CU-BBA-SEM-IV-Risk management-Second draft

life insurance policies, the insured makes premium payments, and the insurance company provides a lump-sum payment to beneficiaries upon the insured person's death. When a company provides insurance against a pure risk, they are engaging in speculative risk because the entity is trying to ensure that the customer will not experience a loss until the after the company has profited from the risk transfer. Pure risks are insurable partly because of the law of large numbers makes insurers capable of predicting loss figures in advance. 3.3 PURE RISK – TYPES OF PURE RISKS Pure risks are types of risk where no profit is possible and only full loss, partial loss or break- even situation are probable outcomes. Types of pure risks are.  Personal risks,  Property risks, and  Liability risks Pure risks are types of risk where no profit or gain is possible and only full loss, partial loss or break-even situation are probable outcomes. There are three types of pure risk. The result is always unfavorable, or maybe the same situation (as existed before the event) has remained without giving birth to a profit (or loss). Pure risk is a situation that holds out only the possibility of loss or no loss or no loss. For example, if you buy a new Samsung Note 7, you face the prospect of the book being stolen or not being stolen and no profit from this situation. There is only the prospect of loss or no loss, and no prospect of gain or profit under pure risk. So, pure risks are those risks where the outcome shall result in loss only or at best a break-even situation. We cannot think about a gain-gain situation. 51 CU IDOL SELF LEARNING MATERIAL (SLM)

Figure 3.1: Types of pure risk 3.3.1. Personal Risks These are the risks that directly affect the individual’s capability to earn income. Personal risks can be classified into the following types:  Premature Death: Death of the bread earner with unfulfilled or unprovided financial obligations.  Old Age: It refers to the risk of not having sufficient income at the age of retirement or the age becoming so that mere is a possibility that the individual may not be able to earn the livelihood.  Sickness or Disability: The risk of poor health or disability of a person to earn the means of survival. E.g. the possibility of damage to limbs of a driver due to an accident.  Unemployment: The risk of unemployment due to socio-economic factors resulting in financial insecurity. 3.3.2. Property Risks These are the risks to the persons in possession of the property being damaged or lost. The immovable like land and building being damaged due to flood, earthquake or fire, the movables like appliances and personal assets being destroyed due to the fire or stolen. The losses may be direct or indirect/consequential. A direct loss implies the visible financial loss to the property due to mis happenings. Whereas the indirect ones are the losses arising from the occurrence of an incident resulting in direct/physical damages or loss. 52 CU IDOL SELF LEARNING MATERIAL (SLM)

The loss to crops due to flood is a direct loss – the destruction of the growing power is a consequential one. 3.3.3 Liability Risks These are the risks arising out of the intentional or unintentional injury to the persons or damages to their properties through negligence or carelessness. Liability risks generally arise from the law. E.g., liability of the employer under the workmen’s compensation law or other labor laws in India. In addition to the above categories, risks may also arise due to the failure of others. For example, the financial loss arising from the non-performance or standard performance in a contract, in engineering or construction contracts. 3.4 OTHER TYPES OF RISK MANAGEMENT Longevity Risk One of the greatest concern’s investors have been that they will outlive their money. This is longevity risk in a nutshell. People are living longer and living healthier. That’s the good news. The bad news is that you should plan on funding a potentially longer retirement. You may have built a substantial balance during your working life, but will it provide the lifestyle you desire throughout your retirement? Longevity risk is a good place to start our conversation about risk for two reasons. Figure 3.2: Comparision of life expentancy of man and women First, it clearly demonstrates that a discussion of investment risk is ultimately about people, not abstract returns. The desire to meet a personal goal such as replacing your paycheck in retirement becomes more important than abstract concerns such as the performance of your investments against a benchmark. 53 CU IDOL SELF LEARNING MATERIAL (SLM)

Second, longevity risk is interesting because it clearly demonstrates how different parties view the same risk. Insurance companies, for example, view increased longevity from the standpoint of being on the hook for paying benefits on certain types of contracts (long-term care or annuities, for example) for a longer duration. This can increase the cost (or lower the benefits) of those products to consumers, making it even more important for them to attempt to ensure additional savings in retirement. Investors can limit their longevity risk in many ways including, working longer, delaying social security for a higher benefit that may represent a greater percentage of retirement income and planning for a conservative portfolio withdrawal rate in retirement, generally no more than 4% for those retiring at a normal age. Inflation Risk Inflation is the increase in the cost of goods and services in an economy relative to the currency. When we experience inflation in the United States, the same number of dollars will buy less in the market that it did in the past. You may not have thought much about inflation early in life. This is very common for a couple reasons, the most obvious of which is that when you are young you haven’t lived long enough to see inflation have a substantial material impact on the cost of everyday items. Think of inflation as the hour hand on an analog watch. You know it’s moving, but you can’t see the movement in real time – you can only recognize it has moved in retrospect. You also become more concerned with inflation later in life because you’ve had an opportunity to build savings that can be affected negatively by inflation. When you are younger and have yet to build substantial savings, you may be indifferent to inflation. If you are in debt, you may benefit since inflation erodes the value of what you owe. As an investor, you will need to be keenly aware of inflation risk and select asset classes and investment strategies with the potential to provide a “real rate of return” which is a return above the rate of inflation. If inflation is 3%, for example, you haven’t really made progress in your portfolio by achieving a 3% return for the year. You’ve simply maintained your purchasing power which means the balance you have would buy the same goods and services it would have a year ago. To increase your wealth from a practical standpoint, you will need to achieve a rate above inflation, greater than 3% in this example. This is particularly important to consider when evaluating low yielding asset classes such as cash or cash equivalent items including bank CDs, money market, and savings accounts. If you’re 54 CU IDOL SELF LEARNING MATERIAL (SLM)

offered a rate below the rate of inflation, don’t confuse the numeric increase in your account value with progress that will allow you to purchase more with your money. These is not to say you should avoid those assets entirely but simply that you should evaluate the effects of inflation on your overall portfolio and include assets such as equities that can provide long-term returns above the rate of inflation. Sequence of Returns Risk Often investors focus on average returns. This can be the average of a portfolio allocation or their own experiences in the past. The challenge with a plan based on an average return is that even if it is achieved, there can be wide variation from year to year and the order in which returns occur can affect your investment experience. Imagine you have a balance of one million dollars to invest. The first year you’re up ten percent and the following year you’re down ten percent. Your average annual return may be 0% but you’re not even. You would have $990,000 since the ten percent loss was experienced on a higher balance. You can lessen your sequence of return risk by choosing a conservative withdrawal amount, also known as a sustainable distribution rate. For many retiring at a normal age, this is 4%. It will generally be well below your expected return for the portfolio. This will not only provide a cushion but also assist in combating the previously mentioned risk of inflation. In addition to selecting a conservative withdrawal rate, you can make sure to rebalance your portfolio periodically to make sure you are not exceeding the level of risk necessary to reach your goals. This is important since your most aggressive asset classes can potentially through appreciation represent a larger portion of your overall balance than they did in your initial allocation. Interest Rate Risk Changes in interest rates can affect your portfolio in many ways. When interest rates go up, for example, fixed income items such as bonds may no longer be as competitive and may decrease in value. Even equities may experience the effect of the changing interest rates on the overall economy or a specific business. Think of credit as the fuel that drives economic activity. Interest is the cost of credit. What happens to your driving habits when fuel costs go up? You can protect yourself from interest rate risk by owning many different asset classes and choosing your fixed-income investments so that you have a variety of maturity dates among short, intermediate, and long-term since longer maturities usually carry the greatest interest rate risk. This strategy also comes with a bonus in that it also helps with our next risk, liquidity. Liquidity Risk 55 CU IDOL SELF LEARNING MATERIAL (SLM)

You may have checked the value of your home online recently and been excited to see the value, only to have your thoughts turn to the process of selling. How long will it take? How much will the commission be? What if it sits for too long after I’ve purchased the next property? This is a perfect example of liquidity risk, but it’s not confined to real estate only. Many investments have lock-up periods or charges for early sale, often called “surrender charges” in annuity contracts. The non-monetary costs such as hassle and uncertainty can often be a large factor in considering some investments without a liquid market. You can protect yourself from liquidity risk by limiting the amount of your portfolio that is difficult to liquidate or difficult to do so without incurring expenses. You don’t need access to your entire balance at all times, but you should easily be able to convert a portion to cash in a reasonable timeframe if necessary. Market Risk Market risk is what most investors imagine when they think of risk in general. It’s the possibility that the value of your investment can decrease. Fortunately, there are ways to limit your market risk. Avoid investing a sizable portion of your portfolio in a single asset. Investors often get “oneitis” and are so convinced in the merits of a single investment that they lose sight of the additional risk they take by owning too much of any single investment. A Sample of a Diversified 60% Stocks / 40% Bonds Portfolio Figure.3.3: Diversification of market risk 56 CU IDOL SELF LEARNING MATERIAL (SLM)

