Risk Is An Uncertainty About Loss

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02 Nov 2017

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Risks may relate to financial or non-financial objectives, entity specific, intra-agency and can also relate to an entity’s assets, resources or probable exposures to liability claims. Risks can be written off as operational, financial, compliance or strategic. Out of these four categories, individual risks could also relate to reputation, information technology, people, knowledge, contractual, regulatory, legal, accounting, reporting, economic and social risks.

A risk in relation to the insurance represents an accidental or fortuitous event by which the insured sustains pecuniary loss.

Risk is universal and Risk is essential to progress. "Higher the risk, Higher is the return." Risk and opportunity go hand in hand. There is a thin line of demarcation between RISK and UNCERTAINITY.

The objective is to reduce the risk as far as possible & practicable by MANAGING THE RISKS.

Assets are insured, because they are likely to be destroyed or made non-functional before the expected life time, through accidental occurrence. Such possible occurrences are called ‘Perils’. For example; Fire, Floods, Breakdowns, Lightening, Earthquakes etc. If such perils can cause damage to the asset, we say that the asset is exposed to that risk.

Perils Vs Hazards

Assets are insured, because they are likely to be destroyed or made non-functional before the expected life time, through accidental occurances. Such possible occurances are called ‘Perils’. Fire, floods, breakdowns, lightning, earthquakes etc. are perils. If such perils can cause damage to the asset, we say that the asset is ‘exposed to that risk’. Perils are the events. Risks are the consequential losses or damages. For example; an owner of a building is exposed to a risk of peril, may be earthquake and the loss due to which can be few lacs or a few crores of rupees, depending on the cost of the building, the contents in it and the extent of damage.

Perils covered under various policies

Fire Policy: Fire, Lightning, Explosion / Implosion, Impact damage, Air craft damage, Riot, Strike, Malicious damage, Storm, Cyclone, Tempest, Hurricane, Flood & Inundation, earthquake, Subsidence & land slide ( including rock slide).

Mediclaim Policy: Covers reimbursement of medical expenses incurred in a hospital as an inpatient as a direct result of accident or sickness occurring or contracted anywhere in the world.

Householders' Shop-keepers' Policy: The cover includes fire & allied perils, burglary, & house breaking, personal accident, baggage, plate glass and public liability.

Hence, the meaning of risk is the uncertainty about the occurrence of an event that creates loss whereas peril is the loss of producing the cause. Fire policy covers the risks of fire, lightning, explosion etc.

Hazard refers to the condition which creates or increase the chance of loss arising from any peril. Hazards may increase the probability of losses, their frequency, their severity, or both. Hazard may be physical, morale, moral and legal.

‘Physical Hazard’ refers to the risk arising from the material features of the subject matter of insurance. Consider the peril of collision, which may cause loss to an automobile. A physical condition that makes the occurance of collision more likely is a slippery road. Physical hazards include such phenomena as the existence of dry forests (a hazard affecting the peril of fire, poorly lit stairwells (likelihood of slips and falls), earth faults (a hazard for earthquakes), slippery roads (a hazard for road accidents), old wiring (which may increase the likelihood of a fire). Such hazards may not be within human control, although their existence often may be observed.

‘Morale Hazard’ refers to the mental attitude of a careless or accident-prone person and lack of concern.

For example; poor housekeeping (allows trash to accumulate in attics or basements), careless cigarette smoking (leading to asthamas and lung cancers), unnecessary exposure to poisoning, electrocution, radiation, venomous stings/bites, air pollution (can affect health and life expectancy); increase the probability of losses. Sometimes a subconscious desire for a loss may exist, even though the individual is not fully aware of this desire. Sometimes, such lack of concern occurs due to circumstances which may cause someone to be indifferent to the possiblilty of a loss, thus causing that person to behave in a cereless manner. For example; a person driving carelessly, who is insured against his auto accident insurance policy and meets with an accident and dies.

‘Moral Hazard’ refers to the risk arising from human nature or mental attitude and from general economic and social conditions. It is associated with intentional actions, dishonesty or charater defects in an individual designed either to cause a loss or to increase its severity. By and large, moral hazards gets activated when a person can gain from the incidence of a loss. For example; tendency of individuals to consume more health care if the costs are covered by insurance, an insured business that is totally unprofitable and out-of-date machinery may feel an incentive to cause intentional fire and destroying the property, fake accident, submitting a fraudulent claim. Moral Hazard is not measurable as there is no test to establish it, it is just a matter of opinion. For example; old proposer not insured so far and wants and insurance policy of larger amount, large amount of proposal filed of one of the life member and main earning member is not insured or medical examination is done at some other place other than his own residence.

