Risk Management & Insurance Planning PDF - 2020 Edition

Title: RISK MANAGEMENT & INSURANCE PLANNING 1st Edition 2002 2nd Edition 2004 3rd Edition 2008 4th Edition 2014 5th Edition 2020 All rights reserved. No part of this publication may be produced, translated, stored in a retrieval system, or transmitted in any form or by any mea...

Title: RISK MANAGEMENT & INSURANCE PLANNING 1st Edition 2002 2nd Edition 2004 3rd Edition 2008 4th Edition 2014 5th Edition 2020 All rights reserved. No part of this publication may be produced, translated, stored in a retrieval system, or transmitted in any form or by any means, electronic, mechanical, photocopying, and recording, without prior written permission of the copyright owner and the publisher. Disclaimer: While every effort has been made in getting the facts right, this text is distributed to participants with the understanding that the writers, publisher and editors are not responsible for the results of any actions taken on the basis of the information in this work, nor for any errors or omissions. The writers, publisher and editors expressly disclaim all and any liability to any person, in respect of anything and of the consequences of anything done or omitted to be done by any such person in reliance, whether whole or partial, upon the whole or any part of the contents of this text. If there arises a need for legal or expert advice at anytime the service of a competent professional personnel should be sought. The right to reproduce this material for Module 2 students only is granted to Malaysian Financial Planning Council (MFPC) Malaysian Financial Planning Council (MFPC) Suite 22.7, Level 22, Menara One Mont’ Kiara, No. 1, Jalan Kiara, 50480 Mont’ Kiara Kuala Lumpur Website: www.mfpc.org.my  ACKNOWLEDGEMENTS The Malaysian Financial Planning Council (MFPC) gratefully acknowledges the advice and feedback of Bank Negara Malaysia (BNM), Securities Commission (SC), the Life Insurance Association of Malaysia (LIAM), The Malaysian Insurance Institute (MII), the National Association of Malaysian Life Insurance and Financial Advisors (NAMLIFA), Malaysian Association of Chartered Financial Consultants (MAChFC) and various organizations and individuals in developing the RFP programme. We thank you to all committee members, writers and editors for their commitment and kind efforts to develop and up-date RFP programme; Mr Lim Yuen Seong, Mr. Alex Foong Soo Hah, Mr. Mohd Taipor Suhadah, Mr. Andy Ng Yen Heng, Mr. K. Karunamoorthy, Mr. Bose Dasan, Mr. Paramjit Singh, Dr. Chai Kon Lim, Mr. K Karunamoorthy, Mr. Ezamshah Ismail, Mr. Roland Lee Meang Sun, Mr. Teh Loo Hai, Mr. Michael Kok Fook On, Dr. Desmond Chong Kok Fei, Dr. Achene Lahsasna, Mr. Mohamad Sani Bin Ayob, Dr. Stanley Yap @ Yap Peng Lok, Mr. Adrian Ho Kian Wei, Dr. Khoong Tai Wai. Module 2 – Risk Management & Insurance Planning RFP Programme Preface The subject of risk management covers a very wide area that encapsulates all types of risks, the manifestations of those risks and the implications of such risks on individuals, corporations, governments and the world in general. No one, in the true sense, is spared from risks. In this text, the scope of study is limited to the personal risks that are faced by individuals. While personal risks cover both speculative risks (related to investments) and pure risks, these are dealt with on a separate basis – speculative risks in Module 3 on investments and pure risks in this module. The subject starts with an appreciation of risks and the process of risk management. It evolves to elaborate the risks faced by individuals and how such risks can be quantified and mitigated. The candidate is exposed to the insurance products that are generally available in the market place and the coverage provided by SOCSO for risk mitigation solutions. Another area that has been given due attention is that apart from the personal risks of the client, the financial planner also faces certain risks, such as reputational risk, compliance risk and legal risk. As such the module will cover several key elements of law that highlight a working knowledge of legal principles and compliance requirements. It is envisioned that completion of this module will provide the financial planner with greater knowledge and confidence in dealing with clients. i  Registered Financial Planner (RFP) Programme Module 2: Risk Management and Insurance Planning Contents Chapter 1. Understanding Risks 2. Risk Management 3. Insurance Needs Analysis 4. Life Insurance Policies 5. Health insurance Policy 6. Annuities 7. General Insurance Products in Insurance Planning 8. Takaful 9. Legal Principles and relevant legislation in insurance 10. Consumer Protection and Life Insurance Industry Code of Practice 11. SOCSO RFP Programme - Module 2 Chapter 1: Understanding Risks Chapter 1 Understanding Risks Chapter Objectives Students must be able to:  Understand the Nature of Risk and its Implications  Understand the Different Types of Risks  Describe the Factors that can Influence a Person’s Rational Thinking  Understand the Relationship Between Demography and Attitude Towards Risk.  Assess the Risk Tolerance of Clients With Different Methods Malaysian Financial Planning Council (MFPC) 1-1 RFP Programme - Module 2 Chapter 1: Understanding Risks Chapter 1 Understanding Risks Introduction Risk is subjective as its meaning is based on people’s perception which vary from person to person. Every person has a version of what the word means. Not surprisingly, even professionals impute meanings to the word in accordance to their trade. Investors, economists, behavioral authorities and risk theorists have their own definition of risk. Investors, for instance, will look at risk as a chance of loss or gain in an investment.. For the financial planner, it is necessary to understand that every client has a different perspective of what is risky and what is not. More importantly, every client’s capacity to risk a financial loss is different. Therefore, it is the responsibility of the financial planner to determine the client’s risk appetite before solutions are recommended. This Chapter examines some of the concepts of risk and risk tolerance and how information about risk situations can be handled. It is anticipated that armed with this knowledge, the financial practitioner will be more perceptive of the client’s risk tolerance level and the possible reasons why a client declines or takes on a certain risk. Risk Defined To handle risk, one first needs to understand the nature of risk. What is risk? There is no single definition of risk. Different professionals will define risk differently, usually in association with the nature of their work. Thus, a surgeon, scientist, investment banker etc will define risk differently. However all definitions will nevertheless have an element of uncertainty and some unpleasant potential impact or outcome. For our purpose, risk may be defined as “uncertainty about financial loss from an exposure”. Loss is the unpleasant outcome of risk. Losses can exist in two forms – losses that have precipitated (occurred) or losses that exist in the form of loss exposures (which are losses that might turn out in the future). Terminology Associated with Loss The terms peril and hazard are associated with loss, but they are different. Peril may be defined as the source of loss. If a house is burnt down, the peril is fire. On the other hand, hazard is a condition 1-2 Malaysian Financial Planning Council (MFPC) RFP Programme - Module 2 Chapter 1: Understanding Risks that creates or increases the probability of loss. Essentially, there are three main types of hazards, namely: physical hazard, moral hazard and morale hazard.  A physical hazard is a physical condition that increases the chance of loss. Example, an oil- spilled road increases the chance of an accident.  A moral hazard is dishonesty or character defects in an individual that increase the occurrence or grievousness of loss. Example of moral hazard would be faking an accident to make a PA claim.  Morale hazard is slackness or indifference to a loss because of the presence of insurance coverage. Example of morale hazard would be leaving for a holiday without locking the house because all the major household items are well covered with insurance. Classifications of Risks (i) Fundamental risk There are many forms of risk. For example, a fundamental risk is a risk that affects the entire economy or a large number of persons or groups within the economy. Examples will include, hyperinflation, earthquakes and war. Fundamental risks, which arise from nature or society, are usually not insurable. (ii) Particular risk As opposed to a fundamental risk, a particular risk is a risk that affects only individuals and not the entire community. Examples will include robbery, fires and thefts. These risks are generally insurable. (iii) Dynamic risks These are risks resulting from the changes in the economy that may cause financial losses to people. In recent times, one of the most notable dynamic risks are those arising from rapid changes happening in the field of information technology. Many companies were made to close down while others emerge as new successes. (iv) Static risks Static risks refer to those losses that would occur even if there are no changes in the economy. In good or bad times, there will be people who make losses. Examples of static risks are losses arising from mismanagement, dishonesty, floods etc. Static risks confer no benefits to society – only losses. Malaysian Financial Planning Council (MFPC) 1-3 RFP Programme - Module 2 Chapter 1: Understanding Risks (v) Pure risk In a pure risk situation, there is either a loss or no loss. There is no chance of a gain in pure risk situations. In pure risk, two aspects of the risk that must be considered in risk management, as these determine the potential impact of the risk. The first is the amount or quantum that could potentially be lost – the ringgit or dollar value involved if a loss occurs. The second aspect is the chance of the loss occurring – the probability of the loss occurring. People will either accept or reject a risk after an objective or subjective evaluation (evaluation based on the perception) of these two aspects of pure risk. Insurance is concerned with pure risk. (vi) Speculative risk Investment risk or speculative risk is not pure risk. In investment, the risk lies in either obtaining less or more than the anticipated return or sustaining a loss or making a gain of the principal. The potential gain that can be made in investments distinguishes investment risk from pure risk. Although speculative risks are not insurable, the pure risk consequences of speculative risks are