Risk Management & Insurance Key Theory Concepts PDF

CFA Risk Management & Insurance Key theory concepts www.proschoolonline.com What are Financial risks? Financial risk of Financial...

CFA Risk Management & Insurance Key theory concepts www.proschoolonline.com What are Financial risks? Financial risk of Financial the possibility is loss Risks can be of two types 1. Low-level daily risks: E.g., Catching a cold 2. Substantive future risks: E.g., House getting robbed, being in a car accident Risks are shown as a probability between 0% (never occur) and 100% (guaranteed) Risks that are high probability, Risks that are low probability, e.g. e.g. Age-related health issues House damaged due to freak Demise at some point in time weather www.proschoolonline.com www.proschoolonline.com Types of financial risk Speculative Pure Risks that can generate either profit Risks that only have potential for loss or loss (or no change) No possibility of profit or gain Insurance will not cover such Insurance coverage is often risks available for pure risks Examples include Examples include Gambling Loss of income Starting a business Death or illness Investing in stocks Property damage etc www.proschoolonline.com www.proschoolonline.com Risk → Perils  Hazards Insurance policies specify a list of Perils Examples that they will cover Property damage (=Substantive Perils are the cause of losses, e.g. future risk) Hail and fire cause property damage Cancer can lead to disability or death. Perils (=Specified in Policy) Fire, hail, lightening Theft, robbery Hazards increase chance of Peril Physical hazards like road conditions, driving under influence etc Hazards: (= increased chance of peril) Lack of fire safety in building Moral hazards like faking death to claim insurance High crime rate in locality Morale hazards (forgetfulness or carelessness) www.proschoolonline.com www.proschoolonline.com  CFA Risk Management Process What is risk management / Process of risk management Process of relating to insurable and uninsurable risks addressing concerns Identify risk management goals Collect information to identify risk exposures facing the client Analyze and evaluate the information Construct a risk management strategy (i.e., determine appropriate risk treatment methods) Implement the recommendations Monitor the recommendations for any needed changes www.proschoolonline.com www.proschoolonline.com Risk management techniques For each aspect of life, you can develop a risk strategy High Severity For e.g., for a person who actively treks in the mountains Reduce Avoid Reduce: Wear proper safety gear High Low Avoid: Stop trekking. Hence no risk chance chance Retain: Take the risk that an accident may happen while trekking Retain Transfer Transfer: Buy insurance for possible accidents while trekking Low Severity www.proschoolonline.com www.proschoolonline.com 3 rules when in doubt about recommending Insurance In cases when a risk management decision is not obvious, check if any of the following apply to the situation and act accordingly Consider the Don’t risk a lot Don’t risk more odds for a little than you can lose Higher the odds Don’t carry a Don’t be greedy. of a risk catastrophic loss Take calculated occurring, higher if the cost to risks that will not its premium insure is small ruin you if they Insuring a high- fail. probability risk will be exorbitant www.proschoolonline.com www.proschoolonline.com  CFA Basics of Insurance www.proschoolonline.com What is insurance and how does it work Guarantee of for specified loss, in return for payment compensation damage, illness or death of a premium Insurer underwrites a risk Insurer issues an Insurance Policy Consumers buy the policy & pay premiums Consumers claim compensation www.proschoolonline.com www.proschoolonline.com Underwriting = Acceptance of Risk by an insurer To underwrite a risk, the underwriter will consider 4 factors 1st and 2nd factors relate to risk probability, the 3rd and 4th relate to commercial viability Law of large Measurable & Loss to Insurer is Loss by Chance number defined Loss not catastrophic Foundational Loss must be a Loss to insurer Loss amount principle result of an must be should not Is there enough accident or measurable by result in Insurer data to predict random event insurer in going bankrupt the probability monetary of loss? terms Risk of insuring 20,000 Value of each house to Catastrophic loss (i.e. Likelihood of a house homes against fire can be insured can be all 20,000 houses catching fire is random be predicted and measured and defined catching fire) would (fortuitous) premiums calculated by Insurer ruin insurer www.proschoolonline.com www.proschoolonline.com 9 core Principles of an Insurance Policy Insurable interest Insurance Indemnity principles Utmost good faith Subrogation a legal activity as per law Must fall under some Jurisdiction Legal Between legal parties (able to enter contract) principles Offer and Acceptance (By Insurer to Insured) Have a consideration (payment / performance) www.proschoolonline.com www.proschoolonline.com 1. Insurable interest Insurable interest is the basis of all insurance policies. To pass this check, there needs to be an object and an associated