Risk management
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Risk Management & Insurance Planning What is Risk? We live in an uncertain world. Accidents and mishaps happen every day. Illness a nd natural disasters fell millions of people every year. A person, who is happy, healthy and alive today, does not know what will happen tomorrow. This uncertai nty is known as Risk. Types of Risk There are different classifications of risk: • Financial and Non-financial risk: Risk may involve financial loss in some cases; in other cases, there is no financial loss. • Static and Dynamic risk: Dynamic risks are those resulting from changes in the economy. Changes in price level, consumer tastes, income and output, and technol ogy may cause financial loss to members of the economy. Static risks involve tho se losses that would occur even if there were no changes in the economy, such as the perils of nature and the dishonesty of other individuals. • Fundamental and Particular risks: Fundamental risks are caused byconditions more or less beyond the control of the individuals who suffer the losses. Examples o f such risks are earthquakes, floods etc. Particular risks involve losses that a rise out of individual events and are felt by individuals rather than by an enti re group. Example of such risks are car thefts, accidents etc. • Pure and Speculative risks: Pure risk is used to designate those situations that involve only the chance of loss or no loss. Speculative risk describes situatio ns in which there is a possibility of loss, but also a possibility of gain. Gamb ling is an example of a speculative risk. In the context of financial planning we are concerned only with pure risks. Types of Pure Risks Personal Risks Personal risks are those risks that directly affect an individual. They cause fi nancial insecurity because they usually result in reduction or stoppage of incom e, increase in expenses and depletion of financial resources. Some of the major personal risks are: • Risk of premature death • Risk of poor health • Risk of temporary or permanent disability • Risk of insufficient income during retirement Risk of premature death: If a person who has obligations like dependants to support, loans to pay off or children to educate dies then the surviving family members face financial insecu rity. They need sufficient replacement income to take care of the obligations. Risk of poor health: The risk of poor health may result in depletion of financial resources due to in creased medical expenses as well as loss of income. Unless a person has adequate financial resources, the risk of poor health can cause financial insecurity. Risk of temporary or permanent disability: As with the risk of poor health, the risk of temporary or permanent disabilty ma y also cause financial insecurity due to depletion of financial resources as a r esult of increased medical expenses and loss of income. Risk of insufficient income during retirement Most people experience a significant reduction in their income when they retire. Unless they have saved for their retirement in a planned manner, they are likel y to experience financial insecurity. Property Risks Persons owning property face the risk of having that property damaged or destroy ed or lost due to different causes. They cause financial insecurity because they affect the income streams being produced from usage of the property. They also increase expenses because the damaged/destroyed/lost assets need to be repaired/ replaced. Property risks can cause loss in two major ways: • Direct Loss • Loss of Income from properties used for business purpose. • Indirect or Consequential Loss
Direct Loss A direct loss results from physical damage, destruction or theft of property. Fo r example if your house is damaged due to earthquake, the amount of loss is know n as direct loss. Indirect or Consequential Loss An indirect loss results from the consequences of a direct loss. For example, if your house is destroyed in an Liability Risks Liability risks arise from the possibility of being held legally liable for the loss to another person. If a person commits a mistake or because of negligence c auses bodily harm or injury to another person, a court of law can order that ind ividual to pay damages to the injured party. Liability risks can be categorized into: • Statutory Liability eg Third Party Liability in M.V. Act, I.D. Act, W.C.Act, P. I. • Under Common Law eg. Libel & Slender • Under Contract eg Contractual Obligations These liabilities may arise in personal or professional capacity. Personal Liability Personal liability arises when a person acts negligently or carelessly during th e course of his personal life and causes harm to another. For example, if you hi t a pedestrian with your car due to jumping traffic lights, you may be asked to bear the treatment expenses and pay damages to the victim. Professional Liability Professional liability arises when a person harms another while performing as a professional. For example, a doctor who causes harm due to a wrong diagnosis can be held professionally liable to pay damages to the patient. Liability risks cause financial insecurity because they result in depletion of e xisting financial resources. How can we manage risk? While risks cannot be eliminated, measures can be taken to reduce the probabilit y and size of loss caused by risks. This process is known as risk management. Risk