Insurance Services

Dr. Rintu Anthony

Rajagiri Centre for Business Studies
Risk
• Risk is a potential variation in outcomes (usually treated as negative or leading to loss)
• However risk and uncertainty are different (American Academy of Actuaries)
• Risk – Probability of outcomes are known with some level of accuracy
• Uncertainty - Probability of outcomes are not known

• Loss exposure
• Is any situation or circumstance in which a loss is possible, regardless of whether the loss occurs
• Objective Risk vs Subjective risk
• Objective risk - the relative variation of actual loss from expected loss.
• Can be statistically calculated by some measure of dispersion, such as the standard deviation
• Subjective Risk - uncertainty based on a person’s mental condition or state of mind.
• High subjective risk often results in conservative and prudent behavior, whereas low subjective risk may result
in less conservative behavior
Risk is present everywhere
Chance of loss
• Chance of loss - Probability that an event will occur
• Probability has both objective and subjective aspects
• Objective probability refers to the long-run relative frequency of an event based on the
assumptions of an infinite number of observations and of no change in the underlying
conditions: computing probability using priori probability and inductive reasoning
(Inductive reasoning is the act of making generalized conclusions based on specific
scenarios)
• Subjective probability is the individual’s personal estimate of the chance of loss
• For example, assume that a slot machine in a casino requires a display of three
lemons to win. The person playing the machine may perceive the probability of
winning to be quite high. But if there are 10 symbols on each reel and only one is
a lemon, the objective probability of hitting the jackpot with three lemons is
Calculation of risk
• Expected Value
• Expected value of distribution provides the information about where the
outcome tends to occur
• E(Ri)=
• Variance & Standard Deviation
• Gives the likelihood and magnitude by which a particular outcome from the
distribution will differ from the expected value
• Variance (s2) = S pi (Ri – E(R))2
• Sd is the square root of variance
The following table lists the probability and possible
damages due to fire. Compute the expected value and SD
Possible Outcomes from damages Probability
$0 0.5
$500 0.3
$1000 0.1
$5000 0.06
$10000 0.04
Classification of risk
• Pure risk vs Speculative risk
• Pure risk is defined as a situation in which there are only the
possibilities of loss or no loss. Speculative risk is defined as a situation
in which either profit or loss is possible
• Pure risk: premature death, job-related accidents, catastrophic
medical expenses, Speculative risk: buying shares and betting
• Pure risk is utilized by private insurers
• Law of large numbers can be applied more easily to pure risks
Peril and Hazard
• Peril is defined as the cause of loss. If your house burns because of a fire, the peril, or
cause of loss, is the fire.
• Hazard is a condition that creates or increases the frequency or severity of a loss. There are
four major types of hazards:
• Physical hazard : a physical condition that increases the frequency or severity of a loss.
• Examples of physical hazards include icy roads that increase the chance of an auto accident
• Moral hazard: is dishonesty or character defects in an individual that increase the
frequency or severity of loss
• Attitudinal hazard (moral hazard): carelessness or indifference to a loss, which increases
the frequency or severity of a loss. Examples of attitudinal hazards include leaving car keys
in an unlocked car, which increases the chance of theft
• Legal hazard: Examples include adverse jury verdicts or large damage awards in liability
lawsuits
Diversifiable Risk and Non-diversifiable Risk
• Diversifiable risk is a risk that affects only individuals or small groups
and not the entire economy. It is a risk that can be reduced or
eliminated by diversification.
• Non-diversifiable risk is a risk that affects the entire economy or large
numbers of persons or groups within the economy.
• Social insurance and government insurance programs, as well as
government guarantees or subsidies, may be necessary to insure
certain non-diversifiable risks
Other Risks
• Enterprise risk is a term that encompasses all major risks faced by a
business firm. Such risks include pure risk, speculative risk, strategic
risk, operational risk, and financial risk.
• Systemic risk is the risk of collapse of an entire system or entire
market due to the failure of a single entity or group of entities that
can result in the breakdown of the entire financial system.
Personal Risk
• Personal risks are risks that directly affect an individual or family.
They involve the possibility of the loss or reduction of earned income,
extra expenses, and the depletion of financial assets.
• Premature death
• Inadequate retirement income
• Poor health
• Unemployment
Commercial risks
• Property risks
• Direct risk vs indirect risk
• Liability risks
• Loss of business income,
• Cybersecurity and identity theft
• Other risks (HR exposure, Foreign loss exposure, loss of business
income)
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
• Evolution of Risk Management as a core area
• Large organizations – full-time risk manager
• Growing acceptance and popularity of professional bodies like GARP
Objectives of Risk Management
• Pre-loss objectives
• Preparation of potential losses
• Reduction of anxiety
• Prepares the organization to meet legal obligations
• Post-loss objectives
• Survival
• Enabling continuity of operation
• Stability of earnings
• Continued growth
• Social responsibility to minimize the effect of loss on society and individuals
• https://www.moneycontrol.com/news/business/karuvannur-co-operative-bank-kerala-scam-administrative-panel-dissolved-borrower-suicide-7210921.html
• https://www.thenewsminute.com/article/how-multi-crore-cooperative-bank-scam-kerala-has-shattered-lives-depositors-166666
