Question 1:-“Risk can be classified into several distinct categories”. Explain.

Answer :- Classification of Risk

The previous section explained the differences between certainty, risk and uncertainty. This section
explains the different types of risks.

Risks are classified or grouped into a similar category in the insurance industry to quantify risk and
define the insurance premium to be charged. Classification of risks also helps in placing individual risks
with similar expectations of loss in a group or class of risks. By classifying we can also estimate risks
from probabilities associated with occurrence, timing and magnitude of events.

Pure and speculative risk

Pure risks are defined as situation in which there are only two outcomes that is the possibility of loss or
no loss to an organisation but no gain – the event either happens or does not happen. When this risk
happens, the chance of making any profit is very badly low. Few examples of pure risk are earthquake,
theft, accident, fire etc. A car may or may not meet with an accident. If an insurance policy is bought for
the car, then if accident occurs the insurance company incurs loss but on the contrary if accident does
not occur there is no gain to the insured.

Speculative risks describe situations in which there is a possibility of gain as well as loss. The element
of gain is inherent or structured based on the situation. Few examples are gambling on horses, investing
in a stock market, merging with an organisation. Thus most of the speculative risks are business related
and some speculative risks are optional and can be avoided if desired.

The distinguishing characteristics of pure and speculative risks which is of importance to insurers are
the following:

The contract of insurance is usually applicable only to pure risks but not to speculative risks. Insurance
is meant to assure us against losses that arise as pure risk, but not to outcomes that lead to both loss and
gain. Moreover a particular type of risk may appear speculative for the insurance company but a pure
risk for the organisation.
The law of large numbers is easily applicable to pure risks than to speculative risks. The law is
important to insurers since it predicts future loss experience. An exception is the example of gambling,
where the casino operators apply the law of large numbers in a most efficient way.

Speculative risk may profit the society even if a loss occurs. It carries some inherent advantages to the
economy. For example speculative activity in the stock market may lead to more efficient allocation of
capital. The same does not apply to pure risk. A fire, flood, earthquake cannot benefit the society.

Since pure risk is usually insurable, the discussion on risk is skewed towards pure risks only.

Pure risk is broadly classified into the following four categories:

Property risk.

Personal risk.

Liability risk.

Loss of income risk.

Property risk

This is a risk to a person in possession of the property which faces loss because of some unforeseen
events. Property includes both movable and immovable possessions. Movable assets are personal assets
like personal computer, any appliance. Immovable assets are land, building which suffers loss due to
natural calamities. Property risk is further divided into direct and indirect loss.

Direct loss – A direct loss is defined as a physical damage due to a given calamity or peril in a direct
way. For example, if an office building is damaged by fire, the damage incurred in the direct way is the
direct loss.

Indirect loss – The additional expense incurred due to the destruction of the property is the indirect loss.
Thus in addition to the physical damage after a fire, the office would lose profits for several months
because of reconstruction. The loss of profits is a consequential loss as a consequence of the damage
incurred.

Personal risk
Personal risks are risks that directly affect the individual’s income. This may either be loss of earned
income or extra expenditure or depletion of financial assets. There are four major types of personal
risks:

Risk of premature death.

Risk of insufficient income during old age.

Risk of poor health.

Risk of unemployment.

Risk of premature death – Premature death occurs when the bread earner of a family dies with
unfulfilled financial obligations. Therefore this can cause financial problems only if the deceased has
dependents to support. There are four costs which results from this. First, the present value of the
family’s share of the deceased breadwinner’s future earnings is lost. Secondly, additional expenses like
funeral expenses, uninsured medical bills, inheritance taxes can result. Thirdly, due to insufficient
income, the family of the deceased has trouble in making ends meet. Finally, intangible costs due to loss
of role model, guidance, and counseling result.

Risk of insufficient income during old age – The risk arises when retired people do not have sufficient
income after their retirement and it leads to social insecurity. Retired people need to have financial
assets from which they can draw income or have access to other sources like private pension.

Risk of poor health – The sudden disability of a person to earn income for living happens to be a
disadvantage or sudden risk to that person. The risk of poor health includes payment of medical bills
and the loss of earned income. The loss of earned income is a financial insecurity if the disability is
severe. Employee benefits may be lost or reduced, savings are depleted and extra care must be taken for
the disabled person.

Risk of unemployment – This risk is due to socio-economic factors resulting in financial insecurity.
Unemployment results due to business cycle down swings, technology and structure changes in the
economy and imperfections in the labor market.

