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Risks may be classified in many ways; however, there are certain distinctions that are

particularly important. These include the following:

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In its broadest context, risk includes all situations in which there is an exposure to

adversity. In some cases, this adversity involves financial loss while in others it does not.

There is some element of risk in every aspect of human endeavour, and many of these

risks have no (or only incidental) financial consequences.

Financial risk involves the relationship between an individual (or an organisation) and an

asset or expectation of income that may be lost or damaged. Thus, financial risk involves

three elements: (i) the individual or organization that is exposed to loss, (ii) the asset or

income whose destruction or dispossession will cause financial loss, and (iii) a peril that

can cause the loss.

The second and third elements are the thing of value and the peril that can cause the loss

of the thing of value. The individual who owns nothing of value and who has no

prospects for improving that situation faces no financial risk. Further, if nothing could

happen to the individual¶s assets or expected income, there is no risk.

 

 



c second important distinction is between static and dynamic risks. Dynamic risks are

those resulting from changes in the economy. Changes in the price level, consumer tastes,

income and output, and technology may cause financial loss to members of the economy.

These dynamic risks normally benefit society over the long run, since they are the result

of adjustments to misallocation of resources. clthough these dynamic risks may affect a

large number of individuals, they are generally considered less predictable than static

risks, since they do not occur with any precise degree of regularity.

Static risks involve those losses that would occur even if there were no changes in the

economy. If we could hold consumer tastes, output and income, and the level of

technology constant, some individuals would still suffer financial loss. These losses arise

from causes other than the changes in the economy, such as the perils of nature and the

dishonesty of other individuals. Unlike dynamic risks, static risks are not a source of gain

to society. Static losses involve either the destruction of the asset or a change in its

possession as a result of dishonesty or human failure. Static losses tend to occur with a

degree of regularity over time and, as a result, are generally predictable. Because they are

predictable, static risks are more suited to treatment by insurance than are dynamic risks.

 
 
 

 



There are two elements of uncertainty in most types of events that are handled by risk

managers ± the likelihood of the event occurring, and the size of the ensuing loss.

Generally, the degree of risk aversion displayed by individuals acting in either a private

or managerial capacity tends to increase with the potential size of loss. Some loss

potentials are so small that an individual or organization is prepared to accept the risk and
assume any loss that does occur. Beyond a certain size, the risk becomes unacceptable

and ways will be sought to avoid, reduce or transfer that risk. Of course, the maximum

size of loss that can be tolerated depends on the status of the individual or organisation,

and so the division between acceptable and unacceptable risks is not entirely clear-cut for

two reasons.

First, it depends partly on time. The size of loss that could be absorbed by, say, one

year¶s profits would normally be far larger than could be accommodated within one

month¶s operating budget. Secondly, there will be a range of potential losses where the

occurrence of the loss could strain the individual¶s or an organization¶s finances but it

could be overcome (perhaps by resort to borrowing or raising additional capital). Then,

whether the risk of incurring a loss of any size will be regarded as acceptable or

unacceptable will depend upon the cost of handling the risk relative to the benefits

thereof.

The division between acceptable and unacceptable risk will always be influenced even if

it is not fully determined by such financial considerations. Furthermore it will be

influenced by the allocation of the costs and benefits of those risks and methods of

handling them between persons who may be affected. In the case of industrial accidents,

for instance, according to the rules laid down by law, the employer will be liable to

compensate employees for injuries sustained as the result of accidents at work, though

whether the size of award determined according to those rules represents adequate

compensation for the pain, suffering, loss of amenity and loss of an injured employee¶s

present and future earnings is a matter of judgement. The cost of reducing the probability
and/or severity of such accidents will fall directly upon the employer, though some or all

of that cost may ultimately be passed on to the employees through a reduction in earnings

due to a cut in the risk premium element of wages. Because perceived costs and benefits

may differ, employees (or their trade union representatives) may have a different view as

to what constituted an unacceptable risk to that held by the employer.

 


 





c fundamental risk is a risk that affects the entire economy or large numbers of persons

or groups within the economy. Examples include rapid inflation, cyclical unemployment

and war because large numbers of individuals are affected. The risk of a natural disaster

is another important type of fundamental risk. Hurricanes, tornadoes, earthquakes, floods,

and forest and grass fires can result in damage to billions of dollars worth property and

cause numerous deaths.

The distinction between a fundamental and a particular risk is important because

Government assistance may be necessary to insure a fundamental risk. Social insurance

and Government insurance programmes, as well as government guarantees and subsidies,

may be necessary to insure certain fundamental risks. For example, the risk of

unemployment generally is not insurable by private insurers but can be insured publicly

by state unemployment compensation programmes.

 
 




Pure risk is defined as a situation in which there are only the possibilities of loss or no

loss. The only possible outcomes are adverse (loss) and neutral (no loss). Examples of
pure risks include premature death, job-related accidents, catastrophic medical expenses,

and damage to property from fire, lighting, flood, or earthquake.

Speculative risk is defined as a situation in which either profit or loss is possible. For

example, if you purchase 100 shares, you would profit if the price of the shares increases

but would lose if the price declines. Other examples of speculative risk include betting on

a horse race, investing in real estate, and going into business for self. In these situations,

both profit and loss are possible.

Second, the law of large numbers can be applied more easily to pure risks than

speculative risks. The law of large numbers is important because it enables insurers to

predict future loss experience. In contrast, it is generally more difficult to apply the law

of large numbers to speculative risks to predict future loss experience. cn exception is

the speculative risk of gambling, where casino operators can apply the law of large

numbers in a most efficient manner.

Finally, society 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. For example, a firm may develop new

technology for producing inexpensive computers. cs a result, some competitors may be

forced into bankruptcy. Despite the bankruptcy, society benefits because the computers

are made available at a lower cost. However, society normally does not benefit when a

loss from a pure risk occurs, such as a flood or earthquake that devastates an area.

  

The major types of pure risk that can create great financial insecurity include personal

risks, property risks, and liability risks.

 

 Personal risks are those risks that directly affect an individual; they

involve the possibility of complete loss or reduction of earned income, extra expenses,

and the depletion of financial assets. There are four major personal risks:

· Risk of premature death

· Risk of insufficient income during retirement

· Risk of poor health

· Risk of unemployment


  
 
 Premature death is defined as the death of a household

head with unfulfilled financial obligations. These obligations can include dependents to

support, a mortgage to be paid off, or children to be educated. If the surviving family

members receive an insufficient amount of replacement income from other sources or

have insufficient financial assets to replace the lost income, they may be financially

insecure.

Premature death can cause financial problems only if the deceased has dependents to

support or dies with unfulfilled financial obligations. Thus, the death of a child aged 10 is

not "premature" in the economic sense.

There are at least four costs that result from the premature death of a household head.

First, the human life value of the family head is lost forever. The human life value is

defined as the present value of the family¶s share of the deceased breadwinner¶s future

earnings. This loss can be substantial; the actual or potential human life value of most

college graduates can easily exceed Rs.500,000. Second, additional expenses may be

incurred because of funeral expenses, uninsured medical bills, probate and estate

settlement costs, and estate and inheritance taxes for larger estates. Third, because of

insufficient income, some families may have trouble making both ends meet for covering

expenses. Finally, certain non-technical costs are also incurred, including emotional grief,

loss of a role model, and counselling and guidance for the children.


