RISK MANAGEMENT AND INSURANCE 20MBAFM401

Module -1 Introduction to Risk Management

DEFINITIONS OF RISK
There is no single definition of risk. Economists, behavioural scientists, risk theorists,
statisticians, and actuaries each have their own concept of risk. However, risk historically has
been defined in terms of uncertainty.
Based on this concept, RISK is defined as uncertainty concerning the occurrence of a loss.

For example, the risk of being killed in an auto accident is present because uncertainty is
present. The risk of lung cancer for smokers is present because uncertainty is present. The
risk of flunking a college course is present because uncertainty is present.

Risk is defined in financial terms as the chance that an outcome or investment's actual gains
will differ from an expected outcome or return.

Peril
Peril is defined as the cause of loss . If your house burns because of a fire, the peril, or cause
of loss, is the fire. If your car is damaged in a collision with another car, collision is the peril,
or cause of loss. Common perils that cause loss to property include fire, lightning, windstorm,
hail, tornado, earthquake, flood, burglary, and theft.

Hazard
A hazard is a condition that creates or increases the Frequency or severity of loss.

CLASSIFICATION OF RISK
Risk can be classified into several distinct classes.
They include the following:
■ Pure and speculative risk
■ Diversifiable risk and non-diversifiable risk
■ Enterprise risk

BURDEN OF RISK ON SOCIETY

The presence of risk results in certain undesirable social and economic effects. Risk entails
three major burdens on society.
■ The size of an emergency fund must be increased.
■ Society is deprived of certain goods and services.
■ Worry and fear are present.

Larger Emergency Fund

 It is precaution to set aside funds for an emergency. However, in the absence of
insurance, individuals and business firms would have to increase the size of their
emergency fund to pay for unexpected losses.
 For example, assume you have purchased at Rs 300,000 home and want to accumulate a
fund for repairs if the home is damaged by fire, windstorm, or some other peril. Without
insurance, you would have to save at least Rs 50,000 annually to build up an adequate
fund within a relatively short period of time. Even then, an early loss could occur, and
your emergency fund may be insufficient to pay for the loss.

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 If you are a middle- or low-income earner, you would find such saving difficult. In any
event, the higher the amount that must be saved, the more current consumption spending
must be reduced, which results in a lower standard of living.

Loss of Certain Goods and Services

 A second burden of risk is that society is deprived of certain goods and services.
 For example, because of the risk of a liability lawsuit, many corporations have
discontinued manufacturing certain products. Numerous examples can be given.
 Some 250 companies in the world once manufactured childhood vaccines; today, only a
small number of firms manufacture vaccines, due in part to the threat of liability suits.
Other firms have discontinued the manufacture of certain products, including asbestos
products, football helmets, silicone-gel breast implants, and certain birth-control devices,
because of fear of legal liability.

Worry and Fear

 The final burden of risk is that of worry and fear. Numerous examples illustrate the
mental unrest and fear caused by risk.
 Parents may be fearful if a teenage son or daughter when they go to trip because the risk
of being killed on an icy road is present.
 Some passengers in a commercial jet may become extremely nervous and fearful if the jet
encounters severe turbulence during the flight.
 A college student who needs a grade of C in a course to graduate may enter the final
examination room with a feeling of apprehension and fear.

Sources of risk

1. Decision/Indecision:
Taking or not taking a decision at the right time is generally the first cause of risk.
Suppose a banker takes deposits and decides not to put money in statutory liquidity
requirements, the bank would be called upon to pay penalties. Indecision in selling a
Government security when the market is upswing is also a risk as it causes loss of
revenue. The risk of revenue loss is on account of indecision.

2. Business Cycles/Seasonality:
There are certain exposures that are affected by seasonality or business cycles. Lending to
sugar industry in India disregarding the fact that the production of sugar is restricted to
six/seven months in a year, may give rise to risky situations.

3. Economic/Fiscal Changes:
The Government’s economic and taxation policies are sources of risk. The levying of
import duty on certain capital goods can escalate the funding cost and bank finance
requirement. While the borrower’s repaying capacity remains the same, such a situation
enhances the exposure adding to the risk. The changes in Government policies can impact
the cash inflow for the borrowing customer thereby limiting his repayment capacity.

