Insurance and Risk Management

‡ Insurance and Risk Management
Risk Magt What is risk? ‡ Intuitive Notion:- Uncertainty about the future outcome normally associated with unfavourable consequences. ‡ ‡ Formal Approach to Understanding Risk:A notion of indeterminacy of outcome i.e. possibility of more than one outcome. Hence a possibility of variation from what is expected or hoped for. ‡ The consequence of at least one of the outcomes in adverse leading to a financial or non financial loss. Workable def. of risk:‡ Risk is a condition in which there is a possibility of an adverse deviation from a desired outcome that is expected, with only requirement being its possibility and not its measure Risk & uncertainty:- In common usage ‡ The two terms are used interchangeably. However in terms of risk Magt. they have minor conceptual difference. ‡ Uncertainty is related to risk but is a psychological reaction to a risk situation. A doubt in the mind regarding what will happen in future. ‡ Element or extent of doubt could differ person to person for same risk depending on personality, conviction, etc. This could affect decision making in managing risk because of subjective bias & needs to be minimized. ‡ Two important elements of a risky situationn : ± ± ‡ Outcome is uncertain i.e. at least two possible outcomes for a situation Out of the possible outcomes, one is unfavorable to the individual

Basic definitions used in Risk Management :

a. Loss a. Accounting sense : portion of the expired cost for which no compensating value has been received b. General Sense : instance of losing something previously possessed b. Perils : refers to the immediate causes of loss. E.g. fire, storm, burglary, accident etc. c. Hazards : are the conditions that increase the severity of loss (arising due to perils). Risk mgt. decision are greatly influenced by understanding the hazards.

Types of hazards 1. Physical Hazards:- Physical properties or conditions which increase the possibility of loss from various perils (e.g. storing crackers in office or faulty electrical installation increase the possibility of a peril like fire.) 2. Moral Hazard:- Losses getting increased due to dishonest intentions / actions of insured (e.g. putting fire to an insured factory running in losses or exaggerated claims by forging automobile damages) 3. Morale Hazard:- Not to be confused with moral hazard described in (2). Morale Hazard is linked to attitude of carelessness towards the insured object/property as the loss will be indemnified by insurance company due to existence of insurance contract (e.g. smoking in an oil refinery) 4. Legal Hazards:- Increase in frequency & severity of losses arising out of legal doctrines enacted by legislatures / courts in favor of plaintiffs. (e.g. constructing buildings in unauthorized colonies, with possibilities of demolition) ‡ CLASSIFICATION OF RISKS

 Speculative Risks & Pure Risks  Dynamic Risks & Static Risks  Fundamental Risks  Particular Risks ‡ ‡ ‡ DYNAMIC RISKS Changes with the change in fashion, buying behavior, trends, technology etc It denotes dynamic nature of the customer behavior and the products they like to own or use ‡ ‡ ‡ If an organization is not prepared then it may go out of existence STATIC RISKS Like pure risks these risks remain static and do not change due to other reasons like that of dynamic risks ‡ ‡ ‡ ‡ ‡ ‡ The operation of these risks always bring about losses Operation is not desired May result in partial or total cessation of activities PARTICULAR RISKS Risks which relate to one or few firms, factories or organizations only Losses are suffered by one or few more members of the society

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FUNDAMENTAL RISKS Relates to the society at large Losses are suffered by large section of the society/nation(s) Losses may be due to natural catastrophes, riots, epidemics etc

Pure & Speculative risks ‡ ‡ Pure risks are risks which involve outcomes of loss or at best no loss. Speculative risks could lead to gain & loss both. It can have a no loss / no gain outcome also.