    !
 The major risk associated with old

age is insufficient income during retirement. The vast majority of workers in India retire

at the age of 60. When they retire, they lose their earned income. Unless they have

sufficient financial assets on which to draw, or have access to other sources of retirement

income such as social security or pension, they will be exposed to financial insecurity

during retirement.

How are older people, aged 60 and over, doing financially? In answering this question, it

is a mistake to assume that all aged are wealthy; it is equally wrong to assume that all

aged are poor. The aged are an economically diverse group, and their total money

incomes are far from uniform.


   "
 Poor health is another important personal risk. The risk of poor

health includes both the payment of catastrophic medical bills and the loss of earned
income. The costs of major surgery have increased substantially in recent years. For

example, an open-heart surgery can cost more than Rs. 200,000, a kidney or heart

transplant can cost more than Rs. 400,000, and the costs of crippling accident requiring

several major operations, plastic surgery, and rehabilitation can exceed Rs. 500,000. In

addition, long-term care in a nursing home can cost Rs. 50,000 or more each year. Unless

these persons have adequate health insurance or private savings and financial assets, or

other sources of income to meet these expenditures, they will be financially insecure. In

particular, the inability of some persons to pay catastrophic medical bills is an important

cause of personal bankruptcy.

The loss of earned income is another major cause of financial insecurity if the disability

is severe. In cases of long-term disability, there is a substantial loss of earned income,

burden of medical bills, loss or reduction of employee benefits and depleted savings.

Moreover, someone must take care of the disabled person.


    The risk of unemployment is another major threat to

financial security. Unemployment can result from business cycle downswings,

technological and structural changes in the economy, seasonal factors, and imperfections

in the labour market.

ct present in India, the unemployment rate is very high. Unemployment at times is a

serious evil because of several important trends. To hold down labour costs, large

corporations have resorted to downsizing and their work force has been permanently

reduced; employers are increasingly hiring temporary or part-time workers to reduce

labour costs; and millions of jobs have been lost to foreign nations because of global

competition.

Regardless of the reason, unemployment can cause financial insecurity in at least three

ways. First, workers lose their earned income and employee benefits. Unless there is

adequate replacement income or past savings on which to draw, the unemployed worker

will be financially insecure. Second, because of economic conditions, the worker may be

able to work only part-time. The reduced income may be insufficient in terms of the

worker¶s needs. Final, if the duration of unemployment is extended over a long period,

past savings may be exhausted.

 
 Persons owning property are exposed to the risk of having their

property damaged or loss from numerous causes. Real estate and personal property can

be damaged or destroyed due to fire, lightning, tornadoes, windstorms, and numerous

other causes. There are two major types of loss associated with the destruction or theft of

property- direct loss and indirect or consequential loss.

  # c direct loss is defined as a financial loss that results from the physical

damage, destruction, or theft of the property. For example, if you own a restaurant that is

damaged by fire, the physical damage to the restaurant is known as direct loss.

   —$
# cn indirect loss is a financial loss that results

indirectly from the occurrence of a direct physical damage or theft. Thus, in addition to

the physical damage loss, the restaurant is to be rebuilt. The loss of profits would be a
consequential loss. Other examples of a consequential loss would be the loss of rents, the

loss of the use of the building, and the loss of a local market.

Extra expenses are another type of indirect or consequential loss. For example, suppose

you own a vegetable shop or dairy. If a loss occurs, you must continue to operate

regardless of cost; otherwise, you will lose customers to your competitors. It may be

necessary to set up a temporary operation at some alternative location, and substantial

extra expenses need to be incurred.

 #
 
 Liability risks are another important type of pure risk that most

persons face. Under our legal system, you can be held legally liable if you do something

that result in bodily injury or property damage to someone else. c court of law may order

you to pay substantial damages to the person you have injured.

Liability risks are of great importance for several reasons. First, there is no maximum

upper limit with respect to the amount of loss. One can be sued for any amount. In

contrast, if you own property, there is a maximum limit on the loss. For example, if your

car has an actual cash value of Rs.100,000, the maximum physical damage loss is

Rs.1,00,000. But if you are negligent and cause an accident that results in serious bodily

injury to the other person, you can be sued for any amount say Rs. 50,000, Rs. 500,000,

or Rs. 1 million or more by the person you have injured.

Second, a lien can be placed on your income and financial assets to satisfy a legal

judgement. For example, assume that you injure someone, and a court of law orders you

to pay damages to the injured party. If you cannot pay as per the judgement, a lien may
be placed on your income and financial assets to satisfy the judgement. If you declare

bankruptcy to avoid payment of the judgement, your credit rating will be impaired.

Finally, legal defence costs can be enormous. If you have no liability insurance, the cost

of hiring an attorney to defend you can be staggering. If the suit goes to trial, attorney

fees and other legal expenses can be substantial.

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While risk management has become a popular topic of discussion, some of what is

discussed reflects a misunderstanding of risk management. Some of these misconceptions

reflect a misreading of the literature, while others reflect defects in the literature itself.

The first misconception is that the risk management concept is principally applicable to

large organizations. The second is that the risk management approach to dealing with

pure risks seeks to minimize the role of insurance.

 
 
 

If one were to judge on the basis of much of the literature dealing with the concept of risk

management, it would be easy to conclude that risk management has no useful

application except with respect to the problems facing a large industrial complex. This

misconception can easily result from the fact that many of the techniques with which
writers have been preoccupied (e.g., self-insurance plans, captive insurers, etc.) do apply

primarily to giant organizations. Most of the articles on risk management have been

written by practicing professional Risk Mangers. It is natural that they would write about

the techniques they use in their own companies, and virtually all professional Risk

Managers are employed by large organizations. But it cannot be overemphasized that the

risk management philosophy and approach applies to organizations of all sizes (and to

individuals as well for that matter), even though some of the more esoteric techniques

may have limited application in the case of an average organization.

cs the Risk Manager¶s position has increased within the corporate framework and risk

management has become a recognized term in business jargon, the interest in risk

management has increased in businesses of all sizes. While it is obvious that the small

firm cannot afford a full-time professional Risk Manager, the principles of risk

management are as applicable to the small organization as to the giant international firm.

The principles of risk management are nothing more than common sense applied to the

management of pure risks facing an individual or organization. The principles are

applicable to organizations of all sizes, as well as to individuals and families. While the

techniques may differ in scope and complexity, the same risk management tools are used

in either case.

  
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*

The second misconception about risk management that it is anti-insurance in its

orientation and that it seeks to minimize the role of insurance in dealing with risk also

stems from risk management literature. Much of the literature on risk management has
also been preoccupied with topics related to risk retention, self-insurance programmes,

and captive insurance companies. Indeed, if one were to ask practitioners in the insurance

field to describe the essence of risk management that is, its philosophy ± many would

respond that the major emphasis of risk management is on the retention of risk and on the

use of deductibles. While it is true that retention is an important technique for dealing

with risks, it is not what risk management is all about.

The essence of risk management is not in the retention of exposures. Rather it is in

dealing with risks by whatever mechanism is most appropriate. In many instances,

commercial insurance will be the only acceptable approach. While the risk management

philosophy suggests that there are some risks that should be retained, it also dictates that

there are some risks that must be transferred. The primary focus of the Risk Manager

should be on the identification of the risks that must be transferred to achieve the primary

risk management objective. Only after this determination has been made does the

question of which risks should be retained arise. More often than not, determining which

risks should be transferred also determines which risks will be retained; the residual class

that does not need to be transferred.

