Chapter 2 (Risk management in Insurance)

Risk: A probability or threat of damage, injury, liability, loss, or any other negative occurrence
that is caused by external or internal vulnerabilities, and that may be avoided through preemptive
action.

Uncertainty: Uncertainty implies a condition where the future events are not known.
Uncertainty cannot be measured in quantitative terms through past methods.

Difference between Risk and Uncertainty

Topics Risk Uncertainty
[Link] Risk is referred to a situation where the If no information is available
probability of distribution of cash flows of an to formulate a probability
investment proposal in known. distribution of the cash flows
the situation is known.
[Link] Risk is formed by information with probability It is formed by no
distribution. information with probability
distribution.
[Link] Measured by statistical concept. It cannot be measured.
[Link] Probability of occurrence of outcome is known Probability of occurrence of
to all. outcome is unknown.
[Link] Measurement tools are standard deviation and There is no tool for
variance. measurement.
[Link] Risk is related with income. It is related without income.
[Link] Risk is avoidable It is unavoidable.
[Link] By insurance it can be transferable. It is no Insurable.
[Link] It can be controlled. It is not controlled.
[Link] Risk management is required to avoid it. Risk management is not
management required.

Classification of Risk

There are different types of risk. The most important types of risk include:
a. Pure Risk
b. Speculative Risk
c. Particular Risk
d. Fundamental Risk
e. Static Risk
f. Dynamic Risk.
PURE RISK

Pure risk is a situation that holds out only the possibility of loss or no loss. For example, if you
buy a new textbook, you face the prospect of the book being stolen or not being stolen. The
possible outcomes are loss or no loss. Also, if you leave your house in the morning and ride to
school on your motorcycle you cannot be sure whether or not you will be involved in an
accident, that is, you are running a risk. There is the uncertainty of loss. Your motorcycle may
be damaged or you may damage another person’s property or injured another person. If you are
involved in any one of these situations, you will suffer loss. But if you come back home safely
without any incident, then you will suffer no loss. So in pure risk, there is only the prospect of
loss or no loss. There is no prospect of gain or profit under pure risk. You derive no gain from
the fact that your house is not burnt down. If there is no fire incident, the status would be
maintained, no gain no loss, or a break-even situation. Therefore, it is only the pure risks that are
insurable.
Different Types of Pure Risk:

Both the individual and business firms face different types of pure risks that pose great threat to
their financial securities. The different types of pure risks that we face can be classified under
any one of the followings:

a. Personal risks
b. Property risks
c. Liability risks

Personal Risks

Personal risks are those risks that directly affect an individual.

Personal risks detrimentally affect the income earning power of an individual. They involve the
likelihood of sudden and complete loss of income, or financial assets sharp increase in expenses
or gradual reduction of income or financial assets and steady rise in expenses. Personal risks can
be classified into four main types:

a. Risk of premature death

b. Risk of old age
c. Risk of sickness
d. Risk of unemployment

· Risk of Premature Death

It is generally believed that the average life span of a human being is 70 years. Therefore,
anybody who dies before attaining age 70 years could be regarded as having died
prematurely. Premature deaths usually bring great financial and economic insecurity to
dependents. In most cases, a family breadwinner who dies prematurely has children to educate,
dependents to support, mortgage loan to pay. In addition, if the family bread-winner dies after a
protracted illness, then the medical cost may still be there to settle and of course the burial
expenses must have to be met. By the time all these costs are settled, the savings and financial
assets of the family head may have been seriously depleted or possibly completely spent or sold
off and still leaving a balance of debt to be settled.

The death of family head could render some families destitute and sometimes protracted illness
could so much drain the financial resources of some families and impoverish them even before
the death of the family breadwinner.

When a family breadwinner dies, the human-life value of the breadwinner would be lost
forever. This loss is usually very considerable and creates grate financial and economic
insecurity. What is a human life value? A human life value is the present value of the share of
the family in the earnings of the family head.

· Risk of Old Age

The main risk of old age is the likelihood of not getting sufficient income to meet one’s financial
needs in old age after retirement. In retirement, one would not be able to earn as much as before
and because of this, retired people could be faced with serious financial and economic insecurity
unless they have build up sufficient savings or acquired sufficient financial assets during their
active working lives from which they could start to draw in old age.