This hypothetical example is used for illustrative purposes only. Diversification and asset location do not guarantee positive results. Purchasing investments at various times or “averaging in” can reduce the risk associated with timing your investment. You will also want to consider diversifying among a variety of asset classes. Owning several different stocks may provide some diversity, but stocks, in general, may be affected by similar market forces and move in similar directions. If you use an electronic site to follow your quotes, how often is it all green or all red? When you have not just a variety of stocks but also items from other asset classes such as bonds, real estate, commodities, or others, you will have returns that are less correlated to one another, meaning they do not move in the same direction or react similarly to the same market conditions. Opportunity Risk Opportunity risk is interesting because it is a type of risk people often assume unknowingly when they are attempting to avoid risk in general. Sitting on the sidelines or placing your money under the mattress can seem safe. You will, after all, preserve your principal balance. However, you are experiencing the opportunity cost of not receiving a return on the balance, which can be detrimental to your investment goals over extended periods of time. Trying to time the market and “sit out” the downturns can do more harm than good for many investors. This is because by doing so you miss out on the possibility for upside that often happens specifically during a downturn. You may have heard the phrase that one should focus on the “time in the game” rather than “timing of the game.” Reacting Can Hurt Your Performance: Missing Only a Few Days of Strong Returns Can Drastically Impact Overall Performance Performance of the S&P 500 Index, 1990–2017 57 CU IDOL SELF LEARNING MATERIAL (SLM)

Figure 3.4: Bar diagram for opportunity risk In US dollars. For illustrative purposes. The missed best day(s) examples assume that the hypothetical portfolio fully divested its holdings at the end of the day before the missed best day(s), held cash for the missed best day(s), and reinvested the entire portfolio in the S&P 500 at the end of the missed best day(s). Annualized returns for the missed best day(s) were calculated by substituting actual returns for the missed best day(s) with zero. S&P data copyright 2018 S&P Dow Jones Indices LLC, a division of S&P Global. All rights reserved. “One-Month US T- Bills” is the IA SBBI US 30 Day T-bill TR USD, provided by Ibbotson Associates via Morningstar Direct. Data is calculated off rounded daily index values. Indices are not available for direct investment. Their performance does not reflect the expenses associated with the management of an actual portfolio. Past performance is not a guarantee of future results. Opportunity risk is also frequently coupled with inflation risk. It’s not just that you’re preserving your balance only while missing out on an additional return. The balance you preserve is worth less over time due to inflation. Standing still is going backward when you consider what you can purchase with your money. In our discussion of inflation risk, we pointed out that you need a return at least equal to the rate of inflation before you have a “real rate of return” above it. Sitting on the sidelines and looking for the ideal time to jump back in can prevent this from happening. A strategy to limit opportunity risk is to have an emergency fund that will cover three to six months of emergency expenses but not more. The specific amount within that range can be decided based on how many earners are in the household and the stability of the jobs but having an emergency fund will prevent you from needing to pay a fee, commission, or tax bill to get out of an investment and prevent needing to sell at a less than ideal time. You understand you’re not going to get a large return from money in a savings account or similar vehicle, but you make the tradeoff for liquidity. It’s unlikely that you will need more than this amount in a brief period so having an emergency fund greater than a few months of expenses can lead to too much opportunity risk. Tax Risk Tax risk is a very important consideration for investors. You may have an excellent return on your investments, but it’s the amount you’re able to keep after tax that will most directly affect your lifestyle. There are several ways to contain tax risk and ensure you can keep the most amount of your money possible. Invest in all available “pools” of money. Often investors have most of their savings in tax- deferred accounts such as their employer-sponsored retirement accounts. Tax-deferred accounts 58 CU IDOL SELF LEARNING MATERIAL (SLM)

are only one of the three “pools” available to investors in the United States. You can also invest in tax-free accounts, such as your Roth IRA and taxable or “non-qualified” accounts. Figure 3.5: 2018 Tax Rates Having money in all three pools is called “tax diversification” and it’s one of the most powerful tools that investors can use to avoid tax risk. When you are finally spending your funds, you will have a variety of options to pull from depending on your tax situation at the time which can increase not only your after-tax return but also the flexibility of how you can use all accounts. You’ll also want to consider the tax features of the investments themselves for those funds held in taxable accounts. For those in a high tax bracket, investments with a slightly lower return but favorable tax treatment may be a good overall choice. A common example of this would be to select the lower-yielding municipal bond instead of a higher yielding corporate option if the after-tax return is higher. The timing of your investment sales may make a material impact. When items are held longer than one year, the more favorable investment rate, also known as the dividend and capital gain rate applies. This is more favorable than the ordinary income rate and can be as low as zero depending on other income received during the year. Some highly appreciated assets may be better passed through inheritance to your heirs to avoid capital gains entirely if you wish to leave a legacy in general. Giving these items to qualified charities during your life can have a similar 59 CU IDOL SELF LEARNING MATERIAL (SLM)

effect by avoiding capital gains. For advanced strategies such, you’ll want to address your plans with your financial planner, tax professional, and potentially your estate planning attorney. By focusing on risk management in addition to return, you can not only reach your financial goals but do so in a way that allows you to sleep at night and enjoy your returns. 3.5 SUMMARY  Many business ventures encounter risks that can affect their survival and growth. As a result, it is important to understand the basic principles of risk management and how they can be used to help mitigate the effects of risks on business entities. Risk management is a tool for managing risks in a project and a project manager should be prepared for managing uncertainties not included in a risk management plan.  Tax risk is a probability of unplanned financial losses in the activities of a state, its regions or a business entity. Tax risks can entail real losses in the course of tax relations in adverse economic situations.  Effective management of risky project demands rapid and realistic predictions of alternative courses of action and positive decision making and requires flexible attitudes and procedures.  Business risk is the exposure a company or organization has to factor(s) that will lower its profits or lead it to fail. Anything that threatens a company's ability to achieve its financial goals is considered a business risk.  Perception of severity and frequency of occurrence of risk is to be done in tandem between the stakeholders. This will eliminate lot of unnecessary correspondence as well as misunderstanding and friction between the stakeholders.  Insurance is just one aspect of risk mitigation and it cannot absorb all the risks. Insurance is project specific and it should be taken as per the needs of client/contractor. Other ways of risk mitigation needs to be explored.  Adoption of good project management practices like proper planning and implementation, willingness of stake holders to share the risks in the project is essential for success of a project.  Executing a complex project requires meticulous planning, i.e. planning to the smallest details, and this can be achieved through concerted dedication from the concerned stakeholders.  Risks are to be thoroughly studied and understood before bidding for the project. 60 CU IDOL SELF LEARNING MATERIAL (SLM)

 Special care should be taken regarding the seasonal variation of laborers, so that the construction activities does not get delayed due to shortfall in man-power resources during execution, which can have adverse effects on cost and time  Proper risk allocation techniques should be framed between the stakeholders so that in the event of occurrence of a risk, this will eliminate doubts as to which stakeholder should address the risk. 3.6 KEYWORDS  Risk avoidance: Risk avoidance involves changing the project management plan to eliminate the threat entirely. The project manager may isolate the project objectives that are in jeopardy.  Risk transfer: Risk transfer requires shifting some or all of the negative impact of a threat along with ownership of the response to a third party.  Risk reduction: Risk reduction implies reduction in the probability and consequence of an adverse risk event to be within acceptable threshold limits. Risk reduction is adopted where the resultant increase in costs is less than the potential loss that could be caused by the risk being mitigated  Contingency planning: Removal of engineering/structural barriers, Strengthening the quality assurance procedures, Paying higher amount than recommended by Govt for land acquisition.  Risk acceptance: This strategy is adopted when it is not possible to eliminate all risks from a project. This strategy indicated that the project team had decided not to change the project management plan or is unable to identify any other suitable response strategy. 3.7LEARNING ACTIVITY 1. Assessing and communicating uncertainty often befuddles decision-makers and risk managers. How are these needs handled, and how well, in current practice and analysis? How can we do better? _____________________________________________________________________________ _____________________________________________________________________________ While risks are an inescapable part of the governance and democratic process, the reservoir of social trust is and has been in long-term decline. How successfully is declining trust handled in risk governance processes? 61 CU IDOL SELF LEARNING MATERIAL (SLM)

_____________________________________________________________________________ _____________________________________________________________________________ 3.8 UNIT END QUESTIONS A. Descriptive Questions Short Questions 1. Define the various types of risk? Explain the term pure risk? How is liability a type of risk? What do you mean by personal risk? Name 3 types of pure risk? Long Questions 1. What are the basic objectives and concepts of different types of risk? 2. What do you understand by the term pure risk? Define by giving examples. 3. Differentiate between personal and property risk. 4. Why is management of risk considered as an important objective in business? Except pure risk what are the various other types of risk? B Multiple Choice Questions 1. ---------------- are types of risk where no profit is possible and only full loss, partial loss or break-even situation are probable outcomes. a. Tax risk b. Liability risk c. Pure risk d. Opportunity risk These are the risks arising out of the intentional or unintentional injury to the persons or damages to their properties through negligence or carelessness. a. Longevity risk b. Inflation risk c. Liquidity risk d. Liability risk 62 CU IDOL SELF LEARNING MATERIAL (SLM)