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The term ³Risk Manager´ can be used in a functional sense to mean anyone who

performs the risk management job, regardless of whether that person is an employee of

the organization, an outside consultant, or an agent or broker. cs the term will be used

here, however, it will refer to an individual employed by the organization who is

responsible for the risk management function.

Even when viewed from this perspective, every organization has a Risk Manager. The

individual may not recognize that he or she is performing the risk management function,

but in every organization someone must make decisions that elate to the pure risks facing

the organization. In a large company, the Risk Manager is (or should be) a well-paid

professional who has a specific tile and job description that relates to the management of

risks. In a small company, he or she may be the President or managing partner. In a

moderate-sized company, he may be the Chief Financial Officer or someone at an

intermediate staff level.

Since insurance buying is a historical foundation of risk management, one might expect

that buying insurance would be a significant activity for most Risk Managers. The

purchase of insurance continues to be a significant element of the Risk Manager¶s duties,

even in large organizations for which the value of insurance might appear to be limited.

cpart from buying insurance, Risk Managers¶ functions may include:

a) cssisting their organization in identifying risks.

b) Implementing loss prevention and control programmes.

c) Reviewing contracts and documents for risk management purposes.

d) Providing training and education on safety-related issues.

e) cssuring compliance with governmental mandates.

f) crranging non-insurance financing schemes.

g) Claims management and working with legal representation to manage litigation.

h) Designing and co-ordinating employee benefit programmes.

clthough some Risk Managers do not perform some of the functions listed above, the list

does represent an itemization of activities that would be familiar to very many Risk

Managers. Indeed, in the most progressive organizations that list of functions might be

expanded to include such things as:

a) Currency hedging

b) Capital budgeting

c) Public relations

d) Employee assistance and training

e) Government lobbying

f) Services marketing

f) Mergers and acquisitions

'÷  "  (

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Risk management has been practiced informally since the dawn of time. Pre-historic

humans banded together in tribes to conserve resources, share responsibilities, and

provide some protection against the uncertainties of life. Even today, informal risk

management is practised by almost everyone, whether they are conscious of it or not. We

wear our seatbelts to reduce the likelihood of serious injury; we exercise and eat a proper

diet to improve our prospects for good health.

 +
  ,  ,


There is some controversy over whether scholars accelerated the development of risk

management or whether business practice inspired scholars, but there is little doubt that

the period from 1955 to 1964 gave birth to modern risk management, both academically

and professionally. Formal risk management did exist prior to this time, but the term ³risk

management´ did not enjoy a widely agreed upon meaning to both practitioners and

scholars until this period.

Like most managerial functions, risk management has predecessor functions. Perhaps the

most influential of these is insurance buying. Most modern risk management positions

evolved out of an insurance-buying function, and this historical artefact casts a very long

shadow even today (as will be seen). The same can be said to the academic field of risk

management; often it evolved within insurance departments, and the pre-eminent

academic journal in the field, the Journal of Risk and Insurance, was known as the

Journal of Insurance until 1964.

Early studies reflect some of the tensions that were to influence the field from that day

forward. clthough risk management appeared to be evolving to a broader management

function, organizations tended to persist in viewing risk management as a sub function of

finance, owing to the financial nature and purchasing processes of insurance buying. On a

practitioner level, this tension was most obviously manifested in the placement of the
Risk Manager within the organization. Insurance buyers mainly were located in either a

Finance Department, a Purchasing Department, or, later (when employee benefit

concerns became important) a Human Resources Department. However, by the late

1950s, a number of Risk Managers (the term ³Risk Manager´ became more widely used

during this period as well) began to express the view that their duties had moved beyond

merely financial or purchasing concerns. Interestingly, most Risk Managers today remain

placed within Finance or Human Resource departments.

 -.


One of the important evolutionary stories in risk management is the movement away

from the use of traditional insurance products. clthough insurance is still used widely,

larger organizations have reduced their reliance on more conventional arrangements as

Risk Managers discovered that insurance did not meet specific organizational needs or

that internal activities could control the impact of risk and uncertainty on the

organization. For instance, some very large organizations found that they were able to

forecast certain types of losses as well as the insurers, which led to decisions to self-

insure risks. In other organizations, loss prevention activities were found to be an

effective response to particularly challenging problems. Regardless of how this discovery

process occurred within individual organizations, the cumulative effect was the

expansion of the Insurance Buyer/Risk Manager function and an important shift away

from insurance buying.

Ironically, one important influence, safety engineering, is only today being fully

recognized and integrated into risk management. Risk Managers have long acknowledged
the relationship between their responsibilities and safety engineering. However, the

merging of the two into a cohesive whole has not occurred to any great extent. Part of the

explanation for this fact derives from the organizational structure of most businesses and

governments, which has permitted parallel but unrelated growth of the two functions. Part

of the explanation must come from the fairly technical orientation of safety engineering.

Since many early Risk Managers were ³insurance people,´ there may have been some

difficulty in interacting effectively with engineers.

That separation is slowly disappearing. In a 1992 article in the Geneva Papers on Risk

and Insurance, Dr. Vernon Leslie Grose discusses the historical development of

³technological risk management.´ In that paper, Grose tracks the development of the

engineering side of risk management through the ³reliability´ movement of the 1950s,

and through the ³system safety´ movement of the 1960s and 1970s. He notes that safety

engineering has created or promoted several concepts that have filtered into insurance-

buyer side of risk management (Grose refers to this side as the financial side of risk

management). cmong the many concepts he cites are totally integrated systems for

ranking hazards, risk management direction from top management, organization-wide

involvement in the risk management process, and the concept of spill-over benefits from

risk management practices.

Professor H. Wayne Snider of Temple University argues that risk management began to

move into an international phase in the mid-1970s, what he refers to as a ³globalization

phase´. He observes that the Risk and Insurance Management Society (RIMS, the pre-

eminent professional association in the field) began establishing contacts with European
and csian Risk Managers, which led to the formation of professional associations around

the globe. In terms of the practice of risk management, the field began to gain wider

acceptance in the 1970s and 1980s, and the practices began to increase in sophistication.

RIMS began publishing a periodic ³state of the profession´ survey, which tracked the

expanding responsibilities and increasing complexity of risk management practices. This

period was characterized by a particular interest in risk financing activities ± self-

insurance plans, captive insurance companies, finite insurance plans, risk retention

groups, and so on. Further, two severe contractions in the commercial insurance market,

the most severe occurring in the mid-1980s, resulted in an even more rapid movement

away from the use of insurance as a means of financing the cost of losses.


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! 


In the 1990s, risk management practices continue to evolve. Specific duties and functions

vary widely among Risk Managers, largely because the significance of specific categories

of risk varies substantially across organizations. For example, issues related to legal

liability are likely to be paramount for the Risk Manager of a large hospital but are likely

to be of smaller relative importance for a financial service organization such as a lending

institution. Regardless of variations among different organizations, it does seem to be

clear that risk management has moved beyond its primary root; for though insurance

buying continues to be a significant part of most Risk Manager¶s responsibilities, its

relative importance is diminishing. Further, the insurance-buying side of the discipline is

beginning to blend with other organizational risk management activities, such as safety

engineering, legal risk management, information systems security, and so on.

   /

State whether the following statements are  


1. Modern risk management positions evolved out of an insurance buying function.

2. Risk Managers have not acknowledged the relationship between their responsibilities

and safety engineering.

3. The period between 1970 and 1980 was characterised by a particular interest in risk

financing activities.


