Risk Management

Risk

The term risk may be defined as the possibility of adverse results flowing from any occurrence.
Therefore risk is Uncertain. The term risk in insurance means either a peril to be insured against.

Definition
Risk is a condition where there is a possibility of an adverse deviation from a desired outcome
that is expected or hoped for. Risk is the like hood of a hazard causing harm.
Risk is also defined as uncertainty concerning the occurrence of a loss.

An important category of pure risks encompasses those risks that traditionally were managed by
purchasing insurance – the risk of reduction of firm value due to fires, natural disasters, liability
lawsuits, work injuries, and other types of accidents or legal actions. However, pure risks also
include other sources of volatility that have not traditionally been traded in insurance markets.
The latter category includes weather risks and credit risks, among others. An important category
of pure risks are those that can result in a loss to the firm but do not offer the
Opportunity for gain, i.e., risks that have downside but not upside potential.

Types of Risk:

Objective Risk:
o As the relative variation of actual loss from the expected loss.
o Declines as the number of exposure units increases
o Is measurable by using the standard deviation or coefficient of variation
Subjective Risk:
o Is defined as uncertainty based on a persons mental condition or a state of mind.
(Drink & Drive)
o Difficult to measure
Financial & Non Financial Risk
Dynamic Risk: are those resulting from changes in the economy. Changes in price level,
consumer taste, and income & out put in technology.
Static Risk: involve losses that occur even if there were no changes in the economy. If
we would hold Changes in price level, consumer taste, income & out put in technology still
individuals will suffer financial loss.
There is no requirement that the possibility be unmeasurable, only that it must exist. Since our
purpose is related to insurance risk our focus will be risk which entails of possibility financial
loss.

Degree of Loss

For those who define risk as uncertain the greater the uncertainty the greater the risk.
For individual the higher the probability of loss, the greater is the probability of an
adverse deviation from what is hoped for & therefore greater is the risk.

Degree of loss Can be defined: The expected value of a given loss is a given situation or the
mathematical value of risk at any point of time is the probability of the loss materializing
multiplied by the amount of the potential or anticipated loss.

Risk Distinguished from peril & Hazard

The term peril is cause of loss, Eg, Fire Wind storm, Theft
A hazard is anything that has the potential to cause harm / increase the chance of
loss.(e.g., a slippery floor).

Hazard.
A specific situation that increases the probability of the occurrence of loss arising from a
peril, or that may influence the extent of the loss. For example, accident, sickness, fire,
flood, liability, burglary, and explosion are perils. Slippery floors, unsanitary conditions,
shingled roofs, congested traffic, unguarded premises, and uninspected boilers are also
hazards.

Moral Hazard.
A condition of morals or habits, character that increases the probability of loss from a
peril. (Employee Dishonesty) An extreme example would be an individual who previously
burned his own property to collect the insurance.
Morale Hazard.
Hazard arising out of an insured's indifference to loss because of the existence of
insurance. The attitude, "It's insured, so why worry," is an example of a morale hazard / is
carelessness or indifference to a loss because

Physical Hazard.
Any hazard arising from the material, structural, or operational features (Physical
condition) of the risk itself apart from the persons owning or managing it. Ex: Defective
Wiring can increase the chance of fire.

Legal Hazard
Refers to character in a legal system or a regulatory environment that increase the
frequency of loss.

Categories of risk

Pure risk
A risk involving the probability or possibility of loss with no chance for gain. A pure risk is
generally insurable.

Definition of Pure Risk

Pure risks can be broadly defined as risks that are beyond the core competencies of the majority
of firms in the economy. These are risks that must be managed or avoided in order to enable
management to add value by focusing on the firm’s primary activity.

Speculative risks
A risk for which it is uncertain as to whether the final outcome will be a gain or loss. Gambling is
a speculative risk. Generally, cannot be insured.

Fundamental Risk; involves losses that are impersonal in origin & consequences. They are the
group risk caused for the most part in the economic, social & political conditions. Ex: War, Flood,
Inflation, earth quake.

Particular Risk; involves losses that arise out of an individual event rather felt by individual
rather by an entire group. Burning of house
 Methods of handling Risk

Risk may be retained:

•Active Retention: means that an individual is consciously aware of the risk & deliberately
plans to retain all / part of it. A motorist may wish to retain the risk of a small collusion loss by
purchasing an auto insurance policy.

•Passive Retention: Certain risk may be unknowing retained because of in difference /

ignorance.

Transfer of risk

The basis for insurance is "transfer of risk”. This means that the insurer agrees to compensate
you if you suffer a loss. Without the insurance you would have to pay for that loss yourself.
Obviously this contract is made on the basis that the insurance company calculates the risk that
you, or the total number of people buying insurance, will cost more in payouts than what is
received in premiums. This is determined by the use of statistics and the information you
disclose on your application for insurance.