Different types of pure risk are: a. Personal , property , liability risk b. Liability , tax and personal risk c. Personal , property and longevity risk d. None of these What is the greatest concern that the investors have? a. Business is doing well b. That they outlive their money c. The world will end d. They will have a good profit These are the risks that directly affect the individual’s capability to earn income. a. Personal risk b. Property risk c. Liquidity risk d. Tax risk Answers 1-c, 2-d, 3-a, 4-b, 5-a 3.9 REFERENCES References  Adrian, T. and Shin, H. S. (2010). Liquidity and Leverage, Journal of Financial Intermediation, 19, pp. 418–437.  Alexander, S. T., Coleman, F., and Li, Y. (2004). Minimizing VaR and CVaR for a Portfolio of Derivatives, Working Paper, Cornell University, 2004.  Almgren, R. and Chriss, N. (2000). Optimal Execution of Portfolio Transactions, Journal of Risk, 3 (2), pp. 5–39. Textbooks 63 CU IDOL SELF LEARNING MATERIAL (SLM)

 Acerbi, C. (2002). Spectral Measures of Risk: A Coherent Representation of Subjective Risk Aversion, Journal of Banking and Finance  Acharya, V., Almeida, H., and Campello, M. (2010). Aggregate Risk and the Choice Between Cash and Credit Lines, Working Paper, New York University and University of Illinois.  Gamma E., Helm R., Johnson R., Vlissides J., Design Patterns: Elements of Reusable Object-Oriented Software, Addison Wesley, 1996. Websites  https://searchcompliance.techtarget.com/definition/pure-risk-absolute-risk  https://www.researchgate.net/publication/331783796_Process_of_Risk_Management  https://www.tandfonline.com/toc/rjrr20/17/10?nav=tocList 64 CU IDOL SELF LEARNING MATERIAL (SLM)

UNIT – 4: METHODS OF HANDLING RISK STRUCTURE 4.0 Learning Objectives 4.1 Introduction 4.2 Various Methods of Handling Risks 4.2.1 Avoidance 4.2.2 Retention 4.2.3 Sharing 4.2.4 Transferring 4.2.5 Loss Prevention and Reduction 4.3 Summary 4.4 Keywords 4.5 Learning Activity 4.6 Unit End Questions 4.7 References 4.0 LEARNING OBJECTIVES After studying this unit, you will be able to:  Explain the definition of risk management.  Illustrate the objectives of risk management.  Evaluate the steps in risk management process, by application to your University's risks.  Explain valuation of the loss exposure unit.  Expalin and review the risk management program continuously.  Explain, how can you manage your family's risks. 4.1 INTRODUCTION 65 CU IDOL SELF LEARNING MATERIAL (SLM)

It is known that everyone, family, firm, or other organization face a lot of risks. Consequently, the risks that large organizations and firms face are so important such that a specialized management known as risk management has developed. The risk management in any organization is managed by a person is called as \"the risk manager\". Risk management is a scientific approach to problem of dealing with pure risks faced by individuals and business. Hence, large firms, particularly, in Europe countries and United States of America (U.S.A) have developed risk management in the same style as marketing management, financial management, personnel management …. etc. The responsibility of risk management in any organization may be considered identification the exposure units in the organization that create pure risks and designing programs to handle them. Avoidance means not participating in activities that could harm you; in the case of health, smoking is a good example. Retention acknowledges the inevitability of certain risks, and in terms of health care, it could mean picking a less expensive health insurance plan that has a higher deductible rate. Sharing risk can be applied to how employer-based benefits are often more affordable than if an individual gets their own health insurance. Transferring risk relates to healthcare in that the cost of the care is transferred to the insurer from the individual, beyond the cost of premiums and a deductible. Loss prevention and reduction are used to minimize risk, not eliminate it—the same concept is used in healthcare with preventative care. Managing pure risk entails the process of identifying, evaluating, and subjugating these risks—a defensive strategy to prepare for the unexpected. The basic methods for risk management— avoidance, retention, sharing, transferring, and loss prevention and reduction—can apply to all facets of an individual's life and can pay off in the long run. Here's a look at these five methods and how they can apply to the management of health risks. Sharing risk is often implemented through employer-based benefits that allow the company to pay a portion of insurance premiums with the employee. In essence, this shares the risk with the company and all employees participating in the insurance benefits. The understanding is that with more participants sharing the risks, the costs of premiums should shrink proportionately. Real life Examples of methods of handling risk are as follows,  Talk about individual impacts 66 CU IDOL SELF LEARNING MATERIAL (SLM)

Through a series of experiments focused on positive and negative risks, the authors of a study published in the Harvard Business Review determined that a person is more likely to make an objective, logical decision when a single significant impact is presented, as opposed to being presented along with a number of other lower impact outcomes. Counter-intuitive as it may seem, simple communication that conveys the more important impact—and that only—can be more effective than providing a whole slew of impacts. Recognizing that risk owners are frequently reluctant to commit time or political influence to actively respond to a risk, we might be tempted to try to stack the deck in our favor by communicating multiple potential impacts which might result if the risk gets realized. By doing this, we might actually diminish the perceived threat or opportunity presented by the risk resulting in risk owners responding in the exact opposite manner than what we had hoped for. To avoid this, while it is a good idea to capture complete information in our risk registers, when presenting risks to stakeholders, focus on communicating the single impact which presents the greatest threat or opportunity. Then, if you don’t get the buy-in you were hoping for, add weight to your argument by sharing other potential impacts.  Get your eternal optimism in check It’s hard to think about negative risks, much less plan for them, when you think that everything will be fine. Optimism is good—just not blind optimism. If such optimism is the prevailing mindset within a company, it can be difficult for risk owners to envision things not going according to plan. What has always intrigued me is how the same leadership teams which can be moderately effective at implementing operations or business risk capabilities will be so much weaker when it comes to project risk management. A risk averse culture will take a long time to change for an overall organization, but a project manager should be able to influence it within the ecosystem of their projects.  Use data to show how risk management is working We work hard to manage risks. But all of that doesn’t mean much to the outside person unless we can demonstrate, with numbers, that all of this risk management is producing real, beneficial effects. To be meaningful to stakeholders, executives, clients, and teams, part of your risk management effort needs to include analyzing not only the risks but the effort spent on risk management too. Show the positive correlation between effective risk management and successful project outcomes. In the absence of supporting internal empirical data or strong pressure from the outside to create a valid sense of urgency, senior leaders and project teams will be unwilling to sustainably invest in the required behavior and practice changes.  Managing risk takes time, so make sure your team has it 67 CU IDOL SELF LEARNING MATERIAL (SLM)

Too often, unhealthy levels of multitasking by project teams and stakeholders result in those practices perceived as unnecessary being jettisoned or being given lip service only. If a team barely has time to deliver the scope of their project, how can they or equally busy risk owners be expected to expend any real efforts on considering or responding to potentialities which may never be realized? And, if we combine this limited availability with “one size fits all” approaches to project risk management, it is no wonder that many teams will do the absolute bare minimum required to meet onerous governance requirements. 4.2 VARIOUS METHODS OF HANDLING RISKS Figure 4.1: Various methods of handling risk As people begin to age, they usually encounter more health risks. Managing pure risk entails the process of identifying, evaluating, and subjugating these risks—a defensive strategy to prepare for the unexpected. The basic methods for risk management—avoidance, retention, sharing, transferring, and loss prevention and reduction—can apply to all facets of an individual's life and can pay off in the long run. Here's a look at these five methods and how they can apply to the management of health risks. 68 CU IDOL SELF LEARNING MATERIAL (SLM)

 Avoidance means not participating in activities that could harm you; in the case of health, smoking is a good example.  Retention acknowledges the inevitability of certain risks, and in terms of health care, it could mean picking a less expensive health insurance plan that has a higher deductible rate.  Sharing risk can be applied to how employer-based benefits are often more affordable than if an individual gets their own health insurance.  Transferring risk relates to healthcare in that the cost of the care is transferred to the insurer from the individual, beyond the cost of premiums and a deductible.  Loss prevention and reduction are used to minimize risk, not eliminate it—the same concept is used in healthcare with preventative care. Various methods of handling risks are:  Avoidance  Retention  Sharing  Transferring  Loss Prevention and Reduction 4.2.1 Avoidance 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. According to the American Lung Association, smoking is the leading cause of preventable death in the U.S. and claims more than 480,000 lives per year. Additionally, the U.S. Centers for Disease Control and Prevention notes that smoking is the No. 1 risk factor for getting lung cancer, and the risk only increases the longer that people smoke. Life insurance companies mitigate this risk on their end by raising premiums for smokers versus nonsmokers. Under the Affordable Health Care Act, also known as Obamacare, health insurers can increase premiums based on age, geography, family size, and smoking status. The law allows for up to a 50% surcharge on premiums for smokers. Risk management strategies used in the financial world can also be applied to managing one's own health. 69 CU IDOL SELF LEARNING MATERIAL (SLM)

