Chapter-3 Risk Management through Insurance

Certificate in Insurance Concepts

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Notice
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identification and explanation, without an intention to infringe.

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Contents
Chapter – 3Risk Management through Insurance ..................................................................4
3.1 Fundamentals of Risk ................................................................................................... 5
3.2 Types of Risk................................................................................................................6
3.3 Risk Management ........................................................................................................9
3.4 Insurance and Risk ..................................................................................................... 12
3.4.1 Risk Management Vs Insurance Management..................................................... 15
3.4.2 Insurance, Vs Gambling, Speculation and Hedging ............................................. 16
3.5 Perils, Loss and Hazards............................................................................................. 17
Summary: ....................................................................................................................... 21

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Chapter – 3Risk Management through Insurance

Introduction
Insurance has traditionally been used for risk management. More specifically, it manages
“pure” risk, which means it insures only that risk which offers no gain. It is mainly used for
risk transfer. This chapter describes various kinds of risk and how insurance is used in risk
management.

Learning Objective
After reading this chapter you will:
• Understand what risk is
• Know various risk types
• Which risk insurance handles
• Know the difference between insurance and risk management

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3.1 Fundamentals of Risk

Before delving into the subject of insurance, it’s important to understand what risk is. In
professional insurance language, risk is a term given to one of the following:
• A peril which is being insured
• The insured person/group
• The proposed insured (person who is applying for insurance)

Risk always carries a chance of loss. Depending on the person or property’s circumstances,
the insurer may call it a good risk or bad risk. This kind of reference is very different from the
industry definition of risk, which is “uncertainty of financial loss”. This means that the loss
must be uncertain. If a person deliberately sets his house on fire, then it’s not uncertain and
may not be called risk. However, if the house is on fire due to electric malfunction then it’s
totally unexpected and is called risk. Such loss is covered by insurance.

There are certain characteristics of risk.

• It is likelihood of an unfortunate event
• It is unpredictable
• It is uncertainty about the future
• It is possibility of an unfavourable change from expected results
• It is an unfavourable outcome

All these features indicate one common element of risk – uncertainty, which is completely
dependent on a person’s risk perception. What is risk for one may not be risk for another.
Uncertainty will also depend on information availability. If no information is given, the
individual may be uncertain about a result.

Risk As a consequence of uncertainty

Often Risk is used in different context and everybody has a personal notion on what we
mean by the term “risk”. The word “Risk” is used and interpreted daily. Hence giving a
single clear definition of what we mean by risk is a difficult task. The word risk has different
interpretations in different contexts. In all cases, however, the concept of risk is inextricably
linked to the notion of uncertainty.

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While concept of risk is linked with the notion of uncertainty, risk is not synonymous with
uncertainty. Risk is not the same as the underlying precondition of uncertainty. Risk has to
do with consequences which can be either positive or negative. The consequences can be
behavioral, psychological, or financial. Uncertainty also creates chances for gain and the
potential for loss. However if there is no possibility for a negative outcome at all then the
situation is normally not referred to be having risk but just uncertainty.

3.2 Types of Risk

Risks can be categorized into three main groups:

• Pure and speculative risks.
• Subjective and objective risks.
• Fundamental and particular risks

Pure risks and speculative risks

In events of pure risks, there are no profits to either party – the insurance company or the
insured person, when a loss occurs. This category of risk has only loss as the possible
outcome and there is no beneficial result for the person involved.

This type of risk is beyond the risk-taker’s control. For example, the possibility that a
person’s house will be destroyed due to some natural disaster is pure risk. At the most, the
situation will go back to its original state before the loss. For instance - if a factory burns
down, then with money the factory can be built back, again reaching a similar or even a less
than before condition. This means there is no favourable result. In this example there
cannot be any potential benefit to the owner and the event is also not in control of the
owner.

Other examples of pure risk are premature death, fire, theft, bankruptcy of a customer and
disaster.There are two outcomes to pure risks – loss or no loss. Pure risk can be
compensated by purchasing products like home insurance where a person’s home is insured
to protect him from the risk of getting his home destroyed.

“A pure risk involves only the chance of a loss, never the chance of a gain”

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Pure risks can arise from

• Personal risks-
As the name suggests, it directly impacts an individual. Things which affect an
individual’s assets, income or expenses are personal risks.
The major personal risks are: Health Risk (major illness can have dual risk both
medical costs and loss of income), Premature death, unemployment etc

• Property risks
This risk exists for anyone who owns property, whether it's your home or personal
belongings. Any property may be damaged or destroyed and personal property can
be stolen. Even a home's soil may get contaminated and require expensive cleanup
to restore it

• Liability risks
These risks are some of the most serious financial risks one can get exposed to. If
ones actions injure someone or damage property, that person may be held legally
responsible. This means that person will have to pay for the loss, even if the actions
were unintentional.
Even if the person is innocent, to prove so he has to pay an hefty amount as defence
cost to the lawyers.