Speculative Risks:‡ Characterized by loss & gain both. Applicable in areas like interest rate fluctuation, price fluctuations in commodities & stocks / shares, currency rate fluctuations. Techniques / instruments used are; future & options, forwards, hedging, swaps, etc. Essentially covers financial risks. Pure Risks:‡ Are static in nature because they are seldom influenced by economic changes (being linked to perils of nature, dishonesty / failure of humans). ‡ ‡ Deal with loss or no loss situations only. Insurance is one of the ways these risks are managed. Insurance concept forbids gain or profit motive (we shall see it later in the course). Note:- In this course Pure Risks & their mgt. will be the focus. Classification of Pure Risks:‡ Personal Risks:- Loss of earning power or loss/damage of an asset related to individual due to perils of; (a) Death (b) Dependent old age (i.e. living long) (c) Sickness or disability (d) Unemployment. ‡ Property Risks:- All kinds of property owned by individuals or organizations or Govt., face the risk of damage / total loss due to various perils like fire, natural calamities, burglary, etc. Loss could be direct or indirect. ‡ Liability Risks:- Unintentional injury, damage to other persons or their property due to negligence / carelessness it could be intentional also. Legal systems provide protection & hence they are also called legal liabilities arising out of causes mentioned above. ‡ Risk arising from failure of others:- This arises on a/c of individual / org. unable to fulfill their obligations in an arrangement / agreement eg.; ± ± Contractor not meeting his schedules in a construction job leading to financial loss. Debtors not able to meet repayment schedules (NPA s, o/s debts, etc.)

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HOW THE LOSS IS CAUSED? Loss is caused by the operation of perils which refers to the causes for the losses The loss potential ( extent of loss) depends on conditions which are favorable for the incident to assume large proportions. This is known as hazard or potential of the loss.

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More the potential severe will be the extent of loss PERIL ( CAUSE)----------------LOSS(EFFECT) HAZARD

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CAUSES OF LOSSES Perils- such as fire, explosion etc Human factors- such as negligence, carelessness, inadequate training, inadequate supervision, lack of proper systems and controls

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Inadequate maintenance ( predictive/ routine/ annual maintenance) Failure of Plant/ machinery due to breakdowns (failure of safety devices) Natural perils such as flood, cyclone, earthquake, landslide, rockslide & subsidence Extraneous: Accidents involving Gas or chemical in nearby units TYPES OF LOSSES Property losses- losses which can happen to the Assets Pecuniary losses- Financial Loss which can be caused by business interruption due to the loss to the assets, financial loss due to infidel acts of employees, storekeepers and other employees

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Liability losses- Loss to the Third Party property or third party personnel due to activities of the Organisation

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Personal injuries- accidents resulting in fatal or non-fatal injuries to the employees

‡ RISK MANAGEMENT
Risk Management is defined as the systematic way of ensuring protection of business resources and income against losses so that the aim , goals and vision of the company can be reached. Risk Management is a scientific approach for dealing with pure risks by anticipating possible accidental losses & designing & implementing procedures that minimize the occurrence of loss or the financial impact of the losses that do occur. Thus Risk Management creates stability and contributes to growth and profitability of the Organization.

‡ ADVANTAGES OF RM
y y To achieve the objectives of the Organization To ensure that the goals short term and long term are achieved without any disruption or delay y y To optimize the utilization of the resources To have knowledge of insurance arrangements and have considered decisions on insurances to be availed ‡ y DEVELOPMENT OF RISK MANAGEMENT The Industries / Business houses want to have incident free/ accident free working to achieve their objectives y For this purpose it is necessary to understand the loss producing events , the nature of losses/ extent of losses to come up with the loss control measures. EXPOSURE ANALYSIS y Risk Management aims to help the owners to have control on loss incidents and to reduce the extent of losses by proper study of the exposures and actions to be taken to control the same

‡ CHALLENGES TO RISK MANAGEMENT
‡ ‡ ‡ It is an increasing financial cost & mental worry. Variety of new kinds of risks with economic & technological advancements. Severity of losses increasing.

