MF0009 – Insurance & Risk Management -Set-1

Q.1) “Risk can be classified into several distinct categories”. Explain. Ans: Risks may be classified in several distinct ways as explained below: (a) Financial and Non-financial Risks In its broadest context, risk includes all situations in which there is an exposure to adversity. In some cases, this adversity involves financial loss while in others it does not. There is some element of risk in every aspect of human endeavour, and many of these risks have no (or only incidental) financial consequences. Financial risk involves the relationship between an individual (or an organisation) and an asset or expectation of income that may be lost or damaged. Thus, financial risk involves three elements: (i) the individual or organization that is exposed to loss, (ii) the asset or income whose destruction or dispossession will cause financial loss, and (iii) a peril that can cause the loss. The first element in financial risk is that someone will be affected by the occurrence of an event. During the devastating floods, a considerably large area of farmland is damaged by flood waters, causing a financial loss to the tune of several billions to the owners. The second and third elements are the thing of value and the peril that can cause the loss of the thing of value. The individual who owns nothing of value and who has no prospects for improving that situation faces no financial risk. Further, if nothing could happen to the individual’s assets or expected income, there is no risk. b) Static and Dynamic Risk A second important distinction is between static and dynamic risks. Dynamic risks are those resulting from changes in the economy. Changes in the price level, consumer tastes, income and output, and technology may cause financial loss to members of the economy. These dynamic risks normally benefit society over the long run, since they are the result of adjustments to misallocation of resources. Although these dynamic risks may affect a large number of individuals, they are generally considered less predictable than static risks, since they do not occur with any precise degree of regularity. Static risks involve those losses that would occur even if there were no changes in the economy. If we could hold consumer tastes, output and income, and the level of technology constant, some individuals would still suffer financial loss. These losses arise from causes other than the changes in the economy, such as the perils of nature and the dishonesty of other individuals. Unlike dynamic risks, static risks are not a source of gain to society. Static losses involve either the destruction of the asset or a change in its possession as a result of dishonesty or human failure. Static losses tend to occur with a degree of regularity over time and, as a result, are generally predictable. Because they are predictable, static risks are more suited to treatment by insurance than are dynamic risks.
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c) Acceptable and Unacceptable Risk There are two elements of uncertainty in most types of events that are handled by risk managers – the likelihood of the event occurring, and the size of the ensuing loss. Generally, the degree of risk aversion displayed by individuals acting in either a private or managerial capacity tends to increase with the potential size of loss. Some loss potentials are so small that an individual or organization is prepared to accept the risk and assume any loss that does occur. Beyond a certain size, the risk becomes unacceptable and ways will be sought to avoid, reduce or transfer that risk. Of course, the maximum size of loss that can be tolerated depends on the status of the individual or organisation, and so the division between acceptable and unacceptable risks is not entirely clear-cut for two reasons. First, it depends partly on time. The size of loss that could be absorbed by, say, one year’s profits would normally be far larger than could be accommodated within one month’s operating budget. Secondly, there will be a range of potential losses where the occurrence of the loss could strain the individual’s or an organization’s finances but it could be overcome (perhaps by resort to borrowing or raising additional capital). Then, whether the risk of incurring a loss of any size will be regarded as acceptable or unacceptable will depend upon the cost of handling the risk relative to the benefits thereof. For example, if loss reduction measures would greatly exceed the expected reduction in losses; or if the premium required by insurers is deemed high relative to the risk that would be transferred, then no attempt may be made to reduce the risk or insure it. The division between acceptable and unacceptable risk will always be influenced even if it is not fully determined by such financial considerations. Furthermore it will be influenced by the allocation of the costs and benefits of those risks and methods of handling them between persons who may be affected. In the case of industrial accidents, for instance, according to the rules laid down by law, the employer will be liable to compensate employees for injuries sustained as the result of accidents at work, though whether the size of award determined according to those rules represents adequate compensation for the pain, suffering, loss of amenity and loss of an injured employee’s present and future earnings is a matter of judgement. The cost of reducing the probability and/or severity of such accidents will fall directly upon the employer, though some or all of that cost may ultimately be passed on to the employees through a reduction in earnings due to a cut in the risk premium element of wages. Because perceived costs and benefits may differ, employees (or their trade union representatives) may have a different view as to what constituted an unacceptable risk to that held by the employer. d) Fundamental and Particular Risks A fundamental risk is a risk that affects the entire economy or large numbers of persons or groups within the economy. Examples include rapid inflation, cyclical unemployment and war because large numbers of individuals are affected. The risk of a natural disaster is another important type of fundamental risk. Hurricanes, tornadoes, earthquakes, floods, and forest and grass fires can result in damage to billions of dollars worth property and cause numerous deaths.
