Risk Management – Insurance Law and Practice Important Questions
Write short notes on the following:
(i) Types of pure risk
(ii) Emergency risk management
Answer:
(i) Some types of pure risk pose a substantial threat to the Financial Security of both individuals and business firms. The major types of pure risk that are associated with great Financial and Economic insecurity include personal risks (risk of old age, risk of premature death; risk of unemployment; risk of poor health); property risks (Direct loss, indirect or consequential loss, natural disasters) and liability risks.
Answer:
(ii) Emergency risk management is a systematic process that produces a range of measures, Which contributes to the well being of communities and the environment. Disaster plans are in place in all emergency management areas throughout developed countries and were prepared using the hazard analysis process. The hazard analysis process concentrated on the causes, characteristics and affects of the hazard rather than the level of risk to a community.
The process sometimes overlooked three very important issues:
- Process Documentation,
- Planning,
- Stakeholder Consultation.
The ERM process provides a logical and systematic approach that will integrate combat and other agency-specific public safety programs (prevention, preparedness, response and recovery) at local district and state level.
The aim of the Emergency Risk Management process is:
To identify, analyze and evaluate risks with potential to require a significant and coordinated multi-agency response.
Question 2.
Write short notes on the following:
(iii) Personal risks (v) Emergency risk management
Answer:
(iii) Personal Risks
Personal Risks are those risks that directly affect an individual; they involve the possibility of the complete loss or reduction of earned income, extra expenses and the depletion of financial assets.
There are four major personal risks:
- Risk of old age.
- Risk of premature death.
- Risk of unemployment.
- Risk of poor health.
Question 3.
Write short notes on the following:
(iv) Risk management insurance.
Answer:
Risk management insurance:
Risk management can be defined as various alternatives concerning the management of pure risks. It is a discipline that provides for the systematic identification and analysis of loss exposures faced by the firm or organization, and for the best methods of handling these loss exposures in relation to the firm’s profitability. As a general rule, the risk manager is concerned only with the management of pure risks, not speculative risks. All pure risks are treated, including those that are uninsurable.
A successful risk management programme requires the cooperation of a large number of individuals and departments throughout the firm, and risk management decisions have a greater impact on the firm than insurance management decisions.
A firm or organization has several risk management objectives prior to the occurrence of a loss.
The most important of these includes the following:
- Economy;
- Reduction of anxiety; and
- Meeting externally imposed obligations.
Question 4.
Write a short note on ‘Risk Retention’, as a risk management strategy. Should an insurance company opt for reinsurance or retention?
Answer:
Risk-retention is one of the methods of handling risk. An individual or a business firm may retain all or part of a given risk. Risk-retention can be either active or passive.
Active Risk Retention: Active risk retention means that 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 small collision loss by purchasing an own damage insurance policy with a 22000 voluntary excess.
A homeowner may retain a small part of the risk of damage to the house by purchasing a Householders policy with substantial voluntary excess. A business firm may deliberately retain the risk of petty thefts by employees, shoplifting or the spoilage of perishable goods.
In these cases, the individual or business firm makes a conscious decision to retain part or all of a given risk. There are benefits to active retention if the funds remain untouched and avoidable in the event the need for them arises.
Passive Risk Retention: Risk can also be retained passively. Certain risks may be unknowingly retained because of ignorance, indifference or laziness. This is often dangerous if a risk that is retained has the potential for destroying a person financially. For example, many persons with earned incomes are not insured against the risk of long term disability under either an individual or group disability income plan.
In summary risk retention can be extremely useful technique for handling risk, especially in a modern corporate risk management program. Risk-retention, however, is appropriate primarily for high frequency, low severity risks where potential losses are relatively small. Except under unusual circumstances, an individual should not use the technique of risk retention to retain low frequency, high severity risks such as the risk of catastrophic losses like earthquake and floods.
Reinsurance is when an insurance company will guard themselves against the risk of loss. Reinsurance in simpler terms is the insurance that is taken out by an insurance company. Since insurance companies provide protection against the risk of loss, insurance is a very risky business, and it is important that an insurance company has its own protection in place to avoid bankruptcy.