financial hardship I.e. the insured suffers financial hardship if a defined object occurs To exercise insurable interest, the policyholder must buy insurance on the item or entity (the insured interest). Any change in the insurable interest usually requires a new policy. Company insures its Flat-owner insures Individual buys CEO own flat health insurance Object = Life of CEO Object = Damage to Object = Health Financial hardship = flat from perils care for self cost of rehiring and Financial hardship = Financial hardship = retraining catastrophic loss cost of healthcare www.proschoolonline.com www.proschoolonline.com 2. Indemnity Indemnity means to make whole i.e. restore condition to what it was prior to loss It restricts the Policy-holder to the amount of covered loss, i.e. it ensures a policy- holder does not make a loss or a profit from a policy In effect, Indemnity ensure a policy-holder is not able to claim more than their loss Indemnity does not strictly apply to Life or Personal Accident insurance, since they are classified as “contingent” risks House insured for Rs 50 lacs Gold insured for Rs2000 Life insured Event: Fire Event: Theft Event: Death Insurance received: Rs 50 Was valued 3 years ago Unable to make whole lacs Since then gold has The fact that the current appreciated 100% market price of house was however insurer still pays Rs 80 lacs does not matter Rs 2000 www.proschoolonline.com www.proschoolonline.com 3. Doctrine of Utmost Good Faith Means the highest degree of honesty and sincerity Pre-policy: policy-holder disclosing relevant information prior to accepting policy Nowadays, specific questionnaires are used to ensure such gaps are minimized Post-policy: Fraudulent claims by policy holders AND delay tactics employed by Insurers Individual buys Life Individual buys health Insurer has to pay life Insurance insurance insurance Does not disclose a Does not disclose Delays the process by life-threatening job or diabetes at time of 6 months citing file profession at time of policy since premium was lost or that taking the policy would go up signing authority was Policy can be void Policy can be void www.proschoolonline.com www.proschoolonline.com 4. Subrogation Insurer can legally pursue the party that caused loss to the policy holder. E.g. The insurer pays its client’s claim for losses directly, then seeks reimbursement from the other party's insurance company. By law, the Insurer can also sue the party in order to recover due money It also restricts the insurer from making a profit on the claim Auto insurance Health insurance Special case Insurer pays the car If a policy-holder is Occasionally a policy can owner for damage to car injured in a car accident, have Subrogation waived Insurer claims this the Insurer can recover by the Policy-holder amount from the insurer the claim from the party In such case, the Insurer who’s policy owner at fault will raise the premium as caused the damage they cannot subrogate www.proschoolonline.com www.proschoolonline.com Additional contract terms and sections Aleatory: Financial participation is unequal Terms Adhesion: Insurer made it, so must abide by terms Unilateral: one-directional from Insurer to holder (important) Conditional: Conditions to be followed for claims Duty of disclosure: Reminds holder of obligations Declarations: Statements made by policy-holder Sections Insuring agreement: What is being insured Conditions: Rules to be followed to claim Exclusions: Things not covered by policy www.proschoolonline.com www.proschoolonline.com Underinsurance / Co-insurance Underinsurance (= problem) Arises when insured value is lower than actual value E.g. home valued at 100,000 by insurer but insured for a value of 70,000 by homeowner Becomes a problem when all policy-holders do the same thing Since the insurer then receives insufficient premiums to maintain viability of the pool Coinsurance ( = solution), applied in case of Underinsurance Clause that states that only complete destruction will result in payment of sum insured In all other cases, coinsurance (or average) formula will apply for partial damage (Actual Amount of Insurance ) * Amount of Loss = Amount of Claim (Required Amount) = 70000/100000 or 70% of loss amount will be paid under Coinsurance clause www.proschoolonline.com www.proschoolonline.com  CFA Insurance in India www.proschoolonline.com Governments support Insurance as a sector A well-built insurance sector provides the Government with a safety net from loss-causing events and enhances its risk-taking ability 1. To fund infrastructure projects: Since funds 2. Attract investments & FDI growth: By collected by Insurance companies are available for deregulating the sector (allowing private players the long term, infrastructure projects can be fast- to participate) and opening to Foreign Direct tracked using these funds Investment in Insurance companies Benefits of Insurance to the Government 3. Individual safety nets: On an individual basis, 4. Stimulate society: Due to external risks being insurance money provides support to the family in managed through insurance, society can focus on the event of loss due to death, immobility, work productive activities like buying