insurable. For instance, the marketing of a new line of children’s toys has a speculative risk- that is the venture may or may not be profitable. This risk is clearly not insurable. However, the risk associated with the venture may have risks that are insurable, for example, a flood could damaged the machines in the factory where the toys are manufactured or the toys could be stolen, resulting in production stoppage. These are pure risks that are insurable. Risks as Differs from Chance The word risk implies some kind of uncertainty about an outcome in a given situation. It is interesting to distinguish the word risk with the word chance, which also implies some doubt about the outcome in a given situation. Chance differs in that the outcome is normally favourable, whereas for risk, the focus is on the possibility of loss. For instance, we talk about the risk of making a serious mistake, but the chance of winning a contest. People’s Attitude towards Risks Peoples’ attitude towards risk is influence by the way an individual comprehends and interprets the risk that is faced. People generally interpret risks on an objective or perceived basis. Perceived Risk and Objective Risk We may view a risk as having two dimensions - an objective and subjective dimension. Let us take a simple example to illustrate these two aspects of risks – a person who drives after consuming a considerable amount of alcohol. From the drunk driver’s perspective, there is no risk because he ‘feels’ he is in control driving the car even with so much alcohol in his blood. His attitude is 1-4 Malaysian Financial Planning Council (MFPC) RFP Programme - Module 2 Chapter 1: Understanding Risks reinforced by the fact that he has done it on several occasions and had never met an accident after a drinking session in the past. That is his perspective. But for the wife sitting beside him, driving after a heavy drinking session is risky because she ‘feels’ that under such condition, her husband can lose control easily and cause an accident. Although the wife does not drink alcohol or drive, she has read about drink driving accidents in the papers. In both cases, the risk is perceived differently. Without considering the facts, their views are both subjective in nature. In the husband’s case, the ‘no risk’ perception is shaped by his past experience, i.e. no accident caused by his drunk driving. And in the wife’s case, it is shaped by her view -point and the reports in the new papers. The interpretation of risk in an encountered situation is known as a perceived risk. The actual risk may or may not match that of the perceived risk. Now let us look at the facts of the case. Statistically, it has been shown that drunk driving does have a higher chance of causing a road accident. Hence, the husband’s drunk driving is risky based on the available facts. This dimension of the risk is known as the objective risk – a factual risk. Perception does not change the reality, but it does affect the way a person behaves when confronted with the reality. If, in the above case, the husband is aware of the facts without any form of mental distortion of the reality, he may not drive as he did. His behavior is influenced by his perception of the risk but not the reality of the risk. To him, his perception is the reality, and his actions are in accordance to his ‘reality’. Categories of Risk Behavior Every person behaves according to how he is “mentally wired”. Individuals would thus be expected to react differently (in varying degree) from one another if faced with the same set of risk stimuli. For the purpose of risk assessment, we may classify people into three categories as follows:  Risk taking or seeking,  Risk indifferent, and  Risk averting. Risk taking or seeking and risk averting behaviors are at the opposite ends of the risk spectrum. Placed in-between is risk indifference. Studies have shown that most people prefer safety to taking risk, i.e. majority of people are risk averse. It is therefore imperative to understand the three types of risk behavior and to determine the risk category of the client.  Risk Taking or Seeking: Risk takers are the “gung ho” type of individuals whose perspective of risk is that it is an opportunity rather than a threat. They tend to have a partiality or leaning for uncertainty over certainty in given situations. Because of their often over positive outlook, they have a tendency to underrate the degree of risk in risky situations. In their daily lives, such Malaysian Financial Planning Council (MFPC) 1-5  RFP Programme - Module 2 Chapter 1: Understanding Risks risk takers have a preference for variety and uncertainty – they participate in activities that help to spice up their life. Risk taking is considered an important criterion for those involved in business.  Risk Indifferent: Risk indifferent persons are neither influenced by the danger nor the opportunity presented by a risky situation. They are neither attracted nor repulsed by risk.  Risk Averting: Risk averse individuals are generally unadventurous people whose perspective of risk is that it is a threat. To avoid risk, they have a preference for certainty over uncertainty. Because of their conservative approach to life, they have a tendency to overestimate risk and hence tend to be pessimistic in varying degree to risky situations, focusing on the “loss” potential of those situations. According to a study made by LIMRA, most people fall into this category of behavior. Human Behavior and Degree of Rationality To appreciate clients’ risk tolerance, we must first understand some distinct human behaviors with regard to risks and people’s rationality when faced with a risky situation. Some of the factors that may restrain a person’s ability to think and act rationally are discussed below:  Influenced by Individual’s Beliefs and Value System Although people generally have the ability to work things out logically, the underlying makeup that guides decisions are emotional in nature. Emotions distort reality and influence behavior. For instance, when the “compulsory seat-belt” rule was first introduced in Malaysia, many people complained, despite the fact that having a seat belt has been proven to save lives. From the rational standpoint, the complaints should not have arisen. On the other hand, no one complained when asked to put on the seat belt in a plane, although the precaution would be of little help to save lives in a plane mishap. From this, we may say that people are not totally rational even when making financial decisions of some significance. Economist and psychologist describe this behavior as “bounded” rationality. People are bounded (or walled up) in their thoughts and emotions that influence their rationality. Their choices and decisions are filtered through rational thinking but shaped by emotions and values. The Malaysian stock market performance over the years gives an indication of how people make investment decisions. Investors rush in and out of the stock market influenced by rumors and the behavior of the masses.  Overconfidence People tend to over-value their personal judgment of a situation. When a person says he is 100% certain that a particular event will happen, it may in fact be only 80%. An example would be an investor in the stock market who happens to be “sure” of a particular stock going up, in such a case he tends to ignore the other possibilities that may cause a stock to fall. 1-6 Malaysian Financial Planning Council (MFPC) RFP Programme - Module 2 Chapter 1: Understanding Risks  Mislead by Short-Run Trends Many people cannot recognize the difference between results for short-run and long-run trends. The law of large numbers works only in long run wherein the sample base is large enough. For instance, in the short run, it is possible that the stock market keeps going up without any correction. Many people influenced by the short run trend invest at the wrong time, thinking that the trend will keep going that way.  Misjudging the Magnitude of Risk For most, the actual scale of a volatile risk is difficult to judge in a precise manner. In some assessments carried out, it was found that people neglect to factor exposure time accurately into their assessment of the risk. There is a tendency to overestimate the effect of short- duration high-risk events. People tend to feel a higher degree of danger than they are exposed to in reality if they are placed in a dangerous situation for a short period of time.  Denial of Risk Denial of a risk is another common attitude towards risk. Many people who are engaged in high- risk projects or activities either do not know the level of danger involved or simply reject the possibility that the risky situation will materialize and they will harmed personally. For instance, those amateurs who constantly go diving in the sea deny that the activity is risky. The danger posed by small, negative probabilities is often denied completely. This attitude assumes that low risk is equal to no risk at all.  Influence of Bias Attitudes We are all biased to some extent. From the risk perspective, biases can distort the level of risk faced by a person. It is common to find people influenced by some kind of bias when they respond to risk. Below are some of the types of biases that the practitioner may have to deal with in carrying out his task. i. Availability Bias: Those events that can be easily recalled or imagined are often viewed as more real or probable to take place. Likewise, those incidents that are not easily recalled are treated as less likely to occur. A good case is the payment of insurance policy claims. Although most claims are paid without hassle, the reports in the media and the consumer magazines highlighting rare unpaid claims have created an impression that most insurance claims are not paid out. ii. Familiarity Bias: Ignorance creates fear, while knowledge dispels fear. As such, those risks that are more intimately known to a person are less feared. Most investors have favorite counters, those that they are more familiar with and are more willing to buy than other counters unfamiliar to them. iii. Evidence Bias: This is the tendency where people will selectively seek evidence to support their action or their belief. They will either distort or ignore evidence that is contrary to their Malaysian Financial Planning Council (MFPC) 1-7 RFP Programme - Module 2 Chapter 1: Understanding Risks beliefs. For instance, if a doctor has told a person that he has a cancerous tumor which is incurable, the person decided to seek the aid of a bomoh who says it can be cured through the performance of certain rituals. The evidence given by the doctor is ignored despite the fact that it is more reliable than that of the bomoh. iv. Illusion of Control Bias: People who have control of a situation will be inclined to think they need to feel less fear of the risk. An example would be some investors like to invest directly in a stock market rather than through fund managers who are better trained to invest.  