CHAPTER 5

RISK AND INSURANCE

5.1 Understanding Risk

5.2 Types of risk

5.3 Risk management - Objectives

5.4 Risk identification and measurement - Pooling arrangements and diversification of risk

5.5 Risk aversion and demand for insurance – By individuals- By corporations-

5.6 Insurability of risk- contractual provisions- Legal doctrine- - Loss control –Risk retention
and reduction decisions
5.1 Introduction

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. Risk includes the possibility of losing some
or all of an original investment. Quantifiably, risk is usually assessed by considering
historical behaviours and outcomes. In finance, standard deviation is a common metric
associated with risk. Standard deviation provides a measure of the volatility of asset prices in
comparison to their historical averages in a given time frame.

5.2 Types of risk

The 2 broad types of risk are systematic and unsystematic.

Systematic risk is risk within the entire system. This is the kind of risk that applies to an
entire market, or market segment. All investments are affected by this risk, for example risk
of a government collapse, risk of war or inflation, or risk such as that of the 2008 credit crisis.
It is virtually impossible to protect your portfolio against this risk. It cannot be completely
diversified away. It is also known as un-diversifiable risk or market risk.

Unsystematic risk is also known as residual risk, specific risk or diversifiable risk. It is
unique to a company or a particular industry. For example strikes, lawsuits and such events
that are specific to a company, and can to an extent be diversified away by other investments
in your portfolio are unsystematic risk.

Within these two types, there are certain specific types of risk, which every investor must
know.

1. Credit Risk (also known as Default Risk)

Credit risk is just the risk that the person you have given credit to, i.e. the company or
individual, will be unable to pay you interest, or pay back your principal, on its debt
obligations.

If you are investing in Infrastructure Bonds or Company Fixed Deposits right now, you
should be aware of the credit / default risk involved. Government bonds have the lowest
credit risk (but it is not zero - think of Portugal, Ireland or Spain right now), while low rated
corporate deposits (junk bonds) have high credit risk. Before investing in a bond or a
corporate deposit, be sure to check how highly it is rated by a well known rating agency such
as CRISIL, ICRA or CARE.
Remember, even a bank FD has some credit risk, as only a maximum of Rs. 1 lakh is
guaranteed by the Government.

2. Country Risk
When a country cannot keep to its debt obligations and it defaults, all of its stocks, mutual
funds, bonds and other financial investment instruments are affected, as are the countries it
has financial relations with. If a country has a severe fiscal deficit, it is considered more
likely to be risky than a country with a low fiscal deficit, ceteris paribus.
Emerging economies are considered to be riskier than developed nations.

3. Political Risk
This is also higher in emerging economies. It is the risk that a country's government will
suddenly change its policies. For example, today with the continuing raging debate on FDI in
retail, India's policies will not be looking very attractive to foreign investors, and stock prices
are negatively affected.

4. Reinvestment Risk
This is the risk that you lock into a high yielding fixed deposit or corporate deposit at the
highest available rate (currently above 9.50%), and when your interest payments come in,
there is no equivalent high interest rate investment avenue available for you to reinvest these
interest proceeds (for example if your interest is paid out after 1 year and the prevailing
interest rate is 8% at that time).

Currently as we are at an interest rate peak, it would be advisable to lock in for a longer tenor
(provided your financial goal time horizon permits) to avoid facing reinvestment risk.

5. Interest Rate Risk

A golden rule in debt investing is this: Interest Rates go up, prices of bonds go down. And
vice versa. So for example in our situation today, we appear to be at an interest rate peak.
This means that since interest rates are going to go down from here, prices of bonds are going
to go up. So if you were to invest in debt funds now, you would be buying at a low, and can
sit back and watch as your investments start to give gains as interest rates fall.
6. Foreign Exchange Risk
Forex risk applies to any financial instruments that are denoted in a currency other than your
own. For example, if a UK firm has invested in India, and the Indian investment does well in
rupee terms, the UK firm might still lose money because the Rupee has depreciated against
the Pound, so when the firm decides to pull out its investment on maturity, it gets fewer
pounds on redemption. With the recent very sharp fall in the rupee, the forex risk of our
country as an investment destination has greatly increased.

