INSURANC AND RISK MANAGEMENT- THIS MODULE INCLUDE THE INTRODUCTION TO INSURANCE AND RISK MANAGEMENT
- 1. 1. Introduction to Risk Management DR.RITESH AMARSELA MBA SEM 3 MODULE 1
- 2. Risk Risk is a condition in which there is a possibility of an adverse deviation from a desired outcome that is expected or hoped for. • it is a combination of circumstances in the external environment. • In this combination of circumstances, there is a possibility of loss. • When we say that an event is possible, we mean that it has a probability between zero and one; it is neither impossible nor definite. • Note also that there is no requirement that the possibility be measurable—only that it must exist. • We may or may not be able to measure the degree of risk
- 5. Risk Vs. Peril and Hazard • A peril is a cause of a loss. • Peril of fire, or windstorm, or hail, or theft. • Each of these is the cause of the loss that occurs. • A hazard, on the other hand, is a condition that may create or increase the chance of a loss arising from a given peril. • It is possible for something to be both a peril and a hazard. • Sickness is a peril causing economic loss, but it is also a hazard that increases the chance of loss from the peril of premature death. • Hazards are normally classified into three categories:
- 7. Physical hazards • Physical properties that increase the chance of loss from the various perils. • Examples of physical hazards that increase the possibility of loss from the peril of fire are the type of construction, the location of the property, and the occupancy of the building. Moral hazard • Increase in the probability of loss that results from dishonest tendencies in the character of the insured person. • Dishonest tendencies on the part of an insured that may induce that person to attempt to defraud the insurance company. • A dishonest person, in the hope of collecting from the insurance company, may intentionally cause a loss or may exaggerate the amount of a loss in an attempt to collect more than the amount to which he or she is entitled. • Fraud is a significant problem for insurance companies and increases the cost of insurance.
- 8. Morale hazard • Acts to increase losses where insurance exists, not necessarily because of dishonesty but because of a different attitude toward losses that will be paid by insurance. • Careless attitude toward preventing losses or may have a different attitude toward the cost of restoring damage. • Reflected in the attitude of persons who are not insured. • Physicians provide more expensive levels of care when costs are covered by insurance is a part of the morale hazard. • Juries make larger awards when the loss is covered by insurance—the so-called deep-pocket syndrome—is another example of morale hazard. • Increase both, the frequency and severity of losses when such losses are covered by insurance.
- 9. TYPE OF RISK Reputational risk • the potential that negative publicity will cause a loss Strategic risk • the risk of failing to successfully implement the firm’s strategies Compliance risk • The risk of failing to comply with laws and regulations.
- 10. Risk Management - Definition Risk management is a scientific approach to dealing with risks by anticipating possible losses and designing and implementing procedures that minimize the occurrence of loss or the financial impact of the losses that do occur.
- 11. Tools for Risk Management Risk Control Risk Avoidance Risk Reduction Risk Financing Risk Retention Risk Transfer
- 12. Risk Control • Consists of those techniques that are designed to minimize, at the least possible costs, those risks to which the organization is exposed. • Risk control methods include risk avoidance and the various approaches at reducing risk through loss prevention and control efforts. • Methods – Risk Avoidance and Risk Reduction
- 13. Risk Control – Risk Avoidance • Technically, avoidance takes place when decisions are made that prevent a risk from even coming into existence. • Risks are avoided when the organization refuses to accept the risk, even for an instant • Eg. not to manufacture a particularly dangerous product because of the inherent risk. • Should be used in instances where exposure has catastrophic potential and risk cannot be reduced/transferred. • Generally, these conditions will exist in the case of risks for which both the frequency and the severity are high and neither can be reduced.
- 14. Risk Control – Risk Reduction • All techniques that are designed to reduce the likelihood of loss, or the potential severity of those losses that do occur. • loss prevention - preventing losses from occurring. • loss control - minimizing the severity of loss if it should occur.
- 15. Loss Prevention and Loss Control • Emphasis of loss prevention is on preventing the occurrence of loss; that is, on controlling the frequency. • Prohibition against smoking in areas where flammables are present is a loss prevention measure. • Measures to decrease number of employee injuries by protective devices around machinery are aimed at reducing the frequency of loss. • Other techniques focus on lessening severity of losses that actually do occur, such as the installation of sprinkler systems. These are loss control measures. • Methods of controlling severity include segregation or dispersion of assets and salvage efforts. • Dispersion of assets will not reduce the number of fires or explosions that may occur, but it can limit the potential severity of the losses that do occur. • Salvage operations after a loss has occurred can minimize the resulting costs of the loss.