4.2.2 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. Here are a few other examples of avoidance: Someone might avoid triggers such as people, places, and things that may incite uncomfortable feelings. Those dealing with social anxiety, for example, might avoid crowds of people or hanging out with a group of friends. 4.2.3 Sharing Sharing risk is often implemented through employer-based benefits that allow the company to pay a portion of insurance premiums with the employee. In essence, this shares the risk with the company and all employees participating in the insurance benefits. The understanding is that with more participants sharing the risks, the costs of premiums should shrink proportionately. Individuals may find it in their best interest to participate in sharing the risk by choosing employer health care and life insurance plans when possible. Sharing is distributing, or letting someone else use your portion of something. An example of sharing is two children playing nicely together with a truck. 4.2.4 Transferring The use of health insurance is an example of transferring risk because the financial risks associated with health care are transferred from the individual to the insurer. Insurance companies assume the financial risk in exchange for a fee known as a premium and a documented contract between the insurer and individual. The contract states all the stipulations and conditions that must be met and maintained for the insurer to take on the financial responsibility of covering the risk. By accepting the terms and conditions and paying the premiums, an individual has managed to transfer most, if not all, the risk to the insurer. The insurer carefully applies many statistics and algorithms to accurately determine the proper premium payments commensurate to the requested coverage. When claims are made, the insurer confirms whether the conditions are met to provide the contractual payout for the risk outcome. 70 CU IDOL SELF LEARNING MATERIAL (SLM)

Transfer is defined as to move, carry or transport from one person or place to another. An example of to transfer is the owner of a car signing the title over to a new owner. An example of to transfer is picking up a package from one location and bringing it to another. 4.2.5 Loss Prevention and Reduction This method of risk management attempts to minimize the loss, rather than eliminate it. While accepting the risk, it stays focused on keeping the loss contained and preventing it from spreading. An example of this in health insurance is preventative care. Health insurers encourage preventative care visits, often free of co-pays, where members can receive annual checkups and physical examinations. Insurers understand that spotting potential health issues early on and administering preventative care can help minimize medical costs in the long run. Many health plans also provide discounts to gyms and health clubs as another means of prevention and reduction to keep members active and healthy. Driving slower is an example of both loss prevention and loss reduction, since it both reduces the probability of an accident and, if an accident does occur, it reduces the magnitude of the losses, since accidents at slower speeds generally cause less damage. Salvage operations may also reduce the cost of the loss. Figure 4.2: Risk management techniques 71 CU IDOL SELF LEARNING MATERIAL (SLM)

4.3 SUMMARY  The risk management programs and techniques handling for any organization (firm – university – institution …. etc.) have many benefits that can be summarized in the following benefits:  The cost of the risk in the organization is reduced. Consequently ,the profits in the organization may increase.  Risk control is the best method of managing risk and usually the least expensive. Risk control involves avoiding the risk entirely or mitigating the risk by lowering the probability and magnitude of losses. Many risks cannot be avoided, but almost all risks can be mitigated through the use of loss control. Nonetheless, even losses from mitigated risks can be expensive, so both people and businesses usually transfer some of that risk to 3r d parties.  Risk avoidance is the elimination of risk. You can avoid the risk of a loss in the stock market by not buying or shorting stocks; the risk of a venereal disease can be avoided by not having sex, or the risk of divorce, by not marrying; the risk of having car trouble, by not having a car. Many manufacturers avoid legal risk by not manufacturing particular products.  Of course, not all risks can be avoided. Notable in this category is the risk of death. But even where it can be avoided, it is often not desirable. By avoiding risk, you may be avoiding many pleasures of life, or the potential profits that result from taking risks.  A business cannot operate without taking some risk. Virtually any activity involves some risk. Generally, risk should be avoided when losses are large and gains are small. Where avoidance is not possible or desirable, loss control is the next best thing.  Loss prevention requires identifying the factors that increase the likelihood of a loss, then either eliminating the factors or minimizing their effect. For instance, speeding and driving drunk greatly increase auto accidents. Not driving after drinking alcohol is a method of loss prevention that reduces the probability of an accident. Driving slower is an example of both loss prevention and loss reduction, since it both reduces the probability of an accident and, if an accident does occur, it reduces the magnitude of the losses, since accidents at slower speeds generally cause less damage. Salvage operations may also reduce the cost of the loss.  Since both direct and indirect losses in the organization are reduced, as a result of the risk management program. Consequently, pain and suffering in the community are reduced. So, the community benefits. 72 CU IDOL SELF LEARNING MATERIAL (SLM)

 Risk management program objectives (Before the loss – after the loss) are more easily attainable  A formal risk management enables firm to attain its pre-loss and post-loss objectives more easily  A risk management program can reduce a firm’s cost of risk  Reduction in pure loss exposures allows a firm to enact an enterprise risk management program to treat both pure and speculative loss exposures  Society benefits because both direct and indirect losses are reduced. In conclusion the risk manager is extremely important to the financial success of business firms in today`s economy. 4.4 KEYWORDS  The loss prevention: It is the appropriate method to deal with a particular risk; the proper loss prevention program must be designed and implemented.  Risk control: refers to methods that reduce the frequency and severity of probable losses. Major risk control , include avoidance – loss control.  Risk financing: refers to methods that provide for funding of losses after they occur. Major risk financing, include (retention –non insurance transfer – insurance)  Unimportant Risks: These risks include loss exposure units in which the probable losses could be met out of the current income of the factory. Consequently, theses risks would not affect the factory's activities  Important risks: These risks include loss exposure units in which the probable losses would not lead to bankruptcy. So, they are difficult to bear by factory. 4.5 LEARNING ACTIVITY 1. Find out how can the risk manager in factory of spinning select the appropriate method for dealing with risks. In other words, how can the risk manager make choice between insurance and other risk handling methods. ____________________________________________________________________________ ____________________________________________________________________________ Do you think that the risk management process is a decision-Making process? What are the steps of risk management process? 73 CU IDOL SELF LEARNING MATERIAL (SLM)

____________________________________________________________________________ ____________________________________________________________________________ 4.6 UNIT END QUESTIONS A. Descriptive Question Short Questions 1. Describe the steps in risk management process, by application to your university’s risks? 2. What do you mean evaluation of the loss exposure unit? 3. Why do you have to review the risk management program continuously? 4. What is the definition of risk management? 5. What are the objectives of risk management? Long Questions 1. Explain and define how can you manage your family's risks? 2. What are the various methods of handling risks? 3. What are risk management techniques? Explain with suitable examples. 4. What are the main objectives of risk management techniques? Explain how an organization will benefit from adapting these techniques. 5. Define the term, the risk management process is a decision- making process applying suitable examples. B. Multiple Choice Questions 1. -------------is a method for mitigating risk by not participating in activities that may incur injury, sickness, or death a. Avoidance b. Retention c. Sharing d. Transferring The use of ----------------is an example of transferring risk because the financial risks associated with health care are transferred from the individual to the insurer. a. policy b. Health insurance 74 CU IDOL SELF LEARNING MATERIAL (SLM)

c. funds d. Capital ---------------------is the acknowledgment and acceptance of a risk as a given source a. avoidance b. sharing c. transferring d. Retention --------------------risk relates to healthcare in that the cost of the care is transferred to the insurer from the individual, beyond the cost of premiums and a deductible. a. Transferring b. Securing c. Crediting d. Funding Loss prevention and reduction are used to---------------, not eliminate it, the same concept is used in healthcare with preventative care. a. Maximize risk b. Minimize risk c. Avoid risk d. Retain risk Answers 1-a, 2-b, 3-d, 4-a, 5-b 4.7 REFERENCES References  Adrian, T. and Shin, H. S. (2010). Liquidity and Leverage, Journal of Financial Intermediation, 19, pp. 418–437.  Alexander, S. T., Coleman, F., and Li, Y. (2004). Minimizing VaR and CVaR for a Portfolio of Derivatives, Working Paper, Cornell University, 2004. 75 CU IDOL SELF LEARNING MATERIAL (SLM)

 Almgren, R. and Chriss, N. (2000). Optimal Execution of Portfolio Transactions, Journal of Risk, 3 (2), pp. 5–39. Textbooks  ARM, “ARMISTICE Project”, http://www.madsgroup.org/armistice, 2007.  Booch G., Jacobson I., Rumbaugh J., The Unified Modeling Language, Addison Wesley, 1998.  Acharya, V., Almeida, H., and Campello, M. (2010). Aggregate Risk and the Choice Between Cash and Credit Lines, Working Paper, New York University and University of Illinois. Websites  https://www.investopedia.com/articles/investing-strategy/082816/methods-handling-risk- quick-guide.asp  https://www.slideshare.net/PranavkumarJain/methods-of-handling-risk  https://www.pthistle.faculty.unlv.edu/Fin321Class/LectureNotes/Chapter4.pdf 76 CU IDOL SELF LEARNING MATERIAL (SLM)

