3 To 5th Lecture Notes

Notes By Nasir M. Iqbal, MBA-IRM, MBA Fin., PGD App..Eco, Cert. CII. E: nasiriq1974@yahool.
com, T: 03214004203
Risk Management
Comprehensive Notes
Teacher Name:
Nasir M. Iqbal
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Notes By Nasir M. Iqbal, MBA-IRM, MBA Fin., PGD App..Eco, Cert. CII. E: nasiriq1974@yahool.com, T: 03214004203
A Gentle Introduction to Risk:

Contemporary organizations operate in a risky context. Unexpected events can lead to
major losses in terms of market share, money, or reputation. Planning for those
contingencies and creating mitigation tactics is one the key processes a modern
business needs to undertake. The course on Risk Management focuses on formally
defining what risk is, and presenting different approaches to modeling it. We will look
at risk from a more quantitative perspective which is usual for financial organizations
and large corporations but only for the benefit of clarity of exposition. The main
principles espoused go well beyond the large organization and the financial markets
and can easily be applied in a lot a different contexts - ranging from the small company
to personal decisions. The field of Risk Management (RM) is broad and growing, with a
large diversity of positions and roles. The unifying theme happens to be trying to
predict the (almost) unpredictable and to minimize losses or maximize benefits. Such
an ambitious goal calls for an effective blend between theoretical knowledge and
practical skill. This need is also reflected in the structure of the Risk Management
course - it combines key theoretical insights with hands-on tasks and problems to
solve using state-of-the-art software applications. The ultimate goal is to present the
breadth of the discipline, outline the most poignant debates, focus on some subtleties
and present some of the key instruments of the RM toolbox. The reader should turn
into an intelligent yet critical user of RM methods and concepts. There are naturally
many books that provide a more comprehensive treatment of risk.
The concept of risk

The word ‘risk’ is used in several ways in the insurance marketplace and we need to
look at each of these in turn. In simple terms, risk is the possibility of something bad
happening. ... Risk involves uncertainty about the effects/implications of an activity
with respect to something that humans value (such as health, well-being, wealth,
property or the environment), often focusing on negative, undesirable consequences..
First we will examine the term ‘risk’ in its everyday use sense and here we find our
first problem. There is no universally recognized definition for the term.
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Definition of Risk
Consider the following statements, each giving a different slant to the term ‘risk’:
● Possibility of an unfortunate occurrence;
● Doubt concerning the outcome of a situation;
● Unpredictability;
● Possibility of loss
● Chance of gain (such as a hoped for benefit from an investment strategy) ..

Whichever we choose (umbrella or no umbrella, for example), we need to
recognize the elements of uncertainty and unpredictability or, in some cases,
danger. The term ‘risk’ often implies something that we do not want to happen.
Consider for example the many risks associated with owning a car. These include:
The risk that the car will be stolen in the future;

The risk of a car accident with or without injury to the driver;
The risk of injuring others as a result of a car accident; and
The risk of damage to the car caused by another driver.
Other meanings of the term ‘risk’:

Although this section is devoted to risk in its generic sense, there are other ways;
The first refers to the contingency e.g. – the fire risk, the theft risk and so on.
The second use of the term relates to the thing (or liability) context the ‘risk’ could
be a factory, or a manufacturer’s liability to the public.
Attitude to risk:
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Each person’s attitude to risk is different. Therefore, we all respond to risk in a

different way. Some people are willing to carry certain risks themselves and are
termed risk-seeking. Other people lean more towards being risk-averse, feeling
happier minimizing the risk to which they are exposed
Components of risk:
In order to gain a deeper understanding of the meaning of risk, we must now take a
closer look at the various components of risk. These include:
1- Uncertainty
2- Level Of Risk
3- Peril And Hazard
1- Uncertainty
The concept of uncertainty implies doubt about the future, as a result of our
incomplete Knowledge. Uncertainty is at the very core of the concept of risk for, if
we know what is going to happen, there is no element of risk involved. If you know
that your house will burn down at 4.00 p.m. tomorrow, or that on the way home
you will have an accident in the car, there is no risk of the event happening, as the
event would become a certainty. As we do not have this prior knowledge, we can
say that we live in an uncertain or risky environment and that risks exist
separately from the individual.
2- Level Of Risk
The second aspect of risk relates to the different levels of risk that exist. We know
that there is a greater likelihood of some things happening than others and this is
what we mean by the level of the risk involved. Risk is usually assessed in terms of:
Frequency – how often it will happen; and
Severity – how serious it will be if it does happen.
These are the measurement criteria used in the risk-management process.
3- Peril and Hazard
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The concept of peril and hazard together form the final aspect of risk. This aspect
relates to the causes of losses:
A peril can be defined as that which gives rise to loss or risk.
A hazard can be defined as that which influences the operation or effect of the
peril.
What Is Peril?
● Probable cause (such as an earthquake, fire, theft) that exposes a person or
property to the risk of damage, injury, or loss, and against which an
insurance cover (policy) is purchased.
● A peril is something that can cause a loss. Examples include falling,

