RISK MANAGEMENT &

INSURANCE
Unit - 1
 WHAT IS RISK ?
Risk is uncertainty about the outcome… in a general
sense
Possible variability in outcomes around some
expected values….Specific meaning used for events.
Expected value is outcome that would occur on an
average when a person or business is exposed
repeatedly to the same type of risk.
Ex: Sachin’s batting average is 67 based on past data.
So the expected score he is likely to hit is 67.
However, there is a degree variability around this
value. He might duck out or hit a century.
 Risk

Expected loss Variability/Uncertainty

 RISK V/S UNCERTAINTY
Risk Uncertainty
Probability of the probability of the
possible outcomes of possible outcomes is
the event is known not known

Dispersion of the Lack of confidence

probability that the estimated
distribution is risk probability
distribution is correct
 TYPES OF RISKS
 BUSINESS RISK
Business risk is possible reductions in value of business from
any source. Business value depends upon size, timing and risk
variability in cash flows. Unexpected changes in future cash
flows can lead to business risk.
There are three main risks involved in business:
Price risk, Credit risk and Pure risk
1. Price risk:
Refers to uncertainty over magnitude of cash flows due to
possible changes in output and input prices. Analysis of price
risk associated with sale and production of existing and future
products gains strategic management. Three specific types of
price risks are
Commodity price risk
Exchange rate risk
Interest rate risk (affects terms of credit, speed of repayment
and cost of borrowings)
 TYPES OF RISK
2. Credit risk:
Risk that a firm’s customers and the parties to which it has lent money
will delay or fail to make promised payments is called credit risk. Most
firms face credit risk from accounts receivables. Financial institutions
carry risk of default by borrowers. Firms carry risk of non-payment and
bankruptcy. Firms have to pay more to borrow money as risk increases.
3. Pure risk:
Risk management function traditionally concentrates on management of
pure risk. Pure risk relates to losses associated with assets. It comprises
of:
Damage to assets: (reduction of value of business assets due to physical
damage, theft, and expropriation (seizure by foreign govt)
Legal liability: of harm to customers, suppliers, share holders, other
parties
Worker injury: risk of paying compensation and damages to employees
Employee benefits: risk of death, illness and disability to
employees/families as per contracts/Acts.
 TYPES OF RISK
4. Personal risk:
Earnings risk: refers to potential fluctuations in a family’s
earnings which can occur as a result of decline in in the
value of an income earner’s productivity due to death,
disability, aging, or a change in technology.
Medical expense risk:
Liability risk on auto and home
Risk of loss of value of physical assets like auto, home,
boats, watercrafts, electronics. They can be lost stolen or
damaged.
Risk of loss of value of financial assets like stocks and
bonds
Longevity risk refers to retired people outliving their
financial resources.
 BURDEN OF RISK
Risk results in certain social and economic effects:
 Larger emergency fund: one needs huge funds to take
care of emergency requirements of repair and loss of
property. This affects business
 Loss of certain goods and services: because of risk
companies have discontinued manufacturing certain
goods and services. Eg: certain vaccines, asbestos
products, breast inplants, birth control devices due to
fear of law suits
 Worry and fear: induced in the mind of people when
they encounter risk involved in jet flight, writing
exams, skiing etc
 SOURCES OF RISK
External sources:
 Business factors

 Natural factors – earthquake, famine, cyclone, lightning,

 Political factors – change of govt, civil war, riots, policy

changes
Internal sources:
 Operational -

 Technological

 Human factors

 Technological

 physical
 DEGREE OF RISK/OBJECTIVE RISK
 Degree of risk is defined as relative variation of actual loss
from actual loss.
 Assume that out of 10000 houses, 1% ie 100 houses bun every
year. In reality 110 houses or 90 houses may burn. Relative
variation is 10%. This is objective risk or degree of risk
 Objective risk declines with increase in number of exposures.
More specifically, objective risk varies inversely with the
square root of number of cases under observation.
 Assume that 1 million houses are insured. Expected houses to
burn is 1% ie 10000. 10% relative variation is 100 houses.
Objective risk therefore is 100/10000 = 1%
 Therefore square root of the number of house goes up 10 times
from 100 to 1000, the objective risk comes down to 10% from
original level.
 Objective risk can be statistically measured by measure of
dispersion like standard deviation. As the number of exposure
increases prediction will be more accurate as variation is
lesser.
 RISK MANAGEMENT
 Risk management is the identification, assessment
and prioritization of risks followed by coordinated
and economical application of resources to minimize
monitor and control the probability and/or impact of
unfortunate events.
 Jorin defined risk management as the process by
which various risk exposures are identified.,
measured and controlled.
 Risk management refers to the systematic
application of principles, approach and processes to
the tasks of identifying and assessing risks and then
planning and implementing risk responses.
 METHODS OF RISK MANAGEMENT