• Risks arising out of failure of others

In contrast, speculative risk may not only lend to pure risk, but also have an added element
of profit. Speculative risk is result of choice and not chance. They are not uncontrollable
events and are chosen by risk-takers. For instance lottery and other forms of gambling,
share trading, property speculation, provision of credit can be seen as speculative risks.
Almost all investment activities are example of speculative risk as it is difficult to predict the
success or failure of investment activity in advance.

However some investment activities involve more risk than others. For example – investing
in stocks and real estate is riskier than investing in government bonds. There is no insurance
for these risks. Hence, there are three outcomes to speculative risks – loss, no loss or profit.

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The table below gives the examples of pure vs speculative Risk exposures

Pure Risk Speculative Risk

Physical damage risk to property caused Market Risks –Interest risk, foreign exchange
by fire, flood, weather damage risk, stock market risk

Natural disaster damage: floods, Political risk

earthquakes, windstorms

Operational risk: mistakes in process or Credit risk (at the individual enterprise level)
procedure that cause losses

Environmental risks: water, air, Population changes

hazardous-chemical, and other pollution;
depletion of resources; irreversible
destruction of food chains

Man-made destructive risks: nuclear risks, Regulatory change risk

wars, unemployment,

Subjective risks and objective risks

Subjective risks are due to the mental condition of an individual, who is uncertain about an
event’s result. In an investment that involves speculative risk, the investor has no idea
whether his investments will give him roaring success or sheer failure. This risk cannot be
measured. Another example - if we consider speculative risk then investing in government
bond has much less speculative risk than investing in junk bonds as the return in
government bonds are much lower and carry lesser risk.

Hence subjective risk is what somebody perceives to be a likely unwanted event. The level
of subjective risk perceived by a person depends on their history and their expected
likelihood of its occurrence known as subjective probability. Example- A person who has lost
a lot of money in the stock market will feel more risky then somebody who has won money
in the stock market.

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Objective risks, on the other hand can be measured, as they can be observed. To estimate
probability of such risks, two methods can be used-

• Deductive reasoning such as tossing of a coin

• Inductive reasoning such as a statistician estimating probability of an earthquake
occurring

For example actuarial tables of people who died in a heart attack in a specific time span for a
particular age group (age between 40-45 years).
Another example- Based on pooled mortality data, one can estimate the probability that an
individual will die before he or she reaches age 50.

Fundamental risks and particular risks

Fundamental risks pertain to group risks that arise from social, economic and political
changes in a nation, as also natural disasters. A risk of such nature can affect a large
number of people or a major segment of society. Some instances are crisis in the economy,
unemployment, war, earthquakes, political instability, inflation, shortages, boycotts,
technology, drought, rupee appreciation etc.

Particular risks on the other hand, impact only the individual or an entity. Examples are fire,
robbery, accidents, injuries, ill-health, and theft. Particular risk can be a part of fundamental
risk. For example a natural catastrophe such as an earthquake or flood affects an individual
as well as the society as a whole.

3.3 Risk Management

Risk Management is the process of identifying and analyzing any risk which can pose a
threat not just to human beings and property, but also the earning capacity of any
organization and then arriving at a solution to control its effects.

Principles of Risk management

According to the International Organization for Standardization, there are certain basic
principles of risk management.

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Risk management should:

• Create value.
• Be an integral part of organizational processes.
• Be part of decision making.
• Explicitly address uncertainty.
• Be systematic and structured.
• Be based on the best available information.
• Be tailored.
• Take into account human factors.
• Be transparent and inclusive.
• Be dynamic, iterative and responsive to change.
• Be capable of continual improvement and enhancement

It is very important to develop an effective risk management system so that all risk which
can cause losses can be identified and severity of those losses can be estimated.

Risk Management process

The objective of risk management is to pick efficient methods to handle risk so as to avoid
catastrophic losses. Though Risk management includes insurance management, the
process of risk management should be used to measure both insurable and non-insurable
risk.
The process of risk management follows 6 steps:

Step1: Identify risk management goals and objectives

Step2: Gather pertinent data to determine the risk exposure

Step3: Analyze and evaluate the client's status

Step4: Develop and Present risk management recommendations

Step5: Implementation

Step6: Review and monitoring

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These risks can be managed through a combination of five strategies: Risk avoidance, Risk
Abatement, Risk retention, Risk Transfer, and Risk Allocation.