UNIT – 5: INSURANCE AND RISK STRUCTURE 5.0 Learning Objectives 5.1 Introduction 5.2 Meaning and Definition 5.3 Requirements of Insurable Risks 5.4 Benefits of Insurance 5.5 Costs of Insurance to Society 5.6 Significance of Insurance 5.7 Significance of Risk 5.8 General Structure of the Insurance Market 5.9 Significant Aspects of this Insurance Industry 5.10 Summary 5.11 Keywords 5.12 Learning Activity 5.13 Unit End Questions 5.14 References 5.0 LEARNING OBJECTIVES After studying this unit, you will be able to:  Evaluate the functioning of insurance market;  Illustrate risk defraying options for insurance;  Evaluate the problems posed to insurance market by adverse selection and moral hazard; and  Explain and derive the equilibrium condition in the presence of adverse selection 5.1 INTRODUCTION 77 CU IDOL SELF LEARNING MATERIAL (SLM)

In the preceding unit, we have seen that people, in general, are risk averse and would be willing to buy insurance. Viewed from such a perspective, insurance is an exchange in which you make a payment to get rid of a gamble -that is, to avoid or reduce a risk. However, if everyone is risk averse, a seller of insurance seems a part of the group. You cannot then explain the existence of an insurance market without saying that insurance company is risk lover. To come to a definite conclusion, if will be necessary for us to examine the operation of insurance market. You can buy insurance for all kinds of things: to replace lost earnings in the event of premature death (life insurance), to cover the costs of damage to your home (homeowners insurance), automobile (car insurance), or even your newly purchased television or electronics gadget (what we call gadget insurance). Health insurance constitutes an important part of our insurance, but the complexity of that field precludes us from covering it here. From a finance standpoint, the steps in managing these risks are straightforward: 1. Identify the risk – in common words, what do you fear? 2. Determine how much of this risk you can bear, and 3. Insure the remainder of the risk. The trick here is to put the risk in dollars. In the case of life insurance, for instance, lay out the expected income that will be lost if the insured were to die. Rules of thumb are handy, but there is no substitute for laying out the cash flows. This step is the one that is the source of most of the mistakes – you spend too much money if you take too little risk, and you can lose big if you take too much risk. The market will pay you to take risk. The premium you pay for an insurable risk must cover not only the expected loss, but also the administrative expenses incurred by the insurance company. Over the course of your life, you will be taking many, many risks. So long as each of the risks is a manageable amount – i.e., no one event can “knock you out of the game” – you can expect the large number of risks to average very close to the expected loss. By accepting those risks, you will be keeping the money that would have been paid to cover the administrative costs of the insurance company. The trick is to keep the level of each risk at that “manageable amount” – if you suffer a huge loss, it is very difficult to recover. The standard that we recommend is to accept risk up to the point where it will affect your lifestyle if events go against you. 78 CU IDOL SELF LEARNING MATERIAL (SLM)

This step provides an immediate application for most people: don’t buy “gadget insurance.” For most of us, our lifestyle will not be interrupted if the new electronic gadget suddenly stops working. So, resist that sales pressure. Speaking of sales pressure, you may find it useful to discuss these principles with your insurance agent. Many agents assume that their clients wish to have “everything covered” so they proceed to recommend coverage that entails almost no risk for the client. Finally, let us add a word about some psychological aspects of this step. There is usually some comfort in being “fully insured.” Similarly, there is usually some pain in paying a loss even though it doesn’t affect your immediate lifestyle and you believe that your lifestyle will be better over the long term. For you, this combination of comfort and potential pain may be so great that you would prefer to bear no risk in these matters. That’s OK – just recognize that by avoiding risks that you could bear financially, you are incurring financial costs. 5.2 MEANING AND DEFINITION  Insurance Risk Management — a term for the traditional risk management concept, which focuses primarily on pure risks rather than operational, market, credit, and other types of risk. This term is frequently used to distinguish between the traditional risk management concept and the newer practice of enterprise risk management (ERM).  Risk Management — the practice of identifying and analyzing loss exposures and taking steps to minimize the financial impact of the risks they impose. Traditional risk management, sometimes called \"insurance risk management,\" has focused on \"pure risks\" (i.e., possible loss by fortuitous or accidental means) but not business risks (i.e., those that may present the possibility of loss or gain). Financial institutions also employ a different type of risk management, which focuses on the effects of financial risks on the organization. For example, interest rate risk is a bank's most important financial risk, and various hedging tools and techniques such as derivatives are used to manage banks' exposure to interest rate volatility.  An insurance risk is a threat or peril that the insurance company has agreed to insure against in the policy wordings. These types of risks or perils have the potential to cause financial loss such as property damage or bodily injury if it were to occur.  If the insured event takes place and a claim is filed, the insurance company has to pay the policyholder the agreed reimbursement amount. 79 CU IDOL SELF LEARNING MATERIAL (SLM)

 Examples of insurance risks include the risk of fire, earthquake losses, or even liability when an insured is found responsible for causing bodily injury, death, or property damage to 3rd parties.  The more risks your insurance provider agrees to insure, the more comprehensive—and therefore expensive—your policy will be.  The best policies are the ones that cover the most relevant insurance risks you might face at the most reasonable cost. 5.3 REQUIREMENTS OF INSURABLE RISK  A large number of homogeneous exposures (in order for the deviation of actual losses from expected losses to approach zero and the creditability of the prediction to approach one).  Loss must be definite in time and amount.  Loss must be fortuitous. An insured cannot cause the loss to happen; it must be due to chance.  Must not be an exposure to catastrophic loss; risks must be spread over a large geographical area to prevent their concentration. reinsurance often is used to spread potentially catastrophic risks.  Premium must be reasonable in relation to the potential loss. In theory, one could even insure against a pencil point breaking, but the premium would be much greater than any possible loss. 5.4 BENEFITS OF INSURANCE Insurance is a risk management tool not only benefits the individual and businesses but also benefits the society and economy in numerous ways. Following is some of the important benefits 80 CU IDOL SELF LEARNING MATERIAL (SLM)

of insurance: Figure 5.1: Benefits of insurance  Provides peace of mind: Insurance provides protection against various uncertainties that can put you or your family in financial crisis. By covering the uncertainties of human life and businesses, insurance provides a sense of security. Having life insurance gives you peace of mind that the financial stability of your family will remain intact even when you are not around. Having health insurance gives you a sense of security that you do not need to shell out all your savings in the event of medical emergencies.  Promotes risk control: As insurance works on risk transfer mechanism, it promotes risk control activity.  Promotes economic growth: As insurance funds are invested in various projects like water supply, power, and roads etc., it contributes to the overall economic growth of the nation. Also, insurance provides employment opportunity to people. Insurance contributes to economic growth in many other ways such as 81 CU IDOL SELF LEARNING MATERIAL (SLM)

getting Foreign Direct Investment, paying taxes on the profit earned and by investing in the capital market etc.  Distribution of risk: Risk of insurance is spread across various individuals and organization instead of concentrating on only one.  Helps to get loan easily: There are loan facilities offered against insurance policies. In case of home loans, having an insurance cover can help to get the loan easily from the lender.  Inculcates savings habit: There are many life insurance products that come with investment cum protection benefit. Such products inculcate a regular saving habit among individuals. Plans like endowment insurance plans help in achieving long-term financial goals. Pension plans help to receive regular income flow in older age.  Provides tax benefit: Insured gets the tax benefits for premium paid depending on the insurance product type. For example, the premium paid towards life insurance plans qualifies for tax deduction under Section 80C of the Income Tax Act. and the premium paid towards health insurance plans qualifies for tax deduction under Section 80D of the Income Tax Act. Following is some of the examples that demonstrate the importance of insurance: i. Case 1: Ram, a software engineer living in Bangalore meets with an accident and dies on the spot leaving his wife and son in deep emotional shock. He was just 40! He also has a home loan of INR. 30 lakhs running. Luckily, Ram has taken a term insurance cover of INR. 1 Cr. at the age of 32 years for 25 years of the policy tenure. His wife received compensation from the insurance company within 10 days which helped her pay off the debt and invest the corpus for future needs. If he had not taken the wise decision of investing in life insurance, his family would have been a huge financial crisis today! Insurance is important to secure your family’s future. ii. Case 2: Sunil, an employee in a multinational company in Mumbai suddenly feel unconscious due to high fever. He was then rushed to the nearest hospital. He was admitted for 3 days in the hospital for diagnosis and treatment. When he was discharged after 3 days, his hospital bill came up to around INR. 70,000. Luckily, he had taken a health insurance coverage for INR. 3, 00,000. As the hospital was listed in the network hospitals of his insurer, bills were directly settled to the 82 CU IDOL SELF LEARNING MATERIAL (SLM)

hospital. If he had not known the importance of insurance, he would have to pay INR.70, 000 out of his pocket. Insurance helps you to have financial stability during unforeseen events. To conclude, shield your life and important assets against all the uncertainties with the help of insurance. Know what insurance coverages you need, compare, and invest wisely. It’s important to understand that the need for insurance is to secure what you love. 5.5 COSTS OF INSURANCE TO SOCIETY Insurance contributes towards society in many ways. However, the essential gift of insurance to the community is the stipulation of risk sharing, risk transfer capabilities and loss prevention steps, which are a primary element of the insurance industry and are necessary for a well- functioning economy but remain mostly unseen. Insurance benefits consumers, businesses, and society altogether. Individuals take insurance to dodge being faced with financial trouble when accidental damage resulting from a particular event (non-life insurance) or when an individual wants to build up a monetary reserve for a specific plan and tries to decrease mortality, deprivation, and endurance risks (life-insurance). 83 CU IDOL SELF LEARNING MATERIAL (SLM)