Risk Perspectives Under Alcoholic Influence Many studies on alcohol consumption have shown that it affects a person’s judgment in varying degree. Compared to non-drinkers, those who are under the influence of alcohol tend to take more risk.  Influenced by Parties Bearing the Consequences People will tend to be more careful and risk-averse, if their decision affects themselves or loved ones and be more risk tolerant when the decision affect others (excluding loved ones). Risk Taker and a Thrill Seeker Some studies on human behavior have shown that most risk takers do not take risk in an appreciable or recognizable regular pattern – that is, they choose to take risk only under certain situations and not in all situations. Based on research, four broad types of life situations involve risk-taking:  Money: Risks involving loss of capital, e.g. business projects, investments, etc.  Physical: Risks involving loss of life, e.g. sky-diving  Social: Risks involving loss of face, e.g. singing in a contest  Ethical: Risks involving loss of freedom, e.g. money laundering In those studies, it was found that a risk-taker is more likely to take on the same or similar risk and less likely to take on unfamiliar risks. For instance, those who take risks involving money may not take on risks involving the potential loss of life. Another personality type linked to risk taking is called a thrill seeker. Thrill seekers are people who consistently seek out or create risks in all life situations. In other words, if no risk exists, they will create one to satisfy their thirst for excitement. More men than women fall under this category of people. All thrill seekers despise routine and want experiences that are new, challenging and 1-8 Malaysian Financial Planning Council (MFPC) RFP Programme - Module 2 Chapter 1: Understanding Risks complex. An example would be those who love dangerous sports and would try any sports in that category. Risk Tolerance Risk Tolerance and Demographic Attributes In an effort to better understand how people react to risk, extensive studies have been made on the relationship between risk tolerance and demographic characteristics. In this section we will briefly explore seven main demographic characteristics, these are:  Age: As a person grows older, there is a tendency to take less risk. Researches have found a biological link to this tendency. It seems an enzyme called monoamine oxidase (MAO) is found in abundance in those who are risk averse, and that MAO increases with age.  Gender: Women are generally more risk averse than their male counterparts across all ages. This is especially so in Asian countries where the environmental conditioning dictates that the man should take the lead and bear most of the decision making in the family.  Birth Sequence: From observations (as little studies are done in this area), it can be noted that the eldest child is most Asian families tend to be more risk averse. In countries with group culture, such as those generally found in Asia, the eldest child of the family is expected to be a role model for the younger siblings and bear the responsibility of taking care of the parents in old age. As a result, the eldest child is groomed to be more careful and dependable – an attitude shaping ground for him to be more risk-averse, especially with money matters.  Marital Status: Single persons are generally presumed to be more risk tolerant than those who are married, especially those singles with no or little responsibilities. However, some studies have concluded that it is not the marital status that really determines the risk tolerant behavior but whether or not that person has any dependents. It was also found that some dual-income couples are able to take on more investment risk because of the dual source of earnings.  Occupation: Government servants are generally more risk averse than those working in the private sector. This is probably due to work environment exposure and conditioning, where the private environment engages the individuals to take on more risk as compared to a government job, which is considered safe and secured. Those who are knowledgeable and more exposed to the world of business, like professionals, tend to take on more risk than those with less knowledge and business exposures (non-professionals), which is consistent with the supposition that risk tolerance increases with knowledge, awareness and familiarity. It was also found that in the same groupings of professionals, those who work in small firms tend to be more risk tolerant than those who work for big firms. At the managerial level, risk takers tend to hold more senior positions, earn better income and have greater authority. For those who seek work, risk takers tend to prefer commissions to fixed pay, especially if the potential earnings are high. Malaysian Financial Planning Council (MFPC) 1-9 RFP Programme - Module 2 Chapter 1: Understanding Risks  Wealth: Generally, the wealthier the person, the higher their risk tolerance – both in absolute and relative terms. Absolute risk tolerance is measured by the dollar size of wealth one allocates to risky investments. It is generally accepted that absolute risk tolerance increases with the size of one’s wealth, because a wealthy person has more to spend and greater capacity to absorb risk. Relative risk tolerance is measured by the proportion of wealth a person allocates to risky investments  Educational Background: Knowledge brings about a better understanding of issues and as such a better assessment of risks. Measuring the Client’s Risk Tolerance In financial planning, the purpose of measuring the client’s risk tolerance level is to assist the client in understanding his or her disposition towards risk. With the understanding, it is easier for the financial practitioner to make the appropriate recommendations for the client’s financial wellbeing. Measuring Approaches Essentially, there are two broad approaches in measuring a client’s risk tolerance – that is the qualitative and quantitative approach. Generally, it is recommended that financial practitioners use both methods in their assessment to ensure better accuracy of the assessment.  In the qualitative approach, the financial practitioner captures the relevant information mainly based on unstructured discussions with the client. The evaluation of the information is on an instinctive or generalized orientation, which are reliant on the practitioner’s knowledge, skill and experience. This suggests that those practitioners who are less apt in communication or have less experience might face problems in using the qualitative approach.  As for the quantitative approach, the client is interviewed on a structured format, where the information obtained is translatable to some kind of useful mathematical score. If standardization is required, the quantitative approach is an easier method to use. However, care must be taken in the construction of the risk assessment questionnaire or other any other format used for quantitative analysis. The questions must avoid the tendency to skew the client towards bias in the required answers. The ideal quantitative approach would be to have an established benchmark. For instance, the practitioner is able to compare the risk tolerant level of a client who is a female, age 25, with others in the same age and gender group. The questions can be broad (global) or narrow (specific) in scope depending on the objective of the questionnaire. An example of a broad approach would be to ask the client whether they see themselves as a risk averter or a risk taker. Broad questions such as, “On a scale of 5, where 1 stands for ultimate risk averter and 5 stands for an ultimate risk taker, where would you place yourself?” may be used to give a global picture of the client’s lean towards risk. Another form of question is to elicit specific reactions to risk from the client. Some of the questions that cover specific areas indicative of risk propensity may be as follows: 1-10 Malaysian Financial Planning Council (MFPC) RFP Programme - Module 2 Chapter 1: Understanding Risks  Do you experience sleeplessness after you have made a risky investment?  Do you believe that a person can only move ahead by taking chances?  Are you afraid to lose a part of your wealth due to bad investment decisions?  Are you prepared to take loan from the bank to invest?  Would you see risky decisions as an opportunity to make money? It should be noted that the framing of the questions (overall structure, wordings, clarity) is important. In relation to this’ questions may be formatted in a specific manner rather than in a general manner to elicit more information. For example, rather than asking a client, “What is your overall capacity to take risk?”, a question could be framed to ask what is your capacity to take risk in the following situations …. equities, unit trust,commodities etc This is also referred to as the “unpacking effect”- breakdown a question to elicit specific information in certain areas – to get a clearer picture of the thinking and disposition of the individual concerned. Some of the issues that need to be considered in assessing the risk tolerance of the client include the following:  Client’s Investment Objectives: An approach to determine the client’s risk tolerance is to determine his risk inclination by establishing his financial objectives. The client’s risk tolerant should be the basis to checking the congruity of the client’s financial objectives. The financial objectives approach is to check whether the client prefers liquidity, safety, capital appreciation, inflation-adjusted returns, current income or tax diminution. From the answers provided, a deduction is made to determine his level of risk tolerance. For instance, if the client prefers a high current income and inflation-adjusted returns from his investments, then a risk tolerant lean is inferred. And if he prefers safety of principal or liquidity, then a risk aversion lean is inferred.  