Through a reinsurance scheme, an insurance company is able to bring together or ‘pool’ its insurance policies and then divide up the risk among a number of insurance providers so that in the event that a large loss occurs this will be divided up throughout a number of firms, thereby saving the insurance company from large losses. The Insurance Company should prefer reinsurance over risk retention.
Question 5.
Distinguish between the following:
‘Morale hazard’ and ‘moral hazard’,
Answer:
‘Morale hazard’ and ‘moral hazard’:
Morale hazard refers to insured who are simply careless about protecting their property because the property is insured against loss. Moral hazard is more serious since it involves unethical or immoral behaviour by the insured who seek their own financial gain at the expense of the insurers and other policyholders.
Question 6.
Differentiate between risk, peril and hazard.
Answer:
Risk is part of every human endeavour From the moment we get up in the morning, drive or take public transportation to get to school or to work until we get back into our beds (and perhaps even afterwards), we are exposed to risks of different degrees. Risk is the potential of loss (an undesirable outcome, however not necessarily so) resulting from a given action, activity and/or inaction.
The notion implies that a choice having an influence on the outcome sometimes exists (or existed). Potential losses themselves may also be called “risks”. Any human endeavour carries some risk, but some are much riskier than others.
A peril is an event or circumstance that causes or may potentially cause a loss and give rise to risk. Examples of perils include fire, flooding, hailstorms, tornado, hurricane, auto accidents or home accidents such as falling.
A hazard is an action, condition, circumstance or situation that makes a peril more likely to occur or a loss more likely to be suffered as the result of a peril. Examples of hazards include dangerous behaviours, such as skydiving or base jumping, that increase the likelihood of injury.
A risk is simply the possibility of a loss, but a peril is a cause of loss. A hazard is a condition that increases the possibility of loss. For instance, fire is a peril because it causes losses, while a fireplace is a hazard because it increases the probability of loss from fire.
Flood is the peril and the proximity of the house to the river is the hazard. The peril is the prime cause; it is what will give rise to the loss. Often it is beyond the control of anyone who may be involved. In this way we can say that storm, fire, theft, motor accident and explosion are all perils. Thus, if a house burns because of a fire, the peril, or cause of loss, is the fire. If a car is totally destroyed in an accident with another motorist, accident (collision) is the peril or cause of loss. Some common perils that result in the loss or destruction of properly include fire, cyclone, storm, landslide.
Question 7.
‘Risk management and ‘Insurance management’,
Answer:
Risk management can be defined as various alternatives concerning the management of pure risks. It is a discipline that provides for the systematic identification and analysis of loss exposures faced by the firm or organisation, and for the best methods of handling these loss exposures in relation to the firm’s profitability.
Difference Between Risk Management and Insurance Management:
Risk management should not be confused with insurance management. Risk management is a much broader concept and differs from insurance management in several respects. First, risk management places greater emphasis on the identification and analysis of pure loss exposures. Second, insurance is only one of several methods that can be used to meet a particular loss exposure; as you will see, the techniques for meeting losses, not just insurance.
Finally, a successful risk management programme requires the cooperation of a large number of individuals and departments throughout the firm, and risk management decisions have a greater impact on the firm than insurance management decisions. Insurance management affects a smaller number of persons.
Risk Management Process in an Organisation:
In order to attain the preceding goals and objectives, the risk manager must perform certain functions. There are four basic functions of a risk manager.
- Identifying potential losses;
- Evaluating potential losses;
- Selecting the appropriate technique or combination of techniques for handling losses; and
- Administering the programme
Identifying Potential Losses:
The first function of a risk manager is to identify all pure loss exposures. This involves a painstaking identification of all potential losses to the firm.
The risk manager normally tries to identify six types of potential losses.
- Property losses
- Business income losses
- Liability losses
- Death or disability of key persons
- Losses resulting from job-related injuries or disease; and
- Losses from fraud, criminal acts, and employee dishonesty.
Evaluating Potential Losses:
After the potential losses are identified, the next step is to evaluate and measure the impact of losses on the firm. This involves an estimation of the potential frequency and severity of loss. The risk manager must estimate the frequency and severity of loss for each type of loss exposure. The various loss exposures can then be ranked according to their relative importance.