homes or restraints, illness etc. expanding businesses and demand www.proschoolonline.com www.proschoolonline.com Indian laws relating to Insurance Laws help - Protect the customer - Regulate the insurance companies Acts The Insurance Laws Consumer Doctrines of Waiver The Insurance Act, Indian Contract Act, (Amendment) Act, Protection Act, and Equitable 1938 1872 2015 2015 Estoppel www.proschoolonline.com www.proschoolonline.com The Insurance Act, 1938 The Insurance Act, 1938 was the primary legislation governing all types of insurance to furnish strict state jurisdiction over insurance business (Amended in 2002 applicable to whole of India). Part I of this Act lays down the definitions such as ‘the insurance company’, ‘insurer’, ‘insurance agent’, ‘actuary’, ‘intermediaries’ and others related to all aspects of the Insurance industry. Part II is the main section of this Act which deals with the provisions applicable to the insurers. Part V of this Act lays down the penalty for default in complying with this Act. It also gives power to the Authority (IRDA) to make regulations. www.proschoolonline.com www.proschoolonline.com  The Insurance Laws (Amendments) Act, 2015 This Act amended three previous Acts related to the insurance sector in India: - The Insurance Act, 1938. - The General Insurance Business (Nationalization) Act, 1972. - The Insurance Regulatory and Development Authority Act, 1999. Under the new Act: - Provisions related to investments by insurance companies and prohibition for investment of funds outside India have been strengthened. - The power of investigation and inspection by the Authority has been further increased. - Provisions related to assignment and transfer of insurance policies, nomination of policy holder, prohibition of payment by way of commission have all been strengthened. - Revised limitation of management expenses in insurance business have been set. - New provisions have been inserted related to the appointment and record of insurance agents. As per Section 7A, the cap on Foreign Direct Investment (FDI) in Indian insurance companies has been raised to 49% providing additional capital flow in the insurance sector. To set up an efficient grievance redressal system, the Securities Appellate Tribunal (SAT) has been made the appellate authority to IRDAI’s order. www.proschoolonline.com www.proschoolonline.com Indian Contract Act, 1872 Section 182 of the Act defines an “agent” as a person employed to do any act for another, or to represent another in dealings with third persons, known as the “principal”. It is important for a financial advisor to understand the laws regarding Agency because nearly all business transactions worldwide are meted out through this relationship between the Agent and the Principal. An Agency is created when one person delegates his authority to some different person, or appoints him to do some specific tasks in their specified areas of work. It also deals with appointment and authority of agents/sub-agents, Agent’s duty to Principal and Principal’s duty to Agent amongst other important subject matters. www.proschoolonline.com www.proschoolonline.com Consumer Protection Act, 2019 The Consumer Protection Act, 2019 is enacted to protect the interests of the consumers in India. It makes provision for the establishment of authorities for timely and effective administration and settlement of consumer’s disputes. It applies to all goods and services. The 2019 Act repeals the 1986 Act whereby it has substantially enhanced the scope of protection afforded to consumers by bringing within its purview advertising claims, endorsements and product liability. While it continues to have Dispute Redressal Commissions at the District, State and National levels, the monetary value of complaints that can be entertained at each of these commissions has been increased substantially. The 2019 Act also introduces the power of judicial review, which will allow Consumer Commissions to review their orders. The IRDA act along with Consumer Protection Act, 1986 helps protects the interest of consumers and give them the right to seek consumer redressal. It would provide consumers rights to prevent consumers from fraud and unfair practices while availing insurance services www.proschoolonline.com www.proschoolonline.com Doctrines of Waiver & Equitable Estoppel The legal doctrines of Waiver and Estoppels are directly related to the responsibilities of insurance agents. They are important to individuals because they can work to their advantage when dealing with an insurance company. Waiver is the conscious and discretionary giving Estoppel: “a legal rule that prevents someone from up of a known legal right. changing their mind about something they have A waiver can be express or implied. previously said is true in court”. Often described as a rule of fair play. Express waiver could be oral or written. In either From the insurance point of view, an insurer may waive a case, it is a clear statement that a right is being right, and after the policy holder has relied upon the given up. waiver and acted upon it, the insurer will be stopped from claiming the right. Implied waivers are created through the conduct of the waiving