crashing your car, fire, wind, hail, lightning, water, volcanic eruptions,
choking, or falling objects.
● A source of danger; a possibility of incurring loss or misfortune
Types Of Peril
1- Human Perils
These are the man-made perils e.g. fire, theft, terrorism, strike riot etc.
2- Economic Perils
The perils which are originate from economy of a country e.g. Inflation,
Unemployment, Economic instability etc.
3- Natural Perils
The peril which is act of God. The natural perils include: rain, hurricane, wind,
earthquake or flood and many others.
What Is Hazard?
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● A hazard is a situation in the workplace that has the potential to harm the health
and safety of people or to damage plant and equipment.
● A hazard is any biological, chemical, mechanical, environmental or physical
agent that is reasonably likely to cause harm or damage to humans, other
organisms.
The meaning of the word hazard can be confusing. Often dictionaries do not give
specific definitions or combine it with the term "risk". For example, one dictionary
defines hazard as "a danger or risk" which helps explain why many people use the
terms interchangeably.
There are many definitions for hazard but the more common definition when
talking about workplace health and safety is:
A hazard is any source of potential damage, harm or adverse health effects on

something or someone under certain conditions at work.
Basically, a hazard can cause harm or adverse effects (to individuals as health
effects or to organizations as property or equipment losses).
Sometimes a hazard is referred to as being the actual harm or the health effect it
caused rather than the hazard. For example, the disease tuberculosis (TB) might be
called a hazard by some but in general the TB-causing bacteria would be
considered the "hazard" or "hazardous biological agent".
Types of Hazard:
Physical hazard is a physical condition that increases the possibility of a loss. Thus,
smoking is a physical hazard that increases the likelihood of a house fire and illness.
Moral hazards are losses that results from dishonesty. Moral hazards (most of
which are avoidable), like dishonesty (such as burning down the warehouse when
your company goes bankrupt to collect insurance money Thus, insurance
companies suffer losses because of fraudulent or inflated claims.
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Legal hazard can also result from laws or regulations that force insurance
companies to cover risks that they would otherwise not cover, such as including
coverage for alcoholism in health insurance.
Morale hazard because it increases the possibility of a loss that results from
the insured worrying less about losses. Therefore, they take fewer
precautions and may engage in riskier activities—because they have
insurance.
What is the difference between a peril and a hazard?

A peril is something that can cause a loss. Examples include falling, crashing your
car, fire, wind, hail, lightning, water, volcanic eruptions, choking, or falling objects.
A hazard is any condition or situation that makes it more likely that a peril
will occur and spread the loss
Categories of risks:
It does not follow that, having identified a risk, it will automatically be insurable.
Not every type of risk or eventuality is insurable. It will help our understanding if
we look at (and contrast) different types of risk to identify those that are insurable
and those that are not. The groupings that we will look at are:
1- Financial and non-financial risk
2- Pure and speculative risk
3- Particular and fundamental risk
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Financial and Non-Financial Risks
Some of the risks that we face are not capable of financial measurement. They may
have a financial aspect to them, but it is incidental. The real risk arises from
decisions and actions motivated by other considerations. Take for example the
choice of a marriage partner or our enjoyment of a holiday. We cannot measure
these in financial terms,
For a risk to be insurable the outcome of adverse events must be capable of