Selecting the Appropriate Technique For Handling Loss:
After the frequency and severity of losses are estimated, the risk manager must then select the most appropriate technique, or combination of techniques, for handling each loss exposure.
They are as follows
- Avoidance
- Retention
- Non-insurance transfers
- Loss control; and
- Insurance.
Administering the Risk Management Program:
The fourth and final function of the risk manager is the administration of risk management program. Common activities of the risk managers included loss exposure identification and measurement, arrangement of insurance handling claims, design and installation of employee benefit plans, participation in loss control measures, safety, group insurance, and self-insurance administration. A risk management policy statement is necessary in order to have effective administration of the risk management program.
This statement outlines the risk management objectives of the firm as well as company policy with respect to the treatment of loss exposures. It also educates top-level executives in regard to the risk management process, gives the risk manager greater authority in the firm, and provides standards for judging the risk manager’s performance. The risk management process involves the entire firm.
Other functional departments within the firms are extremely important in identifying pure loss exposures and methods for treating these empower. Indeed, without the active cooperation of the other departments, the risk management programme will be a failure.
Question 8.
low does ‘insurance’ differ from ‘hedging’?
Answer:
Though both Insurance and Hedging techniques are similar in that risk is transferred by a contract and no new risk is created, there are major differences between them which are as under:
| Insurance | Hedging |
| 1. Insurance transactions involve transfer of insurable risk which can generally be met. | 1. Hedging on the other hand is a technique of handling risks that are typically uninsurable, for example, protection against decline the price of agriculture products and raw materials. Which are speculative risks and not pure and insurable risks. |
| 2. Insurance can reduce the risk of an insured by the law of large numbers. | 2. Hedging risk typically involves only risk transfer, not risk reduction. |
| 3. In an insurance contract, both the parties win if the loss does not occur. | 3. Hedging contract, the risk of adverse price fluctuation is transferred to speculators who believe that they can make a profit because of superior knowledge of market conditions. Thus mere transfer of risk takes place, but no reduction. |
Question 9.
Why the insurance is considered the most practical method for handling risk?
Answer:
For most individuals, the insurance is the most practical method for handling a major risk. Here, risk transfer is used since a pure risk is transferred to the insurer. Then the pooling technique is used to spread the losses of the few over the entire group so that average loss is substituted for actual loss finally, the risk may be reduced by application of the law of large numbers, whereby an insurer can predict future loss experience with some accuracy.
Question 10.
How is the need for insurance assessed by the risk manager?
Answer:
The risk manager must assess the insurance coverage’s that are needed. Since there may not be enough money in the insurance budget to insure all possible losses, the need for insurance can be divided into several categories depending upon the importance.
One useful approach is to classify the need for insurance into three categories:
Essential insurance:
It includes that coverage required by law or by contract, such as workers compensation insurance. Essential insurance also includes that coverage which will protect the firm against a catastrophic loss or a loss that threatens the firms survival.
Desirable insurance :
It is protection against that may cause the firm financial hardships, but not bankruptcy.
Available insurance:
It is coverage for small losses that do not disrupt the activities of the firm on a large scale.
Question 11.
Comment on the following:
(i) Only pure risks are insurable.
Answer:
(i) Only pure risks are insurable: The statement is correct. Pure risk is defined as a situation where there are only the possibilities of loss or no loss. Only pure risks are insurable as insurers don’t insure speculative risks.
Question 12.
Attempt the following:
(iii) What are the major advantages of retention technique in a risk management programme?
Answer:
Advantages of retention technique in a risk management programme
The retention technique in a risk management programme has the following
advantages:
- Saves money: The firm can save money in the long run if its actual loss is less than the insurance premium.
- Lower expenses: There may be sizable expenses saving, The firm may at a lower cost provide the services by the insurer. Some expenses may be reduced, including loss adjustment expenses, general administration expenses, etc.
- Encourage loss prevention: Since the expenses are retained, there may be a greater incentive for loss prevention within the firm.
- Increases cash flow: Cash flow may be increased by retention since the firm can use the funds that normally would be held by the insurer.
