MF0009 – Insurance & Risk Management -Set-1

Q.1) “Risk can be classified into several distinct categories”. Explain.

Ans: Risks may be classified in several distinct ways as explained below:

(a) Financial and Non-financial Risks

In its broadest context, risk includes all situations in which there is an exposure to adversity. In
some cases, this adversity involves financial loss while in others it does not. There is some
element of risk in every aspect of human endeavour, and many of these risks have no (or only
incidental) financial consequences.

Financial risk involves the relationship between an individual (or an organisation) and an asset
or expectation of income that may be lost or damaged. Thus, financial risk involves three
elements: (i) the individual or organization that is exposed to loss, (ii) the asset or income
whose destruction or dispossession will cause financial loss, and (iii) a peril that can cause the
loss.

The first element in financial risk is that someone will be affected by the occurrence of an
event. During the devastating floods, a considerably large area of farmland is damaged by
flood waters, causing a financial loss to the tune of several billions to the owners.

The second and third elements are the thing of value and the peril that can cause the loss of
the thing of value. The individual who owns nothing of value and who has no prospects for
improving that situation faces no financial risk. Further, if nothing could happen to the
individual’s assets or expected income, there is no risk.

b) Static and Dynamic Risk

A second important distinction is between static and dynamic risks. Dynamic risks are those
resulting from changes in the economy. Changes in the price level, consumer tastes, income
and output, and technology may cause financial loss to members of the economy. These
dynamic risks normally benefit society over the long run, since they are the result of
adjustments to misallocation of resources. Although these dynamic risks may affect a large
number of individuals, they are generally considered less predictable than static risks, since
they do not occur with any precise degree of regularity.

Static risks involve those losses that would occur even if there were no changes in the
economy. If we could hold consumer tastes, output and income, and the level of technology
constant, some individuals would still suffer financial loss. These losses arise from causes
other than the changes in the economy, such as the perils of nature and the dishonesty of
other individuals. Unlike dynamic risks, static risks are not a source of gain to society. Static
losses involve either the destruction of the asset or a change in its possession as a result of
dishonesty or human failure. Static losses tend to occur with a degree of regularity over time
and, as a result, are generally predictable. Because they are predictable, static risks are more
suited to treatment by insurance than are dynamic risks.

AMBRISH Page 1
 MF0009 – Insurance & Risk Management -Set-1

c) Acceptable and Unacceptable Risk

There are two elements of uncertainty in most types of events that are handled by risk
managers – the likelihood of the event occurring, and the size of the ensuing loss. Generally,
the degree of risk aversion displayed by individuals acting in either a private or managerial
capacity tends to increase with the potential size of loss. Some loss potentials are so small
that an individual or organization is prepared to accept the risk and assume any loss that does
occur. Beyond a certain size, the risk becomes unacceptable and ways will be sought to avoid,
reduce or transfer that risk. Of course, the maximum size of loss that can be tolerated
depends on the status of the individual or organisation, and so the division between
acceptable and unacceptable risks is not entirely clear-cut for two reasons.

First, it depends partly on time. The size of loss that could be absorbed by, say, one year’s
profits would normally be far larger than could be accommodated within one month’s operating
budget. Secondly, there will be a range of potential losses where the occurrence of the loss
could strain the individual’s or an organization’s finances but it could be overcome (perhaps by
resort to borrowing or raising additional capital). Then, whether the risk of incurring a loss of
any size will be regarded as acceptable or unacceptable will depend upon the cost of handling
the risk relative to the benefits thereof. For example, if loss reduction measures would greatly
exceed the expected reduction in losses; or if the premium required by insurers is deemed
high relative to the risk that would be transferred, then no attempt may be made to reduce the
risk or insure it.

The division between acceptable and unacceptable risk will always be influenced even if it is
not fully determined by such financial considerations. Furthermore it will be influenced by the
allocation of the costs and benefits of those risks and methods of handling them between
persons who may be affected. In the case of industrial accidents, for instance, according to the
rules laid down by law, the employer will be liable to compensate employees for injuries
sustained as the result of accidents at work, though whether the size of award determined
according to those rules represents adequate compensation for the pain, suffering, loss of
amenity and loss of an injured employee’s present and future earnings is a matter of
judgement. The cost of reducing the probability and/or severity of such accidents will fall
directly upon the employer, though some or all of that cost may ultimately be passed on to the
employees through a reduction in earnings due to a cut in the risk premium element of wages.
Because perceived costs and benefits may differ, employees (or their trade union
representatives) may have a different view as to what constituted an unacceptable risk to that
held by the employer.

d) Fundamental and Particular Risks

A fundamental risk is a risk that affects the entire economy or large numbers of persons or
groups within the economy. Examples include rapid inflation, cyclical unemployment and war
because large numbers of individuals are affected. The risk of a natural disaster is another
important type of fundamental risk. Hurricanes, tornadoes, earthquakes, floods, and forest and
grass fires can result in damage to billions of dollars worth property and cause numerous
deaths.

