INTRODUCTION TO RISK AND TYPES

 

INTRODUCTION TO RISK

Risk

—  According to federation of insurance institute, “ risk may be thought of as the degree of variation in the possible outcome from an uncertain event or as the variable in the possible outcomes”

—  According to LIC India, risk may be defined as “a condition where there is possibility of an adverse deviation from the desired outcome that is expected or hoped for, there is no requirement that possibility be unmeasurable, only that must exist”.

Peril

—  A peril refers to the cause of loss or the contingency that may cause a loss.

—  In literary sense, it means the serious and immediate danger.

—  Perils refer to the immediate causes of loss.

—  Perils may be general or specific and may resulting in a financial loss

—  E.g., fire may affect assets like building, automobile, machinery, equipment and also, humans.

Hazards

—  Hazards are the conditions that increase the severity of loss or the conditions affecting perils.

—  These are the conditions that create or increase the severity of losses.

—  Economic slowdown is a peril that may cause a loss to the business,

—  But it is also a hazard that may cause a heart attack or mental shock to the proprietor of the business.

Hazards can be classified as follows

Physical Hazards — Property Conditions

—  Physical hazard relates to the physical characteristics of the risk, such as the nature of construction of a building, security protection at a shop or factory, or the proximity of houses to a riverbank. Therefore a physical hazard is a physical condition that increases the chances of loss

A physical hazard is an agent, factor or circumstance that can cause harm with contact. They can be classified as type of occupational hazard or environmental hazard. Physical hazards include ergonomic hazards, radiation, heat and cold stress, vibration hazards, and noise hazards

Intangible Hazards — Attitudes and Culture

Moral Hazard — Fraud

Moral hazard concerns the human aspects which may influence the outcome. Moral hazard is dishonesty or character defects in an individual that increase the chance of loss. For example, a business firm may be overstocked with inventories because of a severe business recession. If the inventory is insured, the owner of the firm may deliberately burn the warehouse to collect money from the insurer. In effect, the unsold inventory has been sold to the insurer by the deliberate loss. A large number of fires are due to arson, which is a clear example of moral hazard.

Moral hazard is present in all forms of insurance, and it is difficult to control. Dishonest insured persons often rationalise their actions on the grounds that "the insurer has plenty of money". This is incorrect since the company can pay claims only by collecting premiums from other policy owners.

Because of moral hazard, premiums are higher for all insured, including the honest. Although an individual may believe that it is morally wrong to steal from a neighbour, he or she often has little hesitation about stealing from an insurer and other policy owners by either causing a loss or by inflating the size of a claim after a loss occurs.

 

Morale Hazard — Indifference

This usually refers to the attitude of the insured person. Morale hazard is defined as carelessness or indifference to a loss because of the existence of insurance. The very presence of insurance causes some insurers to be careless about protecting their property, and the chance of loss is thereby increased. For example, many motorists know their cars are insured and, consequently, they are not too concerned about the possibility of loss through theft. Their lack of concern will often lead them to leave their cars unlocked.

The chance of a loss by theft is thereby increased because of the existence of insurance.

Morale hazard should not be confused with moral hazard. Morale hazard refers to an Insured who is simply careless about protecting his property because the property is insured against loss.

Moral hazard is more serious since it involves unethical or immoral behaviour by insurers who seek their own financial gain at the expense of insurers and other policy owners. Insurers attempt to control both moral and morale hazards by careful underwriting and by various policy provisions, such as compulsory excess, waiting periods, exclusions, and exceptions.

When used in conjunction with peril and hazard we find that risk means the likelihood that the hazard will indeed cause the peril to operate and cause the loss. For example, if the hazard is old electrical wiring prone to shorting and causing sparks, and the peril is fire, then the risk, is the likelihood that the wiring will indeed be a cause of fire.

Societal Hazards — Legal and Cultural

Social hazards, also called complex emergencies, seriously limit a population's access to health services, water, food, and transportation, all of which are determinants of health. They also often lead to a lack of safety and tend to come hand in hand with natural disasters such as floods.

TYPES OF RISK

—  Pure and speculative Risks,

—  Other types of Risk

◦      Dynamic risk,

◦      Static risk

◦      Fundamental risk and

◦      Particular Risks

Pure and speculative Risks,

Pure risk situations are those where there is a possibility of loss or no loss. There is no gain to the individual or the organization on it.

Pure risk is a category of risk that cannot be controlled and has two outcomes: complete loss or no loss at all. There are no opportunities for gain or profit when pure risk is involved.

Pure risk is generally prevalent in situations such as natural disasters, fires, or death. These situations cannot be predicted and are beyond anyone's control. Pure risk is also referred to as absolute risk.

 

Speculative risks are those where there is possibility of gain as well as loss. The element of gain is inherent or structured in such a situation.

Speculative risk is a risk category, which results in an uncertain degree of gain or loss when undertaken. All theoretical risks are made as deliberate decisions and are not merely the product of uncontrollable circumstances. The speculative risk is the contrast of pure risk (the possibility of a failure only and no gain potential) because there is some chance of a gain or a loss.

Classifying Pure Risks

Personal Risks

Personal risk is the potential for losses that impact an individual or family. Risk surrounds everything in life such that individuals inherently manage risk in everyday situations. It is also possible for individuals to apply formal risk management techniques such as identifying and treating risks

Example,

Risk of Premature Death

Risk of Insufficient Income during Retirement

Risk of Poor Health

Risk of Unemployment

Property Risks

The term “property risk” refers to risk events that specifically impact an organization's facilities and other physical infrastructure. Risk events such as fires, adverse weather conditions, and terrorist attacks all fall into the category of property risk.