4. Market Preferences:
Over the years, the consumer demands and preferences particularly from the youth
segment are changing substantially. The preference for a motorcycle over a scooter is an

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example. Lending to scooter dealers or manufacturers will have to be cautious due to this
market trend.

5. Political Compulsions:
A Government may force the banks to lend in areas where the rewards may not be
proportional.

6. Regulations:
The impact of change in regulations is similar to the changes in Government policies. In
developed countries like the USA, there are certain anti- boycott laws prescribing
restrictions. The anti-boycott laws specifically refer to boycotts involving one foreign
Government against another foreign Government and participation of people in the US in
those boycotts.
Indian banks operating in the USA do have to assess the regulatory risks. With the
passing of USA Patriot Act, the processes for anti-money laundering have been
strengthened. Compliance of a variety of regulations is also a source of risk.

7. Competition:
In order to remain competitive banks assume risks for enhancing the returns. In the quest
to achieve better result there could be a tendency to assume risks highly unrelated to the
return. The selection of the right counter party, lack of proper risk assessment, failure to
appreciate the borrower rating, etc., all contribute in risk acceleration. Competition
remains a major source of risk for banks as for all other sect

8. Technology:
Technology is both, a solution and a cause of risk. Deals worth millions are made in
treasury operations through advanced technology supports. The process of maker-checker
is scrupulously followed while entering into such deals. Still, machines can go wrong.
The reflection of inaccurate values like dates, amounts, interest rates, etc., can cause a
huge risk. It is a part of operational risk wherein technology itself becomes the source of
risk.

9. Non-availability of Information:
Technology is an enabler for decision support for rational and data-based decision mak-
ing. More often than not, in the absence of information support, banks do take decisions.
The banks fix exposure limits per party or per industry. Exposures exceed these
prudential limits in the absence of real time information, thereby multiplying the risk
exposures.

In reality, the risk drivers are:

1. Changes in external environment, including regulatory aspects,
2. Deficiencies in systems and procedures,
3. Errors, either intentional or otherwise,
4. Inadequate information and absence of required flows,
5. Unsuitable technology supports,
6. Communication gap or failure,
7. Lack of leadership, and
8. Excessive and unreasonable incentives

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Methods of handling Risk/ Techniques for managing risk

Techniques for managing risk can be classified broadly as either risk control or risk
financing.
Risk control refers to techniques that reduce the frequency or severity of losses.
Risk financing refers to techniques that provide for the funding of losses .Risk managers
typically uses a combination of techniques for treating each loss exposure.

1. Risk control

Risk control is a generic term to describe techniques for reducing the frequency or severity of
losses. Major risk-control techniques include the following:
■ Avoidance
■ Loss prevention
■ Loss reduction
-Duplication
-Separation
-Diversification

Avoidance: Avoidance is one technique for managing risk. For example, you can avoid the
risk of being mugged in a high crime area by staying away from high crime rate area; you can
avoid the risk of divorce by not marrying; and a business firm can avoid the risk of being
sued for a defective product by not producing the product.

Not all risks should be avoided, however. For example, you can avoid the risk of death or
disability in a plane crash by refusing to fly. But is this choice practical or desirable? The
alternatives—driving or taking a bus or train—often are not appealing. Although the risk of a
plane crash is present, the safety record of commercial airlines is excellent, and flying is a
reasonable risk to assume.

Loss Prevention: Loss prevention aims at reducing the probability of loss so that the
frequency of losses is reduced. Several examples of personal loss prevention can be given.
Auto accidents can be reduced if motorists take a safe-driving course and drive defensively.
The number of heart attacks can be reduced if individuals control their weight, stop smoking,
and eat healthy diets.

Loss Reduction: Strict loss prevention efforts can reduce the frequency of losses; however,
some losses will inevitably (certainly) occur. Thus, the second objective of loss control is to
reduce the severity of a loss after it occurs.
For example, a department store can install a sprinkler system so that a fire will be promptly
extinguished, thereby reducing the severity of loss; a plant can be constructed with fire-
resistant materials to minimize fire damage; fire doors and fire walls can be used to prevent a
fire from spreading; and a community warning system can reduce the number of injuries and
deaths from an approaching tsunami.

Duplication: losses can also be reduced by duplication. This technique refers to having back-
ups or copies of important documents or property available in case a loss occurs.
For example, back-up copies of key business records (Eg, accounts receivable) are available
in case the original records are lost or destroyed.