AMBRISH Page 2
 MF0009 – Insurance & Risk Management -Set-1

In contrast to a fundamental risk, a particular risk is a risk that affects only individuals and not
the entire community, Examples include car thefts, bank robberies, and dwelling fires. Only
individuals experiencing such losses are affected, not the entire economy.

The distinction between a fundamental and a particular risk is important because Government
assistance may be necessary to insure a fundamental risk. Social insurance and Government
insurance programmes, as well as government guarantees and subsidies, may be necessary
to insure certain fundamental risks. For example, the risk of unemployment generally is not
insurable by private insurers but can be insured publicly by state unemployment compensation
programmes.

e) Pure and Speculative Risks

Pure risk is defined as a situation in which there are only the possibilities of loss or no loss.
The only possible outcomes are adverse (loss) and neutral (no loss). Examples of pure risks
include premature death, job-related accidents, catastrophic medical expenses, and damage
to property from fire, lighting, flood, or earthquake.

Speculative risk is defined as a situation in which either profit or loss is possible. For example,
if you purchase 100 shares, you would profit if the price of the shares increases but would lose
if the price declines. Other examples of speculative risk include betting on a horse race,
investing in real estate, and going into business for self. In these situations, both profit and
loss are possible.

It is important to distinguish between pure and speculative risks for three easons. First, private
insurers generally insure only pure risks. With certain exceptions, speculative risks are not
considered insurable, and other techniques for coping with risk must be used. (One exception
is that some insurers will insure institutional portfolio investments and municipal bonds against
loss).

Second, the law of large numbers can be applied more easily to pure risks than speculative
risks. The law of large numbers is important because it enables insurers to predict future loss
experience. In contrast, it is generally more difficult to apply the law of large numbers to
speculative risks to predict future loss experience. An exception is the speculative risk of
gambling, where casino operators can apply the law of large numbers in a most efficient
manner.

Finally, society may benefit from a speculative risk even though a loss occurs, but it is harmed
if a pure risk is present and a loss occurs. For example, a firm may develop new technology
for producing inexpensive computers. As a result, some competitors may be forced into
bankruptcy. Despite the bankruptcy, society benefits because the computers are made
available at a lower cost. However, society normally does not benefit when a loss from a pure
risk occurs, such as a flood or earthquake that devastates an area.

AMBRISH Page 3
 MF0009 – Insurance & Risk Management -Set-1

Types of Pure Risk

The major types of pure risk that can create great financial insecurity include personal risks,
property risks, and liability risks.

a) Personal Risks: Personal risks are those risks that directly affect an individual; they involve
the possibility of complete loss or reduction of earned income, extra expenses, and the
depletion of financial assets. There are four major personal risks:

· Risk of premature death

· Risk of insufficient income during retirement

· Risk of poor health

· Risk of unemployment

i) Risk of Premature Death: Premature death is defined as the death of a household head
with unfulfilled financial obligations. These obligations can include dependents to support, a
mortgage to be paid off, or children to be educated. If the surviving family members receive an
insufficient amount of replacement income from other sources or have insufficient financial
assets to replace the lost income, they may be financially insecure.

Premature death can cause financial problems only if the deceased has dependents to
support or dies with unfulfilled financial obligations. Thus, the death of a child aged 10 is not
"premature" in the economic sense.

There are at least four costs that result from the premature death of a household head. First,
the human life value of the family head is lost forever. The human life value is defined as the
present value of the family’s share of the deceased breadwinner’s future earnings. This loss
can be substantial; the actual or potential human life value of most college graduates can
easily exceed Rs.500,000. Second, additional expenses may be incurred because of funeral
expenses, uninsured medical bills, probate and estate settlement costs, and estate and
inheritance taxes for larger estates. Third, because of insufficient income, some families may
have trouble making both ends meet for covering expenses. Finally, certain non-technical
costs are also incurred, including emotional grief, loss of a role model, and counselling and
guidance for the children.

ii) Risk of Insufficient Income during Retirement: The major risk associated with old age is
insufficient income during retirement. The vast majority of workers in India retire at the age of
60. When they retire, they lose their earned income. Unless they have sufficient financial
assets on which to draw, or have access to other sources of retirement income such as social
security or pension, they will be exposed to financial insecurity during retirement.

