MF009 – Insurance & Risk Management

Assignment Set – 1

1) “Risk can be classified into several distinct categories”. Explain.

Ans:

Classification of Risk

Risks may be classified in many ways; however, there are certain distinctions that are particularly
important. These include the following:

a) Financial and Non- financial Risks

In its broadest context, risk includes all situations in which there is an exposure to adversity. In
some cases, this adversity involves financial loss while in other it does not. There is some element
of risk in every aspect of human endeavor, and many of these risks have no (or only incidental)
financial consequences.

Financial risk involves the relationship between an individual (or and organization) and an asset or
expectation of income that may be lost or damaged. Thus financial risk involves three element: (i)
the individual or organization that is exposed to loss, (ii) the asset or income whose destruction or
dispossession will cause financials loss, and (iii) a peril that can cause the loss.

The first element in financial risk is that someone will be affected by the occurrence of an event.
During the devastating floods, a considerably large area of farmland is damaged by flood waters,
causing a financial loss to the tune of several billions to the owners.

The second and third elements are the thing of value and the peril that can cause the loss of the
thing of value. The individual who owns nothing of value and who has no prospects for improving
that situation faces no financial risk. Further, if nothing could happen to the individual’s assets or
expected income, there is nor risk.

b) Static and Dynamic Risk

A Second important distinction is between static and dynamic risks. Dynamic risks are those
resulting from changes in the economy. Changes in the price level, consumer tastes, income and
output, and technology may cause financial loss to members of the economy. These dynamic risks
normally benefit society over the long run, since they are the result of adjustments to misallocation
of resources. Although these dynamic risks may affect a large number of individuals, they are
generally considered less predictable than static risks, since they do not occur with any precise
degree of regularity.

Static risks involve those losses that would occur even if there were no changes in economy. If we
could hold consumer tastes, output and income, and the level of technology constant, some
individuals would still suffer financial loss. These losses arise from caused other than the changes
in the economy, such as the perils of nature and the dishonesty of other individuals. Unlike dynamic
risks, static risks are not a source of gain to society. Static losses involve either the destruction of
the asset or a change in its possession as a result of dishonesty or human failure. Static losses
tend to occur with a degree of regularity over time and, as a result, are generally predictable.
Because they are predictable, static risks are more suited to treatment by insurance than are
dynamic risks.

c) Acceptable and Unacceptable Risk

There are two elements of uncertainty in most types of events that are handled by risk mangers- the
likelihood of the event occurring, and the size of the ensuing loss. Generally, the degree of risk
aversion displayed by individuals acting in either a private or managerial capacity tends to increase
with the potential size of loss. Some loss potentials are so small that an individuals or organization
is prepared to accept the risk and assume any loss that does occur. Beyond a certain size, the risk
becomes unacceptable and ways will be sought to avoid, reduce or transfer that risk. Of course, the
maximum size of loss that can be tolerated depends on the status of the individual or organization,
and so the division between acceptable and unacceptable risks is not entirely clear-cut for two
reasons.

First, it depends partly on time. The size of loss that could be absorbed by, say,, one year’s profits
would normally be far larger than could be accommodated within one month’s operating budged.
Secondly, there will be a range of potential losses where the occurrence of the loss could strain the
individual’s or and organization’s finances but it could overcome (perhaps by resort to borrowing or
raising additional capital). Then, whether the risk of incurring a loss of any size will be regarded as
acceptable or unacceptable will depend upon the cost of handling the risk relative to the benefits
thereof. For example, if loss reduction measures would greatly exceed the expected reduction in
losses; or if the premium required by insurers deemed high relative to the risk that would
transferred, then no attempt may be made to reduce the risk or insure it.

d) 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. Example includes rapid inflation, cyclical unemployment and war because
large numbers of individuals are affected. The risk of a natural disaster is another important type of
fundamental risk. Hurricanes, tornadoes, earthquakes floods, and forest and grass fires can result
in damage to billions of dollars worth property and cause numerous deaths.