Note :- If moral hazard is suspected, no amount of extra premium will be appropriate. Usually underwriters would hesitate to accept such proposals at any cost. But, would like to be fairly certain before deciding so.

‘Legal Hazard’ refers to characyterstics of the legal system/ regulatory environment that increases the frequency or severity of losses. For example; adverse jury asking for large damages for liability lawsuit or statues that require insurance companies to include certain benefits like alcoholism.

Hazard management, therefore, can be a highly effective risk management tool. At this point, many corporations around the world lay emphasis on disaster control management to reduce the impact of biological or terrorist attacks. Safety inspections at airports is one of the examples of disaster control management that intensified after September 9/11. 

BASIC CONCEPT OF RISK

The risk only means that there is a possibility of loss or damage. The damage may or may not happen. For example; the earthquake may occur, but the building may not have been affected at all. Therefore, Insurance is done against the possibility that the damage may happen.

If there is certainty of happening of event or risk, insurance cannot be done. For example; certainty that the plane will be crashed or risk of lung cancer for as chain smoker. Therefore, Insurance is relevant only if there are uncertainties.

In case of human being, death is certain, but the time of death is uncertain. The person is insured because of the uncertainty about the time of his death.

Insurance can be done only for those things which have the risk of perishability.

Insurance does not protect the subject-matter but the consequences/losses due to that subject-matter. i.e., Insurance does not protect the asset. It does not prevent its loss due to the peril. The peril cannot be avoided through insurance. The risk can sometimes be avoided, through better safety and damage control measures. Insurance only tries to reduce the impact of the risk.

The loss/ risk have to be economic or financial. Certain things which do not have economic value, insurance cannot be done. For example; love, relationships, leadership quality etc.

Exhibit 2 : Types of Risks Covered/ not Covered by Insurance Company

RISKS

Covered by Insurance Company

Not Covered by Insurance Company

Critical/ Catastrophic-Bankruptcy of Owner,

Total Loss, Tsunami

Important-Economic Recession (affects business)

Unimportant-Temporary Illness, Accidents

Dynamic-Inflation, Political Upheavals

Static-Fire, Theft (no effect on economy)

Speculative-Betting, Gambling

Fundamental-Train accidents (affect large population)

Non-Financial- Love, Leadership Quality, etc.

Particular-Theft (affect specific person)

Pure-Act of God

Human Being Risk-Living too long, Dying Early

Managing business risks in the 21st century in this new developed economy is very different to managing risks in the closing years of the 20th century. Whereas, in the past, risk management used to be restricted only to finance and operational functions such as crisis management, but, today due to the knowledge explosion and the new economy, the companies are aware about the risky situations in the organization as a whole and they know that survival and growth is possible only after managing them efficiently. (See exhibit 3; Universe of Risk)

BASIC CATEGORIES OF RISK

Pure (Absolute) and Speculative Risk

Dynamic Risk and Static Risk

Subjective and Objective Risk

Fundamental and Particular Risk

Pure (Absolute) and Speculative Risk

‘Pure risks’ are those risks where there is a ‘chance of loss’ or ‘no loss’ but, never a gain (maintaining status quo). Pure risk can be explained as a physical loss sustained by the insured on account of a peril insured against. Physical loss may consequently result into loss of expected profits due to stoppage of production in the factory, nearby property sustaining damage due to fire accident in the insured premises, court awarding reasonable compensation. In addition, the owner of the factory may sustain injuries for which reasonable medical expenses could be incurred. These all come in the fold of financial losses. Such of these losses are termed as ‘pure risks’ or ‘risks of trade’. For example; if property is damaged or destroyed, there is loss, but, if no damage there is no loss. Job related accidents, damage to property from fire, flood or earthquake.

Types of Pure (Static) Risk

The major types of pure risks that are associated with great economic and financial insecurity include;

Personal Risks

Property Risks

Liability Risks

Personal Risks - Risks that directly affect an individual in particular. They involve the possibility of loss or reduction of income and the elimination of financial assets. There are four major personal risks; premature death, old age, poor health and unemployment.

Premature Death Risk - i.e. living too short. It means the risk of death of the keyman with unfulfilled financial obligations if the spouse, children and dependents rely on you for income or care. Purchasing life insurance is the best and cheapest way where the insured person can save his family from financial crisis at the time of any mishappening or after death. Life Insurance pays a lump sum on death or terminal illness. It provides you a lumpsum to pay off your mortgage, other debts and take care of family needs and expenses.

