CHANDAN KISHORE SHARMA 510931712 LC CODE : 1799

Master of Business Administration MBA Semester 4

1) Risk can be classified into several distinct categories. Explain. Answer: Risks may be classified in many ways; however, there are certain distinctions that are particularly important. These include the following: (a) Financial and Non-financial Risks In its broadest context, risk includes all situations in which there is an exposure to adversity. In some cases, this adversity involves financial loss while in others it does not. There is some element of risk in every aspect of human endeavour, and many of these risks have no (or only incidental) financial consequences. Financial risk involves the relationship between an individual (or an organisation) and an asset or expectation of income that may be lost or damaged. Thus, financial risk involves three elements: (i) (ii) the individual or organization that is exposed to loss, the asset or income whose destruction or dispossession will cause financial loss, and a peril that can cause the loss.

(iii)

The first element in financial risk is that someone will be affected by the occurrence of an event. During the devastating floods, a considerably large area of farmland is damaged by flood waters, causing a financial loss to the tune of several billions to the owners. The second and third elements are the thing of value and the peril that can cause the loss of the thing of value. The individual who owns nothing of value and who has no prospects for improving that situation faces no financial risk. Further, if nothing could happen to the individuals assets or expected income, there is no risk. b) Static and Dynamic Risk : A second important distinction is between static and dynamic risks. Dynamic risks are those resulting from changes in the economy. Changes in the price level, consumer tastes, income and output, and technology may cause financial loss to members of the economy. These dynamic risks

normally benefit society over the long run, since they are the result of adjustments to misallocation of resources. Although these dynamic risks may affect a large number of individuals, they are generally considered less predictable than static risks, since they do not occur with any precise degree of regularity.

Static risks involve those losses that would occur even if there were no changes in the economy. If we could hold consumer tastes, output and income, and the level of technology constant, some individuals would still suffer financial loss. These losses arise from causes other than the changes in the economy, such as the perils of nature and the dishonesty of other individuals. Unlike dynamic risks, static risks are not a source of gain to society. Static losses involve either the destruction of the asset or a change in its possession as a result of dishonesty or human failure. Static losses tend to occur with a degree of regularity over time and, as a result, are generally predictable. Because they are predictable, static risks are more suited to treatment by insurance than are dynamic risks. c) Acceptable and Unacceptable Risk: There are two elements of uncertainty in most types of events that are handled by risk managers the likelihood of the event occurring, and the size of the ensuing loss. Generally, the degree of risk aversion displayed by individuals acting in either a private or managerial capacity tends to increase with the potential size of loss. Some loss potentials are so small that an individual or organization is prepared to accept the risk and assume any loss that does occur. Beyond a certain size, the risk becomes unacceptable and ways will be sought to avoid, reduce or transfer that risk. Of course, the maximum size of loss that can be tolerated depends on the status of the individual or organisation, and so the division between acceptable and unacceptable risks is not entirely clear-cut for two reasons. First, it depends partly on time. The size of loss that could be absorbed by, say, one year's profits would normally be far larger than could be accommodated within one month's operating budget. Secondly, there will be a range of potential losses where the occurrence of the loss could strain the individual's or an organization's finances but it could be overcome (perhaps by resort to borrowing or raising additional capital). Then, whether the risk of incurring a loss of any size will be regarded as acceptable or unacceptable will depend upon the cost of handling the risk relative to the benefits thereof. For example, if loss reduction measures would greatly exceed the expected reduction in losses; or if the premium required by insurers is deemed high relative to the risk that would be transferred, then no attempt may be made to reduce the risk or insure it. The division between acceptable and unacceptable risk will always be influenced even if it is not fully determined by such financial considerations. Furthermore it will be influenced by the allocation of the costs and benefits of those risks and methods of handling them between persons who may be affected. In the case of industrial accidents, for instance, according to the rules laid down by law, the employer will be liable to compensate employees for injuries sustained as the result of accidents at work, though whether the size of award determined