How are older people, aged 60 and over, doing financially? In answering this question, it is a
mistake to assume that all aged are wealthy; it is equally wrong to assume that all aged are

AMBRISH Page 4
 MF0009 – Insurance & Risk Management -Set-1

poor. The aged are an economically diverse group, and their total money incomes are far from
uniform.

iii) Risk of Poor Health: Poor health is another important personal risk. The risk of poor
health includes both the payment of catastrophic medical bills and the loss of earned income.
The costs of major surgery have increased substantially in recent years. For example, an
open-heart surgery can cost more than Rs. 200,000, a kidney or heart transplant can cost
more than Rs. 400,000, and the costs of crippling accident requiring several major operations,
plastic surgery, and rehabilitation can exceed Rs. 500,000. In addition, long-term care in a
nursing home can cost Rs. 50,000 or more each year. Unless these persons have adequate
health insurance or private savings and financial assets, or other sources of income to meet
these expenditures, they will be financially insecure. In particular, the inability of some persons
to pay catastrophic medical bills is an important cause of personal bankruptcy.

The loss of earned income is another major cause of financial insecurity if the disability is
severe. In cases of long-term disability, there is a substantial loss of earned income, burden of
medical bills, loss or reduction of employee benefits and depleted savings. Moreover,
someone must take care of the disabled person.

iv) Risk of Unemployment: The risk of unemployment is another major threat to financial
security. Unemployment can result from business cycle downswings, technological and
structural changes in the economy, seasonal factors, and imperfections in the labour market.

At present in India, the unemployment rate is very high. Unemployment at times is a serious
evil because of several important trends. To hold down labour costs, large corporations have
resorted to downsizing and their work force has been permanently reduced; employers are
increasingly hiring temporary or part-time workers to reduce labour costs; and millions of jobs
have been lost to foreign nations because of global competition.

Regardless of the reason, unemployment can cause financial insecurity in at least three ways.
First, workers lose their earned income and employee benefits. Unless there is adequate
replacement income or past savings on which to draw, the unemployed worker will be
financially insecure. Second, because of economic conditions, the worker may be able to work
only part-time. The reduced income may be insufficient in terms of the worker’s needs. Final, if
the duration of unemployment is extended over a long period, past savings may be exhausted.

b) Property Risks: Persons owning property are exposed to the risk of having their property
damaged or loss from numerous causes. Real estate and personal property can be damaged
or destroyed due to fire, lightning, tornadoes, windstorms, and numerous other causes. There
are two major types of loss associated with the destruction or theft of property- direct loss and
indirect or consequential loss.

i) Direct Loss: A direct loss is defined as a financial loss that results from the physical
damage, destruction, or theft of the property. For example, if you own a restaurant that is
damaged by fire, the physical damage to the restaurant is known as direct loss.

AMBRISH Page 5
 MF0009 – Insurance & Risk Management -Set-1

ii) Indirect or Consequential Loss: An indirect loss is a financial loss that results indirectly
from the occurrence of a direct physical damage or theft. Thus, in addition to the physical
damage loss, the restaurant is to be rebuilt. The loss of profits would be a consequential loss.
Other examples of a consequential loss would be the loss of rents, the loss of the use of the
building, and the loss of a local market.

Extra expenses are another type of indirect or consequential loss. For example, suppose you
own a vegetable shop or dairy. If a loss occurs, you must continue to operate regardless of
cost; otherwise, you will lose customers to your competitors. It may be necessary to set up a
temporary operation at some alternative location, and substantial extra expenses need to be
incurred.

c) Liability Risks: Liability risks are another important type of pure risk that most persons
face. Under our legal system, you can be held legally liable if you do something that result in
bodily injury or property damage to someone else. A court of law may order you to pay
substantial damages to the person you have injured.

Liability risks are of great importance for several reasons. First, there is no maximum upper
limit with respect to the amount of loss. One can be sued for any amount. In contrast, if you
own property, there is a maximum limit on the loss. For example, if your car has an actual
cash value of Rs.100,000, the maximum physical damage loss is Rs.1,00,000. But if you are
negligent and cause an accident that results in serious bodily injury to the other person, you
can be sued for any amount say Rs. 50,000, Rs. 500,000, or Rs. 1 million or more by the
person you have injured.

