Risk Management

Nature and Treatment of Risk

• Risk is defined as uncertainty concerning the occurrence of
a loss
• Chance of a loss is the long run relative frequency of a loss
and can be defined as the probability that an event occurs
• Objective risk (also called degree of risk) refers to the
chance of a loss measured by an objective probability,
rather than by individual judgement. It may be defined as
the relative variation of actual loss from expected loss.
(Refer to Law of Large Numbers).
• Subjective risk is the chance of loss as measured by an
individual’s subjective probability, or judgement, rather
than by statistics.
 Nature and Treatment of Risk
• Systematic risk is the chance of loss which is
predictable under relatively stable circumstances.
Over time such risks can be accurately predicted,
despite short-term fluctuations
• Unsystematic risk is the chance of loss which is
highly unpredictable in the aggregate because it
arises from forces which are difficult to predict. For
e.g. Unemployment, epidemics and war related
• Peril is defined as the cause of loss (e.g. Fire,
earthquake, theft, etc.). Mixed peril is when two or
more perils simultaneously cause loss.
 Nature and Treatment of Risk
• A Hazard is a condition that creates or enhances the chance
of a loss. Three major types of hazards:
• Physical hazard arises from physical characteristics of
animate or inanimate objects (say inflammable material
increase the chances of fire)
• Moral hazard arising from personal characteristics like habits,
methods of management, mental condition or lack of integrity
• Morale hazard that causes persons to be less careful than
they would otherwise be (carelessness or indifference to loss
because of the existence of insurance)
• Legal hazard refers to characteristics of the legal or
regulatory system that increases the frequency or severity of
losses – say large damage awards in liability law suits.
 Basic Categories of Risk

• Pure and Speculative Risks:

• Pure Risk: Uncertainty as to whether a loss will
occur. It is defined as a situation in which there
are only two possible outcomes: `loss’ or `no loss’
(e.g. Premature death, damage to property)
• Speculative Risk: Uncertainty as to whether a gain
or loss will occur (e.g. Horse racing, investing in
stock market)
• Insurers typically insure only pure risks.
 Basic Categories of Risk

• Fundamental and Particular Risks:

• A fundamental risk affects the entire economy or
large number of persons or groups within the
economy
• A particular risk affects only individuals and not
the entire economy
• Government assistance or subsidy may be required
in order to cover fundamental risks. (e.g. social
insurance, unemployment insurance)
 Personal Risks
• Major types of pure risk include personal risks,
property risks and liability risks.
• Personal risks are those risks that directly affect an
individual:
• Risk of premature death
• Risk of old age
• Risk of poor health
• Risk of personal accident
• Risk of unemployment
 Property Risks
• Persons owning property are exposed to property
being damaged or lost for many reasons.
• A direct loss is one that arises as a direct
consequence of a particular peril. It is a financial
loss that results from the physical damage,
destruction or theft of property
• Indirect or Consequential Loss – This type of
financial loss arises indirectly from the occurrence
of a direct physical damage or theft loss – say
business loses profits on account of closure after a
fire. Extra expenses incurred could be another
consequential loss.
 Liability Risks