Even some of the workers who make sufficient savings for old age would still have to contend
with corrosive effect of inflation on such savings. High rate of inflation can cause great financial
and economic distress to retired people as it may reduce their real incomes.

· Risk of Poor Health

Everybody is facing the risk of poor health. It is only when people are healthy, that they can
meaningfully engage themselves in any productive activity and earn full economic income. Poor
health can bring serious financial and economic distress to an individual. For example, without
good health, nobody can gainfully engage himself in any serious economic undertaking and
maximized his economic income.
A sudden and unexpected illness or accident can result in high medical bills. Therefore, poor
health will result in loss of earned income and high medical expenses. And unless the person has
adequate personal accident and health insurance cover or has made adequate financial
arrangements for income from other sources to meet these expenses, the person will be
financially unsecured.

Risk of Unemployment

The risk of unemployment is a great threat to all those who are working for other people or
organizations in return for wages or salaries. The risk equally poses a great threat to all those
who are still in school or undergoing courses of vocational training with the notion of taking up
salaried job after the training period. Self-employed persons, whose services or products are no
longer in demand, could also be faced with the problem of unemployment.

Unemployment is a situation where a person who is willing to work and is looking for work to
do cannot find work to do. Unemployment always brings financial insecurity to people. This
financial insecurity could come in many ways, among which are:

a. The person would lose his or her earned income. When this happens, he will suffer some
financial hardship unless he has previously built up adequate savings on which he can
now start to draw.
b. If the person fails to secure another employment within reasonable period of time, he
may fully deplete his savings and expose himself to financial insecurity.
c. If he secures a part-time job, the pay would obviously be smaller than the full-time pay
and this entails a reduction of earned income. This would also bring financial insecurity.

Liability Risks

Most people in the society face liability risk. The law imposes on us a duty of care to our
neighbor and to ensure that we do not inflict bodily injury on them. If anyone breaches this duty
of care, the law would punish him accordingly. For example, if you injure your neighbor or
damage his property, the law would impose fines on you and you may have to pay heavy
damages.

Unfortunately, one can be found liable for breach of duty of care in different ways and the best
security seems to be the purchase of liability insurance cover.

Liability Risks have two peculiarities:

a. Under liability risk, the amount of loss that can be involved has no maximum upper limit.
 b. The wrong doer can be sued for any amount. For example, while riding on your bicycle
valued $500, you negligently cause serious bodily injury to another person, that person
can sue you for any amount of money, say $5000, N10,000 or even more depending on
the nature of the injury.

c. In contrast, if the bicycle value at $500 is completely damaged by another person, the
maximum amount of compensation (indemnity) that would be paid to you for the loss of
the bicycle is just $500, that is, the actual value of the bicycle.

d. Under liability risks your future income and assets may be attached to settle a high court
fines if your present income and assets are inadequate to pay the judgment debt. When
this happens, your financial and economic security would be greatly endangered.

Property Risks

Property owners face the risk of having their property stolen, damaged or destroyed by various
causes. A property may suffer direct loss, indirect loss, losses arising from extra expenses of
maintaining the property or losses brought about by natural disasters.

Natural disasters such as flood, earthquake, storm, fire etc can bring about enormous property
losses as well as taking several human lives. The occurrence of any of these disasters can
seriously undermine the financial security of the affected individual, particularly if such
properties are not unsecured.

SPECULATIVE RISK

Speculative risk is a situation that holds out the prospects of loss, gain, or no loss no gain (break-
even situation). Speculative risks are very common in business undertakings. For example, if
you establish a new business, you would make a profit if the business is successful and sustain
loss if the business fails.

If you buy shares in a company you would make a gain if the price of the shares rises in the stock
market, and you would sustain a loss if the price of the shares falls in the market. If the price of
the shares remains unchanged, then, you would not make a profit or sustain a loss. You break-
even. Gambling is a good example of speculative risk. Gambling involves deliberate creation of
risk in the expectation of making a gain. There is also the possibility of sustaining a loss. A
person betting $500 on the outcome of the next weekend English Premier League Match faces
both the possibility of loss and of gain and of no loss, no gain.
Other examples of speculative risk include taking parts in a football pool, exporting to a new
market, betting on horse race or motor race.
Speculative risks are no subject of insurance, and then are therefore not normally
insurable. They are voluntarily accepted because of their two-dimensional nature of gain or loss.