Old Age – i.e. risk of inadequate income during retirement. When older workers retire, they lose their normal amount of earnings. Unless they have accumulated sufficient assets and foresee financial stability, they would be facing a serious problem of economic insecurity. Retirement insurance plans help to build a retirement corpus which is invested on maturity to generate a regular stream of monthly income to cover the old age expenses.

Risk of Poor Health – i.e. heavy medical bills and the loss of earned income. The health care expenses have increased by leaps and bounds in recent years. The loss of income is another major cause of financial instability. In cases of severe long term disability, there is a considerable loss of earned income, medical bills are incurred, employee benefits may be lost and savings exhausted. Health insurance covers diseases, injuries, surgery or any medicare that is needed by an individual or family. Health insurance also includes hospitalization coverage if you are hospitalized for more than 24 hours. Health Insurance also pays you for your regular checkup and consultation fees.

The Risk of Unemployment - i.e. financial disaster in the average families by way of income loss and employment benefits. Unemployment can be the result of an industry cycle downswing, economic changes, seasonal factors and frictions in the labour market. Regardless of the cause, unemployment can create financial disaster in the average families by way of income loss and employment benefits.

Property Risks - ‘Property Risks’ are the risks of having property damaged or loss from various perils. Property loss can occur as a result of fire, lightening, windstorms, earthquakes, floods and number of other causes.

Liability Risks - ‘Liability Risks’ are another important type of pure risks that many people face. Moreover, we are living in a controversial society, where one can be sued for any frivolous reason. Hence, one has to defend himself when sued, even when the suit is without merit.

(Personal property and liability insurance is covered in detail in chapter 7)

‘Speculative Risks’ describe a situation where there is possibility of gain, loss or no loss. These risks or losses represent business or trade losses. For example; the owner of the factory may suffer loss due to other reasons like; the existing garments/ assessories do not suit to the present fashion/ trend, goods may not be sold due to declaration of war, goods remain stagnant due to ‘exchange control regulations’ etc. There can be some more reasons like investments in shares, betting on a horse race, investing in real estate, going into business for yourself etc. On the other hand, society as a whole may sometimes get benefitted from a speculative risk even though a loss occurs. For example; a computer manufacturer’s competitor develops a new technology to make faster computer processors at cheaper rates. As a result, it forces the earlier one into bankruptcy, but, society at large gets benefitted since the competitor’s computers work faster and are also sold at a lower prices. On the other hand, society would not benefit when most pure risks, such as an earthquake occur.

Note : Pure risks are insurable but speculative risks are beyond the scope insurance cover.

Exhibit 4 : Examples of Pure versus Speculative Risk Exposures

Pure Risk (Loss or No Loss Only)

Speculative Risk (Possible Gains or Losses)

Physical damage risk to property (at the enterprise level) such as caused by fire, flood, weather damage

Market risks: interest risk, foreign exchange risk, stock market risk

Liability risk exposure (such as products liability, premise liability, employment practice liability)

Reputational risk

Innovational or technical obsolescence risk

Brand risk

Operational risk: mistakes in process or procedure that cause losses

Credit risk (at the individual enterprise level)

Mortality and morbidity risk at the individual level

Product success risk

Intellectual property violation risks

Public relation risk

Environmental risks: water, air, hazardous-chemical and other pollution; depletion of resources; irreversible destruction of food chains

Population changes

Natural disaster damage: floods, earthquakes, windstorms

Market for the product risk

Man-made destructive risks: nuclear risks, wars, unemployment, population changes, political risks

Regulatory change risk

Mortality and morbidity risk at the societal and global level (as in pandemics, social security program exposure, nationalize health care systems, etc.)

Political risk

Accounting risk

Longevity risk at the societal level

Genetic testing and genetic engineering risk

Investment risk

Research and development risk

Dynamic Risk and Static Risk

‘Dynamic Risks’ are those risks which result from changes or evolution in the society. For example; risk resulting from changes in economy, price level, consumer tastes and technology.

‘Static Risks’ are those risks which arise from the natural course of business activity. Such risks only result in loss. For example; losses arising from natural causes, dishonesty etc.

Subjective Risk and Objective Risk

‘Subjective Risk’ is psychological uncertainty based on a person’s mental condition or state of mind of an individual who experiences doubt or worry as to the outcome of a given event.

The concept of subjective risk is especially important because it provides a way to interpret the behaviour of individuals faced with seemingly identical situations yet arriving at different decisions.

For example; one person may be ultraconservative and tend always to take the "safe way" out, even in cases that may seem quite risk-free to other decision makers.