Choice of Investment Vehicles: In this approach, the risk tolerant lean of the client is inferred by observing his choice of investment products, which is considered the most direct approach in assessing the client’s risk tolerant level. Commonly, the client is asked to allocate the preferred percentage of his funds among the various classes of investments, such as shares, bonds, real property and derivatives, if he is given a lump sum of money. As this is not a real life situation, the danger is the client may be more gung ho than he is in reality. Another approach is to ask the client to rank his preference for each of the investment products given in a list. If on the overall, he has a lean towards those investments that are high risk, an inference is drawn that he is risk tolerant. In both approaches, it should be noted that the knowledge of the client on the actual risk potential of the various investment vehicles is crucial for accurately determining his risk tolerance  Past Behavior Pattern on Monetary Risk: It has been observed that one of the best methods to assess risk tolerance is to observe the client’s distinctive past behavioral pattern on monetary Malaysian Financial Planning Council (MFPC) 1-11 RFP Programme - Module 2 Chapter 1: Understanding Risks matters. While this is not a guarantee, the past pattern of behavior on monetary matters does indicate how the client is ‘wired-up mentally’ when he thinks of his finances, which in turn would provide a good clue of his prospective conduct in the future. Here are some daily behavior that can be used to weigh a client’s temperament towards monetary risk: Current Investment Portfolio The current investment portfolio can give a good picture of the clients lean towards risk tolerance. Some of the indicators are:  If the investments composed of mainly the ‘safe’ type, like savings account, time deposits and unit trusts, then we can reasonably assume the client is risk averse.  Current liabilities to his gross assets: Generally, if the ratio indicates a large percentage of his assets are leveraged with borrowings, it is a fair indication of risk taking behavior, and vice versa.  Extensiveness of insurance policies: If the client is extensively covered by insurance in all areas of financial risk, it is an indication of a safety mentality, a likely hood that he is risk averse.  Number of job change: The frequency of job change is a general indication that the client is a risk taker, as every change requires the movement into unknown territory. However, the circumstances leading to those job changes will provide a more accurate picture.  Year-to-year income variation: Risk takers are adventurous in trying out new ways of making more money and their income generally fluctuates in accordance to their year-to-year swing of fortune. For employed individual who has moved into a new employment, a lower that the previous job salary may indicate that he is risk averse.  Probability and Payoff Preferences: In any risk situation, a client is faced with the combination of one or more of the following :  The probability of loss  The probability of gain  The amount to be lost  The amount to be gained The permutations of these aspects of risk provide a wide spectrum in decision making and the impact of those decisions in terms of certainty (or uncertainty) and gain (or no gain). 1-12 Malaysian Financial Planning Council (MFPC) RFP Programme - Module 2 Chapter 1: Understanding Risks Preferences for certainty versus uncertainty: Some individuals prefer certainty over uncertainty, thus if faced with a situation the individual who has a risk averse lean, will prefer certainty (low probability of loss). Conversely, individuals who have a risk tolerance lean will prefer uncertainty and more potential gains. Minimal required probability of success: Some individuals may stipulate a minimum probability of success. The higher the stipulated probability (say, 90%), the greater the risk averse lean. The lower the stipulated probability of success (say, 50%), the greater the risk tolerance lean. Minimal required return: There are instances where the client may stipulate a minimal return rate. As the return rate is related to risk (the higher the risk, the greater the potential return and vice versa), the greater the required return rate, the greater is the risk propensity (risk tolerance) of the client. Malaysian Financial Planning Council (MFPC) 1-13 RFP Programme - Module 2 Chapter 1: Understanding Risks Self Assessment 1. Different people have different attitude toward risk, how does a financial planner deals with this issue when constructing a financial plan? A. find out the client’s net worth B. understand the client’s risk tolerance level C. always recommend the lower risk investment plan to avoid risk D. advise the client to take addition insurance to hedge the risk 2. The term ‘Thrill seeker’ refers to a person A. who is consistently seeking out or creating risks in all life situations B. whose perspective of risk is that risk is an opportunity C. whose perspective of risk is danger D. who is neutral to both the danger and opportunity presented by risk 3. If Alan feels that scuba diving is a dangerous sport notwithstanding that actually it is a very safe sport if a person goes through a proper training, Alan is basing his judgment on a A objective risk B. risk indifferent C. risk averse D. perceived risk 1-14 Malaysian Financial Planning Council (MFPC) RFP Programme - Module 2 Chapter 1: Understanding Risks 4. An individual’s risk tolerance is affected by his/her own experience and rationality when making judgment. Which factor below does not influence an individual from thinking and acting rationally when making risk judgment? A. Perception of the risk B. When one does not face a detriment from the risk C. Over confidence D. Influenced by individual’s beliefs and value system 5. Ah Fatt reads an article in the newspapers about a customer’s complaint of not having been paid by his insurer over his accident claim. He is now concerned about buying a life insurance policy. Ah Fatt is said to be under the influence of A. Rationality bias B. Availability bias C. Intimacy bias D. Evidence bias 6. Research has shown that there is some relationship between risk tolerance and demographic characteristics. Choose the correct combination of demographic characteristics below that influence the attitude towards risk A. wealth, age and family size B. family size, marital status and sex C. family size, age and population density D. wealth, age and occupation 7. A person feels that working for the government is secure and as such has no plans for a change in career. Such a person would probably be A. a risk averse person B. a risk indifferent person C. a thrill seeking person D. a risk seeking person Malaysian Financial Planning Council (MFPC) 1-15 RFP Programme - Module 2 Chapter 1: Understanding Risks 8. Risks in the most basic sense is defined as the. Choose the most appropriate answer. A. chance of an investment loss B. chance of a financial loss C. chance of a physical loss D. chance of an income loss 9. Object risk can be defined as: A. risk involving loss of face B. risk based on person’s beliefs and value system C. risk involving loss of freedom D. risk based on facts 10. A person’s attitude toward risk in which a person is willing to accept high returns for an increase in the risk level is said to be : A. risk tolerant B. risk averse C. risk indifferent D. risk thriller Answers: 1-B, 2-A, 3-D, 4-B, 5-B, 6-D, 7-A, 8-B, 9-D, 10-A. 1-16 Malaysian Financial Planning Council (MFPC) RFP Programme - Module 2 Chapter 2: Risk Management Chapter 2 Risk Management Chapter Objectives Students must be able to:  Understand the Impact of Risk in Financial Planning  Define What is Risk Management  Understand the Character of Risk and Risk Management  Distinguish Among the Terms Risk, Peril and Hazard and their Relationship to Loss  Identify and Explain the Different Types of Hazards  Differentiate Type of Risks Within Each Class of Risks  Understand the Risk Management Process  Identify and Explain the Key Methods of Dealing with Risk Malaysian Financial Planning Council (MFPC) 2-1 RFP Programme - Module 2 Chapter 2: Risk Management Chapter 2 Risk Management Introduction With a basic understanding of risk and the factors that influence risk tolerance in planning in the previous chapter, let’s move forward and look at what is risk management in the context of financial planning. In financial planning, the process of dealing with risks is called risk management. In life, it is apparent that the path leading to the achievement of an individual’s financial goal is lined with challenges, constrains and risks. For the financial planner, the key concern would be to identify the potential risks in the way of his client’s financial goals and provide solutions that will reduce or eliminate all risks.. Generally these risks relate to the two major areas of financial planning, that is:  wealth or asset accumulation Here the efforts of the client and financial planner are focused on building and accumulating wealth through investments. Thus, the client’s wealth is exposed to speculative risks. Examples of such risks are risk of investment in the equity market and risk to capital in unit trust investments.  wealth or asset conservation. This relates to any type of risk that can :  reduce or destroy the wealth that has been built or  reduce or extinguish the ability to earn income to fund a desired life-style. Examples of such risks are related to health (critical illness or disability) which require the liquidation of current assets, or pre-mature death that extinguishes the capacity to earn an income to fund the life-style of the dependents. ( Note: As stated earlier, Module 2 will focus on the risk management aspects of pure risk (insurance related risks). While investments and investment risks will be dealt with in Module 3 of the RFP programme, it must be noted that the steps in the risk management process outlined in this chapter can be used in managing investment risks). 