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  1. 1. 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. 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. Page 1 of 8
  2. 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) 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 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 specific assets) 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. Page 2 of 8
  3. 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. Page 3 of 8
  4. 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) 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 insurance or use of captives. (A captive is an insurance company controlled, in whole or in part, by the company being insured.) 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. Page 4 of 8
  5. 5. MF0009 INSURANCE AND RISK MANAGEMENT 4. What is risk – financing technique? (5 Marks) Answer: Statement of Financial Accounting Concepts 2, quot;Qualitative Characteristics of Accounting Information,quot; 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 results. 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 Page 5 of 8
  6. 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. Page 6 of 8
  7. 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 reachable. Answer: LIFE INSURANCE 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. Page 7 of 8
  8. 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. Page 8 of 8