‡ RISK MANAGEMENT PROCESS
1. RISK ANALYSIS Risk Analysis: ± Risk Identification ‡ ‡ ‡ ‡ ± Checklist method Flowchart method On-site inspections Statistical record of losses

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Risk Evaluation ‡ ‡ Probability of loss occurring Severity of loss occurring

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1. RISK ANALYSIS Needs to be done by a person who is conversant in the identification and measurement of possible losses

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The severity of the risk depends on two factors extent and frequency ( probability)- ranges from 0-1

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There are various methods to analyze the extent of loss The frequency is to be analyzed based on the analysis of data ( loss events and the frequency ) using statistical methods

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RISK ANALYSIS- METHOD List all possible risks Investigate Study Inquiry Document review Physical inspection Analyze each risk 1 a. METHODS OF RISK IDENTIFICATION HAZOP study- hazard operability Event analysis Threat analysis Input- output analysis Fault tree analysis HAZOP ANALYSIS Meant for chemical plants Hazard operability studies Effect of more of, less of, part of , none EVENT ANALYSIS Investigate causes and effects Failure of boiler explosion Failure of a critical item Explosion in pressure vessel Hazard logic trees- various hazards which may result in operation of a peril leading to loss EVALUATION OF RISKS-THREAT Analyze the threats to business

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Denial of access- chemical leakage, collapse of nearby buildings, strike, picketing, damage to water/sewer mains, government restrictions

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Loss of services water, power, rains, floods, cyclones INPUT OUTPUT ANALYSIS To trace the flow of goods and services to identify the contribution of parts of organization to the total earnings and to analyze exposures at each step

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FAULT TREE ANALYSIS Examine relationship of various types of failures The tree is constructed by asking what must occur before a loss producing event happens Explosion requires- formation of explosive mixture- cloud formation- source of ignition Probability analysis will help in appreciation of the risk involved SAFETY AUDITS Thorough knowledge Team of experienced officials Walk in audits Examination of the standards housekeeping security, training and preparedness of employees, means of escape

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1 b. RISK EVALUATION Risk evaluation breaks down into two parts: ± ± ± Finding the probability of loss occurring Ascertaining the severity of loss, if occurred 2. RISK CONTROL

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Risk Control : Techniques to minimize at least possible costs, the impact & or occurrence of events associated with risks to which individual / org. is exposed.

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Preserve continuity of operations under safe operating conditions Proper planning layout of buildings/plant/machinery Build in safety to avoid losses to perils such as fire, explosion natural or human negligence causing serious losses

Methods of Risk Control: ± ± ‡ ‡ Risk Avoidance Risk Reduction

2 a. RISK AVOIDANCE Risk Avoidance:- Means taking decisions so that risk is prevented from coming into existence within the org. or individual s life. E.g. A company (Medical) avoids producing a

product with dangerous side effects on user s health even though it may cure the basic malady. ‡ Risk avoidance is somewhat a negative rather than a positive strategy in dealing with risks. However, some situations call for its application. ‡ ‡ ‡ ‡ ‡ ‡ This is also known as Risk Elimination Identify the risk and if possible avoid the risk by eliminating the source It is like avoiding a location due to seismic activity in the area Avoiding a low lying location which is susceptible for flooding 2 b. RISK REDUCTION Risk Reduction:- Is achieved either by Loss Prevention or Loss Control or both as a Mix of strategies. 1. Loss Prevention Aims at reducing frequency of occurrence of an adverse event. 2. Loss Control Aims at reducing the severity of loss as & when it occurs. 3. Both 1 & 2 above can be attempted wherever possible. Note: This category of risk control can be approached from a perspective: ‡ RISK FINANCING

Risk Financing:- Consists of risk mgt. techniques focusing on arrangements designed to guarantee the availability of funds to make good fully or substantially the losses. Two Methods of Risk Financing are: ‡ ‡ ‡ ‡ Retention of risk. Transfer of risk.

3 a. RISK RETENTION Risk Retention: - Conscious or unconscious decisions to accept the risk & do nothing to mitigate it by organized action.

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To keep the costs under control, after analyzing the risks the Management, may decide to retain some of such losses to its account.