In contrast to a fundamental risk, a particular risk is a risk that affects only individuals and not the
entire community. Examples include car thefts, bank robberies, and dwelling fires. Only individuals
experiencing such losses are affected, not the entire economy.

e) Pure and speculative Risks

Pure risk is defined as a situation in which there are only the possibilities of loss or no loss. The
only possible outcomes are adverse (loss) and neutral (no loss). Examples of pure risks include
premature death, job related accidents, catastrophic medical expenses, and damage to property
from fire, lighting, flood, or earthquake.
 Speculative risk is defined as a situation in which either profits or loss is possible. For example, if
you purchase 100 share, you would profit if the price of the share increases but would lose if the
price declines. Other example of speculative risk includes betting on a horse race investing in real
estate, and going into business for self. In these situations, both profit and loss and possible.

2) Identify common misconceptions about risk management and explain why

these misconceptions are developed.

Ans:

Misconceptions about Risk management

While risk management has become a popular topic of discussion, some of what is discussed reflects a
misunderstanding of risk management. Some of these misconceptions reflect a misreading of the
literature, while others reflect defects in the literature itself. The first misconception is that the risk
management concept is principally applicable to large organization. The second is that the risk
management approach to dealing with pure risks seeks to minimize the role of insurance.

a) Universal Applicability

If one were to judge on the basis of much of the literature dealing with the concept of risk management,
it would be easy to conclude that risk management has no useful application except with respect to the
problems facing a large industrial complex. This misconception can easily result from the fact that many
of the techniques with which writers have been preoccupied (e.g. self-insurance plans, captive insurers
etc.)do apply primarily to giant organizations. Most of the articles on risk management have been
written by practicing professional Risk Manager. It is natural that they would write about the techniques
they use in their own companies, and virtually all-professional Risk managers are employed by large
organizations. But is cannot be overemphasized that the risk management philosophy and approach
applies to organizations of all sized (and to individuals as well for that matter),even though some of the
more esoteric techniques may have limited application in the case of an average organization.

As the risk Manager’s position has increased within the corporate framework and risk management has
become a recognized term in business jargon, the interest in risk management has increased in
businesses of all sizes. While it is obvious that the small firm cannot afford a full-time professional Risk
Manager, the principles of risk management are as applicable to the small organization as to the giant
international firm. The principals of risk management are nothing more than common sense applied to
the management of pure risks facing an individual or organization. The principles are applicable to
organization of all sizes, as well as to individuals and families. While the techniques may differ in scope
and complexity, the same risk management tools are used in either case.

b) Anti-Insurance Bias?

The second misconception about risk management that it is anti-insurance in its orientation and that it
seeks to minimize the role of insurance in dealing with risk also stems from risk management literature.
Much of the literature on risk management has also been preoccupied with topic related to risk
retention, self-insurance programmes, and captive insurance companies. Indeed, if one was to ask
practitioners in the insurance field to describe the essence of risk management that is, its philosophy-
many would respond that the major emphasis of risk management is on the retention of risk and on the
use of deductibles. While it is true that retention is an important technique for dealing with risk, it is not
what risk management is all about,

The essence of risk management is not in the retention of exposures. Rather it is in dealing with risks
by whatever mechanism is most appropriate. In many instance, commercial insurance will be the only
acceptable approach. While the risk management philosophy suggests that there are some risks that
should be retained, it also dictates that there are some risks that must be transferred. The primary
focus of the Risk Manager should be on the identification of the risks that must be transferred to
achieve the primary risk management objective. Only after this determination has been made does the
question of which risks should be retained arise. More often than not, determining which risks should be
transferred also determines which risks will be retained; the residual class that does not need to be
transferred.

3) What are the social values of insurance? What are the social costs?
Explain.

Ans:

Social and Economic Values

There are many social and economic values of insurance, which are as follow:

Reduced Reserve Requirements

Perhaps the greatest social value – indeed, the central economic function – of insurance is to obtain the
advantage that flow from the reduction of risk. One of the chief economic burdens of the risk is the
necessity of accumulating funds to meet possible losses, and one of the greatest advantages of the
insurance mechanism is that it greatly reduces the total of such reserves necessary for a given
economy. Because the insurer can predict losses in advance, it needs to keep readily available only
enough funds to meet those losses and to cover expenses. If each insured has to set aside such funds,
there would be need for a far greater amount. For example, in many localities, a Rs. 100,000 building
can be insured against fire and other physical perils for about Rs. 500 a year. If insurance is not
available, the insured would probably feel a need to set aside funds at a much higher rate than Rs.500
a year.

