1.

Risk Management The process of identification, analysis and either acceptance or mitigation of uncertainty in investment decision-making refers to risk management in business. Risk management involves essential features such as reliable resources, financial strategies and foresight. It prevents or reduces the possibility of external as well as internal risks in business by employing intelligent strategies, and thus forms an integral part of business or investment.

Risk Management Methods These methods are not mutually exclusive and may be largely categorized as: loss control loss financing internal risk reduction
Loss control The activities which decrease the expected cost of losses by lowering the occurrence of losses and/or their extent are referred as loss control. Sometimes loss control is also termed as risk control. Usually, the actions basically affecting the frequency of losses are referred as loss prevention methods. Actions primarily influencing the severity of losses that do occur are often called loss reduction methods. An example of loss prevention would be routine inspection of aircraft for mechanical problems. These inspections help reduce the frequency of crashes; they have little impact on the magnitude of losses for crashes that occur. An example of loss reduction is the installation of heat- or smoke-activated sprinkler systems that are designed to minimize fire damage in the event of a fire. Many types of loss control influence both the frequency and severity of losses and cannot be readily classified as either loss prevention or loss reduction. For example, thorough safety testing of consumer products reduces the number of injuries, but it may also affect the severity of injuries. Similarly, equipping automobiles with airbags in most cases should reduce the severity of injuries, but airbags also might influence the frequency of injuries. The increase or decrease in the injuries is dependent upon whether the number of injuries that are completely prevented for the accidents that occur exceeds the number of injuries that might be caused by airbags inflating at the wrong time or too forcefully, as well as any increase in accidents and injuries that may occur if protection by airbags causes some drivers to drive less safely. Viewed from another perspective, there are two general approaches to loss control: (i) reduction of the risky activity level, and (ii) increasing precautions against loss for the activities undertaken. First, exposure to loss can be reduced by reducing the level of risky activities, for example, by cutting back the production of risky products or shifting attention to less risky product lines. Limiting the level of risky activity primarily affects the frequency of losses. The main cost of this strategy is that it forgoes any benefits of the risky activity that would have been achieved apart from the risk involved. In the limit, exposure to losses can be completely eliminated by reducing the level of activity to zero; that is, by not engaging in the activity at all. This strategy is called risk avoidance

Loss financing Methods applied to obtain funds for paying for or offsetting losses that occur are termed as loss financing (sometimes called risk financing). There are four broad methods of financing losses: (1) Retention, (2) Insurance, (3) Hedging, and (4) Other contractual risk transfers. These approaches are not mutually exclusive; that is, they are often used in combination. With retention, a business or individual retains the obligation to pay for a part or the entire loss incurred. For example, a trucking company might decide to retain the risk that cash flows will drop due to oil price increases. When coupled with a formal plan to fund losses for medium-to-large businesses, retention is generally called self-insurance. Firms can pay retained losses using either internal or external funds. The second major method of financing losses is the purchase of insurance contracts. As you most likely already know, the typical insurance contract requires the insurer to provide funds to pay for the specified losses (thus financing these losses) in exchange for receiving a premium from the purchaser at the inception of the contract. Insurance contracts reduce risk for the buyer by transferring some of the risk of loss to the insurer. Insurers in turn reduce risk through diversification. For example, they sell large numbers of contracts that provide coverage for a variety of different losses. The third broad method of loss financing is hedging. As noted above, financial derivatives, such as forwards, futures, options and swaps, are used extensively to manage various types of risk, most notably price risk. These contracts can be used to hedge risk; that is, they may be used to offset losses that can occur from changes in interest rates, commodity prices, foreign exchange rates and the like. Some derivatives have begun to be used in the management of pure risk, and it is possible that their use in pure risk management will expand in the future. The fourth major method of loss financing is to use one or more of a variety of other contractual risk transfers that allow businesses to transfer risk to another party. Like insurance contracts and derivatives, the use of these contracts also is pervasive in risk management. Internal risk reduction In addition to loss financing methods that allow businesses and individuals to reduce risk by transferring it to another entity, businesses can reduce risk internally. There are two major forms of internal risk reduction: (i) Diversification, and (ii) Investment in information. Regarding the first of these, firms can reduce risk internally by diversifying their activities (i.e., not putting all of their eggs in one basket). Individuals also routinely diversify risk by investing their savings in many different stocks. The ability of shareholders to reduce risk through portfolio diversification is an important factor affecting insurance and hedging decisions of firms. The second major method of reducing risk internally is to invest in information to obtain superior forecasts of expected losses. Investing in information can produce more accurate estimates or forecasts of future cash