Subjective Risk  Conservative Behavior

‘Objective Risk’ is a relative variation of actual loss from expected loss. It is more precisely observable and therefore measurable. In general, objective risk is the probable variation of actual from expected experience. This term is most often used in connection with pure static risks, although it can also be applied to the other type of uncertainities. It may actually be the same in two cases but may be viewed very differently by those examining this risk from their own perspectives. Thus, it is not enough to know only the degree of objective risk; the attitude toward risk of the person who will act on the basis of this knowledge must also be known.

1

Objective Risk 

No. of Exposures

Fundamental Risks and Particular Risks

‘Fundamental Risks’ affect the economy as a whole where large number of people or groups within the economy are affected. For example; speedy inflation, cyclical employment, war, natural disasters such as earthquakes, hurricanes, tornadoes, floods etc. It is to be noted that, government assistance is necessary to insure such fundamental risks. Several social insurances, government insurance programs, government guarantees and subsidies may be used to meet these type of fundamental risks in our country. For example; the risk of unemployment is generally not insurable by private insurance companies but can be insured publicly by the government agencies at state or central level.

‘Particular Risks’ are risks that affects only the individual in particular and not the economy as a whole which remains unaffcted. For example; bank robberies, car thefts, auto accident, fire at factory premises due to lack of adequate safety measures.

Diversifiable (Unsystematic) and Non-diversifiable (Systematic) Risks

Another significant type of risk which the professionals use is diversifiable and non-diversifiable risk. 

‘Diversifiable Risk’ – is also known as unsystamatic risk. It is one which is eliminated by diversification. This risk represents the unstable conditions in a company due to factors specific to that particular firm only and not the market as a whole. For example; worker’s unrest, strike, change in market demand, change in competitive environment, change in consumer preferences etc. Since these these factors affect affect one firm/industry at a time, they must be examined separately for each company. Diversification is the core of the modern portfolio theory in finance and in insurance. Risks, which are ‘idiosyncratic’ (with particular characteristics that are not shared by all) in nature, are often viewed as being agreeable to having their financial consequences reduced or eliminated by holding a well-diversified portfolio.

‘Non-diversifiableRisk’ - is also known as systamatic risk or market risk. It is that part of total risk which cannot be eliminated by diversification. This part of the risk arises because every security has a built in tendency to move in line with the fluctuations in the market. For example; general factors in the market such as money supply, inflation, economic recession, industrial policy, interest rate policy of the government, credit policy, tax policies etc. These are the factors which affect almost every firm equally. No investor can avoid or eliminate this risk whatsoever precautions of diversification may be resorted to. (See exhibit 5 for better understanding of the concept).

Exhibit 6, provides examples of risk exposures by the categories of diversifiable and non-diversifiable risk exposures. Many of them are self explanatory, but the most important distinction is whether the risk is unique or idiosyncratic to a firm or not. For example; the reputation of a firm is unique to the firm. Destroying one’s reputation is not a systemic risk in the economy or the market-place. On the other hand, market risk, such as devaluation of the dollar is systemic risk for all firms in the export or import businesses. The examples are not complete and the student is invited to add as many examples as desired.

Exhibit 6 : Examples of Risk Exposures by the Diversifiable and Non-diversifiable Categories

Diversifiable Risk

(Idiosyncratic / Unsystematic Risk)

Non-diversifiable Risks

(Systemic Risk)

Reputational risk

Market risk

Brand risk

Regulatory risk

Credit risk (at the individual enterprise level)

Environmental risk

Product risk

Political risk

Legal risk

Inflation and recession risk

Physical damage risk (at the enterprise level) such as fire, flood, weather damage

Accounting risk

Liability risk (products liability, premise liability, employment practice liability)

Longevity risk at the societal level

Innovational or technical obsolesce risk

Mortality and morbidity risk at the societal and global level (pandemics, social security program exposure, nationalize health care systems, etc.)

Operational risk

 

Strategic risk

 

Longevity risk at the individual level

 

Mortality and morbidity risk at the individual level

 

METHODS OF MANAGING RISK/ RISK MITIGATION

Once the sources of risks have been predicted, it is often helpful to measure the degree and scope of the risk which exists. It is usually argued that risks cannot be exactly measured but are readily observable. Several important concepts related to the measurement of risks are discussed in this chapter earlier and in chapter 2 and 3 such as chance of loss and degree of risk whereby ‘chance of loss’ is the long-term chance of occurance or relative frequency of loss; whereas the ‘degree of risk’ is the amount of objective risk present in a situation. In making chance of loss calculations, it is a common practice to perform separate computations for different causes of loss like perils, hazards (discussed earlier in the chapter).

