MF0009 INSURANCE AND RISK MANAGEMENT
1. Explain the major types of Pure risks.
(5 Marks)
Answer:
Pure risk is defined as a situation in which there are only the possibilities of loss or no loss. The only possible outcomes are adverse (loss) and neutral (no loss). Example of pure risks include premature death, job related accidents, catastrophic medical expenses, and damage to property from fire, lighting, flood, or earthquake.
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ath r a The major types of pure risk that can create great financial insecurity include personal Sh risks, property risks, and liability risks. by y t om affect an individual; they a. Personal Risks: Personal risks are those risks rsi that directly c e . l iv > ai involve the possibility of complete lossUorn reduction 09 gm of earned income, extra expenses, l 0 a /2 are4@ and the depletion of financial assets.ipThere four major personal risks: 5 n a e/0 lva8 M death n i. Risk of premature m <Ju atha i ii. Risk of insufficient during retirement ar kk hincome Si s : iii. Risk oftopoor health ail d e m itt of unemployment iv. m Risk Eb b. Property Risks: Su Persons owning property are exposed to the risk of having their Types of Pure Risk:
property damaged or loss from numerous causes. Real estate and personal property can be damaged or destroyed due to fire, lightning, tornadoes, windstorms, and numerous other causes. There are two major types of loss associated with the destruction or theft of property- direct loss and indirect or consequential loss. c. Liability Risks: Liability risks are another important type of pure risk that most persons face. Under our legal system, you can be held legally liable if you do something that result in bodily injury or property damage to someone else. A court of law may order you to pay substantial damages to the person you have injured.
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MF0009 INSURANCE AND RISK MANAGEMENT
2. The rule of the risk management provides a basic framework within which risk management decisions can be made. Discuss.
(5 Marks)
Answer: Risk Management is the identification, assessment, and prioritization of risks followed by coordinated and economical application of resources to minimize, monitor, and control the probability and/or impact of unfortunate events. Risks can come from uncertainty in financial markets, project failures, legal liabilities, credit risk, accidents, natural causes and disasters as well as deliberate attacks from an adversary. Several risk management standards have been developed including the Project Management Institute, the a National Institute of
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management, security, engineering, industrial processes, by financial portfolios, actuarial
y sit om r c e . l v ai following elements, performed, ni 9> ofmthe For the most part, these methodologiesUconsist l 00 g pa 5/2 84@ more or less, in the following order: i an e/0 lva M threats n 1. identify, characterize, and assess m <Ju atha i k r 2. assess the vulnerability ofikcritical assets ha to specific threats S s to the expected il: 3. determine the risk (i.e. consequences of specific types of attacks on a d e m t specific assets)mit E b u 4. identify ways S to reduce those risks assessments, or public health and safety.
5. prioritize risk reduction measures based on a strategy The strategies to manage risk include transferring the risk to another party, avoiding the risk, reducing the negative effect of the risk, and accepting some or all of the consequences of a particular risk. In ideal risk management, a prioritization process is followed whereby the risks with the greatest loss and the greatest probability of occurring are handled first, and risks with lower probability of occurrence and lower loss are handled in descending order. In practice the process can be very difficult, and balancing between risks with a high probability of occurrence but lower loss versus a risk with high loss but lower probability of occurrence can often be mishandled. Page 2 of 8
MF0009 INSURANCE AND RISK MANAGEMENT
Intangible risk management identifies a new type of a risk that has a 100% probability of occurring but is ignored by the organization due to a lack of identification ability. For example, when deficient knowledge is applied to a situation, a knowledge risk materializes. Relationship risk appears when ineffective collaboration occurs. Process-engagement risk may be an issue when ineffective operational procedures are applied. These risks directly reduce the productivity of knowledge workers, decrease cost effectiveness, profitability, service, quality, reputation, brand value, and earnings quality. Intangible risk management allows risk management to create immediate value from the identification and reduction of risks that reduce productivity. Risk management also faces difficulties allocating resources. a This is the idea
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MF0009 INSURANCE AND RISK MANAGEMENT
3. A risk manager has several source of information to identify the preceding loss exposures. Explain some important sources of information.