Risk Retention

Liability insurance companies owned by their policyholders. Membership is limited to people in

the same business or activity, which exposes them to similar liability risks. The purpose is to
assume and spread liability exposure to group members and to provide an alternative risk
financing mechanism for liability.
 Types of Pure risk:
Personal risks; that are risk affect an individual. The following risks are the four basic risk
individual has to face
1. Premature death
2. Dependent old age
3. Sickness or disability
4. Unemployment

Property risk: that is risk results from the physical damage, destruction.
1. The loss of the property
2. Loss of use of the property
3. Additional expenses occasioned by the loss of the property.

Liability risk: The basic peril in the liability risk is the unintentional injury of the other person or
damage to their property through negligence or carelessness.
It’s of great importance because of
1. There is no maximum upper limit in respect to amount of loss
2. Lien can be places on income & financial asset to satisfy a legal judgment
3. Legal defense cost could be high.

Methods of Handling Risk:

1. Risk may be avoided
2. Risk may be retained
3. Risk may be Transferred
4. Risk may be shared
5. Risk may be reduced

Risk Handling
Techniques

Risk avoidance Risk Reduction Risk transfer Risk retention

Modify objectives or Reduce likelihood Contract Contingency funds

Performance targets Reduce impact Insurance Contingency plans
Modify approach Partnerships/ Fix-on-fail
Joint ventures Crisis management
 Risk & Its Impacts to different Environment

Burden of Risk on Society

1. Need for a Larger Emergency Fund

2. Loss of Needed Goods and Services
3. Fear and Worry

Different types of Insurance Policy to cover Risk

Insurance of Property:

Everyone possesses material value in the form of tangible assets. Assets can be in the form of a
landed estate or a vehicle, share holdings or plain old paper money. Since tangible property has
a physical shape and consistency, it is subject to many risks ranging from fire, allied perils to
theft and robbery. An individual's lifetime of hard work can be wiped out in a blink of an eye.
 Insurance of Liability:

Policy indemnifies the Directors or Officers or other professionals against loss arising from
claims made against them by reason of any wrongful Act in their Official capacity. If due to
lack of control over his actions or prejudiced behavior, a person incurs any liability then he
has to provide compensation out of his personal resources.

o Personal Accident Insurance provides compensation for loss of life or injury (partial
or permanent) caused by an accident. This includes reimbursement of cost of
treatment and the use of hospital facilities for the treatment.

o Property Insurance policy is designed to cover the various risks under a single
policy. It provides protection for property and interest of the insured and family.

o Travel Insurance covers the insured against various eventualities while traveling
abroad. It covers the insured against personal accident, medical expenses and
repatriation, loss of checked baggage, passport etc.

o Health Insurance takes care of medical expenses following hospitalization from

sudden illness or accident.

o Motor Insurance Motor Vehicles Act states that every motor vehicle plying on the
road has to be insured, with at least Liability only policy.

o Architects - A high profile client feels that the quality of building materials used in
his farmhouse is inferior.

o Consulting Physicians - A referred patient is wrongly diagnosed owing to a

laboratory mix-up. He decides to initiate legal proceedings against one.

o Directors - A group of majority shareholders thinks that you are unfit to run the
firm that is funded by their investments.

o Doctors & Surgeons - Have you ever calculated what is the worth of your clinic's
specialised equipment with its imported fittings? A wrongly administered dose of
medicine could have severe implications, on the patient's health as well as on your
professional reputation.
o Engineers - The last project undertaken by your firm is not showing signs of rapid
progress. What if your client decides to take his business elsewhere and sue the
shirt off your back?

o Exporters - Are you unsure about your overseas client's credit worthiness?

o Hoteliers - Protect yourself from legal libel in the event of food poisoning. Or why
not insure your frozen supplies from spoilage?

o Jewellers - Aren't you subject to major risks and perils while conducting your
business?

o Lawyers & Legal Advisors- while underwriting a legal paper, you might slip up on a
minor detail somewhere.

o Medical Establishments - Your patients can hold you liable in case of a wrong dose
of medicine.

o Officers - your Company’s shareholders seem dissatisfied and suspicious regarding

the last balance sheet.

o Oncologists - A minor error by the data-entry clerk can result in the wrong
diagnosis of a serious malady.

o Shopkeepers - Your business premises, employees and their fidelity, stocks and
financial assets are at constant risk from natural and man-made perils.

o Solicitors - The nature of your profession leaves little scope for errors. And one
error in a legal paper is all it takes for your legal reputation to be tarnished forever.