These risks cuases discomfort and the uncertainty associated with it causes anxiety and worry. The unpleasant nature of risk requires immediate attention and is to be treated effectively. Hence, after the sources of risks have been identified and measured, a decision has to be taken as to how the risks should me managed, mitigated or handled. Risks handled efficiently leads to growth and success of the organization. As discussed earlier, pure risks are handled through the collective efforts of society and the government. But, there are some risks that are purely the responsibility of an individual. Risks are directly proportional to return; i.e. profits in business comes only from taking adequate amount risk, hence, risks are inseperable part of any business and they cannot be completely eliminated. But, it is important that an entrepreneur recognize potential risks they face and prepare effective strategies to minimise its negative impact by adopting a suitable risk management strategy. It is also important for entrepreneurs to design ‘contingency plans’ or alternative courses of action. Contingency plans show that the entrepreneur is sensitive to important risks and is prepared to handle risks as they occur. From this point of view, there are five basic risk management strategies :

Avoidance

Loss Prevention and Reduction

Retention

Transfer

Share

Exhibit 7 illustrates various risk management strategies which are primary in nature but not exclusive. In many cases combination of strategies will be used. For example; taking precautions against fire, such as removing fire hazards, fitting a sprinkler system and also purchasing fire insurance combine elements of risk avoidance, loss reduction and risk transfer.

Exhibit 7 : Categorisation of Primary Risk Management Strategies

Frequency of Loss (Likelihood)

Low

High

Severity of Loss

(Consequence)

Low

Retention

Loss Prevention and Reduction

High

Share

Avoidance

Risk Avoidance – It means elimination of risk; abandoning or refusing to undertake any activity in which the risk seems too high. Firstly, risk is avoided when the individual refuses to accept the risk even for an instant. This is accomplished by merely not engaging in the action that gives rise to risk. For example; you can avoid the risk of loss in the stock market by not buying or shorting stocks; the risk of a genital disease can be avoided by not having sex; avoiding risk of divorce by not marrying; avoiding the risk of car trouble by not having a car. Many manufacturers avoid legal risk by not manufacturing particular products, but, the downfall of using avoidance as your main form of risk management, you will avoid all those opportunities which are knocking your door to earn or accomplish as well. Secondly, if you do not want to risk your hard earned savings in a hazardous endeavor, then pick one where there is less risk involved. For example; if you want to avoid the risks associated with the purchase of property, go for lease or rental arrangement.

The avoidance of risk is one method of dealing with risk, but it is a negative treatment of risk rather than positive technique. Personal advancement of the individual and progress in the economy both require risk taking. If risk avoidance were utilized comprehensively, both the individual and society would suffer. For this reason, avoidance is an unsatisfactory approach to dealing with many risks. Virtually any activity involves some risk. Where avoidance is not possible or desirable, loss control/ risk reduction is the next best thing.

Risk Prevention and Reduction - It means minimizing the risk. It works by either loss prevention, which involves reducing the probability of risk or loss reduction, which minimizes the loss. Although some risks cannot be avoided, most can be appreciably reduced. The primary control technique is prevention, including the use of safety and protective techniques. Losses can be prevented by identifying the factors that increase the likelihood of a loss, then either eliminating the factor or minimizing its effect. For example; speed and driving drunk greatly increase auto accidents. Not driving after drinking alcohol is a method of loss prevention that reduces the probability of an accident. Driving slower is an example of both loss prevention and loss reduction, since it both reduces the probability of an accident and, if an accident does occur, it reduces the magnitude of the losses, since slower speeds yield less damage. Most businesses actively control losses because it is a cost-effective way to prevent losses from accidents and damage to property, and generally becomes more effective the longer the business has been operating.

Risk Retention - It means acceptance of risk. Risk retention is widely accepted method to deal with the risk. Risk acceptance is simply accepting the identified risk, when the individual does not take any action to avoid, reduce or transfer the risk, the possibility of loss involved in that risk is retained. This approach is ideal for those risks that will not create a high amount of loss if they occur. These risks in fact would be considered more costly to manage than to allow. Risk retention may be either :

Active or Passive

Be Conscious or Unconscious

Voluntary or Involuntary

‘Active Risk Retention’ is handling the unavoidable risk internally as it is much more cost-effective way of handling the risks. Usually, retained risks occur with greater frequency, but have a low severity. An insurance deductible is a common example of risk retention to save money, since a deductible is a limited risk that can save money on insurance premiums for larger risks. Businesses actively retains many risks—self-insurance—because of the cost or unavailability of commercial insurance.