• (https://www.livemint.com/news/india/thrissur-bank-fraud-case-ed-conducts-raid-at-karuvannur-service-co-op-bank-11660111799674.html
• https://www.thehindu.com/news/national/kerala/man-commits-suicide-after-receiving-revenue-recovery-notice-from-karuvannur-service-cooperative-bank/article35461011.ece
Techniques for managing risk
• Risk control refers to techniques that reduce the frequency or severity
of losses.
• Risk financing refers to techniques that provide for the funding of
losses.
Risk Control
• Avoidance
• Loss prevention
• Loss reduction
– Duplication
– Separation
– Diversification
• Avoidance – loss exposure is abandoned. Eg: A Pharmaceutical
company finds dangerous side effects of a drug in its catalog and
eventually removes the drug from the market to avoid possible legal
liability.
• Prevention –Reduce the frequency of a particular loss. Strict security
measures at airports and aboard commercial flights can reduce acts
of terrorism; boiler explosions can be prevented by periodic
inspections by safety engineers; occupational accidents can be
reduced by the elimination of unsafe working conditions and by
strong enforcement of safety rules
• Loss Reduction: Reduce the severity of a particular loss. Strict loss
prevention efforts can reduce the severity of losses; for example, a
department store can install a sprinkler system so that a fire will be
promptly extinguished
• Duplication: Having back-ups or copies of Important documents or property
available in case of a loss
• Separation: The assets exposed to loss are separated or divided to minimize
the financial loss from a single event.
• Diversification: reduces the chance of loss by spreading the loss exposure
across different parties
Risk Financing
• Retention means that an individual or a business firm retains part of
all of the losses that can result from a given risk. Risk-retention can be
active or passive. It is used when no other treatment is available
• No other treatment is available
• Worst possible loss is not serious
• Losses are fairly predictable
• Retention level can be 5% of company earnings before taxes or a percent of
firm’s net working capital as decided by the firm
• Payments can be done through current net income, unfunded reserve,
funded reserve, credit line
• Active retention vs passive retention
Retention
• Active Retention: an individual is consciously aware of the risk and
deliberately plans to retain all or part of it. For example, a motorist
may wish to retain the risk of a small collision loss by purchasing an
auto insurance policy with a $500 or higher deductible. (an insurance
deductible is an amount you pay before your insurer kicks in with its
share of an insured loss)
• Passive retention: Certain risks may be unknowingly retained because
of ignorance, indifference, laziness, or failure to identify an important
risk. For example, many workers with earned incomes are not insured
against the risk of total and permanent disability.
• Transfers
• Non-insurance transfer
• Insurance
Non-insurance transfers
• Transfer of Risk by Contracts: risk of a defective television or stereo
set can be transferred to the retailer by purchasing a service contract,
warranty, rental agreement.
• Hedging Price Risks: is a technique for transferring the risk of
unfavorable price fluctuations to a speculator by purchasing and
selling futures contracts
• Incorporation of a Business Firm: If a firm incorporates, personal
assets cannot be attached by creditors for payment of the firm’s debts
 Insurance
• Pooling of losses: the spreading of losses incurred by the few over the entire
group,
• law of large numbers: greater the number of exposures, the more closely
will the actual results approach the probable results that are expected from
an infinite number of exposures
• Payment of Fortuitous Losses: one that is unforeseen and unexpected by the
insured and occurs as a result of chance.
• Risk Transfer: 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.
• Indemnification: insured is restored to his or her approximate financial
position
Self Insurance (Self funding)
• A kind of funded reserve
• A special form of planned retention by which part or all of a given
loss exposure is retained by the firm.
• Group health, dental, vision, and prescription drug benefits to
employees.
• Can save money and control healthcare costs.
• Self-insurance plans can protected by stop-loss limit that caps the
employers out of pocket costs
Advantages of Self Insurance
• The self-funded plan has a lower fixed cost. Most expenses are variable based on the actual
claims.
• The self-funded employer may use the independent, managed- care measures, such as
preferred provider organizations, pre-certification, and utilization review, that save the most
money
• Any leftover funds in the claim account may be reconciled against future contributions.
• Interest earned on the claim account is considered income.
• Benefit plan administration through a professional third-party administrator is reasonably and
competitively priced. Only slightly more involvement by the employer is required, such as
verifying eligibility, printing employee communication materials, and distributing claim checks.
• Self-funding with stop-loss coverage simplifies budgeting
• Administrative services such as claims handling are simpler, faster, and performed on a more
personal and professional basis. Bureaucratic red tape is eliminated.
Steps in Risk Management
Identify the loss exposure
• Property loss exposures
• Liability loss exposures
• Business income loss exposures
• Human resources loss exposures
• Crime loss exposures
• Employee benefit loss exposures
• Foreign loss exposures
• Intangible property loss exposures
• Failure to comply with government laws and
• regulations
Methods of Exposure Identification
• May involve risk manager, producer, risk inspectors and others. Teamwork
produces the best results.
• Both risk managers and insurance personnel may seek help from outside
sources (Fire Department, Police, Lawyers, Consultants).
• Commonly used methods of exposure identification:
• S
• F
• F
• I