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In contrast to a fundamental risk, a particular risk is a risk that affects only individuals and not the entire community, Examples include car thefts, bank robberies, and dwelling fires. Only individuals experiencing such losses are affected, not the entire economy. The distinction between a fundamental and a particular risk is important because Government assistance may be necessary to insure a fundamental risk. Social insurance and Government insurance programmes, as well as government guarantees and subsidies, may be necessary to insure certain fundamental risks. For example, the risk of unemployment generally is not insurable by private insurers but can be insured publicly by state unemployment compensation programmes. e) Pure and Speculative Risks Pure risk is defined as a situation in which there are only the possibilities of loss or no loss. The only possible outcomes are adverse (loss) and neutral (no loss). Examples of pure risks include premature death, job-related accidents, catastrophic medical expenses, and damage to property from fire, lighting, flood, or earthquake. Speculative risk is defined as a situation in which either profit or loss is possible. For example, if you purchase 100 shares, you would profit if the price of the shares increases but would lose if the price declines. Other examples of speculative risk include betting on a horse race, investing in real estate, and going into business for self. In these situations, both profit and loss are possible. It is important to distinguish between pure and speculative risks for three easons. First, private insurers generally insure only pure risks. With certain exceptions, speculative risks are not considered insurable, and other techniques for coping with risk must be used. (One exception is that some insurers will insure institutional portfolio investments and municipal bonds against loss). Second, the law of large numbers can be applied more easily to pure risks than speculative risks. The law of large numbers is important because it enables insurers to predict future loss experience. In contrast, it is generally more difficult to apply the law of large numbers to speculative risks to predict future loss experience. An exception is the speculative risk of gambling, where casino operators can apply the law of large numbers in a most efficient manner. Finally, society may benefit from a speculative risk even though a loss occurs, but it is harmed if a pure risk is present and a loss occurs. For example, a firm may develop new technology for producing inexpensive computers. As a result, some competitors may be forced into bankruptcy. Despite the bankruptcy, society benefits because the computers are made available at a lower cost. However, society normally does not benefit when a loss from a pure risk occurs, such as a flood or earthquake that devastates an area.

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Types of Pure Risk The major types of pure risk that can create great financial insecurity include personal risks, property risks, and liability risks. a) Personal Risks: Personal risks are those risks that directly affect an individual; they involve the possibility of complete loss or reduction of earned income, extra expenses, and the depletion of financial assets. There are four major personal risks: · Risk of premature death · Risk of insufficient income during retirement · Risk of poor health · Risk of unemployment i) Risk of Premature Death: Premature death is defined as the death of a household head with unfulfilled financial obligations. These obligations can include dependents to support, a mortgage to be paid off, or children to be educated. If the surviving family members receive an insufficient amount of replacement income from other sources or have insufficient financial assets to replace the lost income, they may be financially insecure. Premature death can cause financial problems only if the deceased has dependents to support or dies with unfulfilled financial obligations. Thus, the death of a child aged 10 is not "premature" in the economic sense. There are at least four costs that result from the premature death of a household head. First, the human life value of the family head is lost forever. The human life value is defined as the present value of the family’s share of the deceased breadwinner’s future earnings. This loss can be substantial; the actual or potential human life value of most college graduates can easily exceed Rs.500,000. Second, additional expenses may be incurred because of funeral expenses, uninsured medical bills, probate and estate settlement costs, and estate and inheritance taxes for larger estates. Third, because of insufficient income, some families may have trouble making both ends meet for covering expenses. Finally, certain non-technical costs are also incurred, including emotional grief, loss of a role model, and counselling and guidance for the children. ii) Risk of Insufficient Income during Retirement: The major risk associated with old age is insufficient income during retirement. The vast majority of workers in India retire at the age of 60. When they retire, they lose their earned income. Unless they have sufficient financial assets on which to draw, or have access to other sources of retirement income such as social security or pension, they will be exposed to financial insecurity during retirement. How are older people, aged 60 and over, doing financially? In answering this question, it is a mistake to assume that all aged are wealthy; it is equally wrong to assume that all aged are