Control Risk Control methods are those that try to minimize the losses from risks. These can be of two types: Risk Avoidance Risk avoidance is accomplished by not engaging in the action that gives rise to risk. Avoiding risk is an appropriate strategy for high frequency and high sever ity risks. While the avoidance of risk is one method of dealing with risk, but it has many negative consequences. While you can avoid dying in an air crash by giving up ai r travel; it also means giving up the huge time savings and convenience that air travel offers. Risk Reduction Risk reduction is achieved through loss prevention and control. For example the risk of fire can be reduced by measures like installing fire extinguishing syste ms and sprinklers, using fire retardant materials in construction. It is an appr opriate strategy when for high frequency and low severity risks. Risk Financing Risk financing methods are those that pay for losses that actually happen. These can be of two types: Risk Retention Risk retention is used when the risk is retained. The retention may be voluntary or involuntary. This is an appropriate strategy for low frequency and low sever ity risks. For example, the risk of suffering from common cold can be retained. As a general rule, risks that should be retained are those that lead to relative ly small certain losses. Risk Transfer Risk transfer is the transfer of risk from one individual to another who is more willing to bear the risk. Insurance is the most widely used means for reducing
risk by transfer. Risk transfer is appropriate for low frequency and high severi ty risks. Personal Risk Management The methods discussed above can be applied to the financial risks to which an in dividual is exposed. List events that have the potential to cause financial loss (whether through increase in expenses or through decrease in earning potential) . Some of these events are listed below: • Death • Disability • Major surgery or hospitalization • Illness • Liability for injuries to others • Burglary of home • Destruction of house and contents • Car accident – major damage to car • Car accident – minor damage to car • Professional Liability, etc Risk and Insurance Insurance is the most common method used for transferring risks. It shifts the r isk from an individual to a group. It also provides a means for paying for losse s. Insurance provides an important means of preventing risk from interfering wit h a client’s achieving financial objectives. How Insurance works To understand the concept of insurance, let us imagine a small town with 100 hou ses. The town is located in an area where storms of great severity occur frequen tly. Each family in the town faces the risk that a storm will destroy their house com pletely. If the house is destroyed, the family will have to spend Rs. 50,000 to reconstruct the house. However, at the same time it is unlikely that a storm wi ll destroy all the 100 houses simultaneously. Let’s suppose all the citizens of the town agree to share the losses (if and when they occur) equally, so that no single family will be forced to bear the entire loss of Rs. 50,000. This means that whenever any house is destroyed, every famil y will pay a sum of Rs. 500 to the affected family to rebuild their house. While the cost of Rs. 50,000 would have been crippling for a single family, the expen se of Rs. 500 is easily affordable Thus the risk is transferred from a single family to the entire village and the loss (when it occurs) is shared. In our example, the risk sharing and risk transfer is dependent upon the town pe ople successfully agreeing to bear the expenses of reconstruction of houses. In the real world it would be very difficult to reach at such an agreement and even more difficult to enforce it, because: 1. Some people might not agree to be part of such an agreement, making it d ifficult to reach the large numbers of participants, necessary for the scheme to work. 2. Some people might not pay their share, even though they were part of the agreement. 3. Someone would need to perform the task of collecting money from the peop le and providing it to the affected family. In the real world, insurance companies act as facilitators and remove the obstac les to risk transfer and risk sharing. They perform the functions of making agre ements, collecting money, calculating losses and providing payments to affected persons. Benefits and Costs of Insurance to Society Apart from protecting insured individuals, insurance offers many benefits to the society as a whole. These are: • Indemnification of loss • Reduction of anxiety • Source of investment funds • Loss prevention
• Enhancement of credit Human Life Value Approach The human life value approach aims to replace the expected future income of the insured in case of death. Here, the insurance purchased is based on the value of the income the insured breadwinner can expect to earn during his or her lifetim e. By focusing only on a family breadwinner s expected future earnings stream, t he human life value provides a rough estimate of life insurance needs. To help m ake the insurance needs estimate more accurate, the income replacement approach allows for some adjustments to the human life value. Therefore, the Human life value approach projects an individual s income through his remaining working life expectancy, and then the present value is determined by means of a discount rate.