measurement in financial terms. Most general insurances are compensatory in
nature: some seek to provide relief to the person who has suffered loss and others
indemnify the person for their liability towards others. This means the value
placed on the loss is not determined in advance.
Important exceptions to this general rule are personal accident and sickness
policies. This is because there is no way of valuing precisely the loss of a life or the
loss of sight so these policies are taken out in order to provide pre-agreed amounts
in the event of an accident or sickness and are known as benefit policies. Similar
considerations apply to life assurance policies.
Types Of Financial and Operational Risk
1- Property risk affects either personal or real property. Thus, a house fire or car
theft are examples of property risk. A property loss often involves both a direct
loss and consequential losses
● A direct loss is the loss or damage to the property itself.
● A consequential loss(indirect loss) is a loss created by the direct loss.
Thus, if your car is stolen, that is a direct loss; if you have to rent a car
because of the theft, then you have some financial loss—a
consequential loss—from renting a car.
2- Legal risk (liability risk) is a particular type of personal risk that you will
be sued because of neglect, malpractice, or causing willful injury either to
another person or to someone else's property. Legal risk is the possibility
of financial loss if you are found liable, or the financial loss incurred just
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defending yourself, even if you are not found liable. Most personal,
property, and legal risks are insurable.
3- Economic risks, such as unemployment, are also fundamental risks
because they affect many people.
4- Enterprise risk is the set of all risks that affects a business enterprise.
5- Strategic risk results from goal-oriented behavior. A business may want
to try to improve efficiency by buying new equipment or trying a new
technique, but may result in more losses than gains.
6- Operational risks arise from the operation of the enterprise, such as the
risk of injury to employees, or the risk that customer’s data can be leaked
to the public because of insufficient security.
7- Financial risk is the risk that an investment will result in losses.

8- Investment Risk – it is about possibility of losing money. Today you
invest R lakh in equity & get Rs 4 after 3 years. Investment risk can be
measured by Standard Deviation.
9- Inflation Risk – it is losing purchasing power of money. In 2011 you invest Rs 5

Lakh in debt & get Rs 10 Lakh in 2020. But your Rs 10 Lakh is not able to buy
you the item which was available for Rs 4 Lakh in 2011.
10 -Liquidity Risk – if you have some bonds that you would like to sell for
immediate requirement but there is no buyer or fewer buyers than sellers –
you may have to sell your bonds at discount.
Funding Liquidity: refers to the risk that a company will not be able to meet

its short-term financial obligations when due.
Asset Liquidity: risk of loss arising from an inability to convert assets into

cash at carrying value when needed.
11 - Execution risk – the time between when you see your price and when the
trade actually goes to the market.
12 - Information Risk – This is again a very important risk to understand. You take
your financial decisions based on some information – this information is
provided either by manufacturer of financial products or
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agents/distributors/advisors or media. What will happen if this critical

information is wrong or not complete?
13 - Timing risk: - You are too early or too late to the market.
14 - Market Risk: Market risk is the risk in which value of an investment will
decrease due to move in market risk factors. The standard market risk
factors are interest rate, commodities prices, foreign exchange rate,
stocks indices etc.
Let us look at some examples of financial risks to help us understand this concept:
1- Accidental damage to a motor car

2- Theft of property
3- Loss of business profits following a fire
4- Legal liability to pay compensation for personal injury to others
Pure and speculative risk

Speculative Risk, There are many situations in life when we speculate with a view
to making some kind of gain. Obvious examples are the lottery or other forms of
gambling. There are also situations such as investing in the stock market or
starting up a new business that fall into this category, as well as pricing decisions
and other aspects of marketing. With each activity we aim to make a gain, but each
carries the possibility of break-even or failure. Consequently, although there are
some aspects of business activity that can be insured, this does not include things
such as misreading the market or a business failing because of local competition.
These are called speculative risks and they cannot be insured.
Pure risks, on the other hand, are those where there is the possibility of a loss but
not of gain, and where the best that we can achieve is a break-even situation.
Travelling in an aircraft is a good example. The best that we can hope for is a safe
arrival. The possibility exists however, that there might be an accident and aircraft
damaged or someone injured. It is these types of risks that are generally insurable.
Let us look at some examples of pure risks to help us understand this concept:
1- Risk of fire
2- Risk of machinery breakdown
3- Risk of injury to employees at work
Particular and fundamental risks

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Fundamental Risk There are some risks that occur on such a vast scale that they
are uninsurable. Take for example the risk of famine, economic recession or a more
general risk – that of war.
Particular risks are localized or even personal in their cause and effect. Sometimes
the cause may be more widespread (a storm over a whole region), but the effect is
localized or even related to an individual. For example, not all properties in the
region will have been damaged.
Let us look at some examples of particular risks to help us understand this

concept
1- Factory fire
2- Car collision
3- Theft of personal possessions from a home
Source Of Risk Generation