2-2 Malaysian Financial Planning Council (MFPC) RFP Programme - Module 2 Chapter 2: Risk Management The Risk Management Concept Where risk exists, a person may wish to manage it or ignore the risk. Obviously, it is unwise to ignore a risk as its impact could be disastrous, hence the need for risk management. The purpose of risk management is to devise methods of handling the risks faced by the client. We may describe personal risk management as an organized approach to the problem of managing risks faced by individuals. Initially, risk management evolved out of the need to deal with pure risks, e.g. insurance-related risk. However, over the years, the term has been utilized to include the process of managing speculative risks such as investment risks and risk of bad debts. To prevent confusion, some experts have termed the latter as financial risk management. In the case of financial planning, there is a need to handle issues that relate to both pure risk and speculative risk. Module 2 of the RFP programme will deal with the pure risk, while speculative risk will be dealt with in Module 3. The Risk Management Process – Pure Risk Risk management concerning pure risk involves the identification, measurement, evaluation and treatment of property, liability and other loss exposures of an individual. We shall examine these issues in the context of personal financial planning. The risk management process comprises of a six-step process which is detailed below. The Six-Step Risk Management Process Table 2-1 1. Setting Risk Management Objectives 2. Gather Information for Risk Identification and Evaluation 3. Analyse Information to Identify and Evaluate Risk 4. Develop Risk Management Plan 5. Implement Risk Management Plan 6. Review, Monitor and Revise Risk Management Plan Malaysian Financial Planning Council (MFPC) 2-3 RFP Programme - Module 2 Chapter 2: Risk Management 1. Establish Risk Management Objectives The process of setting risk management objectives should start with the question, “why are we doing it?” What do we want to achieve?” Generally, the risk management objectives define the direction of the financial plan and give meaning to the recommended actions that are required to make the plan work. The client must identify with the plan and appreciate the fact that if the plan were to succeed, the client would in the end, achieve the financial goals that have been set. In elucidating the risk management objectives, we need to define the risk management objectives under the categories of pre-loss objectives and post-loss objectives. Pre-loss Objectives Some of the most important pre-loss objectives would include: Efficiency (cost factor) To satisfy the first pre-loss objective, the financial practitioner will have to determine how to manage possible losses the client may face in the most low-priced way feasible. For instance, if a term policy can cover the risk of death adequately in the context of the client’s circumstance, there is no reason to recommend an endowment policy which will cost more – especially when the client has a greater need for protection than savings. To determine this, the financial practitioner will have to engage in a thorough analysis of the needs and the possible risk management products that are needed vis-à-vis those that are already in place. Efficiency means maximizing the use of the client’s available resources to achieve the desired risk management objectives. Lessening of distress (stress factor) To meet the second objective of lessening anxiety, the financial practitioner will have to map out the potential risks that the client is concerned about – that is risks that will have a direct or indirect financial impact on the client and his or her dependents. For example, if he is the only breadwinner, surely the client will worry about the impact of pre-mature death on the family. How will the family carry on without him? This anxiety (and stress) can be reduced by instituting a life insurance policy that will create sufficient capital fund the life-style of the dependents. Once the potential risks that can be detrimental have been identified, a proposed plan of action to diminish such loss exposures can be constructed. The meeting of externally imposed responsibility (obligation factor) The third objective is to ensure that any risks imposed by a third party are appropriately mitigated. For instance, a bank may require the client to take up a mortgage reducing term policy of the loan amount taken, or landlord may impose upon the tenant (through the tenancy agreement) to take a fire policy for the premises. 2-4 Malaysian Financial Planning Council (MFPC) RFP Programme - Module 2 Chapter 2: Risk Management Post-loss Objectives Another dimension of looking at setting risk objectives is to anticipate the client’s circumstance if a risk were to materialize. For example, what happens if a critical disease strikes? Are there adequate resources to fund treatment? Are there adequate resources to fund the life style of the dependents? How many months of funding would the current resources provide? How much more is required, if there is a deficiency? Once these objectives have been set, the practitioner will move into the next stage, that is, to gather the information necessary for risk identification, measurement and evaluation. 2. Gathering Information for Analysis Gathering of information is the second step in the risk management process. It enables the financial practitioner to identify the client’s loss exposure during each of his life phases. This step is important as without adequate information, it is impossible to perform an accurate analysis of the personal risk exposures of the individual and make the appropriate recommendations. To obtain adequate information, the financial planner must understand the nature of the risks that the client is exposed to. For an individual client, the information gathering process involved in risk management may include the following:  A detailed discussion with the client of his financial position and a physical examination of some of his possessions and property.  The filling of a fact-finding form by the client providing broad-spectrum information on the property owned and his sources of income.  Getting information of the current general and life insurance coverage owned by the client. Generally, the client and family are exposed to three classes of risk exposures, i.e. property, liability and personal risk exposures. Let’s take a look at each of these in turn. (i) Property Risks Property risk exposures of the client arise out of the ownership of property, and such exposures can be direct or indirect in nature.  Direct property exposures of the client are those risks relating to the damage and disappearance of property. Thus the theft, dishonesty of staff, accident, fire etc are examples of direct exposures  Indirect property exposures refer to the situation where the individual or his family suffers a loss of income or increased expenses due to damage caused to the property. Thus, a car accident can lead to damage to the vehicle, and injuries to the driver. The indirect loss would be the additional costs of medical expenses incurred as a result of the accident. Malaysian Financial Planning Council (MFPC) 2-5 RFP Programme - Module 2 Chapter 2: Risk Management (ii) Liability Loss Exposures Under the current legal system, a person can be held legally liable for some wrong doings that resulted in harming a third party bodily or his reputation or his property. In such instances, a court may if the facts so prove, order the payment of damages to the aggrieved party. For instance, a person can be liable for damages if he accidentally knocks a bottle of off his window on the fifth floor, and the bottle hits the head of a person walking along the pavement below. (iii) Personal Loss Exposures Personal risks are risks that directly relate to an individual and involve the entire loss or decrease of earned income, additional expenses being incurred and the liquidation of accumulated property. The dominant personal risk factors are as follows: i. Premature death ii. Retirement iii. Education planning iv. Deterioration of Health (Disability and Medical coverage) In Malaysia, property exposures and liability loss exposure risks are handled by general insurance companies, while personal loss exposure risks are mainly handled by life insurance companies. 3. Analyse Information to Identify and Evaluate Risk Once the information is gathered, it is analysed through a 3 stage process - identify, measure and evaluate the risks faced by the client. Let’s take a look at each of these in turn. Stage 1 : Identifying the Risks Identification in simple terms means making a list of all risks that can have a detrimental effect on the client’s financial situation. The following are some of the procedures to that can be used for identifying possible risks faced by client: 1. Through Discussion with the Client: This enables a face-to-face interaction that gives the financial ample opportunity to understand the financial position of the client. 2. Through Physical Observation: This can be used to evaluate the life-style of the individual, the physical condition of the client, the personal disposition of the client which provides some indication of risks that the client may face. It also provides an opportunity to re-affirm the facts that have been obtained through earlier discussions. 2-6 Malaysian Financial Planning Council (MFPC) RFP Programme - Module 2 Chapter 2: Risk Management 3. Through Information in the Fact-finding Sheet: The fact finding form provides a structured method of collecting information from the client. If the form is well structured the information obtained from the fact finding form can be very comprehensive. 4. Through Current Insurance Coverage: An examination of the current insurance structure will reveal the risks that have been covered and may provide an opportunity to explore what other risks the client is exposed to. Let’s looks at the consideration of each risk type before getting into the mathematical aspect of measuring risks: Stage 2 : Measuring the Risks The second stage in risk analysis is measuring the quantum or monetary size of the risks identified. This is further elaborated in Chapter 3 of this Module. In the interim, the financial planner just needs to note that in providing a solution to the client, it is imperative that the quantum of protection for each category of risk be worked out. This is important for several reasons: (i) the client understands exactly “how much” coverage is need in each area of risk exposure. (ii) it helps in matching the resources available to the cost of providing the appropriate cover (iii) it can be determined if there is sufficient affordability on the part of the client. Stage 3 : Evaluate the Risks Evaluation is the process of determining the significance of the risk and its potential impact on the client’s financial position. In this step the quantum’s calculated in Stage 2 above provide a good basis for deciding the type and kind of actions that need to be taken to mitigate the risks after considering the client’s resources that available. Here, the financial planner must also know and quantify the resources that will be available in the event of a personal risk materializing. Table 2-1 Resources Explanation Examples Classification Those resources that are Cash in Bank received in cash form and made Cash Resources EPF available on death within a reasonable time Contractual Death Gratuities Life Insurance Those resources that are not Cash Equivalent in cash form, but generally can Unit Trust Resources be converted into cash without Listed Shares much difficulty. Others Malaysian Financial Planning Council (MFPC) 2-7 RFP Programme - Module 2 Chapter 2: Risk Management Not all risks are significant and need to be managed. The probable occurrence and potential impact of the risk helps to determine which risks should be addressed. Risks that are low or insignificant in probability with a small potential impact can be ignored. On the other hand, risks which have a slight chance of occurrence but carry potentially severe financial impact should be managed. In this process, the resources of the client should also be evaluated to determine what and how much can be committed to the risk mitigation solution. If there are ample resources available, the risk management process is less constrained. More often than not, the resources of the client are insufficient to mitigate all risks and such prioritization based on the criteria above (probability and impact) must be undertaken. The financial practitioner should also inform the client of the risk that are not mitigated and the potential consequences to ensure the client is aware of ‘what’ has been handled and ‘what has not’. 