Pure Risk Speculative Risk

1. Pure risk is a risk where there is only 1. Speculative risk is a risk where both
the possibility of a loss or you maintain a status profit and loss are possible. Speculative risks
quo. Only pure risks are insurable. are not normally insurable.

The few exceptions of speculative risks are

insurable firms that insure their institutional
portfolio of investments against loss.
2. Although there are some exceptions of 2. Speculative risks are not
pure risks which are not insurable. generally easily predictable. So, the law of
large numbers cannot be easily applied to
speculative risk.

However, gambling is one exception of

speculative risks to which the law of large
numbers can easily be efficiently applied.

Society may benefit from a speculative risk if a

loss occurs. For example, a firm may develop
a new invention for producing a commodity
more cheaply. As a result of this, a competitor
may be forced out of the market into
bankruptcy. In this situation, the society will
benefit since the products are produced more
efficiently and at lower cost to consumers,
even though competitor has been forced into
bankruptcy.

Speculative risks are more voluntarily accepted

because of its two-dimensional nature of gain
or loss.
3. Pure risk are generally easily predictable
than speculative risks. So the application of
the law of large numbers can be more easily
applied to pure risk.
4. Society will not benefit from a pure risk
if a loss occurs. For example, if a flood or
earthquake devastates a region, society will not
benefit from such devastation.
5. Pure risk is not voluntarily accepted.

Direct Loss

Direct loss is that loss which flows directly from the unsecured peril. For example, if you insure
your house against fire, and the house is eventually destroyed by fire, then the physical damage
to the property is known as direct loss.

Indirect Loss or Consequential Loss

Indirect or consequential loss is a loss that arises because of a prior occurrence of another
loss. Indirect loss flows directly from an earlier loss suffered. The loss is the consequence of
some other loss. It arises as an additional loss to the initial loss suffered. For example, if a
factory that has a fire policy suffers fire damage, some physical properties like building,
machinery maybe destroyed. The loss of these properties flows directly from the insured peril
(fire). The physical damage to the properties is known as direct fire loss.

But in addition to the physical damage to the properties, the firm may stop production for several
months to allow for the rebuilding of the damaged of the premises and replacement of damaged
equipment, during which no profit would be earned.

This loss of profit is a consequential loss. It Is not directly brought about by fire but flows
directly from the physical damage brought about by fire and hence indirectly from the fire
incident. Other examples of consequential loss are the loss of the use of the building and the loss
of a market.

Extra Expenses

Alternative arrangement may have to be made to rend a temporary premise, pending the repairs
or reinstatement of the damaged building and it may also be necessary to rent, hire or lease a
machine in order to keep production going so as not to disappoint customers and in the process
lose market to competitors. The expenses incurred in securing the alternative premises, an
renting, hiring or leasing a machine are referred to as extra expenses. These expenses may not
have been insured if there has been no fire damage.
FUNDAMENTAL RISK

A fundamental risk is a risk which is non-discriminatory in its attack and effect. It is impersonal
both in origin and consequence. It is essentially, a group risk caused by such phenomena like
bad economy, inflation unemployment, war, political instability, changing customs, flood,
draught, earthquake, weather (e.g. harmattan) typhoon, tidal waves etc. They affect large
proportion of the population and in some cases they can affect the whole population e.g. weather
(harmattan for example). The losses that flow from fundamental risks are usually not caused by
a particular individual and the impact of their effects falls generally on a wide range of people or
on everybody. Fundamental risk arises from the nature of the society we live in or from some
natural occurrences which are beyond the control of man.

The striking peculiarity of fundamental risk is that is incidence is non-discriminatory and falls on
everybody or most of the people. The responsibility of dealing with fundamental risk lies with
the society rather than the individual. This is so because, fundamental risks are caused by
conditions which are largely beyond human’s control and are not the fault of anyone in
particular. The best means of handling fundamental risk is the social insurance, as private
insurance is very inappropriate. Although, it is on record that some fundamental risk, like
earthquake, flood are being handle by private insurance.