There are following source of risk generation;
1- Within the organization

2- Around the organization
3- Organization is responsible to others
Within the organization
There are some risk which are generate through organization internal source like
fire in a store room or theft.
Around the organization
There are some risk which are generate through external means like office
damaged due to fire in public transformer or due to strike.
Organization is responsible to other
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There are some risk which are generate due to organizational noncompliance
behavior like third party risk or Contractual Liabilities.
Calculation Of Risk
For example, if performing activity X has a probability of 0.01 of suffering an

accident of A, with a loss of 1000, then total risk is a loss of 10, the product of 0.01
and 1000.
Situations are sometimes more complex than the simple binary possibility case. In
a situation with several possible accidents, total risk is the sum of the risks for each
different accident, provided that the outcomes are comparable:
For example, if performing activity X has a probability of 0.01 of suffering an

accident of A, with a loss of 1000, and a probability of 0.000001 of suffering an
accident of type B, with a loss of 2,000,000, then total loss expectancy is 12, which
is equal to a loss of 10 from an accident of type A and 2 from an accident of type B.
Risk Perception
Risk perception is the subjective judgement that people make about the
characteristics and severity of a risk.
Risk perceptions are beliefs about potential harm or the possibility of a loss. It is a

subjective judgment that people make about the characteristics and severity of
a risk.
Risk perception is important in health and risk communication because it

determines which hazards people care about and how they deal with them. ...
Laypeople have been found to evaluate risks mostly according to
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subjective perceptions, intuitive judgments, and inferences made from media

coverage and limited information
There are the following feature or factors which are associate with risk perception.
1- Voluntariness
2- Controllability
3- Delay
4- Man Made and Nature Risk
5- Familiarity
6- Expected Benefits
7- Media
8- Dread And Unknown Risk
Voluntariness
This is confirmed our perception of risk is reduce if we choose a risk voluntarily

and our risk perception increase if the risk is imposed on us.
Controllability
People are more willing to accept risk they think they can control. Risk that are out
of our control are more frightening because we cannot influence their outcome .
Delay
If the effect of risk is far in to the future we are may be more willing to accept that
risk now and vice versa.
Man-made and natural risk
Man-made and natural risk perceive differently, in case of man-made risk people
are more willing to avoid risk as compare to natural process can be accepted as a
act of God or fate.
Familiarity
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Familiarity with risk also affects our perception, for example a good driver is ready
to accept risk pertaining to high speed vehicles.
Expected Benefit
Expected benefit also influence our view of risk. We have already seen that driving,
for example a known high risk is accepted because of the overriding benefit of
getting quickly from one place to another place.
Media
Finally, perception of risk was influenced by the media. Risks are not in the media
are not seen as important as those that are. Right or wrong we think risks must be
important if the media has chosen to cover them.
Dread and unknown risk
Dread risk are characterized by perceive lack of control, catastrophic potential,

inequitable distribution of risk and benefits and dreadful consequences.
Unknown risks are those less generally known, with limited knowledge of the risk,
perhaps with delayed effects and where the risk type is new.
Stakeholder:
Person, group, or organization that has direct or indirect stake in an organization
because it can affect or be affected by the organization’s actions, objectives, and
policies. Key stakeholders in a business organization include creditors, customers,
directors, employees, government (and its agencies), owners (shareholders),
suppliers, unions, and the community from which the business draws its resources.
Although stake-holding is usually self-legitimizing (those who judge themselves to
be stakeholders are de facto so), all stakeholders are not equal and different
stakeholders are entitled to different considerations. For example, a firm's
customers are entitled to fair trading practices but they are not entitled to the
same consideration as the firm's employees.
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A corporate stakeholder is a party that can affect or be affected by the actions of

the business as a whole. The stakeholder concept was first used in a 1963 internal
memorandum at the Stanford Research institute. It defined stakeholders as "those
groups without whose support the organization would cease to exist."[1] The
theory was later developed and championed by R. Edward Freeman in the 1980s.
Since then it has gained wide acceptance in business practice and in theorizing
relating to strategic management, corporate governance, business purpose and
corporate social responsibility
How an individual or corporation or entity will became

stakeholder of a particular Organization.
A company, or individual will became stakeholder due to the following.
1- Due to Financial impact