Question 13.
Attempt the following:
(ii) “The first function of a risk manager is to identify all pure loss exposures”. Explain.
Answer:
The first function of a risk manager is to identify all pure loss exposures. This involves a painstaking identification of all potential losses to the firm. Main task involved is the identification of sources of hazard to which the firm is exposed. This may be done by past record, thorough checklist of various perils or through physical inspection of the construction of the building, occupation of the building, process of manufacture therein and exposure points in the process.
The risk manager normally tries to identify six types of potential losses, viz. Property losses, Business income losses, liability losses, death or disability of key persons, losses relating to job-related injuries or diseases, losses from fraud, criminal acts and employee dishonesty. The risk manager has several sources of information that can be used to identify the major and minor loss exposures.
Question 14.
It is generally believed that an insurance contract wholly and fully handles and eliminates all ris.’.s. Do you agree with the statement? Discuss.
Answer:
One of the important components of management is planning and control and once a risk is identified and analysed, it is important to plan and adopt a suitable strategy for effective controlling. Risk planning and controlling is the stage that comes after the risk analysis process is over.
There are five types of handling and controlling risk and these are-
- Risk avoidance
- Risk-retention
- Risk transfer
- Loss control and
- Insurance
Of all the type stated above, Insurance is a type of risk financial or loss financing, which is used to guard against the risk of losses. Losses are guarded against by transferring the risk to another party through the payment of an insurance premium, as an incentive for bearing the risk. Insurance is a more commonly known concept that describes the act of guarding against risk.
An insured is the party who seeks to obtain an insurance policy while the insurer is the party that shares the risk for a paid price called an insurance premium. Yet, it is to be noted that an insurance cover does not wholly or fully handle or eliminates all risks. Insurance does not eliminate risk. It only compensated or indemnifies for the losses as per the policy conditions and provisions. Therefore, an the Insurance policy pays compensation only if a loss has occurred due to insured perils or insured risks and for insured properties.
Purchasing insurance, however, is not risk management. A thorough and thoughtful risk management plan is the commitment to prevent harm. Risk management also addresses many risks that are not insurable, including brand integrity, potential loss of tax-exempt status for volunteer groups, public goodwill and continuing donor support. Further Insurance is primarily concerned with risks that have a financially measurable outcome. But not all risks are capable of measurement in financial terms.
One example of a risk that is difficult to measure financially is the effect of bad publicity on a company-consequently this risk is very difficult to insure. However, this is a good point to stress how innovative some insurers are in that they are always looking for ways to provide new covers, which the customers want.
The difficult part is to be innovative and still make a profit. It is hence that the concept of insurance is only one of the methods of risk management and is practised in useful situations. It must be noted here that the Insurance contract covers only all pure risks and not speculative risks. Further, all risks Insurance policy covers all the risk, it is a myth. The fact is all policies are subject to certain exclusions.
Question 15.
Loss control is an important method in handling risk. What are its major objectives? Describe them briefly.
Answer:
Loss control is an important method for handling risk. It has two major objects:
- Loss prevention:
Loss prevention aims at reducing the probability of loss so that frequency of losses are reduced, e.g. if you follow good health habits, watch your weight and give up smoking, the chances of heart attacks are minimized. Loss prevention is important for business of the enterprises as loss frequency can be reduced by enforcement of strong safety measures. - Loss reduction:
Loss reduction involves reduction in severity of loss. This can be achieved by installing sprinkler system in a warehouse which would help in speedy extinguishment of fire, installing perfect partition wall between two highly inflammable commodities, practising segregation and constructing of fire-resistant materials to minimize losses.
Question 16.
Why do insurers insure ‘pure risks’ only? Define ‘risk’ and distinguish between ‘pure risk’ and ‘speculative risk’.
Answer:
1. Pure (static) risk is a situation in which there are only the possibilities of loss or no loss. The only outcome of pure risks are adverse (in a loss) or neutral (with no loss) never beneficial. Examples of pure risks include premature death, occupational disability catastrophic medical expenses, and damage to property due to fire, lightning, or flood.