Figure 5.2: Cost of insurance to society The following focuses on measures of insurance that display its role in society:  Peace of mind for individuals The most prevalent of all non-life insurance products are the Motor Third Party Liability insurance. If somebody causes a mishap, then the individual is bound to repay the losses which the third party has suffered. Depending on conditions of the accident, the person might be liable to pay a large sum of money (loss of future income, hospital bills, and material damage). By considering MTPL insurance, the individual assures that the third party’s damages get paid, while an individual’s financial situation stays intact. When an individual gets life insurance, he collects funds on a consistent interval to create a wealth of funds for a particular aim. In other words, insurance assists the individual in preserving their financial condition firm. It also lowers the need for additional savings and enables money to be invested in high-profit domains. Consequently, insurance motivates investment and expenditure by decreasing the funds secured in relatively unfruitful sectors. 84 CU IDOL SELF LEARNING MATERIAL (SLM)

 A financial backup and safety net for businesses Like individuals, business entities can be endangered to claims for damages following a particular event. Example, manufacturers can be made liable for a faulty product that caused casualties to an individual. Therefore, the manufacturer will be required to pay a hefty amount in compensation. Consequently, the company would have fewer funds to invest in new tech and innovation. Since, insurance promotes economic growth by sharing risks, which ordinarily the business corporations would bear, it also helps innovative technologies to be capitalized. The insurance premiums paid by the holder cover the firm’s operational costs and create financial reserves for future payouts. Since some payouts do not happen shortly (e.g., long-term life), the funds obtained by premiums could be re-invested in the market to produce income. Insurers are significant investors in the global economy. They make their resources available to private organization’s (e.g., manufacturers, energy providers, and the financial industry) by funding in their shares. Besides, they also assist governments by financing for infrastructure and other things that benefit the society. Also, insurance allows filtering out sudden floods in monetary requirements linked to a disaster that might push companies into bankruptcy.  Natural disasters and climate change Natural disasters have been progressing over recent years. The reason isn’t just global warming. The cause is also the increasing density of people and infrastructures that are inclined to natural calamities. The populations of coastal areas are growing steadily, and hazards often knock-on communities living in poverty. Micro-insurance can contribute to disaster management in third world nations. It has been devised to be affordable for the needy and poor households. Natural calamities end in even more significant damages. Not only individual and industrial properties are damaged, but also basic foundations such as roads, harbor’s, communication, water and drainage systems and electrical systems. Insurance protection helps in reconstruction, re- establishment and stabilizes the economy. 5.6 SIGNIFICANCE OF INSURANCE  The world we live in is full of uncertainties and risks. Individuals, families, businesses, properties and assets are exposed to different types and levels of risks. These include risk of losses of life, health, assets, property, etc. While it is not always possible to prevent unwanted events from occurring, financial world has developed products that protect individuals and businesses against such losses by compensating them with financial resources. Insurance is a financial product that reduces or eliminates the cost of loss or effect of loss caused by different types of risks. 85 CU IDOL SELF LEARNING MATERIAL (SLM)

 Apart from protecting individuals and businesses from many kinds of potential risks, the Insurance sector contributes significantly to the general economic growth of the nation by providing stability to the functioning of businesses and generating long-term financial resources for the industrial projects. Among other things, Insurance sector also encourages the virtue of savings among individuals and generates employments for millions, especially in a country like India, where savings and employment are important.  Provides Safety and Security to Individuals and Businesses: Insurance provides financial support and reduces uncertainties that individuals and businesses face at every step of their lifecycles. It provides an ideal risk mitigation mechanism against events that can potentially cause financial distress to individuals and businesses. ). For instance, with medical inflation growing at approximately15% per annum, even simple medical procedures cost enough to disturb a family’s well-calculated budget, but a Health Insurance would ensure financial security for the family. In case of business insurance, financial compensation is provided against financial loss due to fire, theft, mishaps related to marine activities, other accidents etc.  Generates Long-term Financial Resources: The Insurance sector generates funds by way of premiums from millions of policyholders. Due to the long-term nature of these funds, these are invested in building long-term infrastructure assets (such as roads, ports, power plants, dams, etc.) that are significant to nation-building. Employment opportunities are increased by big investments leading to capital formation in the economy.  Promotes Economic Growth: The Insurance sector makes a significant impact on the overall economy by mobilizing domestic savings. Insurance turn accumulated capital into productive investments. Insurance also enables mitigation of losses, financial stability and promotes trade and commerce activities those results into sustainable economic growth and development. Thus, insurance plays a crucial role in the sustainable growth of an economy.  Provides Support to Families during Medical Emergencies: Well-being of family is important for all and health of family members is the biggest concern for most. From elderly parents to newborn children, medication and hospitalization play important role while ensuring well-being of families. Rising medical treatment costs and soaring medicine prices are enough to drain your savings if not well prepared. Anyone can fall victim to critical illnesses (such as heart attack, stroke, cancer etc.) unexpectedly. And rising medical expense is of great concern. Medical Insurance is a policy that protects individuals financially against different type of health risks. With a Health Insurance policy, an insured gets financial support in case of medical emergency. 86 CU IDOL SELF LEARNING MATERIAL (SLM)

 Spreads Risk: Insurance facilitates moving of risk of loss from the insured to the insurer. The basic principle of insurance is to spread risk among a large number of people. A large population gets insurance policies and pay premium to the insurer. Whenever a loss occurs, it is compensated out of corpus of funds collected from the millions of policyholders. 5.7 SIGNIFICANCE OF RISK  The uncertain economic times of the past few years have had a major effect on how companies operate these days. Companies that used to operate smoothly with the help of forecasts and projections now refrain from making business judgments that are set in stone. Now, companies have a renewed focus: to manage risk.  Risk is the main cause of uncertainty in any organization. Thus, companies increasingly focus more on identifying risks and managing them before they even affect the business. The ability to manage risk will help companies act more confidently on future business decisions. Their knowledge of the risks they are facing will give them various options on how to deal with potential problems.  According to a survey conducted by advisory firm PPB, risk is defined in this manner: “Organizations face internal and external actors and influences that make it uncertain whether, when, and the extent to which they will achieve or exceed their objectives. The effect this uncertainty has on the organization’s objectives is risk.”  Risk can come from both internal and external sources. The external risks are those that are not in direct control of the management. These include political issues, exchange rates, interest rates, and so on. Internal risks, on the other hand, include non-compliance or information breaches, among several others.  Risk management is important in an organization because without it, a firm cannot possibly define its objectives for the future. If a company defines objectives without taking the risks into consideration, chances are that they will lose direction once any of these risks hit home.  In recent years, many companies have added risk management departments to their team. The role of this team is to identify risks, come up with strategies to guard against these risks, to execute these strategies, and to motivate all members of the company to cooperate in these strategies. Larger organizations generally face more risks, so their risk management strategies also need to be more sophisticated. Also, the risk management team is responsible for assessing each risk and determining which of them are critical for 87 CU IDOL SELF LEARNING MATERIAL (SLM)

the business. The critical risks are those that could have an adverse impact on the business; these should then be given importance and should be prioritized. The whole goal of risk management is to make sure that the company only takes the risks that will help it achieve its primary objectives while keeping all other risks under control.  To become eligible for risk management jobs, you will need a bachelor’s degree. Some companies and firms also require an MBA. Some risk management certifications will also help you progress up the career ladder.  Risk management jobs are very rewarding, primarily because a risk professional plays a crucial function in an organization. They are also rewarded well in financial terms. However, the job can also be challenging especially when there are turbulent risk factors that affect the firm. Nevertheless, the risk management position is currently one of the most well-respected positions in firms and companies 5.8 GENERAL STRUCTURE OF THE INSURANCE MARKET The insurance market has evolved from the establishment of the first automobile insurance policy to the various types of life insurance products that are available today. The insurance market has a structure that involves property and casualty insurers, life insurers as well as health insurers. Each of these types of insurers have regulations that apply to the policies that they provide. Insurers are regulated by a combination of state and federal laws, depending on the type of insurance they offer.  Property and Casualty Property and casualty insurers offer various types of insurance for individuals to purchase, such as automobile and homeowners’ insurance. A property and casualty insurer can also offer types of commercial insurance, such as a small business package, general business liability, umbrella policies and workers compensation. Property and casualty insurers are regulated by laws in each state where they sell policies.  Mutual Insurance Companies A mutual insurance company is a company owned by policyholders. This means that each policyholder is given a vote to decide who will sit on the board of directors. A mutual insurance company can sell types of insurance or only provide one type of product or service to their customers. The earnings from a mutual insurance company are distributed to policyholders in the form of dividends.  Stock Insurance Companies 88 CU IDOL SELF LEARNING MATERIAL (SLM)