• Liability Risk is a type of pure risk. Any form of

coverage whereby the insured is protected against
the claims of other parties from specified events.
• There are situations under which you can be held
legally liable if you do something that results in
bodily injury or property damage to someone else.
• There is also the problem that there may be no
upper limit to the amount of loss.
• Further, legal defence costs may be large.
 What is Risk Management?
• Risk management could be defined as the
systematic identification and analysis of the
various loss exposures faced by a firm or
individual and the best methods of treating the
identified loss exposures consistent with the firm’s
or individual’s objectives.
• Insurance is only one of the methods for treating
risk exposures.
• Generally, a risk manager of a company is
concerned only with the management of pure
risks, not speculative risks.
 Catastrophic losses
• Catastrophic losses
– A person can be exposed to risk that can cause loss,
which can financially destroy or cripple the person.
– Example:
• A serious illness can cause a person to incur heavy medical
bills, which can severely affect the financial health of the
family. If the illness is prolonged and debilitating, the person
will not be able to work, whilst his medical cost may keep on
escalating.
• The person's property may be destroyed by fire or severely
damaged or stolen. For example, a home normally constitutes
the main asset owned by a person. If the house was gutted by
fire, substantial and irreparable loss will be caused.
 Rules of Risk Management
• Risk Management decisions are made automatically
without much thought.
– For example, before crossing the road, a pedestrian would look to
see if there are any cars before negotiating the crossing. This will
reduce the chance of being knocked down by a car.
• The financial planner should approach the matter in a
systematic and methodical manner. In this respect,
reference can be made to the three rules expressed by
Mehr and Hedges and they are:
– Don't risk more than you can afford to lose.
– Consider the odds.
– Don't risk a lot for a little.
 Contd.
• Don't risk more than you can afford to lose
– This rule stipulates that if a particular loss has severe consequence
for you, then you should not retain it. For example, the owner of a
house may suffer severe loss in the event of a fire gutting the place
and as such he should not retain the risk and instead acquire fire
insurance coverage.
• Consider the odds
– Under this rule, consideration is given to the probability of the loss
occurring. If the probability is high, it may not be viable to resort
to insurance. This is because the premiums may be too high to
justify coverage.
• Don't risk a lot for a little
– Under this rule, if the cost of adopting the risk management
technique is small compared to the consequences of the risk,
which is large, then the party should effect the risk management
technique. For example, the premiums for most fire insurance
policies are not high and the consequences of a fire affecting a
home can be very substantial.
 Managing Risks
• Risk mgt is an on-going process. In a dynamic
environment, the risk manager must remain alert to
factors that affect his company. The risk manager
therefore has to take the responsibility for periodic
evaluation of risks as well as techniques for tackling
various loss situations.
• Many companies operate globally, and the role of the
risk manager in identifying overseas risks is
increasing.
• The risk manager also cannot act in isolation. Co-
operation of various departments is necessary for the
entire programme to be successful.
 Objectives of Risk Management

• Risk management can be divided into a pre-loss

stage and a post-loss stage.
• The primary objective of risk management at the
pre-loss stage is to prepare the firm for potential
losses in the most economical way possible. A
second objective is reduction of anxiety. The risk
manager must also prepare the firm in order to meet
any obligations imposed by outsiders. For example,
insurers may want fire protection equipment
installed, or a lending bank may require credit
guarantee coverage.
 Objectives of Risk Management

• The second broad type of objectives is post-loss

objectives. The most important post-loss objective
is to ensure survival of the firm in the event of a
loss. Secondly, the firm has to resume operations
as soon as possible. Ensuring stability of earnings
is also important.
• Finally, the firm cannot forget its social
responsibility to the community in which it
operates.
 The Risk Management Process

There are basically four steps in the risk

management process:
• Identification of potential loss situations
• Evaluation of potential losses
• Selecting the appropriate techniques for tackling
various loss exposures
• Implementation of the risk management
programme
 Identification of Potential Losses
The following list covers major potential loss areas:
• Property losses including fire, marine, motor
insurance, etc.
• Liability losses
• Business income losses
• Losses relating to employee dishonesty
• Employee benefit loss exposures including workers’
compensation, gratuity benefits, etc.
• Financial losses relating to exchange rate movements,
adverse commodity price movements, etc.
 Evaluation of Potential Losses
• Once potential losses are identified, an estimate of
the frequency and severity of the losses is made to
arrive at the impact of losses on the co. This type of
ranking or mapping is also useful for arriving at the
appropriate techniques that can be used by the risk
manager to handle the loss exposures.
• Two definitions used to estimate the severity of
loss: The `max. possible loss’ is the worst possible
loss that could possibly happen to the firm during its
lifetime. This is a single catastrophic loss that could
wipe out the firm. The `max. probable loss’ is the
worst loss that is likely to happen.
 Selection of Appropriate Technique to
Handle Loss Exposures
The major techniques for handling loss exposures
are the following:
• Avoidance
• Loss Control
• Retention
• Non-insurance transfers
• Insurance
 Avoidance
• Avoidance would imply that a loss exposure is not
acquired, or an existing loss exposure is abandoned.
E.g.: A power generating company may decide not
to put up a hydro power plant in the earthquake
prone zone. However, if the earthquake prone zone
is also the area where the river runs through a
valley, avoiding the area would also mean
abandoning the plan to build a hydro power plant
using damming of the river to generate the
electricity. The company may finally decide to build
the power plant taking suitable precautions.
 Loss Control