flows, thus reducing variability of cash flows around the predicted value. Examples include: estimates of the frequency and severity of losses from pure risk marketing research on the potential demand for different products to reduce output price risk forecasting future commodity prices or interest rates One way that insurance companies reduce risk is by specializing in the analysis of data to obtain accurate forecasts of losses. Medium-to-large businesses often find it advantageous to reduce pure risk in this manner as well. Given the large demand for accurate forecasts of key variables that affect business value and determine the price of contracts that can be used to reduce risk (such as insurance and derivatives), many firms specialize in providing information and forecasts to other firms and parties. 2. Elements of a Life Insurance Organization An organization is a legal entity which is created to do some activity or to achieve some purpose. It is created under some law, which gives it a status and identity. Because of the identity, the organization is considered to be a person in law. Therefore, it can enter into contracts, be sued in courts, accumulate property and wealth, and do business, in the same manner as any individual can do. The way activities are grouped lead to the formation of offices, departments and sections Responsibilities (for results) have to be clarified and authorities (to take decisions and utilize resources) have to be defined. When all these are clarified, there will be people holding various positions, with designations, occupying places in offices and with clear authority and responsibilities. Important activities The important activities in a life insurance company are: Procuring applications or proposals from prospective buyers of life insurance. Scrutinizing and making decisions on the proposals for insurance. This is called underwriting. Issuing the policy document, incorporating the terms and conditions of the insurance cover. Keeping track of the performance of the insurance contract by either party, like payment of premium or payment of benefits. Attending to the various requirements that may arise during the term of the contract like nominations, assignment, alteration of terms, surrenders and payment of claims. Other supporting activities like advertising, investment of funds, maintenance of accounts, management of personnel, processing of data, compliance with regulations and laws Internal organization Within an insurance office, the following departments are likely to exist. These may be located in the branch office (as in the LIC now) or in the Divisional / Head offices (as in the LIC earlier and new companies now). These departments are to be identified by the activities being carried out, although they may be called by different names. Business development or agency or marketing concerned with the development of agency force, market development and business growth.

New business, which would receive, scrutinize and take underwriting decisions on the new proposals for insurance and also issue the policy. Policy-holders servicing which would be concerned with administration of the policy, monitoring premium payments, lapses and revivals, attending to alterations, nominations, assignments, surrenders, loans and claims. Accounts to handle the financial flows. The following departments are likely to be centralized in the Head Offices, as they require specialized skills and also because they impact the whole organization. Actuarial, studying the experience, doing valuations, declaring bonuses, monitoring the adequacy of premiums, setting underwriting standards, studying mortality rates, etc. The distribution system Life insurance is not compulsory under law. General insurance is frequently purchased due to compulsions under the law (Motor Vehicles Act) or from the financiers demanding insurance as collateral security. In the case of life insurance, the compulsion is negligible. There is often a tendency of deferring the decision. Death as a practical possibility is either ignored or not considered imminent. The requirements of today take priority over the requirements of tomorrow. Even if not absolutely essential, the requirements of today seem to be more compelling. Life insurance has to be secured when in the best of health. Otherwise, the insurer will refuse to grant the insurance cover. Agents are the ones who do the job of meeting, explaining and persuading people. They have to be licensed under the Insurance Act. A licensed agent can work with only one life insurer of his choice and is paid commission on the premiums collected through his agency. Another category of intermediary is the broker. In the rest of this unit, the word agent is used to refer to all salesmen, whether called an agent or insurance advisor or by any other name. Functions of the agent The major function of the agent is to solicit and acquire life insurance business for the insurer, which has appointed him as an agent. While proposing a person for insurance, the agent has to assess his needs and his paying capacity, make all reasonable enquiries about the health and habits of the life to be insured and get proof of his age to be admitted at the commencement of the policy. If medical examination is required, the agent has to arrange for the same. After the proposal becomes a policy, the agent has to ensure continuance of the policy by the means of timely payment of renewal premiums, get nomination or assignment effected and help in prompt settlement of claims. Agents of the LIC are not authorized to collect premiums other than the first premium along with the proposal. If a policyholder pays premium to an agent, the LIC does not accept any liability for the same. The premium is treated as paid only when it is paid into the office. However, in practice agents do collect premiums from policyholders to ensure promptness in payment.