2- Due to Environmental impact
3- Due to emotional impact
Types Of Stakeholders
Example Of Stakeholders
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Stakeholders Examples of interests

taxation, VAT, legislation, low unemployment, truthful
Government
reporting
rates of pay, job security, compensation, respect, truthful
Employees
communication
Customers value, quality, customer care, ethical products
providers of products and services used in the end product
Suppliers
for the customer, equitable business opportunities
Creditors credit score, new contracts, liquidity
jobs, involvement, environmental protection, shares,
Community
truthful communication
Trade Unions quality, Staff protection, jobs
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

It will be cumbersome for the risk manager to clearly identify that where the
risk lies. If the wrong risk has been identified then all the practice of having the
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risk management process will be wasted. This is the challenge for the risk
manager to extract out the useful and the best information from the available
information and then shape the information in such a way, that it useful in
identifying the risk. Risk manager should also make sure that the information
he acquires is from a trusted source, wrong information will lead to a wrong
risk management process.
There are various techniques which are used to identify the risk, to decide
which technique to use will depend upon certain questions:-
1- What are the risks involved?

2- What could happen?
3- When will it happen?
4- What would be the impact of that risk if there is worst case scenario?
5- Where do the risk lies?
6- How can the risk information be shaped for making any key decisions?
7- How could the people and organization be affected by the risk?
These are the key questions which have to be kept in mind before selecting and
applying any technique of risk management.
Risk management has the following objectives before and after a loss occurs.
Pre-loss objectives:
1- Prepare for potential losses in the most economical way
2- Reduce anxiety (if you have uncertainty and know about it, then you fix it,
that’s less anxiety)

3- Meet any legal obligations (law requires car insurance)
Post-loss objectives:
1- Ensure survival of the firm (didn’t die)
2- Continue operations (able to keep going after loss, keep doors open)
3- Stabilize earnings (made as much as we would’ve made)
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4- Maintain growth (grow the same amount as we expected)
5- Minimize the effects that a loss will have on other persons and on society
(stakeholders)
Risk Management Process

Steps involve in Risk Management Process
● Identify potential losses
● Measure and analyze the loss exposures
● Select the appropriate combination of techniques for treating the loss
exposures
● Implement and monitor the risk management program
Exhibit 3.1 Steps in the Risk Management Process
Identifying Loss Exposures
Following are example of loss exposures which normally faced by an organization.
● Property loss exposures

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● Liability loss exposures

● Business income loss exposures
● Human resources loss exposures
● Crime loss exposures
● Employee benefit loss exposures
● Foreign loss exposures
● Intangible property loss exposures
● Failure to comply with government rules and regulations
Method Of Risk Identifications.
● Orientation
● Risk Analysis Questionnaires
● Exposure Checklists
● Insurance Policy Checklists
● Flowcharts
● Analysis of Financial Statements
● Other Internal Records
● Inspections
● Interviews
Orientation
The first requirement in risk identification is to gain as through a knowledge as
possible of the organisation and its operations. The risk manager needs a general
knowledge of the goals and functions of the organisation, the practices of the
particular industry, and the specific activities of the organisation itself. The history
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of the organisation and the scope of its current operations are captured in a variety
of records, and these records represent a basic source of information required fro
risk analysis and exposure identification. A variety of tools are available to assist in
extracting information pertinent to the identification process.
Risk Analysis Questionnaires

The key tool in the risk identification process is a risk analysis questionnaire, also
sometimes called a "fact finder". Risk analysis questionnaires are designed to lead
the risk manager to the discovery of risks through a series of detailed and
penetrating questions about the organisation. In some instances, these
questionnaires are designed to include both insurable and uninsurable risks.
Unfortunately, because these questionnaires are usually designed to be used by a
wide range of businesses, they do not always include unusual exposures or identify
loss areas that may be unique to a given firm.
Exposure Checklists
A second important aid in risk identification and simply a listing of common
exposures is called an exposure checklist. Obviously, a checklist cannot include all
possible exposures to which an organisation may be subject; the nature and
operations of different organisations vary too widely for that. However, it can be
used effectively in conjunction with other risk identification tools to reduce the
chance of overlooking a serious exposure.
Insurance Policy Checklists

