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ESSENTIALS OFINSURANCE ANDRISK MANAGEMENT[As per New Syllabus (CBCS) for First Semester, B.Com. (Hons.),Delhi University w.e.f. 2015-16]Prof. Dr. P.K. GuptaM.Com., Ph.D. (Finance), FICWA, FCS, CFS, FIIIProfessor,Centre for Management Studies,Jamia Millia Islamia, New Delhi.ISO 9001:2008 CERTIFIED(i)

AuthorNo part of this publication may be reproduced, stored in a retrieval system, or transmitted in any form orby any means, electronic, mechanical, photocopying, recording and/or otherwise without the priorwritten permission of the publisher.First Edition : 2016Disclaimer – The material in this book has been compiled from many sources including books, magazines,report of various agencies, websites, research article etc. nationally and globally. These sources havebeen quoted appropriately. If there is any resemblance to the material in the book, the author shall not beresponsible in any manner what so ever. The ideology behind this book is to provide a study material forthe students and readers and not for any commercial purpose.Published by: Mrs. Meena Pandey for Himalaya Publishing House Pvt. Ltd.,“Ramdoot”, Dr. Bhalerao Marg, Girgaon, Mumbai - 400 004.Phone: 022-23860170/23863863, Fax: 022-23877178E-mail: [email protected]; Website: www.himpub.comBranch Offices:New Delhi: “Pooja Apartments”, 4-B, Murari Lal Street, Ansari Road, Darya Ganj,New Delhi - 110 002. Phone: 011-23270392, 23278631; Fax: 011-23256286Nagpur: Kundanlal Chandak Industrial Estate, Ghat Road, Nagpur - 440 018.Phone: 0712-2738731, 3296733; Telefax: 0712-2721216Bengaluru: Plot No. 91-33, 2nd Main Road, Seshadripuram, Behind Nataraja Theatre,Bengaluru-560 020. Phone: 08041138821, 9379847017, 9379847005Hyderabad: No. 3-4-184, Lingampally, Besides Raghavendra Swamy Matham, Kachiguda,Hyderabad - 500 027. Phone: 040-27560041, 27550139Chennai: New-20, Old-59, Thirumalai Pillai Road, T. Nagar, Chennai - 600 017.Mobile: 9380460419Pune: First Floor, "Laksha" Apartment, No. 527, Mehunpura, Shaniwarpeth(Near Prabhat Theatre), Pune - 411 030. Phone: 020-24496323/24496333;Mobile: 09370579333Lucknow: House No. 731, Shekhupura Colony, Near B.D. Convent School, Aliganj,Lucknow - 226 022. Phone: 0522-4012353; Mobile: 09307501549Ahmedabad: 114, “SHAIL”, 1st Floor, Opp. Madhu Sudan House, C.G. Road, Navrang Pura,Ahmedabad - 380 009. Phone: 079-26560126; Mobile: 09377088847Ernakulam: 39/176 (New No.: 60/251) 1st Floor, Karikkamuri Road, Ernakulam,Kochi – 682 011. Phone: 0484-2378012, 2378016 Mobile: 09387122121Bhubaneswar: 5 Station Square, Bhubaneswar - 751 001 (Odisha).Phone: 0674-2532129, Mobile: 09338746007Kolkata: 108/4, Beliaghata Main Road, Near ID Hospital, Opp. SBI Bank,Kolkata - 700 010. Phone: 033-32449649, Mobile: 7439040301DTP by: PravinPrinted at: Infinity Imaging System, New Delhi. On behalf of HPH.(ii)

Dedicated to theSacred Memory of my father(iii)