Capital Freed for Investment

Another aspect of the advantage just described is the fact that the cash reserve that insurers
accumulate are made available for investment insurers as group, and life insurance firms in particular,
are among the largest and most important institutions collecting and distributing the nation’s saving.
From the viewpoint of the individual, the insurance mechanism enables renting an insurer’s assets to
cover uncertain losses rather than providing this capital internally, much like renting a building instead
of owning one. Capital that is thereby released frees funds for investment purposes. Thus the insurance
mechanism encourages new investment. For example, if an individual knows that his or her family will
be protected by life insurance in the event of premature death, the insured may be more willing to
invest savings in a long desired project such as a business venture, without feeling that the family is
being robbed of its basic income security. In this way a better allocation of economic resources is
achieved.

Reduced Cost of Capital

Because the supply of funds that can be invested is greater than it would be without insurance, capital
is available at a lower cost than would otherwise be possible. This result brings about a higher standard
of living because increased investment itself will raise production and cause lower prices that would
otherwise be the case. Also, because insurance is an efficient device to reduce risks, investors may be
willing to enter fields they would otherwise reject as too risky. Thus, society benefits from increased
services and new products, the hallmarks of increased living standards.

Reduced Credit Risk

Another advantage of insurance lies in its importance to credit. Insurance has been called the basis of
the nation’s credit system. It follows logically that if insurance reduces the risk of loss from certain
sources, it should mean that an entrepreneur is a better credit risk if adequate insurance is carried.
Today it would be nearly impossible to borrow money for many business purposes without insurance
protection that meets the requirements of the lender.

Loss Control Activities

Another social and economic value of insurance lies in its loss control or loss prevention activities.
Although the main function of insurance is not to reduce loss but merely to spread losses among
members of the insured group, insurers are nevertheless vitally interested in keeping losses at a
minimum. Insurers know that if no effort is made in this regard, losses and premiums would have a
tendency to rise. It is human nature to relax vigilance when it is know that the loss will be fully paid by
insurer. Furthermore, in any given year, a rise in loss payment reduces the profit to the insurer, and so
loss prevention provides a direct avenue of increased profit.

Business and Social Stability

Finally, the existence and availability of insurance can lead to increased business and social stability.
Several illustrations may be helpful in envisioning this point. For example, if adequately protected, a
business need not face the grim prospect of liquidation following a loss. Similarly need not break up
following the death or permanent disability of one or more income producers. A business venture can
be continues without interruption even though a key person or the sole proprietor dies. A family need
not lose its life’s saving following a bank failure. Old-age dependency can be avoided. Loss of a firm’s
assets by theft can be reimbursed. Whole cities ruined by hurricane can be rebuilt from the proceeds of
insurance.

Social costs of insurance

No institution can operate without certain costs. The costs for an insurance institution include operating
the insurance business, losses that are caused intentionally, and losses that are aggregated.
1. Operating the Insurance Business

The main social cost of insurance lies in the use of economic resources mainly labor, to operate the
business. The average annual overhead of property insurers account for about 25 per cent of their
earned premiums but ranges widely, depending on the type of insurance. In the insurance, an
average of 20 per cent of the premium rupee is absorbed in expenses. In other words, the
advantages of insurance should be weighed against the cost of obtaining the service.

2. Losses that are intentionally Caused

A second social cost of insurance is attributed to the fact that if it were not insurance, certain losses
would not occur- losses that are caused intentionally by people in order to collect on their policies.
Although there are no reliable estimates as to the extent of such losses. It is likely they are only a
small fraction of total payment. Insurers are well award of this danger, however, and take numerous
steps to keep it to a minimum.