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poor. The aged are an economically diverse group, and their total money incomes are far from uniform. iii) Risk of Poor Health: Poor health is another important personal risk. The risk of poor health includes both the payment of catastrophic medical bills and the loss of earned income. The costs of major surgery have increased substantially in recent years. For example, an open-heart surgery can cost more than Rs. 200,000, a kidney or heart transplant can cost more than Rs. 400,000, and the costs of crippling accident requiring several major operations, plastic surgery, and rehabilitation can exceed Rs. 500,000. In addition, long-term care in a nursing home can cost Rs. 50,000 or more each year. Unless these persons have adequate health insurance or private savings and financial assets, or other sources of income to meet these expenditures, they will be financially insecure. In particular, the inability of some persons to pay catastrophic medical bills is an important cause of personal bankruptcy. The loss of earned income is another major cause of financial insecurity if the disability is severe. In cases of long-term disability, there is a substantial loss of earned income, burden of medical bills, loss or reduction of employee benefits and depleted savings. Moreover, someone must take care of the disabled person. iv) Risk of Unemployment: The risk of unemployment is another major threat to financial security. Unemployment can result from business cycle downswings, technological and structural changes in the economy, seasonal factors, and imperfections in the labour market. At present in India, the unemployment rate is very high. Unemployment at times is a serious evil because of several important trends. To hold down labour costs, large corporations have resorted to downsizing and their work force has been permanently reduced; employers are increasingly hiring temporary or part-time workers to reduce labour costs; and millions of jobs have been lost to foreign nations because of global competition. Regardless of the reason, unemployment can cause financial insecurity in at least three ways. First, workers lose their earned income and employee benefits. Unless there is adequate replacement income or past savings on which to draw, the unemployed worker will be financially insecure. Second, because of economic conditions, the worker may be able to work only part-time. The reduced income may be insufficient in terms of the worker’s needs. Final, if the duration of unemployment is extended over a long period, past savings may be exhausted. b) Property Risks: Persons owning property are exposed to the risk of having their property damaged or loss from numerous causes. Real estate and personal property can be damaged or destroyed due to fire, lightning, tornadoes, windstorms, and numerous other causes. There are two major types of loss associated with the destruction or theft of property- direct loss and indirect or consequential loss. i) Direct Loss: A direct loss is defined as a financial loss that results from the physical damage, destruction, or theft of the property. For example, if you own a restaurant that is damaged by fire, the physical damage to the restaurant is known as direct loss.
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ii) Indirect or Consequential Loss: An indirect loss is a financial loss that results indirectly from the occurrence of a direct physical damage or theft. Thus, in addition to the physical damage loss, the restaurant is to be rebuilt. The loss of profits would be a consequential loss. Other examples of a consequential loss would be the loss of rents, the loss of the use of the building, and the loss of a local market. Extra expenses are another type of indirect or consequential loss. For example, suppose you own a vegetable shop or dairy. If a loss occurs, you must continue to operate regardless of cost; otherwise, you will lose customers to your competitors. It may be necessary to set up a temporary operation at some alternative location, and substantial extra expenses need to be incurred. c) Liability Risks: Liability risks are another important type of pure risk that most persons face. Under our legal system, you can be held legally liable if you do something that result in bodily injury or property damage to someone else. A court of law may order you to pay substantial damages to the person you have injured. Liability risks are of great importance for several reasons. First, there is no maximum upper limit with respect to the amount of loss. One can be sued for any amount. In contrast, if you own property, there is a maximum limit on the loss. For example, if your car has an actual cash value of Rs.100,000, the maximum physical damage loss is Rs.1,00,000. But if you are negligent and cause an accident that results in serious bodily injury to the other person, you can be sued for any amount say Rs. 50,000, Rs. 500,000, or Rs. 1 million or more by the person you have injured. Second, a lien can be placed on your income and financial assets to satisfy a legal judgment. For example, assume that you injure someone, and a court of law orders you to pay damages to the injured party. If you cannot pay as per the judgment, a lien may be placed on your income and financial assets to satisfy the judgment. If you declare bankruptcy to avoid payment of the judgement, your credit rating will be impaired. Finally, legal defence costs can be enormous. If we have no liability insurance, the cost of hiring an attorney to defend can be staggering. If the suit goes to trial, attorney fees and other legal expenses can be substantial.