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Once a decision is taken , then necessary provision needs to be made to avoid such a loss ,if happens, eating into the operating budget

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Special contingency funds are therefore to be created for this purpose 3 a. RISK RETENTION Risk is retained by the organization if: ± ± The consequential losses are small Losses can be shown as operating expense or be funded from profits retained

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Methods of Risk Retention

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Self Insurance having contingency funds with self to finance losses Captive Insurance parent co. insuring the subsidiary 3 b. RISK TRANSFER

Risk Transfer : the party exposed to risk transfers whole or partial losses to another party for a cost.

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Methods of risk Transfer are: ± ± Insurance Non Insurance Transfers ‡ Contractual relationships (party specifying that all losses be borne by other party like relationship of tenant and landlord) ‡ ‡ ‡ Incorporation (liability of partners is limited vs sole proprietorship) Hedging (to transfer speculative risks e.g. derivative contracts) Diversification (of business and geographical locations)

‡ RISK MANAGEMENT POLICY
‡ ‡ ‡ ‡ ‡ The RMP is to be adopted by the Management The Policy details should be communicated to the employees The need to have the RM Policy should be felt by the employees The Corporate Risk manager is responsible for the implementation of the RM Plan The RM Dept will produce its own report and follow it up with an annual report on its performance ‡ RISK HANDLING METHODS

ADOPTION OF LOSS CONTROL MEASURES ‡ Loss control measures depends on the nature of the devices utilized and the human factor deployed ‡ For any system to be effective the employees concerned need to be properly trained and knowledgeable. ‡ The Management need to ensure that the systems employed are in good working order & the employees are regularly trained. ‡ ‡ RISK MINIMIZATION-RISK CONTROL If risk can not be eliminated then it is necessary to minimize the extent of loss/damage/liability by employing loss control measures ‡ ‡ ‡ Utilizing fire fighting measures like detectors/ hydrants/sprinklers Using CCTVs/ watch & ward to ensure adequate security Employees need to be well trained for fire fighting operations

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Employing proper checking /screening systems/ regular and its inventory controls Checking the antecedents of persons employed

‡ EFFECT OF LOSSES
‡ ‡ Huge losses will upset the functioning of the Power Station Besides the interruption losses, the loss of goodwill, investigation by Government and other agencies will be tedious ‡ The direct impact of any incident is in the monetary loss and in restarting of the affected unit. ‡ ‡ ‡ Employees morale gets affected CORPORATE RISK MANAGER The Corporate risk manager is essentially the coordinator . He has to analyze the various activities and find out the risks involved and analyze which are to be controlled, avoided and which are to be insured. ‡ Once the plans are finalized and adopted by the Management , the Insurance dept ensures that the insurance policies are obtained and maintained during the annual period ‡ Periodical reviews need to be done to ensure that the risks are analyzed and necessary modifications are done to suit the organization's policies.

‡ CONTINEGENCY PLANNING
‡ ‡ ‡ ‡ ‡ ‡ Identification of alternate sources Identification of key areas Planning for comeback in shortest possible time Backups or duplicate records of vital information to be maintained in alternate safe locations INCIDENT /ACCIDENT INVESTIGATION All incidents whether these result in an accident or not need to be reported and analysed to avoid a furute loss or recurrence. ‡ All losses need to be studied whether small or medium or big with a view to learn the causes and to ensure that preve

‡ CONTRIBUTIONS OF RM TO THE BUSINESS
‡ ‡ Achievement of objectives/ goals Reduced anxiety due to losses are of reasonable magnitude and does not cause serious loss situations ‡ ‡ Goodwill is maintained by meeting the obligations The business is able to survive competition

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Successful and continued operations Resultant growth and sustained earnings Better care for employees and society at large Reduction of expenses Better relationships between customers, suppliers, employees

Insurance
‡ ‡ Definition of Insurance Def: Large no. of people come together facing similar risks either on their lives or their possessions & Assets, to share the unfortunate losses of a smaller few in future. ‡ Insurance