• Avoidance – This is perhaps the most commonly applied risk management

technique. The person or group will simply avoid as many risks as possible. For
instance, a person afraid of a train crashing will choose not to travel by train or a
person will lease equipment instead of buying it to avoid ownership risk. However,
such a risk strategy is not practical because avoiding a risk means loosing the profit
that accepting the risk would have allowed. For example not buying a property or
starting a new business is a risk avoidance technique but it also avoids the possibility
of earning profits.

• Abatement – This is the method of combining loss control to lessen a risk. This
approach serves to diminish the loss probability and also the rigorousness of the
loss. Risk abatement is often used in combination with other risk management
approaches since using this method alone will not totally eradicate the chances of
risk.

• Retention - Risk can also be retained, when the person or group takes on its
responsibility. All risk that are not avoided or transferred is retained by default. This
risk is retained because they are so large that they cannot be insured against or
paying premium for them is not feasible. This involves accepting the loss when it
occurs. War can be an example where the assets are not insured against war, so the
losses in such a case are retained by the insured.

• Transfer – Risk can be transferred to another person or group. This involves causing
another person to accept certain portion of risk. For instance, a contractor may
transfer some construction risk to a sub-contractor.

• Risk Allocation – This is the method of sharing the burden of risk with other parties.
One common example of this is when a client takes a business decision. When a
client feels that the cost of undertaking a project is too large and needs to be shared
with some other firm, then they may enter into a joint deal to reduce the risk.

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3.4 Insurance and Risk

Id Non-Sanabile Singulatim Curandum Est Gregatim - If Risk Cannot Be Avoided

Individually, Mitigate It Collectively

Insurance is a common tool in risk management. It is mainly applied to pure risk and
speculative risks are not covered due to the element of gain. Insurance has mainly been
designed to compensate people for losses and not gains.

In insurance parlance, the possibility of a loss is known as exposure. It shows the level to
which a property or person is vulnerable to risk. For instance, a mining company has more
exposure than a consulting firm.

Insurance is mainly a tool for risk transfer from a person or entity to another with a similar
risk profile. This can be achieved through a contract between the person or group and the
insurance company. This contract is called an insurance policy.

As per the contract, the insured needs to make payments to the insurer, which in turn will
compensate the insured if an event covered in the policy happens. This will hence restore
the insured to the “pre-loss” condition. This payment made by the insured is called
premium.

However, the insurer will not protect all risks, only risks that are “insurable” are insured.
Such risks have to meet certain requirements:

• Chance of loss must be calculable by the insurer;

This is to established an adequate premium

• Premiums must be affordable;

So people can afford to buy

Premium must be substantially less than the face value of the policy

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• Loss must be noncatastrophic;

to allow the pooling technique to work

exposures to catastrophic loss can be managed by :dispersing coverage
over large geographical are, using reinsurance, catastrophic bonds

• Large number of homogeneous (similar) exposures must exist;

To predict average loss

• Loss must be accidental from the insured's standpoint;

To control moral hazard

To assure randomness

• Loss must be measurable (number and amount).

to facilitate loss adjustment i.e. insurer must be able to determine if the loss
is covered and if so, how much should be paid

Examples to understand insurable risk requirements:

Risk of fire as an insurable Risk
Requirements Requirements sufficed?

Chance of loss must be calculable by the Yes. Chance of fire can be calculated
insurer

Premiums must be affordable Yes. Premium rate per $100 of fire insurance
is relatively low

Loss must be noncatastrophic Yes. Though catastrophic event has occurred

but all exposure units normally do not burn
at the same time.

Large number of homogeneous (similar) Yes. Numerous homogeneous exposure

exposures must exist exist

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Loss must be accidental from the insured's Yes. With the exception of arson, most fire
standpoint losses are accidental and unintentional

Loss must be measurable (number and Yes. If there is a disagreement over the
amount) amount paid, a property insurance policy has
provisions for resolving clashes

Risk of unemployment as an Insurable risk

Requirements Requirements sufficed?

Chance of loss must be calculable by the No. Generally as the different type of
insurer unemployment are too irregular it is difficult
to estimate the chance of loss.

Premiums must be affordable No. Adverse selection, moral hazard and the
potential for a catastrophic loss could make
the premium too high

Loss must be noncatastrophic No. A severe global or national recession or a

slow local business conditions can result in a
catastrophic loss

Large number of homogeneous (similar) Not completely as there exist different kinds
exposures must exist of employment and labour

Loss must be accidental from the insured's No. A large proportionof unemployment is
standpoint due to individuals voluntarily quitting the
jobs.