   
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!

Both the expected value strategy and the minimax strategy have application in risk

management decisions. Because the decisions recommended by these strategies are

diametrically opposed (the expected value strategy always suggests retention as the

preferred approach and the minimax strategy always suggests transfer), the obvious key

is to determine the situations in which each strategy should be applied. One of the earliest

contributions to the risk management field was the development of a set of ³rules of risk

management.´ These rules are simply common sense principles applied to risk situations:

a) Don¶t risk more than you can afford to lose.

b) Consider the odds.

c) Don¶t risk a lot for a little.

Simple as they appear, these three rules provide a basic framework within which risk

management decisions can be made. Unfortunately, they are sometimes misunderstood

and are often neglected.

 0   
  

  

The first of the three rules ± ³Don¶t risk more than you can afford to lose´ ± is the most

important. clthough it does not necessarily tell us what should be done about a given

risk, it does identify the risks about which something must be done. If we begin with the

recognition that when nothing is done about a particular risk that risk is retained,

identifying the risks about which something must be done resolves into determining

which risks cannot be retained. The answer is explicitly stated in the first rule.

The most important consideration in determining which risks require some specific action

is the maximum potential loss that might result from the risk. If the maximum potential

loss from a given exposure is so large that it would result in an unbearable loss, retention

is not realistic. The possible severity must be reduced to a manageable level or the risk

must be transferred. If severity cannot be reduced and the risk cannot be transferred, it

must be avoided. In decision terms, ³Don¶t risk more than you can afford to lose´

identifies the decisions for which either the minimax cost or minimax regret strategy is

appropriate.

 —  

If an individual can determine the probability that a loss may occur, he or she is in a

better position to deal with the risk than would be the case without such information.
However, it is possible to attach undue significance to such probabilities, since the

probability that a loss may or may not occur is less important than the possible severity if

it does occur. Even when the probability of loss is low, the primary consideration is the

potential severity.

This is not to say that the probability associated with a given exposure is not a

consideration in determining what to do about that risk. Just as the potential severity

indicates the risk about which something must be done (that is, the risks that cannot be

retained), knowing whether the probability that a loss will occur is slight, moderate, or

quite high can assist the Risk Manager in deciding what should be done about a given

risk (although not in the way that most people think).

c high probability is an indication that insurance is probably not an economical way of

dealing with the risk. This is because insurance operates on the basis of averages. Based

on past experience, the insurer estimates the amount that it must collect in premiums to

cover the losses that will occur. In addition to covering the losses, the premium must

cover the insurer¶s other expenses. Therefore, paradoxical though it may seem, the best

buys in insurance involve those losses that are least likely to happen. The higher the

probability of loss, the less suitable is insurance as a device for dealing with the exposure.

The best buys in insurance are those in which the probability is low and the possible

severity is high. The worst buys are those in which the size of the potential loss is low

and the probability of loss is high. The most effective way to deal with those exposures in

which the probability of loss is high is through loss prevention measures aimed at

reducing the probability of loss.

The second rule of risk management, ³consider the odds´, suggests that the likelihood or

probability of loss may be an important factor in deciding what to do about a particular

risk ± but which risks? Logically, consideration of the odds is limited to those situations

in which the first rule, ³Don¶t risk more than you can afford to lose,´ does not apply. For

decisions in which one of the possible states of nature is ruin, the minimax cost or

minimax regret strategies are appropriate.

Having limited our application of probability to situations in which ruin is not one of the

possible outcomes or states of nature, it should be noted that even in this limited set of

decisions, situations in which probability theory is useful abound. cmong the more fertile

fields for analysis are the selection of deductibles, and the decision to insure or retain

moderate losses.

 0 
 
 

Whereas the first rule provides guidance for those risks that should be transferred (those

involving catastrophic losses in which the potential severity cannot be reduced) and the

second rule provides guidance for those that should not be insured (those in which the

probability of loss is very high), they leave a residual class of risks for which another rule

is needed.

The third rule dictates that there should be a reasonable relationship between the cost of

transferring risk and the value that accrues to the transferor. It provides guidance in two

directions. First, risks should not be retained when the possible loss is large (a lot)

relative to the premiums saved through retention (a little). On the other hand, there are
instances in which the premium that is required to insure a risk is disproportionately high

relative to the risk transferred. In these cases, the premium represents ³a lot´ while the

possible loss is ³a little.´

Whereas the rule ³Don¶t risk more than you can afford to lose´ imposes a maximum level

on the risks that should be retained, the rule ³Don¶t risk a lot for a little´ suggests that

some risks below this maximum retention level should also be transferred. While the

maximum retention level should be the same for all risks, the actual retention level for

some exposures may be less than this maximum.

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! 

Risk management activities occur before, during, and after losses. Most planning is done

before losses occur. Losses involving natural disaster and other emergencies also require

action while losses are happening. cfter the loss, the Risk Manager must file insurance

claims and analyze loss patterns.

The risk management process involves four steps: (a) identifying potential losses, (b)

evaluating potential losses, (c) selecting the appropriate techniques for treating loss

exposures, and (d) implementing and administer the programme. Each of these is

discussed in some detail in the following section:

! 
#

The first step in the risk management process is to identify all major and minor loss

exposures. This step involves a painstaking analysis of all potential losses. Important loss

exposures relate to the following:

(a) Property loss exposures

‡ Building, plants, other structures

‡ Furniture, equipment, supplies

‡ Electronic Data Processing (EDP) equipment; computer software

‡ Inventory

‡ cccounts receivable, valuable papers and record

‡ Company planes, boats, mobile equipment

(b) Liability loss exposures

‡ Defective products

‡ Environmental pollution (land, water, air, noise)

‡ Sexual harassment of employees, discrimination against employees, wrongful

termination

‡ Premises and general liability loss exposures

‡ Liability arising from company vehicles

‡ Misuse of the Internet and e-mail transmission, transmission of pornographic material

‡ Directors¶ and officers¶ liability suits

(c) Business income loss exposures

‡ Loss of income from a covered loss

‡ Continuing expenses after a loss

‡ Extra expenses

‡ Contingent business income losses

(d) Human resources loss exposures

‡ Death or disability of key employees

‡ Retirement or unemployment

‡ Job-related injuries or disease experienced by workers

(e) Crime loss exposures

‡ Hold-ups, robberies, burglaries

‡ Employee theft and dishonesty

‡ Fraud and embezzlement

‡ Internet and computer crime exposures

(f) Employee benefit loss exposures

· Fairly to comply with Government regulations

· Violation of fiduciary responsibilities

· Group life and health and retirement plan exposures

· Failure to pay promised benefits

(g) Foreign loss exposure

‡ Plants, business property, inventory

‡ Foreign currency risks

‡ Kidnapping of key personnel

‡ Political risks

c Risk Manager has several sources of information that he or she can use to identify the

preceding loss exposures. They include the following:

a) aisk and analysis questionnaires. Questionnaires require the risk management to

answer numerous questions that identify major and minor loss exposures.

b) Physical inspection. c physical inspection of company plants and operations can

identify major loss exposures.

c) Flowcharts. Flowcharts that show the flow of production and delivery can reveal

production bottlenecks where a loss can have severe financial consequences for the firm.

d) Financial statements. cnalysis of financial statements can identify the major assets

that must be protected.

e) Historical loss data. Historical and departmental loss data over time can be invaluable

in identifying major loss exposures.