Q.2) Identify common misconceptions about risk management and explain why these misconceptions are developed. Ans: Misconceptions about Risk Management and Reasons for its development Now a days risk management has become a popular topic of discussion, some of what is discussed reflects a misunderstanding of risk management. Some of these misconceptions reflect a misreading of the literature, while others reflect defects in the literature itself. The first misconception is that the risk management concept is principally applicable to large
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organizations. The second is that the risk management approach to dealing with pure risks seeks to minimize the role of insurance. a) Universal Applicability If one were to judge on the basis of much of the literature dealing with the concept of risk management, it is be easy to conclude that risk management has no useful application except with respect to the problems facing a large industrial complex. This misconception can easily result from the fact that many of the techniques with which writers have been preoccupied (e.g., self-insurance plans, captive insurers, etc.) do apply primarily to giant organizations. Most of the articles on risk management have been written by practicing professional Risk Mangers. It is natural that they would write about the techniques they use in their own companies, and virtually all professional Risk Managers are employed by large organizations. But it cannot be overemphasized that the risk management philosophy and approach applies to organizations of all sizes (and to individuals as well for that matter), even though some of the more esoteric techniques may have limited application in the case of an average organization. As the Risk Manager’s position has increased within the corporate framework and risk management has become a recognized term in business jargon, the interest in risk management has increased in businesses of all sizes. While it is obvious that the small firm cannot afford a full-time professional Risk Manager, the principles of risk management are as applicable to the small organization as to the giant international firm. The principles of risk management are nothing more than common sense applied to the management of pure risks facing an individual or organization. The principles are applicable to organizations of all sizes, as well as to individuals and families. While the techniques may differ in scope and complexity, the same risk management tools are used in either case. b) Anti-Insurance Bias? The second misconception about risk management that it is anti-insurance in its orientation and that it seeks to minimize the role of insurance in dealing with risk also stems from risk management literature. Much of the literature on risk management has also been preoccupied with topics related to risk retention, self-insurance programmes, and captive insurance companies. Indeed, if one were to ask practitioners in the insurance field to describe the essence of risk management that is, its philosophy – many would respond that the major emphasis of risk management is on the retention of risk and on the use of deductibles. While it is true that retention is an important technique for dealing with risks, it is not what risk management is all about. The essence of risk management is not in the retention of exposures. Rather it is in dealing with risks by whatever mechanism is most appropriate. In many instances, commercial insurance will be the only acceptable approach. While the risk management philosophy suggests that there are some risks that should be retained, it also dictates that there are some risks that must be transferred. The primary focus of the Risk Manager should be on the identification of the risks that must be transferred to achieve the primary risk management objective. Only after this determination has been made does the question of which risks should be retained arise. More often than not, determining which risks should be transferred
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also determines which risks will be retained; the residual class that does not need to be transferred.