Loss must be measurable (number and No. Level of employment can be determined
amount) but measurement of loss is difficult

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As per the table above ideally risk of unemployment is not privately Insurable, but it can be
insured by social insurance programs.
Insurance is an ideal tool for managing financial risk, which may arise due to changes in
income patterns, investments, and other actions. For instance, assets maybe stolen and to
protect from loss, people may take non-life insurance. Insurance manages risk through
various strategies:

• Internal Hedging – Insurers develop suitable investments portfolio for premium

assets and may revise them periodically.
Other strategies involve:
o Use of law of large numbers or averaging
o Developing portfolio mix thus ensuring independence of risks

• External hedging – Insurance companies also adopt external strategies for risk
management. This can be done mainly through coinsurance (joint insurance),
reinsurance (insurance for insurers), pooling, reciprocal transfer of risk, etc.

Did You Know?

A group of insurers sold an integrated risk package to British Aerospace (BAe), protecting
the company from the credit risk exposure on $3.8 billion-worth of revenues from its
aircraft lease arrangements, over 15 years.

3.4.1 Risk Management Vs Insurance Management

Risk management as is currently viewed has come into the picture recently. In fact, the
insurance manager was often called the risk manager even in the 20th century. Thus
insurance was synonymous with risk management. However, risk management has a
completely different area of operation when compared to insurance management, though
insurance purchase maybe a part of it.

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(Source: www.icai.org)

3.4.2 Insurance, Vs Gambling, Speculation and Hedging

There are three main differences between insurance and gambling:

Gambling Insurance

Creates new speculative risk Manages existing pure risk

Has no social productivity – one’s loss is Has social productivity – there is no gain at
another’s gain the cost of someone else. Both the insurer
and insured benefit if there is no loss

Loser never regains original position Financial position maybe restored in whole
or partially

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Insurance also differs from speculation, as the former is pure risk based, while the latter
involves speculative risks. Insurers can use the law of large numbers to predict future loss
experience, which cannot be used with speculation.

Insurance is also not the same as hedging, even though both transfer risk through a
contract, and do not create any new risk. Insurance deal mainly involves transfer of
“insurable” risks, but hedging only manages risks that are uninsurable. In addition,
insurance can decrease risk for insurer by use of law of large numbers. But, hedging cannot
do this, it only transfers risk but does not reduce risk.

Insurance Hedging

Insurance mainly involves transfer of Hedging mainly manages risk that are
“insurable” risks typically “uninsurable”

Insurance can decrease risk for insurer by use Hedging can only transfers risk but can not
of law of large numbers reduce risk.

3.5 Perils, Loss and Hazards

In insurance world some terms like perils hazard and loss are often used interchangeably.
Though these words are interconnected their meanings are different.

Following are the terms explained in details-

• Peril – This means the actual cause for a loss. Perils could include occurrences such
as fire, auto collisions, hailstorm, etc. In an insurance policy, a named peril means
coverage is given only if a loss occurs due to a peril specified in a policy. In case of
any other peril, benefits are not paid. However, the insured has to prove that the loss
has happened due to the named peril. On the other hand, an open perils policy has
very wide coverage.

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• Hazards – This refers to a factor or situation that can increase the probability of a
loss happening (Frequency of loss) or increase the size of loss (Severity of loss).
There are four main types of hazards – physical, moral, morale and legal.

o Physical hazards
These are structural, material, structural or operational features of the risk
itself, like faulty foundation of a house, defective materials used for the
construction of a building may result in collapse of building, bad weather
conditions increases chance of accident of an airplane.

Here frequency of loss increases due to physical characteristics of an object

or due to an individual.

o Moral hazards
These refer to the insured’s dishonest conduct such as faking an accident or
giving false information to get insurance benefits, inflating the amount of
claim. Here the frequency and severity of loss increases due to an
individual’s dishonesty, or bad attitude of employees.

Moral Hazards are typically habits with no regard toward impending

responsibilities. It’s basically the tendencies individuals have that increase
the chance of suffering a peril.

o Morale hazards
These refer to indifferent or careless attitude of the insured towards a risk,
as he can recover due to insurance. Examples of morale hazard are rash
driving, driving without using seatbelt, leaving the house door unlocked
while going out etc.

o Legal hazards
This means vulnerability of legal actions, which can result in paying
damages. A legal hazard increases the likelihood and severity of a loss due
to a condition imposed by the legal process that forces an insurer to cover a
risk that it would otherwise reckon as uninsurable.

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For example, the American legal system encourages many people to bring
litigation suits in order to realize the potential lucrative profits in doing so.
Anything that might prompt a lawsuit involving an insurer can be
considered a legal hazard.