A stock insurance company is a company owned by stockholders. Unlike a mutual insurance company, a stock insurer not only needs to protect its policyholders but also maximize profits for the company's policyholders. A stock insurance company can pay dividends to stockholders but generally do not pay dividends to their policyholders.  Life Insurance Property and casualty insurers can also provide types of life insurance. A life insurance company can be a mutual insurance company or part of a stock insurance company. Companies that provide life insurance usually offer financial products to their policyholders, such as annuities and certain types of mutual funds.  Health Insurance The insurance market also contains companies that provide health insurance policies to individuals as well as employers in the form of a group health insurance policy. Companies that provide a group health insurance policy to an employer are regulated by a combination of federal and state laws. States can also provide health insurance to residents if it is unavailable from a private insurer because of cost or ineligibility.  Common Ownership Many insurance companies are under a common ownership in which one corporation has one or more insurance business that act as independent companies. The most common type of common ownership for an insurance company is when it is established as a captive insurer. A captive insurer can be formed to provide coverage for various types of business risks. The most common type of captive insurer provides reinsurance coverage. This is a type of insurance where multiple insurance companies share the same loss. 5.9 SIGNIFICANT ASPECTS OF THIS INSURANCE INDUSTRY The insurance industry is critical for any country’s economic development. A well-developed insurance sector boosts risk-taking in the economy, as it provides some security in the event of an unforeseen, loss-causing incident. It also provides much-needed support to family members in the case of loss of life or health. Since the assets under management of insurance companies represent long-term capital, they also act as a pool in which to invest in long-term projects such as infrastructure development. The insurance industry in India has also grown along with the country’s economy. Several insurance companies in the country are expanding their operations, across both the public and private sector.  History 89 CU IDOL SELF LEARNING MATERIAL (SLM)

The history of India’s insurance industry reflects the history of India’s economy. Insurance companies in India were nationalized during pre-liberalization. This was done to protect the interests of policyholders. Two state-owned insurance companies were thus created: the Life Insurance Corporation in 1956, and the General Insurance Corporation in 1972 for the non-life insurance business. Post liberalization, the industry was opened. The Insurance Regulatory and Development Authority of India (IRDAI) was created in 1999 to regulate the insurance industry in India. Thus, the insurance sector was opened to private players. This allowed foreign players to collaborate with Indian entities to enter the sector. The number of insurance companies in India has increased quickly and continuously, and this has led to a vibrant insurance sector- with more variety and affordability for the consumer.  Present scenario There are currently 57 insurance companies in India, of which 46 are from the private sector. There are 24 life insurance and 33 non-life insurance companies in India. The major names in the sector are: Life insurance:  LifeInsuranceCorporation(LIC  HDFC Standard Life  SBI Life Insurance  ICICI Prudential Life Insurance  Non-life insurance:  New India Assurance  United India Assurance  National Insurance company  ICICI Lombard  Oriental Insurance Company  Bajaj Allianz The market share of private sector players has increased over the years. In the non-life insurance sector, private companies had a market share of 54.68 % in FY 19 (as of Jan ‘19). In the life insurance sector, private companies had a market share of 33.74 % in FY 19 (as of Jan ‘19).  Recent developments in the sector: 90 CU IDOL SELF LEARNING MATERIAL (SLM)

The last few years have seen a lot of activity in the sector. This is a testament to the vibrancy of the industry in India. Here are a few examples from different categories of deals/ developments: Strategic deals: HDFC ERGO General Insurance Co. is in talks to acquire Apollo Munich Health Insurance (Reported valuation: $ 370 mn) Financial investors: A consortium of private equity firms- Westbridge Capital and Madison Capital, as well as billionaire investor Rakesh Jhunjhunwala, are in discussions to acquire over 90% stake in Star Health and Allied Insurance. (Estimated deal size: $ 1 bn) Initiatives by non-sector players: Indian e-commerce giant Flipkart has tied up with Bajaj Allianz General Insurance to provide customized insurance products for mobile phones sold on Flipkart. 5.10 SUMMARY  In this unit we have discussed the operation of insurance market through the mechanism of defraying risk, identified the major problems posed to it due to adverse selection and moral hazard. The equilibrium processes attained in the presence of adverse selection are also examined.  The risk reduction mechanism adopted by the insurance markets depend on the law of large numbers, which helps evaluate uncertain outcomes with almost certainty. Consequently, risk pooling risk, spreading and risk transfer tools are adopted. The risk pooling and risk transfer mechanisms result in Pareto improvement in the society.  The fact that insurance market exhibits the persistence of either no insurance or less than full insurance is tried to be explained. While credit constraints could be a major factor for people to not buying insurance, there are structural problems like adverse selection of moral hazard, which result in less than full insurance as a viable option. Insurers may have less information about potential risks than the insurance purchasers resulting in adverse selection.  Bond values vary inversely with interest rates – bond values decline when rates rise, and bond values increase when interest rates fall. This is called interest-rate risk (the risk that interest rates will move, causing a change in bond value). Longer-maturity bonds are more sensitive to interest rate risk.  One way to minimize default risk in your bond portfolio is to invest in U.S. Treasury securities, which are considered risk-free from a default standpoint. Alternatively, you can invest in bonds with varying degrees of default risk, from AAA securities that are considered almost risk-free to “junk” bonds that carry significant risk of default. We 91 CU IDOL SELF LEARNING MATERIAL (SLM)

would note, however, that the recent economic meltdown provided a strong reminder that “almost” risk-free is not the same as risk-free.  If you invest in bonds that carry default risk, it is important to diversify your holdings. The principles of diversification from the CAPM apply to bonds as well as to stocks: the market will not pay you to take risks that you could diversify away. Thus, if you invest in a small number of risky bonds, you will be taking additional risk without receiving any additional compensation.  Another way to reduce the risk of stock investments is by using the time dimension. The variance in one-year returns for the stock market is huge  Insurers unable to monitor for the behavior of insured leads to moral hazard problems. Such problems give rise to self-selection in insurance markets. When the resulting equilibrium exist, which are seen by considering pooling and separating equilibrium, often found to be Pareto inefficient. 5.11 KEY WORDS  Adverse Selection: Depict a situation when buyers and seller do not of have equal excess to information and transaction takes place. Trade executed is biased to favour the agent with better information.  Moral Hazard: Effect of insurance encouraging risk an insurance party takes;an unshaved action emerges that affects the probability expected before hand and triggers payment from the insurer.  Risk Pooling: The practice of bringing several risks together for insurance purposes in order to balance the consequences of the realization of each individual risk.  Risk Transfer: The shifting of risk through insurance. Risk transfer is a risk management and control strategy that involves the contractual shifting of a pure risk from one party to another. One example is the purchase of an insurance policy, by which a specified risk of loss is passed from the policyholder to the insurer.  Risk-spreading: Diversification or spreading of one's wealth among a large number of different assets to ensure that if one area goes sour, one may still be doing well in some other.  Self Selection: Consequence of a contract that induces only one group to participate.In statistics, self-selection bias arises in any situation in which individuals select themselves into a group, causing a biased sample with nonprobability sampling. ... Self-selection bias 92 CU IDOL SELF LEARNING MATERIAL (SLM)

is a major problem in research in sociology, psychology, economics and many other social sciences. 5.12 LEARNING ACTIVITY 1. Explain that the market for insurance is competitive: insurers are risk neutral and make zero expected profits. What unit price will be charged to the agents? ______________________________________________________________________________ ______________________________________________________________________________ 2. Conduct a survey on significant aspects of insurance on Indian economy. ______________________________________________________________________________ ______________________________________________________________________________ 5.13 UNIT END QUESTIONS A. Descriptive Questions Short Questions 1. Explain the term insurance and risk. 2. What are the requirements of insurable risks? 3. What is the significance of insurance? 4. Define the general structure of insurance market? 5. Explain in brief, how insurance and risks are related. Long Questions 1. What are the benefits of insurance? 2. Define the term “cost of insurance to society” with the help of suitable examples. 3. What are the significant aspects of insurance industry which have direct effect on economy? 4. Explain significance of risk and significance of insurance. 5. Explain meaning, definition, and requirements of insurable risks. B. Multiple Choice Questions 93 CU IDOL SELF LEARNING MATERIAL (SLM)

