insurance chapter 2

CHAPTER 2 - NATURE OF RISK AND RISK MANAGEMENT

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Overview 2.1. Concepts of Risk 2.2. Related Concepts 2.3. Basic Categories of Risk

2.4. Methods of Handling Risks 2.5. Risk Management

2.6. Characteristics of Insurable Risk

OVERVIEW

This chapter focuses on risk and a detailed discussion of the following is provided:

• Characteristics of Risk

• Concepts Related to Risk

• The Measurement of Risk

• The Management of Risk

• The Characteristics of Insurable Risks

2.1. CONCEPTS OF RISK

We live in a world in which we are continually exposed to perils. A peril is usually a cause of loss.Typicalperils includefire,collision,flood,sickness and premature death. When perils occur, propertymay be destroyed or lost andpeople injured or killed. Any loss of property or liveswillinvariablyleadtofinanciallosses.

Figure 2.1. Examples of Perils and their Consequent Losses


Although we are continually exposed to perils,weareuncertainastowhensuchloss-producingeventswilloccur.Inotherwords,weare uncertain about the losses we may suffer in the future. An uncertainty regarding loss is often termed as “risk”. Since risk exists whenever the futureisunknown,itcanbesaidtobepresenteverywhere and in all circumstances. It is present in human lives and in industry.

Measurement of Risk

Even though we are uncertain about a future loss, it ispossible todetermine thechanceofloss using a branch of mathematics known as the probability theory. The term “probability” refers to an area of study which measures the chance of occurrence of particular events. The study of chance, events or probability can beapproachedalongthreepossiblelines:Apriori,empirical and judgmental.

Application of A Priori Probability

A priori probability is determined when the total numbers of possible events are known. For example, theprobabilityofgettingafiveonaroll of dice is 1/6 or 0.1666. The priori concept has limited practical application in the study of risk and insurance because situations where the possible outcomes have an equal chance of occurrence are very rare.

Application of Empirical Probability

Empirical probability is determined on the basis of historical data. For example, a transportcompany which operates a fleet of 1000vehicles and experiences an average of 50 accidents over the previous year has a 50/1000 or 0.05 probability of an accident occurring the next year. The underlying concept that makes it possible for empirical probability to be measured accurately is the law of large numbers. (See 1.3.)

Application of Judgmental Probability

Judgmental probability is determined based on the judgment of the person predicting the outcomes. Judgmental probability is used when there is a lack of historical data or credible statistics. For example, judgmental probabilityis used in insurance of nuclear plants because of a lack credible statistics. In practice, actual outcomes differ from expected outcomes

Inpractice,an insurancecompany,dependingontheavailabilityandcredibilityofdata,usestheempirical or judgmental probability techniques to predict future losses. In any events, eithertechnique provides an estimation of the future loss. This implies that actual outcomes may not be the same as the expected outcomes. Forexample,aninsurancecompanywhichhaspredicted that 30 of its insured cars may be destroyed next year faces the possibility that the numberofcarsactuallydestroyedmaybe20,40 and 50 or even 100. Such random variations from predicted outcomes arise because the requirements of the law of large numbers are seldom met in practice.

Other Possible Definitions of Risk

Even though an insurance company has a large number of similar loss exposures and thereforeisabletopredictanexpectedloss,itis nevertheless subject to uncertainly because the actual loss may not be the same as the predictedloss.Andwhenuncertainlyexists,riskremains. In this respect,we can takeanotherstepfurtherbydefiningriskasthevariation inoutcomes in a given situation. In addition to the two definitions given, the term “risk” has alsobeen loosely referred to as

• the possibility of loss;

• the exposure to danger;

• the subject matter of insurance.

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In conclusion, it can be said that risk hasseveral meanings and the meaning of risk will therefore depend on the context in which it is being used.

2.2. RELATED CONCEPTS

Beforeweconsidertheotheraspectsofrisk,itis important to distinguish risk from the following concepts:

• Loss : a reduction or disappearance of economic value.

• Peril : a cause of loss.

• Hazard: a condition that increases the chance of loss.

There are two major types of hazards.

Physical Hazard Defined

Physical hazard is a physical characteristic that increases the outcome of a loss. Examples of physical hazards include the wooden construction of building and the poor mechanical condition of a motor car.

Moral Hazard Defined

Moral hazard is a character defect in an individual that increase the outcome of a loss. Examplesofmoralhazardsincludedishonesty,carelessness and unreasonableness.