4. Develop A Risk Management Plan Once the practitioner has evaluated of the risks completely, it is time for him to select and apply the different techniques of risk management that are suitable in terms of cost and effectiveness. The options available in a managing risk will comprise a mixture of risk avoidance, risk (loss) control, risk retention and risk transfer. These four techniques used in a risk management plan are explained below:  Risk avoidance can be implemented with one or a combination of the following four techniques, namely: elimination, substitution, separation and rational planning.  Elimination concerns the removing of the source of risk in the plan. For example, avoid taking part in dangerous sports (to avoid hospitalization due to injury). Quit smoking and drinking to avoid the possibility of degenerative diseases later on in life.  Substitution refers to the replacement of one activity or substance with another, which is less dangerous. An example would be to replace taking part in a dangerous sport (scuba diving) with another sport like table tennis  Separation refers to the division or placement of items separately so that potentially dangerous mixtures cannot occur. An example would be to separate and place flammable (petrol) and easily flammable materials (paper) in separate storage areas.  Rational Planning is to avoid some risks through careful study and organization to develop alternative solutions or to create contingency sources of supply for critical items. For example, the business should get more suppliers of a critical production raw material so that it will not get caught in an out of stock position on that item.  Risk (loss) control is a technique of dealing with risks that cannot be avoided and the individual concern does not wish to fully retain or transfer the risk. This technique can exist in three forms, i.e. 2-8 Malaysian Financial Planning Council (MFPC) RFP Programme - Module 2 Chapter 2: Risk Management  Loss prevention to reduce the chance of loss for any risk that cannot be avoided, e.g. wearing proper protective attire and sticking to guidelines when working in a hospital with SARS (severe acute respiratory syndrome) patients.  Loss reduction to control the severity of the losses when an undesirable event takes place, e.g. using fire-resistant materials, water sprinkler systems, fire walls/barriers, smoke detectors in a factory.  Loss sharing to reduce the amount of losses by sharing risky ventures with others, e.g. getting in partners to conduct a business so that losses and liabilities are shared among more people. LOSS FINANCING TECHNIQUES Diagram 6-2 Risk Retention Techniques Loss sharing Risk Transfer Techniques Insurance Based Non-Insurance Based  Risk retention is when the client retains the risk instead of passing it out to others. Intentionally or unintentionally, this form of dealing with risks is the most pervasive. In life, the client has to face almost an unlimited assortment of risks, many of which cannot be prevented at all. When these risks are not reduced, transferred or avoided, the client retains the possibility of loss. For planning purposes, the risks that should be retained are those that will lead to relatively bearable loss for the client if it occurs. It should be noted that this technique does not affect the frequency or the severity of a loss but provides an indication of how the individual or Malaysian Financial Planning Council (MFPC) 2-9 RFP Programme - Module 2 Chapter 2: Risk Management business will pay for the loss when it occurs. For instance, by investing in the share market, the funds of the client are always exposed to possible losses at any time. The investment in negatively co-related shares or other investment is one way of dealing with the risk. The gains from the rise in other shares when one class falls will be used to finance the loss. Risk retention is sometimes considered a form of self-insurance. Technically speaking, however, self-insurance represents a definition incongruity. For the insurance device to operate, there must be a transfer of risk or pooling of exposure units – which no one can do unto himself. However, this term self-insurance has gained unbridled usage to mean the person is taking all the risk within the situation. Most people, those not insured, self-insure by default rather than by choice. There are also situations where a business or organizations (but not individuals) engaged in some form of activities that resemble that of an insurer. An example would be the establishment of a business reserve fund to cover potential losses. Such activities are often also termed “self-insurance”.  Risk transfer or risk shifting can exist in two forms, i.e. in the form of non-insurance transfer of the risk or the risk transfer could be insurance-based. Essentially, the initiative is to plan how to finance those losses when they arise. An example of non-insurance transfer would be to contractually transfer a risk to another party, forcing that party to either retain or insure the risk. To demonstrate an instance where this has occurred, a property owner could by agreement transfer his property risk to a tenant by laying down in the contract that the tenant must insure the property. Although insurance is used, the owner of the property is not the one insuring the property. Insurance-based risk shifting is appropriate where the issue at hand is in a pure risk situation. For instance, a client can transfer the risk of loss of his earnings due to death to the insurer by insuring himself for an appropriate sum. In the case of a business, the business owner transfers the risk in his business by insuring the subject matter against the financial loss resulting from the insured risk. 2-10 Malaysian Financial Planning Council (MFPC) RFP Programme - Module 2 Chapter 2: Risk Management Examples of Risks and Risk Management Strategies Table 6-2 Personal Risks Strategies Risk Planning Defensive Financial Consequences Events Measures Instruments ♦ Death  Income Loss ♦ Estate Planning ♦ Life Insurance  Final Expenses ♦ Insurance Planning ♦ Wills & Trusts ♦ Disability ♦ Income Loss ♦ Health Programme ♦ Disability Insurance ♦ Treatment Costs ♦ Insurance Planning ♦ Power of Attorney ♦ Critical Illness ♦ Income Loss ♦ Health Programme ♦ Dread Diseases Insurance ♦ Treatment Costs ♦ Insurance Planning ♦ Health Insurance ♦ Retirement ♦ Income Reduction ♦ Prudent Investments ♦ EPF ♦ Old-Age Illness Costs ♦ Reduce Expenditures ♦ Approved/Non-Approved Funds ♦ Pensions ♦ Annuities ♦ Direct/Indirect ♦ Income Loss ♦ Proper Upkeep ♦ Direct Property Insurance Property Loss/ ♦ Replacement Costs ♦ Safety Measures ♦ Consequential Insurance Damage ♦ Repair Costs ♦ Insurance Planning ♦ Liability ♦ Claims & Settlement Costs ♦ Safety Measures ♦ Liability Insurance ♦ Legal Expenses ♦ Liability Insurance 5. Implement Risk Management Plan Once the techniques are matched to the risks identified, the plan is ready for implementation. In performing this step, the financial practitioner should be concerned with prioritising the risks in order of their importance and then matching the actions to be taken (such as insuring the risk) to deal with the risks. The other consideration in the plan implementation is the allocation of the resources of the client for the success of the plan. 6. Review, Monitor and Revise Risk Management Plan The final step in the risk management process involves: (i) undertaking periodic reviews, (ii) monitoring the implementation of the risk management programme, and Malaysian Financial Planning Council (MFPC) 2-11 RFP Programme - Module 2 Chapter 2: Risk Management (iii) adapting the risk management plan to changes as the client’s circumstances change. This step is imperative in risk management as the changing and evolving circumstances of the client requires amendments and fine-tuning of the initial plan over the years. Earnings may rise, debt level may, new needs may evolve for example (child education in a family where there were no children when the planning was initially done), and circumstances can change ( as in a divorce, where alimony payment have to made). The financial planner working jointly with the client should review any changing situation on an on going basis. Monitoring is an important step as it ensures proper execution of the action plans to manage the risks identified. We may assume that the more regularly this is done, the more updated the plan will be in meeting the risk management needs of the client. 2-12 Malaysian Financial Planning Council (MFPC) RFP Programme - Module 2 Chapter 2: Risk Management Self Assessment 1. Simon Lim bought a house for RM600,000. Which of the following best describes the pure risk situation of Simon? a. The risk that his house may be burnt down in a fire accident b. The risk that the value of his house may drop in a downturn c. The risk of losing the money had he invested it elsewhere d. None of the above. 