 Broadly 3 methods:

 Loss control
 Loss financing

 Internal risk reduction

 1 and 3 involves decisions to invest/not invest to reduce

losses while 2nd one refers to how to pay for losses if they
do occur
 1. LOSS CONTROL
 Actions that reduce the expected cost of losses by reducing the
frequency of losses and/or the severity (size) of losses that occur
are known as loss control. It is also sometimes known as risk
control.
 Actions that reduce the frequency of losses are commonly
called loss prevention methods. Eg: routine inspection of
aircrafts. Actions that reduce the severity of losses are called
loss reduction methods. Eg: smoke detectors. Some are both
eg: airbags in vehicles.
 There are 2 general approaches to loss control.
- Reducing the level of risk activity (truck with toxic
chemicals shifting over to other products)
- increasing precautions against loss of activity
 2. LOSS FINANCING
 Methods used to obtain funds to pay for or offset losses
that occur is called loss financing
 Broad methods

- retention: business retains the right to pay up losses. Also

called self-insurance
- Insurance: pay premium and receive funds to make good
losses. Risk transferred to insurers.
- Hedging: Derivatives like futures, forwards, options,
swaps manage mainly the price risk.
- Other contractual risk transfers: indemnity taken from
others (contractors) for damage/injury etc.
 3. INTERNAL RISK REDUCTION
 Businesses can reduce risk internally by:
 1. Diversification: Businesses spread
across different areas can help reduce risk.
Do not keep all eggs in the same basket.
 2. Invest on information: in order to get
superior forecasts of future cash flow
thereby reducing variability.
 RISK MANAGEMENT PROCESS
 Identifyall significant process
 Evaluate the potential frequency and severity of
losses
 Develop and select methods for managing risk

 Implement the risk management methods chosen

 Monitor the performance and suitability of the

risk management methods and strategies on an
ongoing basis.
(Detailed explanations given in guide)
 OBJECTIVES OF RISK MANAGEMENT

 To be consistent with corporate objectives of returns and

safety
 To provide good service to customers

 Initiate action to reduce or prevent risk and its effects

 Minimise human costs of risk

 To meet statutory and legal obligations

 Minimise financial losses and claims

 Minimise the risks associated with new developments and

activities.
 To be able to make informed decisions and make choices
on possible outcomes.
COST OF RISK
 We know the actual cost only ex-post. Ex-ante
estimate of loss is done on the basis of
 1. expected loss

 2. cost of loss control

 3. cost of loss financing

 4. cost of internal risk reduction

 5. cost of any residual uncertainty that remains

after 2,3,4 are implemented
 COST OF RISK

 1. Expected loss = direct loss of the value of the asset + indirect

loss arising out of the event. If a house is destroyed additional
indirect losses occur because of hotel expenses, additional food
expenses. additional travel costs etc. This is in addition to the
direct loss of cost of house.
If a factory is destroyed, then,
 direct loss is the value of the factory, cost of repair, cost of
paying compensation,/claims, cost of defending liability claims.
 Indirect losses are:
- Loss of normal profit,
- Extra operating expenses
- Higher costs of funds
- Legal expenses and Bankruptcy costs
- Foregone investments
- Reorganisation and liquidating costs.
 COST OF RISK
 2. cost of Loss control
Cost of actions that reduce the expected cost of losses by
reducing the frequency of losses and/or the severity (size) of
losses.
eg: cost of testing facilities, lost profit because of limited
distribution of defective goods.
 3. cost of loss financing:
Cost of methods used to obtain funds to pay for or offset
losses that occur is called loss financing. This includes cost
of maintaining reserve funds for self-insurance- tax on
interest and opportunity cost, insurance premiums,
transaction cost of arranging, negotiating and enforcing
hedging arrangements and other risk transfers
COST OF RISK
 4. Cost of internal risk reduction methods:
 Transaction costs associated with achieving and
managing diversification and cost of obtaining
and analysing data to obtain more accurate cost
forecasts. This may include consultancy costs of
procuring more accurate data.
 5. Cost of residual uncertainty:
 Cost of uncertainty left over after selecting and
implementing loss control, loss financing,
internal risk reduction is called cost of residual
uncertainty. This increases the risk of business
and increases the cost of holding that stock.
Employees require higher wages.
 COST TRADEOFFS