Second, a lien can be placed on your income and financial assets to satisfy a legal judgment.
For example, assume that you injure someone, and a court of law orders you to pay damages
to the injured party. If you cannot pay as per the judgment, a lien may be placed on your
income and financial assets to satisfy the judgment. If you declare bankruptcy to avoid
payment of the judgement, your credit rating will be impaired.

Finally, legal defence costs can be enormous. If we have no liability insurance, the cost of
hiring an attorney to defend can be staggering. If the suit goes to trial, attorney fees and other
legal expenses can be substantial.

Q.2) Identify common misconceptions about risk management and explain why these
misconceptions are developed.

Ans: Misconceptions about Risk Management and Reasons for its development

Now a days risk management has become a popular topic of discussion, some of what is
discussed reflects a misunderstanding of risk management. Some of these misconceptions
reflect a misreading of the literature, while others reflect defects in the literature itself. The first
misconception is that the risk management concept is principally applicable to large
AMBRISH Page 6
 MF0009 – Insurance & Risk Management -Set-1

organizations. The second is that the risk management approach to dealing with pure risks
seeks to minimize the role of insurance.

a) Universal Applicability

If one were to judge on the basis of much of the literature dealing with the concept of risk
management, it is be easy to conclude that risk management has no useful application except
with respect to the problems facing a large industrial complex. This misconception can easily
result from the fact that many of the techniques with which writers have been preoccupied
(e.g., self-insurance plans, captive insurers, etc.) do apply primarily to giant organizations.
Most of the articles on risk management have been written by practicing professional Risk
Mangers. It is natural that they would write about the techniques they use in their own
companies, and virtually all professional Risk Managers are employed by large organizations.
But it cannot be overemphasized that the risk management philosophy and approach applies
to organizations of all sizes (and to individuals as well for that matter), even though some of
the more esoteric techniques may have limited application in the case of an average
organization.

As the Risk Manager’s position has increased within the corporate framework and risk
management has become a recognized term in business jargon, the interest in risk
management has increased in businesses of all sizes. While it is obvious that the small firm
cannot afford a full-time professional Risk Manager, the principles of risk management are as
applicable to the small organization as to the giant international firm. The principles of risk
management are nothing more than common sense applied to the management of pure risks
facing an individual or organization. The principles are applicable to organizations of all sizes,
as well as to individuals and families. While the techniques may differ in scope and complexity,
the same risk management tools are used in either case.

b) Anti-Insurance Bias?

The second misconception about risk management that it is anti-insurance in its orientation
and that it seeks to minimize the role of insurance in dealing with risk also stems from risk
management literature. Much of the literature on risk management has also been preoccupied
with topics related to risk retention, self-insurance programmes, and captive insurance
companies. Indeed, if one were to ask practitioners in the insurance field to describe the
essence of risk management that is, its philosophy – many would respond that the major
emphasis of risk management is on the retention of risk and on the use of deductibles. While it
is true that retention is an important technique for dealing with risks, it is not what risk
management is all about.

The essence of risk management is not in the retention of exposures. Rather it is in dealing
with risks by whatever mechanism is most appropriate. In many instances, commercial
insurance will be the only acceptable approach. While the risk management philosophy
suggests that there are some risks that should be retained, it also dictates that there are some
risks that must be transferred. The primary focus of the Risk Manager should be on the
identification of the risks that must be transferred to achieve the primary risk management
objective. Only after this determination has been made does the question of which risks
should be retained arise. More often than not, determining which risks should be transferred
AMBRISH Page 7
 MF0009 – Insurance & Risk Management -Set-1

also determines which risks will be retained; the residual class that does not need to be
transferred.

Q.3) What are the social values of insurance? What are the social costs? Explain.

Ans: Social and Economic Values of Insurance:

There are many social and economic values of insurance, which are as follows:

1. Reduced Reserve Requirements

Perhaps the greatest social value – indeed, the central economic function – of insurance is to
obtain the advantages that flow from the reduction of risk. One of the chief economic burdens
of risk is the necessity of accumulating funds to meet possible losses, and one of the greatest
advantages of the insurance mechanism is that it greatly reduces the total of such reserves
necessary for a given economy. Because the insurer can predict losses in advance, it needs
to keep readily available only enough funds to meet those losses and to cover expenses. If
each insured has to set aside such funds, there would be need for a far greater amount. For
example, in many localities, a Rs. 100,000 building can be insured against fire and other
physical perils for about Rs. 500 a year. If insurance is not available, the insured would
probably feel a need to set aside funds at a much higher rate than Rs. 500 a year.