The following examples clearly distinguishes a hazard from perils-

Example 1
A roof covered with snow could be considered a physical hazard. If the amount of snow is so
great that the roof ultimately collapses, then the snow is considered a peril.

Example 2
A fire breaks out in an office building; due to defective wiring. In this case Fire is the peril
which caused the damage and defective wiring in the building increase the chances of fire
hence defective wiring is the hazard.

Example 3
An icy street makes the occurrence of collision more likely to occur .The icy street is the
hazard and collision is the peril.

Example 4
A burglar breaks into a restaurant safe and steals a great deal of money. It was later found
that the door to the safe was left unlocked. In this case the act of theft is considered the peril
whereas leaving the door unlocked is considered as hazard.

A Hazard simply increases the likelihood of a loss, whereas a peril is the

specific event that causes a loss

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• Loss
Probability of an event occurring is called chance of loss or an exposure to loss. Loss
is defined for insurance purposes as unintended, unforeseen damage to property,
injury, or the amount the insurance company is obligated to pay for the injury.

• Chance of loss means likelihood of occurrence of an event, which can cause some
loss.

Chances of loss = No. Of likely losses / Total no. of possible losses

Losses maybe direct or indirect, and insurance can protect against both of these.
o Direct loss – This is an actual loss such as bodily injury, property damage,
etc. It is the Loss incurred due to direct damage to property, as opposed to
time element or other indirect losses.

o Indirect loss – This is a financial loss brought upon from a direct damage.
For instance an injury to a person is direct loss, but loss of income arising
from this injury is indirect loss.

In this context, it is important to know what proximate cause means. Proximate cause is the
nearest causative factor in an uninterrupted series of occurrences that results in a loss due
to damage, injury or carelessness.

For instance, there is fire in a building, which caused a short circuit that damaged a
television set. In this case fire was the proximate cause of TV damage.

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Globalization of Risk management and the Insurance Industry

Due to advancement in technology, improvement in transportation and reduced

barriers between countries a globalization of business has occurred. Organizations
which deal in multiple countries are exposed to different kinds of loss exposures
and they also use different types of risk handling methods. Globalization and
differences in future growth potential have led many insurers to reevaluate the
focus of their business and to consider expansion overseas
Global risk management

Majority of the organizations have atleast some employees who travel overseas
for business.These actions can give rise to unique exposures that are not faced if
the company operates exclusively within its own home country.
Examples of some activities giving rise to such exposure are:
• Exporting goods and services overseas
• Manufacturing or importing products from overseas
• Hiring part-time or permanent employees overseas

Global Risk Exposure

Some types of risk exposure faced by international firms are the same as those
faced by firms that do business only in their home country
For example- fire, natural disasters, or damage to goods in transit.

However, many of these exposures can be altered in both frequency and severity
by differences in various parts of the world.For example- frequency of deaths from
natural disasters is more in developing countries,on the other hand damage of
property resulting from natural disasters is predominant in industrial nations.Fire
loss potential is much greater in countries with poor infrastructure and lower-
quality building standards

Global firms also face unique kinds of loss exposure that arise as a result of
conducting business in multiple countries, including Terrorism, kidnapping,
political instability, uncertain legal environment, currency risk, import/export
restrictions, technology and communications, financial markets’ weaknesses, and
substandard infrastructure.

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Summary:
• In professional insurance language, risk is a term given to one of the following:
o A peril which is being insured
o The insured person/group
o The proposed insured (person who is applying for insurance)
• Industry definition of risk is “uncertainty of financial loss”
• Risks are classified as - Pure and speculative risks; Subjective and objective risks; and
Fundamental and particular risks
• In events of pure risks, there are no profits to any party. Speculative risk may not only
lend to pure risk, but also have an added element of profit
• Risks can be managed through a strategy involving four strategies: Risk avoidance,
Controlling losses, Risk retention and Risk Transfer
• Insurance is a common tool in risk management. It is mainly applied to pure risk.
• In insurance parlance, the possibility of a loss is known as exposure.
• Insurance is mainly a tool for risk transfer from a person or entity to another with a
similar risk profile.
• Lately, insurance companies are providing integrated risk management products
• Insurance is not the same as hedging, even though both transfer risk through a
contract.
• Peril means the actual cause for a loss
• Hazard refers to a factor or situation that can increase the probability of a loss
happening (Frequency of loss) or increase the size of loss (Severity of loss). There are
four main types of hazards – physical, moral, morale and legal.
• Probability of an event occurring is called chance of loss or an exposure to loss.
• Proximate cause is an uninterrupted series of occurrences that results in a loss due to
damage, injury or carelessness.

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