In addition, Risk Managers must keep abreast of industry trends and market changes that

can create new loss exposures and cause concern. Major risk management issues include

rising workers compensation costs, effects of mergers and consolidations by insurers and

brokers, increasing litigation costs, financing risk through the capital markets, increasing

repetitive motion injury claims, and numerous other issues.

'÷.÷' +

! 
#

The second step in the risk management process is to evaluate and measure the impact of

losses on the firm. This step involves an estimation of the potential frequency and

severity of loss. Loss frequency refers to the probable number of losses that may occur

during some given time period. Loss severity refers to the probable size of the losses that

may occur.

Once the Risk Manager estimates the frequency and severity of loss for each type of loss

exposure, the various loss exposures can be ranked according to their relative importance.
For example, a loss exposure with the potential for bankrupting the firm is much more

important in a risk management programme than an exposure with a small loss potential.

In addition, the relative frequency and severity of each loss exposure must be estimated

so that the Risk Manager can select the most appropriate technique, or combination of

techniques, for handling each exposure. For example, if certain losses occur regularly and

are fairly predictable they can be budgeted out of a firm¶s income and treated as a normal

operating expense. If the annual loss experience of a certain type of exposure fluctuates

widely, however, an entirely different approach is required.

clthough the Risk Manager must consider both loss frequency and loss severity, severity

is more important, because a single catastrophic loss could wipe out the firm. Therefore,

the Risk Manager must also consider all losses that can result from a single event. Both

the maximum possible loss and maximum probable loss must be estimated. The

maximum possible loss is the worst loss that could possibly happen to the firm during its

lifetime. The maximum probable loss is the worst loss that is likely to happen. For

example, if a plant is totally destroyed in a flood, the Risk Manager estimates that

replacement cost, debris removal, demolition costs, and other costs will total Rs.10

million. Thus, the maximum possible loss is Rs.10 million. The Risk Manager also

estimates that a flood causing more than Rs.8 million of damage to the plant is so

unlikely that such a flood would not occur more than once in 50 years. The Risk Manager

may choose to ignore events that occur so infrequently. Thus, for this Risk Manager, the

maximum probable loss is Rs.8 million.

Catastrophic losses are difficult to predict because they occur infrequently. However,

their potential impact on the firm must be given high priority. In contrast, certain losses,

such as physical damage losses to cars and trucks, occur with greater frequency, are

usually relatively small, and can be predicted with greater accuracy.

'÷.÷  !  
 $  
! # +%

The third step in the risk management process is to select the most appropriate techniques

for treating loss exposures. These techniques can be classified broadly as either risk

control or risk financing. Risk control refers to techniques that reduce the frequency and

severity of accidental losses. Risk financing refers to techniques that provide for the

funding of accidental losses after they control. Many Risk Managers use a combination of

techniques for treating each loss exposure.

(a)
 —

Risk control encompasses techniques that prevent losses from occurring or reduce the

severity of a loss after it occurs. Major risk control techniques include avoidance and loss

control.

i) cvoidance: cvoidance means a certain loss exposure is never acquired, or an existing

loss exposure is abandoned. For example, flood losses can be avoided by not building a

new plant in a flood plain. c pharmaceutical firm that markets a drug with dangerous side

effects can withdraw the drug from the market.

The major advantage of avoidance is that the chance of loss is reduced to zero if the loss

exposure is never acquired. In addition, if an existing loss exposure is abandoned, the

chance of loss is reduced or eliminated because the activity or product that could produce

a loss has been abandoned. cbandonment, however, may still leave the firm with a

residual liability exposure from the sale of previous products.

cvoidance, however, has two major disadvantages. First, the firm may not be able to

avoid all losses. For example, a company may not be able to avoid the premature death of

a key executive. Second, it may not be feasible or practical to avoid the exposure. For

example, a paint factory can avoid losses arising from the production of paint. Without

paint production, however, the firm will not be in business.

ii) Loss Control: Loss control has two dimensions ± Loss prevention and loss reduction.

Loss prevention refers to measures that reduce the frequency of a particular loss. For

example, measures that reduce truck accidents include driver examinations, zero

tolerance for alcohol or drug abuse, and strict enforcement of safety rules. Measures that

reduce lawsuits by the consumer of a defective product include installation of safety

features on hazardous products, placement of warning labels on dangerous products, and

institution of quality control checks.

Loss reduction refers to measures that reduce the severity of a loss after it occurs.

Examples include installation of an automatic sprinkler system that promptly

extinguishes a fire; segregation of exposure units so that a single loss can not

simultaneously damage all exposure units, such as having ware-houses with inventories
at different locations; rehabilitation of workers with job-related injuries; and limiting the

amount of cash on the premises.

Loss control is especially effective in reducing job-related accidents and disease that can

result in costly workers compensation claims. Studies by insurers show that loss-control

programmes can substantially reduce workers¶ compensation costs.

(b) Risk Financing

Risk financing refers to techniques that provide for the funding of losses after they occur.

Major risk-financing techniques include retention, non-insurance transfers and

commercial insurance.

(i) Retention: Retention means that the firm retains part or all of the losses that can result

from a given loss. Retention can be either active or passive. Active risk retention means

that the firm is aware of the loss exposure and plans to retain part or all of it, such as

automobile collision losses to a fleet of company cars. Passive retention, however, is the

failure to identify a loss exposure, failure to act. For example, a Risk Manager may fail to

identify all company assets that could be damaged in an earthquake.

Retention can be effectively used in a risk management programme under the following

conditions:

First, no other method of treatment is available. Insurers may be unwilling to write a

certain type of coverage, or the coverage may be too expensive. Non-insurance transfers

may not be available. In addition, although loss prevention can reduce the frequency of
loss, all losses cannot be eliminated. In these cases, retention is a residual method. If the

exposure cannot be insured or transferred, then it must be retained.

Second, the worst possible loss is not serious. For example, physical damage losses to

automobiles in a large firm¶s fleet will not bankrupt the firm if the automobiles are

separated by wide distances and are no likely to be simultaneously damaged.

Finally, losses are highly predictable. Retention can be effectively used for workers¶

compensation claims, physical damage losses to automobiles, and shoplifting losses.

Based on past experience, the Risk Manager can estimate a probable range of frequency

and severity of actual losses. If most losses fall within that range, they can be budgeted

out of the firm¶s income.

(ii) Non-insurance Transfers: Non-insurance transfers are another type of risk financing

technique. Non-insurance transfers are methods other than insurance by which a pure risk

and its potential financial consequences are transferred to another party. Examples of

non-insurance transfers include contracts, leases, and hold-harmless agreements. For

example, a company¶s contract with a construction firm to build a new plant can specify

that the construction firm is responsible for any damage to the plant while it is being

built. c firm¶s computer lease can specify that maintenance, repairs, and any physical

damage loss to the computer are the responsibilities of the computer firm. Or a firm may

insert a hold-harmless clause in a contract, by which one party assumes legal liability on

behalf of another party. Thus, a publishing firm may insert a hold-harmless clause in a

contract, by which the author, and not the publisher, is held legally liable if the publisher
is sued for plagiarism. In a risk management programme, non-insurance transfers have

several advantages:

i) The Risk Manager can transfer some potential losses that are not commercially

insurable.

ii) Non-insurance transfers often cost less than insurance.

iii) The potential loss may be shifted to someone who is in a better position to exercise

loss control.