Insurance policy checklists are available from insurance companies and from
publishers specializing in insurance-related publications. Typically, such lists
include a catalogue of the various policies or types of insurance that a given
business might need. The risk manager simply consults such a list, picking out
those policies applicable to the firm. A principal defect of this approach is that it
concentrates on insurable risks only, ignoring the uninsurable pure risks.
Flowcharts
In certain instances, analysis of a flowchart of the firm's operations may alert the
risk manager to singular aspects of the firm's operations that give rise to special
risks. Probably the most positive benefit of using flow charts is that they force the
risk manager to become familiar with the technical aspects of the firm's operations,
thereby increasing the likelihood of recognizing special exposures.
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Analysis of Financial Statements

Analysis of the firm's financial statements can also aid in the process of risk
identification. The asset listing is the balance sheet may alert the risk manager to
the existence of assets that might otherwise be overlooked. The income and
expense classification in the income statement may likewise indicate areas of
operation of which the risk manager was aware.
Other Internal Records

In addition to financial statements, there are a variety of other internal records and
documents that are useful in the risk identification process. These include
corporate bylaws, annual reports, and minutes of board of director meetings,
organisation charts, and policy manuals, records of past losses, and contracts such
as leases and rental agreements, purchase orders, and construction contracts.
Inspections
Just as one picture is worth a thousand words, one inspection tour may be worth a
thousand checklists. An examination of the firm's various operations sites and
discussions with managers and workers will often uncover risks that might
otherwise have gone undetected.
Interviews
Some information is not recoded in documents or records, and exists only in the
minds of executives and employees. Interviews with various parties within an
organisation are sometimes required to dig this information out and add it to the
general information that is used to identify exposures. The number and scope of
such interviews will depend on the situation. Depending on the circumstances,
these can include the CEO, operations manager, CFO, legal counsel, plant engineer,
purchasing agent, personnel manager, plant nurse, safety manager, employees and
supervisors. External parties such as the organisation's attorney and CPA may also
be able to provide useful information.
Measure and Analyze Loss Exposures
1- Estimate the frequency and severity of loss for each type of loss exposure
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● 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
2- Once loss exposures are analyzed, they can be ranked according to their
relative importance
3- 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 probable maximum loss is the worst loss that is likely to happen
Select the Appropriate Combination of Techniques for Treating

the Loss Exposures
Risk control refers to techniques that reduce the frequency and severity of losses
Methods of risk control include:

● Avoidance
● Loss prevention
● Loss reduction
1- 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
2- Loss prevention refers to measures that reduce the frequency of a particular
loss
● e.g., installing safety features on hazardous products
3- Loss reduction refers to measures that reduce the severity of a loss after is
occurs
● e.g., installing an automatic sprinkler system
Risk financing refers to techniques that provide for the funding of losses
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● Methods of risk financing include:
1. Retention
2. Non-insurance Transfers
3. 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
● Financially strong firm can have a higher retention level than a

financially weak firm
● The maximum retention may be calculated as a percentage ofthe
firm’s net working capital
– 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
⮚ A captive insurer is an insurer owned by a parent firm for the purpose of

insuring the parent firm’s loss exposures
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– A single-parent captive is owned by only one parent

– An association or group captive is an insurer owned by several parents
– Many captives are located in the Caribbean because the regulatory
environment is favorable
– Captives are formed for several reasons, including:
● The parent firm may have difficulty obtaining insurance
● To take advantage of a favorable regulatory environment
● 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
⮚ Self-insurance is a special form of planned retention
– Part or all of a given loss exposure is retained by the firm
– Another name for self-insurance is 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 line
– Federal regulation allows employers, trade groups, governmental units,
and other parties to form risk retention groups

– They are exempt from many state insurance laws
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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: Insurance
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Insurance is appropriate for loss exposures that have a low probability of loss but
for which the severity of loss is high
Definition Of Insurance: is the equitable transfer of the risk of a loss, from one
entity to another in exchange for payment. It is a form of risk management
primarily used to hedge against the risk of a contingent, uncertain loss.
An insurer, or insurance carrier, is a company selling the insurance; the insured, or

policyholder, is the person or entity buying the insurance policy. The amount to be
charged for a certain amount of insurance coverage is called the premium. Risk
management, the practice of appraising and controlling risk, has evolved as a
discrete field of study and practice.
The transaction involves the insured assuming a guaranteed and known relatively
small loss in the form of payment to the insurer in exchange for the insurer's
promise to compensate (indemnify) the insured in the case of a financial
(personal) loss. The insured receives a contract, called the insurance policy, which
details the conditions and circumstances under which the insured will be
financially compensated.
Insurance involves pooling funds from many insured entities (known as

