Chapter 5: Insurable Risks & Risk Mitigators PDF

# Chapter 5: Insurable Risks & Various Risk Mitigators To be insurable, the event being insured against, such as death, accident or fire must result in a financial loss which can be quantified and insured against. The premium payable will depend upon this expected loss and the probability of the ev...

# Chapter 5: Insurable Risks & Various Risk Mitigators To be insurable, the event being insured against, such as death, accident or fire must result in a financial loss which can be quantified and insured against. The premium payable will depend upon this expected loss and the probability of the event occurring during the period of contract. ## Requirements of an Insurable Risk: There are certain requirements for a risk to be insurable: - **Large number of exposure units**: Large group of similar, though not necessarily identical, units are subject to the same peril or group of perils. An insurance company is able to offer the protection it does because it operates a common pool in which only a few will suffer loss in any one year. The entire pool pays premium but the liability for the insurance company will be only to a few in a year. In the absence of a large number of people being exposed to the same risk, the premium payable would be much higher, and it would be unviable for the insurer and the insured. - **Accidental and unintentional**: Loss must be accidental, unintentional, and uncertain. The only exception is life insurance where the event being insured against, namely death, is certain. However, the time of death is uncertain, which makes it insurable. Loss should be fortuitous and outside the insured's control. - **Determinable and measurable**: Loss should be definite as to cause and amount. - **No prospect of gain or profit**: A further characteristic of the insurable risk is that it does not involve any prospect of gain or profit. This means that, if it was possible to insure against not making a profit from selling goods in a shop, there would be very little incentive to try to sell the goods if the owner knew the insurance company would step in and pay up anyway. - **Chance of loss must be calculable**: Insurer must be able to calculate with some accuracy, average frequency, and average severity of future losses. - **Premium must be economically feasible**: Premiums should not only be affordable but also far less than the value of the policy. Else the option to retain risk will be more feasible than transfer risk through insurance. ## How Insurance Works? Firstly, these must be an asset which has an economic value. The **ASSET**: - May be physical (like a car or a building) - May be non-physical (like name and goodwill) - May be personal (like One's eyes, limbs, and other aspects of One's body) The asset may lose its value if a certain event happens. This chance of loss is called as **risk**. The cause of the risk event is known as **peril**. There is a principle known as **pooling**. This consists of collecting numerous individual contributions (known as premiums) from various persons. These persons have similar assets which are exposed to similar risks. This pool of funds is used to compensate the few who might suffer the losses as caused by a peril. This process of pooling funds and compensating the unlucky few is carried out through an institution known as the **insurer**. The insurer enters into an **insurance contract** with each person who seeks to participate in the scheme. Such a participant is known as **insured**. ## Insurance Reduces Burdens Burden of risk refers to the costs, losses, and disabilities one has to bear as a result of being exposed to a given loss situation/event. ### Diagram 3: Risk Burdens that One Carries | **Risk Burden** | |---------------------| | Primary Burden of Risk | | Secondary Burden of Risk | There are two types of risk burdens that one carries – primary and secondary. ### Primary Burden of Risk The **primary burden of risk** consists of losses that are actually suffered by households (and business units), as a result of pure risk events. These losses are often direct and measurable and can be easily compensated for by insurance. **Example** When a factory gets destroyed by fire, the actual value of goods damaged or destroyed can be estimated and the compensation can be paid to the one who suffers such loss. If an individual undergoes a heart surgery, the medical cost of the same is known and compensated. In addition, there may be some indirect losses. **Example** A fire may interrupt business operations and lead to loss of profits which also can be estimated, and the compensation can be paid to the one who suffers such a loss. ### Secondary Burden of Risk Suppose no such event occurs and there is no loss. Does it mean that those who are exposed to the peril carry no burden? The answer is that apart from the primary burden, one also carries a **secondary burden of risk**. The **secondary burden of risk** consists of costs and strains that one must bear merely from the fact that one is exposed to a loss situation. Even if the said event does not occur, these burdens have still to be borne. By transferring the risk to an insurer, it becomes possible to enjoy peace of mind, invest funds that would otherwise have been set aside as a reserve, and plan One's business more effectively. It is precisely for these reasons that insurance is needed. ## Equity Among Risks Let us now consider equity among risks. The term "Equity" means that applicants who are exposed to similar degrees of risk must be placed in the same premium class. Insurers would like to have some type of standardization to determine the premiums to be charged. Thus, people posing average risks should pay similar premium while people who pose higher risks should pay higher premium. They would like standardization