2.3. BASIC CATEGORIES OF RISK

Risk can be classified into two majorcategories:

• Fundamental and particular risks;

• Pure and speculative risks.

2.3.1. Fundamental and Particular Risks

Fundamental Risks Defined

A fundamental risk affects the entire economy or large numbers of persons / groups within the economy. Examples include the risk of property damage from earthquake, flood andtyphoon(forcesofnature), theriskofdamagetoproperty,thelossoflivesarisingoutofwar,and the risk of mass unemployment.

Particular Risks Defined

A particular risk affects individuals and not the entire community or country. Examples include the risk of damage to property from fire andthe risk of death or injury resulting from road accidents

Whose Responsibility?

Becauseoftheirdifferenceineffects,particularrisks are the responsibility of individuals whereas fundamental risks are the responsibility of the government and society as a whole.

2.3.2. Pure and Speculative Risks

Pure Risks Defined

Pure risk exists when there is the possibility of either loss or no loss. Examples include the risk of damage to property resulting from fire andthe risk of premature death.

Speculative Risks Defined

Speculative risk exists when there is the possibility of profit, loss or no loss.Examplesinclude investment in the stock market or real estate, venturing intobusiness,andbetting ina horse race.

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Figure 2.2. The Main Characteristics of Pure and Speculative Risks

Other Characteristics of Pure Risks

In addition to thedifference in outcome,purerisks are more predictable because it is easier to apply the law of large numbers to such risks. This also implies that pure risks can generally be handled by insurance techniques, whilespeculative risks are rarely insured.

2.4. METHODS OF HANDLING RISKS

In this section we will look at the methods of handling pure risks. Basically there are four methods of handling risks:

• Risk avoidance

• Loss control

• Risk retention

• Risk transfer

2.4.1. Risk Avoidance

Riskavoidanceinvolvesavoidingtheproperty,personoractivity,whichproducestherisk.

Examples:

i. A manufacturer who is worried about a product liability lawsuit arising from one of his products can avoid it by not manufacturing that product.

ii. An individual who is worried about health problems arising from lung cancer can avoid them by not smoking.

2.4.2. Loss Control

Loss control aims to reduce the total amount of loss.Thetotalamountof lossis influencedbythe frequency and severity of loss.

Frequencyoflossisthenumberoftimesaloss-producing event will occur over a given period of time.

Severityof loss is thecostoramountof loss,in money terms, arising from loss- producingevents.

Loss control measures handle risks by:

• Loss Prevention

Loss prevention refers to reducing the frequencyof loss, say forexample, bytheuseof fire resistantmaterial in theconstruction of a building to help prevent firelosses.

• Loss Minimization

Loss minimization refers to reducing the severity or amount of loss, sayfor example, by the installation of anautomatic fire sprinkler system to helpreduce theamountoffire losseswhenafireoccurs.

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Pure Risk

Speculative Risk

Loss

No Loss

Loss

Break-even

Gain


2.4.3. Risk Retention

Risk retention involves the retaining of risks by an individual or organization. When risks are retained, the losses incurredareborneby theparty retaining the risks. Risk retention may be planned or unplanned. When risk retention is planned, risks are retained deliberately.Unplanned risk retention involves the retaining of risks unknowingly.

2.4.4. Risk Transfer

Risk transfer involves the transferring of risks to an organization or individual. When a risk is transferred, the losswill be paid for by theorganization or individual to whom the risk is transferred. There are two ways of transferring risks.

• Insurance Contract

Example: A house owner can transfer the loss incurred when his house is destroyedbyfirebyenteringintoafireinsurance contract.

• Non Insurance Contract

Example: A supermarket can transfer potential liability arising from the sale of a defective product by entering into an agreement whereby the manufacturer agrees to compensate the supermarket from any liability arising from the defective product.

Figure 2.3. The Risk Management Process

Identification

Evaluation

SelectionAvoidanceLoss ControlTransferRetention

Implementation

Control

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2.5. RISK MANAGEMENT

Earlier we learnt that risk is ever present in our livesandthatpurerisksleadtofinanciallosses.In this section, we will look into how risksare managed through a process called Risk Management.

Risk management may be defined as asystematic approach to dealing with risks that threaten the assets and earnings of a business or enterprise.

The risk management process involves the following steps:

• identifying loss exposures

• evaluating potential losses

• selecting techniques of risk handling

• implementing the risk management programme

• controlling the risk management programme.

The process is represented schematically in Figure 2.3.


