Risk management and

Insurance

Professor M. Muzahidul Islam

Dept. of Banking and Insurance
University of Dhaka
 THE NATURE, ELIMINATION AND
SPREADING OF RISK,

Risk and uncertainty are incidental to life:
some men live dangerously, others
exercise extreme caution.

Nevertheless, the fortuitous element cannot
be avoided, although its effects may be
either good or bad.

Some fortuitous events are advantageous
and some not.
For example, a farmer may make a
considerable profit from a single harvest or
he may sustain a heavy loss. He constantly
runs the risk of the fortuitous in the shape
of weather and price fluctuations beyond
his control.
 THE NATURE, ELIMINATION AND
SPREADING OF RISK,

Although hard work, initiative and ingenuity
play an important part in the success of a
business venture, the fortuitous can be
equally relevant to the making of a profit or
the sustaining of a loss.

The disastrous consequences of sustaining
a heavy loss are, however, so great that the
average business man, given the
opportunity, would forgo the possibility of
making a large fortuitous profit in a single
year if he could also rule out the fear of
sustaining a heavy fortuitous loss.
 RISK, UNCERTAINTY, CHANCE AND
PROBABILITY
 

While there is no general agreement on
terminology the following terms are frequently
used:
Chance: refers to the desirable probability of the
outcome of a future fortuitous event. Often it is
used qualitatively, e.g. One speaks of the chance
of passing an examination as being high (or low).

Risk: Risk is the probable, undesirable outcome of a

Future fortuitous event. This term in used for
uncertainties where the doubt as to outcome can
be measured either mathematically or statistically.
More specifically it may be defined as objective
doubt as to the outcome of a future event, being
measured by the degree of variation in actual from
expected results.
 RISK, UNCERTAINTY, CHANCE AND
PROBABILITY
 

Probabillity: A neutral mathematical term, used
quantitatively and usually expressed by the symbol
P and measured in a range from 0 to 1. 0
represents absolute impossibility, and 1 absolute
certainty. Thus, the probability of a coin when
tossed coming down heads is 1 in 2. so P = .5; the
probability of throwing a 4 on a dice is I in 6 ‑‑the
dice having six sides – so p = .166..
Uncertainty: Refers to subjective doubt as to the
outcome of a future event. ‘It may rain’, for
example is an expression of the subjective doubt
about the rainfall.

As insurance contracts cover the consequences of
undesired events, we refer to covering a risk.
Often, however, the Word is used loosely to refer
to the subject matter insured or the peril.

 
 MATHEMATICAL VALUE OF A RISK
 
As we know, risk is a kind of uncertainty relating to
a potential loss that is measurable either
mathematically or statistically. In other words,
every insurable risk should be measurable, the
basic premium equation being:
 
Premium = (P X C) + E where,
P = probability of a loss occurring c = average size of
loss that occurs E = loading for expenses and
profit
 
The first term of the equation (p x c) gives the loss
expectancy of pure premium. The probability of
loss p is estimated by observing the number of
times the event occurs during a given time period
and dividing this figure by the number of units
exposed to loss.
MATHEMATICAL VALUE OF A RISK
 
In the case of life assurance such information
is tabulated in mortality tables, but for most
fire, accident and marine risks often it is
difficult to obtain a sufficiently large number of
similar cases in similar conditions to make a
reasonable basis for arriving at a theoretical
value of the risk which will apply generally.
Furthermore, in life assurance the claim is
always total which simplifies the calculation.
Nevertheless, for the purpose of insurance it
is as a rule assumed that there is a
theoretical probability which can be
expressed mathematically for the events
which may cause loss, and an endeavor is
made to arrive at this figure.
Functions of Risk
Management
 FUNCTIONS OF RISK MANAGEMENT
1. The first step to manage the risk is to find out
the potential sources of risk. For example,

i)  To get information about the causes of a

particular types of loss we used survey.
i)  To get information about amount of loss we
used both survey and analysis of financial
statement.