party. E.g.,, if the insurance Example: An individual fails to disclose some information company accepts the premium from a in the insurance proposal form and the insurer does not policyholder after the expiration of the grace request that information and issues the insurance policy period, the company has impliedly waived its right (a waiver). In future when a claim arises, the insurer to claim that the policy had lapsed. cannot question the contract because of non-disclosure. This is estoppel. www.proschoolonline.com www.proschoolonline.com  CFAInfrastructure Regulatory around Insurance www.proschoolonline.com Structure of Indian Insurance two categories – Life and General both governed by the Insurance Regulatory and Development Authority of India (IRDAI) IRDAI established via Insurance Regulatory and Development Authority (IRDAI) Act, 1999. Indian postal department provides life insurance through Postal Life Insurance This is exempt from the purview of IRDAI As of 2019, 70 insurance companies active 24 are life insurance (including LIC ) 27 more are general insurance 7 are stand-alone health 12 are re-insurers www.proschoolonline.com www.proschoolonline.com 1. About IRDAI The Insurance Act, 1938 provides the powers to IRDAI IRDAI is an autonomous and statutory body incorporated in 2000 following recommendations of the Malhotra Committee. It has a 10-member board, appointed by the government (Chairman, 5 full- time directors, 4 part-time directors) Its Mission as stated in the preamble to the IRDAI Act, 1999, is “to protect the interests of holders of insurance policies, to regulate, promote and ensure orderly growth of the Insurance industry” Its goals are 1. Encourage 3. Promote high 2. Protect the 5. Set standards systematic standards of 4. Speed up claim interest of the and conduct growth of the integrity in the settlement. policyholders. vigilance. industry. market www.proschoolonline.com www.proschoolonline.com IRDAI duties, powers, functions Section 14 of the IRDAI Act includes some of the following Registering and regulating insurance companies Protecting policyholders’ interests Licensing and establishing norms for intermediaries Promoting professional organizations in insurance Regulating and supervision of premium rates and terms of general insurance covers Specifying financial reporting norms of insurance companies Regulating investment of policyholders’ funds by insurance companies Ensuring the protection of solvency margin by insurers Safeguarding insurance coverage in rural and weaker areas of society www.proschoolonline.com www.proschoolonline.com IRDAI Duties, Power & Functions 1. Licensing & Governance of Insurance companies and Intermediaries Rules were evolved over time by IRDAI as follows 2009 -outlined comprehensive guidelines on Corporate Governance practices of insurance functions. 2013- Companies Act changed, used to review the 2009 guidelines 2016- recast as Corporate Governance Guidelines for Insurers in India - 2016, Key aspects of these rules are as follows Key Role of Governance Board of management appointed structure Directors functions actuaries Relationships External auditor Whistle-blower Disclosures with appointment policy stakeholders www.proschoolonline.com www.proschoolonline.com IRDAI Duties, Power & Functions 2. Apex Insurance Regulator and Industry Watch-Dog IRDAI as the Apex body overseeing all insurance in India sets the following rules Every insurance company IRDAI sets all the rules for the IRDAI served as Watch Dog for needs to be registered under industry insurance / reinsurance IRDAI All companies and associates It must protect interest of Oversee economic growth of (agents, TPA’s, brokers etc) policy holders the sector must follow IRDAI rules and reporting guidelines www.proschoolonline.com www.proschoolonline.com IRDAI Duties, Power & Functions 3. Supervision of Tariff Advisory Committee (TAC) TAC is a statutory body established by the Insurance (Amendment) Act, 1968, and mandated to “ control and regulate the rates, advantages, terms and conditions that may be offered by insurers in respect of general insurance business” It is a complementary body to IRDAI and its composition (basis various acts) is currently as follows IRDAI chairman is TAC chairman A senior officer of IRDAI is the TAC vice-chairman It has 10 elected members from the Indian insurance market TAC’s decisions are final and binding to all non-life insurers as well as the insured in India and is tasked with following duties and functions as per Section 14(2) of IRDAI Act Publishing Tariffs Ensuring Collection of Clarifying Inspection of Drawing up and and Other Implementation Data and Queries of Risks Updating Tariffs Regulations of the Tariffs Analysis Insurers www.proschoolonline.com www.proschoolonline.com IRDAI Duties, Power & Functions 4. Power to Issue Guidelines and Directions Power to delegate to the Chairperson, or any other member, any of its powers and functions Also form committees of the members and delegate to them the powers and functions of the Authority by a general or special order Also establish a Committee, to be known as the Insurance Advisory Committee (IAC) In consultation with the IAC, make