7. Inflationary Risk
Inflationary risk, or simply, inflation risk, is when the real return on your investment is
reduced due to inflation eroding the purchasing power of your funds by the time they mature.
For example, if you were to invest in a fixed deposit today and you were to earn a 10%
interest on it in 1 year's time, then if inflation has been 8% in that year, your real rate of
return comes down to 2%, keeping purchasing power in mind.

8. Market Risk
This is the risk that the value of your investment will fall due to market risk factors, which
include equity risk (risk of stock market prices or volatility changing), interest rate risk (risk
of interest rate fluctuations), currency risk (risk of currency fluctuations) and commodity risk
(risk of fluctuations in commodity prices).There are other types of risk too, such as legislative
risk, global risk, timing risk and more, but for the scope of this article, the ones explained
above are the main ones you need to keep in mind, both on a macro (country) and a micro
(individual investments) level.

5.3 Risk management - Objectives

In the financial world, risk management is the process of identification, analysis, and
acceptance or mitigation of uncertainty in investment decisions. Essentially, risk management
occurs when an investor or fund manager analyzes and attempts to quantify the potential for
losses in an investment, such as a moral hazard, and then takes the appropriate action (or
inaction) given the fund's investment objectives and risk tolerance.
Objectives of Risk Management

a) Ensure the management of risk is consistent with and supports the achievement of the
strategic and corporate objectives.

b) Provide a high-quality service to customers.

c) Initiate action to prevent or reduce the adverse effects of risk.

d) Minimize the human costs of risks where reasonably practicable.

e) Meet statutory and legal obligations.

f) Minimize the financial and other negative consequences of losses and claims.

g) Minimize the risks associated with new developments and activities.

h) Be able to inform decisions and make choices on possible outcomes.

Risk Management Process

The risk management process is a framework for the actions that need to be taken. There are
five basic steps that are taken to manage risk; these steps are referred to as the risk
management process. It begins with identifying risks, goes on to analyze risks, then the risk is
prioritized, a solution is implemented, and finally, the risk is monitored. In manual systems,
each step involves a lot of documentation and administration.

The Risk Management Process

The risk management process is the set of steps you should be taking routinely, habitually, to
assess and mitigate the hazards present in your organization and lines of business. This
should become part of your organization’s culture. It should become as habitual for your
company as it is for a person to look both ways before they cross the street. It needs to be a
cycle because it can take several iterations to get where you need to be and also because
things change over time. Risk management and mitigation is not a project, but an ongoing
aspect of resiliency.
Risk Management Process
The 5 Step Risk Management Process
Implementing a risk management process is vital for any organization. Good risk
management doesn’t have to be resource intensive or difficult for organizations to undertake
or insurance brokers to provide to their clients. With a little formalization, structure, and a
strong understanding of the organization, the risk management process can be rewarding.

Risk management does require some investment of time and money but it does not need to be
substantial to be effective. In fact, it will be more likely to be employed and maintained if it is
implemented gradually over time. The key is to have a basic understanding of the process and
to move towards its implementation.

The 5 Step Risk Management Process

1. Identify potential risks

What can possibly go wrong?

The four main risk categories of risk are hazard risks, such as fires or injuries; operational
risks, including turnover and supplier failure; financial risks, such as economic recession;
and strategic risks, which include new competitors and brand reputation. Being able to
identify what types of risk you have is vital to the risk management process.

An organization can identify their risks through experience and internal history, consulting
with industry professionals, and external research. They may also try interviews or group
brainstorming, as discussed in this Project Manager article 8 New Ways to Identify Risks.

It’s important to remember that the risk environment is always changing, so this step should
be revisited regularly.

2. Measure frequency and severity

What is the likelihood of a risk occurring and if it did, what would be the impact?

Many organizations use a heat map to measure their risks on this scale. A risk map is a visual
tool that details which risks are frequent and which are severe (and thus require the most
resources). This will help you identify which are very unlikely or would have low impact,
and which are very likely and would have a significant impact.

Knowing the frequency and severity of your risks will show you where to spend your time
and money, and allow your team to prioritize their resources.

More details on risk maps can be found in our blog posts on the topic: The Importance of
Risk Mapping and How to Build a Risk Map.