PARTICULARS RISKS

A particular risk is a risk that affects only an individual and not everybody in the
community. The incidence of a particular risk falls on the particular individual
affected. Particular risk has its origin in individual events and its impact is localized (felt
locally). For example, if your textbook is stolen, the full impact of the loss of the book is felt by
you alone and not by the entire members of the class. You bear the full incidence of the
loss. The theft of the book therefore is a particular risk.
If your shoes are stolen, the incidence of the loss falls on you and not on any other
person. Particular risks are the individual’s own responsibility, and not that of that society or
community as a whole. The best way to handle particular risk by the individual is the purchase
of insurance cover.

STATIC RISK

Static risks are risks that involve losses brought about by irregular action of nature or by
dishonest misdeeds and mistakes of man. Static losses are present in an economy that is not
changing (static economy) and as such, static risks are associated with losses that would occur in
an unchanging economy. For example, if all economic variables remain constant, some people
with fraudulent tendencies would still go out steal, embezzle funds and abuse their positions. So
some people would still suffer financial losses. These losses are brought about by causes other
than changes in the economy (perils of nature and the dishonesty of other people).

Static losses involve destruction of assets or change in their possession as a result of

dishonesty. Static losses seem to appear periodically and as a result of these they are generally
predictable. Because of their relative predictability, static risks are more easily taken care of; by
insurance cover then are dynamic risks. Example of static risk includes theft, arson assassination
and bad weather. Static risks are pure risks.

DYNAMIC RISK

Dynamic risk is risks brought about by changes in the economy. Changes in price level, income,
tastes of consumers, technology etc (which is examples of dynamic risk) can bring about
financial losses to members of the economy. Generally dynamic risks are the result of
adjustments to misallocation of resources. In the long run, dynamic risks are beneficial to the
society. For example, technological change, which brings about a more efficient way of mass
producing a higher quality of article at a cheaper price to consumers than was previously the
case, has obviously benefited the society.
Dynamic risk normally affects a large number of individuals, but because they do not occur
regularly, they are more difficult to predict than static risk.

Methods of risk management

Here are the 6 techniques associated with risk management.

1. Avoidance

Avoidance is the best means of loss control. This is because, as the name implies, you’re
avoiding the risk completely. If your efforts at avoiding the loss have been successful, then there
is a 0% probability that you’ll suffer a loss (from that particular risk factor, anyway). This is why
avoidance is generally the first of the risk control techniques that’s considered. It’s a means of
completely eliminating a threat.

2. Prevention

Loss prevention is a technique that limits, rather than eliminates, loss. Instead of avoiding a risk
completely, this technique accepts a risk but attempts to minimize the loss as a result of it. For
example, storing inventory in a warehouse means that it is susceptible to theft. However, since
there really is no way to avoid it, a loss prevention program is put in place to minimize the loss.
This program can include patrolling security guards, video cameras, and secured storage
facilities.

3. Reduction
Loss reduction is a technique that not only accepts risk, but accepts the fact that loss might occur
as a result of the risk. This technique will seek to minimize the loss in the event of some type of
threat. For example, a company might need to store flammable material in a warehouse.
Company management realizes that this is a necessary risk and decides to install state-of-the-art
water sprinklers in the warehouse. If a fire occurs, the amount of loss will be minimized.

4. Separation

Separation is a risk control technique that involves dispersing key assets. This ensures that if
something catastrophic occurs at one location, the impact to the business is limited to the assets
only at that location. On the other hand, if all assets were at that location, then the business
would face a much more serious challenge. An example of this is when a company utilizes a
geographically diversified workforce.

5. Duplication

Duplication is a risk control technique that essentially involves the creation of a backup plan.
This is often necessary with technology. A failure with an information systems server shouldn’t
bring the whole business to a halt. Instead, a backup or fail-over server should be readily
available for access in the event that the primary server fails. Another example of duplication as
a risk control technique is when a company makes use of a disaster recovery service.

6. Diversification

Diversification is a risk control technique that allocates business resources to create multiple
lines of business that offer a variety of products and/or services in different industries. With
diversification, a significant revenue loss from one line of business will not cause irreparable
harm to the company’s bottom line.

Risk control is a key component in any sound company strategy. It’s necessary to ensure long-
term organization sustainability and profitability.