exposures) to pay for the losses that some may incur. The insured entities are
therefore protected from risk for a fee, with the fee being dependent upon the
frequency and severity of the event occurring. In order to be insurable, the risk
insured against must meet certain characteristics in order to be an insurable risk.
Insurance is a commercial enterprise and a major part of the financial services
industry, but individual entities can also self-insure through saving money for
possible future losses.
Principles / Mechanism of Insurance and Reinsurance
Reactions covers all aspects of the insurance and reinsurance industry including
insurers, reinsurers, brokers. A lot of our focus is on how the industry transfers
risk and the financial risks and opportunities inherent in the process. The
following is a guide for people new to the industry – or people who have
managed to bluff their way through up to now.
26
The risk transfer chain

Insurance companies are in the business of taking on the risks of firms and
individuals, which will often run to billions of dollars worth of exposure across
an insurer’s portfolio of risks.
In most instances the absolute level of exposure an insurance company has will
outweigh the capital it has on its balance sheet. As a consequence insurance
companies find it necessary to transfer their risk to third parties, whether they
are in the traditional reinsurance market or the capital markets through the
services of an intermediary (or broker) or directly with the reinsurer.
Reinsurance is a means by which an insurance company can protect itself with

other insurance companies against the risk of losses. Individuals and
corporations obtain insurance policies to provide protection for various risks
(hurricanes, earthquakes, lawsuits, collisions, sickness and death, etc.).
Reinsurers, in turn, provide insurance to insurance companies.
27
Principles Of Insurance
1- Insurability
2- Legal
Insurability
Large number of similar exposure units: Since insurance operates through pooling
resources, the majority of insurance policies are provided for individual members
of large classes, allowing insurers to benefit from the law of large numbers in which
predicted losses are similar to the actual losses. Exceptions include Lloyd's of
London, which is famous for insuring the life or health of actors, sports figures and
other famous individuals. However, all exposures will have particular differences,
which may lead to different premium rates.
Definite loss: The loss takes place at a known time, in a known place, and from a
known cause. The classic example is death of an insured person on a life insurance
28
policy Fire, automobile accidents and worker injuries may all easily meet this
criterion.
Accidental loss: The event that constitutes the trigger of a claim should be
fortuitous, or at least outside the control of the beneficiary of the insurance. The
loss should be pure, in the sense that it results from an event for which there is
only the opportunity for cost. Events that contain speculative elements, such as
ordinary business risks or even purchasing a lottery ticket, are generally not
considered insurable.
Large loss: The size of the loss must be meaningful from the perspective of the
insured. Insurance premiums need to cover both the expected cost of losses, plus
the cost of issuing and administering the policy, adjusting losses, and supplying the
capital needed to reasonably assure that the insurer will be able to pay claims. For
small losses these latter costs may be several times the size of the expected cost of
losses. There is hardly any point in paying such costs unless the protection offered
has real value to a buyer.
Affordable premium: If the likelihood of an insured event is so high, or the cost of

the event so large, that the resulting premium is large relative to the amount of
protection offered, it is not likely that the insurance will be purchased, even if on
offer. Further, as the accounting profession formally recognizes in financial
accounting standards, the premium cannot be so large that there is not a
reasonable chance of a significant loss to the insurer. If there is no such chance of
loss, the transaction may have the form of insurance, but not the substance. (See
the US Financial Accounting Standards Board standard number 113)
Calculable loss: There are two elements that must be at least estimable, if not
formally calculable: the probability of loss, and the attendant cost. Probability of
loss is generally an empirical exercise, while cost has more to do with the ability of
a reasonable person in possession of a copy of the insurance policy and a proof of
loss associated with a claim presented under that policy to make a reasonably
definite and objective evaluation of the amount of the loss recoverable as a result
of the claim.
Limited risk of catastrophically large losses: Insurable losses are ideally

independent and non-catastrophic, meaning that the losses do not happen all at
once and individual losses are not severe enough to bankrupt the insurer; insurers
may prefer to limit their exposure to a loss from a single event to some small
29
portion of their capital base. Capital constrains insurers' ability to sell earthquake
insurance as well as wind insurance in hurricane zones. In the US, flood risk is
insured by the federal government. In commercial fire insurance it is possible to
find single properties whose total exposed value is well in excess of any individual
insurer's capital constraint. Such properties are generally shared among several
insurers, or are insured by a single insurer who syndicates the risk into the
reinsurance market.
Legal
When a company insures an individual entity, there are basic legal requirements.
Several commonly cited legal principles of insurance include;
Indemnity – the insurance company indemnifies, or compensates, the insured in