(5 Marks)
Answer: Within an organization's management team, the risk manager has the responsibility of identifying loss exposures and selecting risk control and risk financing techniques to reduce the potential for losses and to fund recovery from actual losses. Instead of addressing business loss potential such as loss of market share, risk managers generally attempt to fund recovery from accidental losses through risk financing techniques. These programs can range from various kinds of commercial insurance to alternatives, such as self a insurance or use of
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A risk manager first needs to identify and quantify loss exposures. One process by
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iv l 20 @g pa flow sheet reviews, and analyses of organizational 4 manufacturing processes, personnel i 5/ charts, an e/0 lva8 n policies, and on-site inspections. AnM analysis of the loss exposures will look at both m <Ju atha i r frequency of occurrence and severity ofhafinancial loss. Probabilities are assigned to the kk Si s : exposures identified in ordertoto assign ail priorities. Once loss exposures have been identified d e m itt and prioritized, risk financing alternatives can be addressed within three broad financing Em b u techniques: retention, S which is the use of internal funds; hybrid, which is the use of internal > income, and liability for lawsuits. These exposures Un can 09 bemidentified through surveys, balance
and external funds; and transfer, which is the use of external funds. The risk manager will analyze these types of programs in light of the overall goals of the firm (in particular the risk acceptability profile) articulated by top management. Net present value methodology should be used as part of the selection criteria; tax deductibility, too, should play a part in the selection process.
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MF0009 INSURANCE AND RISK MANAGEMENT
4. What is risk – financing technique?
(5 Marks)
Answer: Statement of Financial Accounting Concepts 2, "Qualitative Characteristics of Accounting Information," provides guidance in determining the issue of materiality when considering risk financing techniques. Briefly stated, if the item would influence a reasonable person relying upon the financial statement, then the item should be included. Loss can be defined as a decrease in the value of an asset or the incurrence of a liability. Statement of Financial Accounting Standards (SFAS) 5 provides for the recognition of loss in financial statements when there are two conditions: (1) decrease in the value ofaan asset or incurrence
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1. A large number of homogeneous exposure units. by The vast majority of insurance
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iv l 0 @g pa in5/2effect called “law of large numbers,” which 4 states that as the number of exposure i an e/0 lva8 M aren increasingly likely to become close to expected units increases, the actual results m <Ju atha i r results. kk ha Si s l: rise to the loss that is subject to the insured, at to thataigives 2. Definite Loss. The event d e m itttake place least in principle, E- at a known time, in a known place, and from a known m ub example is death of an insured person on a life insurance policy. cause. The Sclassic > m insurers to benefit from the solarge number of homogeneous exposure Ununits 09 allows
Fire, automobile accidents, and worker injuries may all easily meet this criterion. 3. Accidental Loss. The event that constitutes the trigger of a claim should be fortuitous, or at least outside the control of the beneficiary of the insurance. The loss should be ‘pure,’ in the sense that it results from an event for which there is only the opportunity for cost. Events that contain speculative elements, such as ordinary business risks, are generally not considered insurable. 4. Large Loss. The size of the loss must be meaningful from the perspective of the insured. Insurance premiums need to cover both the expected cost of losses, plus the cost of issuing and administering the policy, adjusting losses, and supplying the capital needed to reasonably assure that the insurer will be able to pay claims. For small losses these latter costs may be several times the size of the expected cost of Page 5 of 8
MF0009 INSURANCE AND RISK MANAGEMENT
losses. There is little point in paying such costs unless the protection offered has real value to a buyer. 5. Affordable Premium. If the likelihood of an insured event is so high, or the cost of the event so large, that the resulting premium is large relative to the amount of protection offered, it is not likely that anyone will buy insurance, even if on offer. Further, as the accounting profession formally recognizes in financial accounting standards, the premium cannot be so large that there is not a reasonable chance of a significant loss to the insurer. If there is no such chance of loss, the transaction may have the form of insurance, but not the substance. 6. Calculable Loss. There are two elements that must be at least a estimable, if not
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iv l 20 @g / 4 The essential risk is often aggregation. pa 5losses. 7. Limited risk of catastrophically large i an e/0 lva8 M ton numerous policyholders of the same insurer, the If the same event can cause losses m <Ju atha i k issue apolicies r ability of that insurer ikto becomes constrained, not by factors h S s : to characteristics surrounding the individual of a given policyholder, but by the factors ail d e m t it of all Epolicyholders so exposed. surrounding themsum b Su > m objective evaluation of the amount of the as a result of the claim. Unloss09recoverable
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MF0009 INSURANCE AND RISK MANAGEMENT
Case study (10 Marks) Assume you are an insurance consultant dealing with an umbrella of insurance products of various insurance companies. You have been approached by the Dean of a college to give presentation on the insurance titled â&#x20AC;&#x153;life insurance fulfils the needs of a personâ&#x20AC;?. The presentation should include the various needs of a person at different stages of life. You have been requested to include sufficient examples to make the presentation more reachable.