 1. Trade off between expected cost of

direct/indirect loss and loss control costs
 2. Tradeoff between expected cost of indirect loss
and cost of loss financing /internal risk reduction
 3. Tradeoff between cost of loss financing
/internal risk reduction and cost of residual
uncertainty.
An increase in the cost of one would reduce the
cost of the other. Companies have to decide on the
right mix of cost of each risk management tool.
INDIVIDUAL RISK MANAGEMENT AND COST OF RISK
 Apart from pure risk under business risks, concepts of risk
management applies to individual risk management as well.
An individual would consider expected loss (both direct and
indirect) from accidents, loss prevention activities (driving
less at night), loss reduction activities like insurance , cost of
gathering weather information. He would also consider cost
of residual uncertainty which depends upon the person’s
attitude towards risk.
 Amount of risk management undertaken by an individual
depends upon degree of his risk aversion . Risk aversion is
the tendency to choose alternative with lesser outcome
variability. Eg: 100, -100 v/s 1000, -1000 .
 Most people are risk averse. They are willing to pay more to
reduce risk (more insurance). They also need to be
compensated more for taking risk.
RISK MANAGEMENT AND SOCIETAL WELFARE
 How to reduce the total aggregate cost of risk – cost
of losses, cost of risk control, loss financing, internal
risk reduction, and residual uncertainty.
 Minimising the cost of risk for the society produces
an efficient level of risk. Efficient level is where the
marginal benefit of risk reduction equals marginal
cost of these methods.
 Maximising the value of resources with minimum
cost of risk makes the economy more efficient
 Differential insurance premia in the society (like
differential taxes) works against maximisation of
wealth to some extent.
RISK MANAGEMENT AND SOCIETAL WELFARE
 Minimising the cost of risk for a business does not
lead to minimising cost of risk to the society. It
works adversely as the employees/contractors/
suppliers etc get exposed to more risk. Therefore
the business must build in the social cost of risk
into its own private cost of risk. (Total cost to
society). Business value maximisation does not
result in minimising total social cost to society.
 Regulation from the governement legally takes
care of the fact that businesses do not concentrate
on reducing private cost to maximise profits which
results in a higher risk to the society.
 RISK IDENTIFICATION

 Critical aspect of risk management.

Failure to identify risk exposures will lead
to huge losses. There is no scientific
method to identify risks and sometimes
they may even be unknown. It is usually
done on the basis of what is insurable
and on the basis of past experience.
 “Risk identification is the process by which
a business systematically and continuously
identifies property, liability and personal
exposures as soon as or before they
emerge” …. Williams and Heins
RISK IDENTIFICATION

Risk
identification

Individual
Business risk
risk
exposures
exposures
IDENTIFYING BUSINESS RISK EXPOSURES