3. Examine alternative solutions

What are the potential ways to treat the risk and of these, which strikes the best balance
between being affordable and effective? Organizations usually have the options to accept,
avoid, control, or transfer a risk.Accepting the risk means deciding that some risks are
inherent in doing business and that the benefits of an activity outweigh the potential risks.
To avoid a risk, the organization simply has to not participate in that activity.

Risk control involves prevention (reducing the likelihood that the risk will occur) or
mitigation, which is reducing the impact it will have if it does occur. Risk transfer involves
giving responsibility for any negative outcomes to another party, as is the case when an
organization purchases insurance.

4. Decide which solution to use and implement it

Once all reasonable potential solutions are listed, pick the one that is most likely to achieve
desired outcomes. Find the needed resources, such as personnel and funding, and get the
necessary buy-in. Senior management will likely have to approve the plan, and team
members will have to be informed and trained if necessary.

Set up a formal process to implement the solution logically and consistently across the
organization, and encourage employees every step of the way.

5. Monitor results

Risk management is a process, not a project that can be “finished” and then forgotten about.
The organization, its environment, and its risks are constantly changing, so the process should
be consistently revisited. Determine whether the initiatives are effective and whether changes
or updates are required. Sometimes, the team may have to start over with a new process if the
implemented strategy is not effective.
Potential Risk Treatments

Once risks have been identified and assessed, all techniques to manage the risk fall
into one or more of these four major categories;

A. Risk Transfer

Risk Transfer means that the expected party transfers whole or part of the
losses consequential o risk exposure to another party for a cost. Insurance
contracts fundamentally involve risk transfers. Apart from the insurance
device, there are certain other techniques by which the risk may be transferred.

B. Risk Avoidance

Avoid the risk or the circumstances which may lead to losses in another way,
Includes not performing an activity that could carry risk. Avoidance may seem
the answer to all risks, but avoiding risks also means losing out on the
potential gain that accepting (retaining) the risk may have allowed. Not
entering a business to avoid the risk of loss also avoids the possibility of
earning the profits.

C. Risk Retention

Risk-retention implies that the losses arising due to a risk exposure shall be
retained or assumed by the party or the organization. Risk-retention is
generally a deliberate decision for business organizations inherited with the
following characteristics. Self-insurance and Captive insurance are the two
methods of retention.

D. Risk Control
 Risk can be controlled either by avoidance or by controlling losses. Avoidance
implies that either a certain loss exposure is not acquired or an existing one is
abandoned. Loss control can be exercised in two ways.

Definition of 'Risk Averse'

Definition: A risk averse investor is an investor who prefers lower returns with
known risks rather than higher returns with unknown risks. In other words,
among various investments giving the same return with different level of risks,
this investor always prefers the alternative with least interest.

Description: A risk averse investor avoids risks. S/he stays away from high-risk
investments and prefers investments which provide a sure shot return. Such
investors like to invest in government bonds, debentures and index funds.

5.6 Insurability of risk- contractual provisions- Legal doctrine- - Loss

control –Risk retention and reduction decisions

Insurable risks are risks that insurance companies will cover. These include a
wide range of losses, including those from fire, theft, or lawsuits.

When you buy commercial insurance, you pay premiums to your insurance
company. In return, the company agrees to pay you in the event you suffer a
covered loss. By pooling premiums from many policyholders at once, insurers
are able to pay the claims of the few who do suffer losses, while providing
protection to everyone else in the pool in case they need it.
Contractual provisions
1. A legal doctrine is a framework, set of rules, procedural steps, or test,
often established through precedent in the common law, through which
judgments can be determined in a given legal case. A doctrine comes
about when a judge makes a ruling where a process is outlined and
applied, and allows for it to be equally applied to like cases. When enough
judges make use of the process, it may become established as the de
facto method of deciding like situations.
2. Loss control
Loss control is a risk management technique that seeks to reduce the
possibility that a loss will occur and reduce the severity of those that do
occur. A loss control program should help reduce claims, and insurance
companies reduce losses through safety and risk management information
and services.
3. Risk retention and reduction
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. A business is more likely to engage in risk retention
when it determines that the cost of self-insurance is lower than the
insurance payments or hedging costs required to transfer the risk to a third
party. A large deductible on an insurance policy is also a form of risk
retention.