However, non-insurance transfers have several disadvantages. They are summarised as

follows:

i) The transfer of potential loss may fail because the contract language is ambiguous.

clso, there may be no court precedents for the interpretation of a contract that is tailor-

made to fit the situation.

ii) If the party to whom the potential loss is transferred is unable to pay the loss, the firm

is still responsible for the claim.

iii) Non-insurance transfers may not always reduce insurance costs, because an insurer

may not give credit for the transfers.

(c) Insurance: Commercial insurance is also used in a risk management programme.

Insurance is appropriate for loss exposures that have a low probability of loss but for
which the severity of loss is high. If the Risk Manager uses insurance to treat certain loss

exposures, five key areas must be emphasized. They are as follows:

1. Selection of insurance coverages

2. Selection of an insurer

3. Negotiation of terms

4. Dissemination of information concerning insurance coverages

5. Periodic review of the programme

First, the Risk Manager must select the insurance coverages needed. The coverages

selected must be appropriate for insuring the major loss exposures identified in step one.

To determine the coverages needed, the Risk Manager must have specialised knowledge

of commercial property and liability insurance contracts.

Second, the Risk Manager must select an insurer or several insurers. Several important

factors come into play here, including the financial strength of the insurer, risk

management services provided by the insurer, and the cost and terms of protection. The

insurer¶s financial strength is determined by the size of policy owners¶ surplus,

underwriting and investment results, adequacy of reserves for outstanding liabilities,

types of insurance written, and the quality of management. Several trade publications are

available to the Risk Manager for determining the financial strength of a particular

insurer.
The Risk Manager must also consider the availability of risk management services in

selecting a particular insurer. cn insurance agent or broker can provide the desired

information concerning the risk management services available from different insurers.

These services include loss-control services, assistance in identifying loss exposures, and

claim adjustment services. The cost and terms of insurance protection must be considered

as well. cll other factors being equal, the Risk Manager would prefer to purchase

insurance at the lowest possible price. Many Risk Managers will solicit competitive

premium bids from several insurers to get the necessary protection and services at the

lowest price.

Third, after the insurer or insurers are selected, the terms of the insurance contract must

be negotiated. If printed policies, endorsements, and forms are used, the Risk Manager

and insurer must agree on the documents that will form the basis of the contract. If a

specially tailored manuscript policy is written for the firm, the language and meaning of

the contractual provisions must be clear to both parties. Finally, if the firm is large, the

premiums may be negotiable between the firm and insurer. In many cases, an agent or

broker will be involved in the negotiations.

In addition, information concerning insurance coverages must be disseminated to others

in the firm. The firm¶s employees and managers must be informed about the insurance

coverages, the various records that must be kept, the risk management services that the

insurer will provide, and the changes in hazards that could result in a suspension of

insurance. Those persons responsible for reporting a loss must also be informed. The firm
must comply with policy provisions concerning how notice of a claim is to be given and

how the necessary proofs of loss are to be presented.

Finally, the insurance programme must be periodically reviewed. This review is

especially important when the firm has a change in business operations or is involved in a

merger or acquisition of another firm. The review includes an analysis of agent and

broker relationships, coverages needed, quality of loss control services provided, whether

claims are paid promptly, and numerous other factors. Even the basic decision ± whether

to purchase insurance ± must be reviewed periodically.

The use of commercial insurance in a risk management programme has certain

advantages:

1. The firm will be indemnified after a loss occurs. The firm can continue to operate and

may experience little or not fluctuation in earnings.

2. Uncertainty is reduced, which permits the firm to lengthen its planning horizon. Worry

and fear are reduced for managers and employees, which would improve their

performance and productivity.

3. Insurers can provide valuable risk management services, such as loss-control services,

exposure analysis to identify loss exposures, and claims adjusting.

4. Insurance premiums are income-tax deductible as a business expense.

'÷.÷  !

! 

 (

! !

ct this point, we have discussed three of the four steps in the risk management process.

The fourth step is implementation and administration of the risk management

programme. This step begins with a policy statement.

(a)
 (

!   


c risk management policy statement is necessary to have an effective risk management

programme. This statement outlines the risk management objectives of the firm, as well

as company policy with respect to treatment of loss exposures. It also educates top-level

executives with 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.

In addition, a Risk Management Manual may be developed and used in the programme.

The Manual describes in some detail the risk management programme of the firm and can

be a very useful tool for training new employees who will be participating in the

programme. Writing the Manual also forces the Risk Manager to state precisely his or her

responsibilities, objectives, and available techniques.

(b) —
 &  


The Risk Manager does not work alone. Other functional departments within the firm are

extremely important in identifying pure loss exposures and methods for treating these

exposures. These departments can co-operate in the risk management process in the

following ways:
‡ Accounting. Internal accounting controls can reduce employee fraud and theft of cash.

‡ Finance. Information can be provided showing how losses can disrupt profits and cash

flow, and the effect that losses will have on the firm¶s balance sheet and profit and loss

statement.

‡ Marketing. cccurate packaging can prevent liability lawsuits. Safe distribution

procedures can prevent accidents.

‡ Production. Quality control can prevent the production of defective goods and liability

lawsuits. Effective safety programmes in the plant can reduce injuries and accidents.

‡ Human resources. This department may be responsible for employee benefit

programmes, pension programmes, safety programmes, and the company¶s hiring,

promotion, and dismissal policies.

This list indicates how the risk management process involves the entire firm. Indeed,

without the active co-operation of the other department, the risk management programme

will be failure.

(c) 
&
 +



To be effective, the risk management programme must be periodically reviewed and

evaluated to determine whether the objectives are being attained. In particular, risk

management costs, safety programmes, and loss-prevention programmes must be

carefully monitored. Loss records must also be examined to detect any changes in

frequency and severity. Finally, the Risk Manager must determine whether the firm¶s
overall risk management policies are being carried out and whether the Risk Manager is

receiving the total co-operation of the other departments in carrying out the risk

management functions.

3. what are the social values of insurance ? what are the social costs ? explain



 + 1


There are many social and economic values of insurance, which are as follows:

-÷


$

Perhaps the greatest social value ± indeed, the central economic function ± of insurance is

to obtain the advantages that flow from the reduction of risk. One of the chief economic

burdens of risk is the necessity of accumulating funds to meet possible losses, and one of

the greatest advantages of the insurance mechanism is that it greatly reduces the total of

such reserves necessary for a given economy. Because the insurer can predict losses in

advance, it needs to keep readily available only enough funds to meet those losses and to

cover expenses. If each insured has to set aside such funds, there would be need for a far

greater amount. For example, in many localities, a Rs. 100,000 building can be insured

against fire and other physical perils for about Rs. 500 a year. If insurance is not

available, the insured would probably feel a need to set aside funds at a much higher rate

than Rs. 500 a year.

'÷ —

  

cnother aspect of the advantage just described is the fact that the cash reserves that

insurers accumulate are made available for investment. Insurers as a group, and life

insurance firms in particular, are among the largest and most important institutions

collecting and distributing the nation¶s savings. From the viewpoint of the individual, the

insurance mechanism enables renting an insurer¶s assets to cover uncertain losses rather

than providing this capital internally, much like renting a building instead of owning one.

Capital that is thereby released frees funds for investment purposes. Thus, the insurance

mechanism encourages new investment. For example, if an individual knows that his or

her family will be protected by life insurance in the event of premature death, the insured

may be more willing to invest savings in a long-desired project such as a business

venture, without feeling that the family is being robbed of its basic income security. In

this way, a better allocation of economic resources is achieved.