1 •Physical assets/property

2 •Financial assets

3 •Legal liability

4 •Human assets/personnel

5 •External economic forces

 TYPES OF PROPERTY LOSS EXPOSURE
 Direct loss: direct loss happening to the property either partly or
wholly on coming in contact with the incident . Eg: building, P&M
 Indirect loss: indirect loss occuring while the direct damage is on
some other property. Eg: factory being torn down to facilitate
rebuilding
 Net income loss: refers to reduction in net income(revenue-
expenses)
 Decrease in revenue may be because of loss of rent, interruption of
operation, contingent business interruption (losses occuring
because a loss eg loss of records)
 Increase in expenses: owing to spending extra money on the
wake of a damage. Eg: spending extra money to hire a house/hotel
room, spending extra money to continue running the operation ./3P
production.
 VALUE OF EXPOSURES OF PHYSICAL ASSETS
 Property insurance policies indemnifies the
insured on the basis of either… or…
 Actual Cash Value (ACV) : cost to replace or
repair damaged property less value of physical
depreciation and obsolescence.
 Replacement Cost : cost to replace or repair
damaged property with same or like-kind
property WITHOUT any value of physical
depreciation and obsolescence. Also called re-
instatement cost.
 Value by second method is always higher.
TYPES OF EXPOSURE TO FINANCIAL ASSETS
 Risk of loss of financial assets like
 1. credit exposure: debtors or accounts receivables fail to
pay or delay payments. Bad-debts can lead to heavy losses.
Delayed payments lead to loss of money owing to interest
cost .
 2. currency exposure: involves losses in adverse movement
of exchange rates. It affects companies which are in
international trade. Indirectly it also affects companies
which have competitions from abroad.
 3. country exposure: arising out of problems in the country
of opeartion. Comprises of political risk, regulatory risk and
economic risk.
 4. Liquidity exposure: this refers to the risk of a financial
asset like bond, debentures going illiquid.
FEATURES OF FINANCIAL ASSET EXPOSURE
 Financial asset exposure depends upon its financial
structure
 If the capital structure makes earnings unstable the
company may fail
 When company raises funds to finance its growth it will have
impact on future earnings and stability
 Debt financing offers a low cost source of funds to the
company and financial leverage to stock holders
 Large amounts of debt increases variability of returns to the
stock holders thereby increasing their risk
 Variability in returns is for shareholders is more in leveraged
firms than in unleveraged firms.
TYPES OF LEGAL LIABILITY EXPOSURE
 Arising out of ownership/use/possession: this puts
onus to keep it risk free. And safe
 Arising from manufacture/distribution/sale:
owing to breach of warranty, defective product.
May lead to penal provisions
 Arising from fiduciary relations: failure to
discharge duty towards shareholders by the
directors
 Employers’ liability: for job related injuries and
compensation to workmen. Usually discharged by
workmen compensation policies.
 LEGAL WRONG
 A legal wrong is a violation of a person’s legal rights, or a
failure to perform legal duty towards another person or
society.
 There are 3 broad categories of legal wrongs:

- a crime is a legal wrong against society and is

punishable by fines, imprisonment, death.
- a breach of contract is another legal wrong
- a tort is a legal wrong for which the remedy is in the
form of money damages. It is a personal injury law. Torts
are of 3 types: intentional torts, absolute/strict liability
and negligence.
 A person who is harmed (plaintiff, claimant) can sue for
damages from the defendant or tortfeasor.
CATEGORIES OF LEGAL LIABILITY
 Criminal liability: comes under IPC,
generally directed at wrongs against the
society. Police begins the legal procedure
and the court will impose penalty and/or
imprisonment.
 Civil liability: directed at wrongs against
individuals/organisations where one party
files a liability suit against another.
Penalty in the form of indemnity for losses
or punitive damages may be levied by the
court.
EXPOSURE OF HUMAN ASSETS/PERSONNEL
 Exposure when employees/people die, get
injured, reach old age, fall ill or lose jobs.
Companies manage these exposures either
due to legal strictures or as part of
compensation/motivation to employees.
 Employers resort to provisioning to PF,
pension, gratuity, life and health
insurance cover and disability benefits.
 A special kind of risk is a key person’s
death or disability . Keyman insurance is
available for this purpose.
EXPOSURE FROM EXTERNAL ECONOMIC FORCES
Losses arise from factors outside
the firm like,
Changes in input/output prices,
changes in exchange rate, and
financial distress experienced by
important suppliers/buyers.
IDENTIFYING PERSONAL RISK EXPOSURES

•Personal loss/injury
1 exposures

•Property loss exposures

2

•Legal liability loss

3 exposures
PERSONAL LOSS/INJURY EXPOSURES

Loss of income to the family because

of death of the family head
Huge medical bills and loss of
earnings during disability
Insufficient income/assets during
retirement
Loss of income from unemployment
Identity theft
 PROPERTY LOSS EXPOSURES
 Direct physical damage to home/personal
property because of fire, lightning, flood,
earthquake, etc
 Indirect expenses arising out of above direct
physical loss like expenses for hotel, travel
during period of reconstruction, loss of rent loss
of use of the building etc
 Theft of valuable personal property including
money, securities, jewellery, electronics etc
 Direct physical damage to cars, Bykes, etc from
collision and non-collision reasons
 Theft of cars, bykes, and other vehicles
LEGAL LIABILITY LOSS EXPOSURE

Legal liability arising out of:

Personal acts that cause bodily injury
to others
Libel, slander, defamation of
character and similar exposures
Negligent operation of vehicles
Business or professional activities
Payment of attorney fees and other
legal defense costs
PROBABILITY AND STATISTICS - CONCEPTS
 Random Variable – A variable whose outcome is
uncertain. Eg: head or tail in a coin flip is
uncertain.
 Discrete variable v/s continuous variable.
 All the possible outcome in a random variable
and their probabilities is identified in a
probability distribution. This can be represented
tabular or graphical. (propability of head and
probability of tail ccuring)
 In a graphical representation, you put outcome
on the X axis and probability on the Y axis.
Possible outcome for X probability