2. One important aspect of financial planning is risk management. Which of the following is the best way to define risk management? a. The methods used in eliminating all the risks faced by an individual b. The systematic process of dealing with risks faced by an individual c. The use of insurance as the sole method to manage risks d. A process of increasing one’s wealth by reducing risk exposures 3. Different professionals will define risk in a different way. As a financial practitioner, which of the following best describe the term “risk” in the context of your profession? a. Uncertainty about financial losses from an exposure b. Certainty about financial losses from an exposure c. Exposure to investment risks d. Exposure to systemic risks 4. Fill in the blanks. In risk management, is the unpleasant outcome of. a. Loss; risk b. Risk; Loss c. Exposure; loss d. Loss; business ventures Malaysian Financial Planning Council (MFPC) 2-13 RFP Programme - Module 2 Chapter 2: Risk Management 5. There are two forms of loss. is a loss that has precipitated; is a loss that may happen. a. Occurred loss; loss exposure b. Loss exposure; happened loss c. Loss event; loss risk d. Expected loss; unexpected loss 6. Harban Singh, a well-paid construction worker in a high risk/high rise area decides to buy a large accident policy from an agent. He is a single without dependent. In an attachment to the proposal form to the insurer, the agent reported that Harban is currently being pressed by the credit card company for outstanding payments of a large amount. The insurer promptly turns down the proposal. What are the likely grounds for the insurer to turn down the proposal? i. High physical hazard: Harban works in a high risk area ii. Likely moral hazard: Harban is in debts iii. Possible morale hazard: Harban has no dependents a. i only b. i, & ii. c. None of the above d. All the above 7. Risk exists in many forms. A is a risk that affects the entire economy; whereas a is a risk that affects only individuals. a. fundamental risk; particular risk b. particular risk; fundamental risk c. Speculative risk; pure risk d. static risk; dynamic risk 2-14 Malaysian Financial Planning Council (MFPC) RFP Programme - Module 2 Chapter 2: Risk Management 8. Risk management is primarily concern with pure risks. Which are the three main types of pure risk faced by individuals? a. Group risks, personal risks and liability risks. b. Insurable risks; property risks and liability risks. c. Personal risks; property risks and liability risks. d. Death risks, disability risks and illness risks. 9. Which of the following pure risk situations fall under personal risks for an individual? i. Risk of Premature death ii. Risk of Retirement iii. Risk of Health Deterioration iv. Risk of Unemployment a. i & ii only. b. ii & iii only c. i, ii & iii only d. All of the above. (Questions 10 refers to this passage) Afire burned down Mr. Kong’s factory. Before the fire, he was doing a lucrative business manufacturing advertisement boxes for export before the fire. He has several contracts on hand, which require special precision printing machines to produce the materials to fulfill them on time. Because of the fire and the special machines destroyed, he cannot fulfill the contract on time and loss profits. 10. Property loss can be direct or indirect. In the above situation, which of loss can be classified as an indirect loss to Mr. Kong as a result of the fire? a. The loss of the factory b. The loss of the special printing machines c. The loss of profits d. The loss of printing materials Answers: 1-A, 2-B, 3-A , 4-A, 5-A, 6-D, 7-A, 8-C, 9-D, 10-C Malaysian Financial Planning Council (MFPC) 2-15 RFP Programme - Module 2 Chapter 3: Insurance Needs Analysis Chapter 3 Insurance Needs Analysis Chapter Objectives Students must be able to:  Determine the Amount of Coverage Needed Depending on the Risks Faced  Measure the Life Insurance Needs Based on Following: a) Human Life Value Approach b) Capital Needs Approach (i) Capital Liquidation (ii) Capital Conservation  Understand Property and Liability Needs  Understand Needs Analysis - Total Needs and Single Needs  Identify and Understand the Factors Affecting Insurance Needs with Special Reference to: a) Death b) Disability c) Critical Illness/Dread Disease d) Education Funding e) Retirement  Understand the Risks that Business Individuals Faced Malaysian Financial Planning Council (MFPC) 3-1 RFP Programme - Module 2 Chapter 3: Insurance Needs Analysis Chapter 3 Insurance Needs Analysis Introduction In evaluating the personal risks and consequently the needs of the client, the financial planner has to be very thorough in understanding the: Current Circumstances of the Client This is to determine the risks faced by the client and to ensure that the current risks can be adequately mitigated, and there is little or no financial impact on the client and dependents, if such personal risks materialize. Examples of current personal risks will include pre-mature death, consequences of illness and hospitalization, disability, property loss etc Future Aspirations of the Client Once the current risks have been established, the financial planner will need to ascertain the aspirations of the client for the future to ensure that future goals have been factored into the financial solution. Omission of this element will leave the client exposed to the risk of not being able to meet future goals. Examples of risks associated with future aspirations include accumulation of wealth for retirement, for funding education needs and for leaving an estate for distribution to dependents. The Resources of the Client The client’s resources and the arrangement of these resources (how the resources are being used, where are the resources being committed and over what duration it has been committed) are important issues that the financial planner needs to understand. This will provide an indication of  the financial resilience of the client  the ability to fund the financial plan, and  the ability to withstand the impact of a risk or contingency materializing. The consideration of the issues stated above is imperative in the development of a risk based financial solution for the client. Once that has been done, there is a need to structure a methodology 3-2 Malaysian Financial Planning Council (MFPC) RFP Programme - Module 2 Chapter 3: Insurance Needs Analysis to constantly monitor the risks faced by the client as it is essential to fine-tune the financial plan to match the changing and evolving risks associated with the client’s circumstances. Risks Analysis In Module 1 of the RFP program, we have learnt that individuals are exposed to personal, property and liability risks. We have also learnt that those risks with the highest potential financial consequence should be treated with priority over those which have a lower financial consequence. This section will cover the analysis of individual needs and priorities in relation to the three individual risk exposures, namely, personal, property and liability risks. A. Life Insurance : Personal Risk Exposures Personal risks are risks that are directly related to an individual’s circumstances and such risks may result in:  the loss of all or part of the income earning ability  additional expenses being incurred due to illness  additional expenses being incurred due to disability  the inability to lead the desired life-style during retirement  the inability to fund the desired education for children  the uncertainty associated with personal wealth accumulation  inability to adequately fulfil the estate distribution desires As far as life insurance is concerned, the five dominant types of personal risk factors that can lead to the above consequences are: 1. Pre-mature Death – We may define pre-mature death as the demise of an individual while the individual still has the capacity to generate an income. Generally this is pegged to the ‘accepted retirement age’. Thus, if the accepted retirement age is 55 years, a person who is working (and earning) an income is said to have died pre-maturely if death occurs before 55 years of age. Pre-mature death, thus, destroys the earning capacity and capability of an individual pre-maturely. The risk associated with premature death is related to  the financial impact of death on the dependents, and  the loss of potential income for the dependents. Malaysian Financial Planning Council (MFPC) 3-3 RFP Programme - Module 2 Chapter 3: Insurance Needs Analysis i. The financial impact of death on the dependents What is the residual financial situation of the dependents if a breadwinner dies? Do they have enough wealth to carry on with the current life-style or must compromises be made leading to a more austere life style? How long will the current wealth fund the current life-style? Are there any residual financial obligations resulting from death that must be settled by the dependents, and if so, are there enough resources to settle those obligations? Answers to such questions are fundamental in ensuring that adequate provisions are made for dependents in the event of pre-mature death. In determining the extent of risk exposure of the individual to pre-mature death and its impact on the financial condition of the dependents, there is a need to determine: i. the amount needed to provide for the continued life-style of the dependents ii. the amount needed for the settlement of loans or borrowings iii. the amount needed for the settlement of other possible financial obligations. ii. The loss of potential income for the dependents One issue related to pre-mature death concerns the loss of income, that is, the loss of income the individual would have earned if that individual had been able to work until retirement. This can also be deemed to be the ‘economic’ loss the dependents would suffer – the potential income loss – in the event of pre-mature death. To determine whether there is a risk of loss resulting from pre-mature death, the following questions need to be asked: 1. What is the potential loss of income? 2. Will the dependents suffer financial hardship due to the loss of income resulting from pre- mature death? 3. What expenses will be incurred upon death? 4. Are there current resources sufficient to mitigate the financial hardship consequent upon death?  