Liability risk

This risk arises to a person when there is a possibility of an unintentional damage caused by him to
another person because of negligence. Therefore this risk arises when one’s activity causes adversity to
another person. For example, construction of factories or dams which results in dislocating number of
villagers. This risk arises due to government regulations and acts. It is quite different from the other
risks as there is no maximum upper limit to the amount of the loss. A lien can be placed on one’s
income and financial assets to satisfy legal judgment and the cost of legal defense could be huge.

Loss of income risk

This risk is due to an indirect loss from a certain given risk. For example if a firm is not able to operate
due to legal issues or destruction by peril, it takes time to resume its normal operations. Therefore in
this period, production stoppage will lead to loss of income.

Fundamental and particular risk

This classification is based on the people who are affected by the event. Those risks which affect an
entire economy or a large group within the economy are termed as fundamental risks. For example,
cyclic unemployment, epidemics, drought, political and economic changes, and terrorist attacks of
recent times affect a large group of people and hence these are fundamental risks. On the other hand,
losses that arise out of individual events and are felt by particular individuals and not by a community
or a group is termed as particular risks. Examples are burning of a house or an automobile accident.

The distinction between a fundamental and a particular risk is that an individual or a concern can have
control over particular risk but fundamental risks can hardly be controlled. Social insurance and
government insurance compensates for the loss incurred by a fundamental risk but in case of particular
risk an individual or a particular enterprise bears the burden of loss.

Enterprise risk

This is a risk which includes all major risks faced by a business firm. It encompasses risks such as pure
risk, speculative risk, strategic risk, operational risk and financial risk. We already studied about pure
and speculative risks. Strategic risk is when an organisation is uncertain about its goals and objectives.
Operational risks may result due to a firm’s business operations. Financial risk is when there is
uncertainty of loss because of changes in interest rates, foreign exchange rates and value of money.

Enterprise risk plays a vital role in commercial risk management, which is a process in an organisation
to treat all minor and major risks. Major risks can be addressed by bringing them all together and
treating them as one single program. By doing so, the firm can offset one risk against another and also if
some risks are negatively correlated overall risk can significantly be reduced.
Question 2:-What are the social values of insurance? What are the social costs? Explain?
Answer:- In law and economics, insurance is a form of risk management primarily used to hedge
the risk of a contingent, uncertain loss. Insurance is defined as the equitable transfer of the risk of
a loss, from one entity to another, in exchange for payment. An insurer is a company selling the
insurance; an insured or policyholder is the person or entity buying the insurance policy. The
insurance rate is a factor used to determine the amount to be charged for a certain amount of
insurance coverage, called the premium. Risk management, the practice of appraising and
controlling risk, has evolved as a discrete field of study and practice.
The social values of insurance are:
Risk Cover - Life today is full of uncertainties; in this scenario Life Insurance ensures that your
loved ones continue to enjoy a good quality of life against any unforeseen event.
Planning for life stage needs - Life Insurance not only provides for financial support in the event
of untimely death but also acts as a long term investment. You can meet your goals, be it your
children's education, their marriage, building your dream home or planning a relaxed retired life,
according to your life stage and risk appetite. Traditional life insurance policies i.e. traditional
endowment plans, offer in-built guarantees and defined maturity benefits through variety of
product options such as Money Back, Guaranteed Cash Values, Guaranteed Maturity Values.
Protection against rising health expenses - Life Insurers through riders or stand alone health
insurance plans offer the benefits of protection against critical diseases and hospitalization
expenses. This benefit has assumed critical importance given the increasing incidence of lifestyle
diseases and escalating medical costs.
Builds the habit of thrift - Life Insurance is a long-term contract where as policyholder, you have
to pay a fixed amount at a defined periodicity. This builds the habit of long-term savings.
Regular savings over a long period ensures that a decent corpus is built to meet financial needs at
various life stages.
Safe and profitable long-term investment - Life Insurance is a highly regulated sector. IRDA, the
regulatory body, through various rules and regulations ensures that the safety of the
policyholder's money is the primary responsibility of all stakeholders. Life Insurance being a
long-term savings instrument, also ensures that the life insurers focus on returns over a long-term
and do not take risky investment decisions for short term gains.
Assured income through annuities - Life Insurance is one of the best instruments for retirement
planning. The money saved during the earning life span is utilized to provide a steady source of
income during the retired phase of life.
Protection plus savings over a long term - Since traditional policies are viewed both by the
distributors as well as the customers as a long term commitment; these policies help the
policyholders meet the dual need of protection and long term wealth creation efficiently.
Growth through dividends - Traditional policies offer an opportunity to participate in the
economic growth without taking the investment risk. The investment income is distributed
among the policyholders through annual announcement of dividends/bonus.