‘Passive Risk Retention’ is retaining risk because the risk is unknown or because the risk taker is either not aware about the risk or considers it as a less risky affair than it actually is. For example; smoking cigarettes can be considered a form of passive risk retention, since many people smoke without knowing that the number of diseases which can happen to them due to smoking or are under the impression that they don't think these diseases can happen to them. Another example is speeding of an automobile. Many people think that they can handle speed, therefore no risk is involved. However, there is always greater risk to speeding, since it always takes longer to stop and in a collision, higher speeds will always result in more damage or risk of serious injury or death, because higher speeds have greater kinetic energy that will be transferred in a collision as damage or injury. It will be more easier to handle the automobiles at slower speeds than at higher speeds. For example, if someone fails to stop at an intersection just as you are driving through, then, at slower speeds, there is obviously a greater chance of avoiding a collision, or if there is a collision, there will be less damage or injury than would result from a higher speed collision.

‘Conscious Risk Retention’ takes place when the risk is apparent and not transferred or reduced.

‘Unconscious Risk Retention’ takes place when the risk is not predicted, it is automatically unconsciously retained. In these cases, the person so exposed retains the consequences of the possible loss without realizing that he or she does so.

‘Voluntary Risk Retention’ means that the person is aware of the risk and he is ready to bear it along with the implied losses. The decision to retain is taken as there are no other alternatives more attractive.

‘Involuntary Risk Retention’ takes place when risks are unconsciously retained. It also takes place when the risk cannot be avoided, transferred or reduced.

Risk retention is a legitimate method of dealing with risk; sometimes it is actually the best way. The decision to retain, avoid, transfer or reduce the risk is taken based on the margin for contingencies or personal ability to bear the loss. A loss that might be a financial disaster for one individual or family might easily be borne by another. As a general rule, risks that should be retained are those that lead to relatively small losses.

Transfer of Risk - Risk may be transferred from one individual to another who is more willing to bear the risk like process of hedging, wherein a position established in one market in an attempt to offset exposure to the price risk of an equal but opposite obligation or position in another market. For example; long 1000 shares of Company ‘A’ @ 100 per share and simultaneously short 500 shares of Company ‘B’ @ 200 per share or a wheat farmer can sell wheat futures to protect the value of his crop prior to harvest. If there is fall in price, the loss in the cash market position will be countered by a gain.

In addition, risk may be transferred or shifted through contracts. A hold-harmless agreement, in which one individual assumes another's possibility of loss, is an example of such a transfer. For example; a tenant may agree under the terms of a lease to pay any judgments against the landlord that arise out of the use of the premises. Insurance is also a means of shifting or transferring risk. In consideration of a regular payment which is called the premium, by one party (the insured), the second party (the insurer) contracts to indemnify the first party up to a certain limit for the specified loss that may or may not occur.

Sharing of Risk - Risk is shared when there is some type of arrangement to share losses. Risks are shared in a number of ways in our society. One exceptional example of a device through which risk is shared is the corporation wherein the investments of a large number of persons are pooled together, bearing only a portion of the risk that the enterprise may fail. Insurance is another example which is designed to deal with risk through sharing. One basic characteristic of the insurance device is the sharing of risk by the members of the group.

Hence, determining the suitable strategy or combination of strategies is generally based on minimising the cost in long term or short term. Relevant factors in deciding this include :

direct annual outlays, for example; costs that will be incurred even if the risk does not materialise (e.g. insurance premiums, compensation of security guards, amortized capital cost and annual maintenance, cost of items such as sprinkler systems, security fences, etc); and

expected and maximum losses if the risk does materialise (e.g. capital outlay of replacing buildings and equipment, business interruption costs such as revenue foregone and cost of hiring other premises, etc).

On this basis, a more detailed analysis would suggest :

‘Retention Strategy’ is preferred where the benefits of loss prevention and reduction do not justify the costs;

‘Loss Prevention’ and ‘Reduction Strategy’ is preferred where the cost is less than it would be to assume or share the risk;

‘Sharing Strategy’ is preferred where loss prevention and reduction or retention of the risk are not viable options in their own right or the cost of sharing the risk is less than the cost of retaining it; and

‘Avoidance Strategy’is chosen where prevention and reduction strategies are not appropriate in their own right and the agency can choose to discontinue the activities to which the significant risk is aligned.

It is to be noted that, within each category, there are various other tools also available that can be used to manage specific risk exposures.