• Loss control activities are designed to reduce both

the severity and frequency of loss exposures.
Burglar alarm systems will not prevent burglary
under all circumstances; but they do reduce the
frequency of losses due to burglary. Similarly, fire
protection systems should reduce the severity of
losses attributable to fire. Of course many loss
control measures that can be taken are quite
complicated, and experts may have to be brought
in to get the best results.
 Retention of Risks
• Retention implies the company retains part or all of
the possible losses that may result from a given loss
exposure. Quite often a company may retain the
risks by default, i.e. the company is not aware of the
risks. However, we are talking here of risk retention
which the risk manager is undertaking after being
fully aware of the loss exposures.
• Risk retention may become necessary because no
other method of treatment is possible. For example,
the coverage may be too expensive. It may not be
possible to insure or transfer the risk. Then there is
no option but to retain the risk.
 Retention of Risks

• Another situation where retention is recommended

is where even in the worst possible situation, the
worst possible loss is not serious. If the retention
method is used, the company should follow an
acceptable method of funding the losses that will
arise as a result. The company can decide to pay for
the losses out of the current income for the year.
However, this may mean substantial variation from
year to year. Some companies use the approach of
funding a reserve to take care of the variations from
year to year on this account.
 Retention of Risks
• Sometimes retention of risks is also known as self-
insurance. For example, the company instead of
taking out health insurance may meet health care
needs of its employees directly. This may be on
account of pressure from labour unions, or it may be
because the company finds it cheaper to do so.
However, the risk manager needs to consider all
aspects of retention carefully. Retention may lead to
overall savings of money, but it may also lead to
possible higher losses. One usual advantage of
retention is that there is a greater incentive for loss
prevention.
 Retention of Risks

• The risk manager can also go in for small

retention in the form of a deductible while
arranging for insurance. A deductible is used to
eliminate small claims and the administrative
hassles of adjusting these small claims. Agreeing
for deductibles may lead to substantial savings in
premium payments.
 Retention of Risks

• A sophisticated method of taking care of such

losses has been the concept of `captive insurer’. A
captive insurer is an insurer which is established
and owned by a parent firm for the purpose of
insuring the parent company’s loss exposures.
Many captives are located at offshore centres like
Bermuda on account of tax and other regulatory
advantages. In India `captive insurers’ are not
possible on account of regulatory reasons, but in
future as the market evolves such things may
become possible.
 Non-Insurance Transfers
• Non-insurance transfers, as the name implies, relate
to transfer of potential risks to third parties. For
example, the purchase of computers by a firm can
be accompanied by a maintenance contract.
Similarly, while setting up a new plant the
contractor may agree to be responsible for any
damage to the plant during the construction stage.
Another type of non-insurance risk transfer is to
hedge price risks by using derivative contracts.
Such non-insurance transfers are often very useful
as the potential loss may be shifted to some one
who is in a better position to exercise loss control.
 Insurance
• After considering the above four techniques of
handling risk exposures, the risk manager has to use
insurance to tackle the remaining loss exposures.
The risk manager has to select the insurance
coverage required and then identify a suitable
insurer. Once the terms are negotiated with the
insurer, the details of the coverage should be
disseminated throughout the organisation to
appropriate persons. The risk manager’s work does
not end here. There has to be a periodic review of
the entire programme so that emerging scenarios
can be tacked appropriately.
 Selecting the Appropriate Risk
Management Technique
Loss Frequency Loss Severity Appropriate
Technique
Low Low Retention