2. Evaluating the impact on the individual or

organization if a loss should occur.
That is to see, for example, what maximum or
minimum of loss would result if the loss event
actually takes place. If the probable loss is
minimum and negligible then it is better not to
take any policy
 FUNCTIONS OF RISK MANAGEMENT

3. Exploring the alternative courses of action to

respond the risk:

There might be several ways to deal with the risk.

Easy vs. difficult, costlier vs. cheaper alternative
course of actions should be distinguished.

4. Selecting the most effective technique or

techniques to deal with the risk.

Once the different alternative courses of actions

are identified and listed, now is the time for
selecting the best course of action
 OBJECTIVES OF RISK MGT
1. Eliminating or reducing the factors that may
cause a loss to a person or organization
2. Minimizing the loss when it occurs. This can be
done in four ways;

a)detecting the adverse occurrence when it
occurs and then attempting to eliminate it.
Example: building a structure of what were
believed to be fireproof materials
b)minimizing the loss after the advance
occurrence has happened.
Example:
i)filling sprinklers which will restrict the fire
ii)salvage effort (fire brigade etc.) after happening
of the fire.
 OBJECTIVES OF RISK MGT

3. To avoid relatively risky ventures by

accepting less risky ventures.
4. To have proper assessment of different types
risk so that action could be there accordingly.
5. To minimize the burden of risk either by
distribution or by transferring it to insurance
company.
6. To indemnify the sufferer after happening of a
loss.
7. To prevent any body from getting more than
his actual loss.
 
 OBJECTIVES OF RISK MGT
1. Eliminating or reducing the factors that may
cause a loss to a person or organization
2. Minimizing the loss when it occurs. This can be
done in four ways;

a)detecting the adverse occurrence when it
occurs and then attempting to eliminate it.
Example: building a structure of what were
believed to be fireproof materials

b)minimizing the loss after the advance
occurrence has happened.

Example:

i)filling sprinklers which will restrict the fire

ii)salvage effort (fire brigade etc.) after happening
of the fire.
 FUNCTIONS OF RISK MANAGEMENT

3. Exploring the alternative courses of action to

respond the risk:

There might be several ways to deal with the risk.

Easy vs. difficult, costlier vs. cheaper alternative
course of actions should be distinguished.

4. Selecting the most effective technique or

techniques to deal with the risk.

Once the different alternative courses of actions

are identified and listed, now is the time for
selecting the best course of action
CLASSIFICATION OF RISK
Pure Risk

A Pure risk is one where there are only two

possibilities: either loss or no loss.
The risk of fire totally damaging a car is an
example of pure risk. one possibility is that
the car will burn down, in that case the owner
of the car has to suffer a loss, the other
possibility is that the car will not burn down, in
that case the owner of the car neither suffer
loss nor gain. There is no third possibility of
making profit.
Speculative risk,
Speculative risk, on the other hand, is taken with
the possibility of gain or loss. For example, if a
trader buys a car at tk 5 lac with a hope to resell
it at tk. 6 lac he is taking a speculative risk. Now
there are three possibilities. He may win or he
may loss even he may be at a no profit no loss
position.. If he resale the car at a price greater
than tk. 5 lac he gains. But if he get a price lower
than tk. 5 lac he loses. Again, if he sell the
exactly at 5 lacs then he neither suffer loss nor
gains
 Pre requisites of an Insurable Risk

From the viewpoint of an Insurer

Objects to be sufficient in number and homogenous in quality.

Loss to be accidental and Unintentional

Loss should be determinable and measurable

Loss should not be subject to catastrophic hazards.

The risk must be a pure risk

The risk should be particular in nature

 

Requisites From the viewpoint of the insured

Loss should be unbearable on the part of the insured

Loss should not be too remote

The insured should be well aware of the potential losses

The cost of insurance must not be more than the potential loss
 Pre requisites of an Insurable Risk

From the viewpoint of an Insured

Loss should be unbearable on the part of the
insured

Loss should not be too remote

The insured should be well aware of the
potential losses

The cost of insurance must not be more than
the potential loss
Techniques of Managing Risk
 TECHNIQUES OF RISK MANAGEMENT
1. Avoidance of Risk:
This involves either avoiding risky ventures or
accepting less risky alternatives. For example,
one can avoid the risk involved with a car
simply by not buying a car. Rather he can rent
a car or he can use public vehicle. In case of
business it means selecting those projects or
activities where the amount of risk is minimum.