Q.3) What are the social values of insurance? What are the social costs? Explain. Ans: Social and Economic Values of Insurance: There are many social and economic values of insurance, which are as follows: 1. Reduced Reserve Requirements Perhaps the greatest social value – indeed, the central economic function – of insurance is to obtain the advantages that flow from the reduction of risk. One of the chief economic burdens of risk is the necessity of accumulating funds to meet possible losses, and one of the greatest advantages of the insurance mechanism is that it greatly reduces the total of such reserves necessary for a given economy. Because the insurer can predict losses in advance, it needs to keep readily available only enough funds to meet those losses and to cover expenses. If each insured has to set aside such funds, there would be need for a far greater amount. For example, in many localities, a Rs. 100,000 building can be insured against fire and other physical perils for about Rs. 500 a year. If insurance is not available, the insured would probably feel a need to set aside funds at a much higher rate than Rs. 500 a year. 2. Capital Freed for Investment Another aspect of the advantage just described is the fact that the cash reserves that insurers accumulate are made available for investment. Insurers as a group, and life insurance firms in particular, are among the largest and most important institutions collecting and distributing the nation’s savings. From the viewpoint of the individual, the insurance mechanism enables renting an insurer’s assets to cover uncertain losses rather than providing this capital internally, much like renting a building instead of owning one. Capital that is thereby released frees funds for investment purposes. Thus, the insurance mechanism encourages new investment. For example, if an individual knows that his or her family will be protected by life insurance in the event of premature death, the insured may be more willing to invest savings in a long-desired project such as a business venture, without feeling that the family is being robbed of its basic income security. In this way, a better allocation of economic resources is achieved. 3. Reduced Cost of Capital Because the supply of funds that can be invested is greater than it would be without insurance, capital is available at a lower cost than would otherwise be possible. This result brings about a higher standard of living because increased investment itself will raise production and cause lower prices than would otherwise be the case. Also, because insurance is an efficient device to reduce risks, investors may be willing to enter fields they would otherwise reject as too risky. Thus, society benefits from increased services and new products, the hallmarks of increased living standards.
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4. Reduced Credit Risk Another advantage of insurance lies in its importance to credit. Insurance has been called the basis of the nation’s credit system. It follows logically that if insurance reduces the risk of loss from certain sources, it should mean that an entrepreneur is a better credit risk if adequate insurance is carried. Today it would be nearly impossible to borrow money for many business purposes without insurance protection that meets the requirements of the lender. 5. Loss Control Activities Another social and economic value of insurance lies in its loss control or loss prevention activities. Although the main function of insurance is not to reduce loss but merely to spread losses among members of the insured group, insurers are nevertheless vitally interested in keeping losses at a minimum. Insurers know that if no effort is made in this regard, losses and premiums would have a tendency to rise. It is human nature to relax vigilance when it is known that the loss will be fully paid by the insurer. Furthermore, in any given year, a rise in loss payment reduces the profit to the insurer, and so loss prevention provides a direct avenue of increased profit. 6. Business and Social Stability Finally, the existence and availability of insurance can lead to increased business and social stability. Several illustrations may be helpful in envisioning this point. For example, if adequately protected, a business need not face the grim prospect of liquidation following a loss. Similarly, a family need not break up following the death or permanent disability of one or more income producers. A business venture can be continued without interruption even though a key person or the sole proprietor dies. A family need not lose its life’s savings following a bank failure. Old-age dependency can be avoided. Loss of a firm’s assets by theft can be reimbursed. Whole cities ruined by a hurricane can be rebuilt from the proceeds of insurance. Social Costs of insurance: No institution can operate without certain costs. The costs for an insurance institution include operating the insurance business, losses that are caused intentionally, and losses that are aggregated. 1. Operating the Insurance Business The main social cost of insurance lies in the use of economic resources, mainly labour, to operate the business. The average annual overhead of property insurers accounts for about 25 per cent of their earned premiums but ranges widely, depending on the type of insurance. In life insurance, an average of 20 per cent of the premium rupee is absorbed in expenses. In other words, the advantages of insurance should be weighed against the cost of obtaining the service.
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2. Losses that are Intentionally Caused A second social cost of insurance is attributed to the fact that if it were not insurance, certain losses would not occur – losses that are caused intentionally by people in order to collect on their policies. Although there are no reliable estimates as to the extent of such losses, it is likely they are only a small fraction of total payments. Insurers are well aware of this danger, however, and take numerous steps to keep it to a minimum. 3. Losses that are Exaggerated Related to the cost of intentional losses is the tendency of some insured to exaggerate the extent of damage that results from purely unintentional losses. For example, Company ABC has an old photocopy machine that does not work well. When a small fire in ABC building causes some smoke damage throughout the building, ABC may be tempted to claim that its fire insurance should pay for a new photocopy machine. The old machine has likely been affected by smoke, but in reality, the machine did not work well before the fire and probably would have been replaced soon anyway. The existence of insurance tempts ABC to exaggerate its loss in this situation. Similarly, health expenses for families that have health insurance may be higher than the expenses for uninsured families. Once an accident or sickness has occurred, an individual may decide to undergo more expensive medical treatment, or the physician may prescribe it if it is known that an insurer will bear most or all of the cost.

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