POINTS TO PONDER

How to Identify Risk

Risks exposures differ between organisations and within parts of individual entities. In this context the process of identifying risk needs to be broad enough to recognize as many risks as possible. Following probable tools can be used within an organisation to facilitate the identification of risks.

Internal staff interviews - Staff within each organization is a source of expert information as while conducting their daily tasks they will be acutely aware of many of the issues that are likely to arise.

External interviews - Clients, customers and stakeholders may have a different perspective on the organisation than staff. Tapping into the knowledge they have about the operations of an entity can shed additional light on potential risks. Likewise, dialogue with similar organisations is likely to inform the risk identification process.

Brainstorming Exercises and Focus Groups - As with interviews, making use of knowledge of those who work in and deal with the daily operations will help identify exposures.

Cchronological Data - Data gathered from past claims history, industry experience, audits and reviews can provide specific insights into the risk exposures of an organization.

SWOT Analysis – An analysis of strengths, weaknesses, opportunities and threats will provide appropriate mechanisms to identify risk exposures.

When utilising these tools the following questions should be asked:

What are the organisation’s aims and what risks arise from delivering these aims ?

What is it that the organization holds (which may include property owned by others) that could be at risk ?

What are the different types of risks and how they might be affected by factors from within the organization, from the operational environment and forces outside the organisations control ?

What are the likely impacts of the risks being discussed and identified ?

Which risks require priority treatment ?

Furthermore, risks can also be managed by Non-insurance transfers and Insurance to some extent (refer chapter 3 for more details).

Non-insurance Transfers

The 3 major forms of noninsurance risk transfers are; by ‘Contract’, ‘Hedging’ and for business risks by ‘Incorporating’.

A common way to transfer risk by ‘Contract’ is by purchasing the warranty extension that many retailers sell for the items that they sell. The warranty itself transfers the risk of manufacturing defects from the buyer to the manufacturer. Transfers of risk through contract is often accomplished or prevented by a hold-harmless clause, which may limit liability for the party to which the clause applies. ‘Hedging’ is a method of reducing portfolio risk or some business risks involving future transactions. Thus, the possible decline of a stock price can be hedged by buying a put for the stock. A business can hedge a foreign exchange transaction by purchasing a forward contract that guarantees the exchange rate for a future date.

Investors can reduce their liability risk in a business by forming a corporation or a limited liability company. This prevents the extension of the company's liabilities to its investors.

Insurance

It is another major method that most people, businesses, and other organizations can use to transfer pure risks by paying a premium to an insurance company in exchange for a payment of a possible large loss. By using the ‘law of large numbers’, an insurance company can estimate fairly reliable amount of loss for a given number of customers within a specific time. An insurance company can pay for losses because it pools and invests the premiums of many subscribers to pay the few who will have significant losses. Not every pure risk is insurable by private insurance companies. Events which are unpredictable and that could cause extensive damage, such as earthquakes, are not insured by private insurers.

Nor are most speculative risks—risks taken in the hope of making a profit.

Exhibit 8 : Notable Notions on Current Risk Handling

INSURED

Property Liabily

Tornadao

Inventory Theft

E-Risk

Political Risk

IT System Failure

AVOID/ HEDGED

Credit Risk

Foreign Exchange Risk

Interest Rate Risk

UNINSURED

Reputation Risk

Intellectual Property Piracy

RETAINED/ PARTIALLY INSURED

Earthquake

Terrorism

Mold

Worker’s Compensation

Enterprise Risk Management

Some persons use the term ‘risk management’ only in connection with businesses and often the term refers only to the management of pure risks. In this sense, the traditional risk management goal has been to minimize the cost of pure risk to the Company. But now a days, firms are brodening their outlook towards managing different types of risk, hence, the need for new terminology has become apparent. The terms ‘Enterprise Risk Management (ERM)’ and ‘Integrated Risk Management (IRM)’reflect the intent to manage all forms of risk, regardless of their types.

Many businesses have a special department charged with overseeing the firm’s risk management activities; the head of such a department is often titled as ‘Risk Manager (RM)’. Usually, the traditional type of risk manager may be charged with minimizing the adverse impact of losses on the achievement of the company’s goals. But, in implementing more integrated approach to risk management, however, some firms have formed risk management committees. Others have created a new position of ‘Chief Risk Officer (CRO)’ to coordinate the firm’s risk management activities, regardless of the source of the risk. As a part of his or her duties, the RM and/ or CRO is likely to be involved in many aspects of a firm’s activities. Examples may include developing employee safety programs, examining planned mergers and acquisitions , analyzing investment opportunities, purchasing insurance to protect against some types of risk, setting up pension and health plans for employees. The evolution of IRM and ERM reflects the realization of the importance of coordinating risk management activities of the firm at wider level in order to meet its strategic goals.