3. Health Insurance
Types of Mediclaim/Health Policy Broadly speaking, health insurance policies in India are of the following types: Individual Mediclaim Policy Group Mediclaim Policy Deferred Mediclaim Policy Overseas Mediclaim Policy Innovative Mediclaim Policy Individual mediclaim policy Individual and group mediclaim policies are similar in scope and nature. These policies provide for reimbursement of hospitalization/domiciliary hospitalization expenses for illness/disease suffered or accidental injury sustained during the policy period. The policy covers for expenses incurred under the following heads: (a) Room, boarding expenses in the hospital/nursing home (b) Nursing expenses (c) Surgeon, anaesthetist, medical practitioner, consultant, specialist fees (d) Anaesthesia, blood, oxygen, operation theatre charges, medicines, diagnostic materials, etc.
Group mediclaim policy The group mediclaim policy is available to any group/association/institution/ corporate body, provided it has a central administration point and subject to minimum number of 100 persons to be covered. The group policy is issued in the name of group/association/institution/ corporate body (called insured) with a schedule of names of the members including his/her eligible family members (called insured person) forming part of the policy. Group mediclaim policies are often customized to provide more benefits to its members and many of the general exclusions are waived off from the standard mediclaim policy. Deferred mediclaim policy Also widely known as Bhavishya Arogya Policy, this policy can be taken at any age from 25 years onwards up to 55 years. The insured at the time of taking the policy has to select a retirement age between fifty-five and sixty years after which the coverage for hospitalization expenses will commence. The coverage under the policy is similar to what is available under a standard mediclaim policy with the following differences: (a) Pre- and post-hospitalization expenses are not covered under the policy. (b) The following exclusions of the mediclaim policy are not applicable. Thirty days waiting period First year exclusions Pre-existing diseases exclusion Circumcision, pregnancy, etc. Overseas mediclaim policy This policy provides for medical expenses in respect of illness suffered or

accident sustained by Indian residents during their overseas visits for official or personal purpose. First started in 1984, this insurance policy has been since modified to provide for additional benefits such as in-flight personal accident coverage, compensation for the loss of passport, personal liability, etc. Videsh Yatra Mitra policy The widest coverage available under a variation of the overseas mediclaim policy is known as Videsh Yatra Mitra policy. There are five sections under the policy and the insured has the option to choose minimum three and maximum all six sections by paying appropriate premium. The six sections are as under: Section A (personal accident): This section covers death or bodily injury resulting in total or partial permanent disablement to the insured. Section B (medical expenses and repatriation): This section covers medical related expenses during and in course of the overseas stay. Section C (loss of checked baggage): Total loss of a baggage during the course of travel is covered in this section. Section D (delay of checked baggage): This section covers emergency purchase of replacement items if there is a delay in delivery of checked baggage of more than 12 hours from the scheduled arrival time at the destination. Section E (loss of passport): This section covers actual expenses necessarily and reasonably incurred by the insured person in connection with obtaining a duplicate or fresh passport. Section F (personal liability): This section covers legal liability that may attach to the insured person for any bodily injury or property damage to a third party accidentally caused by any act of the insured.

Liability Insurance
Liability insurance is broadly classified into two categories: (i) Public liability insurance and (ii) Product liability insurance. Public liability insurance is broadly classified into two categories: Compulsory public liability insurance and Voluntary public liability insurance policies. 7.4.1 Types of Liability Policies Compulsory public liability policy The Public Liability Insurance Act, 1991 imposes no fault liability, i.e., irrespective of any wrongful act, neglect or default on the part of the owner of any hazardous substance, he has to pay relief in the event of death or injury to any person other than a workman or damage to property of any person arising out of an accident involving the hazardous substance. No fault liability means the claimant is not required to prove that the death, injury or damage was due to any wrongful act, neglect or default of any person. The death/ injury/damage may arise out of manufacture, processing, treatment, packaging, storage, transportation, transfer, offering for sale, destruction, etc., of the hazardous substance. Voluntary public liability policy The owner of any industrial risk or non-industrial risk may take a voluntary public liability policy to cover his legal liability in respect of accidental physical death/ injury/property damage of a third party arising out of his property. Industrial risks are manufacturing premises including godowns and warehouses. Non-industrial