3. Losses that are Exaggerated

Related to the cost of international losses is the tendency of some insured to exaggerate the extent
of damage that results from purely unintentional losses. For example, Company ABC has an old
photocopy machine that does not work well. When a small fire in ABC building causes some smoke
damage throughout the building, ABC may be tempted to claim that its fire insurance should pay for
a new photocopy machine. The old machine has likely been affected by smoke, but in reality, the
machine did not work well before the fire and probably would have been replaced soon anyway.
The existence of insurance tempts ABC to exaggerate its loss in this situation. Similarly, health
expenses for families that have health insurance may be higher than the expenses for uninsured
families. Once an accident or sickness has occurred, an individual may decide to undergo more
expensive medical treatment, or the physician may prescribe it if it is known that an insurer will bear
most or all of the cost.
 MF009 – Insurance & Risk Management
Assignment Set – 2

1) What is the nature of actuarial practice? Discuss the actuarial modeling principles.

Ans:

Nature of Actuarial Practice

The primary focus of actuarial work is on the financial and economic consequences of events involving
risk and uncertainty. Actuarial practice involves the management of these implications and their
associated uncertainties. To gain insights about future possibilities, the actuary depends on observation
and the wisdom gained through prior experience. The actuary uses these observations and this
experience when constructing validating and applying models.

Actuarial models are constructed to aid in the assessment of the financial and economic consequences
associated with phenomena that are subject to uncertainty with respect to occurrence, timing, or
severity. This requires:

a) Understanding the conditions and processes under which past observations were obtained.

b) Anticipating changes in those conditions that will affect future experience.

c) Evaluating the quality of the available data.

d) Bringing judgment to bear on the modeling process.

e) Validating the work as it progresses.

f) Estimating the uncertainty inherent in the modeling process itself.

Actuarial Modeling Principles

Principles abstract the key elements of the scientific framework. Principles are not prescriptions that
specify how actuarial work is to be done, but are statements grounded in observations and experience.
The concept of actuarial risk defines the subject matter of actuarial science. An actuarial risk is a
phenomenon that has economic consequences and is subject to uncertainty with respect to one or
more of the actuarial risk variables occurrence, timing and severity.

1. Principle of Modeling or Actuarial risks

This provides assurance that actuarial risk can be analyzed and that estimates of future behavior can
be obtained. Actuarial risks can be stochastically modeled based on assumptions about the probability
that will apply to the actuarial risk variables in the future, including assumptions about the future
environment.

2. Principle of Exposure

For most actuarial models there exist one or more exposure measures that are approximately
proportional to the economic consequences of one or more collections of the actuarial risks being
modeled.

3. Principle of continued validity of Actuarial models

The change over time in the degree of accuracy of an initially valid actuarial model depends upon
changes in the:

a. Nature of the right to receive or the duty to make a payment

b. Various environments (for example, regulatory, judicial, social, financial, and economic) within which
the modeled events occur financial, economic) within which the modeled events occur.

c. Sufficiency and quality of the data available to validate the model.

d. Actuary understands the environment.

2) Discuss the various methods of reinsurance. Explain with suitable examples.

Ans:

Method of Reinsurance

There are three methods of Re-insurance:

1.Facultative method

2. Treaty method

3. Pooling method

1. Fecultative Method: this is the very oldest method of reinsurance. Under this method, both the
parities are found into a contract for any specific risk. It is an arrangement to reinsure specific risk at a
specific time. The reinsurer has the liberty to accept or reject a proposal received for re-insurance. This
method is a flexible one: reinsurance can be effected according to the need of circumstance. This
method is more suitable for emergency situations.

Merits: Certain important merits are as follows:

1. There is no restriction on re-insurance.

2. This method is flexible. The facility to make reinsurance is based on the circumstances of the case.

3. This method is more useful where the risk is not standardized.

4. This method can be adopted even in emergency situations. This method makes the original insurer
vigilant and makes arrangement for reinsurance before the insurance is made. In case no re-insurance
is available, he may refuse to accept heavy proposal involving heavy risks

Demerits: The important demerits of this method are as follows:

1. This is an uncertain method

2. Many paper-works are involved in the process of reinsurance.

3. This method is more expensive.

4. Unnecessary delays take place since the consent of the reinsurer is to be taken again and again.

5. This sort of delay in getting the consent of the reinsurer leaves the chance of getting the insurance
proposal.
6. In absence of getting prior consent of the re-insurer, if the proposals involving heavy risk are
accepted, the insurer has to suffer heavy losses due to involvement of heavy risk.