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PrefaceWith the increasing dynamism of risk and the growth of professional riskmanagement, the insurance device has become more and more popular these days.Looking at the recent catastrophic events, demand for insurance has increasedtremendously with more and more demand for complex and sophisticated products.Also, the liberalization of markets especially in developing countries has accentuatedthe need for risk products. Also the recent government policy initiatives like cropinsurance, financial guarantee schemes for unemployed, various social securityprogrammes and raising limits of FDI in insurance has resulted into a sudden spurtin the demand of insurance professionals. More and more academic institutions allover the countries are offering highly specialized insurance programmes to cater tothis demand.Recently, the universities in India and abroad have introduced insurance as aspecialized study both at graduate and postgraduate level. This has accentuated thedire demand for the literature on insurance in the Indian context. It is expected thatthe book shall be useful to the students and as well as the trainers. I would be highlyobliged for comments from the readers that would further help me in improving thebook.ORGANIZATION OF THE BOOKThe book has been organized into five modules.Part 1 introduces the concept of risk management to the readers. It conceptualizesthe risk definitions, classes of risk; risk management process also discusses thevarious aspects of disaster risk management.Part 2 discusses the concept of insurance, its need and presents a global view ofinsurance. Also, various reinsurance strategies have been discussed.Part 3 enumerates the underlying principles of insurance. Legal aspects of insuranceand various non-life insurance categories, viz., Fire, Marine, Motor and Healthinsurance have been discussed.Part 4 deals with IRDA legislation, rules and regulations and other important aspectsof insurance.I hope that book shall definitely be useful to the readers and provide an in-depthinsight into the various facets of insurance business in India.New Delhi, July 2016P.K. Gupta(v)

AcknowledgementsI am inspired by my wife Rachna Gupta who strongly suggested me to write acustomized book on the subject from a pure student’s perspective. Her inspiration hasbeen continuously flowing since my first attempt of Insurance and Risk Management,2004 and 2010 editions.I am indebted to my beloved Ayush and Manvi who have made sacrifices at all levelsin various forms and contexts for timely completion of this book. I also thank mymother, brother and other family members for necessary support.I also thank my Ph.D. supervisor, Dr. B.L. Surolia, who has provided me necessarypresentation skills, which, I feel is the most important tool in any literary work.I thank from my heart Mr. Vijay Rawat at Delhi office who provided me immensesupport and motivation for timely completion of this edition.I also thank Nimisha and other staff members of Mumbai office of HimalayaPublishing House Pvt. Ltd. for their support in various forms.New Delhi, July 2016P.K. Gupta(vi)

SyllabusB.Com. (Hons.) Semester – IPaper BCH 1.4(b): Insurance and Risk ManagementDuration: 3 HrsObjective: To develop an understanding among students about identifying, analyzing andmanaging various types of risk. Besides, the students will be in a position to understandprinciples of insurance and its usefulness in business, along with its regulatoryframework.Unit I:Concept of Risk, Types of Risk, Managing Risk, Sources and Measurement of Risk, RiskEvaluation and Prediction. Disaster Risk Management, Risk Retention and Transfer.Unit II:Concept of Insurance, Need for Insurance, Globalization of Insurance Sector, Reinsurance,Co-insurance, Assignment. Endowment.Unit III:Nature of Insurance Contract, Principle of Utmost Good Faith, Insurable Interest,Proximit Cause, Contribution and Subrogation, Indemnity, Legal Aspects of InsuranceContract, Types of Insurance, Fire and Motor Insurance, Health Insurance, MarineInsurance, Automobile Insurance.Unit IV:Control of Malpractices, Negligence, Loss Assessment and Loss Control, Exclusion ofPerils, Actuaries, Computation of Insurance Premium.Regulatory Framework of Insurance: Role, Powers and Functions of IRDA, Compositionof IRDA, IRDA Act, 1999.(vii)

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ContentsPART IINTRODUCTIONChapter 1Understanding Risk1.11.21.31.41.51.61.71.81.9Chapter 2RISK MANAGEMENT3 – 14The Concept of RiskRisk vs. UncertaintyLoss and Chance of LossPerilsHazardsTypes of RisksRisk for Financial InstitutionsClassifying Pure RisksRisk Perception and MisconceptionsManaging Risk2.12.22.32.42.52.62.72.82.92.10Chapter 3TO15 – 37Risk Management – Definition and Process2.1.1Risk Identification2.1.2Risk Evaluation2.1.3Risk Control2.1.4Risk FinancingRisk RetentionRisk TransferLevels of Risk ManagementHedging via DerivativesCorporate Risk ManagementProcess of Risk Management by IndividualsFinancial Risk and its ManagementRisk Management Information Systems (RMIS)Enterprise Risk ManagementMeasuring Risk3.13.23.33.43.53.638 – 60Measures of RiskMathematical Measures3.2.1Statistics3.2.2Analytics3.2.3Scenario Analysis3.2.4Value at Risk (VaR)3.2.5Sensitivity Analysis3.2.6Simulation Modeling3.2.7Maximum LossSubjective MeasuresValue at RiskRisk Measurement and Modeling – Insurance Case3.5.1Probability and its Use in Insurance3.5.2Theories of Risk ManagementUtility Analysis in Financial Markets and Insurance Cases(ix)