to apply to the vast majority of individuals who pose average risks while they could devote more time to decide upon and rate risks which are riskier. ### a) Risk Classification To usher equity, the underwriter engages in a process known as **risk classification** i.e., individuals are categorized and assigned to different risk classes depending on the degree of risks they pose. There are four such risk classes. - **Standard risks**: These consist of those people whose anticipated morbidity (chance of falling ill) is average. - **Preferred risks**: These are the ones whose anticipated morbidity is significantly lower than average and hence could be charged a lower premium. - **Substandard risks**: These are the ones whose anticipated morbidity is higher than the average but are still considered to be insurable. They may be accepted for insurance with higher (or extra) premiums or subjected to certain restrictions. - **Declined risks**: These are the ones whose impairments and anticipated extra morbidity are so great that they could not be provided insurance coverage at an affordable cost. Sometimes an individual's proposal may also be temporarily declined if he or she has been exposed to a recent medical event, like an operation. ### C. Risk Management Techniques Another question one may ask is whether insurance is the right solution to all kinds of risk situations. The answer is "No". Insurance is only one of the methods by which individuals may seek to manage their risks. Here they transfer the risks they face to an insurance company. However, there are some other methods of dealing with risks, which are explained below: 1. **Risk avoidance**: Controlling risk by avoiding a loss situation is known as **risk avoidance**. Thus, one may try to avoid any property, person, or activity with which an exposure may be associated. **Example** One may refuse to bear certain manufacturing risks by contracting out the manufacturing to someone else. One may not venture outside the house for fear of meeting with an accident or may not travel at all for fear of falling ill when abroad. But risk avoidance is a negative way to handle risk. Individual and social advancements come from activities that need some risks to be taken. By avoiding such activities, individuals and society would lose the benefits that such risk-taking activities can provide. 2. **Risk retention**: One tries to manage the impact of risk and decides to bear the risk and its effects by oneself. This is known as **self-insurance**. 3. **Risk reduction and control**: This is a more practical and relevant approach than risk avoidance. It means taking steps to lower the chance of occurrence of a loss and/or to reduce severity of its impact if such loss should occur. **Important:** The measures to reduce chance of occurrence are known as "**Loss Prevention**". The measures to reduce degree of loss are called "**Loss Reduction**". Risk reduction involves reducing the frequency and/or sizes of losses through one or more of: - **Education and training**: such as holding regular "fire drills" for employees, or ensuring adequate training of drivers, forklift operators, wearing of helmets and seat belts and so on. - **Making Environmental changes**: such as improving “physical” conditions, e.g., better locks on doors, bars, or shutters on windows, installing burglar or fire alarms or extinguishers. The State can take measures to curb pollution and noise levels to improve the health status of its people. Regular spraying of Malaria medicine helps in prevention of outbreak of the disease. - **Changes made in dangerous or hazardous operations**: while using machinery and equipment or in the performance of other tasks **For example**, leading a healthy lifestyle and eating properly at the right time helps in reducing the incidence of falling ill. **Separation**, spreading out various items of property into varied locations rather than concentrating them at one location, is a method to control risks. The idea is, if a mishap were to occur in one location, its impact could be reduced by not keeping everything at that one place. **For instance**, one could reduce the loss of inventory by storing it in different warehouses. Even if one of these were to be destroyed, the impact would be reduced considerably. ## 4. Risk Financing This refers to the provision of funds to meet losses that may occur. ### Risk retention through self-financing Involves self-payment for any losses as they occur. In this process the firm assumes and finances its own risk, either through its own or borrowed funds, this is known as **self-insurance**. The firm may also engage in various risk reduction methods to make the loss impact small enough to be retained by the firm. ### Risk Transfer Is an alternative to risk retention. Risk transfer involves transferring the responsibility for losses to another party. Here the losses that may arise because of a fortuitous event (or peril) are transferred to another entity. **Insurance** is one of the major forms of risk transfer, and it permits uncertainty to be replaced by certainty through insurance indemnity. ## Insurance vs Assurance Both insurance and assurance are financial products offered by companies operating commercially. Of late the distinction between the two has increasingly become blurred and the two are taken as somewhat similar. However, there are subtle differences between the two as discussed hereunder. - **Insurance** refers to protection against an event that might happen whereas **assurance** refers to protection against an event that will happen. - **Insurance** provides cover against a risk while **assurance** covers an event that is definite e.g., death, which is certain, only the time of occurrence is uncertain. Assurance policies are associated with life cover. There are other ways to transfer