Direct Loss A direct loss results from physical damage, destruction or theft of property. Fo r example if your house is damaged due to earthquake, the amount of loss is know n as direct loss. Indirect or Consequential Loss An indirect loss results from the consequences of a direct loss. For example, if your house is destroyed in an Liability Risks Liability risks arise from the possibility of being held legally liable for the loss to another person. If a person commits a mistake or because of negligence c auses bodily harm or injury to another person, a court of law can order that ind ividual to pay damages to the injured party. Liability risks can be categorized into: • Statutory Liability eg Third Party Liability in M.V. Act, I.D. Act, W.C.Act, P. I. • Under Common Law eg. Libel & Slender • Under Contract eg Contractual Obligations These liabilities may arise in personal or professional capacity. Personal Liability Personal liability arises when a person acts negligently or carelessly during th e course of his personal life and causes harm to another. For example, if you hi t a pedestrian with your car due to jumping traffic lights, you may be asked to bear the treatment expenses and pay damages to the victim. Professional Liability Professional liability arises when a person harms another while performing as a professional. For example, a doctor who causes harm due to a wrong diagnosis can be held professionally liable to pay damages to the patient. Liability risks cause financial insecurity because they result in depletion of e xisting financial resources. How can we manage risk? While risks cannot be eliminated, measures can be taken to reduce the probabilit y and size of loss caused by risks. This process is known as risk management. Risk Control Risk Control methods are those that try to minimize the losses from risks. These can be of two types: Risk Avoidance Risk avoidance is accomplished by not engaging in the action that gives rise to risk. Avoiding risk is an appropriate strategy for high frequency and high sever ity risks. While the avoidance of risk is one method of dealing with risk, but it has many negative consequences. While you can avoid dying in an air crash by giving up ai r travel; it also means giving up the huge time savings and convenience that air travel offers. Risk Reduction Risk reduction is achieved through loss prevention and control. For example the risk of fire can be reduced by measures like installing fire extinguishing syste ms and sprinklers, using fire retardant materials in construction. It is an appr opriate strategy when for high frequency and low severity risks. Risk Financing Risk financing methods are those that pay for losses that actually happen. These can be of two types: Risk Retention Risk retention is used when the risk is retained. The retention may be voluntary or involuntary. This is an appropriate strategy for low frequency and low sever ity risks. For example, the risk of suffering from common cold can be retained. As a general rule, risks that should be retained are those that lead to relative ly small certain losses. Risk Transfer Risk transfer is the transfer of risk from one individual to another who is more willing to bear the risk. Insurance is the most widely used means for reducing
risk by transfer. Risk transfer is appropriate for low frequency and high severi ty risks. Personal Risk Management The methods discussed above can be applied to the financial risks to which an in dividual is exposed. List events that have the potential to cause financial loss (whether through increase in expenses or through decrease in earning potential) . Some of these events are listed below: • Death • Disability • Major surgery or hospitalization • Illness • Liability for injuries to others • Burglary of home • Destruction of house and contents • Car accident – major damage to car • Car accident – minor damage to car • Professional Liability, etc Risk and Insurance Insurance is the most common method used for transferring risks. It shifts the r isk from an individual to a group. It also provides a means for paying for losse s. Insurance provides an important means of preventing risk from interfering wit h a client’s achieving financial objectives. How Insurance works To understand the concept of insurance, let us imagine a small town with 100 hou ses. The town is located in an area where storms of great severity occur frequen tly. Each family in the town faces the risk that a storm will destroy their house com pletely. If the house is destroyed, the family will have to spend Rs. 50,000 to reconstruct the house. However, at the same time it is unlikely that a storm wi ll destroy all the 100 houses simultaneously. Let’s suppose all the citizens of the town agree to share the losses (if and when they occur) equally, so that no single family will be forced to bear the entire loss of Rs. 50,000. This means that whenever any house is destroyed, every famil y will pay a sum of Rs. 500 to the affected family to rebuild their house. While the cost of Rs. 50,000 would have been crippling for a single family, the expen se of Rs. 500 is easily affordable Thus the risk is transferred from a single family to the entire village and the loss (when it occurs) is shared. In our example, the risk sharing and risk transfer is dependent upon the town pe ople successfully agreeing to bear the expenses of reconstruction of houses. In the real world it would be very difficult to reach at such an agreement and even more difficult to enforce it, because: 1. Some people might not agree to be part of such an agreement, making it d ifficult to reach the large numbers of participants, necessary for the scheme to work. 2. Some people might not pay their share, even though they were part of the agreement. 3. Someone would need to perform the task of collecting money from the peop le and providing it to the affected family. In the real world, insurance companies act as facilitators and remove the obstac les to risk transfer and risk sharing. They perform the functions of making agre ements, collecting money, calculating losses and providing payments to affected persons. Benefits and Costs of Insurance to Society Apart from protecting insured individuals, insurance offers many benefits to the society as a whole. These are: • Indemnification of loss • Reduction of anxiety • Source of investment funds • Loss prevention
• Enhancement of credit Human Life Value Approach The human life value approach aims to replace the expected future income of the insured in case of death. Here, the insurance purchased is based on the value of the income the insured breadwinner can expect to earn during his or her lifetim e. By focusing only on a family breadwinner s expected future earnings stream, t he human life value provides a rough estimate of life insurance needs. To help m ake the insurance needs estimate more accurate, the income replacement approach allows for some adjustments to the human life value. Therefore, the Human life value approach projects an individual s income through his remaining working life expectancy, and then the present value is determined by means of a discount rate.