 
TECHNIQUES OF RISK MANAGEMENT
2. Assumption of Risk:
This refers to the individual or business
firm assuming the risk itself and bearing
the probable risk. This is the most
commonly practiced response to risk. This
is simply retaining risk oneself and doing
nothing whatsoever about the risk.
 TECHNIQUES OF RISK MANAGEMENT
Following are the situations when
assumption of risk is usual:

Because of Ignorance:
 Because of capacity to retain the risk

Because of risk being too remote
 Because the cost of insurance exceeds
the cost of potential loss.
 TECHNIQUES OF RISK MANAGEMENT
3. Prevention of Risk:
Some risk can be eliminated while some
risk could only be reduced to some extent.
For example, a fire proof material can
eliminate the risk of fire While stopping
smoking can only reduce the risk of lung
cancer, but does not eliminate it entirely.
 TECHNIQUES OF RISK MANAGEMENT
prevention of risk deals with:

Eliminating or reducing the factors that
may cause a loss to a person or
organisation. While dealing with risk of
fire, for example, building a structure of
what were believed to be fireproof
materials.
 Minimizing the loss when it occurs when
prevention methods are not fully effective.
TECHNIQUES OF RISK MANAGEMENT
4. Distribution of Risk:
This involves spreading of risk by means
of group sharing. For example a Sole
propritorship could be transformed in to a
partnership or a company to distribute risk
from one to many, in this case to the
partners or the shareholders.
TECHNIQUES OF RISK MANAGEMENT
5. Neutralization :
This involves offsetting loss from the
occurrence of a risk by a compensating
gain from another activity.
TECHNIQUES OF RISK MANAGEMENT
6. Diversification:
Risk can also be minimized by
diversification. For example, an investor,
instead of concentrating on a particular
industry or sector can select a number of
potential sector, or industry for investment.
 TECHNIQUES OF RISK MANAGEMENT
7. Arbitraging:
One who profits from the difference of price
when the same of the extremely similar
security, currency or commodity is traded on
two or more markets. The arbitrager profits by
simultaneously purchasing and selling these
securities to take advantage of pricing
differentials (spreads) created by market
conditions.

 
TECHNIQUES OF RISK MANAGEMENT
8. Hedging : Hedging is an instrument that
permits the individual or firm to ensure
against asset price fluctuation. These
instruments include Options and Futures.
Options are financial contracts that grant the
holder the right to buy and/or sell specified
securities or goods in specific amount and at
specific price for a specific period of time.
Futures are financial contracts under which
a person
 TECHNIQUES OF RISK MANAGEMENT
or firm agrees to provide a specific quantity
of a security or a commodity at a specific
price at some future time. By using options
and futures contracts, a person can smooth
out the risk of price fluctuation for purchase
and sale of some other financial instrument,
such as an exchange of another nation’s
currency in the foreign exchange market