Eg. Direct Loss, Indirect or Consequential Loss

Liability Risks

A liability risk involves the threat of the company or individual having to bear the consequences of damage or of breaching standards due to operations, a product, an act or neglect. A liability risk survey involves the analysis, through interviews and review of documents, of the company's key liability risks.

 

Other types of Risk

Dynamic risk

—  A dynamic risk assessment is the process of continually observing and analysing risks and hazards in a changing, or high-risk, environment. This allows workers to quickly identify new risks and remove them. Formal risk assessments are prepared in advance, recorded and monitored on a regular basis

—  Dynamic risks are those resulting from the changes in the economy or the environment.

—  Eg. economic variables like inflation, income level, price level, technology changes etc.

Static risk

A static risk refers to damage or loss to a property or entity that is not caused by a stable economy but by destructive human behavior or an unexpected natural event. This risk can be covered by insurance.

—  Static risks are risks connected with losses caused by the irregular action of nature or by the mistakes and misdeeds of human beings.

—  Eg. Assets possession as result of dishonesty or human failure.

Fundamental risk

Fundamental Risk. Exposure to loss from a situation affecting a large group of people or firms, and caused by (a) natural phenomenon such as earthquake, flood, hurricane, or (b) social phenomenon, such as inflation, unemployment, war. Fundamental risks may or may not be insurable.

—  Fundamental risks affect the entire economy or large numbers of people or groups within the economy.

—  Eg. high inflation, unemployment, war, and natural disasters such as earthquakes, hurricanes, tornadoes, and floods.

Particular Risks

Particular risks are risks that affect only individuals and not the entire community. Examples of particular risks are burglary, theft, auto accident, dwelling fires. With particular risks, only individuals experience losses, and the rest of the community are left unaffected.

—  Particular risks are risks that affect only individuals and not the entire community. With particular risks, only individuals experience losses, and the rest of the community are left unaffected.

—  Eg , theft, auto accident, dwelling fires.

 

METHODS OF HANDLING PURE RISK

Avoidance of risk

Avoidance is a method for mitigating risk by not participating in activities that may incur injury, sickness, or death. Smoking cigarettes is an example of one such activity because avoiding it may lessen both health and financial risks

Loss control (Loss prevention and Loss reduction)

Loss Control

Loss control is another important method for handling risk. Loss control consists of certain activities undertaken to reduce both the frequency and severity of losses. Thus, loss control has two major objectives:

(a) Loss prevention.

(b) Loss reduction

Loss prevention

Loss prevention aims at reducing the probability of loss so that the frequency of losses is reduced. Several examples of personal loss prevention can be given. Automobile accidents can be reduced if motorists pass a safe driving course and drive defensively. Dropping out of college can be prevented by intensive study on a regular basis. The number of heart attacks can be reduced if individuals watch their weight, give up smoking, and follow good health habits.

Loss prevention is also important for business firms. For example, a boiler explosion can be prevented by periodic inspections by a safety engineer; occupational accidents can be reduced by the elimination of unsafe working conditions and by strong enforcement of safety rules; and fire can be prevented by forbidding workers to smoke in an area where highly flammable materials are being used. In short, the goal of loss prevention is to prevent the loss from occurring.

Loss reduction

Although stringent loss prevention efforts can reduce the frequency of losses, some losses will inevitably occur. Thus, the second objective of loss control is to reduce the severity of a loss after it occurs. For example, a warehouse can install a sprinkler system so that a fire is promptly extinguished, thereby reducing the loss; highly flammable materials can be stored in a separate area to confine a possible fire to that area; a plant can be constructed with fire resistant materials to minimize a loss; and fire doors and fire walls can be used to prevent a fire from spreading.

 

Risk retention

Retention is the acknowledgment and acceptance of a risk as a given. Usually, this accepted risk is a cost to help offset larger risks down the road, such as opting to select a lower premium health insurance plan that carries a higher deductible rate. The initial risk is the cost of having to pay more out-of-pocket medical expenses if health issues arise. If the issue becomes more serious or life-threatening, then the health insurance benefits are available to cover most of the costs beyond the deductible. If the individual has no serious health issues warranting any additional medical expenses for the year, then they avoid the out-of-pocket payments, mitigating the larger risk altogether.

Non insurance transfer

A noninsurance transfer is the transfer of risk from one person or entity to another by way of something other than a policy of insurance. Most commonly, the techniques used involve hold harmless agreements, indemnity clauses, leases, hedging, and insurance provisions in contracts that require you to be added as an additional insured, thus granting you insurance protections under their policy.

While the noninsurance transfer of potential financial consequences might be tempting as you can save on paying insurance premiums, it can also be risky. There is the possibility that the contract may be challenged in court or the party you have transferred the liability to is unable to pay and so the plaintiff pursues you instead of compensation. Where possible, noninsurance risk transfers should be used as part of a risk management strategy alongside an adequate insurance policy.

A noninsurance transfer is also sometimes known as a contractual risk transfer. It is important to make the distinction that not all contractual risk transfers are noninsurance transfers as an insurance policy is also technically a contract.

Examples,

◦      Transfer of risk by contract

◦      Hedging prices

◦      Incorporation of business firm

Insurance

Insurance is a contract, represented by a policy, in which an individual or entity receives financial protection or reimbursement against losses from an insurance company. The company pools clients' risks to make payments more affordable for the insured.

Insurance is a contract (policy) in which an insurer indemnifies another against losses from specific contingencies or perils. There many types of insurance policies. Life, health, homeowners, and auto are the most common forms of insurance. The core components that make up most insurance policies are the deductible, policy limit, and premium.