Chapter 4Disaster Risk Management4.14.24.34.4Part IIChapter 5INSURANCE MARKETS73 – 84Concept of Insurance5.1.1Definitions of Insurance5.1.2Elements of Insurable Risk5.1.3Insurance versus Gambling5.1.4Insurance as a Contingent ContractNeed and Economic Importance of InsuranceGlobalization of Insurance6.16.26.36.46.56.685 – 98Need for Globalization of MarketsGlobalization of Insurance MarketsMotives for Foreign VenturesBarriers and Limits to Cross-border Market IntegrationGlobal Picture of Insurance6.5.1Global StatisticsGlobalization and its Impact on IndiaReinsurance7.17.27.37.47.57.67.77.87.9Chapter 8VIAConcept of Insurance5.2Chapter 761 – 70– Meaning and TypesRisk Management StrategiesRisk Transfer StrategiesRisk Management – Changing PhilosophyMITIGATING RISK5.1Chapter 6DisasterDisasterDisasterDisaster99 – 117Introduction to Reinsurance7.1.1Reinsurance Defined7.1.2Objectives of ReinsuranceRole of the ReinsurersTechniques of Reinsurance7.3.1Reinsurance Treaties7.3.2Facultative7.3.3Reinsurance ArrangementsNature of Reinsurance RisksThe Reinsurance ContractReinsurance in Indian PerspectiveIssues and Challenges in Indian ReinsuranceGlobal Reinsurance MarketReinsurance TradingMiscellaneous Concepts8.18.28.38.48.58.68.7118 – tionsForeclosureLapse and Revivals(x)

Part IIIChapter 9INSURANCE CONTRACTS, PRINCIPLESInsurance Contracts9.19.29.39.49.5ANDTYPESChapter 10 Principles of Insurance10.110.210.310.410.510.6146 – 155Principle of Indemnity10.1.1 Subrogation10.1.2 ContributionPrinciple of Utmost Good Faith (Uberimmae Fidei)Principle of Insurable InterestPrinciple of Proximate Cause (Causa Proxima)The Principle of Loss MinimizationArbitration and AverageChapter 11 Life 131 – 145Regulation of Insurance Business in IndiaLegal Framework of Insurance BusinessIndian Contract Act, 1872 Applied to Insurance ContactsInsurance Contracts – Important Features9.4.1Elements of Insurance Contract9.4.2Maxims Applicable to Insurance ContractsLaws Relevant to Insurance156 – 204Life Insurance – Concept and DefinitionFeatures of Life InsuranceBenefit of Life InsuranceLife Insurance IndustryLife Insurance ContractsContractual Provisions of Life InsuranceLife Insurance ProceduresLife Insurance ValuationLife Insurance CoversTerm Life PolicesWhole Life PolicesEndowment Insurance PoliciesAnnuitiesPolicies Based on Other ClassificationsMarried Women’s Property Act PoliciesUnderwriting in Life InsuranceMethod of Risk Classification in Life InsuranceFactors Affecting the Pricing of Life Insurance ProductsTreatment of Substandard Life Insurance RisksLife Insurance Claims Management11.20.1 Types of Claims11.20.2 Additional Benefits11.20.3 Claims Procedure11.20.4 Claim Amount11.20.5 Claim Concession11.20.6 Presumption of Death(xi)

