types of risk management

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Risk Management:

Risk Management

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Risk Risk is a condition in which there is a possibility of an adverse deviation from a desired outcome that is expected or hoped for Uncertainty Uncertainty refers to a situation where the outcomes is not certain or unknown. Loss Loss is accounting sense means that portion of the expired cost for which no compensating vale has been received

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Perils A peril refers to the chances of loss or the contingency that may cause a loss. Hazard Hazards are the conditions that increase the severity of loss or the conditions affecting perils a. Physical hazard : - Property conditions - physical properties that increase the chance of loss from the various perils.

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b. Intangible hazard: - attitudes and culture – more of less physical in nature 1. M oral hazard: - Fraud – increase in the possibility or putting fire to a factory running in losses. 2. Morale Hazard: - indifference – the attitude of indifference to take care of the property. 3. Societal Hazard: - legal and culture – increase in the frequency and severity of loss arising from legal doctrines or social customs and structure.

Types of risk:

Types of risk 1.Financial and non financial risk Some one is adversely affected by the happening of the event. The assets or income is likely to be exposed to a financial loss from the occurrence of the event. The peril can cause the loss. When the possibility of financial loss does not exist, the situation can be referred to as non financial nature

2.Individual and group risk:

2.Individual and group risk A risk is said to be a group risk or fundamental risk if it affects the economy or its participants on a macro basis. These risk factors may be socio – economic or political or natural calamities. E.g : wars, earthquake. Individual / particular risks are confined to individual or small groups. E.g : Theft , fire.

3.Static and dynamic risks:

3.Static and dynamic risks Dynamic risks are those resulting from the changes in the economy or the environment. These risk factors are inflation , technology changes. These risk are emanate from the economic environment and therefore, these are difficult to anticipate and quantify. Static risk are more or less predictable and are not affected by the economic conditions. Eg . the possibility of loss in a business.

4.Quantifiable and non-quantifiable risks:

4.Quantifiable and non-quantifiable risks The risk which can be measured like financial risks are known to be quantifiable. While the situation result in tension or loss of peace are called as non quantifiable . 5 . Credit risk The risk that a firm’s customer and the parties to which it has lent money will delay or fail to make promised payments .

6.Price Risk:

6.Price Risk Price risk refers to uncertainty over the magnitude of cash flows due to possible changes in output and input prices. Output price risk refers to the risk of changes in the price that firm can demand for its goods and services. Input price risk refers to the risk o changes in the prices that a firm may pay for labor, materials , and other input to its production process.

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Commodity price risk arises from fluctuations in the prices of commodities, such as coal, copper, oil, gas, and electricity , that are the input for some firms and output for others. Exchange rate risk arises because of the globilization of economic activity, output and input prices for many firms are affected by fluctuation of foreign exchange rates. Interest rate risk: output and input prices also can fluctuate due to changes in interest rates.

7.Pure and speculative risks.:

7.Pure and speculative risks. Speculative risk are those there is possibility of gain as well as loss. Eg . Investment in stock market Pure risk situations are those where there is a possibility of loss or no loss. There is no gain to individual or the organization Eg . Motor insurance

Classification of pure risk:

Classification of pure risk Personal risk: the risks that directly affect the individuals capability to earn income.

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Property risk: these are the risks to the persons in possession of the property being damaged or lost. The immovable's like land and building being damaged due to flood , earthquakes or fire. Liability risk : these are risks arising out of the intentional or unintentional injury to the persons or damages to their properties through negligence or carelessness.

Losses from pure risk:

Losses from pure risk

Factors affecting an individual’s demand for insurance:

Factors affecting an individual’s demand for insurance Premium loading The premium on an insurance policy equals expected claim costs plus a loading for administrative and capital costs. Insurance with a zero loading does not change expected wealth but reduces the variability of wealth, a risk averse person will purchase full insurance coverage if the policy has a zero loading.

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A positive loading implies that the policyholders pays a premium in excess of the expected payments from the insurer. The demand for insurance follows the fundamental economic principle that the quantity demand decreases as the price increases. If the loading on an insurance policy is too high , then people will not purchase insurance

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Income and wealth : Having more wealth usually is associated with having more assets subject to loss which typically will increase the total amount of insurance purchased. Some people simply do not have sufficient income to afford large amount of insurance coverage. The degree of risk aversion may decline as a person’s wealth increases. e.g a person with Rs20,000 of wealth is likely to insure against the possibility or Rs.10,000 than a person with Rs.1 million in wealth

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Information The demand of insurance will depend on information that the individual has about the loss distribution If an individual perceives that the expected loss is lower than the amount perceived by the insurer, the individual will demand less insurance than a person who has the same probability assessment as the insurer.

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Other sources of indemnity When deciding whether to purchase insurance, a person will consider whether there are other sources of payment The purchase of health insurance – if a person thinks that society will pay some of his or her medical costs, then the demand for health insurance will be reduced.

Factors that limit the insurability of risk:

Factors that limit the insurability of risk

Premium loadings:

Premium loadings If an insurance contracts premium equals the present value of expected costs, a risk averse people will likely demand full insurance coverage for monetary losses that otherwise would be paid by the person Premiums almost always have a positive loading, however, risk averse people will demand less than full coverage. The loading increases the quantity of coverage demanded is likely to decrease. Any factor the increase the administrative costs or capital costs will limit the amount of private market insurance coverage

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Exposures with low severity: Exposures with low severity of losses are not likely to be insured on an individual basis because the fixed costs associated with underwriting and distributing a policy make the loading very high compared to expected losses. Exposures with high frequency: when the probability of loss is high , insurance is less likely to be observed. With a high probability of loss, expected claim costs are high which in turn causes administrative costs, which are proportional to expected claim costs, to be high

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The demand for the insurance in such a situation is low, because the high insurance premium reduces a person’s wealth almost as much as the contingency being insured. Correlated exposures: when losses are highly correlated across potential policyholders, the variance of the distribution of average losses also will be high The problem with insuring correlated losses is that need to hold a large amount of capital to keep the probability of insolvency low. The cost of raising and holding this capital imply that insurance against highly correlated losses will have a high loading.

Moral hazard:

Moral hazard Moral hazard refers to the effect of insurance on the insured’s incentives to reduce expected losses. The moral hazard implies that the policyholders will have to bear risk Conditions of moral hazard: expected losses must depend on the insured’s behaviour after having obtained insurance eg. Life insurance – the expected claim costs depends on the insured’s drinking habits and exercise routine.

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It must be costly for the insurer to observe precautions by policyholders and measures their impact on expected claim costs. Reducing moral hazard: experience rating and limited coverage are the 2 major methods of reducing moral hazard. both the approaches provide incentives for the insured to take precautions after policies are issued by placing some risk on the insured.

Adverse selection:

Adverse selection Adverse selection refers to situations in which consumers have different expected losses, but the insurer in unable to distinguish between the types of customers and charge them different premiums