risk. For example, when a firm is part of a group, the risk may be transferred to the parent group which would then finance the losses. Thus, insurance is only one of the methods of risk transfer. ## D. Insurance as a tool for managing risk When we speak about a risk, we are not referring to a loss that has actually been suffered but a loss that is likely to occur. It is thus an expected loss. The cost of this expected loss (which is the same as the cost of the risk) is the product of two factors: - The **probability** that the peril being insured against may happen, leading to the loss - The **impact** or the amount of loss that may be suffered as a result. The cost of risk would increase in direct proportion with both probability and amount of loss. However, if the amount of loss is very high, and the probability of its occurrence is small, the cost of the risk would be low. ### Diagram 5: Considerations before opting for insurance | Consideration | |---------------------------------------| | Don't risk a lot for a little | | Don't risk more than what you can afford to lose | | Consider the likely outcomes of the risk carefully | ### 1. Considerations before opting for Insurance When deciding whether to insure or not, one needs to weigh the cost of transferring the risk against the cost of bearing the loss, that may arise, oneself. The cost of transferring the risk is the insurance premium – it is given by two factors mentioned in the previous paragraph. The best situations for insurance would be where the probability is very low but the loss impact could be very high. In such instances, the cost of transferring the risk through its insurance (the premium) would be much lower while the cost of bearing it on oneself would be very high. ### a) Do not risk a lot for a little: A reasonable relationship must be there between the cost of transferring the risk and the value derived. ### b) Do not risk more than you can afford to lose: If the loss that can arise as a result of an event is so large that it can lead to a situation that is near bankruptcy, retention of the risk would not appear to be realistic and appropriate. ### c) Consider the likely outcomes of the risk carefully: It is best to insure those assets for which the probability of occurrence (frequency) of a loss is low but the possible severity (impact), is high. ## Role of insurance in society Insurance companies play an important role in a country's economic development. They are contributing in a significant sense to ensuring that the wealth of the country is protected and preserved. Some of their contributions are given below. - Their investments benefit the society at large. An insurance company's strength lies in the fact that huge amounts are collected and pooled together in the form of premiums. These funds are collected and held for the benefit of the policyholders. - Insurance companies are required to keep this aspect in mind and make all their decisions in dealing with these funds to be in ways that benefit the community. This applies also to its investments. That is why successful insurance companies would not be found investing in speculative ventures i.e., stocks and shares. - The system of insurance provides numerous direct and indirect benefits to the individual, his family, to industry and commerce and to the community and the nation as a whole. - The insured - both individuals and enterprises - are directly benefitted because they are protected from the consequences of the loss that may be caused by an accident or fortuitous event. Insurance, thus, in a sense protects the capital in industry and releases the capital for further expansion and development of business and industry. - Insurance removes the fear, worry and anxiety associated with One's future and thus encourages free investment of capital in business enterprises and promotes efficient use of existing resources. Thus, insurance encourages commercial and industrial development along with generation of employment opportunities, thereby contributing to a healthy economy and increased national productivity. A bank or financial institution may not advance loans on property unless it is insured against loss or damage by insurable perils. Most of them insist on assigning the policy as collateral security. Before acceptance of a risk, insurers arrange survey and inspection of the property to be insured, by qualified engineers and other experts. They not only assess the risk for rating purposes but also suggest and recommend to the insured, various improvements in the risk, which will attract lower rates of premium. Insurance ranks with export trade, shipping, and banking services as an earner of foreign exchange to the country. Indian insurers operate in more than 30 countries. These operations earn foreign exchange and represent invisible exports. Insurers are closely associated with several agencies and institutions engaged in fire loss prevention, cargo loss prevention, industrial safety, and road safety. ## Insurable Interest: The existence of "insurable interest" is an essential ingredient of every insurance contract and is considered as the legal pre-requisite for insurance. Let us see how insurance differs from a gambling or wager agreement. It would be relevant here to make a distinction between the subject matter of insurance and the subject matter of an insurance contract. - **Subject matter of insurance** relates to property being insured against, which has an intrinsic value of its own. - **Subject matter of an insurance contract** on the other hand is the insured's financial interest in that property. It is only when the insured has such an interest in the property that he has the legal right to insure. The insurance policy in the strictest sense covers not the property per se, but the insured's financial interest in the property.