2. Insurance companies generally insure only pure risks through their commercial, personal and liability insurance policies, since the law of large numbers can be applied more easily to pure risks than to speculative risks. The law of large numbers is important in insurance because it enables insurers to predict loss figures in advance.
3. Risk is the potential of loss (an undesirable outcome, however not necessarily so) resulting from a given action, activity and/or inaction. The notion implies that a choice having an influence on the outcome sometimes exists (or existed). Potential losses themselves may also be j called “risks”. Any human endeavour carries some risk, but some are much riskier than others.
4. Pure (static) risk is a situation in which there are only the possibilities of loss or no loss, as oppose to loss or profit with speculative risk.
5. Speculative (dynamic) risk is a situation in which either profit or loss is possible. Examples of speculative risks are betting on a horse race, investing in stocks, bonds and real estate. In Business, the decision to venture into a new market, purchase new equipment’s, diversify on the existing product line, expand or contract areas of operations, commit more to advertise, borrow additional capital, etc., carry risks which are inherent to the business. Speculative risk is uninsurable.
6. Society as a whole may benefit from a speculative risk even though a loss occurs, but it is harmed if a pure risk is present and a loss occurs. Therefore, the insurances insure only pure risks.
Question 17.
“Risk is inherent in nature.” Discuss the different categories of risks encountered by Insurance companies.
As a Compliance official, how would you ensure Own Risk and Solvency Assessment (ORSA) requirements by Companies as a part of Enterprise Risk Management?
Answer:
(a) Investing in the insurance business can be a daunting task if you are a newbie to start with. There are certain insurance risks that have affected this industry and the failure to do something to avert the risk can be detrimental to the success of your insurance company.
6 Common Risks faced by insurance Companies Some common types of Insurance Risks are given below:
1. Liquidity Risk
Liquidity is the ease in which business assets can be converted into cash. This is an important aspect of consideration for success in an insurance company. Liquidity risks may arise due to a large number of claims in general insurance and a large surrender of policies in life insurance. This may lead to a loss of the company property in case when the company may not be able to raise the required cash.
2. Actuarial Risks
Actual studies deal with the study of risks and quantifying the amount of compensation according to each risk. Actuarial risks may be caused by different factors such as mortality rate variance, perils and certain other variance. Calculation’s of the given risks may be subjected to a variety of adjustments.
One may consider current statistical data, some past experience and future possibilities but it is to be noted that in the future, there may be a great variance in the speculated and the amount of the risk.
3. Reputation Risks
Reputation risks are faced when an insurance company has lost value in the insurance market. This has a great impact on the amount of revenue which will be raised by the insurance company. In the short run, it may not be an easy task to quantify the exact value caused by the reputation risks but adverse results may pop up during auditing. In extreme cases, reputation risks may lead to bankruptcy also.
4. Business Risks
Business risks that are faced by the insurance company are just the normal risks faced by many other businesses. Risks ranging from data breaches have resulted in a loss of the great amount of relevant data in the insurance industry. Other related business insurance risks include human capital loss, loss of damage and some of the relevant professional service mistakes that may be relevant. There is a lot to do when faced with these risks. A lot of professionalism is required to handle these risks, especially in the insurance industry.
5. Strategic Risks
Strategic risks in the insurance sector require excellent strategic management skills to avert such risks. Strategic risks involve the process of identification, assessing and the management of the insurance strategy.
6. Underwriting insurance Risks
Underwritings of risks results from the process of selection and approval of the risks that need to be insured. Insurance risks may also be caused by the use of an inflexible underwriting process of
risks. The process of underwriting forms the basis of insurance and the failure to get it right at this step may result in great loses in the future.
7. Insurance Risks (Pricing and Product Line Profit)
The risk arising from the exposure to financial loss from transacting insurance and/or annuity business where costs and liabilities experienced in respect of a product line exceeds the expectation in pricing the product line. Newer product lines experience losses due to the high expenses of operating an under-scale business.
Insurers are always worried about their pricing and profitability, and the market price is not always correct. There is a persisting temptation to label a jump in claims as a temporary aberration or to cut rates to increase sales. Pricing and product-line profit issues are predominantly a higher-frequency and lower-severity risk.