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Surveys
• Checklists, survey forms and questionnaires are used to systematically
search for exposures to loss.
• Checklist describes subjects of insurance, highlights the perils and lists
the types of insurance policies appropriate for the exposures
identified. Elicits underwriting information
• Contents schedule is a detailed survey form devoted to contents and
legal liabilities flowing from such property
• Software programs more sophisticated programs help to determine
likelihood of loss and probably location.
• Related survey forms – form used should be appropriate for the type
of operation. Information collected must be relevant.

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Flow Charts
• Helps to identify exposures to loss.
• Maps the sequence of business activity graphically
• May be simple or complex.
• Reveals bottlenecks in production.

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Flow Charts Moonshine

Consumption Furniture Polish Rust Remover

Packaging Bottling

Shipping

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Financial Statements
• Financial statements help to identify loss exposures.
• Balance sheet will show major categories of assets.
• Must not be used to establish the anticipated cost of loss or insurable
value.
• Income statement provides information about other activities.
• The clues found in financial statements must be probed to determine the
full extent of loss exposures.

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Inspections
• No substitute for inspections – first hand information
• Cost-conscious decisions must be made in every situation. Can be
expensive especially if outsourcing or locations around the world.
• Reserve for perceived greatest risks
• Joint inspections can improve relationships. Experience is gained through
observation and studying different business operations.
• Everyone benefits by having standards for risks to reduce the possibility of
insurance losses.

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Analysis of Loss Exposures
• Once exposures are identified, predictions are made on the likelihood and
probable seriousness of potential losses.
• Each loss exposure is analyzed considering the following:
• Likelihood of the loss occurring (loss frequency);
• Seriousness of the loss (loss severity);
• Financial effect of all losses in any given period of time (frequency
times severity);
• Reliability of the predictions of frequency and severity.

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Statistical Probability
• Statistics are used to evaluated risk and make predictions using
sophisticated mathematical models (actuaries)
• Predictions based on statistics are relevant only when the statistical base
has sufficient numbers of exposures and losses.
• Operation of Law of Large Numbers – credibility and true underlying
probabilities improve as the statistical base grows.
• If an event cannot occur it has a probability of %, if it is certain to occur
the probability is %.

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Statistical Probability
• For the Law of Large numbers to work each exposure to loss must exist
independently from the others (unlikely two or more units will be affected
by a single occurrence).
• The exposures must also be similar and share the same major
characteristics.
• Predict with as much certainty as possible what the probabilities are of
future losses.
• Predictions must consider changes.
• Calculations based on the past can reliably predict the probabilities of
future events only if everything else remains unchanged.

www.en.Wikipedia.org

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Statistical Probability
• It is possible to calculate average severity of loss for a given period and the
probabilities for specific ranges of possibilities.
• Catastrophic occurrences are difficult to predict simply because they
happen so infrequently. Knowing the potential cost of losses helps when
considering the financial impact these losses could have.
• This aspect is a key factor in determining the risk financing method to
be used.
• Most risk management specialists believe that predictable high frequency,
low severity loss exposures should be retained. “Cost of doing business”
• Noninsurance techniques and deductibles can help free up premium
dollars.

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Sources of Information
• Risk analysis questionnaires and checklists
• Physical inspection
• Flowcharts.
• Financial statements
• Historical loss data.
Measure and analyze loss exposure
• Estimation of the frequency and severity of loss.
• Loss frequency refers to the probable number of losses that may
occur during some given time period.
• Loss severity refers to the probable size of the losses that may occur.
• The maximum possible loss is the worst loss that could happen to the
firm during its lifetime.
• The probable maximum loss is the worst loss that is likely to happen.
The table represents accidents and medical payments related to
the accidents in2002 for two restaurants – Calculate the frequency
and severity
The table represents accidents and medical payments
related to the accidents in2002 for two restaurants -
Selection of appropriate technique
Implement the risk management program
• Draft the risk management policy statement & Risk management
manual
• Periodic Review and Evaluation
Personal risk management
• Personal risk management refers to the identification and analysis of
pure risks faced by an individual or family, and to the selection and
implementation of the most appropriate technique(s) for treating such
risks.
Steps
• Identify loss exposures
• Measure and analyse the loss exposures
• Select appropriate techniques for treating the loss exposures:
Avoidance, control, retention, insurance, and non insurance transfers
• Implement and review the risk management program periodically.