Facility of loans without affecting the policy benefits - Policyholders have the option of taking
loan against the policy. This helps you meet your unplanned life stage needs without adversely
affecting the benefits of the policy they have bought.
Tax Benefits-Insurance plans provide attractive tax-benefits for both at the time of entry and exit
under most of the plans.
Mortgage Redemption- Insurance acts as an effective tool to cover mortgages and loans taken by
the policyholders so that, in case of any unforeseen event, the burden of repayment does not fall
on the bereaved family.
Social cost, in economics, is generally defined in opposition to "private cost". In economics,
theorists model individual decision-making as measurement of costs and benefits. Rational
choice theory often assumes that individuals consider only the costs they themselves bear when
making decisions, not the costs that may be borne by others.
With pure private goods, the costs carried by the individuals involved are the only economically
meaningful costs. The choice to purchase a glass of lemonade at a lemonade stand has little
consequence for anyone other than the seller or the buyer. The costs involved in this economic
activity are the costs of the lemons and the sugar and the water that are ingredients to the
lemonade, the opportunity cost of the labour to combine them into lemonade, as well as any
transaction costs, such as walking to the stand.
If there is a negative externality, then social costs will be greater than private costs.
Environmental pollution is an example of a social cost that is seldom borne completely by the
polluter, thereby creating a negative externality. For example, when a supplier of educational
services indirectly benefits society as a whole but only receives payment for the direct benefit
received by the recipient of the education: the benefit to society of an educated populace is a
positive externality. In either case, economists refer to this as market failure because resources
will be allocated inefficiently. In the case of negative externalities, private agents will engage in
too much of the activity; in the case of positive externalites, they will engage in too little. (The
marginal rate of transformation in production will not be equal to the marginal rate of
substitution in consumption due to the effect of the externality and as a result Pareto optimality
will not occur—see welfare economics for an explanation.)
Question 3:-What is the nature of actuarial practice? Discuss the actuarial modeling principles?
Answer:- Many Social Security Programs (SSP) face major financial challenges in planning for the
future due, among other things, to the effects of changing demographic structures over time.
Important political decisions are being planned, considered and/or made in order to meet these
challenges. In many cases, the main concern is future long-term costs. Therefore the need arises
to perform financial projections and analyses of SSPs. This was acknowledged also as early as
1952 in Article 71 (3) of the Social Security (Minimum Standards) Convention, No. 102 of the
International Labour Organisation (ILO). Actuaries possess significant expertise in preparing
long-term financial projections and therefore have an important role carrying out analyses of
SSPs. Accordingly it is vital that all demographic and economic analyses carried out by actuaries
provide reasonable projections of long-term future costs and financial impact on which those
important decisions can be based.
In many countries, actuarial professional bodies set professional standards and guidelines
of actuarial practice for insurance and pension programs, but generally they do not apply to
SSPs. Actuarial work for SSPs is also carried out in many countries where the profession is not
well developed and no standards of practice exist. The need for guidelines of actuarial practice in
this area has also been identified by the International Social Security Association (ISSA) and the
ILO. These IAA Guidelines of Practice were established to fill the gap and aim at ensuring that
all actuaries involved in this type of work provide reliable financial evaluations.

PRINCIPLES OF ACTUARIAL PRACTICE

In producing actuarial work with respect to SSPs the actuary should comply with the
following principles:
1. Scientific rigour
The actuary should ensure that the methodology used for the long-term financial projections is
based on actuarial principles. The actuary should comply with any general or specific
professional guidance that may apply in the relevant circumstances. The actuary should also
ensure that the calculations accurately reflect the methods and assumptions adopted. In this
context, the actuary should indicate in the report that assumptions, though reasonably
determined, are not predictions and that eventual differences between future experience and the
report’s assumptions will be analysed and taken into account in subsequent reports.
2. Objectivity
If the determination of assumptions used for demographic and financial projections is part of the
actuary's mandate, he/she should ensure that they are determined without inappropriate political
or external influences. If the actuary is not mandated to determine the assumptions but they are
set by another entity, and whenever external work is relied upon in the determination of
assumptions, the actuary should state the origins of the assumptions and, when needed to give a
fair view of the SSP, show a sensitivity analysis of the impact of alternative assumptions.
3. Transparency, explicitness, simplicity and consistency of the information supplied in the
report. When preparing a report, a paper or a presentation the actuary should aim to
communicate as clearly as possible, having regard to the various audiences to whom it is
addressed and the different stakeholders who will place reliance on the results. The actuary is
accordingly recommended to include in the report an executive summary written in plain
language, describing the purpose and the main findings of the report.