risks are hotels, restaurants, cinema halls, auditoriums, residential premises, office premises, schools, amusement parks and film studios. Products liability policy Products sold to their users/consumers, if defective, may cause death, bodily injury, illness or property damage. The manufacturers/marketers of such products are liable to pay relief to the accidental victims of their products under law. The product liability insurance policy provides insurance cover to manufacturers/ marketers. The structure of the policy is similar to voluntary public liability policy with differences relating to only the coverage and some exclusion. The indemnity is available to claims arising out of accidents during the period of accident and first made in writing against the insured during the policy period arising out of any defects in the products specified in the policy schedule. Professional indemnity policy Professional indemnities are designed to provide insurance protection to professional people such as doctors, solicitors, chartered accountants, architects, etc., against their legal liability to pay damages arising out of negligence in the performance of their professional duties. Directors and officers liability policy Directors and officers of an organization hold positions of trust and responsibility. They may become liable to pay damages to shareholders, employees, creditors, etc., of the company for wrongful acts committed by them in the management and supervision of the affairs of the company. The policy is designed to provide protection to directors and officers against their personal civil liability. Employers liability policy Also known as workmens compensation insurance, the policy provides protection to the employers against their legal liability for payment of compensation in case of death or disablement of the employees arising out of and in the course of employment. There are two tables under the policy: Table A cover and Table B cover. Table A cover provides indemnity against legal liability under the Workmens Compensation Act, Fatal Accidents Act and Common Law. This is issued for only those employees who come within the definition of workmen under the Workmens Compensation Act. Table B cover provides indemnity against legal liability under the Fatal Accidents Act and Common Law. This may be issued to cover only those employees who are not workmen within the meaning of that term under the Workmens Compensation Act.

4. Pricing Individual Life and Health Insurance Pricing objectives I. Rate adequacy To avoid financial problems and insolvency, insurance company rates must be adequate in the light of benefits promised under the companys insurance products. Rate adequacy means that for a given block of policies, total payments collected now and in the future by the insurer plus the investment earnings attributable to any net retained funds are sufficient to

fund the current and future benefits promised plus cover-related expenses. II. Rate equity Equity means charging premiums commensurate with the expected losses and other costs that insured bring to the insurance pool. The pursuit of equity is one of the goals of underwriting (classification and selection of insured). III. Rates not excessive Rates should not be excessive in relation to the benefits provided. This objective is achieved by establishing a ceiling on the rates. Competition discourages excessive pricing. Pricing elements The pricing elements underlying the pricing of life and health insurance contracts are: expected mortality or morbidity experience expected investment return expenses 1. The probability of the insured event occurring It is shown by mortality tables in life insurance and morbidity tables in health insurance. The part of risk premium can be calculated by multiplying the sum assured with relevant information in these tables. 2. The time value of money The time value of money through rate of interest is the second factor taken into account for the calculation of premium. Net premium can be calculated by deducting interest component from risk premium. 3. Loading to cover expenses, taxes, profits and contingencies Tabular premium can be calculated by adding all these office expenses to net premium. 4. The benefits promised The fourth factor is the benefits promised under the contract. A loading in this respect is also included to arrive at the actual premium payable. Office premium is the sum of tabular premium and the promised benefits. Conceptually, the office premium or the final premium for a life insurance contract is determined from the following equation: Expected value of office premiums = Expected Present Value of Insured Benefits + Expected Present Value of Expenses We use the concept of present value because life insurance contract is a longterm contract. We are using the word Expected because the period for which the premiums are payable and the period for which the expenses will be incurred will depend upon when the insured benefit becomes payable. To determine when the insured benefit becomes payable, we use the expected mortality experience. The present value is usually calculated by using the expected investment return as the discount rate. Typically, health insurance contracts offered in the Indian market are yearly renewable contracts. To price such contracts, we use the following equation: Office Premium = Risk Premium / (1Expenses Loading) where, Risk premium = Probability of occurrence of a claim Expected size of the claim. The probability of occurrence of a claim can be determined using the expected morbidity experience. The expense loading is expressed as a percentage of the office premium.