regulations consistent with the Act and the rules made thereunder to bring out the purposes of the Act. However, such changes must the laid before House of parliament while in session www.proschoolonline.com www.proschoolonline.com 2. Insurance Councils / General Insurance Council Were constituted in 2001 under Section 64C of the Insurance Act 1928 A forum of all stakeholders (government, statutory bodies etc) that works as an active link between the Indian insurance industry and the global markets. Life Insurance Council: Assists the life insurers in maintaining high standards of service to policyholders. Also aims to transform the life insurance industry into a profitable service along with the welfare of policyholders. General Insurance Council: Promotes better understanding of non-life insurance industry. Aims to strengthen the non-life insurance industries. The council develops codes of conduct for the members companies, compliance programs to observe rules and regulations etc. www.proschoolonline.com www.proschoolonline.com 3. Insurance Information Bureau of India (IIB) Insurance is data driven. Hence in 2009, IRDAI constituted IIB to support it as an advisory body and in 2012 IIB was registered as an independent society. IIB has dedicated IT/ data support verticals for Life, Health, Motor, Property, Fire, etc. It also provides services for third party motor insurance data (V-Seva package) and handles the Central Index Server that acts as a nodal point between insurance repositories and helps de-duplicate demat accounts. The main functional areas of IIB includes: Sole point for Provide Publish reports to Publish reports for insurance industry benchmark rates help IRDAI and the advantage of data for the industry insurers the entire industry Provide inputs for Detect any fraud, Ensure data is accessible policy analysis insurance gaps etc to market players www.proschoolonline.com www.proschoolonline.com 4. Insurance Ombudsman 1. Establishment & Objective Created by a Government of India Notification in 1998. Aim to ensure impartial and speedy grievance handling, Any person who has a grievance against an insurer can 2. Appointment, Tenure and Jurisdiction make a complaint in writing to the Ombudsman Eligibility: drawn from Insurance Industry, Civil Services, Administrative Services and Judicial Services. 3. Rights and Power Tenure: term of three years or till the age of seventy, whichever is earlier, and is eligible for re-appointment. Empowered to act as counselor and mediator for complaints on all aspects of insurances including: Jurisdiction: The Executive Council of Insurers has repudiation of claims by the insurer appointed seventeen (17) Ombudsman across the delay in settlement of claims country allotting them different geographical areas. dispute regarding premium paid or payable dispute on the legal construction of the policies non-issuance of insurance documents to policyholders after receipt of premium www.proschoolonline.com www.proschoolonline.com 5. Insurance Insitute of India 1. Introduction 2. Education & Training The Insurance Institute of India (III), earlier known as The IRDAI has recognized the Institute as Federation of Insurance Institutes, was formed in the examining body to conduct pre- 1955 in Mumbai, as an apex education and training recruitment examinations for Insurance provider Agents, Corporate Agents, Web The institute awards Certificates and Diplomas to Aggregators, Insurance Marketing Firm and successful candidates. Renewal of Insurance Broker exams, pre- These are recognized by the Indian Government, the licensing test for Insurance Surveyors and IRDAI and various insurance companies in India and Loss Assessors and as the exam conducting abroad. body for Postal Life Insurance Agents. 3. Authority and functions To run college and conduct examinations within the insurance field and award certificates, diplomas and degrees To prepare and provide reading materials and similar alternative education methods To form and maintain a library. To provide scholarships, grants and prizes for research or any other educational work pertaining to insurance. To ascertain the law and practice and to disseminate such knowledge among those interested in insurance. Assist people in the insurance industry to acquire necessary skills and expertise. www.proschoolonline.com www.proschoolonline.com  CFA Insurance Intermediation in India www.proschoolonline.com Different parties involved in Insurance Insurance involves multiple parties. There are various additional parties involved in Insurance The first 6 are directly involved with sale of policies. The remaining 3 provide support to the sector Insurance Agents Others Web Aggregators Insurance Brokers Marketing Firms Surveyors, loss Third party Point-of-sales Insurance assessors, Medical administrators Person Repositories examiners (TPAs) www.proschoolonline.com www.proschoolonline.com Risk Management is a core foundation Upside = Financial goals, Wealth creation Protect client from risks Cash Flow & Health & Life Legal assets Downside Loss of What if / Client = Potential income, unforeseen exposure to for loss assets event(s) litigation www.proschoolonline.com www.proschoolonline.com