according to those rules represents adequate compensation for the pain, suffering, loss of amenity and loss of an injured employee's present and future earnings is a matter of judgement. The cost of reducing the probability and/or severity of such accidents will fall directly upon the employer, though some or all of that cost may ultimately be passed on to the employees through a reduction in earnings due to a cut in the risk premium element of wages. Because perceived costs and benefits may differ, employees (or their trade union representatives) may have a different view as to what constituted an unacceptable risk to that held by the employer. d) Fundamental and Particular Risks : A fundamental risk is a risk that affects the entire economy or large numbers of persons or groups within the economy. Examples include rapid inflation, cyclical unemployment and war because large numbers of individuals are affected. The risk of a natural disaster is another important type of fundamental risk. Hurricanes, tornadoes, earthquakes, floods, and forest and grass fires can result in damage to billions of dollars worth property and cause numerous deaths. In contrast to a fundamental risk, a particular risk is a risk that affects only individuals and not the entire community, Examples include car thefts, bank robberies, and dwelling fires. Only individuals experiencing such losses are affected, not the entire economy. The distinction between a fundamental and a particular risk is important because Government assistance may be necessary to insure a fundamental risk. Social insurance and Government insurance programmes, as well as government guarantees and subsidies, may be necessary to insure certain fundamental risks. For example, the risk of unemployment generally is not insurable by private insurers but can be insured publicly by state unemployment compensation programmes. e) Pure and Speculative Risks : 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). Examples of pure risks include premature death, jobrelated accidents, catastrophic medical expenses, and damage to property from fire, lighting, flood, or earthquake. Speculative risk is defined as a situation in which either profit or loss is possible. For example, if you purchase 100 shares, you would profit if the price of the shares increases but would lose if the price declines. Other examples of speculative risk include betting on a horse race, investing in real estate, and going into business for self. In these situations, both profit and loss are possible. It is important to distinguish between pure and speculative risks for three easons. First, private insurers generally insure only pure risks. With certain exceptions, speculative risks are not considered insurable, and other techniques for coping with risk must be used. (One exception is that some insurers will insure institutional portfolio investments and municipal bonds against loss). Second, the law of large numbers can be applied more easily to pure risks than speculative risks. The law of large numbers is important because it enables insurers to predict future loss experience. In contrast, it is generally more difficult to apply the law of large numbers to speculative risks to predict future loss experience. An exception is the speculative risk of gambling, where casino operators can apply the law of large numbers in a

most efficient manner. Finally, society may benefit from a speculative risk even though a loss occurs, but it is harmed if a pure risk is present and a loss occurs. For example, a firm may develop new technology for producing inexpensive computers. As a result, some competitors may be forced into bankruptcy. Despite the bankruptcy, society benefits because the computers are made available at a lower cost. However, society normally does not benefit when a loss from a pure risk occurs, such as a flood or earthquake that devastates an area. Types of Pure Risk The major types of pure risk that can create great financial insecurity include personal risks, property risks, and liability risks. a) Personal Risks: Personal risks are those risks that directly affect an individual; they involve the possibility of complete loss or reduction of earned income, extra expenses, and the depletion of financial assets. There are four major personal risks:

Risk Risk Risk Risk

of of of of

premature death insufficient income during retirement poor health unemployment

i) Risk of Premature Death: Premature death is defined as the death of a household head with unfulfilled financial obligations. These obligations can include dependents to support, a mortgage to be paid off, or children to be educated. If the surviving family members receive an insufficient amount of replacement income from other sources or have insufficient financial assets to replace the lost income, they may be financially insecure. Premature death can cause financial problems only if the deceased has dependents to support or dies with unfulfilled financial obligations. Thus, the death of a child aged 10 is not "premature" in the economic sense. There are at least four costs that result from the premature death of a household head. First, the human life value of the family head is lost forever. The human life value is defined as the present value of the family's share of the deceased breadwinner's future earnings. This loss can be substantial; the actual or potential human life value of most college graduates can easily exceed Rs.500,000. Second, additional expenses may be incurred because of funeral expenses, uninsured medical bills, probate and estate settlement costs, and estate and inheritance taxes for larger estates. Third, because of insufficient income, some families may have trouble making both ends meet for covering expenses. Finally, certain non-technical costs are also incurred, including emotional grief, loss of a role model, and counselling and guidance for the children. ii) Risk of Insufficient Income during Retirement: The major risk associated with old age is insufficient income during retirement. The vast majority of workers in India retire at the age of 60. When they retire, they lose their earned income. Unless they have sufficient financial assets on which to draw, or have access to other sources of retirement income such as social security

or pension, they will be exposed to financial insecurity during retirement. How are older people, aged 60 and over, doing financially? In answering this question, it is a mistake to assume that all aged are wealthy; it is equally wrong to assume that all aged are poor. The aged are an economically diverse group, and their total money incomes are far from uniform.