In financial sense It is a social device in which  a group of individuals (insured)  transfer risk to another party (insurer)  in order to combine loss experienced, which  permits statistical prediction of losses and  provides for payment of losses from funds contributed (premium) by all members who transferred risk ‡ Insurance

In legal sense ‡ It is a contract by which

 one party (Insurer)  in consideration of price paid to him proportionate to risk provides security to  the other party (Insured) that

 he shall not suffer loss, damage or prejudice by the happening of certain specified events. Insurance is meant to protect insured against uncertain events which may cause disadvantage to him ‡ Elements In Insurance

Insurance - combination of three elements 1. Insurance as a Transfer System - transferring of risks from Insured to Insurance Co which is financially sound and has capacity and willingness to take risks. ‡ A Loss exposure can give rise to three types of losses, namely:

a) Property loss (including net income loss),

b) Liability loss, and c) Human and personnel loss. 2. Insurance as a Business - insurance primarily attempts to meet its costs and expenses from premium that it earns and also make a reasonable margin of profit for its own sustainability. ‡ Other benefits to society as a whole such as:

a) Payments for the costs of covered losses b) Reduction of the insured s financial uncertain c) Efficient use of resources d) Support for credit e) Satisfaction of legal requirements f) Satisfaction of business requirements

g) Source of investment funds for infrastructure development h) Reduction of social burden 3. Insurance as a Contract - an insurance policy is a legally enforceable contract. The contract is between IC and the Insured. ‡ An insurance contract must meet these four requirements: i. ii. iii. iv. ‡ ‡ ‡ Offer and acceptance Consideration Capacity Legal purpose

Fundamental Advantages Transfer of risk from one person (Insured) to another (Insurer) Sharing (Pooling) of losses on some equitable basis such that i. Fortuitous (random) losses will be indemnified (paid)

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Reduction in tension and fear Credit multiplication Avenue for investment Functions of Insurance Primary functions i. ii. iii. Provides certainty Provides protection Risk sharing

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Secondary functions i. Prevention of Loss

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Provides Capital Helps in economic progress

‡ Nature of Insurance
1. Sharing of Risk 2. Cooperative Device 3. Value of Risk 4. Payment at Contingency 5. Amount of payment 6. Large No. of insured persons 7. Insurance is not Gambling ‡ ‡ Purpose and need of insurance Individual 1. Provides security and safety 2. Affords peace of mind 3. Protects mortgaged property 4. Eliminates dependency 5. Encourages saving 6. Provides profitable investment 7. Life insurance fulfills needs of a person 1. Family needs 2. Old-age needs 3. Re-adjustment needs 4. Special needs ‡ ‡ ‡ ‡ ‡ ‡ ‡ ‡ ‡ ‡ Purpose and need of insurance Business Reduces uncertainty of Business Losses Increases Business Efficiency Indemnifies loss of Key Man Helps in enhancement of credit Ensures Business Continuation Provides for welfare of employees Purpose and need of insurance Insurance as a Macro-Economic Issue education/marriage/settlement of Children

1. Mobilization of scattered Resources

2. Creation of Liquidity 3. Economies of Scale Insurance and GDP Insurance and Income redistribution Insurance and Business cycles, Inflation Insurance and population Changes ‡ Insurance history in India

‡ Requisites of Insurable Risks
‡ ‡ Not all risks are commercially insurable Requisites of insurable risks ± ‡ ‡ Characteristics of risks that make it feasible for private insurers to offer insurance

Should be viewed as guides or standards that are not always completely attained in practice Even when their absence makes it impossible for insurance to be offered by private insurers ± Government agencies may offer some protection

‡ Elements of an Insurable Risk
1. Large No. of exposure units 2. Defined and measurable loss 3. Determinable probability distribution 4. Random Loss (Fortuitous Loss) 5. Non-catastrophic Loss 6. Economically feasible premium 7. Insurance vs Gambling ‡ ‡ Large Number of Similar Objects Probable loss must be subject to advance estimation

