INS 3101: PRINCIPLES OF RISK MANAGEMENT AND INSURANCE
By 5315045 Pichaya Sadudeechevin
Chapter 1: Risk and Its treatment
What is risk?
Risk is uncertainty concerning the occurrence of loss.
-
-
Objective risk: relative variation of actual loss from the expected loss. It declines as
the number of exposures increases. An insurer can predict its loss more accurately
because it can rely on the law of large numbers; the more exposure units, the more
closely will the actual loss experience approach the probable loss experience.
Subjective risk: is a person’s mental condition or state of mind. It depends on the
individual. Two persons in the same situation may have a different perception of risk.
Chance of loss
Chance of loss is the probability that an event will occur
-
-
Objective probability: an infinite number of observations and of no change in the
underlying conditions.
Can be determined in two ways:
1. Deductive reasoning: these probabilities are called a priori probabilities.
2. Inductive reasoning: from the experience
Subjective probability: is the individual’s personal estimate of the chance of loss. A
wide variety of factors has been found to influence subjective probability, including a
person’s age, sex, intelligence, education, and the use of alcohol.
Peril and hazard
Peril: cause of loss
Hazard: a condition that creates or increase the chance of loss.
There are 4 major types of hazards:
1. Physical hazard: a physical condition that increase the chance of loss.
2. Moral hazard: dishonesty or character defects in an individual that increase the
frequency or severity of loss. It is difficult to control.
3. Morale hazard: carelessness or indifference to a loss
4. Legal hazard: refer to characteristics of the legal system or regulation environment
that increase the frequency or severity of losses.
Basic Categories of Risk
Pure Risk and Speculative risks
Pure risk: a situation in which there are only the possibilities of loss or no loss
Speculative risk: a situation in which either profit of loss is possible.
Different between pure and speculative risks
1. Private insurers insure only pure risks.
2. The law of large numbers can be applied more easily to pure risk than to speculative
risks.
3. Society may benefit from a speculative risk even though a loss occurs, but it is
harmed if a pure risk is present and a loss occurs.
4.
Fundamental and Particular Risks
A fundamental risk is a risk that affects the entire economy or large numbers of persons or
groups within the economy.
A particular risk is a risk that affects only individuals and not the entire community.
Enterprise Risks
Enterprise risk: encompasses all major risks faced by a business firm.
Strategic risk: uncertainty regarding the firm’s financial goal and objectives.
Operational risk: the firm’s business operations
Financial risk: uncertainty of loss because of adverse changes in commodity prices, interest
rates, foreign exchange rates, and the value of money.
Type of Pure Risks
1. Personal risks: directly affect an individual.
There are four major personal risks.
i. Risk of premature death: a household head with unfulfilled financial obligations
which can cause financial problems. There are at least four costs that result from
the premature death of a household head.
a. The human life value of the family head is lost forever.
b. Additional expenses may incur because of burial and probate costs, estate
and inheritance taxes, and any remaining medical expenses.
c.
The family income from all sources may be inadequate just in terms of basic
needs.
d. Certain non-economic costs are also incurred such as emotional grief and
loss of guidance and a role model for the children.
ii. Risk of insufficient income during retirement
Old age is insufficient income during retirement.
iii. Risk of poor health
Poor health includes both catastrophic medical bills and the loss of earned income.
iv. Risk of unemployment
Unemployment can result from a business cycle downswing.
2. Property risks: persons owning property are exposed to the risk of having their
property damaged or lost numerous causes.
There are two major types of loss associated with the destruction or theft of property.
i. Direct loss: the physical damage
ii. Indirect loss: a financial loss that results indirectly from occurrence of a direct
physical damage or theft loss.
3. Liability risks: you can be held legally liable of you do something that result in
bodily injury or property damage to someone else.
Liability risks are of great importance for several reasons:
i. There is no maximum upper limit with respect to the amount of the loss.
ii. A lien can be placed on your income and financial assets to satisfy a legal
judgment.
iii. Legal defense costs can be enormous.
Burden of Risk on Society
1. Large emergency fund
2. Loss of certain goods and services
3. Worry and fear
Method of Handling Risks
1. Avoidance
2. Loss control
- Loss prevention: reducing the probability of loss so that the frequency of losses is
reduced.
- Loss reduction: reducing the severity of loss after it occurs.
3. Retention
i. Active Retention means that an individual is consciously aware of the risk and
deliberately plans to retain all or part of it.
ii. Passive retention ignorance, indifference, or laziness.
4. Noninsurance transfers
i. Transfer of risk by contracts: unwanted risks can be transferred by contracts.
ii. Hedging price risks:
Hedging: transferring the risk of unfavorable price fluctuations to a speculator by
purchasing and selling futures contracts.
iii. Incorporation of a business firm
If a firm is a sole proprietorship the owners’ personal assets can be attached by
creditors for satisfaction of debts
5. Insurance
Insurance is the most practical method for handling a major risk.
Three major characteristics should be emphasized.
i. Risk transfer
ii. Pooling technique
iii. The risk may be reduced by application of the law of large numbers.
Chapter 2:The Insurance Mechanism
Insurance is the pooling of fortuitous losses by transfer of such risks to insurers, who agree
to indemnify the insured for such losses
Basic Characteristics of Insurance
1. Pooling of Losses
Pooling is the spreading of losses incurred by the few over the entire group, so that in
the process, average loss is substituted for actual loss.
2. Payment of Fortuitous Losses\
Fortuitous loss is one that s unforeseen and unexpected and occurs as a result of
chance. In other words, the loss bust be accidental.
3. Risk Transfer
A pure risk is transferred from the insured to the insurer, who typically is in a stronger
financial position to pay the loss than the insured.