the case of certain losses only up to the insured's interest.
Insurable interest – the insured typically must directly suffer from the loss.
Insurable interest must exist whether property insurance or insurance on a person
is involved. The concept requires that the insured have a "stake" in the loss or
damage to the life or property insured. What that "stake" is will be determined by
the kind of insurance involved and the nature of the property ownership or
relationship between the persons. The requirement of an insurable interest is what
distinguishes insurance from gambling.
Utmost good faith – the insured and the insurer are bound by a good faith bond of
honesty and fairness. Material facts must be disclosed.
Contribution – insurers which have similar obligations to the insured contribute in

the indemnification, according to some method. Like deductible
“Deductible is the amount paid out of pocket by the policy holder / Insured and
over and above that amount paid by insurance company”
Subrogation – the insurance company acquires legal rights to pursue recoveries on

behalf of the insured; for example, the insurer may sue those liable for insured's
loss.
Causa proxima, or proximate cause – the cause of loss (the peril) must be covered
under the insuring agreement of the policy, and the dominant cause must not be
excluded
30
Mitigation - In case of any loss or casualty, the asset owner must attempt to keep
loss to a minimum, as if the asset was not insured.
∙ internal environment: the organization’s rules and
31

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Notes By Nasir M. Iqbal, MBA-IRM, MBA Fin., PGD App..Eco, Cert. CII. E: nasiriq1974@yahool.

A Gentle Introduction to Risk:

The concept of risk

● Possibility of an unfortunate occurrence;

● Doubt concerning the outcome of a situation;

● Chance of gain (such as a hoped for benefit from an investment strategy) ..

The risk that the car will be stolen in the future;

Other meanings of the term ‘risk’:

Each person’s attitude to risk is different. Therefore, we all respond to risk in a

Frequency – how often it will happen; and

Severity – how serious it will be if it does happen.

These are the measurement criteria used in the risk-management process.

3- Peril and Hazard

A peril can be defined as that which gives rise to loss or risk.

● A peril is something that can cause a loss. Examples include falling,

● A source of danger; a possibility of incurring loss or misfortune

A hazard is any source of potential damage, harm or adverse health effects on

What is the difference between a peril and a hazard?

1- Financial and non-financial risk

2- Pure and speculative risk

3- Particular and fundamental risk

Financial and Non-Financial Risks

For a risk to be insurable the outcome of adverse events must be capable of

Types Of Financial and Operational Risk

7- Financial risk is the risk that an investment will result in losses.

9- Inflation Risk – it is losing purchasing power of money. In 2011 you invest Rs 5

Funding Liquidity: refers to the risk that a company will not be able to meet

Asset Liquidity: risk of loss arising from an inability to convert assets into

agents/distributors/advisors or media. What will happen if this critical

1- Accidental damage to a motor car

Pure and speculative risk

Particular and fundamental risks

Let us look at some examples of particular risks to help us understand this

Source Of Risk Generation

1- Within the organization

Within the organization

Around the organization

Organization is responsible to other

For example, if performing activity X has a probability of 0.01 of suffering an

For example, if performing activity X has a probability of 0.01 of suffering an

Risk perceptions are beliefs about potential harm or the possibility of a loss. It is a

Risk perception is important in health and risk communication because it

subjective perceptions, intuitive judgments, and inferences made from media

This is confirmed our perception of risk is reduce if we choose a risk voluntarily

Man-made and natural risk

Dread and unknown risk

Dread risk are characterized by perceive lack of control, catastrophic potential,

A corporate stakeholder is a party that can affect or be affected by the actions of

How an individual or corporation or entity will became

1- Due to Financial impact

Stakeholders Examples of interests

Meaning of Risk Management

A loss exposure is any situation or circumstance in which a loss is possible,

Objectives of Risk Management

1- What are the risks involved?

that’s less anxiety)

3- Stabilize earnings (made as much as we would’ve made)

4- Maintain growth (grow the same amount as we expected)

Risk Management Process

Exhibit 3.1 Steps in the Risk Management Process

Identifying Loss Exposures

Following are example of loss exposures which normally faced by an organization.

● Property loss exposures