Risk and Insurance Management

Chapter One
Risk and its management
1.1
Risk is “The threat or probability that an action or event will adversely or beneficially affect an
organization, a society, an individual”.

In Insurance, risk is a situation where the probability distribution of a variable (such as burning
down of a building) is known but its mode of occurrence or actual value (whether the fire will
occur at a particular property) is not.

Risk has two faces:

a. The certain face: a certain risk is technically defined as the description of the expected
losses. An example of the certain risk is the one facing Insurance Companies. While it is certain
that such companies will suffer certain losses in the form of claims paid to the clients, it remains
to be seen how much those costs/losses will be.

b. The uncertain risk is technically defined as the invariability around the expected value.
An example of the uncertain risk is the one facing Profitable Business Companies. Such
companies may make profits or suffer losses as a result of their business.

1.2
Risk and Cost are directly proportional:

The higher the risk is, the higher the consequent losses will prove to be.
Example: Two gentlemen are driving two different vehicles in the same area, under same circumstances.
Driver one is driving an old 1980 vehicle valued at SR. 10,000/-. Driver two is driving a sports car
valued at SR. 100,000/-. If a crash were to happen to both cars, causing total damage, the costs suffered
by driver two will be higher.

1.3
Direct and Indirect losses:

Direct loss is the loss caused by an unbroken chain of events covered under an insurance policy.
In home insurance policies; direct losses are those suffered as a direct consequence of the risk
confronting the person/Company.
Example 1: Brian works for an esteemed IT company. Following a clash with his manager, Brian loses
his job. The direct loss is that Brian is now jobless. The Indirect losses include among others delay or
failure in honoring regular payments such as the house rental, school fees, electricity bills and phone
bills.
Example 2: living room furniture lost in a fire originating in the kitchen is a direct loss
Indirect loss is income loss caused by a direct loss, such as when a firm cannot sell its
merchandise due to a fire at its premises. Indirect losses are not covered by ordinary insurance
policies unless specifically included on payment of additional premium

Indirect losses are those suffered at later stages because of the same – direct - risk.

1.4
The Business Risks:

The “Business Risk” is the risk of reductions in the value of the business. Being an amount X of
money, the value of one business is directly affected by the cash flow.
The “Business Risk” is calculated as follows: cash inflows – cash outflows. When the cash
inflows are superior to cash outflows, the business value will increase. On the contrary, when the
outflows are superior to the inflows, the business value will decrease and the Company may
suffer various indirect losses such as fluctuation, instability and bankruptcy among others.

There are three types of business risks:

a. The Price Risk
b. The Credit Risk
c. The Pure Risk

1.4.a.
The Price Risk:
Probability of loss occurring from adverse movement in the market of an asset; it is the
uncertainty over Input prices and Output prices.
Input prices are those paid by the Company in return of materials, equipments, labor or any
other component that forms part of the Company’s production process. Output prices are the
ones that a Company asks for in return of its products (labeled prices that we see in
mini/supermarkets on each product).

There are three types of Price Risk:

- Commodity: such as oil, gas, electricity, coal.
- Exchange rates: Rises and falls in the world currencies can be of various effects to
companies.
- Interest rates: similarly, changes in the interest rates charged by loaners can have
an effect on the amount of the loan and the period of its
payment.

1.4.b.
The Credit Risk:
Probability of loss from a debtor's default. By default we mean the delay or failure of
payment of promised amounts by clients, customers, dealers, suppliers or any other party
indebted to the Company. The Credit risk is higher for Banks and financial institutions. Its
results could be as deadly as bankruptcy.
 1.4.c.
The Pure Risk (also known as absolute risk):
It is the situation where there is a chance of either loss or no loss, but no chance of gain; for
example either a building will burn down or it won't. Only pure risks are insurable because
otherwise (where the chance of the occurrence of a loss is determinable) insurance is similar
to betting and the insured may stand to gain from it a situation contrary to the most
fundamental concept of insurance

The most common type of Business risks, the pure risks are divided into four different types:

- Damage to assets such as Theft, Fire, Seizure by foreign or local army forces.
- Legal liability towards customers, shareholders, suppliers or other third parties as a
result of damages caused to these parties
- Workers’ injuries which lead to the payment of benefits for employees under the
Workmen Compensation Policy (Insurance Policy covering occupational/work-related
injuries)
- Employee benefits such as Death, Disability, Retirement and Pension.