 
TECHNIQUES OF RISK MANAGEMENT
Insurance - Transfer and pooling of Risk:
This is simply to transfer of risk by the
insured to the insurer and by accepting the
risk of many the insurer himself assumes a
risk. The insurer dares to take this risk
because he is the doctor of risk, he knows
better how to deal with risk. He knows the
magic of the ‘Law of Large number’ and he
got the skill applying risk reduction
techniques.
Functions of Insurance
 1. Equitable Distribution of Loss
The main function of insurance is the equitable distribution of
losses of one or a few over many. In insurance each of the
policyholders contribute a premium to the common premium
fund. The amount of premium depends on the amount and
nature of risk to be covered. The insurer assesses the
premium. If any of the insured suffer any loss then he is to
be indemnified from the accumulated premium fund. In other
words all the policyholders are contributing as per their
ability to compensate their ill-fated fellow policyholders. The
insurer ensure the equitable distribution of losses by
applying the Rating Principle that determines lower rate of
premium for super standard risk and comparatively higher
rate of premium for sub-standard risks.
1. Equitable Distribution of Loss
premium fund. In other words all the
policyholders are contributing as per their
ability to compensate their ill-fated fellow
policyholders. The insurer ensure the
equitable distribution of losses by applying
the Rating Principle that determines lower
rate of premium for super standard risk
and comparatively higher rate of premium
for sub-standard risks.
 2. Rating
Determination of premium rate is the second
important function of insurance. The rate of
premium for two different persons and subject
matter is not supposed to be the same. The
rate of premium depends on specific risk
pattern, amount of expenditure and expected
profit of the insurer. To express mathematically,
 Premium = (P X c) + E where p = probability of

a loss occurring c = average size of loss which

occurs E = loading for expenses and profit
 3. Reduction of Losses:
Determination of premium rate is the second
important function of insurance. The rate of
premium for two different persons and subject
matter is not supposed to be the same. The
rate of premium depends on specific risk
pattern, amount of expenditure and expected
profit of the insurer. To express mathematically,
 Premium = (P X c) + E where p = probability of

a loss occurring c = average size of loss which

occurs E = loading for expenses and profit
 3. Reduction of Losses:
a. By Rating Principle
b. By Inspection Services
c. By Research and Publicity
 4. Assistance to Business Enterprise
a. No large-scale trade or industry could
possibly function without the aid of
insurance. Without insurance ,
businessmen would have to set aside some
of their capital resources against the
possibility that one or another of these
losses might happen. Insurance, then, not
only safeguard the capital but also free it for
further investment.
5. Invisible Export
Insurance represents a valuable
contribution to the so called invisible
export of the country. There are various
invisible items that affect the balance of
payment of a country such as shipping,
banking and insurance services. Foreign
currency could be earned by providing the
service of insurance in two ways.
5. Invisible Export
Firstly, by opening branch of insurance
company in foreign countries and earning
profit by providing direct service to them.
Secondly, revenue in the form of foreign
currency could be earned by providing
reinsurance facilities to foreign insurance
companies.
6. Investment
Insurance by nature of their business are
constantly receiving sums of money in the
form of premiums and part of this money
have to be paid out as in claim over a
period of time. Insurers are therefore the
custodian of vast sums that they receive,
which they naturally invest in the capital
market to earn interest or dividends.
 6. Investment
In our countries most of insurance
companies invest a significant amount in
real estate business. The investments of
premium fund must be so arranged,
however, that when claims occur the
money will be ready to pay the claims both
promptly and fully.

 
Classification of Insurance
 Classification of Insurance
Insurance is classified in two broad categories:
a. Life Insuranceident Insurance
b. General Insurance 
General Insurance further classified as
a. Marine Insurance
b. Fire Insurance
c. Accident Insurance
d. Liability Insurance
e. Aviation Insurance
f. Engineering Insurance
g. Social Insurance
 Classification of Life Insurance
1. Ordinary Life assurance
2. Industrial life assurance
Classification of Ordinary life assurance
a. Whole Life Policy
b. Term Policy
c. Endowment Policy
d. Personal accident and sickness policy
e. Group life policy
 Classification of Marine Insurance
a. A. Hull Insurance
b. Cargo Insurance
c. Freight Insurance

d. Classification of Fire Insurance

e. Material Loss Insurance
f. Consequential Loss Insurance
 Classification of Accident Insurance
a. Personal Accident insurance
b. Property Accident Insurance

c. Classification of Property accident Insurance

d. Motor Insurance
e. Theft Insurance
f. Burglary Insurance
 Principles of Insurance
a. Principles of Indemnity
b. Principle of Utmost Good faith
c. Principle of Insurable Interest
d. Principle of Subrogation
e. Principle of Contribution
f. Principle of Proximate Cause