Answer:
a lv A Human have always sought security. This quest for security was an important ath r a motivating force in the earliest formation of families, clans, htribes, and other groups. Indeed, S groups have been the primary source both emotional by and physical security since the y t omof life necessities then that beginning of humankind. They ensured a less volatile rsi source c e . l v > ai ni & 9help which isolated humans & families could provide U 0 gmtheir less fortunate members in the l 0 a time of crisis. ip 05/2 84@ n a / lva M untoe achieve Humans today continue their quest security & reduce uncertainty. We still m <J atha i rely on groups for financial stability. ar may be our employer, the government, or an kk The hgroup Si s to is the il: same. In some ways however, we today are more insurance company, but concept a d e -m itt TheEphysical vulnerable than our ancestors. & economical securities formerly provided by the m b u tribe or extended family diminished with industrialization. Our income dependent, wealth S LIFE INSURANCE
acquiring lifestyle renders us and our families more vulnerable to environmental & societal changes over which we have no control. Humans are exposed to many serious perils, such as property loss from fire or windstorm, and personnel losses from incapacity & death. All though individual cannot predict or completely prevent such occurrences, they can provide for their financial effects. Encyclopedia of finance & banking defines insurance as the elimination of or protection against risk amenable to actual calculation, voidance or reduction of losses occurring through misfortunes such as death, fire, accident, tornado, shipwreck, etc. Insurance is a contact between an insurer and the insured where by the insurer identifies the insured against loss due to specific risks such as from fire, storm and death. Insurance contracts require an agreement, considerations, capacity, legality, compliance with the statute of frauds, and delivery. Page 7 of 8
MF0009 INSURANCE AND RISK MANAGEMENT
Insurance is an integral part of most enterprises, risk management program. Insurance does not prevent losses, it substitutes a small certain loss (premium) for a possible or contingent large loss. The insured is indemnified for the amount of loss, for the insured amount, or for the face of his policy, in return for payment of periodic premiums. The principal kinds of insurance are the following. 1. Life – Term, ordinary, endowment, limited payment, group industrial and annuities, with a variety of combinations of the first four basic forms. 2. Fire & Marine - Fire, ocean marine, motor vehicle, inland navigation and transportation, tornado and windstorm, sprinkler leakage, earthquake, riot and civil,
a lv A 3. Causality and Surety – Automobile liability, liability other than automobile workers ath r a automobile property damage, compensation fidelity and surety, burglary and theft, Sh y etc. accident in health, steam boiler, machinery, plate bglass, y t om rsi c e . l v ni 9> mai The Human Asset U 0 al /20 4@g pan • We can say that a human life is also income-generating asset. i 5 an e/0 lva8 n • Human life may be lost due Mto Juunexpected early death or become nonfunctional m < atha i r kk following sickness or disabilities caused ha by accidents. Si s to to another il: • Human beings are exposed type of risk. It is the risk of living too long. a d e m t t • A person, whomihas madeEnecessary arrangement to meet his financial needs after b u retirement, Salso would need insurance. It is because the arrangement would have been commotion, explosion, rain, hale, flood, aircraft, etc.
made on the basis of certain assumptions. One assumption can be that he will live for another 20 years. Another assumption can be that his children will support him financially. Still another can be that he will earn an interest of 10% yearly on his investments. If any of these assumptions does not come out to be true, the original arrangement, which he has made, will be inadequate and he will be facing financial difficulties. This means that living too long is as much a problem as dying too young. Insurance provides safeguard against these risks.
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