1.5
Differences between Pure Risks and the other types of risks:

a. The pure risk never results in profits/gains, meaning that they never affect the business
value positively. Whereas other types of risks result in profit to certain parties and losses
to others (example: when Input prices increase, suppliers will make profits whereas
manufacturers will suffer losses)

b. Pure risks can only be covered by Governmental parties (GOSI) or Insurance contracts.
Damage to assets can for example be covered by a “Property All Risks” policy; Legal Liability
can be covered by “Comprehensive General Liability” policy; workers injuries can be covered
by “Workmen Compensation” policy and finally employees’ benefits can be covered by “Life and
Personal Accidents” policy.
On the other side, other types of risks are covered by financial/non-insurance contracts
such as the forwards or the swaps.

c. Pure risks can, to a certain extent, be controlled. For example, additional precautions can
help reduce the severity and frequency of a pure risk. Oppositely, other risks cannot be
controlled because they are affected/influenced by external/out-of-hand changes and
alterations such as rises and falls in Exchange and/or interest rates.
1.6
Personal risks:

Earnings: Death,
disability, retirement,
unemployment

Medical expenses

Liability to third parties

resulting from damages
caused by autos, home,
etc

Physical assets such as

the autos, homes, boats,
electronics

Financial risks such as

those related to stocks
and bonds*

Longevity meaning
excesses in the expected
period

*Written and signed promise to pay a certain sum of money on a certain date, or on fulfillment of a
specified condition. All documented contracts and loan agreements are bonds.

1.7
Risk Management definition:
Risk Management is the technique aiming at the control of the severity and frequency of the risk.

1.7.a
Risk Management steps:
The secret to a successful Risk Management plan resides in following the five following
steps:
- S1: Identifying all the risks
- S2: Evaluating the frequency and severity of those risks
- S3: Choosing the adequate Risk Management method
- S4: Implementing the method chosen
- S5: Monitoring the method chosen and assessing its convenience to the situation.

1.7.b
Risk Management methods:
There are three methods for managing risks:
ba. Loss control
bb. Loss financing
bc. Internal Risk Reduction

1.7.ba.
Loss Control:
Multidisciplinary approach in which human, engineering, and risk management
practices are employed to reduce the frequency or severity of losses
When the loss control method aims at reducing the risk’s frequency, it is called “Loss
Prevention”; when the loss control method aims at reducing the risk’s severity, it is
called “Loss Reduction”.
There are two types of loss control.
The first is called risk avoidance. It consists of reducing the activity to try and reduce
the risk’s frequency and/or severity.
The second consists on increasing precautions to try and reduce the risk’s frequency
and/or severity.

1.7.bb.
Loss financing:
Money consumed in losses, funded either from internal reserves or from purchase of
insurance.

There are four types of loss financing classified in two categories: Retention and
Transfer
Retention consists solely on self-insuring the business
Transfer can be insured through three different types of contracts: Insurance
contracts, derivatives (non-insurance contracts) such as forwards and swaps, and
finally sub-contracts like, for example, those purchased by a contractor in the name
of a property owner to protect the latter’s liability towards third parties resulting from
damages caused by contracting works.

1.7.bc
Internal Risk Reduction:
 Systematic reduction in the extent of exposure to a risk and/or the likelihood of its
occurrence

Such reduction can be divided into two types: Diversification and Investment in
information.
Diversification is a practice under which a firm enters an industry or market different
from its core business. Reasons for diversification include (1) reducing risk of relying
on only one or few income sources, (2) avoiding cyclical or seasonal fluctuations by
producing goods or services with different demand cycles, (3) achieving a higher
growth rate, and (4) countering a competitor by invading the competitor's core
industry or market. In contrast to vertical integration, diversification does not increase
a firm's market or monopolistic power. Daewoo produces motor vehicles, motor bikes
and electrical appliances.

Investment in information refers to market studies and researches as well as accurate

forecasts of cash flows. In some cases, it is recommended to use the expertise of
companies specialized in such forecasts and researches.

1.7.c
Role of an internal Risk Management Department:

- Working in full cooperation with the other departments including but not limited to:
Finance, HR and Marketing
- consisting of staff with various expertise: Economists, Insurance specialists and
financial experts among others
- Identifying particular events or circumstances relevant to the organization's objectives
(risks and opportunities)
- Assessing those events in terms of likelihood and magnitude of impact
- Determining a response strategy, and
- Monitoring progress.

By identifying and proactively addressing risks and opportunities, business enterprises

protect and create value for their stakeholders, including owners, employees, customers,
regulators, and society overall.