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2.5.4. Implementing the Risk Management Programme

After the selection of the most appropriate technique or combination of techniques, thenext step is to implement the risk management programme.

2.5.5. Controlling the Risk Management Programme

Once implemented, a risk managementprogramme needs to be monitored to ensure that it is achieving the results expected and to makechangestotheprogramme,ifnecessary.

2.6. CHARACTERISTICS OF INSURABLE RISK

Not all risks are capable of being insured. Risks that are insurable must fulfil certaincharacteristics. The main characteristics are as follows:

2.6.1. Financial Value

Insurance is concerned with situations where monetary compensation can be given following aloss.Therefore,insurablerisksshouldinvolvelosses that are capable of being financiallymeasured. The following are some examples of such risks:

2.5.1. Identifying Loss Exposures

Thefirststepinriskmanagementistoidentifyall pure loss exposures including

• physical damage to property;

• business interruption losses;

• liability lawsuits;

• lossesarisingfromfraud,criminal acts and dishonesty of employees;

• losses arising from the death or disability of key employees.

Lossexposurescanbeidentifiedfromvarioussources including questionnaires, financialstatements,flowchartsandpersonalinspectionof facilities.

2.5.2. Evaluating Potential Losses

After identifying potential losses, the nextstep is to evaluate the potential losses of the firm. Evaluation involves the estimation ofthe frequency and severity of loss exposures and ranking them according to their relative importance. Loss exposures with high loss potential will be given priority in the risk management programme.

2.5.3. Selecting Risk Handling Techniques

Riskhandlingtechniquesincluderiskavoidance,loss control, risk retention and risk transfer.The selection of a risk handling technique may bebasedonfinancialornon-financial criteria.Selectionbasedonfinancialcriteriawillconsiderhow the choice will affect the organization’s profitability or rate of return. Non-financialconsiderations will include humanitarian aspects and legal requirements.

Risks Financial Measurementi. Damage to Property Cost of Repairs

ii. Injury to Others Court Awards

iii. Death of a Life Assured The ability to pay the premium in relation to the sum assured and his

financial standing


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2.6.2. Large Number of Similar Risks

There must be a large number of similar risks before any one of the risks is capable of being insured. There are two reasons for this:

• To enable the insurer to predict losses more accurately.

• Ifthereareonlyfewrisks,the principle of losses of a few to be borne by many cannot be applied.

2.6.3. Pure Risks Only

Insurance is concerned only with pure risks becauseinapurerisksituation,onewillsufferalossorincurnoloss,thusthereisnopossibilityofprofiting fromapure risk.Speculative riskshold out the prospect of loss, break-even orprofit,andthusarerarelyinsured.Aninsuredinsuch a situation would be less inclined to put in efforts to bring about a gain because the insurer will indemnify any loss.

2.6.4. No Catastrophic Losses

Fora risk tobe insurable, the lossshouldnotbe so catastrophic in nature as to render it too heavy to be borne by an insurer. A catastrophic loss arises when a very large number of risks incur losses at the same time or when one risk results in a huge loss. Examples of catastrophic losses include losses arising from wars and earthquakes.

2.6.5. Fortuitous Losses

Another characteristic of insurable risk is that the loss must be fortuitous. A fortuitous loss is one that is accidental and unintentional. Insurance

cannotfunctionproperlyandefficientlyiflossesare intentionally or fraudulently brought about by the insured.

2.6.6. Insurable Interest

Generally, a person who wishes to effectinsurance must have insurable interest in the property, rights, interest, life, limb or potentialliability to be insured. The existence of insurable interest in contracts of insurance is one of the main factors that differentiate insurance from gambling. (Insurable interest will be dealt with further in Chapter 3.)

2.6.7. Legal and Not Against Public Policy

The object of insurance must be legal and not against public policy. A ship engaged in smuggling or a wager on a life is not an insurable risk because such a risk is of an illegal nature. Fines and penalties imposed by law are not insurable because it is against public policy to provide insurance for such events.

2.6.8. Reasonable Premium

The final characteristic of an insurable risk isthat the premium must be reasonable in relation to the potential loss. A risk that has a very high probability of loss or near certainty would involve a premium that may be unreasonable from the prospective insured’s point of view. On the other hand,theinsurancepremiumrequiredtocoverthe riskof fireonaballpointpenwortha fewcents may be quite unreasonable in relation to the potential loss in view of the insurer’s claim handling expenses.

insurance chapter 2

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