Since enterprise risk management is a key concept today, the enterprise risk map of life insurers is offered here as an example in exhibit 9. Operational risks include public relations risks, environmental risks and several others. Because operational risks are so important, they usually include a long list of risks from employment risks to the operations of hardware and software for information systems.

As discussed above, the opportunities in the risks and the fear of losses encompass the holistic risk or the enterprise risk of an entity.

Exhibit 9 : Spectrum of Risks of Life Insurers

Capital Structure (Financial Risk)

Asset-Liability Matching

ASSET RISK

PRODUCT RISK

OPERATIONAL RISK

Default Risk

Volatility Risk (Market Risk)

Liquidity Risk

Inflation Risk

Catastrophe Risk

Incomplete Contract Risk

Reserves Risk

IT Risk

Distribution Risk

Regulatory Risk

Legal Risk

Globalization Risk

ERM in business includes the methods and processes used by organizations to manage risks and immediately grab opportunities related to the achievement of their objectives. ERM provides a framework for risk management, which typically involves identifying particular events or circumstances relevant to the organization's objectives (risks and opportunities), assessing them in terms of likelihood and magnitude of impact, determining a response strategy and monitoring progress. See the overview of Enterprise Risk Management in Exhibit 10.

Exhibit 10 : Overview of Enterprise Risk Management

MARKETING

New business sold.

Retention of old businesses.

Mix of businesses : new and renewal

Market share by customer type

Average premium or assets by per customer.

Percentage of high-yield customers.

Customer satisfaction

Average number of products per customer.

HUMAN RESOURCES

Agency Composition (number, age, service)

Total employment by department

Turnover Ratio

Vacancy Rates

Average salary increase Vs. Planned

Employee commitment and engagement.

FINANCIAL

Revenue

Underwriting Profit

Investment Profit

Pre-Tax Operating Income.

Net Income

Return on Equity and Total Capital

Economic Value Added.

SALES & DISTRIBUTION

Acquisition cost per sale

Sale by distribution channels

Growth/ retention of agents

EXTERNAL DATA

Audit compliance

Inflation rates

Interest rate

GNP

Competitor pricing

UNDERWRITING

Price achieved Vs. Target price

Exposure date (no. of cars, pay roll etc.)

Exposure Mix

Quotes (accepted / declined)

Variance analysis

Premium Persistency

Loss Ratio

Loss adjustment expense.

INVESTMENTS

Cash flow

Yield on new investments

Yield on Portfolio by class and duration

Convexity of assets

Duration of assets

Investment mix : new and portfolio

Credit default

Total Return

ERM is widely accepted technique to manage all forms of risk, but it has some inherent limitations which includes; a reality that decisions taken by people cannot always be correct, sometimes the breakdowns can occur because of human errors/ mistakes also, the management of the organization has the ability to override the ERM process, it is very necessary to consider the relative costs and benefits of risk responses.

CASE APPLICATION

For any business, the safety of its employees and customers is a major concern. But to comply workplace health and safety regulations and completing exhaustive risk assessments was, in the past, a daunting administrative burden for many organizations.

Small and medium businesses were often confused by the task of completing an assessment. Larger organizations sometimes found that the fast moving nature of their business meant it was difficult to keep up with the amount of detailed documentation required. Some used to hire costly external consultancies to complete assessments for them.

The biggest bookmaker who has plenty of outlets, The Landmark, the Health and Safety Manager, Mr. Sain admits that we fulfll all our assessments in-house inspite of having high volume of paperwork.

Now, employers of all types can find all the guidance and information they need to complete their risk assessments in one place, on the website. Simple, easy to understand, industry-specific risk management tactics are available to download as well as examples of common control measures.

Mr. Sain has been working in health and safety regulation department for l6 years. He says this new online service for employers is a major step forward.

"Now it’s all there for you, whatever type of risk your business faces. It's very simple. It's the best thing that has happened in the safety area for our industry - there’s no reason why any shop, large or small, can’t follow this online procedure."

"The new online service has simplified the whole thing so much; it's actually improved the industry standard. It's that simple."

Questions for Discussion

Discuss whether the government has the right to impose great cost to many in terms of lost time in using air travel, inconvenience, and affronts to some people’s privacy to protect a few individuals.

Do you see any morale or moral hazards associated with the homeland security monitoring and actively searching people and doing preflight background checks on individuals prior to boarding?

Discuss the issue of personal freedom versus national security as it relates to this case.



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