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Number of insured objects must be sufficiently large ± The objects themselves must be similar enough to allow the law of large numbers to operate

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Nature of the objects must be enough alike so that reliable statistics on loss can be formulated

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Sometimes insurers act as risk transferees even when it is impossible to obtain a sufficiently large number of exposure units to allow the law of large numbers to operate

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Accidental and Unintentional Loss There must be some uncertainty surrounding the loss Insurers normally exclude any loss caused intentionally by the insured in all policies ± If the insured knew that the insurer would pay for intentional losses ‡ A moral hazard would be introduced ± Causing losses and premiums to rise

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Adverse selection ± Tendency of insureds who know that they have a greater than average chance of loss to seek to purchase more than an average amount of insurance ± Asymmetric information ‡ When an insured possesses knowledge about likely losses that is unavailable to insurers ‡ Its existence is one cause of adverse selection

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Underwriting ± Process of selecting and classifying insureds from among the many applicants

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Determinable and Measurable Loss The loss must be definite in time and place Even if it is clear that a loss has occurred it may not be easy to measure it ± For example, what is the loss from pain and suffering of an auto accident victim?

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Loss Not Subject to Catastrophic Hazard Conditions should not be such that all or most of the objects in the insured group might suffer loss at the same time and possibly from the same peril ± For instance, large fires, floods, earthquakes, hurricanes in particular major geographical areas

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Most insurers reduce this possibility by dispersion of insured objects Insurers themselves may purchase insurance against the possibilities of excessive losses ± Called reinsurance

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Following the 9/11 terrorist attacks many firms had difficulty obtaining insurance for trophy properties ± Due to the recognition by insurers of the catastrophic loss potential associated with these buildings

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Large Loss The maximum possible loss must be relatively large ± A requisite from the standpoint of the insured

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States that businesses and individuals should insure potentially serious losses before relatively minor losses ± To do otherwise is uneconomical ‡ Small losses tend to occur frequently and are very costly to recover through insurance

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Probability of Loss must not be too High Probability of loss must be reasonable ± Else the cost of risk transfer will be excessive

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Insureds are often willing to pay more to avoid a loss than the true expected value of that loss ± ± If it were not for this phenomenon, insurance could not exist Insurers must always charge more for their service than the expected value of a loss

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Table 6-1: Examples of Requisites of Insurable Risks

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‡ Basic terms
‡ ‡ ‡ ‡ ‡ Insurer : The party to an insurance arrangement who undertakes to indemnify for losses. Insured: A person whose interests are protected by an insurance policy. Subject matter of insurance: The thing or property insured Insurable Interest: the interest of the assured in the subject-matter Premium: Financial cost of obtaining an insurance cover, paid as a lump sum or in installments during the duration of the policy. ‡ ‡ Policy: Written contract or certificate of insurance Exposure to Loss: In insurance, areas in which the risk of loss exists. Four loss risk areas are: (1) property; (2) income; (3) legal vulnerability; and (4) key personnel in an organization ‡ ‡ Basic terms Life annuity: A life annuity is a financial contract in the form of an insurance product according to which a seller (issuer) company typically a financial institution such as a life insurance

makes a series of future payments to a buyer (annuitant) in exchange for the

immediate payment of a lump sum (single-payment annuity) or a series of regular payments (regular-payment annuity), prior to the onset of the annuity. ‡ Nomination: It is the right of the policy holder on his/ her own life to designate a living person to receive the policy proceeds in the event of him predeceasing the nominee before the maturity of the policy. ‡ Nominee: Nominee should not be a stranger because its against the objective of insurance which in most cases is family protection. ‡ ‡ Basic terms Assignment: An agreement under which one party the assignor transfers some or all of his ownership rights in a particular property, such as a life insurance policy or an annuity contract, to another party the assignee. ‡ Assignor: A property owner who transfers some or all of the ownership rights in a particular property to another party by means of an assignment. ‡ Assignee: A person or party to whom a property owner transfers some or all of the property owner's rights in a particular property by means of an assignment.