Chapter 12 Fire Insurance12.112.212.312.412.512.612.712.8205 – 229Fire Insurance Contracts12.1.1 Features of a Fire Insurance Contract12.1.2 Application of Insurance Principles to Fire InsuranceFire Insurance Proposals12.2.1 WarrantiesFire Insurance Coverages12.3.1 Standard Fire Policy12.3.2 Standard Policy CoveragesSpecial Coverages12.4.1 Reinstatement Value Policies12.4.2 Policies for Stocks12.4.3 Consequential Loss PoliciesFire Underwriting and Rating12.5.1 Rate Fixation in Fire Insurance12.5.2 Fire Insurance Documents12.5.3 Cancellation of Policies12.5.4 Mid-term Cover12.5.5 Claims Experience Discount12.5.6 FEA DiscountFire Insurance Claims12.6.1 Fire Claims Procedure12.6.2 Extent of Indemnity12.6.3 Valuation under Valued Policies12.6.4 Valuation under Unvalued PoliciesProgress of Fire Insurance12.7.1 Profitability Before Privatization12.7.2 Post-liberalization ProgressFire Reinsurance – An IllustrationChapter 13 Marine Insurance13.113.213.313.413.513.613.713.8230 – 265IntroductionHistory of Marine InsuranceMarine Insurance – Definition and Types13.3.1 Ocean Marine Insurance13.3.2 Inland Marine InsuranceNature of Marine Insurance ContractMarine Insurance Policies13.5.1 Types of Policies13.5.2 Nature of Marine PoliciesMarine Insurance Policy Conditions13.6.1 Insurance Cargo Clauses (ICC)13.6.2 Institute War Clauses (Air Cargo) (Excluding Sendingsby Post)13.6.3 Institute Strikes Clauses (Cargo)13.6.4 Other Incidental Clauses and Warranties13.6.5 Inland Transit Clauses13.6.6 Institute Time Clauses – HullSpecial Marine CoversCargo Underwriting(xii)

13.913.1013.1113.1213.13Hull UnderwritingMarine LossesSettlement of ClaimsMarine Cargo Losses and FraudsMarine Stock Throughout PolicyChapter 14 Auto Insurance14.114.214.314.414.5266 – 285Overview of the Losses Due to Automobile Ownership andUsageNeed for Automobile InsuranceTypes of Motor Insurance Policies14.3.1 Form A Policy14.3.2 Form B14.3.3 Auto Policy in United StatesFactors Considered for Premium RatingMotor Insurance Claims14.5.1 Own Damage Claims14.5.2 Theft Claims14.5.3 Third Party Bodily Injury Claims: Fatal and Non-fatal14.5.4 Motor Accident Claims Tribunals14.5.5 Hit and Run Accidents and Solatium FundChapter 15 Health Insurance15.115.215.315.415.5Part IV286 – 308Health Insurance – IntroductionHealth Insurance Plans in IndiaHealth Insurance Schemes15.3.1 Government/State-based Systems15.3.2 Market-based Systems15.3.3 Employee-managed Systems15.3.4 NGO SystemsMicro Health Insurance in IndiaThird Party AdministratorsINSURANCE REGULATIONSANDOTHER ASPECTSChapter 16 IRDA Framework16.116.216.3311 – 318Privatization of Insurance Sector and Formation of IRDAIRDA Act16.2.1 Constitution of the Authority16.2.2 Duties16.2.3 Powers16.2.4 Functions16.2.5 Other ProvisionsIRDA RegulationsChapter 17 Insurance Pricing17.117.217.3319 – 360Fundamentals of Insurance PricingPricing ObjectivesTypes of Rating17.3.1 Judgment Rating17.3.2 Class Rating17.3.3 Merit Rating(xiii)

17.4Other Rating Consideration17.4.1 Pricing and Deductible17.4.2 Pricing and Warranties17.4.3 Pricing and IRDA Requirements17.5 Rating in Life Insurance17.6 Mortality Table17.6.1 Construction of Mortality Table17.6.2 Components of a Complete Mortality Table17.6.3 Probabilities of Survival and Death17.7 Calculation of Life Premium17.7.1 Whole Life Assurance17.7.2 Pure Endowment Assurance17.7.3 Ordinary Endowment Assurance17.7.4 Double Endowment Assurance17.7.5 Net Level Premium17.7.6 Calculation of Gross Premium17.8 Life Insurance vs. Non-life Insurance Pricing17.9 Rate Making Entities17.10 Rate Making in General InsuranceChapter 18 Miscellaneous Aspects18.118.218.318.4361 – 370Control of MalpracticesNegligenceLoss Assessment and Loss ControlExclusions(xiv)