7. This method is impractical and non beneficial to small and medium re-insurers.

Because of these, and many other drawbacks of facultative reinsurance method, the Auto-Facultative
reinsurance method has been developed. Under this new method, a special category of risks is
reinsured. Re-insurance of this method has much importance in Engineering Insurance, Air Transport
insurance, Satellite insurance, Corp insurance, and Disturbance Insurance etc.

2. Treaty method: It is an informal agreement between two insurers under which the re-insurer agree
to reinsure risks written by the other insurance company (propose) subject to the terms and conditions
of the treaty and within the prescribed time limit. Treaty is a formal and legally binding agreement
between the parties. The following types of treaty is or agreements are made under this method:

a) Quota or fixed share treaty

b) Surplus treaty

c) Excess of loss treaty

d) Excess of loss ratio or stop-loss treaty.

Merits: This method of re-insurance has the following merits:

1. This method of re-insurance is simple, secured and reasonable for the insured.

2. In this method provision exists automatically for reinsurace.

3. This method is more suitable for new and medium class insurers to organize the business well.

4. It is easier for the insurer to secure more business.

5. The insurer can run the business with more freedom.

6. The risk is balancing.

7. The insurance agents get encouragement because the proposals brought by them get accepted
easier.

8. Minimum paper work is involved in the process of reinsurance.

Demerits: Some important demerits are as follows:

1. Re-insurer would not get the opportunity to select the risks of the own choice.

2. Profits will be very little because reinsurance is made for general insurance risks also.

3. The class of risk and the claim amount become comparatively less.

Pooling method: This is the method to cover larger risks. A “pool” is created by agreement between
different insurance companies. The members of the pool deposit their business earnings to the pool
and claims are paid out of the resources accumulated in the pool. The profit of the pool is distributed
among the members in proportion to their contribution in the pool.
3) What are the critical issues in bancassurance?

Ans:

Bancassurance raises new issues in respect to insurance sales, including ethical ones, which no doubt
lawyers may soon have to address in practical situations.

For example, one issue is the use of information by banks (data mining) which they have in their
capacity as a bank, e.g. the customer’s financial status, bank balances, amount in fixed deposits etc. to
target the sale of particular insurance products to particular customers. It is also not uncommon for
banks to make incentive payment to tellers (who at least know your current bank balance) who direct
customers to a financial planner (sales person). The incentive is paid if the financial planner is
successful in making a sale.

The quick sales process in a banking hall or branch office by the bank’s staff (financial advisor) vis-à-vis
the home visit of an insurance agent may raise question as to whether the customer has had sufficient
opportunity to consider the purchase carefully, especially taking into account the long term commitment
associated which insurance products. And whether in the limited time available, sufficient information
was elicited from the customer to attempt to sell based on the customer’s needs rather than merely
pushing a product.

Not too long ago, the Business Time published letters (from members of the public) who felt that they
had fallen victim to the ‘hard sell’ approach taken and that the sale was not necessarily in the interest of
customer, given the customer’s particular circumstances and attitude to risk. It was highlighted that the
customer had not realized the long-term nature of the commitment.

As in the case of a tied agency, exclusive distributorship arrangements limit what can be offered to the
customer and, therefore, any ‘advice’ that the customer is getting from the bank in respect to the
purchase of an insurance product is by no means impartial.

Issues to be tackled:

Given the roles and diverse skills brought by the banks and insurers to a bancassurance tie up, it is
expected that road to a successful alliance would not be easy task. Some of the issues that are to be
addressed are:

a) The tie-ups need to develop innovative products and services rather than depending on the
traditional methods. The kinds of products that the banks would be allowed to sell are another
major issue. For instance, a complex unit-linked life insurance product is better sold through
brokers or agents, while a standard term product or simple product like auto insurance, home
loan and accident insurance cover can be handled by bank branches.

b) There needs to be clarity on the operational activities of the bancassurance i.e., who will do the
branding, will the insurance company prefer to place a person at the bank branch, or will the
bank branch train and put up one of its own people with additional remuneration.

c) Even though the banks are in personal contact with their clients, a high degree of pro-active
marketing and skill is required to sell the insurance product. This can be addressed through
proper training.

d) There are hazards of direct competition to conventional banking products. Bank personnel may
become resistant to sell insurance product since they might think they would become redundant
if saving were diverted from bank to their insurance subsidiaries.