High Low Loss Control

and Retention
Low High Insurance

High High Avoidance

 Client's Attitudes
Risk Averter Risk Taker
Sees risk as danger Seeks risk as opportunity
Overestimates risk Underestimates risk
Prefers low variability Prefers high variability
Adopts the worst case scenario Adopts the best case scenario
Is pessimistic Is optimistic
Likes structure Likes ambiguity
Dislikes change Enjoys change
Prefers certainty Prefers uncertainty
 Concept of Insurance
• Insurance is probably the most versatile risk
management technique in the political, social and
commercial world.
• Its use as a risk management device is commonly
adopted because it creates certainty concerning the
financial liabilities arising from losses by
spreading the losses systematically and equitably
among consenting parties.
 Criteria for Insurable Risk
• For a risk to be considered insurable certain criteria must be satisfied and they are:
• The law of large numbers must apply
• The loss must be accidental or fortuitous
• The loss must be definite and measurable
• The loss must not be catastrophic
• Criteria 1 is necessary because insurance is based on probabilities of loss occurring.
Relying on relevant statistics and probabilities, the insurers can gauge the amount of
premiums necessary to support the insurance mechanism. However, for the actual
outcome of loss exposures to be reflective of the statistics, there must be a large number
of homogenous exposure unit.

• Criteria 2 is necessary because insurance is based on chance. An individual simply

cannot insure things that he or she has control over or which are certain to happen. For
example, if a person intentionally set his house on fire, the insurer under a fire policy
will not be liable to indemnify him.

