1. MF0009 INSURANCE AND RISK MANAGEMENT
1. Explain the major types of Pure risks. (5 Marks)
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.
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:
i. Risk of premature death
ii. Risk of insufficient income during retirement
iii. Risk of poor health
iv. Risk of unemployment
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 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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2. 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)
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 National Institute of
Science & Technology, actuarial societies, and ISO standards. Methods, definitions and goals
vary widely according to whether the risk management method is in the context of project
management, security, engineering, industrial processes, financial portfolios, actuarial
assessments, or public health and safety.
For the most part, these methodologies consist of the following elements, performed,
more or less, in the following order:
1. identify, characterize, and assess threats
2. assess the vulnerability of critical assets to specific threats
3. determine the risk (i.e. the expected consequences of specific types of attacks on
4. identify ways to reduce those risks
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.
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3. 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. This is the idea
of opportunity cost. Resources spent on risk management could have been spent on more
profitable activities. Again, ideal risk management minimizes spending while maximizing the
reduction of the negative effects of risks.
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4. 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)
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 insurance or use of
captives. (A captive is an insurance company controlled, in whole or in part, by the company
A risk manager first needs to identify and quantify loss exposures. One process
involves identifying the various types of exposures such as damage to property, loss of
income, and liability for lawsuits. These exposures can be identified through surveys, balance
sheet reviews, and analyses of organizational flow charts, manufacturing processes, personnel
policies, and on-site inspections. An analysis of the loss exposures will look at both
frequency of occurrence and severity of financial loss. Probabilities are assigned to the
exposures identified in order to assign priorities. Once loss exposures have been identified
and prioritized, risk financing alternatives can be addressed within three broad financing
techniques: retention, which is the use of internal funds; hybrid, which is the use of internal
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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5. MF0009 INSURANCE AND RISK MANAGEMENT
4. What is risk – financing technique? (5 Marks)
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 of an asset or incurrence
of a liability is probable, and (2) the amount of the loss can be reasonably estimated.
Commercially insurable risks typically share seven common characteristics.
1. A large number of homogeneous exposure units. The vast majority of insurance
policies are provided for individual members of very large classes. The existence of a
large number of homogeneous exposure units allows insurers to benefit from the so-
called “law of large numbers,” which in effect states that as the number of exposure
units increases, the actual results are increasingly likely to become close to expected
2. Definite Loss. The event that gives rise to the loss that is subject to the insured, at
least in principle, take place at a known time, in a known place, and from a known
cause. The classic example is death of an insured person on a life insurance policy.
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
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6. 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 estimable, if not
formally calculable: the probability of loss, and the attendant cost. Probability of loss
is generally an empirical exercise, while cost has more to do with the ability of a
reasonable person in possession of a copy of the insurance policy and a proof of loss
associated with a claim presented under that policy to make a reasonably definite and
objective evaluation of the amount of the loss recoverable as a result of the claim.
7. Limited risk of catastrophically large losses. The essential risk is often aggregation.
If the same event can cause losses to numerous policyholders of the same insurer, the
ability of that insurer to issue policies becomes constrained, not by factors
surrounding the individual characteristics of a given policyholder, but by the factors
surrounding the sum of all policyholders so exposed.
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7. 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 “life insurance fulfils the needs of a
person”. 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
Human have always sought security. This quest for security was an important
motivating force in the earliest formation of families, clans, tribes, and other groups. Indeed,
groups have been the primary source both emotional and physical security since the
beginning of humankind. They ensured a less volatile source of life necessities then that
which isolated humans & families could provide & help their less fortunate members in the
time of crisis.
Humans today continue their quest to achieve security & reduce uncertainty. We still
rely on groups for financial stability. The group may be our employer, the government, or an
insurance company, but concept is the same. In some ways however, we today are more
vulnerable than our ancestors. The physical & economical securities formerly provided by the
tribe or extended family diminished with industrialization. Our income dependent, wealth
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.
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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,
commotion, explosion, rain, hale, flood, aircraft, etc.
3. Causality and Surety – Automobile liability, liability other than automobile workers
compensation fidelity and surety, burglary and theft, automobile property damage,
accident in health, steam boiler, machinery, plate glass, etc.
The Human Asset
• We can say that a human life is also an income-generating asset.
• Human life may be lost due to unexpected early death or become nonfunctional
following sickness or disabilities caused by accidents.
• Human beings are exposed to another type of risk. It is the risk of living too long.
• A person, who has made necessary arrangement to meet his financial needs after
retirement, also would need insurance. It is because the arrangement would have been
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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