Rate computation 1. Yearly renewable term life insurance This plan provides coverage for one year only but guarantees renewal irrespective of the insurability of the policy owner. Premium depends on the rate of mortality. As age increases, premium rate increases. Therefore, there is a possibility that those in good health discontinue the policies because of burdensome premium. 2. Single premium term life plan In this system, premium will not increase year after year. Only one single lumpsum is collected at the inception to cover risk for the selected period of insurance. The single premium will be equal to the present value of total death claims anticipated to be paid by the insurer over the period of insurance is calculated at a chosen rate of interest plus an allowance for expenses. 3. Level premium plan In this system, premium payable throughout the period of insurance is level or uniform. In this system, reserve builds up under each policy because the premium charged in the initial years of the policy is more than what is required to cover the death risk. The difference between the face value of a policy and the reserve under the policy is called the net amount at risk. 4. Flexible premium plan Flexibility of deciding the amount of premium to be paid is allowed by many insurers to policy owners, e.g., universal life policies. Out of the amount paid, mortality charges and expenses are deducted and balance accumulates and the insurer gives interest credit to the insured.

5. Concept of Insurable Interest Despite the conventional belief that everything is insurable, all risks are not insurable. The risks must be financially measurable and there should be adequate number of comparable risks for the purpose of rating. Further, there must be pure and specific risks. The happening of the event insured against should not be against public policy, the premium should be logical, and most importantly, there must be insur-able interest on the part of the insuring individual. There is no one specific, universally accepted definition of insurable interest, but it can be similar to the following:
The legal right to insure arising out of a financial relation-ship recognised under law, between the insured and the subject matter of insurance.

Creation of insurable interest There are a number of ways in which insurable interest will arise or be limited: (a) By common law: Where the essential elements of insurable interest are automatically present, the same can be described as having arisen at common law. The common law duty of care which one owes to the other may give rise to a liability, which again is insurable. (b) By contract: In some contracts a person will agree to be liable for something which he or she would not ordinarily be liable for. (c) By statute: Sometimes an Act of the Parliament will create an insurable interest either by granting some benefit or imposing a duty. While the statute

may create insurable interest where none would otherwise exist, there can be statutes which restrict liability and thereby also restrict insurable interest. Application of insurable interest There are three main categories of application of insurable interest as follows: life property liability Every person has an unlimited insurable interest in his or her own life. However, the obvious restriction in the application of this is the means with which to pay the premium. If a person is married then there is an automatic unlimited insurable interest in the life of the persons husband or wife. However, no other family relationship will give rise to insurable interest by itself. If family members are involved in business together or in the case of some other financial relationship, then in these circumstances, it is not the family ties, which create insurable interest, but it is the extent of the financial involvement. There is a basic rule that insurable interest will exist to the extent of the financial interest in another person or other persons. Thus, partners are capable of insuring each others lives as they incur loss in the event of the demise of any of them. A creditor may incur financial loss in case a debtor meets with death prior to the repayment of a loan.

Insurance and Wagers

Wagering contract is formulated in the nature of a wager. Such contracts include a range of common forms of applicable commercial contracts, e.g., contracts of insurance, contracts dealing in futures, options, etc. The statutes against gambling and betting have made many other wagering contracts illegal and wagering in various cases is termed as a criminal offence.
Table 5.1 Difference between Wagering and Insurance Contract of Insurance Wagering Agreement 1. A contract of insurance is a contract to make good the loss of property (or life) of another person against some consideration called premium. 1. A wagering agreement is an agreement to pay money or money's worth on the happening of an uncertain event. 2. In a contract of insurance the insured must have insurable interest. Without insurable interest it will be a wagering agreement. 2. No insurable interest is necessary in case of a wagering agreement. 3. In a contract of insurance both the parties are interested in the protection of the subject matter, i.e., there is mutuality of interest. 3. In a wagering agreement, there is conflict of interest and in reality there is no interest at all to protect.