Part IIntroduction toRisk Management

2Insurance and Risk Management

CHAPTER 1UNDERSTANDING RISKObjectivesAfter reading this chapter, you will be able to understand Concept of RiskRisk vs. UncertaintyLoss, Perils and HazardsTypes of RisksRisk for Banks and Financial InstitutionsCategories of Pure RisksRisk Perception and MisconceptionsHuman beings are considered the most intelligent creatures on this earth. The thinking poweravailable to human beings is enormous and this has led human beings to define their style ofliving and distinguish between good and bad situations. The criteria for deciding whether thesituation is good or bad depend upon individual’s perception. However, one thing is sure —that human beings always prefer and strive for happy situations and wants to avoid theadverse ones. Actually, the zeal to be happy always has given birth to the jargon risk!1.1 The Concept of RiskPeople express risk in different ways. To some, it is the chance or possibility of loss;to others, it may be uncertain situations or deviations or what statisticians calldispersions from the expectations. Different authors on the subject have defined riskdifferently. However, in most of the terminology, the term risk includes exposure toadverse situations. The indeterminateness of outcome is one of the basic criteria todefine a risk situation. Also, when the outcome is indeterminate, there is a possibilitythat some of them may be adverse and therefore need special emphasis. Look at thepopular definitions of risk.According to the dictionary, risk refers to the possibility that something unpleasant ordangerous might happen.1Risk is a condition in which there is a possibility of an adverse deviation from adesired outcome that is expected or hoped for.21Macmillan English Dictionary, Macmillan Publishers Ltd., 2002, p. 127.2E.J. Vaughan, Risk Management, John Wiley and Sons Inc., 1997, p. 8.Chapter 1 Understanding Risk3

At its most general level, risk is used to describe any situation where there isuncertainty about what outcome will occur. Life is obviously risky.3The degree of risk refers to the likelihood of occurrence of an event. It is a measureof accuracy with which the outcome of a chance event can be predicted.In most of the risky situations, two elements are commonly found:The outcome is uncertain, i.e., there is a possibility that one or other(s) mayoccur. Therefore, logically, there are at least two possible outcomes for a givensituation.Out of the possible outcomes, one is unfavourable or not liked by the individual orthe analyst. 1.2 Risk vs. UncertaintyUncertainty is often confused with the risk. Uncertainty refers to a situation wherethe outcome is not certain or unknown. Uncertainty refers to a state of mindcharacterised by doubt, based on the lack of knowledge about what will or what willnot happen in the future.4 Uncertainty is said o exist in situations where decisionmakers lack complete knowledge, information or understanding concerning theproposed decision and its possible consequences.Risk is sometimes defined as an implication of a phenomenon being uncertain – thatmay be wanted or unwanted.UncertaintySurrounding aFactor or EventEffectProbabilityof Factor orEvent in theProject Outcomeof Occurrence oftheFactor or EventProbabilityDistributionfor theOutcome ValuesUncertainty can be perceived as oppositeof certainty where you are assured ofoutcome or what will happen. Accordingly,some weights or probabilities can beassigned into risky situations butuncertainty, the psychological reaction tothe absence of knowledge lacks thisprivilege.Decision under uncertain situations isvery difficult for the decision-maker. Itall depends upon the skill, the judgmentand of course luck. Uncertainties andtheir implications need to be understoodto be managed properly.Uncertainty being a perceptual phenomenon implies different degrees to differentperson. Assume a situation where an individual has to appear for the first in thenewly introduced insurance examination.(a)(b)an individual student undergone a training in insurance.an individual with training or experience in insurance.3Harrington S.E. and G.R. Michaus, Risk Management and Insurance, McGraw-Hill, 1999, p. 3.4Vaughan, op. cit., p. 3.4Essentials of Insurance and Risk Management