$1 0.5 or 50%

-$1 0.5 or 50%

  Probability
distribution for
damages to your car.
ANOTHER EXAMPLE

Damages Probability

0 0.5

500 0.3

1000 0.1

5000 0.06

10000 0.04
CHARACTERISTICS OF A PROBABILITY DISTRIBUTION

In order to compare and analyze

different probability distributions the
following characteristics may be used:
Expected value
Variance and standard deviation
Skewness
Correlation
 EXPECTED VALUE
 Expected value of an outcome tells where the
outcome tends to average
 Expected value

 = average

 = add up all (outcome*probability)

 = x1p1+x2p2+x3p3+………..

 = Summation xipi (Sigma xipi)

 Graphically expected value = Mean can be easily

identified visually if the graph is symmetric.
 If not, it is a bit difficult.

…
 WHAT IS THE EXPECTED VALUE OF DAMAGES?

Possible outcomes probability

for damage (Rs)

0 0.5
500 0.3
1000 0.1
5000 0.06
10000 0.04
WHAT IS THE EXPECTED VALUE OF DAMAGES?

Possible outcomes probabilit xipi

for damage (Rs) y

0 0.5 0
500 0.3 150
1000 0.1 100
5000 0.06 300
10000 0.04 400 total=950
WHAT IS THE EXPECTED LIABILITY LOSS?

5000000 with probability of 0.004

1500000 0.025
Loss of 500000 0.030
0 0.941
WHAT IS THE EXPECTED LIABILITY LOSS?

5000000 * 0.004 = 20000

1500000 * 0.025 = 37500
 500000 * 0.030 = 15000
 0 * 0.941 = 0
EXPECTED LIABILITY = 72500
VARIANCE & STANDARD DEVIATION
 Variance of a probability distribution provides
information about the likelihood and magnitude by
which a particular outcome will differ from the
expected value (or average)
 A low variance means that an actual outcome is
very close to the expected value and a high
variance means that the actual outcome is far from
the expected value.
 Variance = Sigma pi (xi-mu)2

 It is mathematically more convenient to work with

the square root of variance which is called standard
deviation.
EXAMPLE
 SOLVE…
What is the expected value of
outcome if you win Rs 1 for heads
and lose Rs 1 for tails; in a coin
toss game?
Calculate the sample mean and
sample standard deviation if the
game is played 5 times with the
following results: T,T,H,T,H
EXPECTED VALUE = 1*0.5+(-
1*0.5) = 0
Sample mean = 1*2/5 + (-1*3/5) = -
0.2
Sample standard deviation = root
Summation pi(xi-mu)2
= ROOT OF 2/5(1-(-0.2))2 + 3/5 (-1-(-
0.2))2
Root 0.96 = 0.98
SKEWNESS
Skewness measures the symmetry of
a distribution. A normal distribution
has zero skewness and is symmetric.
Most of the risk management
distributions are skewed.
If one assumes a symmetric
distribution then one would
underestimate the likelihood of very
large losses which can be very
harmful.
 MAXIMUM PROBABLE LOSS

Maximum possible Loss is the

maximum amount a firm may lose
given an incident. It is may be the
total value of the assets
Maximum probable loss is the
expected loss given the most likely
probability of an event happening
eg: MPL at 5% is 20 million, MPL at
1% is 30 million
 VALUE-AT-RISK
 Value at risk is the value of the property at
risk for a givedescribes probability distribution
for the value of a firm/portfolio that is subject
to loss.
 Fig 3.9; 5 million is the value at risk for a
portfolio at 5% risk, the probability that the
firm will lose more than 5 million is 5%(area to
the left of 5 million is 0.05) similarly if 7.5
million is the value at risk at 1% level, the
probability that the firm will lose > 7.5 million
is 1%
 Firms use value at risk concept to measure risk
3.9
NORMAL DISTRIBUTION AND VAR

Probability of VAR (mu+/-1.64

sigma) = 0.05
Probability of VAR (mu+/- 2.33
sigma) = 0.01
3.10
 CORRELATION
 Correlation measures the relationship
between random variables.
 If the correlation between two random
variables is zero then they are not
correlated. I means that knowing value of
one will not reveal the value of the other.
Eg: liability claims for an auto company
and steel prices. They are independent or
uncorrelated.
 on the other hand, demand for new cars
and steel prices are correlated.