Measuring the Risks associated with Pre-mature Death The established methods of evaluating personal risk associated with premature death that will be considered here are: a. the concept of human life value, b. the capital needs method which comprises of : (i) the capital liquidation method (ii) the capital conservation method 3-4 Malaysian Financial Planning Council (MFPC) RFP Programme - Module 2 Chapter 3: Insurance Needs Analysis Let’s take a look at each of these methods in turn. a. The Concept of Human Life Value The development of this concept is generally credited to Dr. S.S. Huebner and is based on the individual’s income earning ability or more accurately, on the potential income earning ability – that is the amount of income the person would earn over the remaining duration of his working life up to the point of retirement. The human life value is defined as the present value of the potential income lost by dependants as a result of the person’s death. The general formula for computation of the present value (which was introduced in Module 1) is re-visited here and used for the computation of the human life value. PVAD = A (1 + r) {1 – (1 + r)– n } (r) where PVAD = Total income required to meet the annual income needs for n number of years A = annual income needs r = interest rate at which the total income will be compounded n =number of years from the current age to the age of retirement Example 3-1 For the purpose of illustration, consider a 30 years old person who will retire at the age of 55. If we estimate his or her annual earnings as $60,000 and that two-thirds of this income will be consumed by the dependants, the individual’s effective economic value to dependants is $40,000 a year for the next 25 years (duration for which the person will work up to retirement). Assuming that the income is placed in an instrument generating an interest rate of 6%, it is possible to compute the human life value for this particular individual as follows: In this case, n = 25, r = 6% p.a., PMT = RM40,000, Using a financial calculator , the human life value will be RM511,335. The human life value method is a straight forward method in calculating the amount that will be lost by the dependents if premature death occurs (in the illustration above, it is RM40,000.00 a year). The total sum of RM511,335.00 is the amount lost due to pre-mature death provided the rate of return is 6% across the period of 25 years. This approach nevertheless has a number of limitations that must be appreciated. Malaysian Financial Planning Council (MFPC) 3-5 RFP Programme - Module 2 Chapter 3: Insurance Needs Analysis Example 3-2 Jason Mark, Aged 30, is expected to retire at Age 55. His annual earnings are RM80,000, out of which RM60,000 is needed to support his family yearly for the next 25 years. Assuming the growth of his income is equal to the inflation rate, which is 6%, his human life value is computed as: The mathematical formula used to compute the amount needed might be expressed as: PVAD = A (1 + r) {1 – (1 + r)– n } (r) Where, PVAD = the present value of the total amount needed to support his family A= the annual income needs of the family r = the interest rate assumption for compounding n = the number of years to retirement In the above case, A = RM 60,000; n = 25; r = 6% Human Life Value = A (1 + r) {1 – (1 + r)– n }/r = RM 60,000 (1+ 0.06)[1- (1.06)] –25/0.06] = RM 60,000 (1.06)[12.7834] = RM 813,024.00 The limitations of the human life value concept can be summarized as follows:  Salary is assumed to be unchanged for the entire period  The interest rate is assumed to be constant throughout the period  The income need is also assumed to be unchanged over the period, thus ignoring other evolving needs such as life-style changes, education needs etc.  The inflation rate is ignored.  It does not consider the fact that the person may work or be involved in some income generating activity after retirement. he considerations of the human life value concept ( no increase in salary, interest rate remains the same and the income need remains unchanged), the economic value of an individual will generally 3-6 Malaysian Financial Planning Council (MFPC) RFP Programme - Module 2 Chapter 3: Insurance Needs Analysis decrease over a period of time as the person moves closer to retirement and become zero at the point of retirement ( as the period (n) of computation decreases and ultimately becomes zero at the point of retirement). This of course is not true in reality. Despite the fact that a person may get closer to retirement, the person’s human life value can increase due to an increase in the salary as can be demonstrated by the following example. No. of years to Human life Age Annual salary Interest rate retirement value 30 25 RM36,000 5% RM 507,382 35 20 RM42,000 5% RM 523,412 Thus, it is pertinent to note the limitations of the human life concept when calculating the amount of coverage required for an individual. Nevertheless it a good method of getting started – at least there is a numerical value to focus on with the client. b. Capital Needs Method The Capital Needs approach examines the amount of funds required to meet the income needs of dependents. There are two basic approaches: i. capital liquidation approach, and ii. capital conservation approach. (i) Capital Liquidation Approach Under the Capital Liquidation approach, both the principal and a portion of the interest will be consumed in meeting the projected income needs. Thus, over a period of time, the funds will eventually all be used up and there is no residual amount. The period will be dependent on the amount of funds provided, the amount of money required and the interest rate available. In the capital liquidation approach, the assumptions used for calculating the sum assured is similar to the methodology used in the human life concept. While the number of years used in the human life value approach is the difference between the retirement age and the current age, the concept of capital liquidation gives the client the financial freedom to fix the number of years for which the income is needed for dependents. For example, a client may want to provide funding for a certain fixed period of time, say ten years, then the value of n in the present value formula will be equal to 10. Let’s look at the illustration below to demonstrate this clearly. Malaysian Financial Planning Council (MFPC) 3-7 RFP Programme - Module 2 Chapter 3: Insurance Needs Analysis Example 3-3. Mr. A is currently earning RM4,500.00 a month. He is married (his wife is not employed) with two children aged 4 and 5 respectively. Mr. A’s father has left a trust fund for Mr. A’s children which will provide a substantial amount of income for the family when the youngest child reaches the age of 21 years and the family will have financial freedom thereon. However, Mr. A is concerned about the next 17 years, and he wants to ensure that the family will be provided a monthly allowance of RM3,000.00 a month. If the interest rate for a fixed deposit account is 3.5%, what is the value of the estate that Mr. A must create immediately to ensure his objective is met? Using the financial calculator: Set : Begin ( need to create an immediate estate) n = 17 i = 3.5% pmt = RM36.000 FV = 0 ( nothing is left at the end of the period) The solution you get will be RM 471,388. (ii) Capital Conservation Under the Capital Conservation approach, sufficient funding is provided so that investment earnings alone will supply the income stream without depleting the original capital sum. The formula for the Capital conservation approach is as follows: PV = A / r, is for the capital conservation approach. In the formula, PV = total income needs to meet the future annual needs A = annual income needs, r = interest rate for compounding, We can also see that the lower the interest rate, the higher will be the amount of the capital sum required to fund the annual income needs. On the other hand, the higher the interest rate, the lower will be the capital sum to generate the annual income needs. To illustrate the Capital Conservation approach, the same facts as stated in the earlier illustration for capital liquidation may be used. The outcome is: 3-8 Malaysian Financial Planning Council (MFPC) RFP Programme - Module 2 Chapter 3: Insurance Needs Analysis PV of capital sum = Annual income required Interest rate PV of capital sum = $36,000 / 0.035 = RM1,028,571. This means that RM1,028,571 is now required to the annual income needs – where the capital is untouched and the interest only is used. The choice between the two methods will depend on the objective or need that has to be met. The capital liquidation strategy is focussed on meeting the income goals for a certain fixed period of time - the risk management strategy of protecting dependants. The capital conservation strategy on the other hand seeks to meet the dual strategy of income needs for the dependents and of transferring wealth to heirs. Once the quantum for the capital needs has been calculated, the amount of funding required is the difference between the capital needs and available assets. Thus: Additional capital sum required at death = Capital need – available assets ( Deficiency) (Note: The Capital Conservation approach will always require a greater amount of capital than the Capital Liquidation approach discussed above. The difference in the amount required will depend on the number of years for which the fixed income is required and on the interest rate assumption used.) The determination of the capital sum required upon death requires the consideration of :  the amount needed for the settlement of loans or borrowings, and  the amount needed for the settlement of other possible financial obligations. These may include personal borrowing, loans not covered by any insurance plans or not supported by pledged collateral, funeral expenses, legacy amounts etc. Thus, Additional capital sum required at death = Capital need – available assets. ( Deficiency)  Capital sum ( based on capital  Current policies liquidation or conservation )  EPF  Loans/borrowings etc  Savings  Funeral expenses  Death gratuity  Legacy sums  Investments etc.  Other financial obligations/desires. Malaysian Financial Planning Council (MFPC) 3-9 RFP Programme - Module 2 Chapter 3: Insurance Needs Analysis Example 3-4 Raymond Wong has total cash and cash equivalent resources totalling RM 300,000. The amount needed to cover his family income replacement need is RM 60,000 per annum based on a 5-year adjustment period. The present value of the capitalized worth of family income replacement need at 6% is RM 267,908.00 [RM 60,000 (1.06)[1- (1.06)] –5/0.06]] using the capital liquidation approach. If the capital conservation approach is used, the amount is RM 1,000,000 [RM 60,000/6%]. He also likes to set aside an amount for charitable purpose, which is RM 80,000. On his death, the estimated cash need is totalled at RM 200,000. Solution 1. Raymond’s Total Life Insurance Need based on the Capital liquidation Approach = [Cash Need + Income Replacement Need + Legacy Needs} – Cash Resources = [RM 200,000 + 267,908+ 80,000] – 300,000 = 247,908 (Deficient amount) 2. Raymond’s Total Life Insurance Need based on the Capital Conservation Approach = [Cash Need + Income Replacement Need + Legacy Needs} – Cash Resources = [RM 200,000 + 1,000,000 + 80,000] – 300,000 = 980,000 (Deficient amount) Table 3-1 Need Classification Explanation Examples Cash Need Pay Final Expenses Funeral Expenses Cancel Liabilities/Debts Mortgage Loan These are primarily needs Fund Important Events Child Education that are usual when an Legal Obligations individual dies. Taxes, Estate Duty, Legal Fees Emergency Fund Unforeseen Expenses Religious Obligations Zakat (for Muslims) As a Special Gift for Selected Loved Legacy Need