iii) Risk of Poor Health: Poor health is another important personal risk. The risk of poor health includes both the payment of catastrophic medical bills and the loss of earned income. The costs of major surgery have increased substantially in recent years. For example, an open-heart surgery can cost more than Rs. 200,000, a kidney or heart transplant can cost more than Rs. 400,000, and the costs of crippling accident requiring several major operations, plastic surgery, and rehabilitation can exceed Rs. 500,000. In addition, long-term care in a nursing home can cost Rs. 50,000 or more each year. Unless these persons have adequate health insurance or private savings and financial assets, or other sources of income to meet these expenditures, they will be financially insecure. In particular, the inability of some persons to pay catastrophic medical bills is an important cause of personal bankruptcy. The loss of earned income is another major cause of financial insecurity if the disability is severe. In cases of long-term disability, there is a substantial loss of earned income, burden of medical bills, loss or reduction of employee benefits and depleted savings. Moreover, someone must take care of the disabled person. iv) Risk of Unemployment: The risk of unemployment is another major threat to financial security. Unemployment can result from business cycle downswings, technological and structural changes in the economy, seasonal factors, and imperfections in the labour market. At present in India, the unemployment rate is very high. Unemployment at times is a serious evil because of several important trends. To hold down labour costs, large corporations have resorted to downsizing and their work force has been permanently reduced; employers are increasingly hiring temporary or part-time workers to reduce labour costs; and millions of jobs have been lost to foreign nations because of global competition. Regardless of the reason, unemployment can cause financial insecurity in at least three ways. First, workers lose their earned income and employee benefits. Unless there is adequate replacement income or past savings on which to draw, the unemployed worker will be financially insecure. Second, because of economic conditions, the worker may be able to work only part-time. The reduced income may be insufficient in terms of the worker's needs. Final, if the duration of unemployment is extended over a long period, past savings may be exhausted. b) Property Risks: Persons owning property are exposed to the risk of having their 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 propertydirect loss and indirect or consequential loss. i) Direct Loss: A direct loss is defined as a financial loss that results from the physical damage, destruction, or theft of the property. For example, if you own a restaurant that is damaged by fire, the physical damage to the restaurant is known as direct loss. ii) Indirect or Consequential Loss: An indirect loss is a financial loss that results indirectly from the occurrence of a direct physical damage or theft. Thus, in addition to the physical damage loss, the restaurant is to be rebuilt. The loss of profits would be a consequential loss. Other examples of a consequential loss would be the loss of rents, the loss of the use of the building, and the loss of a local market. Extra expenses are another type of indirect or consequential loss. For example, suppose you own a vegetable shop or dairy. If a loss occurs, you must continue to operate regardless of cost; otherwise, you will lose customers to your competitors. It may be necessary to set up a temporary operation at some alternative location, and substantial extra expenses need to be incurred. 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. Liability risks are of great importance for several reasons. First, there is no maximum upper limit with respect to the amount of loss. One can be sued for any amount. In contrast, if you own property, there is a maximum limit on the loss. For example, if your car has an actual cash value of Rs.100,000, the maximum physical damage loss is Rs.1,00,000. But if you are negligent and cause an accident that results in serious bodily injury to the other person, you can be sued for any amount say Rs. 50,000, Rs. 500,000, or Rs. 1 million or more by the person you have injured. Second, a lien can be placed on your income and financial assets to satisfy a legal judgement. For example, assume that you injure someone, and a court of law orders you to pay damages to the injured party. If you cannot pay as per the judgement, a lien may be placed on your income and financial assets to satisfy the judgement. If you declare bankruptcy to avoid payment of the judgement, your credit rating will be impaired. Finally, legal defence costs can be enormous. If you have no liability insurance, the cost of hiring an attorney to defend you can be staggering. If the suit goes to trial, attorney fees and other legal expenses can be substantial.

2) Identify common misconceptions about risk management and explain why these misconceptions are developed. Answer: 3) What are the social values of insurance? What are the social costs? Explain Answer: Demand for Life Insurance : In Western societies, cultural/social and demographic forces have resulted in a slow continuous decline in demand for life insurance; hence insurance companies have needed to do two things: 1. Remake themselves as major participants in the annuity/savings market. 2. Vastly increase the complexity of life insurance products to compete in a shrinking market. The first was facilitated by federal government regulation giving taxpreferred status to annuity products. The second was facilitated by advancing computer technology. As a result, the work actuaries do is much more complex and technical than it used to be, increasing the demand for actuaries. Also, compared to the 1970s, considerably more actuaries work on annuity products. The Need for Life Insurance in Two Disparate Cultures Many African societies exhibit a strong sense of community attitudes about mortality and longevity. The community informally spreads the financial risks of death by contributing towards the upkeep of the families of deceased members. For this reason, the market for life insurance remains relatively small in these societies. As a result, actuarial practice in the African life insurance marketplace is limited. In contrast, Europeans and North Americans are characterized by a relatively high degree of individualism and self-sufficiency. Each adult member of these societies is expected to manage the financial risk of untimely death. Family and friends are generally not expected to help manage this risk. Products are designed to meet different risk profiles and play a significant role in wealth accumulation and preservation. Education : The educational level of most societies determines the level of demand and the sophistication level of life insurance products. Recent studies by the World Bank show that educational attainment is a major determinant of the level of life insurance consumption in most countries. Developed countries have high levels of education and more demand for complex insurance products such as variable universal life insurance. On the other hand, simpler life insurance products, such as whole life and term life, are the more common products in developing countries. Religion : Recall the earlier discussion and readings that identified religion as a cultural/social value affecting insurance as well as finance/investment/ERM actuarial work. Lets revisit those now in the context of the life area of practice. The spiritual values of a society will influence its demand for life insurance and may also determine the types of life insurance products that are deemed acceptable. The low rate of penetration (life insurance premiums as a percentage of Gross Domestic Product) of western-style life insurance in Islamic countries is attributable in part to the perception that western-style life insurance is not compliant with certain

requirements of the Islamic religious code known as Sharia. The nascent success of family Takaful, or life insurance products deemed compliant with the Sharia, in countries such as Malaysia confirms the direct relationship between religious beliefs and the demand for life insurance. The growth of the actuarial profession in the life insurance sector of Islamic countries will depend on the extent to which the insurance products reflect Islamic religious requirements. The effect of Christianity on the life and annuity insurance market in countries with a significant JudeoChristian heritage is less clear. Nonetheless, Christian principles that promote providing for dependents are in consonance with the basic purpose of insurance.