A’s perception towards uncertainty of performance in examination is different fromthat of B. Nonetheless, in both situations, outcome that is the questions which will beasked in the examination are different.Uncertainty may be –(a) Aleatory uncertainty – uncertainty arising from a situation of pure chance, whichis known; or(b) Epistemic uncertainty – uncertainty arising from a problem situation where theresolution will depend upon the exercise of judgment.Risk vs. UncertaintyRiskQuantifiableStatistical AssessmentHard DataUncertaintyNon-quantifiableSubjective ProbabilityInformed Opinion1.3 Loss and Chance of LossA risk refers to a situation where there is the possibility of a loss. What is a loss?Loss has been defined in many ways. Loss, in accounting sense, means that portion ofthe expired cost for which no compensating value has been received.5Loss refers to the Act or instance of losing the detriment or a disadvantage resultingfrom losing.6Loss means being without something previously possessed.7The chance of loss refers to a fraction or the relative frequency of loss. The chance ofloss in insurance sense is the probability of loss.For example, assume there are 10,000 factories in the insurance pool which may beaffected due to earthquake and on the basis of past experience, 5 have been affected,then the probability of loss is 0.0005.The whole game of insurance business is based on the probability of loss. If theinsurer estimates correctly, he wins else loses or is forced to close the business.From the insurer’s perspective, it is the probability of loss that accentuate the needfor insurances. The probabilities of losses may be ex-post or ex-ante. In practice, theex-ante probabilities are widely used for undertaking risk in insurance business.The chance or probabilities of loss estimation requires accounting for causes of lossespopularly characterized as perils and hazards.5Arora M.N. (2000), Cost Accounting, Vikas Publishing House, p. 122.6Oxford Advanced Learner Dictionary, Oxford University Press, 1984, p. 504.7Dorfman M.S. (2002), Introduction to Risk Management and Insurance, Prentice-Hall.Chapter 1 Understanding Risk5

1.4 PerilsA peril refers to the cause of loss or the contingency that may cause a loss.8 Inliterary sense, it means the serious and immediate danger.9 Perils refer to theimmediate causes of loss. Perils may be general or specific, e.g., fire may affectassets like building, automobile, machinery, equipment and also, humans. Collusionmay cause damage to the automobile resulting in a financial loss.1.5 HazardsHazards are the conditions that increase the severity of loss or the conditionsaffecting 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 ahazard that may cause a heart attack or mental shock to the proprietor of thebusiness. Hazards can be classified as follows:(1) Physical Hazards — Property Conditions — consists of those physicalproperties that increase the chance of loss from the various perils. For example,stocking crackers in a packed commercial complex increases the peril of fire.(2) Intangible Hazards — Attitudes and Culture — Intangible hazards are more orless psychological in nature. These can be further classified as follows:(a) Moral Hazard — Fraud — These refer to the increase in the possibility orseverity of loss emanating from the intention to deceive or cheat. Forexample, putting fire to a factory running in losses. With an intention tomake benefit out of exaggerated claims, deliberately indulging intoautomobile collusion or damaging it or tendency on part of the doctor to gofor unnecessary checks when they are not required, since the loss will bereimbursed by the insurance company.(b) Morale Hazard — Indifference — It is the attitude of indifference to takecare of the property on the premise that the loss will be indemnified by theinsurance company. So, it is the carelessness or indifference to a lossbecause of the existence of insurance contract. For example, smoking in anoil refinery, careless driving, etc.(c) Societal Hazards — Legal and Cultural — These refer to the increase in thefrequency and severity of loss arising from legal doctrines or societalcustoms and structure. For example, the construction or the possibility ofdemolition of buildings in unauthorized colonies.1.6 Types of RisksFinancial and Non-financial RisksFinancial risk involves the simultaneous existence of three important elements in arisky situation – (a) that someone is adversely affected by the happening of an event,(b) the assets or income is likely to be exposed to a financial loss from the occurrence8Dorfman, op.cit., p. 5.9Oxford Advanced Learner Dictionary, op.cit., p. 622.6Essentials of Insurance and Risk Management