2. Capital Freed for Investment

Another aspect of the advantage just described is the fact that the cash reserves that insurers
accumulate are made available for investment. Insurers as a group, and life insurance firms in
particular, are among the largest and most important institutions collecting and distributing the
nation’s savings. From the viewpoint of the individual, the insurance mechanism enables
renting an insurer’s assets to cover uncertain losses rather than providing this capital
internally, much like renting a building instead of owning one. Capital that is thereby released
frees funds for investment purposes. Thus, the insurance mechanism encourages new
investment. For example, if an individual knows that his or her family will be protected by life
insurance in the event of premature death, the insured may be more willing to invest savings
in a long-desired project such as a business venture, without feeling that the family is being
robbed of its basic income security. In this way, a better allocation of economic resources is
achieved.

3. Reduced Cost of Capital

Because the supply of funds that can be invested is greater than it would be without
insurance, capital is available at a lower cost than would otherwise be possible. This result
brings about a higher standard of living because increased investment itself will raise
production and cause lower prices than would otherwise be the case. Also, because insurance
is an efficient device to reduce risks, investors may be willing to enter fields they would
otherwise reject as too risky. Thus, society benefits from increased services and new
products, the hallmarks of increased living standards.
AMBRISH Page 8
 MF0009 – Insurance & Risk Management -Set-1

4. Reduced Credit Risk

Another advantage of insurance lies in its importance to credit. Insurance has been called the
basis of the nation’s credit system. It follows logically that if insurance reduces the risk of loss
from certain sources, it should mean that an entrepreneur is a better credit risk if adequate
insurance is carried. Today it would be nearly impossible to borrow money for many business
purposes without insurance protection that meets the requirements of the lender.

5. Loss Control Activities

Another social and economic value of insurance lies in its loss control or loss prevention
activities. Although the main function of insurance is not to reduce loss but merely to spread
losses among members of the insured group, insurers are nevertheless vitally interested in
keeping losses at a minimum. Insurers know that if no effort is made in this regard, losses and
premiums would have a tendency to rise. It is human nature to relax vigilance when it is known
that the loss will be fully paid by the insurer. Furthermore, in any given year, a rise in loss
payment reduces the profit to the insurer, and so loss prevention provides a direct avenue of
increased profit.

6. Business and Social Stability

Finally, the existence and availability of insurance can lead to increased business and social
stability. Several illustrations may be helpful in envisioning this point. For example, if
adequately protected, a business need not face the grim prospect of liquidation following a
loss. Similarly, a family need not break up following the death or permanent disability of one or
more income producers. A business venture can be continued without interruption even
though a key person or the sole proprietor dies. A family need not lose its life’s savings
following a bank failure. Old-age dependency can be avoided. Loss of a firm’s assets by theft
can be reimbursed. Whole cities ruined by a hurricane can be rebuilt from the proceeds of
insurance.

Social Costs of insurance:

No institution can operate without certain costs. The costs for an insurance institution include
operating the insurance business, losses that are caused intentionally, and losses that are
aggregated.

1. Operating the Insurance Business

The main social cost of insurance lies in the use of economic resources, mainly labour, to
operate the business. The average annual overhead of property insurers accounts for about
25 per cent of their earned premiums but ranges widely, depending on the type of insurance.
In life insurance, an average of 20 per cent of the premium rupee is absorbed in expenses. In
other words, the advantages of insurance should be weighed against the cost of obtaining the
service.

AMBRISH Page 9
 MF0009 – Insurance & Risk Management -Set-1

2. Losses that are Intentionally Caused

A second social cost of insurance is attributed to the fact that if it were not insurance, certain
losses would not occur – losses that are caused intentionally by people in order to collect on
their policies. Although there are no reliable estimates as to the extent of such losses, it is
likely they are only a small fraction of total payments. Insurers are well aware of this danger,
however, and take numerous steps to keep it to a minimum.

3. Losses that are Exaggerated

Related to the cost of intentional losses is the tendency of some insured to exaggerate the
extent of damage that results from purely unintentional losses. For example, Company ABC
has an old photocopy machine that does not work well. When a small fire in ABC building
causes some smoke damage throughout the building, ABC may be tempted to claim that its
fire insurance should pay for a new photocopy machine. The old machine has likely been
affected by smoke, but in reality, the machine did not work well before the fire and probably
would have been replaced soon anyway. The existence of insurance tempts ABC to
exaggerate its loss in this situation. Similarly, health expenses for families that have health
insurance may be higher than the expenses for uninsured families. Once an accident or
sickness has occurred, an individual may decide to undergo more expensive medical
treatment, or the physician may prescribe it if it is known that an insurer will bear most or all of
the cost.

AMBRISH Page 10