(b) ‘Risk, in insurance terms, is the possibility of a loss or other adverse event that has the potential to interfere with an organization’s ability to fulfil its mandate, and for which an insurance claim may be submitted. On the other hand, risk management ensures that an organization identifies and understands the risks to which it is exposed.
Risk management also guarantees that the organization creates and implements an effective plan to prevent losses or reduce the impact of loss. A risk management plan includes strategies and techniques for recognizing and confronting these threats. Good risk management doesn’t have to be expensive or time-consuming;
it may be as uncomplicated as answering these three questions:
- What can go wrong?
- What will we do, both to prevent the harm from occurring and in response to the harm or loss?
- If something happens, how we will pay for it?
An effective risk management practice does not eliminate risks. However, having an effective and operational risk management practice shows an insurer that your organization is committed to loss reduction or prevention. It makes your organization a better risk to insure.
The essence of risk management policy of any corporate is to be innovative and still make a profit. The Enterprise Risk management policy essentially aims at solvency protection of a company. The supervisor or IRDAI in India establishes enterprise risk management requirements for solvency purposes that require insurers to address all relevant and material risks.
The supervisor establishes enterprise risk management requirements for solvency purposes that require insurers to address all relevant and material risks. The supervisor requires the insurer’s enterprise risk management framework to provide for the identification and quantification of risk under a sufficiently wide range of outcomes using techniques which are appropriate to the nature, scale and complexity of the risks the insurer bears and adequate for risk and capital management and for solvency purposes.
As a Compliance Officer, it would be right on every Company Secretary to ensure the following:
Documentation of enterprise risk management framework:
The supervisor requires the insurer’s measurement of risk to be supported by accurate documentation providing detailed descriptions and explanations of the risks covered, the measurement approaches used and the key assumptions made.
Risk Management policy covered under the enterprise risk management:
The supervisor requires the insurer to have a risk management policy which outlines how all relevant and material categories of risk are managed, both in the insurer’s business strategy and its day-to-day operations. The supervisor requires the insurer to have a risk management policy which describes the relationship between the insurer’s tolerance limits, regulatory capital requirements, economic capital and the processes and methods for monitoring risk.
As per Regulatory compliance, every company should have the following policies in place namely:
(i) ALM Policy:
The supervisor requires the insurer to have a risk management policy which includes an explicit asset-liability management (ALM) policy which clearly specifies the nature, role and extent of ALM activities and their relationship with product development, pricing functions and investment management.
(ii) Investment Policy:
The supervisor requires the insurer to have a risk management policy which is reflected in an explicit investment policy which specifies the nature, role and extent of the insurer’s investment activities and how the insurer complies with the regulatory investment requirements established by the supervisor and establishes explicit risk management procedures within its investment policy with regard to more complex and less transparent classes of asset and investment in markets or instruments that are subject to less governance or regulation.
(iii) ORSA Policy:
The supervisor requires the insurer to perform its own risk and solvency assessment (ORSA) regularly to assess the adequacy of its risk management to ascertain this current, and future solvency position. The supervisor requires the insurer’s Board and Senior Management to be responsible for the ORSA.
According to the ORSA manual, there are a minimum of five key principles that a robust ERM framework should encompass. Risk Culture and Governance Roles and responsibilities need to be well defined and within the organization, a culture should be nurtured that supports accountability in risk making decisions.
Risk Identification and Prioritization:
Clear management of the risk identification process is essential and responsibility for this process must be clear. You need to ensure these procedures are operating effectively throughout your organization. Putting the right risk assessment process in place through the use of ERM software can help tremendously.
Risk Appetite, Tolerance and Limits:
To ensure that the risk strategy of the Board of Directors is made clear, a formal Risk Appetite Statement needs to be written and detailing associated risk tolerance and limits.
Risk Management and Controls:
Throughout your organization, ERM should operate to ensure risk is kept within the boundaries defined by the Risk Appetite Statement.
Risk Reporting and Communication:
To ensure transparency of the risk management processes your key personnel require strong reporting and communication procedures. However, your organization should ensure that this does not impede active, informal management decisions on risk-taking.