- 16. Loss Prevention and Loss Control • Another distinction is made between “engineering approach” to loss prevention and control, in which principal emphasis is on removal of hazards that may cause accidents, and “human behavior approach,” in which elimination of unsafe acts is stressed. • This distinction based on the focus of control measures and represents two schools of thought regarding the emphasis in loss prevention and control. • Human behavior approach is based on the view that since most accidents result from human failure, the most effective approach to loss prevention is to change people’s behavior. • The engineering approach, in contrast, emphasizes systems analysis and mechanical design, aimed at protecting people from careless acts that are viewed as perhaps inevitable. • National Safety Council ads on television and in print media urging drivers not to drink typify the human behavior approach. Air bags in automobiles, which are activated without human intervention, typify the engineering approach. • A final way of classifying risk reduction measures is by the timing of their application, which may be prior to the loss event, at the time of the event, or after the loss event. Safety inspections and drivers’ training classes illustrate measures that are designed to prevent the occurrence before losses occur. • Seat belts and air bags are designed to minimize the amount of damage at the time an accident occurs.
- 17. Risk Financing • In contrast with risk control, consists of those techniques that focus on arrangements designed to guarantee the availability of funds to meet those losses that do occur. • Fundamentally, takes the form of retention or transfer. • All risks that cannot be avoided or reduced must, by definition, be transferred or retained. • Frequently, transfer and retention are used in combination for a particular risk, with a portion of the risk retained and a part transferred.
- 18. Risk Financing – Risk Retention • Most common method of dealing with risk. Individuals, like organizations, face an almost unlimited number of risks; in most cases, nothing is done about them. • Conscious or unconscious (i.e., intentional or unintentional). • Risk retention is the “residual” or “default” risk management technique, any exposures that are not avoided, reduced, or transferred are retained. • When nothing is done about a particular exposure, the risk is retained. • Unintentional (unconscious) retention - when a risk is not recognized. The individual or organization unwittingly and unintentionally retains the risk of loss arising out of the exposure. • Also occurs when risk has been recognized but measures designed to deal with it are improperly implemented. • Always undesirable. • Risk retention may be voluntary or involuntary. • Voluntary retention results from a decision to retain risk rather than to avoid or transfer it. • Involuntary retention occurs when it is not possible to avoid, reduce, or transfer the exposure to an insurance company.
- 19. Risk Financing – Risk Transfer • The purchase of insurance contracts is, of course, a primary approach to risk transfer. • In consideration of a specific payment (the premium) by one party, the second party contracts to indemnify the first party up to a certain limit for the specified loss that may or may not occur. • Another example is the process of hedging, in which an individual guards against the risk of price changes in one asset by buying or selling another asset whose price changes in an offsetting direction. • For example, futures markets have been created to allow farmers to protect themselves against changes in the price of their crop between planting and harvesting. A farmer sells a futures contract, which is actually a promise to deliver at a fixed price in the future.
- 20. Risk Management Vs. Insurance Management 1. Scope • Risk management is broader than insurance management - insurable and uninsurable risks and the choice of the appropriate techniques for dealing with these risks. • Because risk management evolved from insurance management, the focus of some risk managers has been primarily with insurable risk. • Properly, the focus should include all pure risk, insurable and uninsurable. • Risk manager cannot ignore those pure risks that are not insurable. • Eg. shoplifting losses. Although a pure risk exposure, they are not generally insurable on an economical basis.
- 21. 2. Philosophy • The insurance manager views insurance as the accepted norm or standard approach to dealing with risk, and retention is regarded as an exception to this standard. • Insurance Manager Contemplates his/her insurance program and asks: Are there any risks that I should retain? • How much will I save in insurance costs if I retain them? • In viewing loss prevention measures, manager asks, How much will this measure reduce my insurance costs? • Eg. How long will it take for a new sprinkler system to pay for itself in reduced fire insurance premiums? • The risk manager, in contrast, views insurance as simply one of several approaches to dealing with pure risks. • Rather than asking, Which risks should I retain? the risk manager asks, Which risks must I insure?
- 22. 3. Emphasis. • The insurance management philosophy views insurance as the accepted norm, and retention or noninsurance must be justified by a premium reduction • that is, in some sense or another, “big enough.” • Under the risk management philosophy, it is insurance that must be justified. • Since the cost of insurance must generally exceed the average losses of those who are insured, the risk manager believes that insurance is a last resort and should be used only when necessary.
- 23. 4. Coverage • Risk management, then, is something more than insurance management. • It deals with both insurable and uninsurable risks, • But it is something less than general management, since it • does not deal (except incidentally) with business risk.