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Separation: another technique for reducing losses is separation. The assets exposed to loss
are separated or divided to minimize the financial loss from a single event.
For example, a manufacturer may store finished goods in two warehouses in different cities.
If one warehouse is damaged or destroyed by a fire, tornado, or other peril, the finished goods
in other warehouse are unharmed.\

Diversification: Finally, losses can be reduced by diversification. This technique reduces the
chance of loss by spreading the loss exposure across different parties. Risk is reduced if
manufacture has a number of customers and suppliers.
For example, if the entire customer’s base consists of only four domestic purchasers, sales
will be impacted adversely by a domestic recession. However if there are foreign customers
and additional domestic customer as well, this risk is reduced.

From the viewpoint of society, loss control is highly desirable for two reasons.
First, the indirect costs of losses may be large, and in some instances can easily exceed
the direct costs. For example, a worker may be injured on the job. In addition to being
responsible for the worker’s medical expenses and a certain percentage of earnings (direct
costs), the firm may incur sizable indirect costs: a machine may be damaged and must be
repaired; the assembly line may have to be shut down; costs are incurred in training a new
worker to replace the injured worker; and a contract may be cancelled because goods are not
shipped on time. By preventing the loss from occurring, both indirect costs and direct costs
are reduced.

Second, the social costs of losses are reduced. For example, assume that the worker in the
preceding example dies from the accident. Society is deprived forever of the goods and
services the deceased worker could have produced. The worker’s family loses its share of the
worker’s earnings and may experience considerable grief and economic insecurity. And the
worker may personally experience great pain and suffering before dying. In short, these
social costs can be reduced through an effective loss-control program.

2. Risk financing
As stated earlier, risk financing refers to techniques that provide for the payment of losses after they occur.
Major risk-financing techniques include the following:
 Retention
 Noninsurance transfers
 Insurance
An uninsurable risk is a risk that insurance companies cannot insure (or are reluctant to
insure) no matter how much you pay. Common uninsurable risks include: reputational risk,
regulatory risk, trade secret risk, political risk, and pandemic risk .

Retention: It is an important technique for managing risk. Retention means that an

individual or a business firm retains part of all of the losses that can result from a given risk.
Risk retention can be active or passive.

It is the practice of setting up a self-insurance reserve fund to pay for losses as they occur,
rather than shifting the risk to an insurer or using hedging instruments.

Active Retention Active risk retention means that an individual is consciously aware of the
risk and deliberately plans to retain all or part of it.
Example: A homeowner may retain a small part of the risk of damage to the home by
purchasing a homeowners policy with a substantial deductible. A business firm may

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deliberately retain the risk of petty thefts by employees, shoplifting, or the spoilage of
perishable goods by purchasing a property insurance policy with a sizeable deductible.

Passive Retention Risk can also be retained passively. Certain risks may be unknowingly
retained because of ignorance, indifference, laziness, or failure to identify an important risk.
Passive retention is very dangerous if the risk retained has the potential for financial ruin.
Example:, Many workers with earned incomes are not insured against the risk of total and
permanent disability. However, the adverse financial consequences of total and permanent
disability generally are more severe than the financial consequences of premature death.

Self-insurance is a special form of planned retention by which part or all of a given loss
exposure is retained by the firm. Another name for self-insurance is self-funding, which
expresses more clearly the idea that losses are funded and paid for by the firm.
For example, a large corporation may self-insure or fund part or all of the group health
insurance benefits paid to employees.

Noninsurance Transfers Noninsurance transfers are another technique for managing risk. The
risk is transferred to a party other than an insurance company. A risk can be transferred by several
methods, including:
 Transfer of risk by contracts
 Hedging price risks
 Incorporation of a business firm

Transfer of Risk by Contracts Undesirable risks can be transferred by contracts.

For example, the risk of a defective television or stereo set can be transferred to the retailer
by purchasing a service contract, which makes the retailer responsible for all repairs after the
warranty expires. The risk of a rent increase can be transferred to the landlord by a long-term
lease. The risk of a price increase in construction costs can be transferred to the builder by
having a guaranteed price in the contract.

