing to bear the expenses of reconstruction of houses. In the real world, it would be very difficult to reach at such an agreement and even more difficult to enforce it, because: Some people might not agree to be part of such an agreement, making it difficult to reach the large numbers of participants necessary for the scheme to work. Some people might not pay their share, even though they were part of the agreement. Someone would need to perform the task of collecting money from the people and providing it to the affected family. In the real world, insurance companies act as facilitators and remove the obstacles to risk transfer and risk sharing. They perform the functions of making agreements, collecting money, calculating losses and providing payments to affected persons.

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Definition: Insurance is defined as an economic device whereby the individual can substitute a small definite cost (the premium) for a large uncertain financial loss (the risk). In the larger perspective, let us hear what an insider has to say from an expert view point. Expert View In an interview Mr.K R Subramanian, COO, ING Vysya Life mentions that in a fiercely competitive market like life insurance, all players deal in similar products. They use the same Indian mortality assumptions and pricing. The only differentiating factor is cost leadership and efficient service. We have to issue policies faster and make sure that normal insurance applications are processed quickly. Subramanian feels that there is a need to build awareness about risk management so that people adopt good risk minimisation methodology. Insurance is a crucial element of transferring risk. Todays wellinformed customers want to spend an allotted amount intelligently. Insurance has developed to such an extent that it can shift risk from insurance to the capital market by means of a methodology called alternate risk transfer (ART). This includes catastrophe bonds, for instance you get a particular return if earthquake hits Japan or you get another value as return if an earthquake does not hit Japan, says Subramanian. These are high end investment instruments targeted at very specific well informed clientele. Pooling of Risks To perform the function of insurance and to carry out their own activities, insurance companies need to collect contributions from individuals. But since losses are unpredictable, how does the insurance company decide how much to collect from each individual? The theory of probability deals with random events and postulates that while some events appear to be a matter of chance, they actually occur with regularity over a large number of trials revealing a measurable pattern. To draw an analogy it is difficult to state with confidence whether the daytime temperature will cross 40 C on a particular day in Delhi, but if data for the past 15 years is collected, it can be seen that in Delhi, the daytime temperature exceeds 40 C on most days in May and June. Study of historical data is an important means to understand probability of occurance. Statistical tools are also employed to this effect.

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This phenomenon is known as the Law of Large Numbers. Definition: The law of large Numbers implies that the frequency with which an event happens, reflects the actual probability of the event occurring more closely if the number of cases involved is larger. The law of large numbers finds many applications in the field of insurance. The most important of them is that if the risks faced by a large number of individuals are pooled together, then the probability of the adverse events actually occurring can be predicted quite accurately. This enables the insurance companies to predict the losses that will actually occur over a period of time and thereby fix the contributions payable by each individual. Insurance companies also employ other statistical techniques like regression analysis, loss distributions, mortality tables to arrive at the probability of occurrence of a particular event which, in turn, is used to fix the level of premium contributions.

Characteristics of Insurable Risks

Insurance thus appears to be an elegant solution for transfer of all risks. With relative ease, an individual can be free of all risks that can cause financial insecurity. However, not all risks are insurable. Insurance companies do not cover speculative risks. They cannot be expected to absorb risk that a person creates wilfully in expectation of a profit. The essential characteristics of insurable risks are: The risk must be a part of a large number of homogeneous units; otherwise the law of large numbers will not apply making it difficult to estimate the probability of losses. The loss due to the risk must be definite and measurable. The insurer must be able to determine that a loss has occurred and to accurately measure the economic impact of the loss. This is because insurers can only provide re-imbursement of the financial loss occurred. They cannot always undo the damage done. For example, a rare painting of say, Picasso, if destroyed, cant be reconstructed. The damage or loss due to the risk must be fortuitous or accidental. Insurers cannot be held responsible to pay for certain (intentionally caused) losses.

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The damage or loss due to the risk must not be catastrophic. Insurance is based on the principle that the losses of individuals are divided within a group. In a catastrophic loss, each member of the group suffers a loss and hence, would be unable to bear the losses of others. Therefore, the device of insurance fails if the loss is big enough to produce such widespread devastation as to wipe out the total pool of insured homogeneous units.

Benefits and Costs of Insurance to Society

Apart from protecting insured individuals, insurance offers many benefits to the society as a whole. Let us look at these in more detail. Indemnification of loss Insurance restores individuals to their former financial condition after a loss. As a result, it reduces the amount of disruption that such losses would otherwise cause. Insurance contributes immensely to family and business stability in the society. Reduction of anxiety Insurance reduces the level of anxiety and stress in the society because the insured individuals do not have to worry about financial insecurity in case of adverse events. Even if such events occur, insurance reduces worry because the insured know that the insurance they have will pay for the loss. Source of investment funds Insurance companies collect premiums in advance of the loss. Thus, they have large amount of accumulated funds that are used only when losses actually occur. These funds are invested in different forms and promote capital investment and economic growth. Loss prevention Since insurance companies benefit if incidence of loss causing events goes down, they actively promote best practices for loss prevention amongst insured. Insurance companies employ a wide variety of personnel who specialize in loss-prevention such as safety engineers and fire prevention experts. Better safety measures adopted by individuals because of the insurance companies activities go a long way in reducing the losses that would otherwise occur. Enhancement of credit Insurance makes a borrower a better credit risk because it acts as collateral to the lender. The lender knows that in case of any adverse event which causes financial losses or affects the income potential of the borrower, the insurer will restore the borrower to his former financial position.

Costs of Insurance to society

The major social costs of insurance are: Cost of doing business Fradulent Claims Inflated Claims Cost of doing business The administration and sales and marketing costs incurred by the insurers for the purpose of doing business are also recovered from the persons seeking insurance. As a result, the premium they pay is

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slightly higher than that required for pure risk cover. This is called expense loading of the premium. However, these costs are more than justified, considering the many benefits of insurance. Fradulent Claims Dishonest policyholders submit fraudulent claims to insurance companies by faking losses. The payment of such claims increases the cost of insurance for all insureds. Inflated Claims Another related cost of insurance is submission of inflated claims by policyholders. While the loss is actual and accidental, many policyholders inflate the severity of loss so as to profit from insurance. This again results in higher premiums for all insureds.

Chapter Review

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