- 24. THE RISK MANAGEMENT PROCESS 1. Determination of Objectives 2. Identification of Risks 3. Risk Evaluation 4. Consider alt. + sel. of Risk treatment device 5. Implementation 6. Evaluation & Review
- 25. 1. Determination of Objectives • deciding precisely what it is that the organization would like its risk management program to do. • Despite its importance, determining the objectives of the program is the step in the risk management process that is most likely to be overlooked. • As a consequence, the risk management efforts of many firms are fragmented and inconsistent. • Many of the defects in risk management programs stem from an ambiguity regarding the objectives of the program. • Mehr and Hedges - risk mgt has variety of obj, - classify into 2 categories: pre-loss objectives and post-loss objectives
- 26. Sr. Post-Loss Objectives Pre-Loss Objectives 1. Survival Economy 2. Continuity of operations Reduction in anxiety 3. Earning stability Meeting externally imposed 4. Continued growth obligations 5. Social responsibility Social responsibility
- 27. Value Maximization Objectives • Ultimate goal of risk management is same as the ultimate goal of the other functions in a business—to maximize the value of the organization. • Value that is to be maximized is reflected in the market value of the org. common stock. • Risk mgt. decisions should be appraised against the std. of whether they contribute to value maximization. • Value maximization is the ultimate goal of the organization and is a reasonable standard for appraising corporate decisions in a consistent manner. • It is also a logical objective for the individual or family. • Value maximization objective is that it is relevant primarily to business sector. • For other organizations—nonprofit organizations and government bodies— not particularly relevant.
- 28. Primary Objective • The first objective is survival—to guarantee the continuing existence of the organization as an operating entity in the economy. • Not to contribute directly to the other goals of the organization—whatever they may be. • To guarantee that the attainment of these other goals will not be prevented by losses that might arise out of pure risks. • Not to minimize costs or to contribute to the profit of the organization. • Nor to comply with legal requirements or to meet some nebulous responsibility. • The main objective is to preserve the operating effectiveness of the organization. • The primary objective of risk management is to preserve the operating effectiveness of the organization, • To guarantee that the organization is not prevented from achieving its other objectives by the losses that might arise out of pure risk.
- 29. 2. Identifying Risk Exposures • Dig into the operations of the company and discover the risks to which the firm is exposed. • Most difficult step in the risk management process. • It is a continual process and because it is virtually impossible to know when it has been done completely. • Difficult to generalize about the risks that a given organization is likely to face because differences in operations and conditions give rise to differing risks. • Some relatively obvious, while many can be, and often are, overlooked. • To reduce the possibility of failure to discover important risks facing the firm, most risk managers use some systematic approach to the problem of risk identification
- 30. 3. Evaluating Risks • Evaluation implies some ranking in terms of importance, and ranking suggests measuring some aspect of the factors to be ranked. • In the case of loss exposures, two facets must be considered: 1. The possible severity of loss. 2. Possible frequency or probability of loss. • Evaluation involves measuring the potential size of the loss and the probability that the loss is likely to occur. • Critical risks include all exposures to loss in which the possible losses are of a magnitude that would result in bankruptcy. • Important risks include those exposures in which the possible losses would not result in bankruptcy but would require the firm to borrow in order to continue operations. • Unimportant risks include those exposures in which the possible losses could be met out of the existing assets or current income of the firm without imposing undue financial strain.
- 31. 4. Consideration of Alternatives & Selection of Risk Treatment Device • A problem in decision making; • Deciding which of the techniques available should be used in dealing with each risk. • The extent to which mgt. make these decisions on their own varies from org. to org. • Org. risk mgt. policy estb. the criteria to be applied in choice of techniques, outlining the rules within which they may operate. • If the policy is rigid and detailed, there is less latitude in the decision making done by the risk manager. • In deciding techniques available manager considers size, probability of the potential loss and resources available to meet loss if it should occur. • The benefits and costs in each approach are evaluated, • On the basis of info. available and guidance of corporate risk management policy, the decision is made
- 32. 5. Implementation of the Decision • The decision is made to retain a risk. • This may be accomplished with or without a reserve and with or without a fund. • If the plan is to include the accumulation of a fund, proper administrative procedure must be set up to implement the decision. • If loss prevention is selected to deal with a particular risk, the proper loss-prevention program must be designed and implemented. • The decision to transfer the risk through insurance must be followed by the selection of an insurer, negotiations, and placement of the insurance
- 33. 6. Evaluation and Review • Evaluation and review must be included in the program for two reasons. 1. the risk management process does not take place in a vacuum. • Things change; new risks arise and old risks disappear. • The techniques that were appropriate last year may not be the most advisable this year, and constant attention is required. 2. Mistakes are sometimes made. • Evaluation and review of the risk management program permits the risk manager to review decisions and discover mistakes, ideally before they become costly.