Hedging Price Risks Hedging price risks is another example of risk transfer. Hedging is a
technique for transferring the risk of unfavourable price fluctuations to a speculator by
purchasing and selling futures contracts on an organized exchange, such as the NSE or BSE
For example, the portfolio manager of a pension fund may hold a substantial position in
long-term central government Treasury bonds. If interest rates rise, the value of the Treasury
bonds will decline. To hedge that risk, the portfolio manager can sell Treasury bond futures.
Assume that interest rates rise as expected, and bond prices decline. The value of the futures
contract will also decline, which will enable the portfolio manager to make an offsetting
purchase at a lower price.

Incorporation of a Business Firm Incorporation is another example of risk transfer. If a

firm is a sole proprietorship, the owner’s personal assets can be attached by creditors for
satisfaction of debts.

Insurance For most people, insurance is the most practical method for handling major risks.
Although private insurance has several characteristics, three major characteristics should be
emphasized. First, risk transfer is used because a pure risk is transferred to the insurer.
Second, the pooling technique is used to spread the losses of the few over the entire group so
that average loss is substituted for actual loss.

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Degree of risk
Objective risk (also called degree of risk) is defined as the relative variation of actual loss
from expected loss.
For example, assume that a property insurer has 10,000 houses insured over a long period
and, on average, 1 percent, or 100 houses, burn each year. However, it would be rare for
exactly 100 houses to burn each year. In some years, as few as 90 houses may burn; in other
years, as many as 110 houses may burn. Thus, there is a variation of 10 houses from the
expected number of 100, or a variation of 10 percent. This relative variation of actual loss
from expected loss is known as objective risk.

RISK MANAGEMENT is a process that identifies loss exposures faced by an organization

and selects the most appropriate techniques for treating such exposures.

OBJECTIVES OF RISK MANAGEMENT

Risk management has important objectives. These objectives can be classified as follows:1
 Pre-loss objectives
 Post-loss objectives

PRE-LOSS OBJECTIVES
Important objectives before a loss occurs include economy, reduction of anxiety, and meeting legal
obligations.

 The first objective means that the firm should prepare for potential losses in the
most economical way: This preparation involves an analysis of the cost of safety
programs, insurance premiums paid, and the costs associated with the different techniques
for handling losses.
 The second objective is the reduction of anxiety: Certain loss exposures can cause
greater worry and fear for the risk manager and key executives. For example, the threat of
a catastrophic lawsuit because of a defective product can cause greater anxiety than a
small loss from a minor fire.
 The final objective is to meet any legal obligations: For example, government
regulations may require a firm to install safety devices to protect workers from harm, to
dispose of hazardous waste materials properly, and to label consumer products
appropriately. Workers compensation benefits must also be paid to injured workers. The
firm must see that these legal obligations are met.

POST-LOSS OBJECTIVES
Risk management also has certain objectives after a loss occurs. These objectives include
survival of the firm, continued operations, stability of earnings, continued growth, and social
responsibility.
 Survival of the firm: Survival means that after a loss occurs, the firm can resume at least
partial operations within some reasonable time period.
 Continue operating: For some firms, the ability to operate after a loss is extremely
important. For example, a public utility firm must continue to provide service. Banks,
bakeries, and other competitive firms must continue to operate after a loss. Otherwise,
business will be lost to competitors.
 The third post-loss objective is stability of earnings: Earnings per share can be
maintained if the firm continues to operate. However, a firm may incur substantial
additional expenses to achieve this goal (such as operating at another location), and
perfect stability of earnings may be difficult to attain.

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 The fourth post-loss objective is continued growth of the firm: A company can grow
by developing new products and markets or by acquiring or merging with other
companies. The risk manager must therefore consider the effect that a loss will have on
the firm’s ability to grow
 Finally, the objective of social responsibility is to minimize the effects that a loss will
have on other persons and on society: A severe loss can adversely affect employees,
suppliers, customers, creditors, and the community in general. For example, a severe loss
that shuts down a plant in a small town for an extended period can cause considerable
economic distress in the town.