• Criteria 3 is necessary because the insurer must be able to determine when a loss
occurred and measure the extent of the loss to enable the insurer to operate effectively.
When the occurrence and quantification of losses are possible, the insurer can then
ascertain the extent of their liabilities and make necessary contingencies. For example,
under medical insurance, the cost of medical treatment can be obtained from the medical
bills and this will allow the insurer to give a proper indemnity.
Aspects of an Insurance Contract
• The insurance contract is an instrument, which creates the contractual
relationship between the insured and the insurer. It has several
characteristics, some of which are as follows:
• It satisfies the three basic requirements of a contract.
– Firstly, it deals with a legal activity, which is enforceable. If the insurer
reneges (goes back) on its promise to pay in the event of a loss, the
insured can take legal action to seek redress.
– Secondly, there is the existence of offer and acceptance. When the
proposer submits the application form together with the premium payment
to the insurer, an offer has been made and when the insurer issues the
policy, the offer has been accepted.
– Thirdly, the insurance contract is supported by consideration.
Consideration refers to a benefit conferred by one of the contracting
parties to the other, in exchange for the other party conferring some
benefit in return.
• It is based on the concept of insurable interest. This means that the
policy owner must establish a financial link between him and the
subject matter of the insurance.
 Contd.
• It is known as an aleatory contract in which the
consideration or monetary value between the parties to the
contract is not equal. In the case of insurance contracts, the
insured or policyholder pays a premium and may collect
nothing from the insurer if no loss occurs. On the other
hand, if a loss does occur, the insured or policyholder may
collect considerably more than the amount of the premium.
• It is known as a contract of adhesion. In such contracts, the
terms and conditions of the contract are written by the
insurer and the proposer has no ability or right to make any
modification or amendment. The proposer can only either
reject the contract or accept it in its entirety.
• It is a unilateral contract as opposed to a bilateral contract.
This is because the insurer is the only party that can be held
accountable in Court.
 Contd.
• Except for life insurance and personal accident insurance,
insurance contracts are generally based on the indemnity
principle. Such contracts provide a mechanism by which
the insurers only provide financial compensation in an
attempt to place the insured in the same pecuniary position
before the loss.
– The indemnity principle is not applied in life and personal accident
insurance policies. This is because the law recognizes that there is
no limit to the value of human life.
 The Insurance Industry
• In order for the financial planner to render advice on insurance
planning, he or she needs to be familiar with relevant aspects of the
insurance industry. This will enable him to know to what extent
insurance can be an effective risk management tools.
• The major players in the insurance industry, which are:
– The IRDA, which is the regulatory body
– Insurance Advisory Committee set up by IRDA.
– The Insurers : Public Sector & Private Sector
– Association of Insurers (under formation)
– Insurance agents and brokers (life insurance council)
• Relevant legislation and rules governing the insurance industry framed
by IRDA and Insurance Advisory Committee, like:
– The Insurance Act 1938.
– The IRDA Act governing the intermediaries.
– Ombudsman for redressal of grievances of policy owner.
 Insurance Regulatory &
Development Authority (IRDA)
• The IRDA is the regulatory authority supervising the insurance
sector of the economy and will play an important role in the
development of the life insurance industry.
• One of the most important functions of the IRDA is the
administration of the Insurance Act and IRDA Act to ensure that
the life insurance companies are financially solvent at all times.
• Adequate standards for valuation of assets, liabilities and
solvency margins have been set and implemented and there have
been no cases of insolvency since the inception of the Insurance
Act in 1938.
• This has given confidence to the general public about the ability
of the insurance companies to honour their promises to pay
claims when they come due.
Life Insurance Association (LIA) of
Insurers
• Agents Association
– Agents Association is set up with the initiative of the life insurance
agents. By focusing on ethics, product knowledge and quality of
service, the Agents Association is actively encouraging
professionalism in the insurance sales force.
• The Insurers
– The insurers are a major component of the insurance industry.
There are two main types: Public Sector or Private Sector. A
Public Sector (government owned), the other type of insurance
company is a Private Sector (new Indian firms with or without
collaboration with foreign insurers).
• Agents/Brokers
– Insurance companies use agents and/or brokers. All the agents
have contracted with one insurance company and are prohibited
from selling products from any other company.
– There is a significant difference between the insurance agent and
the broker. An agent is the legal representative of the insurance
company while a broker represents the buyer.
 The Insurance Act 1938
• In 1912, the Indian Life Insurance Companies Act
and Provident Fund Insurance Societies Act 1912
was passed. This was the first comprehensive
legislation in India to regulate the business of
insurance.
• The Insurance Act 1938, aimed "to consolidate
and amend the law relating to the business of
insurance" came into force with effect from 1st
July 1939.
 Insurance Regulatory &
Development Authority Act 1999
• IRDA Act was passed by parliament in
December 1999 and it received presidential
assent in January 2000. This Act provides
for the establishment of the Authority to
protect the interest of holders of insurance
policies, to regulate, promote and ensure
orderly growth of insurance industry
 Life Insurance Corporation Act,
1956
• Life Insurance business in India was nationalized
with effect from 19 Jan 1956.
• LIC of India Act was passed by parliament on 18-
06-1956 and came into effect from 01-07-1956.
• LIC of India started its functioning as a corporate
body from 01-09-1956. Its working is governed by
the LIC Act. Some of the important provisions of
this Act (as amended by IRDA Act 1999) are
stated hereafter.
 Consumer Protection Act 1986
• This Act applies to all goods and services. It covers
private, public and co-operative sectors. The Act seeks to
protect following rights of consumers:
– The right to be protected against the marketing of goods which are
hazardous to life and property.
– The right to be informed about the quality, quantity, potency,
purity, standard and price of goods.
– The right to be heard and to be assured that consumers' interest
will receive due consideration at appropriate forum.
– The right to seek redressal against unfair trade practices or corrupt
exploitation of consumers.
– The right to consumer education.
 Risk Management Process
• The risk management process refers to a
systematic approach designed to discover
risk exposures faced by the client and to
manage them in order to minimize or
eliminate loss arising from these exposures.
• The risk management process should be systematic,
comprehensive, effective and be ideally integrated with
other aspects of financial planning. It normally consists of
the following steps:
– Identify risk management goals.
– Gather relevant and comprehensive data to determine the extent
and nature of risk exposures.
– Analyse the risk exposures faced by the client .
– Construct a risk management plan comprising appropriate risk
treatment methods.
– Implement the plan.
– Monitor the plan and the outcome of its implementation.