of the event and (c) the peril can cause the loss. For example, loss occurred in case ofdamage of property or theft of property or loss of business. This is financial risksince risk resultant can be measured in financial terms. When the possibility of afinancial loss does not exist, the situation can be referred to as non-financial innature. Financial risks are more particular in nature. For example, risk in theselection of career, risk in the choice of course of study, etc. They may or may nothave any financial implications. These types of risk are difficult to measure. As faras insurance is concerned, risk is involved with an element of financial loss.Individual and Group RisksA risk is said to be a group risk or fundamental risk if it affects the economy or itsparticipants on a macro basis. These are impersonal in origin and consequence. Theyaffect most of the social segments or the entire population. These risk factors may besocio-economic or political or natural calamities, e.g., earthquakes, floods, wars,unemployment or situations like 11th September attack on US, etc.Individual or particular risks are confined to individual identities or small groups.Thefts, robbery, fire, etc. are risks that are particular in nature. Some of these areinsurable. The methods of handling fundamental and particular risks differ by theirvery nature, e.g., social insurance programmes may be undertaken by the governmentto handle fundamental risks. Similarly, fire insurance policy may be bought by anindividual to prevent against the adverse consequences of fire.Pure and Speculative RisksPure risk situations are those where there is a possibility of loss or no loss. There isno gain to the individual or the organization. For example, a car can meet with anaccident or it may not meet with an accident. If an insurance policy is bought for thepurpose, then if accident does not occur, there is no gain to the insured. Contrarily,if the accident occurs, the insurance company will indemnify the loss.Speculative risks are those where there is possibility of gain as well as loss. Theelement of gain is inherent or structured in such a situation. For example — if youinvest in a stock market, you may either gain or lose on stocks.The distinguishing characteristics of the pure and speculative risks are:(a)(b)(c)Pure risks are generally insurable while the speculative ones are not.The conceptual framework of the risk pooling can be applied to pure risks, whilein most of the cases of speculative risks it is not possible. However, there maybe some situation where the law of mathematical expectation might be useful.Speculative risk carry some inherent advantages to the economy or the society atlarge while pure risks like uninsured catastrophes may be highly damaging.Static and Dynamic RisksDynamic risks are those resulting from the changes in the economy or theenvironment. For example economic variables like inflation, income level, price level,technology changes etc. are dynamic risks. Since the dynamic risk emanates from theeconomic environment, these are very difficult to anticipate and quantify. DynamicChapter 1 Understanding Risk7

risk involves losses mainly concerned with financial losses. These risks affect thepublic and society. These risks are the best indicators of progress of the society,because they are the results of adjustment in misallocation of resources.On the other hand, static risks are more or less predictable and are not affected bythe economic conditions. Static risk involves losses resulting from the destruction ofan asset or changes in its possession as a result of dishonesty or human failure. Suchfinancial losses arise, even if there are no changes in the economic environment.These losses are not useful for the society. These arise with a degree of regularityover time and as a result, are generally predictable. Example for static risk includespossibility of loss in a business: unemployment after undergoing a professionalqualification, loss due to act of others, etc.Dynamic vs. Static RisksDynamic RisksLosses are not easily predictableThese risk result from the changes ineconomic environmentThese risks are not covered by insuranceThese risks benefit the societyStatic RisksLosses can be predictedThere occur even if there is no change ineconomic environmentThese risk can be covered by insuranceThese risks don’t benefit the societyQuantifiable and Non-quantifiable RisksThe risk which can be measured like financial risks are known to be quantifiablewhile the situations which may result in repercussions like tension or loss of peaceare called as non-quantifiable.1.7 Risk for Financial InstitutionsIn line with the BASEL accord, the risks for banks, financial institutions, etc. canclassified as follows:10Credit Risk: The risk that a customer, counterparty, or supplier will fail to meet itsobligations. It includes everything from a borrower default to supplier missingdeadlines because of credit problems. Credit risk is the change in value of a debt dueto changes in the perceived ability of counterparties to meet their contractualobligations (or credit rating). Also known as default risk or counterparty risk, creditrisk is faced by lending institutions like banks, investors in debt instruments ofcorporate houses, and by parties involved in contractual agreements like forwardcontracts. There are independent agencies that assess the credit risk in the form ofcredit ratings.Credit rating is an opinion (of the credit rating agency) on the ability of theorganization to perform its contractual obligations (pay the principle and/or interestof the loan) on a timely basis. Each level of rating indicates a probability of default.10Lam James (2001), Enterprise Risk Management – From Incentives to Controls, Wiley.8Es

Chapter 2 Managing Risk 15 - 37 2.1 Risk Management - Definition and Process 2.1.1 Risk Identification 2.1.2 Risk Evaluation 2.1.3 Risk Control 2.1.4 Risk Financing 2.2 Risk Retention 2.3 Risk Transfer 2.4 Levels of Risk Management 2.5 Hedging via Derivatives 2.6 Corporate Risk Management 2.7 Process of Risk Management by Individuals