STEPS IN THE RISKMANAGEMENT PROCESS

There are four steps in the risk management process
 Identify loss exposures
 Measure and analyze the loss exposures
 Select the appropriate combination of techniques for treating the loss exposures
 Implement and monitor the risk management program

Identify Loss Exposures

The first step in the risk management process is to identify all major and minor loss
exposures. This step involves a painstaking review of all potential losses.
Important loss exposures include the following:
1. Property loss exposures
 Building, plants, other structures
 Furniture, equipment, supplies
 Computers, computer software, and data
 Inventory
 Accounts receivable, valuable papers, and records
 Company vehicles, planes, boats, and mobile equipment
2. Liability loss exposures

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 Defective products
 Environmental pollution (land, water, air, noise)
 Sexual harassment of employees, employment discrimination, wrongful termination,
and failure to promote
 Premises and general liability loss exposures
 Liability arising from company vehicles
 Misuse of the Internet and e-mail transmissions
 Directors’ and officers’ liability suits
3. Business income loss exposures
 Loss of income from a covered loss
 Continuing expenses after a loss
 Extra expenses
 Contingent business income losses

4. Human resources loss exposures

 Death or disability of key employees
 Retirement or unemployment exposures
 Job-related injuries or disease experienced by workers
5. Crime loss exposures
 Holdups, robberies, and burglaries
 Employee theft and dishonesty
 Fraud and embezzlement
 Internet and computer crime exposures
 Theft of intellectual property
6. Employee benefit loss exposures
 Failure to comply with government regulations
 Violation of fiduciary responsibilities
 Group life, health, and retirement plan exposures
 Failure to pay promised benefits
7. Foreign loss exposures
 Acts of terrorism
 Plants, business property, inventory
 Foreign currency and exchange rate risks
 Kidnapping of key personnel
 Political risks
8. Intangible property loss exposures
 Damage to the company’s public image
 Loss of goodwill and market reputation
 Loss or damage to intellectual property
9. Failure to comply with government laws and
Regulations

Workplace injuries or illnesses are generally physical, but can also be psychological. The
sufferer may claim and get get compensation if he or she can prove that his injury or illness
occurred at work or is due to the workplace environment. The concept of work related injury

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is gradually evolving in the world due to human right activists, workers’ associations, and
government laws.
The definition of work related injury or illness, which is the basis of compensation claims, is
not yet universally accepted. However, there are some principles that are generally followed:
Purpose - nature of work related injury
Victim - clearly distinguishing direct workers, indirect victims and others affected by such a
work environment
Type of injury or illness - defining the type of injury and illness
Identifying acute or chronic injury - determining whether the illness is acute or chronic
Burden of proof - must be well defined
Classification systems - classification systems should reflect the above principles for study of
data

A risk manager can use several sources of information to identify the preceding loss
exposures. They include the following:
 Risk analysis questionnaires and checklists .Questionnaires and checklists require the
risk manager to answer numerous questions that identify major and minor loss exposures.
 Physical inspection. A physical inspection of company plants and operations can identify
major loss exposures.
 Flowcharts. Flowcharts that show the flow of production and delivery can reveal
production and other bottlenecks as well as other areas where a loss can have severe
financial consequences for the firm.
 Financial statements. Analysis of financial statements can identify the major assets that
must be protected, loss of income exposures, and key customers and suppliers.
 Historical loss data. Historical loss data can be invaluable in identifying major loss
exposures

Measure and Analyze the Loss Exposures

The second step is to measure and analyze the loss exposures. It is important to measure and
quantify the loss exposures in order to manage them properly.

This step requires an estimation of the frequency and severity of loss.

Loss frequency refers to the probable number of losses that may occur during some given
time period.
Loss severity refers to the probable size of the losses that may occur.

Once the risk manager estimates the frequency and severity of loss for each type of loss
exposure, the various loss exposures can be ranked according to their relative importance. For
example, a loss exposure with the potential for bankrupting the firm is much more important
in a risk management program than an exposure with a small loss potential.

Select the Appropriate Combination of Techniques for Treating the Loss Exposures

The third step in the risk management process is to select the appropriate combination of
techniques for treating the loss exposures. These techniques can be classified broadly as
either risk control or
risk financing.2 Risk control refers to techniques that reduce the frequency or severity of
losses . Risk financing refers to techniques that provide for the funding of losses . Risk
managers typically use a combination of techniques for treating each loss exposure.

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Risk control

Risk control is a generic term to describe techniques for reducing the frequency or severity of
losses. Major risk-control techniques include the following:
■ Avoidance
■ Loss prevention
■ Loss reduction
-Duplication
-Separation
-Diversification

Risk finance
 Retention
 Non-insurancetransfer
 Insurance

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