÷
 —  —


Because the supply of funds that can be invested is greater than it would be without

insurance, capital is available at a lower cost than would otherwise be possible. This

result brings about a higher standard of living because increased investment itself will

raise production and cause lower prices than would otherwise be the case. clso, because

insurance is an efficient device to reduce risks, investors may be willing to enter fields

they would otherwise reject as too risky. Thus, society benefits from increased services

and new products, the hallmarks of increased living standards.

÷
 —

cnother advantage of insurance lies in its importance to credit. Insurance has been called

the basis of the nation¶s credit system. It follows logically that if insurance reduces the

risk of loss from certain sources, it should mean that an entrepreneur is a better credit risk

if adequate insurance is carried. Today it would be nearly impossible to borrow money

for many business purposes without insurance protection that meets the requirements of

the lender.

÷ # — 

cnother social and economic value of insurance lies in its loss control or loss prevention

activities. clthough the main function of insurance is not to reduce loss but merely to

spread losses among members of the insured group, insurers are nevertheless vitally

interested in keeping losses at a minimum. Insurers know that if no effort is made in this

regard, losses and premiums would have a tendency to rise. It is human nature to relax

vigilance when it is known that the loss will be fully paid by the insurer. Furthermore, in

any given year, a rise in loss payment reduces the profit to the insurer, and so loss

prevention provides a direct avenue of increased profit.

÷ )
 

 

Finally, the existence and availability of insurance can lead to increased business and

social stability. Several illustrations may be helpful in envisioning this point. For

example, if adequately protected, a business need not face the grim prospect of

liquidation following a loss. Similarly, a family need not break up following the death or

permanent disability of one or more income producers. c business venture can be

continued without interruption even though a key person or the sole proprietor dies. c

family need not lose its life¶s savings following a bank failure. Old-age dependency can

be avoided. Loss of a firm¶s assets by theft can be reimbursed. Whole cities ruined by a

hurricane can be rebuilt from the proceeds of insurance.


—  


No institution can operate without certain costs. The costs for an insurance institution

include operating the insurance business, losses that are caused intentionally, and losses

that are aggregated.

-÷ 2
!  
 )

The main social cost of insurance lies in the use of economic resources, mainly labour, to

operate the business. The average annual overhead of property insurers accounts for

about 25 per cent of their earned premiums but ranges widely, depending on the type of

insurance. In life insurance, an average of 20 per cent of the premium rupee is absorbed

in expenses. In other words, the advantages of insurance should be weighed against the

cost of obtaining the service.

'÷ # 

 
 —


c second social cost of insurance is attributed to the fact that if it were not insurance,

certain losses would not occur ± losses that are caused intentionally by people in order to

collect on their policies. clthough there are no reliable estimates as to the extent of such
losses, it is likely they are only a small fraction of total payments. Insurers are well aware

of this danger, however, and take numerous steps to keep it to a minimum.

÷ # 

 +%
!!


Related to the cost of intentional losses is the tendency of some insured to exaggerate the

extent of damage that results from purely unintentional losses. For example, Company

cBC has an old photocopy machine that does not work well. When a small fire in cBC

building causes some smoke damage throughout the building, cBC may be tempted to

claim that its fire insurance should pay for a new photocopy machine. The old machine

has likely been affected by smoke, but in reality, the machine did not work well before

the fire and probably would have been replaced soon anyway. The existence of insurance

tempts cBC to exaggerate its loss in this situation. Similarly, health expenses for families

that have health insurance may be higher than the expenses for uninsured families. Once

an accident or sickness has occurred, an individual may decide to undergo more

expensive medical treatment, or the physician may prescribe it if it is known that an

insurer will bear most or all of the cost.

—
     


Traditionally, the life insurers have been solely dependent on the agency distribution

force. On the contrary, the general insurance business has been dependent totally on the

Development Officers. The scenario has been different for the general insurers a µno

agency commission¶ was payable for writing business more than 10 lakh, thus prohibiting

brokers. The new private insurer coming in with the liberalisation of the sector will add
more channel of distribution in the Indian market parallel to that existent. Innovation and

diversification will become the buzzards in the business. Emerging scenario is evolving

as a generic model in markets around the globe. Even in markets, which are consolidating

like Europe, re-strategising distribution has been deciding the success for the insurers.

The situation has become more complex with the development in systems and software

technology and changing social patterns. cll these have conspired to cause an upheaval in

the traditional distribution methods. The new evolving system will now have to integrate

the three players in the insurance market.

The buyers will consist of consumers, employees, and employers. The carriers or the

policy issuers will focus mainly on life and annuities, property and casualties, health and

ancillaries. The critical link in the system will be the distributor. Those who will provide

value-added and low-cost services will be the survivors.



—
  

J
 !

Most of the life insurance companies in India follow the traditional route of marketing

through agents. In case of private players they are nomenclature as Insurance

cdvisors/Planners. The companies emphasise on building a good field force, trained to

get people thinking about their family¶s financial security and recommend appropriate

policies for their needs. The agents are trained to be sensitive to the dominant issues in

any family¶s life like education and marriage of children. Most life insurance agents are

trying to sell the broad concept of pre-planning your life. The success of LIC with its
direct field force, rather, army of 6,51,000 agents is exemplary. In case of non-life

insurance also much of the distribution work is done by the agents or Development

Officers.

J )

Insurance brokers are professionals who assess risk on behalf of a client, advise on the

mitigation of that risk, identify the optimal insurance policy structure, bring together the

insured and insurers, carry out work preparatory to insurance contracts and where

necessary, assist in the administration and performance of such contracts, in particular

when claims arise.

Unlike insurance agents who are retained by Insurance Companies, Brokers are retained

by the insured and therefore their primary responsibility is towards the insured. Some of

the benefits of introducing brokers in the Indian market are:

½mprovement in Customer Service: with increased competition, insurance brokers have a

greater motivation to introduce new and innovative products, to be more responsive to

consumer needs and to deliver higher terms quality services. Indian corporate and

consumers benefit directly in terms of service as well as product and policy innovation,

and are consequently able to secure appropriate insurance cover more cost effectively.

Transfer to Technology and Managerial Know-how: Insurance brokers introduce

international best practice in technical skills and products, training programmes systems

and technology, and managerial techniques. Currently the availability of trained

manpower is a major constraint in the development of the insurance broking business in

India and international players can contribute heavily in bridging this gap.

uenefits to ½nsurance Companies: Most major global insurance companies spend the

majority of their time handling commercial and industrial risk. They find dealing with

brokers to be easier and speedier because only the intricate points or special requirements

need detailed discussion. Brokers also assist in creating insurance awareness, increasing

market penetration and act as a catalyst to increase competition and improve customer

service.

Foreign Exchange Considerations: Brokers enable Indian insurers to increase their

retention capacities by applying their international reinsurance skills in optimising their

reinsurance programmes, thereby effecting further saving in foreign exchange outflow. In

addition, they can assist the local insurers to develop new products and accordingly

increase the premium base.

&  —
 

The new channels of distribution for the Indian insurance industry are:

0irect Marketing ± Company owned sales team concept is now employed by a majority

of the new players and has proved effective in customer creation and retention.

urokers/Corporate Agents ± cuthorised by IRDc to sell customised products on behalf

of insurance companies.
½ndependent Financial Advisors ± cuthorised agents of insurance companies having tie

ups, may be with more than one company.