1. ------------------- provide financial support and reduce uncertainties in business and human life a. risk b. Insurance c. Economy d. Market The Insurance sector contributes significantly to the general economic growth of the nation by a. defending the country against corruption b. Providing stability to the functioning of businesses c. Funding the backward classes d. Offering solutions to defence sector Diversification or spreading of one's wealth among many different assets to ensure that if one area goes sour, one may still be doing well in some other. a. Risk spreading b. Risk pooling c. Self-selection d. Adverse selection the assets under management of insurance companies represent. a. short term capital b. medium term capital c. long-term capital d. all of these Companies that provide a group health insurance policy to an employer are regulated by a a. combination of federal and state laws b. state laws only c. federal laws only d. none of these Answers 94 CU IDOL SELF LEARNING MATERIAL (SLM)

1-b, 2- b, 3-a, 4-c, 5-a 5.14 REFERENCES References  Autor, H. David (2004), Adverse Selection, Risk Aversion and Insurance Markets,Lecture note  Maddala, G. S. and Ellen Miller (1989), Microeconomics: Theory and Applications, McGraw-Hill, USA.  Braude E., Software Engineering. An Object-Oriented Perspective, John Wiley and Sons, 2001. Textbooks  Nicholson, W.(1992), Microeconomic Theory, 5th edition, the Dryden Press, Harcourt Brace Jovanovich, Orlando.  Sen, Anindya (1 999), Microeconomics: Theory and Applications, Oxford University Press, New Delhi.  Varian, Hall (3rd Edition), Microeconomic Analysis, W. w. Norton and Company, Inc., New York. Websites  https://www.irmi.com/term/insurance-definitions/risk-management  https://www.insuranceopedia.com/definition/2430/insurance-risk  https://www.aegonlife.com/insurance-investment-knowledge/what-is-the-impact-of- insurance-on-society/  https://www.careersinaudit.com/article/the-importance-of-risk-management-in-an- organisation/  https://www.investindia.gov.in/team-india-blogs/overview-insurance-industry-india 95 CU IDOL SELF LEARNING MATERIAL (SLM)

UNIT – 6: BASIC CHARACTERISTICS OF INSURANCE STRUCTURE 6.0 Learning Objectives 6.1 Introduction 6.2 Basic Characteristics of Insurance Pooling of Losses 6.3 Risk Transfer 6.4 Advantage and Disadvantage 6.5 Methods of Risk Transfer 6.5.1 Insurance Policy 6.5.2 Indemnification Clause in Contracts 6.6 Indemnification 6.7 Summary 6.8 Keywords 6.9 Learning Activity 6.10 Unit End Questions 6.11 References 6.0 LEARNING OBJECTIVES After studying this unit, you will be able to:  Explain basic Characteristics of Insurance Pooling of Losses  Illustrate and evaluate Risk Transfer.  Explain Advantage and Disadvantage of insurance  Evaluate methods of Risk Transfer.  Explain and evaluate Insurance Policy and Illustrate indemnification Clause in Contracts. 6.1 INTRODUCTION 96 CU IDOL SELF LEARNING MATERIAL (SLM)

In law and economics is a form of risk management primarily used to hedge against 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 transaction involves the insured assuming a guaranteed and known relatively small loss in the form of payment to the insurer in exchange for the insurer’s promise to compensate (indemnify) the insured in the case of a large, possibly devastating loss. The insured receives a contract called the insurance policy which details the conditions and circumstances under which the insured will be compensated. Insurance is a device to share the financial losses which might befall on an individual or his family on the happening of a specified event. The event may be death of a breadwinner to the family in the case of life insurance, marine perils in marine insurance, fire in fire insurance and other certain events in general insurance, e.g., theft in burglary insurance, accident in motor insurance, etc. The loss arising nom these events if insured are shared by all the insured in the form of premium. The most important feature of every insurance plan is the co-operation of large number of persons who, in effect, agree to share the financial loss arising due to a particular risk which is insured. Such a group of persons may be brought together voluntarily or through publicity or through solicitation of the agents. An insurer would be unable to compensate all the losses from his own capital. So, by insuring or underwriting many persons, he can pay the amount of loss. Like all cooperative devices, there is no compulsion here on anybody to purchase the insurance policy. The risk is evaluated before insuring to charge the amount of share of an insured, herein called, consideration or premium. There are several methods of evaluation of risks. If there is expectation of more loss, higher premium may be charged. So, the probability of loss is calculated at the time of insurance. The payment is made at a certain contingency insured. If the contingency occurs, payment is made. Since the life insurance contract is a contract of certainty because the contingency, the death, or the expiry of term, will certainly occur, the payment is certain. In other insurance 97 CU IDOL SELF LEARNING MATERIAL (SLM)

contracts, the contingency is the fire or the marine perils etc., may or may not occur. So, if the contingency occurs, payment is made, otherwise no amount is given to the policyholder. Similarly, in certain types of life policies, payment is not certain due to uncertainty of a particular contingency within a particular period. For example, in term-insurance then, payment is made only when death of the assured occurs within the specified term, may be one or two years. Similarly, in Pure Endowment payment is made only at the survival of the insured at the expiry of the period. General Insurance: Insuring anything other than human life is called general insurance. Examples are insuring property like house and belongings against fire and theft or vehicles against accidental damage or theft. Injury due to accident or hospitalization for illness and surgery can also be insured. Your liabilities to others arising out of the law can also be insured and is compulsory in some cases like motor third party insurance. 6.2 BASIC CHARACTERISTICS OF INSURANCE In the words of JUSTICE CHANNELL” Insurance is a contract whereby one person called the insurer, undertakes in return for the agreed consideration called premium to pay to another person called the insured a sum of money or its equivalent on specified event.” The characteristic of insurance is discussed under the following heads: A Contract The most important feature of insurance is that it is legal contract between the insurer and insured, under this insurer promises to compensate the insured for the loss which is mentioned in the policy and the insured promise to pay a fixed rate of premium which is consideration in this contract for the promise of the insurer. It is a type of contract where one party agrees to compensate in case of loss suffered by another party. Undertaking Of Risk In insurance contract, bearing and protecting of risk is the subject matter of the contract. For example, paying of insured amount in case of death of the assured, loss by fire or happening of marine perils. The risk is undertaken by the insurer to compensate the insured on the happening of the risk mentioned in the policy. The insurance company bears the risk and make good the loss. It restores the person standing as it was before the loss, it provides a mental relief to the insured that in case of loss, the insured will undertake his risk. 98 CU IDOL SELF LEARNING MATERIAL (SLM)

A Cooperative Device: Insurance is cooperative device of sharing the burden of risk of one on the shoulders of many. All the insured contribute the premium out of which the person who suffers loss is compensated or is paid up; insurance is a device to share the financial loss of few among many others. Payment of Policy Amount on the Happening of Events: On the happening of a specified event, the insurance company is bound to make good the loss to the insured. Happening of an event is specific in life insurance that is death, but it is not so in case of marine, fire, or accidental insurance. In life insurance, a fixed amount is paid but in indemnity insurance (fire, marine, etc.) amount of payment is uncertain depending upon the quantum of damage. Premium: Payment of premium by the insured is another feature of an insurance contract. Like other contracts, the factor of consideration is fulfilled by the premium because it is the subject for which insurer promises to undertake or bear the risk if insured. In absence of premium, the promise will be NUDAM PACTUM, hence void. To conclude insurance is a method to transfer the risks from insurer to insurers who agrees to it for a consideration known as premium and promises to bear and compensate the insured on the specified extent of loss. Contract of Adhesion It means it is contract which is not arrived by mutual negotiations between the parties, it means he must adhere to the policy in which way it is offered there is no chance if bargain. It means the insured accepting the policy must accept whole of it he cannot accept one part of and leave another. All he can do is that he can select the most appropriate policy among various policies which the insurer is offering. Development of Larger Industries Insurance helps industries to develop who have more risk in their setting up, the owner may get the industries assets insured and in case of loss he will be compensated. The financial institution may be ready to give credit to such industrial units which have insured their assets including plant and machinery etc. Provide Protection Insurance provides protection against future risk, accidents, uncertainty. 99 CU IDOL SELF LEARNING MATERIAL (SLM)

6.3 RISK TRANSFER Risk transfer can be defined as a mechanism of risk management that involves the transfer of future risks from one person to another, and one of the most common examples of risk management is purchasing insurance where the risk of an individual or a company is transferred to a third party (insurance company). Risk transfer, in its true essence, is the transfer of the implications of risks from one party (individual or an organization) to another (third party or an insurance company). Such risks may or may not necessarily take place in the future. Transfer of wagers can be executed through buying an insurance policy, contractual agreements, etc.  How does Risk Transfer Work? One of the most common areas where risk transfer takes place is in the case of insurance. An insurance policy can be defined as a voluntary arrangement between the individual or an organization (policyholder) and an insurance company. A policyholder gets insured against potential financial risks by purchasing an insurance policy from the insurance company. The policyholder will need to make regular and periodic payments to the insurance company for ensuring that his or her insurance policy is not getting lapsed on account of the failure of making timely payments, i.e., premiums. A policyholder might choose from a variety of insurance policies offered by various companies. 100 CU IDOL SELF LEARNING MATERIAL (SLM)