4. Indemnification
Indemnification means that the insured is restored to his or her approximate financial
position prior to the occurrence of the loss
Requirements of an Insurable Risk
Before a risk can be insured with an insurer, it must meet the following requirements:
•
•
•
•
•
•
There must be a large number of exposure units.
The loss must be accidental and unintentional.
The loss must be determinable and measurable.
The loss should not be catastrophic.
The chance of loss must be calculable.
The premium must be economically feasible.
1. Large number of Exposure Units
There should be a large group of roughly similar, but not necessarily identical,
exposure units that are subject to the same peril or group of perils so that the insurer
can accurately predict both the average frequency and average severity of loss.
2. Accidental and unintentional loss
It should be fortuitous and outside the insured’s control, this means that if an
individual deliberately causes a loss, he or she should not be indemnified for the loss.
3. Determinable and measurable loss
The loss must be definite as to cause, time, place, and amount
4. No catastrophic loss
A large proportion of exposure units should not incur losses at the same time.
However, it is impossible for insurers to avoid all catastrophic losses, which
periodically result from flood, hurricane, tornados, earthquake, forest fire and others.
Therefore, there are two approaches are available for meeting the problem of a
catastrophic loss:
1. Reinsurance can be used by which insurance companies are indemnified by
reinsurers for catastrophic losses.
It is the shifting of part or all of the insurance originally written by one insurer to
another insurer. Then, the reinsurer is responsible for the payment of excess losses
that exceed a maximum limit.
2. Insurers can avoid the concentration of risk by dispersing their coverage over a
large geographic area.
5. Calculable chance of loss
The insurer must be able to calculate both the average frequency and the average
severity of future losses with some accuracy so that a proper premium can be charged.
6. Economically feasible premium
The insured must be able to afford to pay the premium. To be an attractive purchase,
the premium paid must be substantially less than the face value of the policy.
Base on six requirements, most personal risks, property risks, and liability risks can be
privately insured, since the requirements of insurable risk can be met.
By contrast, most market risk, financial risks, production risks, and political risks are difficult
to insure by private insurers because
-
These are speculative and so difficult to insure privately
It is such a catastrophic loss
It is difficult to calculate the proper premium.
Adverse Selection and Insurance
Adverse selection is the tendency of persons with a higher-than-average chance of loss to
seek insurance at standard rates, which if not controlled by underwriting, results in higherthan expected loss levels. This can be controlled by careful underwriting.
Underwriting refers to the process of selecting and classifying applicants for insurance.
Insurance and Gambling Compared
There are two important differences between insurance and gambling.
Gambling
1. Create a new speculative risk
Insurance
1. Handling an already existing pure risk
2. Socially unproductive. The winner’s
gain comes from the expense of the
loser.
3. Never restore the loser to insured’s
financial position
2.
3.
Both insurer and insured have a
common interest in prevention of
loss.
Restore the insured in whole or part
of a loss occurs
Types of Insurance
1. Private insurance
- Life and health insurance: benefits to beneficiaries when the insured dies.
- Property and liability insurance:
Property insurance-indemnifies property owners against the loss
Liability insurance- covers the insured’s legal liabilities
2. Government insurance
- Social insurance
- Other government insurance
Benefits of insurance to society
1. Indemnification for loss
2.
3.
4.
5.
Reduction of worry and fear
Source of investment funds
Loss prevention
Enhancement of credit
Cost of Insurance to society
1. Cost of doing business
2. Fraudulent claims
3. Inflated claims
Chapter 3: Fundamental of Risk Management
Meaning of Risk Management
Risk management is a process that identifies loss exposures faced by an organization and
selects the most appropriate techniques for treating such exposures.
A loss exposureis any situation or circumstance in which a loss is possible, regardless of
whether a loss occurs.
Objectives of Risk management
1. Pre-loss objectives: important objectives before a loss occurs are:
i.
Economy-The firm should prepare for potential losses in the most economical
way. This preparation involves an analysis of safety program expenses,
insurance premiums, and the costs associated with the different techniques for
handling losses.
ii.
The reduction of anxiety-Minimize the anxiety and fear associated with the
potential risks.
iii.
Meeting any legal obligations
2. Post-loss objectives: the risk manager also has certain objectives after a loss occurs.
i.
Survival of the firms – the most important post-loss objective. It means after a
loss occurs, the firm can at least resume partial operation within some
reasonable time period.
ii.
To continue operating – ability to continue operating
iii.
Stability of earnings – maintain the firm’s earnings per share.
iv.
Continued growth of the firm – risk manager must consider the impact that a
loss will have on the firm’s ability to grow.
v.
Social responsibility - minimizes the impact that a loss has on other persons
and on the society.
The risk management process
i.
ii.
iii.
iv.
Identify loss exposures: Identify all major and minor loss exposures.
Analyze the loss exposures: estimate the potential frequency and severity of loss.
Select the appropriate techniques for treating the loss exposures: A techniques can
be classified broadly as either risk control or risk financing.
A. Risk control
o Avoidance: never acquired loss exposure, chance of loss is reduced to
zero.
o Loss prevention: reduce the frequency of a particular loss.
o Loss reduction: reduce the severity.
B. Risk financing
o Retention: the firms retain part or all of the losses
 Paying loss: the risk manager must have some method for paying
losses
 Self-insurance: a special form of planned retention by which part or
all of a given loss exposure is retained by the firm.
o Noninsurance transfers: pure risk and its potential financial consequences
are transferred to another party.
o Insurance: appropriate for loss exposures that have a low probability of
loss but the severity of a potential loss is high.
Implement and monitor the risk management program
1. Risk management policy statement
2. Cooperation with other departments
3. Periodic review and evaluation