Telemarketing ± Marketing through telephonic devices, generating leads through cold

calls and forwarding the leads to the main sales team of the company.

Work site Marketing ± Under this strategy, the seller sends his team to the target group

and explains the products and services suitable for them. Organisations such as the

groups: HDFC, ICICI, Kotak Mahindra are using this kind of distribution strategy

effectively.

aetail Chains ± Cross selling of products at retail outlets.

½nternet Marketing ± internet-based product offerings.

uancassurance ± Distribution of insurance products by banks (this is elaborated in detail

in Unit 6).

  

The function performed by any insurer necessarily depends on the type of business it

writes, the degree to which it has shifted certain duties to others, the financial resources

available, the size of the insurer, the type of organization used, and other factors.

Nevertheless, it is possible to describe the usual activities that are carried out, although it

should be remembered that the specific nature and extent of each varies somewhat from

insurer to insurer. These functions, which are normally the responsibility of definite

departments or divisions within the firm, are:

-÷  J


One of the most vital needs of an insurance firm is securing a sufficient number of

applicants for insurance to enable the company to operate. This function is often called

production in the context of the insurance industry; it corresponds to the sales or

marketing function in an industrial firm. The term is a proper one for insurance because

the act of selling is production in its true sense. Insurance is an intangible item and thus

does not exist until a policy is sold.

The µproduction sales management team¶ of any insurer supervises the relationships with

agents in the field. In firms such as exclusive agents, where a high degree of control over

field activities is maintained, it recruits, trains and supervises the agents or salespersons.

However, many insurers support marketing research departments whose job is to assist

the production department in planning marketing activities, such as determining market

potentials, designing and supervising advertising, conducting surveys to ascertain

consumer attitudes toward the company¶s services, and forecasting sales volume.

'÷ &!

Underwriting includes all the activities necessary to select risks offered to the insurer in

such a manner that general company objectives are fulfilled. In life insurance,

underwriting is performed by branch or regional office personnel, who scrutinize

applications for coverage and make decisions as to whether they will be accepted, and by

agents, who produce the applications initially in the field. In the property-liability

insurance area, agents can make binding decisions in the field, but these decisions may be
subject to post-underwriting at a higher level because the contracts are cancellable on due

notice to the insured. In all fields of insurance, however, agency personnel usually do

considerable screening of risks before submitting them to home office underwriters.

÷


!

cn insurance rate is the price per unit of insurance. Like any other price, it depends on

the cost of production. However, in insurance, unlike other industries, the cost of

production is not known when the contract is sold, and it will not be known until

sometime in the future, when the policy has expired. One basic difference between

insurance pricing and the pricing function in other industries is that the price for

insurance must be based on a prediction. The process of predicting future losses and

future expenses and allocating these costs among the various classes of the insured is

called µratemaking¶.

The ratemaking function in a life insurance company is performed by the actuarial

department, or in smaller companies, by an actuarial consulting firm. In the property and

liability fields, rates are developed from trended loss statistics provided by an advisory

organization or accumulated by the individual insurer. In the field of marine insurance

and inland marine insurance, rates are often made by the underwriter on a judgement

basis.

In addition to the statutory requirements that insurance rates must be adequate, not

excessive, and not unfairly discriminatory, certain other characteristics are considered

desirable. To the extent possible, for example rates should be relatively stable over time,
so that the public is not subject to wide variations in cost from year to year. ct the same

time, rates should be sufficiently responsive to changing conditions to avoid inadequacies

in the event of deteriorating loss experience. Finally, whenever possible, it is also

desirable that the rate provide some incentive for the insured to prevent loss.

÷ (

!! —

 #

Settling losses under insurance contracts and adjusting any differences that may arise

between the company and the policyholder are the functions of claim management. In

large organizations, risk managers are very involved with this process. Claim

management is often accomplished in the field through adjusters who are employed to

negotiate certain types of settlements on the spot. Such adjusters may have considerable

legal training. The Claims Department of an insurer will have the responsibility of

ascertaining the validity of written proofs of loss, of investigating the scene of the loss, of

estimating the amount of the loss, of interpreting and applying the terms of the policy in

loss situations, and finally of approving payment of the claim. These functions are more

extensive in property-liability insurance than in life insurance because of the higher

frequency of losses, the predominance of partial losses, and the uncertainty of the amount

of loss in individual cases.

In many cases, the adjuster is a salaried staff employee of the insurer. In territories where

an insurer does not have a sufficient volume of business to employ a staff adjuster, the

insurer will often make use of an independent adjuster.

Careful management of claim statements is of paramount importance to the success of an

insurer. Reluctant claims settlement brings with it public ill-will, which may take years to

overcome. Often negotiation with the Claims Department is the only direct contact that

the insurance buyer has with the insurer. c bad impression received on that contact may

result in loss of business, court action, regulatory censure, or even suspension of the right

to carry on business in the jurisdiction involved. On the other hand, an overly liberal

claims-settlement policy may ultimately result in higher rate levels and loss of business to

competitors charging lower premiums.

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!

When an insurance policy is written, the premium is generally paid in advance for

periods varying from six months to a year. This advance payment of premiums gives rise

to funds held for policyholders by the insurer, funds that must be invested in some

manner. Every insurance company has such funds, as well as funds representing paid-in

capital, accumulated surplus and various types of loss reserves. Selecting and supervising

the appropriate investment medium for these assets is the function of an Investment

Department. Investment income is a vital factor to the success of any insurer. In life

insurance, solvency of the insurer depends on earning a minimum guarantee return on

assets. In property and liability insurance, investment income has accounted for a

substantial portion of total profits and has served to offset frequent underwriting losses.

Because the manner in which insurance monies are invested is the subject of somewhat

intricate government regulation, the investment manager must be familiar with the laws

of the regulatory bodies.


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The accounting function for insurance management has essentially the same purpose as

accounting for the operating results of any firm, namely, to record, classify, and interpret

financial data in such a way as to guide management in its policy making.

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Various functions such as legal advice, marketing research, engineering services, and

personnel work are often performed for an insurer by individuals or firms outside the

company or by a specialized department set up within the company.

 #!
 The function of the legal adviser is to assist others in the company in

their tasks. Underwriters receive aid in the preparation of policy contracts and

endorsements so that the company¶s intention will be phrased in correct legal

terminology. In the administration of claims, particularly disputed claims, legal aid is

important; if court action is required, the legal staff must represent the company.

 (
!

 Marketing research typically involves selected types of

research, such as testing and developing effective advertising that can be a vital factor in

the long-run success of any insurer. The success that direct writers have had in winning

markets away from those insurers using the indirect channel of distribution has increased

the interest of the latter in marketing research.

 +!!  Engineering services are used as valuable aids to rate making

and underwriting. For example, the engineer provides information that will help answer
the question, ³How long will fire-proof glass resist breaking when subject to the heat of a

burning building?´ If a building has such glass, the underwriter is in a much better

position to assess its importance.

  (

! Personnel management normally includes selecting and

discharging employees, keeping employment records, supervising training and

educational programs, administering recreational and fringe benefit programmes, and

other similar functions. Most large companies and many small ones have separate

Personnel Departments. Regardless of the size of the firm, personnel management is an

essential function. Insurance, particularly life insurance, has experienced a somewhat

more rapid turnover of employees than other industries. The need for giving increased

attention to the problem of turnover and discovering its causes has increased the scope

and importance of personnel management among insurance companies.