4. Except life insurance, a contract of insurance is a contract of indemnity, i.e., a contract to make good the loss. 4. In case of a wagering agreement there is no question of indemnity. On the happening of the event fixed amount becomes payable. 5. Contracts of insurance are based on scientific and actuarial calculation of risks. 5. Wagering agreements are not based on such calculations and are in the nature of gambling.

6. 1. Role of insurance in managing risk financing

Business organizations and individuals take insurance policies. These insurance policies help them to cover the losses in case of any emergency. Here, the idea is to transfer the risk involved with the business to the insurance provider by taking an insurance policy. This insurance policy will honour claims in case certain emergencies disrupt the working of the organization. This type of financing strategy offers the benefit of knowing that even if the project faces financial trouble due to unseen events, the losses will be settled without having to use other company assets. However, these events will have to be mentioned in the insurance papers that the organization signs with the insurer. If an insurance policy does not cover theft, the organization cannot claim the amount from his insurer. The organization should maintain an adequate insurance to cover all insurance risks relating to the calamities that can happen. Insurance should be maintained in at least the following major areas of coverage such as: Real and personal property Machinery Crime coverage Extra expense and valuable papers Workers compensation Comprehensive general liability Automobile liability and physical damage

Insurance Transaction
Insurance is a contract. One party, namely, the insurer, contracts with another, the policyholder, to perform a particular service. The nature of insurance transaction can be represented by the following triangle:
The risk The insured The insurer

At the apex of this triangle there is the risk insured against. The insured policyholderis the person or company entering into the insurance contract and the insurer is the insurance company which has contracted with the insured to provide cover for the risk insured against. Let us delve briefly into a few important concepts associated with insurance:

An indemnity is a sum paid by A to B by way of compensation for a particular loss suffered by B. from the perspective of the insured. Subrogation has its purpose in compelling the ultimate payment of a debt by the party who, in Equity and good conscience, should pay it. This subrogation is an equitable device used to prevent injustice. The principle according to which two or more insurers each liable for an insured loss ought to indulge in the payment of that loss. Having paid its share of a loss, an insurer may be entitled to equitable contributiona legal right to recover part of the payment from another insurer whose policy was also applicable. Insurable interest exists when an insured person derives a financial or other kind of advantage from the continuous existence of the insured object (or in the context of living persons, their continued survival). A person has an insurable interest in something when loss-of or damage-to that thing would cause the person to suffer a financial loss or other kind of loss. Referral of a dispute to an impartial third party chosen by the parties in the dispute who agree in advance to abide by the arbitrators award issued after a hearing at which both parties have a chance to be heard. In the law, a proximate cause is an event sufficiently related to a legally recognizable injury to be held to be the cause of that injury. Looking at this triangle from the perspective of the insured one could say that: (a) The insured knows the nature of the risk; (b) The insured has to describe the risk to the insurer. At this stage insured could more properly be termed the pro-poser as he, she or the firm is at the point of describing the risk to the insurer in order to obtain insurance; (c) The proposer will look for acceptable protection. He may have a particular form of insurance cover in mind or want a special clause included or even excluded. The proposer knows, or should know, what he wants, and will go into the market place in an effort to satisfy his needs; d) Price is an important determinant in selecting an insurer. The proposer will also, of course, be concerned with service and security, but price will be extremely important. From the perspective of the insurer (a) It will be told about the risk by the proposer; (b) In many cases the insurer will not rely on this source of information alone but will make its own inquiries. This may imply using skilled risk surveyors to look at pro-posals and make physical inspection or doctors to carry out medical examination for a life or permanent health insurance proposal; (c) The insurer will decide on the level of cover which it is prepared to offer to the proposer; (d) Finally, the insurer will have to determine the price to be charged for the cover it is willing to offer. This price will have to reflect a number of relevant factors. The triangle is not the whole story. At the insured end of the triangle, there is the intermediary. The intermediarythe agent or brokerwill assist insured or proposer at various stages in the transaction of insurance. For any large industrial insured, the use of a broker is almost essential as the role, he performs, is of crucial importance. At the insurers side of the triangle, there is the reinsurer who essentially offers the same kind of protection to the insurer as the insurer offered to the insured.